IIF Theory at Universität Konstanz

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Strong Market Efficiency 


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Bond Valuation 

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Bond Valuation in Practise 

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If interest rates change, does the price of high-coupon bonds change proportionally more than that of low-coupon bonds?


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Do longer maturity bonds necessarily have longer durations than bonds with shorter maturity?


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Liquidity Preference Theory 

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What does the liquidity-preference theory say about the relationship between the forward rate and the one-year spot rate at time 1?


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If the liquidity-preference theory is a good approximation and you have to meet long-term liabilities, is it safer to invest in long-term or short-term bonds? Assume inflation is predictable.


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Inflation Premium 

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f)  What does the inflation-premium theory say about the relationship between the forward rate and the one-year spot rate at time 1?


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Expectations hypothesis of forward rates.


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One of the first tasks of an LBO’s financial manager is to pay down debt.


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Exemplary flashcards for IIF Theory at the Universität Konstanz on StudySmarter:

IIF Theory

Strong Market Efficiency 


  • The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form
  • Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information.
  • adding that the best way to maximize returns is by following a buy-and-hold strategy.

IIF Theory

Bond Valuation 

  • Bond valuation is a way to determine the theoretical fair value (or par value) of a particular bond.
  • It involves calculating the present value of a bond's expected future coupon payments, or cash flow, and the bond's value upon maturity, or face value.
  • As a bond's par value and interest payments are set, bond valuation helps investors figure out what rate of return would make a bond investment worth the cost.
  • A bond is a debt instrument that provides a steady income stream to the investor in the form of coupon payments. At the maturity date, the full face value of the bond is repaid to the bondholder. The characteristics of a regular bond include:
    • Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders semi-annually. 
      • The coupon rate is the fixed return that an investor earns periodically until it matures.
    • Maturity date: All bonds have maturity dates, some short-term, others long-term. When a bond matures, the bond issuer repays the investor the full face value of the bond. For corporate bonds, the face value of a bond is usually $1,000 and for government bonds, the face value is $10,000. The face value is not necessarily the invested principal or purchase price of the bond.
    • Current Price: Depending on the level of interest rate in the environment, the investor may purchase a bond at par, below par, or above par. For example, if interest rates increase, the value of a bond will decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade at a discount, that is, below par. However, the bondholder will be paid the full face value of the bond at maturity even though he purchased it for less than the par value.

IIF Theory

Bond Valuation in Practise 

Like a stock, the value of a bond determines whether it is a suitable investment for a portfolio and hence, is an integral step in bond investing.











Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon payments. The theoretical fair value of a bond is calculated by discounting the present value of its coupon payments by an appropriate discount rate. The discount rate used is the yield to maturity, which is the rate of return that an investor will get if s/he reinvested every coupon payment from the bond at a fixed interest rate until the bond matures. It takes into account the price of a bond, par value, coupon rate, and time to maturity.


=> Bei der Bewertung von Anleihen wird der Gegenwartswert der erwarteten zukünftigen Kuponzahlungen einer Anleihe berechnet. Der theoretische Marktwert einer Anleihe wird berechnet, indem der Gegenwartswert ihrer Kuponzahlungen mit einem geeigneten Diskontsatz diskontiert wird. Der verwendete Diskontsatz ist die Rendite bis zur Fälligkeit, d.h. die Rendite, die ein Anleger erhält, wenn er jede Kuponzahlung aus der Anleihe bis zur Fälligkeit der Anleihe zu einem festen Zinssatz reinvestiert. Er berücksichtigt den Kurs einer Anleihe, den Nennwert, den Kuponsatz und die Zeit bis zur Fälligkeit.


Example 

For example, let’s find the value of a corporate bond with an annual interest rate of 5%, making semi-annual interest payments for 2 years, after which the bond matures and the principal must be repaid. Assume a YTM of 3%.


F = $1000 for corporate bond


Coupon rateannual = 5%, therefore, Coupon ratesemi-annual = 5%/2 = 2.5%


C = 2.5% x $1000 = $25 per period


t = 2 years x 2 = 4 periods for semi-annual coupon payments


T = 4 periods


Present value of semi-annual payments = 25/(1.03)1 + 25/(1.03)2 + 25/(1.03)3 + 25/(1.03)4


= 24.27 + 23.56 + 22.88 + 22.21


= 92.93


Present value of face value = 1000/(1.03)4


= 888.49


Therefore, value of bond = $92.93 + $888.49 = $981.42


Case Zero Bond 


Zero-Coupon Bond Valuation 

A zero-coupon bond makes no annual or semi-annual coupon payments for the duration of the bond. Instead, it is sold at a deep discount to par when issued. The difference between the purchase price and par value is the investor’s interest earned on the bond. To calculate the value of a zero-coupon bond, we only need to find the present value of the face value.

