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# Money Bank & Fin Markets EC 330

MSU

GPA 3.81

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This 13 page Class Notes was uploaded by Kareem Larkin PhD on Saturday September 19, 2015. The Class Notes belongs to EC 330 at Michigan State University taught by Norman Obst in Fall. Since its upload, it has received 28 views. For similar materials see /class/207647/ec-330-michigan-state-university in Economcs at Michigan State University.

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Date Created: 09/19/15

chapter 5 1182011 92600 PM Risk a measure of uncertainty about the future payoff to an investment measured over some time horizon relative to a benchmark Risk is a measure that can be quantified Risk arises from uncertainty about the future Risk has to do with the future payoff of an investment which is unknown Our definition of risk refers to an investment or group of investments We can use the term investment very broadly here to include everything from the balance in a bank account to shares of a mutual fund to lottery tickets and real estate Risk must be measure over some time horizon Every investment has a time horizon Risk must be measured relative to a benchmark rather than in isolation o Benchmark the performance of a group of experienced investment advisors or money managers 0 If you want to know the risk associated with a specific investment strategy the most appropriate benchmark would be the risk associated with other strategies Probability is a measure of the likelihood that an event will occur Always expressed as a number between zero and one The closer the probability is to zero the less likely it is that an event will occur If the probability is exactly zero we are sure that the event will not happen The closer the probability is to one the more likely it is that an event will occur If the probability is exactly one the even will definitely occur One important property of probabilities is that we can compute the chance that one or the other even will happen by adding the probabilities together Expected Value is the average or the most likely outcome mean 0 Computing the expected value of the investment take the probability and multiply by associated payoff amount you could get back Riskfree asset is an investment whose future value is known with certainty and whose return is the riskfree rate of return Variance the average of the squared deviations of the possible outcomes from their expected value weighted by their probabilities c we square the differences from the expected value so that high and low payoffs don t cancel each other out and we get a measure of how spread out they are Steps to compute the variance o Compute the expected value c Subtract the expected value from each of the possible payoffs o Square each of the results o Multiply each result times its probability and add up the results Standard Deviation o The positive square root of the variance o The standard deviation is more useful than the variance because it is measure in the same unit as the payoffs dollars variance is measured in dollars squared o Given a choice between two investments with the same expected payoff most people would choose the one with the lower standard deviation A higherrisk investment would be less desirable o The more spread out the distribution of possible payoffs from an investment the higher the standard deviation and the bigger the risk o Standard deviation is the most common measure of financial risk and for most purposes it is adequate Value at Risk o Measures risk as the maximum potential loss answer to the question How much will I lose is the worst possible scenario occurs o A more sophisticated valueatrisk analysis would include a time horizon and probabilities o The worst possible loss over a specific time horizon at a given probability Riskaversion c We pay to avoid risks because most of us are risk averse o EX if you are offered a single chance to play a game in which a fair coin will be tossed If it comes up heads you will win 1000 if it comes up tails you will get nothing How much would you be willing to pay to play the game just once The expected value of the game is 500 that is on average the game yields 500 Would you pay 500 to play the game if so you are risk neutral Most people would not play the game at 500 though they would less than the amount These people are risk averse c We can conclude that a riskaverse investor will always prefer an investment with a certain return to one with the same expected return but any amount of uncertainty A riskneutral person wouldn t care as long as the expected return is the same o A riskfree investment with a guaranteed return is clearly preferable to a risky investment with the same expected return but an uncertain outcome RiskPremium o The riskier an investment the higher the compensation investors require for holding it the higher the risk premium Sources of Risk o Idiosyncratic unique risks 0 One set of firms is affected in one way and other firms in another way o Systematic economywide risks 0 The risk that everyone will do poorly at the same time Diversification