Since we have been all over the place I will provide extra structure here to ease the study process. Beginning with the first 3 chapters, you should read thinking about possible multiple choice questions. I hope that you know almost everything from the chapters from just your life experiences, but make sure you understand the jargon and can use it correctly.
Chapter 1
a.
Money: used to pay for purchases and store wealth.
b.
Financial instruments: used to transfer resources from savers to investors and
to transfer risk to those best equipped to bear it.
c.
Financial markets: allow us to buy and sell financial instruments quickly and
cheaply.
d.
Financial institutions: provide a myriad of services, including access to
financial markets, and collect information about prospective borrowers to ensure
that they are creditworthy.
e.
Central banks: monitor and stabilize the economy.
a.
Money has evolved from coins to paper money to today’s electronic funds
transfers.
b.
Financial instruments: where once investing was an
activity reserved for the wealthy, today’s small investors have the opportunity
to purchase shares in “mutual funds.”
c.
Financial markets have evolved from trading places to
electronic networks. Transactions
are cheaper and markets offer a broader array of financial instruments than were
available even 50 years ago.
d.
Financial institutions: Today’s banks are more like
financial supermarkets offering a huge assortment of financial products and
services for sale.
e.
Central banks: what had been government treasuries have
evolved into the modern central bank that controls the availability of money and
credit in such a way as to ensure low inflation, high growth, and the stability
of the financial system. Policy
makers strive for transparency in their operations, which were once shrouded in
mystery.
3.
We must therefore develop a way to understand and adapt
to the evolutionary structure of the financial system.
4.
One way to do that is to discuss money and banking
within a framework of core principles that do not change over time; this is the
focus of the next section.
A.
Time
1.
time has value.
2.
interest rates.
B.
Risk requires compensation.
1. Risk is uncertainty about returns
2.
To deal effectively with risk one must consider the full
range of possibilities: eliminate some risks, reduce others, pay someone else to
assume particularly onerous risks, and just live with what’s left.
3.
Investors must be paid to assume risk and the higher the
risk the higher the required payment.
4. Insurance is an example of paying for someone else to shoulder a risk you don’t want to take.
C.
Information is the basis for decisions.
1.
Most of us collect information before making decisions.
2. information is costly to collect.
D.
Markets determine prices and allocate resources.
1.
Markets are the core of the economic system; they are
the place, physical or virtual, where firms go to issue stocks and bonds, and
where individuals go to purchase assets.
2.
Financial markets are essential to the economy,
channeling its resources and minimizing the cost of gathering information and
making transactions.
3.
Well-developed financial markets are a necessary
precondition for healthy economic growth.
4.
Markets determine prices and allocate resources and thus
are sources of information.
5.
By attaching prices to different stocks or bonds,
markets provide the basis for the allocation of capital.
E.
Stability improves welfare.
1.
Reducing volatility reduces risk.
2.
government policymakers can reduce some risks.
3.
By stabilizing the economy monetary policymakers
eliminate risks that individuals can’t eliminate, and so improve everyone’s
welfare in the process.
I want you to read the book. The above outline is nearly complete and it is so easy that I am fearful you will shirk on your readings. Future chapters are far more challenging so do not take on bad habits with these easy early sections.
Terms Introduced in Chapter 1
central bank
European Central Bank
Federal Reserve System
financial institution
financial instrument
financial market
financial system
information
markets
money
risk
stability
time
Another wimpy chapter so do not get complacent. While nearly 100% is review from 203, I am sure that few know ACH and we did not talk about it in class. Please read.
Chapter 2
money is an asset that is generally accepted as payment for goods and services or repayment of debt.
1.
The primary use of money is as a means of payment.
2.
Barter is an alternative to using money and doesn’t work
very well.
a.
Barter requires a “double coincidence of wants,” meaning
that in order for trade to take place both parties must want what the other has.
1. We measure value using dollars and cents, the unit of account.
1.
For money to function as a means of payment it has to be
a store of value too because it must retain its worth from day to day.
2.
The means of payment has to be durable and capable of
transferring purchasing power from one day to the next.
