Bond Markets
2 Chapter Outline
Background on bonds
Treasury and federal agency bonds
Municipal bonds
Corporate bonds
Institutional use of bond markets
Globalization of bond markets
3 Background on Bonds
Bonds represents long-term debt securities that are issued by government agencies or corporations
Interest payments occur annually or semiannually
Par value is repaid at maturity
Most bonds have maturities between 10 and 30 years
Bearer bonds require the owner to clip coupons attached to the bonds
Registered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners
4 Background on Bonds (cont’d)
Bond yields
The issuer’s cost of financing is measured by the yield to maturity
The annualized yield that is paid by the issuer over the life of the bond
Equates the future coupon and principal payments to the initial proceeds received
Does not include transaction costs associated with issuing the bond
Earned by an investor who invests in a bond when it is issued and holds it until maturity
The holding period return is used by investors who do not hold a bond to maturity
5 Treasury and Federal Agency Bonds
The U.S. Treasury issues Treasury notes or bonds to finance federal government expenditures
Note maturities are usually less than 10 years
Bonds maturities are 10 years or more
An active secondary market exists
The 30-year bond was discontinued in October 2001
6 Treasury and Federal Agency Bonds (cont’d)
Treasury bond auction
Normally held in the middle of each quarter
Financial institutions submit bids for their own accounts or for clients
Bids can be competitive or noncompetitive
Competitive bids specify a price the bidder is willing to pay and a dollar amount of securities to be purchased
Noncompetitive bids specify only a dollar amount of securities to be purchased
7 Treasury and Federal Agency Bonds (cont’d)
Treasury bond auction (cont’d)
The Salomon Brothers scandal
In a 1990 bond auction, Salomon Brothers purchased 65 percent of the bonds issued (exceeding the 35 percent maximum)
Salomon resold the bonds at higher prices to other institutions
In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities
In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department
Salomon created a reserve fund of $100 million to cover claims from civil lawsuits
8 Treasury and Federal Agency Bonds (cont’d)
Trading Treasury bonds
Bond dealers serve as intermediaries in the secondary market and also take positions in the bonds
30 primary dealers dominate the trading
Profit from the bid-ask spread
Conduct trading with the Fed during open market operations
Typical daily volume is about $200 billion
Online trading
TreasuryDirect program (http://www.treasurydirect.gov)
9 Treasury and Federal Agency Bonds (cont’d)
Treasury bond quotations
Published in financial newspapers
The Wall Street Journal
Barron’s
Investor’s Business Daily
Bond quotations are organized according to their maturity, with the shortest maturity listed first
Bid and ask prices are quoted per hundreds of dollars of par value
Online quotations at
http://www.investinginbonds.com
http://www.federalreserve.gov/releases/H15/
10 Treasury and Federal Agency Bonds (cont’d)
Stripped Treasury bonds
One security represents the principal payment and a second security represents the interest payments
Investors who desire a lump sum payment can choose the PO part
Investors desiring periodic cash flows can select the IO part
Degrees of interest rate sensitivity vary
Several securities firms create their own versions of stripped securities
11 Treasury and Federal Agency Bonds (cont’d)
Inflation-indexed Treasury bonds
In 1996, the Treasury started issuing inflation-indexed bonds that provide a return tied to the inflation rate
The coupon rate is lower than the rate on regular Treasuries, but the principal value increases by the amount of the inflation rate every six months
Inflation-indexed bonds are popular in high-inflation countries such as Brazil
12 Computing the Interest Payment of an Inflation-Indexed Bond
A 10-year bond has a par value of $1,000 and a coupon rate of 5 percent. During the first six months after the bond was issued, the inflation rate was 1.3 percent. By how much does the principal of the bond increase? What is the coupon payment after six months?
