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Questions and Answers
What is the present value of a payment made in the future?
What is the present value of a payment made in the future?
What is the internal rate of return?
What is the internal rate of return?
What is the relationship between bond prices and interest rates?
What is the relationship between bond prices and interest rates?
What is the nominal interest rate?
What is the nominal interest rate?
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What is risk in finance?
What is risk in finance?
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What is probability in finance?
What is probability in finance?
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What is the real interest rate?
What is the real interest rate?
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What is the Fisher equation?
What is the Fisher equation?
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What is the risk premium?
What is the risk premium?
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What is the value at risk (VaR)?
What is the value at risk (VaR)?
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What is the primary risk faced by bondholders when investing in bonds?
What is the primary risk faced by bondholders when investing in bonds?
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What is the expected value of the payment of a bond if there is a 10% probability of default?
What is the expected value of the payment of a bond if there is a 10% probability of default?
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What is the compensation for inflation risk in a bond?
What is the compensation for inflation risk in a bond?
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What is the effect of an increase in interest rates on the price of a long-term bond?
What is the effect of an increase in interest rates on the price of a long-term bond?
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What is the primary purpose of bond ratings?
What is the primary purpose of bond ratings?
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What is the distinction between investment-grade and non-investment-grade bonds?
What is the distinction between investment-grade and non-investment-grade bonds?
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What is the effect of a rating downgrade on the price of a bond?
What is the effect of a rating downgrade on the price of a bond?
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What is the relationship between the yield to maturity and the default risk of a bond?
What is the relationship between the yield to maturity and the default risk of a bond?
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What is the purpose of independent companies that evaluate the creditworthiness of potential borrowers?
What is the purpose of independent companies that evaluate the creditworthiness of potential borrowers?
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What is the term for bonds that are at serious risk of default?
What is the term for bonds that are at serious risk of default?
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If the yield to maturity of a bond is greater than its coupon rate, what can be concluded about the bond's price?
If the yield to maturity of a bond is greater than its coupon rate, what can be concluded about the bond's price?
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What is the main difference between a zero-coupon bond and a coupon bond?
What is the main difference between a zero-coupon bond and a coupon bond?
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What is the present value of a fixed-payment loan?
What is the present value of a fixed-payment loan?
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What happens to the bond's price when the yield to maturity increases?
What happens to the bond's price when the yield to maturity increases?
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What is the main characteristic of a consol?
What is the main characteristic of a consol?
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What is the holding period return of a bond?
What is the holding period return of a bond?
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What is the relationship between the bond supply curve and the bond price?
What is the relationship between the bond supply curve and the bond price?
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What happens to the bond's price when there is an excess supply of bonds?
What happens to the bond's price when there is an excess supply of bonds?
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What is the main reason why bonds are risky?
What is the main reason why bonds are risky?
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What is the relationship between the bond demand curve and the bond price?
What is the relationship between the bond demand curve and the bond price?
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What type of bond is characterized by a promise to pay a fixed amount on a future date, with no coupon payments?
What type of bond is characterized by a promise to pay a fixed amount on a future date, with no coupon payments?
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What is the relationship between the interest rate and price of a bond?
What is the relationship between the interest rate and price of a bond?
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What is the yield to maturity of a bond?
What is the yield to maturity of a bond?
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What happens to the price of a bond when the yield to maturity increases?
What happens to the price of a bond when the yield to maturity increases?
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What is the main characteristic of a consol?
What is the main characteristic of a consol?
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What is the holding period return of a bond?
What is the holding period return of a bond?
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What determines the price of a bond in the bond market?
What determines the price of a bond in the bond market?
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What happens to the bond's price when there is an excess supply of bonds?
What happens to the bond's price when there is an excess supply of bonds?
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What is the main reason why bonds are risky?
What is the main reason why bonds are risky?
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What is the relationship between the bond supply curve and the bond price?
What is the relationship between the bond supply curve and the bond price?
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What is the primary function of financial intermediaries in terms of liquidity?
What is the primary function of financial intermediaries in terms of liquidity?
