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Lecture 1 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. Topics Course information Understanding interest rates Behaviour of interest rates Course...

Lecture 1 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. Topics Course information Understanding interest rates Behaviour of interest rates Course information Mandatory readings: Mishkin, F.S. (2022). The Economics of Money, Banking & Financial Markets. 13th edition, ISBN: 978-1-292-40948-1, 718 pages (ca. €70); Veestraeten (2019). “Macroprudential regulation: Guiding principles and instruments”, mimeo. Available on Canvas. Tutorials: 22 groups (on-site only). Canvas: Consult it regularly for announcements, solutions to the tutorial exercises, important messages related to the exam, etc. Course information Exams: representative (midterm and final) exam questions can be found on Canvas. exam materials: everything (book, all materials on Canvas, etc.). mid-term exam of 1.5 hours, only multiple-choice questions, 30% of the final mark of the course (result will be ignored in the resit exam). final exam of 2 hours that counts for 70% of the final mark and that consists of multiple-choice questions and open questions. Note: the open questions at the final exam cover the materials of the entire course, whereas the multiple-choice questions at the final exam only cover the last three lecture week of the course. In order to pass the course in the first exam round, the grade for the final exam should at least be 5.5 (no rounding) and the weighted average of the marks for the mid-term exam and the final exam should at least be 5.5 (no rounding). Course information Resit exam: 2 hours with multiple-choice questions and open questions that both cover the materials of the entire course. The result for the mid-term exam is ignored. In order to pass the course in the resit round, the grade for the resit exam should at least be 5.5 (no rounding). There are no conditions as to participation. All exam questions are formulated in English and are to be answered in English. Language dictionaries are not allowed for at the exams. Programmable pocket calculators are not allowed for at the exams. The faculty’s policy of using a guessing correction for the multiple-choice questions will be applied (see the syllabus for the formula). Course information Important note on the lectures and tutorials: Attendance at the lectures and tutorials is not compulsory (attendance at the tutorials is registered). However, past experience has illustrated convincingly that a high correlation exist between attendance and the final mark for the course. That should not come as a surprise as the exams obviously test knowledge that will be trained/discussed intensively in the lectures and tutorials. Course information Week 1: Understanding Interest Rates and their Behaviour Week 2: Risk and Term Structure of Interest Rates; Stock Market Week 3: Economics of Financial Structure; Economics of Banking Week 4: Midterm exam Week 5: Financial Crises and the Global Financial Crisis Week 6: Goals and Structure of Central Banks; Money Supply Process Week 7: Tools, Strategy and Tactics of Monetary Policy; Aspects of Micro- and Macroprudential Regulation Week 8: Some representative exam questions; Final Exam Interest rates on selected bonds (1950-2020) Present Value (or Present Discounted Value) PV = today’s present (discounted) value CF = future cash flow (payment) i = the interest rate n = years to maturity CF PV = (1 + 𝑖)n The Yield to Maturity (YTM) is the interest rate that equates today’s value with today’s present value of all future cash flows up to the maturity date (i.e., up to the final date). Credit Market Instruments Four Main Types: 1. Simple loan (e.g., some commercial loans, interbank loans) 2. Fixed-payment loan (e.g., fixed-rate mortgage) 3. Coupon bond (e.g., government and corporate bonds) 4. Discount (zero-coupon) bond (e.g., Treasury bills) Simple Loan Simple Loan: the lender provides the borrower with an amount of funds (principal) that must be repaid at the maturity date, along with an additional interest payment. PV = today’s (present) value of loan CF CF = cash flow PV = (1 + i ) n n = number of years 110 E.g. 100 = 1 => (1 + i )100 = 110 (1 + i ) 110 − 100 10 i= = = 0.10 = 10% 100 100 Fixed-Payment Loan Fixed-payment loan: must be repaid by making the same payment (consisting of a part of the principal and interest) every period for the entire duration of the loan. LV = loan value FP FP FP LV = + 2 +... + FP = fixed payment (1 + i ) (1 + i ) (1 + i ) n n = years until maturity E.g., Fixed-Payment Loan (LV=1000, FP = 126, n = 25) 126 126 126 1000 = + 2 +... + 25  i = 12% (1 + i ) (1 + i ) (1 + i ) Coupon bond Coupon bond: pays the owner of the bond a fixed payment (coupon payment) every year until the maturity date, when a specified final amount (face value) is repaid. F = face value of the bond C C C F P= + 2 +... + + 1+i (1+i) (1+i) (1+i) n n n = number of years until maturity P = price of the bond C = fixed coupon payment = cF c = coupon rate Coupon Bond: Examples What is the yield to maturity of this coupon bond? P = 1,000 ("at par") F = 1,000 c = 10% n = 10 100 100 100 100 1,000 1,000 = + 2 + 3 +... + 10 + (1+i ) (1+i ) (1+i) (1+i) (1+i)10 => i = 10% And... P = 900 ("below par") F = 1,000 c = 10% n = 10 100 100 100 100 1,000 900 = + 2 + 3 +... + 10 + (1+i ) (1+i ) (1+i) (1+i) (1+i)10 => i = 11.75% Relationship Between Price and Yield to Maturity Three Key Facts 1. When the bond is priced at its face value (“at par”), i.e., P = F, the yield to maturity equals the coupon rate, i.e., i = c 2. Prices and yields to maturity are negatively related 3. The yield to maturity is larger (smaller) than the coupon rate when the bond price is below (above) the par value, i.e., is below (above) par Special case of the coupon bond: Consol or Perpetuity Consol: a bond with no maturity date that thus does not repay the principal (there is no principal) but that pays fixed coupon payments forever. The formula for the price of the consol (Pc) is: Pc = C / ic Pc = price of the consol C = yearly coupon payment ic = yield to maturity of the consol or ic = C / Pc For coupon bonds, the equation for the yield of a consol gives an easy-to-calculate approximation of the yield to maturity of the coupon bond. This approximation is the more accurate, the nearer the price is to par and the longer the maturity of the coupon bond is. Discount (Zero-Coupon) Bond Discount (zero-coupon) bond: bought at a price below the face value (i.e., is bought at a discount), and the face value is repaid at maturity (similar to the simple loan). Obviously, the notion of “buying at a discount” implies that the yield is positive. One-year discount bond: F F −P P= => i = (1 + i ) P 1,100 - 1,000 e.g. 10% = 1,000 Discount (Zero-Coupon) Bond Important note: Some practitioners, however, discuss discount bonds as coupon bonds that are traded below par. We follow the definition of Mishkin: the notion of discount bond thus is to be treated as a synonym for a zero-coupon bond, i.e., for a bond that has no coupon payments. Distinction Between Interest Rate and (Rate of) Return (Expected) Rate of return at time t on a coupon bond that will be held from time t until time t+1: e C + Pet+1 – Pt RETt = Rt = = ic + g e Pt C where: ic = = current yield Pt Pet+1 – Pt ge = = rate of expected capital gain Pt Relationship Between Interest Rate and (Rate Of) Return Maturity and the Volatility of Bond Returns Key Facts: 1. Only bonds whose return = the yield are the ones with maturity = the holding period (and obviously vice versa). 2. Typically, if the maturity > the holding period and i ↑, then P↓ implying a capital loss (this is the general rule, see the tutorial for a counterexample to this general rule). 3. The longer the time to maturity, the greater is the percentage price change of the bond that is caused by an interest rate change. 4. The longer the time to maturity, the more the rate of return will change with a change in the interest rate. 5. A bond with a high initial yield can still have a negative rate of return if i ↑. Maturity and the Volatility of Bond Returns Conclusions from this analysis: 1. Prices and returns are more sensitive/volatile to changes in interest rates for long(er)- term bonds: these bonds have a higher “interest-rate risk”. 2. No interest-rate risk for any bond whose time to maturity equals the holding period. Distinction between real and nominal interest rates Real interest rate (r) = nominal interest rate (i) “adjusted” for the expected inflation rate (e) r = i – e Fisher equation: i = r + e 1. The real interest rate is at times also denoted as ir 2. The real interest rate reflects the true cost of borrowing as well as the true return to lending. 