ECS3701 - Monetary Economics_Notes_2.2022 (All Units)

ECS3701 - Monetary Economics_Notes_2.2022 (All Units).Table of Contents Part 1- Introduction Chapter 1: Why study money, banking and financial markets? Chapter 2: An overview of the financial system Chapter 3: What is money? Part 2 - Financial Markets Chapter 4: Understanding interest rates Chapter 5: The behaviour of interest rates Chapter 6: The risk and term structure of interest rates Part 3 - Financial institutions Chapter 8: An economic analysis of financial structure Chapter 9: Financial crises in advanced economies Chapter 10: Financial crises in emerging market economies Chapter 11: Banking and the management of financial institutions Part 4 - Central banking and the conduct of monetary policy Chapter 14: Central banks: a global perspective Chapter 15: The money supply process Chapter 16: Tools of monetary policy Chapter 17: The conduct of monetary policy Part 5 - Not Prescribed Part 6 - Monetary theory Chapter 20: Quantitative theory, Inflation and the demand for money Chapter 21: The IS curve Chapter 24: Monetary policy theory Chapter 25: The role of expectations in monetary policy Chapter 26: Transmission mechanisms of monetary policy 3 ECS 3701 Lecture Notes Nicolas Souvaris Part one: Introduction (Textbook: Chapters 1, 2 and 3) CHAPTER 1: WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS Why study financial markets? Securities - a claim on the issuer’s future income or assets that is sold by a borrower to a lender. Securities may also be referred to as financial instruments. Financial instruments may be divided into two main categories: money market instruments (e.g. Negotiable Certificate of Deposit (NCDs), Commercial Papers; Retirement Annuity (RAs) and Bankers Acceptance (Bas)) and capital market instruments (e.g. bonds and shares). Bonds - a specific type of security, namely a debt security that promises to make payments periodically for a specified period of time. Interest rate - cost of borrowing or the price paid for the rental of funds. “The” interest rate is made up of a number of different interest rates that exist in an economy. E.g. mortgage, car loan etc Bond Market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and it is where interest rates are determined. Stock Market is the market in which claims on the earnings of corporations (shares of stocks) are traded. In SA we refer to the trading of shares rather than stocks. Stock (share) - equity: a financial instruments representing part ownership of a corporate entity. Sometimes referred to as common stock as compared to the more specialized type of share, e.g. preference shares. Issuing shares is a way in which a company can raise funds. Importance of stock /stock market: the price (value) of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. The higher the price of a firm’s shares the more money can be raised to buy, e.g. machinery and equipment to increase production. Also, as per the study guide: the stock market creates a facility for financial investors to invest their surplus funds and for firms to facilitate real investment. Why study financial institutions and banking? Structure of the Financial System: The financial system is complex, comprising many different types of private sector financial institutions (banks, insurance companies, mutual funds, finance companies, investment banks) all of which are heavily regulated by Government. 4 ECS 3701 Lecture Notes Nicolas Souvaris Financial Intermediaries - institutions that borrow funds from people (surplus units) who have saved and in turn make loans to others (deficit units). Financial Innovation - shows how creative thinking on the part of financial institutions can lead to higher profits. To keep in touch with what is happening within the financial systems of the world it is necessary to study the changes that innovation has brought about. One example is the way in which dramatic improvements in information technology have brought about new means of delivering financial services electronically (e-finance). Why study money and monetary policy? Definition of money: money is defined as anything that is generally accepted in payment for goods and services (in terms of its function as a medium of exchange). In this course, the term money generally refers to the money supply. Importance of Money: money is linked to changes in economic variables and is important to the health of the economy. Money plays an important role in generating business cycles: empirical data indicates that, in the USA, the rate of growth in money supply has declined before every recession; however, not every decline in money growth is followed by a recession. Inflation is believed to be caused by continuing increases in money supply. Money plays an important role in interest rate fluctuations. Aggregate Output: gross domestic product (GDP) = the market (total) value of all final goods and services produced in a country during the course of a year. Aggregate Income: total income received for the use of factors of production (land, labour and capital) used to produce all the goods and services in the economy during the course of the year. Business Cycles: the upward and downward movement of aggregate output produced in the economy. Aggregate price level: the average price of goods and services in an economy. Three commonly used measures are the GDP deflator (nominal GDP divided by real GDP), the consumer price index (CPI) and the personal consumption expenditure deflator (PCE). Inflation: a continual increase in the aggregate price level in an economy. The price level and money supply generally rise together. 