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What is the term for the problem that arises when borrowers know more about their creditworthiness than lenders do?
What is the term for the problem that arises when borrowers know more about their creditworthiness than lenders do?
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What is the purpose of financial intermediaries in terms of risk diversification?
What is the purpose of financial intermediaries in terms of risk diversification?
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What is the problem that arises when lenders cannot distinguish good credit risks from bad ones?
What is the problem that arises when lenders cannot distinguish good credit risks from bad ones?
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What is the term for the problem that arises when borrowers have an incentive to take on more risk than they would if they had to bear the full consequences of their actions?
What is the term for the problem that arises when borrowers have an incentive to take on more risk than they would if they had to bear the full consequences of their actions?
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What is the main problem that arises when managers of a company make decisions that are not in the best interest of the company's owners?
What is the main problem that arises when managers of a company make decisions that are not in the best interest of the company's owners?
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What is the main function of financial intermediaries in terms of information collection and processing?
What is the main function of financial intermediaries in terms of information collection and processing?
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Which of the following is an example of moral hazard?
Which of the following is an example of moral hazard?
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What is the purpose of collateral in a loan agreement?
What is the purpose of collateral in a loan agreement?
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What is the term for the net worth of a firm, which serves as a guarantee for the loan in the event of default?
What is the term for the net worth of a firm, which serves as a guarantee for the loan in the event of default?
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What is the primary function of financial intermediaries in reducing information costs?
What is the primary function of financial intermediaries in reducing information costs?
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What is the main reason why financial intermediaries exist?
What is the main reason why financial intermediaries exist?
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What is adverse selection, and how is it related to financial intermediaries?
What is adverse selection, and how is it related to financial intermediaries?
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What is the main advantage of risk diversification?
What is the main advantage of risk diversification?
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What is the primary benefit of financial intermediaries in terms of information asymmetry?
What is the primary benefit of financial intermediaries in terms of information asymmetry?
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What is the primary role of financial intermediaries in the economy?
What is the primary role of financial intermediaries in the economy?
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What is the relationship between a borrower's credit score and the likelihood of loan approval?
What is the relationship between a borrower's credit score and the likelihood of loan approval?
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What is the main reason why banks engage in off-balance-sheet activities?
What is the main reason why banks engage in off-balance-sheet activities?
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What is the primary function of loan loss reserves?
What is the primary function of loan loss reserves?
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What is the main purpose of credit ratings?
What is the main purpose of credit ratings?
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Which type of institution accepts premiums and invests in securities and real estate?
Which type of institution accepts premiums and invests in securities and real estate?
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What is the main function of asset management firms?
What is the main function of asset management firms?
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What type of institution raises funds directly in financial markets to make loans to individuals and firms?
What type of institution raises funds directly in financial markets to make loans to individuals and firms?
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What is the main function of hedge funds?
What is the main function of hedge funds?
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What type of institution includes brokers, investment banks, underwriters, asset management firms, and private equity firms?
What type of institution includes brokers, investment banks, underwriters, asset management firms, and private equity firms?
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What is the main function of pension funds?
What is the main function of pension funds?
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What is the main characteristic of stablecoins?
What is the main characteristic of stablecoins?
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Why did M2 become more useful in the early 1980s?
Why did M2 become more useful in the early 1980s?
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What is the relationship between M2 and inflation?
What is the relationship between M2 and inflation?
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What can be concluded about inflation when the quantity of money grows quickly?
What can be concluded about inflation when the quantity of money grows quickly?
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Why is M2 no longer a useful tool for forecasting inflation?
Why is M2 no longer a useful tool for forecasting inflation?
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What can be concluded about inflation when money growth is low?
What can be concluded about inflation when money growth is low?
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What is the primary purpose of the internal rate of return in investment analysis?
What is the primary purpose of the internal rate of return in investment analysis?
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Which of the following is a characteristic of a bond?
Which of the following is a characteristic of a bond?
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What is the effect of an increase in the interest rate on the present value of a payment?
What is the effect of an increase in the interest rate on the present value of a payment?
