Econ 330 Exam 1

Sets 1-6

Security (financial instruments)

A claim on the issuer’s future income or assets

Bond

Debt security promising payments over a specified period

Interest rate

The cost of borrowing, or the price paid for renting funds

Common stock

Represents a share of ownership in a corporation

Share of stock

A claim on the residual earnings and assets of the corporation

Equities

A claim to share in the net income and assets of a business

Money markets

Trade short-term debt instruments

Capital market

Trade longer-term debt and equity instruments

Why do financial intermediaries exist

To lower transaction costs, increase liquidity, reduce risk, diversification, and they exist BECAUSE of asymmetric information

Families of intermediaries

• Depository

  institutions (commercial banks, savings and loans, credit unions)

• Contractual savings

  institutions (life insurance, pension & retirement funds)

• Investment

  intermediaries (hedge funds, finance companies, money market mutual funds)

Adverse selection

Borrowers most eager to take a loan at a high rate are often the ones least likely to repay. Raising rate to cover the risk drives out safer borrowers.

Moral hazard

Once the money is lent, the borrower has an incentive to take risks the lender would never have accepted. The upside is the borrowers; a large part of the downside belongs to the lender

• The lender's response: monitoring, and restrictive covenants written into the contract

Money

Anything that is generally accepted as payment for goods and services, or in the repayment of debts. It is a stock concept (measured at a moment)

3 Functions of Money

• eliminates need to find double wants (no more bartering; promotes specialization)

• unit of account

• store of value

M1

The most liquid assets

• currency

• travelers checks

• demand deposits (checking account)

M2

M1 + savings deposits, money market deposit accounts

(what you could spend after a transfer that takes a moment)

Yield to maturity

The interest rate that equates the present value of the cash flow payments received from a debt instrument with its value today

Four Credit Market Instruments

• simple loan

• fixed-payment loan

• coupon bond

• discount bond

Simple Loan

Provides funds now and requires one repayment at maturity

Fixed-payment Loan

Equal periodic payments containing both principal and interest

Discount bond

Purchased below face value and makes no coupon payments

Yield to Maturity

The discount rate that makes the PV of future bond payments equal to the bond's current price

Ex ante real rate

Uses expected inflation—the information available when the decision is made

Ex post real rate

Uses actual inflation—what borrower and lender ultimately experienced

Using Fisher Equation: if actual inflation exceeds expected inflation

• Borrowers gain: repayment uses less valuable dollars

• Lenders lose: realized real return is lower than expected

Wealth

Total stock of assets that share value

Why bond demand is downward sloping

Lower price means higher quantity demanded because buying at lower price (getting the same promised payments) results in a higher yield.

Shifters of Bond Demand

• wealth

• expected return on bonds

• liquidity of bonds

• risk of bonds

• expected inflation

Shifters of bond supply

• expected profitability

• expected inflation

• government budget deficit

Why does money demand slope down

Higher interest rates make bonds more attractive than money.

Shifters of Money Demand

• Income (increase > shift right > interest rate rises)

• Price level (Increase > interest rate rises)

Three reasons maturity yields differ

• default risk

• liquidity

• tax treatment

Risk Premium - expressed in percentage points

Risky bond yield - Comparable (same maturity) treasury bond yield

Bond credit ratings

• Investment grade: Aaa to Baa

• High yield: Ba and below

Expectation theory

Long rates reflect expectations of future short rates

Segmented markets theory

There are separate markets, and supply and demand for each maturity

Long term yield

Average expected future short rates + term premium

Preferred habitat

Investors prefer certain bond maturities, but they will buy bonds outside their preferred maturity if they are offered enough additional return (a risk premium)

Inverted Yield curves

Inversion + positive term premium = expected future short rates must be REALLY low

Liquidity premium theory

Investors demand a higher yield or extra return for holding longer-term, less liquid securities compared to short-term, highly liquid investments

How does a business cycle expansion impact the bond market

Supply shifts right more than demand, causing a drop in price

Income effect

When your income rises or prices fall, your relative purchasing power increases, allowing you to buy more or different goods.

Liquidity effect

Increase in the money supply leads to an immediate decrease in short-term nominal interest rates.

Fisher effect (expected inflation effect)

an increase in expected inflation leads to an equal increase in nominal interest rates

Price level effect

A rise in the overall price level leads to an increase in nominal interest rates

One year holding return

Liquidity preference framework

Explains how interest rates are determined by the supply of and demand for money in an economy