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FIN 326 Module 3

Terms in this set (56)

Current spot rates for an FI's assets (loans) and liabilities (CDs) are as follows. Assets 1-year loan rate: 7.5% and 2-year loan rate: 8.15%. Liabilities 1-year CD rate: 6.5% and 2-year rate: 6.65%. What is the duration of the two-year loan if it is selling at par?
1.92 years
A Treasury security in which periodic coupon payments can be separated from each other and from the principal payment is called a...
STRIP
A bank manager lends a corporate client $1,000,000 for six months. The bank charges $1,000 fee to set up the loan. The corporate borrower repays $1,050,000 in six months. What is the effective annual rate on the loan?
$1,050,000/(($1,000,000-$1,000)^2)= 10.47%
A decrease in interest rates will do what to duration?
Increase the bonds duration
An insurance company is trying to sell you a retirement annuity. The annuity will give you 20 payments with the first payment in 12 years when you retire. The insurance firm is asking you to pay $50,000 today. If this is a fair deal, what must the payment amount be if the interest rate is 8%?
$11,874
Current spot rates for an FI's assets (loans) and liabilities (CDs) are as follows. Assets 1-year loan rate: 7.5% and 2-year loan rate: 8.15%. Liabilities 1-year CD rate: 6.5% and 2-year rate: 6.65%. What is the interest rate risk exposure of the optimal balance sheet that maximizes income over the next 2 years?
The risk that interest rates will rise since the FI must sell a 1-year CD in one year
Calculate the duration of a two-year corporate bond paying 6-percent interest annually, selling at par. Principal of $20,000,000 is due at the end of two years.
1.94 years
a T-bond with a $1,000 par is quoted at 97:14 Bid, 97:15 Ask. The clean price for you to buy this bond is...
$974.69
Question is based on an 18-month, 8 percent (semiannual) coupon Treasury note selling at par. What is the duration of this Treasury note?
1.443 years
On Sept. 1st 2008 an investor purchases a $10,000 par T-bond that matures in 12 years. The coupon rate is 6% and the investor buys the bond 70 days after the last coupon payment (110 days before the next). The ask yield is 7%. The dirty price of the bond is..
$9,313.82
Loanable Fund theory...
views the level of interest rates in financial markets as resulting from factors that affect supply and demand
Determinants of household savings
1. Interest rates and tax policy (increases with interest rates)
2. Income and wealth
3. attitudes about saving vs borrowing
4. credit availability; the greater the amount of easily obtainable consume credit the lower the need to save
5. Job security
What are the factors that affect differences in interest rates across the range of real-world financial markets?
Inflation, Real interest rate, default risk, liquidity risk, special provisions, term to maturity
Inflation
the continual increase in the price level of a basket of goods and services. The higher the level of inflation the higher the level of interest rates.
Real interest rate
the interest rate that would exist if there were no inflation
Fisher effect...
i=RIR + IP
The one-year T-bill rate in 2007 averaged 4.53% and inflation for the year was 4.10%. If investors had expected the same inflation a rate as that actually realized , then according to the Fisher effect the real interest rate for 2007 was?
4.53%-4.10%=0.43%
Default risk
the risk that a security issuer will default on making its promised interest and principal payments to the buyer of the security. The higher the default risk the higher the interest rate that will be demanded by the buyer
Liquidity risk
the risk that a security can be sold at a predictable price with low transaction costs on short notice. A highly liquid asset will have a relatively low interest rate. If it is illiquid there will be a liquidity risk premium added to the interest rate
Unbiased expectations theory
-at a given point in time the yield curve reflects the markets current expectations of future short-term rates
-upward sloping if 1 year rates are expected to increase
- long term interest reates are geometric averages of current and expected future short-term interest rates
Liquidity premium theory
-same as the unbiased theory but investors will hold long-term maturities only if they are offered at a premium to compensate the future uncertainty
-long-term securities are more sensitive to changes in interest rates
- increases with maturity
Market segment theory
-individual investors and FIs have a specific maturity preferences and to get them to hold longer maturity securities they require a higher interest rate
-interest rates are determined by distance supply and demand conditions within maturity segments
-does not consider securities with different maturities as perfect substitutes
Simple interest...