5 ECS 3701 Lecture Notes Nicolas Souvaris Monetary Policy: the management of money and interest rates by the central monetary authorities. Because money can affect many economic variables in the economy, politicians and policymakers care about the conduct of monetary policy. Real versus Nominal GDP: nominal GDP indicates that current prices are used to measure GDP. Real GDP is nominal GDP adjusted to remove inflation and using constant prices from an identified base year. Don’t forget to study Appendix 1 at the end of the chapter! Typical Examination questions 1.1 Explain briefly and in general terms what is the meaning of a security and how it facilitates direct lending and borrowing. (5) 1.2 Explain briefly what is a common stock, what purpose it serves and how it affects business investment decisions. (4) 1.3 List two ways in which the quantity of money may affect the economy. (2) 1.4 Explain the difference between nominal and real GDP and the purpose for which each should be used. (4) 1.5 List and define three commonly used measures of the aggregate price level. (6) True or false review questions Money: 1. Monetary economics primarily teaches students how to make money quickly and effortlessly. 2. A decrease in the interest rate normally increases the money stock in the economy. 3. Because money is complex, it is difficult to demonstrate the real advantages of money within the economy. 4. The use of money introduces sources of instability in the economy. 5. When interest rates rise, then all households are worse off. Securities: 6. A security is a financial instrument. In simple terms it is a "piece of paper" which is sold by the issuer to investors in exchange for funds. The security promises to repay these funds (plus interest) over the term of the security by means of a number of (one or more) future payments to the holder of the security. 7. A security is issued mostly by firms and government that wish to borrow money. 8. The issuer of a security promises to make future payments to the holder (purchaser) of the security. 9. The purchaser of a security provides cash to the issuer of a security. 10. The purchaser of a security is the lender (provider of funds). 11. The issuer of a security is the borrower of funds. 12. The holder (purchaser) of the security receives future payment/s from the issuer of the security. 6 ECS 3701 Lecture Notes Nicolas Souvaris 13. Securities can be traded on the financial market. When holder A of a security sells the security in the financial market at the going market price to B then B pays cash to A and B receives the remaining payments of the security. 7 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 2: AN OVERVIEW OF THE FINANCIAL SYSTEM Function of financial markets. Functions and advantages of financial markets in general: they allow funds to flow from people who lack productive investment opportunities but have surplus funds, to people who have such opportunities but do not have the funds to make it happen Direct financing: borrowers borrow funds directly from lenders in the financial markets by selling them securities. Remember that both borrowers and/or lenders can be households, businesses, government and foreigners. Indirect financing: this refers to the activities of financial intermediaries such as commercial banks in facilitating and reconciling the different requirements of borrowers and lenders via the process of financial asset transformation. [Example: banks accept deposits from savers and lend that money out to borrowers.] Financial markets are critical for producing an efficient allocation of capital. Structure of financial markets How does a debt instrument work? A debt instrument is a contractual agreement by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and principal payment) until a specified date when the final payment is made (maturity date). Maturity of a debt instrument: number of years (term) until the instruments expires or becomes paid up. It is short-term if it is less than a year and longterm if it is ten years or longer with the intermediate-term being between one and ten years. In South Africa however, any financial instrument with a lifespan that is longer than a year is referred to as long-term and is traded in the capital market. An equity instrument: is a claim to share in the income and net assets of a business. It is more commonly known as a stock or share. An advantage of such an instrument is that the holder owns part of the business. You essentially own a part of the business and are therefore awarded the right to vote on important issues to the firm as well as elect the directors. You will also benefit from an increase in the firms profitability or asset value. A disadvantage is that the holder is a residual claimant. This means that the business must pay its debt holders before it pays its equity holders. Such an instrument has no maturity date. The structure of the different financial markets relates to the type of functions and the type of financial instruments that are found in each of them.  