3.
Liquidity is a measure of the ease with which an asset
can be turned into a means of payment (namely money).
a.
The more costly an asset is to turn into money, the less
liquid it is.
b.
Constantly transforming assets into money every time we
wish to make a purchase would be extremely costly; hence we hold money.
II.
The Payments System
The payments system
is the web of arrangements that allow for the exchange of goods and services, as
well as assets, among different people.
The efficient operation of our economy depends on the payment system and
so it is a critical policy concern that it function well.
Money is at the heart of the payments system.
1.
The first means of payment were things with intrinsic
value like silk or salt.
2.
Successful commodity monies had the following
characteristics:
a.
they were usable in some form by most people;
b.
they could be made into standardized quantities;
c.
they were durable;
d.
they had high value relative to their weight and size so
that they were easily transportable; and
e.
they were divisible into small units so that they were
easy to trade.
3.
For most of human history, gold has been the most common
commodity money.
4.
In 1775, the newly formed Continental Congress of the
5.
As a result, people became suspicious of
government-issued paper money.
6. From that period up to the Civil War, the U.S. had individual banks issue bank notes back by gold.
6. The period of the Civil War was the slow beginning of the introduction of Fiat Money starting with the Greenback.
10.
In the
11.
Today we use paper money that is fiat money, meaning
that its value comes from government decree (or fiat).
12.
A note (whether it’s a $1 or a $100 bill) costs about 6
cents to produce.
13.
These notes are accepted as payment for goods or in
settlement of debts for two reasons:
a.
We take them because we believe we can use them in the
future.
b.
The law says we must accept them; that is what the words
“legal tender” printed on the bill means.
14.
As long as the government stands behind its paper money,
and doesn’t issue too much of it, we will use it.
In the end, money is about trust.
1. A check is an instruction to the bank to take funds from your account and transfer them to the person or firm you designate (by writing the name on the check).
1.
The third method of payment is electronic.
2.
There are credit cards, debit cards, and electronic
funds transfer.
3.
A debit card works like a check and there is usually a
fee for the transaction.
4.
A credit card is a promise by a bank to lend the
cardholder money with which to make purchases.
When the card is used to buy merchandise the seller receives payment
immediately.
5.
However, the money that is used for payment does not
belong to the buyer; rather, the bank makes the payment, creating a loan that
the buyer must repay.
6.
For this reason, credit cards do not represent money;
rather, they represent access to someone else’s money.
7.
Electronic funds transfers move funds directly from one
account to another. While such
payments are less well known than credit card or debit card payments, these
transfers account for the bulk of the $30 trillion worth of non-cash retail
payments made electronically each year in the
8.
Banks use these transfers to handle transactions among
themselves.
9.
Individuals may be familiar with such transfers through
direct deposit of their paychecks, etc.
10.
Retail businesses are experimenting with new forms of
electronic payment, including the stored-value card (examples are long-distance
telephone cards).
11.
E-money is another new method of payment that can be
used for purchases on the Internet.
It is really a form of private money.
3.
Finally, money as a store of value is clearly on the way
out as many financial instruments have become highly liquid.
1.
Inflation is a sustained rise in the general price
level.
2.
With inflation you need more money to buy the same
basket of goods because it costs more.
3.
Inflation makes money less valuable.
4.
The primary cause of inflation is the issuance of too
much money.
5.
Because money growth is related to inflation we need to
be able to measure how much money is circulating.
6.
We compute measures of money called the monetary
aggregates: M1 and M2.
a.
M1 is the narrowest definition of money and includes
only currency and various deposit accounts on which people can write checks.
Specifically, it is currency in the hands of the public, traveler’s
checks, demand deposits and other checkable deposits.
b.
M2 includes everything that is in M1 plus assets that
cannot be used directly as a means of payment and are difficult to turn into
currency quickly, like small-denomination time deposits, money market deposit
accounts, and money market mutual fund shares.
M2 is the most commonly quoted monetary aggregate.
