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Money & Banking

Chapters 4 & 5

Debt Instruments and Interest Rates

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Debt Instruments

Chapter 4

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Present Value

What is a future cash flow (FV ) worth now?

ni

FVPV

)1(

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Rule of the Cash Flow Timeline

Cash flows at the same date can be added together, but cash flows at different dates cannot be added together.

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Four Types of Credit Market Instruments

1. Simple loan

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2. Fixed Payment, or Amortized, Loan

Examples: car loans, mortgages

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3. Coupon Bond

Most bonds with maturities greater than a year are of this form.

Coupons bonds issued byFederal government (Treasurys)State and local governments (munis)Corporations (corporates)

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Special Type of Coupon Bond: Consol or Perpetuity

Fixed coupon received forever.

i

couponPV

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4. Discount, or Zero Coupon, Bond

Identical in cash flow structure to a simple loan. The difference is that there’s an active secondary market for zero coupon bonds.

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Draw cash flow diagrams for the four types of credit instruments.

Take the perspective of the lender.

Simple loanAnnuity/Amortized loanCoupon bondZero coupon (discount) bond

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Yield Curve

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Bond Page of the

Newspaper

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Rate Maturity

Mo/Yr

Bid Asked Chg Asked

Yield13 1/4 May 15 143:01 143:02 +14 6.78

Semi annual coupon on $1 mil of face value?$66,250.00Number of coupons remaining?Nov06 … May15 18Asked price of $1 mil of face value?$1,430,625

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Pricing a coupon bond

Suppose I need a 4% rate of return.

How much would I be willing to pay for $1 million of face value of the bond on the previous slide?

(FV=1mil, n=18, i = .02, PMT = 66,250)

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http://online.wsj.com/public/page/8_0004.html?mod=djemITP

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Yield to Maturity

The rate of discount that equates the present value of future cash flows with the price of the credit instrument.

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Relationship Between Price and Yield to Maturity

.

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Calculate the yield to maturity on a consol that pays $100 a year and is

priced at $2,500.

Recall formula for present value of a consol:

i

couponPV

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Approximation for YTM: Current Yield

P

Cic

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Approximation to Yield to Maturity: Yield on a Discount Basis for Bills

ritydaystomatuF

PF 360

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Fisher Equation

The nominal (actual) interest rate equals the real rate plus the expected inflation rate.

e

rii

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TIPS (Treasury Inflation Protection Securities)

• Originally issued in 1997.

• Interest and principal payments are adjusted for inflation.

• In times of high inflation the $ amount paid to investors rises.

• Return on TIPS provides information on expected inflation.

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Supply and Demand

Analysis ofthe Bond Market

Market Equilibrium

1. Occurs when Bd = B

s, at P* =

$850, i* = 17.6%

2. When P = $950, i = 5.3%, Bs >

Bd (excess supply): P to P*, i

to i*

3. When P = $750, i = 33.0, Bd >

Bs (excess demand): P to P*,

i to i*

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Loanable Funds Terminology

1. Demand for bonds = supply of loanable funds

2. Supply of bonds = demand for loanable funds

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Shifts in the Bond Demand Curve

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Factors that Shift the Bond Demand Curve

1. WealthA. Economy grows, wealth , Bd , Bd shifts out to right

2. Expected ReturnA. i in future, Re for long-term bonds , Bd shifts out to rightB. e , Relative Re , Bd shifts out to rightC. Expected return of other assests , Bd , Bd shifts out to right

3. RiskA. Risk of bonds , Bd , Bd shifts out to rightB. Risk of other assets , Bd , Bd shifts out to right

4. LiquidityA. Liquidity of Bonds , Bd , Bd shifts out to rightB. Liquidity of other assets , Bd , Bd shifts out to right

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Shifts in the Bond Supply Curve

1. Profitability of Investment Opportunities

Business cycle expansion, investment opportunities , Bs , Bs shifts out to right

2. Expected Inflation

e , Bs , Bs shifts out to right

3. Government Activities

Deficits , Bs , Bs shifts out to right

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Changes in e: the Fisher Effect

If e 1. Bd shifts in to

left2. Bs , Bs shifts

out to right3. P , i

© 2005 Pearson Education Canada Inc.