Debt and Equity markets: Debt market is that market in which debt instruments are traded, while an equity market is a market in which equity instruments are traded, e.g. stock exchange. 8 ECS 3701 Lecture Notes Nicolas Souvaris  Primary and Secondary markets: Primary market is the market in which financial instruments are issued, while the secondary market is the market in which financial instruments are traded. o An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities and guarantees a price for a corporations securities and then sells them to the public.  Exchanges and OTC Markets: Secondary markets can be organised in two ways:  Exchanges: a place specifically designed for the meeting of buyers and sellers of securities.  Over-the-counter-markets: dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to buy (e.g. US bond market).  Money and Capital Markets: the money market is the market in which short-term financial instruments are traded, such as TBs, NCDs, CPs etc. The capital market is where longer-term financial instruments are traded e.g. stocks and long-term bonds. Financial (Money) Market Instruments Treasury Bills (TBs): short-term (1, 3, 6 month) debt instrument issued by government. It is a primary security. It represents a claim on the government payable at some future date. TBs are fully secured and guaranteed by the government in SA. Negotiable Certificate of Deposit (NCD): a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. Negotiable NCDs are sold in the secondary market. Commercial Paper: a short-term debt instrument issued by large banks and well-known corporations. In SA it is described as a short- or medium-term security (securities) issued by corporations and other non-banking institutions to acquire working capital. Banker’s Acceptances (BAs): a bank draft (a promise of payment) issued by a firm, payable at some future date, and guaranteed for a fee by the bank that stamps it. The firm issuing the instrument is required to deposit the required funds into its account with the bank to cover the draft. 9 ECS 3701 Lecture Notes Nicolas Souvaris Repurchase agreements (Repos or RAs): short-term loans (normally less than two weeks) for which TBs serve as collateral. Most notable lenders in this case is large corporations. Capital Market Instruments Debt and equity instruments have maturities of greater than one year (medium and long term) and are traded in the capital market. Prices of these instruments fluctuate more than those of money market instruments. Generally considered to be riskier investments. Stocks: equity claims on the net income and assets of a corporation. Mortgages: loans to households and/or firms to purchase housing, land or other real structures where the structure or land serves as collateral for the loans. The mortgage market is the largest debt market in the USA. Corporate Bonds: long-term bonds issued by corporations with very strong credit ratings. Typical corporate bond will grant the holder an interest payment twice a year and pays off the face value when the bond matures (on maturity date). Convertible Bonds: Work in the same way as corporate bonds with the added benefit of the holder being able to convert the bond into a specified number of shares of stock at any time up to the maturity date. Government Securities: long-term debt instruments issued by the Treasury to finance deficits of the central government. They are the most widely traded bonds in the USA (and in SA). They are also the most liquid of the securities traded in the secondary market. Local government bonds are also referred to as municipal bonds. The market for these bonds in South Africa is very limited. In the US the income on these bonds is exempt from federal taxes and state taxes. 10 ECS 3701 Lecture Notes Nicolas Souvaris Function of financial intermediaries The main function of financial intermediaries is moving funds between borrowers and lenders in the economy. This process is referred to as financial intermediation and is the primary way in which funds are moved from lenders to borrowers. In order to understand the importance of this form of “financing” it is necessary to consider the role of each of the following:  transaction costs  risk sharing  information costs in financial markets Transaction costs: financial intermediaries can substantially reduce transaction costs because they can take advantage of economies of scale. They can also provide customers with liquidity services which make it easier to conduct transactions e.g. cheque accounts and providing interest on these accounts. Risk sharing: financial intermediaries can help reduce the exposure of investors to risk through the process of risk sharing. They create and sell assets with risk characteristics that people are comfortable with and then the financial intermediaries can use these funds to buy and sell other assets that are more risky. Costs are kept low by the fact that intermediaries are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This may also be referred to as asset transformation. Risk sharing is also made possible by diversification which entails investing in a collection (portfolio) of assets, the returns of which do not all move in the same direction. 