Terms Introduced in Chapter 2
automated clearinghouse transaction (ACH)
checks
credit card
debit card
demand deposits
electronic funds transfer
e-money
fiat money
gross domestic product
inflation
inflation rate
liquidity
M1 and M2
means of payment
money
monetary aggregates
payments system
store of value
stored-value card
time deposits
unit of account
wealth
Chapter 3
A financial instrument is the written legal obligation of
one party to transfer something of value—usually money—to another party at some
future date, under certain conditions.
1.
As a group, they have three functions or uses:
a.
They can act as a means of payment.
b.
They can be stores of value.
c.
They allow for the taking of risk.
3.
Most financial instruments involve some sort of risk
transfer.
1.
Financial instruments are complex contracts.
2.
Standardized agreements are used in order to overcome
the potential costs of complexity.
3.
Because of standardization, most of the financial
instruments that we encounter on a day-to-day basis are very homogeneous.
4.
Another characteristic of financial instruments is that
they communicate information.
5.
Financial instruments summarize certain essential
information about the issuer.
6.
Financial instruments are designed to handle the problem
of “asymmetric information,” which comes from the fact that borrowers have some
information that they don’t disclose to lenders.
1.
The two fundamental classes of financial instruments are
underlying instrument (sometimes called primitive securities) and derivative
instruments.
2.
Stocks and bonds are examples of underlying instruments.
3.
Derivatives are so named because they take their value
and their payoffs are “derived from” the behavior of the underlying instruments.
4.
Futures and options are examples of derivatives.
1.
Four fundamental characteristics influence the value of
a financial instrument:
a.
the size of the payment that is promised
b.
when the promised payment is to be made
c.
the likelihood that the payment will be made
d.
the conditions under which the payment is to be made
2.
People will pay more for an instrument that obligates
the issuer to pay the holder a greater sum.
The bigger the size of the promised payment, the more valuable the
financial instrument.
3.
The sooner the payment is made the more valuable is the
promise to make it.
4.
The more likely it is that the payment will be made, the
more valuable the financial instrument.
5.
Payments that are made when we need them most are more
valuable than other payments.
Financial markets are the places where financial
instruments are bought and sold.
They enable both firms and individuals to find financing for their activities.
They promote economic efficiency by ensuring that resources are placed at
the disposal of those who can put them to best use.
When they fail to function properly, resources are no longer channeled to
their best possible use and we all suffer.
This section looks at the role of financial markets and the economic
justification for their existence.
1.
Financial markets serve three roles in our economic
system: they offer savers and
borrowers liquidity; they pool and communicate information; and they allow risk
sharing.
2.
Financial markets need to be designed in a way that
keeps transactions costs low.
1.
There are lots of financial markets and many ways to
categorize them.
a.
Primary versus secondary markets:
in a primary market a borrower obtains funds from a lender by selling
newly issued securities. Most of the
action in primary markets goes on out of public view.
Most companies use an investment bank, which will determine a price and
then purchase the company’s securities in preparation for resale to clients;
this is called underwriting. We hear
more about the secondary markets where people can buy and sell existing
securities; these are the prices reported in the news.
b.
Centralized Exchanges, Over-the-Counter Markets, and
Electronic Networks: Secondary
financial markets can be centralized exchanges (like the New York Stock
Exchange) or over-the-counter (or OTC) markets, which are electronic networks of
dealers who trade with one another from wherever they are located (Nasdaq, for
example). Today we can add
electronic communications networks (ECNs) to the list. Compared to centralized
exchanges, electronic markets have advantages and disadvantages:
customers can see the orders, but the speed of execution means errors can
happen.
c.
Debt and Equity versus Derivative Markets:
equity markets are the markets for stocks, which are usually traded in
the countries where the companies are based.
Debt instruments can be categorized as money market (maturity of less
than one year) or bond markets (maturity of more than one year).
C.
Characteristics of a Well-Run Financial Market
1.
Well-run financial markets exhibit a few essential
characteristics that are related to the role we ask them to play in our
economies.
a.
They must be designed in a way that keeps transactions
costs low.
b.
The information the market pools and communicates must
be both accurate and widely available.
If not, the prices will not be correct and those prices are the link
between the financial markets and the real economy.
c.
