2Treasury Bills Government sells t-bills to raise cash. Issued through an auctionShort term zero-coupon bondMaturities of 28, 91, and 182 days issued weeklyHighly liquidExempt from all state and local taxesTaxable at the Federal levelVirtually free of default riskTreasury/Agency issues (WSJ)
3Bonds and Yields When the coupon rate =YTM Bond Price = Face Value (Par)When the coupon rate > YTMBond price > Face Value (Par)When the coupon rate < YTMBond Price < Face Value (Par)
4Bid and Ask Prices T-bills are bought and sold through dealers. Ask Price: The lowest price at which any dealer stands ready to sell.Bid Price: The highest price at which any dealer stands ready to buyAs a market participant (not a dealer) at which price do you buy/sell?Which price is higher?
5Treasury Bill Quotations The WSJ (Sept 13, 2006) gave the following quotes for Treasury bills expiring on December 7MaturityDays to MaturityBidAskedChgAsk YldDec 07 06864.824.810.014.93
6Treasury Bill Quotations Numbers under “bid” and “asked” are not pricesThese numbers are discount yields, quoted in hundredths.
7Treasury Bill Quotations Quotes of T-bills are expressed using bank-discount yields and are expressed in %.yBD is the bank discount yieldP is the price of a T-billF is the face valuen is the number of days until maturity.
8Treasury Bill Quotations Assume a face value of 10,000The bid price is the price at which a customer can sell the bill to a dealer.PB=10,000[ (86/360)] = $The ask price is the price at which a customer can buy the bill from a dealer.PA=10,000[ (86/360)] = $The “Chg” in the WSJ is the change in the asked bank discount yield from the previous day.
9Treasury Bill Quotations The “Ask Yld” in the WSJ is the Bond Equivalent Yield or APR of a T-bill:How would you find the EAR?
10EAR The total return over the next 86 days for this bond is This is the “86 day growth rate”We want an annual growth rateHow many 86-day periods are in a year?365/86The effective annual return is therefore
11Bond Quotes Treasury bonds often pay coupons semi-annually Coupon rates are quoted as APRsIf coupon rate is stated as 8%, bond pays 4% of face value every 6 months.
12Treasury Bond QuotesThe WSJ quoted on Jan 13, 2006 the following T-bondWhat does this mean?RateMaturityBidAskedChgAsk Yld6.000Aug 09n105:13105:1454.34
13Treasury Bond Quotes The bond expires in August 2009. This bond pays an interest rate of 6.000%.An investor receives interest semi-annually.Thus, the interest is $3 every February and August.The price quotes are given in 32nds as a percentage of face valueThe bid price is 100(105+13/32)(.01)=$105.41The ask price is 100(105+14/32)(.01)=$105.44The price increased by 5/32 of the face value on January 12, 2006The bond equivalent ask-yield (APR) is 4.34%.
14Inflation Inflation: A general rise in the price level Fixed-weight Index - CPICPI in 1992: 139.7CPI in 2005: 197.6Gas in 1992: $1.12 per gallonHolding relative prices constant, what should be the price of gas today?The US Department of Labor's Bureau of Labor Statistics (BLS) is responsible for calculating the CPIBased on individual prices for a fixed market basket of goods and services.Collects prices each month for thousands of goods and services from thousands of outlets.
15Inflation CPI has increased by a factor of 1.41 197.6/139.7 = 1.41If relative prices are constant, price of gas today should be1.12(1.41) = $1.58
16Inflation Example CPI 1976: 56.8 CPI 2005: 197.6 If the average house cost $60,000 in 1976, what would the average house cost in 2005 assuming relative prices are constant?
