Finance assignment， Due 10/26

JJJQQQZZZ

FinancialMarketsandInstitutions7thEditionbyAnthonySaunders.pdf

Home >Business & Finance homework help >Finance assignment， Due 10/26

sau19714_fm_i-xxii.indd i 10/04/17 06:53 PM

s e v e n t h e d i t i o n

Financial Markets and Institutions

Final PDF to printer

sau19714_fm_i-xxii.indd ii 10/04/17 06:53 PM

FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Ninth Edition

Brooks FinGame Online 5.0 Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition

Cornett, Adair, and Nofsinger M: Finance Fourth Edition

DeMello Cases in Finance Third Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Twelfth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Twelfth Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value Second Edition

INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Tenth Edition

Bodie, Kane, and Marcus Investments Eleventh Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Eighth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition

Saunders and Cornett Financial Markets and Institutions Seventh Edition

INTERNATIONAL FINANCE Eun and Resnick International Financial Management Eighth Edition

REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Sixteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fifth Edition

FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Twelfth Edition

Altfest Personal Financial Planning Second Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An active approach to help you achieve financial literacy Sixth Edition

Kapoor, Dlabay, Hughes, and Hart Personal Finance Twelfth Edition

Walker and Walker Personal Finance: Building Your Future Second Edition

THE MCGRAW-HILL EDUCATION SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Final PDF to printer

sau19714_fm_i-xxii.indd iii 10/04/17 06:53 PM

s e v e n t h e d i t i o n

Financial Markets and Institutions Anthony Saunders

Stern School of Business New York University

Marcia Millon Cornett Bentley University

Final PDF to printer

sau19714_fm_i-xxii.indd iv 10/10/17 02:03 AM

FINANCIAL MARKETS AND INSTITUTIONS, SEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2015, 2012, and 2009. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 LWI 21 20 19 18

ISBN 978-1-259-91971-8 MHID 1-259-91971-4

Brand Manager: Charles Synovec Product Developer: Noelle Bathurst Marketing Manager: Trina Maurer Content Project Managers: Heather Ervolino; Evan Roberts Buyer: Sandy Ludovissy Design: Matt Diamond Content Licensing Specialist: Beth Thole Cover Image: © Shutterstock / Rudy Balasko Compositor: SPi Global Printer: LSC Communications

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Names: Saunders, Anthony, 1949- author. | Cornett, Marcia Millon, author. Title: Financial markets and institutions / Anthony Saunders, Stern School of Business, New York University, Marcia Millon Cornett, Bentley University. Description: Seventh edition. | New York, NY : McGraw-Hill Education, [2019] Identifiers: LCCN 2017031881 | ISBN 9781259919718 (alk. paper) Subjects: LCSH: Securities—United States. | Stock exchanges—United States. | Financial institutions—United States. | Rate of return—United States. | Interest rates—United States. Classification: LCC HG4910 .S28 2019 | DDC 332—dc23 LC record available at https://lccn.loc.gov/2017031881

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

Final PDF to printer

sau19714_fm_i-xxii.indd v 10/04/17 06:53 PM

To Ingo Walter: a mentor, coauthor, and friend. —TONY SAUNDERS

To my parents, Tom and Sue. —MARCIA MILLON CORNETT

Final PDF to printer

sau19714_fm_i-xxii.indd vi 10/04/17 06:53 PM

ABOUT THE AUTHORS

Anthony Saunders

Anthony Saunders is the John M. Schiff Professor of Finance

and former chair of the Department of Finance at the Stern

School of Business at New York University. Professor Saun-

ders received his PhD from the London School of Eco-

nomics and has taught both

undergraduate- and graduate-

level courses at NYU since

1978. Throughout his aca-

demic career, his teaching

and research have specialized

in financial institutions and

international banking. He has

served as a visiting professor all over the world, including

INSEAD, the Stockholm School of Economics, and the Uni-

versity of Melbourne.

Professor Saunders holds or has held positions on the

Board of Academic Consultants of the Federal Reserve

Board of Governors as well as the Council of Research

Advisors for the Federal National Mortgage Association. In

addition, Dr. Saunders has acted as a visiting scholar at the

Comptroller of the Currency and at the International Mon-

etary Fund. He is editor of the Journal of Financial Mar-

kets, Instruments and Institutions, as well as the associate

editor of a number of other journals. His research has been

published in all of the major finance and banking journals

and in several books. He has just published a new edition

of his textbook, with Dr. Marcia Millon Cornett, Financial

Institutions Management: A Risk Management Approach,

for McGraw-Hill/Irwin (ninth edition) as well as a third edi-

tion of his book on credit risk measurement for John Wiley

& Sons. Professor Saunders was ranked the most prolific

author out of more than 5,800 who have published in the

seven leading finance academic journals from 1959 to 2008

(“Most Prolific Authors in the Financial Literature, 1959–

2008,” Jean Heck and Philip Cooley).

Marcia Millon Cornett

Marcia Millon Cornett is the Robert A. and Julia E. Dorn

Professor of Finance at Bentley University. She received her

BS degree in economics from Knox College in Galesburg,

Illinois, and her MBA and PhD degrees in finance from

Indiana University in Bloomington, Indiana. Dr. Cornett has

written and published several articles in the areas of bank

performance, bank regulation, corporate finance, and invest-

ments. Articles authored by Dr. Cornett have appeared in

such academic journals as the Journal of Finance, the Jour-

nal of Money, Credit, and Banking, the Journal of Finan-

cial Economics, Financial Management, and the Journal

of Banking and Finance. She was recently ranked the 124th

most published out of more than 17,600 authors and the

number five female author in finance literature over the last

50 years. Along with Anthony Saunders, Dr. Cornett has

recently completed work on the ninth edition of Financial

Institutions Management

( M c G r a w - H i l l / I r w i n ) .

With Troy A. Adair Jr.

(Harvard University) and

John Nofsinger (University

of Alaska, Anchorage), she

has also recently completed

work on the fourth edition

of Finance: Applications and Theory and the third edition

of M: Finance (McGraw-Hill/Irwin). Professor Cornett

serves as an associate editor for the Journal of Banking

and Finance, the Journal of Financial Services Research,

Review of Financial Economics, Financial Review, and

Multi-national Finance Journal. Dr. Cornett has served as

a member of the Board of Directors, the Executive Commit-

tee, and the Finance Committee of the SIU Credit Union.

She has also taught at Southern Illinois University at Car-

bondale, the University of Colorado, Boston College, South-

ern Methodist University, and Boston University.

Final PDF to printer

vii

sau19714_fm_i-xxii.indd vii 10/04/17 06:53 PM

PREFACE

he last 30 years have been dramatic for the financial services industry. In the 1990s and 2000s, boundaries between the traditional industry sectors, such as commercial banking and investment banking, broke down and competi- tion became increasingly global in nature. Many forces contributed to this breakdown in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–2009, the

financial services industry experienced the worst financial crisis since the Great Depres- sion. Even into the mid-2010s, the U.S. and world economies have not recovered from this crisis. It is in this context that this book is written.

As the economic and competitive environments change, attention to profit and, more than ever, risk become increasingly important. This book offers a unique analysis of the risks faced by investors and savers interacting through both financial institutions and financial mar- kets, as well as strategies that can be adopted for controlling and better managing these risks. Special emphasis is also put on new areas of operations in financial markets and institutions such as asset securitization, off-balance-sheet activities, and globalization of financial services.

While maintaining a risk measurement and management framework, Financial Markets and Institutions provides a broad application of this important perspective. This book recognizes that domestic and foreign financial markets are becoming increasingly integrated and that financial intermediaries are evolving toward a single financial services industry. The analytical rigor is mathematically accessible to all levels of students, under- graduate and graduate, and is balanced by a comprehensive discussion of the unique envi- ronment within which financial markets and institutions operate. Important practical tools such as how to issue and trade financial securities and how to analyze financial statements and loan applications will arm students with the skills necessary to understand and man- age financial market and institution risks in this dynamic environment. While descriptive concepts so important to financial management (financial market securities, regulation, industry trends, industry characteristics, etc.) are included in the book, ample analytical techniques are also included as practical tools to help students understand the operation of modern financial markets and institutions.

INTENDED AUDIENCE Financial Markets and Institutions is aimed at the first course in financial markets and institutions at both the undergraduate and MBA levels. While topics covered in this book are found in more advanced textbooks on financial markets and institutions, the explana- tions and illustrations are aimed at those with little or no practical or academic experience beyond the introductory-level finance courses. In most chapters, the main relationships are presented by figures, graphs, and simple examples. The more complicated details and tech- nical problems related to in-chapter discussion are provided in appendixes to the chapters (available through McGraw-Hill Connect Finance or your course instructor).

ORGANIZATION Since our focus is on return and risk and the sources of that return and risk in domestic and foreign financial markets and institutions, this book relates ways in which a modern finan- cial manager, saver, and investor can expand return with a managed level of risk to achieve the best, or most favorable, return–risk outcome.

Part 1 provides an introduction to the text and an overview of financial markets and institutions. Chapter 1 defines and introduces the various domestic and foreign financial markets and describes the special functions of FIs. This chapter also takes an analytical look at how financial markets and institutions benefit today’s economy. In Chapter 2, we provide an in-depth look at interest rates. We first look at factors that determine interest rate levels,

Final PDF to printer

viii Preface

sau19714_fm_i-xxii.indd viii 10/04/17 06:53 PM

as well as their past, present, and expected future movements. We then review the concept of time value of money. Chapter 3 then applies these interest rates to security valuation. In Chapter 4, we describe the Federal Reserve System and how monetary policy implemented by the Federal Reserve affects interest rates and, ultimately, the overall economy.

Part 2 of the text presents an overview of the various securities markets. We describe each securities market, its participants, the securities traded in each, the trading process, and how changes in interest rates, inflation, and foreign exchange rates impact a financial manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), stock markets (Chapter 8), for- eign exchange markets (Chapter 9), and derivative securities markets (Chapter 10).

Part 3 of the text summarizes the operations of commercial banks. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector. Chapter 12 describes the financial statements of a typical commercial bank and the ratios used to ana- lyze those statements. This chapter also analyzes actual financial statements for representative commercial banks. Chapter 13 provides a comprehensive look at the regulations under which these financial institutions operate and, particularly, the effect of recent changes in regulation.

Part 4 of the text provides an overview describing the key characteristics and regula- tory features of the other major sectors of the U.S. financial services industry. We discuss other lending institutions (savings institutions, credit unions, and finance companies) in Chapter 14, insurance companies in Chapter 15, securities firms and investment banks in Chapter 16, investment companies in Chapter 17, and pension funds in Chapter 18.

Part 5 concludes the text by examining the risks facing a modern FI and FI manag- ers and the various strategies for managing these risks. In Chapter 19, we preview the risk measurement and management chapters in this section with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management along two lines: measuring and managing risks on the balance sheet, and managing risks off the balance sheet. In Chapter 20, we begin the on-balance-sheet risk measurement and management section by looking at credit risk on individual loans and bonds and how these risks adversely impact an FI’s profits and value. The chapter also discusses the lending process, including loans made to households and small, medium-size, and large corpora- tions. Chapter 21 covers liquidity risk in financial institutions. This chapter includes a detailed analysis of the ways in which FIs can insulate themselves from liquidity risk and the key role deposit insurance and other guarantee schemes play in reducing liquidity risk.

In Chapter 22, we investigate the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate risk and the mismatching of asset and liabil- ity maturities on FI risk exposure. At the core of FI risk insulation is the size and adequacy of the owner’s capital stake, which is also a focus of this chapter.

The management of risk off the balance sheet is examined in Chapter 23. The chapter highlights various new markets and instruments that have emerged to allow FIs to bet- ter manage three important types of risk: interest rate risk, foreign exchange risk, and credit risk. These markets and instruments and their strategic use by FIs include forwards, futures, options, and swaps.

Finally, Chapter 24 explores ways of removing credit risk from the loan portfolio through asset sales and securitization.

NEW FEATURES

· Tables and figures in all chapters have been revised to include the most recently avail- able data.

· Revised “After the Crisis” boxes highlighting significant events related to the financial crisis have been added to chapters throughout the book.

· Updates on the major changes proposed for the regulation of financial institutions are included where appropriate throughout the book.

· Discussion of how financial markets and institutions continue to recover from the financial crisis has been added throughout the book. Virtually every chapter includes

Final PDF to printer

Preface ix

sau19714_fm_i-xxii.indd ix 10/04/17 06:53 PM

new material detailing how the financial crisis affected risk management in financial institutions.

· Several chapters include a discussion of Brexit as its affects the risk and return for investors in financial markets and financial institutions.

· Several chapters include a discussion of the impact of initial interest rate increases by the Federal Reserve.

· Several chapters include a discussion of the impact of China’s economic policies and economic slowdown on financial markets.

· Chapter 1 includes a new section on enterprise risk management. The chapter also pro- vides an update on the implementation of the Wall Street Reform and Consumer Protec- tion Act enacted as a result of the financial crisis.

· Chapter 4 provides an update on the Federal Reserve’s actions intended to strengthen the U.S. economy, including the interest rate increases instituted by the Fed.

· Chapter 5 includes updates on the LIBOR scandal. · Chapter 6 discusses China’s and worldwide Treasury holdings and the potential impact

of these holdings on the U.S. economy. · Chapter 8 includes more on dark pools and Brexit’s impact on worldwide stock markets. · Excel spreadsheets containing bank financial statements and ratio calculations have

been added to Chapter 12. · Chapter 13 includes a discussion of how the Volcker Rule and Consumer Protection

Regulation have affected the operations of financial institutions. · Chapter 14 includes a discussion of new payday lending legislation · Chapter 17 includes more on new regulations for money market mutual funds. · Chapter 21 includes updates of the new international liquidity standards enacted as a

result of the financial crisis.

ACKNOWLEDGMENTS We take this opportunity to thank all of those individuals who helped us prepare this and previous editions. We want to express our appreciation to those instructors whose insight- ful comments and suggestions were invaluable to us during this revision.

Keldon Bauer Tarleton State University Jen-Chi Cheng Wichita State University Kathy English Wilmington University Andrew Fodor Ohio University–Athens Robert Goldberg Adelphi University Walt Nelson Missouri State University Abdullah Noman Nicholls State University

Ozde Oztekin Florida International University–Miami O. John Paskelian University of Houston Downtown Blaise Roncagli Cleveland State University Matthew Ross Western Michigan University–Kalamazoo Benjamin Thompson Lincoln Memorial University Ann Marie Whyte University of Central Florida–Orlando David Zalewski Providence College

We would like to thank the staff at McGraw-Hill for their help and guidance, especially Chuck Synovec, executive brand manager; Noelle Bathurst, senior product developer; Heather Ervolino, content project manager; Tobi Philips, digital product developer; Trina Maurer, senior marketing manager; and Dave O’Donnell, marketing specialist. Additional thanks to Alex Marden for his editorial assistance.

Anthony Saunders

Marcia Millon Cornett

Final PDF to printer

sau19714_fm_i-xxii.indd x 10/04/17 06:53 PM

Confirming Pages

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 97

sau19714_ch04_093-131.indd 97 07/07/17 03:10 PM

Federal Open Market Committee

The Federal Open Market Committee (FOMC) is the major monetary policy-making body of the Federal Reserve System. As alluded to earlier, the FOMC consists of the seven members of the Federal Reserve Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve Banks (on a rotating basis). The chair of the Board of Governors is also the chair of the FOMC. The FOMC is required to meet at least four times each year in Washington, DC. However, eight regularly scheduled meetings have been held each year since 1980.

The main responsibilities of the FOMC are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. The FOMC seeks to accomplish this by setting guidelines regarding open market operations. Open market operations—the purchase and sale of U.S. government and fed- eral agency securities—is the main policy tool that the Fed uses to achieve its monetary tar- gets (although the operations themselves are normally carried out by traders at the Federal Reserve Bank of New York, as discussed below). The FOMC also sets ranges for the growth of the monetary aggregates, sets the federal funds rate (see below), and directs operations of the Federal Reserve in foreign exchange markets (see Chapter 9). In addition, although reserve requirements and the discount rate are not specifically set by the FOMC, their levels are monitored and guided by the FOMC. Associated with each meeting of the FOMC is the release of the Beige Book. The Beige Book summarizes information on current economic conditions by Federal Reserve district. Information included in the Beige Book is drawn from reports from bank directors, interviews with key business leaders, economists, market experts, and other sources. Meetings of the FOMC are some of the most closely watched economic meetings in the world. As the FOMC formulates and implements monetary pol- icy, its actions affect not only the U.S. economy, but economies worldwide.

Functions Performed by Federal Reserve Banks

As part of the Federal Reserve System, Federal Reserve Banks (FRBs) perform multiple func- tions. These include assistance in the conduct of monetary policy; supervision and regulation of member banks and other large financial institutions; consumer protection; and the provision of services such as new currency issue, check clearing, wire transfer, and research services to the federal government, member banks, or the general public. We summarize these functions in Table 4–1. The In the News box in this section describes how the Federal Reserve provided extraordinary services in many of these areas in response to the recent financial crisis.

Federal Open Market Committee (FOMC) The major monetary policy-making body of the Federal Reserve System.

open market operations Purchases and sales of U.S. government and fed- eral agency securities by the Federal Reserve.

TABLE 4–1 Functions Performed by the Federal Reserve Banks

Assistance in the conduct of monetary policy—Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC). FRBs set and change discount rates.

Supervision and regulation—FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district.

Consumer protection and community affairs—FRBs write regulations to implement many of the major consumer protection laws and establish programs to promote community development and fair and impartial access to credit.

Government services—FRBs serve as the commercial bank for the U.S. Treasury. New currency issue—FRBs are responsible for the collection and replacement of damaged

currency from circulation. Check clearing—FRBs process, route, and transfer funds from one bank to another as checks

clear through the Federal Reserve System. Wire transfer services—FRBs and their member banks are linked electronically through the

Federal Reserve Communications System. Research services—each FRB has a staff of professional economists who gather, analyze, and

interpret economic data and developments in the banking sector in their district and economywide.

WALKTHROUGH

Chapter Features

Confirming Pages

sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM

MAJOR DUTIES AND RESPONSIBILITIES OF THE FEDERAL RESERVE SYSTEM: CHAPTER OVERVIEW Central banks determine, implement, and control the monetary policy in their home countries. The Federal Reserve (the Fed) is the central bank of the United States. Founded by Congress under the Federal Reserve Act in 1913, the Fed’s original duties were to pro- vide the nation with a safer, more flexible, and more stable monetary and financial system. This was needed following a number of banking crises and panics that had occurred in the first decade of the 20th century (particularly 1907)1 and the last decades of the 19th century. As time passed, additional legislation, including the Banking Act of 1935, the Full Employment Act of 1946, and the Full Employment and Balanced Growth Act of 1978 (also called the Humphrey-Hawkins Act), revised and supplemented the original purposes and objectives of the Federal Reserve System. These objectives included economic growth

1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country was in the midst of an economic recession. The New York Stock Exchange index fell by 50 percent in less than a year, and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- ruptcies; and a near collapse of the U.S. financial system.

O U T L I N E

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

Structure of the Federal Reserve System

Organization of the Federal Reserve System

Board of Governors of the Federal Reserve System

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Balance Sheet of the Federal Reserve

Monetary Policy Tools

Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

The Federal Reserve, the Money Supply, and Interest Rates

Effects of Monetary Tools on Various Economic Variables

Money Supply versus Interest Rate Targeting

International Monetary Policies and Strategies

Systemwide Rescue Programs Employed during the Financial Crisis

Challenges Remain after the Crisis

The Federal Reserve System, Monetary Policy, and Interest Rates

L e a r n i n g G o a l s

4 c h a p t e r

LG 4-1 Understand the major functions of the Federal Reserve System.

LG 4-2 Identify the structure of the Federal Reserve System.

LG 4-3 Identify the monetary policy tools used by the Federal Reserve.

LG 4-4 Appreciate how monetary policy changes affect key economic variables.

LG 4-5 Understand how central banks around the world adjusted their monetary policy during the recent financial crisis.

Introduction and Overview of Financial Markets part one

Confirming Pages

sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM

O U T L I N E

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

Structure of the Federal Reserve System

Organization of the Federal Reserve System

Board of Governors of the Federal Reserve System

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Balance Sheet of the Federal Reserve

Monetary Policy Tools

Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

The Federal Reserve, the Money Supply, and Interest Rates

Effects of Monetary Tools on Various Economic Variables

Money Supply versus Interest Rate Targeting

International Monetary Policies and Strategies

Systemwide Rescue Programs Employed during the Financial Crisis

Challenges Remain after the Crisis

The Federal Reserve System, Monetary Policy, and Interest Rates

L e a r n i n g G o a l s

4 c h a p t e r

LG 4-1 Understand the major functions of the Federal Reserve System.

LG 4-2 Identify the structure of the Federal Reserve System.

LG 4-3 Identify the monetary policy tools used by the Federal Reserve.

LG 4-4 Appreciate how monetary policy changes affect key economic variables.

LG 4-5 Understand how central banks around the world adjusted their monetary policy during the recent financial crisis.

Introduction and Overview of Financial Markets part one

Confirming Pages

96 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 96 07/07/17 03:10 PM

Federal Reserve Banks operate as nonprofit organizations. They generate income pri- marily from three sources: (1) interest earned on government securities acquired in the course of Federal Reserve open market transactions (see below), (2) interest earned on reserves that banks are required to deposit at the Fed (see reserve requirements below), and (3) fees from the provision of payment and other services to member depository institutions.

Board of Governors of the Federal Reserve System

The Board of Governors of the Federal Reserve (also called the Federal Reserve Board) is a seven-member board headquartered in Washington, DC. Each member is appointed by the president of the United States and must be confirmed by the Senate. Board mem- bers serve a nonrenewable 14-year term.4 Board members are often individuals with PhD degrees in economics and/or an extensive background in economic research and political service, particularly in the area of banking. Board members’ terms are staggered so that one term expires every other January. The president designates two members of the board to be the chair and vice chair for four-year terms. The board usually meets several times per week. As they carry out their duties, members routinely confer with officials of other gov- ernment agencies, representatives of banking industry groups, officials of central banks of other countries, members of Congress, and academics.

The primary responsibilities of the Federal Reserve Board are the formulation and con- duct of monetary policy and the supervision and regulation of banks. All seven board mem- bers sit on the Federal Open Market Committee, which makes key decisions affecting the availability of money and credit in the economy (see below). For example, the Federal Reserve Board, through the FOMC, can and usually does set money supply and interest rate targets. The Federal Reserve Board also sets bank reserve requirements (discussed in Chapter 13) and reviews and approves the discount rates (see below) set by the 12 Federal Reserve Banks.

The Federal Reserve Board also has primary responsibility for the supervision and regulation of (1) all bank holding companies (their nonbank subsidiaries and their foreign subsidiaries), (2) state-chartered banks that are members of the Federal Reserve System (state-chartered member banks), and (3) Edge Act and agreement corporations (through which U.S. banks conduct foreign operations).5 The Fed also shares supervisory and regu- latory responsibilities with state and other federal supervisors (e.g., the OCC, the FDIC), including overseeing both the operations of foreign banking organizations in the United States and the establishment, examination, and termination of branches, commercial lend- ing subsidiaries, and representative offices of foreign banks in the United States. The board approves member bank mergers and acquisitions and specifies permissible nonbank activities of bank holding companies. The board is also responsible for the development and administration of regulations governing the fair provision of consumer credit (e.g., the Truth in Lending Act, the Equal Credit Opportunity Act). Finally, the Wall Street Reform and Consumer Protection Act of 2010 provided unprecedented powers to the Federal Reserve, putting it in charge of monitoring any of the country’s biggest financial firms— those considered critical to the health of the financial system as a whole.

The chair of the Federal Reserve Board, currently Janet Yellen, often advises the pres- ident of the United States on economic policy and serves as the spokesperson for the Fed- eral Reserve System in Congress and to the public. All board members share the duties of conferring with officials of other government agencies, representatives of banking indus- try groups, officials of the central banks of other countries, and members of Congress.

4. The length of the term is intended to limit the president’s control over the Fed and thus to reduce political pressure on board members; the nonrenewable nature of an appointment prevents any incentives for governors to take actions that may not be in the best interests of the economy yet may improve their chances of being reappointed.

5. An Edge Act corporation is a subsidiary of a federally chartered domestic bank holding company that generally spe- cializes in financing international transactions. An agreement corporation operates like an Edge Act but is a subsidiary of a state-chartered domestic bank. Created by the Edge Act of 1919, Edge Act corporations are exempt from certain U.S. bank regulations, thus allowing U.S. banks to compete against foreign banks on an even level. For example, Edge Act corporations are exempt from prohibitions on investing in equities of foreign corporations. Ordinarily, U.S. banks are not allowed to undertake such investments.

www.occ.treas.gov

www.fdic.gov

The following special features have been integrated throughout the text to encourage student interaction and to aid students in absorbing and retaining the material

CHAPTER-OPENING OUTLINES

These outlines offer students a snapshot view of what they can expect to learn from each chapter’s discussion.

LEARNING GOALS

Learning goals (LGs) appear at the beginning of each chapter to provide a quick introduction to the key chapter material. These goals are also integrated with the end-of-chapter questions and problems, which allows instructors to easily emphasize the learning goal(s) as they choose.

BOLD KEY TERMS AND A MARGINAL GLOSSARY

The main terms and concepts are emphasized throughout the chapter by bold key terms called out in the text and defined in the margins

PERTINENT WEB ADDRESSES

Website addresses are referenced in the margins throughout each chapter, providing additional resources to aid in the learning process.

Final PDF to printer

sau19714_fm_i-xxii.indd xi 10/04/17 06:53 PM

Confirming Pages

sau19714_ch04_093-131.indd 98 07/07/17 03:10 PM

In the first half of 2007, as the extent of declining home prices became apparent, banks and other financial market participants started to reas- sess the value of mortgages and mortgage-backed securities that they owned, especially those in the subprime segment of the housing market. The autumn of 2007 saw increasing strains in a number of market segments, including asset- backed commercial paper, and banks also began to exhibit a reluctance to lend to one another for terms much longer than overnight. This reluctance was reflected in a dramatic rise in the London Interbank Offered Rate (LIBOR) at most maturities greater than over- night. LIBOR is a measure of the rates at which international banks make dollar loans to one another. Since that initial disruption, financial markets have remained in a state of high vola- tility, with many interest rate spreads at historically high levels.

In response to this turbulence, the Fed and the federal govern- ment have taken a series of dramatic steps. As 2007 came to a close, the Federal Reserve Board announced the creation of a Term Auction Facil- ity (TAF), in which fixed amounts of term funds are auctioned to deposi- tory institutions against any collateral eligible for discount window loans. So while the TAF substituted an auc- tion mechanism for the usual fixed interest rate, this facility can be seen essentially as an extension of more conventional discount window lend- ing. In March 2008, the New York Fed provided term financing to facilitate the purchase of Bear Stearns by J.P. Morgan Chase through the creation of a facility that took a set of risky assets

The Financial Crisis: Toward an Explanation and Policy Response

I N T H E N E W S

off the company’s balance sheet. That month, the board also announced the creation of the Term Securities Lending Facility (TSLF), swapping Treasury securities on its balance sheet for less liquid private securities held in the private sector, and the Primary Dealer Credit Facility (PDCF). These actions, particularly the latter, represented a significant expansion of the federal financial safety net by making available a greater amount of central bank credit, at prices unavail- able in the market, to institutions (the primary dealers) beyond those banks that typically borrow at the discount window. . . .

In the fall of 2008, financial mar- kets worldwide experienced another round of heightened volatility and his- toric changes: Lehman Brothers filed for Chapter 11 bankruptcy protec- tion; investment banking companies Goldman Sachs and Morgan Stanley successfully submitted applications to become bank holding companies; Bank of America purchased Merrill Lynch; Wells Fargo acquired Wachovia; PNC Financial Services Group pur- chased National City Corporation; and the American International Group received significant financial assistance from the Federal Reserve and the Treasury Department. On the policy front, the Federal Reserve announced the creation of several new lending facilities—including the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF), the last of which became operational in March

2009. The TALF was designed to support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration, while also expanding the TAF and the TSLF. The creation of these programs resulted in a tremendous expansion of the Federal Reserve’s balance sheet. Furthermore, Congress passed the Troubled Asset Relief Program (TARP) to be administered by the Treasury Department. And in February 2009, the president signed the American Recovery and Reinvestment Act, a fiscal stimulus program of roughly $789 billion. . . .

Much of the public policy response to turmoil in financial markets over the two years took the form of expanded lending by the Fed and central banks in other countries. The extension of credit to financial institutions has long been one of the tools available to a central bank for managing the supply of money—specifically, bank reserves—to the economy. Indeed, discount window lending by the 12 Reserve Banks was the primary means for affecting the money sup- ply at the time the Fed was created. Over time, open market operations, in which the Fed buys and sells securi- ties in transactions with market partici- pants, have become the main tool for managing the money supply. Lending has become a relatively little-used tool, mainly accessed by banks with occasional unexpected flows into or out of their Fed reserve accounts late in the day. If such banks were to seek funding in the market, they would likely have to pay above- normal rates for a short-term (overnight) loan.

continued

Confirming Pages

108 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 108 07/07/17 03:10 PM

of 0 percent to 0.25 percent as of December 16, 2008. The rate remained at these his- torically low levels into 2010, and in June 2010 the Fed announced that the fed funds rate would remain at these levels for an “extended period.” It was not until the spring and sum- mer of 2013 that the Fed mentioned the end of these low interest rates and the tightening of monetary policy. And even then, the Fed repeatedly stated that the end of its monetary eas- ing actions would not come until the very slow economic growth picked up. It was not until December 2015 that the Fed eventually raised interest rates (for the first time in 10 years).

Open Market Operations

As mentioned earlier, open market operations are the Federal Reserves’s purchases or sales of securities in the U.S. Treasury securities market. When a targeted monetary aggregate or interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a state- ment called the policy directive. The manager of the Trading Desk uses the policy direc- tive to instruct traders on the daily amount of open market purchases or sales to transact. These transactions take place on an over-the-counter market in which traders are linked to each other electronically (see Chapter 5).

To determine a day’s activity for open market operations, the staff at the FRBNY begins each day with a review of developments in the fed funds market since the previous day and a determination of the actual amount of reserves in the banking system the previ- ous day. The staff also reviews forecasts of short-term factors that may affect the supply and demand of reserves on that day. With this information, the staff decides the level of transactions needed to obtain the desired fed funds rate. The process is completed with a daily conference call to the Monetary Affairs Division at the Board of Governors and one of the four voting Reserve Bank presidents (outside of New York) to discuss the FRBNY plans for the day’s open market operations. Once a plan is approved, the Trading Desk is instructed to execute the day’s transactions.

Open market operations are particularly important because they are the primary deter- minant of changes in bank excess reserves in the banking system and thus directly impact the size of the money supply and/or the level of interest rates (e.g., the fed funds rate). When the Federal Reserve purchases securities, it pays for the securities by either writing a check on itself or directly transferring funds (by wire transfer) into the seller’s account. Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the securities. This transaction increases the bank’s excess reserve levels. When the Fed sells securities, it either collects checks received as payment or receives wire transfers of funds from these agents (such as banks) using funds from their accounts at the Federal Reserve Banks to purchase securities. This reduces the balance of the reserve account of a bank that purchases securities. Thus, when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed.

www.newyorkfed.org

Federal Reserve Board Trading Desk Unit of the Federal Reserve Bank of New York through which open market opera- tions are conducted.

policy directive Statement sent to the Fed- eral Reserve Board Trading Desk from the FOMC that specifies the daily amount of open market purchases or sales to transact.

EXAMPLE 4–1 Purchases of Securities by the Federal Reserve Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Trea- sury securities. Traders at the FRBNY call primary government securities dealers of major commercial and investment banks (such as Goldman Sachs and Morgan Stanley),9 who provide a list of securities they have available for sale, including the denomination, matu- rity, and the price on each security. FRBNY traders seek to purchase the target number of securities (at the desired maturities and lowest possible price) until they have purchased the $500 million. The FRBNY then notifies its government bond department to receive and pay the sellers for the securities it has purchased. The securities dealer sellers (such as

9. As of June 2016, there were 23 primary securities dealers trading, on average, $0.82 trillion of securities per day.

Confirming Pages

226

sau19714_ch07_208-239.indd 226 07/20/17 04:15 PM

bank retains the loan and the risk exposure, until the loan is paid off. Rather, mortgage securitization and loan syndication allows banks to retain little or no part of the loans, and hence little or no part of the default risk on loans that they originate: bank have moved to the originate-to-distribute model of banking. Thus, as long as the borrower does not default within the first months after a loan’s issuance and the loans are sold or securitized without recourse back to the bank, the issuing bank can ignore longer term credit risk con- cerns. This decoupling of the risk from the lending activity allows the market to efficiently transfer risk across counterparties. However, it also loosens the incentives to carefully per- form each of the steps of the lending process. This loosening of incentives was an important factor leading to the global financial crisis of 2008–2009, which witnessed the after-effects of poor loan underwriting, shoddy documentation and due diligence, failure to monitor borrower activity, and fraudulent activity on the part of both lenders and borrowers. The result was a deterioration in credit quality at the same time as there was a dramatic increase in consumer and corporate leverage. Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates as it began to fear infla- tion. Since many of the subprime mortgages that originated in the 2001–2005 period had adjustable rates, the cost of meeting mortgage commitments rose to unsustainable levels for many low-income households. The result of these events was a wave of mortgage defaults in the subprime market and foreclosures that only reinforced the downward trend in hous- ing prices. As this happened, the poor quality of the collateral and credit quality underlying subprime mortgage pools became apparent, with default rates far exceeding those appar- ently anticipated by the rating agencies who set their initial subprime mortgage securitiza- tions ratings. The financial crisis began.

Although bank regulators attempt to examine the off-balance-sheet activities of banks so as to ascertain their safety and soundness, these activities receive far less scrutiny than on-balance-sheet activities (i.e., traditional lending and deposit taking). To the extent

In January 2016, Goldman Sachs agreed to pay more than $5 billion, the largest regulatory penalty in its history. In settling with the Justice Department and a collection of other state and federal entities, Goldman resolved claims stemming from the Wall Street firm’s sale of mortgage bonds heading into the financial crisis. It joined a list of other big banks in moving past one of the biggest, and most costly, legal problems of the crisis era. The govern- ment had earlier won multibillion-dollar settlements from J.P. Morgan Chase, Bank of America, and Citi- group. Crisis-related settlements by banks, mortgage firms, brokerages and others total at least $181.1 billion.