3. When the real interest rate is lower, the incentives to borrow (lend) are larger (smaller): if i = 5% and e = 3% => r = 5% – 3% = 2% if i = 8% and e = 10% => r = 8% – 10% = –2% Distinction between real and nominal interest rates Note: The previous slide defined the ex ante real interest rate. Often, also ex post real interest rates are discussed. The ex ante real interest rates are predictions based on the expected inflation rate and thus give an indication of what the real cost (benefit) of borrowing (lending) is expected to be over – for instance – the next year. The ex post real interest rates use the past inflation rate to calculate what the real cost (benefit) of borrowing (lending) has been over – for instance – the past year. US Real and Nominal Interest Rates (Three-month Treasury Bill, 1953-2020) Behaviour of Interest Rates Factors explaining fluctuations in nominal interest rates Tool: supply and demand analysis Demand for and Supply of Bonds Demand for bonds: At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher. => negative relationship between price and quantity Supply of bonds: At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower. => positive relationship between price and quantity Derivation of the Demand for Bonds Zero-Coupon Bond e (F – P) R = i = i = interest rate or yield to maturity P Re = expected return Point A: F = face value of the discount bond = 1000 P = initial purchase price of the discount bond P = 950 (1000 – 950) i= = 0.053 = 5.3% 950 d Let us assume that the quantity of bonds demanded B is at: d B = 100 billion Derivation of the Demand of Bonds Point B: P = 900 (1000 – 900) i= = 0.111 = 11.1% 900 d B = 200 billion d Point C: P = 850, i = 17.6% B = 300 billion d Point D: P = 800, i = 25.0% B = 400 billion d Point E: P = 750, i = 33.0% B = 500 billion d The demand curve is B and connects the points A, B, C, D, E, and it has the usual downward slope. Derivation of the Supply of Bonds s Point F: P = 750, i = 33.0%, B = 100 billion s Point G: P = 800, i = 25.0%, B = 200 billion s Point C: P = 850, i = 17.6%, B = 300 billion s Point H: P = 900, i = 11.1%, B = 400 billion s Point I: P = 950, i = 5.3%, B = 500 billion s The supply curve is B and connects the points F, G, C, H, I, and it has the usual upward slope. Demand and Supply Analysis of the Bond Market Market Equilibrium d s 1. Occurs when B = B , at P* = 850, i* = 17.6% 2. When P = 950, i = 5.3%, s d B > B (excess supply): P  to P*, i to i* 3. When P = 750, i = 33.0, d s B > B (excess demand): P  to P*, i  to i* Shift in the Demand for Bonds Factors that Shift the Demand for Bonds: “Theory of Asset Demand” 1. Wealth: total resources in the economy / at the level of the individuals Economy grows: wealth , Bd , Bd shifts to the right Note: when wealth increases, we can expect that the demand for all asset categories increases (cf. portfolio diversification). 2. Expected return of bonds relative to the expected return of other assets Expected return of bonds relative to that of other assets decreases: Bd shifts to the left Expected interest rate (ceteris paribus): ie , Pe , Re , Bd shifts to the left Expected inflation (ceteris paribus): e , r , Bd shifts to the left Factors that Shift the Demand for Bonds: “Theory of Asset Demand” 3. Risk when investing in bonds relative to the risk of other assets Risk of bonds relative to the risk of other assets , Bd , Bd shifts to the left 4. Liquidity of bonds relative to the liquidity of other assets (liquidity = the ease and speed with which an asset can be turned into cash at low cost and without incurring a major value loss) Liquidity of bonds relative to the liquidity of other assets , Bd , Bd shifts to the right An example of an increase in the liquidity of bonds: the introduction of the Belgian OLOs (in French / Dutch: Obligations Linéaires / Lineare Obligaties, in English: linear bonds). Bonds with one particular coupon rate, face value and one particular maturity date are called “lines” (e.g., the “line” of March 2029 6% coupon bonds). New bonds are issued that have the coupon rate and the maturity date of a particular “line”. They may be issued at a higher/lower/identical price when compared with the previous bonds of that “line” such that their yield to maturity reflects the market conditions at the time of issuance. Each new bond issuance then increases the outstanding amount of that particular “line”, i.e., the size of the market of that particular “line” and hence its liquidity increases. - 35 - Shifts in the Supply of Bonds: “Theory of Asset Supply” Factors that Shift the Supply of Bonds : “Theory of Asset Supply” 1. Expected Profitability of Investments Business cycle expansion, investment opportunities , Bs , Bs shifts to the right. 2. Expected Inflation  e , r , Bs , Bs shifts to the right: the lower real interest rate thus leads to a larger supply of bonds for a given nominal interest rate (cf. movement of Bs to the right) given that the real cost of bond financing decreases. 3. Government Deficit Deficit (G - T) , Bs , Bs shifts to the right. Note: Keynes’ liquidity preference framework has been covered in other courses such that its treatment on p. 150-161 in Chapter 5 is NO exam material References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 8: Figure 1 on p. 52 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 2. Slide 15: Table 1 on p. 120 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 3. Slide 20: Table 2 on p. 126 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 4. Slide 25: Figure 1 on p. 130 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 5. Slide 31: Figure 1 on p. 138 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 6. Slide 32: Figure 2 on p. 141 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 7. Slide 36: Table 2 on p. 142 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 8. Slide 37: Figure 3 on p. 145 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 9. Slide 39: Table 3 on p. 144 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. Lecture 2 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- 4-2 Topics 1. More on the Fisher effect 2. Inflation-indexed bonds and extracting inflation expectations 3. Interpretation of 10-year government bond yields in the UK -2- Distinction between real and nominal interest rates Real interest rate (r) = nominal interest rate (i) “adjusted” for the expected inflation rate (e) r = i – e Fisher equation: i = r + e 1. The real interest rate is at times also denoted as ir. 2. The real interest rate reflects the true cost of borrowing as well as the true return to lending. 3. When the real interest rate is lower, the incentives to borrow (lend) are larger (smaller): if i = 5% and e = 3% => r = 5% – 3% = 2% if i = 8% and e = 10% => r = 8% – 10% = –2% Distinction between real and nominal interest rates The Fisher equation actually is an approximation (≈) although it typically is presented as an equality (=). This is an acceptable practice as long as one examines an environment in which both the real interest rate and the expected inflation rate are small (see below). Indeed, the expected real outcome, i.e. in purchasing-power terms, of investing 1 now for one year can be expressed in two ways: 1+r (1 + i) / (1 + e ) -4-  Distinction between real and nominal interest rates Thus: 1 + r = (1 + i) / (1 + e ) 1 + i = (1 + r) (1 + e ) 1 + i = 1 + r + e + r e r e ≈ 0 if r and e are small (e.g., r e = 0.0006 if r = 0.03 and e = 0.02). Then: 1 + i ≈ 1 + r + e i ≈ r + e -5- Changes in e : “The Fisher Effect” One can illustrate the Fisher equation or Fisher effect via the bond market. For brevity, the below focusses on the corporate bond market. Suppose, e increases. The Fisher equation predicts that the nominal interest rate then will increase as well. -6- Changes in e : “The Fisher Effect” The effects on the bond market and thus on the interest rate can be studied via the theory of demand and supply for the bond market that we examined in the previous lecture: Demand for corporate bonds decreases as the expected real return of corporate bonds relative to the expected real return of other assets decreases -> Bd shifts to the left. Supply of corporate bonds increases as the expected real cost of borrowing by issuing bonds decreases -> Bs shifts to the right. The price of corporate bonds decreases and ultimately the nominal interest rate increases as illustrated on the next slide. -7- Changes in e : “The Fisher Effect” -8- Evidence of the “Fisher Effect” in the US, three-month Treasury bill, 1953-2020 -9-  Evidence of the “Fisher Effect” in the US, three-month Treasury bill, 1953-2020 Expected inflation and the nominal interest rate are typically positively related to each other (not only in the US). Two implications: The real interest rate generally is fairly stable. Keeping nominal interest rates low and stable requires that expected inflation rates should also remain