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41 Cards in this Set

  • Front
  • Back
Interest rates influence...
investment decisions and allocation of resources.
interest rates reflect...
market expectations.
Home loan demand _________ as interest rates rise
Credit instruments
•Simple loan- borrow $1000 and agree to pay $1100 back at some fixed date in the future
•Fixed payment loan
•Coupon bond
•Discount bond
Present Value (PV):
•Value today of $1 to be received n years in the future
oPV= $1/(1+i)n
Yield to maturity (YTM):
YTM = i that equates today’s value (price with PV)
Discount Bond:
•A $10,000 discount bond matures in n years.
•PV = $10,000/ (1+i)n
Coupon Bonds:
•F= Face or par value
•C= Coupon
•Coupon rate (CR)= C/F
•n= maturity
•P=C/(1+i) + C/ (1+i)2 + C/ (1+i)3 … C/(1+i)n + F/ (1+i)n
•Price and YTM are negatively related
Current Yield:
•CY = C/P, is good approximation to YTM nearer price is to par and greater is n
•CY and YTM move in same direction
Treasury Bills:
•Yield on a discount basis:
oIdb = (F-P)/F * 360/ (number of days to maturity)
•Understates YTM by more the longer the maturity
Rate of return:
RET = (C+Pt+1 – P1)/P1
RET on bonds
1.If held until maturity RET = initial YTM
2.If sold before maturity
a.RET will depend on YTM at time of sale
b.Rise in I implies capital loss
c.Loss is greater the longer the maturity
d.High initial I can still result in negative RET if I increases
3.P and RET more volatile for long term bods
4.No interest rate risk for any bond whose maturity equals holding period
Bond demand curve
•Shows decrease in the quantity of bonds demanded as the price of bonds rises
•Bd depends on wealth, expected return, risk and liquidity
Bond Supply Curve
•Shows increase in the quantity of bonds supplied as the price of bond increases
•Bs depends on:
oProfitable investment opportunities
oExpected inflation
oGovernment activities
•If firms expect an economic expansion, bond supply curve shifts to the right
•A rise in Pie (expected inflation) causes bond supply curve to shift to the right
•A rise in government deficits shifts bond supply curve to the right
Loanable funds theory
•Bonds demanded equals bonds supplied determines i
•Expansion will raise income and saving
oBond demand curve will shift to right
•Expansion will also shift Bond supply curve to the right
Fisher effect
•When expected inflation rises (Pie rises) interest rates rise
Business cycle expansion
•Saving increases
•Investment rises
•If bond supply curve shifts more than bond demanded then i increases
Liquidity preference framework
•Keynes’s assumed to assets:
•Money and bonds
•Wealth = Ms + Bs = Bd + Md
•Then Ms – Md = Bd – Bs
•Excess value of money = excess value of bonds
Open market operation:
•Fed buys of sells Treasury Bonds
•If fed buys, then money supply is rising
oIf fed buys treasury bonds, it demands T-bonds and supplies money
oBonds price increases, interest rate falls
•Md – Ms = 0 implies that Bd – Bs = 0
Default risk:
•Chance that issuer will be unable to pay coupons or face value at maturity
•Default free bonds: Bonds with no default risk (Treasury Bonds)
•Applies to any country’s bonds issued in terms of own currency
•Risk premium = ic - iT
•Junk bonds refers to High Yield bonds
Risk Premium Increases:
o During a recession
o If asymmetry of information worsens
Bond ratings
• Investment grade: Low risk of default Baa or BBB and above
• Speculative grade (junk bonds): Below Baa or BBB
Increased asymmetric information:
• Demand for corporate bonds decreases
• Demand for treasury bonds rises
Asymmetric information problem:
•Price of corporate bonds falls, ic rises
•Price of treasury bonds rises
•Risk premium, ic – iT, Rises
Perfect substitutes
expectations theory
Perfect non-substitutes
segmented markets theory
Partial substitutes
liquidity premium theory
Expectations theory
•Interest rate on n year bond is average of short rates expected over n years
•i3t = (it + iet+1 + iet+2) / 3

•If the treasury yield curve is flat, expectations theory suggests that markets expect short term interest rates to remain the same.
Liquidity premium theory (LPT)
• Investors must be paid positive liquidity premium, lnt, to hold long term bonds
• For three year bond
• i3t = (it + iet+1 + iet+2)3+l3t
•LPT suggests that a flat yield curve is forecasting a fall in short term interest rates
Liquidity premium theory explains why:
•Long and short interest rates move together
•YC is usually upward sloping
Flat yield curve
short term interest will stay the same
Sources of external U.S. Finance-
• Bank Loans
• Non bank loans
• Bonds
• Stock
External Finance:
• Direct Finance
• Indirect finance
Direct Finance
o Equity, marketable debt securities
Indirect finance
Loans from financial intermediaries
Financial structure explained by
o Adverse selection
o Moral hazard
o Transaction cost
Financial intermediaries make profits:
• By reducing transactions costs
o Economies of scale
o Developing expertise
• By acquiring info on borrowers
• Make private loans
Lemons Problem
Good and bad securities difficult to distinguish
Adverse Selection problem reduced by:
Private production and sale of info. / free rider problem
Government regulation to increase information
Principal- agent problem:
Managers (agents) act in own rather than stock holders’ (principals) best interest