13 Treasury and Federal Agency Bonds (cont’d)
Savings bonds
Issued by the Treasury
Denomination is as small as $25
Have a 30-year maturity and no secondary market
Series EE bonds provide a market-based interest rate
Series I bonds provide a rate of interest tied to inflation
Interest on savings bonds is not subject to state and local taxes
Federal agency bonds
Ginnie Mae issues bonds and purchases mortgages that are insured by the FHA and the VA
Freddie Mac issues bonds and purchases conventional mortgages
Fannie Mae issues bonds and purchases residential mortgages
14 Municipal Bonds
Municipal bonds can be classified as either general obligation bonds or revenue bonds
General obligation bonds are supported by the municipal government’s ability to tax
Revenue bonds are supported by the revenues of the project for which the bonds were issued
Municipal bonds typically pay interest semiannually, with minimum denominations of $5,000
Municipal bonds have a secondary market
Most municipal bonds contain a call provision
15 Municipal Bonds (cont’d)
Credit risk
Less than .5 percent of all municipal bonds issued since 1940 have defaulted
Moody’s, Standard and Poor’s, and Fitch Investor Service assign ratings to municipal bonds
Some municipal bonds are insured against default
Results in a higher cost for the investor
16 Municipal Bonds (cont’d)
Variable-rate municipal bonds
Coupon payments adjust to movements in a benchmark interest rate
Some variable-rate munis are convertible to a fixed rate under specified conditions
17 Municipal Bonds (cont’d)
Tax advantages
Interest income is normally exempt from federal taxes
Interest income earned on bonds that are issued by a municipality within a particular state is exempt from state income taxes
Interest income earned on bonds issued by a municipality within a city in which the local government imposes taxes is normally exempt from the local taxes
18 Municipal Bonds (cont’d)
Trading and quotations
Investors can buy or sell munis by contacting brokerage firms
Electronic trading has become popular
http://www.tradingedge.com
Online quotations are available at http://www.munidirect.com and http://www.investinginbonds.com
19 Municipal Bonds (cont’d)
Yields offered on municipal bonds
Differs from the yield on a Treasury bond with the same maturity because:
Of a risk premium to compensate for default risk
Of a liquidity premium to compensate for less liquidity
The federal tax exemption of municipal bonds
20 Municipal Bonds (cont’d)
Yield curve on municipal bonds
Typically lower than the Treasury yield curve because of the tax differential
The municipal yield curve has a similar shape as the Treasury yield curve because:
It is influenced similarly by interest rate expectations
Investors require a premium for longer-term securities with lower liquidity in both markets
21 Corporate Bonds
Corporations issue corporate bonds to borrow for long-term periods
Corporate bonds have a minimum denomination of $1,000
Larger bonds offerings are achieved through public offerings registered with the SEC
Secondary market activity varies
Financial and nonfinancial institutions as well as individuals are common purchasers
Most corporate bonds have maturities between 10 and 30 years
Interest paid by corporations is tax-deductible, which reduces the corporate cost of financing with bonds
22 Corporate Bonds (cont’d)
Corporate bond yields and risk
Interest income earned on corporate represents ordinary income
Yield curve
Affected by interest rate expectations, a liquidity premium, and maturity preferences of corporations
Similar shape as the municipal bond yield curve
Default rate
Depends on economic conditions
Less than 1 percent in the late 1990s
Exceeded 3 percent in 2002
23 Corporate Bonds (cont’d)
Corporate bond yields and risk (cont’d)
Investor assessment of risk
Investors may only consider purchasing corporate bonds after assessing the issuing firm’s financial condition and ability to cover its debt payments
Investors may rely heavily on financial statements created by the issuing firm, which may be misleading
Bond ratings
Bonds with higher ratings have lower yields
Corporations seek investment-grade ratings, since commercial banks will only invest in bonds with that status
Rating agencies will not necessarily detect any misleading information contained in financial statements
24 Corporate Bonds (cont’d)
Private placement of corporate bonds
Often, insurance companies and pension funds purchase privately-placed bonds