o Risk can be reduced through diversification the principle of holding more than one risk at a time o Holding several different investments can reduce the idiosyncratic risk an investor bears o A combination of risky investments is often less risky than any one individual investment Hedging Risk o The strategy of reducing idiosyncratic risk by making two investments with opposing risk 0 When one does poorly the other does well and vice versa o Splitting your investment between two stocks with different payoff patterns has eliminated your risk entirely Spreading Risk c To spread your risk all you need to do is find investments whose payoffs are unrelated o By spreading your investment among independently risky investments you lower the spread of the outcomes and lower the risk chapter 6 1182011 92600 PM Bond Prices o A standard bond specifies the fixed amounts to be paid and the exact dates of the payments Zero Coupon Bonds Promise a single future payment such as a US Treasury bill T bills The most straightforward type of bond There are no coupon payments which is why Tbills are known as zerocoupon bonds Also called pure discount bonds since the price is less than their face value they sell at a discount The US Treasury doesn t issue Tbills with a maturity of more than one year six month Tbills are much more common The shorter the time until the payment is made the more we are willing to pay for it When the price moves the interest rate moves with it albeit in the opposite direction FixedPayment loans o Such as conventional mortgages Home mortgages car loans o These loans are amortized meaning that the borrower pays off the principal along with the interest over the life of the loan Coupon Bonds o Make periodic interest payments and repay the principal at maturity US Treasury bonds and most corporate bonds are coupon bonds o The issuer of a coupon bond promises to make a series of periodic interest payments called coupon payments plus a principal payment at maturity Consols o Make periodic interest payments forever never repaying the principal that was borrowed The price of a consol is the present value of all the future interest payments The price of a consol equals the annual coupon payment divided by the interest rate Yield to Maturity O O o The most useful measure of the return on holding a bond o The yield bondholders receive if they hold the bond to its maturity when the final principal payment is made o Conclusions from formula 0 If the price of the bond is 100 then the yield to maturity equals the coupon rate Because the price rises as the yield fails when the price is above 100 the yield to maturity must be below the coupon rate Because the price falls as the yield rises when the price is below 100 the yield to maturity must be above the coupon rate o Capital Gain when the price of the bond is below the face value the return is above the coupon rate o Capital Loss when the price is above the face value the bond s yield to maturity falls below its coupon rate Current Yield o Measure of the proceeds the bondholder receives for making a loan o It is the yearly coupon payment divided by the price o The current yield moves in the opposite direction from the price it fails when the bond s price goes up and rises when the price goes down So when the price equals the face value of the bond the current yield and coupon rate are equal Holding Period Return o Since the price of the bond may change between the time of the purchase and the time of the sale the return to buying a bond and selling it before it matures the holding period return can differ from the yield to maturity o Oneyear holding period return is the sum of the yearly coupon payment divided by the price paid for the bond and the change in the price price sold minus the price paid divided by the price paid o The first part is the current yield The second part is the capital gain SO Holding period returncurrent yield Capital gain o The greater the price change the more important a part of the holding period return the capital gain or loss becomes The Bond Market 0 O Bond supply Bond demand and equilibrium prices in the bond market help us figure out how bond prices are determined Investment Horizon assuming an investor is planning to purchase a oneyear bond and hold it to maturity then the holding period return equals the bond s yield to maturity and both are determined directly from the price Bond supply curve the relationship between the price and the quantity of bonds people are willing to sell all other things being equal The higher the price of a bond the larger the quantity supplied will be for two reasons 0 From an investors point of view the higher the price the more tempting it is to sell a bond they currently hold 0 From the point of view of companies seeking finance for new projects the higher the price at which they can sell bonds the better 0 Slopes upward Bond Demand Curve the relationship between the price and quantity of bonds that investors demand all other things equal As the price falls the reward for holding the bond rises so the demand goes up Slopes downward Since the price of bonds is inversely related to