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What is the main difference between a risk-free asset and a risky asset?
What is the main difference between a risk-free asset and a risky asset?
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What is the purpose of diversification in investment portfolios?
What is the purpose of diversification in investment portfolios?
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What is the relationship between the bond price and the interest rate?
What is the relationship between the bond price and the interest rate?
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What is the main purpose of credit ratings in the bond market?
What is the main purpose of credit ratings in the bond market?
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What is the main problem that arises when lenders cannot distinguish good credit risks from bad ones?
What is the main problem that arises when lenders cannot distinguish good credit risks from bad ones?
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What is the main characteristic of a zero-coupon bond?
What is the main characteristic of a zero-coupon bond?
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What is the main purpose of the Fisher equation in finance?
What is the main purpose of the Fisher equation in finance?
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What was the effect of the Gramm-Leach-Bliley Financial Services Modernisation Act of 1999?
What was the effect of the Gramm-Leach-Bliley Financial Services Modernisation Act of 1999?
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What is the main advantage cited by owners and managers of large financial firms for creating financial holding companies?
What is the main advantage cited by owners and managers of large financial firms for creating financial holding companies?
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What is the primary function of insurance companies?
What is the primary function of insurance companies?
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What is the term for firms that engage in a wide range of financial (and possibly non-financial) activities?
What is the term for firms that engage in a wide range of financial (and possibly non-financial) activities?
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What is the reason why large financial firms are working hard to provide one-stop shopping for financial services?
What is the reason why large financial firms are working hard to provide one-stop shopping for financial services?
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What type of institutions include payday loan centres, rent-to-own centres, and peer-to-peer lending firms?
What type of institutions include payday loan centres, rent-to-own centres, and peer-to-peer lending firms?
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What is the main difference between life insurance and property and casualty insurance?
What is the main difference between life insurance and property and casualty insurance?
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What is the primary purpose of financial holding companies?
What is the primary purpose of financial holding companies?
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What is the trend in the financial industry with regards to the size of financial firms?
What is the trend in the financial industry with regards to the size of financial firms?
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What is the main characteristic of a financial holding company?
What is the main characteristic of a financial holding company?
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What is the primary purpose of bond ratings?
What is the primary purpose of bond ratings?
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What is the term structure of interest rates?
What is the term structure of interest rates?
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What is the main function of financial intermediaries in terms of risk?
What is the main function of financial intermediaries in terms of risk?
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What is the problem that arises when borrowers know more about their creditworthiness than lenders do?
What is the problem that arises when borrowers know more about their creditworthiness than lenders do?
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What is the main function of collateral in a loan agreement?
What is the main function of collateral in a loan agreement?
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What is the purpose of financial intermediaries in terms of information?
What is the purpose of financial intermediaries in terms of information?
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What is the relationship between bond yields and default risk?
What is the relationship between bond yields and default risk?
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What is the term for bonds that are at serious risk of default?
What is the term for bonds that are at serious risk of default?
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What is the expectations hypothesis of the term structure of interest rates?
What is the expectations hypothesis of the term structure of interest rates?
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What is the problem that arises when lenders cannot distinguish good credit risks from bad ones?
What is the problem that arises when lenders cannot distinguish good credit risks from bad ones?
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What is the primary function of financial intermediaries in terms of liquidity?
What is the primary function of financial intermediaries in terms of liquidity?
