Macro Lecture 5: Financial Assets

Transcription

1 Macro Lecture 5: Financial Assets Financial Assets and Rates of Return Table 5.1 reports on the recent nominal rates of return for selected financial assets: Cash 0% Checking Accounts.01% Savings Accounts.03% Certificates of Deposit (CD).12% Government Bonds: T-bills.11% Corporate Bonds: Aaa 4.2% Corporate Bonds: Baa 4.8% Apple Stock (2012) 33.5% From $58.75 to $78.43 Apple Stock (2013) 0.8% From $78.43 to $79.02 JC Penny (2013) 53.4% From $20.84 to $8.88 Table 5.1: Recent rates of return These differences can be largely explained by two factors: liquidity; risk. Rates of Return and Liquidity To explain why liquidity is important, focus on the rates of return earned by cash, checking accounts, savings accounts, and certificates of deposit: Rate of Return Cash 0% Checking Accounts.01% Savings Accounts.03% Certificates of Deposit (CDs).11% Liquidity refers to how easily you can gain access to your funds for the purpose of purchasing goods and services. Cash is completely liquid. We can use cash to purchase goods and services by simply handing over the dollar bills. Checking accounts are also completely liquid. We can use the balance in our checking accounts to purchase goods very easily - simply by writing a check. Savings accounts are almost as liquid. Until computer banking became available, we had to go the bank physically to withdraw savings account funds as cash or transfer savings account funds to a checking account before we could use the funds to purchase goods and services. Now, of course it is much easier. We can use a smart phone app to transfer funds from a savings account to a checking account and then simply write a check. Certificates of deposit are less liquid than savings accounts. Before its maturity date we cannot cash in a CD without paying a penalty. Key Point: To induce us to hold (or purchase ) less liquid assets we must be compensated. Less liquid assets must pay a higher rate of return to compensate us for their lack of liquidity.

2 2 Rates of Return and Risk To explain why risk is important, focus on two types of bonds: U.S. government bonds and corporate bonds: U.S. Government Bonds: Treasury bills (T-bills) Corporate Bonds: Aaa Corporate Bonds: Baa Rate of Return.11% 4.2% 4.8% The differences in these rates of return occur as a consequence of risk. Corporate Baa bonds are more risky than corporate Aaa bonds; corporate Aaa bonds are more risky than Treasury bills. But before we do this, we must explain precisely what a bond is. Bonds: Precisely what is a bond? In everyday language, a bond is simply an I Owe You (IOU). The lender gives the borrower some dollars today in exchange for an IOU. The IOU promises that in the future the borrower will repay the IOU (plus interest) to the lender. To summarize: Today: Lenders give borrowers dollars in exchange for IOUs. Future: Borrowers repay the IOUs (plus interest) to the lenders. Many different institutions issue bonds; corporations, local governments, state governments, and the federal government all issue bonds. The bond is a legally binding promise from the institution to pay the bond owner a specified number of dollars at specific dates in the future. If the institution cannot fulfill the promises it has made to bond holders, the bond holders can force the institution into bankruptcy. Borrower Borrower Dollars Today IOU Dollars Future IOU Figure 5.1 Dollars Today IOU Dollars Future IOU Lender Lender The future repayment pattern promised by the bond is Figure 5.2 specified, but the current price of the bond is not. The market determines the price today. To illustrate how the price is determined, we shall focus on one of the most straightforward type of bonds, a U.S. Treasury bill or T-bill for short. Bonds 1-Year Treasury Bill Question: Physically, what is a Treasury bill? Answer: Simply a piece of paper as suggested by figure 5.1. On this piece of paper the U.S. Treasury promises to pay the owner of the bond a specified number of dollars at one specific date in the future. U.S. Treasury promises to pay the owner $1,000 on November 2, 2016 Figure 5.3: U.S. Treasury bill

