Class Materials from January-March 2014 Review Material for Exam I Econ 331 Spring 2014 Bernardo
Topics Included in Exam I Money and the Financial System Money Supply and Monetary Policy Credit Market Instruments/Bonds, the Bond Market and Interest Rates
Money and the Financial System
Major Concepts Describing the structure and function of the financial system Direct and indirect finance; primary, secondary, money and capital markets; financial institutions/intermediaries; financial instruments Money What is money; monetary aggregates; liquidity
The Financial System Transfers funds from savers to borrowers Savers are suppliers of funds; Borrowers are demanders of funds. Financial markets issue claims on borrowers Debt and equity Financial institutions act as go-betweens Connect those with excess funds to those seeking to borrow; Commercial banks are an important financial intermediary Accept deposits and make loans, i.e. Engage in asset transformation; integral in the creation of money
Types of Fund Raising 1. Direct Finance Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower s future income or assets 2. Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower s future income or assets
Financial Markets 1. Debt Markets Short-Term (maturity < 1 year) (Money Market) Long-Term (maturity > 10 year) (Capital Market) Intermediate term (maturity in-between) Represented $38.2 trillion at the end of 2012. 2. Equity Markets Pay dividends, in theory forever Represents an ownership claim in the firm Total value of all U.S. equity was $18.7 trillion at the end of 2012.
Financial Markets 1. Primary Market Newly issued securities sold to initial buyers Typically involves an investment bank who underwrites the offering 2. Secondary Market Securities previously issued are bought and sold Examples include the NYSE and Nasdaq Involves both brokers and dealers (do you know the difference?)
Financial Markets Advantages and Disadvantages of: Debt - Issuers of debt continue to own their assets and can pay fixed payments - For lenders, there is the risk of default Equity - Issuers of Equity do not have a fixed scheduled payment (expect to give dividends) - For lenders there is the risk of no returns
Financial Markets Even though firms don t get any money, per se, from the secondary market, it serves two important functions: Provides liquidity, making it easy to buy and sell the securities of the companies Establishes a price for the securities (useful for company valuation)
Services Provided by Financial System
Financial Institutions/Intermediaries Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: the intermediary obtains funds from savers the intermediary then makes loans to/investments with borrowers
Financial Institutions/Intermediaries This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers. More important source of finance than securities markets (such as issuing stocks) Needed because of transactions costs, risk sharing, and asymmetric information
Financial Institutions/Intermediaries Transactions Costs 1. Financial intermediaries make profits by reducing transactions costs 2. Reduce transactions costs by developing expertise and taking advantage of economies of scale A financial intermediary s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions 1. Banks provide depositors with checking accounts that enable them to pay their bills easily 2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary
Financial Institutions/Intermediaries Another benefit made possible by the FI s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors
Financial Institutions/Intermediaries Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings. Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.
Types of Financial Institutions/ Intermediaries Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts. Commercial banks (11,343 at end of 2012) Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios
Types of Financial Institutions/ Intermediaries Thrifts: S&Ls & Mutual Savings Banks (918) and Credit Unions (905) Raise funds primarily by issuing savings, time, and checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company s workers
Types of Financial Institutions/ Intermediaries All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict
Types of Financial Institutions/ Intermediaries Pension and Government Retirement Funds hosted by corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities
Types of Financial Institutions/ Intermediaries Life Insurance Companies receive funds from policy premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict
Types of Financial Institutions/ Intermediaries Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations. Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds.
Types of Financial Institutions/ Intermediaries Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe shortterm money market instruments Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.
Financial Instruments Financial instruments (also referred to as financial assets or securities) are created in the primary market and traded in the secondary market. Important financial instruments: Money market instruments Treasury Bills (3, 6, 12 months), Commercial Paper, Banker s acceptances, Repurchase agreements, Federal Funds, Eurodollars, CD Capital Market Instruments Treasury Securities, Government Agency Securities, Municipal Bonds, Stocks, Corporate Bonds, Mortgages, Commercial Bank Loans
Money and Monetary Aggregates What is money? Money is anything that is readily exchanged as a source of value. (Remember: Wealth/net worth or income are not money) Money is as money does meaning, anything that performs the functions of money can be money Money is a social construction, meaning it is dependent on peoples willingness to accept that something is money But, not just anything can be money. For something to be money, it must possess certain attributes.