Investors must be protected; a lack of proper safeguards
dampens people’s willingness to invest, and so governments are an essential part
of financial markets.
1)
Financial institutions are the firms that provide access
to the financial markets; they sit between savers and borrowers and so are known
as financial intermediaries.
Examples include banks, insurance companies, securities firms and pension funds.
2)
A system without financial institutions would not work
very well for three reasons:
a.
Individual transactions between saver-lenders and
borrower-spenders would be extremely expensive.
b.
Lenders need to evaluate the creditworthiness of
borrowers and then monitor them to ensure that they don’t abscond with the
funds, and individuals are not equipped to do this.
c.
Most borrowers want to borrow long term, while lenders
favor short-term loans.
1.
Financial institutions reduce transaction costs by
specializing in the issuance of standardized securities.
2.
They reduce the information costs of screening and
monitoring borrowers to ensure that they are creditworthy and that they use the
proceeds of a loan or security issue properly.
3.
Financial institutions curb information asymmetries and
the problems that go along with them, helping to ensure that resources flow into
their most productive uses.
4.
Financial institutions make long-term loans but allow
savers ready access to their funds.
5.
They provide savers with financial instruments that are
both more liquid and less risky than the individual stocks and bonds that savers
would purchase directly in financial markets.
1.
Financial institutions or intermediaries can be divided
into two broad categories called depository and nondepository institutions.
2.
Depository institutions (commercial banks, savings
banks, and credit unions) take deposits and make loans.
3.
Nondepository institutions include insurance companies,
securities firms, mutual fund companies, finance companies, and pension funds.
a.
Insurance companies accept premiums, which they invest
in securities and real estate in return for promising compensation to
policyholders should certain events occur (like death, property losses, etc.).
b.
Pension funds invest individual and company
contributions into stocks, bonds and real estate in order to provide payments to
retired workers.
c.
Securities firms (include brokers, investment banks, and
mutual fund companies): brokers and
investment banks issue stocks and bonds to corporate customers, trade them, and
advise clients. Mutual fund
companies pool the resources of individuals and companies and invest them in
portfolios of bonds, stocks, and real estate.
d.
Finance Companies:
raise funds directly in the financial markets in order to make loans to
individuals and firms.
e.
Government Sponsored Enterprises:
federal credit agencies that provide loans directly for farmers and home
mortgages, as well as guarantee programs that insure the loans made by private
lenders. The government also
provides retirement income and medical care to the elderly (and disabled)
through Social Security and Medicare.
4.
The monetary aggregates are made up of liabilities of
commercial banks, so clearly the financial structure is tied to the availability
of money and credit.
Terms Introduced in Chapter 3
asset
asset-backed security
bond market
centralized exchange
collateral
counterparty
debt market
derivative instrument
direct finance
electronic communications networks (ECNs)
equity market
financial instrument
financial institutions
indirect finance
liability
money market
over-the-counter market
portfolio
primary financial market
secondary financial market
specialist
underlying
instrument
Chapter three will has some big topics that are worthy of graduating from the M/C question up to an essay. And I believe this study guide suggests a few possibilities.
We both know that I must put at least one present value question on the test and probably one should be a bond. Because of time, that will limit the number of multiple choice I can ask in this sections. Make sure you hit the hightlights!
Chapter 4
The Interest Rate, Present Value, and Future Value
Explain
how to use the interest rate in calculating present values and future values.
A. Why Do Lenders Charge Interest on
Loans?
Interest on
loans compensates lenders for inflation, default risk, and the opportunity cost
of waiting to spend money.
B. Most Financial Transactions
Involve Payments in the Future
Most loans
involve future payments to pay off the loans. Interest rates are an important
factor in comparing different financial transactions.
C. Compounding and Discounting
Economists refer to the process of earning
interest on interest as savings accumulate over time as compounding.
