L3 saving & investment II

efficient market hypothesis

in an efficient financial market, asset prices reflect all available info, and investors rapidly respond to opportunities to earn unusually attractive returns

there are three assumptions:

• investors are rational

• to the extent that some are irrational, their errors cancel out

• if investors are systematically irrational, rational investors exploit this and push prices back towards reasonable levels

the no arbitrage condition

arbitrage means exploiting a price discrepancy to earn a profit without taking the corresponding risk

basically arbitrage shouldn’t exist - competitive and rational traders will crowd it and bid the price discrepancy away

what is yield to maturity on a bond

the total annualized return you can expect to earn on a bond if you buy it at its current market price and hold it until its official maturity date

relationship between bond price and yield

inverse - because a bond with a higher on paper yeild will be sold at a premium (more than its face value) like $132 instead of $100 so that decreases the yield relative to the price you actually purchased it for

coupon rate vs current yield

coupon rate is the annual coupon of a bond divided by its face value - 8.75/100

current yield is the annual coupon divided by the bond’s current market price - 8.75/132

how is the price of a treasury bond affected by increased expected inflation

if expected inflation goes up, the TIPS will start to give you more money to acocunt for that inflation.

so in order for the normal treasury bond to give the same (now adjusted for inflation) return interest rate as a TIPS, the market value must go down for the percentages to match.

how do ordinary treasuries and TIPS respond to expected inflation

for the TIPS, the principal payments are inflation adjusted, the inflation protection preserves the real value to account for the inflation

for the ordinary treasury, the existing market price of the bond falls to adjust for the expected rise in inflation so that the interest rate you get on it is now greater

how to find the market implied rate for a treasury X years from now. what is this called

you look at the rate of a current 2X long treasury, say it’s 4%, and the current X year long is only 2%. Then the second X year long will have to average with 2% to create 4% over the coming 2X years so in this case it must be 6%

this is called the forward rate

effect of expectations of short term rates

if you expect short term rates to go up, you would demand a higher rate on your longer term note because it has to account for the rates that you could just get by compounding shorter term ones

if you expect short term rates to go down a longer term note would have a lower yield than today’s short term note

upward sloping yield curve

longer term yields exceed shorter term yields.

this reflects expectations of rising future short term rates

inverted yield curve

longer term yields are lower than shorter term yields, reflecting expectations that future short term rates will decrease

what is a basis point

one one hundreth of a percent

term premium

investors demand extra compensation for committing money to longer maturity secutities instead of many short term ones back to back as they are accepting interest rate risk

so longer term yields = expected short term rates (averaged over relevant time horizon) + term premium

How are term premiums accounted for in forward rates

recall forward rates are the implied interest rate of the future period that you will buy a short term note for.

F = R^e + tau

F is the implied forward rate

tau is the term premium (also a percent)

and R^e is the expected future interest rate

what is a default

when a borrower fails to make the promised payments

why do coporate bonds have higher yields than US treasury bonds

higher default risk

credit spread

= coporate bond yield - us treasury bond yield

usually posotive ecause coporate are higher to account for higher defualt risk

the two D’s that account for differences between bond yields

duration - differences of duration lead to different yields, reflecting expectations about future interest rates and term premiums

default - interest rate differences reflecting default risk

how to calculate number of expected defaults

if you are comparing risky borrowing vs just a treasury yield and you want the returns to match you take (repayment per performing loan)(N-D) + (recovery per default)(D) and set it equal to the treasury yield

what is the risk premium

the premium the bank wants for taking risking borrowers instead of just treasury so if the treasury is 3% and you want a risk premium of 2% you have a 5% total expected return for the risky small business loans

the two cases of S=I equality

savings = investment

can be from strong investment demand where you expect that if ppl save more you would also get more investment. because they just have ore money lying around?

or could be from decreased consumer spending where they are saving more and the investment that comapnies are putting in is actually unplannned investment due to accumulation of inventory.

why does credit spread increase during a recession

During a recession, firms may experience lower revenues and profits, making defaults more likely.

Investors become concerned about lending to these companies.

They therefore demand higher yields to compensate for expected defaults and the additional risk of holding corporate debt.

At the same time, investors may become more willing to hold relatively safe government bonds, pushing their yields downward.

The result is that government and corporate yields move in opposite directions.