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Financial Assets Review: The Federal Reserve Board (Fed), the Taylor Principle, and the Real Interest Rate Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy. Taylor Principle When the inflation rate () increases the Fed “slows down” the economy by increasing the real interest rate (r). Inflation rate () increases Real interest rate (r) increases Loans become more costly Households and firm purchase fewer goods and services In the entire economy fewer goods and services (G&S) purchased Economy “slows down” When the inflation rate () decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). Taylor principle Question: How does the Fed influence the real interest rate? Inflation rate () decreases Real interest rate (r) decreases Loans become less costly Households and firm purchase more goods and services In the entire economy more goods and services (G&S) purchased Economy “speeds up” Economy stabilizes Strategy: We shall study financial assets and what influences their interest rates, their rates of return. Financial Assets and Rates of Return Cash Checking Accounts Savings Accounts Certificates of Deposit (CD) Government Bonds: T-bills Corporate Bonds: Aaa Corporate Bonds: Baa Apple Stock (2012) Apple Stock (2013) JC Penny (2013) 0% .01% .03% .12% .11% 4.2% 4.8% 33.5% 0.8% 53.4% These differences can be largely explained by two factors: Liquidity Risk From $58.75 to $78.43 From $78.43 to $79.02 From $20.84 to $8.88 Liquidity: How easily you can gain access to your funds for the purpose of purchasing goods and services. To induce us to hold (or “purchase”) less To induce us to hold (or “purchase”) liquid assets, less liquid assets must pay a more risky assets, more risky assets must higher rate of return to compensate us for pay a higher rate of return to compensate their lack of liquidity. us for their risk. But to explain Liquidity down Risk up this we must understand Rate of return up Rate of return up bonds What Is a Bond? A bond is an IOU, literally a piece of paper. Printed on this piece of paper is a promise from the borrower describing how and when he/she will repay the lender in the future. Today: Lenders give borrowers dollars in exchange for IOUs. Bond – An IOU The borrower promises to pay the lender a specific number of dollars on a specific data in the future. Future: Borrowers repay the IOUs (plus interest) to the lenders. Dollars Today IOU Many different institutions issue bonds. Corporations Local governments State governments U.S. Federal government Foreign governments Dollars Future Etc. IOU Borrowers What a bond specifies and what it does not? Specified – The future repayment dollars that are promised. Not Specified – The current price of the bond. Question: How is the current price of the bond determined? Lenders U.S. Treasury Bills: Special bonds. A T-bill is a $1,000 IOU issued by the U.S. Treasury U.S. Treasury promises to pay the owner $x,xxx 11-2-2015 $1,000 IOU $1,000 on November 2, 2016 Question: What is the price of a T-bill today, what does $x,xxx equal? U.S. Treasury Simplifying Assumption To keep the arithmetic straightforward assume that the interest rate for bank CDs (certificates of deposits) is 10%. CDs and T-bills similar as far as The U.S. Treasury liquidity is concerned? Yes risk is concerned? Yes Consider two investment strategies: Buy a T-bill. $1,000 11-2-2016 $1,000 IOU The public Invest in a CD. Claim: If you “invest” $909 in a CD, you will have a total of $1,000 one year from today. Question: Could For T-bills the price and CDs of thetoT-bill coexist, be Buy a 1-year greater less whatthan must than $909, the $909, price saysay $900? of $950? a T-bill must equal? T-bill today $909 Costs: Today Returns: One year from today $1,000 NB: Both the CD and the T-bill pay out $1,000 one year from today. “Invest” $909 in a 1-year CD today $909 $909 Principle $91 Interest $1,000 Total Interest Rates and the Price of a Bond Suppose that the interest rate rose from 10 to 12 percent. Claim: If you “invest” $893 in a CD, you will have a total of $1,000 one year from today. Question: For T-bills and CDs to coexist, what must the price of a T-bill must equal? Costs: Today Returns: One year from today Buy a 1-year T-bill today $893 $1,000 “Invest” $893 in a 1-year CD today $893 $893 Principle $107 