professor k.d. hoover, econ 210d topic 3 spring 2015 1 econ 210d intermediate macroeconomics spring...
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Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 1
Econ 210D Intermediate Macroeconomics
Spring 2015
Professor Kevin D. Hoover
Topic 3Financial Markets
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 2
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 3
Figure 6.1 The Flow of Funds
Transactions Among Financial Intermediaries
Financial Intermediaries
Liquid Funds
Financial Instruments
Ultimate Sources of Funds: Savers households, corporations, governments, and net financial flows from abroad
Ultimate Users of Funds: Borrowers
Direct Investment Expenditure
A Portion of Investment Goods
= real flows = monetary flows = financial instrument flows
Real Goods and Services
Expenditure Financed by
Savings
The financial sector connects the ultimate savers (sources of funds) with the ultimate borrowers (uses of funds). Every transaction is the exchange of money either for a real good or service or for a financial instrument. No matter how convoluted the channels through a variety of financial intermediaries, ultimately savings finds its way to the purchase of real goods and services.
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Financial Instrument
Financial Instrument – that is, a record (paper or electronic) that specifies the terms on which the loan of funds will be repaid.
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Figure 6.1 The Flow of Funds
Transactions Among Financial Intermediaries
Financial Intermediaries
Liquid Funds
Financial Instruments
Ultimate Sources of Funds: Savers households, corporations, governments, and net financial flows from abroad
Ultimate Users of Funds: Borrowers
Direct Investment Expenditure
A Portion of Investment Goods
= real flows = monetary flows = financial instrument flows
Real Goods and Services
Expenditure Financed by
Savings
The financial sector connects the ultimate savers (sources of funds) with the ultimate borrowers (uses of funds). Every transaction is the exchange of money either for a real good or service or for a financial instrument. No matter how convoluted the channels through a variety of financial intermediaries, ultimately savings finds its way to the purchase of real goods and services.
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Real Wealth
Stock not flow. Things owned Strictly positive – no negative real
wealth Examples:
o houseso lando cattleo gold
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Financial Wealth
Financial Wealth = claims to payment (or transfers) of something valuable at some future time.
Positive: things ownedo Credit o Asset
Negative: things owedo Debt o Liability
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Balance Sheets
Fundamental Accounting Identity:
Assets – Liabilities = Net Worth
Assets = Liabilities + Net Worth
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T-account
Assets Liabilities
Things Owned
Things Owed
Net Worth
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Valuation of Financial Assets
Principle of Similarity and Replacement Opportunity Cost = the value of the
best alternative choice that a choice forecloses
Yield or interest rate on good substitute financial asset = opportunity cost
Present Value = the value today of the future benefit an asset confers given the relevant opportunity cost.
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Present Value
General Formula:
o PV = present valueo FV = future valueo r = interest rate (opportunity cost)o m = number of periods into future
mr
FVPV
)1(
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Properties of Present Value
1. PV < FV: discount future value by opportunity cost (therefore, r = discount rate; PV also called present discounted value.
2. Discount not related to inflation. 3. Further FV is in future, the lower is
present value. 4. Higher the opportunity cost, the lower
the present value.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 13
Nominal (Market) and Real Interest Rates Exact relationship:
A useful approximation:
or
)ˆ1)(1(1 1 ttt prrr
1ˆ ttt prrr
1ˆ ttt prrr
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 14
Ex Ante vs. Ex Post Real Rates Ex Post Real Rate:
Ex Ante Real Rate:
1ˆ ttt prrr
ett t
prrr1
ˆ
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Types of Financial Instruments Stock (shares or equity) Bonds Derivatives:
o Futures contractso Collateralized Debt Obligations
Many, many others
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Bond -- Definition
Bond = a promise to pay a definite stream of money in some fixed pattern, usually represented by a paper certificate or an entry in a broker’s or government’s books, that may be bought and sold on the open market.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 17
Bond -- Types
Short: Treasury bills, repurchase agreements, commercial paper, certificates of deposit, bankers’ acceptances Stock (shares or equity)
Medium: Treasury notes Long: Treasury bonds, debentures,
municipal bonds
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 18
Mechanics of Bond Pricing
face value (FV): the amount paid when a bond comes due or matures
coupon (Cpn): regular payments to the holder of bond (usually quarterly, semiannual or annual).