Bonds can be placed with the help of a securities firm
Bonds do not have to be registered with the SEC
25 Corporate Bonds (cont’d)
Characteristics of corporate bonds
The bond indenture specifies the rights and obligations of the issuer and the bondholder
A trustee represents the bondholders in all matters concerning the bond issue
Sinking-fund provision
A requirement to retire a certain amount of the bond issue each year
Protective covenants:
Are restrictions placed on the issuing firm designed to protect the bondholders from being exposed to increasing risk during the investment period
Often limit the amount of dividends and corporate officers’ salaries the firm can pay
26 Corporate Bonds (cont’d)
Characteristics of corporate bonds (cont’d)
Call provisions:
Require the firm to pay a price above par value when it calls its bonds
The difference between the call price and par value is the call premium
Are used to:
Issue bonds with a lower interest rate
Retire bonds as required by a sinking-fund provision
Are a disadvantage to bondholders
27 Corporate Bonds (cont’d)
Bond collateral
Typically, collateral is a mortgage on real property
A first mortgage bond has first claim on the specified assets
A chattel mortgage bond is secured by personal property
Unsecured bonds are debentures
Subordinated debentures have claims against the firm’s assets that are junior to the claims of mortgage bonds and regular debentures
28 Corporate Bonds (cont’d)
Low- and zero-coupon bonds:
Are issued at a deep discount from par value
Require annual tax payments although the interest will not be received until maturity
Have the advantage to the issuer of requiring low or no cash outflow
Variable-rate bonds:
Allow investors to benefit from rising market interest rates over time
Allow issuers of bonds to benefit from declining rates over time
Convertibility
Convertible bonds allow investors to exchange the bond for a stated number of shares of common stock
Investors are willing to accept a lower rate of interest on convertible bonds
29 Corporate Bonds (cont’d)
Trading corporate bonds
Bonds are traded through brokers, who communicate orders to bond dealers
A market order transaction occurs at the prevailing market price
A limit order transaction will occur only if the price reaches a specified limit
Bonds listed on the NYSE are traded through the automated Bond System (ABS)
Online trading is possible at:
http://www.schwab.com
http://www.etrade.com
30 Corporate Bonds (cont’d)
Corporate bond quotations
More than 2,000 bonds are traded on the NYSE with a market value of more than $2 trillion
Corporate bond prices are reported in eighths
Corporate bond quotations normally include the volume of trading and the yield to maturity
31 Corporate Bonds (cont’d)
Junk bonds
Junk bonds have a high degree of credit risk
About two-thirds of junk bonds are used to finance takeovers
Size of the junk bond market
Currently about 3,700 junk bond offerings exist with a market value of $80 billion
Participation in the junk bond market
70 large issuers of junk bonds each have more than $1 billion in debt outstanding
Primary investors in junk bonds are mutual funds, life insurance companies, and pension funds
The junk bond secondary market consists of 20 bond traders
32 Corporate Bonds (cont’d)
Risk premium of junk bonds
The typical premium is between 3 and 7 percent above Treasury bonds with the same maturity
Performance of junk bonds
In the early 1990s, the popularity of junk bonds declined because of
Insider trading allegations
The financial problems of a few major issuers of junk bonds
The financial problems in the thrift industry
In the late-1990s, junk bonds performed well with few defaults
33 Corporate Bonds (cont’d)
Junk bonds (cont’d)
Contagion effects in the junk bond market
Specific adverse information may discourage investors from investment in junk bonds
34 Corporate Bonds (cont’d)
How corporate bonds facilitate restructuring
Using bonds to finance a leveraged buyout
An LBO is typically financed with senior debt and subordinated debt
LBO activity increased dramatically in the later 1980s
Many firms with excessive financial leverage resulting from LBOs reissued stock in the 1990s
35 Corporate Bonds (cont’d)
How corporate bonds facilitate restructuring (cont’d)
Using bonds to revise the capital structure
Debt is perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments
Sometimes, corporations issue bonds and use the proceeds for a debt-for-equity swap
