Three Characteristics of Money
Means of Payment
Unit of Account
Store of Value
What is the primary use of money?
It's used as a means of payment
What problem does money solve?
You do not need to collect information, there is no risk of not being paid back, finalizes payments so no claims against parties are necessary
We can compare money as a standard and it gives a relative value of things
More liquid
What is a barter system?
Goods and service exchange using cashless transaction
What are the problems with a barter system?
Not everyone wants to trade for that good (no mutual desire/double coincidence of wants), it's difficult to assess the value of something
How do you tell the number of prices in a barter system?
n(n-1)/2
How is money better than barter?
Prevents bad trade, less prices to keep track of, simplification, better trade leads to better economy
The three methods of payment
Commodity/fiat money
Checks
Electronic payments
What are the principles?
Time has value
Risk requires compensation
Information is the basis for decisions
Market determine prices and allocate resources
Stability improves welfare
Commodity money
Have it's own intrinsic value
Fiat money
The object is worthless but it's backed by governmental law which gives it worth
Most common historical commodity?
Gold
Characteristics of commodity money
Usable by people, durable, easily transportable, divisible
Are checks money?
No. They are intermediates/instructions to tell the bank to make the final payment
Are credit and debit cards money?
No
Are stores value cards and e-money considered money?
Yes
M1
Narrow measure of money used until the 1980s. Consists of currency, traveler's checks, deposit accounts
M2
Broader and more common measure of money in the economy that includes M1 and less-liquid assets, money market accounts and fund shares
Money Market Accounts
A money market account pays a variable interest rate based on various government and corporate securities. Interest paid reflects the current rates of interest being paid in the money markets. They may have a large minimum balance requirement.
Why did they change from M1 to M2?
Inflation was so high in the 1980s and money market accounts developed that were liquid and paid interest. This was becoming more popular and it made a significant amount of the money aggregate
Inflation
A general and progressive increase in prices.
Inflation Rate (Measuring using the CPI)
0
CPI and how to calculate
Consumer Price Index, (consumer price index) a measure of the overall cost of the goods and services bought by a typical consumer. Data is collected by the Bureau of Labor Statistics.
Percentage of expenditure(Price in that year)+Percentage of expenditure
What is substitution bias in relation to the CPI? What does the BLS do to minimize it?
When prices go up, people substitute for inexpensive goods. Basically, the basket is based on what people normally buy, but if prices are high people might not necessarily buy those things. This means CPI often overstates inflation rate. The BLS changes t
Direct Financing
borrowers borrow directly from the lenders
Indirect Financing
An institution borrows from the lender and provides the funds to the borrower
Financial instrument
Written legal obligation of one party to transfer something of value to another party at a future date.
What makes financial instruments valuable? Can they be used as a means of payment?
They can accumulate extra value/interest over time. They can be used as stock options, insurance benefits (policies), etc.
What is having asymmetric information?
One party has more information than another and they might not disclose this
Underlying instruments
directly transfer reserves from savers/investors to borrowers/issuers
Derivative instruments
A financial instrument whose value is based on an index or value of another financial instrument. Basically used to transfer risk. Examples include options, futures contracts.
Give examples of financial instruments that store value and that transfer risk
Bank loans, bonds, mortgages, stocks, asset-backed securities
Insurance policies, futures contracts,
Futures contracts
An agreement to exchange a fixed quantity of an asset at a fixed price on a set future date- this transfers the risk of price changes.
Primary Market vs. Secondary Market
Primary: IPO or new issuance of stock or Seasoned Equity Offer
Secondary: selling and buying of existing securities
Dealer Market vs. Auction Market
Auction Market is like the NYSE which buys and sells shares to the highest bidder in a physical location. Dealer markets or Over the Counter markets have specialists who trade with one another via computers like the NASDAQ.
What are ECNs?
ECNs are electronic communication networks. These computerized trading systems automatically match buy and sell orders. Since they are electronic, ECNs allow for extended trading hours. As fewer humans and physical overheads are required, ECNs provide a p
What is the difference between Debt Markets, Equity Markets, and Derivatives markets?
Debt Markets: Debt markets are split into Money markets which is debt paid in less than a year and bonds markets which have a maturity of over a year.
Equity Markets: Markets for stocks
Derivative markets: transferring of risk through futures.
What do well run financial markets do?
They keep transactions costs low, they provide accurate and available information, and they protect investors.
What is the role of financial institutions?
Reduce transaction costs
Reduce costs of obtaining information
Make long-term loans and allow savers to access their funds
Providence less risky investments by lending to many borrowers at once
What are the two classifications of Financial Institutions?
Depository institutions: take deposits and make loans, mostly banks or credit unions
Non-depository-institutions: provide other functions like risk transfer or pension funds
What are GSEs?
Government Sponsored Enterprises- Federal credit agencies that provide loans directly for people and guarantee programs that insure loans made by private lenders.