Functions/Attributes of Money 1. Medium of exchange Money is something that is generally accepted as payment for goods and services 2. Criteria as a medium of exchange Acceptable to most traders Standardized quality Durable Valuable relative to its weight Divisible
Functions/Attributes of Money 1. Unit of account Gives one standard by which all goods and services in the economy are measured: for example, in the U.S all goods and services are measured in dollars 2. Store of Value Money allows value to be stored easily. Its not the only way to store value, but it allows you easy liquidity (easy to take out and use to exchange for goods and services). 3. Standard of Deferred Payment Provides a standard by which people will accept payment at a later date
Monetary Aggregates Monetary aggregates are used to estimate how much money is in an economy The US uses a nested family of money measures constructed on the basis of decreasing liquidity M1 = Narrowest Measure (Most Liquid) M1 = currency+traveler s checks+demand deposits + other checkable deposits M2 = M1 + Less Liquid Assets M2 = M1 + small denomination time deposits + savings deposits + money market deposit accounts + money market mutual fund shares M3 = M2 + Less Liquid Assets M3=M2+large time deposits, institutional money market fund balances, repurchase agreements
Money Supply and Monetary Policy
Banks Commercial banks play an essential role in the money supply process Banks accept deposits and then use these deposits to make loans (i.e. they engage in asset transformation) Banks are able to do this because they know that not everyone will demand all of their deposits at once. They are required by the Fed to keep a certain percentage of total deposits as required reserves. This enables banks to make sure that they can meet daily obligations of withdrawals and other payments.
Money Supply The money supply is important because it affects key economic variables: Price Levels Interest Rates Rate of economic growth **Recall that MS has many definitions, we stick with M1 to analyze the money supply process**
Bank Balance Sheets Begin by examining the components of a simplified bank s balance sheet. ASSETS LIABILITIES Reserves Demand Deposits Treasury Securities Borrowings Loans
Money Supply What is the major way in which the fed attempts to guide the banking system and the economy? Adjusting the money supply increasing and decreasing the liquidity in the system.
The Money Supply Process This is a model to describe the size and variability of the money supply
Three Key Players in the Money Supply Process 1. Banks (depository institutions) accept deposits and make loans 2. The Central Bank (The Fed) responsible for monetary policy 3. Depositors (the non-bank public) holds money in the form of currency and deposits; demands loans
The Monetary Base Monetary Base= currency in circulation+ reserves (B=C+R) Technically, the MB is the liabilities of the Fed Federal currency in circulation is a liability (to the non-bank public) Cash kept in banks is called vault cash and is counted as part of reserves. Bank reserves are assets held by banks that they can collect from the fed but
Reserves Bank reserves pay no interest so to banks, holding reserves gives them no money (n.b. we will return to this later. The Fed now pays interest on reserves, but the point here is that banks have an incentive to loan out excess reserves to make higher profits) By law, commercial banks are made to hold a certain amount of bank reserves, called required reserves Total Reserves = Required Reserves + Excess Reserves The percentage of deposits of a bank that are require to be held as reserves is called the required reserve ratio. It is set by the Fed.
The Fed s Balance Sheet The components of a simplified Fed s balance sheet. ASSETS LIABILITIES Treasury Securities Currency in Circulation Discount loans Total Bank Reserves to Banks You see here that the Fed s liabilities are C + R = Monetary Base
Changing the Monetary Base The Fed changes the monetary base by changing the levels of its assets.two major ways: 1- Open market operations 2- Discount loans
Open Market Operations In an open market purchase the Fed buys government bonds and increases the base. Say the fed wanted to increase money supply by $1 million. It makes a check payable from the Fed to the seller of the bond (either the non-bank public or a bank). This draws out the securities that were there in the system and replaces it with either currency (if the bank or public wants to hold it as currency) or with reserves (if the bank puts it into reserves). In either case since B=C+R, the base increases (either C goes up by $1 million or R does or some proportion of both)
Open Market Operations
Discount Loans The Fed can also change reserves and the base through changes in discount loans. Fed sets discount rate (rate at which banks borrow from the fed). When this is low, banks will borrow more, thereby decreasing reserves and increasing loans. Discount loans are a less effective method than the OMO method, because banks have to choose to borrow for reserves to go up.