Corporations with an excessive amount of debt can conduct an equity-for-debt swap
36 Institutional Use of Bond Markets
All financial institutions participate in bond markets
On any given day, commercial banks, bond mutual funds, insurance companies, and pension funds are dominant participants
A financial institution’s investment decisions will often simultaneously affect bond market and other financial market activity
37 Globalization of Bond Markets
Bond markets have become increasingly integrated as a result of frequent cross-border investments in bonds
Low-quality bonds issued globally by governments and large corporations are global junk bonds
The global development of the bond market is primarily attributed to bond offerings by country governments (sovereign bonds)
38 Globalization of Bond Markets (cont’d)
Eurobond market
Bonds denominated in various currencies are placed in the Eurobond market
Dollar-denominated bearer bonds are available in the Eurobond market
Underwriting syndicates help place Eurobond issues
Chapter 6
Money Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
2 Chapter Outline
Money market securities
Institutional use of money markets
Valuation of money market securities
Risk of money market securities
Interaction among money market yields
3 Money Market Securities
Money market securities:
Have maturities within one year
Are issued by corporations and governments to obtain short-term funds
Are commonly purchased by corporations and government agencies that have funds available for a short-term period
Provide liquidity to investors
4 Money Market Securities (cont’d)
Treasury bills:
Are issued by the U.S. Treasury
Are sold weekly through an auction
Have a par value of $1,000
Are attractive to investors because they are backed by the federal government and are free of default risk
Are liquid
Can be sold in the secondary market through government security dealers
5 Money Market Securities (cont’d)
Treasury bills (cont’d)
Investors in Treasury bills
Depository institutions because T-bills can be easily liquidated
Other financial institutions in case cash outflows exceed cash inflows
Individuals with substantial savings for liquidity purposes
Corporations to have easy access to funding for unanticipated expenses
6 Money Market Securities (cont’d)
Treasury bills (cont’d)
Pricing Treasury bills
The price is dependent on the investor’s required rate of return:
Treasury bills do not pay interest
To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested
7 Computing the Price of a Treasury Bill
A one-year Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill?
8 Money Market Securities (cont’d)
Treasury bills (cont’d)
Treasury bill auction
Investors submit bids on T-bill applications for the maturity of their choice
Applications can be obtained from a Federal Reserve district or branch bank
Financial institutions can submit their bids using the Treasury Automated Auction Processing System (TAAPS-Link)
Institutions must set up an account with the Treasury
Payments to the Treasury are withdrawn electronically from the account
Payments received from the Treasury are deposited into the account
9 Money Market Securities (cont’d)
Treasury bills (cont’d)
Treasury bill auction (cont’d)
Weekly auctions include 13-week and 26-week T-bills
4-week T-bills are offered when the Treasury anticipates a short-term cash deficiency
Cash management bills are also occasionally offered
Investors can submit competitive or noncompetitive bids
The bids of noncompetitive bidders are accepted
The highest competitive bids are accepted
Any bids below the cutoff are not accepted
Since 1998, the lowest competitive bid is the price applied to all competitive and noncompetitive bids
10 Money Market Securities (cont’d)
Treasury bills (cont’d)
Estimating the yield
T-bills are sold at a discount from par value
The yield is influenced by the difference between the selling price and the purchase price
If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price
11 Money Market Securities (cont’d)
Treasury bills (cont’d)
Estimating the yield (cont’d)
The annualized yield is:
Estimating the T-bill discount
The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:
12 Computing the Yield of a Treasury Bill
An investor purchases a 91-day T-bill for $9,782. If the T-bill is held to maturity, what is the yield the investor would earn?
13 Estimating the T-Bill Discount
Using the information from the previous example, what is the T-bill discount?