low and stable. Phrased differently, the move since the 1990s by most central banks towards keeping inflation (expectations) low contributed to observing low nominal interest rates. We will study central banks later in the course and also study one of the negative effects of low nominal interest rates when examining the financial crisis of 2007-2008. - 10 - Interest rates and the business cycle Typically, nominal interest rates increase during a business cycle expansion. We will illustrate this again for the corporate bond market. - 11 - Interest rates and the business cycle The effects of a business cycle expansion on the market for corporate bonds: Supply of corporate bonds increases as expected profitability increases -> Bs shifts to the right. Demand for corporate bonds increases as wealth increases -> Bd shifts to the right. Typically, the price of corporate bonds decreases and thus the nominal interest rate increases during a business cycle expansion as illustrated in the following slide. - 12 - Interest rates and a business cycle expansion - 13 - Interest rates and the business cycle Note that the interest rate – in the previous slide – could in principle also decrease during a business cycle expansion. Indeed, that would happen if demand would have increased to a stronger degree than supply. However, that is not what we typically observe as evidenced in the following slide. The typical increase in interest rates during business cycle expansions is not that surprising when thinking in terms of the Fisher effect: growing product and labour demand in a business cycle expansion tend to increase expected inflation and nominal interest rates. - 14 - Interest rates and the business cycle: US, three-month Treasury bills, 1951-2020 - 15 - Inflation-indexed bonds What are inflation-indexed bonds? An inflation-indexed bond is a coupon bond of which the face value (the principal) is adjusted for inflation. The coupon rate is fixed and the periodic coupon payments thus are a fixed rate of the inflation-adjusted face value and as such are also adjusted for inflation. Thus, the income streams (repayment of the face value and the coupon payments) move up and down with inflation. - 16 - Inflation-indexed bonds Why do inflation-indexed bonds exist? Governments of countries with a history of high inflation rates have often issued and still often issue inflation-indexed bonds (e.g., in 2017 about 36% of Brazilian government bonds were inflation-indexed bonds). These bonds offer the holder cash flows that are constant in real terms, i.e., constant in purchasing-power terms. Such bonds are therefore attractive to investors when expectations of high and volatile inflation exist (such expectations are quite persistent in reality). Indeed, investors may be very hesitant to buy (government) bonds if such indexation feature were not present. - 17 - Inflation-indexed bonds However, also – for instance – the governments of the US, the UK, Japan, Canada, Germany and Italy issue inflation-indexed bonds. In 2017, 9% of government bonds worldwide were inflation-indexed bonds. The reason for this is not related to fears of high inflation in these countries given that their central banks have a clear and credible anti-inflation stance. Such bonds, in conjunction with identical bonds that possess no such indexation feature, allow investors, unions, governments and central banks to obtain market estimates on expected inflation. - 18 - Inflation-indexed bonds These market estimates on expected inflation are very useful for: Unions that can let those market estimates enter into wage negotiations. Indeed, unions desire to ensure that nominal wages increase with (expected) inflation in order to keep the real wage constant, i.e., to keep the purchasing power of wages constant. Central banks of which the mandate nowadays mostly focusses on keeping inflation low (see later in the course). Information on market estimates and thus on the confidence in the central bank’s ability to fulfil the mandate then are particularly useful. … - 19 - Inflation-indexed bonds How to obtain these market estimates on expected inflation? Example: a 10-year inflation-indexed coupon bond and a 10-year non-inflation indexed coupon bond that apart from the indexation feature are otherwise completely identical. Notation: o F = the face value o c = the coupon rate o C = the yearly coupon payment (= c F) o πe = annual expected inflation rate expected over the maturity of the bond. - 20 - Inflation-indexed bonds The price of the non-indexed bond (PNI): 𝐶 𝐶 𝐶 𝐹 𝑃𝑁𝐼 = + +…+ + 1+𝑖 1 1+𝑖 2 1+𝑖 10 1+𝑖 10 The price of the inflation-indexed bond (PI): 𝐶 1+𝜋𝑒 1 𝐶 1+𝜋𝑒 2 𝐶 1+𝜋𝑒 10 𝐹 1+𝜋𝑒 10 𝑃𝐼 = + +…+ + 1+𝑖 1 1+𝑖 2 1+𝑖 10 1+𝑖 10 Remember from the previous slides that 1 + r = (1 + i) / (1 + e ) and thus that (1 + e ) / (1 + i) = 1 / (1 + r). As a result: 𝐶 𝐶 𝐶 𝐹 𝑃𝐼 = + +…+ + 1+𝑟 1 1+𝑟 2 1+𝑟 10 1+𝑟 10 - 21 - Inflation-indexed bonds As C, F and the time to maturity are contract specifications (and thus are known) and both PI and PNI are observable market prices (bonds are quoted on exchanges), the price equations for PI and PNI allow us to calculate both i and r. Knowing i and r and using the Fisher equation (i = r + e ) then yields the market expectation on expected inflation, namely e. See the next slide for the case of 10-year US Treasury securities. - 22 - 6,00 5,00 4,00 3,00 2,00 1,00 0,00 -1,00 -2,00 real yield nominal yield expected inflation 10-year nominal government bond yields in the UK Plots of government bond yields of a country can give us a variety of information on the economic situation, the national and international environment as well as central bank behaviour. The following two slides illustrate this for the United Kingdom since 2000. - 24 -  0 1 2 3 4 5 7 6 04 Jan 00 12 Jun 00 14 Nov 00 24 Apr 01 28 Sep 01 06 Mar 02 14 Aug 02 21 Jan 03 30 Jun 03 02 Dec 03 12 May 04 15 Oct 04 23 Mar 05 31 Aug 05 06 Feb 06 14 Jul 06 18 Dec 06 UK nominal yield, 2000-2022 30 May 07 01 Nov 07 10 Apr 08 16 Sep 08 20 Feb 09 30 Jul 09 06 Jan 10 15 Jun 10 17 Nov 10 27 Apr 11 04 Oct 11 09 Mar 12 17 Aug 12 24 Jan 13 03 Jul 13 05 Dec 13 16 May 14 21 Oct 14 27 Mar 15 04 Sep 15 10 Feb 16 19 Jul 16 21 Dec 16 02 Jun 17 06 Nov 17 16 Apr 18 20 Sep 18 26 Feb 19 05 Aug 19 10 Jan 20 18 Jun 20 20 Nov 20 30 Apr 21 06 Oct 21 14 Mar 22  0 0,5 1 1,5 2 04 Jan 16 2,5 18 Jan 16 01 Feb 16 15 Feb 16 29 Feb 16 14 Mar 16 30 Mar 16 13 Apr 16 27 Apr 16 12 May 16 26 May 16 10 Jun 16 24 Jun 16 08 Jul 16 22 Jul 16 UK nominal yield, 2016-2017 05 Aug 16 19 Aug 16 05 Sep 16 19 Sep 16 03 Oct 16 17 Oct 16 31 Oct 16 14 Nov 16 28 Nov 16 12 Dec 16 28 Dec 16 12 Jan 17 26 Jan 17 09 Feb 17 23 Feb 17 09 Mar 17 23 Mar 17 06 Apr 17 24 Apr 17 09 May 17 23 May 17 07 Jun 17 21 Jun 17 05 Jul 17 19 Jul 17 02 Aug 17 16 Aug 17 31 Aug 17 14 Sep 17 28 Sep 17 12 Oct 17 26 Oct 17 09 Nov 17 23 Nov 17 07 Dec 17 21 Dec 17 10-year nominal government bond yields in the UK In the second half of the 1990s, the UK decided to move central bank policy towards maintaining low (expected) inflation (expectations). This policy kept nominal 10- year yields in the period 2000-2007 fairly stable. After the credit crisis of 2007-2008 and thus within the Great Recession, 10-year yields decreased substantially. This was due to a wide variety of factors (that will be studied in more detail in various places in this course) : o flight to quality: away from more risky government bonds of Southern European nations and away from more risky corporate bonds into safe British government bonds. o the Bank of England implemented a quantitative easing (QE) policy in which it bought large amounts of (predominantly) long-term government bonds. This policy increased the price of bonds and (further) reduced the interest rate. - 27 - 10-year nominal government bond yields in the UK o The recession and low-growth periods subsequently kept nominal yields low (cf. the Fisher equation). o Note that QE was interrupted between November 2012 and July 2016. o Following the United Kingdom’s vote in June 2016 to leave the European Union, however, the pound lost strongly in value and the outlook for growth in the short to medium term weakened. o On 3 August 2016, the Monetary Policy Committee of the Bank of England therefore voted for a package of measures designed to provide additional support to growth through which it also briefly renewed its buying of long-term government bonds. This again pushed interest rates (briefly) to lower levels. - 28 - 10-year nominal government bond yields in the UK The pandemic that started in March 2020 was accompanied by a substantial decrease in the yield. Again, the Bank of England engaged in massive buying operations in order to keep the economy from (very) sharply contracting due to the pandemic. Since the beginning of 2021, the yields increased again in view of the improved economic outlook