ECON 304
Microprudential supervision
Microprudential supervision: focuses on the safety and soundness of individual financial institutions. Looks at each institution separately and assesses the riskiness of its activities and whether it complies with disclosure requirements. • Most importantly, it checks whether a particular institutions satisfied capital ratios an if it does not either engages in prompt corrective action to force the institution to raise its capital ratios, or the supervisor closes it down • Can lead to runs like the one on in the US shadow banking system
Money Markets
Money Markets: only short-term debt instruments are traded (<1 year).
3 primary functions of money
Money: anything generally accepted as payment for goods or services or to repay debts. 3 primary functions: • Medium of exchange • Unit of account (used to measure value in an economy) • Store of value
Case of Japan
Negative interest rates - how?
Net worth
Net worth (equity capital): the difference between a firm's assets and its liabilities, can perform a similar role to collateral. The more net worth a firm has in the first place, the less likely it is to default because the firm has a cushion of assets that it can use to pay off its loans.
off-balance sheet activities
Off-balance sheet activities: do not appear on bank balance sheets but nevertheless expose banks to risk, involve trading financial instruments and generating income from fees
Over-the-counter markets
Over the Counter Markets: Dealers have inventory at different locations who have an inventory of securities ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices
Overnight Funds
Overnight Funds: the instruments are typically overnight loans between banks of their deposits with the Bank of Canada. Interest rate on these loans, called the overnight interest rate is a closely watched barometer of the tightness of credit market conditions
Theory of Rational Expectations (and 2 implications)
Theory of Rational Expectations: To meet the objections to adaptive expectations, John Muth developed an alternative theory of expectations, called rational expectations. Expectations will be identical to optimal forecasts (the best guess of the future) using all available information 2 Implications: 1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well. 2. The forecast errors of expectations will on average be 0 and cannot be predicted ahead of time. When this is not the case, the expectation will be adjusted to reflect the new average forecast error
Venture Capital firms
Venture Capital Firm: pools the resources of their partners and use the funds to help budding entrepreneurs start new businesses. In exchange for the use of the venture capital, the firm receives an equity share in the new business. This is one way to help reduce the moral hazard problem in equity contracts. Due to this arrangement, the VCF is able to garner full benefits of verification activities and is given the appropriate incentives to reduce moral hazard.
yield to maturity
Yield to maturity: The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today - in other contexts, the YTM is also called the internal rate of return. Economists consider it the most accurate measure of interest rates.
Cash Flow Effect
a. Cash flow effect: a firm with good cash flow can finance its own projects (no information asymmetry), but this is no longer the case when interest payments rise, so they must raise funds from an external source that doesn't know the firm as well. Bank has imperfect information on the quality of the investment project. Thus when interest rates rise and cash flow drops, adverse selection and moral hazard problems become more severs
Expectations Theory
• Expectations theory: the interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond. Says that bonds of different maturities can be perfect substitutes Explains facts number 1 and 2
Credit default swap
• Large fees from writing a type of financial contract called a credit default swap, a financial derivative that provides payments to holders of bonds if they default, also drove insurance companies like AIG to write hundreds of billions of dollars' worth of these risky contracts
Leverage Ratio
• Leverage ratio: the amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3% triggers increased regulatory restrictions on the bank.
