BUSFIN 4250 - Global Finance

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Example: Suppose that to raise the money needed to build cell towers, Verizon issues $1.5 million worth of 10-year bonds with a coupon rate of 4.6%. Let's also suppose it sells 150,000 of these bonds, each with a face value of $1,000. Assume that current market interest rates for a 10-year bond issued by a firm like Verizon is currently 4.6%—the same as the coupon rate. What would the price of each of these bonds be?

$1000 N = 10 I/Y = 4.6 PV = -1000 PMT = 46 CPT FV = 1000

Why we worry about inflation

- Redistributes wealth in favor of the wealthy; when the inflation rate is high, the wealthy can redistribute their assets to protect them from inflation. - wages and salaries tend to lag behind the inflation rate - Inflation can misallocate resources and paralyze the entire economy; business people cut back on their economic activity.

Yield Curve Facts

1. A yield curve generally slopes upward. This means that, holding everything else constant, the yield on long-term bonds tends to be higher than the yield on short-term bonds. 2. The slope of a yield curve can and does change. That is, sometimes the yield curve is flat, or there is not much difference between short-term yields and long-term yields, whereas other times the yield curve is steep, meaning there is a big difference between short- term yields and long-term yields; and sometimes the yield curve slopes downward. This downward-sloping yield curve is sometimes called an "inverted" yield curve. 3. There often are parallel shifts in a yield curve. That is, over time, short-term and long- term interest rates tend to move together. Sometimes all interest rates increase, or the yield curve shifts upward. Other times, all interest rates decrease and there is a parallel downward shift in the yield curve.

Proponents of the Term Premium Theory

1. Short-term bonds are more liquid. A bondholder can get money out of a short-term bond much quicker and easier than from a long-term bond. As a bondholder, all you have to do is hold your short-term bond to maturity and bam! You get your money back. But with a long-term bond you have to hold onto that bond for a much longer time before it matures. Or, if you hold a long-term bond you had better hope there is a well-secondary market so that you can sell that long-term bond easily if you have to. Because savers would like to have liquidity, holding everything else constant they will prefer to hold short-term bonds as opposed to long-term bonds. 2. Short-term bond prices fluctuate less than long-term bond prices. If you are an investor, you really don't want to see the market price of your investments moving around a great deal. High volatility in the market price of your investments means there is a high level of volatility in your wealth levels. In general, people don't like this. But think about bond prices and interest rates. For a given change in interest rate, the price of long-term bond fluctuates more than the price of a short-term bond. Thinking about it mathematically, the long-term bond price is going to see the numerator change more—the longer the time, the higher the exponent of the denominator—than a short-term bond. Thus long- term bond prices change more for a given change in interest rate than do short-term bond prices.

Default Risk Premium Example: So, let's say that in August 2016 an interest rate of 4.5% is paid by the Rigsby Corporation, borrower i. Let's also suppose that, at that same time, an interest rate of 2% is paid by the US Treasury when it issues debt. What is the DRP?

2.5% The interest rate on Treasury securities is often considered the risk-free rate because the chances the US government will default on its debt is very, very small. Thus, in this case, the Rigsby Corporation must pay a DRP of 2.5%, or 4.5% minus 2%.

After Tax Rate of Return Example: Let's say Lisa has a bond with a coupon rate of 7%, but she faces a 25% marginal tax rate. That means her after-tax rate of return on the bond is?

5.25%

Bond Tax Rate Example: Imagine Rachel is considering two bonds, a corporate bond and a muni bond that are exactly the same except for their yields. Suppose Rachel is in the 28% tax bracket, and the muni bond she is thinking about buying pays a 6% interest rate. So the after-tax rate and the before-tax rate on the muni bond is the same at 6%. Rachel knows if she buys the corporate bond she has to pay to the government as taxes 28% of the interest she earns on that corporate bond. How high would the yield on the corporate bond have to be to make her indifferent between the corporate bond and the muni bond?

8.33% So the corporate bond would have to pay a before-tax interest rate of 8.33% to make her indifferent between that bond and a muni bond paying 6%.

