Transcript Lecture Slides

Interest Rate Theory
FNCE 4070
Financial Markets and Institutions
Bond Return
• The return on a bond is determined by:
– The price paid for the bond.
– The length of time that the bond is held - the holding
period
– The coupons received on the bond
– The interest rate received on the coupons to the date
that the bond is held
– The price when the bond is sold.
• Note, when the bond is held to maturity the price at which
the bond is “sold” is the principal plus final interest payment
Bond Return Risks
• Reinvestment Risk
– What yield can one achieve on cashflows received
during the holding period. Generally one assumes
that this is the same as the yield on the bond (one
reinvests the cashflows by buying more bonds)
• Interest Rate Risk
– What will be the yield to maturity on the bond at
the end of the holding period.
Asset Demand
• An asset is a piece of property that is a store of value.
Facing the question of whether to buy and hold an asset
or whether to buy one asset rather than another, an
individual must consider the following factors:
1. Wealth, the total resources owned by the individual, including
all assets
2. Expected return (the return expected over the next period) on
one asset relative to alternative assets
3. Risk (the degree of uncertainty associated with the return) on
one asset relative to alternative assets
4. Liquidity (the ease and speed with which an asset can be
turned into cash) relative to alternative assets
Expected Return
• The Expected Return of an asset is defined as
Re = p1R1 + p2 R2 +
+ pn Rn
• Holding everything else constant increasing
the expected return of an asset increases the
demand for that asset.
Risk
• A simple measure of risk is the standard
deviation of the expected return
p1 ( R1 - Re ) + p2 ( R2 - Re ) +
2
2
+ pn ( Rn - Re )
2
• Holding everything else constant increasing
the risk of an asset will reduce its demand.
Liquidity
• Liquidity describes how quickly an asset can
be converted into cash at a low cost.
– A house might be considered a very illiquid asset –
very high transaction costs (realtor fees, lawyer
fees etc) and it takes time to find a buyer.
– A US Treasury Bill is a highly liquid instrument.
• Leaving everything else constant an asset with
greater liquidity will have greater demand.
Summary of Asset Demand
Bond Supply
• Factors that will affect the bond supply
include:
1.
2.
3.
Expected Profitability of Investment Opportunities: in a
business cycle expansion, the supply of bonds increases,
conversely, in a recession, when there are far fewer expected
profitable investment opportunities, the supply of bonds falls
Expected Inflation: an increase in expected inflation causes
the supply of bonds to increase
Government Activities: higher government deficits increase
the supply of bonds, conversely, government surpluses
decrease the supply of bonds
Market Equilibrium
• When the quantity of bonds supplied equals
the quantity of bonds demanded.
•