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The U.S. Financial System

Describe the financial system and explain the role it plays in the economy.

Understand the role of the central bank in stabilizing the financial system.

Explain how interest rates are determined in the money market and understand the risk structure and the term structure of interest rates.

Appendix: Understand the term structure of interest rates.

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Learning Objectives
After studying this chapter, you should be able to:
3.1
3.2
3.2
3.4
3.3
3.6
3.A

The wonderful world of credit

The financial system provides the means by which funds flow from savers to borrowers.

Car sales in 2012 rose while unemployment was still above 8% because consumers had an easier time obtaining credit. Between 2007 and 2009, consumer credit was much more difficult to obtain.

Small businesses are also highly dependent on bank credit. Between the end of 2008 and end of 2009, businesses with fewer than 50 employees laid off 17 million workers.

No modern economy can prosper without a well-functioning financial system.

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The financial system moves funds from savers to borrowers, which promotes investment and the accumulation of capital goods.

Why did the bursting of the housing bubble that began in 2006 cause the financial system to falter?

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Key Issue and Question

Issue:

Question:

The financial system

The financial system channels funds from savers to borrowers.

Households borrow to finance purchases.

Firms borrow to pay workers and upgrade capital.

Governments borrow to build roads, schools, and bridges; purchase goods and services; and make payments.

When functioning properly, the financial system helps enhance economic activity.

Financial system The financial intermediaries and financial markets that together facilitate the flow of funds from lenders to borrowers.

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Describe the financial system and explain the role it plays in the economy.

3.1

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Learning Objective

Financial markets

The financial system consists of financial markets and financial intermediaries.

Financial market A place or channel for buying or selling stocks, bonds, or other financial securities.

Financial intermediary An institution, such as a commercial bank, that borrows funds from savers to lend to borrowers.

Financial securities are tradable financial assets, meaning they are bought and sold in financial markets.

Asset Anything of value owned by a person or a firm.

Financial asset A financial claim.

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Stocks and bonds

Corporations like General Electric (GE) issue shares of stock, which represent a partial ownership of the firm.

Stock A financial security that represents a legal claim on a share in the profits and assets of a firm.

GE also issues bonds for the purpose of borrowing money that they promise to repay at a future date with interest.

Bond A financial security issued by a corporation or government that represents a promise to repay a fixed amount of funds.

Borrowing using bonds is done directly from lenders, in contrast to borrowing from a financial intermediary like a commercial bank.

Each of these types of financial assets are then often sold in secondary markets.

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May note that stock markets are also known as equity markets.

Reminder on Investors versus Investment

Investors Households and financial firms who buy stocks, bonds, and other securities as financial investments.

Investment Refers to spending by households and firms on investment goods such as houses, factories, machinery, and equipment.

When financial assets are first sold, this takes place in the primary market. When the asset is resold, this takes place in the secondary market.

Financial intermediaries

Intermediaries earn a profit by paying savers a lower interest rate than the rate they charge borrowers.

Many financial intermediaries use saved funds to buy portfolios of assets.

Important financial intermediaries

Table 3.1

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The controversial world of subprime lending

If you apply for a loan at a bank, the bank will check your credit history.

The more likely a borrower appears to default, the higher the interest rate the lender will charge.

Some borrowers with low credit scores have trouble obtaining loans at all; these are subprime borrowers.

Mid-1990s: these borrowers, and the high interest rates they pay, became attractive to lenders.

Mid-2000s: many housing loans made to these buyers, with low introductory interest rates rising after a few years.

Many of these lenders defaulted; lenders suffered heavy losses, and these borrowers again had trouble obtaining loans.

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Making the Connection

The controversial world of subprime lending

By mid-2012, some lenders were again making subprime loans; not mortgages, but prepaid debit cards, low-limit credit cards, and short-term loans.

Is society better off with these subprime borrowers having access to credit?