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Study Notes
Bond Risks
- Bondholders face three major risks: default risk, inflation risk, and interest rate risk
- Default risk: the risk that the bond issuer will not make promised payments on time
- Inflation risk: the risk that inflation will reduce the real return on a bond
- Interest rate risk: the risk that interest rates will change, affecting the bond's price
Default Risk
- No guarantee that a bond issuer will make promised payments
- Default risk premium: the extra return required to compensate for default risk
- Higher default risk results in a higher yield to maturity
Inflation Risk
- Bonds promise fixed-dollar payments, which are eroded by inflation
- To maintain purchasing power, nominal interest rate should equal real interest rate plus expected inflation plus compensation for inflation risk
- The greater the inflation risk, the greater the compensation for it will be
Interest Rate Risk
- Interest rate risk arises from the uncertainty of a bond's holding period return
- When interest rates change, bond prices move, and the longer the term of the bond, the larger the price change
- The more likely interest rates are to change during the bondholder's investment horizon, the larger the risk of holding a bond
Bond Ratings
- Bond ratings: independent evaluations of a bond issuer's creditworthiness
- Top ratings (Aaa to Baa in Moody's) are considered investment-grade bonds with very low risk of default
- Lower ratings indicate higher default risk, with speculative-grade bonds (below Baa) having a higher risk of default
- Bonds with ratings below investment grade are often referred to as junk bonds or high-yield bonds
Impact of Ratings on Yields
- Bond ratings are designed to reflect default risk
- The lower the rating, the higher the risk of default, and the lower the price and higher the yield
- Yield to maturity is higher for lower-rated bonds to compensate for default risk
Interest Rates and Risk Aversion
- Credit is critical for allocating resources
- Interest rates link the present to the future
- To value monetary payments now and in the future, we need to consider future value and present value
Future Value and Compound Interest
- Future value: the value on a future date of an investment made today
- Compound interest: the interest on interest
- The higher the interest rate or the higher the amount invested, the higher the future value
Present Value
- Present value: the value today of a payment that is promised to be made in the future
- Present value is higher when the future value of the payment is higher, the time until payment is shorter, and the interest rate is lower
Bond Pricing
- The value of a bond varies inversely with the interest rate used to calculate the present value of the promised payments
- The higher the interest rate, the lower the present value of the bond
- The value of a bond rises when yearly coupon payments rise, the interest rate falls, or the time until maturity lengthens
Bond Yields and Term Structure
- Treasury bonds have little default risk and are used as a benchmark for other bonds.
- Yields on other bonds are measured in terms of the spread over Treasuries.
- Bond yields can be thought of as the sum of the risk-free rate and the default-risk premium.
- When Treasury yields move, all other yields move with them.
- Changes in U.S. Treasury yield account for most of the movement in Aaa and Baa bond yields.
Term Structure of Interest Rates
- Bonds with the same default rate and tax status but different maturity dates usually have different yields.
- Long-term bonds are riskier than short-term bonds.
- The term structure of interest rates refers to the relationship among bonds with the same risk characteristics but different maturities.
- Comparing information on 3-month and 10-year Treasury yields, we can see that:
- Interest rates of different maturities tend to move together.
- Yields on short-term bonds are more volatile than yields on long-term bonds.
- Long-term yields tend to be higher than short-term yields.
Expectations Hypothesis
- The expectations hypothesis focuses on the risk-free interest rate.
- If there is no uncertainty about the future, an investor will be indifferent between holding a two-year bond and holding a series of two one-year bonds.
- The expectations hypothesis implies that current two-year interest rate should equal the average of the current one-year interest rate and the one-year interest rate one year in the future.
- If interest rates are expected to rise in the future, long-term interest rates will be higher than short-term interest rates, and the yield curve will slope up.
- If interest rates are expected to fall, the yield curve will slope down.
- If interest rates are expected to remain unchanged, the yield curve will be flat.
Liquidity Premium Theory
- A bond yield can be thought of as having two parts: a risk-free part and a risk premium.
- The expectations hypothesis explains the risk-free part, while the liquidity premium theory explains the risk premium.
- The liquidity premium theory states that the term structure of interest rates is determined by the expectations of future short-term interest rates.
Information in the Risk Structure of Interest Rates
- The risk structure of interest rates reflects the market's expectations of future economic conditions.
- When the risk spread rises, output (GDP) falls.
- The yield curve usually slopes upward, but on rare occasions, short-term interest rates exceed long-term yields, indicating a general economic slowdown.
- The term spread – the difference between yields of different maturities – can be used to forecast GDP growth.
Financial Intermediation
- Financial intermediaries investigate the financial condition of individuals and firms to determine which have the best investment opportunities.