Funds in the future are worth less than funds in the present, so funds in the
future have to be reduced, or discounted, to find their present value. Funds in
the future are worth less than funds in the present because: (1) Dollars in the
future will usually buy less than dollars can today; (2) Dollars that are
promised to be paid in the future may not actually be received; and (3) There is
an opportunity cost in waiting to receive a payment because you cannot get the
benefits of the goods and services you could have bought if you had the money
today.
D. Discounting and the Prices of
Financial Assets
By adding up
the present values of all the payments, we have the dollar amount that a buyer
will pay for the asset; in other words, we have determined the asset’s price.
Debt Instruments
and Their Prices
Distinguish among different debt instruments and understand how their prices are
determined.
A.
Loans, Bonds, and the Timing of Payments
Debt
instruments include (1) loans granted by banks and (2) bonds issued by
corporations and governments. Debt instruments take different forms because
lenders and borrowers have different needs. There are four basic categories of
debt instruments:
1. Simple loans: The borrower receives from the lender an amount of funds called
the principal and agrees to repay the lender the principal plus interest on a
specific date when the loan matures.
2. Discount bonds: The borrower pays the lender an amount called the face
value at maturity
but receives less than the face value initially. The interest paid on the loan
is the difference between the amount repaid and the amount borrowed.
3. Coupon bonds: The borrower makes interest payments to the lender in the form
of coupons at regular intervals, typically semi-annually or annually, and repays
the face value at maturity.
4. Fixed-payment loans: The borrower makes periodic payments to the lender. The
payments are of equal amounts and include both interest and principal.
Bond Prices and Yield to
Maturity
Explain the relationship between the yield to
maturity on a bond and its price.
A.
Bond Prices
The price of a coupon bond is equal to the present value of all future payments
including coupons and its face value.
B.
Yield to Maturity
The yield to maturity equates the present value of the payments from an asset
with the asset’s price today. Calculating yields to maturity for alternative
investments allows savers to compare different types of debt instruments.
C.
Yields to Maturity on Other Debt Instruments
For both simple loans and discount bonds, the
yield to maturity is the interest rate that makes the lender indifferent between
having the amount of the loan today or the final payment at maturity.
Calculating the yield to maturity for a fixed-payment loan is similar to
calculating the yield to maturity for a coupon bond. The yield-to-maturity is
the interest rate that ensures that the amount of the loan today equals the
present value of the loan payments.
The Inverse Relationship
Between Bond Prices and Bond Yields
A.
What Happens to Bond Prices When Interest Rates
Change?
Because the coupon is fixed once a bond is issued, a change in market interest
rates affects the present value of future payments and, therefore, affects the
price of the bond. Higher market interest rates reduce the price of existing
bonds, while lower market interest rates increase the prices of existing bonds.
B.
Bond Prices and Yields to Maturity Move in Opposite Directions
If a bond’s
yield to maturity increases, then the present value of the coupon payments and
the face value payment of the bond must decline, causing the price of the bond
to decline. The economic reasoning behind the inverse relationship between bond
prices and yields to maturity is that if interest rates rise, existing bonds
issued when interest rates were lower become less desirable to investors and the
prices of those bonds will fall.
basis point
bond
bond principal value
compound interest
coupon bond
coupon payment
discount rate
face value
fixed-payment loan
future value
internal rate of return (IRR)
maturity date
nominal interest rate
par value
present value
real interest rate
rule of 72
yield
Chapter 4
How to Build an Investment Portfolio
A.
The Determinants of Portfolio Choice
The determinants of portfolio choice include wealth, an asset’s expected
rate of return compared with the expected returns on other assets, an asset’s
degree of risk compared with the risk from investing in other assets, an asset’s
liquidity compared with the liquidity of other assets, and the cost of acquiring
information about the asset relative to the cost of acquiring information about
other assets.
An increase in wealth tends to
increase the demand for most financial assets. Demand for some assets,
such as CDs, stocks, and bonds, are likely to increase more, while other assets,
such as checking accounts, increase less. People choose to acquire assets with
higher expected rates of return. Investors need to consider possible returns and
the probability of those returns occurring when estimating expected returns.
Risk is the degree of uncertainty in the return of an asset.