Liquidity Premium Theory
• Liquidity Premium Theory: states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond o Confirms expectations theory assumption that bonds are substitutes - expected returns on the various bonds do affect one another
4 ways to initiate a financial crisis
- Mismanaged financial liberalization or innovation --> credit boom Asset Price Boom & Bust: asset prices in the stock market and real estate can be driven way above their fundamental economic valued by investor psychology → asset price bubble Spikes in interest rates: due to bank panics that cause a scramble for liquidity. Causes declines in cash flows --> reduction in number of good credit risks Increased uncertainty:when uncertainty is high, financial info is harder to come by → moral hazard and adverse selection
Dodd-Frank Wall Street Reform and consumer Protection Act of 2010 (5 categories)
1) consumer protection: prevent mortgage loans to low income people 2) Resolution Authority: intervene to prevent the failure of firms that are deemed systemic 3) Systemic risk regulation: established oversight council that watches for bubbles, designates SIFIs 4) Volcker Rule 5) Derivatives
6 categories of factors play an important role in financial crises
1) effects on balance sheets 2) Deterioration of financial statements 3) Banking crises (bank panic) 4) Increases in uncertainty 5) Increases in interest rates 6) Government Fiscal Imbalances
Effects on balance sheets caused by... (4)
1) stock market decline 2) unanticipated decline in the price level: raises the value of borrowing firms' liabilities in real terms (increases debt burden) but doesn't increase the real value of the firms' assets 3) unanticipated decline in the value of domestic currency 4) Asset write downs: book value > market value --> downward revision
Types of financial intermediaries (3 with examples)
1. Depository institutions a. Banks b. Trust and loans companies c. Credit unions d. Caisses populaires 2. Contractual savings institutions a. (Life, Property & Casualty) Insurance companies b. Pension funds 3. Investment Intermediaries a. Finance companies b. Mutual Funds c. Hedge Funds d. Investment Banks
3 facts about term structure of interest rates
1. interest rates on bonds of different maturities move together over time 2. when short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted 3. yield curves almost always slope upward All explained by liquidity premium theory
Ways the government can reduce the free-rider problem
1. produce information to help investors distinguish good from bad firms, and provide it to the public free of charge 2. regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are → firms selling securities must have independent audits
Banking Crisis
2. Banking Crisis: Worsening business conditions and uncertainty cause depositors to withdraw rapidly. When banks fail, information is further limited and adverse selection is worsened. a. There is then a sorting or firms that were insolvent (had negative net worth ) from healthy firms by bankruptcy proceedings. The same process occurs for banks with the help of public and private authorities. Once this sorting is complete, uncertainty declines, the stock market recovers, and interest rates fall
Deterioration of Financial Institutions' Balance Sheets
2. Deterioration of Financial Institutions' Balance Sheets: If financial institutions suffer a deterioration in their balance sheets, and so have a substantial contraction in their capital, they will have fewer resources to lend, and this leads to a decline in investment spending, which slows economic activity
3 important facts about coups bonds
3 Facts about Coupon Bonds: 1. When coupon bond is priced at face value, the yield to maturity equals the coupon rate 2. The price of a coupon bond and the yield to maturity are negatively related. AS yield to maturity rises, the price of the bond falls 3. The yield to maturity is greater than the coupon rate when the bond price is below its face value
Banking Crises
3. Banking Crises: If deterioration of financial institutions' balance sheets is severe it may cause them to fail. This causes fear to spread from one institution to another, and deposits can be pulled out very quickly (bank panic)
Debt Deflation
3. Debt Deflation: IF the economic downturn leads to a sharp decline in prices, the recovery process can be short-circuited. Debt deflation occurs when a substantial unanticipated decline in price level sets in, leading to further deterioration in firms' net worth because of the increased burden of indebtedness. This maintains adverse selection and moral hazard to that economic activity remains depressed for a long time
Increases in uncertainty
4. Increases in uncertainty: Dramatic increase in uncertainty (maybe due to the failure of a prominent financial institution) makes it hard for lenders to screen good from bad credit risks → inability of lenders to solve the adverse selection problem → declined lending, investment and economic activity.
