Type:
Solution Manual
Resource:
Financial Markets and Institutions
Edition:
10th Edition
Author(s):
Frederick S. Mishkin Stanley Eakins
Chapter 1 Why Study Financial Markets and Institutions? Why Study Financial Markets? Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions? Structure of the Financial System Financial Crises Central Banks and the Conduct of Monetary Policy The International Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks
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Overview and Teaching Tips
Before embarking on a study of financial markets and institutions, the student must be convinced that this subject is worth studying. Chapter 1 pursues this goal by showing the student that financial markets and institutions is an exciting field because it focuses on phenomena that affect everyday life. An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides the students with a guide as to how they will be studying financial markets and institutions with a unifying, analytic framework and an applied managerial perspective. In teaching this chapter, the most important goal should be to get the student excited about the material. I have found that talking about the data presented in the figures helps achieve this goal by showing the students that the subject matter of financial markets and institutions has real-world implications that they should care about. In addition, it is important to emphasize to the students that the course will have an applied managerial
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Chapter 1: Why Study Financial Markets and Institutions?
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perspective, which they will find useful later in their careers. Going through the web exercise is also a way of encouraging the students to use the web to further their understanding of financial markets and institutions.
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Answers to End-of-Chapter Questions
1.
Well-performing financial markets tend to allocate funds to its more efficient use, thereby allowing the best investment opportunities to be undertaken. The improvement in the allocation of funds results in a more efficient economy, which stimulates economic growth (and thereby poverty reduction).
2.
Businesses would cut investment spending because the cost of financing this spending is now higher, and consumers would be less likely to purchase a house or a car because the cost of financing their purchase is higher.
3.
A change in interest rates affects the cost of acquiring funds for financial institutions, as well as changes the income on assets such as loans, both of which affect profits. In addition, changes in interest rates affect the price of assets such as stocks and bonds that the financial institution owns, which can lead to profits or losses.
4.
While it is true that there are many interest rates in the economy, like the interest rate paid by a corporate bond or the interest rate charged to a homeowner, it is also true that all of these interest rates tend to move together. Evidence shows that movements in different interest rates over time are in large part explained by the same events, and thereby allow economists to refer to “the” interest rate when trying to determine its movements.
5.
The lower price for a firm’s shares means that it can raise a smaller amount of funds, and so investment in plant and equipment will fall.
6.
A bond is a debt instrument, which entitles the owner to receive periodic amounts of money (predetermined by the characteristics of the bond) until its maturity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state that stockholders are residual claimants (i.e., the corporation has to pay all bondholders before paying stockholders).
7.
It makes foreign goods more expensive, and so British consumers will buy less foreign goods and more domestic goods.
8.
It makes British goods more expensive relative to American goods. American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise.
9.
Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets. Also, changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions.
10. In the mid- to late 1970s, the late 1980s, and the early 1990s, the value of the dollar was low, making travel abroad relatively more expensive; that would have been a good time to vacation in the United States and see the Grand Canyon. As the dollar’s value rose in the early 1980s, travel abroad became relatively cheaper, making it a good time to visit the Tower of London.
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Mishkin/Eakins • Financial Markets and Institutions, Tenth Edition
11. In general, people do not lend large amounts of money to one another because of several information problems. In particular, people do not know about the capacity of other people of repaying their debts, or the effort they will provide to repay their debts. Financial intermediaries, in particular commercial banks, tend to solve these problems by acquiring information about potential borrowers and writing and enforcing contracts that encourage lenders to repay their debt and/or maintain the value of the collateral. 12. Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies. 13. The latest financial crisis in the U.S. and Europe occurred in 2007 – 2009. At the beginning it hit mostly the U.S. financial system, but it then quickly moved to Europe, since financial markets are highly interconnected. One specific way in which these markets were related is that some financial intermediaries in Europe held securities backed by mortgages originated in the U.S., and when these securities lost a considerable part of their value, the balance sheet of European financial intermediaries was adversely affected. 14. The profitability of financial institutions is affected by changes in interest rates, stock prices, and foreign exchange rates; fluctuations in these variables expose these institutions to risk. 15. Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.
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Quantitative Problem
1.