14 Money Market Securities (cont’d)
Commercial paper:
Is a short-term debt instrument issued by well-known, creditworthy firms
Is typically unsecured
Is issued to provide liquidity to finance a firm’s investment in inventory and accounts receivable
Is an alternative to short-term bank loans
Has a minimum denomination of $100,000
Has a typical maturity between 20 and 270 days
Has no active secondary market
Is typically not purchased directly by individual investors
15 Money Market Securities (cont’d)
Commercial paper (cont’d)
Ratings
The risk of default depends on the issuer’s financial condition and cash flow
Commercial paper rating serves as an indicator of the potential risk of default
Corporations can more easily place commercial paper that is assigned a top-tier rating
Junk commercial paper is rated low or not rated at all
16 Money Market Securities (cont’d)
Commercial paper (cont’d)
Volume of commercial paper:
Has increased substantially over time
Is commonly reduced during recessionary periods
Placement
Some firms place commercial paper directly with investors
Most firms rely on commercial paper dealers to sell
Some firms (such as finance companies) create in-house departments to place commercial paper
17 Money Market Securities (cont’d)
Commercial paper (cont’d)
Backing commercial paper
Issuers typically maintain a backup line of credit
Allows the company the right to borrow a specified maximum amount of funds over a specified period of time
Involves a fee in the form of a direct percentage or in the form of required compensating balances
Estimating the yield
The yield on commercial paper is slightly higher than on a T-bill
The nominal return is the difference between the price paid and the par value
18 Estimating the Commercial Paper Yield
An investor purchases 120-day commercial paper with a par value of $300,000 for a price of $289,000. What is the annualized commercial paper yield?
19 Money Market Securities (cont’d)
Commercial paper (cont’d)
The commercial paper yield curve:
Illustrates the yield offered on commercial paper at various maturities
Is typically established for a maturity range from 0 to 90 days
Is similar to the short-term range of the Treasury yield curve
Is affected by short-term interest rate expectations
Is similar to the yield curve on other money market instruments
20 Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs):
Are issued by large commercial banks and other depository institutions as a short-term source of funds
Have a minimum denomination of $100,000
Are often purchased by nonfinancial corporations
Are sometimes purchased by money market funds
Have a typical maturity between two weeks and one year
Have a secondary market
21 Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs) (cont’d)
Placement
Directly
Through a correspondent institution
Through securities dealers
Premium
NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety
22 Money Market Securities (cont’d)
Negotiable certificates of deposit (NCDs) (cont’d)
Yield
NCDs provide a return in the form of interest and the difference between the price at which the NCD was redeemed or sold and the purchase price
If investors purchase a NCD and hold it until maturity, their annualized yield is the interest rate
23 Money Market Securities (cont’d)
Repurchase agreements
One party sells securities to another with an agreement to repurchase them at a specified date and price
Essentially a loan backed by securities
A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them
Bank, S&Ls, and money market funds often participate in repos
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one, three, and six months
There is no secondary market for repos
24 Money Market Securities (cont’d)
Repurchase agreements (cont’d)
Placement
Repo transactions are negotiated through a telecommunications network with dealers and repo brokers
When a borrowing firm can find a counterparty to a repo transaction, it avoids the transaction fee
Some companies use in-house departments
Estimating the yield
The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360-day year
25 Estimating the Repo Yield
An investor initially purchased securities at a price of $9,913,314, with an agreement to sell them back at a price of $10,000,000 at the end of a 90-day period. What is the repo rate?
