Introduction to Financial Institutions PDF

1. Introduction Main function performed by financial institutions Inflation, nominal interest rate, and real interest rate Bond valuation Yield Yield curve Related textbook chapters: 1, 2, and 3 1 1.1 Main function performed by financia...

1. Introduction Main function performed by financial institutions Inflation, nominal interest rate, and real interest rate Bond valuation Yield Yield curve Related textbook chapters: 1, 2, and 3 1 1.1 Main function performed by financial institutions In a modern economy, there are many financial institutions, e.g., commercial banks, investment banks, mutual funds, hedge funds, and credit rating agencies. Financial institutions facilitate funds transfer from suppliers to users. In some transactions, there is no need for a financial institution. In the following example, a small company borrows directly from the owner’s friends. 2 In other transactions, a financial institution is useful or even necessary. In the following example, a credit rating agency (Moody’s) facilitates funds transfer. 3 In the following example, a bank facilitates funds transfer. Several questions naturally arise: How do banks make money? Why don’t companies borrow directly from households? What risks do banks face? How do banks manage risks? 4 1.2 Inflation, nominal interest rate, and real interest rate Inflation: The percentage increase in the price of a standardized basket of goods and services over a given period. One way to measure inflation is to use the Consumer Price Index (CPI). Example: In April 2023, the CPI was 303.363. In April 2024, the CPI was 313.548 (source: The Bureau of Labor Statistics). Therefore, over that period, inflation was: 313.548 − 303.363 = 3.4% 303.363 Note: (1) We usually calculate the change in the CPI over a 12-month period. (2) We can say that inflation was 3.4% in April 2024. (3) Inflation calculated using the CPI is also called headline inflation. 5  Headline inflation (%) 10 8 6 4 2 0 2014 2016 2018 2020 2022 2024 -2 https://data.bls.gov/timeseries/CUUR0000SA0?output_view=pct_12mths 6 Core inflation: The percentage increase in the consumer price index that excludes the categories of food and energy prices over a given period. Example: In April 2023, the CPI “all items less food and energy” was 306.899. In April 2024, the index was 317.978 (source: The Bureau of Labor Statistics). Therefore, over that period, core inflation was: 317.978 − 306.899 = 3.6% 306.899 7 Core inflation is less volatile than headline inflation. Some people believe that core inflation can be useful in assessing inflation trends. Core inflation (%) 10 8 6 4 2 0 2014 2016 2018 2020 2022 2024 -2 https://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths 8 The Wall Street Journal, May 15, 2024 “U.S. inflation eased slightly in April, offering relief to investors and the Federal Reserve after a run of economic data at the start of the year revealed simmering price pressures. The consumer-price index, a gauge for goods and service costs across the U.S. economy, rose 3.4% in April from a year ago, the Labor Department said Wednesday. Core prices that exclude volatile food and energy items climbed 3.6% annually, the lowest increase since April 2021.” 9 Expected inflation: At a given point in time, the expected percentage increase in the price of a standardized basket of goods and services over a future period. Nominal interest rate: The interest rate that is observed on a security. Example: On August 9, 2024, the following interest rates were observed: Interest rate (%) 30-year mortgage, fixed 7.04 15-year mortgage, fixed 6.39 New-car loan, 48-month 7.84 https://www.wsj.com/market-data/bonds Real interest rate: The interest rate that would be observed on a security if no inflation is expected over the holding period of the security. 10 Fisher effect: The relationship among nominal interest rate, real interest rate, and expected inflation is 1 + 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = (1 + 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) × (1 + 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖) Because real interest rate and expected inflation are usually small, their interaction term is very small. Thus, the above expression can be approximately written as 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 Example: Suppose that currently nominal interest rate is 3.6% and real interest rate is 1.5%. Then, expected inflation is: 3.6% − 1.5% = 2.1% 11 An illustration of the Fisher effect 12 1.3 Bond valuation Coupon interest: The periodic cash flow that the bond issuer promises to pay the bondholder. Example: A $1,000 face value bond pays 10 percent coupon interest per year, with the coupon interest paid semiannually (i.e., $50 after every six months). Required rate of return on a security: The return that investors require for holding this security. The present value of a bond is given by 𝐶𝐶𝐶𝐶1 𝐶𝐶𝐶𝐶2 𝐶𝐶𝐶𝐶3 𝐶𝐶𝐶𝐶𝑛𝑛 𝑃𝑃𝑃𝑃 = + + + ⋯+ (1 + 𝑟𝑟)1 (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)3 (1 + 𝑟𝑟)𝑛𝑛 where CFt is the cash flow to be received in period t (t = 1,..., n), r is the required rate of return per period, and n is the number of periods in the investment horizon. 13 Example (a zero-coupon bond): A $1,000 face value bond matures in one year. It does not pay coupon interest. If the required rate of return on this bond is 8 percent per year, its present value is: 1,000 𝑃𝑃𝑃𝑃 = = 925.93 1 + 8% If this bond matures in six years, its present value is: 1,000 𝑃𝑃𝑃𝑃 = = 630.17 (1 + 8%)6 14 Example (a coupon bond): A $1,000 face value bond matures in 12 years. It pays 10 percent coupon interest per year, with the coupon interest paid semiannually (i.e., $50 after every six months). The required rate of return on this bond is 8 percent per year. The present value of this bond is 50 50 50 1,050 𝑃𝑃𝑃𝑃 = + + + ⋯+ (1 + 4%)1 (1 + 4%)2 (1 + 4%)3 (1 + 4%)24 = 1,152.47 If the required rate of return on this bond becomes 10 percent per year, its present value becomes 50 50 50 1,050 𝑃𝑃𝑃𝑃 = + + + ⋯+ (1 + 5%)1 (1 + 5%)2 (1 + 5%)3 (1 + 5%)24 = 1,000 15 1.4 Yield Yield to maturity (or simply yield): The return that the bondholder will earn on a bond if he or she buys the bond at its current market price, receives all the interest and principal payments as promised, and holds the bond until maturity. Note: Yield is the return per year, not per period. Example: On August 9, 2024, the yield on 10-year Treasury securities was 3.94 percent (source: The Department of the Treasury). 