ECON 305 Study Guide #2 PDF

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Pi = F · CHAPTER IE BEHAVIOR OF INTEREST RATES Perpetuity i = Coupon Payment 1. Wealth-total resources owned by individual , ind. all assets Current Yield Cy = Price payed 2. expected return-return expected over the next period on one asset relative to alternative assets at par : Cy = coupon rate = YTM assets. 3 Risk-degree of uncertainty associated with the return on one asset relative to alternative 4. Liquidity-ease and speed with which an asset can be turned into cash relative to alternative assets THEORY OF PORTFOLIO CHOICE 1. quantity demanded of an asset is positively related to wealth. 2 quantity demanded of an asset is positively related to its expected return relative to alternative assets. 3 quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4 quantity demanded of an asset is positively related to its liquidity relative to alternative assets SUPPLY AND DEMAND IN THE BOND MARKET bond demand bond supply at lower prices (higher interest rates) , ceters paribus , the quantity demanded of bonds is higher at lower prices (higher interest rates) , ceteris paribus , the quantity supplied of bonds is lower an inverse relationship a positive relationship SUPPLY AND DEMAND FOR BONDS MARKET EQUILIBRIUM occurs when the amount that people are willing to buy I demand) equals the amount that people are willing to sell supply) at a given price BP = B' defines the equilibrium lor market clearingl price and interest rate * B x Bs , excess demand - > ↑ price , ↓ interest rate BdxB' , excess supply > - ↓ price ↑ interest rate , SHIFTS IN THE DEMAND FOR BONDS wealth - in an expansion with growing wealth the demand , curve for bonds shifts to the right expected interest rates future for expected returns higher in the lower the expected return long-term - demand left bonds , shifting the curve to the - expected inflation - increase in expected rate of inflations lowers the expected return for bonds , causing the demand curve to shift to the left (Fix + Var( risk-increase in riskiness of bonds causes the demand curve to shift to the left Profit Revenue Total Cost liquidity increased liquidity of bonds results in the demand cuwe shifting to the right - = - SHIFTS IN THE SUPPLY OF BONDS expected profitability of investment opportunities - in an expansion , the supply curve shifts to the right expected inflation an increase in expected inflation shifts the supply curve for bonds to the right - government budget-increased budget deficits shift the supply curve to the right THE LIQUIDITY PREFERENCE FRAMEWORK equilibrium interest rates are determined by the supply and demand for money two ways to hold wealth : money and demand total wealth equals total amount money and bonds B + TS BP Ma of + = terms BS-BP MP_ MS rearrange > - : = if the the money market must also be in SHIFT IN THE DEMAND OF MONEY bond market is in equilibriums equilibrium interest rate to increase Income Effect a higher level of income causes the demand for money at each DEMAND FOR MONEY IN THE LIQUIDITY PREFERENCE FRAMEWORK - and the demand as the interest rate increases : curve to shift to the right Price-Level Effect - a rise in the price level causes the demand for money at each interest rate to increase opportunity cost of holding money increases... and the demand cure to shift to the right the relative expected return of money decreases.. and therefore quantity demanded money decreases.... the of EQUILIBRIUM IN THE MONEY MARKET SHIFTS IN THE SUPPLY OF MONEY assume that the supply of money is controlled by the FACTORS TIL-SHIFT THE DEMAND FOR AND SUPPLY OF MONEL - central bank an increase in the money supply engineered by the Bank of Canada will shift the supply curve for money to the right  CHANGES IN DEMAND FOR MONEY CHANGES IN THE SUPPLY OF MONEY Interest Rate in MS Interest Rate in He MS in in 2 in = 1 > in = ind a Mo ud · > Quantity of Money M · MONEY SUPPLY AND INTERESTRATES (DOES A HIGHER RATE OF GROWTH OF MONEY SUPPLY LOWER INTEREST RATES ? RESPONSE OVER TIME TO INCREASE IN MONEY SUPPLY GROWTH ·monetarepoevemacumshoguneshifts ↑ in interest