“Excluding millions of Americans from traditional banking services is not an efficient means of commerce and will result in long-term negative consequences for our economy.” - Meredith Whitney, financial analyst

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Making the Connection

Stocks, bonds, and stock market indexes

Financial securities state the terms under which funds pass from the buyer (or supplier of funds) to the seller (who is demanding the funds).

There are only about 5,100 firms in the U.S. that are publicly traded on a U.S. stock market.

Stock prices reflect general economic conditions, but are only one indicator.

Global forces can affect stock markets.

Economy-specific factors also have strong impacts on bond and equity markets.

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Buying stock gives the purchaser a claim of ownership in a firm. In May 2011 for example, Apple (AAPL) had 924.75 million shares outstanding, meaning one share is a very small ownership stake in a firm. Apple (AAPL) had 924.75 million shares outstanding, at a price of about $339 per share. This means Apple has a market capitalization of $313.5 billion.

The New York Stock Exchange (NYSE) is known for larger and older corporations like GE, IBM, and ExxonMobil.

The NASDAQ is an “over the counter” market where many high-tech firms like Apple, Google, and Microsoft are traded.

Stock market indexes

S&P 500: a weighted measure of 500 of the most important publicly traded firms in the U.S.

Nikkei 225: a measure of Japan’s 225 most important firms

Shanghai Composite index: a selection of China’s publicly traded firms.

Stock prices in the United States, Japan, and China, 1980-2012

Figure 3.1

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Investing in the worldwide stock market

You can invest in the stock (or equity) markets in a variety of ways.

Brokers like Merrill Lynch buy shares on your behalf and offer investment advice.

Discount brokers and online brokers like E*Trade and TD Ameritrade also buy shares on your behalf, but do not offer investment advice.

Mutual funds and exchange-traded funds (ETFs) are portfolios of stocks, bonds, or other assets and provide investors diversification.

Firms based outside of the U.S. represent about 90% of all publicly traded firms, and many can be invested in indirectly using American Depository Receipts (ADRs).

ADRs are receipts for shares of stock held in a foreign country.

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Making the Connection

Investing in the worldwide stock market

The New York Stock Exchange is still the largest stock market in terms of market capitalization (i.e., the total value of shares).

Many other international stock exchanges are growing in size.

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Making the Connection

Services provided by the financial system

Risk The chance that the value of a financial security will change relative to what you expect.

Liquidity The ease with which an asset can be exchanged for cash.

Risk sharing

Investors can spread their risk by diversifying their investments across many assets.

Liquidity

Savers sometimes need to turn their financial or real assets into cash. The more liquid an asset, the easier it can be turned into cash without significant loss in value.

Information

The financial system gathers facts about borrowers and expectations on returns and communicates that information to lenders and investors.

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Banking and securitization

Banks can be broadly categorized.

Commercial banks, which take deposits and make loans to households and firms.

Investment banks, which provide advice to firms issuing stocks and bonds, considering mergers, and underwrite new issues of stocks and bonds.

Securitization The process of converting loans and other assets that are not tradable into securities.

Securitization creates a secondary market for financial assets that could not be bought and sold, and increases the quantity of loans banks can make.

Changed the general model of banking from one where banks made loans and waited until maturity to be repaid to one where banks could resell their investments immediately in order to make new loans.

Another benefit to securitization is that banks can diversify their risk from a single local area where they make loans to a national or even global level.

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When underwriting, banks guarantee a certain price for stocks and bonds for a fee.

Banks often still collect payments from the original borrower, but simply pass those on to the new owner of the securitized loan.

Asymmetric information in financial markets

Asymmetric information A situation in which one party to an economic transaction has better information than does the other party.

Adverse selection The situation where one party to a transaction takes advantage of knowing more than the other party.

Moral hazard Actions people take after they have entered into a transaction that make the other party to the transaction worse off.

Principal-agent problems are caused by agents (e.g., firm executives) pursuing their own interests rather than the interests of the principals, (e.g., firm shareholders) who hired them.

For example, shareholders own a firm and act as principals, while the hired management is the agent selected to work for those principals.

Management may receive large salaries or benefits, but might not be concerned with the overall health of the firm.