Discount Loans
Determinants of the BASE: BASE=C+R Fed -OMO -Reserves -Discount lending -Currency in circulation Banks -Vault cash Reserves BASE -Deposits at Fed Non-bank public -Deposits checks -Reserves -Holds currency -Currency in circulation
Please Refer to the Money Supply Document for discussion on the simple deposit multiplier and the money multiplier.
Credit Market Instruments/Bonds, and Interest Rates
Bonds and Interest Rates Major Concepts Types of credit market instruments Present Value Yield to Maturity Rates of Return Real and Nominal Interest Rates
Major Concepts Types of credit market instruments Simple loan, discount bond, coupon bond, fixed-payment loan Basic bond characteristics Face value, maturity, coupon payment, coupon rate, current yield, price, yield to maturity Present value Inverse relationship between bond prices and interest rates Total rate of return Real and nominal interest
Time Lines for Credit Market Instruments
Basic Bond Characteristics Face value/par value The amount of money the bond holder receives when the bond matures [does not change] Maturity The number of years or periods until the bond matures and the holder is paid the face value [does not change] Coupon payment The fixed payment the bond holder receives over the life of the bond [does not change] Coupon rate/ Coupon Interest Rate The coupon payment as a percentage of the face value of the bond [does not change] Price/ Market Price The amount of money the bond was purchased or sold for [changes] Current yield The coupon payment divided by the current market price of the bond [changes] Yield to Maturity The yield an investor will earn if the bond is purchased at current market price and held until maturity. YTM is the interest rate that equates the current price of the bond to the present value of all of the future flows of income generated from ownership of the bond [changes]
Present Value Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. All else being equal, debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow. This evaluation, where the analysis of the amount and timing of a debt instrument s cash flows lead to its yield to maturity or interest rate, is called present value analysis. The concept of present value (or present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. This notion is true because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year. The term present value (PV) can be extended to mean the PV of a single cash flow or the sum of a sequence or group of cash flows.
Present Value Formula
Example I can buy a discount bond which will give me $10,000 after a year. The current interest rate at the moment is 10%. What is the Present Value of this asset? Answer: Interest rate=10%=0.1, n=1 year PV = FV/(1+ i)^n PV=$10,000/(1.1)^1= $9090.9 In other words, I am indifferent between getting the $10,000 from the bond next year and getting $9090.9 today. So if the bond costs more than $9090, don t buy it. If less, buy it.
Example
Yield to maturity Sometimes, all we know is the price of the asset now and the future payment schedule: In this case, to compare between assets, we need to compare the yield to maturity Definition of YTM the interest rate that equates the present value of all future flows of income to the current price
Example of Yield to Maturity Coupon Bond. Assume you can buy a coupon bond with a face value of $5,000 and a 3 year maturity for $4,000. It gives you $500 a year as coupon payment. How to calculate YTM? Price of bond=$4,000 Face= $5,000 n= 3 Coupon= $500 4000 = 500/(1+i) + 500/(1+i)^2 + 500/(1+i)^3 + 5000/(1+i)^3 Using a financial calculator, YTM = 19.406
Yields to Maturity on a 10% Coupon Rate Bond Maturing in 10 Years (Face Value = $1,000) 1. When bond is at par, yield equals coupon rate 2. Price and yield are negatively related 3. Yield greater than coupon rate when bond price is below par value
Bond Price and Yield to Maturity It s straight-forward to show that the value of a bond (price) and yield to maturity (YTM) are negatively related. If the interest rate i increases (YTM increases), the PV of any given cash flow is lower because it is discounted at a higher rate; hence, the price of the bond must be lower.
