What is the yield to maturity (YTM)?
The interest rate that equates the present value of a bond’s payments with its price.
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| Term | Definition |
|---|---|
| What is the yield to maturity (YTM)? | The interest rate that equates the present value of a bond’s payments with its price. |
| How is YTM related to bond prices? | They move inversely |
| What is the simple loan? | A loan where the borrower repays the principal plus interest in one payment at maturity. |
| What is a fixed-payment loan? | A loan that requires equal payments over its life, covering interest and principal. |
| What is a coupon bond? | A bond that pays the owner periodic interest payments (coupons) and returns the face value at maturity. |
| What is a discount bond? | A bond bought below face value that pays no coupons and repays face value at maturity. |
| How is the current yield calculated? | Coupon payment divided by the bond’s price. |
| What is the relationship between coupon rate and YTM when bond price equals face value? | They are equal. |
| When a bond’s price is below face value, how does YTM compare to coupon rate? | YTM is greater than the coupon rate. |
| When a bond’s price is above face value, how does YTM compare to coupon rate? | YTM is less than the coupon rate. |
| What is the rate of return? | The payments to the owner plus the change in the bond’s price, relative to purchase price. |
| What is the difference between return and yield? | Return includes capital gains or losses |
| What is interest rate risk? | The risk that changes in interest rates will affect bond prices and returns. |
| Which bonds have greater interest rate risk? | Longer-term bonds. |
| What is real interest rate? | The nominal interest rate minus the expected inflation rate. |
| What happens when expected inflation rises? | Nominal interest rates rise (Fisher effect). |
| What is the Fisher equation? | i = r + π^e, where i is nominal, r real, and π^e expected inflation. |
| What is the concept of present value? | A dollar today is worth more than a dollar tomorrow. |
| What happens to present value when the interest rate increases? | It decreases. |
| What determines bond demand? | Wealth, expected returns, risk, and liquidity. |
| Why is the demand for bonds downward sloping? | Higher interest rates make bonds more attractive, increasing quantity demanded. |
| Why is the supply of bonds upward sloping? | Higher interest rates make borrowing more attractive to firms. |
| What causes bond demand to increase? | Higher wealth or lower expected inflation. |
| What causes bond supply to increase? | Higher expected profitability of investment or inflation. |
| How does a recession affect bond markets? | Decreases supply and may increase demand, raising prices. |
| How do expectations about inflation affect bond prices? | Higher expected inflation lowers bond prices. |
| What is duration? | A measure of the sensitivity of a bond’s price to interest rate changes. |
| Why is duration useful? | It measures interest rate risk precisely. |
| What is yield on a perpetuity? | Coupon divided by the price of the bond. |
| What is the liquidity preference framework? | It determines interest rates based on supply and demand for money. |
| What shifts the money demand curve? | Changes in income and price level. |
| What happens to interest rates when money supply increases? | They fall. |
| What happens to interest rates when income increases? | They rise. |
| What happens to interest rates when price level increases? | They rise. |
| How does the Fed affect bond prices? | Through open market operations that shift the money supply. |
| What is opportunity cost of holding money? | The interest foregone by holding money instead of bonds. |
| What is the relationship between bond prices and interest rates? | They are inversely related. |
| What is the nominal interest rate? | The interest rate unadjusted for inflation. |
| What is the real return? | Return adjusted for changes in purchasing power. |
| What determines the equilibrium interest rate? | The intersection of money demand and money supply curves. |