Asset/funds market

An asset is a resource having economic value today, with the expectation that it will provide future benet to its owner

Economics 201 Week 3

Asset/Funds Market; Bond Market and Interest Rates

The return (rate of return) on an asset is the rate of increase in its value per unit of time The asset/funds market is process by which savers are matched with borrowers

Prof. William Dupor Every market has an object (in this case funds) and a price (in this case the interest rate). Supplier of funds gets paid a higher price via a higher interest rate Examples of supply and demand: 1 business taking out bank loan demands funds 2 business selling stock demands funds Payments for use of funds occurs after time has passed
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Asset/funds market in the circular ow diagram

Households asset/funds and goods market decisions

consumption-savings decision: how households divide income (minus taxes) between saving and consuming
Households

(a) Moe supplies $10k in funds as a loan

(c)

Businesses
(b)

Mr. Plow

Businesses Asset/Funds Market

Bonds Stocks Bank Loans/Deposits Money (M1)

(b) the business Mr. Plow (owned by Homer) demands $10k in funds as loan (c) $11k (loan plus interest) repaid after one year

Moe

(c) (a)

Asset Markets
Bonds Direct Loan Stocks Bank Loans/Deposits Money (M1)

Households
'supply'

Actor

'demand' payment

Market

portfolio decision: how to allocate savings amongst dierent assets payment lines are suppressed to reduce clutter in gure

consumptionsavings decision
'supply' Actor 'demand'

Goods
Market

Government
portfolio decision

Market

1/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Private savings and public savings

Households Y T = C + Private Savings Government T G = Public Savings National Savings (S), or Savings S = Private Savings + Public Savings

Investment and national savings

From Week 2: Y = C +I +G where I is physical investment (businesses structures & equipment, households residences and change in inventories) Since we know S = Y C G Then, it follows that S =I For the economy as a whole, savings must be equal to investment

= (Y T C ) + (T G ) = Y C G
When an actors savings is negative over a year, he is dissaving or borrowing.

T is taxes, G is government spending, C consumption. We will assume zero net exports.

Week 3 Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Asset/funds market and loanable funds

supply of funds comes from public (government) & private savings (households & businesses) demand for funds comes from government, businesses & households the rate of return is the price that adjusts so that supply equals demand Mankiws loanable funds term is misleading because not all funds are loans (example: stocks)
Week 3

Asset/funds market: movements along each curve

Supply Rate of Return 4%

supply curve slopes up higher rate of return makes delaying consuming more attractive to savers demand curve slopes down higher rate of return makes borrowing more expensive
$1,500 Rate of Return 4%

Supply

Demand $1,500 Funds (in billions of dollars)

Demand Funds (in billions of dollars)

2/11
Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Asset/funds market: movement of a curve

Example: Webvan

How do economic actors decide which assets to use?

Supply Rate of Return 4.1% 4% Demand2

Actors consider an assets three traits:

1 2

New business formed (1990s), Webvan Founders believed large prots possible delivering groceries ordered over Web Require eet of vans & refrigerated warehouses

expected return is forecast or best guess about rate of return high risk if there is a signicant chance its actual return diers from its expected return liquidity is ease with which asset can be converted into economys medium of exchange

the medium of exchange is the item that buyers give to sellers when they want to purchase goods and services
Demand1 $1,500

Funds $1,505 (in billions of dollars)

Expected return (and rate of return) can be thought of as the households price of consuming today relative to consuming in the future

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Random events: a few denitions

Random events: a few more denitions

a random event is one that depends on chance or unpredictable factors a random event has potential outcomes for any random event, we can assign a probability with each potential outcome a probability is the likelihood that one potential outcome actually occurs; it is always a number between, and including, zero and one (or 0% and 100%) the randomness is eventually resolved, and one potential outcome becomes the actual outcome

Two potential outcomes: heads or tails The probability of each potential outcome is 1/2 The actual outcome is either heads or tails A random variable is associated with a random event, it attaches one number to each potential outcome One random variable associated with a coin toss is: 4 for heads, 8 for tails the rate of return on an asset can also be a random variable risk is the amount of randomness about the rate of return on an asset
3/11

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Random variables associated with fair coin tosses

Two formulas

Risk and expected return and Mr. Plow

3 2 1 2 3

expected value (summarizes likely outcome) 1 1 4+ 8 = 6 2 2 1 1 y + z 2 2

standard deviation (measures randomness/risk) 1 |8 4| = 2 2 1 |z y | 2

Snowfall Mr. Plow payment to Moe Actual rate of return

2 ft. $8k -20%

4 ft. $10k 0%

6 ft. $12k 20%

8 ft. $14k 40%

10 ft. $16k 60%

heads 4 or y tails 8 or z
Week 3 Asset/Funds Market; Bond Market and Interest Rates

