CH 6 USgov debt

liquidity risk

because the US gov is the largest securities issuer and most actively traded security, it has virtually no ___ risk

default risk

because the US gov creates its own currency, it also has a lack of ___ risk

• Treasury manages government finances: prints money, collects taxes (IRS), issues securities

• Budget deficits drive heavy borrowing needs

• Minimum denomination: $100 (vs. $1,000 for many other debt securities)

• Five products: Treasury bills, notes, bonds, STRIPS, TIPS

U.S. Treasury overview

treasury bill

• Short-term, zero coupon, money market instrument (maturity ≤ 1 year)

• Maturities: 4, 6, 8, 13, 17, 26, 52 weeks

• Issued at discount; interest = par value minus purchase price (paid at maturity)

weekly (every other treasury product is auctioned monthly)

auction frequency of treasury bills

treasury notes

• interest paying, Intermediate-term, maturities 2–10 years

• Typically issued at par (can be discount/premium)

• Pay semi-annual interest

treasury bonds

• Long-term, maturities up to 30 years

• Typically issued at par (can be discount/premium)

• Pay semi-annual interest

STRIPS

• Stands for Separate Trading of Registered Interest and Principal of Securities

• Zero coupon, long-term bonds (up to 30 years), issued at deep discount, mature at par

• Not suitable for income-seeking investors (interest paid only at maturity)

• Highly price volatile due to long maturity + 0% coupon (interest rate risk still applies)

treasury receipts

• Similar to STRIPS but created by private financial institutions, not U.S. government

• Formed by stripping coupons from Treasury notes/bonds

• Lack risk-free status of government securities (issuer default risk)

phantom tax

• STRIPS/Treasury receipts taxed annually on accrued interest, even though no cash received until maturity

TIPS

• Treasury Inflation Protected Securities; long-term (up to 30 years), pay semi-annual interest

• Fixed coupon rate; principal adjusted every six months based on CPI

• Inflation increases → higher adjusted principal → higher interest payments

• At maturity, investor receives greater of original par or inflation-adjusted par

• Key exam points: long maturity, payments rise with inflation, par adjusts, coupon fixed

maturity and interest payment schedule of:

• T-Bill

• T-Note

• T-Bond

• STRIPS

• TIPS

• T-Bill: 1 year or less, at maturity

• T-Note: 2-10 years, Semi-annual

• T-Bond: up to 30 years, semi-annual

• STRIPS: Up to 30 years, at maturity

• TIPS: up to 30 years, semi-annually

agency bonds

• Indirectly backed by U.S. Government

• Subject to some default risk

unlike treasury products, agency products have indirect backing

federal agency products have what kind of backing

Federal Farm Credit System
Farmers can use this system for:

• Short-term financing (for example, at harvest)

• Long-term funding (for example, to buy farming equipment)

The U.S. government often subsidizes areas it considers essential to American life, and food production is one of them. To support agriculture, the government created the _____, which offers easier-to-obtain loans to farmers across the United States.

• Ginnie Mae, Fannie Mae, and freddie mac

• Fannie Mae and Freddie Mac……. Ginnie Mae

The government supports homeownership through three federal agencies: ___, ____, and ___. These organizations work with banks and lending institutions across the United States: ___ and ___ purchase their mortgages, while ___ guarantees mortgage-backed securities issued by approved private lenders. An example makes the benefit clearer.

Ginnie Mae (GNMA)

• Guarantees VA (Veterans Affairs) and FHA (Federal Housing Administration) insured mortgages

• Directly backed by U.S. Government

Fannie Mae (FNMA)

• Purchases insured (V.A., FHA) and conventional mortgages

• Indirectly backed by U.S. Government

• Publicly owned and traded

Freddie Mac (FHLMC)

• Purchases conventional mortgages

• Indirectly backed by U.S. Government

• Publicly owned and traded

mortgage backed securities

Prepayment risk

• Occurs when interest rates fall

• Homeowners pay off mortgages earlier than expected

Extension risk

• Occurs when interest rates rise

• Homeowners pay off mortgages later than expected

• Make monthly payments of interest and principal

• Subject to prepayment, extension, and reinvestment risk

• Interest is fully taxable

subject to full taxation (fed, state, local)

MBS taxation

Sallie Mae SLMA

• Former federal agency in the student loan business

• Publicly owned and traded

treasury auctions

You can buy new-issue Treasuries either through the government’s platform (TreasuryDirect) or through a broker-dealer. As with any auction, buyers submit bids. Two types exist:

• Competitive bids:

  • are usually submitted by large financial institutions that buy significant amounts of Treasury securities for customers or for their own portfolios. These bids are “competitive” because awards go to the best offers. A competitive bidder states:

    • The amount they want to buy, and

    • The lowest yield they’re willing to accept (sometimes called the discount margin rate)

    For example, a bank might bid for $5 million of Treasury bills at a yield of 4%.