Interest $1,000 Total Price of a Treasury Bill: How is today’s price of a T-bill determined? Interest rate Interest rate up CDs become more attractive To coexist bonds must become more attractive Price of bonds must fall U.S. Government Bonds and Corporate Bonds Question: Why might a bond be risky? Answer: The borrower may not have the dollars to repay the bond in the future. Observation: If the rate of return When this occurs, the borrower is bankrupt. for two bonds were equal, we Have some corporations ever gone bankrupt? Yes would prefer the less risky bond. Has the U.S. government ever gone bankrupt? No To induce a lender to purchase Which bonds are riskier? Corporate more risky assets, more risky assets Cash 0% must pay a higher rate of return to Checking Accounts .01% compensate lenders for their risk. Savings Accounts .1% Certificates of Deposit (CD) .5% Government Bonds: T-bills .2% Corporate Bonds: Aaa 3.8% Corporate Bonds: Baa 5.1% Apple Stock (2012) 33.5% From $58.75 to $78.43 Apple Stock (2013) 0.8% From $78.43 to $79.02 JC Penny (2013) 53.4% From $20.84 to $8.88 Stocks (Equity) Claim: Again, the explanation is risk. Stocks (Equity) The stockholders of a corporation are the owners of the corporation. Apple has issued approximately 860 million shares. Bonds and stocks – A comparison Bonds: The future payments the bond promises are clearly spelled out. If the corporation cannot fulfill its promises the bondholders can force the corporation into bankruptcy. Stocks (Equity): If the corporation does well, the price of the stock will rise and/or it will issue dividends. Alternatively, if the corporation does poorly, the price of the stock will fall and /or it will issue fewer, if any, dividends. Stockholders cannot force the corporation into bankruptcy because the corporation has made no legal commitment to provide the stockholder with any specified payments. Question: Which financial asset is more risky, a bond or a stock? When you purchase a corporate bond you can be assured of the promised payments barring the bankruptcy of the corporation. When you purchase a stock you can be assured of nothing. If the corporation does well its stock’s rate of return will be high; alternatively, if the does poorly the stock’s rate of return will be low. Answer: Stocks Mutual Funds – An Example of Diversification Simplified Example: You have $100,000 to invest and you have narrowed your choice to two possibilities: Florida Resort New England Oil Rates of Return Warm FL Weather Cold FL Weather 10% 0% Cold NE Weather Warm NE Weather 10% 0% No Diversification: Invest entire $100,000 either in the Florida Resort or New England Oil Invest Entire $100,000 in Florida Resort Warm FL weather $10,000 Cold FL weather $0 Invest Entire $100,000 in New England Oil Cold NE weather $10,000 Warm NE weather $0 With no diversification, you will either earn $10,000 or nothing. Diversification: $50,000 in Florida resort and $50,000 in New England Oil Invest $50,000 in Florida Resort Warm FL weather $5,000 Cold FL weather $0 Invest $50,000 in New England Oil Cold NE weather $5,000 Warm NE weather $0 There are now four possibilities: Warm FL weather and Cold NE weather Warm FL weather and Warm NE weather Cold FL weather and Cold NE weather Cold FL weather and Warm NE weather $10,000 $5,000 $5,000 $0 Question: How does diversification affect risk? Old Adage: Don’t put all your eggs in one basket. Financial Assets Cash 0% Checking Accounts .01% Savings Accounts .03% Certificates of Deposit (CD) .12% Government Bonds: T-bills .11% Corporate Bonds: Aaa 4.2% Apple Stock (2012) 33.5% Money: A very special type of financial asset Conceptual definition of money: A medium of exchange; that which is accepted in exchange for goods and services. Operational definition of money: M1 = Cash + Checking Deposits How have AMT’s and cell phones affected the distinction between checking and savings deposits? M2 = M1 + Savings Deposits Common Confusion: Money versus Income Money refers to the financial assets that we own that can be used to purchase goods and services. Our money equals the cash we have in your wallet, our checking account balance, etc. Income refers to have much we earn over the course of a year. Since we measure both money and income in terms of dollars, it is easy to confuse the two. Be careful not to do so.