The investigations examined how Wall Street sold bonds tied to

Goldman Reaches $5 Billion Settlement over Mortgage-Backed Securities

A F T E R T H E C R I S I S

residential mortgages, and whether banks deceived investors by misrepre- senting the quality of underlying loans. The government’s inquiry into Goldman related to mortgage-backed securities the firm packaged and sold between 2005 and 2007, when the housing market was booming and investor demand for related bonds was strong.

The latest settlement is just one of several that Goldman has paid in relation to the crisis. Goldman agreed to pay $1.2 billion in penalties to the Federal Housing Finance Agency in 2014 to settle claims that it failed to disclose the risks on mortgage bonds it sold. In 2010, the firm agreed to pay $550 million to settle a Securi- ties and Exchange Commission complaint stemming from its handling

of a complex mortgage-linked deal. In February 2015, Morgan Stanley reached a preliminary accord with the Justice Department in which the firm agreed to pay $2.6 billion. That month, Goldman said in a regulatory filing that it had been informed by U.S. officials in December 2014 that it might face a civil lawsuit stemming from the govern- ment’s mortgage-bond probe. In May, the firm said it was in talks with U.S. and state authorities to resolve those claims. In the settlement, Goldman agreed to pay to the Justice Depart- ment a $2.385 billion civil monetary penalty. Goldman must also provide $1.8 billion in consumer relief through debt forgiveness to borrowers, the construction and financing of afford- able housing, and other programs.

Confirming Pages

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 123

sau19714_ch04_093-131.indd 123 07/07/17 03:10 PM

INTERNATIONAL MONETARY POLICIES AND STRATEGIES Central banks guide the monetary policy in virtually all countries. For example, the European Central Bank (ECB) is the central bank for the European Union, while the Bank of England is the central bank of the United Kingdom. Like the Federal Reserve, these are independent central banks whose decisions do not need to be ratified by the government. In contrast, the People’s Bank of China, the Reserve Bank of India, and the Central Bank of Brazil are less independent in that the government imposes direct political control over the operations of these central banks. Independence of a central bank generally means that the bank is free from pressure from politicians who may attempt to enhance economic activity in the short term (e.g., around election time) at the expense of long-term economic growth. Therefore, independent central banks operate with more credibility.

Regardless of their independence, in the increasingly global economy, central banks around the world must work not only to guide the monetary policy of their individual coun- tries, but also to coordinate their efforts with those of other central banks. In this section, we look at how central banks around the world took independent as well as coordinated actions as they set their monetary policy during the financial crisis. For example, as news spread that Lehman Brothers would not survive, FIs around the world moved to disentangle trades made with Lehman. The Dow fell more than 500 points, the largest drop in over seven years. By Wednesday, September 17, 2008, tension had mounted around the world. Stock markets saw huge swings in value as investors tried to sort out who might survive (markets from Russia to Europe were forced to suspend trading as stock prices plunged).

As the U.S. government debated a rescue plan, the financial crisis continued to spread worldwide. During the last week of September and the first week of October 2008, the German government guaranteed all consumer bank deposits and arranged a bailout of Hypo Real Estate, the country’s second-largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth- largest mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed the deposits and debt of its six major financial institutions. Iceland rescued its third-largest bank with an $860 million purchase of 75 percent of the bank’s stock and a few days later seized the country’s entire banking system. The Netherlands, Belgium, and Luxembourg central governments together agreed to inject $16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to keep it afloat. However, five days later this deal fell apart and the bank was split up. The Dutch government bought all assets located in the Netherlands for approximately $23 billion. The central bank in India stepped in to stop a run on the country’s second-largest bank, ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their bank- ing systems as banks’ reluctance to lend to each other and a run on Bank of East Asia Ltd. led the Hong Kong Monetary Authority to inject liquidity into its banking system. South Korean authorities offered loans and debt guarantees to help small and midsized busi- nesses with short-term funding. Table 4–9 lists some other systemwide support programs (e.g., on October 12, Australia committed an unspecified amount of funds to guarantee the country’s bank liabilities) and bank-specific actions (e.g., on September 30, the ECB and the French government pledged $3 billion to recapitalize Dexia, one of France’s largest banks) taken by central governments during the heat of the crisis. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets.

Systemwide Rescue Programs Employed during the Financial Crisis

While the previously mentioned actions by central banks represent steps taken by individ- ual countries, they were just part of a coordinated effort by major countries to ease the monetary conditions brought about by the financial crisis and avoid a deep worldwide recession. At the heart of the efforts were 11 countries, which accounted for the bulk of the rescue programs: Australia, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Switzerland, the United Kingdom, and the United States. The central banks in these coun- tries took substantive actions targeted at the balance sheets of financial institutions in their

LG 4-5

Confirming Pages

104 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 104 07/07/17 03:10 PM

by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve accounts. Many asked why banks were choosing to hold so many reserves instead of lend- ing them out, and some claimed that banks’ lending of their excess reserves was crucial for resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity of excess reserves without changing banks’ incentives to lend to firms and households. Thus, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not necessarily affected by private banks’ lending decisions.

therefore function as money (see Chapter 1).

Assets. The major assets on the Federal Reserve’s balance sheet are Treasury and gov- ernment agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange. While interbank loans (loans to domestic banks) are quite a small portion of the Federal Reserve’s assets, they play an important role in implementing mon- etary policy (see below).

Treasury Securities. Treasury securities (54.2 percent of total assets in 2016) are the largest asset on the Fed’s balance sheet. They represent the Fed’s holdings of securities issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve the buying and selling of these securities. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply.

U.S. Government Agency Securities. U.S. government agency securities are the second-largest asset account on the Fed’s balance sheet (39.2 percent of total assets in 2016). However, in 2007 this account was 0.0 percent of total assets. This account grew

as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed secu- rities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC called for the purchase of up to $1.25 trillion of agency MBS. The purchase activity began on January 5, 2009, and continued through 2016. Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial markets.

Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds Treasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fed also holds small amounts of Treasury-issued coinage and foreign- denominated assets to assist in foreign currency transactions or currency swap agreements with the central banks of other nations.

Interbank Loans. As mentioned earlier, depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window (discussed in detail below). The interest rate or discount rate charged on these loans is often lower than other interest rates in the short-term money markets (see Chapter 5). As we discuss below, in January 2003 the Fed implemented changes to its discount window lending policy that increased the cost of discount window borrowing but eased the requirements on which depository institutions can borrow. As part of this change, the discount window rate was increased so that it would be higher than the fed funds rate. As a result, (discount) interbank loans are normally a relatively small portion of the Fed’s total assets.

D O YO U U N D E R S TA N D :

1. What the main functions of Federal Reserve Banks are?

2. What the main responsibilities of the Federal Reserve Board are?

3. How the FOMC implements monetary policy?

4. What the main assets and liabilities of the Federal Reserve are?

“DO YOU UNDERSTAND” BOXES

These boxes allow students to test themselves on the main concepts presented within each major chapter section. Solutions are provided in Connect.

“IN THE NEWS” BOXES

These boxes demonstrate the application of chapter material to real current events.

INTERNATIONAL COVERAGE

An international icon appears in the margin to easily communicate where international material is being introduced.

IN-CHAPTER EXAMPLES

These examples provide numerical demonstrations of the analytical material described in many chapters.

Pedagogical Features

“AFTER THE CRISIS” BOXES

These boxes use articles pertaining to events caused or affected by the 2008–2009 financial crisis to elaborate on chapter material.

Final PDF to printer

xii

sau19714_fm_i-xxii.indd xii 10/04/17 06:53 PM

EXCEL PROBLEMS

Excel problems are featured in selected chapters and are denoted by an icon. Spreadsheet templates are available in Connect.

Confirming Pages

sau19714_ch07_208-239.indd 238 07/20/17 04:15 PM

238 Part 2 Securities Markets

rate offered to you is 5.25 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the first six

payments. 5.

mortgage rate offered to you is 6.50 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the first six

payments. 6. Using a Spreadsheet to Calculate Mortgage

Payments: What is the monthly payment on a $150,000, 15-year mortgage if the mortgage rate is 5.75 percent? 6.25 percent? 7.5 percent? 9 percent? (LG 7-4)

7. Using a Spreadsheet to Calculate Mortgage Payments: What is the monthly payment on

a $150,000, 30-year mortgage if the mortgage rate is 5.75 percent? 6.25 percent? 7.5 percent? 9 percent? (LG 7-4)

8. You plan to purchase a $200,000 house using either a 30-year mortgage obtained from your local savings bank with a rate of 7.25 percent, or a 15-year mortgage with a rate of 6.50 percent. You will make a down payment of 20 per- cent of the purchase price. (LG 7-3) a. Calculate the amount of interest and, separately, prin-

cipal paid on each mortgage. What is the difference in interest paid?

b. Calculate your monthly payments on the two mortgages. What is the difference in the monthly payment on the two mortgages?

9. You plan to purchase a $240,000 house using either a 30-year mortgage obtained from your local bank with a rate of 5.75 percent, or a 15-year mortgage with a rate of 5.00 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-3) a. Calculate the amount of interest and, separately, prin-

cipal paid on each mortgage. What is the difference in interest paid?

b. Calculate your monthly payments on the two mortgages. What is the difference in the monthly payment on the two mortgages?

10. You plan to purchase a house for $115,000 using a 30-year

LG 7-3) a. Your bank offers you the following two options for payment: Option 1: Mortgage rate of 9 percent and zero points. Option 2: Mortgage rate of 8.85 percent and 2 points. Which option should you choose? b. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 10.25 percent and 1 point. Option 2: Mortgage rate of 10 percent and 2.5 points. Which option should you choose?

11. You plan to purchase a house for $195,000 using a 30-year mortgage obtained from your local bank. You will make a down payment of 20 percent of the purchase price. You will not pay off the mortgage early. (LG 7-3) a. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 5.5 percent and zero points. Option 2: Mortgage rate of 5.35 percent and 1.5 points. Which option should you choose? b. Your bank offers you the following two options for

payments: Option 1: Mortgage rate of 5.35 percent and 1 point. Option 2: Mortgage rate of 5.25 percent and 2 points. Which option should you choose?

12. You plan to purchase a house for $175,000 using a 15-year mortgage obtained from your local bank. You will make a down payment of 25 percent of the purchase price. You will not pay off the mortgage early. (LG 7-3) a. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 5 percent and zero points. Option 2: Mortgage rate of 4.75 percent and 2 points. Which option should you choose? b. Your bank offers you the following two options for

payments: Option 1: Mortgage rate of 4.85 percent and 2 points. Option 2: Mortgage rate of 4.68 percent and 3 points. Which option should you choose?

13. You plan to purchase a $220,000 house using a 15-year mortgage obtained from your bank. The mortgage rate offered to you is 4.75 percent. You will make a down pay- ment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the mortgage.

How much total interest is paid on this mortgage? 14. You plan to purchase a $300,000 house using a 15-year

mortgage obtained from your bank. The mortgage rate offered to you is 4.50 percent. You will make a down pay- ment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the mortgage.

How much total interest is paid on this mortgage?

Present Value Periods

Interest Rate ⇒

The Payment Will Be

$150,000 15 × 12 5.75%/12 $1,245.62 150,000 15 × 12 6.25%/12 1,286.13 150,000 15 × 12 7.50%/12 1,390.52 150,000 15 × 12 9.00%/12 1,521.40

Present Value Periods

Interest Rate ⇒

The Payment Will Be

$150,000 30 × 12 5.75%/12 $ 875.36 150,000 30 × 12 6.25%/12 923.58 150,000 30 × 12 7.50%/12 1,048.82 150,000 30 × 12 9.00%/12 1,206.93

Confirming Pages

sau19714_ch04_093-131.indd 131 07/07/17 03:10 PM

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 131

6. MHM Bank currently has $250 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is increasing this requirement to 12 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

MHM Bank if MHM Bank converts all excess reserves to loans, but borrowers return only 80 percent of these funds to MHM Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and MHM Bank if MHM Bank converts 85 percent of its excess reserves to loans and borrowers return 90 percent of these funds to MHM Bank as transaction deposits.

7. The FOMC has instructed the FRBNY Trading Desk to purchase $500 million in U.S. Treasury securities. The Fed- eral Reserve has currently set the reserve requirement at 5 percent of transaction deposits. Assume U.S. banks with- draw all excess reserves and give out loans. (LG 4-3) a. Assume also that borrowers eventually return all of these

funds to their banks in the form of transaction deposits. What is the full effect of this purchase on bank deposits and the money supply?

b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 95 per- cent of these funds to their banks in the form of transac- tion deposits?

8. The FOMC has instructed the FRBNY Trading Desk to purchase $750 million in U.S. Treasury securities. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. Assume U.S. banks withdraw all excess reserves and give out loans. (LG 4-3) a. Assume also that borrowers eventually return all of these

funds to their banks in the form of transaction deposits.

What is the full effect of this purchase on bank deposits and the money supply?

b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 90 percent of these funds to their banks in the form of transaction deposits?

9. Marly Bank currently has $650 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is decreasing this requirement to 9 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

Marly Bank if Marly Bank converts all excess reserves to loans, but borrowers return only 60 percent of these funds to National Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and Marly Bank if Marly Bank converts 90 percent of its excess reserves to loans and borrowers return 75 percent of these funds to Marly Bank as transaction deposits.

10. Brown Bank currently has $350 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is increasing this requirement to 11 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

Brown Bank if Brown Bank converts all excess reserves to loans, but borrowers return only 50 percent of these funds to Brown Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and Brown Bank if National Bank converts 75 percent of its excess reserves to loans and borrowers return 60 percent of these funds to Brown Bank as transaction deposits.

Go to the Federal Reserve Board website and find the latest information available on the prime rate, the discount rate, and the three-month T-bill rate using the following steps. Go to www.federalreserve.gov. Under “Select Statistical Releases,” click on “Selected Interest Rates.” Click on the most recent date. The data will be in this file on your computer screen. Questions

1. What are the current levels for each of these interest rates? 2. Calculate the percentage change in each of these rates since June 2016.

S E A R C H T H E S I T E

Confirming Pages

sau19714_ch04_093-131.indd 130 07/07/17 03:10 PM

130 Part 1 Introduction and Overview of Financial Markets

SUMMARY

This chapter described the Federal Reserve System in the United States. The Federal Reserve is the central bank charged with conducting monetary policy, supervising and regulating depository institutions, maintaining the stability of the financial system, and providing specific financial services to the U.S. government, the public, and financial institutions. We reviewed the structure under which the Fed provides these functions, the monetary policy tools it uses, and the impact of monetary policy changes on money sup- ply, credit availability, interest rates, security prices, and foreign exchange rates.

QUESTIONS 1. Describe the functions performed by Federal Reserve

Banks. (LG 4-1) 2. Define the discount rate and the discount window. (LG 4-2) 3. Describe the structure of the Board of Governors of the

Federal Reserve System. (LG 4-2) 4. What are the primary responsibilities of the Federal Reserve

Board? (LG 4-1) 5. What are the primary responsibilities of the Federal Open

Market Committee? (LG 4-2) 6. What are the major liabilities of the Federal Reserve

System? Describe each. (LG 4-2) 7. Why did reserve deposits increase to the point that this

account represented the largest liability account on the Federal Reserve’s balance sheet in the late 2000s? (LG 4-2)

8. What are the major assets of the Federal Reserve System? Describe each. (LG 4-2)

9. Why did U.S. government agency securities go from nothing to being the largest asset account on the Federal Reserve’s balance sheet in the late 2000s? (LG 4-2)

10. What are the tools used by the Federal Reserve to imple- ment monetary policy? (LG 4-3)

11. Explain how a decrease in the discount rate affects credit availability and the money supply. (LG 4-3)

12. Why does the Federal Reserve rarely use the discount rate to implement its monetary policy? (LG 4-3)

13. What changes did the Fed implement to its discount window lending policy in the early 2000s? in the late 2000s? (LG 4-3)

14. Which of the monetary tools available to the Federal Reserve is most often used? Why? (LG 4-3)

15. Describe how expansionary activities conducted by the Fed- eral Reserve impact the money supply, credit availability, interest rates, and security prices. Do the same for contrac- tionary activities. (LG 4-4)

16. Summarize the monetary policy measures taken by central banks to address the worldwide financial crisis. (LG 4-5)

PROBLEMS 1. Suppose the Federal Reserve instructs the Trading Desk

to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. (LG 4-3)

2. Suppose the Federal Reserve instructs the Trading Desk to sell $850 million of securities. Show the result of this trans- action on the balance sheets of the Federal Reserve System and commercial banks. (LG 4-3)

3. Bank Three currently has $600 million in transaction depos- its on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. (LG 4-3) a. If the Federal Reserve decreases the reserve requirement

to 8 percent, show the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume Bank Three withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits.

b. Redo part (a) using a 12 percent reserve requirement.

4. BSW Bank currently has $150 million in transaction depos- its on its balance sheet. The Federal Reserve has currently

set the reserve requirement at 10 percent of transaction deposits. (LG 4-3) a. If the Federal Reserve decreases the reserve require-

ment to 6 percent, show the balance sheet of BSW and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume BSW withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to BSW in the form of transaction deposits.

b. Redo part (a) using a 14 percent reserve requirement. 5. National Bank currently has $500 million in transaction

deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is decreasing this requirement to 8 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

National Bank if National Bank converts all excess reserves to loans, but borrowers return only 50 percent of these funds to National Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and National Bank if National Bank converts 75 percent of its excess reserves to loans and borrowers return 60 percent of these funds to National Bank as transaction deposits.

WALKTHROUGH

End-of-Chapter Features

END-OF-CHAPTER QUESTIONS AND PROBLEMS

The questions and problems in the end- of-chapter material appear in separate sections, allowing instructors to choose whether they prefer students to engage in quantitative or qualitative analysis of the material. Selected problems are assignable online in Connect.

SEARCH THE SITE

Featured among the end- of-chapter material in most chapters, these Internet exercises weave the web, real data, and practical applications with concepts found in the book.

Final PDF to printer

sau19714_fm_i-xxii.indd xiii 10/04/17 06:53 PM

▪ Connect content is authored by the world’s best subject matter experts, and is available to your class through a simple and intuitive interface.

▪ The Connect eBook makes it easy for students to access their reading material on smartphones and tablets. They can study on the go and don’t need internet access to use the eBook as a reference, with full functionality.

▪ Multimedia content such as videos, simulations, and games drive student engagement and critical thinking skills.

©McGraw-Hill Education

▪ Connect’s assignments help students contextualize what they’ve learned through application, so they can better understand the material and think critically.

▪ Connect will create a personalized study path customized to individual student needs through SmartBook®.

▪ SmartBook helps students study more efficiently by delivering an interactive reading experience through adaptive highlighting and review.

McGraw-Hill Connect® is a highly reliable, easy-to- use homework and learning management solution that utilizes learning science and award-winning adaptive tools to improve student results.

73% of instructors who use Connect

require it; instructor satisfaction increases by 28% when Connect

is required.

Homework and Adaptive Learning

Quality Content and Learning Resources

Over 7 billion questions have been answered, making McGraw-Hill

Education products more intelligent, reliable, and precise.

Using Connect improves retention rates by 19.8%, passing rates by 12.7%, and exam scores by 9.1%.

Final PDF to printer

sau19714_fm_i-xxii.indd xiv 10/04/17 06:53 PM

More students earn As and Bs when they

use Connect.

©Hero Images/Getty Images

▪ Connect Insight® generates easy-to-read reports on individual students, the class as a whole, and on specific assignments.

▪ The Connect Insight dashboard delivers data on performance, study behavior, and effort. Instructors can quickly identify students who struggle and focus on material that the class has yet to master.

▪ Connect automatically grades assignments and quizzes, providing easy-to-read reports on individual and class performance.

▪ Connect integrates with your LMS to provide single sign-on and automatic syncing of grades. Integration with Blackboard®, D2L®, and Canvas also provides automatic syncing of the course calendar and assignment-level linking.

▪ Connect offers comprehensive service, support, and training throughout every phase of your implementation.

▪ If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks from super users, you can find tutorials as you work. Our Digital Faculty Consultants and Student Ambassadors offer insight into how to achieve the results you want with Connect.

Trusted Service and Support

Robust Analytics and Reporting

www.mheducation.com/connect

Final PDF to printer

sau19714_fm_i-xxii.indd xv 10/04/17 06:53 PM

Student progress tracking Connect Finance keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to:

· View scored work immediately and track individual or group performance with assignment and grade reports.

· Access an instant view of student or class performance relative to learning objectives.

· Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

MCGRAW-HILL CUSTOMER CARE CONTACT INFORMATION

At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day to get product-training online. Or you can search our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, e-mail hmsupport@ mcgraw-hill.com, or visit www.mhhe.com/support. One of our Technical Support Analysts will be able to assist you in a timely fashion.

FOR THE INSTRUCTOR

Instructors will have access to teaching support such as electronic files of the ancillary materials, described below, available within Connect.

· Instructor’s Manual Prepared by Tim Manuel, University of Montana, the Instructor’s Manual includes detailed chapter contents and outline, additional examples for use in the classroom, and extensive teaching notes.

· Test Bank Prepared by Ohaness Paskelian, University of Houston–Downtown, the Test Bank includes nearly 1,000 additional problems to be used for test material.

· Solutions Manual Prepared by coauthor Marcia Mil- lon Cornett, this manual provides worked-out solutions to the end-of-chapter questions. Author involvement ensures consistency between the approaches presented in the text and those in the manual.

· PowerPoint Developed by Courtney Baggett, Troy Univerity, the PowerPoint presentation includes full- color slides featuring lecture notes, figures, and tables. The slides can be easily downloaded and edited to bet- ter fit your lecture.

Student Resources The Students Resources page in Connect is the place for students to access additional resources. The Student Study Center offers quick access to the web appendixes, Excel files and templates, eBooks, and more.

SUPPLEMENTS

Final PDF to printer

xvi

sau19714_fm_i-xxii.indd xvi 10/04/17 06:53 PM

part 4 OTHER FINANCIAL INSTITUTIONS 454

14. Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies 454

15. Insurance Companies 480

16. Securities Firms and Investment Banks 506

17. Investment Companies 531

18. Pension Funds 564

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 585

19. Types of Risks Incurred by Financial Institutions 585

20. Managing Credit Risk on the Balance Sheet 604

21. Managing Liquidity Risk on the Balance Sheet 632

22. Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 655

23. Managing Risk off the Balance Sheet with Derivative Securities 683

24. Managing Risk off the Balance Sheet with Loan Sales and Securitization 712

References 739

Index 741

Preface vii

part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1

1. Introduction 1

2. Determinants of Interest Rates 26

3. Interest Rates and Security Valuation 58

4. The Federal Reserve System, Monetary Policy, and Interest Rates 93

part 2 SECURITIES MARKETS 132 5. Money Markets 132

6. Bond Markets 169

7. Mortgage Markets 208

8. Stock Markets 240

9. Foreign Exchange Markets 282

10. Derivative Securities Markets 311

part 3 COMMERCIAL BANKS 353 11. Commercial Banks: Industry

Overview 353

12. Commercial Banks’ Financial Statements and Analysis 380

13. Regulation of Commercial Banks 413

CONTENTS IN BRIEF

Final PDF to printer

xvii

sau19714_fm_i-xxii.indd xvii 10/04/17 06:53 PM

Term Structure of Interest Rates 42 Unbiased Expectations Theory 42

Liquidity Premium Theory 44

Market Segmentation Theory 46

Forecasting Interest Rates 48

Time Value of Money and Interest Rates 49 Time Value of Money 49

Lump Sum Valuation 50

Annuity Valuation 52

3 Interest Rates and Security Valuation 58 Interest Rates as a Determinant of Financial Security Values: Chapter Overview 58

Various Interest Rate Measures 59 Coupon Rate 59

Required Rate of Return 59

Expected Rate of Return 60

Required versus Expected Rates of Return: The

Role of Efficient Markets 61

Realized Rate of Return 62

Bond Valuation 63 Bond Valuation Formula Used to Calculate Fair

Present Values 63

Bond Valuation Formula Used to Calculate

Yield to Maturity 65

Equity Valuation 66 Zero Growth in Dividends 68

Constant Growth in Dividends 69

Supernormal (or Nonconstant) Growth in

Dividends 70

Impact of Interest Rate Changes on Security Values 71

Impact of Maturity on Security Values 72 Maturity and Security Prices 73

Maturity and Security Price Sensitivity to

Changes in Interest Rates 73

Impact of Coupon Rates on Security Values 74 Coupon Rate and Security Price 75

Coupon Rate and Security Price Sensitivity to

Changes in Interest Rates 75

Duration 76 A Simple Illustration of Duration 76

A General Formula for Duration 78

Features of Duration 82

Economic Meaning of Duration 83

Large Interest Rate Changes and Duration 85

Appendix 3A: Duration and Immunization 92

Appendix 3B: More on Convexity 92

Preface vii

part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1

1 Introduction 1 Why Study Financial Markets and Institutions? Chapter Overview 1

Overview of Financial Markets 3 Primary Markets versus Secondary Markets 4

Money Markets versus Capital Markets 6

Foreign Exchange Markets 9

Derivative Security Markets 9

Financial Market Regulation 10

Overview of Financial Institutions 11 Unique Economic Functions Performed by

Financial Institutions 12

Additional Benefits FIs Provide to Suppliers of

Funds 14

Economic Functions FIs Provide

to the Financial System as a

Whole 15

Risks Incurred by Financial Institutions 16

Regulation of Financial Institutions 16

Trends in the United States 17

Globalization of Financial Markets and Institutions 21

Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness 25

2 Determinants of Interest Rates 26 Interest Rate Fundamentals: Chapter Overview 26

Loanable Funds Theory 27 Supply of Loanable Funds 28

Demand for Loanable Funds 29

Equilibrium Interest Rate 30

Factors That Cause the Supply and Demand

Curves for Loanable Funds to Shift 31

Movement Of Interest Rates Over Time 35

Determinants of Interest Rates for Individual Securities 36

Inflation 36

Real Risk-Free Rates 36

Default or Credit Risk 38

Liquidity Risk 40

Special Provisions or Covenants 40

Term to Maturity 40

CONTENTS

Final PDF to printer

xviii Contents

sau19714_fm_i-xxii.indd xviii 10/10/17 02:03 AM

Other Financial Institutions 158

Individuals 158

International Aspects of Money Markets 158 Euro Money Markets 160

Appendix 5A: Single versus Discriminating Price Treasury Auctions 168

Appendix 5B: Creation of a Banker’s Acceptance 168

6 Bond Markets 169 Definition of Bond Markets: Chapter Overview 169

Bond Market Securities 170 Treasury Notes and Bonds 170

Municipal Bonds 181

Corporate Bonds 187

Bond Ratings and Interest Rate Spreads 193

Bond Market Indexes 196

Bond Market Participants 197

Comparison of Bond Market Securities 198

International Aspects of Bond Markets 198 Eurobonds, Foreign Bonds, and Sovereign

Bonds 201

7 Mortgage Markets 208 Mortgages and Mortgage-Backed Securities: Chapter Overview 208

Primary Mortgage Market 210 Mortgage Characteristics 211

Mortgage Amortization 216

Other Types of Mortgages 221

Secondary Mortgage Markets 223 History and Background of Secondary Mortgage

Markets 224

Mortgage Sales 225

Mortgage-Backed Securities 225

Participants in the Mortgage Markets 233

International Trends in Securitization 234

Appendix 7A: Amortization Schedules for 30-Year Mortgage in Example 7–2 and No-Points versus Points Mortgages in Example 7–4 239

8 Stock Markets 240 The Stock Markets: Chapter Overview 240

Stock Market Securities 242 Common Stock 242

Preferred Stock 245

Primary and Secondary Stock Markets 247 Primary Stock Markets 247

Secondary Stock Markets 252

Stock Market Indexes 262

4 The Federal Reserve System, Monetary Policy, and Interest Rates 93 Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview 93

Structure of the Federal Reserve System 94 Organization of the Federal Reserve System 94

Board of Governors of the Federal Reserve

System 96

Federal Open Market Committee 97

Functions Performed by Federal Reserve

Banks 97

Balance Sheet of the Federal Reserve 102

Monetary Policy Tools 105 Open Market Operations 108

The Discount Rate 110

Reserve Requirements (Reserve Ratios) 113

The Federal Reserve, the Money Supply, and Interest Rates 116

Effects of Monetary Tools on Various Economic

Variables 117

Money Supply versus Interest Rate

Targeting 118

International Monetary Policies and Strategies 123

Systemwide Rescue Programs Employed during

the Financial Crisis 123

Challenges Remain after the Crisis 128

part 2 SECURITIES MARKETS 132 5 Money Markets 132

Definition of Money Markets: Chapter Overview 132

Money Markets 133

Yields on Money Market Securities 133 Bond Equivalent Yields 134

Effective Annual Return 134

Discount Yields 134

Single-Payment Yields 135

Money Market Securities 136 Treasury Bills 138

Federal Funds 144

Repurchase Agreements 145

Commercial Paper 148

Negotiable Certificates of Deposit 153

Banker’s Acceptances 154

Comparison of Money Market Securities 155

Money Market Participants 155 The U.S. Treasury 156

The Federal Reserve 156

Commercial Banks 156

Money Market Mutual Funds 157

Brokers and Dealers 157

Corporations 158

Final PDF to printer

Contents xix

sau19714_fm_i-xxii.indd xix 10/10/17 02:03 AM

part 3 COMMERCIAL BANKS 353 11 Commercial Banks: Industry

Overview 353 Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview 353

Definition of a Commercial Bank 355

Balance Sheets and Recent Trends 355 Assets 355

Liabilities 358

Equity 359

Off-Balance-Sheet Activities 359

Other Fee-Generating Activities 363

Size, Structure, and Composition of the Industry 364

Bank Size and Concentration 365

Bank Size and Activities 367

Industry Performance 368

Regulators 371 Federal Deposit Insurance Corporation 371

Office of the Comptroller of the

Currency 372

Federal Reserve System 373

State Authorities 373

Global Issues 373 Advantages and Disadvantages of International

Expansion 373

Global Banking Performance 375

12 Commercial Banks’ Financial Statements and Analysis 380 Why Evaluate the Performance of Commercial Banks? Chapter Overview 380

Financial Statements of Commercial Banks 382

Balance Sheet Structure 383

Off-Balance-Sheet Assets and Liabilities 389

Other Fee-Generating Activities 392

Income Statement 393

Direct Relationship between the Income

Statement and the Balance Sheet 397

Financial Statement Analysis Using a Return on Equity Framework 398

Return on Equity and Its Components 399

Return on Assets and Its Components 401

Other Ratios 406

Impact of Market Niche and Bank Size on Financial Statement Analysis 407

Impact of a Bank’s Market Niche 407

Impact of Size on Financial Statement

Analysis 407

Stock Market Participants 266

Other Issues Pertaining to Stock Markets 268 Economic Indicators 268

Market Efficiency 269

Stock Market Regulations 272

International Aspects of Stock Markets 274

Appendix 8A: The Capital Asset Pricing Model 281

Appendix 8B: Event Study Tests 281

9 Foreign Exchange Markets 282 Foreign Exchange Markets and Risk: Chapter Overview 282

Background and History of Foreign Exchange Markets 283

Foreign Exchange Rates and Transactions 288 Foreign Exchange Rates 288

Foreign Exchange Transactions 288

Return and Risk of Foreign Exchange

Transactions 293

Role of Financial Institutions in Foreign

Exchange Transactions 299

Interaction of Interest Rates, Inflation, and Exchange Rates 302

Purchasing Power Parity 303

Interest Rate Parity 305

Appendix 9A: Balance of Payment Accounts 310

10 Derivative Securities Markets 311 Derivative Securities: Chapter Overview 311

Forwards and Futures 313 Spot Markets 313

Forward Markets 314

Futures Markets 316

Options 323 Call Options 323

Put Options 325

Option Values 327

Option Markets 329

Regulation of Futures and Options Markets 335

Swaps 336 Interest Rate Swaps 337

Currency Swaps 341

Credit Swaps 342

Swap Markets 343

Caps, Floors, and Collars 345

International Aspects of Derivative Securities Markets 347

Appendix 10A: Black–Scholes Option Pricing Model 352

Final PDF to printer

xx Contents

sau19714_fm_i-xxii.indd xx 10/04/17 06:53 PM

Size, Structure, and Composition of the

Industry 455

Balance Sheets and Recent Trends 457

Regulators 459

Savings Institution Recent Performance 460

Credit Unions 461 Size, Structure, and Composition of the

Industry 462

Balance Sheets and Recent Trends 464

Regulators 466

Industry Performance 466

Finance Companies 468 Size, Structure, and Composition of the

Industry 468

Balance Sheets and Recent Trends 469

Industry Performance 474

Regulation 475

Global Issues 476

15 Insurance Companies 480 Two Categories of Insurance Companies: Chapter Overview 480

Life Insurance Companies 481 Size, Structure, and Composition of the

Industry 481

Balance Sheets and Recent Trends 486

Regulation 489

Property–Casualty Insurance Companies 490 Size, Structure, and Composition of the

Industry 490

Balance Sheets and Recent Trends 492

Regulation 500

Global Issues 501

16 Securities Firms and Investment Banks 506 Services Offered by Securities Firms versus Investment Banks: Chapter Overview 506

Size, Structure, and Composition of the Industry 508

Securities Firm and Investment Bank Activity Areas 510

Investment Banking 510

Venture Capital 512

Market Making 514

Trading 514

Investing 515

Cash Management 516

Mergers and Acquisitions 516

Other Service Functions 516

Recent Trends and Balance Sheets 517 Recent Trends 517

Balance Sheets 520

Regulation 522 Global Issues 525

13 Regulation of Commercial Banks 413 Specialness and Regulation: Chapter Overview 413

Types of Regulations and the Regulators 414 Safety and Soundness Regulation 414

Monetary Policy Regulation 417

Credit Allocation Regulation 417

Consumer Protection Regulation 417

Investor Protection Regulation 418

Entry and Chartering Regulation 418

Regulators 419

Regulation of Product and Geographic Expansion 419

Product Segmentation in the U.S. Commercial

Banking Industry 419

Geographic Expansion in the U.S. Commercial

Banking Industry 426

Bank and Savings Institution Guarantee Funds 427

The Federal Deposit Insurance Corporation

(FDIC) 428

The Demise of the Federal Savings and Loan

Insurance Corporation (FSLIC) 429

Reform of Deposit Insurance 430

Non–U.S. Deposit Insurance Systems 431

Balance Sheet Regulations 431 Regulations on Commercial Bank

Liquidity 431

Regulations on Capital Adequacy

(Leverage) 432

Foreign versus Domestic Regulation of Commercial Banks 437

Product Diversification Activities 437

Global or International Expansion Activities 438

Appendix 13A: Calculating Deposit Insurance Premium Assessments 445

Appendix 13B: Calculating Minimum Required Reserves at U.s. Depository Institutions 450