- Financial markets are important because they price economic resources and allocate them to their most productive uses.
- The importance of intermediaries lies in their ability to:
- Pool resources of small savers
- Provide safekeeping and accounting services
- Supply liquidity
- Provide ways to diversify risk
- Collect and process information
- Financial intermediaries perform five functions:
- Pooling resources of small savers
- Providing safekeeping and accounting services, as well as access to the payments system
- Supplying liquidity
- Providing ways to diversify risk
- Collecting and processing information
Diversifying Risk
- Financial institutions enable individuals to diversify their investments and reduce risk.
- Financial intermediaries provide a low-cost way for individuals to diversify their investments.
Collecting and Processing Information
- Financial intermediaries reduce information costs by collecting and processing standardized information.
- Information asymmetry arises when borrowers know more about their business prospects and willingness to work than lenders.
Adverse Selection and Moral Hazard
- Adverse selection arises when lenders can't distinguish between good and bad credit risks.
- Moral hazard arises when lenders can't observe borrowers' actions and therefore can't judge whether a poor outcome was intentional or just a result of bad luck.
- Solutions to adverse selection and moral hazard include:
- Disclosure of information
- Collateral and net worth
- Private information services### Principal-Agent Problem and Moral Hazard
- The separation of ownership from control creates a principal-agent problem, where managers may not act in the best interests of owners/shareholders.
- No foolproof solution has been devised to ensure managers behave in the best interests of owners/shareholders.
Moral Hazard in Debt Finance
- When managers are owners, moral hazard in equity financing disappears.
- Debt contracts allow owners to keep profits in excess of loan payments, encouraging risk-taking.
- Lenders need to ensure borrowers don't take excessive risks, and people with risky projects are attracted to debt finance.
Solving Moral Hazard in Debt Finance
- Legal contracts can solve the moral hazard problem in debt finance.
- Restrictive covenants in bonds and loans limit the amount of risk a borrower can assume.
- Examples of restrictive covenants include maintaining a certain level of net worth, minimum balance in a bank account, or minimum credit rating.
Financial Intermediaries and Information Costs
- Financial intermediaries collect information to reduce information costs and minimize adverse selection and moral hazard.
- To reduce adverse selection, intermediaries screen loan applicants.
- To minimize moral hazard, intermediaries monitor borrowers.
Screening and Certifying to Reduce Adverse Selection
- Loan applicants must fill out an application, which is used to identify them to a company that collects and analyzes credit information.
- The company produces a credit score, which is used to overcome the free-rider problem.
- Banks can collect additional information on borrowers beyond what is included in their loan application or credit report.
Monitoring to Reduce Moral Hazard
- Intermediaries monitor firms that issue bonds and stocks to reduce moral hazard.
- Many financial intermediaries hold significant shares in individual firms and monitor their investments.
- Venture capital firms invest in risky new ventures and monitor their investments closely.
Bank Management
Balance Sheet of Commercial Banks
- Commercial banks provide banking services to businesses, allowing them to deposit funds safely and borrow when necessary.
- A bank's balance sheet specifies its assets, liabilities, and capital (net worth).
Bank Capital and Profitability
- Bank capital (net worth) is the cushion against sudden drops in asset value or unexpected withdrawals of liabilities.
- Capital provides insurance against insolvency.
- Loan loss reserves are an important component of bank capital.
- Measures of bank profitability include return on assets (ROA), return on equity (ROE), and net interest income.
Off-Balance-Sheet Activities
- Banks engage in off-balance-sheet activities to generate fees.
- Examples of off-balance-sheet activities include providing lines of credit and letters of credit.
- Off-balance-sheet activities create risk for financial institutions.
Bank Risk - Liquidity Risk
- Liquidity risk is the risk of a sudden demand for liquid funds.
- Banks face liquidity risk on both sides of their balance sheets.
- Managing liquidity risk involves adjusting assets or liabilities.
- Banks prefer to use liability management to address liquidity risk.
Bank Risk - Credit Risk
- Credit risk is the risk that a bank's loans won't be repaid.
