Money & Banking Exam 1

liquidity

a measure of the ease with which an asset can be turned into a means of payment- (a bond is much more liquid than a house b/c it is cheaper/easier to sell) we hold money because it is liquid

Risk

a measure of uncertainty about the future payoff to an investment, assessed over some time horizon and relative to a benchmark

Bond

a promise to make a series of payments on specific future dates. issued as part of an arrangement to borrow (borrower or seller gives an IOU to the lender, or buyer, in return for some amount of money) governments and corporations both issue bonds

portfolio

a prudent investor holds a collection of assets (portfolio), which includes a number of stocks and bonds as well as various forms of money- a well designed portfolio has a lower overall risk than any individual stock or bond. without the market, we wouldn't be able to share risk

inverted yield curve

a valuable forecasting tool because it predicts a general economic slowdown. Because the yield curve slopes upward even when short term yields are expected to remain constant- its the average of expected future short term interest rates plus a risk premium- an inverted yield curve signals an expected fall in short-term interest rates

risk free asset

an investment whose future value is known with certainty and whose return is the risk-free rate of return. -the payoff that you will receive from such an investment is guaranteed and cannot vary.

Investment Grade- AAA

bonds of the best quality with the smallest risk of default- issuers are exceptionally stable and dependable (exxonmobil, microsoft, canada)

junk bonds define

bonds with ratings below investment grade- high-yield bonds-

How do we measure risk?

by quantifying the spread among an investment's possible outcomes (2 measures, standard deviation and value at risk)

dealer

can act as a counterparty

Expected inflation

can calculate it by listing all possibilities for inflation, assigning each one a probability, and then calculating the expected value of inflation

measuring liquidity

consider a broad category of financial assets and sort them by their degree of liquidity- rank them by the ease which which they can be converted into a means of payment.

municipal or tax exempt bonds

coupon payments on bonds issued by state and local governments- specifically exempt from taxation

when bond price = face value:

coupon rate = current yield = yield to maturity

when bond price is greater than face value:

coupon rate is greater than current yield is greater than yield to maturity

When bond price is less than face value

coupon rate is less than current yield is less than yield to maturity

yield define

a measure of the cost of borrowing and the reward for lending

Centralized exchanges

secondary markets where dealers meet in a central, physical location

The holding period return on a bond:

will be less than the yield to maturity if the bond is sold for less than face value

expected present value

with default risk, expected present value = (sum of payoffs times probabilities)/((i+1)^n)

a bond's inflation risk...

increases with its time to maturity

Trend towards institutionalization

indirect finance- asset holder owns a claim on the financial institution (like a bank or mutual fund_ that in turn, owns a claim on the borrower- different from direct finance where the asset holder has a direct claim on the borrower

a fall in bond prices means...

an increase in interest rates and a corresponding rise in the cost the companies have to pay to borrow

money

pay for purchases/store wealth -used to be gold/silver, then paper, then electronic funds transfers

History of money, US

-1775- Continental Congress of the US issued "continentals" to finance Revolutionary war- became worthless-too much -Civil War- pressure on government finances and 2 warring parties had little choice but to issue paper money to pay for salaries/supplies -After Civil War- went back to gold -Today- paper money

Role of Financial Institutions

-reduce transactions costs by specializing in the issuance of standardized securities -reduce the information costs of screening and monitoring borrowers to make sure they are creditworthy and they use the proceeds of a loan or security issue properly ~in other words, they help resources flow to their most productive uses

Factors that shift bond demand

1 wealth- increases in wealth shift the demand for bonds to the right, raising bond prices and lowering yields (as wealth falls during a recession, the demand for bonds fall, lowering bond prices and raising interest rates 2. expected inflation- fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering the yield- higher real returnon the bond increases the willingness of would-be lenders to buy it at any given price 3. expected returns- if expected 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- bond prices are connected to the stock market 4. expected interest rates-when interest rates are expected to change in the future, bond prices adjust immediately- when interest rates fall, bond prices rise, creating a capital gain-an increase in the expected return on a bond, relative to the return on alternatives, shifts bond demand to the right 5. risk relative to alternatives- if a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right 6. liquidity relative to alternatives- when a bond becomes more liquid relative to alternatives, the demand curve shifts to the right

Examples of financial instruments

1. Bank loans 2. bonds- form of loan- in exchange for obtaining funds today, a corporation/government promises to make payments in the future 3. home mortgages- a loan used to purchase real estate- house is collateral for the loan 4. stocks- the holder of a share of a company's stock owns a small piece of the firm and is entitled to pat of its profits 5. asset-backed securities- shares in the returns or payments arising from specific assets, such as home mortgages, student loans, credit card debt, or even move box-office receipts.- most prominent = mortgage-backed securities- bundle a large number of mortgages together in a pool in which the shares are then sold-securities backed by subprime mortgages-loans to borrowers who are less likely to repay than borrowers of conventional mortgages-played an important role in the financial crisis of 2007-2009

liquidity spectrum

1. Currency 2. Checking account (demand deposits) 3. Saving Accounts (certificates of deposit) 4. U.S. Treasury bonds 5. Stocks and Corporate bonds 6. Houses/Art/Etc.

Steps of a check

1. Hand paper check from your bank to a merchant 2. Merchant deposits check or an electronic image of the check into the merchant's bank and the merchant's account is credited 3. the merchant's bank sends an electronic image of the check to the local federal reserve bank 4. the federal reserve credits the merchant's bank's reserve account and debits your bank's reserve account 5. the federal reserve returns an electronic image of the check to your bank 6. your bank debits your checking account by the amount of the check (your bank has several days to send the check back through the system if you have insufficient funds in your account). -the transaction isnt final until the period has passed

Interest-rate risk would not matter to which of the following bondholders?

A holder of a U.S. government bond that plans on holding it until it matures

Present value and interest rates move in opposite directions, so we can conclude the following:

1. If the price of the bond is $100, then the yield to maturity equals the coupon rate. 2. Because the price rises as the yield falls, when the price is above $100, the yield to maturity must be below the coupon rate 3. Because the price falls as the yield rises, when the price is below $100, the yield to maturity must be above the coupon rate

Financial Instruments Used to Transfer Risk

1. Insurance contracts- assure that payments will be made under particular circumstances 2. Futures contracts- an agreement between 2 parties to exchange a fixed quantity of a commodity (wheat or corn) or an asset (bond) at a fixed price on a set future date-always specifies the price at which the transaction will take place-used to transfer risk of price fluctuations from one party to another 3. options- derivative instruments whose prices are based on the value of some underlying asset- give the older the right, but not the obligation to buy or sell a fixed quantity of the underlying asset at a predetermined price either on a specified date or at any time during a specified period 4. swaps- agreements to exchange two specific cash flows at certain times in the future- ex: an interest rate swap might involved the exchange of payments based on a fixed rate of interest for payments based on a rate of interest that fluctuates ( or floats) with the market

Comparing information on 3 month and 10 year Treasury issues, we can draw 3 conclusions...