Most investors are risk averse and will
choose to invest in a risky asset only if they are compensated by
receiving a higher return. As a result, there tends to be a trade-off between
risk and return. The greater an asset’s liquidity, the more desirable the asset
is to investors. Therefore, an investor will be willing to receive a lower
return on a liquid asset compared to an asset that is less liquid. Investors
find assets more desirable if they do not have to spend much time or money
acquiring information about them. All else equal, investors will accept a lower
return on an asset that has lower costs of acquiring information.
B.
Diversification
To reduce risk, investors typically buy multiple assets, such as shares
of stock issued by different companies. Diversification can eliminate
idiosyncratic risk, the risk associated with a particular asset. Much of the
remaining risk is market risk or systematic risk, which is common to all assets
of a certain type. Diversification cannot eliminate systematic risk.
1.
We need a definition of risk that focuses on the fact
that the outcomes of financial and economic decisions are almost always unknown
at the time the decisions are made.
2.
Risk is a measure of uncertainty about the future payoff
to an investment, measured over some time horizon and relative to a benchmark.
1.
Probability theory tells us that in considering any
uncertainty, the first thing we must do is list all the possible outcomes and
then figure out the chance of each one occurring.
2.
Probability is a measure of the likelihood that an event
will occur; it is always expressed as a number between 0 and 1, such that the
closer to 0 the less likely it is and the closer to 1 the more likely it is (if
it is 0 it is impossible, and if it is 1 it is certain).
3.
Investment payoffs are usually discussed in percentage
returns instead of in dollar amounts; this allows investors to compute the gain
or loss on the investment regardless of its size.
1.
Most of us have an intuitive sense for risk and its
measurement; the wider the range of outcomes the greater the risk.
2.
A financial instrument with no risk at all is a
risk-free investment or a risk-free asset; its future value is known with
certainty and its return is the risk-free rate of return.
3.
We can measure risk by measuring the spread among an
investment’s possible outcomes.
There are two measures that can be used:
a.
Variance and Standard Deviation
i.
The variance is defined as the average of the squared
deviations of the possible outcomes from their expected value, weighted by their
probabilities.
1.
Most people don’t like risk and will pay to avoid it;
most of us are risk averse.
2.
A risk-averse investor will always prefer an investment
with a certain return to one with the same expected return but which has any
amount of uncertainty.
3.
Buying insurance is paying someone to take our risks, so
if someone wants us to take on risk we must be paid to do so.
4.
The riskier an investment—the higher the compensation
that investors require for holding it—the higher the risk premium.
1.
Risk is everywhere. It comes in many forms and from
almost every imaginable place.
2.
Regardless of the source, risks can be classified as
either idiosyncratic or systematic.
3.
Idiosyncratic, or unique, risks affect only a small
number of people.
4.
Systematic risks affect everyone.
a.
A good way to think of this is that while idiosyncratic
risk represents a change in the share of a pie (for an industry, for example),
systematic risk is a change in the size of the entire pie.
5.
Idiosyncratic risks come in two types; in the first,
some firms are affected one way and others are affected in the opposite way, and
in the second risks are completely independent.
6.
In the context of the entire economy, higher oil prices
would be an idiosyncratic risk (and is an example of a risk that can affect
different firms in opposing ways) and changes in general economic conditions
would be systematic risk.
1.
Risk can be reduced through diversification, the
principle of holding more than one risk at a time.
2.
Holding several different investments reduces the
overall risk that an investor bears.
3.
A combination of risky investments is often less risky
than any one individual investment.
4.
There are two ways to diversify your investments:
you can hedge risks or you can spread them among the many investments.
average
benchmark
diversification
expected return
expected value
hedging
idiosyncratic risk
leverage
mean
payoff
probability
risk
risk-free asset
risk-free rate
risk premium
spreading risk
standard deviation
systematic risk
value at risk (VaR)
variance
Graphs, graphs, and more graphs. Must be at least one graphing problem. Do not commit any silly 202 mistakes.
Chapter 6
Market Interest Rates and the Demand and Supply for Bonds
Use a demand and supply
model to determine market interest rates for bonds.
A.