The following table lists foreign exchange rates between U.S. dollars and British pounds during April: Date
U.S. Dollars per GBP
Date
U.S. Dollars per GBP
4/1 4/4 4/5 4/6 4/7 4/8 4/11 4/12 4/13 4/14 4/15
1.9564 1.9293 1.914 1.9374 1.961 1.8925 1.8822 1.8558 1.796 1.7902 1.7785
4/18 4/19 4/20 4/21 4/22 4/25 4/26 4/27 4/28 4/29
1.7504 1.7255 1.6914 1.672 1.6684 1.6674 1.6857 1.6925 1.7201 1.7512
Which day would have been the best day to convert $200 into British pounds? Which day would have been the worst day? What would be the difference in pounds? Solution: The best day is 4/25. At a rate of $1.6674/pound, you would have £119.95. The worst day is 4/7. At $1.961/pound, you would have £101.99, or a difference of £17.96.
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Chapter 2 Overview of the Financial System Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets Internationalization of Financial Markets International Bond Market, Eurobonds, and Eurocurrencies Global Box: Are U.S. Capital Markets Losing Their Edge? World Stock Markets Function of Financial Intermediaries: Indirect Finance Transaction Costs Following the Financial News: Foreign Stock Market Indexes Global Box: The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Economies of Scope and Conflicts of Interest Types of Financial Intermediaries Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroad
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Mishkin/Eakins • Financial Markets and Institutions, Tenth Edition
Overview and Teaching Tips
Chapter 2 is an introductory chapter that contains the background information on the structure and operation of financial markets that is needed in later chapters of the book. This chapter allows the instructor to branch out to various choices of later chapters, thus allowing different degrees of coverage of financial markets and institutions. The most important point to transmit to the student is that financial markets and financial intermediaries are crucial to a well-functioning economy because they channel funds from those who do not have a productive use for them to those who do. Some instructors will want to teach this chapter in detail, and those who focus on international issues will want to spend some time on the section “Internationalization of Financial Markets.” However, those who slant their course to public policy issues may want to give this chapter a more cursory treatment. No matter how much class time is devoted to this chapter, we have found that it is a good reference chapter for students. You might want to tell them that if in later chapters they do not recall what particular financial intermediaries do and who regulates them, they can refer back to this chapter, especially to tables, such as Tables 2.1 and 2.3.
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Answers to End-of-Chapter Questions
1.
Examples of how financial markets allow consumers to better time their purchases include: • The purchase of a durable good, like a car or furniture • Paying for tuition • Paying the cost of repairing a flooded basement In all three cases, consumers were able to pay for a good or service (education or the reparation of a flooded basement) without having to wait to save enough and only then being able to afford such goods and services.
2.
Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $5,500. Since Larry’s loan-sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.)
3.
Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly.
4.
The principal debt instruments used were foreign bonds which were sold in Britain and denominated in pounds. The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads.
5.
If the yen-denominated bond is sold in Tokyo, then it is not considered a Eurobond. If the bond is sold in New York, then it is considered a Eurobond.
6.
You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.
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Chapter 2: Overview of the Financial System
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7. Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member. 8.
Maria cannot participate in a hedge fund since this type of mutual fund requires minimum contributions of $100,000 and sometimes more. This type of financial intermediary is targeted to specific savers that have a less cautious perception of risks, using the collected funds to buy assets that earn high returns, but are quite risky.
9. Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage in moral hazard. 10. They might not work hard enough while you are not looking or may steal or commit fraud. 11. Yes, because eliminating moral hazard requires enforcement even if there is no information asymmetry. Even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so moral hazard remains a problem. 12. True. If there are no information or transaction costs, people could make loans to each other at no cost and would thus have no need for financial intermediaries. 13. Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able to earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor. 14. Financial intermediaries benefit because they can earn profits on the spreads between the returns they earn on risky assets and the payments they make on the assets they have sold. Households and firms benefit because they can now own assets that have lower risk. 15. This is a topic for which there is no clear answer. On one side, it would be beneficial to have financial regulations that are identical in all countries to avoid financial market participants migrating their business to countries with fewer regulations. On the other side, all countries are different and designing a common set of financial regulations seems to be a rather difficult task. Most countries would want to maintain at least part of their regulations, so consensus is difficult to reach.