3 3 Question: Why does the U.S. Treasury issue Treasury bills? Answer: When the federal government runs a deficit, the Federal government s tax revenues do not cover Federal outlays. What does the U.S. Treasury do when this occurs? The Treasury does the same thing that you would do when this might happen to you; the Treasury borrows. How does the U.S. Treasury borrow? The Treasury borrows by issuing bonds. Treasury bills, T-bills, are an important type of bonds issued by the Treasury. Figure 5.2 depicts the sale and repayment of a 1-year T-bill. The U.S. Treasury sells a new 1-year T-bill to an individual today. The individual gives the U.S. Treasury some dollars today on the promise that that the U.S. Treasury will give the individual $1,000 one year from today. This is what we mean by borrowing, isn t it? When you borrow, you get something today on the promise that you will pay something back in the future. Similarly, when the U.S. Treasury sells a Treasury bill, it gets something today on the promise that it will pay something back in the future. The U.S. Treasury issues T-bills that mature at different times in the future: 91 days, 182 days, 1 year, 5 years, etc. U. S. Treasury 1-year Treasury Bill $x,xxx $1,000 IOU $10, $1,000 IOU Figure 5.4: 1-Year U.S. Treasury bill Today: Lenders (those who purchase the T-bills) give borrowers (the U.S. Treasury) dollars in exchange for IOUs (T-bills). Future: Borrowers (the U.S. Treasury) repay the IOU s (the T-bills) to the lenders (those who purchased the T-bills). Next, we will explain how today s price of a T-bill is determined. To keep the arithmetic simple, we will focus on a 1-year T-bill. Also, assume that the interest rate one a 1-year certificate of deposit is 10 percent. As you shall see, even with this assumption the calculations can become cumbersome. As far as liquidity is concerned, certificates of deposits (CD s) and T-bills are similar. To cash in a certificate of deposit prematurely, you must pay a penalty fee; similarly, to sell a T-bill before it matures, you must pay your broker a commission. Furthermore, both are similar in terms of risk; both are guaranteed by the Federal government. Since they are similar in terms of liquidity and risk, their rates of return should be about the same.

4 4 Current Price of a 1-Year Treasury Bill Issued Today If you purchased a 1-year Treasury bill issued today, you would receive $1,000 one year from today. What is the price of the T-bill today? To answer this question, consider two investment strategies that you could pursue today: Buy a 1-year Invest in a T-bill today 1-year CD today Question: When the interest rate is 10 percent how much would you have to invest in a certificate of deposit today in order to generate $1,000 one year from today? The answer is approximately $909. To see why, just do the arithmetic: Invest $909 in a 1-year CD today Costs: Today $909 Returns: One year from today $909 Principle 91 Interest = % = $1,000 Claim: When the interest rate is 10 percent the price of the T-bill today would equal $909. To understand why compare the two investment strategies: Buy a T-bill today versus Invest $909 in a certificate of deposit today. Note that each strategy generates the same return, $1,000 one year from today: Buy a 1-year T-bill today Invest $909 in a 1-year CD today Costs: Today $909 $909 Returns: One year from today $1,000 $909 Principle 91 Interest $1,000 For T-bills and certificates of deposits to coexist, today s T-bill price must equal $909 when the interest rate is 10 percent. To justify this, we shall argue that the price cannot be less than $909 and then argue that the price cannot be greater than $909: On the one hand, if the price of the T-bill were less than $909, everyone would want to purchase the T-bill and no one would want to purchase the certificate of deposit since both provide $1,000 one year from today. This would drive the price of the T-bill up. On the other hand, if the price of the T-bill were more than $909, no one would want to purchase the T-bill and everyone would want to purchase the certificate of deposit since both provide $1,000 one year from today. This would drive the price of the T-bill down. If price of T-bill < $909 If price of T-bill > $909 Everyone wants to buy T-bills No one wants to buy T-bills No one wants to buy CD s Everyone wants to buy CD s Price of T-bills rises Price of T-bills falls When the interest rate is 10 percent, the price of a T-bill must equal $909 for T-bills and certificates of deposits to coexist.