Appendix 13C: Primary Regulators of Depository Institutions 453

Appendix 13D: Deposit Insurance Coverage for Commercial Banks in Various Countries 453

Appendix 13E: Calculating Risk-Based Capital Ratios 453

part 4 OTHER FINANCIAL INSTITUTIONS 454

14 Other Lending Institutions 454 Other Lending Institutions: Chapter Overview 454

Savings Institutions 455

Final PDF to printer

Contents xxi

sau19714_fm_i-xxii.indd xxi 10/10/17 06:53 PM

Liquidity Risk 589

Interest Rate Risk 590

Market Risk 592

Off-Balance-Sheet Risk 594

Foreign Exchange Risk 596

Country or Sovereign Risk 598

Technology and Operational Risk 598

Insolvency Risk 600

Other Risks and Interaction among Risks 600

20 Managing Credit Risk on the Balance Sheet 604 Credit Risk Management: Chapter Overview 604

Credit Quality Problems 606

Credit Analysis 607 Real Estate Lending 608

Consumer (Individual) and Small-Business

Lending 611

Mid-Market Commercial and Industrial

Lending 612

Large Commercial and Industrial Lending 620

Calculating the Return on a Loan 624 Return on Assets (ROA) 624

RAROC Models 626

Appendix 20A: Loan Portfolio Risk and Management 631

21 Managing Liquidity Risk on the Balance Sheet 632 Liquidity Risk Management: Chapter Overview 632

Causes of Liquidity Risk 633

Liquidity Risk and Depository Institutions 634 Liability-Side Liquidity Risk 634

Asset-Side Liquidity Risk 637

Measuring a DI’s Liquidity Exposure 638

Liquidity Risk, Unexpected Deposit Drains, and

Bank Runs 643

Bank Runs, the Discount Window, and Deposit

Insurance 644

Liquidity Risk and Insurance Companies 647 Life Insurance Companies 647

Property–Casualty Insurance Companies 648

Guarantee Programs for Life and

Property–Casualty Insurance

Companies 649

Liquidity Risk and Investment Funds 649

Appendix 21A: Sources and Uses of Funds Statement: J.P. Morgan Chase, September 2016 654

17 Investment Companies 531 Investment Companies: Chapter Overview 531

Size, Structure, and Composition of the Mutual Fund Industry 532

Historical Trends 532

Different Types of Mutual Funds 533

Other Types of Investment Company

Funds 538

Mutual Fund Returns and Costs 539 Mutual Fund Prospectuses and Objectives 539

Investor Returns from Mutual Fund

Ownership 542

Mutual Fund Costs 544

Mutual Fund Balance Sheets and Recent Trends 547

Long-Term Funds 547

Money Market Funds 548

Mutual Fund Regulation 549

Mutual Fund Global Issues 552

Hedge Funds 552 Types of Hedge Funds 555

Fees on Hedge Funds 558

Offshore Hedge Funds 559

Regulation of Hedge Funds 560

18 Pension Funds 564 Pension Funds Defined: Chapter Overview 564

Size, Structure, and Composition of the Industry 565

Defined Benefit versus Defined Contribution

Pension Funds 565

Insured versus Noninsured Pension Funds 567

Private Pension Funds 568

Public Pension Funds 575

Financial Asset Investments and Recent Trends 576

Private Pension Funds 576

Public Pension Funds 577

Regulation 579

Global Issues 581

Appendix 18A: Calculation of Growth in IRA Value during an Individual’s Working Years 584

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 585

19 Types of Risks Incurred by Financial Institutions 585 Why Financial Institutions Need to Manage Risk: Chapter Overview 585

Credit Risk 586

Final PDF to printer

xxii Contents

sau19714_fm_i-xxii.indd xxii 10/04/17 06:53 PM

Comparison of Hedging Methods 703 Writing versus Buying Options 703

Futures versus Options Hedging 705

Swaps versus Forwards, Futures, and

Options 706

Appendix 23A: Hedging with Futures Contracts 711

Appendix 23B: Hedging with Options 711

Appendix 23C: Hedging with Caps, Floors, and Collars 711

24 Managing Risk off the Balance Sheet with Loan Sales and Securitization 712 Why Financial Institutions Sell and Securitize Loans: Chapter Overview 712

Loan Sales 713 Types of Loan Sales Contracts 715

The Loan Sales Market 715

Secondary Market for Less Developed Country

Debt 718

Factors Encouraging Future Loan Sales

Growth 719

Factors Deterring Future Loan Sales

Growth 720

Loan Securitization 721 Pass-Through Security 721

Collateralized Mortgage Obligation 728

Mortgage-Backed Bond 732

Securitization of Other Assets 734

Can All Assets Be Securitized? 734

References 739

Index 741

Appendix 21B: New Liquidity Risk Measures Implemented by the Bank for International Settlements 654

22 Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 655 Interest Rate and Insolvency Risk Management: Chapter Overview 655

Interest Rate Risk Measurement and Management 656

Repricing Gap Model 656

Duration Gap Model 665

Insolvency Risk Management 673 Capital and Insolvency Risk 673

23 Managing Risk off the Balance Sheet with Derivative Securities 683 Derivative Securities used to Manage Risk: Chapter Overview 683

Forward and Futures Contracts 684 Hedging with Forward Contracts 685

Hedging with Futures Contracts 686

Options 689 Basic Features of Options 689

Actual Interest Rate Options 692

Hedging with Options 692

Caps, Floors, and Collars 693

Risks Associated with Futures, Forwards, and Options 694

Swaps 695 Hedging with Interest Rate Swaps 695

Hedging with Currency Swaps 698

Credit Swaps 699

Credit Risk Concerns with Swaps 702

Final PDF to printer

sau19714_ch01_001-025.indd 1 06/28/17 11:03 AM

WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? CHAPTER OVERVIEW In the 1990s, financial markets in the United States boomed. As seen in Figure 1–1, the Dow Jones Industrial Index—a widely quoted index of the values of 30 large corpora- tions (see Chapter 8)—rose from a level of 2,800 in January 1990 to more than 11,000 by the end of the decade; this compares to a move from 100 at its inception in 1906 to 2,800 eighty-four years later. In the early 2000s, as a result of an economic downturn in the United States and elsewhere, this index fell back below 10,000. The index rose to over 14,000 in July 2007, but (because of an increasing mortgage market credit crunch, particularly the subprime mortgage market) fell back to below 13,000 within a month of hitting the all-time high. By 2008, problems in the subprime mortgage market esca- lated to a full-blown financial crisis and the worst recession in the United States since the Great Depression. The Dow Jones Industrial Average (DJIA) fell to 6,547 in March 2009 before recovering, along with the economy, to over 11,000 in April 2010. How- ever, it took until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, closing at 14,253.77 for the day, and the DJIA rose to over 21,000 in mid-2017.

O U T L I N E

Why Study Financial Markets and Institutions? Chapter Overview

Overview of Financial Markets

Primary Markets versus Secondary Markets

Money Markets versus Capital Markets

Foreign Exchange Markets

Derivative Security Markets

Financial Market Regulation

Overview of Financial Institutions

Unique Economic Functions Performed by Financial Institutions

Additional Benefits FIs Provide to Suppliers of Funds

Economic Functions FIs Provide to the Financial System as a Whole

Risks Incurred by Financial Institutions

Regulation of Financial Institutions

Trends in the United States

Globalization of Financial Markets and Institutions

Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness (available through Connect or your course instructor)

Introduction

Introduction and Overview of Financial Markets

L e a r n i n g G o a l s

LG 1-1 Differentiate between primary and secondary markets.

LG 1-2 Differentiate between money and capital markets.

LG 1-3 Understand what foreign exchange markets are.

LG 1-4 Understand what derivative security markets are.

LG 1-5 Distinguish between the different types of financial institutions.

LG 1-6 Know the services financial institutions perform.

LG 1-7 Know the risks financial institutions face.

LG 1-8 Appreciate why financial institutions are regulated.

LG 1-9 Recognize that financial markets are becoming increasingly global.

1 c h a p t e r

part one

Final PDF to printer

2 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 2 06/28/17 11:03 AM

During the financial crisis of 2008–2009, market swings seen in the United States quickly spread worldwide. Stock markets saw huge swings in value as investors tried to sort out who might survive and who would not (and markets from Russia to Europe were forced to suspend trading as stock prices plunged). As U.S. markets recovered in 2010–2013 and, as mentioned earlier, surpassed their pre-crisis highs, European stock markets struggled as Greece battled with a severe debt crisis that eventually spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. Even the growth in the robust Chinese economy slowed to 6.7 percent in 2016, the lowest level in seven years.

World markets were rocked again in June 2016 when the people of the United Kingdom voted to leave the European Union (EU) after 43 years (dubbed “Brexit”). The shock from the UK’s surprise vote to leave the EU swept across global markets, triggering steep drops in stock markets and the British pound and a flight into safe assets such as U.S. bonds and gold. The pound fell more than 11 percent to its lowest point since 1985. The DJIA dropped 610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008, while Japan’s Nikkei Stock Average declined 7.9 percent. Bonds also sold off sharply, pushing UK government borrowing costs sharply higher, as traders and investors grappled with the market implications of Brexit. The UK had its credit rating outlook cut to “negative” by the ratings agency Moody’s.

The UK’s vote to leave the European Union shook the region, precipitating an imme- diate political crisis in Britain and shifting the path of a European project created to bind a continent torn by World War II. Prime Minister David Cameron, who had led the campaign to stay inside the 28-nation bloc, announced he would step down, setting off a leadership contest among Conservatives. Britain’s decision, one of the most momentous by a Western country in the past 50 years, reverses the course of expansion for the EU. It had grown over decades to include most of Europe, absorbing former dictatorships in Greece, Spain, and Portugal, and the countries of the east, formerly under Soviet domination. The UK would be the first member nation to leave, a step some leaders warned beforehand would diminish the global influence of the UK and the EU and risk setting in motion the European bloc’s eventual disintegration. The vote also raised questions about whether the UK itself would split. After a large majority of Scottish citizens voted to remain a part of the EU, Scotland’s First Minister said the Scottish National Party would seek to hold a new referendum on the country’s exit from the EU.

Figure 1–1 The Dow Jones Industrial Average, 1989–2016

Index Value DJIA Index Value

16,000 17,000 18,000 19,000

15,000 14,000 13,000 12,000 11,000 10,000

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

Ja n-

8 9

Ja n-

9 0

Ja n-

9 1

Ja n-

9 2

Ja n-

9 3

Ja n-

9 4

Ja n-

9 5

Ja n-

9 6

Ja n-

9 7

Ja n-

9 8

Ja n-

9 9

Ja n-

0 0

Ja n-

0 1

Ja n-

0 2

Ja n-

0 3

Ja n-

0 4

Ja n-

0 5

Ja n-

0 6

Ja n-

0 7

Ja n-

0 8

Ja n-

0 9

Ja n-

11 Ja

n- 12

Ja n-

Date

Final PDF to printer

Chapter 1 Introduction 3

sau19714_ch01_001-025.indd 3 06/28/17 11:03 AM

Originally the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock invest- ing, insurance provision, etc.). In the early 1930s, the economic and industrial collapse resulted in the separation of some of these activities. In the 1970s and 1980s new, rela- tively unregulated financial services industries sprang up (e.g., mutual funds, brokerage funds) that separated the financial service functions even further.

The last 30 years, however, have seen a reversal of these trends. In the 1990s and 2000s, regulatory barriers, technology, and financial innovation changes were such that a full set of financial services could again be offered by a single financial services firm under the umbrella of a financial services holding company. For example, J.P. Morgan Chase & Co. operates a commercial bank (J.P. Morgan Chase Bank), an investment bank (J. P. Morgan Securities, which also sells mutual funds), and an insurance company (J. P. Morgan Insurance Agency). Not only did the boundaries between traditional industry sectors change, but competition became global in nature as well. For example, J.P. Morgan Chase is the world’s seventh-largest bank holding company, operating in 60 countries.

The financial crisis produced another reshaping of all financial institution (FI) sectors and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most prominent investment banks in the world, Goldman Sachs and Morgan Stanley, converting to bank holding company status. Indeed, as of 2010, all the major U.S. investment banks had either failed, been acquired by a commercial bank, or become bank holding compa- nies. Further, legislation enacted as a result of the financial crisis represents an attempt to again separate FI activities. For example, the “Volcker Rule” provision of the Wall Street Reform and Consumer Protection Act prohibits bank holding companies from engaging in proprietary trading and limits their investments in hedge funds, private equity, and related vehicles. Despite these most recent changes, many FIs operate in more than one FI sector.

As economic and competitive environments change, attention to profit and, more than ever, risk becomes increasingly important. This book provides a detailed overview and analysis of the financial system in which financial managers and individual investors operate. Making investment and financing decisions requires managers and individuals to understand the flow of funds throughout the economy as well as the operation and struc- ture of domestic and international financial markets. In particular, this book offers a unique analysis of the risks faced by investors and savers, as well as strategies that can be adopted for controlling and managing these risks. Newer areas of operations such as asset securi- tization, derivative securities, and internationalization of financial services also receive special emphasis. Further, as the United States and the world continue to recover from the collapse of the financial markets, this book highlights and discusses the impact of this crisis on the various financial markets and the financial institutions that operate in them.

This introductory chapter provides an overview of the structure and operations of various financial markets and financial institutions. Financial markets are differentiated by the characteristics (such as maturity) of the financial instruments or securities that are exchanged. Moreover, each financial market, in turn, depends in part or in whole on finan- cial institutions. Indeed, FIs play a special role in the functioning of financial markets. In particular, FIs often provide the least costly and most efficient way to channel funds to and from financial markets. As part of this discussion, we briefly examine how changes in the way FIs deliver services played a major part in the events leading up to the severe financial crisis of the late 2000s. A more detailed discussion of the causes of, the major events dur- ing, and the regulatory and industry changes resulting from the financial crisis is provided in Appendix 1A to the chapter (available through Connect or your course instructor).

OVERVIEW OF FINANCIAL MARKETS Financial markets are structures through which funds flow. Table 1–1 summarizes the financial markets discussed in this section. Financial markets can be distinguished along two major dimensions: (1) primary versus secondary markets and (2) money versus capital markets. The next sections discuss each of these dimensions.

financial markets The arenas through which funds flow.

Final PDF to printer

4 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 4 06/28/17 11:03 AM

Primary Markets versus Secondary Markets

Primary Markets. Primary markets are markets in which users of funds (e.g., corpora- tions) raise funds through new issues of financial instruments, such as stocks and bonds. Table 1–2 lists data on primary market sales of securities from 2000 through 2016. Note the impact the financial crisis had on primary market sales by firms. New issues fell to $1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007, pre- crisis. As of 2015, primary market sales had still not recovered as only $1,843.2 billion new securities were issued for the year.

Fund users have new projects or expanded production needs, but do not have sufficient internally generated funds (such as retained earnings) to support these needs. Thus, the fund users issue securities in the external primary markets to raise additional funds. New issues of financial instruments are sold to the initial suppliers of funds (e.g., households) in exchange for funds (money) that the issuer or user of funds needs.1 Most primary mar- ket transactions in the United States are arranged through financial institutions called investment banks—for example, Morgan Stanley or Bank of America Merrill Lynch—that serve as intermediaries between the issuing corporations (fund users) and investors (fund suppliers). For these public offerings, the investment bank provides the securities issuer (the funds user) with advice on the securities issue (such as the offer price and number of securities to issue) and attracts the initial public purchasers of the securities for the funds user. By issuing primary market securities with the help of an investment bank, the funds user saves the risk and cost of creating a market for its securities on its own (see the fol- lowing discussion). Figure 1–2 illustrates a time line for the primary market exchange of funds for a new issue of corporate bonds or equity. We discuss this process in detail in Chapters 6 and 8.

Primary market financial instruments include issues of equity by firms initially going public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the first time). These first-time issues are usually referred to as initial public offerings (IPOs). For example, on June 16, 2015, Fitbit announced a $732 million IPO of its common stock.

LG 1-1

primary markets Markets in which corpora- tions raise funds through new issues of securities.

1. We discuss the users and suppliers of funds in more detail in Chapter 2.

initial public offering (IPO) The first public issue of a financial instrument by a firm.

TABLE 1–1 Types of Financial Markets

Primary markets—markets in which corporations raise funds through new issues of securities. Secondary markets—markets that trade financial instruments once they are issued. Money markets—markets that trade debt securities or instruments with maturities of less than

one year. Capital markets—markets that trade debt and equity instruments with maturities of more than

one year. Foreign exchange markets—markets in which cash flows from the sale of products or assets

denominated in a foreign currency are transacted. Derivative markets—markets in which derivative securities trade.

Security Type 2000 2005 2007 2008 2010 2012 2015 2016*

All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,024.7 $1,401.0 $1,843.2 $318.9 Bonds 944.8 2,323.7 2,220.3 861.2 893.7 1,242.5 1,611.3 285.3 Stocks 311.9 115.3 168.8 206.8 131.0 129.5 174.0 33.2 Private placements 196.5 24.6 20.1 16.2 22.2 21.4 28.8 n.a.† IPOs 97.0 36.7 46.3 26.4 37.0 40.9 29.1 0.4

*Through first quarter. †n.a. = not applicable.

TABLE 1–2 Primary Market Sales of Securities (in billions of dollars)

Final PDF to printer

Chapter 1 Introduction 5

sau19714_ch01_001-025.indd 5 06/28/17 11:03 AM

The company’s stock was underwritten by several investment banks, including Morgan Stanley, Deutsche Bank, and Bank of America Merrill Lynch. Primary market securities also include the issue of additional equity or debt instruments of an already publicly traded firm. For example, on January 28, 2016, Molson Coors Brewing Company announced the sale of an additional 29.88 million shares of common stock underwritten by investment banks such as UBS, Bank of America Merrill Lynch, and Citigroup.

Secondary Markets. Once financial instruments such as stocks are issued in primary markets, they are then traded—that is, rebought and resold—in secondary markets. For example, on April 12, 2016, 9.7 million shares of ExxonMobil were traded in the secondary stock market. Buyers of secondary market securities are economic agents (consumers, businesses, and governments) with excess funds. Sellers of secondary mar- ket financial instruments are economic agents in need of funds. Secondary markets pro- vide a centralized marketplace where economic agents know they can transact quickly and efficiently.

These markets therefore save economic agents the search and other costs of seeking buyers or sellers on their own. Figure 1–2 illustrates a secondary market transfer of funds. When an economic agent buys a financial instrument in a secondary market, funds are exchanged, usually with the help of a securities broker such as Charles Schwab acting as an intermediary between the buyer and the seller of the instrument (see Chapter 8). The original issuer of the instrument (user of funds) is not involved in this transfer. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers Auto- mated Quotation (NASDAQ) system are two well-known examples of secondary markets for trading stocks. We discuss the details of each of these markets in Chapter 8.

In addition to stocks and bonds, secondary markets also exist for financial instruments backed by mortgages and other assets (see Chapter 7), foreign exchange (see Chapter 9), and futures and options (i.e., derivative securities—financial securities whose payoffs

secondary market A market that trades finan- cial instruments once they are issued.

derivative security A financial security whose payoffs are linked to other, previously issued securi- ties or indices.

Figure 1–2 Primary and Secondary Market Transfer of Funds Time Line

Users of Funds (Corporations

issuing debt/equity instruments)

Underwriting with Investment Bank

Primary Markets

(Where new issues of financial instruments are o�ered for sale)

Secondary Markets

(Where financial instruments, once issued, are traded)

Financial instruments flow

Funds flow

Initial Suppliers of Funds

(Investors)

Economic Agents (Investors) Wanting to Sell Securities

Financial Markets Economic Agents

(Investors) Wanting to Buy Securities

Final PDF to printer

6 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 6 06/28/17 11:03 AM

are linked to other, previously issued [or underlying] primary securities or indexes of pri- mary securities) (see Chapter 10). As we will see in Chapter 10, derivative securities have existed for centuries, but the growth in derivative securities markets occurred mainly in the 1980s through 2000s. As major markets, therefore, derivative securities markets are among the newest of the financial security markets.

Secondary markets offer benefits to both investors (suppliers of funds) and issuing corporations (users of funds). For investors, secondary markets provide the opportunity to trade securities at their market values quickly as well as to purchase securities with vary- ing risk-return characteristics (see Chapter 2). Corporate security issuers are not directly involved in the transfer of funds or instruments in the secondary market. However, the issuer does obtain information about the current market value of its financial instruments, and thus the value of the corporation as perceived by investors such as its stockholders, through tracking the prices at which its financial instruments are being traded on second- ary markets. This price information allows issuers to evaluate how well they are using the funds generated from the financial instruments they have already issued and provides information on how well any subsequent offerings of debt or equity might do in terms of raising additional money (and at what cost).

Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into cash quickly at its fair market value—as well as information about the prices or the value of their investments. Increased liquidity makes it more desirable and easier for the issuing firm to sell a security initially in the primary market. Further, the existence of centralized markets for buying and selling financial instruments allows investors to trade these instru- ments at low transaction costs.

Money Markets versus Capital Markets

Money Markets. Money markets are markets that trade debt securities or instruments with maturities of one year or less (see Figure 1–3). In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money mar- ket instruments) to economic agents who have short-term needs or shortages of funds (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usually quite small (see Chapters 3 and 22 on interest rate risk). In the United States, money markets do not operate in a specific location—rather, transactions occur via tele- phones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-the-counter (OTC) markets.

Money Market Instruments. A variety of money market securities are issued by corporations and government units to obtain short-term funds. These securities include Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable certificates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major money market securities. Figure 1–4 shows outstanding amounts of money market instruments in the United States in 1990, 2000, 2010, and 2016. Notice that in 2016 federal funds and repurchase agreements, followed by negotiable CDs, Treasury bills, and commercial paper, had the largest amounts outstanding. Money market instru- ments and the operation of the money markets are described and discussed in detail in Chapter 5.

liquidity The ease with which an asset can be converted into cash quickly and at fair market value.

LG 1-2

money markets Markets that trade debt securities or instruments with maturities of one year or less.

over-the-counter (OTC) markets Markets that do not operate in a specific fixed location—rather, transactions occur via tele- phones, wire transfers, and computer trading.

Figure 1–3 Money versus Capital Market Maturities

Money Market Securities

1 year to maturity

0 30 years to maturity

No specified maturity

Notes and Bonds

Capital Market Securities

Stocks (Equities) Maturity

Final PDF to printer

Chapter 1 Introduction 7

sau19714_ch01_001-025.indd 7 06/28/17 11:03 AM

MONEY MARKET INSTRUMENTS

Treasury bills—short-term obligations issued by the U.S. government. Federal funds—short-term funds transferred between financial institutions usually for no more

than one day. Repurchase agreements—agreements involving the sale of securities by one party to another with a

promise by the seller to repurchase the same securities from the buyer at a specified date and price. Commercial paper—short-term unsecured promissory notes issued by a company to raise

short-term cash. Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and

maturity date and are negotiable (i.e., can be sold by the holder to another party). Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by

a bank.

CAPITAL MARKET INSTRUMENTS

Corporate stock—the fundamental ownership claim in a public corporation. Mortgages—loans to individuals or businesses to purchase a home, land, or other real property. Corporate bonds—long-term bonds issued by corporations. Treasury bonds—long-term bonds issued by the U.S. government. State and local government bonds—long-term bonds issued by state and local governments. U.S. government agency bonds—long-term bonds collateralized by a pool of assets and issued

by agencies of the U.S. government. Bank and consumer loans—loans to commercial banks and individuals.

TABLE 1–3 Money and Capital Market Instruments

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues. www .federalreserve.gov

Figure 1–4 Money Market Instruments Outstanding

1990 $2.06 trillion outstanding

2000 $4.51 trillion outstanding

2016 $7.97 trillion outstanding

Federal funds and repurchase agreements Commercial paper U.S. Treasury bills Negotiable CDs Banker’s acceptances

18.1%

25.7% 26.5%

2.6%

35.6% 26.5%

14.4%

23.3%0.2%

0.0%

27.1%

45.8%

11.8%

23.4% 19.0%

2010 $6.5 trillion outstanding

0.0%

16.7%

25.6%

28.6%

29.1%

Final PDF to printer

8 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 8 06/28/17 11:03 AM

Capital Markets. Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year (see Figure 1–3). The major suppliers of capital market securities (or users of funds) are corporations and govern- ments. Households are the major suppliers of funds for these securities. Given their longer maturity, these instruments experience wider price fluctuations in the second- ary markets in which they trade than do money market instruments. For example, all else constant, long-term maturity debt instruments experience wider price fluctuations for a given change in interest rates than short-term maturity debt instruments (see Chapter 3).

Capital Market Instruments. Table 1–3 lists and defines the major capital market secu- rities. Figure 1–5 shows their outstanding amounts by dollar market value. Notice that in 2000, 2010, and 2016, corporate stocks or equities represent the largest capital market instrument, followed by mortgages and corporate bonds. The relative size of the market value of capital market instruments outstanding depends on two factors: the number of

capital markets Markets that trade debt (bonds) and equity (stocks) instruments with maturities of more than one year.

Figure 1–5 Capital Market Instruments Outstanding

1990 $14.93 trillion outstanding

2000 $40.6 trillion outstanding

20.9%

31.3%

16.8% 9.0%

11.4%

4.2%

6.4%

2010 $67.9 trillion outstanding

15.3%

49.6%

13.0%

15.1%

9.0%

4.1%

3.9%

2016 $90.2 trillion outstanding

Corporate stocks Mortgages Corporate bonds

State and local government bonds U.S. government agency bonds Consumer loans

Treasury securities

25.5% 23.6%

11.4%

11.1%

10.9% 9.6%

7.9%

3.7%

5.7%

16.8%

43.4%

12.1%

7.7%

10.6%

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues. www.federalreserve.gov

Final PDF to printer

Chapter 1 Introduction 9

sau19714_ch01_001-025.indd 9 06/28/17 11:03 AM

securities issued and their market prices.2 One reason for the sharp increase in the value of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as the U.S. economy experienced a downturn—partly because of 9/11 and partly because interest rates began to rise—and stock prices fell. Stock prices in most sec- tors subsequently recovered and, by 2007, even surpassed their 1999 levels. Stock prices fell precipitously during the financial crisis of 2008–2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen 53.8 percent in value in less than 1½ years, larger than the decline during the market crash of 1929 when it fell 49 percent. How- ever, stock prices recovered, along with the economy, in the last half of 2009, rising 71.1 percent between March 2009 and April 2010. Capital market instruments and their opera- tions are discussed in detail in Chapters 6, 7, and 8.

Foreign Exchange Markets

In addition to understanding the operations of domestic financial markets, a financial man- ager must also understand the operations of foreign exchange markets and foreign capi- tal markets. Today’s U.S.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, in 2015 a strengthening dollar reduced profits for internationally active firms. IBM experi- enced a drop in its 2015 earnings per share of $1.10 due to foreign exchange trends. Coca- Cola, which gets the majority of its sales from outside the United States, saw 2015 revenues decrease by 5.1 percent as the U.S. dollar strengthened relative to foreign currencies.

Cash flows from the sale of securities (or other assets) denominated in a for- eign currency expose U.S. corporations and investors to risk regarding the value at which foreign currency cash flows can be converted into U.S. dollars. For example, the actual amount of U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative to the U.S. dollar over the investment period (i.e., the period between the time a foreign investment is made and the time it is terminated), the dollar value of cash flows received will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows received on the foreign investment will increase.

While foreign currency exchange rates are often flexible—they vary day to day with demand for and supply of a foreign currency for dollars—central govern- ments sometimes intervene in foreign exchange markets directly or affect foreign exchange rates indirectly by altering interest rates. We discuss the motivation and effects of these interventions in Chapters 4 and 9. The sensitivity of the value of cash flows on foreign investments to changes in the foreign currency’s price in terms of dollars is referred to as foreign exchange risk and is discussed in more

detail in Chapter 9. Techniques for managing, or “hedging,” foreign exchange risk, such as using derivative securities like foreign exchange (FX) futures, options, and swaps, are discussed in Chapter 23.

Derivative Security Markets

Derivative security markets are markets in which derivative securities trade. A derivative security is a financial security (such as a futures contract, option contract, swap contract, or mortgage-backed security) whose payoff is linked to another, previously issued secu- rity such as a security traded in capital or foreign exchange markets. Derivative securities generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. As the

2. For example, the market value of equity is the product of the price of the equity times the number of shares that are issued.

LG 1-3

derivative security markets The markets in which derivative securities trade.

D O YO U U N D E R S TA N D :

1. The difference between primary and secondary markets?

2. The major distinction between money markets and capital markets?

3. What the major instruments traded in the capital markets are?

4. What happens to the dollar value of a U.S. investor’s holding of British pounds if the pound appreciates (rises) in value against the dollar?

5. What derivative security markets are?

LG 1-4

Final PDF to printer

10 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 10 06/28/17 11:03 AM

value of the underlying security to be exchanged changes, the value of the derivative secu- rity changes. While derivative securities have been in existence for centuries, the growth in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4 shows the dollar (or notional) value of derivatives held by commercial banks from 1992 through 2016. Note the tremendous growth in these securities between 1992 and 2013, and the large drop from 2013 to 2016. As we discuss in Chapter 10, part of the Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the financial crisis, is the Vol- cker Rule which prohibits U.S. depository institutions (DIs) from engaging in proprietary trading (i.e., trading as a principal for the trading account of the bank). This includes any transaction to purchase or sell derivatives. Thus, only the investment banking arm of the business is allowed to conduct such trading. The Volcker Rule was implemented in April 2014 and banks had until July 21, 2015, to be in compliance. The result has been a reduc- tion in derivative securities held off-balance-sheet by these financial institutions.

As major markets, derivative security markets are the newest of the financial security markets. Derivative securities, however, are also potentially the riskiest of the financial securities. Indeed, at the center of the recent financial crisis were losses associated with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Losses from the falling value of subprime mortgages and the derivative securities backed by these mortgages reached $700 billion worldwide by early 2009 and resulted in the failure, acqui- sition, or bailout of some of the largest FIs and the near collapse of the world’s financial and economic systems.

We discuss derivative security activity in Chapter 10. Derivative security traders can be either users of derivative contracts for hedging (see Chapters 10 and 23) and other pur- poses or dealers (such as banks) that act as counterparties in trades with customers for a fee.

Financial Market Regulation

Financial instruments are subject to regulations imposed by regulatory agencies such as the Securities and Exchange Commission (SEC)—the main regulator of securities markets since the passage of the Securities Act of 1934—as well as the exchanges (if any) on which the instruments are traded. The main emphasis of SEC regulations (as stated in the Securi- ties Act of 1933) is on full and fair disclosure of information on securities issues to actual and potential investors. Those firms planning to issue new stocks or bonds to be sold to the public at large (public issues) are required by the SEC to register their securities with the SEC and to fully describe the issue, and any risks associated with the issue, in a legal document called a prospectus.

The SEC also monitors trading on the major exchanges (along with the exchanges themselves) to ensure that stockholders and managers do not trade on the basis of inside information about their own firms (i.e., information prior to its public release). SEC regu- lations are not intended to protect investors against poor investment choices, but rather to ensure that investors have full and accurate information available about corporate issuers when making their investment decisions.

derivative security An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future.

www.sec.gov

1992 2000 2008 2013 2016

Futures and forwards $4,780 $ 9,877 $ 22,512 $ 45,599 $ 35,685 Swaps 2,417 21,949 131,706 138,361 107,393 Options 1,568 8,292 30,267 33,760 30,909 Credit derivatives — 426 15,897 13,901 6,986 Total $8,765 $40,544 $ 200,382 $231,621 $180,973

Note: Em dashes represent values that are too small to register. Sources: Office of the Comptroller of the Currency website, various dates. www.occ.treas.gov

TABLE 1–4 Derivative Contracts Held by Commercial Banks, by Contract Product (in billions of dollars)

Final PDF to printer

Chapter 1 Introduction 11

sau19714_ch01_001-025.indd 11 06/28/17 11:03 AM

OVERVIEW OF FINANCIAL INSTITUTIONS Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies, mutual funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). Chapters 11 through 18 discuss the various types of FIs in today’s economy, including (1) the size, structure, and composition of each type; (2) their balance sheets and recent trends; (3) FI performance; and (4) the regulators who oversee each type. Table 1–5 lists and summarizes the FIs discussed in detail in later chapters.

To understand the important economic function financial institutions play in the operation of financial markets, imagine a simple world in which FIs do not exist. In such a world, suppliers of funds (e.g., households), generating excess savings by consuming less than they earn, would have a basic choice: they could either hold cash as an asset or directly invest that cash in the securities issued by users of funds (e.g., corporations or households). In general, users of funds issue financial claims (e.g., equity and debt securi- ties or mortgages) to finance the gap between their investment expenditures and their inter- nally generated savings such as retained earnings. As shown in Figure 1–6, in such a world we have a direct transfer of funds (money) from suppliers of funds to users of funds. In return, financial claims would flow directly from users of funds to suppliers of funds.

financial institutions Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds.

LG 1-5

direct transfer A corporation sells its stock or debt directly to investors without going through a financial institution.

Commercial banks—depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. Commercial banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions.

Thrifts—depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans.

Insurance companies—financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on.

Securities firms and investment banks—financial institutions that help firms issue securities and engage in related activities such as securities brokerage and securities trading.

Finance companies—financial intermediaries that make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding.

Investment funds—financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets.

Pension funds—financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Funds originally invested in and accumulated in pension funds are exempt from current taxation.

TABLE 1–5 Types of Financial Institutions

Figure 1–6 Flow of Funds in a World without FIs

Users of Funds

Financial Claims (equity and debt instruments)

Cash

Suppliers of Funds

Final PDF to printer

12 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 12 06/28/17 11:03 AM

In this economy without financial institutions, the level of funds flowing between sup- pliers of funds (who want to maximize the return on their funds subject to risk) and users of funds (who want to minimize their cost of borrowing subject to risk) is likely to be quite low. There are several reasons for this. First, once they have lent money in exchange for financial claims, suppliers of funds need to monitor continuously the use of their funds. They must be sure that the user of funds neither steals the funds outright nor wastes the funds on projects that have low or negative returns. Such monitoring is often extremely costly for any given fund supplier because it requires considerable time, expense, and effort to collect this information relative to the size of the average fund supplier’s invest- ment. Given this, fund suppliers would likely prefer to leave, or delegate, the monitoring of fund borrowers to others. The resulting lack of monitoring increases the risk of directly investing in financial claims.

