Summary
1. The theory of asset demand tells us that the quantity demanded of an asset is (a)positively related to wealth, (b)positively related to the expected return on the asset relative to alternative assets, (c)negatively related to the riskiness of the asset relative to alternative assets, and (d)positively related to the liquidity of the asset relative to alternative assets.
2. The supply and demand analysis for bonds provides one theory of how interest rates are determined. It predicts that interest rates will change when there is a Chang in demand because of changes in income (or wealth), expected returns, risk, or liquidity or when there is a change in supply because of changes in the attractiveness of investment opportunities, the real cost of borrowing, or the government budget.
3. An alternative theory of how interest rates are determined is provided by the liquidity preference framework, which analyzes the supply of and demand for money. It shows that interest rates will change when there is a change in the demand for money because of changes in income or the price level or when there is a change in the supply of money.
4. There are four possible effects of an increase in the money supply on interest rates: the liquidity effect, the income effect, the price-level effect, and the expected-inflation effect. The liquidity effect indicates that a rise in money supply growth will lead to a decline in interest rates; the other effects work in the opposite direction. The evidence seems to indicate that the income, price-level, and expected-inflation effects dominate the liquidity effect such that an increase in money supply growth lead to higher - rather than lower- interest rates.
-The interest rates are negatively related to the price of bonds, so if we can explain why bond price change, we can also explain why interest rates fluctuate.
I) Determinants of Asset Demand
Buying an asset, must consider:
-Wealth: total resources owned by the individual
-Expected return: on one asset relative to another
-Risk: the degree of uncertainty
-Liquidity: the ease and speed an asset can be turned into cash.
1. Wealth
-When wealth increase, more resources to buy assets.
-Holding everything else constant, an increase in wealth raises the quantity demanded of an asset.
2. Expected Return
-Measures how much we gain from holding an asset
-An incrase in an asset's expected return relative to that of another --> raises the quantity demanded of the asset.
3. Risk
-If an asset's risk rises --> its quantity demanded will fall
4. Liquidity
-An asset is liquid if the market it is traded has many buyers and sellers.
The more liquid an asset is, the more desirable it is, the higher the quantity demanded.
5. Theory of asset demand
-The above factors assemble to the theory of asset demand
-States that, holding all other factors constant:
a. The quantity demanded of an asset is positively related to wealth
b. The quantity demanded of an asset is positively related to its expected return relative to alternative assets.
c. The quantity demanded of an asset is negatively related to the risk of its returns relative to others.
d. The quantity demanded of an asset is positively related to its liquidity relative to others.
II) Supply and Demand In the Bond Market
1. Demand curve - Expected return is equal to interest rate: i=R(e)=(F-P)/P
2. Supply curve
-An important assumption behind the supply and demand curves for bonds is that all other economic variables besides the bond's price and interest rate are held constant.
3. Market Equilibrium
-B(d)=B(s)
-Excess supply: people want to sell more than buy and the price of the bond will decrease
-Excess demand: people want to buy more than sell and price of the bond will increase
4. Supply and Demand Analysis
-An important feature of the analysis is that supply and demand are always in terms of stocks (amounts at a given time) instead of flows.
III) Changes in Equilibrium Interest Rates
-When quantity demanded changes as a result of a change in price --> movement along the demand curve.
-When D changes at a given price in response to a change in some factor besides the bond's price or interest rate --> shift in demand
1. Shifts in the demand for bonds
-Wealth:
*Increase in wealth --> increase in demand --> shift to the right
*Another factor that affects wealth is the propensity to save. If households save more, wealth increases, and demand for bonds rises --> demand to the right.
*As wealth increase, people demand more bonds at the same price.
-Expected returns
*For one year bonds, interest rate and expected return are the same so nothing besides today's interest rate affects the expected return.
*For bonds with maturities greater than one year, expected return may differ from interest rate.
*For example, a rise in interest rate on a long-term bond from 10%-20@ would lead to a sharp decline in price and a very large negative return.
*Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left.
*Changes in expected returns on other assets can affect demand for bonds - expect higher stock prices --> expected return on bonds today relative to stock would fall, lowering the demand for bonds --> demand curve to the left.
-Risk
*Prices more volatile --> risk increases --> bond less attractive --> demand to the left.
*Volatility of prices of other assets --> make bonds more attractive --> demand to the right.
-Liquidity
*Increased liquidity --> demand to the right
*Reduction of brokerage commissions
2. Shifts in the Supply of Bonds
-Expected Profitability of Investment Opportunities
*The more profitable investments that a firm expects it can make, the more willing it will be to borrow to finance these investments.
*In a business cycle expansion --> supply of bonds increases --> supply curve to the right.