Medium randomness Medium risk Medium standard deviation

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Risk and expected return and Mr. Plow

Three examples of risky loan contracts: (1) no risk, (2) medium risk, (3) high risk Homer borrows $10k from Moe. Repayment depends on snowfall. Snowfall (prob.) 6 ft. (prob. 1 ) (1) No risk Loan repayment Return and Risk $12k Actual rate of return = 20% Expected rate of return = 20% Risk (std. dev.) = 0 (2) Medium risk Loan repayment Return and Risk $10k Actual rate of return = 0% $14k Actual rate of return = 40% Expected rate of return = 20% Risk (std. dev.) = 20%

Risk and expected return and Mr. Plow

Snowfall (prob.) 2 ft. (prob. 1/2 ) 10 ft. (prob. 1/2 )

(3) High Loan repayment $8k $16k

risk Return and Risk Actual rate of return = -20% Actual rate of return = 60% Expected rate of return = 20% Risk (std. dev.) = 40%

Snowfall (prob.) 4 ft. (prob. 1/2 ) 8 ft. (prob. 1/2 )

All three cases give identical expected rate of return Dier in terms of their risk

4/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Expected return and risk

Real interest rate versus nominal interest rate

Hugo lives in Venezuela and loves painting in March 06, he has 1000 bolivars in March 06, one tube of paint costs 10 bolivars

Households dislike risk Households can have dierent tolerance levels Will tolerate risk if suciently compensated

Hugo places money in bank for one year, earning 12% rate of return In March 07, Hugo receives 1120 bolivars from bank one tube of paint now costs 11 bolivars Hugo can now buy approx. 102 tubes (1120/11 = 101.81) Giving up 100 tubes in 06, Hugo can buy about 102 tubes in 07. Hugos real rate of return is approximately 2%

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Real and nominal interest rates and ination rate

Real interest rate versus the nominal interest rate

Formula for the real interest rate:

Inflation rate

Nominal interest rate

real interest rate = nominal interest rate ination rate From Week 2: nominal variables are measured in monetary units real variables are measured in physical units

Real interest rate

What would Hugos real rate of return be if the new price of paint were 13 bolivars?

5/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Loan decisions based on expected real interest rate

Compounding
Example

I take a $900 trip real interest rate: not known until loan is repaid depends on ination over life of loan expected real interest rate: known in advance based on expected ination expected real IR = nominal IR - expected ination rate Put it on credit card that charges an annual interest rate 16% every year If I do not pay o the debt for seven years, debt and interest and interest on interest accumulate.
initial debt after 1 year after 2 year . . . after 7 years 900 900 (1 + 0.16) 1044 (1 + 0.16) 2, 193 (1 + 0.16)

900 (1 + 0.16)2

= 1044 = 1, 211 = 2, 543

. . . = 900 (1 + 0.16)7

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Spring break in Panama City with a Visa card

2600 2400 2200 2000 1800 year 1600 1400 1200 1000 $2,543 final debt = $25,536

Compounding
General formula

Value of a loan after N years is: Value after N years = (1 + i )N P where i is the annual interest rate, P is the principal (initial) amount of loan

initial debt = $900

800 2007 2008 2009 2010 2011 value of debt 2012 2013 2014

6/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Our rst asset/funds sub-market: the bond market

Bond market in circular ow diagram

a bond is an IOU or promise to pay from its issuer (borrower) to its holder (lender)

(a) investor supplies funds by purchasing a 10 year corporate bond (b) Ford demands funds by selling a 10 year corporate bond (c) Ford makes annual interest (or coupon) payments and pays face value at maturity

Businesses
(c) (b)

Ford

Investor

(c) (a)

Households
'supply'

Bonds Stocks Bank Loans/Deposits Cash

Asset Markets

Actor

'demand' payment

Market

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

A one year bond

Bond terms

bond holder/buyer (lender)

creditor: holder of bond principal: amount paid (i.e. selling price) by bond buyer to bond seller

term: length of time until bond matures (i.e. is repaid) most bonds are transferable coupon payment: interest payment from bond issuer to bond holder bonds are also called xed income securities

$1,000 $1,000
Principal
bond issuer (borrower)

Par value +

$100
Coupon term = 1 year 12/31/2007 (maturity date)

par value: amount that will be repaid at maturity, also called face value a bonds selling price (when issued) equals or is very close to par value

1/1/2007 (date bond is issued)

7/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Bond issuer Par Value Creditor

Three dierent ways to measure yield on bond

Coupon yield, current yield, yield-to-maturity

The yield on a bond relates payments to bond holder to the bonds prices. Coupon yield = Current yield = Annual interest paid Initial bond price Annual interest paid Current bond price