Second, the relatively long-term nature of many financial claims (e.g., mortgages, corporate stock, and bonds) creates another disincentive for suppliers of funds to hold the direct financial claims issued by users of funds. Specifically, given the choice between holding cash and long-term securities, fund suppliers may well choose to hold cash for liquidity reasons, especially if they plan to use their savings to finance consumption expen- ditures in the near future and financial markets are not very developed, or deep, in terms of the number of active buyers and sellers in the market.

Third, even though real-world financial markets provide some liquidity services, by allowing fund suppliers to trade financial securities among themselves, fund suppliers face a price risk upon the sale of securities. That is, the price at which investors can sell a secu- rity on secondary markets such as the New York Stock Exchange (NYSE) may well differ from the price they initially paid for the security either because investors change their valu- ation of the security between the time it was bought and when it was sold and/or because dealers, acting as intermediaries between buyers and sellers, charge transaction costs for completing a trade.

Unique Economic Functions Performed by Financial Institutions

Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average investor in a world without FIs would likely view direct investment in financial claims and markets as an unattractive proposition and prefer to hold cash. As a result, financial market activity (and therefore savings and investment) would likely remain quite low.

However, the financial system has developed an alternative and indirect way for inves- tors (or fund suppliers) to channel funds to users of funds.3 This is the indirect transfer of funds to the ultimate user of funds via FIs. Due to the costs of monitoring, liquidity risk, and price risk, as well as for other reasons explained later, fund suppliers often prefer to

price risk The risk that an asset’s sale price will be lower than its purchase price.

3. We describe and illustrate this flow of funds in Chapter 2.

indirect transfer A transfer of funds between suppliers and users of funds through a financial intermediary.

Figure 1–7 Flow of Funds in a World with FIs

Cash Cash

Financial Claims (Equity and debt securities)

Financial Claims (Deposits and insurance policies)

FI (Brokers)

FI (Asset

transformers)

Suppliers of FundsUsers of Funds

Final PDF to printer

Chapter 1 Introduction 13

sau19714_ch01_001-025.indd 13 06/28/17 11:03 AM

hold the financial claims issued by FIs rather than those directly issued by the ultimate users of funds. Consider Figure 1–7, which is a closer representation than Figure 1–6 of the world in which we live and the way funds flow in the U.S. financial system. Notice how financial intermediaries or institutions are standing, or intermediating between, the suppliers and users of funds—that is, channeling funds from ultimate suppliers to ultimate users of funds.

How can a financial institution reduce the monitoring costs, liquidity risks, and price risks facing the suppliers of funds compared to when they directly invest in financial claims? We look at how FIs resolve these cost and risk issues next and summarize them in Table 1–6.

Monitoring Costs. As mentioned previously, a supplier of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund user’s actions in a timely and complete fashion. One solution to this problem is for a large number of small investors to group their funds together by holding the claims issued by a financial institu- tion. The FI groups the fund suppliers’ funds together and invests them in the direct finan- cial claims issued by fund users. This aggregation of funds by fund suppliers in a financial institution resolves a number of problems. First, the “large” FI now has a much greater incentive to hire employees with superior skills and training in monitoring. This expertise can be used to collect information and monitor the ultimate fund user’s actions because the FI has far more at stake than any small individual fund supplier. Second, the monitoring function performed by the FI alleviates the “free-rider” problem that exists when small fund suppliers leave it to each other to collect information and monitor a fund user. In an economic sense, fund suppliers have appointed the financial institution as a delegated monitor to act on their behalf. For example, full-service securities firms such as Morgan Stanley carry out investment research on new issues and make investment recommenda- tions for their retail clients (or investors), while commercial banks collect deposits from fund suppliers and lend these funds to ultimate users such as corporations. An important part of these FIs’ functions is their ability and incentive to monitor ultimate fund users.

LG 1-6

delegated monitor An economic agent appointed to act on behalf of smaller investors in collecting information and/ or investing funds on their behalf.

Services Benefiting Suppliers of Funds: Monitoring costs—aggregation of funds in an FI provides greater incentive to collect a firm’s

information and monitor actions. The relatively large size of the FI allows this collection of information to be accomplished at a lower average cost (economies of scale).

Liquidity and price risk—FIs provide financial claims to household savers with superior liquidity attributes and with lower price risk.

Transaction cost services—similar to economies of scale in information production costs, an FI’s size can result in economies of scale in transaction costs.

Maturity intermediation—FIs can better bear the risk of mismatching the maturities of their assets and liabilities.

Denomination intermediation—FIs such as mutual funds allow small investors to overcome constraints to buying assets imposed by large minimum denomination size.

Services Benefiting the Overall Economy: Money supply transmission—depository institutions are the conduit through which monetary

policy actions impact the rest of the financial system and the economy in general. Credit allocation—FIs are often viewed as the major, and sometimes only, source of financing

for a particular sector of the economy, such as farming and residential real estate. Intergenerational wealth transfers—FIs, especially life insurance companies and pension

funds, provide savers with the ability to transfer wealth from one generation to the next. Payment services—the efficiency with which depository institutions provide payment services

directly benefits the economy.

TABLE 1–6 Services Performed by Financial Institutions

Final PDF to printer

14 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 14 06/28/17 11:03 AM

Liquidity and Price Risk. In addition to improving the quality and quantity of infor- mation, FIs provide further claims to fund suppliers, thus acting as asset transformers. Financial institutions purchase the financial claims issued by users of funds—primary securities such as mortgages, bonds, and stocks—and finance these purchases by selling financial claims to household investors and other fund suppliers in the form of depos- its, insurance policies, or other secondary securities. Thus, in contrast to a world with- out FIs, while funds are being transferred from suppliers of funds through FIs to users of funds, ownership of the financial claims is not directly transferred from users of funds to the suppliers of funds. For example, an individual investor in a mutual fund that purchases Apple stock is not a shareholder of Apple Inc. The mutual fund owns Apple shares and the individual investor owns shares of this mutual fund.

Often claims issued by financial institutions have liquidity attributes that are supe- rior to those of primary securities. For example, banks and thrift institutions (e.g., sav- ings associations) issue transaction account deposit contracts with a fixed principal value and often a guaranteed interest rate that can be withdrawn immediately, on demand, by investors. Money market mutual funds issue shares to household savers that allow them to enjoy almost fixed principal (depositlike) contracts while earning higher interest rates than on bank deposits, and that can be withdrawn immediately. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice. Notice that in reducing the liquidity risk of investing funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as depository institutions offer highly liquid, low price-risk securities to fund suppliers on the liability side of their balance sheets, while investing in relatively less liquid and higher price-risk securities— such as the debt and equity—issued by fund users on the asset side. Three questions arise here. First, how can FIs provide these liquidity services? Furthermore, how can FIs be confident enough to guarantee that they can provide liquidity services to fund suppliers when they themselves invest in risky assets? Finally, why should fund suppliers believe FIs’ promises regarding the liquidity and safety of their investments?

The answers to these three questions lie in financial institutions’ ability to diversify away some, but not all, of their investment risk. The concept of diversification is familiar to all students of finance. Basically, as long as the returns on different investments are not perfectly positively correlated, by spreading their investments across a number of assets, FIs can diversify away significant amounts of their portfolio risk. (We discuss the mechan- ics of diversification in the loan portfolio in Chapter 20.) Thus, FIs can exploit the law of large numbers in making their investment decisions, whereas because of their smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with little price risk. As long as an FI is large enough to gain from diversification and monitoring on the asset side of its balance sheet, its financial claims (its liabilities) are likely to be viewed as liquid and attractive to small savers—especially when compared to direct investments in the capital market.

Additional Benefits FIs Provide to Suppliers of Funds

The indirect investing of funds through financial institutions is attractive to fund suppliers for other reasons as well. We discuss these below and summarize them in Table 1–6.

Reduced Transaction Cost. Not only do financial institutions have a greater incentive to collect information, but also their average cost of collecting relevant information is lower than for the individual investor (i.e., information collection enjoys economies of scale). For example, the cost to a small investor of buying a $100 broker’s report may seem inor- dinately high for a $10,000 investment. For an FI with $10 billion of assets under manage- ment, however, the cost seems trivial. Such economies of scale of information production and collection tend to enhance the advantages to investors of investing via FIs rather than

asset transformers Financial claims issued by an FI that are more attrac- tive to investors than are the claims directly issued by corporations.

diversify The ability of an economic agent to reduce risk by holding a number of differ- ent securities in a portfolio.

economies of scale The concept that cost reduction in trading and other transaction services results in increased effi- ciency when FIs perform these services.

Final PDF to printer

Chapter 1 Introduction 15

sau19714_ch01_001-025.indd 15 06/28/17 11:03 AM

directly investing themselves. Nevertheless, as a result of technological advances, the costs of direct access to financial markets by savers are ever falling and the relative benefits to the individual savers of investing through FIs are narrowing.

Maturity Intermediation. An additional dimension of financial institutions’ ability to reduce risk by diversification is their greater ability, compared to a small saver, to bear the risk of mismatching the maturities of their assets and liabilities. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, by maturity mismatch- ing, FIs can produce long-term contracts such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts such as deposits. In addition, although such mismatches can subject an FI to interest rate risk (see Chapters 3 and 22), a large FI is better able than a small investor to manage this risk through its supe- rior access to markets and instruments for hedging the risks of such loans (see Chapters 7, 10, 20, and 24).

Denomination Intermediation. Some FIs, especially mutual funds, perform a unique service relating to denomination intermediation. Because many assets are sold in very large denominations, they are either out of reach of individual savers or would result in savers holding very undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individual small savers may be unable to purchase such instruments directly. However, by pooling the funds of many small sav- ers (such as by buying shares in a mutual fund with other small investors), small savers overcome constraints to buying assets imposed by large minimum denomination size. Such indirect access to these markets may allow small savers to generate higher returns (and lower risks) on their portfolios as well.

Economic Functions FIs Provide to the Financial System as a Whole

In addition to the services financial institutions provide to suppliers and users of funds in the financial markets, FIs perform services that improve the operation of the financial sys- tem as a whole. We discuss these next and summarize them in Table 1–6.

The Transmission of Monetary Policy. The highly liquid nature of bank and thrift deposits has resulted in their acceptance by the public as the most widely used medium of exchange in the economy. Indeed, at the core of the most commonly used definitions of the money supply (see Chapter 4) are bank and/or thrift deposit contracts. Because deposits are a significant component of the money supply, which in turn directly impacts the rate of economic growth, depository institutions—particularly commercial banks— play a key role in the transmission of monetary policy from the central bank (the Federal Reserve) to the rest of the economy (see Chapter 4 for a detailed discussion of how the Federal Reserve implements monetary policy through depository institutions).4 Because depository institutions are instrumental in determining the size and growth of the money supply, they have been designated as the primary conduit through which monetary pol- icy actions by the Federal Reserve impact the rest of the financial sector and the econ- omy in general.

Credit Allocation. FIs provide a unique service to the economy in that they are the major source of financing for particular sectors of the economy preidentified by society as being in special need of financing. For example, policymakers in the United States and a number of other countries such as the United Kingdom have identified residential real estate as

www.federalreserve.gov

4. The Federal Reserve is the U.S. central bank charged with promoting economic growth in line with the economy’s potential to expand.

Final PDF to printer

16 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 16 06/28/17 11:03 AM

needing special attention. This has enhanced the specialness of those FIs that most commonly service the needs of that sector. In the United States, savings associa- tions and savings banks must emphasize mortgage lending. Sixty-five percent of their assets must be mortgage related for these thrifts to maintain their charter sta- tus (see Chapter 14). In a similar fashion, farming is an especially important area of the economy in terms of the overall social welfare of the population. Thus, the U.S. government has directly encouraged financial institutions to specialize in financing this area of activity through the creation of Federal Farm Credit Banks.5

Intergenerational Wealth Transfers or Time Intermediation. The ability of savers to transfer wealth from their youth to old age as well as across generations is also of great importance to a country’s social well-being. Because of this, special taxation relief and other subsidy mechanisms encourage investments by savers in life insurance, annuities, and pension funds. For example, pension funds offer sav- ings plans through which fund participants accumulate tax-exempt savings during their working years before withdrawing them during their retirement years.

Payment Services. Depository institutions such as banks and thrifts are also spe- cial in that the efficiency with which they provide payment services directly ben- efits the economy. Two important payment services are check-clearing and wire transfer services. For example, on any given day, over $4.5 trillion of payments are directed through Fedwire and CHIPS, the two largest wholesale payment wire network systems in the United States. Any breakdowns in these systems would likely produce gridlock to the payment system, with resulting harmful effects to the economy.

Risks Incurred by Financial Institutions

As financial institutions perform the various services described previously, they face many types of risk. Specifically, all FIs hold some assets that are potentially subject to default or credit risk (such as loans, stocks, and bonds). As FIs expand their services to non-U.S. customers or even domestic customers with business outside the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer-term investments, they are further exposed to market risk or asset price risk. Increasingly, FIs hold contingent assets and liabilities off the balance sheet, which presents an additional risk called off-balance-sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. All FIs are exposed to technology risk and operational risk because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide ser- vices). Finally, the risk that an FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces creates insolvency risk for the FI. Chapters 19 through 24 provide an analysis of how FIs measure and manage these risks.

Regulation of Financial Institutions

The preceding section showed that financial institutions provide various services to sec- tors of the economy. Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers of funds and users of funds as well as to the economy overall. The financial crisis of the late 2000s is a prime example of how such a breakdown in the provision of financial services can cripple financial markets

5. The Farm Credit System was created by Congress in 1916 to provide American agriculture with a source of sound, dependable credit at low rates of interest.

LG 1-7

LG 1-8

D O YO U U N D E R S TA N D :

6. The three major reasons that suppliers of funds would not want to directly purchase securities?

7. What the asset transformation function of FIs is?

8. What delegated monitoring function FIs perform?

9. What the link is between asset diversification and the liquidity of deposit contracts?

10. What maturity intermediation is?

11. Why the need for denomination intermediation arises?

12. The two major sectors that society has identified as deserving special attention in credit allocation?

13. Why monetary policy is transmitted through the banking system?

14. The payment services that FIs perform?

Final PDF to printer

Chapter 1 Introduction 17

sau19714_ch01_001-025.indd 17 06/28/17 11:03 AM

worldwide and bring the world economy into a deep recession. For example, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insur- ance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income upon retirement. In addition, indi- vidual FI failures may create doubts in savers’minds regarding the stability and solvency of FIs and the financial system in general and cause panics and even withdrawal runs on sound institutions. Indeed, this possibility provided the reasoning in 2008 for an increase in the deposit insurance cap to $250,000 per person per bank. At this time, the Federal Deposit Insurance Corporation (FDIC) was concerned about the possibility of contagious runs as a few major FIs (e.g., IndyMac and Washington Mutual) failed or nearly failed. The FDIC wanted to instill confidence in the banking system and made the change to avoid massive depositor runs from many of the troubled (and even safer) FIs, more FI failures, and an even larger collapse of the financial system.

FIs are regulated in an attempt to prevent these types of market failures and the costs they would impose on the economy and society at large. Although regulation may be socially beneficial, it also imposes private costs, or a regulatory burden, on individual FI owners and managers. Consequently, regulation is an attempt to enhance the social welfare benefits and mitigate the costs of the provision of FI services. Chapter 13 describes regula- tions (past and present) that have been imposed on U.S. financial institutions.

Trends in the United States

In Table 1–7, we show the changing shares of total assets of financial institutions in the United States from 1948 to 2016. A number of important trends are clearly evident; most apparent is the decline in the total share of depository institutions—commercial banks and thrifts—since World War II. Specifically, while still the dominant sector of the financial institutions industry, the share of commercial banks declined from 54.5 percent in 1948 to 26.1 percent in 2016. Note the particularly large decrease in the share of commercial banks from 2010 (32.8 percent) to 2016 (26.1 percent). The effects of regulation imposed dur- ing the financial crisis (e.g., the Financial Institutions Reform and Recovery Act of 2010 and Basel 3 capital regulations discussed in Chapter 13) and historically low interest rates on bank deposits (discussed in Chapter 2) reflect this relatively large decline. Further, the share of thrifts (savings banks, savings associations, and credit unions) fell from 12.0 to 3.0 percent over the same period.6 Similarly, insurance companies also witnessed a decline

6. Although commercial bank assets as a percentage of total assets in the financial sector may have declined in recent years, this does not necessarily mean that banking activity has decreased. Indeed, off-balance-sheet activities have replaced some of the more traditional on-balance-sheet activities of commercial banks (see Chapter 11). Further, as is discussed in Part Three of the text, banks are increasingly providing services (such as securities underwriting, insurance underwriting and sales, and mutual fund services) previously performed exclusively by other FIs.

1948 1960 1970 1980 1990 2000 2010 2016

Commercial banks 54.5% 40.8% 42.6% 40.7% 32.4% 30.5% 32.8% 26.1% Thrift institutions 12.0 21.0 23.0 25.0 17.1 10.1 7.3 3.0 Insurance companies 26.0 24.2 19.0 16.2 18.0 15.6 14.8 10.9 Investment companies 0.3 0.7 0.7 2.0 9.2 15.8 18.0 24.5 Pension funds 3.8 7.7 8.0 9.5 10.5 8.8 7.6 24.5 Finance companies and mortgage

companies 2.7 5.2 5.7 6.2 6.8 6.9 5.3 2.0 Securities brokers and dealers 0.7 0.4 0.7 0.3 5.7 12.1 13.4 8.0 Real estate investment trusts — 0.0 0.3 0.1 0.3 0.2 0.8 1.0 Total (percentage) 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Total (trillions of dollars) $0.324 $0.810 $1.375 $4.066 $11.557 $29.105 $51.385 $73.124

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, various issues. www.federalreserve.gov

TABLE 1–7 Percentage Shares of Assets of Financial Institutions in the United States, 1948–2016

Final PDF to printer

18 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 18 06/28/17 11:03 AM

in their share, from 26.0 to 10.9 percent. The most dramatic trend involves the increas- ing share of pension funds and investment companies and securities brokers and deal- ers. Investment companies (mutual funds and money market mutual funds) increased their share from 0.3 to 24.5 percent, while pension funds increased from 3.8 to 24.5 percent over the 1948 to 2016 period.

The Rise of Financial Services Holding Companies. To the extent that the financial services market is efficient and the data seen in Table 1–7 reflect the forces of demand and supply, these data indicate a current trend: savers increasingly prefer investments that closely mimic diversified investments in the direct securities markets over the transformed financial claims offered by traditional FIs. This trend may also indicate that the regulatory burden on traditional FIs—such as banks and insurance companies—is higher than that on pension funds, mutual funds, and investment companies. Indeed, traditional FIs are unable to produce their services as cost-efficiently as they previously could.

Recognizing this changing trend, in 1999 the U.S. Congress passed the Financial Ser- vices Modernization (FSM) Act, which repealed the 1933 Glass-Steagall barriers between commercial banking, insurance, and investment banking. The bill, promoted as the biggest change in the regulation of financial institutions in 70 years, allowed for the creation of “financial services holding companies” that could engage in banking activities, insurance activities, and securities activities. After 70 years of partial or complete separation between insurance, investment banking, and commercial banking, the FSM opened the door for the creation of full-service financial institutions in the United States similar to those that existed before 1933 and that exist in many other countries. Thus, while Table 1–7 lists assets of financial institutions by functional area, the financial services holding company (which combines these activities in a single financial institution) has become the dominant form of financial institution in terms of total assets.

The Shift Away from Risk Measurement and Management and the Financial Crisis. Certainly, the financial crisis of the late 2000s changed and reshaped today’s financial markets and institutions. As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in the systemic risk of the financial sys- tem, caused in large part by a shift in the banking model from that of “originate and hold” to “originate and distribute.” In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consum- ers. Banks typically hold these loans to maturity and thus have an incentive to screen and monitor borrower activities even after a loan is made.

However, the traditional banking model exposes the institution to potential liquid- ity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks have shifted to an underwriting model in which they originate or warehouse loans and then quickly sell them. Figure 1–8 shows the growth in bank loan secondary market trading from 1991 through 2015. Note the huge growth in bank loan trading even during the financial crisis of 2008–2009. When loans trade, the secondary market produces information that can substitute for the information and monitoring of banks. Further, banks may have lower incentives to collect information and monitor borrowers if they sell loans rather than keep them as part of the bank’s portfolio of assets. Indeed, most large banks are organized as financial services holding companies to facilitate these new activities.

More recently, activities of shadow banks, nonbank financial services firms (such as structured investment vehicles [SIVs] discussed in Chapter 24) that perform banking ser- vices, have facilitated the change from the originate-and-hold model of commercial bank- ing to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutual and similar funds, which invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and net borrowers. However, instead of

Final PDF to printer

Chapter 1 Introduction 19

sau19714_ch01_001-025.indd 19 06/28/17 11:03 AM

the bank serving as the intermediary, it is the nonbank financial services firm, or shadow bank, that intermediates. These innovations remove risk from the balance sheet of finan- cial institutions and shift risk off the balance sheet and to other parts of the financial sys- tem. Since the FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking, they have little incentive to screen and monitor the activities of borrowers to whom they originated loans. Thus, FIs’ role as specialists in risk measurement and management has been reduced.

Adding to FIs’ move away from risk measurement and management was the boom (“bubble”) in the housing markets, which began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term interest rate that banks and other financial institu- tions pay in the federal funds market. Perhaps not surprisingly, low interest rates and the increased liquidity provided by the central bank resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the “subprime market,” banks and other mortgage-supplying institutions often offered relatively low “teaser” rates on adjust- able rate mortgages (ARMs). These teaser rates provided exceptionally low initial interest rates. But after the expiration of the initial rate period two or three years later, if market rates rose, the loan rates increased substantially.

Figure 1–8 Bank Loan Secondary Market Trading 1991–2015

600

500

700

400

300

Trading Volume ($ billions)

200

100

1 9

9 1

1 9

9 2

1 9

9 3

1 9

9 4

1 9

9 5

1 9

9 6

1 9

9 7

1 9

9 8

1 9

9 9

2 0

0 0

2 0

0 1

2 0

0 2

2 0

0 3

2 0

0 4

2 0

0 5

2 0

0 6

2 0

0 7

2 0

0 8

2 0

0 9

2 0

1 0

2 0

1 1

2 0

1 2

2 0

1 3

2 0

1 4

2 0

1 5

Source: Thomson Reuters LPC website, 2016. www.loanpricing.com

Final PDF to printer

20 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 20 06/28/17 11:03 AM

Under the traditional, originate-and-hold banking model, banks might have been reluctant to so aggressively pursue low-credit-quality borrowers for fear that the loans would default. However, under the originate-and-distribute model of banking, asset secu- ritization and loan syndication allowed banks to retain little or no part of the loans, and hence little or no part of the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer- term credit risk concerns. The result was a deterioration in credit quality at the same time as there was a dramatic increase in consumer and corporate leverage.

Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates as it began to fear inflation. Since many of the sub- prime mortgages that originated in the 2001–2005 period had adjustable rates, the cost of meeting mortgage commitments rose to unsustainable levels for many low-income house- holds. The confluence of falling house prices, rising interest rates, and rising mortgage costs led to a wave of mortgage defaults in the subprime market and foreclosures that only reinforced the downward trend in housing prices. In 2007, the percentage of subprime mortgage-backed securities delinquent by 90 days or more was 10.09 percent, substantially higher than the 5.37 percent rate in May 2005. The financial crisis began. As previously mentioned, Appendix 1A (available through Connect or your course instructor) provides a detailed discussion of the causes of, the major events during, and the regulatory and indus- try changes resulting from the financial crisis.

The economy relies on financial institutions to act as specialists in risk measurement and management. The importance of this was demonstrated in the aftermath of the FIs’ failure to perform this critical function during the global financial crisis. The result was a worldwide breakdown in credit markets, as well as an enhanced level of equity market volatility. When FIs failed to perform their critical risk measurement and management functions, the result was a crisis of confidence that disrupted financial markets.

Enterprise Risk Management. A major theme of this book is the measurement and management of FI risks. While FIs have traditionally examined risk measurement and management by functional area (e.g., credit risk or liquidity risk), more recently they have recognized the value of enterprise risk management. Enterprise risk management (ERM) recognizes the importance of prioritizing and managing the combined impact of the full spectrum of risks as an interrelated risk portfolio. The process also seeks to embed risk management as a component in all critical decisions throughout the FI.

ERM came to the forefront for many FIs during and after the financial crisis, when their risk management practices came under intense scrutiny. Many FIs had invested heavily in advanced risk measurement and management systems only to have them fail to detect or control risk exposures that led up to the crisis. These failures resulted in sig- nificant examinations of what went wrong with risk management systems and practices. For example, since the financial crisis, global FI regulators, such as the Basel Committee on Banking Supervision, have moved to address risk culture, risk appetite setting, and risk governance more explicitly in regulatory standards. This was not the case prior to the cri- sis, when emphasis was predominantly placed on risk management processes and systems, believing that this ought to be sufficient. Prior to the financial crisis, FIs largely failed to take into account behavioral biases that play a critical role in senior management decisions which ultimately affect the risks that a company was willing to take or tolerate. Rather, the advancements in risk management had resulted in a highly analytical-focused discipline that largely ignored fundamental drivers of risk taking that are rooted in subtler behavioral characteristics. Using an ERM framework, decisions include how performance targets are set for staff, how incentive structures are designed, and the stature and resources that are provided to risk management functions within the FI. ERM stresses the importance of building a strong risk culture supported by governance arrangements that are explicitly aligned to a firm’s risk appetite.

enterprise risk management (ERM) Recognizes the importance of managing the combined impact of the full spectrum of risks as an interrelated risk portfolio.

Final PDF to printer

Chapter 1 Introduction 21

sau19714_ch01_001-025.indd 21 06/28/17 11:03 AM

Financial markets and institutions in the United States have their counterparts in many for- eign countries. International debt and equity markets are those markets that trade debt and equity securities issued by domestic and foreign firms. While U.S. markets are the world’s largest, international markets have seen rapid growth in recent years. Table 1–8 lists U.S. dollar equivalent values of money market and debt securities outstanding in countries throughout the world from 1996 through 2015. Notice that U.S. markets dominate the world debt markets. In 2015, for example, 14.9 percent of the world’s debt securities were issued in the United States. The next two most active issuers (the United Kingdom and Germany) had fewer debt securities outstanding than the U.S. market. Table 1–9 reports U.S. dollar equivalent market capitalization on major worldwide stock exchanges. U.S. stock exchanges are again the largest equity markets, followed by Japan and the United Kingdom.

While U.S. financial markets have historically been much larger in value, size, and trading volume than any foreign market, financial markets became truly global in the 1990s as technological improvements resulted in more immediate and cheaper access to real-time data worldwide by domestic and international investors. Added to this was inves- tors’ demand for international securities and international portfolio diversification (such as through the growth of U.S. mutual funds that invest in offshore bonds and stocks). As a result, the volume and values of stocks and other securities traded in foreign markets soared.

The significant growth in foreign financial markets is the result of several other factors as well. First is the increase in the pool of savings in foreign countries (e.g., the European

LG 1-9

GLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONS

Long-Term Debt Money Market Securities

Country 1996 2000 2010 2015* 2000 2010 2015*

Argentina $ 29.0 $ 68.1 $ 53.8 $ 50.9 $ 0.4 $ 0.1 $ 0.1 Australia 77.4 94.1 571.5 599.1 17.9 31.1 22.8 Austria 62.5 82.2 335.6 240.4 9.3 12.4 13.9 Belgium 42.1 65.3 573.9 287.7 12.4 18.3 10.9 Brazil 23.1 48.9 172.6 304.5 3.5 2.8 7.5 Canada 177.8 202.8 649.8 746.8 5.8 18.3 14.2 China n.a. 17.6 71.8 413.5 0.2 2.8 76.1 France 204.4 346.5 75.8 1,489.3 12.7 117.5 78.2 Germany 319.8 769.8 23.9 1,648.9 104.4 121.9 163.6 Hong Kong 15.9 28.4 85.1 126.4 2.5 1.2 5.5 Ireland 20.0 32.0 491.0 286.7 4.1 43.4 6.7 Italy 88.6 198.1 316.2 921.8 12.6 40.5 8.7 Japan 325.6 274.2 399.7 369.3 7.4 19.6 46.2 Luxembourg 8.4 16.4 88.5 124.4 5.4 4.2 10.2 Mexico 41.5 63.7 105.1 207.7 2.9 0.8 2.1 Netherlands 112.2 267.2 257.7 1,192.8 26.2 91.6 63.7 Norway 19.5 39.1 204.2 241.5 1.8 4.8 3.9 South Korea 38.9 48.7 138.1 175.6 0.8 5.0 10.7 Spain 44.2 137.0 720.4 933.6 11.3 60.0 20.4 Sweden 99.6 90.6 9.3 435.7 7.5 47.8 36.2 Switzerland 39.5 89.3 451.9 366.7 8.1 10.5 30.3 United Kingdom 258.7 519.2 3,020.5 2,555.5 48.1 98.2 58.6 United States 372.4 1,662.7 7,074.7 3,083.7 40.9 108.3 51.4 Total debt $ 2,982.5 $ 5,907.7 $ 26,750.8 $ 20,666.7 $ 370.1 $ 913.5 $ 884.4

*As of the end of the first quarter. Source: Bank for International Settlements, “International Banking and Financial Market Developments,” BIS Statistics Explorer. www.bis.org

TABLE 1–8 World Financial Markets, International Debt Outstanding, by Issuer (in billions of dollars)

Final PDF to printer

22 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 22 06/28/17 11:03 AM

Union). Second, international investors have turned to U.S. and other markets to expand their investment opportunities and improve their investment portfolio risk and return characteristics. This is especially so as the retirement value of public pension plans has declined in many European countries and investors have turned to private pension plans to boost their long-term savings. Third, information on foreign investments and markets is now more accessible and thorough—for example, via the Internet. Fourth, some U.S. FIs—such as specialized mutual funds—offer their customers opportunities to invest in foreign securities and emerging markets at relatively low transaction costs. Fifth, while the euro has had a significant effect throughout Europe, it is also having a notable impact on the global financial system. Despite challenges resulting from the Greek (and to some extent, the European) debt crisis of the 2010s, the euro is still one of the world’s most important currencies for international transactions. Sixth, economic growth in Pacific Basin countries, China, and other emerging countries has resulted in significant growth in their stock markets. Finally, deregulation in many foreign countries has allowed inter- national investors greater access and allowed the deregulating countries to expand their investor bases (e.g., until 2012, individual foreign investors faced severe restrictions on their ability to buy Indian stocks). As a result of these factors, the overall volume of invest- ment and trading activity in foreign securities is increasing, as is the integration of U.S. and foreign financial markets.

Table 1–10 shows the extent of the growth in foreign investment in U.S. financial mar- kets. From 1992 through 2015, foreign investors’ holdings of U.S. financial market debt securities outstanding increased from $989.3 billion to $10,470.7 billion, while foreign financial market debt securities held by U.S. investors increased from $315.8 billion to $3,077.4 billion. While U.S. financial markets dominate world markets, the growth of U.S. financial markets depends more and more on the growth and development of other econo- mies. In turn, the success of other economies depends to a significant extent on their finan- cial market development. Further, for the same reasons discussed earlier (i.e., monitoring costs, liquidity risk, and price risk), financial institutions are of central importance to the development and integration of markets globally. However, U.S. FIs must now compete not only with other domestic FIs for a share of these markets, but increasingly with foreign FIs. Table 1–11 lists the 10 largest banks in the world, measured by total assets, as of 2016. Only 2 of these are U.S. banks.

Country 2003 2010 2013 2016

Buenos Aires SE (Argentina) $ 35.0 $ 63.9 $ 43.2 $ 52.3 Australian SE 585.5 1,454.5 1,513.3 1,095.7 TMX Group (Canada) 910.2 2,170.4 2,032.2 1,551.2 Deutsche Börse (Germany) 1,079.0 1,429.7 1,566.4 1,563.4 NYSE Euronext (Europe) 2,076.4 2,930.1 3,016.2 3,190.9 Hong Kong Exchanges 714.6 2,711.3 2,883.1 2,808.0 Irish SE 85.1 60.4 128.7 114.6 Japan Exchange Group—Tokyo 2,953.1 3,827.8 4,223.3 4,522.8 Luxembourg SE 37.3 101.1 62.5 44.4 Mexican Exchange 122.5 454.3 556.2 386.6 Oslo Børs (Norway) 95.9 295.3 250.6 183.5 Korea Exchange 298.2 1,091.9 1,146.7 1,197.1 BME Spanish Exchanges 726.2 1,171.6 1,014.0 703.4 SIX Swiss Exchange 727.1 1,229.4 1,397.4 1,395.7 London SE 2,425.8 3,613.1 3,821.9 3,541.3 NYSE Euronext (U.S.) 11,328.0 13,394.1 15,571.6 16,813.4 WFE Total $ 30,721.0 $ 54,891.1 $ 58,538.9 $ 61,434.5

Source: World Federation of Exchanges. www.world-exchanges.org

TABLE 1–9 World Financial Markets, Market Capitalization (in billions of dollars)

Final PDF to printer

Chapter 1 Introduction 23

sau19714_ch01_001-025.indd 23 06/28/17 11:03 AM

As a result of the increased globalization of financial markets and institutions, U.S. financial market movements now have a much greater impact on foreign markets than historically. For example, in mid-August 2007, overseas markets experienced dramatic selloffs as a result of increasing concern among investors that the credit market problems in the United States could trigger a slowdown in global economic growth. What started as a major decline in the U.S. bond markets led to fears of a wider credit crunch that could affect economies from South Korea to Mexico to China. The global selloff began late Wednesday August 15, 2007, in the United States as credit market worries hit Countrywide Financial Corp., one of the country’s biggest mortgage lenders. The selloff continued on to hit worldwide markets in Asia, where the Japanese stock market fell 2 percent, the Hong Kong stock market fell 3.3 percent, and the South Korean stock market fell 6.9 percent. European stock markets followed, with UK stock markets falling 4.1 percent and German markets by 2.4 percent. The selling continued in the United States, with the Dow Jones

1992 1996 2000 2010 2015* U.S. Financial Market Instruments Held by Foreign Investors

Open market paper $ 12.9 $ 57.9 $ 114.3 $ 191.0 $ 102.7 U.S. government securities 595.0 1,293.9 1,462.8 5,550.6 7,048.2 U.S. corporate bonds 251.5 453.2 1,073.6 2,523.3 3,116.3 Loans to U.S. corporate businesses 129.9 126.2 117.3 160.4 203.5 Total 989.3 1,931.2 2,768.0 8,425.3 10,470.7 U.S. corporate equities held 326.2 666.6 1,632.0 3,475.8 6,289.1 Total financial assets held $ 1,315.5 $ 2,597.8 $ 4,400.0 $ 11,901.1 $ 16,759.8

Foreign Financial Market Instruments Held by U.S. Investors

Commercial paper $ 78.4 $ 67.5 $ 120.9 $ 398.6 $ 444.8 Bonds 147.2 347.7 572.7 1,689.5 2,271.5 Bank loans 23.9 43.7 70.5 115.1 328.0 Other loans & advances 66.4 60.0 50.3 22.1 33.1 Total 315.8 518.8 814.4 2,225.3 3,077.4 Foreign corporate equities held 314.3 1,006.0 1,852.8 4,646.9 6,732.0 Total financial assets held $ 630.1 $ 1,524.8 $ 2,667.2 $ 6,872.2 $ 9,809.4

*As of the end of the first quarter. Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, various issues. www.federalreserve.gov

TABLE 1–10 Financial Market Securities Holdings (in billions of dollars)

Bank Country Total Assets

1. Industrial Commerce Bank of China China $3.42 2. China Construction Bank China 2.83 3. Agricultural Bank of China China 2.74 4. Bank of China China 2.59 5. Mitsubishi UFJ Financial Japan 2.46 6. HSBC Holdings United Kingdom 2.41 7. J.P. Morgan Chase United States 2.35 8. BNP Paribas France 2.17 9. Bank of America United States 2.14 10. Credit Agricole France 1.85

Source: Authors’ research.