11 ECS 3701 Lecture Notes Nicolas Souvaris Information costs: this specifically refers to the problems that occur when the parties involved in a transaction do not have the same level of information. This is referred to as asymmetric information. Lack of information creates problems before the transaction is entered into (adverse selection) and after the transaction (moral hazard). [Ref page 41 TB] Adverse Selection: ………………………………………………………………………………………… ………………………………………………………………………………………………… ……………….………………………………………………………………………………… Moral Hazard: ………………………………………………………………………………………………… ………………………………………………………………………………………………… ………………………………………………………………………………………………… Promoting efficiency in financial markets: financial intermediaries provide liquidity services, promote risk sharing and solve information problems, thereby also make it possible for small savers and borrowers to benefit from the existence of the financial markets. Types of Financial Intermediaries Depository institutions: commonly referred to as banks. These are institutions that accept deposits from individuals and other non-bank institutions and make loans. They include: commercial banks; savings and loan associations (S & L); mutual savings banks, credit unions. Contractual Savings institutions: financial intermediaries that acquire funds at periodic intervals on a contractual basis. Liquidity of assets is not as important to these institutions and they tend to invest their funds primarily in long-term securities. They include life insurance companies; short-term insurers (fire and casualty); pension and retirement funds. Investment intermediaries: which include finance companies (raise funds by selling commercial paper and stocks and bonds); mutual funds (sell shares to individuals and use the funds to invest in a diversified portfolio of stocks and bonds); money market mutual funds (characteristics of a mutual fund but also function as a depository institution). Investment banks: are not banks or financial intermediaries in the ordinary sense. They do not lend out their deposits. Investment banks help corporations issue securities by advising them on what securities are best to issue ie: stocks or bonds and then helps sell (underwrite) the securities by buying them from the corporations and reselling them in the market. 12 ECS 3701 Lecture Notes Nicolas Souvaris Regulation of the financial system The purpose of regulation is to: (a) Increase information to investors, and (b) To ensure the soundness of financial intermediaries and their different forms, etc. Typical Examination questions 2.1 Briefly explain the function of financial markets, the meaning of direct and indirect financing and the meaning of a financial intermediary. (5) 2.2 Explain the differences between debt and equity markets, primary and secondary markets, exchanges and OTC markets, and money and capital markets. (10) 2.3 List and explain the operation of any three money market instruments. (3x5=15) 2.4 List and explain the operation of any three capital market instruments. (3x5=15) 2.5 Explain the functions performed by financial intermediaries and how and why these promote economic efficiency in financial markets. (8) 2.6 Explain the broad purpose and methods used in government regulation of the financial system. (6) True or false review questions 1. If a firm borrows money from a bank to finance its debt, it is an example of indirect finance. 2. If government sells treasury bills to investors to finance a deficit, then it engages in direct financing. 3. If a firm issues a bond that repays the debt over a five-year period, then the firm engages in indirect financing. 4. The term to maturity of a bond remains constant over the term of the bond. 5. The existence of a well-functioning secondary market for a financial instrument ensures the liquidity of the financial instrument. 6. Over-the counter-markets which simultaneously operate in different locations, buy and sell at fixed prices and ignore market conditions. 7. US government securities are long-term debt instruments and are the most liquid securities traded on the capital market. 8. Primary bond markets are more important than secondary bond markets. New lending and borrowing occur in primary markets only, and it is these new issues which are ultimately important. The secondary market does not create new lending and borrowing. 9. In a world of no information and transaction costs, financial intermediaries would not exist. 