26 Money Market Securities (cont’d)
Federal funds
The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate
The rate is influenced by the supply and demand for funds in the federal funds market
The Fed adjusts the amount of funds in depository institutions to influence the rate
All firms monitor the fed funds rate because the Fed manipulates it to affect economic conditions
The fed funds rate is typically slightly higher than the T-bill rate
27 Money Market Securities (cont’d)
Federal funds (cont’d)
Two depository institutions communicate directly through a communications network or through a federal funds broker
The lending institution instructs its Fed district bank to debit its reserve account and to credit the borrowing institution’s reserve account by the amount of the loan
Commercial banks are the most active participants in the federal funds market
Most loan transactions are or $5 million or more and usually have one- to seven-day maturities
28 Money Market Securities (cont’d)
Banker’s acceptances:
Indicate that a bank accepts responsibility for a future payments
Are commonly used for international trade transactions
An unknown importer’s bank may serve as the guarantor
Exporters frequently sell an acceptance before the payment date
Have a return equal to the difference between the discounted price paid and the amount to be received in the future
Have an active secondary market facilitated by dealers
29 Money Market Securities (cont’d)
Banker’s acceptances (cont’d)
Steps involved in banker’s acceptances
First, the U.S. importer places a purchase order for goods
The importer asks its bank to issue a letter of credit (L/C) on its behalf
Represents a commitment by that bank to back the payment owed to the foreign exporter
The L/C is presented to the exporter’s bank
The exporter sends the goods to the importer and the shipping documents to its bank
The shipping documents are passed along to the importer’s bank
Sequence of Steps in the Creation of A Banker’s Acceptance
Importer
Exporter
American Bank
(Importer’s Bank)
Japanese Bank
(Exporter’s Bank)
Purchase Order
Shipment of Goods
L/C Application
L/C
Shipping Documents & Time Draft Accepted
L/C Notification
Shipping Documents & Time Draft
31 Institutional Use of Money Markets
Financial institutions purchase money market securities to earn a return and maintain adequate liquidity
Institutions issue money market securities when experiencing a temporary shortage of cash
Money market securities enhance liquidity:
Newly-issued securities generate cash
Institutions that previously purchased securities will generate cash upon liquidation
Most institutions hold either securities that have very active secondary markets or securities with short-term maturities
32 Institutional Use of Money Markets (cont’d)
Financial institutions with uncertain cash in- and outflows maintain additional money market securities
Institutions that purchase securities act as a creditor to the initial issuer
Some institutions issue their own money market instruments to obtain cash
33 Valuation of Money Market Securities
For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment
The discount rate is the required rate of return by investors
34 Valuation of Money Market Securities (cont’d)
Explaining money market price movements
The price of a noninterest-paying money market security is:
A change in the price can be modeled as:
35 Valuation of Money Market Securities (cont’d)
Indicators of future money market security prices
Economic growth is monitored since it signals changes in short-term interest rates and the required return from investing in money market securities
Employment
GDP
Retail sales
Industrial production
Consumer confidence
Indicators of inflation
36 Risk of Money Market Securities
Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk
Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default
Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuer’s financial condition is limited
Measuring risk
Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates
37 Interaction Among Money Market Yields
Money market instruments are substitutes for each other
Market forces will correct disparities in yield and the yields among securities tend to be similar
In periods of heightened uncertainty, investors tend to shift from risky money market securities to Treasuries
Flight to quality
Creates a greater differential between yields
38 Globalization of Money Markets
Interest rate differentials occur because geographic markets are somewhat segmented
Interest rates have become more highly correlated:
Conversion to the euro
The flow of funds between countries has increased because of:
Tax differences
Speculation on exchange rate movements
A reduction in government barriers
Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in international money markets
39 Globalization of Money Markets (cont’d)
Eurodollar deposits and Euronotes
Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S. banks
Have increased because of increasing international trade and historical U.S. interest rate ceilings
In the Eurodollar market, banks channel deposited funds to other firms that need to borrow them in the form of Eurodollar loans
Typical transactions are $1 million or more
Eurodollar CDs are not subject to reserve requirements
Interest rates are attractive for both depositors and borrowers
Rates offered on Eurodollar deposits are slightly higher than NCD rates
40 Globalization of Money Markets (cont’d)
Eurodollar deposits and Euronotes (cont’d)
Investors in fixed-rate Eurodollar CDs are adversely affected by rising market rates
Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates
Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR
The Eurocurrency market is made up of Eurobanks that accept large deposits and provide large loans in foreign currencies
Loans in the Eurocredit market have longer maturities than loans in the Eurocurrency market
Short-term Euronotes are issued in bearer form with maturities of one, three, and six months
41 Globalization of Money Markets (cont’d)
Euro-commercial paper (Euro-CP):
Is issued without the backing of a banking syndicate
Has maturities tailored to satisfy investors
Has a secondary market run by CP dealers
Has a rate 50 to 100 basis points above LIBOR
Is sold by dealers at a transaction cost between 5 and 10 basis points of the face value
42 Globalization of Money Markets (cont’d)
Performance of foreign money market securities
Measured by the effective yield (adjusted for the exchange rate
Depends on:
The yield earned on the money market security in the foreign currency
The exchange rate effect
43 Computing the Effective Yield
A U.S. investor buys euros for $1.15 and invests in a one-year European security with a yield of 8 percent. After one year, the investor converts the proceeds from the investment back to dollars at the spot rate of $1.16 per euro. What is the effective yield earned by the investor?
Chapter 2
Determination of Interest Rates
Financial Markets and Institutions, 7e, Jeff Madura
2 Chapter Outline
Loanable funds theory
Economic forces that affect interest rates
Forecasting interest rates
3 Loanable Funds Theory
Loanable funds theory suggests that the market interest rate is determined by the factors that affect the supply of and demand for loanable funds
Can be used to explain movements in the general level of interest rates of a particular country
Can be used to explain why interest rates among debt securities of a given country vary
4 Loanable Funds Theory (cont’d)
Household demand for loanable funds
Households demand loanable funds to finance
Housing expenditures
Automobiles
Household items
There is an inverse relationship between the interest rate and the quantity of loanable funds demanded
5 Loanable Funds Theory (cont’d)
Business demand for loanable funds
Businesses demand loanable funds to invest in fixed assets and short-term assets
Businesses evaluate projects using net present value (NPV):
Projects with a positive NPV are accepted
There is an inverse relationship between interest rates and business demand for loanable funds
6 Loanable Funds Theory (cont’d)
Government demand for loanable funds
Governments demand funds when planned expenditures are not covered by incoming revenues
Municipalities issue municipal bonds
The federal government issues Treasury securities and federal agency securities
Government demand for loanable funds is interest-inelastic
7 Loanable Funds Theory (cont’d)
Foreign Demand for loanable funds
Foreign demand for U.S. funds is influenced by the interest rate differential between countries
The quantity of U.S. loanable funds demanded by foreign governments or firms is inversely related to U.S. interest rates
The foreign demand schedule will shift in response to economic conditions
8 Loanable Funds Theory (cont’d)
Aggregate demand for loanable funds
The sum of the quantities demanded by the separate sectors at any given interest rate is the aggregate demand for loanable funds
9 Loanable Funds Theory (cont’d)
Household Demand
Business Demand
10 Loanable Funds Theory (cont’d)
Dg
Federal Government Demand
Dm
Municipal Government Demand
11 Loanable Funds Theory (cont’d)
Foreign Demand
12 Loanable Funds Theory (cont’d)
Aggregate Demand
13Loanable Funds Theory (cont’d)
Supply of loanable funds
Funds are provided to financial markets by
Households (net suppliers of funds)
Government units and businesses (net borrowers of funds)
Suppliers of loanable funds supply more funds at higher interest rates
14 Loanable Funds Theory (cont’d)