-Expected inflation
*The real cost of borrowing is the real interest rate = nominal - inflation.
*When the expected inflation increases, the real cost of borrowing falls --> the quantity of bonds supplied increases at any given bond price.
*An increase in expected inflation causes the supply of bonds to increase and the supply to the right.
-Government Budget
*US Treasury issues bonds to finance deficits = revenues - expenditures.
*When deficits are large --> issue more bonds --> the supply of bonds to the right.
*Vs. govenment surpluses
IV) Changes in the Interest Rate due to Expected Inflation: The Fisher Effect
1. Expected inflation rises --> expected return falls --> demand to the left
2. Expected inflation rises --> the real cost of borrowing has declined --> supply to shift to the right.
3. Depending on the size of the shifts the quantity of bonds could rise or fall.
4. Fisher effect: when expected inflation rises, interest rate will rise.
V) Changes in the Interest Rate due to a Business Cycle Expansion
1. During expansion, national income increases, more profitable opportunities, higher supply of bonds --> supply to the right.
2. Expansion --> wealth increase --> demand to the right
3. Depending on the shifts, the new interest rate can either rise or fall.
VI) Explaining Low Japanese Interest Rates
1. Prolonged recession --> deflation --> negative inflation rate --> expected return on real assets fall --> expected return on bonds rise --> demand for bonds rise --> demand to the right.
2. Negative inflation --> raise real interest rate --> cost of borrowing increases --> supply to the left.
3. Rise in bond price and a fall in interest rates.
VII) Supply ad Demand in the Market for Money: The Liquidity Preference Framework
1. Alternative model by Keynes
2. Determines the Eq interest rate in terms of the supply and demand for money.
3. Closely related to the supply and demand framework of the bond market.
4. Two main assets for store of wealth: money and bonds --> total wealth in economy must equal the total quantity of bonds plus money in the economy --> B(s) + M(s) = B(d) + M(d) or B(s) - B(d) = M(d) - M(s)
5. If the money market is in eq, (Ms = Md) then bond market is also in eq (Bs = Bd).
6. Interest rate can be found by equating supply and demand for bonds or money.
7. Ignores any effects on interest rates that arise from changes in the expected returns on real assets.
8. Bond supply and demand framework is easier to use when analyzing changes in expected inflation
9. Liquidity preference framework easier to use with changes in income, price level, and supply of money.
10. Keynes have expected return equal to interest rate
11. As interest rate rises, expected return on money falls relative to the expected return on bonds --> money demand fall.
12. Money demand and interest rate are negatively correlated because of opportunity cost - the interest sacrificed by not holding a bond.
14. As interest rate on bonds rises, the opportunity cost of holding money rises --> money is less desirable --> money demand fall
15. Interest above eq -->excess money supply --> people holding more money than wanted --> buy bonds with excess money --> price of bonds increase --> interest rate fall until eq.
VIII) Changes in EQ Interest Rates in the Liquidity Preference Framework
1. Shifts in the Demand for Money
-In LPF, two factors cause the demand curve for money to shift: income and price level
-Income effect
*Income affect money demand because: 1. expansion --> wealth increases --> hold more money as a store of value. 2. hold more money to carry out transactions
*Income increases --> demand to the right.
-Price-Level effect
*Price level increases --> money not as valuable --> hold more money to restore money holdings in real terms to former level.
*A rise in price level --> demand to the right.
-Shifts in the supply of Money
*An increase in the money supply by the Fed will shift supply to the right.
IX) Changes in the EQ Interest Rate due to Changes in Income, Price Level, or Money Supply
1. LPF: When income is rising during an expansion, interest rates will rise.
2. Bond market: ambiguous.
3. When price level increase, interest rates will rise.
4. When money supply increases, interest rate will decline.
X). Money and Interest Rates
1. Increase in money supply will lower interest rates: increase money supply to lower interest rates.
-Income effect
*Increase money supply --> raise national income and wealth --> interest rates will rise
*The income effect of an increase in money supply is a rise in interest rates in response to the higher level of income.
-Price-level effect
*The price level effect from an increase in ms is a rise in interest in response to the rise in price level.
-Expected-Inflation effect
*A rise in interest due to rise in expected inflation rate
-Difference between price level and expected inflation effect - the price level effect remains even after prices have stopped rising, whereas the expected-inflation effect disappears.
-Expected-inflation effect will persis only as long as the price level continues to rise
XI) Does a Higher Rate of Growth of Money Supply Lower Interest Rates?
1. Liquidity effect indicate that money growth will cause a decline in interest rate; income, price-level, and expected-inflation effects indicate a rise in interest rates.