interest earned on an investment that is not reinvested; only on the principal
Compounded interest
interest on the principal and on the interest earned
Present value of a lump sum
PV= FV/(1+r)^t...this value decreases as interest rates increase
Future Value of a lump sum
FV=PV(1+r)^t
Present Value of an annuity
PMT x [(1-(1/(1+r)^t))/r]
What are the various interest rate measures?
coupon rate, required rate of return, expected rate of return, realized rate of return
Coupon rate
specific to debt instruments, this is the periodic cash flow to a bond issuer that contractually promises to pay the bond holder
Required rate of return
(investor) rate used by individual market participants to calculate the fair present value
Expected rate of return
(market): rates participants would earn by buying securities at a current market price (P)
Realized rate of return
the rate that is actually earned on an investment. If you hold the bond to maturity this rate=ytm.
If yield > coupon
If yield = coupon
If yield < coupon
price will be lower, discount; price< par
price stays the same, par; price=par
price goes up, premium; price> par
Zero-coupon bond
bonds that do not pay coupon interest
Duration=maturity
As interest rates rise what happens to the bond?
The price drops...the % change in the present value of the bond to a change in interest rates is smaller when interest rates are higher
Impact of maturity to the value of a bond
the longer the maturity the more sensitive to price of the bond is to interest rate changes. Not linear
A higher coupon bond will be less price volatile and more valuable than a lower coupon bond?
True. Because the payments will be given to the bond holder sooner
Duration
-the weighted-average time to maturity (measured in years) on a financial security
-measures the sensitivity of a fixed income security's price to small interest rate changes
-captures the coupon and maturity effects on volatility
What are the features of duration?
1. The higher coupon bond, the lower the duration
2. The higher the yield to maturity the lower the duration
3. Duration increases with the maturity of a bond, but at a decreasing rate
Why are Treasury notes and bonds issued?
to finance national debt and other federal government expenditures
What are STRIPS?
a Treasury security in which periodic coupon interest payments can be separated from each other and from the final principal payment. Used to immunize against interest rate risk
What is the bid and ask price?
The bid price is what the dealer buys for and the investor sells for. The ask price is what the dealer sells for and what the investor buys for
Accrued interset
must be paid to the seller of a bond if it is purchased between interest payments.
= (INT/2) x (actual # of days since last coupon/ actual # of days in coupon period)
You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond's clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)?
Accrued interest=$10.05
Clean price= $1,205.9375
Dirty price= $ 1,215.9875
Primary market for notes and bonds...
similar to T-bills through non-comp and comp but,
2yr notes are auctioned monthly
3,5,10-year notes are actioned quarterly
30 year semi-annually
Municipal bonds
securities issued by state and local governments either to fund temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays activities.
Interest payments on municipal bonds are not exempt from federal taxes?
False. They are exempt and from most local and state income taxes
How do you compare municipal bond yields with corporate yields?
Ra= Rb(1-t)
For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield?
ia = 6%(1- 0.28) = 4.32%
For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate?
ib = 4.5% / (1-0.28) = 6.25%
What is the maturity of a T-note and a T-bond?
T-note: 1-10 years
T-bond: over 10 years
What is the minimum denomination for a T-note or T-bill?
$1,000
Are STRIPS used to immunize against interest rate risk?
YES
What is the clean price? What is the dirty price?
Clean price is without accrued interest and dirty price is with accrued interest
Most secondary trading of notes and bonds occurs directly through brokers and dealers?
True
Munis trade very frequently in the secondary market?
False. Due to lack of information on bond issuers they do not trade frequently
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