increases in interest rates
5. Increases in interest rates: In the face of excess demand for credit, interest rates rise, making good creditors less likely to want to borrow while bad creditors are still willing. Therefore, lenders are no longer willing to make loans. Cash flow effect
Government fiscal imbalances
6. Government fiscal imbalances: in emerging market countries, government fiscal imbalances may create fears of default on government debt → demand from investors for government bonds may fall → the debt then falls in price and financial institutions' balance sheets will weaken, and lending will contract. The same uncertainty can cause foreign exchange crises which further worsen balance sheets and lead to increased adverse selection and moral hazard problems, thus, a decline in lending and economic activity
Adaptive Expectations
Adaptive expectations: Expectations are formed from past experience only. Suggests that changes in expectations will occur slowly over time as past data change. Has been faulted on the grounds that people use more information than just past data on a single variable to form their expectations of that variable. People also change their expectations quickly in light of new information
adjusted forward-rate forecast
Adjusted forward-rate forecast: adjusted to include the liquidity premium
American Recovery and Reinvestment Act of 2009
American Recovery and Reinvestment Act of 2009: Obama administration which was much bigger than bush's and was very controversial
Arbitrage
Arbitrage: market participants eliminate unexploited profit opportunities (i.e. returns on a security that are larger than what is justified by the characteristics of that security)
Asymmetric information Adverse Selection Moral Hazard Free-rider problem
Asymmetric information: one party having insufficient knowledge about the other party involved in a transaction to make accurate decisions Adverse Selection: an asymmetric information problem that occurs before the transaction occurs: potential bad credit risks are the ones who most actively seek out loans Moral Hazard: arises after the transaction occurs: the lender runs the risk that the borrower will engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back Free-rider problem: the system of private production and sale of information does not completely solve the adverse selection problem in securities markets. The free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for. The sale of information will only be a partial solution to the lemons problem.
bank run
Bank run: the incentive to run to the bank to be the first is why withdrawals when there is fear about the health of a bank is called a bank run. Sequential service constraint (first-come, first-served)
Basel Committee on Bank Supervision
Basel Committee on Bank Supervision: established to help combat the problems of risky assets and off-balance sheet activities. Instituted the Basel Accord Dealt with regulatory arbitrage
Business Expansion Effect
Business Expansion effect: business cycle expansion makes businesses more likely to borrow → supply curve shifts right. Business expansion also increases wealth, which shifts the demand curve to the right. Interest rate can either rise or fall depending on which curve shifts further. Normally the supply curve shifts more causing an increase in interest rates
Capital Markets
Capital Markets: Market for longer-term debt (>1 year)
Collateral
Collateral: property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts.
Collateralized debt obligations (CDOs)
Collateralized debt obligations (CDOs): involve a special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. SPV then separates the payment streams from these assets into an umber of buckets known as tranches. Highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk, so it also has the lowest interest rate. It is followed by the senior tranche, the mezzanine tranche, and the equity tranche, each which have increasing interest rates o They can become so complicated that it becomes hard to value the cash flows of the underlying assets or to determine who actually owns the assets. o Increased complexity of structured products can actually reduce the amount of info in financial markets, thereby worsening asymmetric information in the system
Commercial Paper
Commercial Paper: short-term debt instrument issued in Canadian dollars or other currencies by large banks and well-known corporations, such as Back of Montreal and Bombardier
Conflicts of Interest (and 3 cases where they happen the most)
Conflicts of interest: a type of moral hazard problem that arises when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives. They are especially likely to occur when a financial institution provides multiple services. This may lead in individual or firm to conceal information or disseminate misleading information. 3 cases where they occur most often: 1) Underwriting and research in investment banks 2) Auditing and consulting in accounting firms 3) Credit assessment and consulting in credit rating agencies
Consol/Perpetuity
Consol/Perpetuity: it is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever
Costly State Verification
Costly state verification (monitoring): Monitoring of the firm's activities, auditing them frequently and checking on what the management is doing. It is one way for stockholders to reduce the principal agent problem. It makes the equity contract less desirable, and it explains, in part why equity is not a more important element in our financial structure. It is made more costly/less effective through the free-rider problem - if you know that other stockholders are paying to monitor the activities of the company you hold shares in, you can take a free ride on their activities → nobody will spend any resources on monitoring the firm
Coupon Bond
Coupon Bond: pays the owner of the bond a fixed-interest payment (coupon payment) every year until the maturity date, when a specified final amount (face/par value) is repaid
Covenants to discourage undesirable behavior
Covenants to discourage undesirable behavior: restricted covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. Some mandate that a loan can be used only for specific activities, others restrict the borrowing firm from engaging in certain risky business activities, such as purchasing other businesses.ost often, restrictive covenants encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower.
credit rating agencies
Credit Rating agencies: investment and advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default
Debt Contracts
Debt Contracts: Only when a firm cannot meet its debt payments, thereby being in a state of default, is there a need for the lender to verify the state of the firm's profits. Only in this situation do lenders involved in debt contracts need to act more like equity holders and determine the exact amount of the firm's income to get their fair share. Less frequent need to monitor the firm and lower cost of state verification → these are more common than equity contracts for raising capital.
default-free bonds
Default-free bonds: bonds with no default risk, normally those issued by the Canadian government because it can always increase taxes to pay off its obligations
Direct Finance
Direct Finance: Borrowers borrow funds directly from lenders in financial markets by selling the lenders securities (also called financial instruments), which are claims on the borrower's future assets
Discount bond (zero-coupon bond)
Discount bond (zero-coupon bond): bought at a price below its face value (at a discount) and the face value is repaid at the maturity date. No interest payments.
