Class Note for ECON 311 at UMass(10)
Class Note for ECON 311 at UMass(10)
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Date Created: 02/06/15
Bonds and Interest Ratengan 6 009 Chica 0 Board of Trade Treasury FUtures mm Today39s Outline quot KMmmw 393 Interest amp 39 Present Value Yield to Maturity Rate of Return Real Interest Rates Demand and Supply for Bonds CR allocation Copyrlgnt 2007 Pearson Addlsoanesley All ngnts reserved 22 M l f FEW BorrowerSpenders 1 Business firms 2 Government 3 Households 4 Foreigners FIGURE 1 Flows of Funds Through the Financial System Copyright 2007 Pearson Addison Wesley All rights reserved 2 3 Fictitious K Holders of money can either lend their money and receive a flow of interest on it or buy shares and receive a flow of dividends Fictitious K gt market valuation gt net worth Net worth assets liabilities Arises from capitalized or securitized revenue streams Financial system gt interlockingoverlapping claims to these revenue streams Copyright 2007 Pearson Addisoanesley All rights reserved 24 Money and Capital Markets Money markets deal in shortterm debt instruments eg ST bonds Capital markets deal in longerterm debt and equity instruments 1 year eg stocks and LT bonds 39 Stocks ownership gt alienability residual claim control Bonds direct loans Low fluctuation of money market instruments amp CorporateBank use of them for temporary purposes Why Copyright 2007 Pearson Addisoanesley All rights resery 25 Risk versus Uncertainty Risk Uncertainty u I 4 2 1 4 z 1 I 95 I We don t know the probability distribution of the future but we are compelled to make decisions anyways Copyrrgm 2007 Pearson Addisoanesley AH rrgms reserved 26 TA B L E 1 Principal Money Market Instruments Amount Outstanding billions end of year Type of Instrument 1980 1990 2000 2005 US Treasury bills 216 527 647 923 Negotiable bank certificates of deposit large denominations 3 17 543 1 053 1 742 Commercial paper 122 557 1619 1544 Banker s acceptances 42 52 8 4 Repurchase agreements 5 7 144 366 5 18 Federal funds 1 8 61 6O 83 Eurodollars 5 5 92 1 9 5 438 Sources Federal Reserve Flow of Funds Accounts Federal Reserve Bulletin Economic Report of the President Copyright 2007 Pearson AddisonWesley All rights resened 27 TA B L E 2 Principal Capital Market Instruments Amount Outstanding billions end of year Type of Instrument 1980 1990 2000 2005 Corporate stocks market value 1601 4146 1 7627 1 7853 Residential mortgages 11 06 2886 5463 9436 Corporate bonds 366 1008 2230 2983 US government securities 407 1653 2184 2803 marketable longterm US government agency securities 193 435 1616 2696 State and local government bonds 310 870 1192 1807 Bank commercial loans 459 818 1091 1031 Consumer loans 355 813 536 710 Commercial and farm mortgages 352 829 1214 19 19 Sources Federal Reserve Flow of Funds Accounts Federal Reserve Bulletin Copyright 2007 Pearson AddisonWesley All rights resened 28 Bonds and Interest Rates What39s an interest rate Time value of money Fienta cost of K Premium for sacrificing liquidity Copyngm 2007 Peaison Addtsoanesiey AH Hng ieseived 29 Present Value A dollar paid to you one year from now is less valuable than a dollar paid to you today Typicaly people value the present more than the future Keynes In the long run we39re all dead So we discount the future example 210 Simple Present Value PV 2 today39s present value CF 2 future cash ow payment 139 the interest rate CF PV 1in Addtsoanestey AH thts vesevved 211 Compound Interest Simple end of period v A1rquott A V1rquott Continuous compounding v Aequotrt A VeArt Copyngnt 2007 Peavson Addisoanesiey Aii vignts vesevved 212 Compound Interest 2 Annual t compound Continuous 0 100 100 1 110 1 1051 2 121 1221 3 1331 135 4 14641 1492 5 16105 1648 6 17716 1822 7 19487 2013 8 21436 2225 9 23579 2459 10 25937 2717 Difference 1237 Copynght 2007 Peavson Addwsoeres ey AH thts vesevved 213 Four Types of Credit Market Instruments 39 Simple Loan one time principal interest 39 Fixed Payment Loan same payment every period for a set number of years includes interest principal repayment 39 Coupon Bond fixed interest payment every year until maturity when face value is paid t bonds amp corporate 39 Discount Bond bought at a discount no interest payments pays face value at maturity tbills US savings bonds Copyright 2007 Pearson Addisoanesiey All rights reserved 214 Which is best deal Yield to Maturity The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today 2007 