5 5 Price of bonds and the interest rate When the interest rate rises, the price of bonds will decrease. To explain why, suppose that the interest rate rose from 10 percent to 12 percent. Question: When the interest rate is 12 percent how much would you have to invest in a certificate of deposit today in order to generate $1,000 one year from today? The answer is approximately $893. To see why, just do the arithmetic: Invest $893 in a 1-year CD today Costs: Today $893 Returns: One year from today $893 Principle 107 Interest = %= $1,000 Claim: When the interest rate is 12 percent the price of the T-bill today must equal $893. To understand why compare the two investment strategies: buy a T-bill today versus invest $893 in a certificate of deposit today. Note that each strategy generates the same return, $1,000 one year from today: Buy a 1-year Invest $893 in T-bill today a 1-year CD today Costs: Today $893 $893 Returns: One year from today $1,000 $893 Principle 107 Interest $1,000 When the interest rate is 12 percent, the price of a T-bill must equal $893 for T-bills and certificates of deposits to coexist. Summary: When the interest rate increases the price of bonds decreases. What is the intuition behind this? When the interest rate increases, certificates of deposits become more attractive; consequently, the price of bonds must decrease to remain competitive.

6 6 U.S. Government Bonds and Corporate Bonds Recall that we introduced bonds to explain the role that risk plays in affecting a financial assets rate of return. When a bond is issued, the future payments are specified. A bond is a legally binding agreement. If the bond issuer cannot meet its obligations to pay those future payments, those who purchased the bonds can force the issuer into bankruptcy. In the past some corporations have been unable to meet their obligations and consequently they have been forced into bankruptcy. The U.S. government has always met its bond obligations. Question: Which bonds are riskier: U.S. government or corporate bonds? Answer: Corporate. If the rate of return for the two bonds were equal, all of us would choose the less risky alternative. Consequently, to induce us to purchase the more risky corporate bonds, they must offer a higher rate of return: Risk Up Rate of Return Up Government Bonds: T-bills Corporate Bonds: Aaa Corporate Bonds: Baa.11% 4.2% 4.8% Question: What do the terms Aaa and Baa represent? Answer: These terms indicate how likely it is for the corporation to be able to fulfill its bond obligations. Fitch, Moody, and Standard and Poors are rating services which judge the riskiness of a bond and provide it with a rating. Whenever a rating service believes that the issuing institution is more likely to be unable to meet its bond obligations and consequently to be forced into bankruptcy, the letters in its rating become higher. That is, the rating service believes that a corporation whose bonds it rates as Baa is more likely to be forced into bankruptcy than corporation whose bonds it rates as Aaa. Stocks (Equity) The stockholders of a corporation are the owners of the corporation. Each share of stock represents one portion, albeit very small, of the entire corporation. Consequently, the price of a share reflects the value of the corporation. Apple has issued approximately 860 million shares; consequently, if you own one share, you own approximately millionth of the corporation. A corporation s stocks differ from its bonds in several important respects: perhaps the most important are the returns that the owner receives: When you purchase a bond the future payments the bond promises are clearly spelled out. The corporation is legally required to make the payments. If the corporation cannot fulfill its promises, you, the bondholder, can force the corporation into bankruptcy. When you purchase a stock no promises are made. If the corporation does well, the price of the stock will rise and/or it will issue dividends. Alternatively, if the corporation does poorly, the price of the stock will fall and /or it will issue fewer, if any, dividends. Stockholders cannot force the corporation into bankruptcy because the corporation has made no legal commitment to provide the stockholder with any specified payments.

7 7 Question: Which financial asset is more risky, a bond or a stock? When you purchase a corporate bond you can be assured of the promised payments barring the bankruptcy of the corporation. When you purchase a stock you can be assured of nothing. If the corporation does well its stock s rate of return will be high; alternatively, if the does poorly the stock s rate of return will be low. Stocks are more risky than bonds; consequently, we would expect the average rate of returns for stocks to be greater than that for bonds. Figure 5.3 illustrates that stocks are indeed riskier. Figure 5.5: Real Rates of Return Moody Aaa and S&P Between 1930 and 2014, the average real rate of return for a Moody Aaa bond was 4.2 percent, whereas the average real rate of return for an S&P stock was 8.1 percent. While stocks have a higher average rate of return, they are riskier. Sometimes the rate of return is high, but other times it is low even negative. To induce us to purchase the more risky stocks, they must have a higher average rate of return.

