FM 1 REVIEWER (2nd semester)

The percentage charged for borrowing money or earned from lending or saving money. It represents the cost of borrowing or the income received from lending.

Interest Rate

The minimum return an investor expects to earn from an investment based on its risk. Investors use it to assess whether an investment offers enough compensation for the risk involved.

Required Rate of Return

Components of Interest Rates and Required Returns

Real Risk-Free Rate

Inflation Premium

Default Risk Premium

Liquidity Premium

Maturity Risk Premium

The return required for postponing consumption, excluding inflation and default risk.

Real Risk-Free Rate

Additional return required to compensate for expected increases in prices.

Inflation Premium

Additional return required because a borrower might fail to repay a loan.

Default Risk Premium

Additional return required for an investment that is difficult to sell quickly.

Liquidity Premium

Additional return required for risks associated with holding longer-term debt securities.

Maturity Risk Premium

The stated rate before adjusting for inflation.

Nominal Interest Rate

The rate after accounting for inflation and therefore gives a better indication of changes in purchasing power.

Real Interest Rate

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Real Interest Rate Formula

Factors Affecting Interest Rates

Supply and demand for funds

Inflation

Central bank policy

Creditworthiness

Maturity

Economic conditions

Greater demand for borrowing may push interest rates higher.

Supply and Demand for Funds

Higher expected inflation generally leads to higher nominal rates.

Inflation

The Bangko Sentral ng Pilipinas influences financial conditions through monetary policy.

Central Bank Policy

Borrowers with greater default risk generally pay higher interest rates.

Creditworthiness

Longer-term loans and bonds may require additional compensation for risk.

Maturity

Economic growth, uncertainty, and borrowing activity can influence rates.

Economic Conditions

The relationship between interest rates and the time remaining until comparable debt securities mature. It shows how rates differ between short-term and long-term investments.

Term Structure of Interest Rates

The interest rate applicable today to a specific maturity.

Spot Rate

The interest rate implied today for a specified future period.

Forward Rate

Relationship Between Bond Prices and Interest Rates

- Bond prices and market interest rates generally move in ______________

opposite directions

When market interest rates rise, prices of ____________________

existing fixed-rate bonds generally fall

When market interest rates fall, prices of ____________________

existing fixed-rate bonds generally rise

Simple Interest Formula

Interest = Principal × Rate × Time

FV = PV(1 + i)ⁿ

Future Value Formula

PV = FV ÷ (1 + i)ⁿ

Present Value Formula

Explains how interest rates differ depending on the maturity period of an investment. It is commonly shown through a yield curve, which compares short-term and long-term interest rates.

The Term Structure of Interest Rates

THEORIES OF TERM STRUCTURES

Expectations Theory

Liquidity Preference Theory

Market Segmentation Theory

explains that long-term interest rates are influenced by expectations of future short-term rates

Expectations Theory

Long-term rates are based on expected future short-term rates.

If rates are expected to rise, long-term rates may also rise.

Expectations Theory

states that investors prefer short-term investments and may require additional returns for holding long-term investments

Liquidity Preference Theory

explains that interest rates depend on the supply and demand for investments with different maturity periods.

Market Segmentation Theory

The minimum return an investor expects for taking a certain level of risk.

Required Return

A graph that shows the relationship between interest rates (yields) and the length of time until a bond matures. It shows how much interest investors earn for lending money for different periods of time.

Yield Curve

Common Types of Yield Curve

Normal Yield Curve

Inverted Yield Curve

Flat Yield Curve

Long-term interest rates are higher than short-term rates.

Normal Yield Curve

Short-term interest rates are higher than long-term rates.

Inverted Yield Curve

Short-term and long-term interest rates are almost the same.

Flat Yield Curve

Developed by economist John Maynard Keynes in his 1936 book

The General Theory of Employment

It explains why people prefer holding cash (liquidity) over other assets, and how this preference determines interest rates.

The theory views the interest rate as the reward or "price" for parting with liquidity for a specified period.

Liquidity Preference Theory

The interest rate is set where the downward-sloping demand for money (liquidity preference) intersects with the fixed money supply set by the central bank.

Equilibrium

The Three Motives for Holding Cash

Transactions Motive

Precautionary Motive

Speculative Motive

Needing cash for day-to-day purchases and business exchanges. This demand is largely independent of interest rates but rises as overall income increases.

Transactions Motive

Holding a cash buffer to pay for unexpected emergencies or sudden expenses. Like the transaction demand, it correlates closely with income levels.

Precautionary Motive

Holding cash to capitalize on future changes in bond prices and interest rates.

Speculative Motive

In marketing, it refers to the process of dividing a large market into smaller groups of customers who have similar needs, preferences, characteristics, or buying behaviors.

Market Segmentation Theory

Four Common Types of Market Segmentation

Demographic segmentation

Geographic segmentation

Psychographic segmentation

Behavioral segmentation

Based on characteristics such as age, gender, income, and occupation.

Demographic Segmentation

Focuses on the location of customers.

Geographic Segmentation

Considers a person's lifestyle, interests, and personality.

Psychographic Segmentation

Focuses on customers' buying habits and behavior.

Behavioral Segmentation

is important because it helps businesses identify their target customers. It also allows companies to create better products, advertisements, and marketing strategies.