16 Example: A $1,000 face value bond matures in 12 years. It pays 10 percent coupon interest per year, with the coupon interest paid semiannually (i.e., $50 after every six months). The current market price of this bond is $1,100. What is the yield on this bond? 50 50 1,050 1,100 = + + ⋯+ (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)1 (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)2 (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)24 ⇒ 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 = 8.64% If the market price of this bond becomes $900, what is the yield on this bond? 50 50 1,050 900 = + + ⋯ + (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)1 (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)2 (1 + 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦/2)24 ⇒ 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 = 11.56% 17 An article in The Wall Street Journal on July 19, 2011 reports that: “The value of Eastman Kodak Co.’s bonds is sinking rapidly, a sign of growing concern the faded one-time blue chip is running out of time to adapt to the changes sweeping its industry. [...] Kodak, which had $1.3 billion in cash at the end of March, said it has enough funds. ‘We have the resources to fully pay our obligations, and we are confident that will continue to be the case,’ Kodak spokesman Dave Lanzillo said. Some investors aren’t waiting around. Bonds that come due in 2013 have been dumped for prices well below face value and now yield more than 16%, a sign investors are demanding higher compensation for the risk of lending to Kodak.” Note: Kodak filed for bankruptcy protection on January 19, 2012. 18 Usually, after hearing bad news about financial markets or the real economy, investors want to reduce their holdings of risky assets (e.g., stocks), and increase their holdings of safe assets (e.g., Treasury securities). This is known as “flight to safety.” Note: Treasury securities are debt securities issued by the Department of the Treasury, which is part of the U.S. federal government. Later in this course we will discuss different types of Treasury securities such as Treasury bills, Treasury notes, and Treasury bonds. 19 An article in The Wall Street Journal on August 23, 2019 reports that: “Stocks, government bond yields and commodities fell in a wild session Friday as anxieties over trade relations with China sparked fresh worries about global growth and the potential for a recession. The Dow Jones Industrial Average dropped 623.34 points, or 2.4%, after China said it would impose retaliatory tariffs on additional U.S. products and President Trump vowed on Twitter to respond. [...] Investors scooped up traditionally safer assets like government bonds and gold Friday, sending the yield on the 10-year Treasury note down for the fourth consecutive week to 1.523% Friday, from 1.613% Thursday. Yields fall as bond prices rise.” 20 The yield on a bond is calculated by assuming that all the promised interest and principal payments will be received. As a result, it may or may not be what the bondholder will earn. If the bond issuer defaults, the bondholder’s actual return will be (much) lower than the yield. Example: In February 2007, CIT Group Inc. issued $500 million bonds with 5-year maturity. The yield was 5.4%. In November 2009, CIT filed for bankruptcy protection. Bondholders were expected to lose most of the remaining interest and principal payments (source: The Wall Street Journal). 21 The following table reports the yields on several securities on August 8, 2024. Yield (%) 1-month Treasury securities 5.55 2-year Treasury securities 4.04 10-year Treasury securities 3.99 Corporate bonds, Aaa rated 5.05 Corporate bonds, Baa rated 5.77 https://home.treasury.gov/resource-center/data-chart-center/interest- rates/TextView?type=daily_treasury_yield_curve https://fred.stlouisfed.org/series/DAAA https://fred.stlouisfed.org/series/DBAA 22 The yield on a security depends on a few factors, such as: (1) Default risk (also known as credit risk): The risk that a security issuer may fail to make the promised interest or principal payments. Investors typically require higher yields for holding securities with higher default risk. (2) Maturity: Investors typically require different yields for holding securities with different maturities. (3) Liquidity: An asset is said to be liquid if it can be converted to cash quickly with little or no loss in value. Otherwise, the asset is said to be illiquid. Investors typically require higher yields for holding illiquid assets. In this course, we assume all the investment securities are liquid. 23 1.5 Yield curve Yield curve: A plot of the yields on debt securities with different maturities but same default risk, liquidity, and tax considerations. In practice, yield curve is often constructed using Treasury securities. Note: Investors usually believe that Treasury securities have no default risk. Treasury securities are very liquid and have the same tax considerations. The most observed shape of yield curve is upward sloping, i.e., debt securities with longer maturities offer higher yields. But other shapes are also possible. 24  An upward-sloping yield curve (April 1, 2009) 4% 3% 2% 1% 0% 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y https://home.treasury.gov/resource-center/data-chart-center/interest- rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2009 25  A flat yield curve (May 22, 2007) 6% 5% 4% 3% 2% 1% 0% 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y https://home.treasury.gov/resource-center/data-chart-center/interest- rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2007 26  An inverted yield curve (May 25, 2023) 7% 6% 5% 4% 3% 2% 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 20Y 30Y https://home.treasury.gov/resource-center/data-chart-center/interest- rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2023 27