due to for instance the start of the massive vaccination programme in the UK. Subsequently, yields increased fairly sharply due to the sharp increase in inflation (expectations). - 29 - 30 References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 8: Figure 4 on p. 146 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 2. Slide 9: Figure 5 on p. 147 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 3. Slide 13: Figure 6 on p. 148 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 4. Slide 15: Figure 7 on p. 149 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. - 30 - Lecture 3 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- 4-2 Topics Today, we provide the theoretical reasoning of why: 1. bonds with the same maturity but with different default risk, liquidity risk and tax characteristics have different interest rates => Risk structure of interest rates 2. bonds with the same default risk, liquidity risk and tax characteristics but with different maturity have different interest rates => Term structure of interest rates -2- Risk Structure of Interest Rates -3- -4- -5- Increase in Default Risk on Corporate Bonds -6- Increase in Default Risk on Corporate Bonds Corporate Bond Market Relative default risk of corporate bonds , DC , DC shifts to the left, PC , iC  Treasury Bond Market Relative default risk of Treasury bonds , DT , DT shifts to the right, PT , iT  Outcome: (Default) Risk premium (iC – iT) (= spread between interest rates on bonds with default risk and default-free bonds) rises. -7- Bond Ratings: low default risk Moody’s Rating Agency S&P Fitch Definitions Aaa AAA AAA Prime Maximum Safety Aa1 AA+ AA+ High Grade High Quality Aa2 AA AA Blank Aa3 AA– AA– Blank A1 A+ A+ Upper Medium Grade A2 A A Blank A3 A– A– Blank Baa1 BBB+ BBB+ Lower Medium Grade Baa2 BBB BBB Blank Baa3 BBB– BBB– Blank Ba1 BB+ BB+ Noninvestment Grade -8- Bond Ratings: high default risk Moody’s Rating Agency S&P Fitch Definitions Ba2 BB BB Speculative Ba3 BB– BB– Blank B1 B+ B+ Highly Speculative B2 B B Blank B3 B– B– Blank Caa1 CCC+ CCC Substantial Risk Caa2 CCC — In Poor Standing Caa3 CCC– — Blank Ca — — Extremely Speculative C — — May Be in Default — — D Default -9-  -5 0 5 10 15 20 30 25 2001-01 2001-06 2001-11 2002-04 2002-09 2003-02 2003-07 2003-12 2004-05 2004-10 2005-03 2005-08 2006-01 2006-06 2006-11 2007-04 2007-09 2008-02 2008-07 Greece 2008-12 2009-05 2009-10 2010-03 Ireland 2010-08 2011-01 2011-06 2011-11 Italy 2012-04 2012-09 2013-02 2013-07 Portugal 2013-12 2014-05 2014-10 2015-03 Spain 2015-08 2016-01 2016-06 Are All Treasury Bonds Default-Free? 2016-11 2017-04 2017-09 2018-02 2018-07 2018-12 2019-05 2019-10 2020-03 - 10 - 2020-08 2021-01 2021-06 2021-11 2022-04 S&P Ratings in Europe (June 2011) - 11 - S&P Ratings in Europe (June 2016) - 12 - S&P Ratings in the World (March 2019) - 13 - S&P Ratings in the World (March 2024) - 14 - Decrease in Liquidity of Corporate Bonds Corporate Bond Market Relatively less liquid corporate bonds: DC , DC shifts to the left, PC , iC  Treasury Bond Market Relatively more liquid Treasury bonds: DT , DT shifts to the right, PT , iT  Outcome: Liquidity (risk) premium (iC – iT) rises. - 15 - Tax Advantages on Municipal Bonds In the US, interest payments on municipal bonds are exempted from federal income tax. Phrased differently, these bonds carry a tax advantage when compared with Treasury bonds. Implications: see the next slide in which it is assumed that a tax advantage for municipal bonds is introduced starting out of a situation of identical tax treatment of municipal and Treasury bonds as well as identical default risk and liquidity risk. - 16 - Tax Advantages on Municipal Bonds - 17 - Tax Advantages of Bonds Municipal Bond Market Tax exemption raises relative after-tax Re on municipal bonds: Dm , Dm shifts to the right, Pm , im  Treasury Bond Market Relative after-tax Re on Treasury bonds : DT , DT shifts to the left, PT , iT  Outcome: im < iT - 18 - 2. Term Structure of Interest Rates Term structure of interest rates: relationship between the interest rate of bonds (with identical default risk, liquidity risk and tax treatment) and the maturity. Yield curve (aka term structure (of interest rates)): plot of the yields (to maturity) of bonds with different maturity but same default risk, liquidity risk and tax treatment: yields on the vertical axis and time to maturity on the horizontal axis. Yield curves can broadly be classified as: upward-sloping short-term rates < long-term rates flat short-term rates = long-term rates inverted short-term rates > long-term rates - 19 - US Government Bonds 1950-2020 - 20 - Yield Curves for U.S. Government Bonds - 21 - Term Structure Facts to be Explained Fact 1: Interest rates for different maturities tend to move together over time, i.e., they have similar dynamics. Fact 2: Yield curves tend to have a steep upward slope when short rates are exceptionally low and a steep downward slope when short rates are exceptionally high. Fact 3: Yield curve is typically upward sloping. Three Theories of the Term Structure: 1. Expectations Theory 2. Segmented Markets Theory 3. Liquidity Premium Theory - 22 - 1. Expectations Theory Key Assumption: Bonds of different maturities are perfect substitutes. Implication: Re on bonds of different maturities must be equal. Illustration of the expectations theory: two strategies for a two-year investment horizon using zero-coupon bonds: 1.“Buy-and-hold” strategy: Buy a two-year bond of €100 and hold it until maturity. 2.“Rolling” strategy: Buy a one-year bond of €100 and when it matures in one year buy another one-year bond with the sum that you have received at that point of time. - 23 - 1. Expectations Theory 1. “Buy-and-hold” strategy: two-year (expected) return 100(1 + i2t)2 – 100 (1 + 2i2t + i2t2) – 1 = ≈ 2i2t 100 1 2. “Rolling” strategy: two-year expected return 100(1 + it)(1 + iet+1) – 100 (1 + it + iet+1 + itiet+1) – 1 = ≈ (it + iet+1) 100 1 If both strategies are perfect substitutes, their expected returns must be equal: 2i2t = (it + iet+1) => i2t = (it + iet+1)/2 - 24 - 1. Expectations Theory Repeating the above reasoning for an n-period bond then gives the fundamental formula of the expectations theory: it + iet+1 + iet+2 +... + iet+(n–1) int = n In words: The n-period interest rate, i.e., the interest rate of a bond that matures in n periods from now, equals the average of the one-period interest rates expected to occur over the n-period life of the bond. - 25 - 1. Expectations Theory Example: current and expected one-year interest rates: it=5%, iet+1= 6%, iet+2= 7%, iet+3 = 8% and iet+4 = 9% Current two-year interest rate: i2t= (5% + 6%) / 2 = 5.5% ………….. Current five-year interest rate: i5t= (5% + 6% + 7% + 8% + 9%) / 5 = 7% Current interest rates for one to five-year bonds: it=5%, i2t=5.5%, i3t=6%, i4t=6.5% and i5t=7%. - 26 - 1. Expectations Theory Interest Rate, int 7% 6% 5% 1 2 3 4 5 Years to maturity, n - 27 - 1. Expectations Theory The expectations theory is compatible with the different slopes that the yield curve can have: 1. When short rates are expected to rise in the future, the average of the future short rates, i.e., int, is above today’s short rate: the yield curve is upward sloping (see the previous example). 2. When short rates are expected to stay the same in the future, the average of the future short rates, i.e., int, is the same as today’s short rate: the yield curve is flat. 3. When short rates are expected to fall in the future, the average of the future short rates, i.e., int, is below today’s short rate: the yield curve is downward sloping (is inverted). - 28 - 1. Expectations Theory The expectations theory explains Fact 1 according to which short and long rates move together: 1. If it  today, then we typically see that also iet+1, iet+2, …  (cf. the best prediction is today’s value)  average of future rates   int  2. Increases/decreases in expected short-term interest rates affect the long-term averages. For instance, iet+1 enters not only into the calculation of i2t , but also into the calculation of i3t , i4t , i5t , … 3. Therefore: it   iet+i  and int , i.e., short and long rates move together (they tend to be positively correlated). - 29 - 1. Expectations Theory The expectations theory explains Fact 2 according to which yield curves tend to have a steep upward slope when short rates are exceptionally low and a steep downward slope when short rates are exceptionally high. 1. When short rates are exceptionally low, they are expected to rise to their ‘normal’ level, and the long rate, which is the average of the future short rates, will be well above today’s short rate: the yield curve will have a steep upward slope. 