EX Post Real IR

= Nominal IR - Actual Inflation Rate Uses the actually rate of inflation. With ex post, the term post means "after." Think about a postgame interview that takes place after the end of a football game: Postgame means "after the game." In the same way, ex post real interest rate is the interest rate calculated using the inflation rate that has already occurred or the actual rate of inflation.

Ex Ante Real IR

= Nominal IR - Expected inflation rate Uses the expected rate of inflation In terms of ex ante, think about a game of poker that you may have played or seen played on television or in the movies. Before each hand is dealt, players must "ante up," or put their chips into the pot before the cards are played. Thus the term ante means "before." So, an ex ante real interest rate is a real interest rate based on the expected or forecasted rate of inflation.

Nominal or Market IR =

= Real IR + Rate of Inflation So if the real interest rate (IR) is 2% and the inflation rate is 3%, then the nominal or market interest rate should be 5%.

Change in the Demand for Bonds

A change in things from the buyer's perspective other than the price of a bond brings about a change in demand. - exogenous changes *A change in demand causes the demand curve to shift*

Change in the Supply of Bonds

A change in things from the seller's perspective other than the price of a bond brings about a change in supply. - exogenous changes *A change in supply causes the supply curve to shift*

Coupon Payments

A coupon payment on a bond is the annual interest payment that the bondholder receives from the bond's issue date until it matures. Usually paid every six months. (The pictures shows an old bond with the coupons at the bottom that had to be sent in to return interest payments.)

What does the Pure Expectations Theory say about a flat yield curve?

A flat yield curve suggests short-term interest rates in the future will be where they are well into the future. This means that economic and financial markets conditions are not expected to change much at all over time. Conclusion: Things will remain the same.

Pure Expectations Theory and a Flat Yield Curve

A flat yield curve tells us the market believes short-term rates in the future will be the same as what they are today.

Pure Expectations Theory

A framework where long-term interest rates are based on the expectations of what short-term interest rates will be in the future.

Term Premium Theory of the yield curve

A framework where longer-term bonds have higher yields than shorter-term bonds as a way of creating an incentive for bond buyers to purchase the less desirable longer-term bonds.

Rate of Return

A rate of return is simply the ratio of what you put in versus what you get back.

What does the Segmented Market Theory say about a steep (rising) yield curve?

A steep yield curve could come about because either short- term rates have decreased or longer-term interest rates have increased. These outcomes may be caused by several things: (a) Expansionary monetary policy. When a central bank implements monetary policy it is usually in the short-term bond market. If a central bank pursues an expansionary monetary policy, the result will be lower short-term interest rates. Then, however, one wonders why the central bank is pursuing such a policy. Mortgage interest rates increase. The long-term bond market is often affected by what happens in the home mortgage markets. Because most home mortgages in the United States are 30 years in duration, most mortgage-backed securities also are expected to have very long-term maturities. So, if home mortgage interest rates increase (maybe there has been an increase in home buying), then long-term interest rates will increase. Conclusion: It could be good news (central banks have cut interest rates and more homes are being sold) or it could be bad news (central banks have cut interest rates because they are worried about an impending economic slowdown and there are too many homes being built and sold).

What does the Term Premium Theory say about a steep (rising) yield curve?

A steep yield curve suggests that borrowers require a higher term premium in order to hold longer-term bonds. There are two possible reasons why this might occur: (a) Savers currently have a better use for funds. Imagine savers are considering lend- ing money to someone else or using it themselves. If savers do not have a use for the funds they probably will lend it to someone else. On the other hand, if savers have a "good" use for the money, especially in the long term, they are going to demand a higher interest rate on their savings to get them to lend the money to someone else. (b) Savers worry about the future. The future is full of uncertainty. Savers could be worried about the state of the economy in the future. They might worry that if the economy weakens in the future, borrowers will not be able to repay their debts. Thus savers might require a higher interest rate to lend money well into the future. Or, savers could be worried about what the future inflation rate might be. Savers and lenders are concerned that if inflation increases they will be paid back in a currency that buys less. Thus they require a higher interest rate to lend money for the long term. Conclusion: It could be good news (savers have uses for funds) or bad news (savers are worried about the future).

What does the Pure Expectations Theory say about a steep (rising) yield curve?