Supply of loanable funds (cont’d)
Foreign households, governments, and corporations supply funds by purchasing Treasury securities
Foreign households have a high savings rate
The supply is influenced by monetary policy implemented by the Federal Reserve System
The Fed controls the amount of reserves held by depository institutions
The supply curve can shift in response to economic conditions
Households would save more funds during a strong economy
15 Loanable Funds Theory (cont’d)
SA
Aggregate Supply
16 Loanable Funds Theory (cont’d)
Equilibrium interest rate - algebraic
The aggregate demand can be written as
The aggregate supply can be written as
17 Loanable Funds Theory (cont’d)
SA
Equilibrium Interest Rate - Graphic
18 Economic Forces That Affect Interest Rates
Economic growth
Shifts the demand schedule outward (to the right)
There is no obvious impact on the supply schedule
Supply could increase if income increases as a result of the expansion
The combined effect is an increase in the equilibrium interest rate
19 Loanable Funds Theory (cont’d)
SA
Impact of Economic Expansion
20 Economic Forces That Affect Interest Rates (cont’d)
Inflation
Shifts the supply schedule inward (to the left)
Households increase consumption now if inflation is expected to increase
Shifts the demand schedule outward (to the right)
Households and businesses borrow more to purchase products before prices rise
21Loanable Funds Theory (cont’d)
SA
Impact of Expected Increase in Inflation
22 Economic Forces That Affect Interest Rates (cont’d)
Fisher effect
Nominal interest payments compensate savers for:
Reduced purchasing power
A premium for forgoing present consumption
The relationship between interest rates and expected inflation is often referred to as the Fisher effect
23 Economic Forces That Affect Interest Rates (cont’d)
Fisher effect (cont’d)
Fisher effect equation:
The difference between the nominal interest rate and the expected inflation rate is the real interest rate:
24 Economic Forces That Affect Interest Rates (cont’d)
Money supply
If the Fed increases the money supply, the supply of loanable funds increases
If inflationary expectations are affected, the demand for loanable funds may also increase
If the Fed reduces the money supply, the supply of loanable funds decreases
During 2001, the Fed increased the growth of the money supply several times
25 Economic Forces That Affect Interest Rates (cont’d)
Money supply (cont’d)
September 11
Firms cut back on expansion plans
Households cut back on borrowing plans
The demand of loanable funds declined
The weak economy in 2001–2002
Reduced demand for loanable funds
The Fed increased the money supply growth
Interest rates reached very low levels
26 Economic Forces That Affect Interest Rates (cont’d)
Budget deficit
A high deficit means a high demand for loanable funds by the government
Shifts the demand schedule outward (to the right)
Interest rates increase
The government may be willing to pay whatever is necessary to borrow funds, but the private sector may not
Crowding-out effect
The supply schedule may shift outward if the government creates more jobs by spending more funds than it collects from the public
27 Economic Forces That Affect Interest Rates (cont’d)
Foreign flows of funds
The interest rate for a currency is determined by the demand for and supply of that currency
Impacted by the economic forces that affect the equilibrium interest rate in a given country, such as:
Economic growth
Inflation
Shifts in the flows of funds between countries cause adjustments in the supply of funds available in each country
28 Economic Forces That Affect Interest Rates (cont’d)
Explaining the variation in interest rates over time
Late 1970s: high interest rates as a result of strong economy and inflationary expectations
Early 1980s: recession led to a decline in interest rates
Late 1980s: interest rates increased in response to a strong economy
Early 1990s: interest rates declined as a result of a weak economy
1994: interest rates increased as economic growth increased
Drifted lower for next several years despite strong economic growth, partly due to the U.S. budget surplus
29 Forecasting Interest Rates
It is difficult to predict the precise change in the interest rate due to a particular event
Being able to assess the direction of supply or demand schedule shifts can help in understanding why rates changed
30 Forecasting Interest Rates (cont’d)
To forecast future interest rates, the net demand for funds (ND) should be forecast:
31 Forecasting Interest Rates (cont’d)
A positive disequilibrium in ND will be corrected by an increase in interest rates
A negative disequilibrium in ND will be corrected by a decrease in interest rates
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