FINC Chapter 10How does the increase and decrease in the following affect duration?

Inflation targeting involves:

1. Announcing a medium-term inflation target 2.Commitment to monetary policy to achieve the target 3. Inclusion of many variables to make monetary policy decisions 4. Increasing transparency through public communication of objectives 5. Increasing accountability for missed targets

Fed watcher predicts monetary tightening, i

1.Acquire funds at current low i 2.Buy $ in FX market

Open Market Operations

1.Dynamic: Meant to change Reserves 2.Defensive: Meant to offset other factors affecting Reserves, typically uses repos

Advantages of Open Market Operations

1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly

Fed watcher predicts monetary loosening, i

1.Make loans now at high i 2.Buy bonds, price rise in future 3.Sell $ in FX market

What three facts emerge from the calculation of yield to maturity?

1.When a 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; 3. Yield to maturity is greater than the coupon rate when the bond price is below face value.

coupon bond

A 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 value or par value) is repaid.

simple loan

A credit market instrument providing the borrower with an amount of funds that must be repaid to the lender at the maturity date along with an additional payment (interest). The formula for a simple loan repayment is:

discount bond (zero-coupon bond),

A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and face value is repaid at the maturity date. A discount bond doesn't make any interest payments; it just pays off the face value, unlike a coupon bond. U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds are examples of discount bonds.

fixed-payment loan (fully amortized loan),

A fixed-payment loan is a credit market instrument that provides a borrower with an amount of money that is repaid by making a fixed payment periodically (usually monthly) for a set number of years.

Explain why real interest rates can be negative.

A negative yield to maturity would imply that you are willing to pay more for a bond today than you will receive for it in the future. Despite negative interest rates, large investors and banks found it more convenient to hold Treasury bills or keep their funds as deposits at the central bank because they are stored electronically. For that reason, investors and banks were willing to accept negative interest rates, even though in pure monetary terms the investors would be better off holding cash.

What is the relationship Between nominal and real interest rates?

A nominal interest rate refers to the interest rate before taking inflation into account. The real interest rate is the nominal interest rate minus the actual or expected inflation rate.

perpetuity (consol),

A perpetuity, or a consol; it is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of C forever.

Federal Reserve System

Assets - Government securities and Discount loans Liabilities - Currency in circulation and Reserves

What is the relationship between bond prices and interest rates? Why?

Bonds have an inverse relationship to interest rates; when interest rates rise, bond prices fall, and vice-versa.

Lender of Last Resort Function

Can also help avoid panics •Ex: Market crash in 1987 and terrorist attacks in 2001—bad events, but no real panic in our financial system

cash flows

Cash flows are different streams of cash payments to the holder for various debt instruments.

Tactics:

Choosing the Policy Instrument: the day-to-day conduct of monetary policy requires an instrument, and banks usually choose between monetary aggregates or interest rates to achieve the goals.

coupon rate

Coupon rate is the fixed interest payment of a bond, paid every year until maturity date

current yield

Current yield and ic, is the yearly coupon payment divided by the price of the security, and is frequently used as an approximation to describe interest rates (yields to maturity) on long-term bonds.

duration

Duration is the average lifetime of a debt security's stream of payments.

face value (par value)

Face value is the specified final amount repaid at the maturity date of a coupon bond. (Also called par value.)

Explain why real interest rates can be negative.

If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate.

indexed bonds

Indexed bonds have interest and principal payments that are adjusted for changes in the price level and whose interest rate thus provides a direct measure of a real interest rate.

interest-rate risk

Interest-rate risk is the possible reduction in returns that is associated with changes in interest rates.

If there is a decline in interest rates, which would you rather be holding, long term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

Lower expected interest rates in the future increase the demand for long-term bonds. I would rather be holding long term bonds, because I would lose less money on the expected interest rate. Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand. Short term bonds have greater interest-rate risk.

Policymakers have come to recognize the social and economic costs of inflation.

Price stability, therefore, has become a primary focus. High inflation seems to create uncertainty, hampering economic growth. Indeed, hyperinflation has proven damaging to countries experiencing it.

What key findings are true for all bonds?

Prices and interest rates move in opposite directions, an increase in interest rates equals a decrease in bond prices resulting in capital losses.

Really needed? What about the FDIC?

Problem 1: FDIC only has about 1% of deposits in the insurance trust—people need the Fed for additional confidence in the system ─Problem 2: over $1.8 trillion are large deposits not insured by the FDIC

real terms

Real Terms are terms reflecting actual goods and services one can buy, in "real time"; now or at end of a maturity period for a debt instrument.

reinvestment risk

Reinvestment risk is the interest-rate risk associated with the fact that the proceeds of short-term investments must be reinvested at a future interest rate that is uncertain

Asset Price Bubbles:

Should a central bank respond? In the case of credit-driven bubbles, the answer appears to be yes! But the right tool is not obvious.

Define the four types of credit market instruments.

Simple Loan:(is the simplest kind of debt instrument) where a lender provides the borrower with an amount of funds(principal) that must be repaid at the maturity date along with interest. Fixed payment loan: the lender provides a borrower with an amount of money(funds) that is repaid by making a fixed payment periodically (usually monthly) consisting of part of the principal and interest for a set number of years. Coupon bond: pays the owner of the bond a fixed interest payment every year until the maturity date, when a specified final amount (face value or par value) is repaid. Discount bond: is bought at a price below its face value and whose face value is repaid at the maturity date; it does not make interest payments.