the yield the demand curve implies that the higher the demand for bonds the higher the yield Equilibrium in the bond market is the point at which supply equals demand 0 If bond prices start out above the equilibrium point quantity supplied will exceed quantity demanded Excess Supply 0 The excess supply will put downward pressure on the price until supply equals demand 0 Those who wish to buy bonds cannot get all they want at the prevailing price Their reaction is to start bidding up the price 0 When the quantity demanded or quantity supplied changes because of a change in the price it produces a movement along the curve But when the quantity demanded or supplied at a given price changes it shifts the entire curve o A shift in either the supplydemand curve changes the price of bonds so it changes the yield as well Factors that Shift the Bond Supply o Changes in Gov t borrowing 0 Both changes in tax policy and adjustments in fixed spending can affect a gov ts need to borrow 0 Any increase in the government s borrowing needs increases the quantity of bonds outstanding shifting the bond supply curve to the right o Changes in General Business Conditions 0 As business conditions improve the bond supply curve shifts to the right forcing bond prices down and interest rates up o Changes in expected inflation 0 When expected inflation rises the cost of borrowing falls and the desire to borrow rises 0 An increase in expected inflation shifts the bond supply curve to the right 0 Higher expected inflation increases the bond supply reducing bond prices and raising the nominal interest rate o Factors that shift bond supply right lower bond prices and raise interest rates Factors that shift the Bond Demand o Wealth o Increases in wealth shift the demand for bonds to the right raising bond prices and lowering yields o Expected Inflation 0 Fall in expected inflation shifts the bond demand curve to the right increasing demand at each price and lowering yield o Expected Returns and expected interest rates 0 If the return on bonds rises relative to the return on alternative investments the quantity of bonds demanded at every price will rise shifting the bond demand curve to the right o Risk relative to alternatives 0 If a bond becomes less risky relative to alternative investments the demand for the bond shifts to the right Liquidity Relative to Alternatives 0 The less liquid a bond is the lower the demand for it and the lower the price 0 So when a bond becomes more liquid relative to alternatives the demand curve shifts to the right Default Risk o The issuer may not make the promised payments 0 Expected value of company Bond payment sum of payoffs probabilities Inflation Risk o Inflation may turn out to be higher than expected reducing the real return on holding the bond o Bondholders are interested in the real interest rate not just the nominal interest rate purchasing power of the money not the number of dollars InterestRate Risk o Interest rates may rise between the time a bond is purchased and the time it is sold reducing the bond s price o Investors don t know the holding period return of a longterm bond 0 The longer the term of the bond the larger the price change for a given change in the interest rate o Whenever there is a mismatch between your investment horizon and a bond s maturity there is interestrate risk Because the prices of longterm bonds can change dramatically this can be an important source of risk o The more likely interest rates are to change during the bondholder s investment horizon the larger the risk of holding a bond chapter 7 1182011 92600 PM Ratings and the Risk Structure o Changes in bond prices and the associated changes in interest rates can have a pronounced effect on borrowing costs corporations face Default is one of the most important risks a bondholder faces The best known bond rating services are Moody s and Standard amp Poor s 0 These companies monitor the status of individual bond issuers and assess the likelihood that a lenderbondholder will be repaid by a borrowerbond issuer Companies with good credit high profitability and sizable amounts of cash assets earn high bond ratings A high rating suggests that a bond issuer will have little problem meeting a bond s payment obligations o Investmentgrade bonds the top four categories Aaa down to Baa in the Moody s scheme have a very low risk of default These ratings are reserved for most gov t issuers as well as corporations that are among the most financially sound Insurance companies pension funds and commercial banks are not allowed to invest in bonds that are rated below Baa on Moody s scale or BBB on Standard amp Poor s scale speculative grades junk bonds o Junk Bonds 0 Fallen Angels were once investmentgrade bonds but their issuers fell on hard times 0 The second are cases in which little is known about the risk of the issuer o MCI WorldCom telecommunications giant purchased by Verizon in early 2006 Rating dropped to Ba and its 10year bonds were trading for 44 cents on the dollar less than half of their initial prices o If a particular business or country encounters problems moody s and standard amp poor s will lower that