Market Segmentation

Debt securities issued by companies to raise funds for business operations, expansion, and other financial needs. Investors who purchase these securities lend money to a company in exchange for regular interest payments and the repayment of the principal at maturity, depending on the company's ability to fulfill its obligations.

Corporate Bonds

Grades given to bonds by credit rating agencies. These ratings show how likely a company or government is to pay back the money it borrowed and pay the interest on time.

Bond Ratings

Types of Bond Ratings

Investment-Grade Bonds

Non-Investment-Grade Bonds (Junk Bonds)

These bonds have higher ratings, which means the issuer is considered more likely to pay its debt on time. They generally have lower risk and may offer lower interest rates.

Investment-Grade Bonds

These bonds have lower ratings because the issuer has a higher risk of not paying its debt on time. They usually offer higher interest rates to attract investors.

Non-Investment-Grade Bonds (Junk Bonds)

Common Bond Rating Symbols

AAA

AA

A

BBB

BB

B

CCC

CC / C

D

Highest level of credit quality.

AAA

Very strong ability to pay debts.

AA

Strong ability to pay debts.

A

Good ability to pay, but more affected by economic problems.

BBB

Higher risk than investment-grade bonds.

BB

More likely to have difficulty paying debts.

B

Very high risk.

CCC

Extremely high risk of not being paid.

CC / C

The issuer has defaulted on its debt.

D

Popular Types of Bonds

Corporate Bonds

Government Bonds

Municipal Bonds

Corporate bonds are issued by companies to raise capital for business operations, expanding facilities, or funding acquisitions.

Corporate Bonds

Debt securities issued by a national government to support government spending and obligations.

often referred to as Treasuries in the U.S.

Government Bonds

Issued by local government entities like states, cities, counties, or public school districts to fund public projects like building schools, paving roads, or upgrading sewer systems.

Municipal Bonds

Bonds backed by assets such as lands or building.

Secured Bonds

Bonds without specific assets as collateral.

Unsecured Bonds

Bonds that the issuer can repay before maturity.

Callable Bonds

Bonds that investors can convert into company shares under specified conditions.

Convertible Bonds

These bonds do not pay regular interest. Instead, they are sold at a price lower than their face value, and the investor receives the full face value at maturity.

Zero-Coupon Bonds

The interest rate changes based on a reference interest rate. This means the interest payments may increase or decrease over time.

Floating-Rate Bonds

These bonds allow investors to require the company to repay the bond before its maturity date, under specified conditions.

Puttable Bonds

These bonds have no fixed maturity date. They may provide regular interest payments indefinitely, subject to the bond's terms and the issuer's ability to pay.

Perpetual Bonds

A fixed income investment product where you act as a lender, giving money to a government or corporation in exchange for regular interest payments and the return of your original principal.

Bonds Fundamentals

A valuation is about knowing the prevailing value of one's business in order that investors or other stakeholders may have a better, sound, and informed financial decision.

Valuation Fundamentals

The Chartered Financial Institute defines this as the estimation of an asset's value based on either variables perceived to be related to the future investment returns or comparisons with closely similar assets.

Valuation Fundamentals

Since this is but a mere estimation of an asset's value, it primarily deals with projections and estimates of future events which will impact to the asset's value.

Valuation Fundamentals

The value stated on the face of the bond. It represents the amount the firm borrows and promises to repay at the time of maturity.

Face/Par Value

The date which the bond issuer pays back the principal or par amount to bondholders, and also where the debt obligation of the bond ends, and no longer earns interest. This defines the lifetime of the bond.

Maturity Date

The fixed interest rate that the bond issuer promises to pay until the bond reaches its maturity date, calculated using the bond's face value.

Coupon Rate

The interest money that an investor receives from the company or government that issued the bond until the bond reaches maturity.

Coupon Payments

Coupon Payment = Face Value × Coupon Rate

Coupon Payments Formula

The process of determining the theoretical fair value of a particular bond. It involves calculating the present value of the bond's future expected cash flows, which consist of periodic interest payments and the return of the principal amount.

Basic Bond Valuation Concepts

V = C [ 1 - ( 1 + r) ^-n / r ] + F / ( 1 + r ) ^n

Basic Bond Valuation Formula

A bond's expected earnings generated and realized on a fixed-income investment over a particular period of time, expressed as a percentage or interest rate.

Bond Yields

The annual interest earned from a bond compared to its current market price, expressed as a percentage.

Current Yield

Current Yield = Annual Coupon Payment ÷ Current Market Price * 100

Current Yield Formula

The total estimated annual return an investor earns from a bond if they hold it until its maturity date, assuming interest payments are made as promised.

Yield to Maturity

YTM = { [C + (F - P/N)] / [F+P / 2] } *100

Yield to Maturity Formula

Bond valuation is the process of determining the fair value of a bond by calculating the present value of its future interest payments and principal amount.

Bond Valuation

What Drives Bond Prices

Discrepancies between the fixed coupon rate and changing market rates cause bond prices to adjust above, below, or at face value.

Fixed annual interest rate printed on the bond certificate. Strictly constant throughout the bond's life.

Coupon Rate

Prevailing interest rate in the market for similar risk bonds. Constantly fluctuates daily.

Market Interest Rate