How do Financial Intermediaries reduce transaction costs?
Economies of Scale Expertise
Economies of Scope
Economies of Scope: By providing multiple financial services to their customers, such as providing them with bank loans or selling their bonds for them, financial intermediaries can obtain economies of scope - that is, they can lower the cost of information production for each service by applying one information resource to many different services
Efficient Market Hypothesis
Efficient Market Hypothesis/Theory of Efficient Capital Markets: Parallel model of Rational expectations theory created by financial economists (as opposed to monetary economists) • In an efficient market, all unexploited profit opportunities will be eliminated. Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven down to the point at which the efficient market condition holds
Equity
Equity: shares in a corporation, which are claims to the net income and the assets of a business. Residual claimant, meaning that the corporation must pay all debt holders before it pays equity holders
Eurobond
Eurobond: a bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies
Eurocurrencies: foreign currencies deposited in banks outside the home country (Eurodollars, US dollars deposited in foreign banks outside the US or in foreign branches of US banks
Exchanges
Exchanges: buyers and sellers in the secondary market meet in one central location (or their agents and brokers) to conduct trades
Fiat Money
Fiat Money: paper currency decreed by governments as legal tender but not convertible into coins or precious metals
Financial derivatives
Financial derivatives: financial instruments whose payoffs are linked to (derived from) previously issued securities, also were an important source of excessive risk taking
Fisher Effect/Fisher Equation
Fisher Effect: a rise in expected inflation shifts the demand curve left and the supply curve right, which means that bonds are now less expensive and interest rates are higher Fisher Equation: states that the nominal interest rate, i, equals the real interest rate, plus the expected rate of inflation
Fixed Payment Loan
Fixed Payment Loan (Fully Amortized Loan): the lender provides the borrower with an amount of funds that the borrower must repay by making the same payment, consisting of part of the principal and interest, every period (such as a month) for a set number of years.
flight to quality
Flight to quality: After the Subprime mortgage crisis, interest rates on BAA bonds rose by 280 basis points. This led to increased demand for U.S. Treasury bonds and rapidly declining interest rates on these bonds
forward rate
Forward Rate: the one-period interest rate that the pure expectations theory of term structure indicates is expected to prevail one period in the future
Theory of Asset Demand (4)
Holding all other factors constant, the quantity demanded of an asset is... 1) positively related to wealth 2) positively related to expected return relative to alternative assets 3) negatively related to the risk of its returns relative to alternative assets 4) positively related to its liquidity relative to alternative assets
Incentive-compatible debt contract
Incentive-compatible debt contract: One way of describing the solution that the high net worth and collateral provides to the moral hazard problem is to say that it makes the debt contract incentive-compatible, that is, it aligns the incentives of the borrower with those of the lender.
Indexed Bonds
Indexed Bonds: started in 1991 where the government adjusts interest and principal payments for the changes in the price level
Intermediaries help with (5)
Intermediaries help with: transaction costs, risk sharing, asymmetric information, adverse selection, moral hazard
Junk Bonds
Junk Bonds: (Speculative-grade/high-yield bonds) bonds with ratings below BBB and have a higher default risk. Investment-grade securities whose rating has fallen to junk levels are referred to as fallen angels.