2. Likewise, when short rates are exceptionally high, they will be expected to fall in future, and the long rate will be below today’s short rate: the yield curve will have a steep downward slope. - 30 -  1. Expectations Theory The expectations theory does not explain Fact 3 according to which the yield curve usually has an upward slope. It is just as likely that short rates in the future will rise or that they will decrease. As a result, the average of future short rates must not be larger than the current short rate. The expectations theory therefore thus not predict that the yield curve typically is upward-sloping. - 31 - 2. Segmented Markets Theory Key assumption: Bonds of different maturities are not substitutes at all. Implication: Markets are completely segmented and the interest rates for each maturity are determined independently of each other. The segmented markets theory explains Fact 3 according to which the yield curve is usually upward sloping given that people typically prefer bonds of shorter maturities (lower interest-rate risk): higher demand for short-term bonds leads to higher prices and lower interest rates for short-term bonds when compared with long-term bonds. - 32 - 2. Segmented Markets Theory The segmented markets theory does not explain Fact 1 according to which interest rates for different maturities tend to move together over time and it does not explain Fact 2 according to which yield curves tend to have a steep upward slope when short rates are exceptionally low and to have a steep downward slope when short rates are exceptionally high. Reason: The assumption of markets being segmented implies that long and short rates are determined independently from each other. - 33 - 3. Liquidity Premium Theory Key assumption: Bonds of different maturities are substitutes, but they are not perfect substitutes. Implication: The liquidity premium theory essentially modifies the expectations theory by including features of the segmented markets theory. Investors prefer shorter-term over longer-term bonds (cf. the different interest- rate risk) and thus must be paid a positive liquidity premium or term premium (lnt) in order to give them an incentive to hold longer-term bonds. Hence it + iet+1 + iet+2 +... + iet+(n–1) int = + lnt n - 34 - 3. Liquidity Premium Theory The liquidity premium theory thus adds a liquidity premium to the average of expected short-term interest rates that characterises the expectations theory. As the interest-rate risk is larger for bonds with a longer maturity (see the first tutorial), the liquidity premium will be larger for bonds with a longer maturity. It thus becomes more likely to encounter positively sloped yield curves and this even when expected short-term interest rates – for instance – are constant and the expectations theory would predict a flat yield curve. - 35 - 3. Liquidity Premium Theory Theoretical/historical note: The liquidity premium theory is very closely related to the so-called preferred habitat theory. In the preferred habitat theory, investors have a “preferred habitat”, i.e., have a preferred maturity, but are willing to hold bonds of a different maturity if the incentive to do so is large enough. Thus, investors require a positive premium in order to hold bonds with a different maturity, i.e., bonds with a shorter or a longer time to maturity. As one can typically assume that investors have a preference for short-term bonds, the preferred habitat theory and the liquidity premium essentially embody the same prediction. Both the liquidity premium theory and the preferred habitat theory are often treated as essentially being identical and the textbook adheres to this custom (see for instance the next slide). - 36 - - 37 - 3. Liquidity Premium Theory Example: Current and expected one-year interest rates (same as before): it=5%, iet+1= 6%, iet+2= 7%, iet+3 = 8% and iet+4 = 9%. Liquidity premia: lt=0%, l2t= 0.25%, l3t = 0.5%, l4t = 0.75% and l5t =1% Current interest rate on the two-year bond: i2t= (5% + 6%)/2 + 0.25% = 5.75% …… Current interest rate on the five-year bond: i5t= (5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8% Current interest rates for one- to five-year bonds: it=5%, i2t=5.75%, i3t=6.5%, i4t=7.25% and i5t=8%. - 38 - 4-39 3. Liquidity Premium Theory Interest Rate, int Liquidity Premium Theory 8% Expectation Theory 7% 6% 5% 1 2 3 4 5 Years to maturity, n - 39 - 3. Liquidity Premium Theory The liquidity premium theory explains all 3 facts: explains Fact 1 and Fact 2 because the average of future short rates determines the long rate (indeed, the liquidity premium theory starts from the expectations theory that already explained Fact 1 and Fact 2). explains Fact 3 according to which the yield curve typically has an upward slope on account of investors’ preferences for short-term bonds. The resulting term premia that are typically larger for larger maturities make it indeed likely to encounter yield curves that have a positive slope. - 40 - - 41 - References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 3: Figure 1 on p. 166 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 2. Slide 4: Figure 6.1a on p. 109 of Mishkin, Matthews, Giuliodori (2013), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 3. Slide 5: Figure 6.1b on p. 109 of Mishkin, Matthews, Giuliodori (2013), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 4. Slide 6: Figure 2 on p. 167 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 5. Slide 8: Table 1 on p. 168 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 6. Slide 9: Table 1 on p. 168 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 7. Slide 17: Figure 3 on p. 172 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education.. - 42 - References to tables and figures 8. Slide 20: Figure 4 on p. 174 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education.. 9. Slide 21: Figure 7 on p. 184 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education.. 10. Slide 37: Figure 5 on p 180 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education.. 11. Slide 41: Figure 6 on p. 182 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education.. - 43 - Lecture 4 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics 1. More on the yield curve 2. The stock market Three theories on the valuation of stocks: 1. One-Period Valuation Model 2. Generalized Dividend Valuation Model 3. Gordon Growth Model Role of expectations for the behaviour of stock prices: Theory of Rational Expectations (RE) => Efficient Market Hypothesis -2- More on the yield curve How to obtain predictions on future economic activity? 1. Using predictions from elaborate econometric macro-economic models: Behaviour equations for the major sectors of the economy together can provide predictions of future economic development. 2. Surveys of managers of the corporate sector, academic economists, professional forecasters, etc.: so-called “consensus forecasts”. 3. Since the 1980s also: slope of the term structure of interest rates, i.e., of the yield curve. -3- More on the yield curve The yield curve is the relation between the yield to maturity and the time to maturity of bonds with the same characteristics in terms of default risk, liquidity risk and tax treatment. Typically, yield curves are calculated for government bonds due to the fact that o government bonds exist for a wide variety of maturities and default risks are very similar across maturities; o markets for these government bonds of different maturities are (very) large and thus liquid; o their markets are dominated by large and well-informed market participants such as mutual funds, pension funds, large investment banks, insurance companies, etc. Hence, prices of government bonds reflect the opinions of a broad group of well-informed market participants: they “reflect the opinion of the market”. -4- More on the yield curve The next slide illustrates the yield curve for the US as the difference (the spread) between the yield of the 10-year US Treasury bond and the 3-month US Treasury bill for the period 1982- September 2022: o Positive values indicate a positively sloped yield curve; o Negative values indicate a negatively sloped yield curve. -5- More on the yield curve -6- Predictive power of the yield curve? The shaded bars indicate recessions: early 1980s, 1991, 2001, 2007-2008 and 2020. The yield of the 10-year US Treasury bond fell below the yield of the 3-month US Treasury bill: in 1981 (not visible in this figure); in 1989; in 2000; in 2006; in 2019; In 2020 (before the beginning of the pandemic). -7- Predictive power of the yield curve? The negative slope of the yield curve thus appears to have preceded (“predicted”) the last five recessions in the US: early 1980s, 1991, 2001, 2007-2008 and 2020. The negative slope of the yield curve in 2019 was at the time widely discussed in the press as pointing to the expectation of a future recession. Obviously, the Covid-19 recession of 2020 was a completely exogenous shock to the (world) economy and the relation between the negative slope of the yield in 2019 and the Covid-19 recession must be seen as pure coincidence. However, we will never know whether a recession would have occurred in 2020 if there would not have been the Covid- 19 shock. -8- Predictive power of the yield curve? Is this predictive power of the negative slope also present in other rich countries? 