A steep yield curve suggests that short-term interest rates will be significantly higher in the future than what they are currently. There are two main reasons why this might occur: (a) High inflation rates in the future. If the inflation rate is higher than interest rates in the future, even short-term interest rates will be higher than what they are today. (b) Faster economic growth. If the rate of economic growth increases in the future, more borrowing and spending will occur in the future as well. This increased borrowing will push interest rates upward. Remember, interest rates tend to be procyclical. Conclusion: It could be good news (faster growth) or bad news (higher inflation).

Segmented Market Theory

Also called the segmented markets theory or the market segmentation theory, a framework where the short-term, medium-term, and long-term bond markets are all different or segmented markets.

Effects of Business Cycles and Confidence on the Bond Market and Loanable Funds Market

An increase in confidence will lead to a funding of more projects. To fund those projects firms will have to borrow more. This increases the demand for loanable funds. One way to borrow is to sell funds in the primary market, this increases the supply of bonds.

What does the Segmented Market Theory say about an inverted yield curve.

An inverted yield curve comes about because the central bank, such as the Federal Reserve, is implementing a contractionary monetary policy. Monetary policy interventions usually impact only the short-term bond market. Thus a contractionary monetary policy pushes up short-term interest rates, creating an inverted yield curve. A contractionary policy is usually used to control inflation by slowing down the economy. Thus an inverted yield curve signals that the economy is going to slow down. However, if the central bank overdoes it and "tightens" too much, the economy could slide into a recession. Conclusion: The economy is headed for a slowdown or a recession.

What does the Pure Expectations Theory say about an inverted yield curve?

An inverted yield curve suggests that short-term interest rates will be lower in the future than they are today. These relatively "high" short-term interest rates today mean there will be less borrowing, and that means less spending. This reduction in spending means the economy is going to slow down and potentially slide into an economic recession. Conclusion: The economy is headed for a slowdown or a recession.

Relationship between bond prices and bond yields.

As the bond price increases, the yield to maturity falls.

How do changes in price affect the demand for bonds?

As the price of bonds declines, bond buyers have both the incentive and ability to buy more bonds. The bond yields, or rates of return paid to savers, increases, making the bonds more desirable. Similarly, as the price of bonds decreases, savers can afford to buy more bonds with their savings. Thus as the price of bonds falls the quantity demand of bonds increases *This is a change in quantity demanded or a movement along the demand curve*

How do changes in price affect the supply of bonds?

As the price of bonds increases, or their yields decrease, these issuers will want to issue more bonds because the yield, or the interest rate the issuers have to pay to bondholders, has decreased. - thus as the price of bonds increase, the quantity of bonds in demand increases *This is a change in quantity supplied or a moment along the supply curve*

The Loanable Funds Market in Equilibrium

As with any other market, if the price (remember, the price of loanable funds is the interest rate) is higher than the equilibrium price, a surplus develops. A shortage occurs in the loanable funds market if the market interest rate is less than the equilibrium interest rate. When you have a surplus or shortage their will be a movement to the equilibrium point.

Why is the supply curve in the bond market upward sloping?

At lower prices interest rates are high so you are not willing to supply a lot of bonds - point A At higher prices you are willing to supply more because the yield you have to pay out is smaller - point b

Why is the demand for bonds downward sloping?

At the higher price for bonds you get a low yield (return) so the demand is low. - point A At a lower price for bonds you get a high yield so the demand is high

Term Premium Theory and Reality

Be careful before you fully accept the term premium theory as the perfect explanation of the yield curve. Remember, sometimes the yield curve is perfectly flat. When this is the case, there would be no term premium as described by the proponents of the term premium theory. So, the question is: Where did the term premium go? Even more troublesome to the proponents of the term premium theory is the inverted or downward-sloping yield curve. When the yield curve slopes downward, it appears that the term premium has become negative. Why would that be the case?

Primary Bond Market

Bonds are being sold for the first time by the issuers: corporations, governments, and government agencies. The primary market is the part of the capital market that deals with issuing of new securities. Primary markets create long term instruments through which corporate entities raise funds from the capital market.

Bonds

Bonds are promises to repay that are issued by governments, government agencies, and corporations.