8 facts about financial structure throughout the world
Know where to apply lemons problem, characteristics of banks and financial intermediaries
Lemons Problem
Lemons Problem: potential buyers of used cars are frequently unable to assess the quality of a car, that is, they can't tell whether a particular used car is a car that will run well, or a lemon, that will continually give them grief. The price buyers pay thus reflects the average quality of the cars in the market. Owners of good cars will not want to sell at the lower price, so the lemons are all that are left over → adverse selection
Does an increase in money supply bring about a decrease in interest rates? (3 effects)
Liquidity Framework seems to imply that an increase in the money supply will drive down interest rates. This is not true when looking at a number of factors. Only holds true if "everything else remains constant" o Income effect: the income effect of an increase in the money supply is a rise in interest rates in response to a higher level of income o Price level effect: the price level effect from an increase in the money supply is a rise in interest rates in response to the rise in the price level o Expected inflation: a rise in interest rates in response to the rise in expected inflation rate • Difference between price level effect and the inflation effect: the price-level effect remains even after prices have stopped rising, whereas the expected inflation effect disappears. The expected inflation effect will persists only as long as the price level continues to rise These 3 effects take time to work because it takes time for the increasing money supply to raise the price level and income. In most cases they offset the liquidity effect that decreases interest rates right off the bat.
Liquidity Preference Framework
Liquidity Preference Framework: Instead of determining the equilibrium interest rate using the supply of and demand for bonds, an alternative model developed by Keynes, known as the liquidity preference framework, determines the equilibrium interest rate in terms of the supply of and demand for money • Says that the quantity of bonds and money supplied must equal the quantity of bonds and money demanded • As the interest rate on bonds, I, rises, the opportunity cost of holding money rises, and so money is less desirable and the quantity of money demanded must fall
Economic Stimulus act of 2008
• Economic stimulus Act of 2008: whereby the government gave out one-time income tax rebates totaling $78 billion by sending $600 checks to individual taxpayers
Present value
Present value: based on the commonsense notion that a dollar paid to you one year from now is less valuable than a dollar paid to you today.
Price to Earnings Ratio (PE)
Price-Earnings Ratio (PE): measure of how much the market is willing to pay for $1 of earnings from a firm. • A high PE means that the market expects earnings to rise in the future. This would return the PE to a more normal level • A high PE may alternatively indicate that the market feels the firm's earnings are very low risk and is therefore willing to pay a premium for them • Advantageous for valuing firms that do not pay dividends. Since it uses industry average, it does not factor in firm-specific characteristics that might contribute to a long-term PE ratio above or below the average
Primary Market
Primary Market: where new security issues are sold to initial buyers. Not well known to the public because the selling of securities to initial buyers often takes place behind closed doors.
risk premium
Risk Premium: spread between the interest rates on bonds with default risk and default-free bonds. Indicates how much additional interest people must earn in order to be willing to hold that risky bond
Risk structure of interest rates
Risk structure of interest rates: the relationship among interest rates, although risk and liquidity both play a role in determining the risk structure • Explained by 3 factors: o Default risk o Liquidity o Income tax treatment of the bond's interest payment
Sarbanes-Oxley Act of 2002
Sarbanes-Oxley Act of 2002: increased supervisory oversight to monitor and prevent conflicts of interest. Created the Public Company Accounting Oversight Board, overseen by the SEC, to supervise accounting firms and ensure that audits are Independent and controlled for quality.