TABLE 1–11 The Largest (in Total Assets) Banks in the World (in trillions of dollars)

Final PDF to printer

24 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 24 06/28/17 11:03 AM

Industrial Average falling more than 300 points at the beginning of trading on Thursday, August 16.

Conversely, global events now have an impact on U.S. financial markets. For example, by the mid-2010s, after years of rapid growth, China was the world’s second-biggest economy. However, by late 2015, as China matured into a more developed market, demand for raw materials eased significantly. This raised concerns that China’s economy was slowing at a much faster pace than previously thought. For example, a private report released in January 2016 showed China’s manufacturing sector contracted in December 2015 following

two months of stabilization. As a result, the Shanghai Composite plummeted nearly 7 percent in one day. This negative news about China had global ramifications and the sharp selling spread overseas. The DJIA fell by as much as 467 points on January 4, 2016, closing below the 17,000 level for the first time since October 2015. Most recently, and as mentioned in the introduction, the June 2016 vote by the citizens of the UK to leave the European Union sent shockwaves around the world as the fate of the 43-year-old unified Europe was brought into question. Britain’s vote to leave the European Union set in motion an unprecedented and unpredictable process that could unsettle markets for many years.

D O YO U U N D E R S TA N D :

15. What the trends are in the growth of global financial markets since the 1990s?

SUMMARY

This introductory chapter reviewed the basic operations of domestic and foreign financial markets and institutions. It described the ways in which funds flow through an economic system from lenders to borrowers and outlined the markets and instruments that lenders and borrowers employ to complete this process. In addition, the chapter discussed the need for FI managers to understand the functioning of both the domestic as well as the interna- tional markets in which they participate.

The chapter also identified the various factors impacting the specialness of the ser- vices FIs provide and the manner in which they improve the efficiency with which funds flow from suppliers of funds to the ultimate users of funds. Currently, however, some forces—such as technology and especially the Internet—are so powerful that in the future FIs that have historically relied on making profits by performing traditional special func- tions such as brokerage will need to expand the array of financial services they sell as well as the way that such services are distributed or sold to their customers.

QUESTIONS

1. Classify the following transactions as taking place in the primary or secondary markets: (LG 1-1) a. IBM issues $200 million of new common stock. b. The New Company issues $50 million of common stock

in an IPO. c. IBM sells $5 million of GM preferred stock out of its

marketable securities portfolio. d. The Magellan Fund buys $100 million of previously

issued IBM bonds. e. Prudential Insurance Co. sells $10 million of GM com-

mon stock.

2. Classify the following financial instruments as money mar- ket securities or capital market securities: (LG 1-2) a. Banker’s acceptances b. Commercial paper c. Common stock d. Corporate bonds e. Mortgages f. Negotiable certificates of deposit g. Repurchase agreements h. U.S. Treasury bills i. U.S. Treasury notes j. Federal funds

Final PDF to printer

sau19714_ch01_001-025.indd 25 06/28/17 11:03 AM

Chapter 1 Introduction 25

3. How does the location of money markets differ from that of capital markets? (LG 1-2)

4. Which of the money market instruments is the largest in terms of dollar amount outstanding in 2016? (LG 1-2)

5. What are the major instruments traded in capital markets? (LG 1-2)

6. Which of the capital market instruments is the largest in terms of dollar amount outstanding in 2016? (LG 1-2)

7. If a U.S. bank is holding Japanese yen in its portfolio, what type of exchange rate movement would the bank be most concerned about? (LG 1-3)

8. What are the different types of financial institutions? Include a description of the main services offered by each. (LG 1-5)

9. How would economic transactions between suppliers of funds (e.g., households) and users of funds (e.g., corpora- tions) occur in a world without FIs? (LG 1-6)

10. Why would a world limited to the direct transfer of funds from suppliers of funds to users of funds likely result in quite low levels of fund flows? (LG 1-6)

11. How do FIs reduce monitoring costs associated with the flow of funds from fund suppliers to fund investors? (LG 1-6)

12. How do FIs alleviate the problem of liquidity and price risk faced by investors wishing to invest in securities of corpora- tions? (LG 1-6)

13. How do financial institutions help individuals diversify their portfolio risks? Which financial institution is best able to achieve this goal? (LG 1-6)

14. What is meant by maturity intermediation? (LG 1-6) 15. What is meant by denomination intermediation? (LG 1-6) 16. What other services do FIs provide to the financial system?

(LG 1-6) 17. What types of risks do FIs face? (LG 1-7) 18. Why are FIs regulated? (LG 1-8) 19. What events resulted in banks’ shift from the tradi-

tional banking model of originate-and-hold to a model of originate-and-distribute? (LG 1-6, LG 1-7, LG 1-8)

20. How did the boom in the housing market in the early and mid-2000s exacerbate FIs’ transition away from their role as specialists in risk measurement and management? (LG 1-6, LG 1-7, LG 1-8)

21. What countries have the most international debt securities outstanding? (LG 1-9)

22. What countries have the largest commercial banks? (LG 1-9)

Go to the New York Stock Exchange Facts & Figures: Interactive Viewer website at www.nyxdata.com/nysedata/asp/ factbook/viewer_interactive.asp and find the latest figures for top NYSE volume days using the following steps: Click on “Market Activity.” Click on “NYSE Group Volume Records—Top 10 Days.” This brings up a file that contains the relevant data. Questions

1. What is the largest number of daily shares traded on the NYSE? On what day did this occur? 2. Calculate the percentage change in daily trading volume since the 3.3 billion shares traded on April 18, 2016.

S E A R C H T H E S I T E

This appendix is available through Connect or your course instructor.

APPENDIX 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness

Final PDF to printer

sau19714_ch02_026-057.indd 26 07/18/17 02:40 AM

part one Introduction and Overview of Financial Markets

INTEREST RATE FUNDAMENTALS: CHAPTER OVERVIEW Nominal interest rates are the interest rates actually observed in financial markets. These nominal interest rates (or just interest rates) directly affect the value (price) of most securi- ties traded in the money and capital markets, both at home and abroad. Changes in interest rates influence the performance and decision making for individual investors, businesses, and governmental units alike. Figure 2–1 illustrates the movement in several key U.S. interest rates over the past 40 years: the federal funds rate used for interbank borrowing, the three-month T-bill rate, the AAA-rated corporate bond rate, and the home mortgage rate. Notice in Figure 2–1 the variability over time in interest rate levels. For example, the federal funds rate was as low as 3.29 percent in the early 1970s, yet hit highs of almost 20 percent in the early 1980s, was well below 10 percent throughout much of the 1990s,

O U T L I N E

Interest Rate Fundamentals: Chapter Overview

Loanable Funds Theory

Supply of Loanable Funds

Demand for Loanable Funds

Equilibrium Interest Rate

Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift

Movement of Interest Rates over Time

Determinants of Interest Rates for Individual Securities

Inflation

Real Risk-Free Rates

Default or Credit Risk

Liquidity Risk

Special Provisions or Covenants

Term to Maturity

Term Structure of Interest Rates

Unbiased Expectations Theory

Liquidity Premium Theory

Market Segmentation Theory

Forecasting Interest Rates

Time Value of Money and Interest Rates

Time Value of Money

Lump Sum Valuation

Annuity Valuation

Determinants of Interest Rates

L e a r n i n g G o a l s

2 c h a p t e r

LG 2-1 Know who the main suppliers of loanable funds are.

LG 2-2 Know who the main demanders of loanable funds are.

LG 2-3 Understand how equilibrium interest rates are determined.

LG 2-4 Examine factors that cause the supply and demand curves for loanable funds to shift.

LG 2-5 Examine how interest rates change over time.

LG 2-6 Know what specific factors determine interest rates.

LG 2-7 Examine the different theories explaining the term structure of interest rates.

LG 2-8 Understand how forward rates of interest can be derived from the term structure of interest rates.

LG 2-9 Understand how interest rates are used to determine present and future values.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 27

sau19714_ch02_026-057.indd 27 07/18/17 02:40 AM

and fell back to and was even below 4 percent in the early and late 2000s. As we discuss in detail in Chapter 4, in 2008 through 2016, the Federal Reserve lowered interest rates to historic lows as it took steps to stimulate the U.S. economy (which was suffering from its worst recession since the Great Depression).

This chapter examines factors that drive the level of current and future interest rates, as well as the link between interest rates and the time value of money. Sections 1 through 5 (as listed in the Learning Goals for this chapter) generally deal with the levels of inter- est rates, while Sections 6 through 8 are more concerned with differences among various interest rates. Finally, Section 9 demonstrates how interest rates affect the value of finan- cial securities by reviewing time value of money concepts.

nominal interest rates The interest rates actu- ally observed in financial markets.

LOANABLE FUNDS THEORY Interest rates play a major part in the determination of the value of financial instruments. For example, in June 2013 the Federal Reserve announced that it expected to be able to reduce its efforts to support the U.S. economy as it recovered from the financial crisis of 2008–2009 by the end of 2013. The financial markets reacted significantly: the Dow Jones Industrial Average (which had previously posted three consecutive days of gains in value) declined over 200 points, 1.35 percent in value, the interest rate (for bond instruments the

Figure 2–1 Key U.S. Interest Rates, 1972–2016

Source: Federal Reserve Board website, May 2016. www.federalreserve.gov

1 /1

/1 9

7 2

1 /1

/1 9

7 4

1 /1

/1 9

7 6

1 /1

/1 9

7 8

1 /1

/1 9

8 0

1 /1

/1 9

8 2

1 /1

/1 9

8 4

1 /1

/1 9

8 6

1 /1

/1 9

8 8

1 /1

/1 9

9 0

1 /1

/1 9

9 2

1 /1

/1 9

9 4

1 /1

/1 9

9 6

1 /1

/1 9

9 8

1 /1

/2 0

0 0

1 /1

/2 0

0 2

1 /1

/2 0

0 4

1 /1

/2 0

0 6

1 /1

/2 0

0 8

1 /1

/2 0

1 0

1 /1

/2 0

1 2

1 /1

/2 0

1 4

1 /1

/2 0

1 6

Year

Mortgage Rates

Interest Rate (%)

1 /1

/1 9

7 4

1 /1

/1 9

7 6

1 /1

/1 9

7 8

1 /1

/1 9

8 0

1 /1

/1 9

8 2

1 /1

/1 9

8 4

1 /1

/1 9

8 6

1 /1

/1 9

8 8

1 /1

/1 9

9 0

1 /1

/1 9

9 2

1 /1

/1 9

9 4

1 /1

/1 9

9 6

1 /1

/1 9

9 8

1 /1

/2 0

0 0

1 /1

/2 0

0 2

1 /1

/2 0

0 4

1 /1

/2 0

0 6

1 /1

/2 0

0 8

1 /1

/2 0

1 0

1 /1

/2 0

1 2

1 /1

/2 0

1 4

1 /1

/2 0

1 6

1 /1

/1 9

7 2

Federal Funds

1 /1

/1 9

7 2

1 /1

/1 9

7 4

1 /1

/1 9

7 6

1 /1

/1 9

7 8

1 /1

/1 9

8 0

1 /1

/1 9

8 2

1 /1

/1 9

8 4

1 /1

/1 9

8 6

1 /1

/1 9

8 8

1 /1

/1 9

9 0

1 /1

/1 9

9 2

1 /1

/1 9

9 4

1 /1

/1 9

9 6

1 /1

/1 9

9 8

1 /1

/2 0

0 0

1 /1

/2 0

0 2

1 /1

/2 0

0 4

1 /1

/2 0

0 6

1 /1

/2 0

0 8

1 /1

/2 0

1 0

1 /1

/2 0

1 2

1 /1

/2 0

1 4

1 /1

/2 0

1 6

Year

T-Bill

Interest Rate (%)

1 /1

/2 0

1 0

1 /1

/2 0

0 8

1 /1

/2 0

0 6

1 /1

/2 0

0 4

1 /1

/2 0

0 2

1 /1

/2 0

0 0

1 /1

/1 9

9 8

1 /1

/1 9

9 6

1 /1

/1 9

9 4

1 /1

/1 9

9 2

1 /1

/1 9

9 0

1 /1

/1 9

8 8

1 /1

/1 9

8 6

1 /1

/1 9

8 4

1 /1

/1 9

8 2

1 /1

/1 9

8 0

1 /1

/1 9

7 8

1 /1

/1 9

7 6

1 /1

/1 9

7 4

1 /1

/1 9

7 2

1 /1

/2 0

1 4

1 /1

/2 0

1 6

1 /1

/2 0

1 2

AAA-Rated Corporate Debt

Final PDF to printer

28 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 28 07/18/17 02:40 AM

interest rate is most often referred to as the yield to maturity1 or just yield) on Treasury securities increased (i.e., the yield on two-year T-notes increased from 0.126 percent to 2.308 percent, the highest rate in over a year), gold prices dropped 3.4 percent, and the U.S. dollar strengthened against foreign currencies. When the Fed eventually raised inter- est rates in December 2015 (for the first time in 10 years), the DJIA jumped 224.18 points, or 1.3 percent, to 17,749.09, with only two of the 30 blue-chip companies on the index trading lower. Global equity markets rallied in volatile trading, while the dollar rose after the Fed’s statement. However, this rate increase was highly anticipated. In a Reuters poll of more than 90 economists taken between December 4 and 9, the probability that the Fed would raise rates rose to 90 percent. Further, in its announcement, the Fed stressed that the pace of interest rate hikes would be gradual. Thus, benchmark 10-year Treasury notes that yielded 2.294 percent minutes ahead of the announcement, rose to 2.31 percent immedi- ately after the announcement, before falling back to 2.2995 percent. Likewise, gold held steady after the announcement that the interest rate increase was a tentative beginning to a “gradual” tightening cycle. Given the impact a change in interest rates has on security values, financial institution and other firm managers spend much time and effort trying to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time.

One model that is commonly used to explain interest rates and interest rate movements is the loanable funds theory. The loanable funds theory views the level of interest rates as resulting from factors that affect the supply of and demand for loanable funds. It cat- egorizes financial market participants—consumers, businesses, governments, and foreign participants—as net suppliers or demanders of funds.

Supply of Loanable Funds

The supply of loanable funds is a term commonly used to describe funds provided to the financial markets by net suppliers of funds. In general, the quantity of loanable funds sup- plied increases as interest rates rise. Figure 2–2 illustrates the supply curve for loanable funds. Other factors held constant, more funds are supplied as interest rates increase (the reward for supplying funds is higher). Table 2–1 presents data on the supply of loanable funds from the various groups of market participants from U.S. flow of funds data as of 2016.

The household sector (consumer sector) is one of the largest suppliers of loanable funds in the United States—$70.33 trillion in 2016. Households supply funds when they have excess income or want to reallocate their asset portfolio holdings. For example, dur- ing times of high economic growth, households may replace part of their cash holdings with earning assets (i.e., by supplying loanable funds in exchange for holding securities). As the total wealth of a consumer increases, the total supply of loanable funds from that

1. As will be discussed in Chapter 3, the yield to maturity is the return the bond holder will earn on the bond if he or she buys the bond at its current market price, receives all coupon and principal payments as promised, and holds the bond until maturity.

loanable funds theory A theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds.

LG 2-1

Figure 2–2 Supply of and Demand for Loanable Funds

Quantity of Loanable Funds Supplied and Demanded

Interest Rate

Demand Supply

DemandSupply

Final PDF to printer

Chapter 2 Determinants of Interest Rates 29

sau19714_ch02_026-057.indd 29 07/18/17 02:40 AM

consumer will also generally increase. Households determine their supply of loanable funds not only on the basis of the general level of interest rates and their total wealth, but also on the risk of securities investments. The greater the perceived risk of securi- ties investments, the less households are willing to invest at each interest rate. Further, the supply of loanable funds from households also depends on their immediate spending needs. For example, near-term educational or medical expenditures will reduce the supply of funds from a given household.

Higher interest rates will also result in higher supplies of funds from the U.S. business sector ($23.20 trillion from nonfinancial business and $85.91 trillion from financial busi- ness in 2016), which often has excess cash, or working capital, that it can invest for short periods of time in financial assets. In addition to the interest rates on these investments, the expected risk on financial securities and their businesses’ future investment needs will affect their overall supply of funds.

Loanable funds are also supplied by some governments ($5.22 trillion in 2016). For example, some governments (e.g., municipalities) temporarily generate more cash inflows (e.g., through local taxes) than they have budgeted to spend. These funds can be loaned out to financial market fund users until needed. During the recent financial crisis, the federal government significantly increased the funds it supplied to businesses and consumers as it attempted to rescue the U.S. economy from a deep economic recession (see Appendix 1A).

Finally, foreign investors increasingly view U.S. financial markets as alternatives to their domestic financial markets ($23.03 trillion of funds were supplied to the U.S. financial markets in 2016). When interest rates are higher on U.S. financial securities than they are on comparable securities in their home countries, foreign investors increase their supply of funds to U.S. markets. Indeed the high savings rates of foreign households (such as Japanese households) has resulted in foreign market participants being major suppliers of funds to U.S. financial markets in recent years. Similar to domestic suppliers of loanable funds, foreigners assess not only the interest rate offered on financial securities, but also their total wealth, the risk on the security, and their future expenditure needs. Additionally, foreign investors alter their investment decisions as financial conditions in their home countries change relative to the U.S. economy and the exchange rate of their country’s currency changes vis-à-vis the U.S. dollar (see Chapter 9). For example, during the recent financial crisis, investors world- wide, searching for a safe haven for their funds, invested huge amounts of funds in U.S. Trea- sury securities. The amount of money invested in Treasury bills from this “flight to quality” was so large that the yield on the three-month Treasury bill went below zero for the first time ever. Investors were essentially paying the U.S. government to borrow money.

Demand for Loanable Funds

The demand for loanable funds is a term used to describe the total net demand for funds by fund users. In general, the quantity of loanable funds demanded is higher as interest rates fall. Figure 2–2 also illustrates the demand curve for loanable funds. Other factors held constant, more funds are demanded as interest rates decrease (the cost of borrowing funds is lower).

LG 2-2

TABLE 2–1 Funds Supplied and Demanded by Various Groups (in trillions of dollars)

Funds Supplied Funds Demanded

Net Funds Supplied (Funds Supplied— Funds Demanded)

Households $70.33 $14.51 $55.82 Business—nonfinancial 23.20 55.85 −32.65 Business—financial 85.91 96.90 −10.99 Government units 5.22 23.19 −17.97 Foreign participants 23.03 17.24 5.79

Source: Federal Reserve Board website, “Financial Accounts of the United States,” May 2016. www.federalreserve.gov

Final PDF to printer

30 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 30 07/18/17 02:40 AM

Households (although they are net suppliers of funds) also borrow funds in financial markets ($14.51 trillion in 2016). The demand for loanable funds by households reflects the demand for financing purchases of homes (with mortgage loans), durable goods (e.g., car loans, appliance loans), and nondurable goods (e.g., education loans, medical loans). Additional nonprice conditions and requirements (discussed below) also affect a household’s demand for loanable funds at every level of interest rates.

Businesses demand funds to finance investments in long-term (fixed) assets (e.g., plant and equipment) and for short-term working capital needs (e.g., inventory and accounts receivable) usually by issuing debt and other financial instruments ($55.85 trillion for non- financial businesses and $96.90 trillion for financial businesses in 2016). When interest rates are high (i.e., the cost of loanable funds is high), businesses prefer to finance invest- ments with internally generated funds (e.g., retained earnings) rather than through borrowed funds. Further, the greater the number of profitable projects available to businesses, or the better the overall economic conditions, the greater the demand for loanable funds.

Governments also borrow heavily in the markets for loanable funds ($23.19 trillion in 2016). For example, state and local governments often issue debt instruments to finance temporary imbalances between operating revenues (e.g., taxes) and budgeted expenditures (e.g., road improvements, school construction). Higher interest rates can cause state and local governments to postpone borrowings and thus capital expenditures. Similar to house- holds and businesses, governments’ demand for funds varies with general economic con- ditions. The federal government is also a large borrower partly to finance current budget deficits (expenditures greater than taxes) and partly to finance past deficits. The cumula- tive sum of past deficits is called the national debt, which in the United States in 2016 stood at a record $19.21 trillion. Thus, the national debt and especially the interest pay- ments on the national debt have to be financed in large part by additional government bor- rowing. Chapter 4 provides details of how government borrowing and spending impacts interest rates as well as overall economic growth.

Finally, foreign participants (households, businesses, and governments) also borrow in U.S. financial markets ($17.24 trillion in 2016). Foreign borrowers look for the cheapest source of dollar funds globally. Most foreign borrowing in U.S. financial markets comes from the business sector. In addition to interest costs, foreign borrowers consider nonprice terms on loanable funds as well as economic conditions in their home country and the gen- eral attractiveness of the U.S. dollar relative to their domestic currency (e.g., the euro or the yen). In Chapter 9, we examine how economic growth in domestic versus foreign coun- tries affects foreign exchange rates and foreign investors’ demand and supply for funds.

Equilibrium Interest Rate

The aggregate supply of loanable funds is the sum of the quantity supplied by the separate fund supplying sectors (e.g., households, businesses, governments, foreign agents) dis- cussed above. Similarly, the aggregate demand for loanable funds is the sum of the quan- tity demanded by the separate fund demanding sectors. As illustrated in Figure 2–3, the aggregate quantity of funds supplied is positively related to interest rates, while the aggre- gate quantity of funds demanded is inversely related to interest rates. As long as competi- tive forces are allowed to operate freely in a financial system, the interest rate that equates the aggregate quantity of loanable funds supplied with the aggregate quantity of loanable funds demanded for a financial security, Q*, is the equilibrium interest rate for that secu- rity, i *, point E in Figure 2–3. For example, whenever the rate of interest is set higher than the equilibrium rate, such as i H, the financial system has a surplus of loanable funds. As a result, some suppliers of funds will lower the interest rate at which they are willing to lend and the demanders of funds will absorb the loanable funds surplus. In contrast, when the rate of interest is lower than the equilibrium interest rate, such as iL, there is a shortage of loanable funds in the financial system. Some borrowers will be unable to obtain the funds they need at current rates. As a result, interest rates will increase, causing more suppliers of loanable funds to enter the market and some demanders of funds to leave the market. These

www.ustreas.gov

LG 2-3

Final PDF to printer

Chapter 2 Determinants of Interest Rates 31

sau19714_ch02_026-057.indd 31 07/18/17 02:40 AM

competitive forces will cause the quantity of funds supplied to increase and the quantity of funds demanded to decrease until a shortage of funds no longer exists.

Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift

While we have alluded to the fundamental factors that cause the supply and demand curves for loanable funds to shift, in this section we formally summarize these factors. We then examine how shifts in the supply and demand curves for loanable funds determine the equilibrium interest rate on a specific financial instrument. A shift in the supply or demand curve occurs when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate. In either case, a change in the supply or demand curve for loanable funds causes interest rates to move. Table 2–2 recaps the factors that affect the supply and demand for loanable funds discussed in this section, their impact on the supply and demand for loanable funds for a specific security, and the impact on the market clearing (or equilibrium) interest rates holding all other factors constant.

Supply of Funds. We have already described the positive relation between interest rates and the supply of loanable funds along the loanable funds supply curve. Factors that cause the supply curve of loanable funds to shift, at any given interest rate, include the wealth of fund suppliers, the risk of the financial security, near-term spending needs, monetary policy objectives, and economic conditions.

Wealth. As the total wealth of financial market participants (households, businesses, etc.) increases, the absolute dollar value available for investment purposes increases. Accordingly, at every interest rate, the supply of loanable funds increases, or the sup- ply curve shifts down and to the right. For example, as the U.S. economy grew in the early and mid-2010s, total wealth of U.S. investors increased as well. Consequently, the supply of funds available for investing (e.g., in stock and bond markets) increased at

LG 2-4

Figure 2–3 Determination of Equilibrium Interest Rates

Quantity of Loanable Funds Supplied and Demanded

Interest Rate

i H

i L

i *

Final PDF to printer

32 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 32 07/19/17 04:02 PM

every available interest rate. We show this shift (increase) in the supply curve in Panel a of Figure 2–4 as a move from SS to SS″. The shift in the supply curve creates a disequi- librium between demand and supply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls, from i* to i*″, which is associ- ated with an increase in the quantity of funds loaned between fund suppliers and fund demanders from Q* to Q*″.

Conversely, as the total wealth of financial market participants decreases, the absolute dollar value available for investment purposes decreases. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The decrease in the supply of funds due to a decrease in the total wealth of market partici- pants results in an increase in the equilibrium interest rate and a decrease in the equilib- rium quantity of funds loaned (traded).

Risk. As the risk of a financial security decreases (e.g., the probability that the issuer of the security will default on promised repayments of the funds borrowed), it becomes more attrac- tive to suppliers of funds. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right, from SS to SS″ in Panel a of Figure 2–4. Holding all other factors constant, the increase in the supply of funds, due to a decrease in the risk of the financial security, results in a decrease in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″.

Conversely, as the risk of a financial security increases, it becomes less attractive to suppliers of funds. Accordingly, at every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. Holding all other factors con- stant, the decrease in the supply of funds due to an increase in the financial security’s risk results in an increase in the equilibrium interest rate and a decrease in the equilib- rium quantity of funds loaned (or traded). For example, during the financial crisis, the

Panel A: The supply of funds

Factor Impact on Supply of Funds

Impact on Equilibrium Interest Rate*

Interest rate Movement along the supply curve Direct Total wealth Shift supply curve Inverse Risk of financial security Shift supply curve Direct Near-term spending needs Shift supply curve Direct Monetary expansion Shift supply curve Inverse Economic conditions Shift supply curve Inverse

Panel B: The demand for funds

Factor Impact on Demand for Funds

Impact on Equilibrium Interest Rate

Interest rate Movement along the demand curve Direct Utility derived from asset purchased with borrowed funds

Shift demand curve Direct

Restrictiveness of nonprice conditions Shift demand curve Inverse Economic conditions Shift demand curve Direct

*A “direct” impact on equilibrium interest rates means that as the “factor” increases (decreases) the equilibrium interest rate increases (decreases). An “inverse” impact means that as the factor increases (decreases) the equilibrium interest rate decreases (increases).

TABLE 2–2 Factors That Affect the Supply of and Demand for Loanable Funds for a Financial Security

Final PDF to printer

Chapter 2 Determinants of Interest Rates 33

sau19714_ch02_026-057.indd 33 07/19/17 04:02 PM

Baa corporate bond rates spiked and 10-year T-note rates dropped significantly as sup- pliers of funds moved away from riskier investments (Baa corporate bonds) to the saf- est possible investments (Treasury notes). In the loanable funds framework, this can be interpreted as a reduction in the supply of funds, due to investor uncertainty about credit quality of firms in the corporate bond market and as an increase in the supply of funds in the Treasury notes market, as investors fled to quality investments. Consequently, the equilibrium interest rate was higher in the corporate bond market and lower in the Treasury notes market.

Near-Term Spending Needs. When financial market participants have few near-term spending needs, the absolute dollar value of funds available to invest increases. For exam- ple, when a family’s son or daughter moves out of the family home to live on his or her own, current spending needs of the family decrease and the supply of available funds (for investing) increases. At every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. The financial market, holding all other factors constant, reacts to this increased supply of funds by decreasing the equilibrium interest rate and increasing the equilibrium quantity of funds traded.

Figure 2–4 The Effect on Interest Rates from a Shift in the Supply Curve of or Demand Curve for Loanable Funds

Quantity of Funds Supplied

Interest Rate

SS''

E''

i*''

Q* Q*''

(a) Increase in the supply of loanable funds

SS''

Quantity of Funds Demanded

Interest Rate

E''

E i*

i*''

Q* Q*''

DD''

(b) Increase in the demand for loanable funds

Final PDF to printer

34 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 34 07/18/17 02:40 AM

Conversely, when financial market participants have increased near-term spending needs, the absolute dollar value of funds available to invest decreases. At every interest rate, the supply of loanable funds decreases, or the supply curve shifts up and to the left. The shift in the supply curve creates a disequilibrium in the financial market that results in an increase in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned (or traded).

Monetary Expansion. One method used by the Federal Reserve to implement monetary policy is to alter the availability of funds, the growth in the money supply, and thus the rate of economic expansion of the economy (we explain this process in detail in Chapter 4). When monetary policy objectives are to allow the economy to expand (as was the case in the late 2000s, during the financial crisis, and in the early 2010s), the Federal Reserve increases the supply of funds available in the financial markets. At every interest rate, the supply of loanable funds increases, the supply curve shifts down and to the right, and the equilibrium interest rate falls, while the equilibrium quantity of funds traded increases.

Conversely, when monetary policy objectives are to restrict the rate of economic expansion (and thus inflation), the Federal Reserve decreases the supply of funds avail- able in the financial markets. At every interest rate, the supply of loanable funds decreases, the supply curve shifts up and to the left, and the equilibrium interest rate rises, while the equilibrium quantity of funds loaned or traded decreases.

Economic Conditions. Finally, as the underlying economic conditions themselves (e.g., the inflation rate, unemployment rate, economic growth) improve in a country relative to other countries, the flow of funds to that country increases. This reflects the lower risk (country or sovereign risk) that the country, in the guise of its government, will default on its obligation to repay funds borrowed. For example, the severe economic crisis in Greece in the early 2010s resulted in a decrease in the supply of funds to that country. An increased inflow of foreign funds to U.S. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. Accordingly, the equi- librium interest rate falls and the equilibrium quantity of funds loaned or traded increases.

Conversely, when economic conditions in foreign countries improve, domestic and foreign investors take their funds out of domestic financial markets (e.g., the United States) and invest abroad. Thus, the supply of funds available in the financial markets decreases and the equilibrium interest rate rises, while the equilibrium quantity of funds traded decreases.

Demand for Funds. We explained above that the quantity of loanable funds demanded is negatively related to interest rates. Factors that cause the demand curve for loanable funds to shift include the utility derived from assets purchased with borrowed funds, the restrictiveness of nonprice conditions on borrowing, and economic conditions.

Utility Derived from Assets Purchased with Borrowed Funds. As the utility (i.e., satisfac- tion or pleasure) derived from an asset purchased with borrowed funds increases, the will- ingness of market participants (households, businesses, etc.) to borrow increases and the absolute dollar value borrowed increases. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right. For example, suppose a change in jobs takes an individual from Arizona to Minnesota. The individual currently has a convertible automobile. Given the move to Minnesota, the individual’s utility from the convertible decreases, while it would increase for a car with heated seats. Thus, with a potential increased utility from the purchase of a new car, the individual’s demand for funds in the form of an auto loan increases. We show this shift (increase) in the demand curve in Panel b of Figure 2–4 as a move from DD to DD″. The shift in the demand curve creates a disequilibrium in this financial market. Holding all other factors constant, the increase in the demand for funds due to an increase in the utility from the

www.federalreserve.gov

Final PDF to printer

Chapter 2 Determinants of Interest Rates 35

sau19714_ch02_026-057.indd 35 07/18/17 02:40 AM

purchased asset results in an increase in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″.

Conversely, as the utility derived from an asset purchased with borrowed funds decreases, the willingness of market participants (households, businesses, etc.) to borrow decreases and the absolute dollar amount borrowed decreases. Accordingly, at every inter- est rate, the demand for loanable funds decreases, or the demand curve shifts down and to the left. The shift in the demand curve again creates a disequilibrium in this financial market. As competitive forces adjust, and holding all other factors constant, the decrease in the demand for funds due to a decrease in the utility from the purchased asset results in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds loaned or traded.

Restrictiveness of Nonprice Conditions on Borrowed Funds. As the nonprice restric- tions put on borrowers as a condition of borrowing decrease, the willingness of market participants to borrow increases and the absolute dollar value borrowed increases. Such nonprice conditions may include fees, collateral, or requirements or restrictions on the use of funds (so-called restrictive covenants; see Chapter 6). The lack of such restrictions makes the loan more desirable to the user of funds. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right,

from DD to DD″. As competitive forces adjust, and holding all other factors constant, the increase in the demand for funds due to a decrease in the restric- tive conditions on the borrowed funds results in an increase in the equilibrium interest rate, from i* to i*″, and an increase in the equilibrium quantity of funds traded, from Q* to Q*″.

Conversely, as the nonprice restrictions put on borrowers as a condition of borrowing increase, market participants’ willingness to borrow decreases, and the absolute dollar value borrowed decreases. Accordingly, the demand curve shifts down and to the left. The shift in the demand curve results in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds traded.

Economic Conditions. When the domestic economy experiences a period of growth, such as that in the United States in the mid-2000s and early 2010s, market participants are willing to borrow more heavily. For example, state and local governments are more likely to repair and improve decaying infrastructure when the local economy is strong. Accordingly, the demand curve for funds shifts up and to the right. Holding all other factors constant, the increase in the demand for funds due to economic growth results in an increase in the equilib- rium interest rate and an increase in the equilibrium quantity of funds traded.