2. Liquidity effect is immediate, income and pl effect take time, expected-inflation can be slow or fast depending on whether people adjust their expectations slowly or quickly when ms increase.
3. Empirical evidence: increase ms --> increase in interest
Wednesday, October 31, 2007
Tuesday, October 30, 2007
Chapter 6: The Risk and Term Structure of Interest Rates
7). Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years:
a. 5, 6, 7, 6, 5 (%)
b. 5, 4, 3, 4, 5 (%)
9). If a yield curve looks like the one shown in figure (b) below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions about the inflation rate in the future?
Summary:
1. Bonds with the same maturity will have different interest rates because of three factors: default risk, liquidity, and tax considerations. The greater a bond's default risk, the higher its interest rate relative to other bonds; the greater a bond's liquidity, the lower the interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity that arise because of these three factors is known as the risk structure of interest rates.
2. Four theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond. By contrast, the segmented markets theory treats the determination of interest rates for each bond's maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually slope upward.
3. The liquidity premium and preferred habitat theories combine the features of the other two theories, and by so doing are able to explain the facts just mentioned. They view long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. These theories allow us to infer the market's expectations about the movement of future short-term interest rates from the yield curve. A steeply upward-sloping curve indicates that future short-term rates are expected to rise, a mildly upward-sloping curve indicates that short-term rates are expected to stay the same, a flat curve indicates that short-term rates are expected to decline slightly, and an inverted yield curve indicates that a substantial decline in short-term rates is expected in the future.
-Relationship of various interest rates to one another
-Different interest rates on same maturity --> Risk structure of interest rates
-Different interest rates on different maturity --> Term Structure of interest rates
Risk Structure of Interest Rates:
I). What contribute to the different interest rates?
1. Default Risk
-Risk of default when the issuer is unable to make interest payments or pay off bond.
-The diffference between interest rates of default risk and default-free bonds (both with same maturity) is risk premium --> how much more additional interest people should get to be willing to hold that risky bond.
-A bond with default risk always have a positive risk premium and an increase in its default risk will raise the risk premium.
-Credit-rating agencies: low risk (investment-grade >BBB), high risk (junk bonds
The Enron Bankruptcy and the Baa-Aaa Spread
-Investors doubt the health of corporations that are less than Baa. increase in interest rates. More people want Aaa bonds and led to big gap between Aaa and Baa.
2. Liquidity
-The more liquid, the more desirable.
-Liquidity affect interest rate: less liquid, demand decrease, price fall, and interest rates rise.
3. Income Tax Considerations
-The behavior of municipal bond rates which are not default-free and not as liquid as T-bills.
-Municipal bonds have less interest rates than T-bills because interest payments on municipal bonds are exempt from federal income taxes --> increase in expected return.
-T-bills: 1000 face-value with coupon payment 100 (r=10%), income tax 35% --> earn only 6.5%
-Municipal bonds: " " with coupon payment 80 (r=8%), income tax 0% --> earn 8%
-With tax advantage, expected return increases, higher demand, higher prices, lower interest rates.
Effects of Bush tax cut on Bond Interest Rates
-39% to 35%: a decrease in income tax rate means that the after-tax expected return on tax-free municipal bonds relative to the T-bills are lower --> municipal less desirable --> demand decrease, lower price and higher interest rates. T-bills more desirable --> demand increase, higher price, and lower interest rates.
II). Term structure of interest rates
-Another factor that influences interest rate is its term to maturity.
-A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations, is called a yield curve. It describes the term structure of interest rates for particular types of bonds, such as government bonds.
-Yield curve: upward, downward, or flat.
-Upward: the most usual; the long-term interest rates are above the short-term interest rates
-Flat: short- and long-term interest rates are the same.
-Downward: long-term interest rates are below short-term interest rates.
-Term structure must explain different shapes of yield curves and the following:
a. Interest rates on bonds of different maturities move together over time
b. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward.
c. Yield curves almost always slope upward.
-Three theories to explain term structure of interest rates: expectations theory, segmented market theory, and the liquidity premium theory.
-ET explains 12 not 3, SMT explains 3 not 12, LPT 123.
1. Expectations Theory
-The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
-Example: average expected short-term interest rates the next 5 years= 10%, then interest rate on a five-year maturity bond=10%.
-Key assumption: buyers of bonds to not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity --> perfect substitutes --> expcected return on these bonds must be equal.
...137-138
-Expectations theory explains why the term structure of interest rates changes at different times. When yield curves is upward-sloping, the expectations theory suggests that short-term interest rates are expected to rise in the future. In this situation when the long-term rate is higher than the short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can only occur if short-term interest rates are expected to rise.
-Downward: short-term are expected to fall in the future.
