Exam 1 Cheat Sheet - Chapter 3.Different debt instruments...

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Chapter 3. Different debt instruments have very different streams of cash payments to the holder (known as cashflows), with very different timing. Debt instruments are compared based on the amount/timing of each CF, this is PV and leads to YTM/interest rate. PV is the PV of a single CF or the sum of many CFs. LoanPrinicipal-amount lenders provides to borrower; Maturity Date-date loan is repaid; Simple Interest Rate-interest payment divided by loan principal. PV=CF/ (1+i)^n. YTM = interest rate that equates today’s value with present value of all future payments. Simple Loans require payment of one amount which equals the loan principal plus interest. Fixed-Payment Loans are where loan principal and interest rate are repaid in several payments, often monthly in equal amounts. YTM=(FV-PV)/(PV). If interest rate increases, the PV of any CF is lower, so, the price of the bond is lower. Current Yield=Annual CF/Market Price. If a bond’s price is near par, CY is good estimate of YTM. Interest on Discount Basis=(F-P)/F X (360/days to maturity). Interest rates negative if investors find the bonds more convenient than cash. Real Interest Rate=Nominal-Inflation. Rate of Return=CY+((P1-P)/P)-Capital gains). DURATION-higher coupon rate=shorter duration. Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equaling the proportion of the portfolio invested in each. Chapter 4. Asset is property that has store of value. Consider wealth, ER, risk, and liquidity before buying asset. If ER is the same, buy asset with lower SD. Demand For Bonds: Wealth up=D up. Expected Interest Rate up=D down. Expected Inflation up=D down. Riskiness relative to other assets=D down. Liquidity relative to other assets=D up. Increases in ALL of the following increase Supply of Bonds: profitability of investments, expected inflation, and government deficits. If interest rate is forecast to go down, buy long and borrow short. If forecast to rise, buy short and borrow long. Chapter 5. Spread=difference in interest rates that the buyer demands for taking additional risk. Risk of default vs. Default Free bonds. Risk Premium=spread between interest rates on bonds with default risk and default free bonds. If risk on corporate bond goes up, ER and demand on corporate bond goes down; Relative risk on Treasury bond goes up/relative ER goes down; risk premium rises. SAME GOES FOR LIQUIDITY. Muni bonds are exempt from Fed taxes; has same effect on demand as increase in ER. Interest rate on Munis is below Treas. Theory on explaining yield curve MUST explain why: IR’s on different maturities move together, yield curve has steep upward slope when short rates are low and downward slope when short rates are high, and why the curve is typically upward sloping. Liquidity Premium Theory : Bonds of different maturities are substitutes, but not perfect subs. Investors prefer short term bonds; they must be paid positive liquidity premium to hold long term bonds. YC: Steep upward curve when future S-term IR’s expected to rise. Gentle upward slope when ST IR’s expected to stay the same. Flat when ST
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