Conversely, when domestic economic growth is stagnant, market participants reduce their demand for funds. Accordingly, the demand curve shifts down and to the left, result- ing in a decrease in the equilibrium interest rate and a decrease in the equilibrium quantity of funds traded.

D O YO U U N D E R S TA N D :

1. Who the main suppliers of loanable funds are?

2. Who the major demanders of loanable funds are?

3. What happens to the equilibrium interest rate when the demand for loanable funds increases?

4. What happens to the equilibrium interest rate when the supply of loanable funds increases?

5. How supply and demand, together, determine interest rates?

MOVEMENT OF INTEREST RATES OVER TIME As discussed in the previous section of this chapter, the loanable funds theory of interest rates is based on the supply of and demand for loanable funds as functions of interest rates. The equilibrium interest rate (point E in Figure 2–4) is only a temporary equilib- rium. Changes in underlying factors that determine the demand for and supply of loan- able funds can cause continuous shifts in the supply and/or demand curves for loanable funds. Market forces will react to the resulting disequilibrium with a change in the equi- librium interest rate and quantity of funds traded in that market. Refer again to Panel a of Figure 2–4, which shows the effects of an increase in the supply curve for loanable

LG 2-5

Final PDF to printer

36 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 36 07/18/17 02:40 AM

funds, from SS to SS″ (and the resulting decrease in the equilibrium interest rate, from i* to i*″), while Panel b of Figure 2–4 shows the effects of an increase in the demand curve for loanable funds, from DD to DD″ (and the resulting increase in the equilibrium interest rate, from i* to i*″).

Inflation—the continual increase in the price level of a basket of goods and services. Real risk-free rate—nominal risk-free rate that would exist on a security if no inflation were

expected. Default risk—risk that a security issuer will default on the security by missing an interest or

principal payment. Liquidity risk—risk that a security cannot be sold at a predictable price with low transaction

costs at short notice. Special provisions—provisions (e.g., taxability, convertibility, and callability) that impact the

security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions.

Term to maturity—length of time a security has until maturity.

TABLE 2–3 Factors Affecting Nominal Interest Rates

DETERMINANTS OF INTEREST RATES FOR INDIVIDUAL SECURITIES So far we have looked at the general determination of equilibrium (nominal) interest rates for financial securities in the context of the loanable demand and supply theory of the flow of funds. In this section, we examine the specific factors that affect differences in inter- est rates across the range of real-world financial markets (i.e., differences among interest rates on individual securities, given the underlying level of interest rates determined by the demand and supply of loanable funds). These factors include inflation, the “real” risk-free rate, default risk, liquidity risk, special provisions regarding the use of funds raised by a security’s issuance, and the term to maturity of the security. We examine each of these factors in this section and summarize them in Table 2–3.

Inflation

The first factor to affect interest rates is actual or expected inflation in the economy. Inflation of the general price index of goods and services (IP) is defined as the (percent- age) increase in the price of a standardized basket of goods and services over a given period of time. The higher the level of actual or expected inflation, the higher will be the level of interest rates. The intuition behind the positive relationship between interest rates and inflation rates is that an investor who buys a financial asset must earn a higher interest rate when inflation increases to compensate for the increased cost of forgoing consumption of real goods and services today and buying these more highly priced goods and services in the future. In other words, the higher the rate of inflation, the more expensive the same basket of goods and services will be in the future. In the United States, inflation is mea- sured using indexes such as the consumer price index (CPI) and the producer price index (PPI). For example, the annual inflation rate using the CPI index between years t and t + 1 would be equal to:

Inflation (IP) = CP I t +1 − CP I t __________

CP I t × 100

Real Risk-Free Rates

A real risk-free rate is the interest rate that would exist on a risk-free security if no infla- tion were expected over the holding period (e.g., a year) of a security. The real risk-free

LG 2-6

inflation The continual increase in the price level of a basket of goods and services.

real risk-free rate The risk-free rate that would exist on a default- free security if no inflation were expected.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 37

sau19714_ch02_026-057.indd 37 07/18/17 02:40 AM

rate on an investment is the percentage change in the buying power of a dollar. As such, it measures society’s relative time preference for consuming today rather than tomorrow. The higher society’s preference to consume today (i.e., the higher its time value of money or rate of time preference), the higher the real risk-free rate (RFR) will be.

Fisher Effect. The relationship among the real risk-free rate (RFR), the expected rate of inflation [E(IP)], described above, and the nominal interest rate (i) is often referred to as the Fisher effect, named for the economist Irving Fisher, who identified these relationships early last century. The Fisher effect theorizes that nominal risk-free rates observed in financial markets (e.g., the one-year Treasury bill rate) must compensate investors for (1) any reduced purchasing power on funds lent (or principal lent) due to inflationary price changes and (2) an additional premium above the expected rate of inflation for forgoing present consumption (which reflects the real risk-free rate dis- cussed above), or

(1 + i) = [1 + E (IP) ] (1 + RFR)

Rearranging this relation, when an investor purchases a security that pays interest, the nominal risk-free rate exceeds the real risk-free rate because of inflation.

i = RFR + E (IP) + [RFR × E (IP) ]

where RFR × E (IP) is the inflation premium for the loss of purchasing power on the prom- ised nominal risk-free rate payments due to inflation. For small values of RFR and E(IP) this term is negligible.

Thus, the Fisher effect formula is often written as:

i = RFR + E (IP) (2-1)

The approximation formula, in Equation (2-1), assumes RFR × E (IP) is small. Thus, the nominal risk-free rate will be equal to the real risk-free rate only when market partici- pants expect the inflation rate to be zero —E (IP) = 0. Similarly, nominal risk-free rates will be equal to the expected inflation rate only when real risk-free rates are zero. Note that we can rearrange the nominal risk-free rate equation to show the determinants of the real risk- free rate as follows:

RFR = i − E (IP) (2-2)

EXAMPLE 2–1 Calculations of Real Risk-Free Rates The one-year Treasury bill rate in 2007 averaged 4.53 percent and inflation (measured by the consumer price index) for the year was 4.10 percent. If investors had expected the same inflation rate as that actually realized (i.e., 4.10 percent), then according to the Fisher effect the real risk-free rate for 2007 was:

4.53% − 4.10% = 0.43%

The one-year T-bill rate in 2015 was 0.32 percent, while the CPI change for the year was 0.70 percent. This implies a real risk-free rate of −0.38 percent, that is, the real risk-free rate was actually negative.

Panel a of Figure 2–5 shows the nominal risk-free rate (one-year T-bill rate) versus the change in the CPI from 1962 through 2016. Panel b shows the difference in the two rates (i.e., the real risk-free rate over the period). Because the expected inflation rate is difficult to estimate accurately, the real risk-free rate can be difficult to estimate accurately as well, since investors’ expectations are not always realized. Figure 2–5 shows the realized infla- tion and real risk-free rates.

stats.bls.gov/cpi/home.htm

Final PDF to printer

38 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 38 07/18/17 02:40 AM

Default or Credit Risk

Default risk is the risk that a security issuer will fail to make its promised interest and principal payments to the buyer of a security. The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure. Not all securities exhibit default risk. For example, U.S. Treasury securities are regarded as having no default risk since they

default risk The risk that a security issuer will default on that security by being late on or missing an interest or prin- cipal payment.

Sources: Federal Reserve Board website and U.S. Department of Labor website, May 2016. www.federalreserve.gov and stats.bls.gov/cpi/home.htm

Figure 2–5 Nominal Interest Rates versus Inflation

1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 Year

CPI T-Bill Rate

T-Bill Rate/ CPI (%)

Year

Real Rate (%)

2010 2014 –6

–4

–2

1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Final PDF to printer

Chapter 2 Determinants of Interest Rates 39

sau19714_ch02_026-057.indd 39 07/18/17 02:40 AM

are issued by the U.S. government, and the probability of the U.S. government default- ing on its debt payments is practically zero given its taxation powers and its ability to print currency. Some borrowers, however, such as corporations or individuals, have less predictable cash flows (and no taxation powers), and therefore investors charge them an interest rate risk premium reflecting their perceived probability of default and the potential recovery of the amount loaned. The difference between a quoted interest rate on a security (security j) and a Treasury security with similar maturity, liquidity, tax, and other features (such as callability or convertibility) is called a default or credit risk premium (DRPj). That is:

DR P j = i jt – i Tt (2-3)

where

ijt = interest rate on a security issued by a non-Treasury issuer (issuer j) of maturity m at time t

iTt = interest rate on a security issued by the U.S. Treasury of maturity m at time t

The default risk on many corporate bonds is evaluated and categorized by various bond rating agencies such as Moody’s and Standard & Poor’s. (We discuss these ratings in more detail in Chapter 6.)

In May 2016, the 10-year Treasury interest rate, or yield, was 1.77 percent. On Aaa-rated and Baa-rated corporate debt, interest rates were 3.61 and 4.78 percent, respectively. Thus, the average default risk premiums on the Aaa-rated and Baa-rated corporate debt were:

DR P Aaa = 3.61% − 1.77% = 1.84% DR P Baa = 4.78% − 1.77% = 3.01%

Figure 2–6 presents these risk premiums from 1977 through 2016. Notice from this figure and Figure 2–5 that default risk premiums tend to increase when the economy is contracting and decrease when the economy is expanding. For example, from 2008 to 2009 real risk- free rates (T-bills/CPI in Figure 2–5) decreased from 1.73 percent to −2.23 percent. Over the same period, default risk premiums on Aaa-rated bonds increased from 1.97 percent to 2.05 percent and on Baa-rated bonds from 3.78 percent to 4.03 percent. Conversely, from 2009 to 2010, the real risk-free rate increased from −2.23 percent to −1.18 percent. Over this period, default risk premiums on Aaa-rated bonds decreased from 2.05 percent to 1.67 percent and on Baa-rated bonds from 4.03 percent to 2.92 percent.

www.moodys.com

www.standard andpoors.com

Figure 2–6 Default Risk Premium on Corporate Bonds

0.0

1.0

2.0

3.0

4.0

5.0

1 9

7 7

1 9

7 9

1 9

8 5

1 9

8 9

1 9

9 3

1 9

9 9

2 0

0 3

2 0

0 7

2 0

1 1

2 0

1 5

Default Risk Premium (%)

Year

Aaa Risk Premium

Baa Risk Premium

1 9

8 1

1 9

8 3

1 9

8 7

1 9

9 1

2 0

0 1

1 9

9 5

1 9

9 7

2 0

0 5

2 0

0 9

2 0

1 3

Source: Federal Reserve Board website, May 2016. www.federalreserve.gov

Final PDF to printer

40 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 40 07/18/17 02:40 AM

Liquidity Risk

A highly liquid asset is one that can be sold at a predictable price with low transaction costs and thus can be converted into its full market value at short notice. If a security is illiquid, investors add a liquidity risk premium (LRP) to the interest rate on the security that reflects its relative liquidity. In the United States, liquid markets exist for most gov- ernment securities and the stocks and some bonds issued by large corporations. Many bonds, however, do not trade on a regular basis or on organized exchanges such as the NYSE. As a result, if investors wish to sell these bonds quickly, they may get a lower price than they could have received if they had waited until maturity to sell the bonds. Consequently, investors demand a liquidity premium on top of all other premiums to compensate for the bond’s lack of liquidity and the potential price discount from sell- ing it early. Thus, the liquidity risk premium might also be thought of as an “illiquidity” premium.

A different type of liquidity risk premium may also exist (see below) if investors dislike long-term securities because their prices (present values) are more sensitive to interest rate changes than short-term securities (see Chapter 3). In this case, a higher liquidity risk premium may be added to a security with a longer maturity simply because of its greater exposure to price risk (loss of capital value) on the security as interest rates change.

Special Provisions or Covenants

Numerous special provisions or covenants that may be written into the contract underlying a security also affect the interest rates on different securities (see Chapter 6). Some of these special provisions include the security’s taxability, convertibility, and callability.

For example, for investors, interest payments on municipal securities are free of federal, state, and local taxes. Thus, the interest rate required by a municipal bond holder is smaller than that on a comparable taxable bond—for example, a Treasury bond, which is taxable at the federal level but not at the state or local (city) levels, or a corporate bond, whose interest payments are taxable at the state and local levels as well as federal levels.

A convertible (special) feature of a security offers the holder the opportunity to exchange one security for another type of the issuer’s securities at a preset price. Because of the value of this conversion option, the convertible security holder requires a lower interest rate than a comparable nonconvertible security holder (all else equal). In gen- eral, special provisions that provide benefits to the security holder (e.g., tax-free status and convertibility) are associated with lower interest rates, and special provisions that provide benefits to the security issuer (e.g., callability, by which an issuer has the option to retire—call—a security prior to maturity at a preset price) are associated with higher interest rates.

Term to Maturity

Interest rates are also related to the term to maturity of a security.2 This relationship is often called the term structure of interest rates or the yield curve. The term structure of interest rates compares interest rates on securities, assuming that all characteristics (i.e., default risk, liquidity risk) except maturity are the same. The change in required interest rates as the maturity of a security changes is called the maturity premium (MP). The MP, or the difference between the required yield on long- and short-term securities of the same characteristics except maturity can be positive, negative, or zero. The term structure of interest rates for U.S. Treasury securities is the most frequently reported and analyzed yield curve. The shape of the yield curve on Treasury securities has taken many forms over

liquidity risk The risk that a security can be sold at a predictable price with low transaction costs on short notice.

2. As we discuss in Chapter 3, only debt securities have an identifiable maturity date; equity securities do not.

term structure of interest rates A comparison of market yields on securities, assum- ing all characteristics except maturity are the same.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 41

sau19714_ch02_026-057.indd 41 07/18/17 02:40 AM

the years, but the three most common shapes are shown in Figure 2–7. In Panel a, the yield curve on May 4, 2016, yields rise steadily with maturity when the yield curve is upward sloping. This is the most common yield curve, so that on average the MP is positive. Panel b shows an inverted or downward-sloping yield curve, reported on November 24, 2000, for which yields decline as maturity increases. Inverted yield curves do not generally last very long. Finally, Panel c shows a flat yield curve, reported on June 4, 2007, in which the yield is virtually unaffected by the term to maturity.

Note that these yield curves may reflect factors other than investors’ preferences for the maturity of a security, since in reality there may be liquidity differences among the securities traded at different points along the yield curve. For example, yields on newly issued 30-year Treasury bonds may be less than yields on (seasoned issues) 10-year Trea- sury bonds if investors prefer new (“on the run”) securities to previously issued (“off the run”) securities. Specifically, since (historically) the Treasury issues new 10-year notes and 30-year bonds only at the long end of the maturity spectrum, an existing 10-year Treasury bond would have to have been issued 20 years previously (i.e., it was originally a 30-year bond when it was issued 20 years previously). The increased demand for the newly issued “liquid” 30-year Treasury bonds relative to the less liquid 10-year Treasury bonds can be large enough to push the equilibrium interest rate on the 30-year Treasury bonds below that on the 10-year Treasury bonds and even below short-term rates. In the next section, we review three major theories that are often used to explain the shape of the yield curve.

Figure 2–7 Common Shapes for Yield Curves on Treasury Securities

Source: U.S. Treasury, Daily Treasury Yield Curves, various dates. www.ustreas.gov

Interest Rate (%)

5.50

4.50

5.00

4.00 Time to Maturity

3 -m

on th

6 -m

on th

1 -y

ea r

2 -y

ea r

3 -y

ea r

5 -y

ea r

7 -y

ea r

1 0

-y ea

2 0

-y ea

3 0

-y ea

Yield Curve, June 4, 2007

(c)

4.00

3.00

2.00

1.00

0.00

Interest Rate (%)

1 -m

on th

3 -m

on th

6 -m

on th

1 -y

ea r

2 -y

ea r

3 -y

ea r

5 -y

ea r

7 -y

ea r

1 0

-y ea

2 0

-y ea

3 0

-y ea

Yield Curve, May 4, 2016

Time to Maturity

Interest Rate (%)

7.00

6.00

5.00

3 -m

on th

6 -m

on th

1 -y

ea r

3 -y

ea r

2 -y

ea r

5 -y

ea r

7 -y

ea r

1 0

-y ea

2 0

-y ea

3 0

-y ea

Yield Curve, November 24, 2000

(a) (b)

Final PDF to printer

42 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 42 07/18/17 02:40 AM

Putting the factors that impact interest rates in different markets together, we can use the following general equation to determine the factors that functionally impact the fair interest rate (ij*) on an individual (jth) financial security:

i j * = f (IP, RFR, DR P j , LR P j , SC P j , M P j ) (2-4)

where

Inflation premium

RFR

Real risk-free rate

DRP j

Default risk premium on the jth security

LRP j = Liquidity risk premium on the jth security

SCP j

Special feature premium on the jth security

MP j

Maturity premium on the jth security

The first two factors, IP and RFR, are common to all financial securities, while the other factors can be unique to each security.

D O YO U U N D E R S TA N D :

6. What the difference is between inflation and real risk-free rates?

7. What should happen to a security’s equilibrium interest rate as the security’s liquidity risk increases?

8. What term structure of interest rates means?

Unbiased expectations theory—at any given point in time, the yield curve reflects the market’s current expectations of future short-term rates. According to the unbiased expectations theory, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds (as long as the market is in equilibrium).

Liquidity premium theory—long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity risk premiums that increase with the security’s maturity. Longer maturities on securities mean greater market and liquidity risk. So, investors will hold long-term maturities only when they are offered at a premium to compensate for future uncertainty in the security’s value. The liquidity premium increases as maturity increases.

Market segmentation theory—assumes that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. Thus, interest rates are determined by distinct supply and demand conditions within a particular maturity segment (e.g., the short end and long end of the bond market).

TABLE 2–4 Explanations for the Shape of the Term Structure of Interest Rates

TERM STRUCTURE OF INTEREST RATES As discussed previously in the context of the maturity premium, the relationship between a security’s interest rate and its remaining term to maturity (the term structure of interest rates) can take a number of different shapes. Explanations for the shape of the yield curve fall predominantly into three theories: the unbiased expectations theory, the liquidity pre- mium theory, and the market segmentation theory. Table 2–4 summarizes the theories. We discuss them in detail below. Review again Panel a in Figure 2–7, which presents the Trea- sury yield curve as of May 4, 2016. As can be seen, the yield curve on this date reflected the normal upward-sloping relationship between yield and maturity.

Unbiased Expectations Theory

According to the unbiased expectations theory of the term structure of interest rates, at a given point in time the yield curve reflects the market’s current expectations of future short-term rates. As illustrated in Figure 2–8, the intuition behind the unbiased expectations theory is that if investors have a four-year investment horizon, they could either buy a cur- rent, four-year bond and earn the current or spot yield on a four-year bond (1R4, if held to maturity) each year, or invest in four successive one-year bonds—of which they know only the current one-year spot rate (1R1), but form expectations of the unknown future one-year

LG 2-7

Final PDF to printer

Chapter 2 Determinants of Interest Rates 43

sau19714_ch02_026-057.indd 43 07/18/17 02:40 AM

rates [E(2r1), E(3r1), and E(4r1)]. Note that each interest rate term has two subscripts, for example, 1R4. The first subscript indicates the period in which the security is bought, so that 1 represents the purchase of a security in period 1. The second subscript indicates the matu- rity on the security, so that 4 represents the purchase of a security with a four-year life. Simi- larly, E(3r1) is the expected return on a security with a one-year life purchased in period 3.

In equilibrium, the return to holding a four-year bond to maturity should equal the expected return to investing in four successive one-year bonds. If this equality does not hold, an arbitrage opportunity exists. For example, if the investor could earn more on the one-year bond investments, he could short (or sell) the four-year bond, use the proceeds to buy the four successive one-year bonds, and earn a guaranteed profit over the four-year investment horizon. Thus, according to the unbiased expectations theory, if future one-year rates are expected to rise each successive year into the future, then the yield curve will slope upward. Specifically, the current four-year T-bond rate will exceed the three-year bond rate, which will exceed the two-year bond rate, and so on. Similarly, if future one- year rates are expected to remain constant each successive year into the future, then the four-year bond rate will be equal to the three-year bond rate—that is, the term structure of interest rates will remain constant over the relevant time period. Specifically, the unbiased expectations theory posits that current long-term interest rates ( 1 R N ) are geometric aver- ages of current ( 1 R 1 ) and expected future E( N r 1 ) short-term interest rates. The mathemati- cal equation representing this relationship is:

(1 + 1 R N ) N = (1 + 1 R 1 )(1 + E( 2 r 1 )) . . . (1 + E( N r 1 )) (2-5)

therefore:

1 R N = [(1 + 1 R 1 )(1 + E( 2 r 1 )) . . .(1 + E( N r 1 ))] 1/N − 1

where

1 R N

Actual N-period rate today (i.e., the first day of year 1) N = Term to maturity, N = 1, 2, . . . , 4, . . . 1 R 1

= Actual current one-year rate today

E( i r 1 )

Expected one-year rates for years, i = 2, 3, 4, . . . , N in the future

Notice that uppercase interest rate terms, 1Rt , are the actual current interest rates on secu- rities purchased today with a maturity of t years. Lowercase interest rate terms, tr1, are estimates of future one-year interest rates starting t years into the future.

EXAMPLE 2–2 Construction of a Yield Curve Using the Unbiased Expectations Theory of the Term Structure of Interest Rates

Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bond rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

1 R 1 = 1.94%, E( 2 r 1 ) = 3.00%, E( 3 r 1 ) = 3.74%, E( 4 r 1 ) = 4.10%

Figure 2–8 Unbiased Expectations Theory of the Term Structure of Interest Rates

Buy a four-year bond

Buy 4 one-year bonds

(1 + R )4

4 Year0 1 2 3

(1 + R ) 1 1

[1 + E ( r )] 2 1

[1 + E ( r )] 3 1

[1+ E ( r )] 4 1

Final PDF to printer

44 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 44 07/18/17 02:40 AM

Liquidity Premium Theory

A weakness of the unbiased expectations theory is that it assumes that investors are equally willing to invest in short-term and long-term securities with no additional reward (in the form of higher interest rates) to compensate them for any added risk from locking in their funds in long-term securities, i.e., it assumes investors are risk neutral. However, with uncertainty about future interest rates (and future monetary policy actions) and hence about future security prices, these instruments become risky in the sense that the return over a future investment period is unknown. In other words, because of future uncertainty of returns, there is a risk in holding long-term securities, and that risk increases with the security’s maturity, i.e., investors are risk averse.

The second theory, the liquidity premium theory of the term structure of interest rates, is an extension of the unbiased expectations theory. It is based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity. Specifically, in a world of uncertainty, short-term securities provide greater marketability (due to their more active secondary market) and have less price risk (due to smaller price fluctuations for a given change in interest rates) than long-term securities. As a result, investors prefer to hold shorter-term securities because they can be converted into cash with little risk of a capital loss (i.e., a fall in the price of the security below its original purchase price). Thus, investors

Using the unbiased expectations theory, current (or today’s) rates for one-, two-, three-, and four-year maturity Treasury securities should be:

1 R 1 = 1.94%

1 R 2 = [(1 + 0.0194)(1 + 0.03)] 1/2 − 1 = 2.47% 1 R 3 = [(1 + 0.0194)(1 + 0.03)(1 + 0.0374) ] 1/3 − 1 = 2.89%

1 R 4 = [(1 + 0.0194)(1 + 0.03)(1 + 0.0374)(1 + 0.041) ] 1/4 − 1 = 3.19%

and the current yield curve will be upward sloping as shown:

Term to Maturity (in years)

Yield to Maturity

0 1 2 3 4

3.19%

2.89%

2.47%

1.94%

This upward-sloping yield curve reflects the market’s expectation of persistently rising one-year (short-term) interest rates over the future horizon.3

3. That is, E(4r1) > E(3r1) > E(2r1) > 1R1.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 45

sau19714_ch02_026-057.indd 45 07/18/17 02:40 AM

must be offered a liquidity premium to buy longer-term securities which have a higher risk of capital losses. This difference in price or liquidity risk can be directly related to the fact that longer-term securities are more sensitive to interest rate changes in the market than are shorter-term securities—see Chapter 3 for a discussion on bond interest rate sensitivity and the link to a bond’s maturity or duration. Because the longer the maturity on a security the greater its risk, the liquidity premium increases as maturity increases.

The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected short-term rates (as under the unbiased expectations theory), plus liquidity risk premiums that increase with the maturity of the security. Figure 2–9 illustrates the differences in the shape of the yield curve under the unbi- ased expectations theory versus the liquidity premium theory. For example, Panel c of Figure 2–9 shows that according to the liquidity premium theory, an upward-sloping yield curve may reflect investors’ expectations that future short-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless be upward sloping. Indeed, an upward-sloping yield curve may reflect expectations that future interest rates will rise (Panel a), be flat (Panel c), or even fall (Panel b), as long as the liquidity premium increases with maturity fast enough to produce an upward-sloping yield curve. The liquidity premium theory may be mathematically represented as:

1 R N = [(1 + 1 R 1 )(1 + E( 2 r 1 ) + L 2 ) . . . (1 + E( N r 1 ) + L N )] 1/N − 1 (2-6)

where

L t = Liquidity premium for a period t L 2 < L 3 < . . . L N

Figure 2–9 Yield Curve under the Unbiased Expectations Theory (UET) versus the Liquidity Premium Theory (LPT)

Term to Maturity (a)

Yield to Maturity

Upward-Sloping

Term to Maturity (c)

Yield to Maturity

Flat

LPT LPT

UET UET

LPT

UET

Term to Maturity (b)

Yield to Maturity

Inverted or Downward-Sloping

Final PDF to printer

46 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 46 07/18/17 02:40 AM

Market Segmentation Theory

A weakness of both the unbiased expectations and liquidity premium theories is that they assume that investors have no preference when it comes to different maturities and the risks associated with them. The market segmentation theory argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium). Accord- ingly, the market segmentation theory does not consider securities with different maturities

www.ustreas.gov

EXAMPLE 2–3 Construction of a Yield Curve Using the Liquidity Premium Theory of the Term Structure of Interest Rates

Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bond rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

1 R 1 = 1.94%, E( 2 r 1 ) = 3.00%, E( 3 r 1 ) = 3.74%, E( 4 r 1 ) = 4.10%

In addition, investors charge a liquidity premium on longer-term securities such that:

L 2 = 0.10%, L 3 = 0.20%, L 4 = 0.30%

Using the liquidity premium theory, current rates for one-, two-, three-, and four-year maturity Treasury securities should be:

1 R 1

1.94%

1 R 2

= [(1 + 0.0194)(1 + 0.03 + 0.001) ] 1/2 – 1 = 2.52%

1 R 3

[(1 + 0.0194)(1 + 0.03 + 0.001)(1 + 0.0374 + 0.002) ] 1/3 – 1 = 2.99%

1 R 4

[(1 + 0.0194)(1 + 0.03 + 0.001)(1 + 0.0374 + 0.002)(1 + 0.041 + 0.003) ] 1/4 – 1 =3.34%

and the current yield curve will be upward sloping as shown:

Term to Maturity (in years)

Yield to Maturity

0 1 2 3 4

3.34%

2.99%

2.52%

1.94%

Comparing the yield curves in Example 2–2 and this example, notice that the liquidity premium in year 2 (L 2 = 0.10%) produces a 0.05 percent premium on the yield to maturity on a two-year T-note, the liquidity premium for year 3 ( L 3 = 0.20%) produces a 0.10 per- cent premium on the yield to maturity on the three-year T-note, and the liquidity premium for year 4 ( L 4 = 0.30% ) produces a 0.15 percent premium on the yield to maturity on the four-year T-note.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 47

sau19714_ch02_026-057.indd 47 07/18/17 02:40 AM

as perfect substitutes. Rather, individual investors and FIs have preferred investment hori- zons (habitats) dictated by the nature of the liabilities they hold (i.e., investors have com- plete risk aversion for securities outside their maturity preferences). For example, banks might prefer to hold relatively short-term U.S. Treasury bonds because of the short-term nature of their deposit liabilities, while insurance companies may prefer to hold long-term U.S. Treasury bonds because of the long-term nature of their life insurance contractual lia- bilities. Accordingly, interest rates are determined by distinct supply and demand condi- tions within a particular maturity segment (e.g., the short end and long end of the bond market). The market segmentation theory assumes that investors and borrowers are gener- ally unwilling to shift from one maturity sector to another without adequate compensation in the form of an interest rate premium. Figure 2–10 demonstrates how changes in the sup- ply curve for short- versus long-term bond segments of the market result in changes in the shape of the yield curve. Specifically in Figure 2–10, the higher the yield on securities (the lower the price), the higher the demand for them.4 Thus, as the supply of securities decreases in the short-term market and increases in the long-term market, the slope of the yield curve becomes steeper. If the supply of short-term securities had increased while the supply of long-term securities had decreased, the yield curve would have a flatter slope and might even have sloped downward. Indeed, the large-scale repurchases of long-term Treasury bonds (i.e., reductions in supply) by the U.S. Treasury in early 2000 has been viewed as the major cause of the inverted yield curve that appeared in February 2000. More recently, between October 2011 and June 2012 the Federal Reserve conducted its Operation Twist.

4. In general, the price and yield on a bond are inversely related. Thus, as the price of a bond falls (becomes cheaper), the demand for the bond will rise. This is the same as saying that as the yield on a bond rises, it becomes cheaper and the demand for it increases.

Figure 2–10 Market Segmentation and Determination of the Slope of the Yield Curve

Time to Maturity

Yield Percent

Yield Curve

S LQuantity of Long-Term Securities

Yield Percent rL

SL DL

Quantity of Short-Term Securities

Yield Percent rs

Ss Ds

Time to Maturity

Yield Percent

Yield Curve

S LQuantity of Long-Term Securities

Yield Percent rL

SL DL

Quantity of Short-Term Securities

Yield Percent

Ss Ds

Final PDF to printer

48 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 48 07/18/17 02:40 AM

The program involved the sale of $400 billion of short-term Treasuries in exchange for long-term Treasuries. The program was designed to lower rates on long-term bonds, while keeping short-term interest rates unchanged. By inten- tionally lowering yields, the Fed was forcing investors to consider other invest- ments that would help the economy more. Many argue that the policy worked. In June 2012, the yield on the 10-year Treasury fell to a 200-year low. As a result, the housing market and bank lending started to come back.

EXAMPLE 2–4 Calculation of Implied Forward Rates on One-Year Securities Using the Unbiased Expectations Theory

To find an implied forward rate on a one-year security to be issued one year from today, the unbiased expectations theory equation can be rewritten as follows:

1 R 2 = [(1 + 1 R 1 )(1 + [ 2 f 1 ] )] 1/2 – 1

where

2 f 1 = Expected one-year rate for year 2, or the implied forward one-year rate for next year

Therefore, 2 f 1 is the market’s estimate of the expected one-year rate for year 2. Solving for 2 f 1 , we get:

2 f 1 = [(1 + 1 R 2 )2 / (1 + 1 R 1 )] − 1

In general, we can find the one-year forward rate for any year, N years into the future, using the following equation:5

N f 1 = [(1 + 1 R N )N / (1 + 1 R N – 1)N–1] – 1 (2-7)

5. This formula focuses on solving for one-year rates only. However, practitioners construct the entire implied future yield curve. The general formula that allows solving for forward rates beyond the one-year maturity, K, is as follows:

N−K f K = [ (1 + R N ) N __________

(1 + R N−K ) N−K ]

1/K − 1

D O YO U U N D E R S TA N D :

9. What the three explanations are for the shape of the yield curve? Discuss each and compare them.

FORECASTING INTEREST RATES As will be seen in the time value of money examples in the next section, as interest rates change, so do the values of financial securities. Accordingly, the ability to predict or fore- cast interest rates is critical to the profitability of financial institutions and individual investors alike. For example, if interest rates rise, the value of investment portfolios of FIs and individuals will fall, resulting in a loss of wealth. Thus, interest rate forecasts are extremely important for the financial wealth of both FIs and individuals. The discussion of the unbiased expectations theory in the previous section of this chapter indicated that the shape of the yield curve is determined by the market’s current expectations of future short- term interest rates. For example, an upward-sloping yield curve suggests that the market expects future short-term interest rates to increase. Given that the yield curve represents the market’s current expectations of future short-term interest rates, the unbiased expecta- tions theory can be used to forecast (short-term) interest rates in the future (i.e., forward one-year interest rates). A forward rate is an expected or “implied” rate on a short-term security that is to be originated at some point in the future. Using the equations repre- senting the unbiased expectations theory, the market’s expectation of forward rates can be derived directly from existing or actual rates on securities currently traded in the spot market. In this section, we use the notation f, rather than E(r) used in the previous section, to highlight the terminology “forward rate.”

LG 2-8

forward rate An expected rate (quoted today) on a security that originates at some point in the future.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 49

sau19714_ch02_026-057.indd 49 07/18/17 02:40 AM

So far, we have looked at factors that determine the level of interest rates and at what causes interest rate movements over time. We finish the chapter with a look at the technical details of how interest rates affect the value of financial securities by reviewing time value of money concepts. Time value of money is a crucial tool for much of the analysis in this textbook. For example, interest rates have a direct and immediate effect on the value of virtually all financial securities—that is, interest rates affect the price or value the seller of a security receives and the buyer of a security pays in organized financial markets.

Time Value of Money

Time value of money is the basic notion that a dollar received today is worth more than a dollar received at some future date. This is because a dollar received today can be invested and its value enhanced by an interest rate or return such that the investor receives more than a dollar in the future. The interest rate or return reflects the fact that people generally prefer to consume now rather than wait until later. To compensate them for delaying consumption (i.e., saving), they are paid a rate of interest by those who wish to consume more today than their current resources permit (users of funds). Users of funds are willing to pay this rate of interest because they plan to productively use the borrowed funds such that they will earn even more than the rate of interest promised to the savers (suppliers of the funds).

The time value of money concept can be used to convert cash flows earned over an investment horizon into a value at the end of the investment horizon: the investment’s future value (FV). Alternatively, the time value of money concept can be used to convert the value of future cash flows into their current or present values (PV) (i.e., future dol- lars converted into their equivalent present value or current dollars). Two forms of time value of money calculations are commonly used in finance for security valuation pur- poses: the value of a lump sum and the value of annuity payments. A lump sum payment is a single cash payment received at the beginning or end of some investment horizon (e.g., $100 received at the end of five years). Annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon (e.g., $100 a year received each year for five years). In actual practice, “annuity” payments can be paid more

LG 2-9

lump sum payment A single cash flow occurs at the beginning and end of the investment horizon with no other cash flows exchanged.

annuity A series of equal cash flows received at fixed intervals over the invest- ment horizon.