-Also explains fact 1: historically, if short increase today, they are higher in future --> rise in short-term interest rates will raise people's expectations of future short-term rates --> raise in long-term rates --> short and long move together.
-Explains fact 2: when short are low, people expect them to rise to normal level in future --> avg of future expected short is higher than current short rate--> upward sloping
-Does not explain fact 3, suggests that yield curve should be flat.
2. Segmented Markets Theory
-Different maturity bonds have different markets
-Interest rate determined by the supply and demand of that bond independent of other bonds.
-Key assumption: bonds of different maturities are not substitutes so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity.
-Investors have strong preferences for particular maturities.
-Investors have short desired holding periods --> demand for long is lower than short --> long have lower prices and higher interest rates --> upward sloping --> fact 3.
-Cannot explain why interest rates on bonds of different maturities tend to move together (fact 1).
-Not clear on how demand and supply for short vs. long change with short rate (fact 2).
3. Liquidity Premium and Preferred Habitat Theories
-The rate on a long will equal an average of short expected to occur over the life of long plus a liquidity premium that responds to supply and demand for the bond.
-Key assumption: bonds of different maturities are substitutes, but it allows investors to prefer one maturity over another --> substitutes but not perfect substitutes.
-Prefer short bonds so investors must offer a positive liquidity premium to induce them to hold long bonds.
-Preferred habitat theory: related to liquid premium theory
*Investors have preference for maturity: only buy different maturity if have higher expected return.
a. 5, 6, 7, 6, 5 (%)
b. 5, 4, 3, 4, 5 (%)
9). If a yield curve looks like the one shown in figure (b) below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions about the inflation rate in the future?
Summary:
1. Bonds with the same maturity will have different interest rates because of three factors: default risk, liquidity, and tax considerations. The greater a bond's default risk, the higher its interest rate relative to other bonds; the greater a bond's liquidity, the lower the interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity that arise because of these three factors is known as the risk structure of interest rates.
2. Four theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond. By contrast, the segmented markets theory treats the determination of interest rates for each bond's maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually slope upward.
3. The liquidity premium and preferred habitat theories combine the features of the other two theories, and by so doing are able to explain the facts just mentioned. They view long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. These theories allow us to infer the market's expectations about the movement of future short-term interest rates from the yield curve. A steeply upward-sloping curve indicates that future short-term rates are expected to rise, a mildly upward-sloping curve indicates that short-term rates are expected to stay the same, a flat curve indicates that short-term rates are expected to decline slightly, and an inverted yield curve indicates that a substantial decline in short-term rates is expected in the future.
-Relationship of various interest rates to one another
-Different interest rates on same maturity --> Risk structure of interest rates
-Different interest rates on different maturity --> Term Structure of interest rates
Risk Structure of Interest Rates:
I). What contribute to the different interest rates?
1. Default Risk
-Risk of default when the issuer is unable to make interest payments or pay off bond.
-The diffference between interest rates of default risk and default-free bonds (both with same maturity) is risk premium --> how much more additional interest people should get to be willing to hold that risky bond.
-A bond with default risk always have a positive risk premium and an increase in its default risk will raise the risk premium.
-Credit-rating agencies: low risk (investment-grade >BBB), high risk (junk bonds
The Enron Bankruptcy and the Baa-Aaa Spread
-Investors doubt the health of corporations that are less than Baa. increase in interest rates. More people want Aaa bonds and led to big gap between Aaa and Baa.
2. Liquidity
-The more liquid, the more desirable.
-Liquidity affect interest rate: less liquid, demand decrease, price fall, and interest rates rise.
3. Income Tax Considerations
-The behavior of municipal bond rates which are not default-free and not as liquid as T-bills.
-Municipal bonds have less interest rates than T-bills because interest payments on municipal bonds are exempt from federal income taxes --> increase in expected return.
-T-bills: 1000 face-value with coupon payment 100 (r=10%), income tax 35% --> earn only 6.5%
-Municipal bonds: " " with coupon payment 80 (r=8%), income tax 0% --> earn 8%
-With tax advantage, expected return increases, higher demand, higher prices, lower interest rates.
Effects of Bush tax cut on Bond Interest Rates
-39% to 35%: a decrease in income tax rate means that the after-tax expected return on tax-free municipal bonds relative to the T-bills are lower --> municipal less desirable --> demand decrease, lower price and higher interest rates. T-bills more desirable --> demand increase, higher price, and lower interest rates.
II). Term structure of interest rates
-Another factor that influences interest rate is its term to maturity.
-A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations, is called a yield curve. It describes the term structure of interest rates for particular types of bonds, such as government bonds.
-Yield curve: upward, downward, or flat.