Pearson Addisoanesley All rights reserved 215 39 Simple Loan Yield to Maturity PV 2 amount borrowed 100 CF 2 cash ow in one year 110 I number of years 1 110 1 i1 1 139 100 2 110 110 1 392 1 100 i010 10 For simple loans the simple interest rate equals the 100 yield to maturity Copynght 2007 Peavson Addisoanesley AH thts vesevved 216 Fixed Payment Loan Yield to Maturity The same cash ow payment every period throughout the life of the loan LV loan value FP xed yearly payment 11 number of years until maturity PP PP PP PP LV li 112 1z393 1z39 Copynght 2007 Peavson Addtsoanesley AH thts vesewed 217 Coupon Bond Yield to Maturity Using the same strategy used for the xedpayment loan P price of coupon bond C yearly coupon payment F face value of the bond 11 years to maturity date C C C C F P E my my 1i 1i Copynght 2007 Peavson Addisoanesley AH thts vesevved 218 TABLE 1 Yields to Maturity on a loooCouponRate Bond Maturing in Ten Years Face Value 1000 Price of Bond Yield to Maturity 1200 713 1100 848 1000 1000 900 1175 800 1381 When the coupon bond is priced at its face value the yield to maturity equals the coupon rate 39 The price of a coupon bond and the yield to maturity are negatively related The yield to maturity is greater than the coupon rate when the bond price is below its face value Copyright 2007 Pearson AddisonWesley All rights reserved 219 Discount Bond Yield to Maturity For any one year discount bond 1 z E P F Face value of the discount bond P current price of the discount bond The yield to maturity equals the increase in price over the year diVided by the initial price As with a coupon bond the yield to maturity is negatively related to the current bond price Copynght 2007 Peavson AddisoaneSley AH ngms vesevved 220 Moral of the Story The price of a bond its present value is inversely related to its yield to maturity PvTeil PvleiT 2007 Pearson Addisoanesley All rights reserved 221 Yield on a Discount Basis Alternative Less accurate but less difficult to calculate idb F P X 360 F days to maturity in yield on a discount basis F face value of the Treasury bill discount bond P purchase price of the discount bond Uses the percentage gain on the face value Puts the yield on an annual basis using 360 instead of 365 days Always understates the yield to maturity The understatement becomes more severe the longer the maturity oopyngm 2007 Peavson Addisoanesley All ngms reserved 222 Yield to Maturity vs Rate of Return 39 If you want to decide today which bond to issue which loan to take calculate YTM 39 If you want to decide which bond to buy which loan to issue calculate rate of return Copyright 2007 Pearson Addisoanesley All rights reserved 223 Risk versus Uncertainty Risk Uncertainty Again remember this Copyngnt 2007 Pearson Addtsoanestey AH Hgnts reserved 224 Rate of Return The payments to the owner plus the change in value expressed as a fraction of the purchase price RET 9 L143 P P t t RET return from holding the bond from time t to time t 1 R price of bond at time t Pt 1 price of the bond at time t 1 C coupon payment C current yield it 3 P 1P rate of capital gain g t Copyngm 2007 Peavson Addisoanesley All rights vesewed 225 late of Return and Interest Rates 39 The return equals the yield to maturity only if the holding period equals the time to maturity 39 A rise in interest rates is associated with a fall in bond prices resulting in a capital loss if time to maturity is longer than the holding period 39 The more distant a bond s maturity the greater the size of the percentage price change associated with an interestrate change Why Copyright 2007 Pearson Addisoanesley All rights reserved 226 late of Return and Interest Rates cont d 39 The more distant a bond s maturity the lower the rate of return that occurs as a result of an increase in the interest rate 39 Even if a bond has a substantial initial interest rate its return can be negative if interest rates rise Copyright 2007 Pearson Addisoanesley All rights reserved 227 InterestRate Risk Prices and returns for longterm bonds are more volatile than those for shorterterm bonds There is no interestrate risk for any bond whose time to maturity matches the holding period 2007 Pearson Addisoanesley All rights reserved 228 Real and Nominal Interest Rates 39 Nominal interest rate makes no allowance for inflation 39 Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing 39 EX ante real interest rate is adjusted for expected changes in the price level 39 EX post