Chapters 9-12

I expect you to know formulas for

• yield to maturity on zero coupon bonds
• before and after tax yields, equivalent taxable yields, equivalent tax rates

¨what do we mean by the pension plan sponsor?pension plan administrator?

¨what are defined benefit plans? how do they work?

·what are the advantages/disadvantages of this type of plan from the perspective of the employee?

·what is the chief drawback to this type of plan from the perspective of the firm?

·what is vesting?

¨what are defined contribution plans? how do they work? 

·what are the advantages/disadvantages of this type of plan from the perspective of the employee?

·own company stock in 401(k) plans--why is it a problem?

¨how do cash balance plans combine the features of defined benefit and contribution plans?

¨what type of favorable tax treatment do pensions receive?

·what is the tax treatment of pension contributions, earnings, and benefits?

·how does the Roth IRA differ from a traditional IRA and 401ks in this respect?

¨federal regulation on defined benefit plans:1974 ERISA:

·what are theprovisions about:

Þfunding:“pay-as-you-go” vs. fully funded; 

Þvesting

Þinsurance and the PBGC

Þpension fund management

¨Social security

·how is it funded?how are benefits determined?why is it “pay-as-you-go”?

·problems with Social Security

Þwhat are the sources of its financial problems?

Þwhat are the possible solutions?

10  Properties and Pricing of Assets

¨what properties affect the value of financial assets?

¨what properties are desirable/undesirable?

¨what is the basic rule for pricing an asset?

¨terms:maturity, face value, coupon rate, yield to maturity

¨zero coupon bonds

¨how do they work?

¨how to calculate price or yield to maturity on a bond equivalent basis?

¨coupon bonds

¨calculating coupon payments

¨what are the cash flows?

¨using a bond table 

¨what is the relationship between yield and coupon rate, and bond price and face value?

¨What is the relationship between the price and yield of a bond or any debt security?

¨What do we mean by interest rate risk/bond price sensitivity/bond price volatility?

¨What is the relationship between bond price sensitivity and 

¨bond maturity?

¨bond coupon rate? 

¨level of bond yields?

¨What is duration and why use it? How do you interpret duration?

11  Level and Structure of Interest Rates

¨the market for loanable funds 

·who supplies loanable funds?who demands loanable funds?

·what facors shift supply and demand curves for loanable funds? how does this affect the interest rate?

·use this market to determine how different events impact the level of interest rates (homework 4, #3)

¨why are U.S. Treasury securities considered the benchmark interest rate?

¨risk structure of interest rates--different assets, same maturity

·what is the yield spread?(book calls this the risk premium)

·measuring the yield spread in percentage points vs. basis points

·credit risk/ default risk

·any debt backed by the “full faith and credit” of the U.S. government is considered default-free

·comparing bond ratings

·how does default risk vary over the business cycle?

·tax treatment 

·tax treatment of municipal, corporate, and Treasury debt

·calculating before tax vs. after tax yields, tax rates and the equivalent taxable yield

·how does tax policy impact the spread between the before-tax yields on municipal and corporate bonds?

·embedded options

·how do they impact the yield spread?

·Put and call provisions

·liquidity

·what debt securities are most liquid? 

·what are some general rules about liquidity?

·how does risk structure explain why municipal yields < Treasury yields < corporate yields?

12  Term Structure of Interest Rates

¨what is the general pattern of the term structure for U.S. Treasury securities

¨what is the yield curve? how is this difference from a time series graph of interest rates?

·what does the slope of the yield curve tell us about the term structure?

·what is the usual shape of the U.S. yield curve?

¨Tbills, Tnotes, Tbonds--how do they differ in maturity and coupon?

¨theories of the term structure

·expectations theory--what are the central assumptions of this theory?what is the central implication?

·under this theory, what does the shape of the yield curve tell you about expected future short-term rates?

·what is the main problem with this theory?

·what risks are associated with short-term bonds?with long-term bonds?

·liquidity theory--what is the central assumption?what is the central implication?

·why is it more difficult to interpret the yield curve under this theory?

·Why would a flat or upward sloping yield curve be subject to different interpretations under the expectations theory vs.the liquidity theory?

·why is this theory able to explain the usual shape of the U.S. yield curve?

·preferred habitat theory--how does this theory differ from the liquidity theory?

·what are the assumptions/implications of the segmented markets theory? Is it realistic?