• Non-competitive bids:

  • are usually submitted by retail investors. The maximum allowable bid is $10 million. Non-competitive bidders are guaranteed to receive the amount they bid for, and they receive the yield determined by the competitive auction.

U.S. government securities are first sold to investors through ___.

• Percentage of par quotes (generally)

• Quoted in 32nds using a:

  • Dash

  • Colon

  • Period

eg: 95-8

• 95 and 8/32

• 8/32 = .25

• bond is quoted at 952.50

US Gov debt quotes

• Provides both sides of dealer prices

• Bid = dealer buys, customer sells

• Ask = dealer sells, customer buys

eg: 97-8 x 97-12

This quote shows both dealer prices:

• The left side (97-8) is the bid, the price the dealer is willing to pay.

  • If the dealer is buying, the customer is selling.

  • So an investor can sell the bond to the dealer at 97-8 ($972.50 assuming $1,000 par).

• The right side (97-12) is the ask (or offer), the price the dealer is willing to sell at.

  • If the dealer is selling, the customer is buying.

  • So an investor can buy the bond from the dealer at 97-12 ($973.75 assuming $1,000 par).

The difference between the bid and ask is the spread. It represents the dealer’s potential profit if they buy from one customer and sell to another at the same time. In this example, the spread is $1.25 per $1,000 par bond ($972.50 vs. $973.75).

Bid-ask quotes

discount yield form like commercial paper (chapter 4.1)

Treasury bill quotes

Monetary policy

• Controls money supply levels

• Executed by Federal Reserve Board

• Two goals: Dual mandate

  • Economic growth (low unemployment)

  • Manageable inflation levels

increase the money supply….. lower interest rates

Assume we’re in the middle of a recession. Thousands of jobs are being cut each week, and stock market values are dropping rapidly. One of the Fed’s goals is to stimulate economic growth, so it will try to revive economic activity.

A common way to do that is to _____, which tends to ______. With more money available to lend, banks and other financial institutions can charge less to borrow it.

When the Fed puts more money into the system, banks can lend at lower interest rates. Lower borrowing costs can lead to a chain reaction:

• Businesses can finance projects more cheaply

• Profits can become easier to achieve

• Businesses may expand and hire more workers

• More people earning income can lead to more spending

how do lower interest rates boost the economy

“loosens” (expands)

**the fed cant do this forever because The main constraint is inflation. In a world with limited resources, adding more money to the system can eventually push prices higher.

Putting more money into the system _____ the money supply. As interest rates fall, businesses and consumers are more likely to buy goods and services because borrowing is cheaper.

2%

what inflation rate is considered safe or normal

tighten the money supply

With less money available:

• Banks have less money to lend

• Interest rates tend to rise

Higher borrowing costs usually reduce spending on goods and services. That can slow economic growth (and often does), but it can also bring inflation down over time. When demand falls, prices tend to rise more slowly - and may even drop - especially when people have more incentive to save rather than spend.

when inflation is on the rise, the fed will _____ the money supply

Monetaristic theory

theory that Fed’s actions are the most significant economic influence

federal funds rate

Rate for bank-to-bank loans

reserve requirements

_____ are rules that require banks to keep a certain amount of deposits on hand as reserves.

Discount rate

Rate for Fed loans to banks

broker loan rate

• Also known as the call money market rate

• Rate for bank-to-broker-dealer loans

prime rate

• Rate for large bank customer loans

• Typically only available to institutions or corporations

• The discount rate

• Open market operations

• Reserve requirements

• Margin requirements

the four tools the federal reserve has to carry out monetary policy (DORM)

The discount rate is the interest rate the Fed charges when a bank borrows directly from the Federal Reserve. While the Fed tries to influence interest rates throughout the economy, the discount rate is the only rate it controls directly.