For example, on May 4, 2016, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:

1 R 1 = 0.553%, 1 R 2 = 0.774%, 1 R 3 = 0.905%, 1 R 4 = 1.278%

Using the unbiased expectations theory, one-year forward rates on zero-coupon Treasury bonds for years 2, 3, and 4 as of May 4, 2016, were:

2 f 1

[(1.00774)2 / (1.00553)] − 1 = 0.995%

3 f 1 = [(1.00905)3 / (1.00774)2] − 1 = 1.012% 4 f 1

[(1.01278)4 / (1.00905)3] − 1 = 2.405%

Thus, the expected one-year rate, one year in the future, was 0.995 percent; the expected one-year rate, two years into the future, was 1.012 percent; and the expected one-year rate, three years into the future, was 2.405 percent.

D O YO U U N D E R S TA N D :

10. What a forward rate is?

11. How an implied forward rate can be obtained from current short- and long-term interest rates?

TIME VALUE OF MONEY AND INTEREST RATES6

6. The time value of money concept is a topic that finance students probably studied in introductory financial manage- ment courses. However, an understanding of its use in the valuation of financial instruments created, traded, and held by individual investors and financial institutions is critical. Therefore, in this chapter, we review and provide a reference guide to the general relationships between interest rates and security valuation. This material can be included or dropped from the chapter reading, depending on the need for review of the material, without harming the continuity of the chapter. In Chapter 3, we use these general relationships to determine the values of specific securities (e.g., equities and bonds).

Final PDF to printer

50 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 50 07/18/17 02:40 AM

frequently than once a year—so that the term annuity really means a constant payment received at equal intervals throughout an investment horizon (e.g., twice, three times, . . . a year). We first discuss lump sum time value of money calculations, followed by annuity calculations.

Lump Sum Valuation

Present Value of a Lump Sum. The present value function converts cash flows received over a future investment horizon into an equivalent (present) value as if they were received at the beginning of the current investment horizon. This is done by discounting future cash flows back to the present using the current market interest rate. The present value of an investment is the intrinsic value or price of the investment. The time value of money equa- tion used to calculate this value can be represented as follows.

Present value (PV) of a lump sum received at the end of the investment horizon, or future value (FV):

PV = F V t / (1 + r) t (2-8)

where

PV = Present value of cash flows FVt = Future value of cash flows (lump sum) received in t periods r = Interest rate earned per period on an investment (equals the nominal annual interest

rate, i, divided by the number of compounding periods per year—for example, daily, weekly, monthly, quarterly, semiannually)

t = Number of compounding periods in the investment horizon (equals the number of years in the investment horizon times the number of compounding periods per year)

EXAMPLE 2–5 Calculation of Present Value of a Lump Sum You have been offered a security investment such as a bond that will pay you $10,000 at the end of six years in exchange for a fixed payment today. If the appropriate annual interest rate on the investment is 8 percent compounded annually, the present value of this investment is computed as follows:

PV = F V t / (1 + r) t = $10,000 / (1 + 0.08) 6 = $10,000 (0.630170) = $6,301.70

If the annual interest rate on the investment rises to 12 percent, the present value of this investment becomes:

PV = $10,000 / (1 + 0.12) 6 = $10,000 (0.506631) = $5,066.31

If the annual interest rate on the investment rises to 16 percent, the present value of this investment becomes:

PV = $10,000 / (1 + 0.16) 6 = $10,000 (0.410442) = $4,104.42

Finally, if the annual interest rate on the investment of 16 percent is compounded semian- nually (that is, you will receive t = 12 ( = 6 × 2 ) total interest payments, each calculated as r = 8 percent ( = 16 percent ÷ 2 ) times the principal value in the investment, where r in this case is the semiannual interest payment) rather than annually, the present value of this investment becomes:

PV = $10,000 / (1 + 0.08) 12 = $10,000 (0.397114) = $3,971.14

CALCULATOR HINTS N = 6 I = 8 FV = 10,000 PMT = 0 CPT PV = −6,301.70

Notice from the previous examples that the present values of the security investment decrease as interest rates increase. For example, as the interest rate rose from 8 percent to

Final PDF to printer

Chapter 2 Determinants of Interest Rates 51

sau19714_ch02_026-057.indd 51 07/18/17 02:40 AM

12 percent, the (present) value of the security investment fell $1,235.39 (from $6,301.70 to $5,066.31). As interest rates rose from 12 percent to 16 percent, the value of the investment fell $961.89 (from $5,066.31 to $4,104.42). This is because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon. This inverse relationship between the value of a financial instrument—for example, a bond—and interest rates is one of the most fun- damental relationships in finance and is evident in the swings that occur in financial asset prices whenever major changes in interest rates arise.

Note also that as interest rates increase, the present values of the investment decrease at a decreasing rate. The fall in present value is greater when interest rates rose by 4 percent, from 12 percent to 16 percent, compared to when they rose from 8 percent to 12 percent—the inverse relationship between interest rates and the present value of security investments is neither linear nor proportional.

Finally, from this example notice that the greater the number of compounding periods per year (i.e., semiannually versus annually), the smaller the present value of a future amount.7

Future Value of a Lump Sum. The future value of a lump sum equation translates a cash flow received at the beginning of an investment period to a terminal (future) value at the end of an investment horizon (e.g., 5 years, 6 years, 10 years, etc.). The future value (FV) equation can be represented as follows:

Future value (FV) of a lump sum received at the beginning of the investment horizon:

F V t = PV (1 + r) t (2-9)

7. The ultimate of compounding periods is instantaneous, or continuous, compounding over the investment horizon (period). In this case the present value formula becomes:

PV = FV t [1 / (1 + r / ∞)] n∞ = FV n ( e −rn )

where n is the number of years in the investment horizon (period). Thus, in Example 2–5, if the annual interest rate on the investment is 16 percent compounded continuously, the present value of the $10,000 investment in six years is:

PV = $10,000( e −0.16×6 ) = $10,000(0.382893) = $3,828.93

EXAMPLE 2–6 Calculation of Future Value of a Lump Sum You plan to invest $10,000 today in exchange for a fixed payment at the end of six years. If the appropriate annual interest rate on the investment is 8 percent compounded annually, the future value of this investment is computed as follows:

FV = PV(1 + r) t = $10,000 (1 + 0.08) 6 = $10,000 (1.586874) = $15,868.74

If the annual interest rate on the investment rises to 12 percent, the future value of this investment becomes:

FV = $10,000(1 + 0.12) 6 = $10,000 (1.973823) = $19,738.23

If the annual interest rate on the investment rises to 16 percent, the future value of this investment becomes:

FV = $10,000(1 + 0.16) 6 = $10,000 (2.436396) = $24,363.96

Finally, if the annual interest rate on the investment of 16 percent is compounded semian- nually rather than annually (i.e., r = 16% / 2 = 8% and t = 6 × 2 = 12 ), the future value of this investment becomes:

FV = $10,000 (1 + 0.08) 12 = $10,000 (2.518170) = $25,181.70

CALCULATOR HINTS N = 6 I = 8 PV = 10,000 PMT = 0 CPT FV = −15,868.74

Final PDF to printer

52 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 52 07/18/17 02:40 AM

CALCULATOR HINTS N = 6 I = 8 FV = 0 PMT = 10,000 CPT PV = −46,228.80

EXAMPLE 2–7 Calculation of Present Value of an Annuity You have been offered a bond that will pay you $10,000 on the last day of every year for the next six years in exchange for a fixed payment today. If the appropriate annual inter- est rate on the investment is 8 percent, the present value of this investment is computed as follows:

PMT ×

⎡

⎢ ⎣ 1 −

1 _____

(1 + r) t

_________ r

⎤

⎥ ⎦

$10,000 ×

⎡

⎢ ⎣ 1 −

1 ________

(1 + 0.08) 6 ____________

0.08

⎤

⎥ ⎦

$10,000 (4.622880) = $46,228.80

Notice that the future value of an investment increases as interest rates increase. As interest rates rose from 8 percent to 12 percent, the (future) value of the investment of $10,000 for six years rose by $3,869.49 (from $15,868.74 to $19,738.23). As rates rose from 12 percent to 16 percent, the (future) value of the investment rose $4,625.73 (from $19,738.23 to $24,363.96). Note also that as interest rates increase, future values increase at an increasing rate. The increase in future value is greater when interest rates rose by 4 percent, from 8 percent to 12 percent, compared to when they rose from 12 percent to 16 percent—the positive relationship between interest rates and the future value of security investments is neither linear nor proportional. With the compounding of interest rates, as interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to an expotentially larger amount at the end of the investment hori- zon. By contrast, as stated earlier, as interest rates increase, the present value of an invest- ment decreases at a decreasing rate. Finally, notice that as the number of compounding periods per year increases, the future value of a present amount increases.

Annuity Valuation

Present Value of an Annuity. The present value of an annuity equation converts a finite series of constant (or equal) cash flows received on the last day of equal intervals through- out the investment horizon into an equivalent (present) value as if they were received at the beginning of the investment horizon. The time value of money equation used to calculate this value is represented as follows:

Present value (PV) of an annuity stream (PMT) received in the future:

PV = PMT ∑ j = 1

[1 / (1 + r)] j (2-10)

which can be reduced to the simpler equation:

PMT

⎡

⎢ ⎣ 1 −

1 _____

(1 + r) t

_________ r

⎤

⎥ ⎦

where

PMT =

Periodic annuity payment received during an investment horizon

∑ j = 1

= Summation sign for addition of all terms from j = 1 to j = t.

Final PDF to printer

Chapter 2 Determinants of Interest Rates 53

sau19714_ch02_026-057.indd 53 07/18/17 02:40 AM

If the investment pays you $10,000 on the last day of every quarter for the next six years (i.e., r = 8%/4 = 2% and t = 6 × 4 = 24 ), the present value of the annuity becomes:

PV = $10,000 ×

⎡

⎢ ⎣ 1 −

1 _________

(1 + 0.02) 24 ______________

0.02

⎤

⎥ ⎦

$10,000 (18.913926) = $189,139.26

If the annuity is paid on the first day of each quarter (referred to as an annuity due), an extra interest payment would be received for each $10,000 payment. Thus, the time value of money equation for the present value of an annuity due becomes:

PV = PMT [ 1 − 1 ______

( 1 + r ) t ________

r ] (1 + r)

The present value of this investment becomes:

PV = $10,000

⎡

⎢ ⎣ 1 −

1 _________

(1 + 0.02) 24 ____________

0.02

⎤

⎥ ⎦ (1 + 0.02)

$10,000 (18.913926) (1.02) = $192,922.04

CALCULATOR HINTS N = 6 I = 8 PV = 0 PMT = 10,000 CPT FV = −73,359.29

EXAMPLE 2–8 Calculation of the Future Value of an Annuity You plan to invest $10,000 on the last day of every year for the next six years. If the inter- est rate on the investment is 8 percent, the future value of your investment in six years is computed as follows:

FV =

$10,000 [

(1 + 0.08) 6 − 1 ___________

0.08 ]

$10,000 (7.335929) = $73,359.29

Future Value of an Annuity. The future value of an annuity equation converts a series of equal cash flows received at equal intervals throughout the investment horizon into an equivalent future amount at the end of the investment horizon. The equation used to calcu- late this value is represented as follows:

Future value (FV) of an annuity payment stream received over an investment horizon:8

F V t = PMT ∑ j = 0

t − 1

(1 + r) j (2-11)

which can be reduced to the simpler equation:

F V t = PMT × [ (1 + r) t − 1

________ r ]

8. Note that the last annuity payment occurs on the last day of the investment horizon. Thus, it earns no interest (i.e., the future value interest factor takes a power of zero). Similarly, the first annuity payment earns only five years of interest. Thus, the future value interest factor takes a power of five. Accordingly, in the future value interest factor of annuity term, j runs from 0 to t − 1, or, in this example, (6 − 1 =) 5. In Example 2–7, note that the first annuity payment earns one year of interest. Thus, the present value interest factor term takes a power of one. Likewise, the last annuity payment earns six years of interest. Thus, the present value interest factor takes a power of six. Accordingly, in the present value interest factor of annuity term, j runs from 1 to t.

Final PDF to printer

54 Part 1 Introduction and Overview of Financial Markets

sau19714_ch02_026-057.indd 54 07/18/17 02:40 AM

If the investment pays you $10,000 on the last day of every quarter for the next six years (i.e., r = 8%/4 = 2% and t = 6 × 4 = 24 ), the future value of the annuity becomes:

$10,000 [

(1 + 0.02) 24 − 1 ____________

0.02 ]

$10,000 (30.421862) = $304,218.62

If the annuity is paid on the first day of each quarter (an annuity due), an extra interest payment would be earned on each $10,000 investment. The time value of money equation for the future value of an annuity due becomes:

FV = PMT [ (1 + r) t − 1

________ r ] (1 + r)

Thus, the future value of this investment becomes:

$10,000 [

( 1 + 0.02 ) 24 − 1 ____________

0.02 ] (1 + 0.02)

$10,000 (30.421862) (1.02) = $310,303.00

D O YO U U N D E R S TA N D :

12. What should happen to the present value of a lump sum cash flow as interest rates increase?

13. What should happen to the future value of an annuity stream of cash flows as interest rates increase?

SUMMARY

This chapter reviewed the determinants of nominal interest rates and their effects on secu- rity prices and values in domestic and foreign financial markets. It described the way funds flow through the financial system from lenders to borrowers and how the level of interest rates and its movements over time are determined. The chapter also introduced theories regarding the determination of the shape of the term structure of interest rates.

QUESTIONS 1. Who are the suppliers of loanable funds? (LG 2-1) 2. Who are the demanders of loanable funds? (LG 2-2) 3. What factors cause the supply of funds curve to shift? (LG 2-4) 4. What factors cause the demand for funds curve to shift?

(LG 2-4) 5. What are six factors that determine the nominal interest rate

on a security? (LG 2-6) 6. What should happen to a security’s nominal interest rate as

the security’s liquidity risk increases? (LG 2-6) 7. Discuss and compare the three explanations for the shape of

the yield curve. (LG 2-7)

8. If we observe a one-year Treasury security rate higher than the two-year Treasury security rate, what can we infer about the one-year rate expected one year from now? (LG 2-7)

9. How does the liquidity premium theory of the term struc- ture of interest rates differ from the unbiased expectations theory? In a normal economic environment, that is, an upward-sloping yield curve, what is the relationship of liquidity premiums for successive years into the future? Why? (LG 2-7)

10. What is a forward interest rate? (LG 2-8) 11. What is the relationship between present values and interest

rates as interest rates increase? (LG 2-9)

PROBLEMS 1. A particular security’s equilibrium rate of return is

8 percent. For all securities, the inflation risk premium is 1.75 percent and the real risk-free rate is 3.5 percent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has

no special covenants. Calculate the security’s default risk premium. (LG 2-6)

2. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special cov- enants. The Wall Street Journal reports that 1-year T-bills

Final PDF to printer

sau19714_ch02_026-057.indd 55 07/18/17 02:40 AM

Chapter 2 Determinants of Interest Rates 55

are currently earning 3.25 percent. Your broker has deter- mined the following information about economic activity and Moore Corporation bonds: (LG 2-6)

Real risk-free rate

2.25%

Default risk premium

1.15%

Liquidity risk premium = 0.50%

Maturity risk premium

1.75%

a. What is the inflation premium? b. What is the fair interest rate on Moore Corporation

30-year bonds? 3. Dakota Corporation 15-year bonds have an equilibrium rate

of return of 8 percent. For all securities, the inflation pre- mium is 1.75 percent and the real risk-free rate is 3.50 per- cent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the bond’s default risk pre- mium. (LG 2-6)

4. A two-year Treasury security currently earns 1.94 percent. Over the next two years, the real risk-free rate is expected to be 1.00 percent per year and the inflation premium is expected to be 0.50 percent per year. Calculate the maturity risk premium on the two-year Treasury security. (LG 2-6)

5. Tom and Sue’s Flowers Inc.’s 15-year bonds are currently yielding a return of 8.25 percent. The expected inflation premium is 2.25 percent annually and the real risk-free rate is expected to be 3.50 percent annually over the next 15 years. The default risk premium on Tom and Sue’s Flowers’s bonds is 0.80 percent. The maturity risk pre- mium is 0.75 percent on 5-year securities and increases by 0.04 percent for each additional year to maturity. Calculate the liquidity risk premium on Tom and Sue’s Flowers Inc.’s 15-year bonds. (LG 2-6)

6. Nikki G’s Corporation’s 10-year bonds are currently yield- ing a return of 6.05 percent. The expected inflation pre- mium is 1.00 percent annually and the real risk-free rate is expected to be 2.10 percent annually over the next 10 years. The liquidity risk premium on Nikki G’s bonds is 0.25 per- cent. The maturity risk premium is 0.10 percent on 2-year securities and increases by 0.05 percent for each additional year to maturity. Calculate the default risk premium on Nikki G’s 10-year bonds. (LG 2-6)

7. The current one-year Treasury-bill rate is 5.2 percent and the expected one-year rate 12 months from now is 5.8 per- cent. According to the unbiased expectations theory, what should be the current rate for a two-year Treasury security? (LG 2-7)

8. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1 R 1 = 6%, E( 2 r 1 ) = 7%, E( 3 r 1 ) = 7.5%, E( 4 r 1 ) = 7.85%

Using the unbiased expectations theory, calculate the cur- rent (long-term) rates for one-, two-, three-, and four-year- maturity Treasury securities. Plot the resulting yield curve. (LG 2-7)

9. One-year Treasury bills currently earn 3.45 percent. You expect that one year from now, one-year Treasury bill rates

will increase to 3.65 percent. If the unbiased expectations theory is correct, what should the current rate be on two- year Treasury securities? (LG 2-7)

10. Suppose we observe the following rates: 1 R 1 = 8% , 1 R 2 = 10% . If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year interest rate expected one year from now, E( 2 r 1 ) ? (LG 2-7)

11. Suppose we observe the three-year Treasury security rate to be 12 percent, the expected one-year rate next year— E( 2 r 1 ) —to be 8 percent, and the expected one-year rate the following year— E( 3 r 1 ) —to be 10 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year Treasury security rate? (LG 2-7)

12. The Wall Street Journal reports that the rate on four-year Treasury securities is 5.60 percent and the rate on five-year Treasury securities is 6.15 percent. According to the unbi- ased expectations theory, what does the market expect the one-year Treasury rate to be four years from today, E( 5 r 1 ) ? (LG 2-7)

13. A recent edition of The Wall Street Journal reported interest rates of 2.25 percent, 2.60 percent, 2.98 percent, and 3.25 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively. According to the unbiased expectations theory of the term structure of interest rates, what are the expected one-year rates during years 4, 5, and 6? (LG 2-7)

14. Based on economists’ forecasts and analysis, one-year Trea- sury bill rates and liquidity premiums for the next four years are expected to be as follows:

1 R 1

5.65%

E ( 2 R 1 ) = 6.75% L 2 = 0.05% E ( 3 R 1 )

= 6.85% L 3 = 0.10%

E ( 4 R 1 )

7.15%

L 4

0.12%

Using the liquidity premium theory, plot the current yield curve. Make sure you label the axes on the graph and identify the four annual rates on the curve both on the axes and on the yield curve itself. (LG 2-7)

15. Suppose we observe the following rates: 1 R 1 = 10% , 1 R 2 = 14% , and E( 2 r 1 ) = 18% . If the liquidity premium the- ory of the term structure of interest rates holds, what is the liquidity premium for year 2? (LG 2-7)

16. The Wall Street Journal reports that the rate on three-year Treasury securities is 5.25 percent and the rate on four-year Treasury securities is 5.50 percent. The one-year interest rate expected in three years, E( 4 r 1 ) , is 6.10 percent. Accord- ing to the liquidity premium theory, what is the liquidity premium on the four-year Treasury security, L4? (LG 2-7)

17. If you note the following yield curve in The Wall Street Journal, what is the one-year forward rate for the period beginning one year from today, 2 f 1 according to the unbi- ased expectations theory? (LG 2-8)

Maturity Yield One day 2.00% One year 5.50 Two years 6.50 Three years 9.00

Final PDF to printer

sau19714_ch02_026-057.indd 56 07/18/17 02:40 AM

56 Part 1 Introduction and Overview of Financial Markets

18. You note the following yield curve in The Wall Street Jour- nal. According to the unbiased expectations theory, what is the one-year forward rate for the period beginning two years from today, 3 f 1 ? (LG 2-8)

Maturity Yield One day 2.00% One year 5.50 Two years 6.50 Three years 9.00

19. On March 11, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows: 1 R 1 = 4.75%, 1 R 2 = 4.95%, 1 R 3 = 5.25%, 1 R 4 = 5.65%

Using the unbiased expectations theory, calculate the one- year forward rates on zero-coupon Treasury bonds for years two, three, and four as of March 11, 20XX. (LG 2-8)

20. A recent edition of The Wall Street Journal reported inter- est rates of 6 percent, 6.35 percent, 6.65 percent, and 6.75 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively. According to the unbiased expectations theory, what are the expected one-year rates for years 4, 5, and 6 (i.e., what are 4 f 1 , 5 f 1 , and 6 f 1 )? (LG 2-8)

21. Assume the current interest rate on a one-year Treasury bond ( 1 R 1 ) is 4.50 percent, the current rate on a two-year Treasury bond ( 1 R 2 ) is 5.25 percent, and the current rate on a three-year Treasury bond ( 1 R 3 ) is 6.50 percent. If the unbi- ased expectations theory of the term structure of interest rates is correct, what is the one-year interest rate expected on Treasury bills during year 3 ( E ( 3 r 1 ) or 3 f 1 ) ? (LG 2-8)

22. Calculate the present value of $5,000 received five years from today if your investments pay a. 6 percent compounded annually b. 8 percent compounded annually c. 10 percent compounded annually d. 10 percent compounded semiannually e. 10 percent compounded quarterly What do your answers to these questions tell you about the relation between present values and interest rates and between present values and the number of compounding periods per year? (LG 2-9)

23. Calculate the future value in five years of $5,000 received today if your investments pay a. 6 percent compounded annually b. 8 percent compounded annually c. 10 percent compounded annually d. 10 percent compounded semiannually e. 10 percent compounded quarterly What do your answers to these questions tell you about the relation between future values and interest rates and between future values and the number of compounding periods per year? (LG 2-9)

24. Calculate the present value of the following annuity streams: (LG 2-9) a. $5,000 received each year for five years on the last day of

each year if your investments pay 6 percent compounded annually.

b. $5,000 received each quarter for five years on the last day of each quarter if your investments pay 6 percent compounded quarterly.

c. $5,000 received each year for five years on the first day of each year if your investments pay 6 percent com- pounded annually.

d. $5,000 received each quarter for five years on the first day of each quarter if your investments pay 6 percent compounded quarterly.

25. Calculate the future value of the following annuity streams: (LG 2-9) a. $5,000 received each year for five years on the last day of

each year if your investments pay 6 percent compounded annually.

b. $5,000 received each quarter for five years on the last day of each quarter if your investments pay 6 percent compounded quarterly.

c. $5,000 received each year for five years on the first day of each year if your investments pay 6 percent com- pounded annually.

d. $5,000 received each quarter for five years on the first day of each quarter if your investments pay 6 percent compounded quarterly.

26. Compute the future values of the following first assuming that payments are made on the last day of the period and then assuming payments are made on the first day of the period: (LG 2-9)

Payment Years Interest

Rate

Future Value (Payment made on

last day of period)

Future Value (Payment made on

first day of period)

$ 123 13 13% 4,555 8 8

74,484 5 10 167,332 9 1

27. Compute the present values of the following first assuming that payments are made on the last day of the period and then assuming payments are made on the first day of the period: (LG 2-9)

Payment Years Interest

Rate

Present Value (Payment made on

last day of period)

Present Value (Payment made on

first day of period)

$ 678.09 7 13% 7,968.26 13 6

20,322.93 23 4 69,712.54 4 31

28. If you deposit $500 in a bank account that earns 6 percent per year, how much total interest will you have earned after the third year? (LG 2-9)

29. How much money would you have to deposit today in order to have $2,000 in four years if the discount rate is 8 percent per year? (LG 2-9)

Final PDF to printer

sau19714_ch02_026-057.indd 57 07/18/17 02:40 AM

Chapter 2 Determinants of Interest Rates 57

30. If an ounce of gold, valued at $1,200, increases at a rate of 7.5 percent per year, how long will it take to be valued at $2,000? (LG 2-9)

31. You can save $1,000 per year for the next six years in an account earning 10 percent per year. How much will you

have at the end of the sixth year if you make the first deposit today? (LG 2-9)

32. What are the monthly payments (principal and interest) on a 15-year home mortgage for an $180,000 loan when interest rates are fixed at 8 percent? (LG 2-9)

Go to the U.S. Treasury website and find the latest information available on the size of the U.S. national debt. Go to www.treasurydirect.gov. Under “Government,” click on “Public Debt Reports.” Click on “Debt to the Penny.” This will bring up the relevant tables. For example, on May 4, 2016, the size of the national debt was $19.21 trillion. Questions

1. What is the most recent dollar value of the U.S. national debt? 2. Calculate the percentage change in the U.S. national debt since May 4, 2016.

S E A R C H T H E S I T E

Final PDF to printer

sau19714_ch03_058-092.indd 58 07/19/17 04:27 PM

Introduction and Overview of Financial Marketspart one

O U T L I N E

Interest Rates as a Determinant of Financial Security Values: Chapter Overview Various Interest Rate Measures

Coupon Rate Required Rate of Return Expected Rate of Return Required versus Expected Rates of Return: The Role of Efficient Markets Realized Rate of Return

Bond Valuation Bond Valuation Formula Used to Calculate Fair Present Values Bond Valuation Formula Used to Calculate Yield to Maturity

Equity Valuation Zero Growth in Dividends Constant Growth in Dividends Supernormal (or Nonconstant) Growth in Dividends

Impact of Interest Rate Changes on Security Values Impact of Maturity on Security Values

Maturity and Security Prices Maturity and Security Price Sensitivity to Changes in Interest Rates

Impact of Coupon Rates on Security Values

Coupon Rate and Security Price Coupon Rate and Security Price Sensitivity to Changes in Interest Rates

Duration A Simple Illustration of Duration A General Formula for Duration Features of Duration Economic Meaning of Duration Large Interest Rate Changes and Duration

Appendix 3A: Duration and Immunization Appendix 3B: More on Convexity (Appendixes 3A and 3B available through Connect or your course instructor)

Interest Rates and Security Valuation3

c h a p t e r

L e a r n i n g G o a l s

LG 3-1 Understand the differences in the required rate of return, the expected rate of return, and the realized rate of return.

LG 3-2 Calculate bond values.

LG 3-3 Calculate equity values.

LG 3-4 Appreciate how security prices are affected by interest rate changes.

LG 3-5 Understand how the maturity and coupon rate on a security affect its price sensitivity to interest rate changes.

LG 3-6 Know what duration is.

LG 3-7 Understand how maturity, yield to maturity, and coupon rate affect the duration of a security.

LG 3-8 Understand the economic meaning of duration.

INTEREST RATES AS A DETERMINANT OF FINANCIAL SECURITY VALUES: CHAPTER OVERVIEW In Chapter 2, we reviewed the basic concepts of time value of money and how time value of money equations can be used to convert cash flows received or paid over an investment horizon into either a present value or future value. Of particular importance was the fact that interest rate levels, and changes in interest rate levels, affect security values. We also reviewed factors that determine the level of interest rates, changes in interest rates, and interest rate differences among securities (e.g., default risk, callability).

With this understanding of how and why interest rates change, in this chapter we apply time value of money principles to the valuation of specific financial securities, paying par- ticular attention to the change in a security’s value when interest rates change. We examine how characteristics specific to a financial security (e.g., coupon rate and remaining time to maturity) also influence a financial security’s price.1 We conclude the chapter with an

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 59

sau19714_ch03_058-092.indd 59 07/19/17 04:27 PM

analysis of the duration of a security. Duration, which measures the weighted-average time to maturity of an asset or liability, using the present values of the cash flows as weights, also has economic meaning as the sensitivity of an asset or liability’s value or price to a small interest rate change. The valuation and duration models reviewed in this chapter are used by traders to determine whether to transact in the various financial markets we dis- cuss in Chapters 5 through 10.

1. Security valuation is a topic that finance students probably studied in introductory financial management courses. However, these models are critical tools for traders of financial securities and managers of financial institutions. There- fore, in this chapter we review and provide a reference guide to the general pricing relationships. This material can be included or dropped from the chapter reading, depending on the need for review of the material, without harming the continuity of the chapter.

Coupon rate—interest rate on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the bond holder.

Required rate of return—interest rate an investor should receive on a security given its risk. Required rate of return is used to calculate the fair present value on a security.

Expected rate of return—interest rate an investor expects to receive on a security if he or she buys the security at its current market price, receives all expected payments, and sells the security at the end of his or her investment horizon.

Realized rate of return—actual interest rate earned on an investment in a financial security. Realized rate of return is a historical (ex post) measure of the interest rate.

TABLE 3–1 Various Interest Rate Measures

VARIOUS INTEREST RATE MEASURES In Chapter 2, we presented a general discussion of interest rates and how they are deter- mined. The term interest rates can actually have many different meanings depending on the time frame used for analysis and the type of security being analyzed. In this chapter, we start off by defining different interest rate measures employed in the valuation of financial securities by market participants. These definitions are summarized in Table 3–1. In the body of the chapter, we apply these rates to the valuation of bonds (bond markets and their operations are discussed in detail in Chapter 6) and the valuation of stocks (stock markets and their operations are discussed in Chapter 8).

Coupon Rate

One variation on the meaning of the term interest rate specific to debt instruments is the coupon rate paid on a bond. As discussed in detail in the next section, the coupon rate on a bond instrument is the annual (or periodic) cash flow that the bond issuer contractually promises to pay the bond holder. This coupon rate is only one component of the overall return (required, expected, or realized rate of return) the bond holder earns on a bond, however. As discussed below, required, expected, or realized rates of return incorporate not only the coupon payments but all cash flows on a bond investment, including full and partial repayments of principal by the issuer.

Required Rate of Return

Market participants use time value of money equations to calculate the fair present value of a financial security over an investment horizon. As we discussed in Chapter 2 and will see later in this chapter, this process involves the discounting of all projected cash flows2

LG 3-1

coupon rate Interest rate used to calcu- late the annual cash flow the bond issuer promises to pay the bond holder.

2. The projected cash flows used in these equations may be those promised by the security issuer or expected cash flows estimated by the security purchaser (or some other analyst) from a probability distribution of the possible cash flows received on the security. In either case, the cash flows received are not ex ante known with perfect certainty because of default and other risks.

Final PDF to printer

60 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 60 07/19/17 04:27 PM

(CFs) on the security at an appropriate interest rate. (For easy reference to the notation used in this chapter, we list and define all variables used in this chapter at the end of the chapter.) The interest rate used to find the fair present value of a financial security is called the required rate of return (r). This interest rate is a function of the various risks associ- ated with a security (discussed in Chapter 2) and is thus the interest rate the investor should receive on the security given its risk (default risk, liquidity risk, etc.). The required rate of return is thus an ex ante (before the fact) measure of the interest rate on a security. The present value (PV) is determined by the following formula:

PV = C F 1 ______

(1 + r) 1 +

C F 2 ______ (1 + r) 2

+ C F 3 ______

(1 + r) 3 + . . . +

C F n ______ (1 + r) n

= ∑ t =1

C F t ______

(1 + r) t

where

Required rate of return

C F t = Cash flow projected in period t (t = 1, . . . , n) n

Number of periods in the investment horizon

Once a PV is calculated, market participants then compare this present value with the current market price ( P ‾ ) at which the security is trading in a financial market. If the cur- rent market price of the security ( P ‾ ) is less than its fair value (PV), the security is currently undervalued. The market participant would want to buy more of this security at its current price. If the current market price of the security is greater than its present value, the secu- rity is overvalued. The market participant would not want to buy this security at its current price. If the present value of the security equals its current market price, the security is said to be fairly priced given its risk characteristics. In this case, PV equals P ‾ .

required rate of return The interest rate an inves- tor should receive on a security, given its risk.

CALCULATOR HINTS N = 4 I = 11.25 PMT = 100 FV = 960 CPT PV = 935.31

EXAMPLE 3–1 Application of Required Rate of Return A Walmart bond you purchased two years ago for $890 is now selling for $925. The bond paid $100 per year in coupon interest on the last day of each year (the last payment made today). You intend to hold the bond for four more years and project that you will be able to sell it at the end of year 4 for $960. You also project that the bond will continue paying $100 in interest per year. Given the risk associated with the bond, its required rate of return (r) over the next four years is 11.25 percent. Accordingly, the bond’s fair present value is:

100 ___________

(1 + 0.1125) 1 +

100 ___________

(1 + 0.1125) 2 +

100 ___________

(1 + 0.1125) 3 +

100 + 960 ___________

(1 + 0.1125) 4

$935.31

Given the current selling price of the Walmart bond, $925, relative to the fair present value, $935.31, this bond is currently undervalued.

Expected Rate of Return

The expected rate of return, E(r), on a financial security is the interest rate a market participant expects to earn by buying the security at its current market price ( P ‾ ) , receiv- ing all projected cash flow payments (CFs) on the security, and selling the security at the end of the participant’s investment horizon. Thus, the expected rate of return is also an ex ante measure of the interest rate on a security. However, the expected rate of return on an investment is based on the current market price rather than fair present value. As discussed above, these may or may not be equal.

Again, time value of money equations are used to calculate the expected rate of return on a security. In this case, the current market price of the security is set equal to the present value of all projected cash flows received on the security over the investment horizon. The

expected rate of return The interest rate an inves- tor would expect to earn on a security if he or she were to buy the security at its current market price, receive all promised or expected payments on the security, and sell the secu- rity at the end of his or her investment horizon.