(Bei einer Nullkupon-Anleihe erfolgen während der Laufzeit der Anleihe keine jährlichen oder halbjährlichen Kuponzahlungen. Stattdessen wird sie bei ihrer Emission mit einem hohen Abschlag zum Nennwert verkauft. Die Differenz zwischen dem Kaufpreis und dem Nennwert ist der Zinsertrag des Anlegers auf die Anleihe. Um den Wert einer Nullkupon-Anleihe zu berechnen, müssen wir nur den Gegenwartswert des Nennwerts ermitteln.)


Following our example above, if the bond paid no coupons to investors, its value will simply be:


$1000/(1.03)4 = $888.49


Under both calculations, a coupon-paying bond is more valuable than a zero-coupon bond.


Face Value:


  • Face value describes the nominal value or dollar value of a security; the face value is stated by the issuing party.
  • A stock's face value is the initial cost of the stock, as indicated on the certificate of the stock in question; a bond's face value is the dollar figure due to be paid to the investor, once the bond reaches maturity.
  • The actual market value of a stock or a bond is not reliably indicated by its face value, because there are many other influencing forces at play, such as supply and demand.

=> Nennwert beschreibt den Nennwert oder Dollarwert eines Wertpapiers; der Nennwert wird von der ausgebenden Partei angegeben.

Der Nennwert einer Aktie ist der Anfangspreis der Aktie, wie er auf dem Zertifikat der betreffenden Aktie angegeben ist; der Nennwert einer Anleihe ist der Dollarwert, der dem Anleger bei Fälligkeit der Anleihe zu zahlen ist.

Der tatsächliche Marktwert einer Aktie oder einer Anleihe wird durch ihren Nennwert nicht zuverlässig angegeben, da viele andere Einflussfaktoren wie Angebot und Nachfrage im Spiel sind.






- face value (par value) is the amount paid to a bondholder at the maturity date, as long as the bond issuer doesn't default. However, bonds sold on the secondary market fluctuate with interest rates. For example, if interest rates are higher than the bond's coupon rate, then the bond is sold at a discount (below par).

=> - Nominalwert (Nennwert) ist der Betrag, der am Fälligkeitsdatum an einen Anleihegläubiger gezahlt wird, solange der Anleiheemittent nicht ausfällt. Auf dem Sekundärmarkt verkaufte Anleihen schwanken jedoch mit den Zinssätzen. Wenn beispielsweise die Zinssätze höher sind als der Anleihezinssatz, dann wird die Anleihe mit einem Abschlag (unter dem Nennwert) verkauft.


Conversely, if interest rates are lower than the bond's coupon rate, the bond is sold at a premium (above par). While face value of a bond provides for a guaranteed return, the face value of a stock is generally a poor indicator of actual worth.


=> Umgekehrt wird die Anleihe mit einem Aufschlag (über dem Nennwert) verkauft, wenn die Zinsen niedriger sind als der Anleihekupon. Während der Nennwert einer Anleihe eine garantierte Rendite bietet, ist der Nennwert einer Aktie im Allgemeinen ein schlechter Indikator für den tatsächlichen Wert.

IIF Theory

If interest rates change, does the price of high-coupon bonds change proportionally more than that of low-coupon bonds?


No, lower coupon bonds (as Treasury Bonds) have higher duration and are more volatile!

=> Low-coupon bonds are change proportional more. 

IIF Theory

Do longer maturity bonds necessarily have longer durations than bonds with shorter maturity?


No the duration depends also on the maturity date as well as the coupon.


Kann also sein das short maturity bonds have a longer duration weil deren Coupons größer sind

IIF Theory

Liquidity Preference Theory 

First of all: 


Liquidity preference theory is a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings.

