Ch. 4: The Meaning of Interest Rates

Cash flows

Cash payments to the holder of a security

Present Value

Today’s value of a payment to be received in the future, when the interest rate is I

Simple loan

A credit market instrument that provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with an additional payment(interest)

Discounting the future

The process of calculating today’s value of dollars received in the future

Fixed-payment loan

A credit market instrument that provides the borrower within an amount of money that is repaid through fixed, periodic payments made over a certain number of years

1. Mortgage

2. Auto loans

Coupon bond

A credit market instrument that pays the owner a fixed interest payment every year until the maturity date, at which time a specified final amount is repaid.

1. U.S. Treasury bonds and notes

2. Corporate bonds

Face value

A specified final amount paid to the owner of a coupon bond at the maturity date. Also called par value.

Par value

A specified final amount paid to the owner of a coupon bond at the maturity date. Also called par value.

Coupon bond identification information

1. Face value

2. Corporation or government agency that issued the bond

3. Maturity date

4. Coupon rate

Coupon rate

The dollar amount of the yearly coupon payment expressed as a percentage of the face value of a coupon bond.

Discount bond (zero-coupon bond)

A credit market instrument that is bought at a price below its face value and whose face value is repaid at the maturity date; it does not make any interest payments. Also called a zero-coupon bond.

1. U.S. Treasury bills

2. U.S. savings bonds

3. Long-term zero-coupon bonds

Yield to maturity

The interest rate that equates the present value of payments received from a credit market instrument with its value today.

For simple loans, the simple interest rate ___ the yield to maturity

equals

When the coupon bond is priced at its face value, the YTM ___ the coupon rate

equals

The price of a coupon bond and the YTM are ___ related; that is, as the YTM rises, the price of the bond falls. As the YTM falls, the price of the bond rises.

negatively

The YTM is ___ than the coupon rate when the bond price is below its face value and is less than the coupon rate when the bond price is above its face value

greater

Consol

A perpetual bond with no maturity date and no repayment of principal, and that makes periodic, fixed coupon payments.

Perpetuity

A perpetual bond with no maturity date and no repayment of principal, and that makes periodic, fixed coupon payments.

Current yield

An approximation of the yield to maturity; equal to the yearly coupon payment divided by the price of a coupon bond.

rate of return

The payments to the owner of a security plus the change in the security’s value, expressed as a fraction of its purchase price. More precisely called the rate of return.

Rate of capital gain

The change in a security’s price relative to its initial purchase price.

A rise in interest rates is associated with a __ in bond prices

falls

Prices and returns for long-term bonds are more ___ than those for shorter-term bonds

volatile

Interest-rate risk

The possible reduction in returns associated with changes in interest rates.