professor k.d. hoover, econ 210d topic 3 spring 2015 1 econ 210d intermediate macroeconomics spring...

Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015 1

Econ 210D Intermediate Macroeconomics

Spring 2015

Professor Kevin D. Hoover

Topic 3Financial Markets


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.


Financial Instrument

Financial Instrument – that is, a record (paper or electronic) that specifies the terms on which the loan of funds will be repaid.


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.


Real Wealth

Stock not flow. Things owned Strictly positive – no negative real

wealth Examples:

o houseso lando cattleo gold


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


Balance Sheets

Fundamental Accounting Identity:

Assets – Liabilities = Net Worth

Assets = Liabilities + Net Worth


T-account

Assets Liabilities

Things Owned

Things Owed

Net Worth


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.


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(


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.


Nominal (Market) and Real Interest Rates Exact relationship:

A useful approximation:

or

)ˆ1)(1(1 1 ttt prrr

1ˆ ttt prrr

1ˆ ttt prrr


Ex Ante vs. Ex Post Real Rates Ex Post Real Rate:

Ex Ante Real Rate:

1ˆ ttt prrr

ett t

prrr1

ˆ


Types of Financial Instruments Stock (shares or equity) Bonds Derivatives:

o Futures contractso Collateralized Debt Obligations

Many, many others


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.


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


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.


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


Bond - Types

Coupon Bond:

Pure Discount (Zero-Coupon) Bond:

mr

FV

r

CpnPVp

m

ttB

)1()1(1

mBr

FVp

)1(


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.


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.


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


Yields on Shares

Dividend Yield = dividend/ pS

E/P ratio (usually quoted as inverse = P/E ratio.

Capital Gains (or Losses) = pS


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 (?)


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)


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.


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?


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


Arbitrage

Arbitrage = the simultaneous buying and selling of closely related goods or financial instruments in different markets to take advantage of price differentials.


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.


Risk Rating Agencies

Moody’s

Standard and Poors (S&P)

Fitch


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.


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.


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)




Baa Corporate Bond

Aaa Corporate Bond



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)


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)




Baa Corporate Bond

Aaa Corporate Bond



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


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

,


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


Irving Fisher (1867-1947): America’s Greatest Economist


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


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


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.


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.


END of Topic 3

Next Topic: 4. Aggregate Supply

professor k.d. hoover, econ 210d topic 3 spring 2015 1 econ 210d intermediate macroeconomics spring...

Documents

d topic

real flows

net financial flows

financial marketsprofessor

professor kevin

real wealthstock

purchase of real goods

loan of funds