1. Interest rates of different maturities tend to move together 2. Yields on short term bonds are more volatile than yields on long term bonds 3. Long term yields tend to be higher than short term yields

Once a bond rating is assigned, it:

Can change as the financial position of the issuer changes

Five Core Principles of Money and Banking

1. Time 2. Risk 3. Information 4. Markets 5. Stability

2 reasons why we accept bills as payments for goods/settlement for debts

1. We believe we can use them in the future, someone else will take them from us 2. The law says we must accept them- the U.S. government stands behind its paper money (since 1862)

2 types of financial market

1. centralized exchanges NYSE, London, Tokyo 2. over the counter markets, Nasdaq- collection of dealers who trade with one another via computer More recently... ECN- electronic communication networks- enable traders (or brokers) to find counterparties who wish to trade in specific stocks, includign those listed on an exchange

Factors that shift bond supply

1. changes in government borrowing- any increase in the government's borrowing needs increases the quantity of bonds outstanding, shifting the bond supply curve to the right- demand curve stays- has reduced prices/raising interest rates 2. changes in general business conditions-as the amt of debt in the economy rises, the quantity of bonds outstanding with a given risk goes up- as business conditions improve, the bond supply curve shifts to the right- forcing bond prices down and interest rates up 3. changes in expected inflation-when expected inflation rises, the cost of borrowing falls and the desire to borrow at every nominal interest rate rises- an increase in expected inflation shifts the bond supply curve to the right- higher expected inflation increases the bond supply, reducing bond prices and raising the nominal interest rate

2 steps to figure out if you should buy an item for business

1. compute the internal rate of return on your investment in the machine 2. compare that return of the cost of buying the machine If the cost is less than the return, then you should buy the machine ~An investment will be profitable if its internal rate of return exceeds the cost of borrowing

bondholders face 3 major risks

1. default risk- the chance that the bond's issuer may fail to make the promised payment 2. inflation risk- an investor can't be sure of what the real value of the payments will be, even if they are made 3. interest rate risk- arises form a bondholder's investment horizon, which may be shorter than the maturity of the bond

two types of junk bonds

1. fallen angels- were once investment-grade bonds, but their issuers fell on hard times-Sovereigns can be fallen angels (ex. Greece) 2. cases in which little is known about the risk of the issuer

Future value of investment for 2 years, four parts

1. initial investment of $100 2. the interest on the investment in the first year 3. the interest on it in the second year 4. interest you receive during the second year on the interest your received in the first year Interest on the initial investment in first year +interest on the initial investment in second year +interest on the interest from first year in second year = future value in 2 years

Roles of financial markets

1. market liquidity- ensure that owners of financial instruments can buy and sell them cheaply and easily 2. information- pool and communicate information about the issuer of a financial instrument 3. risk sharing- provide individuals with a place to buy and sell risks, sharing them with others ~to buy or sell a stock, you must pay a licensed professional to complete the purchase-

Three functions of financial instruments

1. means of payment (can pay with financial instruments, even if its not in money- ex: stock) 2. store of value (generate increases in wealth that are bigger than those we can obtain from holding money-higher payoffs because higher levels of risk-more uncertain than money) first two like money 3. ALLOW FOR THE TRANSFER OF RISK

Debt instruments can be placed in 1 or 2 categories

1. money markets- debt instruments that are completely repaid in less than a year (from their original issue date)-different names/treaded differently from bond market instruments 2. bond markets- those with a maturity of more than a year are traded in these markets

Characteristics of a well-run financial market

1. must be designed to keep transaction costs low 2. the information the market pools and communicates must be both accurate and widely available (prices are the link between financial marekts and real economy, ensuring the resources are allocated to their most efficient uses) 3. investors need protection- borrowers promises to pay lenders must be credible- lenders must be able to enforce their right to receive repayment

Structural change

1. ongoing technological advances in computing and communications (lowered importance of physical location) 2. increased globalization (encouraged cross border mergers of exchanges-larger pools of providers)

2 parts of the nominal interest rate

1. real interest rate 2. expected inflation

M2 no longer predicts inflation

1. relationship between the two applies only at high levels of inflation 2. we need a new measure of money that takes into account recent changes in the way we make payments and use money

Bonds are legal contracts that... (2 things)

1. require the borrower to make payments to the lender 2. specify what happens if the borrower fails to do so

6 Important elements to risk

1. risk is a measure that can quantified (we want to know which one is riskier and by how much. We expect a riskier investment to be less desirable than others and to command a lower price. Uncertainties that are not quantifiable cannot be priced. 2. Risk arises from uncertainty about the future (future has many possible courses)- only one possibility will occur 3. risk has to do with future payoff of an investment (unknown)- must be able to list all possibilities 4. risk refers to an investment or group of investments. we can include everything from the balance in a bank account to shares of a mutual fund to lottery tickets and real estate 5. risk must be assessed over some time horizon. Every investment has a time horizon. the risk of holding an investment over a short period is smaller than the risk of holding it over a long one 6. risk must be assessed relative to a benchmark rather than in isolation. if an investment is risky, "relative to what?" (relative to a risk free investment)

a bond specifies... ( 2 things)

1. the fixed amounts to be paid 2. the exact dates of the payments

2 important properties of periodic fixed payments

1. the longer the payments go on- the more of them there are- the higher their total value (even though the additional payments fall further in to the future, the overall present value still grows). because a long term bond has more payments than a short term maturity bond, the coupon payments on the long term bond will be worth more than the coupon payments on the short term bond 2. as always the case in present-value calculations, the higher the interest rate, the lower the present value

Four characteristics that influence the value of a financial instrument

1. the size of the payment that is promised (payments that are larger are more valuable) 2. when the promised payment is to be made (payments that are made sooner are more valuable) 3. the likelihood that the payment will be made (payments that are more likely to be made are more valuable) 4. the circumstances under which the payment is to be made (payments that are made when we need them most are more valuable)

2 types of financial institutions

1. those that provide brokerage services (top) 2. those that transform assets (bottom)

2 fundamental classes of financial instruments

1. underlying instruments- primitive securities- used by savers/lenders to transfer resources directly to investors/borrowers (stocks/bonds) 2. derivative instruments- value and payoffs are "derived" from the behavior of the underlying instruments. (futures, options, swaps)- specify a payment to be made between the person who sells the instrument and the person who buys it- primary use = to shit risk among investors

2 facts about valuing the coupon payments plus principal

1. value of the coupon bond, Pcb rises when the yearly coupon payments, C, rise (comes from teh fact that a higher coupon rate means larger payments) 2. the interest rate, i, falls (follows directly from present value relationship) ~lower interest rates mean higher bond prices and higher interest rates mean lower bond prices

Structure of financial markets (3 possibilities)

1. we can distinguish between markets where new financial instruments are sold and those where they are resold, or traded 2. we can categorize markets by the way they trade financial instruments-whether on a centralized exchange or not 3. we can group them based on the type of instrument they trade-those that are used primarily as a store of value or those used to transfer risk

6 parts of the financial system

1.money 2. financial instruments 3. financial markets 4. financial institutions 5. regulatory agencies 6. central banks ~Constantly evolving

Probability theory

1st, list all possible outcomes and then figure out the chance of each one occuring.

According to the expectations theory of the term structure, if interest rates are expected to be 2%, 2%, 4%, and 5% over the next four years, what is the yield on a three-year bond today?

