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Financial market and institutions exam summary
- Instelling
- Vrije Universiteit Amsterdam (VU)
Includes lecture notes1-3 and sample question week 1-6 with answer
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FMI lecture & exam notes Regi-yFinancial Market and Institutions
Exam material contains lecture notes and mock question
Lecture 1-2
First week quiz notes
1. The most accurate measure of the interest rate risk of a bond is the Duration.
2. Compared to interest rates on long-term U.S. government bonds, interest rates on three-month
Treasury bills are lower on average, however fluctuate more.
3. The security is sold at a price lower than present value, meaning its yield to maturity is lower than
the interest rate.
Banks
“Normal” yield curve
- Banks perform maturity transformation: borrow short-term; lend long-term
- Liquidity premium theory
- Under a normal yield curve, bank searn the liquidity premium
Reasons for the liquidity premium:
(why is there usually a liquidity premium in the term structure of interest rates?)
- Counterparty risk (credit risk)
- Inflation rate
- Liquidity risk (the risk of suddenly needing cash)
Pension funds
Higher discount rates lower the present value of pension liabilities. (=future cash flow)
The stock market
Constant Dividend Growth
- The simplest forecast for the firm’s future dividends states that they will grow at a constant rate,
g, forever.
- P0=Div1/re - g
- The re contains a risk-free component, he interest rate
The housing market
- The decline in interest rates in the UK was unanticipated:
bBecause the similar decline in the 20-minus 10 year rates over time.
- Uk: Gilt: Protect the holder against inflation
/ The yield on a gilt is a measure for the real interest rate.
- Long-term house price changes are almost completely covered by changes in gilt yields
Low-interest world (Summary)
- Many rates are low, mostly short-term in the developed world, government & corporations.
- It is historically special.
1
,FMI lecture & exam notes Regi-y
- A flattened yield curve for financial institutions: Funding ratios and margins decline. Profitability
of banks is impaired
- It would also influence asset price: increases in stock price and house price.
- Two problems that pension funds have with low interest rates:
1. The value of their liabilities is high.
2. The expected returns on assets: bonds, are low
Mock exam question: Chapter 4-6
Test questions
Chapter 4: 1, 2, 4, 7, 10, 11, 14, 21, 22
C4Q1: Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%?
Calculate present worth of dollar, when the interest rate is 20%:
The present worth: PW=FW/(1+i)
FW:future worth, so PW= 1/(1+20%）=0.833333
Therefore, the present worth of dollar, when the interest rate is 20% is 0.83.
Same way of 10%, we can get that the PW= 0.91
So, the present worth of dollar, when the interest rate is 10% has higher value.
C4Q2: Write down the formula that is used to calculate the yield
to maturity in a 20-year 10% coupon bond with $1000 face value
that sells for $2000.
C4Q4: 1. Yield to maturity is the total return that the
bondholder expects if the bond is held till the maturity of the
bond. In other words; ytm is the internal rate of return of
investment in bonds if an investor holds it till maturity.
2. There is an inverse relationship between the bond price and ytm. An increase in ytm will
reduce the bond price and a decrease in yield to maturity will increase the bond price.
C4Q7: When is the current yield a good approximation of the yield to maturity?
The current yield is used to approximate the interest rates on long-term bonds. It is a good
approximation to the ytm when a coupon bond has a long term to maturity because the cash
flows in the distant future have extremely small present discounted values. This makes the value
of the long-term coupon bond equal very close to the yield to maturity for any long-term bonds.
C4Q10: TOF: With a discount bond, the return on the bond is equal to the rate of capital gain.
True. The return on discount (Zero-coupon) bond is equal to the rate of capital gain by definition.
Bonds have a face value, generally in denomination of $1000. Discount bonds are ones that are
bought at a price below the face value, with the face value paid out at the time of maturity.
During this time to maturity, no coupon payments were made hence, a “zero-coupon” bond.
2
,FMI lecture & exam notes Regi-y
C4Q11: If there is a decline in interest rates, which would you rather be holding, long term bonds
or short term bonds? Why?
1. When declined, a long term bond would be preferred over short term bond. This is
because the price for long term bonds will rise with a decline in interest rates and as a
result it will generate return that short term bond.
2. The risk will be higher in the long term. In the long run, i rise, the price will fall and the
return can turn to even negative. As a result, although sometimes due to fall in interest
rates people prefer long term bonds but in case of interest rate volatility and any rising
tendencies of interest rates, long term bonds bear a significantly higher amount of risk.
C4Q14: If the interest rate is 10%, what is the present value of security that pays you $1100 next
year, $1210 the year after, and $1331 the year after that?
To get : Discount each year’s payment by the current interest rate.Discount this future stream if
cash flows formula:
PV=
C4Q21: Consider a coupon bond that has a $1000 par value and a coupon rate of 10%. The bond
is currently selling for $1044.89 and two years to maturity. What is the bond’s yield to maturity?
P=
C4Q22: What is the price of a perpetuity that has a coupon of $50 per year and a yield to
maturity of 2.5%? If the ytm doubles, what will happen to the perpetuity’s price?
1. The formula of a price of perpetuity is Pc=C/ic, where C is yearly payment. Ic is ytm.
Pc= 50/0.025=2000
2. Ytm double, then it is 5%, Pc=50/0.05=1000
3
, FMI lecture & exam notes Regi-y
Chapter 5: 4.5.8.10.13.15
C5Q4: Explain why you would be more or less willing buy long term AT&T bongs under the
following circumstances:
Bond definition:
a. Trading in these bonds increases, making them easier to sell.
b. You expected a bear market in stocks (stock prices are expected to decline).
c. Brokerage commissions on stocks fall
d. You expected interest rate to rise
e. Brokerage commissions on bonds fall
C5Q5: What would happen to the demand for Rembrandt paintings if the stock market undergoes
a boom, why?
1. The Financial system majorly contains the market of real estate/assets, stock market,
market if precious metal and market of money. Here, the stock market and money market
has inverse relationships. This is because at the time of low interest rate, investors borrow
money and invest it in the stock market for higher returns.
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