8 8 Mutual Funds An Example of Diversification A mutual fund is a collection of various financial assets (bonds, stocks, etc.) that are pooled together into a single fund. By purchasing shares in a mutual fund, an investor in effect owns a portion of all the financial assets. The price of mutual fund shares rise or fall depending on the performance of the financial assets that the fund includes. Let us consider a simplified example to explain why many investors find mutual funds attractive. Simplified Example: You have $100,000 to invest and you have narrowed your choice to two possibilities: a Florida resort or a New England home heating oil company. The rates of return for both firms depend on the weather in each of the two locations: Rates of Return Florida Resort New England Oil Warm FL Weather 10% Cold NE Weather 10% Cold FL Weather 0% Warm NE Weather 0% How much would you earn if you did not diversify your investment; that is, suppose you invested the entire $100,000 in one alternative or the other: No Diversification: Invest Entire $100,000 in Florida Resort Invest Entire $100,000 in New England Oil Warm FL Weather $10,000 Cold NE Weather $10,000 Cold FL Weather $0 Warm NE Weather $0 If you invest the entire $100,000 in a single firm, you will either earn $10,000 or nothing. Diversification: How much would you earn if you diversified by investing $50,000 in the Florida Resort and $50,000 in New England Oil: Invest $50,000 Florida Resort Invest $50,000 New England Oil Warm FL Weather $5,000 Cold NE Weather $5,000 Cold FL Weather $0 Warm NE Weather $0 There are now four possibilities: Warm FL Weather & Cold NE Weather $10,000 Warm FL Weather & Warm NE Weather $5,000 Cold FL Weather & Cold NE Weather $5,000 Cold FL Weather & Warm NE Weather $0 Diversification can reduce your risk. While it is still possible that you will either earn $10,000 or nothing diversification opens up the possibility a middle ground, earning $5,000. Risk adverse individuals prefer the possibility of the middle ground.

9 9 Money: A very special type of financial asset Thus far we have focused on a few financial assets: bonds, certificates of deposits, stocks, etc. Now we will consider money. The cash, dollars in our wallets and coins in our pockets, are money. We begin with a conceptual definition of money and then introduce an operational definition. Conceptual definition of money If you look the word money up in the dictionary, what definition do you find? Money: A medium of exchange; that which is accepted in exchange for goods and services. The cash that we have in our wallets is money; we use cash all the time when buying goods and services. What else do we use? We also use checks to buy goods and services. The checking account deposits that we have in our banks are also money. Common Confusion: Money versus Income In doing so, it is imperative to distinguish between money and income. Money refers to the financial assets that we own that can be used to purchase goods and services. Income refers to have much we earn over the course of a year. Since we measure both money and income in terms of dollars, it is easy to confuse the two. Be careful not to do so. Operational definition of money Applying the dictionary definition of money strictly, money equals cash, checking account deposits, and traveler s checks. This definition of money is called M1: M1 = Cash + Checking Deposits 5 Technically, your savings account balance is not money. Why is this? Suppose you want to buy a six pack of beer. You cannot use the funds in your savings account directly to do so. But you can easily convert your saving account into money. Just stop by an ATM on your way to a package store and withdraw some of your Figure 5.6: M1 and M2: savings account balance as cash. Or if you want to make a larger purchase you can simply use your cell phone to transfers funds from you savings account to your checking account. It is very easy to convert funds in your savings account. A second definition of money, M2, includes saving deposits and also money market deposits. Money market accounts operate in about the same way as savings accounts: M2 = M1 + Savings Deposits 6 Let us now review the notion of liquidity. Liquidity refers to how easily you can gain access to your funds in order to purchase a good. Cash and checking account deposits are completely liquid. We use cash and the funds in our checking accounts all the time to buy goods and services. Savings accounts are slightly less liquid. A trip to an ATM or a smartphone is required to convert the funds in our savings account into money. Indeed there are a whole series of measures for the money supply: M1, M2, M3, etc. As the number becomes higher, additional less liquid assets are 5 In fact, Travelers checks are also included as part of M1, but in recent years, the have become all but obsolete. 6 Money market deposits are also part of M2. In reality they operate in a way that is very similar to checking and savings deposits.

10 included. M1 sets the highest standard for liquidity, M2 a slightly lower standard, and M3 an even lower one, etc. Figure 5.6 illustrates the growth in both M1 and M2 for the last several decades. 10