2.7%

ratings upgrades

3% of Aa-rated bonds are upgraded to Aaa each year

Bonds rated as "highly speculative

Are commonly referred to as junk bonds

promised yield

=(promised payment/expected present value)-1

Which of the following would be most likely to earn an AAA rating from Standard &Poor's?

A 30-year bond issued by the U.S. Treasury

The bond supply curve slopes upward because:

For companies seeking financing, the higher the price of bonds the more attractive it is to sell bonds

What is the highest bond rating assigned by Standard and Poor's

AAA

Noninvestment Speculative Grade B

Able to pay now but at risk of default in the future (Hertz, Office Depot, Venezuala)

Investment or Prime Grade: Moody's (P-3), S & P (A-3)

Adequate degree of safety for timely repayment (Alcoa)

Speculative, below Prime Grade: S & P (B, C)

Capacity for repayment is small relative to higher rated issuers

One characteristic that distinguishes holding period return from the coupon rate, the current yield and the yield to maturity is:

All of the other returns can be calculated at the time the bond is purchased, but holding period return cannot

electronic communication networks (ECNs)

An electronic system that brings buyers and sellers together for electronic execution of trades without the use of a broker or dealer

Which of the following would lead to a decrease in bond demand?

An increase in expected inflation

Suppose that the expected return on assets such as stocks falls. In the bond market, this will result in:

An increase in the price of bonds

Future of Money

As a means of payment- time is approaching when safe and secure systems for payment will use virtually no money at all -as a unit of account- likely see a similar sort of standardization of money and a dramatic reduction in the number of units of account -as a store of value- on the way out-many financial instruments have become highly liquid ~Forecasting any developments is nearly impossible- who can make such predictions?

The bond demand slopes downward because

At lower prices the reward for holding the bond increases

The lowest rating for an investment grade bond assigned by Moody's is

Baa

taxable bonds

Bondholders must pay income tax on the interest income they receive from owning privately issued bonds- affects return on the bond

Increased borrowing by the U.S. treasury to finance growing budget deficits will:

Cause the yield on U.S. Treasury bonds to increase, but still can be lower than corporate bonds.

Core Principal 2: Risk Requires Compensation

Dealing effectively with risk requires that you consider the full range of possibilities in order to eliminate some risks, reduce others, pay someone to assume particularly onerous risk, and just live with what's left. No one will assume risks for free (car insurance, high interest on loan if there is a chance the person won't pay)

Electronic payments

Debit card- works same way as a check-instructions to transfer funds credit card- a promise by the bank to lend the cardholder money with which to make purchases-bank that issued the credit card makes the payment

Expected value equation

EV=Sum of (Probability times payoff) This is an average payoff- you will obtain either one of the values on your table, you will not get this number.

General formula for future value

FVn=PV * (1+i)^n ~Future value in n years = present value of the investment * (one plus the interest rate) raised to n ~to compute a future value, all we need to do is calculate one plus the interest rate (measured as a decimal) raised to the nth power and multiply it by the present value ~in computing future value, both the interest rate and n must be measured in the same time units (1/12 for one month, 1/365 for one day)

when term spread falls,

GDP gowth tends to fall somewhat later- when the yield curve becomes inverted the economy tneds to go into a recesiion roughly a year later

Investment Grade-A

High-medium quality, with many strong attributes but somewhat vulnerable to changing economic conditions (JPMorgan Chase, Oracle, Israel)

The U.S. Treasury has introduced bonds (such as TIPS) with the return indexed to the consumer price index. We should expect that these bonds, relative to other U.S. Treasury bonds, will have:

Higher price and lower return due to the decreased risk from inflation in holding these bonds

Highly Speculative- Ca (Moody's), CC (S & P)

Highly speculative quality, often in default

Highly speculative- D

In default.

If the default risk on foreign government bonds increases relative to U.S. government bonds, the price of U.S. government bonds should:

Increase as the demand for these bonds increases due to a flight to quality

The risk premium for an investment...

Increases with risk

Suppose the economy has an inverted yield curve. According to the expectations hypothesis, which of the following interpretations could be used to explain this?

Interest rates are expected to fall in the future

the risk structure of interest rates indicates:

Lower rated bonds will have higher yields

monetary aggregates (M1)

M1: narrowest definition of money- includes only currency and various deposit accounts on which people can write checks (most liquid assets)- include currency int eh hands of the public, which is the quantity of dollar bills outstanding excluding the ones in the vaults of the banks; traveler's checks issued by travel companies, banks, and credit card companies, which are guaranteed by the issuer and usually work just like cash; demand deposits at commercial banks, which are standard checking accounts that pay no interest; and other checkable depostits, which are deposits in checking accounts that pay interest

monetary aggregates (M2)

M2-all of M1 plus assets that cannot be used directly as a means of payment and are difficult to turn into currency quickly-include small denomination time deposits (less than $100,000) that cannot be withdrawn without advance notice; savings deposits, including money-market deposit accounts, which pay interest and offer limited check-writing privileges; retail money-market mutual fund shares, or shares in funds that collect relatively small sums from individuals, pool them together, and invest them in short-term marketable debt issued by large corporations.- most commonly quoted monetary aggregate in the US because movements are closely related to interest rates and economic growth

Core Principle 4: Markets Determine Prices and Allocate Resources

Markets- core of economic system- place (physical/virtual) where buyers and sellers meet, where firms go to issue stocks and bonds, and where individuals go to trade assets. -financial markets= essential to the economy- the better developed a country's financial markets, the faster the country will grow.- financial markets gather information from a large number of individual participants and aggregate it into a set of prices that signals what is valuable and what is not- by attaching prices to different stocks or bonds, they provide a basis for the allocation of capital- financial markets do not arise by themselves- require rules in order to work properly- for people to participate, they must perceive it as fair.

Investment Grade-Baa (through Moody's) or BBB (through Standard & Poor's)

Medium quality, currently adequate but perhaps unreliable over the long term (General Mills, Time Warner, Brazil, Italy)

best known bond rating services =

Moody's and Standard & Poor's- monitor the status of individual bond issuers and assess the likelihood that a lender/bondholder will be repaid by a borrower/bond issuer

present value equation

PV = (FV)/(1+i) for 1 year presnt value = future value of the payment divided by (one plus the interest rate) also can be... PV= (FVn)/(1+i)^n present value = future value of a payment made in n years divided by (one plus the interest rate) raised to n ****This is the single most important relationship in our study of financial instruments

Equation for future value

PV+Interest=Future value in one year or FV=PV*(1+i) The higher the interest rate or amount invested, the higher the future value

Equation for present value of bond principal

Pbp=F/(1+i)^n Present value of bond principal (Pbp)=Principal payment (F) divided by (one plus the interest rate) raised to n -higher the n-the lower the value of the payment- higher the interest rate, i, the lower the value of the payment

To value the yearly coupon payments plus principal equation

Pcb = Pcp +Pbp Present value of coupon bond (Pcb) = present value of yearly coupon payments (Pcp) + Present value of principal payment (Pbp)

Highly Speculative-Caa (Moody's), CCC (S& P)

Poor quality, clear danger of default (Cuba, Pakistan)

Investors usually obtain bond ratings from:

Private bond-rating agencies

formula for real GDP

Real GDP = (nominal GDP / price index) x 100

Defaulted

S & P: D

Investment or Prime Grade: Moody's (p-2), S & P (A-2)

Satisfactory degree of safety for timely repayment (General Mills, Time Warner)

Under the Liquidity Premium Theory a flat yield curve implies:

Short-term interest rates are expected to decrease

The default-risk premium

Should vary directly with the bond's yield and inversely with its price

use of checks decreasing

Since 2000- checks in value of noncash transactions has fallen from 58 to 23%- still with us because a cancelled check is legal proof of payment and, in many states, laws require banks to return checks to customers -also people are creatures of habit- still like to receive the processed checks- finally- new electronic mechanism for clearing checks have lowered costs and kept checks as an important, if dwindling, means of payment

Noninvestment, Speculative Grade Ba (Moody's), BB (S & P)

Some speculative element, with moderate security but not well safeguarded (Goodyear tire, general motors, Turkey)

Which of the following assigns widely followed bond ratings? #2

Standard & Poor's

The two best known bond rating services are

Standard & Poor's and Moody's Investment Services

Which of the following assigns widely followed bond ratings?