Municipal (muni) Bonds

Bonds or debt issued by state governments, local governments, and/or local municipalities. To make it easier for these local government entities to sell their bonds (and to keep their financing costs low), the interest paid on these muni bonds is not currently subject to federal income tax.

Who are the winners and losers of an inflationary market? (borrowers or loaners)

Borrowers are the winners - borrowed expensive dollars and paying back cheap dollars Loaners are the losers - lent expensive dollars and got paid back in cheap dollars

The Demand for Loanable Funds

Borrowers in financial markets take funds from our pool of loanable funds. These borrowers, or deficit units, are entities who have an optimal level of expenditure in the current period that is greater than their current income. These borrowers or deficit units include the following: - Households - Firms - Governments - Rest of the World *As interest rates increase we see a decrease in the quantity of loanable funds demanded. As interest rates increase, some deficit units that were willing to borrow at the lower interest rate now find borrowing too expensive at the higher interest rate.*

What are things from a seller's prospective that can bring about change in supply in Bonds?

Business Expectations - If businesspeople become more optimistic about the future, they will want to borrow more money to expand their output. Thus they will issue more bonds Expected Inflation - If firms expect that there will be inflation in the future, they want to borrow more now because the real burden of that debt will decline with inflation. Thus they issue more bonds. Government Deficits - When governments spend more than they take in or run bigger bud- get deficits, they have to go out and borrow the difference. Investment Tax Credits - An increase in the amount of investment tax credits leads to an increase in the supply of bonds in the bond market.

New Equilibrium in the Bond Market

Caused by change in the supply and demand of bonds. The graphs show an increase (a) and decrease (b) in the supply of bonds and an increase (c) and decrease (d) in the demand for bonds.

Change in Demand vs Change in Quantity Demanded

Change in demand is a change in the price and quantity relationship from a buyer's perspective, whereas a change in quantity demanded comes about from a change in the price of the good or service. Demand curves are downward sloping

Change in Supply versus Change in Quantity Supplied

Change in supply is a change in the price and quantity relationship from a seller's perspective, whereas a change in quantity supplied comes about from a change in the price of the good or service. Supply curves are upward sloping

Week 2 - Loanable Funds

Chapter 3 - Bonds and Loanable Funds

What happens is consumers and businesses are pessimistic about the future economy?

Consumers are worried about what will happen to their salaries or if they will have a job so they do not make major purchases Business do not know if people will buy the quantities the need to clear the market so they will slow down on investments. This leads to a decrease of demand in the loanable funds market which leads to a decrease in the IR in the loanable funds market. The economy is contracting Again the IR is procyclical to business cycles

Implicit Costs

Costs that do not involve the payment of money. - the opportunity costs such as time spent to find information for example.

Explicit Costs

Costs that involve the payment of money

How does expected inflation effect the IR in the loanable funds marker?

Demand for loanable funds increases and supply for loanable funds decreases so this results in the IR for loanable funds increasing Firms - firms have an increase in borrowing costs - fewer capital projects undertaken - the change in expected inflation implements uncertainty in the market

Yield Curve

Graph of the yields of bonds or debt at one point in time.

Pure Expectations Theory and an Inverted Yield Curve

If a yield curve slopes downward, or is inverted, the pure expectations theory suggests the market thinks short-term interest rates in the future will be lower than what they are today.

New Equilibrium in the Loanable Funds Market

If the demand or supply shifts in the loanable funds market this causes there to be a new equilibrium.

Bond Market Surplus

If the market price of bonds is higher than the equilibrium price, the quantity of bonds supplied will be greater than the quantity of bonds demanded and a surplus will develop. At a very high price or a low yield or interest rate, the bond suppliers are willing to sell a great number of these bonds because the borrowing cost is low. At this high price, or low yield, however, savers are not interested in buying many of these bonds.

Labor Income

Income earned from selling your time, effort, and brains to an employer.

How does positive expectations of future markets effect the Loanable funds market?

It causes an increase in demand for loanable funds because consumers will want to borrow more money as well as businesses to take on more projects. The economy is expanding This will increase the IR This is why we say IR are procyclical - IR move in conjunction with business cycles

How does expansionary policy effect the loanable funds market?