What is a Bond?
A financial security that represents a promise to repay a fixed amount of funds
What is a zero-coupon bond?
A type of bond that has a 0% coupon rate, therefore there are no coupon payments. You are just repaid the principal and therefore it costs less than the face value returned to you. A good example would be U.S. treasury bills.
What is a coupon bond?
A promise from the issuer of the bond, to make a series of periodic interest payments called coupon payments, plus a principal payment at maturity.
How do you calculate the price of a coupon bond?
C/(1+i)^1 + C/(1+i)^2 + C/(1+i)^3 + ... +F/(1+i)^n
C= bond price * coupon rate
i= interest rate
Consider a $100 bond with a 10% coupon rate and 3 years to maturity. If the current interest rate s 3% what is the bond's price?
91.51 + 9.71 + 9.43 + 9.15 = 119.80
How to calculate the price of a zero coupon bond?
PV: F/(1+i)^n
You would receive F-PV is interest at the end
Discount Bond
Bond selling below its par value.
U.S. Treasury Bills
Short term debt instruments of the U.S. government with typical maturities of 3 to 12 months that sell at a discount. They are zero-coupon bonds, no maturity of over a year
Fixed Payment Loans and how to calculate the Price/Value
Ex. car loans, mortgages
Amortized fixed payments- borrower pays off the principal and the interest over time
P= pmt/(1+i)^1 + pmt/(1+i)^2 + pmt/(1+i)^3 + ...
Consols
Only offers periodic interest payments, but is not paid the face value at the end, like a coupon bond without maturity, just continually pays interest payments. Not used as much anymore because people are living longer.
The price/value is the PV of all th
Yield to Maturity
Most useful measure of the return on holding a bond, is calculated from the PV formula Have an inverse relationships. When prices increase, YTM decreases.
Relationship between bond prices and interest rates
Interest rate goes up, bond prices go down
Interest rate goes down, bond prices go up
What is the relationship in the demand for bonds?
The quantity demanded decreases as the price goes up
The quantity demanded increases as the price does down
What are the risks of bonds?
Default risk: chance the bonds issuer will fail to may the promised payments
Inflation risk: Bonds promise to make payments regardless of inflation- more risky in long-term bonds, the higher the inflation the less actual interest the lender is getting
Int
Downgrade
The lowering of a bond rating
An improvement in the rating of a bond
Upgrade
What are two common bond rating systems?
Moody and S&P
What are the three categories of bond ratings
Investment Grade
Non-investment, speculative grade
Highly speculative
What are the two types of junk bonds?
Fallen angels- once investment grade, but the company's situation changed
Original issue- junk bonds are bonds for which little is known about the risk of the issuer
Commercial Paper
Short-term bond, lasting less than 270 days (usually shorter) usually, issues by companies and governments and is NOT backed by collateral, not much can happen in that short of a time span so there is no need for collateral
Why would commercial paper not be issued with a speculative grade?
There is no collateral to back up the bond so they would have to be a more reliable company
Municipal Bond
a bond issued by a state or local government or municipality to finance such improvements as highways, state buildings, libraries, parks and schools
Bond Yield=
Bond Yield= U.S. Treasury Bond Yield + Default Risk Premium
Why are U.S. Treasury bonds used to measure default risk spread?
U.S. Treasury bonds are viewed as having very little default risk so they are used as the benchmark to measure yields on all bonds
What should happen to the default risk premium as an issuer's rating gets worse?
It should increase because people want to be paid more for the increase risk
When Treasury bond yields move, what would happen to yield of other bonds?
They should move the same amount in the same direction
What happens to the default risk spread in times of financial stress?
It increases because already risky bonds become riskier
A company wants to issue a 10-year, zero-coupon $100 bond at a rate of 6%. How much will investors pay for this bond?
$55.84
Tax-Exempt Bonds
Municipal bonds are tax-exempt bonds
These are bonds with tax breaks, this gives incentive as normally bondholder must pay income tax on the interest income they receive from privately issued bonds
Why are municipal bonds tax exempt?
Certain levels of government do not tax other levels of government
The government knows its good for municipal governments to be tax- exempt in order to get fast capital
Longer Term maturity -> ?
Higher Yield
Time to maturity goes up, Yield goes up
Interest Rates of different maturities move...
Together
Are yields on short-term bonds more or less volatile than those on long-term bonds?
More volatile
Are long-term yields higher or lower than short-term yields?
Higher- there is more risk
The Expectations Hypothesis
The slope of the yield curve depends on the expectations for future short-term rates
Short-term and long-term bonds are perfect substitutes
Investing in a series of short-term bonds or a single long-term bond will have the same yield
It does NOT prove how
Coupon Bonds
Bonds with interest coupons attached to their certificates; bondholders detach coupons when they mature and present them to a bank or broker for collection.
What is the bond worth on a zero-coupon bond?
The face value
Perpetuities
Streams of equal payments that are expected to continue forever.
