EC223 Final

- IR on bonds of diff maturities move together over time

- If bonds of different maturities are perfect substitutes then the IR on a long term bond is the average of the short term IR

- Upward slope= short term IR rising

- Downward = short term IR falling

Expectations Theory

Bond market

Which financial market are interest rates determined in?

- Transfer of funds from people who have an excess (sellers/savers) to people who have a shortage (buyers/borrowers)

Financial Market

- Where interest rates are determined

- Allows borrowing

- Bond: certify someone has borrowed money and will pay back at a future date

Bond Market

- Sell stocks to raise financial capital

- When company issues stocks for first time= going public with IPO

- Common Stock: share of ownership in corporation

- Share of Stock: Claim on residual earnings of corporation

Stock Market

Stocks:

- Claim to partial ownership in firm

- Pays dividends (share of firms profits that can increase if the firm is more profitable)

- Never matures

- Greater risk and return

*If company goes bankrupt bondholders get paid before stockholders, their value depends on future value of the firm

Bonds:

- Certificate of indebtedness

- Pays interest

- Fixed time to maturity

Similarities

- Both considered financial instruments to raise money for investment

- Both traded on exchanges

- Both subject to risk and returns are taxed

Stock VS Bonds

Institutions that accept deposits and make loans

- Chartered banks, mortgage companies, credit unions

Financial Intermediaries

Management of money supply and interest rates

Monetary Policy

- Decisions regarding spending and taxation (T) by government (G)

- Government budget= T-G

- Budget deficit T-G<0, must be financed by borrowing

- Budgest surplus T-G>0

Fiscal Policy

- Where the foreign exchange rate is determined

- Foreign exchange rate: price of one countries currency in terms of another

Foreign Exchange Market

- Rise in the value of the dollar

- Dollar strong= consumer better off, business worse off

Appreciation

- Fall in the value of the dollar

- Dollar weak= consumer worse off, businesses better off

Depreciation

peak, recession, trough, expansion

Four phases of the business cycle

- Allocate capital

- Financial markets and intermediaries channel funds from savers to spenders

- SEE CHART

Financial Systems

Borrow directly from lenders by selling them securities

Direct Finance

Intermediary between lender and borrower

Indirect Finance

1. Securities

2. Liabilities

3. Bonds

4. Stocks

Financial Instruments

- Direct finance: claims on borrowers future income or assets, assets for the person who buys them

Securities

- Liabilities for the person who issues the funds

Liabilities (IOU's, debts)

- Debt securities that promise to make payment in time

Bonds

- Securities that entitle owners to share of companies profits and assets

Stocks

-Mortgages and Bonds

- Assured steady income, no dividends

Debt Market

- Stocks

- More volatile, increased risk

- During period of difficulty dividends may be reduced

Equity Market

- Securities sold for the first time

- Must go through investment dealer

- If dealer is unable to find buyers for whole issue they will buy shares themselves

- Investment Industry Regulatory Organization of Canada regulates investment dealers

Primary Market

- Securities that have been previously issued can be re-sold

- Requires brokers (agents of investors who match buyers with sellers of securities) and dealers (link buyers to sellers by buying and selling securities at stated price)

1. Exchanges- meet at 1 central location

2. Over the counter- decentralized, linked by computers

Secondary Market

- Short-term debt instruments (maturities <1yr) are traded

- Banks borrowing and lending to each other

- Least price fluctuations because short terms to maturity (decreased risk)

Money Market

- Longer term debt maturity >1yr

- Bond mortgages and stocks

Capital Market

1. Treasury Bills

2. Commercial Paper

3. Repurchase Agreements

4. Overnight Funds

Money Market Instruments

- 1, 2, 6, 12 month maturities to finance federal government

- Pay set amount at maturity

- No interest payments, sell at discount

- Most liquid because most actively traded

- Safest, no possibility of default

Treasury Bills

- Unsecured short term debt instrument issued by banks or corporations

- Interest rate reflects firms level of risk

- Minimum denominations of 50,000

Commercial Paper

- Short term loans (<2 weeks) for which treasury bill serves as collateral, asset lender receives if borrower does not pay back loan

Repurchase Agreements

- Overnight loans by banks to other banks

- Bank might not have enough settlement balances form BOC and therefore borrows balances from another bank

- Overnight IR increases= banks low on funds

- Overnight IR decreases= banks credit needs low

Overnight Funds

1. Stocks

2. Mortgages

3. Corporate Bonds

4. Government of Canada Bonds

5. Canada Savings Bonds

6. Provincial and Municipal Government Bonds

7. Government Agency Securities

8. Consumer Bank and Commercial Loans

Capital Market Instruments

- Issued by corporations with strong credit ratings

- Sends holder an interest payment twice per year and pays off face value when the bond matures

