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54 Cards in this Set
- Front
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Suppose you purchased a coupon bond last year for its face value ($1,000) at a 12% coupon rate. Today, you have the opportunity to sell that bond to another investor for $980 after the initial coupon payment. If you decide to sell the bond, what is the yield to maturity on the bond? What is your rate of return on the bond? If prices rose by 3% between last year and today, what is your real rate of return?
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120/1000 - 20/1000
= 10% = Rate of Return Yield to Maturity of the Bond is 12% And rise in price is inflation (3%) so real rate of return = 7% |
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4 Determinants of Asset Demand
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W (Wealth)
E (Expected Return) R (Risk) L ( Liquidity) |
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4 Determinants of Asset Demand
Wealth |
The total resources owned by the individual, including all assets.
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4 Determinants of Asset Demand
Expected Return |
The return expected over the next period on one asset relative to alternative assets.
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4 Determinants of Asset Demand
Risk |
The degree of uncertainty associated with the return on one asset relative to alternative assets.
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4 Determinants of Asset Demand
Liquidity |
The ease and speed with which an asset can be turned into cash relative to alternative assets.
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Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:
Your Wealth Falls |
Less wealth means less ability to purchase stock.
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Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:
Expect stock to appreciate in value |
An increase in the expected value of the stock will cause people to buy more of it.
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Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:
The bond market becomes more liquid |
The more liquid an asset is relative to alternative assets, the more desirable it is, and the greater quantity demanded.
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Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:
You expect gold to appreciate in value |
An appreciation of gold means that the expected return of the stock is decreasing relatively. Thus, the demand will fall.
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Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:
Prices in the bond market become more volatile. Prices in the bond market become more volatile. |
A decrease in relative volatility increases the demand for the asset.
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What happens to demand for a Van Gogh painting if the stock market booms?
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All else held constant, the demand for paintings would decrease due to the relative loss in expected return.
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Everything else held constant, what effect will a sudden increase in the volatility of gold prices have on interest rates?
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The decrease in relative volatility for bonds will cause the de- mand curve to shift to the right, decreasing interest rates in the process.
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Greece has a huge debt, and tries to sell bonds to get money, but owed way more than their GDP could pay in a year. Using bond supply and demand analysis, explain what has happened to interest rates both in Greece and here in the United States.
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IfthereisasuddenconfidencecrisisinGreekbonds,thedemand for said bonds will collapse, sending the demand curve to the left. This is due to the increase in the relative risk of the bonds. With this in mind, the relative risk of American bonds falls, making them more desirable to these same investors who left the Greek market. Thus, the demand curve for American bonds will shift to the right. Considering these events the interest rates in Greece will increase, while those in the United State will fall.
This example shows us that events on the other side of the planet can have a direct effect on markets here. |
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What are the three determinants that shift the supply curve for bonds?
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G (government budget deficits)
E (expected profitability of investment opportunities) E (expected inflation) |
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GRAPHICALLY SHOW:
Supply and Demand for Bonds: Consider a situation in which your company is planning to expand its facilities and needs a bond issuance in order to fund it. What happens to the market for your bonds if the price of some of the equipment needed for the project suddenly spikes? |
SUPPLY CURVE SHIFTS LEFT
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GRAPHICALLY SHOW:
Liquidity Preference: Consider a situation in which oil prices (which are connected to nearly all other prices) suddenly rise. What does this model suggest will happen in the market for money? |
DEMAND CURVE SHIFTS RIGHT
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Asset
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Any financial claim or piece of property that is subject to ownership.
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Bond
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A debt security that promises to make payments periodically for a specified period of time.
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Interest Rate
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The cost of borrowing or the price paid for the rental of funds.
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Inflation
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A continual increase in the price level.
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Inflation Rate
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The rate of change of the price level, usually measured as a percentage change per year.
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Deflation
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A continual decrease in the price level.
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Disinflation
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A decrease in the inflation rate.
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Financial Intermediary
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Institutions that borrow funds from people who have saved and in turn make loans to others.
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Monetary Policy
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The management of money and interest rates.
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Fiscal Policy
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The decisions government makes regarding spending and taxation.
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What are the three functions of money?
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1) Store of Value
2) Unit of Account 3) Medium of Exchange SUM |
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What are the five standards that make a commodity a good medium of exchange?
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1) Does not deteriorate quickly
2) Easy to carry 3) Widely accepted 4) Divisible 5) Standardized |
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Consider a situation in which you own a hardware store that sells 56 different items. If you were unable to use one commodity as a unit of account, how many prices would you have to quote? If you could use a commodity as a unit of account, how many prices would you have to quote?
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N (N − 1) / 2
= 1, 540 prices. If we are able to use a unit of account, there will only be 56 prices to quote. |
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A country had rapid inflation, and US dollars were used instead of domestic currency. Why?