Expiration date

example: if (i) bond pays $150 in interest in a year, (ii) its initial purchase price is $1000, (ii) its current market price is $750 then: coupon yield = 15% or 0.15 current yield = 20% or 0.20

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Yield-to-maturity of a one-year bond

Yield-to-maturity (YTM) tells what current rate of return on bond is if it is held until its maturity date. The yield-to-maturity r of a one-year bond is: r= Total payments in one year 1 Current bond price

Present value of a payment in one-year

Given a current bond price, you can compute yield-to maturity of a bond Given a current market interest rate, you can also compute the present value of any kind of future payment present value of any future sum of money is amount today that would be needed, at current interest rate, to produce a given future amount of money Payment in one year 1+i where i is current market interest rate Present value =
8/11

Numerator on right side includes interest payment & bonds face value In this class, yield or interest rate on bond refers to its YTM unless stated otherwise On CNBC, government bond yield data refer to YTM

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Yield-to-maturity of a bond that pays o in N years

Slightly dierent than formula than one-year bond. From previous compounding formula: Value after N years = (1 + i )N P Now, change the formula using: Yield-to-maturity (r ) = i, current price of bond = P Value after N years = Total bond payment in N years Then, yield-to-maturity is r=
N

Three Ways to Express an Interest Rate

Most common 12% 0.54%

For doing calculations 0.12 0.0054

On CNBC 1200 basis points 54 basis points

Total bond payment 1 Current bond price

Also, present value formula for payment in N years: Present value = Payment in N years (1 + i )N
Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

where i is current market interest rate

Week 3

A bonds price moves inversely with its yield

Multiple payments: YTM & present value formulas

YTM of a bond that makes multiple payments: P1 in one year, P2 in two years, etc. YTM is the r that solves this equation: Current bond price = P2 P1 PN + ++ 2 (1 + r ) (1 + r ) (1 + r )N

Using above formula requires a special calculator or web site! Present value of multiple payments: P1 in one year, P2 in two years, etc. Present value = P2 P1 PN + ++ 2 (1 + i ) (1 + i ) (1 + i )N

where i is the current market interest rate.

9/11
Week 3 Asset/Funds Market; Bond Market and Interest Rates Week 3 Asset/Funds Market; Bond Market and Interest Rates

Pg. 34 of 35

Risk and expected return of bonds:

Table: Summary of yield-to-maturity and present value formulas.

One year until payment N years until payment Multiple payments over time r is solution to this equation: Yield-tomaturity of bond (r)

r=

Future payment 1 Current Bond Price

r=N

Future payment Current bond price = 1 Current Bond Price P P2 PN 1 + + + N 1 + r (1 + r ) 2 (1 + r )

Standard and Poors, Moodys and other companies evaluate riskiness of businesses bonds
S&P Grade Riskiness Examples Credit Worthiness AAA very, very low MobilExxon Default risk almost zero AA ... CC Chrysler Bankruptcy very likely C very risky D very very risky Charter Comm. Bankruptcy most likely

Present value (PV) [current market interest rate = i]

PV =

Future payment 1+ i

PV =

Future payment

PV =

(1 + i )

P P2 PN 1 + ++ N 1 + i (1 + i ) 2 (1 + i )

Notes: Yield-to-maturity formula takes bond price and future payment(s) as given and computes r. Present value formula take payment(s) and i as given and computes present value. Payments in yield-to-maturity formula can include both par value and interest.

U.S. Federal government bonds (Treasuries) are considered riskless

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Corporate bond yields

Secondary bond market

GM sells a new 10-year bond in Jan. 07
initial buyer

Baa bond yield (higher risk)

$1,000 $1,000 $100

Coupon Jan. 08 Par value +

$100
Coupon Jan. 17

issuer Principal
Principles of Modern Macroeconomics, William Dupor, 2009

Jan. 07

Aaa bond yield (lower risk)

Risk Premium

In Jan. 08, General Electric (GE) sells a new 10-year bond suppose there is reduced supply of funds GE must give $200 coupon payments to sell its bond in secondary market in 08, GM 07 bond price will fall
10/11

Week 3

Asset/Funds Market; Bond Market and Interest Rates

Week 3

Asset/Funds Market; Bond Market and Interest Rates

GM sells a new 10-year bond in Jan. 07

initial buyer

$1,000 $1,000 $100

Coupon Jan. 08 Par value +

$100
Coupon Jan. 17

issuer Principal

Jan. 07

One year later, initial GM bond buyer sells to somebody else

new owner

$697
Cost of Used Bond

$1,000 $100
Coupon Par value +

(approx. $700)

issuer

Jan. 09

$100
Coupon Jan. 17

Jan. 08
Paid by new bond owner to initial owner
Week 3

(Assuming new bond owner gets yr. 1 coupon)

Asset/Funds Market; Bond Market and Interest Rates

11/11