The Wall Street Journal

If the U.S. government's borrowing needs increase, in the bond market this would cause:

The bond supply curve to shift right

If a bond's rating improves it should cause

The bond's price to increase and its yield to decrease, all other factors constan

If a bond's rating improves it should cause:

The bond's price to increase and its yield to decrease, all other factors constant

When expected inflation increases, for any given nominal interest rate:

The cost of borrowing decreases and the desire to borrow increases

If a bond's purchase price equals the face value:

The coupon rate equals the yield to maturity, which equals the current yield

shadow banking system

The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions ~non-depository banks investment banks, structured investment vehicles (SIVs), conduits, hedge funds, non-bank financial institutions and money market funds

The bond rating of a security reflects

The likelihood the lender/borrower will be repaid by the borrower/issuer

The rating of a bond reflects:

The likelihood the lender/borrower will be repaid by the borrower/issuer

The difference in the prices of a zero-coupon bond and a coupon bond with the same face value and maturity date is simply:

The present value of the coupon payments

How much should someone be willing to pay for a bond?

The price of a bond is the present value of its payments

An increase in expected inflation for any given nominal interest rate will cause:

The real return to bondholders to decrease

Which of the following statements pertaining to the yield curve is not true?

The yield curve shows the difference in default risk between securities

When the price of a bond is above face value

The yield to maturity is below the coupon rate

Bonds issued by the U.S. treasury are referred to as benchmark bonds because:

They are the closes thing to a risk-free bond

which of the following is true

U.S. Treasury Bill yields are lower than the yields on commercial paper

benchmark bonds

U.S. Treasury issues -yields on other bonds are measured in terms of the spread over treasuries

Income

a flow of earnings over time

Commercial paper refers to:

Unsecured short-term debt issued by corporations and governments

Most commercial paper is:

Used exclusively for short-term financing needs

Which of the statements is most correct?

Usually higher expected returns are associated with higher risk premiums

Which fact about the term structure of interest rates is the expectations theory unable to explain?

Why longer-term yields tend to be higher than shorter term yields

If the quantity of bonds demanded exceeds the quantity of bonds supplied, bond prices:

Would rise and yields would fall

Financial Instrument, Redefined

Written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions -subject to government enforcement - specifies that the payments will be made -dates may be specific (loan) or payment is triggered (car insurance) -specified conditions- some specify payments only when certain events happen- holder of a stock owns a small part of a firm and can expect to receive occasional cash payments called dividends, when the company is profitable-no way to know in advance

Once you buy a coupon bond, which of the following can change?

Yield to maturity

Risk free investment

a financial instrument with no risk at all

Diversification

a way to reduce risk not putting all the eggs in one basket holding more than one risk at a time can reduce the idiosyncratic risk an investor bears. A combination of risky investments is often less risky than any one individual investment 2 ways to diversify your investments (hedge risks or spread them) basis for the insurance business

Insurance companies

accept premiums, which they invest in securities and real estate (their assets) in return for promising compensation to policy holders should certain events occur (their liabilities)

Dodd-Frank Wall Street Reform and Consumer Protection Act

adopted in 2010- (Dodd-Frank Act)- largest US regulatory change since the 1930s-went from only a few to now- nearly every country in the world has one-control the availability of money and credit to promote low inflation, high growth, and the stability of the financial system)-used to be mystery but now- they serve the public- explain rationale for decisions (European Central Bank/US Federal Reserve)

Investors base their decisions on

after-tax yield

Financial Institutions, redifined

aka- financial intermediaries- banks, insurance companies, securities firms, and pension funds- any disturbance to them can have severe adverse effects on economy -without and intermediary, individuals/households wishing to save would have to hold wealth in cash or funnel it directly to companies/households that could put it to use- assets would be some combination of government liabilities and the equity/debt issued by corporations and other households. All finance would be direct, with borrowers obtaining funds straight from lenders. (wouldnt work- transactions would be too expensive, would have difficulty finding each other, lenders would need to evaluate the creditworthiness of borrowers and then monitor them- arent' specialists in that, and borrowers would want to borrow for long term, while lenders favor more liquid short-term loans) -a financial market could be created in which the loans and other securities could be resold, but that would create risk of price fluctuation

plot of risk structure of interest rates

all yields move together- when U.S. treasury yield goes up or down, the Aaa and Baa yields do too. While the default-risk premiums do fluctuate-rising particularly in periods of financial stress- changes in the U.S. Treasury yeild account for most of the movement in the Aaa and Baa bond yeidls. -the yield on the higher rated U.S. treasury bond is consistently the lowest -ratings are crucial to corporations' ability to raise financing. Whenever a company's bond rating declines, the cost of funds goes up, impairing the company's ability to finance new ventures

financial markets

allow us to buy and sell financial instruments quickly/cheaply -originally located in coffeehouses/taverns-then= organized markets (NYSE), today=electronic networks- even small investors can afford to participate

Basel III

also adopted in 2010- third, major update of standards for internationally active banks-named after swiss citywher ethey meet-

Money redefined

an asset that is generally accepted as payment for goods and services or repayment of debt

E-money

another method of payment-can be used instead of a credit or debit card to pay for purchases on the internet or via mobile phone-transfer funds to issuer of the e-money- then instruct issuer to send e-money to merchants- form of private money- not issued or guaranteed by government so can't use it to pay taxes- "monetary value, as represented by a claim on the issuer which is stored on an electronic device, issued on receipt of funds, and accepted as a means of payment by persons other than the issuer)- most successful example = M-Pesa in Kenya- Kenyans can deposit, withdraw, and transfer funds using their phones-improved access to financial system- cell phone substitutes for a conventional bank account.

yield

another word for interest rate

bond define

any financial arrangement involving the current transfer of resources from a lender to a borrower, with a transfer back at some point (car loans, mortgages, credit card balances)

interest-rate risk

arises from a mismatch between the investor's investment horizon and bond's time to maturity.- if a bondholder plans to sell a bond prior to maturity, changes in the interest rate (which cause bond prices to move) gerneate capital gains or losses- the longer the term of the bond, the greater the price changes for a given change in interest rates and the larger the potential for capital losses