coupon rate: the coupon expressed as a percentage of the face value – that is, the coupon rate = Cpn/FV
market value or bond price (pB): the actual price a bond commands on the current market.
maturity: the date at which a bond pays off its face value and ceases to be a liability to its issuer or an asset to its holder.
time to maturity: periods until FV is paid off. yield to maturity (r): the rate of return earned if a
bond is bought at the current market price and held until it matures and its face value is paid off.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 19
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 20
General Bond-Pricing Formula
or
mmB r
FV
r
Cpn
r
Cpn
r
Cpn
r
CpnPVp
)1()1()1()1(1 32
mr
FV
r
CpnPVp
m
ttB
)1()1(1
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Bond - Types
Coupon Bond:
Pure Discount (Zero-Coupon) Bond:
mr
FV
r
CpnPVp
m
ttB
)1()1(1
mBr
FVp
)1(
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Relationship between Bond Prices and Yields Inverse: bond prices and bond yields
move in the opposite direction Mantra:
o prices up, yields down;o prices down, yields up;o yields up, prices down;o yields down, prices up.
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Equities
Corporation = legal structure in which owners (stockholders) have only limited liability.
Corporate equity (also known as stock or shares) = fractional claims to corporate ownership.
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General Share Price Formula
pS = share price N = number of outstanding shares; = expected profits at time t
1 )1()/1(
tt
et
S rNp
et
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Yields on Shares
Dividend Yield = dividend/ pS
E/P ratio (usually quoted as inverse = P/E ratio.
Capital Gains (or Losses) = pS
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Fundamentals and Bubbles
Fundamentals = factors that determine the actual profitability of firms
Bubbles = phenomenon of purchasing stocks (or other assets) in the expectation of capital gains which in fact occur because others too are willing to purchase on that basis independent of the fundamentals.o Tulip Maniao 2000s housing prices (?)
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 27
Stock Indices -- Examples
Dow Jones Industrial Average (30 stocks)
S&P 500 (large capitalization stocks) New York Stock Exchange Composite
Index NASDAQ (“over-the-counter”; now
electronically traded) FTSE 100 (UK stock index)
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 28
0
5
10
15
20
1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
Yie
ld to
Matu
rity
(perc
en
t)
Figure 7.1Selected Interest Rates
3-month Treasury Bill 3-month Commercial
10-year Treasury Bond
Baa Corporate Bond
Aaa Corporate Bond
A selection of interest rates illustrates some common features: 1. Rates tend to move in similar broad patterns; 2. but they do not move perfectly together; 3. long-rates are usually (though not always) higher than short-term rates; 4. long-term corporate rates are higher than long-term government rates and short-term corporate rates are higher than short-term government rates.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 29
Five Questions About Interest Rates1. Why do rates move together?2. Why do only imperfectly?3. Why do short rates typically yield less
than long rates? 4. Why are government rates lower than
private sector rates?5. What determines the level of interest
rates?
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Substitution Among Financial Instruments Substitute = a good the demand for which
rises when the price of another good rises. Perfect substitutes = practically identical
goodso two identical government bondso must have identical price
Imperfect Substitute: a higher price of one good does not eliminate demand for it in favor of the substitute.o a government bond and a corporate bondo prices can differ
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Arbitrage
Arbitrage = the simultaneous buying and selling of closely related goods or financial instruments in different markets to take advantage of price differentials.
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Two Types of Risk
Default Risk = bond issuer may go bankrupt and not pay back all or part of debt
Price or Interest-rate Risk = market value of bond may change with changing market interest rates.
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Risk Rating Agencies
Moody’s
Standard and Poors (S&P)
Fitch
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AAA
S&P Bond Rating CategoriesHighest quality. Ability to pay interest and principal very
strong.
AA High quality. Ability to pay interest and principal strong.
AMedium to high quality. Ability to pay interest and principal,
but more susceptible to changes in circumstances and the economy.
BBBMedium quality. Adequate ability to pay, but highly
susceptible to adverse circumstances.
