MONEY & BANKING EXAM #2

Why do bonds with the same maturity have different interest rates?

due to default risk, liquidity, and tax considerations

risk structure of interest rates

groups bonds with the same maturities and explains the differences in interest rates

term structure of interest rates

groups bonds with the same risk factors but different maturities and explains the differences in interest rates

default risk

probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the dace value

What bonds are considered default free?

US treasury bonds

why are US treasury bonds default free?

government can raise taxes

risk premium

the spread between the interest rates on bonds with default risk and the interest rates on treasury bonds

What does risk premium indicate?

how much additional interest investors must earn to be willing to hold a risky bond

When corporations fail to meet their payments, what happens to the price of their bonds?

the price will fall

default risk equation

bond yield = US treasury yield + default risk premium

What does higher default risk indicate?

higher the probability that the bond holder will not receive the promised payments

What does risk do to the expected value?

it lowers the expected value, lowering the price an investor is willing to pay and increases the yield

What does an increase in default risk do to corporate bonds?

shifts the demand curve to the left

What does an increase in default risk do to treasury bonds?

shifts the demand curve to the right

What do bond rating agencies do?

monitor the status of individual bond issuers assessing the likelihood of repayment

Liquidity in risk structure

the relative ease with which an asset can be converted to cash

• cost of selling a bond

• number of buyers/ sellers in the bond market

What is the most liquid long-term bond?

US Treasury bonds

What kind of bond has lowest taxes?

municipal bonds

income tax consideration

interest payments on municipal bonds are exempt from federal income tax

• yield lower than other bonds

How does interest rate risk arise?

from the fact investors do not know the actual holding period yield of a long term bond

What affect does interest rate change have on bond prices?

when interest rates change, bond prices move and the longer the term on a bond, the larger the price change

When does interest rate risk appear?

When there is a mismatch between you investment horizon and bond’s maturity

yield curve

plot of the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations

upwards sloping yield curve

long term rates are higher than short term rates

flat yield curve

short term and long term rates are the same

inverted yield curve

long term rates are lower than short term rates

what are rising interest rates associated with

economic growth/ boom

What do steep yield curves predict?

a future increase in inflation

What do flat yield curves suggest?

economic slow down or possible recession

What are falling interest rates associated with?

recessions

What does inverted yield curve suggest?

future recession

What yields are the most volatile?

yields on short term bonds

facts that theory of term structure of interest rates explains

1. interest rates on bonds of different maturities move together overtime

2. when short term interest rates are low, yield curves are more likely to have an upwards slope

3. yield curves almost always slope upwards

theories to explain observations regarding term structure of interest rates

1. expectations theory

2. segmented market theory

3. liquidity premium theory

expectations theory

interest rates on long term bonds will equal an average of short term bond interest rates

key assumptions in expectations theory

1. no preference of bond maturity

2. bonds with different maturities are perfect substitutes

3. if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal

What does the expectations theory explain?

• why the term structure if interest rates changes at different times

• why interest rates on bonds with different maturities move together overtime (fact 1)

• why yield curves tend to slope upwards when short term rates are low and slope downwards when short term rates are high (fact 2)

What can the expectations theory NOT explain?

why yield curves usually slope upwards (fact 3)

segmented market theory

• bonds of different maturities are not substitutes

• interest rate for each bond with different maturity is determined by the supply and demand for that bond

• investors have preferences for bonds of one maturity over another

key assumption in segmented market theory

bonds of different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the other bonds with different maturities

What does segmented market theory say about lenders who prefer stability over capital value?

want to avoid interest rate risk, so place funds in short term market

What does segmented market theory say about lenders who are more interested in income return than stable capital value?

they invest in longer term financial instruments

Liquidity premium theory

• extension of expectations theory

• adds a liquidity premium to longer term bonds as an incentive to lenders

Interest rate on long term bonds with liquidity premium

equals an average of short term interest rates plus a liquidity premium that responds to supply and demand conditions for that bond

preferred habitat theory

• closely related to liquidity theory

• investors have a preference for bonds with one maturity over another

• willing to buy bonds of different maturities only if they earn a somewhat higher expected return

what kind of bonds do investors prefer in preferred habitat theory?

short term, however they will hold long term bonds only if they have higher expected return

examples of financial systems

banks, insurance companies, mutual funds, stock/ bond market

transaction costs for small investors

• face higher transaction costs

• only a limited number of possible investments (introducing cost of risk)

What do transaction costs include?

legal fees, commissions, information, risk, and lack of diversity

How do financial intermediaries help with transaction costs?