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Adverse selection example: Those who most want to borrow money are often the people lenders least want to lend money to with full information.

Moral hazard example: An owner of a firm borrows money from a bank to upgrade their business, but they instead spend the money in Las Vegas gambling.

Understand the role of the central bank in stabilizing the financial system

3.2

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Learning Objective

The role of the central bank in the financial system

Central banks are established to operate as a “banker’s bank” and perform several functions.

Regulate the money supply.

Act as a lender of last resort to the banking system.

Act as the government’s bank by playing a role in the collection and disbursement of government funds.

Facilitate the payment system by providing banks with check-clearing and other services.

These are the routine functions of a central bank. During a financial crisis, it might need to take other, less common, actions.

Financial crisis A significant disruption in the flow of funds from lenders to borrowers.

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Leverage

Leverage A measure of how much debt an investor takes on in making an investment.

When you buy a $200,000 house with a mortgage, you have a leveraged asset.

Traditionally, U.S. borrowers make a 20% down-payment, borrowing the other 80%.

During the housing boom of the early to mid-2000s, down-payments of 5% or less were common—even higher leverage.

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Leverage in the housing market

The degree of leverage becomes very important when the house changes in value.

The more leveraged an investment, the greater the potential gain and the greater the potential loss. Or, put another way, increased leverage results in increased risk.

Leverage in the housing market

Table 3.2

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Financial intermediaries and leverage

Commercial banks finance most of their assets—loans and securities—with leveraged deposits.

Just like homeowners, banks can suffer losses on their assets; highly leveraged banks can lose net worth quickly.

The figure shows a simplified balance sheet of a typical commercial bank.

Simplified balance sheet of a commercial bank

Figure 3.2

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Financial intermediaries and leverage

The government regulates a bank’s leverage ratio: the value of its capital relative to the value of its assets.

Why? Bank managers may otherwise take on too much risk—too high leverage. This is a principal-agent problem.

Other financial intermediaries face less regulation.

Simplified balance sheet of a commercial bank

Figure 3.2

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Bank panics

Central banks can make loans to financial institutions, usually commercial banks, that are having temporary problems accessing funding.

The U.S. has a fractional reserve banking system, meaning banks keep less than 100% of deposits on hand in the form of reserves.

Bank runs and panics can occur if depositors rapidly lose confidence in the value of a bank’s assets.

Banks facing a run experience liquidity problems, since they cannot sell assets fast enough to pay off depositors

Bank run The process by which depositors who have lost confidence in a bank simultaneously withdraw their funds.

Bank panic A situation in which many banks simultaneously experience runs.

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Insolvency and contagion

Insolvent The situation in which the value of the assets held by a bank or another firm declines to less than the value of its liabilities, leaving the bank with negative net worth.

Contagion The process by which a run on one financial institution spreads to other financial institutions, resulting in a financial crisis.

The Fed acts as a lender of last resort to stop contagion, when the run on one bank spreads to another bank. Fear of a general problem with the banking system leads depositors to simultaneously want their money.

One trigger of Asset deflation is when banks close and are forced to sell their assets to repay depositors and lenders. If many banks close at once, the values of many assets fall together or deflate.

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The feedback loop during a bank panic

Recessions caused by bank panics result in downward spirals, as they cause even more banks to fail.

Thus good banks as well as bad can be affected, unless the government intervenes.

The feedback loop during a bank panic

Figure 3.3

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Government policies to deal with bank panics

Governments have two main ways to help avoid bank panics:

Central bank can act as lender of last resort

Government can insure deposits

In the U.S. the Fed makes discount loans to banks experiencing liquidity problems.

In the early 1930s, the Fed made too few loans to stop the bank panic. This led to the formation of the Federal Deposit Insurance Corporation (FDIC) which insures deposit accounts, effectively ending the era of bank panics.

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The financial crisis of 2007-2009

Policies after the Great Depression of the 1930s did not extend to nonbank financial intermediaries, such as investment banks or mutual funds.