- To manage credit risk, banks can diversify or undergo credit risk analysis.
- Diversification involves spreading risk, which can be difficult for banks.
- Credit risk analysis uses a combination of statistical models and information specific to the loan applicant.
Bank Risk - Interest Rate Risk
- Interest rate risk is the risk of a mismatch between the assets and liabilities on the balance sheet.
- When interest rates rise, banks face the risk that the value of their assets will fall more than the value of their liabilities.
- Managing interest rate risk involves determining the sensitivity of the bank's balance sheet to changes in interest rates.
Bank Risk - Trading Risk
- Trading risk (or market risk) is the risk that the price of an instrument purchased differs from the price at which it's sold.
- Traders normally share in the profit from good investments, but the bank pays for losses.
- Solution to the moral hazard problem in trading is to compute the risk traders generate using measures like standard deviation and value at risk.
Cyber Risk and Other Operational Risks
- Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems.
- Cyber risk is a type of operational risk that arises from the failure of information technology systems or their compromise.
- Financial institutions are vulnerable to cyber risk and must work to protect electronic records and networks.
Financial Industry Structure
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Competition and consolidation are important issues in the financial industry.
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The structure of the financial industry is shaped by factors such as competition, consolidation, and regulation.### Types of Bonds
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Fixed-payment loans: promise a fixed number of equal payments at regular intervals, loans are amortized, and value of the loan today is the present value of all payments
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Coupon bonds: issuer promises to make series of periodic interest payments (coupon payments), plus a principal payment at maturity
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Consols (perpetuities): like coupon bonds, but payments last forever
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Zero-coupon bonds (T-bills): promise to pay a fixed amount on a future date, with no coupon payments, sold at a discount, and have an inverse relationship between interest rate and price
Bond Pricing and Yield
- Yield to maturity (YTM): the return on holding a bond to its maturity, considering coupon rate and bond price
- If bond price = $100, YTM = coupon rate
- If bond price > $100, YTM < coupon rate
- If bond price < $100, YTM > coupon rate
Holding Period Returns
- Holding period return: return on buying a bond and selling it before maturity
- Holding period return = yearly coupon payment / price paid + (change in price / price paid)
- Capital gain or loss affects holding period return, and price changes have a greater impact on longer-term bonds
Bond Market and Interest Rates
- Bond prices are determined by supply and demand in the bond market
- Bond supply curve slopes upwards, and bond demand curve slopes downwards
- Equilibrium is where supply meets demand, and prices adjust to balance supply and demand
- Excess supply leads to downward pressure on prices, while excess demand leads to upward pressure on prices
Risks Associated with Bonds
- Bonds are risky due to changes in interest rates and bond prices
- Investors face potential losses if they sell their bonds before maturity
Money and Inflation
- Until the early 1980s, M1 was used as a measure of money, but with changes in accounts, M2 became more useful.
- M2 includes savings deposits, money-market deposit accounts, and retail money-market mutual fund shares, which represent nearly one-half of GDP.
- The quantity of money growing quickly can produce high inflation, but there is no correlation between M2 and inflation from 1990 to 2019, making M2 no longer a useful tool for forecasting inflation.
- At low levels of money growth, inflation is likely to stay low.
Stablecoins
- Stablecoins are a type of crypto-asset designed to maintain a stable value relative to a specified unit of account or store of value, such as a national currency or commodity.
- They aim to overcome the shortcomings of unbacked crypto-assets.
Financial Institutions
- Depository institutions take deposits and make loans.
- Insurance companies accept premiums, invest in securities and real estate, and promise compensation to policyholders in case of certain events.
- Pension funds invest individual and company contributions in stocks, bonds, and real estate to provide payments to retired workers.
- Securities firms include brokers, investment banks, underwriters, asset management firms, private equity firms, and venture capital firms.
- Finance companies raise funds directly in financial markets to make loans to individuals and firms.
- Government-sponsored enterprises (GSEs) provide loans directly for farmers and home mortgagors.