  •  demand for liquidity holds speculative power, investments that are more liquid are easier to cash in for full value. Cash is commonly accepted as the most liquid asset. According to the liquidity preference theory, interest rates on short-term securities are lower because investors are not sacrificing liquidity for greater time frames than medium or longer-term securities. 
    • Die Nachfrage nach Liquidität birgt Spekulationskraft, Investitionen, die liquider sind, können leichter zum vollen Wert eingelöst werden. Bargeld wird allgemein als der liquideste Vermögenswert akzeptiert. Nach der Liquiditätspräferenztheorie sind die Zinssätze für kurzfristige Wertpapiere niedriger, weil die Anleger die Liquidität nicht für größere Zeiträume opfern als bei mittel- oder längerfristigen Wertpapieren.
  • Liquidity preference theory suggests that investors demand progressively higher premiums on medium and long-term securities as opposed to short-term securities.
  • onsider this example: a three-year Treasury note might pay a 2% interest rate, a 10-year treasury note might pay a 4% interest rate and a 30-year treasury bond might pay a 6% interest rate. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange for agreeing to have the cash tied up for a longer period of time.


3 Motives for Liquidity Preferences

  • transactions motive 
    • states that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic day-to-day needs.
    • In other words, stakeholders have a high demand for liquidity to cover their short-term obligations, such as buying groceries, paying rent and/or the mortgage. 
    • Higher costs of living mean a higher demand for cash/liquidity to meet those day-to-day needs. 
  • precautionary motive 
    • relates to an individual's preference for additional liquidity
    • in the event that an unexpected problem or cost arises that requires a substantial outlay of cash. 
    • These events include unforeseen costs like house or car repairs.
  • speculative motive
    •  When interest rates are low, demand for cash is high and they may prefer to hold assets until interest rates rise.
    • When higher interest rates are offered, investors give up liquidity in exchange for higher rates
    • As an example, if interest rates are rising and bond prices are falling, an investor may sell their low paying bonds and buy higher paying bonds or hold onto the cash and wait for an even better rate of return.

IIF Theory

What does the liquidity-preference theory say about the relationship between the forward rate and the one-year spot rate at time 1?


  • the forward rate equals the expected spot rate plus a liquidity premium, i.e., f2 = E[r1 at t = 1] + liquidity premium.


IIF Theory

If the liquidity-preference theory is a good approximation and you have to meet long-term liabilities, is it safer to invest in long-term or short-term bonds? Assume inflation is predictable.



  • Investing in long-term bonds is safer: 
    • by assumption there is no inflation risk
    • liquidity risk is irrelevant for long-term liabilities (plus it earns a premium). 
    • Reinvestment risk matters as well.


IIF Theory

Inflation Premium 

  • The higher return that investors demand in exchange for investing in a long-term security where inflation has a greater potential to reduce the real return. 
  • The inflation premium is the reason that most yield curves trend upward.
  • Thus, a bond with a maturity of 30 years almost always has a higher coupon rate than one with a maturity of 30days.
  • Investors expect to make a larger nominal return in part to compensate them for the lower real return that is almost inevitable (unvermeidlich) because of the nature of inflation. 

IIF Theory

f)  What does the inflation-premium theory say about the relationship between the forward rate and the one-year spot rate at time 1?



  1. (f)  The forward rate equals the expected spot rate plus a premium for the inflation risk, i.e., f2 = E[r1 at t = 1] + inflation premium.


IIF Theory

Expectations hypothesis of forward rates.


Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. The theory suggests that an investor earns the same interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today. The theory is also known as the "unbiased expectations theory."


  • Expectations theory predicts future short-term interest rates based on current long-term interest rates
  • The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today
  • In theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future
  • Let's say that the present bond market provides investors with a two-year bond that pays an interest rate of 20% while a one-year bond pays an interest rate of 18%. The expectations theory can be used to forecast the interest rate of a future one-year bond.




    • The first step of the calculation is to add one to the two-year bond’s interest rate. The result is 1.2.
    • The next step is to square the result or (1.2 * 1.2 = 1.44).
    • Divide the result by the current one-year interest rate and add one or ((1.44 / 1.18) +1 = 1.22).
    • To calculate the forecast one-year bond interest rate for the following year, subtract one from the result or (1.22 -1 = 0.22 or 22%).



  • In this example, the investor is earning an equivalent return to the present interest rate of a two-year bond. If the investor chooses to invest in a one-year bond at 18%, the bond yield for the following year’s bond would need to increase to 22% for this investment to be advantageous.







IIF Theory

One of the first tasks of an LBO’s financial manager is to pay down debt.


True: A leveraged buyout (LBO) is an acquisition in which a large part of the purchase is

debt-financed and the remaining equity is privately held by a small group of investors.


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