Banking - Money and the meaning of interest rates

What are the functions of money?

Medium of exchange (must be: easily standardised, widely accepted, divisble, easy to carry, not deteriorate quickly)

Unit of account

Store of value

What is M1?

M1 (most liquid assets) = currency + checks + demand deposits (money deposited) + other checkable deposits (the way deposist are spent eg cards)

What is M2?

M2 adds semi liquid assets to M1 = M1 + small denomination time deposits (deposits with higher interest but cannot be used till maturity) + saving deposits and money market deposit accounts + money market mutual fund shares (low risk short term investment in debt securities etc)

What is present value?

A dollar paid to you in a year is less valuable than one paid now because a dollar can be deposited and earn interest on it

What is the equation for present value

$Payment x (1+ interest rate)

What is the equation for simple present value?

$Cashflow in period / (1 + interest rate)^amount of years

What are the 4 types of credit market instruments

Simple loan

Fixed payment loan

Coupon bond

Discount bond

What is yield to maturity?

The interest rate received from a debt instrument (the present value of cash flow payments)

What is the equation for yield to maturity on a SIMPLE LOAN?

Amount borrowed = Cash flow in period / (1 + interest rate)^amount of years

What is the equation for yield to maturity on a FIXED PAYMENT LOAN?

Loan Value = Fixed yearly payment / (1 + interest rate) + FP / (1 + i)² (AND SO ON FOR EACH YEAR ^n)

What is the equation for yield to maturity on a COUPON BOND?

SAME AS FIXED PAYMENT LOAN just different wording

Price = Yearly coupon payment / (1 + i) + …….

YTM is negatively related to current price as when interest rates rise, demand for new fixed coupon rates rise making them less attractive to investors who operate in the secondary market, which decreases price causing YTM to fall

What is a consol/perpetuity coupon bond?

A bond with no repay principal, instead it pays out money for its entire existence

What is the equation for yield to maturity of a discount bond?

Face value of bond - current price / current price of bond

As with coupon bond, YTM is negatively related to current price