Interest rate risk

arises from the fact that investors don't know the holding period return of a long term bond.- if you have a shot investment horizon- if you buy a long-term bond, you will need to sell the bond before it matures, so you have to worry about what will happen if interest rate changes- -when there is a mismatch between your investment horizon and a bond's maturity= interest rate risk- ~The more likely interest rates are to change during the bondholder's investment horizon = the larger the risk of holding a bond

Money as a means of payment

as a means of payment- other alternatives don't work to well (like bartering, where you rely on a "double coincidence" of wants) -money finalizes payments so that buyers and sellers have no further claim on eachother. -increase in both the number of transactions and the number of potential buyers and sellers (vast majority of whom never see each other) argues for something that makes payment final and whose value is easily verified.

secondary market transaction

ask broker-dealer to buy it for you- purchases it from others or sells it to you from the broker-dealer's own account- your acquisition is a secondary-market transaction

Inflation risk

bond holders are interested in real interest rate, not just nominal interest rate 3 components: 1. real interest rate 2. expected inflation 3. compensation for infaltion risk remember nominal interest rate = real interest rate plus expected inflation plus compensation for inflation risk ~standard deviation is lower because we are more certain that the inflation rate will be close to expected value (means this is the less risky option)

current yield falls when...

bond's price goes up

junk bonds

bonds a company/government that is on the verge of being unable to pay its bills may still be able to issue- extremely high interest rate due to risk

because 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

broker/dealer

can do both

broker

can find a counterparty

Measuring money

changes in the amt of money in the economy are related to changes in interest rates, economic growth, and most important, inflation

Funds flowing through the financial system

channels funds from lenders to borrowers through intermediaries- in indirect finance, a financial institution like a bank takes the resources from the lender in the form of a deposit and then provides them to the borrower in the form of a loan. Even in the case of direct finance, where the saver acquires a direct claim on the user of the funds, a financial institution like a stockbroker or an investment bank is usually involved in the transaction.

Core Principle 3: Information is the Basis for Decisions

collect info before making a decision- more important the decision = more information ex: lender and borrower for mortgage- when lenders fail to assess creditworthiness properly, they end up with borrowers who are unable to repay loans in the future

Financial instruments handle problem of asymmetric information

comes from the fact that borrowers have some information they don't disclose to lenders- gathers information on borrowers before giving them resources and to monitor their use for the resources afterwards.

high bond ratings

companies with good credit-low levels of debt, high profitability, sizable amounts of cash assets -suggests a bond issuer will have little problem meeting a bond's payment obligations ~firms or governments with an exceptionally strong financial position carry the highest ratings and are able to issue the highest rated bonds

Easiest way to understand quantitative impact of ratings on bond yields...

compare different bonds that are identical in every way except for the issuer's credit rating -US Treasury are the comparison b/c they have little default risk

to compute variance of an investment...

compute the expected value and then subtract it from each other possible payoffs. Then square each one of the results, multiply it by its probability, and finally, add up the results.

default risk premium

compute the expected value of holding the bond- the higher the default risk, the higher the probability that the bondholders will not receive the promised payments. Risk reduces the expected value of a given promise, lowering the price an investor is willing to pay and raising the yield. the higher the default risk, the higher the yield

original sources of financing

confiscation, taxation, debasement of currency, a tax on currency, and borrowing

Advantages of trading on decentralized electronic exchanges

customers can see the orders, orders are executed quickly, trading occurs 24/7, costs are low, reduces a menacing operational risk that became evident on 9/11/2001

over the counter markets

decentralized secondary markets where dealers stand read to buy and sell securities electronically

bond ratings

designed to reflect default risk- lower the rating, higher risk of default

What if one investment has a wider range of payoffs than another but has the same EV?

doesn't mean the investor would be indifferent. Because one has a winder range of payoffs (the highest payoff being higher and the lowest payoff being lower) than for the first investment- the 2 investments simply carry different levels of risk

What does doubling the future value of the payment do?

doubling the future value of the payment, without changing the time of the payment or the interest rate, doubles the present value

systematic risks

economywide risks. Maybe you own stock in Ford and the U.S. industry as a whole does poorly- this is a change in the share of the automarket pie of the entire economy, in which the auto market is a part- risk that everyone will do poorly at the same time- economy could be slow for reasons that are completely unrelated to any individual company's performance

risk neutral

ex: if you played a game and could win a 1000 dollars, so you agree to place 500 down, one time -a risk neutral person wouldn't care as long as the expected return is the same)

liquidity premium theory of the term structure of interest rates

expectations hypotheseis explains the risk-free part, and inflation and interest rate risk explain the risk premium- these 2 together form this - yield curve will normally slope upwards -flat yield curve=interest rates expected to fall -downward sloping yield curve = financial markets are expecting a significant decline in interest rates)

Stored-value card

experiment through retail businesses and their banks- looks like a credit/debit card with no name- go the bank or ATM machine- put the card into an electronic devise that transfers funds from your checking account to your card- take card to merchant who has a reader capable of deducting funds from the card and depositing them directly into the store's account-if you lose card, its current value can be cancelled- still have limited usefulness- hard to buy anything but subway rides- merchants lack hardware to read cards

Main reason for enduring unpopularity of interest

failure to appreciate the fact that lending has an opportunity cost. interest is like a rental fee that borrowers must pay lenders to compensate them for lost opportunities

Government-sponsored enterprises (GSEs)-

federal credit agencies that provide loans directly for farmers and home mortgagors. guarantee programs that insure loans and by private lenders- government also provides retirement income and medical care to the elderly through Social Security and Medicare. Pension funds and insurance companies perform these functions privately

funding liquidity

financial institutions' ability to borrow money to buy securities or make loans- both market and funding liquidity are critical to daily operations for financial institutions)

Spreading risk

find investments whose payoffs are unrelated (GE and Microsoft) 3 strategies GE Microsoft 1/2 GE 1/2 Microsoft ~The more independent sources of risk you hold in your portfolio, the lower your overall risk -fundamental investment strategy

non-depository institutions

include insurance companies, securities firms, mutual fund companies, hedge funds, private equity or venture capital firms, finance companies and pension funds

Commodity monies

first means of payment-things with intrinsic value (silk, whale teeth, salt, etc)- all things had value even if not used as money-they could be made into standardized quantities, they were durable, they had high value relative to their weight and size so that they were easily transportable and they were divisible into small units so easy to trade Fun Fact: A swede, Johan Palmstruck issued Europe's first paper money (1656)-ultimately bank failed b/c king issued too much, people lost faith in system

Money as a Store of Value

for money to function as a means of payment, it has to be a store of value- it must retain its worth from day to day- has to be durable and capable of transferring purchasing power from one dyay to the next- paper currency does degrade with use ($1 bills= lifespan of 71 months)- but regardless of its physical condition, usually accepted at face value- not the only store of value (wealth can be held in lots of other forms- stocks, bonds, houses, cars, etc)- many are preferred to money (ex: stocks offer potential for appreciation in nominal value)

broker institutions

give households and corporations access to financial markets and direct finance -institutions that transform assets take deposits or investments or issue insurance contracts to households. they use the proceeds to make loans and purchase stocks, bonds, and real estate.

expected return

given as a percentage return, not as a dollar. For example if you invest 1000 and you end up with an expected value of 1050, the expected gain is 50, but we express it as a percentage. 5%.

