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

2 Debt Instruments Chapter 4

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

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.

5 Four Types of Credit Market Instruments 1. Simple loan

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

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.

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.

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

12 Yield Curve

13 Bond Page of the Newspaper

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

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)

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

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

18 Relationship Between Price and Yield to Maturity.

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:

20 Approximation for YTM: Current Yield

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

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

23 TIPS (Treasury Inflation Protection Securities) Originally issued in 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.

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*

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

26 Shifts in the Bond Demand Curve

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

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

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.