10. If there were no asymmetry in the information that a borrower and a lender had, there could still be a moral hazard problem. 13 ECS 3701 Lecture Notes Nicolas Souvaris CHAPTER 3: WHAT IS MONEY? Meaning of money Define money: economists define money as anything that is generally accepted in payment for goods and services or in repayment of debts. Money does not mean the same as wealth or income. In a modern economy money consists of two major components: currency plus deposits (M = C + D) Wealth: consists of money but also includes assets such as stocks, bonds, houses, cars etc. Income: is the flow of earnings per unit of time. Money on the other hand is a stock at a given point in time. Functions of money Medium of Exchange: money serves as a medium of exchange allowing it to be used as payment for goods and services. As such it promotes economic efficiency by reducing the time taken for transactions to take place. Money needs the following characteristics: 1. Standardised: simple for everyone to ascertain its value. 2. Widely accepted 3. Divisible: so that it is easy to make change. 4. Easy to carry 5. Not deteriorate quickly Unit of Account: used to measure value of goods and services in an economy and helps to reduce transaction costs by reducing the number of prices that need to be considered. Store of Value: serves as a store of purchasing power from the time the income is earned to the time it is spent. Wealth = total collection of pieces of property that serve to store value. Income = Flow of earnings per unit of time. Evolution in the payment system The history of money is closely linked to the payment system. Several hundred years ago, the payments system in all but the most primitive societies was based primarily on precious metals. The introduction of paper currency lowered the cost of transporting money. The next major advance was the introduction of cheques which lowered the transaction costs still further. Currently the move is towards an electronic payments system in which paper is eliminated and transactions are handled by computers. This will likely lower 14 ECS 3701 Lecture Notes Nicolas Souvaris transaction costs still further. The following table explains the different terms in relation to the different types of payment systems and the related concepts: Description Advantages Disadvantages Commodity Money: money made up of precious metals or other valuable commodities. An early medium of exchange that was universally acceptable. This form of money is very heavy and is hard to transport from place to place. Fiat Money: paper currency decreed by government as legal tender. Largely dependent upon trust of the value of currency. Much lighter than precious metals or even coins. Easily stolen. Can be expensive to transport in large quantities. Cheques: an instruction from you to your bank to transfer money from your account to someone else’s account. Allow transactions to take place without carrying around large sums of money. Improved the efficiency of the payment system. Loss from theft is greatly reduced. Takes time to get cheques from place to place. The administration required to support the use of cheques is expensive. Electronic payments: transmit payments via the internet. “Money” moves directly from one persons account to that of another. It is quick and efficient. It is a cheap means of payment. Problems of making errors in transmission do exist and are really difficult to reverse. While security is good, there is a risk of “hackers” being able to intervene in transactions. E-Money: substitute for cash and exists only in electronic form. The debit card is a form of e-money. Efficient and convenient. Expensive to set up. Electronic means of payment raise security and privacy concerns. Leaves an electronic trail which contains personal data. NOTE: The following must be studied from the study guide: C7 Measuring money in South Africa The customary measures of money are M1, M2 and M3. Learn the descriptions from Study Guide, pages 11 - 14. Note the following:  The measures are all based on the relationship: M = C + D and differ according to which types of deposits are included. Make sure you can describe each of them (M1, M2, M3) 15 ECS 3701 Lecture Notes Nicolas Souvaris C8 What causes money stock to increase?  Net increases in bank loans to the private sector contribute, by far, most of the increase in M3.  M = C + D where D is deposits held by the private nonbank sector with the banks. Only when D changes does the stock of money change. These deposits change because of the following:  Banks’ loans to firms and individuals  Transactions in financial assets between banking sector, central bank and private sector.  Government transactions with the private nonbank sector (pays for services or changes taxes).  Foreign exchange transactions (exports +, imports -) C9 Can government print money? Make sure you are able to answer this question, specifically compare the two ways in which the money supply is increased. Refer to pages 15 - 17 in the study guide. 