Consumer Price Index

help gauge the value of our salary increases or the purchasing power of the money we hold- and adjusting interest rates for inflation is critical for making investment decisions CPI = [(cost of basket in current year)/(cost of basket in base year)] *100 Inflation rate 2015 = [(cpi in 2015-cpi in 2014)/(cpi in 2014)] *100 -inflation measured using CPI tells us how much more money we need to give someone to restore the purchasing power they had in the earlier period when the survey was done -overstatement of inflation comes from substitution bias- inflation is not uniform- some prices of goods will increase by more than others-people will being substituting goods and services that have sustained less inflation- by assuming that any substitution makes people worse off, the index overstates the impact of price changes

Investment Grade- AA

highest quality with slightly higher degree of long-term risk (general electric, proctor & gamble, china)

ratings downgrade

if a particular business or country encounters problem -avg of 2% of bonds that begin a year in an investment grade category have their ratings downgraded to one of the noninvestment grades

highly speculative bonds

in serious risk of default

Direct finance

in which a borrower sells a security directly to a lender

Indirect finance

in which an institution like a bank stands between a lender and the borrower

Securities firms

include brokers, investment banks, underwriters, mutual-fund companies, private equity firms, and venture capital firms. Brokers and investment banks issue stocks and bonds for corporate customers, trade them, and advise customers- give customers access to financial markets. Mutual fund companies pool the resrouces of individuals and companies and invest them in portfolios of bonds, stocks, and real estate. Hedge funds do the same for small groups of wealthy investors. Portfolios are less risky than individual securities, and individual savers can purchase smaller units than they could if they went directly to the financial markets. Private equity and venture capital firms also serve wealthy investors .Acquire controlling stakes in a few firms and manage them actively to boost the return on investment before reselling them.

rule in U.S.

interest income from bonds issued by one government is not taxed by another government, although the issuing government may tax it.- state and local governments usually choose not to tax the interest on their own bonds, exempting it from all income taxes (to make more attractive to investors)

Compound interest

interest on the interest- need this to compute the value of an investment that will be repaid more than one year from now ~

nominal interest rate

interest rate expressed in current-dollar terms - do not worry about the possibility that inflation might change the purchasing power of the dollars- borrowers and lenders care about the purchasing power of the money they pay out and receive, they care about inflation- we need to adjust the return on a loan at the inflation-adjusted interest rate called the REAL INTEREST RATE

Pension funds

invest individual and company contributions in stocks, bonds, and real estate (their assets) in order to provide payments to retired workers (their liabilities)

investment horizon

investor plans to purchase a bond and hold it to maturity - the holding period return equals the bond's yield to maturity, and both are determined directly from the price.

What is true for long term bond yields...

is true for short term bond yields; they move together, and lower ratings imply higher yields -U.S. Treasury bill yield is always lower than the yield on commercial paper -investors must be compensated for assuming risk. The less creditworthy the borrower, the higher the risk of default, the lower the borrower's rating, and the higher the cost of borrowing. The lower the rating of the bond or commercial paper, the higher the yield.

a shift in either the supply or demand curve changes the price of bonds, so...

it changes the yield as well

when the yield curve slopes downward,

it indicates that policy is tight because policymakers are attempting to slow economic growth and inflation

when the quantity demanded or supplied changes because of a change in price,

it produces a movement along the curve

when quantity demanded or supplied at a given price changes...

it shifts the entire curve

US stock markets

low transactions costs, usually very liquid- several billion shares per day- very high trading volumes

An increase in expected inflation reduces the real cost of borrowing, shifting bond supply to the right, at the same time, this increase in expected inflation...

lowers the real return on lending, shifting bond demand to the left- these 2 effects lower the price of the bond and raise the interest rate

Highly speculative- C

lowest-rated poor prospects of repayment though may still be paying (Greece)

coupon bonds

make periodic interest payments and repay the principal at maturity (U.S. treasury bonds and most corporate bonds) Pcb= [(coupon payment)/(1+i)^1)+((coupon payment)/(1+i)^2)+... ((coupon payment)/(1+i)^n)] + (face value)/(1+i)^n right side = interest left side=value of the promise to repay the principal at maturity

regulatory agencies

make sure that the elements of a financial system-including its instruments, markets, and institutions-operate in a safe and reliable manner (introduced after Great Depression)- provide wide-ranging financial regulation-rules for operation of financial institutions and markets-and supervision-oversight through examination and enforcement- the evolution of everything else has also caused this to evolve- used to visit banks/count money- now they look at the systems that a bank uses to manage its various risks

equity markets

markets for stocks- traded in countries where companies are based

Secondary Markets

markets where existing securities are traded - ones we hear about in news

derivative markets

markets where investors trade instruments like futures, options, and swaps, which are designed primarily to transfer risk -in debt and equity markets, actual claims are bought/sold for immediate cash payment, in derivative markets, investors make agreements that are settled later

Primary Market

markets where newly issued securities are sold- a borrower obtains funds from a lender by selling newly issued securities-business use them to raise the resources needed to grow, governments use them to finance operations-most occurs out of public view

noninvestment grade bonds

may have difficulty meeting their bond payments but are not at risk of immediate default

current yield

measure of the proceeds the bondholder receives for making a loan.-the part of the return from buying the bond that arises solely from the coupon payments Current yield = (yearly coupon payment)/(price paid)

inflation rate

measure of the process of prices increasing over time-

central banks

monitor and stabilize the economy (Federal Reserve System)- began as large private banks founded by monarchs to finance wars

market liquidity

more specific term- financial institutions use this for their ability to sell assets for money

coupon bond

most common type of bond- bond issuer is required to make annual payments, called coupon payments. annual amount of those payments is called coupon rate (percentage of the amt borrowed) - specifies when the issuer is going to repay the initial $100 and the payments will stop (maturity date) -final payment/repayment is the principal, face value, or par value of the bond

GDP

most commonly used measure of economic activity-in order to see if economy is growing- look at whether GDP is growing and the rate of the growth- to compare well-being in two countries- look at GDP per person in each country (per capita GDP)- GDP- the market value of final goods and services produced in a country during a year

Fisher equation

named after 20th century economist Irving Fisher i = r+pi^e nominal interest rate = real interest rate + forecasted inflation when people say interest rate= nominal interest rate

how do you figure out if you should buy an item for business?

need to figure out whether the revenue of the item purchased will be high enough to cover the payments on the loan you would need to buy it

Checks

not legal tender- not money at all- an instruction to the bank to take funds from your account and transfer them to the person or firm whose name you have written in the "pay to the order of"- not a final payment- sets in motion a series of transactions

basis point

one one-hundredth of a percentage point

3. consider the market for a one year zero coupon bond with a face value of $100

one that makes no coupon payments

Fiat money

paper money- high quality paper, nicely engraved, with lots of special security features- called this b/c value comes from government decree, or fiat.- the money has little intrinsic worth- cost of production is only a small fractions of the face value- (US Treasury's Bureau of Engraving and Printing pays about 9 cents to print a note, regardless of whether it's a $1 or $100) -Critics still use gold standard)

risk averse

pay to avoid risks, being careful, not betting at all for 1000 dollars - a risk averse investor will always prefer an investment with a certain return to one with the same expected return but any amount of uncertainty