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Chapter 3 What Do Interest Rates Mean, and What Is Their Role in Valuation? Measuring Interest Rates Present Value Four Types of Credit Market Instruments Yield to Maturity The Distinction Between Real and Nominal Interest Rates Global Box: Negative Interest Rates? Japan First, Then the United States, Then Europe The Distinction Between Interest Rates and Returns Mini-Case Box: With TIPS, Real Interest Rates Have Become Observable in the United States Maturity and the Volatility of Bond Returns: Interest-Rate Risk Reinvestment Risk Summary Mini-Case Box: Helping Investors to Select Desired Interest-Rate Risk The Practicing Manager: Calculating Duration to Measure Interest-Rate Risk Calculating Duration Duration and Interest-Rate Risk
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Overview and Teaching Tips
In our years of teaching financial markets and institutions, we have found that students have trouble with what we consider to be easy material because they do not understand what an interest rate is—that it is negatively associated with the price of a bond, that it differs from the return on a bond, and that there is an important distinction between real and nominal interest rates. This chapter spends more time on these issues than does any other competing textbook. Our experience has been that giving this material so much attention is well rewarded. After putting more emphasis on this material in my financial markets and institutions course, we witnessed a dramatic improvement in students’ understanding of portfolio choice and asset and liability management in financial institutions. An innovative feature of the textbook is the set of over twenty special applications called, “The Practicing Manager.” These applications introduce students to real-world problems that managers of financial institutions have to solve and make the course both more relevant and exciting to students. They are not meant to fully prepare students for jobs in financial institutions—it is up to more specialized courses such as bank or financial institutions management to do this—but these applications teach them some of the special analytical tools that they will need when they enter the business world.
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Chapter 3: What Do Interest Rates Mean, and What Is Their Role in Valuation?
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This chapter contains the Practicing Manager application on “Calculating Duration to Measure InterestRate Risk.” The application shows how to quantify interest-rate risk using the duration concept and is a basic tool for managers of financial institutions. For those instructors who do not want a managerial emphasis in their financial markets and institutions course, this and other Practicing Manager applications can be skipped without loss of continuity.
◼ Answers to End-of-Chapter Questions 1.
When comparing amounts of money that are disbursed at different dates, one has to take into consideration the concept of present value of money. To calculate the present value of the $5,500 promised one year from today, one needs to know the annual interest rate. In this case, for an interest rate larger than 10%, one would prefer to accept the $5,000 today (since one can deposit that amount and receive more than $5,500 one year from today).
2.
You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return.
3.
The rate of capital gain is the part of the rate of return formula that incorporates future changes in the price of the bond. The other part of the formula, the current yield, is composed of the coupon payment (completely determined by the bond´s face value and coupon rate) and the price you paid for the bond today. The rate of capital gain incorporates the future price of the bond and is therefore the part of the formula that reflects the consequences of future price changes.
4.
People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (=5 percent – 2 percent) to 1 percent (=10 percent – 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)
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Quantitative Problems
1. Calculate the present value of a $1,000 zero-coupon bond with 5 years to maturity if the required annual interest rate is 6%. Solution: PV = FV/(1 + i)n where
FV = 1000, i = 0.06, n = 5 PV = 747.25
2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first payment is made immediately, what is this grand prize really worth? Use a discount rate of 6%. Solution: This is a simple present value problem. Using a financial calculator, N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode. Compute PV: PV = $6,079,058.25 3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table: Years to Maturity 3 3
Discount Rate 5 7
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Current Price
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Mishkin/Eakins • Financial Markets and Institutions, Tenth Edition
6 9 9
7 7 9
What relationship do you observe between yield to maturity and the current market value? Solution: Years to Maturity 3 3 6 9 9
Yield to Maturity
Current Price
5 7 7 5 9
$1,054.46 $1,000.00 $1,000.00 $1,142.16 $ 880.10
When yield to maturity is above the coupon rate, the band’s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate. For a given maturity, the bond’s current price falls as yield to maturity rises. For a given yield to maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond’s current price equals its face value regardless of years to maturity. 4. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently selling for $1,150 and has 8 years to maturity. What is the bond’s yield to maturity? Solution: To calculate the bond’s yield to maturity using a financial calculator, N = 8; PMT = 1000 0.10 = 100; FV = 1000; PV = 1150 Compute I: I = 7.44 5.
Suppose that a commercial bank wants to buy Treasury Bills. These instruments pay $5,000 in one year and are currently selling for $5,012. What is the yield to maturity of these bonds? Is this a typical situation? Why? Solution: The yield to maturity of these bonds solves the following equation: 5,000/(1+i) = 5,012. After some algebra, the yield to maturity happens to be around – 0.24%. This is not a typical situation. In normal times banks will not choose to pay more than the face value of a discount bond, since that implies negative yields to maturity. This example illustrates situations as the ones described in the Global Box in this chapter.
6. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%? If the yield to maturity doubles, what will happen to its price? Solution: The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price would fall to half its previous value, to $1000 = $50/.05. 7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just bought a $100,000 home, what is the PV of all the future property tax payments? Assume that the house remains worth $100,000 forever, property tax rates never change, and that a 9% discount rate is used for discounting.
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Chapter 3: What Do Interest Rates Mean, and What Is Their Role in Valuation?
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Solution: The taxes on a $100,000 home are roughly 100,000 0.0266 = 2,660. The PV of all future payments = 2,660/0.09 = $29,555.55 (a perpetuity). 8.
Suppose you want to take out a loan and that your local bank wants to charge you an annual real interest rate equal to 3%. Assuming that the annualized expected rate of inflation over the life of the loan is 1%, determine the nominal interest rate that the bank will charge you. What happens if, over the life of the loan, actual inflation is 0.5%? Solution: The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if actual inflation turns out to be lower than expected, then you will be worse off than originally planned, since the real cost of borrowing (measured by the real interest rate) turned out to be 4% – 0.5% = 3.5%.
9.
Lucia just bought two coupon bonds, one with a face value of $1,000 and the other with a face value of $5,000. Both bonds have a coupon rate of 5% and sold at par today. Calculate both bonds’ current yield and rate of return if Lucia is able to sell these bonds one year later for $100 more than the buying price. Can you estimate what happened to the interest rate over that year? Solution: The current yield (CY) is calculated as the coupon payment over the selling price of the bond. When a coupon bond sells at par, its current yield equals the coupon rate, since the numerator of the CY is: Face Value x Coupon Rate (always) and the denominator is Face Value (in this particular situation only in which Price = FV). Both bonds have a CY = 5%. If Lucia is able to sell the $1,000 FV coupon bond for $1,100, then the rate of return is: 5% + 10% (since the rate of capital gain is 100/1,000 =10%). The same reasoning yields a RET = 5% + 2% (g = 100/5,000) for the other bond. The interest rate must have fallen over that year for bonds’ prices to increase. Note, however, that it is unlikely that both bonds’ prices increased by the same amount. Other determinants of bonds’ prices (see Chapters 4 and 5) likely explained this effect.
10. You have paid $980.30 for an 8% coupon bond with a face value of $1,000 that matures in five years. You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, what price must you sell the bond for? Is this realistic? Solution: To find the price, solve:
80 + Pt +1 − 980.30 = 0.09 for Pt +1 . Pt +1 = 988.53. 980.30 Although this appears possible, the yield to maturity when you purchased the bond was 8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the yield would have to drop to 8.35% for the price to be $988.53. 11. Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%. Solution: Year Payments PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price
.
1
2
3
60.00 56.07 56.07 0.06
60.00 52.41 104.81 0.11
1060.00 865.28 2595.83 2.67
Sum 973.76 2.83
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Mishkin/Eakins • Financial Markets and Institutions, Tenth Edition
This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76, which is the sum of the individual “PV of payments.” 12. Consider the bond in the previous question. Calculate the expected price change if interest rates drop to 6.75% using the duration approximation. Calculate the actual price change using discounted cash flow. Solution: Using the duration approximation, the price change would be:
P = −DUR
i −0.0025 P = −2.83 973.76 = 6.44. 1+ i 1.07
The new price would be $980.20. Using a discounted cash flow approach, the price is 980.23—only $.03 different. Year Payments PV of payments
1
2
3
Sum
60.00 56.21
60.00 52.65
1060.00 871.3
980.23
13. The duration of a $100 million portfolio is 10 years. $40 million in new securities are added to the portfolio, increasing the duration of the portfolio to 12.5 years. What is the duration of the $40 million in new securities? Solution: First, note that the portfolio now has $140 million in it. The duration of a portfolio is the weighted average duration of its individual securities. Let D equal the duration of the $40 million in new securities. Then, this implies:
12.5 = (100/140 10) + (40/140 D) 12.5 = 7.1425 + 0.2857 D 18.75 = D The new securities have a duration of 18.75 years. 14. A bank has two, 3-year commercial loans with a present value of $70 million. The first is a $30-million loan that requires a single payment of $37.8 million in 3 years, with no other payments until then. The second is for $40 million. It requires an annual interest payment of $3.6 million. The principal of $40 million is due in 3 years. a. What is the duration of the bank’s commercial loan portfolio? b. What will happen to the value of its portfolio if the general level of interest rates increased from 8% to 8.5%? Solution: The duration of the first loan is 3 years since it is a zero-coupon loan. The duration of the second loan is as follows: Year Payment PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price
.