Interest Rates and Risk Aversion
Valuing Monetary Payments
- To compare the value of payments made on different dates, we need to calculate the future value and present value.
- Future value is the value on a future date of an investment made today.
- The higher the interest rate or the amount invested, the higher the future value.
- Compound interest is the interest on interest.
- Present value is the value today of a payment promised to be made in the future.
- Present value is higher when the future value of the payment is higher, the time until the payment is shorter, and the interest rate is lower.
Bond Basics
- A bond is a promise to make a series of payments on specific future dates.
- Bonds create obligations and are thought of as legal contracts that require the borrower to make payments to the lender and specify what happens if the borrower fails to do so.
- A coupon bond is the most common type of bond, with an issuer making annual payments (coupon payments) and a specified maturity date.
- The present value of the bond principal is affected by the interest rate and the time until the payment.
- The value of a coupon bond rises when the yearly coupon payments rise, and the interest rate falls.
Bond Pricing
- The value of a bond varies inversely with the interest rate used to calculate the present value of the promised payment.
- Nominal interest rate is used to calculate present value, but we need to adjust the return on a loan using the real interest rate, the inflation-adjusted interest rate.
- The Fisher equation states that the nominal interest rate (i) must be based on expected inflation (πe) over the term of the loan, plus the real interest rate (r).
Defining Risk
- Risk is a measure of uncertainty about the future payoff to an investment, assessed over some time horizon and relative to a benchmark.
- Risk is a measure that can be quantified.
- Risk arises from uncertainty about the future.
- Risk has to do with the future payoff of an investment.
- Risk must be assessed over some time horizon.
- Risk must be measured relative to a benchmark, not in isolation.
Measures of Risk
- A risk-free asset is an investment whose future value is known with certainty and whose return is the risk-free rate of return.
- Variance is the average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities.
- Standard deviation is the positive square root of the variance.
- Value at risk (VaR) is the worst possible loss over a specific time horizon, at a given probability.
Risk Aversion, Risk Premium, and Risk-Return Trade-Off
- Risk-averse investors prefer an investment with a certain return to one with the same expected return but any amount of uncertainty.
- A risky investment must have an expected return higher than the return on a risk-free asset – it must offer a risk premium.
- The riskier the investment, the higher the risk premium.
Sources of Risk
- Risks can be classified into two groups: idiosyncratic risks (unique risks) and systematic risks (economy-wide risks).
- Idiosyncratic risks come in two types: one set of firms is affected in one way, and another set in another way.
- Some unique risks are specific to one person or company and no one else.
Reducing Risk through Diversification
- Risk can be reduced through diversification – holding more than one risk at a time.
- Holding several different investments can reduce idiosyncratic risk an investor bears.
- Diversification through spreading of risk is the basis for the insurance business.
Bond Prices and Yields
- Bond prices depend on the bond's characteristics.
- Four basic types of bonds: zero-coupon bonds, promise a single payment, such as a U.S. Treasury bill.### Bond Yields and Term Structure
- Treasury bonds have little default risk and are used as a benchmark for other bonds.
- Yields on other bonds are measured in terms of the spread over Treasuries.
- Bond yields can be thought of as the sum of the risk-free rate and the default-risk premium.
- When Treasury yields move, all other yields move with them.
- Changes in U.S. Treasury yield account for most of the movement in Aaa and Baa bond yields.
Term Structure of Interest Rates
- Bonds with the same default rate and tax status but different maturity dates usually have different yields.
- Long-term bonds are riskier than short-term bonds.
- The term structure of interest rates refers to the relationship among bonds with the same risk characteristics but different maturities.
- Comparing information on 3-month and 10-year Treasury yields, we can see that:
- Interest rates of different maturities tend to move together.
- Yields on short-term bonds are more volatile than yields on long-term bonds.
- Long-term yields tend to be higher than short-term yields.
Expectations Hypothesis
- The expectations hypothesis focuses on the risk-free interest rate.
- If there is no uncertainty about the future, an investor will be indifferent between holding a two-year bond and holding a series of two one-year bonds.