- Convertible bonds: allow holder to convert them into specified number of stock shares

Corporate Bonds

- Issued by federal government to finance its deficit

- Most widely traded bonds, most liquid

- Registered Bonds: name of owner appears on certificate

Government of Canada Bonds

- Non-marketable bonds issued by government

- DO NOT rise or fall in value

- can be redeemed at face value + interest

Canada Savings Bond

- Finance local government expenditures

Provincial and Municipal Government Bonds

- Issued by various government agencies to finance mortgages, farm loans or power equipment

Government Agency Securities

- Loans to consumers and business's made by banks or finance companies

Consumer Bank and Commercial Loans

Sold in foreign country and denominated in that countries currency

Foreign Bonds

a bond denominated in a currency other than that of the country in which it is sold

Eurobond

Foreign currencies deposited in banks outside of home country

Eurocurrencies

- decrease transaction costs

- decrease risk

- deal with asymmetric info problems

Financial Intermediaries (Indirect Finance)

1. Depository Institutions (banks)

2. Contractual Savings Institutions

3. Investment Intermediaries

Types of Financial Intermediaries

- accept deposits from individuals and make loans

- chartered banks, trust and loan companies, credit unions

Depository Institutions (banks)

- Acquire funds at periodic intervals on contractural basis

- Life insurance companies, property insurance, pension funds

Contractural Savings Institutions

- Finance companies, mutual funds, money market mutual funds

Investment Intermediaries

1. Increased info to investors

- Decreased adverse and moral hazard problem

- increased efficiency

- Restricts insider trading

2. Ensuring soundness of intermediaries

- limits financial panics and competition

3. Improve monetary policy control

Primary Reasons for Regulation of Financial Markets

The action of creating and selling an asset with risk characteristics that people are comfortable with, then using the funds they acquire by selling these assets to purchase other assets that may have far more risk

Risk Sharing

anything that is generally accepted in payment

Money

total collection of pieces of property that serve to store value

Wealth

flow of earnings per unit time

Income

1. Medium of Exchange

2. Unit of Account

3. Store of Value

Functions of Money

- used to buy things

- eliminates bartering and decreases transaction costs

- promotes specialization

Medium of Exchange

- measures value in the economy

- Allows us to quote prices

- decreases transaction costs

# Prices needed for n goods:

N(N-1)/2

Unit of Account

- allows us to save purchasing power over time

- Liquidity: ease at which store of value can be converted into medium of exchange with little loss of value

- Money is most liquid of all assets

- Value of money inversely related to price level

Store of Value

Barter

Commodity Money

Paper Money (Flat)

E-Money

Evolution of Payment System

Measuring Money

- narrowest

- includes currency and chequable deposits

- extremely liquid assets

M1+

- more broad

- currency, checkable deposits and non-chequable deposits

M1++

- includes less liquid assets

- currency, checkable deposits, personal and non-personal deposits, fixed term deposits

M2

- everything in M2 plus deposits at TML, CUCP, life insurance companies, government savings institutions, money market mutual funds

M2+

- broadest definition

- everything in M2+ plus canada savings bonds and other retail debt instruments and non-money market mutual funds

M2++

- everything in M2 plus non-personal term deposits, includes interbank deposits

M3

Neither. Although PayPal and many other e-money systems work as other forms of money do to facilitate purchases of goods and services, it does not count in the M1 or M2 money supplies. Because PayPal and similar payment systems are generally credit-based, this requires payment at a future date for funds used today; those future payments must be made using existing money that is already in the system.

If you use an online payment system such as PayPal to purchase goods or services on the Internet, does this affect the M1 money supply, the M2 money supply, both, or neither? Explain.

PV= CF/(1+i)^n

Present Value

1. Simple Loan

2. Fixed Payment/Fully Amortized Loan

3. Coupon Bond

4. Discount Bond/Zero Coupon Bond

Credit Market Instruments

- Payments only at their maturity dates along with additional payment for interest

- Commercial Loans

Simple Loan

- Principal is repaid by making same payment (principal+interest) for set period of time

- Mortgage

Fixed Payment/Fully Amortized Loan

- Pays the owner of the bond a fixed interest payment until maturity date when specified final amount is repaid

- Coupon Rate: dollar amount of yearly coupon payment expressed as % of the face value of the bond