Bond Yields and Prices Bond yields (the yield to maturity) and the price of the bond are inversely related. As interest rates rise, price of bonds falls. The simplest version of yield is calculated using the current yield following formula: yield = coupon/price. When you buy a bond at par, yield is equal to the coupon interest rate. When the price changes, so does the yield. Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200)
Different concept of yields with changing bond prices Current yield = coupon/current price Coupon rate = coupon/face value Example: $1000 bond with coupon payment of $100 and current price of $800. Then current yield=$100/$800=12.5% coupon rate=$100/$100=10%
The Arithmetic of Current Price and Face Value If current price = face value, then yield to maturity = current yield = coupon rate. (previous example: if current price=$1000, then CY=100/1000=10%, same as the coupon rate) If current price < face value, then yield to maturity > current yield > coupon rate. (previous example: if current price=$800, then CY=100/800=12.5%,more than the coupon rate) If current price > face value, then yield to maturity < current yield < coupon rate. (previous example: if current price=$1500, then CY=100/1250=8%,more than the coupon rate)
What happens to the price of a long term bond if interest rates rise? Sensitivity of Bond Prices to Interest Rate Changes The price of a bond and the yield to maturity are negatively related. Suppose that the yield to maturity for a $10,000 face value bond is expected to rise from 10% to 15% one year from now. What happens to the price of the bond? A change in the yield to maturity affects the prices of long-term bonds more than it affects the prices of those closer to maturity. The above figure shows the price changes for bonds with a 1yr, 5yr and 20yr maturity.
Three Types of Risk Any financial claim entails 3 kinds of risk: Default or Credit Risk (The risk that a borrower will default) Liquidity Risk (The risk that the asset cannot be sold easily) Interest Rate Risk (The risk that the interest rates will move so as to make the asset less valuable)
Default Risk for Bonds Typically done by specialists called Ratings Agencies Moody s, Standard & Poor, Fitch
Interest Rate Risk Two components: Price risk. Results from interest rate changes in accordance with first bond theorem (that price and interest rate are inversely related) Reinvestment risk. Results form coupon payments that cannot be reinvested at the bonds promised yield. However, they partially offset each other. If interest rates increase, bond s price drops, but we get a higher rate on the reinvestment of coupon payments.
Total Rate of Return The total rate of return is the sum of current yield and actual capital gain or loss. Rate of return can differ from yield to maturity. The formula for total rate of return is: R = C/Pt + (Pt+1 - Pt)/Pt. (rate of return = current yield + capital gains Example: A bond with par value of $1000 redeemable in a year is bought today for $800 and pays a coupon of $100. R=100/800+(1000-800)/800=300/800=37.5%
Real and Nominal Interest Rates The real interest rate is the nominal interest rate adjusted for changes in purchasing power, i.e. inflation Expected real interest rate = nominal interest rate - the expected rate of inflation. Fisher hypothesis: change in expected inflation = change in nominal interest rate. The real rate of return equals the nominal rate of return adjusted for expected inflation.
The Bond Market
The Market For Bonds Ok. The bond market is big and powerful- but what on earth is being exchanged? What is it a market for? Two intertwined markets
Two Views of Bond Market Bond is the good. Use of funds is the good.
Bond is the Good Buyer: Lender who buys bond (say, the public) Seller: Borrower issuing bond (say, a corporation or the state) Price: Bond price
Use of Funds as the Good Buyer: Borrower raising funds (a corporation or a state) Seller: Lender supplying funds (the public) Price: Interest rate
Supply and Demand Analysis Example 1 year bond with par value of $10,000 If you sell it at $8000, the interest rate earned is ($10,000- $ 8,000)/$8000= $2000/$8,000= 25% If you sell it at $9500, the interest rate earned is ($10,000- $9,500)/$9500= $500/$9,500= 5.2%
Demand for Bonds. Those who demand the bonds are the ones supplying the funds
Supply of Bonds: Those who supply the bonds are the ones who demand loanable funds
Market Equilibrium
Explaining Changes in Equilibrium Interest Rates Changes in bond demand or supply will change the bond price and interest rate. Theory of portfolio allocation can explain bond demand curve shifts. Changes in willingness and ability to borrow shifts the supply curve.
Shifts in Bond Demand
Theory of Asset Allocation/Portfolio Choice
Factors Increasing Bond Demand Higher wealth Higher expected returns on bonds Lower expected inflation Lower expected return on other assets Lower relative riskiness of bonds Higher relative liquidity of bonds Lower relative information costs of bonds
Factors Increasing Bond Supply Higher expected profitability of capital Lower business taxes Higher expected inflation Higher government borrowing
Shifts in the Supply of Bonds
Variable Change in Variable Change in Bd Change in Bs Change in i Wealth increase increase decrease Expected Interest Rates Expected Inflation Summary increase decrease increase increase decrease increase increase Relative Risk increase decrease increase Relative Liquidity Expected Profitability of Firms Government Deficits increase increase decrease increase increase increase increase increase increase
Why Do Interest Rates Fall During Recessions?