issuer s bond rating in what is called a ratings downgrade 0 An average of 5 to 7 percent of bonds that bein a year in an investmentgrade category Aaa to Baa have their ratings downgraded to one of the noninvestment Ratings upgrades also occur roughly 7 of Aarated bonds are upgraded to Aaa o Commercial Paper A shortterm version of a bond Issued by both corporations and governments Because the borrower offers no collateral this form of debt is unsecured Issued on a discount basis as a zerocoupon bond that specifies a single future payment with no associated coupon payments Usually has a maturity of less than 270 days More than 13 of all commercial paper is held by money market mutual funds 0 Most are issued with a maturity of 5 to 45 days and is used exclusively for shortterm financing 0 90 of issuers carry Moody s Pl rating and another 9 are rated P2 P primegrade commercial paper The Impact of Ratings on Yields Bond ratings are designed to reflect default risk the lower the the higher the risk of default Benchmark Bonds the closest to being risk free c Any bond yield the yield on the benchmark US Treasury bond a defaultrisk premium risk spread o The Risk Structure of interest Rates 0 When the US treasury yield goes up or down the Aaa and Baa yields do too 0 The yield on the higherrated US Treasury bond is consistently the lowest 0 Whenever a company s bond rating declines the cost of funds goes up impairing the company s ability to finance new ventures Differences in Tax Status 0 O O O O O O Taxable bonds bondholders must pay income tax on the interest income they receive from owning privately issued bonds Municipal taxexempt bonds the coupon payments on bonds issued by state and local governments are specifically exempt from taxation General rule in the US is that the interest income from bonds issued by one government is not taxed by another government Taxexempt bond yield taxable bond yield 1tax rate Term Structure of Interest Rates The relationship among bonds with the same risk characteristics but different maturities Conclusions 0 Interest rates of different maturities tend to move together 0 Yields on shortterm bonds are more volatile than yields on longterm bonds 0 Longterm yields tend to be higher than shortterm yields Expectations Hypothesis of the term structure Begins with the observation that the riskfree interest rate can be computed assuming there is no uncertainty about the future 0 We know not just the yield on bonds available today but the yields that will be available on bonds next year Certainty means that bonds of different maturities are perfect substitutes for each other When interest rates are expected to rise in the future long term interest rates will be higher than short term interest rates 0 Meaning that the yield curve will slope up If bonds of different maturities are perfect substitutes for each other then we can construct investment strategies that must have the same yields Tells us that longterm bond yields are all averages of expected future shortterm yields the same set of short term interest rates so interest rates of different maturities will move together Implies that yields on shortterm bonds will be more volatile than yields on longterm bonds o Cannot explain why longterm yields are normally higher than shortterm yields since it implies that the yield curve slopes upward only when interest rates are expected to rise o Has gotten us 23 of the way toward understanding the term structure of interest rates o By ignoring risk and assuming that investors view short and long term bonds as perfect substitutes we have explained why yields at different maturities move together and why shortterm interest rates are more volatile than long term rates But we have failed to explain why the yield curve slopes upward The Liquidity Premium Theory o Risk is the key to understanding the usual upward slope of the yield curve o Longterm interest rates are typically higher than short term interest rates because long term bonds are riskier than short term bonds 0 The longer the term of the bond the greater both types of risk o Uncertainty about inflation creates uncertainty about a bond s real return making the bond a risky investment o A bond s inflation risk increases with its time to maturity o The expectation hypothesis explains the risk free par and inflation and interest rate risk explain the risk premium Together they form the liquidity premium theory of the term structure of interest rates o Predicts that interest rates of different maturities will move together and that yields on shortterm bonds will be more volatile than yields on long term bonds and by adding a risk premium that grows with time to maturity it explains why longterm yields are higher than short term yields o Tells us that the yield curve will normally slope upward only rarely will it lie flat or slope downward because the risk premium increases with time to maturity o A flat yield curve means that interest rates are expected to fall a downward sloping yield curve suggests that the financial markets are expecting a significant decline in interest rates

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