The Financial System. Instructor: Prof. Menzie Chinn UW Madison
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1 Economcs 435 The Fnancal Sysem (2/13/13) Insrucor: Prof. Menze Chnn UW Madson Sprng 2013
2 Fuure Value and Presen Value If he presen value s $100 and he neres rae s 5%, hen he fuure value one year from now s: $100 $100(0.05) 05) = $105 Ths also shows ha he hgher he neres rae, he hgher he fuure value. In general: FV = PV PV() = PV(1 ) And: FV PV = ( )
3 Fuure Value and Compound Ineres Wha f you leave your $100 n he bank for wo years a 5% yearly neres rae? The fuure value s: In general $100 $100(0.05) 05) $100(0.05) 05) $5(0.05) 05) = $ $100(1.05)(1.05) = $100(1.05) 2 FV n = PV(1 ) ) n PV = FV ( 1 ) n 4-3
4 Complcaons Wha f paymens, X, occur all he way along unl he end? unl he end? Wha f he neres rae,, s no consan? = ) )...(1 ) (1 (1... ) ) (1 (1 ) 1 ( n n X X X PV Bu a me, one doesn know n nformaon so: nformaon so: = ) )...(1 ) (1 (1... ) ) (1 (1 ) (1 X n n X X PV ε ε ε correced
5 Bond Bascs The mos common ype of bond s a coupon bond. 4-5 Issuer s requred o make annual paymens, called coupon paymens. The annual neres he borrower pays ( c ), s he coupon rae. The dae on whch he paymens sop and he loan s repad (n), s he maury dae or erm o maury. The fnal paymen s he prncpal, face value, or par value of he bond.
6 Bond Prces 1. Zero-coupon or dscoun bond Promse a sngle paymen on a fuure dae Example: Treasury bll 2. Fxed-paymen loan Sequence of fxed paymens Example: Morgage or car loan 3. Coupon bond perodc neres paymens prncpal repaymen a maury Example: U.S. Treasury Bonds and mos corporae bonds 4Consol 4. perodc neres paymens forever, prncpal never repad Example: U.K. governmen has some ousandng 6-6
7 Zero-Coupon Bonds U.S. Treasury blls (T-blls) are he mos sraghforward ype of bond. Each T-bll represens a promse by he U.S. governmen o pay $100 on a fxed fuure dae. No coupon paymens - zero-coupon bonds Also called pure dscoun bonds (or dscoun bonds) snce he prce s less han face value - hey sell a a dscoun. Prce of $100 face value zero-coupon bond 6-7 = $100 n (1 )
8 Zero-Coupon Bonds Assume = 5% Prce of a One-Year Treasury Bll 100 = = $ ( ) Prce of a Sx-Monh Treasury Bll = 100 = $ / 2 (1 0.05) 6-8
9 Zero-Coupon Bonds For a zero-coupon bond, he relaonshp beween he prce and he neres rae s he same as we saw on presen value calculaons. When he prce moves, he neres rae moves wh, n he oppose drecon. We can compue he neres rae from he prce usng he presen value formula. The prce of a one-year T-bll s $95. = ($100/$95) - 1 = = 5.26% 6-9
10 Fxed-Paymen Loans Home morgages and car loans are fxed-paymen loans. They promse a fxed number of equal paymens a regular nervals. Amorzed loans - he borrower pays off par of he prncpal along wh he neres for he lfe of he loan. Value of a Fxed Paymen Loan = FxedPaymen FxedPaymen L FxedPaymen (1 ) (1 ) 2 (1 ) n The sum of he presen value of he paymens. 6-10
11 Coupon Bonds The ssuer of a coupon bond promses o make a seres of perodc neres paymens (coupon paymens), plus a prncpal paymen a maury. Prce of Coupon Bond = P CB CouponPaymen CouponPaymen CouponPaymen (1 ) (1 ) (1 ) = n 6-11 FaceValue n ( 1 )
12 Consols Consols or perpeues, are lke coupon bonds whose paymens py las forever. The borrower pays only neres, never repayng py he prncpal. p The U.S. governmen sold consols once n 1900, bu he Treasury has bough hem all back. The prce of a consol s he presen value of all fuure neres paymens. Yearly Coupon Paymen P Consol = 6-12
13 Bond Yelds We know how o calculae bond prces gven an neres rae. We also need o be able o go n he oher drecon. Calculae he reurn o an nvesmen, mplc n he bond s prce. We wll combne nformaon abou he promsed paymens wh he prce o oban he yeld: ld A measure of he cos of borrowng and he reward for lendng. We wll use he erms yeld and neres rae nerchangeably. 6-13
14 Yeld o Maury The mos useful measure of he reurn on holdng a bond s called he yeld o maury: The yeld bondholders receve f hey hold he bond o s maury when he fnal prncpal p paymen s made. $5 $100 Prce of 1yr 5% Coupon Bond = (1 ) (1 ) 6-14 The value of ha solves he equaon s he yeld o maury.
15 Curren Yeld Example: 1 year, 5% coupon bond sellng for $99 5 Curren Yeld = = , or 5.05% 99 Yeld o maury for hs bond s 6.06 percen found as he soluon o: 6-15 $5 $100 (1 ) (1 ) = $99
16 Holdng Perod Reurns The one-year holdng gperod reurn s he sum of he yearly coupon paymen dvded by he prce pad for he bond and he change n he prce dvded by he prce pad. = Yearly Coupon Paymen Prce Pad Change n Prce Prce of he of he Bond Bond 6-16 = Curren Yeld Capal Gan (as a %)
17 Daa on Treasury Noes and Bonds hp://onlne.wsj.com/mdc/publc/page/2_3020-reasury.hml
18 Daa on Treasury Blls On he run
19 Daa on Treasurys hp://fnance.yahoo.com/bonds h /b See also: hp://
20 Secondary Marke, Consan Maury year consan maury Treasurys Three monh Treasurys, sec. mk /8
21 Real and Nomnal Ineres Raes The nomnal neres rae you agree on () mus be based on expeced nflaon (π e ) over he erm of he loan plus he real neres rae you agree on (r). = r π e Ths s called he Fsher Equaon. The hgher expeced nflaon, he hgher he nomnal neres rae. 4-21
22 Daa on Treasury Inflaon Proeced Secures (TIPS) hp://onlne.wsj.com/mdc/publc/page/2_3020-ps.hml
23 Nomnal vs. Real 7 6 Ten yeartreasurys, consan maury Ten year adjused by exp'd nfl Ten year TIPS, consan maury
24 Consan Maury vs. On he Run Ten year TIPS, consan maury yr 1-1/81/8 TIPS, Jan /21
25 6-25 Facors Tha Shf Bond Supply
26 Facors Tha Shf Bond Demand 6-26
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