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FIN 300 Study Guide - Interest Rate Risk, Fisher Equation, Price Equation

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School
Ryerson University
Department
Finance
Course
FIN 300
Professor
Scott Anderson

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Document Summary

Answers to concepts review and critical thinking questions. As interest rates fluctuate, the value of a government security will fluctuate. Long-term government securities have substantial interest rate risk. All else the same, the government security will have lower coupons because of its lower default risk, so it will have greater interest rate risk. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. Since the bid price must be lower, the bid yield must be higher. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. The cost to the company is a higher coupon.

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Related Questions

o Mortgages are securities used to finance real estate purchasesthat originate from various financial institutions. How arefinancial institutions affected by interest ratefluctuations?

o What is the relationship between mortgage rates and long-termgovernment security rates?

Mortgage Rates and Risk What is the general relationship between mortgage rates and long term government security rates? Explain how mortgage lenders can be affect by interest rate movements. Also explain how they can insulate against interest rate movements.

The Fed controls interest rates to either tighten or loosen theeconomy. When the Feds are needing to tighten the economy, theywill raise the interest rates. When interest rates are changed, itsends a ripple effect through the entire financial market. Wheninterest rates rise, cost of capital and borrowing increase.Consumers will borrow and spend less. This will lead to a slowereconomy and help to hedge inflation. However, the change ininterest rates can affect the market values of different assetswhich can affect the return for investors and the overall profitfor companies. A rise in interest rates will also cause assetprices to fall. When prices fall, yield will be affected. This iswhat interest rate risk is. When rates increase, bond prices fall.When rates decrease, prices will rise. When prices fall, the yieldto maturity will increase. According to the SEC (2019), bondmaturity and coupon rates will affect how price changes due to achange in interest rates (p. 3). So, the higher the coupon rate,the lower the interest rate risk. The opposite is true when thecoupon rates are lower. The lower the coupon rates, the more themarket value will be affected. It will likely decrease more forbond with lower coupon rates. Market values will always varythroughout the life of the bond, depending on what happens to therates. According to Mike Patton in an article written in Forbesmagazine in 2013, when rates fall, bonds are sold at a discount.They are worth less than their face values. Investors should holdonto their bonds when rates rise to keep from selling bonds at adiscount. Assets with shorter maturities will be less affected by achange in interest rates and same with their market values. Do youagree or disagree with this statement?