rates ↑ in money supply in response to higher level of ↑ is a a income to ins LECTURE NOTES : UNDERSTANDING RISK RISK i s a measure of uncertainty about the future payoff of an investment , measured over some time horizon and relative to a benchmark Measure : uncertainties that are not quantifiable can't be priced time horizon : longer is usually more risky Uncertainty about the future future : is one of a series of possible outcomes benchmark : measured relatively to risk-free investment : broadly d e f i n e d payol) : list the possible payoffs MEASURING RISK 1. List all possible outcomes 2. List the probability of each occuring CASE 1 Investment $1000 Prob Payoft Payoff- Prob 1. compute expected value : (1400 - 0.5) + (700 · 0 5). = 1050 1. Rise in value to $1400 #1 700 350. 2 subtract from each pos. payoff : 1400 - 1050 = 350/700 - 1050 = ( - 350) 2 Fall in value. to $700 #2 1400 700. 3 Square both results : 3502 = 122 , 5/7350)2 = 122. 5 > both equally likely 1050 /expected 4. multiply each result times its prob and add up (122 5 0. 5) + 1122 5 0. 5) 122 5 - Sum 1 value : = · -. , ,.. 5 Standard deviation = variance = 122 52 , = $350 CASE 2 What if : a $1000 investment Prob Payoff Prob. Payolf COMPARING CASE 1 & 2 1. ↑ in value to $2000 #1 0 1. 108 10 expected value is same - 1050 or 5% on $1000 inv 2. ↑ in value to $1400 #2 0 4. 700 280 Case 2 has more risk-why ?. 3 ↓ in value to $700 #30. 4 1400 560 consider a risk-free investment $1000 yields $1050 with certainty 4. ↓ in value to $100 #4. 4 0 2000 200 > - compare to Case 1 Sum 1 1050 as spread of potential payoff ↑ , risk * APPLYING THE CONCEPT standard deviation · It's not return that matters 350 just expected (1 > - = investments with return risky 22 higher 528 > are - = > - risk means you can end up with less than the expected return > - NSD > - ↑ risk DEFINING A RISK-FREE ASSET > is an investment future value is with certainty and whose return is the risk-free rate of return TOOLS OF TRADE THE IMPACT OF LEVERAGE ON RISK - whose known - investment VARIANCE Leverage borrowing the finance part of an - deviation of from expected value by the probabilities invest average of squared weighted > the outcomes - · , STANDARD DEVIATION Square root of variance - same units as payoffs $1000 or your own + $1000 borrowed VALUE-AT-RISK expected return and SD doubles · sometimes we are less concerned with spread than with worst possible outcome > - VaR : worst possible loss over a specific horizon at a given probability RISK AVERSION RISK PREMIUM RISK-RETURN TRADEOFF expected return x T exp return higher risk higher =. A SOUREUniquealetaspec risk premium business erdas in or V "riskfree - V y risk more risk I bigger risk premium > - higher expected return T risk requires compensation REDURegosigs Spreading Risk independent payol patterns 2. : make investments with So the more independent sources of risk in your portfolio , the lower the overall risk unrelated you can't always bedge find investments whose payoffs - > are - payof from investment volatile , together the payoffs stable m while each is are only. 2 Sears only. in Bombardier 3 and 1 in sears > - $100 Inv. - > $50 in Bombardier and $50 in Sears has eliminated the risk -hedging CHAPTER 6 : THE RISK AND TERM STRUCTURE OF INTEREST RATIS RISK STRUCTURE OF INTEREST RATES BOND RATINGS bondswiththesamematunityhavedifferentinterstrats duetodeut nliquidityandarconsiderationents or pay off the face value government of Canada bonds considered default free (gov raise taxes > - are. can risk premium : spread between interest rates on bonds with default risk and their interest rates on Isame matunity) Canada bonds liquidity asset : relative ease with which an can be converted to cash > cost of selling bond No of buyers/sellers in market -. , income tax considerations : interest payments on muncipal bonds are exempt from federal income taxes TERM STRUCTURE OF INTEREST RATES bonds with identical risk, , liquidity and tax characteristics may have different interest rates due to different time remaining to maturity vield curve : a plot of the yield on bonds with differing terms to maturity