Over time, this shadow banking system for firms became more important—by 2007, controlling more assets than commercial banks.

Economists and policymakers did not believe these intermediaries would fall prey to runs; but these did occur in response to the collapse of the housing bubble.

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The mortgage market and the subprime lending disaster

Congress created two entities to help in securitizing mortgages:

1938: Federal National Mortgage Association (Fannie Mae)

1970: Federal Home Loan Mortgage Corporation (Freddie Mac)

Fannie Mae and Freddie Mac sell bonds to investors, and use the funds to purchase mortgages from banks. The mortgages would often be sold as mortgage bonds or mortgage backed securities.

By the 2000s, investment banks were also buying mortgages, bundling them, and reselling them as mortgage-backed securities.

Because these securities were popular, banks made more loans—including to subprime borrowers.

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The mortgage market and the subprime lending disaster

As more housing loans became available, a housing bubble formed in many parts of the country.

Bubble The situation in which the price of an asset rises significantly above the asset’s fundamental value; an unsustainable increase in the price of a class of assets.

Fundamental value reflects the total expected future returns from owning a particular asset.

In housing, future rents might reflect the potential fundamental value.

Dividend payments out of profits on a share of stock.

Because many homebuyers were highly leveraged, when the housing bubble “burst”, they suffered heavy losses. Similarly, the value of the mortgage-backed securities declined heavily, resulting in billions of dollars of losses for the largest banks.

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Runs on the shadow banking system

August 2007: French bank BNP Paribas announces investors in three of its funds cannot redeem their shares.

https:// www.cnbc.com/video/2017/08/03/cramers-they-know-nothing-10th-anniversary-rant.html

Fall 2007, spring 2008: Credit conditions worsen, concerns about health of financial firms begin.

March 2008: Bear Stearns saved from bankruptcy by Fed, JPMorgan Chase.

August 2008: Nearly 25% of subprime mortgages >30 days past due. September 2008:

Bank of America buys Merrill Lynch

Lehman Brothers files for bankruptcy

Reserve Primary Fund allows value of its shares <$1

Run on money market mutual funds

Many parts of financial system become frozen as trading in securitized loans largely stopped

Crisis on Wall Street: The Week that Shook the World, Premiered on CNBC 9/12/18

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Government policies to deal with the financial crisis

New government policies:

March 2008: Fed extends role as lender of last resort to investment banks

September 2008: Fed begins lending to non-financial corporations

2008: U.S. Treasury and Fed help financial firms by lending to them or arranging for mergers

October 2008: Congress passes Troubled Asset Relief Program (TARP), purchasing stock in many banks

New legislation: Dodd-Frank Act (2010)

Designed to address insufficient regulation, economy-wide risk of large financial firms failing, and excessive risk-taking

Created Consumer Financial Protection Bureau and Financial Stability Oversight Council

Granted FDIC authority to close insolvent shadow banks

Required financial derivatives to be traded on exchanges

Implemented “Volcker Rule”, restricting commercial bank trading

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Government policy toward failing financial firms

Government doesn’t “bail out” most firms; what makes financial firms different?

Widely-held belief that allowing commercial banks to fail will cause wider problems: bank panics, asset deflation.

Would failure of investment banks have similar consequences?

“Too Big to Fail”

But helping financial firms is similar to insuring them against losses.

Creates moral hazard problem (people act differently when insured).

Policymakers continue to struggle with this tradeoff.

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Fed policy during panics, then and now

The worst bank panic in history was in the 1930s, after the Fed was established but before the FDIC began operation.

In October 1930, the Bank of United States experienced a bank run.

The Bank appealed to the Fed to receive a loan to continue operation.

The Fed denied the request because such action could be seen as rewarding and rescuing bank managers who had made bad decisions.

The Fed also believed the Bank of United States was insolvent, meaning if all assets were sold the bank could not repay depositors.

Depositors received only 75 cents on the dollar for their deposits, as long as 14 years after the bank failed.

The failure of the bank led to shaken confidence in other depositors and waves of other bank failures.