Consols

periodic interest payments forever, never repaying the principal that was borrowed -also called perpetuities-like coupon bonds whose payments last forever-no privately issued consols -price = present value of all the future interest payments Pconsol= (Yearly coupon payment)/i

time consistent

policy lacks time consistency whenever policymakers have a strong incentive to give up in the future on their current promises or plans (some people have doubts saying government will issue too much paper money, threatening its value)

Material changes in a firm's or governments financial conditions...

precipitate changes in its debt ratings- rating services are constantly monitoring events and announcing modifications to their views on teh creditworthiness of borrowers.

important properties of present value

present value is higher... 1. the higher the future value of the payment, FVn 2. the shorter the time until the payment, n 3. the lower the interest rate, i (conversely, higher interest rates are associated with lower present values) = at any fixed interest rate, an increase in the time until a payment is made reduces its present value ~not only does the present value of a future payment fall with the interest rate; the further in the future the promised payment is to be made, the more the present value falls (a change in interest rates has a much greater impact on the present value of a payment made far in the future than it has on one to be made soon)

current yield rises when...

price goes down

High Frequency traders (HFTs)

profit by trading an instant faster than competitors when the new information becomes available, such as a stock issuer's quarterly profit statement or the nations' monthly employment report (microsecond gains)- this can diminish the willingness of market makers to provide liquidity because they don't wish to be picked off by well equipped HFTs(high-frequency traders)

zero coupon bonds

promise a single future payments, such as a U.S. treasury bill -also called pure discount bonds- the price is less than their face value (sell at a discount)-b/c it makes a single payment on a future date, its price is the present value of that payment:Price of $100 face value zero-coupon bond($100/(1+i)^n) *i =interest expressed in decimal form, n=time until payment is made, same time units as interest rate ~The shorter time period until payment is made, the more we are willing to pay for it now. ~when price moves, the interest rate moves in the opposite direction

Disadvantages of trading on decentralized electronic exchanges

prone to errors, entire system is fragile (a mistyped spell order in japan cost a broker more than $300) trading algorithm error has not resulted in a single, integrated, and transparent US stock market can create an arms race existence of multiple, disconnected order books- a customer's order may not be executed a tthe best possible price

financial institutions

provide a myriad of services, including access to the financial markets and collection of information about prospective borrowers to ensure they are creditworthy (banks, securities firms, and insurance companies) -banks used to be vaults-then, they accepted deposits and made loans, now= a supermarket (huge assortment of financial products and services for sale)

when price is below equilibrium point

quantity demanded will exceed quantity supplied- people cannot get all they want the prevailing price- they start bidding up the price. excess demand continues to put upward pressure on the price until the market reaches equilibrium

1. stock of bonds

quantity of bonds outstanding

when bond prices start out above equilibrium point

quantity supplied will exceed quantity demanded- suppliers cannot sell the bonds they want to at the current price, they will start cutting the price. this will put downward pressure on the price until supply equals demand

equation to directly observe real interest rate

r = i-pi^e real interest rate = nominal interest rate +forecasted

Frequent, sharp downgrades during such periods of market stress...

raise doubts about the usefulness of the ratings in anticipating default

Finance companies

raise funds directly in the financial markets in order to make loans to individuals and firms. Tend to specialize in particular types of loans, such as mortgage, automobile, or certain types of business equipment. assets are similar to a banks, liabilities are debt instruments that are traded in financial markets, not deposits.

hedging risks

reducing idiosyncratic risk by making 2 investments with opposing risks- when one does poorly, the other does well. (Ex: electric and gas) 3 strategies with this could do GE only Texaco only or 1/2 and 1/2 ~1/2 and 1/2 will guarantee a payout where as the other two options provide possibilities

National Best Bid and Offer (NBBO) mechanism

requires brokers to provide the best prevailing prices to customers- other government rules make all trades visible after they occur- but not all bids are visible prior to a trade-

capital gain

rise in value- part of the return on your investment (when the price of the bond is below the face value, the return is above the coupon rate)

expectations hypothesis of the term structure

risk free interest rate can be computed, assuming there is no uncertainty about the future. ~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 ~means that the yield curve (plots the yield to maturity on the vertical axis) and the time to maturity on the horizontal axis will slope up ~If interest rates are expected to fall, the yield curve will slope down. ~if interest rates are expected to remain unchanged, the yield curve will be flat ~long-term bonds are all averages of expected future short term yields-the same set of short term interest rates-so interest rates of different maturities will move together-

trading algorithm

rule-based program for automatically executing hundred or thousands of trades

fixed payment loan

same as car loan/mortgage- using present value, we know that the amount of the loan must equal the present value of the payments. say we borrow $1 million 1 million = present value of 10 equal annual payments at interest rate i

most holders of long term bonds plan to...

sell them well before they mature

commercial paper

short term version of a bond- both corporations and governmetns issue these- borrower offers no collateral-unsecured-only the most creditworthy companies can issue it. -issued on a discount basis as a zero-coupon bond that specifies a single future payment with no associated coupon payments -has a maturity of less than 270 days 1/3 of all commercial paper is held by money-market mutual funds which require very short-term assets with immediate liquidity ~90% of issuers carry Moody's P-1 rating and another 9 % are rated P-2 (p= prime-grade commercial paper)

Standardized financial instruments

similar terms used- used to overcome potential costs of complexity- very homogeneous -standard application processes-standardized terms

interest rate spreads

simultaneous increase in some interest rates and delcine in others

standard deviation

square root of the variance -more useful than the variance because it is measured in the same unit as the payoff, dollars (variance is measured in dollars squared) -given a choice between 2 investments with the same expected payoff, most people would choose the one with the lower standard deviation. A higher-risk investment would be less desirable -most common measure of financial risk

Core Principle 5: Stability Improves Welfare

stability is a desirable quality- instability brought us closer to a collapse (2008)- related to core principle 2-reducing volatility reduces risk. while many can eliminate risk on their own, some can only be reduced by government policymakers (like business cycle fluctuations)-moneytary policymakers can moderate the downswings by carefully adjusting interest rates. Central banks also have powerful tools to steady fragile financial systems and to repair or support dysfunctional markets-primary function of central banks(work to keep inflation low and stable and to keep growth high and stable)

Money as a Unit of Account

standard of value money is the unit of account that we use to quote prices and record debts -relative prices matter- one product being higher than the price of another- -used to quote prices

Investment or Prime Grade: Moody's (p-1) S& P (A-1+, A-1)

strong likelihood of timely repayment (coca-cola, general electric, procter and gamble)

Fixed-payment loans

such as conventional mortgages -amortized- borrower pays off principal along with teh interest over the life of the loan (each payment includes interest and a portion of the principal) -value of loan today is present value of all payments. (fixed payment/(1+i)) + (fixed payment/(1+i)^2)+...

equation for the one year holding period return

sum of the yearly coupon payment divided by the price paid for the bond, and the change in the price (price sold minus price paid) divided by the price paid: Holding period return=(yearly coupon payment/price paid)+(change in price of bond/price paid) first part = the current yield second part = capital gain so... Holding period return = current yield + capital gain

Financial instruments communicate information

summarize certain essential details about the issuer-designed to eliminate the expensive and time-consuming process of collecting information about issuer/purchaser

How are bond prices determined?

