Financial Institutions Study Guide #2 Essay

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Bond Valuation: Ch.8, App.8B pp.227-233, and Ch.9 Appx 9A 1. Bond Pricing. Compute Price of the bond (using formula or financial calculator). a. Price of a bond is the present value of the future cash flows promised, discounted at the market rate of interest. b. Bond Value=PV of coupons +PV of Par 2. Reading Bond Quotes: ability to transfer quotes into price in dollars. c. Treasury bonds are quoted in 32’s of a percent (quote of 105:19 = 105 and 19/32, or 105.594%= dollar price of $1055.94) d. Corporate bonds are listed as a percentage of par (quote of 97.876 = dollar price of $978.76) i. Corporate bonds are riskier than treasuries and therefore offer a higher return. e. Municipal bonds are quoted in percent of par (quote of 100.46= dollar price of $5023) ii. Usually have a par value of $5000 rather than $1000 3. Bonds Yields. Compute YTM, current yield, yield to call. f. Interest rate: cost of borrowing g. Yields: measure of interest rates (used interchangeably) h. Returns: Ex-post measures of yields i. Current yield= Annual Coupon Bond Price Measures the portion of total return that is due to the coupon interest payments, ignores portion of return due to price changes or capital gain j. Yield to Maturity: total return to bondholder if the bond is held to maturity. iii. Coupon rate=7%, semiannual, 8 years to maturity, current price=$1150, YTM? iv. N=16, PV=-1150, PMT=35, FV=1000, Find i/y… 2.363 k. Yield to Call: calculated the same way as YTM, except N= # of periods to first call date, F=call price ($) 4. Bond Price Sensitivity/Volatility. The Relationship between Bond Price Volatility and the Coupon Rate. l. Bond Price Volatility Price Risk= P1-P1-tP1-t×100 m. Price of the bond changes in the OPPOSITE direction of the change in the required yield on the bond. v. Bond prices are inversely related to bond yields n. Lower coupon rate= Price volatility  (higher captures average prices/rates) o. Longer term to maturity= Price volatility (more fluctuations and unknowns) p. Interest rate risk: risk that changes in interest rates will cause a bonds realized yield to differ from the promised yield (YTM) vi. Price risk: variability in bond prices due to changes in market interest rates vii. Reinvestment risk: variability in realized yield due to changing market interest rates at which coupons can be reinvested viii. DURATION is a measure of interest rate risk. (considers both coupon rate & maturity) Duration=ΣCF × t(1+i)tCF(1+i)t ix. Positively related to interest rate risk x. Higher coupon rates mean shorter duration and less price volatility xi. Longer maturities mean longer duration and greater price volatility xii. Higher market rate of interest means shorter duration xiii. For zero coupon securities, duration is equal to term to maturity
Term Structure of Interest Rates: Ch.8, App.8B pp.227-233, and Ch.9 Appx 9A 1. Interest Rates. What are Interest Rates? Determinants of Interest Rates. Reinvestment risk, price risk. a. Interest rates: cost of borrowing or the price paid for the rental of funds (% per year) b. Determinates of interest rates: Supply and Demand of funds i. Supply: household supply, foreign supply, fed policy ii. Demand: household demand, business demand, govt demand iii. If D > S, in interest rates. iv. If S > D,  in interest rates. c. Reinvestment risk: “long-funded”. Risk ROA will  Asset maturity < Liab. maturity d. Refinance Risk: “short-funded” 2. Interest Rates and Inflation. Fisher Effect/Equation. e. Fisher equation=1+i=1+r1+expected annual rate of inflation f. Lender gets compensated for: v. Rental of
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