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Making the Connection

Fed policy during panics, then and now

In 1933, President Franklin Roosevelt declared bank holidays where all banks were ordered closed.

Bank runs were fairly common in the 1920s and peaked in 1933. After establishment of the FDIC in 1934, bank runs essentially ceased.

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Making the Connection

Fed policy during panics, then and now

In the spring of 2008, Bear Stearns ran into liquidity problems as many of their lenders demanded a return of their funds.

The Fed and Treasury organized a purchase of Bear Stearns by JPMorgan Chase.

Fear of moral hazard led the Fed and Treasury to allow Lehman Brothers, also a large investment bank, to fail.

At the time Lehman failed, there was a jump in the perceived risk of lending to a bank as measured by the TED spread.

Days later, the Treasury and Fed did save AIG, the largest U.S. insurance company, from bankruptcy.

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Making the Connection

Fed policy during panics, then and now

The TED spread signifies a level of risk in lending to banks and is the difference between the 3-month London Interbank Offer Rate (LIBOR), a rate at which banks can borrow from one another, and the 3-month T-bill rate.

A spike in the TED spread in 2007 and 2008 coincided with the financial crisis.

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Making the Connection

Fed policy during panics, then and now

Once banks became afraid of lending to one another, banks could not manage to sell previously issued credit card debt.

Since banks could not sell new credit card loans, they became reluctant to create new loans and restricted already outstanding credit lines.

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Making the Connection

Explain how interest rates are determined in the money market and understand the risk structure and the term structure of interest rates

3.3

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Learning Objective

The money market

The interest rate is a key economic variable in the financial system.

Initial model for interest rates: the money market model (also called the liquidity preference model).

Money market model focuses on the interaction of the demand and supply of money to determine the short-term nominal interest rate.

Households have a choice between holding money and other assets like T-bills, which offer a return. The holding of paper currency offers a zero nominal return, while checking deposits offer a very low return.

When nominal interest rates on T-bills are higher, you are forgoing a higher amount of interest. Thus, at higher interest rates, you demand less cash.

Foregone interest is the opportunity cost of holding money.

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The demand for money

Lower nominal interest rates cause households and firms to switch from financial assets like T-bills to money.

As nominal interest rates on other assets declines from 4% to 3%, the quantity of money demanded rises from $900 to $950 billion in this example.

The demand for money

Figure 3.4

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Shifts in the money demand curve

Changes in GDP or the price level shift the money demand curve.

Increases in real GDP shift money demand to the right, while declining real GDP shifts money demand to the left.

Higher price levels shift money demand to the right, while falling price levels shift money demand to the left.

Shifts in the money demand curve

Figure 3.5

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Equilibrium in the money market

We assume that the Fed is able to perfectly control the supply of money (MS).

MS is therefore a vertical line.

Changes in the interest rate have no impact on the supply of money provided by the Fed.

The adjustment process:

The central bank increases the quantity of money available.

Households and firms are faced with additional money that they do not wish to hold.

They shift new money into other assets like Treasury bills.

The increased price of T-bills leads to a reduction in the interest rate.

The effect on the interest rate when the Fed increases the money supply

Figure 3.6

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Money market model summary

Summary of the money market model

Table 3.3

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Present value

Present value The value today of funds that will be received in the future.

The funds a person holds today are more valuable than prospective funds held in the future.

If you loaned $1,000 to a friend for a year, you would likely want more than $1,000 back. The amount over $1,000 is the interest you are charging.

Why would you charge interest?

Compensation for inflation

Compensation for default risk—the chance the borrower will not pay the loan back

Compensation for the opportunity cost of waiting to spend your money

The more impatient you are, the higher the interest rate you will charge

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Present value one year in the future

Suppose you lend $1,000 for one year, expecting $1,100 back. We write:

Dividing both sides by (1 + 0.10) gives:

The future value to be received in one year, divided by 1 plus the interest rate, is equal to the present value. Generally:

This gives a general formula for the present value of a future amount to be received in one year.

