Four Types of Credit Market Instruments

Makro Summary for Final Exam

Chapter 4)

Four types of Credit Market Instruments:

1. Simple Loan → principal is repaid at the maturity date with interest

E.g.:[pic 1]

CF = cash flow in one year                 = $110

n = number of years                        = 1

Interest rate                                = 10%

1. Fixed payment Loan → is repaid by making the same payment (principal + interest) every period for a set period of time

E.g.:

LV = loan value (present value)[pic 2]

FP = fixed yearly payment

N = number of years until maturity

1. Coupon Bond

E.g.:

P = price of coupon bond[pic 3]

C = yearly coupon payment

F = face value of the bond

n = years to maturity

Three Facts:

• When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate
• The price of a coupon bond and the yield to maturity are negatively related
• The yield to maturity is greater than the coupon rate when the bond price is below its face value

1. Discount Bond (same formula as simple loan)

E.g.:[pic 4]

F = face value of the discount bond

P = current price of the discount bond

n = years to maturity

Consol or Perpetuity: a bond with no maturity date that does not repay principal but pays fixed coupon payments forever[pic 5][pic 6]

Pc = price of the consol or perpetuity

C = yearly interest payment

ic = yield to maturity of the consol

Yield to Maturity: the interest rate that equates the present value of cash flow payments received from debt instrument with its value today

E.g.: discount bond

F= face value of the discount bond                        
P= current price of the discount bond[pic 7]

The distinction between interest rates and returns:

[pic 8]

• The return equals the yield to maturity only if the holding period equals the time to maturity
• A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period
• The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change
• The more distant a bond’s maturity, the lower the rate of return that occurs as a result of an increase in the interest rate
• Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise

Interest-Rate Risk:

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds

• There is no interest-rate risk for any bond whose time to maturity matches the holding period

Real and Nominal Interest Rates:

• Nominal interest rate makes no allowance for inflation
• Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing
• Ex ante real interest rate is adjusted for expected changes in the price level
• Ex post real interest rate is adjusted for actual changes in the price level

Fisher Equation:

i= nominal interest rate[pic 9]

r= real interest rate

πe= expected inflation rate

• When the real interest rate is low, there are greater incentives to borrow
• Low interest rates reduces the incentives to lend
• The real interest rate is a better indicator of the incentives to borrow or lend

Chapter 5) Interest Rate behavior

Theory of Portfolio Choice:

1. The quantity demanded of an asset is positively related to wealth
2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets
3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

Supply and Demand in the Bond Market:

Bond prices are determined by supply and demand forces. Each bond price is associated with a particular level of interest rates. (Bond prices are inversely related to YTM)

Demand of bonds depends on their quantity of saving and the current price of the bond.
As the prices increases the quantity demanded will decrease (inverse relationship). Alternatively, we can say as the interest rate falls, the quantity demanded will decrease.

Factors that shift the Demand curve right or left (decrease or increase in variables would result in opposite reactions):

1. Wealth rises → quantity demanded rises (shifts right)
2. Expected return relative to other assets rises → quantity demanded rises (shifts right)
3. Liquidity relative to other assets rises → quantity demanded rises (shifts right
4. Expected interest rate rises → quantity demanded falls (shifts left)
5. Expected inflation rises → quantity demanded falls (shifts lefts)
6. Riskiness of bonds relative to other asset rises → quantity demanded falls (shifts left)

Supply in the Bond Market → borrowers supply/sell bonds to finance projects. As price increases the quantity supplied will increase (positive relationship). Alternatively, we can say that as the interest rate falls, the quantity supplied will increase.

Factors that shift the Supply curve:

1. Expected profitability of investment opportunities→ raises firms desire to fund the investment; supply of bonds increases thus shifting the curve to the right. Likewise, in a recession, when there are fewer expected profitable investments, the supply of bonds falls and the curve shifts left
2. Expected Inflation → lowers the cost of borrowing, causes the supply of bonds to increase and thus shifts the curve to the right
3. Government Budget → Canadian government issues bonds to finance their deficits. High deficits increase the supply of bonds and shifts the curve to the right. On the other hand, government surpluses decrease the supply of bonds and shifts the curve to the left

Market Equilibrium:

• Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price
• Bd = Bs defines the equilibrium (or market clearing) price and interest rate.
• When Bd > Bs, there is excess demand, price will rise and interest rate will fall
• When Bd < Bs, there is excess supply, price will fall and interest rate will rise
• Interest rate is negatively related to bond price, so when the equilibrium bond price rises, the equilibrium interest rate falls (bond price falls, interest rate rises)
• Fisher effect: when expected inflation rises, interest rate will rise.

The Liquidity Preference Framework (by Keynes):

Equilibrium interest rates are determined by the supply and demand for money → is equivalent to the framework that analyzes supply and demand in the bond market in order to determine the equilibrium interest rate