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The local currency was deteriorating fast, and US dollars were holding value well, and the foreign currency offset some of the inflation risk of the domestic currency.
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What is the difference between commodity money and fiat money?
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Commodity money has value outside its medium of exchange function to purchase goods and services, while fiat money is intrinsically worthless.
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Most to least liquid
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1) Currency, 2) checking account deposits, 3) savings deposits, 4) automobile, and 5) houses.
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Why is simply taking the total amount of currency an inadequate measure of money? Why is simply adding the dollar value of all financial assets together a poor measure of the money supply?
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Money is more than just currency, each component of the money supply is inherently different in terms of return, maturity, liquidity, risk, etc.
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Would a dollar tomorrow be worth more to you today when the interest rate is 20%, or when it is 10%?
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The dollar would be worth more to you today if the interest rate is 10%. This comes from the simple asset pricing
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Suppose you receive $X1 in the first year, $X2 in the second year, and $X3 in the third year. Suppose also that the interest rate is y. What is the present value of your receipts of dollars for three years?
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PV= X1/1+y + X2/(1+y) ^2 + X3/(1+Y)^3
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If the interest rate is 10%, what is the present value of a security that pays you $1,100 next year, $1,210 year after, and $1,331 the year after that?
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PV = 1,100 / 1.10 + 1,210 / (1.10)^2 + 1,331 / (1.10)^3
= $3,000 |
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Two jobs. The first job offers you a three year contract with present value of $140,000. The second job requires you to sign a contract for three years, paying you $46,000 in the first year, $48,000 in the second year, and $49,000 in the third year. If the market interest rate is four percent (4%), which offer should you take? Why?
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PV = 46,000 / 1.04 + 48,000 / (1.04)^2 + 49,000 / (1.04)^3
= $132,170 You take the first offer, the lump sum of $140,000 |
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We talked about term structure of interest rates, and specifically "term premium". What does a TP do, and what happens to its value as the maturity of the bond increases?
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The term premium, τn on an n period bond is added for a long term bond because of its riskiness, especially due to changing interest rates. As the maturity n gets larger, the term premium also gets larger on average.
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Why do we consider the changes in expected return, risk, and liquidity in relative terms and not in absolute terms?
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Relative terms because our portfolio of assets only changes if there is a change in the composition. If the expected return on all of my assets increased, there would be no reason for me to shift my wealth from one asset to another. However, if the expected return on only one of the assets increased, I would want to change the structure of my asset portfolio to take advantage of this.
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Show on the graph below what would happen to the money market if the economy were to go through an expansion. Be sure to label any new curves (M1s or M1d) and any new equilibrium interest rates (i1) and quantities (q1 ).
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The money demand (MD1 now) shifts right, the money supply did not change. Therefore new equilibrium is at a higher interest rate but Q did not change.
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$500
5% = i 4% = inflation What is nominal and real return |
2013 dollars 500 x 1.01 = $505 --> REAL
2014 dollars 500 x 1.05 = $525 --> NOMINAL |
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Coupon = $20
Face Value = $1000 n = 3 i = 5% |
PV = 20 / 1.05 + 20 / (1.05)^2 + 20 / (1.05)^3 + 1,000 / (1.05)^3
= about $918 --> Present Value |
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Pt1 = $918
Pt = $900 C = $20 |
R = C /Pt1 + Pt - Pt1 / Pt1
20-18 / 918 Don't be a ******* moron, common denominator. |
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As the interest rate goes up
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The price goes down
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Present Value of any Asset =
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The sum of it's future discounted cash flows.
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CF = PV (1+i)^n
$250 i= 15% |
250 = PV (1+.15)^2
PV=189.04 |
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To find i=
PV=300 CF=600 n=7 |
i= (CF/PV) ^1/n -1
i= (600/300)^1/7 - 1 i=10.4% |
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Fixed Payment Loan
n=3 20,000 i=.07 |
FP = 20,000/ (1/1.07) + (1/1.07^2) + (1/1.07^3)
= $7621.03 |
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P= FV/(1+i)
FV=1000 T-Bill i= .25 = 2.5% .0025 |
1000/1.0025
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The payments to the owner of the security plus the change in its value as a fraction of its purchase price.
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Rate of Return
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The return on a bond held from time t to time t +1 can be written as:
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R= C+Pt1 - Pt / Pt
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What happens if interest rate changes?
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A rise in interest rate causes a fall in bond prices, leading to capital losses
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Consider a $1,000-face-value coupon bond with a 10% coupon rate that is sold for $1,200 next year.
What’s the yield to maturity on this bond? |
Its yield to maturity is 10%
Its return is: $100+$200/ $1000 = 30% Return |
