ECON 23000 MONEY & BANKING MIDTERM REVIEWPressing Questions:

1. What is the relationship between interest rate and yield on a security? 2. How is the no-arbitrage condition applied in this class? 3. How do LSAP relate to what we studied?

Practice: 1. Apply the yield curve concepts to historical events, e.g. Volcker deflation, oil crisis, etc. 2. What is the relationship between business cycles and interest rates?

Goals: Understand monetary policy both conceptually and technically CB controls the overnight rate. How does the short-rate affect the economy? What are different interest rates? How are they determined? What is the financial system?

Financial System Functions:

o Financial institutions serve as an intermediary between lenders and borrowers. Instruments:

o Equity and debt instruments Interest rate is a fee paid to borrow/return received for lending Risk: market fluctuations, default risk Maturity: Time until an instrument expires

Primary and Secondary: o Primary markets are where initial offerings of financial assets are made, such as

IPO or issuing corporate/Treasury bonds. o Secondary markets are where assets are traded, and provide liquidity to investors.

Exchanges and OTC: NYSE and NASDAQ are national exchanges that serve as middlemen, or brokers, between buyers and sellers. OTC involve dealers who have inventories of securities, and sell those securities.

Government bonds make up a large part of the OTC market. Money and Capital Markets:

o Money markets are a subset of the financial market where highly liquid, short maturity instruments are traded. Some examples of instruments are T-Bills, CDs, commercial papers, and repos.

o Capital markets are where corporations seek funding through debt instruments, skipping out on the intermediary. This sort of direct financing is not prevalent, and corporations go to banks most of the time.

Intermediaries:o Financial institutions such as banks serve as middlemen to facilitate trades of

financial assets, and more importantly match buyers and sellers together who want to exchange at a specified price.

o Benefits of having an Intermediary Lower Transactions Costs

Risk Sharing Asymmetric Information: Intermediaries can spend more resources and

have more resources as an overseer of many exchanges, so that they can better determine the state of a company and expose any information that is not openly apparent.

Notes:

Yield, Price, Return I. No Arbitrage Condition

o Any security with coupon payments and face value can be replicated by a portfolio of ZCBs, which means that all assets should pay a return equivalent to the market interest rate of each period, along with some risk premium.

II. Interest Rateo Relative price of intertemporal consumption: It is effectively an opportunity cost,

or exchange rate of present consumption v. future consumption. o OR Rate of growth of money upon saving or investing in a bond.

III. Yield to Maturity : The interest rate that equates the PV of future cash flows from a debt instrument with its value today.

o Use: It can be useful to compare loans with different term arrangements, since YTM can be viewed as a measure of the returns on a bond.

o Fundamental Qualities: It is a moving average of per period interest rates. o Inverse Relationship with Price: As the price of a bond changes, the yield will

change, holding the coupon payments and face value constant. When the price increases, then the yield will go down because you are paying more money for a small value of coupon payments and FV. Conversely, when the price goes down, the yield will go up because you are paying less for the same amount of coupons and FV.

o Yield and Interest Rates: When interest rates rise, then prices of bonds go down. Given the same level of coupons and face value, the yield will therefore go up.

o Unique Case: YTM and Coupon Rate are not the same, except in the Par Value Case: When the bond price and FV are the same, then the interest rate must equal the coupon rate. If the coupon rate is greater than the interest rate, then the price should be higher than FV. If the coupon rate is smaller than the interest rate, then the price should be smaller than the FV.

IV. Rate of Return (Internal?): If the IRR is greater than the cost of capital, one should follow through with a project (?).

Notes:

Interest Rates I. Yield Curve

o Things a Yield Theory Should Explain Interest rates of bonds with different maturities move together over time

Expectations Theory: Because all yields are an average of short term yields, bonds with different maturities move together.

Yield curves are almost always upward sloping o Theory:

Expectations Theory: Long term rates are the averages of expected short term rates going into the future. For example, under normal conditions, investors expect short term interest rates to rise in the future with inflation, so the yield curve should be upward sloping.

Flaw: In practice, short-term rates are just as likely to fall as they are to rise, so expectations are not helpful in explaining upward sloping curves.

Liquidity Premium Theory: Long term rates depend not only on expectations of future rates, but also depend on the uncertainty of future circumstances.

Unlike the ET, bonds are NOT assumed to be prefect substitutes, due to the addition of a liquidity premium term that makes investors prefer some bonds over others.

o Curve Shape Factors Federal Reserve Policy can change interest rates. When expectations of the future change, the expected rate of return and

interest rates also change. (this can be viewed as physical rate of return or asset rate of return). If they anticipate better economic conditions in the future and consequently higher returns, then the interest rate will also

increase. If they anticipate recession, then they expect lower returns, and interest rates will decrease.

If people expect better market conditions, people will seek equity for higher rates of return. As a result, people demand more equity and less bonds, so bond prices will go down while yields go up.

II. Types of Curveso Normal Curve

Why Upward Sloping? During normal economic conditions, people prefer to have funds at their disposal, so the yield on short term securities is lower. Longer-term securities are desired because people believe that the economy will grow in the future. This expectation also means an expectation of inflation, so people will expect the Fed to hike short term interest rates in the future. Longer term securities therefore have higher interest rates, and higher yields. Higher yields also compensate for the fact that long term bonds are riskier due to uncertainty of the future.

o Flat Curve Why Flat? Investors might expect a slump in the economy, and so the Fed

might loosen interest rates, companies may stop investing in capital, and people may turn away from bonds to equities. All three of these factors would cause long-term yields to go down.

o Inverted Curve Why Inverted? If investors think the economy will enter a recession in

the future, they become willing to hold low-yield bonds because interest rates may drop even further and because they are less risky to hold.

III. Other Important Topicso Loanable Fundso Stock Market Performance o Fed Policy

Notes:

E [ R ]= 1E [ M ]

−cov (M , 1+r )

E [ M ]

cov ( M ,1+r )<0: When the economy booms, consumption tomorrow increases, so M decreases. If M decreases, then the rate of return on the asset increases. The second term gets larger, and the overall rate of return on the asset increases. These are characteristics of an equity.

cov ( M ,1+r )>0: When the economy booms, M decreases. When M decreases, so does the return on the asset. For a bond, the price increases when the economy is in a recession, because people demand more bonds. As a result, people selling the bonds will achieve a higher price.