Expected Inflation and Interest Rates
Risk and Term Structure of Interest Rates There are many different interest rates in the financial system. The following factors help to explain why: Default Risk Liquidity Risk Structure Taxation Maturity Term Structure
The Risk Structure of Interest Rates
Liquidity and Information Costs Investors care about liquidity, so they are willing to accept a lower interest rate on more liquid investments. Spending time and money acquiring information on a bond reduces the bond s expected return. A change in a bond s liquidity or the cost of acquiring information about the bond affects its demand. During the financial crisis of 2007 2009, homeowners defaulted on many of the mortgages contained in mortgage-back bonds. Investors also had difficulty finding information about the types of mortgages in them.
Tax Treatment Investors care about the return they receive left after paying their taxes. How the Tax Treatment of Bonds Differs Municipal bonds are bonds issued by state and local governments.
Changes in Default Risk and in the Default Risk Premium The default premium typically rises during a recession. The increase in the default premium was much larger in the 2007-2009 recession than the 2001 recession.
Bond Ratings
The Term Structure of Interest Rates Explain why bonds with different maturities can have different interest rates. The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar but that have different maturities. The Treasury yield curve shows the relationship among the interest rates on Treasury bonds with different maturities. An upward-sloping yield curve occurs when short-term rates are lower than long-term rates. Infrequently, a downward-sloping yield curve occurs when short-term interest rates are higher than long-term interest rates.
Treasury Yield Curve
The Interest Rates on 3-Month Treasury Bills and 10-Year Treasury Notes, January 1970 August 2012 The figure shows that most of the time since 1970, the interest rates on 3-month Treasury bills have been lower than the interest rates on 10-year Treasury notes.
Explaining the Term Structure Any explanation of the term structure should be able to account for three 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. Economists have advanced three theories to explain these facts: expectations theory segmented markets theory liquidity premium theory or preferred habitat theory
Theories of the Term Structure of Interest Rates
Can the Term Structure Predict Recessions? Economists have found the yield curve to be useful for predicting recessions. During every recession since 1953, the term spread between the yields on long-term and short-term Treasury securities narrowed significantly. During recessions, interest rates typically fall, and short-term rates tend to fall more than long-term rates. In this situation, the liquidity premium theory predicts that longterm rates should fall relative to short-term rates, making the yield curve inverted.
Yield Curves and the Market s Expectations of Future Short- Term Interest Rates According to the Liquidity Premium Theory
Lottery Prizes A lottery claims a rice of $10 million, paid over 20 years at $500,000 per year. Olga won () and the first payment is made today. Assume an interest rate of 6% and calculate the actual value of the total grand prize.
Solution Solution: This is a simple present value problem. PV = 500K + 500K/(1.06)^1 + 500k/(1.06)^2+ +500k/(1.06)^19 Using a financial calculator, N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode. Compute PV: PV = $6,079,058.25
Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table: Years to Maturity Yield to Maturity 3 5 3 7 6 7 9 5 9 9 Current Price What relationship do you observe between the YTM and current market price?
Solution M YTM PRICE 3 5 $1,054.46 3 7 $1,000.00 6 7 $1,000.00 9 5 $1,142.16 9 9 $ 880.10 When yield to maturity is above the coupon rate, the band s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate. For a given maturity, the bond s current price falls as yield to maturity rises. For a given yield to maturity, a bond s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond s current price equals its face value regardless of years to maturity.
An economist has estimated that, near the point of equilibrium, the demand curve and supply curve for $1000 face, one-year discount bonds can be estimated using the following equations: B B d s 2 : Price = Quantity + 940 5 : Price = Quantity + 500 a. What is the expected equilibrium price and quantity of bonds in this market? b. Given your answer to part (a), which is the expected interest rate in this market?
Solution a. Solve the equations simultaneously: (-2/5)Q + 940 = Q +500 -(2/5)Q + 440 = Q 440 = (2/5)Q + Q 440 = Q(2/5 + 1) 440 = Q(7/5) 440* 5/7=Q 314.2857= Q Thus P= 814.2857 (plug Q into the equations. ) b. For the interest rate. i= expected return. and the expected return is equal to Face-Price/Price= (1000-814.2857)/814.2857= 22.8%