supply and demand-

Changes in general economic conditions usually produce

systemic risk

Depository institutions

take deposits and make loans; they are what most people think of as banks, whether they are commercial banks, savings banks, or credit unions-commercial banks, savings banks, credit unions)

on rare occasions, when short term interest rates exceed long term yields...

term structure is inverted- yield curve slopes downward

variance

the average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities. 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

when price equals the face value of the bond

the current yield and coupon rate are equal

When price rises above the face value

the current yield falls below the coupon rate

when price falls below the face value

the current yield rises above the coupon rate

without free flow of resources through bond markets...

the economy would freeze up

internal rate of return

the interest rate that equates the present value of an investment with its cost ~to find the internal rate of return, take the sum of the present value of each of the yearly revenues (we can't take the present value of the total revenue) and equate it with the machine's cost. then solve for interest rate, i. solve using a financial calculator or spreadsheet

the higher the price of a bond...

the larger the quantity supplied will be 1. the higher the price, the more tempting it is to sell a bond they (the investors) currently hold 2. from the point of view of the companies seeking finance for new projects, the higher the price at which they can sell bonds, the better -the bond supply curve slopes upwards

debt markets

the markets for loans, mortgages, and bonds- the instruments that allow for the transfer of resources from lenders to borrowers and at the same time, give investors a store of value for their wealth

Probability

the measure of likelihood that an event will occur. -always between 0 and 1 if the probability is 1, the event will DEFINITELY happen -some people prefer to think of random outcomes in terms of frequencies rather than probabilities (the coin will come down heads once every two tosses on average)

If we look at a graph for computing standard deviation

the more spread out the distribution of possible payoffs from an investment, the higher the standard deviation and the bigger the risk

Electronic funds transfers

the movements of funds directly from one account to another- used extensively by banks - most common form for individuals = automated clearinghouse transaction (ACH)- used for recurring payments such as paychecks and utility bills- ACH transactions- like checks except entirely electronic -banks use electronic transfers to handle transactions among themselves- most common = FEDWIRE- send money through a system maintained by Federal Reserve

inflation

the pace at which prices in general are increasing over time -makes money less valuable -primary cause = issuance of too much money-the value of the means of payment depends on how much of it is circulating

A good benchmark for considering the performance of a particular investment adviser or money manager

the performance of a group of experienced investment advisers or money managers. ~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

counterparty

the person or institution on the other side of a contract- a number of mechanisms exist to reduce the cost of monitoring the behavior of the counterparties to a financial arrangement- solution to high cost of obtaining information on the parties to a financial instrument is to standardize both the instrument and the information provided about the issuer- hire a specialist

Financial markets, redefined

the places where financial instruments are bought at sold- central nervous system- relaying and reacting to information quickly, allocating resources, and determining prices -enable firms/individuals to find financing for activities -promote economic efficeintcy

term structure of interest rates

the relationship among bonds with the same characteristics but different maturities

bond demand curve

the relationship between the price and quantity of bonds that investors demand, all other things being equal -as price falls, the reward for holding the bond rises (demand goes up) -the lower the price potential bondholders must pay for a fixed-dollar payment on a future date, the more likely they are to buy a bond -the bond demand curve slopes downward -because 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

bond supply curve

the relationship between the price and the quantity of bonds people are willing to sell, all other things being equal

risk premium

the riskier the investment, the higher the risk premium (the higher the compensation investors require for holding it) -higher risk premiums = higher expected returns you can't get a high return without taking a reasonable risk

General formula for a string of yearly coupon payments made over n years

the sum of the present value of the payments for each year from one to n years (see pate 91) Present value of a series of bond coupon payments (Pcp)= sum of yearly coupon payments (C) divided by (one plus the interest rate) raised to the power equal to the number of years from now.

wealth

the value of assets minus liabilities (money=one of these assets)

value at risk (VaR)

the value of the worst income- -the maximum potential loss- over a specific time horizon, at a given probability - such a collapse (for financial institutions) is called tail risks or black swans

Future value

the value on some future date of an investment made today

present value

the value today (in the present) of a payment that is promised to be made in the future (also known as present discounted value)-

payments system

the web of arrangements that allow for the exchange of goods and services, as well as assets, among different people. a critical public policy concern is that it function well- money is at the heart of this system

yield to maturity

the yield bondholders receive if they hold the bond to its maturity when the final principal payment is made Price of one year 5 percent coupon bond = ($5/(1+i))+($100/(1+i)) value of i that solves this equation is the yield to maturity

An inverted yield curve is a valuable forecasting tool because:

the yield curve seldom is inverted and it can signal an economic slowdown

relationship between the yields on taxable and tax-exempt bonds

the yield on a tax exempt bond equals the taxable bond yield times one minus the tax rate: tax exempt bond yield = (taxable bond yield) * (1-tax rate)

bond yield=sum of two parts

the yield on the benchmark U.S. Treasury Bond plus a default risk premium, sometimes called a risk-spread Bond yield = U.S. Treasury Yield + Default Risk premium -the lower the rating of the issuer, the higher the default-risk premium in equation -When Treasury yields move, all other yields move with them

if interest rates are comparatively high

they serve as a brake on real economic activity

Core Principal 1: Time has Value

time has a price- affects the value of financial transactions-if you take out a loan- you pay interest to compensate the lender for the time during which you use the funds (it has an opportunity cost to the lender)

2. bond prices

together with its various characteristics determines yield. (once we know price, we know yield)

Investment grade bonds

top four categories- low risk of default

financial instruments

transfer resources from savers to investors and to transfer the risk to those who are best equipped to bear it (stocks, mortgages, insurance policies) -originally could buy individual stocks through stockbrokers (for the wealthy b/c of cost)-today can do mutual funds (pool savings of a large number of investors)

risk is the key to...

understanding the usual upward slope of the yield curve

idiosyncratic risks

unique risks (ex: maybe you have stock in Ford Motor Company, one risk is that Ford could lose sales to other car markets)- this affects specific firms, not everyone. If ford does bad, some other company could be doing well ~not all are balanced by opposing risks to other firms/industries. some are specific to one person or company and no one else- risk that 2 people have an automobile accident is unrelated to whether anyone else has one

underwriting

used in primary financial market- bank examines the company's financial health to determine whether the proposed issue is sound. If it is, the bank will determine a price and then purchase the securities in preparation for resale to clients

Present value is additive- what does this mean?

valuing a stream of payments means summing their present values- the value of the whole is the sum of the value of its parts.

Value of a bond

varies inversely with the interest rate used to calculate the present value of the promised payment

An important property of probabilities

we can compute the chance that one or the other event will happen by adding the probabilities together. the values in the probabilities in the table should sum to one

A business cycle downturn reduces business investment opportunities, shifting the bond supply to the left, and reduces wealth, shifting bond demand int eh same direction

when both curves shift in the same direction the price can rise or fall- we need to look for regular movements in the data to help resolve the question- in this case we know that in recessions, interest rates tend to fall, so (for bonds with unchanged risk) prices should increase

capital loss

when price is above face value bond's yield to maturity falls below its coupon rate

True statements pertaining to the yield curve

yield curves usually slope upwards, yield curve shows the relationship among bonds with the same risk characteristics but different maturities, the yield curve can be flat or downward sloping depending on the market conditions