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Money and Financial Institutions. Mike & Ryan. Bonds . Bonds: certificate that promises to pay some money in the future Future money can be paid in two ways Maturity Value (Par Value, Face Value) Coupon (most coupon bonds pay semi-annually)

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Presentation Transcript
  • Bonds: certificate that promises to pay some money in the future
  • Future money can be paid in two ways
    • Maturity Value (Par Value, Face Value)
    • Coupon (most coupon bonds pay semi-annually)
  • Yield or yield to maturity=interest rate paid on a bond
  • $90.91 matures to $100 equivalent to earning 10%
  • Inverse relationship with prices and yields
    • i.e. high price, low yield
    • Seesaw
government bonds
Government Bonds
  • 3 Types
    • T-Bills
      • Zero coupon bond
      • Maturity = 1-12 months
    • T-Notes
      • Semi-annual coupons
      • 2-10 years
    • T-Bonds
      • Semi-annual coupons
      • 20-30 years
income risk
Income Risk
  • Income risk is the risk that changing interest rates will reduce the income from portfolio
  • Income Risk higher for short term assets
  • CUs face income risk when rates change
  • Because CUs have longer term assets and shorter term liabilities, income risk occurs when interest rates rise.
capital risk
Capital Risk
  • Higher for longer term assets
  • Higher interest rates reduce the market value of assets and reduce the market value of equity capital
  • Defined as cash outside of banks plus checking deposits, plus travelers checks
    • Cash outside of banks=cash not in vault, not in federal reserve, not in banking system
structure of federal reserve system
Structure of Federal Reserve system
  • 12 District banks each with president
  • Board of Governors with chair and 6 other governors
  • Combine = FOMC (Federal Open Market Committee)
    • FOMC= All 7 governors plus 5 district bank presidents
  • Chair serves 4 year term NOT synchronous with president term, CAN be reappointed
  • Governors serve 14 year terms
  • FOMC meets every 6 weeks, 1951 Fed Treasury accord made Fed independent
loanable funds model
Loanable funds Model
  • Supply meets Demand = Equilibrium
    • “market clearing rate”
  • Rise in loan demand will push interest rates UP
  • Rise in loan supply will push interest rates DOWN
money multiplier
Money Multiplier
  • Real world multiplier is around 2 or 3 due to leakages
    • Leakage = currency in system, required reserves, excess reserves
  • Reserve Requirements
    • Has an inverse relationship with money supply
      • Lower reserves = higher money supply
  • Discount Rate
    • Lower discount rate=more discount loans=more bank reserves=more bank deposits=money supply raises
    • Higher discount rate=less discount loans=less reserves=less bank deposits=money supply decreases
  • Discount rate typically non-factor as volume of loans is low
fomc open market operations
FOMC Open Market Operations
  • Open market purchase = money supply increases, loans rise
  • Open market sale=money supply decreases, loans fall
  • Fed target rate=Federal Funds rate
    • Uses open market operations to maintain Fed Target Rate
Short term rates move together because short term assets are close substitutes.
  • If Fed funds rate goes above target, Fed will buy bonds until rate lowers. Opposite if rate is below target.
  • Expectations theory
    • Long term rates=expected average short term rates over the life of the bond
      • 3yr bond yield is 8%, people expect 1yr bonds to average 8% of the next 3 years
When market expects short term rates to be high in the long run, then long term rates will be high. Opposite for low short term rates
  • Adjusted conclusions to theory
    • When long term rates is higher than normal relative to short term rates, people expect short term rates to rise. Opposite for when lower than normal.
    • When there is a normal gap between short term and long term rates, then people expect rates to stay the same.
Income we earn is spread between short term and long term rates
    • Larger spread tends to push up CU income
  • Can Fed control long term rates?
    • Can influence but NOT control
  • Fed established dual mandate
    • Maximum employment, stabile prices (inflation)
  • Taylor Rule
    • Fed Funds rate is a positive function of inflation minus unemployment
    • When inflation is high relative to unemployment, Fed increases short term rates
    • When unemployment is higher, Fed sets short term rates low