1. Canada (1974-1993) -9- Predictive power of the yield curve? Strong predictive power of negatively sloped yield curves also for Canada? the two recessions in the early 1980s and the recession in the early 1990s were preceded by a negatively sloped yield curve; however, the recession of the mid 1970s was not preceded by a negatively sloped yield curve; the negatively sloped yield curve in 1987 did not precede a recession. - 10 - Predictive power of the yield curve? 2. Sweden (1980-1999) - 11 - Predictive power of the yield curve? Strong predictive power of negatively sloped yield curves also for Sweden? the slope of the yield curve did turn negative fairly often in the period 1980-1986 without being followed by a recession; the recessions in the early 1990s (related also to banking crises after collapses of real-estate bubbles) were preceded by negatively sloped yield curves. - 12 - Predictive power of the yield curve? 3. UK (1994-2013) - 13 - Predictive power of the yield curve? Strong predictive power of negatively sloped yield curves also for the UK? the slope of the yield curve did turn negative shortly before and shortly after 2000 without being followed by a recession; the recession of 2007-2008 was preceded by negatively sloped yield curves. - 14 - Predictive power of the yield curve? 4. Germany (1996-2015) - 15 - Predictive power of the yield curve? Strong predictive power of negatively sloped yield curves also for Germany? none of the recessions in 1996-2015 was preceded by a negatively sloped yield curve. - 16 - Predictive power of the yield curve? Conclusion: a negatively sloped yield curve seems to predict recessions in the case of the US and to some extent also in the case of Canada; for the three European countries, a clear link between negatively sloped yield curves and recessions seems not to be present most of the time. - 17 - Predictive power of the yield curve? Does this imply that the slope of the yield curve – apart from the US – is of limited use in forecasting future economic growth? No, several empirical studies have detected a fairly strong correlation between changes in the spread and changes in economic growth rates in the following year: the smaller the spread, the lower future growth appears to be (see for instance slide 15 for Germany). In fact, using consensus forecasts of future economic growth in combination with the slope of the yield curve provides better predictions when compared with predictions that are only based on consensus forecasts. - 18 - Predictive power of the yield curve? Why would the move from a steeper to a flatter yield curve point to market expectations of lower economic growth in the future? This is not surprising when thinking of the theoretical arguments that we have encountered until now. Remember here that we have yield curves for government bonds (not corporate bonds but obviously the two markets are closely connected when thinking for instance of the relative expected return in the theory on asset demand). Before developing some arguments, it is necessary to examine who has the most impact on the short end of the yield curve and who has the most impact on the long end of the yield curve. - 19 - Predictive power of the yield curve? The central bank controls the shortest-term interest rates (actually the overnight interbank interest rate, i.e. one-day interest rate, see weeks 6 and 7 for more detail). However, we know that interest rates of different maturities tend to move together such that the yields of other shorter-term maturities then also strongly reflect the policy stance of the central bank (cf. Fact 1 in the discussion of the term structure of interest rates). The longer-term interest rates (e.g., yields of government bonds with a maturity of ten years) are determined by market forces. For instance, the most active market participants in the market for ten-year government bonds are mutual funds, pension funds, investment banks and insurance companies. Exception: periods of Quantitative Easing in which central banks also buy such longer-term government bonds. - 20 - Predictive power of the yield curve? Thus, it is argued that a flatter yield curve following a more positively sloped yield curve would correlate with slowing down of economic activity or even a recession. This needs to be explained. But first: what can lead to a decrease in the typically positive level of the spread? 1. An increase in the short end and A. no change in the long end; B. a decrease in the long end; C. an increase in the long end that is smaller than the increase in the short end. 2. A decrease in the short end and a decrease in the long end that is larger than the decrease in the short end or a constant short end and a decrease in the long end. - 21 - Predictive power of the yield curve? It is unlikely to see an increase in the short end when the economic outlook is worsening or is expected to worsen. Indeed, central banks would refrain from increasing the policy interest rates as that would discourage economic growth. So, we can exclude the events under 1. on the previous slide. Hence, we need to explain how a decrease in the short end can come about coupled with a decrease in the long end that is larger than the decrease in the short end or assume a constant short end and a decrease in the long end (events under 2. on the previous slide). Hereto, we can use various insights from the theory of demand and supply of assets and the theories on the term structure of interest rates. - 22 - Predictive power of the yield curve? What could explain a decrease in the short end? The central bank may in a period of lower expected economic growth decrease policy interest rates in order to stimulate economic growth. Due to the positive correlation between interest rates of different maturities, it then is likely that the short end of the yield curve also decreases (think of Fact 1 of the term structure of interest rates). - 23 - Predictive power of the yield curve? What could explain a decrease in the long end? Hereto we have several arguments that strengthen each other. 1. The central bank may in a period of lower expected economic growth decrease short-term interest rates in order to stimulate economic growth. Expectations may then arise that short-term interest rates will remain low for quite some time, i.e., until growth accelerates again in the (distant) future. According to the expectations and liquidity premium theories, long-term interest rates are averages of future short-term interest rates (with or without a liquidity premium) such that then also long-term interest rates on government bonds, i.e., the long end of the yield curve, will decrease. - 24 - Predictive power of the yield curve? 2. The theory on the supply of assets predicts that the supply of long-term corporate bonds decreases when expected profitability decreases in a situation of expected worsening of the economic situation. The prices of long-term corporate bonds then increase and their yields decrease (corporations tend to borrow long-term). The theory on the demand for assets then predicts that the relative expected return on long-term government bonds increases causing demand for them to increase. Prices of long-term government bonds increase and their yield, i.e., the long end of the yield curve, decreases. - 25 - Predictive power of the yield curve? 3. The theory on the demand of assets predicts that the demand for long-term corporate bonds decreases when the economic outlook worsens due to an increase in expected corporate defaults. Indeed, the decrease in relative risk of long-term government bonds then pushes up demand for long-term government bonds. Prices of long-term government bonds increase and their yield, i.e., the long end of the yield curve, decreases. - 26 - Predictive power of the yield curve? 