Speculative
BBSpeculative. Less near-term likelihood of default relative to
other speculative issues.
BCurrent capacity to pay interest and principal, but highly
susceptible.
CCCLikely to default, where payment of interest and principal is
dependent.
CC Debt subordinate to senior debt rated CCC.
C Debt subordinate to senior debt rated CCC-D.
DCurrently in default, where interest or principal has not been
made as promised.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 35
Price or Interest-rate Risk
Capital Gain = increase in bond value accompanying fall in yield.
Capital Loss = fall in bond value accompanying rise in yield
Risk rises with the maturity of the bond. Risk premium compensates for risk.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 36
0
5
10
15
20
1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
Yie
ld to
Matu
rity
(perc
en
t)
Figure 7.1Selected Interest Rates
3-month Treasury Bill 3-month Commercial
10-year Treasury Bond
Baa Corporate Bond
Aaa Corporate Bond
A selection of interest rates illustrates some common features: 1. Rates tend to move in similar broad patterns; 2. but they do not move perfectly together; 3. long-rates are usually (though not always) higher than short-term rates; 4. long-term corporate rates are higher than long-term government rates and short-term corporate rates are higher than short-term government rates.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 37
The Term Structure of Interest Rates Yield Curve = graph of yields to
maturity against maturity Term Structure of Interest Rates = the
relationships among the returns to bonds of different maturities (i.e., the shape of the yield curve)
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 38
0
5
10
15
20
1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
Yie
ld to
Matu
rity
(perc
en
t)
Figure 7.1Selected Interest Rates
3-month Treasury Bill 3-month Commercial
10-year Treasury Bond
Baa Corporate Bond
Aaa Corporate Bond
A selection of interest rates illustrates some common features: 1. Rates tend to move in similar broad patterns; 2. but they do not move perfectly together; 3. long-rates are usually (though not always) higher than short-term rates; 4. long-term corporate rates are higher than long-term government rates and short-term corporate rates are higher than short-term government rates.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 39
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 40
No-Arbitrage Condition
General Rule:
Solution:
Geometric Mean
1)1)(1()1)(1)(1( 1,12,12,11,1,1, m e
mte
mtet
etttm rrrrrr
)1)(1()1)(1)(1()1( 1,12,12,11,1,1,e
mte
mtet
ett
mtm rrrrrr
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 41
No-Arbitrage Condition – Approximation Approximation fact:
Approximate No-arbitrage condition:
Arithmetic Mean
xx )1log(
m
rrrrrr
emt
emt
et
ett
tm1,12,12,11,1,1
,
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 42
Expectations Theory of the Term Structure Expectations Theory of the Term
Structure of Interest Rates = the shape of yield curves implied by the no-arbitrage condition among different maturities
Risk-adjusted Expectations Theory of the Term Structure of Interest Rates = the shape of yield curves implied by the no-arbitrage condition among different maturities plus maturity-related risk premia
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Irving Fisher (1867-1947): America’s Greatest Economist
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Inflation and Interest Rates
Fisher Effect = a point-for-point increase in the market rate of interest that results ceteris paribus from an increase in the expected rate of inflation
Fisher Hypothesis = the empirical phenomenon in which a change in market rates of interest is associated approximately point for point with a change in the actual rate of inflation
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Inflation and Interest Rates in Practice
Inflation and Nominal and Real Interest Rates
-5.0
0.0
5.0
10.0
15.0
20.0
1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
1-year T reasury Bill Rate
Annual Inflation
Ex Post Real Interest Rate
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 46
The Level of Interest Rates
Monetary policy determines the shortest interest rates.
Arbitrage with real returns (e.g., in stock markets or real investment) determines long rates.
Arbitrage among interest rates at different maturities and risk determines the overall structure.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 47
Summing Up1. Why do rates move together?
Substitution and arbitrage.
2. Why do only imperfectly?Imperfect substitutability (including maturity differences)
3. Why do short rates typically yield less than long rates? Price-risk premia.
4. Why are government rates lower than private sector rates?Default-risk premia
5. What determines the level of interest rates?Monetary policy at the short end; arbitrage to real returns at the long end.
Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 48
END of Topic 3
Next Topic: 4. Aggregate Supply