Economics of the Financial System (Aug 2021 - Week 10 - 13)
1) FV, PV and ir
Valuing Monetary Payments
Applying PV (to stream of returns)
2) Bond Market (BM)
Fair Value of Bond = Sum of .....
Market price of Bond
Optional (Just for fun)
Bond valuation: Valuing the
In the future (Future Value)
Compound r
Simple r
Rule of 72
given r%
Now (Present Value)
*Interest Rates, r (inverse relationship)
Future Value, FV
Coupon Payments
Principal + Coupon Payments
Principal Payment
Internal rate of return
Example #2: Loan = $225 (paid over 3 year $100/yr;
paid over 2 years $125/yr)
Activity #1(a)
= Discounting Future Value
Activity #1(a)
Retire 65 (today: 45)
with $1.5 mn
r=1%: Find: PV of $1.5 mn (25 years from today)? Ans: $554,567
Retire = 65 (live = 85)
Annuity = $50K p.a. (for 25 years)
r=7%: Find: How much save? Ans: $529,701
r=3%: Find: PV of $1.5 mn (25 years from today)? Ans: $78,050
r=2%: Find: How much save? Ans: $817,572
See STUDENT WORKSHEET
Example #1: Machine that cost $1 mn (generates $150,000 a year) for 10 years
TIme, n
Number of years to double income/investment
PV of Principal
Demand for Bond-C rises (Shifts in DD)
PV of coupon payments
Supply of Bonds rises (Shifts in SS)
Real interest rates (nominal r less inflation)
Expectations of interest rates falls (Bond-C pays higher coupon cf newly-issued bonds)
Expectation of Bond Performance > Equity performance
Contractionary Monetary Policy (OM sales of T-securities)
Government Budget
Expectations of inflation rise (cheaper for firms to borrow)
Expansionary Monetary policy (OM purchase of T-securities)
Credit rating deteriorates (existing holders of Bond sell)
Credit rating for Bond-C improves
Budget Surplus
Budget Deficit
Improvements in business conditions (encourage firms to raise funds in Bond market)
Expectations of inflation fall (PV of Bond-C will be higher)
Impact: Bond-C will be more attractive / Bond demand increase
Demand for T-bills increase
Price of T-bills increase
Yield of T-bill falls
Banks' reserves increase
FFR falls
Proportional increase in Money Supply (market r falls)
Government borrowing (New issuance)
Government buys back bonds
Bond SS shifts left
Bond supply shifts right
Impact: Factors that cause Bond Supply to increase
Crowding-out private sector bond borrowing
Supply of T-bills rise
Bank reserves to fall
Price of T-bills falls
Yield of T-bills rise
Proportional fall in Money supply (market r rises)
FFR rises
3) Money Market (MM)
Money demand
Money Supply
Transactions = f(income)
Precautionary = f(income)
Speculative = f (interest rates)
Liquidity vs Yield
Downward sloping DD for money
Low r - More Liquidity / Less Yield
Liquidity Trap
4) Monetary Policy and the Bond Market
Conventional MP Tools
Unconventional MP
Tools
Quantitative Easing
Reserve Requirement Ratio (0% effective 26 Mar 2020); set by Fed
Discount rate, or Cash rate = Rates that Fed charges commercial banks
FFR (Fed funds rate) = Rates that commercial banks charge each other Interbank market
Fed Funds Market (Market for Bank Reserves)
Low r
High savings rate
Forward Guidance
IOR (Interest on Reserves) = Rates that Fed pays commercial banks on reserves
Interest on Required Reserves (IORR)
Interest on Excess Reserves (IOER)
Target: Fed Funds Rate (FFR) Interbank Lending
Min: IOER (Fed pays banks who have surplus reserves)
Negative Interest Rate Policy (NIRP)
Cases
Reserve Demand Curve (Downward sloping)
Reserve Supply Curve
Max: Fed Discount Rate (Fed charges banks who needs more reserves)
(i) Liquidity Trap (a new normal?)
Unwinding the QE
Zero Interest Rate Policy (ZIRP)
Fed OM purchase (increase Bank Reserves)
Fed OM sales (decrease Bank Reserves)
Set by Fed
Target FFR (Set by FOMC) = 0 to 0.25% (16 Mar 2020)
Effective FFR (Median weighted average data reported by banks)
Unsecured borrowings
Activity #3a; #3b: US Recessions (1990, 2001, 2008, 2020) - QE & ZIRP
Activity #4(a), #4(b): Japan (1990's; 2016) - QE, ZIRP; & NIRP
Case
Scenario (b): Expansionary MP
Scenario (a) Contractionary MP
Activity #2: Expansionary MP (Equilibrium in MM and BM)
High r - Less Liquidity / More Yield
MM and BM equilibrium
Money (More liquid; Lower r)
Bond (Less liquid; Higher r)
Activity #1: Bond-3%
(Market r) > (Coupon 3%)
(Market r) < (Coupon 3%)
Bond price falls / Bond price rise until YTM = Market r
Fractional Reserve Banking
Vertical line
Rendering MP ineffective
Effective Market FFR