-Upward: the most usual; the long-term interest rates are above the short-term interest rates
-Flat: short- and long-term interest rates are the same.
-Downward: long-term interest rates are below short-term interest rates.
-Term structure must explain different shapes of yield curves and the following:
a. Interest rates on bonds of different maturities move together over time
b. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward.
c. Yield curves almost always slope upward.
-Three theories to explain term structure of interest rates: expectations theory, segmented market theory, and the liquidity premium theory.
-ET explains 12 not 3, SMT explains 3 not 12, LPT 123.
1. Expectations Theory
-The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
-Example: average expected short-term interest rates the next 5 years= 10%, then interest rate on a five-year maturity bond=10%.
-Key assumption: buyers of bonds to not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity --> perfect substitutes --> expcected return on these bonds must be equal.
...137-138
-Expectations theory explains why the term structure of interest rates changes at different times. When yield curves is upward-sloping, the expectations theory suggests that short-term interest rates are expected to rise in the future. In this situation when the long-term rate is higher than the short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can only occur if short-term interest rates are expected to rise.
-Downward: short-term are expected to fall in the future.
-Also explains fact 1: historically, if short increase today, they are higher in future --> rise in short-term interest rates will raise people's expectations of future short-term rates --> raise in long-term rates --> short and long move together.
-Explains fact 2: when short are low, people expect them to rise to normal level in future --> avg of future expected short is higher than current short rate--> upward sloping
-Does not explain fact 3, suggests that yield curve should be flat.
2. Segmented Markets Theory
-Different maturity bonds have different markets
-Interest rate determined by the supply and demand of that bond independent of other bonds.
-Key assumption: bonds of different maturities are not substitutes so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity.
-Investors have strong preferences for particular maturities.
-Investors have short desired holding periods --> demand for long is lower than short --> long have lower prices and higher interest rates --> upward sloping --> fact 3.
-Cannot explain why interest rates on bonds of different maturities tend to move together (fact 1).
-Not clear on how demand and supply for short vs. long change with short rate (fact 2).
3. Liquidity Premium and Preferred Habitat Theories
-The rate on a long will equal an average of short expected to occur over the life of long plus a liquidity premium that responds to supply and demand for the bond.
-Key assumption: bonds of different maturities are substitutes, but it allows investors to prefer one maturity over another --> substitutes but not perfect substitutes.
-Prefer short bonds so investors must offer a positive liquidity premium to induce them to hold long bonds.
-Preferred habitat theory: related to liquid premium theory
*Investors have preference for maturity: only buy different maturity if have higher expected return.
Saturday, October 13, 2007
Chapter 4: Understanding Interest Rates
Summary
1. The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that equates the present value of future payments of a debt instrument with its value today. Application of this principle reveals that bond prices and interest rates are negatively related: when the interest rate rises, the price of the bond must fall, and vice versa.
2. Two less accurate measures of interest rates are commonly used to quote interest rates on coupon and discount bonds. The current yield, which equals the coupon payment divided by the price of a coupon bond, is a less accurate measure of the yield to maturity the shorter the maturity of the bond. The yield on a discount basis (also called the discount yield) understates the yield to maturity on a discount bond, and the understatement worsens with the distance from maturity of the discount security. Even though these measures are misleading guides to the size of the interest rate, a change in them always signals a change in the same direction for the yield to maturity.
3. The return on a security, which tells you how well you have done by holding this security over a stated period of time, can differ substantially from the interest rate as measured by the yield to maturity. Long-term bond prices have substantial fluctuations when interest rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large, which is why long-term bonds are not considered to be safe assets with a sure return.
4. The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is a better measure of the incentives to borrow and lend than the nominal interest rate, and it is a more accurate indicator of the tightness of credit market conditions than the nominal interest rate.
-The ytm is an accurate measurement of interest rates. ytm=interest rate
I)Measuring Interest Rate
1. Present Value
-Present discounted value: a dollar paid to you one year later is less valuable than a dollar paid today
-The process of calculating today's value of dollars received in the future --> discounting the future --> PV=CF/(1+i)^n; CF = cash flow payment
2. Four types of Credit Market Instruments
-Simple loan: repaid to lender at maturity date along with interest
*Commercial loans to business
-Fixed-payment loan: repaid by making the same payment every period, consisting of part of the principal and interest for a number of years.
*Ex. borrowed 1000, require to pay 126 every year for 25 years.
*Installment loans, mortgages
-Coupon bond: pays a fixed interest payment (coupon payment) until maturity date when a specified final amount (face value) is repaid.
*Ex. FV=1000, pay a coupon payment of 100/yr for ten years and at maturity date, pay 1000.