• If the Fed lowers the discount rate, banks can borrow more cheaply. That tends to increase lending, loosen the money supply, and push interest rates down for customers.

• If the Fed raises the discount rate, borrowing from the Fed becomes more expensive. That tends to reduce lending, tighten the money supply, and push interest rates up.

1. discount rate

Open market operations are the Fed’s purchases and sales of securities with banks.

To loosen the money supply, the Fed buys securities from banks. These transactions are called repurchase agreements because the bank will buy back the securities at a later date. In the short term, the Fed is putting cash into the banking system in exchange for securities the banks own (for example, Treasury bonds). With more cash available, banks can lend more, and interest rates tend to fall.

To tighten the money supply, the Fed sells securities to banks. These are called reverse repurchase agreements. In the short term, the Fed is taking cash out of the banking system in exchange for securities. With less cash available, banks have less to lend, and interest rates tend to rise. Later, the Fed will buy back the securities.

The Federal Open Market Committee (FOMC), part of the Federal Reserve, oversees open market operations. It typically trades Treasury securities and prime banker’s acceptances.

2. open market operations (repurchase/reverse repurchase agreements)

As discussed in the Rates chapter, banks must continually meet reserve requirements. The Fed can raise or lower these requirements as part of monetary policy.

• When the Fed lowers reserve requirements, banks can lend out more of their deposits. That increases the amount of money in the financial system (loosening). With more money available to lend, interest rates tend to fall, and borrowing becomes cheaper.

• When the Fed raises reserve requirements, banks must hold more deposits in reserve and can lend out less. That decreases the amount of money in the financial system (tightening). With less money available to lend, interest rates tend to rise, and borrowing becomes more expensive.

3. reserve requirements

when investors use margin, they borrow money to invest. This is called leveraging, and it magnifies both gains and losses.

Regulation T was created to limit how much investors can borrow. It requires investors to deposit 50% of the purchase price for initial margin transactions.

For example, if you buy $10,000 of stock in a margin account, Regulation T requires a deposit of at least $5,000.

• If the Fed wanted to loosen (expand) the money supply, it could lower Regulation T below 50%. That would allow investors to borrow more for investment purposes, expanding the money supply.

• If the Fed wanted to tighten (contract) the money supply, it could raise Regulation T. That would reduce borrowing for investment purposes, shrinking the money supply.

4. margin requirements (regulation T)

• Lower the discount rate

• Pursue repurchase agreements

• Lower reserve requirements

• Lower margin requirements

DORM to loosen (grow) the money supply

• Raise the discount rate

• Pursue reverse repurchase agreements

• Raise reserve requirements

• Raise margin requirements

DORM to tighten (shrink) the money supply

• GDP/GNP

• Consumer price index (CPI)

• Yield curves

• Leading indicators

• Coincident indicators

• Lagging indicators

• Economic market structures

Economists track a range of indicators, data sets, and market signals to know what action to take

GDP

measures the value of all goods and services produced within a country’s borders. Economists often use it as a broad measure of domestic economic strength.

rises

falls

The faster GDP rises, the faster the economy is growing.

If GDP declines for an extended period, the economy can enter a recession or depression.

When GDP ____, more goods and services are being produced and sold, which signals economic growth.

When GDP ____, fewer goods and services are being produced and sold, which signals economic distress.

2 quarters (6months)

6 quarters (year and 6months)

how many quarters of GDP decline is a recession

how many quarters of GDP decline is a depression

GNP

measures the value of all goods and services produced by a country’s residents, including production that occurs outside the country (for example, goods sold by a U.S. citizen temporarily living in Spain).

demand falls

when prices rise, demand for elastic goods and services does what

loosening policies

what activities will the fed pursue when GDP is declining

Expansion

• Growing GDP - Unemployment falls

Peak

• Highest GDP

• Lowest unemployment

Recession

• Shrinking GDP

• Unemployment rises

Trough

• Lowest GDP

• Highest unemployment

Recovery

• GDP growing again

• Unemployment starts falling

5 parts of the economic cycle

CPI

U.S. Bureau of Labor Statistics tracks the prices of goods and services commonly purchased by consumers, including gasoline, groceries, cell phone contracts, and real estate.

leading indicators

Common leading indicators include:

• S&P 500 level

• Average weekly initial claims for unemployment

• Index of new manufacturing orders

• Number of new building permits

• Consumer confidence index

• Interest rate spread between 10 year Treasury notes and fed funds rate

indicators that tend to change before the overall economy changes

• Initial unemployment claims measure how many people are just now losing their jobs. Newly unemployed workers often reduce spending, which can contribute to GDP declines.