Secondary Market
Secondary Market: previously issued securities can be bought and sold. Brokers are agents of investors who match buyers and sellers, while dealers link buyers and sellers by buying and selling securities at stated prices
Simple Loan
Simple loan: lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date along with an additional payment for the interest
Structured credit products
Structured credit products: paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with different preferences
Term structure of interest rates definition
Term structure of interest rates: bonds with identical risk, liquidity and tax characteristics may have different interest rates because the time remaining to maturity is different
3 ways to solve the too big to fail problem
• Break up large, systematically important institutions - could decrease overall efficiency though • Higher capital requirements during booms and lower when credit is contracting • Leave it to Dodd-Frank
Shadow Banking System
composed of hedge funds, investment banks, and other non-depository financial firms, which are not as tightly regulated as banks are. They flowed through the financial system and for many years supported the issuance of low-interest rate mortgages and auto loans. o Funded by repurchase agreements (repos) which are short term borrowing that, in effect, uses assets like mortgage-backed securities as collateral
Macroprudential supervision
focuses on the safety and soundness of the financial system in the aggregate. Seeks to mitigate system-wide fire sales and deleveraging by assessing the overall capacity of the financial system to avoid them • Macroprudential policies prevent the leverage cycle by making capital requirements countercyclical. That is, they are adjusted upward during a boom and downward during a bust • In addition during the upward swing in the leverage cycle, it might involve forcing financial institutions to tighten credit standards or even direct limits on the growth of credit • Agreement around the world that we need more focus on this • Make sure that financial institutions have enough liquidity, macroprudential policies could require that they have sufficiently low net stable funding ratio (percent of the institutions short-term funding in relation to total funding - prevent over reliance on short term wholesale funding)
Volcker rule
o Volcker rule: banks in the US are limited in the extent of their proprietary trading - that is, trading with their own money and can own only a small percentage of hedge and private equity funds
Yield Curve as a forecasting tool
rising interest rates are associated with economic booms and falling rates with recessions. When the yield curve is either flat or negatively sloped, it suggests that future short-term interest rates will be falling and therefore that the economy is more likely to enter a recession. • A steep yield curve does predict a future rise in inflation, while a flat or negatively sloped one forecasts a future fall in inflation
Too big to fail problem
the moral hazard created by a government safety net and the desire to prevent financial failures have presented regulators with the too bit to fail quandary, in which regulators are reluctant to close down large financial institutions and impose losses on their depositors and creditors because doing so might precipitate a financial crisis. Worsens the moral hazard problem with big banks. • If there is a fear of a bank failing (and use of the payoff method) depositors have incentives to monitor the bank and withdraw funds if it is too risky. No such incentive if the bank is too big to fail → Bank free to take on all the risk it wants
Leverage Cycle
the run-up to a global financial crisis in which a feedback loop resulted from a boom in issuing credit, which led to higher asset prices, which resulted in higher capital buffers at financial institutions, which supported further lending in the context of unchanging capital requirements, which then raised asset prices further, and so on; in the bust, the value of the capital dropped precipitously, leading to a cut in lending • Macroprudential policies prevent this by making capital requirements countercyclical. That is, they are adjusted upward during a boom and downward during a bust
Systemically important financial institutions (SIFIs)
these are held to higher capital standards, must write a living will, which is a plan for orderly liquidation
paper loss
when interest rates rise but you hold on to a bond until maturity
Canadian Deposit insurance Corporation (CDIC) 2 strategies to prevent bank panics
• Payoff method: CDIC allows the bank to fail and then pays off the first $100,000 that depositors had stored in the bank 9the insurance limit acquired from the insurance premiums paid by the banks that have bought CDIC insurance) • Purchase and assumption method: CDIC reorganizes the bank, typically by finding a willing merger partner who takes over all of the failed bank's liabilities so that no depositor or other creditor loses a penny
Preferred Habitat Theory
• Preferred habitat theory: similar to liquidity premium theory but takes a somewhat less-direct approach to modify the expectations hypothesis but comes up with a similar conclusion. Investors have a preference for bonds of one maturity over another, a particular bond maturity (preferred habitat) in which they prefer to invest o Because they prefer bonds of one maturity over another, they will be willing to buy bonds that do not have the preferred maturity only if they earn a somewhat higher expected return
Segmented Markets Theory
• Segmented Markets theory: sees markets for different-maturity bonds as completely separate and segmented. Bonds of different maturities are not perfect substitutes, so the expected return from holding a bond of one maturity has not effect on the demand for a bond of another maturity o If, as seems sensible, investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, the segmented markets theory can explain fact 3, that yield curves typically slope upwards. Because in the typical situation, the demand for long term bonds is relatively lower than that for short-term bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slop upwards
Why use theory of asset demand as well as the liquidity preference framework?
• The reason that we approach the determination of interest rates with both frameworks is that the bon supply and demand framework is easier to use when analyzing the effects from changes in expected inflation whereas the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of money
Troubled Asset Relieve Program
• Troubled Asset Relief Program (TARP): the most important provision of the Bush administration's Emergency Economic Stabilization Act, which authorized the US Treasury to spend $700 billion, purchasing subprime mortgage assets from troubled financial institutions or to inject capital into these institutions