Why are bonds risky?
Default risk- risk they won't pay off on bond
Inflation risk- risk that inflation will be higher than expected and recuse the real return
Interest-rate risk- rates will rise between purchasing and time sold, this reduces the bonds price
Stability and Welfare are directly/inversely related and thus, risk and welfare are directly/inversely related.
Directly
Inversely
When inflation arises, the value of money...
Falls
Interest rates of different maturities tend to move together/inversely
Together
Longer term maturity is a high or lower yield?
Higher yields on longer term maturities because there is more risk involved
If interest rates are expected to rise, with long term rates higher than short term rates it will result in a _______ sloping yield curve
Upward Sloping
If interest rates are expected to fall, with long term rates lower than short term rates it will result in a _______ sloping yield curve
Downward sloping
If interest rates are expected to be the same, with long term rates equal to short term rates it will result in a _______ sloping yield curve
Zero sloping curve
The Liquidity Premium Theory
The fact that long-term securities have greater risk and investors require greater premiums to give up liquidity (short-term securities)
This does explain why long-term yields are normally higher than short-term yields
What does an inverted yield curve indicate?
rates will drop before an economic slowdown
What are the ratings from commercial paper?
Investment Grade, Speculative, Highly Speculative/Defaulted
How do you calculate the tax-exempt bond yield?
(Taxable bond yield) x (1-Tax Rate)
True or False: The set of questions you're are asked in getting a loan is standardized to reduce the cost of making the loan.
True
If the U.S. Securities and Exchange Commission eliminated its requirement for public companies to disclose information about their finances, what would you expect to happen to the stock prices of these companies?
You should expect the stock prices to fall. Gathering sufficient information upon which to make an informed investment decision would become much more costly for investors, reducing the demand for the stock at a given price.
Explain how money encourages specialization, and how specialization improves everyone's standard of living.
Without money, people have to barter to exchange goods and services. This requires a "double coincidence of wants," which makes it difficult to specialize. In the example in the text, a plumber is buying groceries; if the grocer doesn't need a plumbing re
Despite the efforts of the United States Treasury and the Secret Service, someone discovers a cheap way to counterfeit $100 bills. What will be the impact of this discovery on the economy?
People will be unwilling to accept $100 bills as payment and will require payment via check, credit card, debit card, or electronic transfer instead, all of which are more costly. Theoretically, inflation could result if the supply of money was increased
Under what circumstances might you expect barter to reemerge in an economy that has fiat money as a means of payment?
You might expect an economy to revert to barter when the public loses confidence in the fiat money issued by the government, perhaps because of over-use of the printing presses. For example, this as happened during episodes of extremely high inflation, su
You visit a tropical island that has only four goods in its economy�oranges, pineapples, coconuts, and bananas. There is no money in this economy. Under what circumstances would you recommend the issue of a paper currency by the government of the island?
The islanders must have enough confidence in their government to accept notes backed only by a government decree that have no intrinsic value themselves. They have to believe that these notes will be widely accepted by other islanders as final payment for
Consider two scenarios. In the first, the nominal interest rate is 6 percent and the expected rate of inflation is 4 percent. In the second, the nominal interest rate is 5 percent and the expected rate of inflation is 2 percent. In which situation would y
In the first scenario you would rather be a borrower In the second scenario, you would rather be a lender
Use the Fisher equation to explain in detail what a borrower is compensating a lender for when he pays her a nominal rate of interest.
The Fisher equation illustrates that the nominal interest rate (i) can be broken down into two components where i = r + expected inflation. Taking i to be an annual interest rate, the borrower is compensating the lender for the inflation that is expected
The Fisher Equation
real interest rate(r) = Nominal interest rate(i) - Inflation rate (Pie)
If the current interest rate increases, what would you expect to happen to bond prices?
You would expect bond prices to fall because bond prices are the sum of the present values of the future payments associated with the bond. The higher the interest rate, the lower the present value of these payments.
How many parts to the financial system are there? What are they?
6. Money, Financial instruments, Government regulatory agencies, the central bank, Financial markets, financial institutions
Central banks...
stabilize the economy
Government regulatory agencies...
aim to make the financial system operate safely and reliably
When does the supply for bonds increase?
When inflation increases
Governments need to borrow
Business conditions improve
When does the demand for bonds increase?
When inflation is expected to be low
Expected return rises
The expected return of other securities falls
Bonds become less risky
Bonds become more liquid
Expected interest rate falls
What is the price of a consol?
Present value of all future interest payments
What is the price of a zero-coupon bond?
Present value of the future payment
What is the price of a fixed payment bond?
The present value of all the payments
What is the price of a coupon bond?
The future value of all the coupons plus the future value of the face value
How to calculate the YTM?
Present the Value formula
How to calculate current yield?
A bond's annual coupon divided by its price.
Holding Period Returns
Rate of return over a given investment period