1. economies of scale

2. expertise

economies of scale

reduction in transactions costs per dollar of investment as the size (scale) of the transaction increases

economies of scale in financial market

helps explain why FI developed and became an important part of the financial structure

How does FI create economies of scale?

combine funds of many savers

Expertise examples

computer systems, telecom systems, legal, and research

Where does transaction costs and need for research and expertise come from?

lack of information on the part of the investor (saver)

asymmetric information

refers to imbalance of information between 2 parties in a financial transaction

adverse selection

• occurs before the transaction

• lenders decide not to make loans because they fear bad credit risks, thus penalizing good credit risks

risk avoidance behavior

bank does not want any bad loans, so no loans are made at all

moral hazard

• takes place after transaction

• lenders run the risk that the borrower will engage on activities that are undesirable from the lender’s POV as they make it less likely that loan will be repaid

• lowers probability that the loan will be repaid, causing no loans to be made

lemon problem in financial structure

• if quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality

• sellers of good quality items will not want to sell at average price

• buyer will decide not to buy at all because market is mainly filled with bad quality items

tools to help solve adverse selection

1. private production and sale of information

2. government regulation to increase information

3. financial intermediation

4. collateral and net worth

private production of information in adverse selection problem

• provides investors who supply funds will full details about the individual/ firm seeking to borrow

• private companies collect and publish information to be sold to subscribers

• credit rating companies gather information about firms’ balance sheet and investment activities

• not a complete solution because of free riders

free riders

• those who do not pay for information, yet take advantage of information other people have paid for

• prevent the private market from producing enough information to eliminate asymmetric information

government regulation in adverse selection problem

• regulate securities markets to enable investors to determine the worth of a form by encouraging firms to be honest about activities

• disclosure requirements don’t always work well

• lessens adverse selection, but does not eliminate

financial intermediation in adverse selection problem

• FI becomes expert in producing information about firms so they can sort good credit risk from bad credit risk

• banks are able to identify and lend to mostly good firms

• produce information for their own uses helping to avoid free rider problem

• banks make private loans rather than purchasing securities that are traded in the open market

collateral and net worth in adverse selection problem

• collateral reduces the consequences of adverse selection as it reduces the lender’s losses resulting from default

• lenders are willing to make loans secured by collateral and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely the borrower will obtain the loan

net worth

difference between a firm’s assets and its liabilities

• more net worth a firm has, the less likely they are to default

What does moral hazard affect?

the choice between equity and debt contracts

debt contracts

complicated documents placing restrictions on the behavior of the borrower including interest rates and repayment schedule

principal agent problem

• stockholders are principals (owners of the firm)

• managers are agents for the owners

• managers may act in their own interests rather than those of the principals

What are equity contracts subject to?

principal agent problem

tools to offset principal agent problem

1. lack of information monitoring

2. government regulation

3. financial intermediation

4. debt contracts

production of information in principal agent problem

lack of information is an issue, so firm’s activities are frequently monitored

debt contracts on principal agent problem

• requires the borrower to pay the lender a fixed dollar amount at periodic intervals

• as long as payments are made, lender is indifferent

tools to avoid moral hazard in debt contracts

1. net worth and collateral

2. monitoring and enforcement of restrictive covenants

3. financial intermediation

monitoring and enforcement of restrictive covenants

• discourage undesirable behavior

• encourage desirable behavior

• keep collateral valuable

• provide information

list of facts about financials

1. stocks are not the most important source of external financing

2. marketable securities are not the primary source of financing

3. indirect finance is more important than direct finance

4. banks are the most important source of external funds

5. the financial system is heavily regulated

6. only large, well established firms have access to the securities markets

7. collateral is prevalent in debt contracts

8. debt contracts have numerous restrictive covenants

what is the most important source of external funding?

banks

financial repression

• poor system of property rights

• poor legal system

• weak accounting standards

• government intervention through directed credit programs and state-owned banks