Final_Exam_review_notes_FIN_353[1] - Final Exam FIN 353...

Final Exam FIN 353 Review Notes
July 2, 2010
1 Chapter 3
1.1 YTM
What is the Interest Rate on a fixed payment loan of $250 where $100 is due at the end of
the year for the next three years?
250 =
100
(1 + r )
+
100
(1 + r )
2
+
100
(1 + r )
3
(1)
r=9.5%
Be able to calculate YTM and Price for a simple loan, fixed loan, coupon bond, or discount
bond.
1.2 Relationship between YTM and Price
YTM < coupon → bond is trading at a premium.
YTM > coupon → bond is trading at a discount.
The longer the maturity the more sensitive bond prices are to changes in interest rates.
Example, a one percentage increase in interest rates will decreases prices for 1 year tbill less
than a 30 year treasury bond.
1

1.3 real interest rate
If nominal is 10% and expected inflation is 2% than real rate is 8%.
The real interest rate is the true cost of borrowing. A lower real interest rate or greater
expected inflation benefits the borrower.
2 Chapter 4
Factors to affect demand:
1. wealth
2. expected returns
3. risk
4. liquidity
Interest rates are expected to increase which means bond returns are expected to decline
leading to reduction in the demand for bonds, lower price, and higher interest rates.
If stock market risk is relatively higher than risk for bonds, demand for bonds will increase
pushing the price up and interest rates down.
Factors to affect supply
1. business cycle
2. expected inflation
3. government deficit
Currently if have expanding business cycle, firms are going to borrow more to finance growth
of their companies. Therefore, they will sell bonds to borrow money. The supply curve shifts
to the right, prices decline, and interest rates increase.
2

when expected inflation increases, the true cost of debt decreases, and firms are more likely
to borrow by selling bonds. Prices fall and rates increase.
If government has a large deficit than they need to finance it by selling bonds, pushing supply
curve to the right, prices down, and rates up.
2.1 Fisher Effect
What happens when expected inflation increases:
On the demand side, demand shifts to the left since if expected inflation increases, then
prices of real goods will increase like housing. People put money into housing, pushing the
demand down for bonds, the price down, and rates up. On the supply side, the real cost of
borrowing has declined, so people will borrow more or sell more bonds shifting the curve to
the right, reinforcing the increase in interest rates.
2.2 Business Cycle
In a business cycle boom more wealth so people buy more bonds. Demand shifts to the
right. Also, supply shifts to the right since businesses want to finance growth. Supply shifts
more than demand so rates increase.
3 Chapter 5
1. default
2. liquidity
3. taxes
Remember default and liquidity is part of the risk premium.
If default risk increases for corporate bonds what happens to the spread? - demand for
corporate decreases, prices fall, rates increase. demand for tbills increase, prices rise, rates,
fall, spread widens.