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Financial Instrument

Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 3 Financial Markets. Financial Instrument. Financial Instrument – that is, a record (paper or electronic) that specifies the terms on which the loan of funds will be repaid. Real Wealth. Stock not flow.

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Financial Instrument

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  1. Econ 210D Intermediate MacroeconomicsSpring 2015Professor Kevin D. HooverTopic 3Financial Markets Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

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

  4. Financial Instrument • Financial Instrument – that is, a record (paper or electronic) that specifies the terms on which the loan of funds will be repaid. Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  6. Real Wealth • Stock not flow. • Things owned • Strictly positive – no negative real wealth • Examples: • houses • land • cattle • gold Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  7. Financial Wealth • Financial Wealth = claims to payment (or transfers) of something valuable at some future time. • Positive: things owned • Credit • Asset • Negative: things owed • Debt • Liability Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  8. Balance Sheets • Fundamental Accounting Identity:Assets – Liabilities = Net WorthAssets = Liabilities + Net Worth Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  9. T-account Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  11. Present Value • General Formula: • PV = present value • FV = future value • r = interest rate (opportunity cost) • m = number of periods into future Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  12. Properties of Present Value • PV < FV: discount future value by opportunity cost (therefore, r = discount rate; PV also called present discounted value. • Discount not related to inflation. • Further FV is in future, the lower is present value. • 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 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: Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  15. Types of Financial Instruments • Stock (shares or equity) • Bonds • Derivatives: • Futures contracts • Collateralized Debt Obligations • Many, many others Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  21. Bond - Types • Coupon Bond: • Pure Discount (Zero-Coupon) Bond: Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  22. Relationship between Bond Prices and Yields • Inverse: bond prices and bond yields move in the opposite direction • Mantra: • prices up, yields down; • prices down, yields up; • yields up, prices down; • yields down, prices up. Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  24. General Share Price Formula • pS = share price • N = number of outstanding shares; • = expected profits at time t Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  25. Yields on Shares • Dividend Yield = dividend/ pS • E/P ratio (usually quoted as inverse = P/E ratio. • Capital Gains (or Losses) =  pS Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  26. 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. • Tulip Mania • 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. Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  29. Five Questions About Interest Rates • Why do rates move together? • Why do only imperfectly? • Why do short rates typically yield less than long rates? • Why are government rates lower than private sector rates? • What determines the level of interest rates? Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  30. Substitution Among Financial Instruments • Substitute = a good the demand for which rises when the price of another good rises. • Perfect substitutes = practically identical goods • two identical government bonds • must have identical price • Imperfect Substitute: a higher price of one good does not eliminate demand for it in favor of the substitute. • a government bond and a corporate bond • prices can differ Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  31. Arbitrage • Arbitrage = the simultaneous buying and selling of closely related goods or financial instruments in different markets to take advantage of price differentials. Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  33. Risk Rating Agencies • Moody’s • Standard and Poors (S&P) • Fitch Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  41. No-Arbitrage Condition – Approximation • Approximation fact: • Approximate No-arbitrage condition: • Arithmetic Mean 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 Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

  43. Irving Fisher (1867-1947): America’s Greatest Economist Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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

  45. Inflation and Interest Rates in Practice 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 Up • Why do rates move together?Substitution and arbitrage. • Why do only imperfectly?Imperfect substitutability (including maturity differences) • Why do short rates typically yield less than long rates? Price-risk premia. • Why are government rates lower than private sector rates?Default-risk premia • 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 Professor K.D. Hoover, Econ 210D Topic 3 Spring 2015

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