1. Printing banknotes and coins. a. Only SARB has right to print money b. SARB sells new money to the banks and pays proceeds to government. c. Banks use extra money to replace old worn notes or will issue it to private sector when they need it in exchange for deposits. Money stock has still not increased yet. d. Only when government decides to spend extra money (build a school) then deposits of private building contractor and therefore money stock will increase. This process can be dangerous if government is corrupt and misuses printing press to create excessive money. 2. Forcing central bank to buy excessive issues of government securities (government borrows excessively from central bank) – monetization of government debt. a. Government issues new government securities to central bank b. Government spends newly acquired deposits, say by paying its employees, then private sector deposits (money stock) increases. c. Consequences: MV = PY. If V and Y are constant then increases in M cause increases in P d. Hyperinflation occurs when this process is repeated many times over. E.g. Zimbabwe Typical Examination questions 3.1 Provide a formal definition of money. Then explain how the money stock is measured in principle. (5) 3.2 Briefly distinguish between money and income, and money and wealth. (4) 3.3 List and explain the three primary functions of money. (3x2=6) 16 ECS 3701 Lecture Notes Nicolas Souvaris 3.4 Explain the meaning of the following terms as well as the advantages/ disadvantages of each in facilitating payments: (5x3=15): Commodity money, fiat money, cheques, electronic payment, e-money. 3.5 Define the following measures of aggregate money stock in South Africa: M1A, M1, M2, M3.(4x2=8) 3.6 Explain the meaning and implications of the government "printing" money. (10) True or false review questions 1. In principle, economists are not exactly sure how to measure money. 2. The use of a credit card to purchase goods does not affect the money stock. 3. The following transactions typically increase the money stock: a. trade credit b. payment of taxes c. government expenditure d. exports e. imports 4. An increase in the interest rate will cause increases in M1A and M3. 17 ECS 3701 Lecture Notes Nicolas Souvaris Part two: Financial markets (Textbook: chapters 4, 5 and 6) CHAPTER 4: UNDERSTANDING INTEREST RATES Measuring interest rates (Calculations not included) Interest rates are most accurately measured by the concept yield to maturity. Present value (PV): is a concept used to compare one kind of debt instrument with another. This is based on the notion that a rand (dollar) paid to you one year from now is less valuable to you then, than a rand (dollar) paid to you today. Also referred to as present discounted value. Four types of credit market instruments: these are categorized according to the timing of their cash flow payments: 1. Simple loan: the lender provides the borrower with an amount of funds (the principal) which must be repaid to the lender at the maturity date, along with an additional payment for interest. Money market instruments are of this type. For simple loans the simple interest rate equals the yield to maturity. Formula (SG pg 21): PV = CF/ (1 + i)n (where CF is cash flow at end of period n) 2. Fixed payment loan: lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period, consisting of part of the principal and interest for a set number of years. Example: mortgage payments on houses or cars. In this case the fixed yearly payment and the number of years until maturity are known quantities, only the yield to maturity is not. For example, if you borrowed $1000, a fixed-payment loan might require you to pay $126 every year for 25 years. (Refer textbook page 111). Formula: (SG pg 21): LV = + ( ) + ( ) + …..+ ( ) (where i is interest rate per period, LV is the Loan Value, FP is Fixed Payments) 3. Coupon bond: pays the owner of the bond a fixed interest payment (coupon) every year until the maturity date, when a specified final amount (face value/ par value) is repaid. Four pieces of information are required for a coupon bond: 1) the issuing party (government or corporation), 2) The maturity date of the bond 3) The coupon rate 4) Face value of the bond. 18 ECS 3701 Lecture Notes Nicolas Souvaris Three important facts relating to coupon bonds: (i) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. (ii) The price of a coupon bond and the yield to maturity are negatively related (when the yield to maturity rises, the price of the bond falls). (iii) The yield to maturity is greater than the coupon rate when the bond price is below its face value. A higher interest rate implies that the future coupon payments and final payment are worth less when discounted back to the present, therefore, the price of the bond must be lower. Formula (textbook pg 115): P = ( ) + ( ) + ( ) + …. + ( ) + ( ) Where C is coupon rate and F is final payment or face value of bond C, F and n are fixed when the bond is issued. The current market price then determines i: the yield to maturity of the coupon bond. 4. Discount bond (also called zero-coupon bond): bought at a price below its face value (at a discount) and the face value is repaid