*Identified by three info: issuer, maturity date, coupon rate.
*US Treasury bonds and notes, corporate bonds
-Discount bond: bought at a price below face value and face value is repaid at maturity.
*No interest payments
*T-bills, US saving bonds, long-term 0-coupon bonds
-Require payments at different times: Simple loans and discount bonds may payment only at maturity dates; fixed payment and coupon bonds have periodic payments.
-For simple loans, simple interest rate equals the ytm.
-Table 1
*When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
*The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the bond falls. As the yield to maturity falls, the price of the bond rises.
*The yield to maturity is greater than the coupon rate when the bond price is below its face value.
-Consol or perpetual bond: no maturity date and no repayment of principal; makes fixed coupon payments forever.
-Long-term coupon bonds (>20 yrs), acts like perpetual bonds because cash flow in the far future have very small present value.
-Current bond prices and interest rates are negatively correlated: when interest rate rises, the price of bond falls.
II) Yield on a Discount Basis
1. Yield to maturity is hard to calculate
2. Alternative method: yield on a discount basis.
3. It uses the % gain on the face value of the bill (F-P)/F rather than the % gain on the purchase of the bill (F-P)/P.
4. It puts the yield on an annual basis 360 days.
5. Understates interest rate: year; #3 above.
-Always understate the yield to maturity and this becomes more severe the longer the maturity of the discount bond.
6. It is negatively related to the price of the bond just like ytm.
7. DB and ytm always move together
III) Distinction between interest rates and returns
1. How well a person does by holding a bond --> return
2. Rate of return = payments to the owner plus the change in its value, expressed as a fraction of its purchase price.
3. The return on a bond will not necessarily equal the yield to maturity on that bond.
4. Table 2
-The only bond whose return equals the initial ytm is one whose time to maturity is the same as the holding period (last bond in table 2)
-A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period.
-The more distant a bond's maturity, the greater the size of the percentage price change associated with an interest-rate change.
-The more distant a bond's maturity, the lower the rate of return that occurs as a result of the increase in the the interest rate.
-Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise.
5. Maturity and the Volatility of Bond Returns: Interest Rate Risk
-Prices and returns for long-term bonds are more volatile than those for short-term bonds.
IV) The Distinction Between Real and Nominal Interest Rates
1. When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
2. Returns vs. real returns
1. The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that equates the present value of future payments of a debt instrument with its value today. Application of this principle reveals that bond prices and interest rates are negatively related: when the interest rate rises, the price of the bond must fall, and vice versa.
2. Two less accurate measures of interest rates are commonly used to quote interest rates on coupon and discount bonds. The current yield, which equals the coupon payment divided by the price of a coupon bond, is a less accurate measure of the yield to maturity the shorter the maturity of the bond. The yield on a discount basis (also called the discount yield) understates the yield to maturity on a discount bond, and the understatement worsens with the distance from maturity of the discount security. Even though these measures are misleading guides to the size of the interest rate, a change in them always signals a change in the same direction for the yield to maturity.
3. The return on a security, which tells you how well you have done by holding this security over a stated period of time, can differ substantially from the interest rate as measured by the yield to maturity. Long-term bond prices have substantial fluctuations when interest rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large, which is why long-term bonds are not considered to be safe assets with a sure return.
4. The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is a better measure of the incentives to borrow and lend than the nominal interest rate, and it is a more accurate indicator of the tightness of credit market conditions than the nominal interest rate.
-The ytm is an accurate measurement of interest rates. ytm=interest rate
I)Measuring Interest Rate
1. Present Value
-Present discounted value: a dollar paid to you one year later is less valuable than a dollar paid today
-The process of calculating today's value of dollars received in the future --> discounting the future --> PV=CF/(1+i)^n; CF = cash flow payment
2. Four types of Credit Market Instruments
-Simple loan: repaid to lender at maturity date along with interest
*Commercial loans to business
-Fixed-payment loan: repaid by making the same payment every period, consisting of part of the principal and interest for a number of years.
*Ex. borrowed 1000, require to pay 126 every year for 25 years.
*Installment loans, mortgages
-Coupon bond: pays a fixed interest payment (coupon payment) until maturity date when a specified final amount (face value) is repaid.
*Ex. FV=1000, pay a coupon payment of 100/yr for ten years and at maturity date, pay 1000.
*Identified by three info: issuer, maturity date, coupon rate.
*US Treasury bonds and notes, corporate bonds
-Discount bond: bought at a price below face value and face value is repaid at maturity.
*No interest payments
*T-bills, US saving bonds, long-term 0-coupon bonds
-Require payments at different times: Simple loans and discount bonds may payment only at maturity dates; fixed payment and coupon bonds have periodic payments.