4. In periods of a worsening economic outlook, central banks may start with Quantitative Easing (QE): buying long-term government bonds and at times also long-term corporate bonds in order to bring down interest rates. Buying long-term government bonds pushes up demand for long-term government bonds. Prices of long-term government bonds increase and their yield, i.e., the long end of the yield curve, decreases. Buying long-term corporate bonds within QE decreases yields on long-term corporate bonds: demand for corporate bonds increases, their prices increase and their yields decrease. The theory of the demand for assets then predicts that the increase in the relative return on long-term government bonds increases and that the demand for long-term government bonds increases. Prices of long-term government bonds increase and their yield, i.e., the long end of the yield curve, decreases. - 27 - The stock market The stock market is to be studied on the basis of supply as well as demand considerations: 1. Supply of stocks Firms can obtain external funding via: issuing corporate bonds: see past lectures and tutorials. issuing stocks: focus of the remainder of this lecture. borrowing from banks: next lecture. - 28 - The stock market 2. Demand for stocks Investors (private individuals, mutual funds, pension funds, (investment) banks, investment funds, insurance companies, etc.) can hold bonds but also other financial assets including stocks (cf. remember the qualification “relative” in three of the four determinants within the theory of the demand for assets). - 29 - The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis - 30 - 4-31 1. One-Period Stock Valuation Model 𝐷𝑖𝑣1 𝑃1 𝑃0 = + (1 + 𝑘𝑒 ) (1 + 𝑘𝑒 ) 𝑃0 = the current price of the stock; 𝐷𝑖𝑣1 = the dividend paid at the end of year 1; 𝑘𝑒 = the required return on an investment in equity; 𝑃1 = the expected selling price of the stock at the end of year 1; - 31 - 4-32 2. Generalised Dividend Valuation Model The value of stock today is the present value of all future cash flows D1 D2 Dn Pn P0 = + +... + + (1 + ke ) (1 + ke ) 1 2 (1 + ke ) (1 + ke ) n n If Pn is far in the future, it will not affect P0  Dt P0 =  t =1 (1 + k e ) t The price of the stock is determined only by the present value of the future dividend stream - 32 - 4-33 3. Gordon Growth Model 𝐷0 (1 + 𝑔) 𝐷1 𝑃0 = = (𝑘𝑒 − 𝑔) (𝑘𝑒 − 𝑔) 𝐷0 = the most recent dividend paid 𝐷1 = the dividend in the next period 𝑔 = the expected constant growth rate in dividends 𝑘𝑒 = the required return on an investment in equity Assumptions: 1. Dividends are assumed to continue growing at a constant rate forever. 2. The growth rate of the dividends is assumed to be smaller than the required return on investment in equity (see below). - 33 - 4-34 3. Gordon Growth Model Derivation of the stock valuation formula: 𝐷1 𝐷2 𝐷∞ 𝑃0 = 1+ 1+𝑘 2 +⋯+ 1+𝑘 ∞ 1 + 𝑘𝑒 𝑒 𝑒 1 2 𝐷0 × 1 + 𝑔 𝐷0 × 1 + 𝑔 𝐷0 × 1 + 𝑔 ∞ 𝑃0 = + +⋯+ 1 + 𝑘𝑒 1 1 + 𝑘𝑒 2 1 + 𝑘𝑒 ∞ 1+𝑔 1 1+𝑔 2 1+𝑔 ∞ 𝑃0 = 𝐷0 1 + 2 +⋯+ 1 + 𝑘𝑒 1 + 𝑘𝑒 1 + 𝑘𝑒 ∞ 1+𝑔 1+𝑔 1+𝑔 ∞ 𝑃0 = 𝐷0 1+ +⋯+ 1 + 𝑘𝑒 1 + 𝑘𝑒 1 + 𝑘𝑒 ∞ - 34 - 4-35 3. Gordon Growth Model Let us define 1+𝑔 𝑥≡ , 1 + 𝑘𝑒 which then gives 𝑃0 = 𝐷0 𝑥 1 + 𝑥 + 𝑥 2 + ⋯ + 𝑥 ∞. We know from the first week’s tutorial that ∞ 1 1+𝑥+ 𝑥2 +⋯+ 𝑥∞ =෍ 𝑥𝑛 = for 𝑥 < 1. 1−𝑥 𝑛=0 Thus 𝑥 𝑃0 = 𝐷0. 1−𝑥 - 35 - 4-36 3. Gordon Growth Model Re-introducing the definition of 𝑥 then gives 1+𝑔 1+𝑔 1+𝑔 1 + 𝑘𝑒 1 + 𝑘𝑒 1 + 𝑘𝑒 1+𝑔 𝑃0 = 𝐷0 = 𝐷0 = 𝐷0 = 𝐷0 1+𝑔 1 + 𝑘𝑒 − 1 − 𝑔 𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔 1− 1 + 𝑘𝑒 1 + 𝑘𝑒 1 + 𝑘𝑒 and thus 1+𝑔 𝐷1 𝑃0 = 𝐷0 =. 𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔 - 36 - 4-37 3. Gordon Growth Model Some questions concerning the Gordon growth model: 1. Remember that we needed the assumption 𝑥 < 1, which implies 1+𝑔 < 1 or 𝑔 < 𝑘𝑒. 1 + 𝑘𝑒 What is the economic intuition of the restriction 𝑔 < 𝑘𝑒 ? If 𝑔 > 𝑘𝑒 , the discounted dividend would grow to infinity since the dividend’s growth rate would outpace the discount rate, i.e., the required return on investment in equity. As a result, the stock would then have an infinitely large price, which obviously makes no sense. - 37 - 4-38 3. Gordon Growth Model 2. Does the model preclude the dividend growth rate to be negative (e.g., g = -0.02 and thus 1 + g = 0.98)? No, dividends may grow at a positive rate, may be constant over time and nothing prevents them from decreasing over time either. The latter may well be the case for firms in sectors that are in a secular decline (delivering surface mail, production of incandescent light bulbs, etc). Assuming a positive required return on investment in equity and a negative growth rate 1+𝑔 of dividends would imply ≪ 1 such the future will contribute less and less to the 1+𝑘𝑒 value of the stock price or the stock price would predominantly be determined by the nearby future. - 38 - 4-39 3. Gordon Growth Model 3. What does an increase in 𝑘𝑒 mean in intuitive terms? What is the effect on the stock price? An increase in 𝑘𝑒 means that investors use/require a higher required return on investment in equity when discounting future income streams towards the present point of time. Investors thus desire a higher rate of return in order for instance to compensate them for the higher perceived risk. The heavier the discounting of future income streams will be, the smaller the current value of the stock price will be. - 39 - 4 - 4 0 3. Gordon Growth Model Intuitively, the stock is less attractive when it is associated with higher risk and then, other things being equal, it will be valued at a lower price (remember the theory on demand of assets). Formally, this effect can be illustrated via the first derivative of the stock price, P0, to the required return on investment in equity, ke: 𝐷1 1 𝜕𝑃0 𝜕 𝜕 −1 𝜕 𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔 = = 𝐷1 = 𝐷1 2 𝜕𝑘𝑒 𝜕𝑘𝑒 𝜕𝑘𝑒 𝑘𝑒 − 𝑔 𝜕𝑘𝑒 −1 𝜕𝑘𝑒 −𝐷1 = 𝐷1 2 𝜕𝑘 = 2 < 0. 𝑘𝑒 − 𝑔 𝑒 𝑘𝑒 − 𝑔 - 40 - 4-41 3. Gordon Growth Model 4. The Gordon Growth Model and the Great Recession that accompanied the subprime financial crisis of 2007-2008 and the start of the Covid pandemic in March 2020: o Downward revision of growth prospects: ↓ g and ↓ D1 o Increased uncertainty: ↑ ke The Gordon Growth Model thus indeed predicted the sharp drop in stock prices in these two cases. - 41 - 4-42 3. Gordon Growth Model 5. The Gordon Growth Model and expansionary monetary policy (i.e., lower interest rates): o The lower interest rate can be expected to stimulate economic activity and thus to increase future revenues and profits of firms: ↑ D1 and ↑ g o The lower interest rate and improved economic environment reduce uncertainty: ↓ ke The Gordon Growth Model indeed predicts an increase in stock prices. - 42 - 4-43 Adaptive Expectations Expectations are formed from past experience only. Changes in expectations will occur slowly over time as data changes. However, people use more than just past data to form their expectations and sometimes change their expectations quickly. - 43 - 4-44 Theory of Rational Expectations Expectations will be identical to optimal forecasts using all available information (John Muth, 1961). Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be accurate. Reasons: It takes too much effort to make the expectation the best guess possible; Best guess will not be accurate if the predictor is unaware of some relevant information; Unpredictable shocks, chance and coincidence. - 44 - 4-45 Formal Statement of the Theory X =X e of X = expectation of the variable that is being forecast e of X = optimal forecast using all available information - 45 - 4-46 Implications If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well. For instance, expectations change due to changes in the conduct of monetary policy (e.g., the central bank adopts a lower target interest rate). The forecast errors of expectations, X – Xe, will on average be zero and cannot be predicted ahead of time. - 46 - 4-47 Efficient Markets: Application of Rational Expectations The rate of return from holding a security equals the sum of the capital gain on the security, plus any cash payments divided by the initial purchase price of the security. Pt +1 − Pt + C R= Pt R = the rate of return on the security Pt +1 = price of the security at time t + 1, the end of the holding period Pt = price of the security at time t , the beginning of the holding period C = cash payment (coupon or dividend) made during the holding period - 47 - 48 Efficient Markets (cont’d) At the beginning of the period, at time t, we know Pt and C. However, Pt+1 is unknown and we thus must form an expectation on this price. P − Pt + C e The expected return then is R =e t +1 Pt Expectations of future prices are equal to optimal forecasts using all currently available information so Pt e+1 = Pt of+1  R e = R of Supply and demand analysis states Re will equal the equilibrium return R*, so Rof = R* - 48 - 4-49 Efficient Markets (cont’d) Current prices in a financial market are thus set such that the optimal forecast of a security’s return (using all available information) equals the security’s equilibrium return (Rof = R*). Phrased differently, in an efficient market, a security’s price fully reflects all available information. - 49 - 4-50 Rationale: arbitrage R  R  Pt  R  of * of R of  R*  Pt  R of  until R =R of * In an efficient market, all unexploited profit opportunities will be eliminated - 50 - 4-51 Application: Investing in the Stock Market Recommendations from investment advisors cannot help us outperform the market. A hot tip is probably based on information that is already contained in the price of the stock. Stock prices respond to announcements only when the information is new and unexpected. A “buy-and-hold” strategy is the most sensible strategy for the small investor (savings of transaction costs) or buy shares into a mutual fund. - 51 - References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 6: Figure created on the basis of the FRED database of the Federal Reserve Bank of St Louis. 