• New manufacturing orders and building permits reflect planned future activity. If fewer orders and permits are being issued, production and construction may slow later.

• The consumer confidence index measures how optimistic consumers feel about the economy. Higher confidence tends to support spending; lower confidence tends to reduce it.

• The interest rate spread between the 10-year Treasury note and the federal funds rate is also used to predict economic declines. In particular, when Treasury note rates fall below the federal funds rate, it can indicate an upcoming recession. You don’t need to interpret this spread in detail for most test questions - what matters most is recognizing it as a leading indicator.

explain intuitive leading indicators:

1. initial unemployment claims

2. new manufacturing orders/building permits

3. consumer confidence index

4. interest rate spread

coincident factors

indicators that reflect current economic conditions.

lagging indicators

• Changes in CPI levels

• Corporate profits

• Change in labor cost per unit of output

• Average duration of unemployment*

indicators that provide insight into the economy’s past performance

perfect competition

• Large number of buyers and sellers

• Virtually identical goods/services

• Price is the primary demand factor

• Price manipulation is impossible

market structure has many buyers and sellers offering virtually identical products. No single participant is large enough to influence prices.

Monopolistic competition

• Large number of buyers and sellers

• Similar products, but unique characteristics

• Consumers maintain preferences for certain goods

• Price manipulation is very difficult

market structure with many buyers and sellers but products with unique characteristics

Oligopoly

• Large number of buyers, but only 3-5 sellers

• Consumers have limited choices

• Significant barrier to entry as a vendor

• Price manipulation is fairly easy

has many buyers but only a small number of sellers (often 3-5). The limited number of sellers is usually due to high barriers to entry.

Monopoly

• Large number of buyers, only 1 seller

• Consumers only have one choice

• Price manipulation is very easy

• Typically involve heavy government regulation

A monopoly has many buyers but only one dominant seller. Regulations exist to prevent

fiscal policy

controlled and implemented by the U.S. Congress (the House of Representatives and Senate) and the President. This type of economic policy focuses on how the federal government collects money (revenue) and how it spends that money.

The IRS enforces a progressive tax system for personal income taxes. People with higher income levels pay higher tax rates on their income.

progressive tax system

A regressive tax system applies the same tax rate regardless of income level or the amount of money involved. Sales tax is a common example.

regressive tax syste,

In a recession, Keynes argued that the government should spend large amounts of money. That spending increases demand for goods and services and can raise employment.

Keynes also argued that tax rates can be used to influence the economy:

• In a recession, tax rates should fall to encourage individuals and businesses to spend more, supporting economic growth.

• In an inflationary environment, the government should raise taxes to help stabilize prices.

• Gov’t spending and taxation influence the economy

• In a recession:

  • Gov’t spending increases

  • Tax rates fall

• In an inflationary environment:

  • Gov’t spending decreases

  • Tax rates rise

Keynesian (demand-side) theory

supply-side theorists focus on increasing the supply of goods and services across the economy, often through reduced taxation and reduced government spending.

supply-side theory

When comparing supply-side and demand-side (Keynesian) theory, the key difference is what each view treats as the main driver of economic activity:

• Demand-side proponents emphasize demand for goods and services, including demand created by government spending.

• Supply-side proponents emphasize the supply of goods and services produced by the private (business) sector.

demand vs supply fiscal policy theory

Fiscal policy

• Controlled by Congress and the President

• Keynesian (demand-side) theory

  • Increased gov’t spending benefits the economy

• Supply-side theory

  • Decreased gov’t spending benefits the economy

Monetary policy

• Controlled by the Federal Reserve

• In a recession

  • Increase (loosen) money supply

  • Bring interest rates down

• In an inflationary environment

  • Decrease (tighten) money supply

  • Bring interest rates up

fiscal vs monetary policy comp