Present value concept, how to compute PV

The concept of present value (or present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. This notion is true because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year.

9) Yield to maturity and calculation of YTM for all 4 debt instruments;

YTM- the most accurate measurement equates today’s value with PV of all future payments.

10) Relationships between the YTM, coupon rate, present value and face value;

YTM- interest rate that equates the PV of CF received from a debt instrument with its value today.

CY-interest rate on long-term bonds that have no maturity date.

Coupon bond- is identified by 3 pieces of info:1) Corp or goverm agencies that issue the bond. 2) Maturity date of a bond. 3)Coupon rate-the $ amount of the yearly coupon pmt expressed as a % of the Face Value of the bond.

-PV

-Face value-it is specified final amount in a coupon bond.

11) Current Yield and Yield to Maturity;

YTM- the most accurate measurement equates today’s value with PV of all future payments.

Current yield (CY) is frequently used as an approximation to describe interest rates on long-term bonds.

12) Consol bonds and its YTM and present value calculation;

Consol bond- it is a perpetual bond with no maturity date and no repayment off principal that makes fixed coupon payments of $C forever.

13) Real and nominal interest rates;

• Real interest rate
• Interest rate that is adjusted for expected changes in the price level:

· Real interest rate more accurately reflects true cost of borrowing

· When the real rate is low, there are greater incentives to borrow and less to lend

Nominal interest rate –interest rate that ignores the effect of inflation on the cost borrowing.

14) Calculating the Return on one-year investments;

RR-how well a person does by holding a bond or any other security over a particular time period. RR is defined as the payments to the owner plus the change in its value, expressed as fraction of its purch prices. The return on a bond will not necessarily equal the interest rate on that bond. We can decompose returns into 2 pieces.

15) Nature of the Reinvestment risk;

Occurs if hold series of short bonds over long holding period. i at which reinvest uncertain.

Gain from i ­, lose when i ¯

16) Duration and interest rate risk; all definitions of duration;

Dur- the aver lifetime of a debt security’s stream of pmts.

a) Time to recover the initial investment

b) Best measurement of market sensitivity or elasticity.

c) Weighted aver time maturity taken.

• The greater is the duration of a security, the greater is the percentage change in the market value of the security for a given change in interest rates
• Therefore, the greater is the duration of a security, the greater is its interest-rate risk

17) How to compute duration;