Financial Markets and Institutions (2-downloads)

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Part 2 Fundamentals of Financial Markets

Years to 

Maturity

Yield to 

Maturity

Current

Price

3

5

3

7

6

7

9

7

9

9

K E Y   T E R M S

cash flows, p. 37

coupon bond, p. 39

coupon rate, p. 39

current yield, p. 46

discount bond (zero-coupon bond),

p. 40

duration, p. 56

face value (par value), p. 39

fixed-payment loan (fully amortized

loan), p. 39

indexed bond, p. 50

interest-rate risk, p. 54

nominal interest rate, p. 48

perpetuity (consol), p. 44

present value (present discounted

value), p. 37

rate of capital gain, p. 52

real interest rate, p. 48

real terms, p. 48

reinvestment risk, p. 54

return (rate of return), p. 50

simple loan, p. 37

yield to maturity, p. 40

to reinvestment risk, which occurs because the pro-

ceeds from the short-term bond need to be reinvested

at a future interest rate that is uncertain.

4. Duration, the average lifetime of a debt security’s

stream of payments, is a measure of effective maturity,

the term to maturity that accurately measures interest-

rate risk. Everything else being equal, the duration of

a bond is greater the longer the maturity of a bond,

when interest rates fall, or when the coupon rate of

a coupon bond falls. Duration is additive: The duration

of a portfolio of securities is the weighted average of

the durations of the individual securities, with the

weights reflecting the proportion of the portfolio

invested in each. The greater the duration of a secu-

rity, the greater the percentage change in the market

value of the security for a given change in interest

rates. Therefore, the greater the duration of a security,

the greater its interest-rate risk.

Q U E S T I O N S

1. Write down the formula that is used to calculate the

yield to maturity on a 20-year 10% coupon bond with

$1,000 face value that sells for $2,000.

2. If there is a decline in interest rates, which would you

rather be holding, long-term bonds or short-term

bonds? Why? Which type of bond has the greater

interest-rate risk?

3. A financial adviser has just given you the following

advice: “Long-term bonds are a great investment

because their interest rate is over 20%.” Is the finan-

cial adviser necessarily right?

4. If mortgage rates rise from 5% to 10%, but the

expected rate of increase in housing prices rises from

2% to 9%, are people more or less likely to buy houses?

Q U A N T I TAT I V E   P R O B L E M S