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1 Money & Banking Chapters 4 & 5 Debt Instruments and Interest Rates

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2 Debt Instruments Chapter 4

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3 Present Value What is a future cash flow (FV ) worth now?

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4 Rule of the Cash Flow Timeline Cash flows at the same date can be added together, but cash flows at different dates cannot be added together.

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5 Four Types of Credit Market Instruments 1. Simple loan

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6 2. Fixed Payment, or Amortized, Loan Examples: car loans, mortgages

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7 3. Coupon Bond Most bonds with maturities greater than a year are of this form. Coupons bonds issued by Federal government (Treasurys) State and local governments (munis) Corporations (corporates)

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9 Special Type of Coupon Bond: Consol or Perpetuity Fixed coupon received forever.

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10 4. Discount, or Zero Coupon, Bond Identical in cash flow structure to a simple loan. The difference is that there’s an active secondary market for zero coupon bonds.

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11 Draw cash flow diagrams for the four types of credit instruments. Take the perspective of the lender. Simple loan Annuity/Amortized loan Coupon bond Zero coupon (discount) bond

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12 Yield Curve

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13 Bond Page of the Newspaper

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14 RateMaturity Mo/Yr BidAskedChgAsked Yield 13 1/4May 15143:01143:02+146.78 Semi annual coupon on $1 mil of face value? $66,250.00 Number of coupons remaining? Nov06 … May15 18 Asked price of $1 mil of face value? $1,430,625

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15 Pricing a coupon bond Suppose I need a 4% rate of return. How much would I be willing to pay for $1 million of face value of the bond on the previous slide? (FV=1mil, n=18, i =.02, PMT = 66,250)

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16 http:// online.wsj.com/public/page/8_0004.html?mod=djemITP

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17 Yield to Maturity The rate of discount that equates the present value of future cash flows with the price of the credit instrument.

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18 Relationship Between Price and Yield to Maturity.

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19 Calculate the yield to maturity on a consol that pays $100 a year and is priced at $2,500. Recall formula for present value of a consol:

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20 Approximation for YTM: Current Yield

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21 Approximation to Yield to Maturity: Yield on a Discount Basis for Bills

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22 Fisher Equation The nominal (actual) interest rate equals the real rate plus the expected inflation rate.

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23 TIPS (Treasury Inflation Protection Securities) Originally issued in 1997. Interest and principal payments are adjusted for inflation. In times of high inflation the $ amount paid to investors rises. Return on TIPS provides information on expected inflation.

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24 Supply and Demand Analysis of the Bond Market Market Equilibrium 1. Occurs when B d = B s, at P* = $850, i* = 17.6% 2. When P = $950, i = 5.3%, B s > B d (excess supply): P to P*, i to i* 3. When P = $750, i = 33.0, B d > B s (excess demand): P to P*, i to i*

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25 Loanable Funds Terminology 1. Demand for bonds = supply of loanable funds 2.Supply of bonds = demand for loanable funds

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26 Shifts in the Bond Demand Curve

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27 Factors that Shift the Bond Demand Curve 1. Wealth A.Economy grows, wealth , B d , B d shifts out to right 2. Expected Return A.i in future, R e for long-term bonds , B d shifts out to right B. e , Relative R e , B d shifts out to right C.Expected return of other assests , B d , B d shifts out to right 3. Risk A.Risk of bonds , B d , B d shifts out to right B.Risk of other assets , B d , B d shifts out to right 4. Liquidity A.Liquidity of Bonds , B d , B d shifts out to right B.Liquidity of other assets , B d , B d shifts out to right

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28 Shifts in the Bond Supply Curve 1.Profitability of Investment Opportunities Business cycle expansion, investment opportunities , B s , B s shifts out to right 2.Expected Inflation e , B s , B s shifts out to right 3.Government Activities Deficits , B s , B s shifts out to right

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29 Changes in e : the Fisher Effect If e 1.B d shifts in to left 2.B s , B s shifts out to right 3.P , i © 2005 Pearson Education Canada Inc.

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