A Demand and Supply Graph of the Bond Market
The demand curve for bonds
represents the relationship between the price of bonds and the quantity of bonds
demanded by investors, holding constant all other factors. As the price of bonds
increases, the interest rate on the bonds falls and bonds become less desirable
to investors, so the quantity demanded will
decline, resulting in a downward-sloping demand curve. The supply curve
represents the relationship between
the supply of bonds and quantity of bonds supplied
by investors who own existing bonds and
by firms that are considering issuing new bonds. As the price of bonds
increases, the interest rate on the bonds
falls and holders of existing bonds
will be more inclined to sell them, resulting in an upward-sloping supply
curve. An excess supply of bonds leads to a lower bond price and, therefore, a
higher interest rate, whereas an excess demand for bonds leads to a higher bond
price and a lower interest rate.
B.
Explaining Changes in Equilibrium Interest Rates
Along a given demand or supply
curve for bonds we hold constant everything that could affect the willingness of
investors to buy bonds, or firms and investors to sell bonds, except for the
price of bonds. If any other relevant variable—such as wealth or the expected
rate of inflation—changes, then the demand (or supply) curve shifts and we have
a change in demand (or supply).
C.
Factors that Shift the Demand Curve for Bonds
An increase in wealth increases the demand for bonds. If the expected return on bonds rises, relative to expected returns on other assets, then investors will increase their demand for bonds and the demand curve for bonds will shift to the right. If expected inflation increases, the expected real interest rate will decline, reducing the demand for bonds. An increase in the risk of bonds, relative to the riskiness of other assets, decreases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the left. If the liquidity of bonds increases, investors demand more bonds at any given price and the demand curve for bonds shifts to the right. Lower information costs for bonds causes the demand curve for bonds to shift to the right.
D.
Factors That Shift the Supply Curve for Bonds
An increase in firms’ expectations of the profitability of investments in physical capital will, holding all other factors constant, shift the supply curve for bonds to the right as firms seek to finance new investment. When the government raises business taxes, the profits firms earn on new investments in physical capital decline and firms will issue fewer bonds, causing the supply curve for bonds to shift to the left. An increase in the expected inflation rate results in a decline in the real interest rate for any given nominal interest rate, causing the supply curve for bonds to shift to the right. If the government runs a larger budget deficit, it will need to issue more bonds, causing the supply curve for bonds to shift to the right. If the government runs a deficit, households may save more in anticipation of higher future tax payments, causing the demand curve for bonds to shift to the right. However, studies indicate that households do not increase their saving by the full amount of the budget deficit; therefore, all else equal, bond prices are likely to decline and interest rates increase.
Explaining Changes in Interest Rates
Use the bond market model to
explain changes in interest rates.
Why Do Interest Rates Fall During
Recessions?
Do Changes in Expected Inflation Affect Interest Rates?
Do increases in the government deficit affect interest rates?
The Loanable Funds Model and the International Capital Market
I did not use this model, but you are welcome to use it if you are more comfortable. Just be sure to label everything correctly.
Bondholders face three major risks:
1.
There is no guarantee that a bond issue will make the
promised payments.
2.
Investors who are risk averse require some compensation
for bearing risk; the more risk, the more compensation they demand.
3.
The higher the default risk the higher the probability
that bondholders will not receive the promised payments and thus, the higher the
yield.
1.
Bonds promise to make fixed-dollar payments, and
bondholders are concerned about the purchasing power of those payments.
2.
The nominal interest rate will be equal to the real
interest rate plus the expected inflation rate plus the compensation for
inflation risk.
3.
The greater the inflation risk, the larger will be the
compensation for it.
1.
Interest-rate risk arises from the fact that investors
don’t know the holding period yield of a long-term bond.
2.
If you have a short investment horizon and buy a
long-term bond you will have to sell it before it matures, and so you must worry
about what happens if interest rates change.
3.
