fina exam 2: Interest Rates and Risks

High Interest rates

1) Borrowing is expensive, reducing the # of borrowers

2) return earned from saving is higher, incentivizing people to save more, spend less

Low interest rates

1) Borrowing is cheaper, increasing the # of borrowers

2) Return earned from saving is lower, incentivizing people to save less, spend more

High demand, low supply

interest rates rise to balance the market

low demand, high supply

interests rates fall

federal funds rate

interest rate controlled by federal reserve and at which commercial banks borrow and lend each other overnight

federal reserve goals

low inflation & strong labor market

2 factors that drive the cost of debt

1) Interest rate risk

2) Default bounds

Interest rate risk

capital loss due to rising interest rates in the future

default bounds

borrower will fail to fulfill their obligations to their bondholders greater bonds w/ longer maturity and w/ lower coupon rates

duration

measure of bonds sensitivity to interest rate changes

high duration

indicates a greater sensitivity to yield changes, leading larger price fluctuations and greater risk for bondholders

low duration

indicates lower sensitivity to yield changes, leading in smaller price fluctuations and less risk for bondholders

what normally has a high duration?

bonds with longer maturities and lower coupon rates

credit rating

default risk for major bond issuers, such as corporations and government, is measured using credit ratings

high credit ratings

bonds with lower coupon rate and yields

low credit ratings

bonds with high coupon rates and yields

investment grade

bonds with relatively low risk of default. Rated at least Baa (by Moody’s) or BBB (by S&P or Fitch)

non-investment grade (high yield/ junk bonds)

bonds with relatively high risk of default, rated below Baa or BBB

credit spread

• corporate bond- treasury yield w/ the same maturity

• wider issues with greater default risk and bonds with longer maturity

term structure

refers to the relationship b/w interest rates and time to maturity (“term”) for the same type of debt contract

term premium

refers to the difference b/w the rates for long-maturity vs. short maturity bonds

yield curve

visual representation of the term structure

inverted yield curve

historically served as a reliable predictor of an upcoming economic recession

yield spread metric system

10 yr, 3 months

equity

refers to a part ownership of company

stock

refers ownership interest in a corporation that can be traded b/w investors

share

stock divided into shares; “equity holders” “Stock holders” “Shareholders”

Initial public offering (IPO)

The 1st time a corporation issues shares to the public, lists its stock exchange, and begins trading

seasoned equity offering (SEO)

when an already public corporation raises money by issuing additional shares

short selling

borrowing shares and selling them

buyback (AKA: “share repurchase”)

a company buying its own shares on the stock market

traders are prone to:

disposition effect and overconfidence

formula for operating margin

operation income / total revenues

earning per share (EPS)

net income / avg. # of shares outstanding

YTM

factors in both the coupon rate and the price you pay for the bond

YTM is your actual annual return IF:

• you hold the bond till maturity

• the borrower does not default