but the same risk , liquidity and tax considerations upwards sloping rales are above short-term rates ~ : long-term flat ~ : Short-and long-term rates are the same inverted : rales are below · short-term rates long-term RESPONSE TO AN INCREASE IN DEFAULT RISK ON CORPORATE BONDS Papmumshisthedemandcuneto the toD : equilibrium price for corporate bonds falls from Ps to Pe and equilibrium interest rate rises to is i n CA market , equilibrium bond prices rises from PT to PT and equilibrium interest rate falls to it -brace indicates the difference between i'2 and in > - the risk premium on corporate bonds FACTS THAT THE THEORY OF THE TERM STRUCTURE OF INTEREST RATES MUST EXPLAIN 1. interest rates on bonds of different maturities move together over time 2. when short-term interest rates are low , yield curves are more likely to have an upward slope , when short-term rates are high yield , curves are more likely to slope downward and be inverted. 3 yield curves almost always slope upward THREE THEORIES TO EXPLAIN THE THREE FACTS 1. expectations theory explains the first two facts but not the third. 3 liquidity premium theory combines the two theories to explain all three facts. 2 Segmented markets theory explains fact three but not the first two EXPECTATIONS THEORY interest rate on a longterm bund will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity bond holders consider bonds with different maturities to be perfect substitutes it today's interest rate 1 period bond Example · = on i + 1 = interest rate on a 1 period bond expected for next period · current rate on Myr bond = 6% S interest rate in Myr = 8% 6 i st today's interest rate 2 period bond expected return for two tyr bonds % 8 buying = on averages expectedturovepetomegthpenobondand holding it -interest rate purchase it or a pornoin hyr bond must be 7% for you to be willing to · on a ·wenbuthiti Lizt = it + iEre itlie is extremely small , simplifying we get it in · explains why the term structure of interest rates changes at different times explains why interstrales onbondswithdifferentmatunitiemove s together overtie d slope up when short-term rates are high cannot explain why yield curves usually slope upware SEGMENTED MARKETS THEORY of different disubstitutesatals bonds maturities are not the interest rates for each bond with a determined by the demand for and the supply of that nan investors have preferences for bonds with specific maturities prefer bonds with (Fact if investors generally shorter maturities that have less interest rate risk , than this explains why yield curves usually slope upwards 31 LIQUIDITY PREMIUM AND PREFERRED HABITATTHEORIES the interest rate on a long-term bond will equal an average on a short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond bonds with different maturities are partial (not perfect substitutes LIQUIDITY PREMIUM THEORY it + in + i +... + iE +a + (n 1)- int n = + Int > Int liquidity premium for the n-period bond at time - i is always positive and increases with term to maturity - = PREFERRED HABITAT THEORY investors have a preference for bonds of one maturity over another they will be willing to buy bonds of other maturities only if they earn a somewhat higher ELR) · investors are likely to prefer short-term bonds over long-term bonds CHAPTER 7 : THE STOCK MARKET , THE THEORY OF RAT EXPECTATIONS AND THE EFFICIENT MARKET HYPOTHESIS. COMMON STOCK the principal way that corporations > is raise equity capital - stockholders have the right to vote and be residual claimants of all funds flowing to the company dividends are payments made periodically to stockholders · ONE PERIOD VALUATION MODEL GORDON GROWTH MODEL Poly DIVe Pr Po = 1tke + 1 + ke Po = Po current stock price most recent dividend paid rale in dividends : Do = g = expected constant growth DV : dividend paid at end of year 1 ke = required return on an investment in equity ke required return of investment equity Dividends assumed to continue at constant rate forever : in are growing a Pr sale stock price at end of 1st period is assumed to be less than required return equity : growth rate on GENERALIZED DIVIDEND VALUE MODEL