2. Slide 9: Figure from the article “Curveball” in The Economist, 27 July 2019, p. 69. 3. Slide 11: Figure from the article “Curveball” in The Economist, 27 July 2019, p. 69. 4. Slide 13: Figure from the article “Curveball” in The Economist, 27 July 2019, p. 69. 5. Slide 15: Figure from the article “Curveball” in The Economist, 27 July 2019, p. 69. 6. Slide 27: Figure 2 on p. 53 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. - 52 - Lecture 5 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics The main functions, structure and instruments of the financial system. The important role of financial intermediaries in the functioning of the financial system. Banking and the management of financial institutions. -2- Flow of funds in the financial system -3- Function of the Financial System The financial system allows to channel funds from economic agents with saved surplus funds (the lender-savers) to those with a shortage of funds (the borrower-spenders). Advantages: Promotes efficient allocation of capital: capital is channelled from economic agents that lack productive investment opportunities to economic agents that have such opportunities. This leads to higher production and higher economic growth; Improves directly the well-being of consumers by allowing them to time their purchases better (e.g., young people can buy a house notwithstanding that they have limited savings); Allows firms to bridge the time gap between incurring production costs and obtaining the revenues of the sale of their products. -4- Flow of funds in the financial system. First channel: direct finance via financial markets -5- Structure of Financial Markets Debt Markets => debt instruments (e.g., bonds and mortgages): short- (1 year and 10 years). Equity Markets => (common) stocks, a.k.a. shares, equity. Primary Market => issuance of new securities (bonds, stocks, etc.). Secondary Market => securities previously issued are resold in two ways on: (1) exchanges (e.g., NYSE, Euronext, etc.); (2) over-the-counter (OTC) markets (e.g., government bond market). Money Market => Short-term (< 1 year) debt instruments. Capital Market => Long-term (> 1 year) debt instruments + stocks. -6- Financial Market Instruments 1. Main Money Market Instruments in the US (similar elsewhere): US Treasury bills Negotiable Bank Certificates of Deposit (CD) Commercial paper Repurchase agreements (repos) Federal (FED) Funds -7- Table 1 Principal Money Market Instruments in the US Amount ($ billions, end of year) Type of Instrument 1990 2000 2010 2019 U.S. Treasury bills 527 647 1,767 2,416 Negotiable bank certificates of deposit (large 547 1,053 1,923 1,859 denominations) Commercial paper 558 1,602 1,058 1,045 Federal funds and security repurchase agreements 372 1,197 3,598 4,356 -8- Financial Market Instruments 2. Main Capital Market Instruments in the US (similar elsewhere): (Corporate) Stocks Mortgages and Mortgage-Backed Securities (MBS) Corporate Bonds US Government Securities US Government Agency Securities State and Local Government Bonds (a.k.a. Municipal Bonds) Consumer and Bank Commercial Loans -9- Table 2 Principal Capital Market Instruments in the US Amount ($ billions, end of year) Type of Instrument 1990 2000 2010 2019 Corporate stocks (market value) 3,530 17,628 23,567 54,624 Residential mortgages 2,676 5,205 10,446 11,159 Corporate bonds 1,703 4,991 10,337 14,033 U.S. government securities (marketable long-term) 2,340 3,171 7,405 14,204 U.S. government agency securities 1,446 4,345 7,598 9,431 State and local government bonds 957 1,139 2,961 3,068 Bank commercial loans 818 1,497 2,001 3,818 Consumer loans 811 1,728 2,647 4,181 Commercial and farm mortgages 838 1,276 2,450 3,230 - 10 - Flow of funds in the financial system. Second channel: indirect finance via financial intermediaries - 11 - Function of Financial Intermediaries Why are financial intermediaries important in the financial system? They: 1. Lower transaction costs They reduce transaction costs by developing expertise and economies of scale. 2. Reduce exposure to risk They create and sell assets with low risk and use the funds that they obtain that way to buy assets with more risk: risk sharing and asset transformation. E.g., create and sell deposits in order to give loans to corporations. Help people to diversify their asset portfolio. 3. Deal with/reduce asymmetric information (see below). - 12 - Asymmetric information Adverse Selection (AS) Takes place before the transaction occurs. The borrowers that are most likely to produce adverse outcomes (“the bad credit risks”) are also the ones most likely to seek loans => lenders provide fewer/no loans and/or buy fewer/no securities. Moral Hazard (MH) Takes place after the transaction occurs. The borrowers have incentives to engage in undesirable (immoral) and risky (hazard) activities that make it more likely that they will not be able to pay back the loan => lenders provide fewer/no loans and/or buy fewer/no securities. - 13 - Function of Financial Intermediaries AS and MH are important (potential) impediments to the well-functioning of financial markets (bonds/stocks), i.e., to direct finance. Financial intermediaries reduce these problems. How? Adverse selection: financial intermediaries are better equipped than private individuals to screen (ex ante) and distinguish the bad from the good credit risks. Moral hazard: financial intermediaries have developed strong expertise in monitoring (ex post) the parties they lend to. - 14 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US Type of Intermediary Primary Liabilities Primary Assets (Uses of (Sources of Funds) Funds) Depository institutions Blank Blank (banks) Commercial banks Deposits Business and consumer loans, mortgages, U.S. government securities, and municipal bonds Savings and loan Deposits Mortgages associations Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer loans - 15 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US (continued) Type of Intermediary Primary Liabilities Primary Assets (Uses of (Sources of Funds) Funds) Contractual savings Blank Blank institutions Life insurance companies Premiums from policies Corporate bonds and mortgages Fire and casualty Premiums from policies Municipal bonds, corporate insurance bonds and stocks, and U.S. companies government securities Pension funds, Employer and employee Corporate bonds and stocks government contributions retirement funds - 16 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US (continued) Primary Liabilities Primary Assets (Uses of Type of Intermediary (Sources of Funds) Funds) Investment Blank Blank intermediaries Finance companies Commercial paper, Consumer and business loans stocks, bonds Mutual funds Shares Stocks, bonds Money market mutual Shares Money market instruments funds Hedge funds Partnership Stocks, bonds, loans, foreign participation currencies, and many other assets - 17 - Table 4 Primary Financial Intermediaries and Value of Their Assets in the US Value of Assets ($ billions, end of year) Type of Intermediary 1990 2000 2010 2019 Depository institutions (banks) Blank Blank Blank Blank Commercial banks, savings and loans, and mutual savings banks 4,744 7,687 12,821 18,518 Credit unions 217 441 876 1,534 Contractual savings institutions Blank Blank Blank Blank Life insurance companies 1,367 3,136 5,168 8,508 Fire and casualty insurance companies 533 866 1,361 2,650 Pension funds (private) 1,619 4,423 6,614 10,919 State and local government retirement funds 820 2,290 4,779 9,335 Investment intermediaries Blank Blank Blank Blank Finance companies 612 1,140 1,589 1,528 Mutual funds 608 4,435 7,873 17,660 Money market mutual funds 493 1,812 2,755 3,634 - 18 - Economic Analysis of Financial Structure The financial system plays a key role in promoting economic efficiency. But how important is indirect finance relative to direct finance? What are the main basic facts regarding the financial systems in different parts of the world? - 19 - External vs Internal Funds for Investment - 20 - Sources of External Funds for Nonfinancial Businesses - 21 - Basic Facts of Financial Structure 1. Stocks are not the most important source of external finance for businesses. 2. Issuing marketable debt and equity securities (bonds and stocks) is not the primary funding source for businesses. 3. Indirect finance is more important than direct finance. 4. Financial intermediaries and in particular banks are the most important source of external finance. - 22 - Basic Facts