Financial Markets and Bond Valuation Vocabulary

Vocabulary flashcards generated from the financial markets and bond valuation lecture notes.

Financial markets

Structures through which funds flow

Primary Market

Where initial public offerings and new issue stocks + bonds are sold; equity = IPO, bonds must be paid back

Secondary Markets

Provide liquidity, pricing info, and lower transaction costs; the more participants, the better

Money markets

Trade debt securities with maturities of one year or less; mostly OTC; less risky, more liquid, lower return than capital markets

Capital markets

Trade debt + equity instruments with maturities of more than one year; wider price fluctuations

Banks

Required to retain 10% of deposits as reserves; profit by charging higher interest on loans than they pay on deposits

Thrifts

Small town banks; make low risk loans

Insurance Companies

Invest mostly in bonds because they're predictable

Investment Banks

Arrange finance, buy + sell securities, merge companies (ex: JP Morgan, Goldman Sachs)

Mutual Funds Company

A pool of assets (ex: Fidelity)

Pension Funds

Institutional investors managing retirement funds

Fed Dual Mandate

Employment and inflation (price stability)

Nominal interest rate

The rate actually observed in financial markets, before accounting for inflation

Real rate

Nominal rate minus inflation

Loanable Funds Theory

Interest rates are set where the supply of funds (savers) meets the demand for funds (borrowers)

Supply of loanable funds

Higher rates lead to more funds supplied (positively correlated); households are the largest supplier

Demand for loanable funds

Lower rates lead to more funds demanded (inversely correlated); comes from households, businesses, and governments

Fair interest rate ($i^*$)

The fair interest rate on an individual security, expressed as $i^* = f(\text{RFR}, \text{IP}, \text{DRP}, \text{LRP}, \text{SCP}, \text{MP})$

RFR

Risk-free rate

MP

Maturity risk premium

IP (Inflation premium)

Inflation premium, calculated as $\text{IP} = \frac{\text{CPI}_{t+1} - \text{CPI}_t}{\text{CPI}_t} \times 100$

DRP

Default risk premium

LRP

Liquidity risk premium

SCP

Special provisions/covenants risk premium

Loanable funds demand curve shift

An increase in demand moves the curve right, requiring a higher rate to attract more suppliers, so interest rates go up

Loanable funds supply curve shift

A decrease in supply moves the curve left, so interest rates go up

Steeper yield curve

A greater difference between short-term and long-term rates

Flatter yield curve

A smaller difference between short-term and long-term rates

Inverted yield curve

Can be a signal that predicts a recession

Unbiased Expectations Theory

The yield curve reflects the market's current expectations of future short-term rates

Liquidity Premium Theory

Long-term rates equal expected short-term rates plus a premium that increases with maturity

Market Segmentation Theory

Investors have preferred maturity habitats, so rates are set by supply/demand within each maturity segment

Spot market

Cash paid today, on the 'spot' trade

Forward rate

An interest rate applicable to a financial transaction in the future

Bond

An 'I owe you' — a loan from investor to issuer

Issuer

The borrower of a bond

Investor (bond)

The lender/creditor

Principal / Par Value / Face Value

The amount borrowed

Coupon Rate

The stated interest rate on a bond

Coupon

The interest payment

Maturity

The bond's due date

Term

The time remaining until maturity

YTM

The annualized return on a bond investment

Market Value

The bond's current price

Required rate of return

The rate an investor should receive on a security given its risk; used to calculate fair present value

Expected rate of return

The rate an investor expects to receive on a security given its risk

Realized rate of return

The actual rate of return received on an investment

Coupon bonds

Pay a constant interest payment (INT) per year based on the stated coupon rate

Zero-coupon bond

Pays no coupon interest (INT = 0); investor receives only the par value at maturity

Premium Bond

Coupon rate is greater than YTM/required return, so market price is greater than face value

Discount Bond

Coupon rate is less than YTM/required return, so market price is less than face value

Par bond

Coupon rate equals the required rate of return, so price equals par value

Duration

The weighted average time to maturity on an investment, using the present value of cash flows as weights

Duration's purpose

Measures how sensitive a bond's price is to a change in yield; more accurate for small interest rate changes, less accurate for large changes

Zero-coupon bond duration

Equals the bond's maturity date

Convexity

The degree of curvature of the price-interest rate curve around some interest rate level

Accrued Interest

Interest owed since the last payment; $\text{loan amount} \times \left(\frac{\text{yearly interest}}{365}\right) \times \text{period accrued}$, or $\left(\frac{\text{days held}}{\text{days till payment}}\right) \times \text{PMT}$