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Present value further in the future

If you lent the $1,000 for two years instead, at 10% interest, you would get:

Dividing both sides by (1 + 0.10)2 gives:

This gives the present value of an amount two years in the future. Generally, we have the following formula:

Economists refer to this idea as the time value of money.

Time value of money The way the value of a payment changes depending on when the payment is received.

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Present value and the interest rate

The higher the interest rate, the lower the present value of a future payment.

The lower the interest rate, the higher the present value of a future payment.

The present value of $1,000,000 25 years in the future depends on the interest rate. At 10%,

While at 5%,

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Present value and the price of bonds

Buying a financial asset like a bond or share of stock are purchases of a promise to receive certain payments in the future.

Investors in bonds receive coupon payments, which are received intermittently, such as annually or bi-annually. The coupon payment is usually fixed throughout the life of the bond.

Example: A five-year coupon with an annual coupon of $60, and a face value of $1,000, is worth:

More generally, if C is the coupon payment, FV is the face value, and n is the number of years to maturity:

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Present value and treasury bills

The present value of a payment depends on the interest rate used to calculate it. An increase in interest rates reduces the prices of existing financial assets, and a decrease in interest rates increases the prices of existing financial assets.

U.S. Treasury bills are discount bonds: they do not pay a coupon, but rather are sold at a discount to their face value.

If you pay $961.54 for a $1,000 one-year T-bill, the interest rate is:

If investors change to requiring 5% return on one-year T-bills, the price would fall to:

This would be a capital loss for you: the price of the asset you own fell. If the price rose, that would be a capital gain—for example, if the interest rate fell to 3%.

XXX

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Interest rates and Treasury bond prices

The U.S. Treasury issues a variety of securities such as Treasury notes which have maturities from 2 years to 10 years, and Treasury bonds which have maturities of 30 years.

Suppose that a Treasury bond was issued 28 years ago, so it will mature in 2 years.

If the bond pays a coupon of $45 per year and will make a final par value, or face value, payment of $1,000 at maturity, what is its price if the relevant market interest rate is 5%?

What is its price if the relevant market interest rate is 10%?

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Solved Problem

Interest rates and Treasury bond prices

Step 1 Review the chapter material.

Step 2 Explain what determines the price of a Treasury bond. The price of a financial asset equals the present value of the payments to be received from owning the asset. Thus, we calculate the present value of all future cash flows.

Step 3 Determine the price of the Treasury bond if the interest rate is 5%. Calculate the present values of all three payments. Note: you receive two additional coupon payments over the final two years of the bond, and at maturity you receive the face value of the bond.

Step 4 Determine the price of the Treasury bond if the interest rate is 10%. Just change the “0.05” to a “0.10”, and recalculate:

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Solved Problem

The economy’s many interest rates

“The interest rate” is a misnomer; there are many interest rates in an economy.

Risk structure of interest rates The relationship among interest rates on bonds that have different characteristics but the same maturity.

Bonds with the same maturity will pay different rates of interest because of:

Default risk: The chance a firm will declare bankruptcy and stop paying interest on the bond before maturity. GM was facing bankruptcy in 2009 and therefore had a higher default risk.

Liquidity: The secondary market for a bond might have fewer buyers and sellers, or a smaller outstanding issuance. The easier it is to buy and sell a bond, the more liquid it is. Treasury securities are very liquid.

Tax treatment of interest: Municipal bonds receive a preferential tax treatment relative to corporate bonds. So, investors are willing to accept a lower interest rate.

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The risk structure of interest rates

Bonds perceived as riskier, more illiquid, or subject to higher taxes, will be required to pay higher nominal interest rates to attract buyers.

The risk structure of interest rates

Figure 3.7a

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The term structure of interest rates

This panel shows an example of the term structure of interest rates, which is the relationship among interest rates on bonds that have the same characteristics except for having different maturities.

This is known as the yield curve.