What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year?

Solution The real interest rate is -2%. Although you will be receiving 8% more dollars at the end of the year, you will be paying 10% more for goods. The result is that you will be able to buy 2% fewer goods at the end of the year, and you will be 2% worse off in real terms. i r = i − π e ir=i−πe i = nominal interest rate = 0.08 π e = expected inflation rate = 0.10 i r = 0.08 − 0.10 = − 0.02 = − 2 %

Explain the concept of present value

The commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today; this notion is true because you can deposit a dollar in a savings account that earns interest and have more than a dollar in one year.

present value (present discounted value),

The concept of present value (or present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today: This notion is true because you can deposit a dollar in a savings account that earns interest and have more than a dollar in one year.

What is meant by the term "reinvestment rate risk" and why is it of concern to purchasers of bonds?

The interest rate risk associated with the fact that the proceeds of short-term investments must be reinvested at a future interest rate that is uncertain. (if an investor's holding period is longer than the term to maturity)

nominal interest rate

The nominal interest rate is not adjusted for inflation

What is interest rate risk?

The possible reduction in returns that is associated with changes in interest rates.

real interest rate

The real interest rate is the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. The formula for determining real interest rate is i = i r + π e + ( i r × π e ) or final form: i r = i − π e The real interest rate adjusted for expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing

return (rate of return

The return on a security or investment or the payments to the owner of a security plus the change in the security's value, expressed as a fraction of its purchase price; more precisely called the rate of return.

Inflation Targeting:

This policy has advantages: clear, easily understood, and keeps central bankers accountable. But is this at the cost of growth and employment?

Monetary Policy Tools of the ECB:

We compared the ECB and Fed in its stance on monetary policy, tools, and targets.

Should Price Stability be the Primary Goal of Monetary Policy?

We outlined conditions when this goal is both consistent and inconsistent with other monetary goals.

How does the increase and decrease in the following affect duration?

a. Term to maturity: The longer the time to maturity, the longer the duration. The shorter the time to maturity, the shorter the duration. b. Interest rate on coupon bond: The greater the coupon on a bond, lower the duration. The smaller the coupon on a bond, longer the duration. c. Coupon rate: The bond with the higher coupon rate will recoup the initial investment quicker, though a bond with a lower coupon rate will take longer to recoup the investment.

yield to maturity

method of calculating interest payments, the yield to maturity is the interest rate that equates the present value of cash flows received from a debt instrument with its value today, equating today's value of the debt instrument with the present value of all of its future cash flow payments

monetary policy

refers to the management of the money supply. Although the idea is simple enough, the theories guiding the Federal Reserve are complex and often controversial. But, we are affected by this policy, and a basic understanding of how it works is, therefore, important

The Price Stability Goal and the Nominal Anchor:

stable inflation has become the primarily goal of central banks, but this has pros and cons.

Other Goals of Monetary Policy:

such as employment, growth, and stability, need to be considered along with inflation.

The Market for Reserves and the Federal Funds Rate:

supply and demand analysis shows how Fed actions affect market rates.

Reserve Requirements:

the Fed and other central banks set the required reserves for banks. The U.S. will allow for interest on reserves in the future.

Tools of Monetary Policy:

the Fed can use open market operations, discount loans, and reserve ratios to enact Fed directives.

The Federal Reserve's Balance Sheet:

the Fed's actions change both its balance sheet and the money supply. Open market operations and discount loans were examined.

Discount Policy:

the Fed's role in making loans and as a lender of last resort were discussed.

The Fed

uses a dual mandate, where ―maximizing employment, stable prices, and moderate long-term interest rates‖ are all given equal importance.

The ECB

uses a hierarchical mandate, placing the goal of price stability above all other goals.

The monetary liabilities of the Fed include:

─Currency in circulation: the physical currency in the hands of the public, which is accepted as a medium of exchange worldwide. ─Reserves: All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves. The Fed does not pay interest on reserves, but that may change because of legislative changes for 2011. ─Government Securities: These are the U.S. Treasury bills and bonds that the Federal Reserve has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply. ─Discount Loans: These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply.

Criteria for Policy Instruments

─Observable and Measurable •Some are observable, but with a lag (eg. reserve aggregates) ─Controllable •Controllability is not clear-cut. Both aggregates and interest rates have uncontrollable components. ─Predictable effect on goals •Generally, short-term rates offer the best links to monetary goals. But reserve aggregates are still used.

The Fed's discount loans are primarily of three types:

─Primary Credit: Policy whereby healthy banks are permitted to borrow as they wish from the primary credit facility. ─Secondary Credit: Given to troubled banks experiencing liquidity problems. ─Seasonal Credit: Designed for small, regional banks that have seasonal patterns of deposits.

The trading desk typically uses two types of transactions to implement their strategy:

─Repurchase agreements: the Fed purchases securities, but agrees to sell them back within about 15 days. So, the desired effect is reversed when the Fed sells the securities back—good for taking defense strategies that will reverse. ─Matched sale-purchase transaction: essentially a reverse repro, where the Fed sells securities, but agrees to buy them back.

Lender of Last Resort Function

─To prevent banking panics ─Example: Continental Illinois