- The expectations hypothesis implies that current two-year interest rate should equal the average of the current one-year interest rate and the one-year interest rate one year in the future.
- If interest rates are expected to rise in the future, long-term interest rates will be higher than short-term interest rates, and the yield curve will slope up.
- If interest rates are expected to fall, the yield curve will slope down.
- If interest rates are expected to remain unchanged, the yield curve will be flat.
Liquidity Premium Theory
- A bond yield can be thought of as having two parts: a risk-free part and a risk premium.
- The expectations hypothesis explains the risk-free part, while the liquidity premium theory explains the risk premium.
- The liquidity premium theory states that the term structure of interest rates is determined by the expectations of future short-term interest rates.
Information in the Risk Structure of Interest Rates
- The risk structure of interest rates reflects the market's expectations of future economic conditions.
- When the risk spread rises, output (GDP) falls.
- The yield curve usually slopes upward, but on rare occasions, short-term interest rates exceed long-term yields, indicating a general economic slowdown.
- The term spread – the difference between yields of different maturities – can be used to forecast GDP growth.
Financial Intermediation
- Financial intermediaries investigate the financial condition of individuals and firms to determine which have the best investment opportunities.
- Financial markets are important because they price economic resources and allocate them to their most productive uses.
- The importance of intermediaries lies in their ability to:
- Pool resources of small savers
- Provide safekeeping and accounting services
- Supply liquidity
- Provide ways to diversify risk
- Collect and process information
- Financial intermediaries perform five functions:
- Pooling resources of small savers
- Providing safekeeping and accounting services, as well as access to the payments system
- Supplying liquidity
- Providing ways to diversify risk
- Collecting and processing information
Diversifying Risk
- Financial institutions enable individuals to diversify their investments and reduce risk.
- Financial intermediaries provide a low-cost way for individuals to diversify their investments.
Collecting and Processing Information
- Financial intermediaries reduce information costs by collecting and processing standardized information.
- Information asymmetry arises when borrowers know more about their business prospects and willingness to work than lenders.
Adverse Selection and Moral Hazard
- Adverse selection arises when lenders can't distinguish between good and bad credit risks.
- Moral hazard arises when lenders can't observe borrowers' actions and therefore can't judge whether a poor outcome was intentional or just a result of bad luck.
- Solutions to adverse selection and moral hazard include:
- Disclosure of information
- Collateral and net worth
- Private information services### The Future of Banks
- In 1999, the Gramm-Leach-Bliley Financial Services Modernisation Act repealed the Glass-Steagall Act of 1933, allowing commercial banks, investment banks, and insurance companies to merge and form financial holding companies.
- This led to the formation of large financial holding companies, such as Citigroup, which already included commercial banking, investment banking, and insurance services.
- Investment firms like J.P.Morgan were acquired by commercial banks, and commercial banks like Bank of America purchased large securities dealers and retail brokers.
Financial Holding Companies
- Financial holding companies are a limited form of universal bank, engaging in a wide range of financial activities.
- In the U.S., different financial activities must be undertaken in separate subsidiaries, and financial holding companies are still prohibited from making equity investments in non-financial companies.
- Owners and managers of large financial firms cite three reasons to create financial holding companies: diversification, economies of scale, and economies of scope.
Non-Depository Institutions
- There are five categories of non-depository institutions: insurance companies, pension funds, securities firms, finance companies, and government-sponsored enterprises.
- Non-depository institutions also include alternative intermediaries, such as payday loan centers, rent-to-own centers, peer-to-peer lending firms, pawnshops, and loan sharks.
Insurance Companies
- Insurance companies specialize in three of the five functions performed by intermediaries: pooling small premiums, diversifying risks, and screening and monitoring policyholders.
- Insurance companies offer two types of insurance: life insurance and property and casualty insurance.
- Life insurance protects the insured against the loss of earnings from disability, retirement, or death, while property and casualty insurance protects against loss or damage to property or assets.
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Learn about the three major risks associated with bond investments, including default risk, inflation risk, and interest rate risk. Understand the concept of default risk premium and its impact on bond returns.