real interest rate is adjusted for actual changes in the price level Copyright 2007 Pearson Addisoanesley All rights reserved 229 i i fie i nominal interest rate i 2 real interest rate rte 2 expected in ation rate When the real interest rate is low there are greater incentives to borrow and fewer incentives to lend The real interest rate is a better indicator of the incentives to borrow and lend Most prices are in nominal terms some are indexed for in ation Copynght 2007 Peavson Addisoanesley All thts vesevved 230 Interest Rate 16 12 8 Nominal Rate 4 0 v 1 y Estimated Real Rate 4 l l l 1955 1960 1965 1970 1975 1980 1985 1990 1 995 2000 2005 F I GU RE 1 Real and Nominal Interest Rates ThreeMonth Treasury Bill 19532005 Copyright 2007 Pearson AddisonWesley All rights resened Sources Nominal rates from wwwfederalreservegovreleasesHl5 The real rate is constructed using the procedure outlined in Frederic S Mishkin quotThe Real Interest Rate An Empirical Investigationquot CarnegieRochester Conference Series on Public Policy 15 1981 151 200 This procedure involves estimating expected inflation as a function of past interest rates inflation and time trends and then subtracting the expected inflation measure from the nominal interest rate 2 31 Moving to Ch 5 Behavior of Interest Rates Demand and Supply for Bonds Copynght 2007 Peavson Addwsoanestey AH thts vesevved 232 Determining the Quantity Demanded of an Asset Wealth the total resources owned by the individual including all assets Expected Return the return expected over the next period on one asset relative to alternative assets Risk the degree of uncertainty associated with the return on one asset relative to alternative assets Liquidity the ease and speed with which an asset can be turned into cash relative to alternative assets 233 Copyright 2007 Pearson Addisoanesley All rights reserved l quot f Co A Theory of Asset Demand S UM M ARY TA B L E 1 Response of the Quantity of an Asset Demanded to Changes in Wealth Expected Returns Risk and Liquidity Change in Variable Change in Variable Quantity Demanded l Wealth T T Expected return relative to other assets T T Risk relative to other assets T l Liquidity relative to other assets T T Note Only increases in the variables are shown The effect of decreases in the variables on the change in quantity demanded would be the opposite of those indicated in the rightmost column Copyright 2007 Pearson AddisonWesley All rights reserved 2 34 Supply and Demand for Bonds At lower prices higher interest rates oeteris paribus the quantity demanded of bonds is higher an inverse relationship At lower prices higher interest rates oeteris paribus the quantity supplied of bonds is lower a positive relationship 2007 Pearson Addisoanesley All rights reserved 235 Shifts in the Demand for Bonds Wealth in an expansion with growing wealth the demand cune for bonds shifts to the right Expected Returns higher expected interest rates in the future lower the expected return for longterm bonds shifting the demand cune to the left Expected Inflation an increase in the expected rate of inflations lowers the expected return for bonds causing the demand cune to shift to the left Risk an increase in the riskiness of bonds causes the demand cune to shift to the left Liquidity increased liquidity of bonds results in the demand cune shifting right Copyright 2007 Pearson Addisoanesley All rights reserved 236 Shifts in the Supply of Bonds Expected profitability of investment opportunities in an expansion the supply curve shifts to the right Expected inflation an increase in expected inflation shifts the supply curve for bonds to the right Government budget increased budget deficits shift the supply curve to the right 2007 Pearson Addisoanesley All rights reserved 237 r A Tomorrow Wednesday Jan 7 7 gt Linking Money Mrkt 39 and Bond Mrkt Risk and Term Structure Iv CR Contemporary theories on money Copyright 2007 Pearson Addisoanesiey Aii rights reserved 238 Critical Readings You will Write 2 pg paper 5007OO wds Summarize hypothesis and main points of supporting arguments and evidence Critically assess reading Do you agreedisagree Why Are they strong arguments What is convincing and what is not What evidence would convince you What did you find most interesting What questions did you have after reading Prepare a 1O min presentation teaching the reading to the class Glassspreparemgydiscussion questions
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