-For simple loans, simple interest rate equals the ytm.
-Table 1
*When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
*The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the bond falls. As the yield to maturity falls, the price of the bond rises.
*The yield to maturity is greater than the coupon rate when the bond price is below its face value.
-Consol or perpetual bond: no maturity date and no repayment of principal; makes fixed coupon payments forever.
-Long-term coupon bonds (>20 yrs), acts like perpetual bonds because cash flow in the far future have very small present value.
-Current bond prices and interest rates are negatively correlated: when interest rate rises, the price of bond falls.
II) Yield on a Discount Basis
1. Yield to maturity is hard to calculate
2. Alternative method: yield on a discount basis.
3. It uses the % gain on the face value of the bill (F-P)/F rather than the % gain on the purchase of the bill (F-P)/P.
4. It puts the yield on an annual basis 360 days.
5. Understates interest rate: year; #3 above.
-Always understate the yield to maturity and this becomes more severe the longer the maturity of the discount bond.
6. It is negatively related to the price of the bond just like ytm.
7. DB and ytm always move together
III) Distinction between interest rates and returns
1. How well a person does by holding a bond --> return
2. Rate of return = payments to the owner plus the change in its value, expressed as a fraction of its purchase price.
3. The return on a bond will not necessarily equal the yield to maturity on that bond.
4. Table 2
-The only bond whose return equals the initial ytm is one whose time to maturity is the same as the holding period (last bond in table 2)
-A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period.
-The more distant a bond's maturity, the greater the size of the percentage price change associated with an interest-rate change.
-The more distant a bond's maturity, the lower the rate of return that occurs as a result of the increase in the the interest rate.
-Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise.
5. Maturity and the Volatility of Bond Returns: Interest Rate Risk
-Prices and returns for long-term bonds are more volatile than those for short-term bonds.
IV) The Distinction Between Real and Nominal Interest Rates
1. When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
2. Returns vs. real returns
Chapter 3: What is Money?
Summary
1. To economists, the word money has different meaning from income or wealth. Money is anything that is generally accepted as payment for goods or services or in the repayment of debts.
2. Money serves three primary functions: as a medium of exchange, as a unit of account, and as a store of value. Money as a medium of exchange avoids the problem of double coincidence of wants that arises in a barter economy, and thus lowers transaction costs and encouraging specialization and the division of labor. Money as a unit of account reduces the number of prices needed in the economy, which also reduces transaction costs. Money also functions as a store of value, but performs this role poorly if it is rapidly losing value due to inflation.
3. The payments system has evolved over time. Until several hundred years ago, the payments system in all but the most primitive societies was based primarily on precious metals. The introduction of paper currency lowered the cost of transporting money. The enxt major advance was the introductino of checks, which lowered transcation costs still further. We are currently moving toward an electronic payments system in which paper is eliminated and all transactions are handled by computers. Despite the potential efficiency of such a system, obstacles are slowing the movement to the checkless society and the development of new forms of electronic money.
4. The Federal Reserve System has defined two different measures of the money sypply - M1 and M2. These measures are not equivalent and do not always move together, so they cannot be used interchangeably by policymakers. Obtaining the precise, correct measure of money does seem to matter and has implications for the conduct of monetary policy.
5. Another problem in the measurement of money is that the data are not always as accurate as we would like. Substantial revisions in the data do occur; they indicate that initially released money data are not a reliable guide to short-run movements in the money supply, although they are more reliable over longer periods of time, such as a year.
Meaning of money
1. Economists define money as anything that is generally accepted in payment for goods or services or in the repayment of debts.
2. Currency, paper money and coins, is one type of money.
3. Wealth, income and money are different things. Income is a flow of earnings and money is a stock.
Functions of money
I). Medium of exchange
1. used to pay for goods and services
2. barter economic: goods and services are exchanged directly for other goods and services.
- has transaction cost: high because people have to satisfy a "double coincidence of wants"
3. money lower transaction cost and encourage specialization and the division of labor.
4. effective money: easily standardized, making it simple to ascertain its value; widely accepted; divisible, so to "make change"; easy to carry; not deteriorate quickly.
II). Unit of Account
1. unit of account: used to measure value in the economy
III). Store of Value
1. used to save purchasing power from the time income is received until the time it is spent.
2. money not unique to store of value; any asset can be used to store wealth.
3. other assets have more benefits than money as store of value but we still use money because it is extremely liquid.
4. money is the most liquid asset because it is the medium of exchange; other assets have transaction costs when converting into money.
5. how good money is as a store of value depends on the price level.
Evolution of the payments system
1. functions of money and the forms it has taken over time
2. payments system: method of conduction transactions in the economy.