Coupon Bond

- Bought at price below face value and face value repaid at maturity date

- Does not make interest payments

Discount Bond

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

Yield to Maturity

- Tells you how well you've done, includes capital gains or losses

- Capital gains increase in market value debt instruments

- Capital losses decrease in market value debt instruments

Rate of Return

- A increase in interest rates is associated with a fall in bond prices, resulting in capital losses

- More distant a bonds maturity, the greater the size of the % price change associated with an interest rate change

- The more distant maturity the lower the rate of return

- Prices and risks for long term bonds are more volatile than short term

- No interest rate risk for any bond whose time to maturity=holding period

Interest Rates and Rate of Return

- No allowance for inflation, not been corrected

Nominal Interest Rate

- Adjusted for inflation, reflects cost of borrowing

Ir=I=Pe

- When IR low their is greater incentive to borrow

- Low IR decreases the incentive to lend

Real Interest Rate

Chapter 5

1. Wealth (↑ W = ↑ QD)

- Total resources owned including all assets

2. Expected Return (↑ ER = ↑ QD)

- Return expected over the next period on one asset relative to alternative assets

3. Risk (↑ risk = ↓ QD)

- Degree of uncertainty

4. Liquidity (↑ L = ↑QD)

- Ease and speed with which an asset can be turned into cash relative to alternative assets

Determinants of Asset Demand

- Tells us how much of an asset people want to hold in their portfolio

Theory of Portfolio Choice

- Lower prices (higher IR) the QD of bonds is higher

Bond Demand

- Lower prices (higher interest rates) the QS of bonds is lower

Bond Supplied

1. Wealth ↑ = D ↑

2. Expected Return ↑ = D ↑

3. Expected Inflation ↑ = D ↓

4. Liquidity ↑ = D ↑

5. Expected Interest Rate ↑ = D ↓

6. Expected Inflation↑ = D ↓

Shifts in Demand for Bonds

1. Expected profitability of investment opportunities ↑ = S ↑

2. Expected Inflation ↑ = S ↑

3. Government Budget Deficit ↑ = ↑

Shifts in Supply for Bonds

- Supply and Demand for money determines interest rates

- Bs+Ms=Bd+Md

1. Income Effect

- Higher level of income causes demand for money at each IR to increase and demand shifts right

- As wealth increases people hold money and carry out increased transactions

2. Price Level Effect

- Rise in price level causes demand for money at each IR to increase and demand shifts right

Shifts in Demand for Money

- An increase in money supply by BOC will shift supply right

- Increase income= increase Md and increased IR

-Increase Price level= increase Md and increased IR

- Increase Ms= increase Ms and decreased IR

Shifts in Supply of Money

occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures

Default

- Bonds with same maturity have different IR due to:

- Default Risk

- Liquidity

- Tax considerations

Risk Structure of IR

- Probability that the issuer of bond is unable to make interest payments or pay off face value

Default Risk

- Issued by govt, default free because no risk of default

- raises taxes to pay back

- most liquid because widely traded and easy to sell

Canadian Gov't Bonds

- issued by corporations

- subject to default risk

Corporate Bonds

- Interest payments on municipal bonds exempt from federal income taxes

- It is more beneficial to hold a tax exempt bond versus taxable bond when IR are high

Income Tax

- explains why bonds with same risk, liquidity and tax treatment have different IR due to different terms to maturity

Term Structure of IR

- Upward sloping= long term rates > short term

- Flat = short and long term rates the same

-Downward= long term rates < short term

Yield curve

Yield curves almost always slope upward

- Bonds of different maturities are not substitutes, the market is segmented

- IR is determined by D and S

- Investors have preferences for bonds of 1 maturity over another

- Investors prefer short term bonds because they have a lower IR and higher P

Segmented markets

- IR on bonds of diff maturities move together over time

- Upward slope= high short term IR

- Downward= short term IR high

- Yield curves almost always slope upward

- Bonds at different maturities are substitutes but NOT perfect substitutes

- IR on long term bonds are an avg of short term IR's expected to occur over life of long term bonds

- Liquidity premium is greater in long term bonds

Liquidity Premium

- IR on bonds of diff maturities move together over time

- Upward slope= short term IR rising

- Downward = short term IR falling

- Yield curves almost always slope upward

- Willing to buy bonds of different maturities if they have higher returns

Preferred Habit

the excess return required from an investment in a risky asset over that required from a risk-free investment

risk premium

- Assumes you buy stock, hold it for a period of time to get a dividend and then sell the stock

- 1. Determine PV

- 2. Determine current price of stock

One period valuation model

True

True or False: a bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.