1
2
3
3.60 3.33 3.33 0.08
3.60 3.09 6.18 0.15
43.60 34.61 103.83 2.53
Sum 41.03 2.76
Chapter 3: What Do Interest Rates Mean, and What Is Their Role in Valuation?
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The duration of a portfolio is the weighted average duration of its individual securities. So, the portfolio’s duration = 3/7 (3) + 4/7 (2.76) = 2.86 If rates increased, P = −DUR 15. Year
i 0.005 P = −2.86 70,000,000 = −926,852. 1+ i 1.08
Consider a bond that promises the following cash flows. The required discount rate is 12%. 0 1 2 3 4
Promised Payments
160
170
180
230
You plan to buy this bond, hold it for 2½ years, and then sell the bond. a. What total cash will you receive from the bond after the 2½ years? Assume that periodic cash flows are reinvested at 12%. b. If immediately after buying this bond, all market interest rates drop to 11% (including your reinvestment rate), what will be the impact on your total cash flow after 2½ years? How does this compare to part (a)? c. Assuming all market interest rates are 12%, what is the duration of this bond? Solution: a. You will receive $160 reinvested for 1.5 years, and $170 reinvested for 0.5 years. Then you will sell the remaining cash flows, discounted at 12%. This gives you:
160 (1.12)1.5 + 170 (1.12)0.5 +
180 230 + = $733.69. 0.5 1.12 1.121.5
b. This is the same as part (a), but the rate is now 11%.
160 (1.11)1.5 + 170 (1.11)0.5 +
180 230 + = $733.74. 0.5 1.11 1.111.5
Notice that this is only $0.05 different from part (a). c.
The duration is calculated as follows: Year Payments PV of Payments Time Weighted PV of Payments Time Weighted PV of Payments Divided by Price
1
2
3
4
160.00 142.86 142.86 0.26
170.00 135.52 271.05 0.49
180.00 128.12 384.36 0.70
230.00 146.17 584.68 1.06
Sum 552.67
Since the duration and the holding period are the same, you are insulated from immediate changes in interest rates! It doesn’t always work out this perfectly, but the idea is important.
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2.50
Chapter 4 Why Do Interest Rates Change? Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Theory of Portfolio Choice Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply-and-Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds Case: Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect Case: Changes in the Interest Rate Due to a Business Cycle Expansion Case: Explaining the Current Low Interest Rates in Europe, Japan, and the United States The Practicing Manager: Profiting from Interest-Rate Forecasts Following the Financial News: Forecasting Interest Rates Appendix 1: Models of Asset Pricing Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Appendix 3: Loanable Funds Framework Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework
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Overview and Teaching Tips
As is clear in the preface to the textbook, we believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates
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Chapter 4: Why Do Interest Rates Change?
15
are determined, how financial institutions manage their assets and liabilities, why financial innovation takes place, and how prices are determined in the stock market and the foreign exchange market. One teaching device that we have found helps students develop their intuition is the use of summary tables, such as Table 4.1, in class. We use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. We use this device continually throughout the course and in this book, as is evidenced from similar summary tables in later chapters. We recommend this approach highly. The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market. An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using a stock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with modern treatment of asset markets by financial economists. Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principles of economics textbooks. The ceteris paribus derivations of supply and demand curves with numerical examples are presented, the concept of equilibrium is carefully developed, the factors that shift the supply and demand curves are outlined, and the distinction between movements along a demand or supply curve and shifts in the curve is clearly drawn. Our feeling is that the step-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of financial markets and institutions. We have found that even those students who have had excellent training in earlier courses find that this chapter provides a valuable review of supply and demand analysis. The Practicing Manager application at the end of the chapter shows how interest rate forecasts can be used by managers of financial institutions to increase profits. This application shows students how the analysis they have learned is useful in the real world. This chapter has an extensive set of appendices on the web to enhance its material. Appendix 1 provides models of asset pricing in case an instructor wants to make use of the capital asset pricing model or the arbitrage pricing model in this course. Appendix 2 shows how the analysis developed in the chapter can be applied to understanding how any asset’s price is determined. Students particularly like the application to the gold market because this commodity piques almost everybody’s interest. Appendix 3 provides another interpretation of the supply and demand analysis for bonds using a different terminology involving the supply and demand for loanable funds. Appendix 4 provides an alternative approach to interest rate determination developed by John Maynard Keynes, known as the liquidity preference framework.
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