The term structure of interest rates

Figure 3.7b

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The term structure of interest rates

Why would an investor buy a one-month Treasury bill with an interest rate of 0.07%, when she could purchase a 30-year Treasury bond with an interest rate of 2.55%?

Term structure of interest rates The relationship among interest rates on bonds that are otherwise similar but have different maturities.

The expectations theory of the term structure of interest rates says that it is because people expect the (short-term) interest rate to rise in the future.

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The term structure of interest rates

Compare two options

Option 1: Buy a bond maturing in two years—a two-year bond.

Option 2: Buy a one-year bond today, and when it matures in a year, invest the proceeds in a second one-year bond

If the interest rate on the one-year bond today is 4%, and the interest rate on the one-year bond a year from now is expected to be 6%, then the interest rate on the two-year bond today should be 5%--the average of the two one-year bond interest rates.

Why? Suppose the two-year bond paid 5.5%. Then that is more attractive than two one-year bonds.

The demand for the one-year bond would fall.

The price of the one-year bond would fall.

This implies the interest rate on the one-year bond would rise.

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The expectations theory

The expectations hypothesis holds if investors have no reason to prefer buying a long-term bond to a series of consecutive short-term bonds.

The expectations hypothesis predicts that the yield curve is upward sloping if investors expect future short-term rates to be higher than they are at present. A downward-sloping yield curve would occur if investors predict falling short-term rates in the future.

The expectations hypothesis does not completely explain the term structure of interest rates as it fails to take into account the fact that long-term bonds are riskier than short-term bonds.

Changes in interest rates affect the prices of long-term bonds more strongly than short-term bonds. This is interest rate risk.

Interest-rate risk The risk that the price of a financial asset will fluctuate in response to changes in market interest rates.

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Liquidity premium theory

Because of the interest-rate risk, investors require additional interest to buy long-term bonds.

Term premium The additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds.

Taking the term premium and the expectations hypothesis together, we have the liquidity premium theory of the term structure of interest rates.

This is a better explanation for why the yield curve is upward sloping.

The yield curve would slope downwards only if investors expect future short-term rates to be significantly lower than current short-term rates.

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Answering the key question

“Why did the bursting of the housing bubble that began in 2006 cause the financial system to falter?”

When housing prices began to fall in 2006, home buyers began to default on home loans.

Many firms had significant investments in mortgage-backed securities (MBS) containing subprime mortgages.

As the prices of these MBS fell, many financial firms suffered heavy losses and some were forced into bankruptcy.

This led to a decline in the flow of funds through the financial system; while the Fed took measures to contain these problems, the effects were felt for several more years.

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Understand the term structure of interest rates.

3.A

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Learning Objective

More on the term structure of interest rates

Consider again the situation if you want to invest funds over a two-year period. Compare the two-year bond to two consecutive one-year bonds.

i1t = interest rate on a one-year bond at time t i2t = interest rate (per year) on a two-year bond at time t ie1t+1 = expected interest rate on a one-year bond at t+1

If you are investing only $1, compare expected returns under both strategies. A two-year bond would be on the left side below, while two consecutive one-year bonds are on the right side.

$1(1+ i2t) (1+ i2t) = $1(1+ i1t) (1+ ie1t+1)

2 i2t + i22t = i1t + ie1t+1 + i1t(ie1t+1)

Assuming the product of two interest rates is negligible, we get:

i2t = (i1t + ie1t+1)/2

This equation can be expanded to any maturity of bond.

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Appendix

Understanding the term structure of interest rates

If you have a $1,000 one-year bond with a 10% coupon and the interest rate is 10%, then the bond is priced at par, or $1,000. The same is true for a two-year 10% coupon bond with a 10% interest rate.

If the interest rate rises to 15% the next day:

On the one-year bond, you suffer a $43.48 loss, or 4.3%

On the two-year bond, you suffer an $81.29 loss, or 8.1%:

Because cash flows received further in the future are more affected by changes in interest rates, investors in longer-term bonds demand a term premium in order to purchase them.

i2t = (i1t + ie1t+1)/2 + iTP2t

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Appendix