17Inflation Example CPI increased by factor of 197.6/56.8 = 3.48 Average house today should cost60,000(3.48) = 208,000
18Inflation CPI tends to be biased upward: Quality change and new product biasSubstitution biasOutlet substitution biasSee page 31 of Cecchetti for more infoQuality change and new product bias, the largest source of bias, arises because the CPI does not immediately take into account either improvements in the quality of goods and services or the introduction of new products. To the extent that the CPI fails to account for changes in quality, the index will not reflect "true" changes in prices. And new products need to be incorporated into the CPI on a timely basis, so that the early declines in price that are a normal part of the product life cycle are captured. Example: a VCR in 1980 cost somewhere around $600. A VCR in 2006 cost $30. So technology has caused the prices of VCRs to go down. What the CPI would not take into account is that the VCR bought in 2006 is about 10 times better than the VCR produced in A VCR of the same quality may only cost $5.DVD players need to be incorporated early. Otherwise early declines in price won’t be captured.Substitution bias occurs because the formula used for CPI calculations assumes that consumers purchase a constant mix of various goods and services despite changes in their relative prices. In actuality, if the price of one good rises relative to that of another good, consumers will tend to substitute cheaper goods for higher-priced ones. Because the weights of goods in the CPI are adjusted infrequently (about once every 10 years), substitution is not taken into account.Example: Suppose gas prices shot out the window - $1000 per gallon. People would substitute away from using cars, and start using bicycles. CPI would reflect change in gas prices. If you were to adjust wages according to the CPI index, you would pay people enough so that they could still afford the same amount of gas as before. But even if people were paid enough to afford the same amount of gas as before, they probably wouldn’t buy gas. They’d invest more in thie homes or other things, so the impact would be that people would be better off than before.Outlet substitution bias occurs because the CPI does not adequately take into account the extent to which new discount stores have offered lower prices and enticed consumers away from the traditional outlets that tend to be more fully represented in the CPI market basket. For example, as more Walmarts become available, people will start buying more of their products from Walmart rather than from expensive grocery stores.
19Real Returns Beginning of year: pizza is $10.00. You have $100 in cash.You could buy 10 pizzasInstead, you invest the $100 in a long term gov. bond. The return on the bond is 5%.Inflation over the year is 3%.
20Real ReturnsThe investment provides you a nominal income at year end of 100(1.05) = $105.At year end, the cost of a pizza is 10.00(1.03)=$10.30.At year end, you could buy pizzas (105/10.3)=10.19.Your real return is therefore only ____?%1.9%
21Real Returns C = amount of cash at beginning of period P = price of a good at beginning of periodrn = nominal return,rr = real returni = inflation rateThe real (gross) rate of return was found above by solving the following equation
22Example: Real Returns The rate of return on a t-bill is 8% Inflation over the next year is 4%What is your real return?1.08/1.04 = = 1+rr = 3.8%approximately 4% = t-bill - inflation
23Bond Returns If I own a bond and rates change why should I care? I may need to sell the bond before it matures.When rates increase bond prices go down.When rates decrease, bond prices go up.The return I get from owning the bond depends on what rates are when I sell the bond.
24Example: Zero Coupon Bonds Annual BondBeginning of yearMatures 10 yearsYTM=10%Coupon Rate=10%FV=1000Price=?End of yearYTM=11%
25Example: Zero Coupon Bonds Return from buying and selling:944.63/ = -5.54%Prices of long term bonds are more sensitive to interest rate changes than short-term bonds
26Bond ReturnsIf I own a bond and I plan on holding it to maturity and rates change why should I care?Opportunity Cost of funds investedFor example, when rates go up, I am losing outInflation is higher and my real return is lower and/orI am missing out on a higher real return
27Money and the Payments System Chapter 2 of CecchettiMoney and the Payments System
28Money Money 1. A means of payment. 2. A unit of account Money is an asset that is generally accepted as payment for goods and services or repayment of debt.1. A means of payment.TransferabilityInformation2. A unit of accountAllocation of resourcesRelative prices3. A store of valueLiquidityMoneyMeans of payment – money eliminates the need to know anything about the other partyNeed something that is easy to transfer, and whose value is easily verified.Store of value – must have value for sellers to acceptWe use other things as a store of valueWhat is the big advantage of money? - LiquidityUnit of account – think if we didn’t have money how many prices do we need?Prices act as a signal to marketsWhat matters are relative prices.When one product suddenly increases in price, this acts as a signalThat investors should invest more money to develop that product.
29Money and Value What makes money valuable? Gold Regime: Fiat Money: Government stands ready to trade gold for dollarsFiat Money:Paper currency decreed by local governments as legal tender, but not convertible into precious metals.TrustGovernment will always accept as taxesBefore, people used assets with intrinsic value as money: silk, butter, salt, cigarettes