at the maturity date. A discount bond does not make interest payments, it only pays the face value. The yield to maturity is negatively related to the current bond price. Formula (textbook pg 118): i = (where i is yield to maturity) The borrower receives P (current price of discount bond at beginning of period), he repays F (face value of bond) at end of period (one year’s time). The concept of PV is used to compare these different types of instruments based on their respective yield to maturity. Yield to Maturity: of the several common ways to calculate interest rates, the most important is the yield to maturity, the interest rate that equates the PV of cash flow payments received from a debt instrument with its value today. This is the most accurate measure of interest rates. Distinction between interest rates and returns The rate of return can be defined as payments to the owner plus the change in its value, expressed as a fraction of its purchase price. The return on a bond is not necessarily equal to the yield to maturity on a bond. The return on a security shows how well you have done by holding this 19 ECS 3701 Lecture Notes Nicolas Souvaris security over a stated period of time and it can differ substantially from the interest rate measured by the yield to maturity. Because of fluctuating interest rates, the capital gains and losses on longterm bonds can be large. [When an investor sells a financial instrument before its maturity date, the sale will be subject to market rates. These market rates mean that the instrument might be sold at a profit or a loss depending on whether prices have increased or decreased.] E.g. With a $1000 face value coupon bond with a coupon rate of 10% that is bought for $1000, held for one year and then sold for $1200. The payments to owner are the yearly coupon payments of $100 and the change in its value is $1200 - $1000 = $200. Adding these together and expressing them as a fraction of the purchase price of $1000, gives us the one-year holding-period return for this bond: $ $ $ = $ $ = 0.30 = 30% This demonstrates that the return on a bond will not necessarily equal the yield to maturity on that bond. Therefore, the return on a bond held from time t to time t + 1 is: R = Where C = coupon payment Pt = price of bond at time t The following factors are important: (i) Rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds where the terms to maturity are longer than the holding period. (ii) The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change. (iii) The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the increase in interest rate. [P↓→i↑] (iv) Even if a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise. Maturity and volatility of bond returns: prices and returns for longer-term bonds are more volatile than those for shorter-term bonds. The riskiness of an asset’s return that results from interest rate changes is so important that it has been given a special name: interest-rate risk. Bonds that have a maturity that is longer than the holding period are subject to interest-rate risk. The only time this risk is eliminated is when the holding period and the maturity period are the same. This is because the price at the 20 ECS 3701 Lecture Notes Nicolas Souvaris end of the holding period is already fixed at the face value. The change in interest rates can then have no effect on the price at the end of the holding period for these bonds, and the return will therefore be equal to the yield to maturity known at the time the bond is purchased. Distinction between nominal and real interest rates Nominal interest rates: makes no allowance for inflation. Real interest rates: interest rate is adjusted by subtracting expected changes in price level. When real interest rates are low there are greater incentives to borrow and fewer incentives to lend. Indexed Bonds: a bond whose interest and principal payments are adjusted for changes in price levels and whose interest rate thus provides a direct measure of real interest rates. These bonds are useful to policy makers, because by subtracting their interest rate from a nominal interest rate on a non-indexed bond, they generate more insight into expected inflation, a valuable piece of information. Typical Examination questions 4.1 Explain the meaning of the following four types of credit market instruments (4x3=12) Simple loan, fixed payment loan, coupon bond, discount bond. 4.2 Explain the meaning of the following concepts in the context of a coupon bond: coupon rate, yield to maturity and the return on a bond. (7) 4.3 Distinguish between the nominal and the real interest rate. Which one is more important and why?(5) True or false review questions 1. The yield to maturity (i) of each of the four types of credit market instruments and its price (P, PV or LV, whatever applies) are inversely related. 2. Investors cannot ever be worse off when investing in bonds. 3. A negative real interest rate on coupon bonds implies that the interest earned on the bond does not fully compensate for the loss of purchasing power of money. Thus the investor is worse off.