I). Commodity money
1. commodity money: money made up of precious metals or valuable items
2. hard to transport
II). Fiat money
1. paper currency: backed by governments but not convertible into precious metals.
2. easy to carry but only works if there is trust in government
3. can be easily stolen --> invention of checks.
III). Checks
1. an instruction from you to your bank to transfer money from your account to another account.
2. reduces transaction costs; loss from theft reduced
3. takes time and money to process checks
IV). Electronic payments
1. substitutes checks
V). E-money
1. substitutes cash: debit card, smart card(computer chip loaded with digital cash from bank account), e-cash(used on internet to buy goods).
Measuring Money
1. money defined by people's behavior
I). The Fed's Monetary Aggregates
1. Monetary aggregates: measures of the money supply
2. M1: currency, traveler's checks, demand deposits, other checkable deposits
3. M2: M1, small-denomination time deposits, savings deposits and money market deposit accounts, money market mutual fund shares
How reliable are the money data?
1. should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements.
1. To economists, the word money has different meaning from income or wealth. Money is anything that is generally accepted as payment for goods or services or in the repayment of debts.
2. Money serves three primary functions: as a medium of exchange, as a unit of account, and as a store of value. Money as a medium of exchange avoids the problem of double coincidence of wants that arises in a barter economy, and thus lowers transaction costs and encouraging specialization and the division of labor. Money as a unit of account reduces the number of prices needed in the economy, which also reduces transaction costs. Money also functions as a store of value, but performs this role poorly if it is rapidly losing value due to inflation.
3. The payments system has evolved over time. Until several hundred years ago, the payments system in all but the most primitive societies was based primarily on precious metals. The introduction of paper currency lowered the cost of transporting money. The enxt major advance was the introductino of checks, which lowered transcation costs still further. We are currently moving toward an electronic payments system in which paper is eliminated and all transactions are handled by computers. Despite the potential efficiency of such a system, obstacles are slowing the movement to the checkless society and the development of new forms of electronic money.
4. The Federal Reserve System has defined two different measures of the money sypply - M1 and M2. These measures are not equivalent and do not always move together, so they cannot be used interchangeably by policymakers. Obtaining the precise, correct measure of money does seem to matter and has implications for the conduct of monetary policy.
5. Another problem in the measurement of money is that the data are not always as accurate as we would like. Substantial revisions in the data do occur; they indicate that initially released money data are not a reliable guide to short-run movements in the money supply, although they are more reliable over longer periods of time, such as a year.
Meaning of money
1. Economists define money as anything that is generally accepted in payment for goods or services or in the repayment of debts.
2. Currency, paper money and coins, is one type of money.
3. Wealth, income and money are different things. Income is a flow of earnings and money is a stock.
Functions of money
I). Medium of exchange
1. used to pay for goods and services
2. barter economic: goods and services are exchanged directly for other goods and services.
- has transaction cost: high because people have to satisfy a "double coincidence of wants"
3. money lower transaction cost and encourage specialization and the division of labor.
4. effective money: easily standardized, making it simple to ascertain its value; widely accepted; divisible, so to "make change"; easy to carry; not deteriorate quickly.
II). Unit of Account
1. unit of account: used to measure value in the economy
III). Store of Value
1. used to save purchasing power from the time income is received until the time it is spent.
2. money not unique to store of value; any asset can be used to store wealth.
3. other assets have more benefits than money as store of value but we still use money because it is extremely liquid.
4. money is the most liquid asset because it is the medium of exchange; other assets have transaction costs when converting into money.
5. how good money is as a store of value depends on the price level.
Evolution of the payments system
1. functions of money and the forms it has taken over time
2. payments system: method of conduction transactions in the economy.
I). Commodity money
1. commodity money: money made up of precious metals or valuable items
2. hard to transport
II). Fiat money
1. paper currency: backed by governments but not convertible into precious metals.
2. easy to carry but only works if there is trust in government
3. can be easily stolen --> invention of checks.
III). Checks
1. an instruction from you to your bank to transfer money from your account to another account.
2. reduces transaction costs; loss from theft reduced
3. takes time and money to process checks
IV). Electronic payments
1. substitutes checks
V). E-money
1. substitutes cash: debit card, smart card(computer chip loaded with digital cash from bank account), e-cash(used on internet to buy goods).
Measuring Money
1. money defined by people's behavior
I). The Fed's Monetary Aggregates
1. Monetary aggregates: measures of the money supply
2. M1: currency, traveler's checks, demand deposits, other checkable deposits
3. M2: M1, small-denomination time deposits, savings deposits and money market deposit accounts, money market mutual fund shares
How reliable are the money data?
1. should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements.
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