Because the price of long-term bonds can change
dramatically, this can be an important source of risk.
capital gain
capital loss
consol (or perpetuity)
current yield
default risk
holding period return
inflation risk
inflation-indexed bonds
interest-rate risk
investment horizon
stripped bond
tax incentive
yield to maturity
zero-coupon bond
Chapter 7
The Risk Structure of Interest Rates i.e. The 2 graph framework
Explain why bonds with the
same maturity can have different interest rates.
A.
Default Risk
Default risk is the risk that the bond
issuer will fail to make payments of interest and principal.
Bonds with higher default risk pay
higher interest rates. The default risk premium on a bond is the difference
between the interest rate on the bond and the interest rate on a Treasury bond
with the same maturity. An increased perceived risk of default leads to a
decline in the demand for a bond, resulting in a lower price and a higher
interest rate. During recessions, investors seek safety, leading to an increase
in the demand for U.S. Treasury bonds and a decrease in the demand for corporate
bonds, resulting in a higher risk premium for corporate bonds.
B.
Liquidity and Information Costs
An increase
in a bond’s liquidity or a decrease in the cost of acquiring information about
the bond will increase the demand for the bond, resulting in a higher price and
a lower interest rate.
C.
Tax Treatment
Investors
care about the after-tax return on their investments; that is, the return the
investors have left after paying their taxes. Other things equal, a bond with
coupons that are not subject to taxes has a lower interest rate than a bond with
taxable coupons. The coupons on municipal bonds are typically not subject to
federal, state, or local taxes. The coupons on Treasury bonds are subject to
federal tax, but not to state or local taxes. The coupons on corporate bonds can
be subject to federal, state, and local taxes.
The Term Structure of Interest Rates
Explain why bonds with
different maturities can have different interest rates.
A.
Explaining the Term Structure
One way to
analyze the term structure is by looking at the Treasury yield curve, which is
the relationship on a particular day among
the interest rates on Treasury bonds of different maturities. Any
explanation of the term structure should be able to account for three important
facts:
1.
Interest rates on long-term bonds are usually higher than interest rates
on short-term bonds.
2.
Interest rates on short-term bonds
are occasionally higher than interest rates on long-term bonds.
3. Interest rates on bonds of all
maturities tend to rise and fall together.
B.
The
Expectations Theory of the Term Structure
The expectations theory holds that the interest rate on a long-term bond
is an average of the interest rates investors expect on short-term bonds
over the lifetime of the long-term bond. According to the expectations theory,
investors view bonds of different maturities as being perfect substitutes.
Because interest rates on long-term bonds
are usually higher than interest rates on short-term bonds, the expectations
theory implies that future short-term rates are typically expected to rise at
any particular point in time, which is unrealistic.
C.
The Segmented Markets Theory of the Term
Structure
The segmented markets theory assumes bonds with different maturities are in
separate markets.
Factors that affect the demand for Treasury bills or other short-term bonds will
have no effect on the demand for Treasury bonds or other long-term bonds.
Because long-term bonds carry higher interest-rate risk and tend to be less
liquid, investors need to be compensated by receiving higher interest rates on
long-term bonds than on short-term bonds. The segmented markets theory fails to
explain why short-term interest rates are sometimes higher than long-term
interest rates as well as why interest rates tend to move together.
D.
The Liquidity Premium Theory
The liquidity premium theory (also known as the preferred habitat theory) holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium that increases in value the longer the maturity of the bond.
E.
Can The Term Structure Predict Recessions?
The slope of the yield curve
shows the short-term interest rates that bond market participants expect in the
future. If fluctuations in expected real interest rates are small, the yield
curve contains expectations of future inflation rates. The yield curve can also
indicate likely future economic activity. With only one exception, every time
the yield on the 3-month bill was higher than the yield on the 10-year note, a
recession followed within a year.
benchmark bond
commercial paper
expectations hypothesis of the term structure
fallen angel
flight to quality
high grade bond
interest-rate spread
inverted yield curve
investment grade bond
junk bond
liquidity premium theory of the term structure
municipal bonds
prime-grade commercial paper
rating
ratings downgrade
ratings upgrade
risk spread
risk structure of interest rates
spread over Treasuries
tax-exempt bond
taxable bond
term Structure of Interest Rates
term Spread
yield curve