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 61

sau19714_ch03_058-092.indd 61 07/19/17 04:27 PM

expected rate of return is the discount rate in the present value equation that just makes the present value of projected cash flows equal to its current market price ( P ‾ ) 3 That is:

P ‾ = C F 1 ________

[1 + E(r)] 1 +

C F 2 ________ [1 + E(r)] 2

+ C F 3 ________

[1 + E(r)] 3 + . . . +

C F n ________ [1 + E(r)] n

where

E (r)

Expected rate of return

C F t = Cash flow projected in period t (t = 1, . . . , n) n

Number of periods in the investment horizon

Once an expected rate of return, E(r), on a financial security is calculated, the market participant compares this expected rate of return to its required rate of return (r). If the expected rate of return is greater than the required rate of return, the projected cash flows on the security are greater than is required to compensate for the risk incurred from invest- ing in the security. Thus, the market participant would want to buy more of this security. If the expected rate of return is less than the required rate of return, the projected cash flows from the security are less than those required to compensate for the risk involved. Thus, the market participant would not want to invest in the security.4 We summarize these relation- ships in Table 3–2.

3. We are also assuming that any cash flows on the investment can be reinvested to earn the same expected rate of return.

4. Note also that by implication, if E(r) > r, then the market price of a security ( P ‾ ) is less than its fair present value (PV ) and vice versa if E(r) < r.

E(r) ≥ r or P ‾ ≤ PV The projected cash flows received on the security are greater than or equal to those required to compensate for the risk incurred from investing in the security. Thus, buy this security.

E(r) < r or P ‾ > PV The projected cash flows received on the security are less than is required to compensate for the risk incurred from investing in the security. Thus, do not buy this security.

TABLE 3–2 The Relation between Required Rate of Return and Expected Rate of Return

CALCULATOR HINTS N = 4 PMT = 100 FV = 960 PV = –925 CPT l = 11.607%

EXAMPLE 3–2 Application of Expected Rate of Return Refer to information in Example 3–1 describing a Walmart bond you purchased two years ago for $890. Using the current market price of $925, the expected rate of return on the bond over the next four years is calculated as follows:

925

100 ________

[1 + E(r)] 1 +

100 ________

[1 + E(r)] 2 +

100 ________

[1 + E(r)] 3 +

100 + 960 _________

[1 + E(r)] 4

⇒ Er

11.607%

Given that the required return on the bond is 11.25 percent, the projected cash flows on the bond are greater than is required to compensate you for the risk on the bond.

Required versus Expected Rates of Return: The Role of Efficient Markets

We have defined two ex ante (before the fact) measures of interest rates. The required rate of return is used to calculate a fair present value of a financial security, while the expected rate of return is a discount rate used in conjunction with the current market price of a

Final PDF to printer

62 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 62 07/19/17 04:27 PM

security. As long as financial markets are efficient (see below), the current market price of a security tends to equal its fair price present value. This is the case most of the time. However, when an event occurs that unexpectedly changes interest rates or a characteris- tic of a financial security (e.g., an unexpected dividend increase, an unexpected decrease in default risk), the current market price of a security can temporarily diverge from its fair present value. When investors determine a security is undervalued (i.e., its current market price is less than its fair present value), demand for the security increases, as does its price. Conversely, when investors determine a security is overvalued (i.e., its current market price is greater than its fair present value), they will sell the security, resulting in a price drop. The speed with which financial security prices adjust to unexpected news, so as to maintain equality with the fair present value of the security, is referred to as market efficiency. We examine the three forms of market efficiency (weak form, semistrong form, and strong form) in Chapter 8.

Realized Rate of Return

Required and expected rates of return are interest rate concepts pertaining to the returns expected or required just prior to the investment being made. Once made, however, the market participant is concerned with how well the financial security actually performs. The realized rate of return ( _ r ) on a financial security is the interest rate actually earned on an investment in a financial security. The realized rate of return is thus a historical interest rate of return—it is an ex post (after the fact) measure of the interest rate on the security.

To calculate a realized rate of return ( _ r ) , all cash flows actually paid or received are incorporated in time value of money equations to solve for the realized rate of return. By setting the price actually paid for the security ( P ‾ ) equal to the present value of the realized

cash flows (RCF1, RCF2, . . . , RCFn), the realized rate of return is the discount rate that just equates the purchase price to the present value of the realized cash flows. That is:

P ‾ = RC F 1 ______

(1 + _ r ) 1 +

RC F 2 ______ (1 + _ r ) 2

+ . . . + RC F n ______

(1 + _ r ) n

where

RC F t

= Realized cash flow in period t (t = 1, . . . , n)

_ r =

Realized rate of return on a security

If the realized rate of return ( _ r ) is greater than the required rate of return (r), the market participant actually earned more than was needed to be compensated for the ex ante or expected risk of investing in the security. If the realized rate of return is less than the required rate of return, the market participant actually earned less than the interest rate required to compensate for the risk involved.

market efficiency The process by which financial security prices move to a new equilibrium when interest rates or a security-specific character- istic changes.

realized rate of return The actual interest rate earned on an investment in a financial security.

D O YO U U N D E R S TA N D :

1. The difference between a required rate of return and an expected rate of return?

2. The difference between the coupon rate on a bond and the realized rate of return on a bond?

CALCULATOR HINTS N = 2 PMT = 100 FV = 925 PV = –890 CPT l = 13.08%

EXAMPLE 3–3 Application of Realized Rate of Return Consider again the Walmart bond investment described in Examples 3–1 and 3–2. Using your original purchase price, $890, and the current market price on this bond, the real- ized rate of return you have earned on this bond over the last two years is calculated as follows:

890

100 ______

(1 + _ r ) 1 +

100 + 925 ________

(1 + _ r ) 2

⇒ _ r

13.08%

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 63

sau19714_ch03_058-092.indd 63 07/19/17 04:27 PM

The valuation of a bond instrument employs time value of money concepts. The fair value of a bond reflects the present value of all cash flows promised or projected to be received on that bond discounted at the required rate of return (rb). Similarly, the expected rate of return, E(rb), is the interest rate that equates the current market price of the bond with the present value of all promised cash flows received over the life of the bond. Finally, a real- ized rate of return (

_ r b ) on a bond is the actual return earned on a bond investment that has

already taken place. Promised cash flows on bonds come from two sources: (1) interest or coupon payments paid over the life of the bond and (2) a lump sum payment (face or par value) when a bond matures.

Bond Valuation Formula Used to Calculate Fair Present Values

Most bonds pay a stated coupon rate of interest to the holders of the bonds. These bonds are called coupon bonds. The interest, or coupon, payments per year, INT, are generally constant (fixed) over the life of the bond.5 Thus, the fixed interest payment is essentially an annuity paid to the bond holder periodically (normally semiannually) over the life of the bond. Bonds that do not pay coupon interest are called zero-coupon bonds. For these bonds, INT is zero. In addition to coupon payments, the face or par value of the bond, M, is a lump sum payment received by the bond holder when the bond matures. Face value is generally set at $1,000 in the U.S. bond market. When new bonds are issued, the coupon rate on the new bonds is typically set at the current required rate of return. As discussed below, this results in the original sale of the bond occurring at the par value.

Using time value of money formulas, and assuming that the bond issuer makes its promised semiannual coupon and principal payments, the present value of a bond, Vb, can be written as:6

V b

INT / 2

________ (1 + r b / 2) 1

+ INT / 2

________ (1 + r b / 2) 2

+ . . . + INT / 2

_________ (1 + r b / 2) 2T

+ M _________

(1 + r b / 2) 2T

INT

____ 2 ∑

t = 1

2T (

1 _______

1 + r b / 2 )

+ M _________

(1 + r b / 2) 2T

INT

____ (2)

⎡

⎢ ⎣ 1 −

1 __________

( 1 + r b / 2 ) 2T _____________

r b / 2

⎤

⎥ ⎦ + M [ 1 _________

(1 + r b / 2) 2T ]

where

V b

Present value of the bond

Par or face value of the bond

INT = Annual interest ( or coupon ) payment on the bond; equals the par value of the bond times the (percentage) coupon rate

Number of years until the bond matures

r b

Annual interest rate used to discount cash flows on the bond

LG 3-2

coupon bonds Bonds that pay interest based on a stated coupon rate. The interest, or cou- pon, payments per year are generally constant over the life of the bond.

5. Variable rate bonds pay interest that is indexed to some broad interest rate measure (such as Treasury bill rates) and thus experience variable coupon payments. Income bonds pay interest only if the issuer has sufficient earnings to make the promised payments. Index (or purchasing power) bonds pay interest based on an inflation index. Each of these types of bonds, therefore, can have variable interest payments.

zero-coupon bonds Bonds that do not pay interest.

6. More generally, for bonds that pay interest other than semiannually:

V b = INT

____ m

⎡

⎢ ⎣ 1 −

1 ___________

(1 + r b / m) mT ______________

r b / m

⎤

⎥ ⎦ + M [ 1 ___________ (1 + r b / m) mT ] where m = Number of times per year interest is paid.

BOND VALUATION

Final PDF to printer

64 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 64 07/19/17 04:27 PM

In the preceding example, when the required rate of return (rb) on the bond is 8 percent, the present value of the bond, $1,152.47, is greater than its face value of $1,000. When the bond’s coupon rate is greater than the required rate of return (10 percent versus 8 percent in our example), the bond should sell at a premium. To achieve the required rate of return, the bond holder takes a loss on the difference between the purchase price of the bond and the face value received at maturity. When the bond’s required rate of return is 12 percent, its present value is less than its face value and the bond should sell at a discount. This occurs because the coupon rate on the bond is below the required rate of return. To achieve the required rate of return, the bond holder experiences a gain on the difference between the purchase price of the bond and the face value received at maturity. Finally, when the bond’s required rate of return is 10 percent, its present value is equal to its face value and the bond should sell at par. This occurs because the coupon rate on the bond is equal to the required rate of return on the bond. To achieve the required rate of return on the bond, the bond holder experiences neither a gain nor a loss on the difference between the pur- chase price of the bond and the face value received at maturity. We summarize the sce- narios for premium, discount,7 and par bonds in Table 3–3.

bond Long-term debt obligation issued by corporations and government units.

premium bond A bond in which the pres- ent value of the bond is greater than its face value.

discount bond A bond in which the pres- ent value of the bond is less than its face value.

par bond A bond in which the pres- ent value of the bond is equal to its face value. 7. The term discount bond is also used to denote a zero-coupon bond.

CALCULATOR HINTS N = 12(2) = 24 I = 4.00 PMT = 50 FV = 1,000 CPT PV = –1,152.47

EXAMPLE 3–4 Calculation of the Fair Value of a Coupon Bond You are considering the purchase of a $1,000 face value bond issued by ExxonMobil. The bond pays 10 percent coupon interest per year, with the coupon paid semiannually (i.e., $50 [= 1,000(0.10)/2] over the first half of the year and $50 over the second half of the year). The bond matures in 12 years (i.e., the bond pays interest (12 × 2 =) 24 times before it matures). If the required rate of return (rb) on this bond is 8 percent (i.e., the periodic discount rate is (8%/2 = 4 percent), the market value of the bond is calculated as follows:

V b = 1,000 (0.10)

__________ 2

⎡

⎢ ⎣ 1 −

1 _______________

[1 + (0.08 / 2) ] 2 (12) __________________

0.08 / 2

⎤

⎥ ⎦ + 1,000 / [1 + (0.08 / 2) ] 2 (12)

50 (15.24696) + 1,000 (0.39012) = $1,152.47

or an investor would be willing to pay no more than $1,152.47 for this bond. If the required rate of return on this bond is 10 percent, the market value of the bond

is calculated as follows:

V b = 1,000 (0.10)

__________ 2

⎡

⎢ ⎣ 1 −

1 _______________

[1 + (0.10 / 2) ] 2 (12) __________________

0.10 / 2

⎤

⎥ ⎦ + 1,000 / [1 + ( 0.10 / 2 ) ] 2 (12)

50 (13.79864) + 1,000 (0.31007) = $1,000.00

or an investor would be willing to pay no more than $1,000.00 for this bond. If the required rate of return on this bond is 12 percent, the market value of the bond

is calculated as follows:

V b = 1,000 (0.10)

__________ 2

⎡

⎢ ⎣ 1 −

1 _______________

[1 + ( 0.12 / 2 ) ] 2 (12) __________________

0.12 / 2

⎤

⎥ ⎦ + 1,000 / [1 + ( 0.12 / 2 ) ] 2 (12)

50 (12.55036) + 1,000 (0.24698) = $874.50

or an investor would be willing to pay no more than $874.50 for this bond.

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 65

sau19714_ch03_058-092.indd 65 07/19/17 04:27 PM

The designation as a premium, discount, or par bond does not help in the decision to buy or sell a bond. These terms are simply descriptive designations regarding the relation- ship between the present value of the bond and its face value. Rather, investors make the decision to buy or sell by comparing the bond’s present value to its current market price. As we noted above, the present value of the bond will equal the bond’s price only in an efficient market where prices instantaneously adjust to new information about the secu- rity’s value.

Bond issuers usually set a bond’s coupon rate close to the required rate of return at the time of issuance, which forces new bonds to sell close to par. As time goes by, a bond’s required rate of return may change due to the arrival of new information (e.g., changes in future expected inflation or the issuer’s credit risk). As a result, a bond may become a premium or a discount bond, and its price may oscillate above and below par throughout the bond’s life.

Bond Valuation Formula Used to Calculate Yield to Maturity

The present value formulas can also be used to find the expected rate of return, E(rb), or, assuming all promised coupon and principal payments are made as promised, what is often called the yield to maturity (ytm) on a bond (i.e., the return the bond holder will earn on the bond if he or she buys the bond at its current market price, receives all coupon and principal payments as promised, and holds the bond until maturity). The yield to maturity calculation implicitly assumes that all coupon payments periodically received by the bond holder can be reinvested at the same rate—that is, reinvested at the calculated yield to maturity.8

Rewriting the bond valuation formula, where Vb is the current market price that has to be paid to buy the bond, we can solve for the yield to maturity (ytm) on a bond as follows— where we write ytm instead of E(rb):

V b

INT / 2 __________

(1 + ytm / 2) 1 +

INT / 2 __________

(1 + ytm / 2) 2 + . . . +

INT / 2 ___________

(1 + ytm / 2) 2T +

M ___________

(1 + ytm / 2) 2T

INT

____ 2

⎡

⎢ ⎣ 1 −

1 ___________

(1 + ytm / 2) 2T _______________

ytm / 2

⎤

⎥ ⎦ + M [1 + (ytm / 2) ] 2T

yield to maturity The return or yield the bond holder will earn on the bond if he or she buys it at its current market price, receives all coupon and principal payments as promised, and holds the bond until maturity.

8. As discussed in Appendix 3A to this chapter (available through Connect or your course instructor), if coupon payments are reinvested at less (more) than this rate, the yield to maturity will be lower (higher) than that calculated in this section. This concept will be key to understanding interest rate risk discussed later in the text (Chapters 22 and 23).

TABLE 3–3 Description of a Premium, Discount, and Par Bond

Premium bond—when the coupon rate on a bond is greater than the required rate of return on the bond, the fair present value is greater than the face value of the bond.

When the coupon rate on a bond is greater than the yield to maturity on the bond, the current market price is greater than the face value of the bond.

Discount bond—when the coupon rate on a bond is less than the required rate of return on the bond, the fair present value is less than the face value of the bond.

When the coupon rate on a bond is less than the yield to maturity on the bond, the current market price is less than the face value of the bond.

Par bond—when the coupon rate on a bond is equal to the required rate of return on the bond, the fair present value is equal to the face value of the bond.

When the coupon rate on a bond is equal to the yield to maturity on the bond, the current market price is equal to the face value of the bond.

Final PDF to printer

66 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 66 07/19/17 04:27 PM

EQUITY VALUATION The valuation process for an equity instrument (such as preferred or common stock) involves finding the present value of an infinite series of cash flows on the equity discounted at an appropriate interest rate. Cash flows from holding equity come from dividends paid out by the firm over the life of the stock, which in expectation can be viewed as infinite since a firm (and thus the dividends it pays) has no defined maturity or life. Even if an equity holder decides not to hold the

stock forever, he or she can sell it to someone else who in a fair and efficient market is willing to pay the present value of the remaining (expected) dividends to the seller at the time of sale. Dividends on equity are that portion of a firm’s earnings paid out to the stock- holders. Those earnings retained are normally reinvested to produce future income and future dividends for the firm and its stockholders. Thus, conceptually, the fair price paid for investing in stocks is the present value of its current and future dividends.10 Growth in dividends occurs primarily because of growth in the firm’s earnings, which is, in turn, a function of the profitability of the firm’s investments and the percentage of these profits paid out as dividends rather than being reinvested in the firm. Thus, earnings growth, divi- dend growth, and stock value (price) will generally be highly correlated.

We begin by defining the variables we use to value an equity:

Di v t

Dividend paid to stockholders at the end of the year t

P t

= Price of a firm’s common stock at the end of the year t

P 0 = Current price of a firm’s common stock

r s

Interest rate used to discount cash flows on an investment in a stock

As described above, time value of money equations can be used to evaluate a stock from several different perspectives. For example, the realized rate of return (

_ r s ) is the

appropriate interest rate (discount rate) to apply to cash flows when evaluating the histori- cal performance of an equity.

LG 3-3

9. The yield to maturity is the nominal return on the bond. Its effective annual return is calculated as:

EAR = (1 + ytm / 2) 2 − 1 = (1 + 0.12 / 2) 2 − 1 = 12.36%

10. For firms that pay no dividends can be valued using a firm’s free cash flows (FCF) (cash flows available for distribu- tion to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations) discounted at the weighted average cost of capital. Such that the value of the firm is equal to:

V = ∑ t = 1

∞

FCF t ___________

(1 + WACC) t =

FC F t + 1 _________ WACC − g

The fair price of each share of stock would then be equal to V/number of shares of common stock outstanding.

CALCULATOR HINTS N = 15(2) = 30 PV = –931.176 PMT = 110/2 = 55 FV = 1000 CPT l = 6.0 @ MONTHS 6.0 × = 12.0 @ YEAR

EXAMPLE 3–5 Calculation of the Yield to Maturity on a Coupon Bond You are considering the purchase of a $1,000 face value bond that pays 11 percent coupon interest per year, paid semiannually (i.e., $55 [= $1,000(0.11)/2] per semiannual period). The bond matures in 15 years and has a face value of $1,000. If the current market price of the bond is $931.176, the yield to maturity, or E(rb) is calculated as follows:

931.176 = 1,000 (0.11)

__________ 2

⎡

⎢ ⎣ 1 −

1 _____________

(1 + ytm / 2) 2 (15) ________________

ytm / 2

⎤

⎥ ⎦ + 1,000 / (1 + ytm / 2)

2 (15)

Solving for ytm, the yield to maturity (or expected rate of return) on the bond is 12 percent.9 Equivalently, you would be willing to buy the bond only if the required rate of return (r) was no more than 12 percent (i.e., the yield to maturity is greater than or equal to the required return on the bond).

D O YO U U N D E R S TA N D :

3. The difference between a zero-coupon bond and a coupon bond?

4. What the differences are among a discount bond, a premium bond, and a par bond?

5. How the difference between the yield to maturity on a bond and the coupon rate on the bond will cause the bond to sell at a premium or a discount?

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 67

sau19714_ch03_058-092.indd 67 07/19/17 04:27 PM

The expected rate of return, E(rs), is the appropriate interest rate when analyzing the expected future return on stocks, assuming the investor buys the stock at its current market price, receives all promised payments, and sells the stock at the end of his or her invest- ment horizon.

CALCULATOR HINTS N = 2 PV = –25 PMT = 1 FV = 35 CPT l = 22.02%

EXAMPLE 3–6 Calculation of Realized Rate of Return on a Stock Investment

Suppose you owned stock in General Monsanto for the last two years. You originally bought the stock two years ago for $25 (P−2) and just sold it for $35 (P0). The stock paid an annual dividend of $1(Div) on the last day of each of the past two years. Your realized rate of return on the General Monsanto stock investment can be calculated using the following time value of money equation:

P −2

Div

⎡

⎢ ⎣ 1 −

1 _______

(1 + _ r s ) 2 ___________

_ r s

⎤

⎥ ⎦ + P 0 / (1 + _ r s ) 2

⎡

⎢ ⎣ 1 −

1 _______

(1 + _ r s ) 2 ___________

_ r s

⎤

⎥ ⎦ + 35 / (1 + _ r s ) 2

Solving for _ r s your annual realized rate of return on this investment was 22.02 percent.

25 = 1 (1.4912) + 35 (0.6716)

CALCULATOR HINTS N = 3 PV = −32 PMT = 1.50 FV = 45 CPT l = 16.25%

EXAMPLE 3–7 Calculation of Expected Rate of Return on a Stock Investment

You are considering the purchase of stock in Hewlett-Packard (HP). You expect to own the stock for the next three years. The current market price of the stock is $32 (P0) and you expect to sell it for $45 in three years’ time (P3). You also expect the stock to pay an annual dividend (Div) of $1.50 on the last day of each of the next three years. Your expected return on the HP stock investment can be calculated using the following time value of money equation:

P 0

Div

⎡

⎢ ⎣ 1 −

1 _________

[1 + E( r s )] 3 ______________

E( r s )

⎤

⎥ ⎦ + P 3 / [1 + E ( r s ) ] 3

1.50

⎡

⎢ ⎣ 1 −

1 __________

[ 1 + E ( r s ) ] 3 _____________

E ( r s )

⎤

⎥ ⎦ + 45 / [1 + E( r s )] 3

Solving for E(rs), your annual expected rate of return on this investment is 16.25 percent.

Finally, the required rate of return (rs) is the appropriate interest rate when analyzing the fair value of a stock investment over its whole lifetime. The fair value of a stock reflects the present value of all relevant (but uncertain) cash flows to be received by an investor

Final PDF to printer

68 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 68 07/19/17 04:27 PM

discounted at the required rate of return (rs)—the interest rate or return that should be earned on the investment given its risk.

Present value methodology applies time value of money to evaluate a stock’s cash flows over its life as follows:

P 0 = Di v 1 ______

(1 + r s ) 1 +

Di v 2 ______ (1 + r s ) 2

+ . . . + Di v ∞ ________

(1 + r s ) ∞

The price or value of a stock is equal to the present value of its future dividends (Divt), whose values are uncertain. This requires an infinite number of future dividend values to be estimated, which makes the equation above difficult to use for stock valuation and rs cal- culation in practice. Accordingly, assumptions are normally made regarding the expected pattern of the uncertain flow of dividends over the life of the stock. Three assumptions that are commonly used are (1) zero growth in dividends over the (infinite) life of the stock, (2) a constant growth rate in dividends over the (infinite) life of the stock, and (3) noncon- stant growth in dividends over the (infinite) life of the stock.

Zero Growth in Dividends

Zero growth in dividends means that dividends on a stock are expected to remain at a con- stant level forever. Thus, Div0 = Div1 = Div2 = . . . = Div ∞ = Div. Accordingly, the equity valuation formula can be written as follows:

P 0 = Di v 1 ______

(1 + r s ) 1 +

Di v 2 ______ (1 + r s ) 2

+ . . . + Di v ∞ ________

(1 + r s ) ∞ = Div ∑

t = 1

∞ (

1 _____

1 + r s )

where

Di v 0

= Current ( time 0 ) value of dividends

Di v t

= Value of dividends at time t = 1, 2, . . . , ∞

or11

P0 = Div / r s

This formula can be generalized as follows:

Pt = Div / r s

Companies that issue preferred stock usually pay investors dividends that exhibit zero growth through time. The value of a stock with zero growth in dividends is equal to the (current) dividend divided by the return on the stock. If the required rate of return (rs) is applied to the formula, the price we solve for is the fair market price. If the expected return E(rs) is applied to the formula, the price we solve for is the current market price. Furthermore, the formula can be rearranged to determine a return on the stock if it were purchased at a price, P0.

r s = Div / P 0

If the fair present value is applied to this formula, the return we solve for is the required rate of return (rs). If the current market price is applied to the formula, the price we solve for is the expected return E(rs). Recall from above, in efficient markets the required rate of return equals the expected rate of return. Thus, the current market price on a security equals its fair present value.

11. Remember that, in the limit:

∑ t = 1

∞

( 1 _____

1 + x )

= ( 1 _____

1 + x )

1 + (

1 _____

1 + x )

2 + . . . + (

1 _____

1 + x )

∞

= 1 __

Thus:

∑ t = 1

∞

( 1 _____

1 + x r s )

= 1 __

r s

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 69

sau19714_ch03_058-092.indd 69 07/19/17 04:27 PM

Constant Growth in Dividends

Constant growth in dividends means that dividends on a stock are expected to grow at a constant rate, g, each year into the future. Thus, Div1 = Div0(1 + g)1, Div2 = Div0(1 + g)2, . . . , Div∞ = Div0(1 + g)∞. Accordingly, the equity valuation formula can now be written as follows:

P 0 = Di v 0 (1 + g) 1 __________

(1 + r s ) 1 +

Di v 0 (1 + g) 2 __________ (1 + r s ) 2

+ . . . + Di v 0 (1 + g) ∞ ___________

(1 + r s ) ∞ = Di v 0 ∑

t = 1

∞ [

(1 + g) _______ (1 + r s )

] t

or12

P 0 = Di v 0 (1 + g) 1 __________

r s − g =

Di v 1 ____ r s − g

This formula can be generalized as follows:

P t = Di v 0 (1 + g) t __________

r s − g =

Di v t + 1 ______ r s − g

If the required rate of return (rs) is applied to the formula, the price we solve for is the fair present value. If the expected return, E(rs), is applied to the formula, the price we solve for is the current market price. The equity valuation formula can also be rearranged to deter- mine a rate of return on the stock if it were purchased at a price P0:

r s = Di v 0 (1 + g) _________

P 0 + g =

Di v 1 ____ P 0

+ g

If the fair present value is applied to the formula, the return we solve for is the required rate of return (rs). If the current market price is applied to the formula, the price we solve for is the expected return E(rs).

12. Remember that in the limit:

∑ t = 1

∞

( 1 + g

_____ 1 + r s

) t

= ∑ t = 1

∞

( 1 _______

1 + r s − g ___ 1 + g )

= 1 + g

_____ r s − g

EXAMPLE 3–8 Calculation of Stock Price with Zero Growth in Dividends

A preferred stock you are evaluating is expected to pay a constant dividend of $5 per year each year into the future. The required rate of return, rs, on the stock is 12 percent. The fair value (or price) of this stock is calculated as follows:

P 0 = 5/0.12 = $41.67

EXAMPLE 3–9 Calculation of Stock Price with Constant Growth in Dividends

You are evaluating J.P. Morgan Chase (JPM) stock. The stock paid a dividend at the end of last year of $3.50. Dividends have grown at a constant rate of 2 percent per year over the last 20 years, and this constant growth rate is expected to continue into the future. The

Final PDF to printer

70 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 70 07/19/17 04:27 PM

EXAMPLE 3–10 Calculation of the Expected Rate of Return, E(rs), on a Stock with Constant Growth in Dividends

You are evaluating Bank of America (BOA) stock. The stock paid a dividend at the end of last year of $4.80. Dividends have grown at a constant rate of 1.75 percent per year over the last 15 years, and this constant growth rate is expected to continue into the future. The stock is currently selling at a price of $52 per share. The expected rate of return on BOA stock is calculated as follows:

E ( r s ) = 4.80 (1 + 0.0175)

_____________ 52

+ 0.0175 = 11.14%

Supernormal (or Nonconstant) Growth in Dividends

Firms often experience periods of supernormal or nonconstant dividend growth, after which dividend growth settles at some constant rate. The stock value for a firm experienc- ing supernormal growth in dividends is, like firms with zero or constant dividend growth, equal to the present value of the firm’s expected future dividends. However, in this case, dividends during the period of supernormal (nonconstant) growth must be evaluated indi- vidually. The constant growth in dividends model can then be adapted to find the present value of dividends following the supernormal growth period.

To find the present value of a stock experiencing supernormal or nonconstant divi- dend growth, we calculate the present value of dividends during the two different growth periods. A three-step process is used as follows:

Step 1: Find the present value of the dividends during the period of supernormal (non- constant) growth.

Step 2: Find the price of the stock at the end of the supernormal (nonconstant) growth period (when constant growth in dividends begins) using the constant growth in dividends model. Then discount this price to a present value.

Step 3: Add the two components of the stock price together.

EXAMPLE 3–11 Calculation of Stock Price with Supernormal or Nonconstant Growth in Dividends

You are evaluating Home Depot (HD) stock. The stock is expected to experience supernor- mal growth in dividends of 10 percent, gs, over the next five years. Following this period, dividends are expected to grow at a constant rate of 4 percent, g. The stock paid a dividend of $4 last year, and the required rate of return on the stock is 15 percent. The fair present value of HD stock is calculated as follows:

Step 1: Find the present value of the dividends during the period of supernormal growth.

required rate of return (rs) on the stock is 10 percent. The fair present value (or price) of JPM stock is calculated as follows:

P 0 = 3.50 (1 + 0.02)

___________ 0.10 − 0.02

= $44.625

As an investor, you would be willing to pay no more than $44.625 for this stock.

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 71

sau19714_ch03_058-092.indd 71 07/19/17 04:27 PM

TABLE 3–4 Summary of Factors That Affect Security Prices and Price Volatility when Interest Rates Change

Interest rate—there is a negative relation between interest rate changes and present value (or price) changes on financial securities.

As interest rates increase, security prices decrease at a decreasing rate. Time remaining to maturity—the shorter the time to maturity for a security, the closer the price

is to the face value of the security. The longer the time to maturity for a security, the larger the price change of the security for a

given interest rate change. The maturity effect described above increases at a decreasing rate. Coupon rate—the higher a security’s coupon rate, the smaller the price change on the security

for a given change in interest rates.

Step 2: Find the present value of dividends after the period of supernormal growth. a. Find stock value at beginning of constant growth period:

P 5 = Di v 6 ____ r s − g

= Di v 0 (1 + g s ) 5 (1 + g) 1 ________________

r s − g =

4 (1 + 0.1) 5 (1 + 0.04) 1 _________________

0.15 − 0.04 = $60.906

b. Find present value of constant growth dividends:

P 0 = P 5 / (1 + 0.15) 5 = 60.906 (0.4972) = $30.283

Step 3: Find present value of the HD stock = Value during supernormal growth period + Value during normal growth period:

$17.537 + $30.283 = $47.820

D O YO U U N D E R S TA N D :

6. How stock valuation differs from bond valuation?

7. The difference between constant growth in dividends and supernormal growth in dividends?

As already discussed in this chapter and in Chapter 2, the variability of financial security prices depends on interest rates and the characteristics of the security. Specifically, factors that affect financial security prices include interest rate changes, the time remaining to maturity, and the cash flows received prior to and at maturity. We evaluate next the impact of each of these factors as they affect bond prices. In the discussion, the interest rate used in the pricing formula is the required rate of return on a bond, and thus the price we refer to is the fair value of the bond. However, all relations apply equally if the interest rate used in the pricing formula is the expected rate of return on a bond and thus the price is the current market price of the bond. The impact on equity prices is similar. Table 3–4 summarizes the major relationships we will be discussing.

Refer back to Example 3–4. Notice in this example that the present values of the cash flows on bonds decreased as interest rates increased. Specifically, when the required rate of return increased from 8 percent to 10 percent, the fair present value of the bond fell from $1,152.47 to $1,000, or by 13.23 percent [i.e., (1,000 − 1,152.47)/1,152.47 = 0.1323 = 13.23%]. Similarly, when the required rate of return increased from 10 percent to 12 percent,

LG 3-4

IMPACT OF INTEREST RATE CHANGES ON SECURITY VALUES

Year Dividends [Div0 (1 + gs)t ] 1/(1 + 0.15)t Present Value

1 4(1 + 0.1)1 = 4.400 0.8696 3.826 2 4(1 + 0.1)2 = 4.840 0.7561 3.659 3 4(1 + 0.1)3 = 5.324 0.6575 3.500 4 4(1 + 0.1)4 = 5.856 0.5718 3.349 5 4(1 + 0.1)5 = 6.442 0.4972 3.203

Present value of dividends during supernormal growth period $17.537

Final PDF to printer

72 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 72 07/19/17 04:27 PM

the fair present value of the bond fell from $1,000 to $874.50, or by 12.55 percent [(874.50 − 1,000)/1,000]. This is the inverse relationship between present values and inter- est rates we discussed in Chapter 2. While the examples refer to the relation between fair values and required rates of return, the inverse relation also exists between current market prices and expected rates of return—as yields on bonds increase, the current market prices of bonds decrease. We illustrate this inverse relation between interest rates on bonds and the present value of bonds in Figure 3–1.

Notice too from the earlier example that the inverse relationship between bond prices and the required rate of return is not linear. Rather, the percentage change in the present value of a bond to a given change in the required rate of return is smaller when interest rates are higher. When the required rate of return on the bond increased from 8 percent to 10 percent (a 2 percent increase), the fair present value on the bond decreased by 13.23 percent. However, another 2 percent increase in the required rate of return (from 10 percent to 12 percent) resulted in a fair present value decrease of only 12.55 percent. The same nonlinear relationship exists for current market prices and yields to maturity. Thus, as interest rates increase, present values of bonds (and bond prices) decrease at a decreasing rate. This is illustrated in Figure 3–1.

The relationship between interest rates and security values is important for all types of investors. Financial institutions (FIs) such as commercial banks, thrifts, and insurance companies are affected because the vast majority of the assets and liabilities held by these firms are financial securities (e.g., loans, deposits, invest- ment securities). When required rates of return rise (fall) on these securities, the fair present values of the FI’s asset and liability portfolios decrease (increase) by possibly different amounts, which in turn affects the fair present value of the FI’s equity (the difference between the fair present value of an FI’s assets and liabili- ties). We examine the measurement and management of an FI’s interest rate risk in more detail in Chapter 22.

In the next two sections we look at how the maturity of, and coupon rate on, a security affects the size of the value changes for a given change in interest rates.

Figure 3–1 Relation between Interest Rates and Bond Values

Bond Value

Interest Rate

874.50 1,000 1,152.47

12%

10%

D O YO U U N D E R S TA N D :

8. What happens to the fair present value of a bond when the required rate of return on the bond increases?

9. What happens to the fair present value of a bond when the required rate of return on the bond decreases?

IMPACT OF MATURITY ON SECURITY VALUES A bond’s price sensitivity is measured by the percentage change in its present value for a given change in interest rates. If interest rate changes are measured using required rates of return, fair present value is the price sensitivity being measured. If interest rate changes are measured using expected rates of return, current market price is the price sensitivity being measured. The larger the percentage change in the bond’s value for a given interest

LG 3-5

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 73

sau19714_ch03_058-092.indd 73 07/19/17 04:27 PM

rate change, the larger the bond’s price sensitivity. An important factor that affects the degree to which the price of a bond changes (or the price sensitivity of a bond changes) as interest rates change is the time remaining to maturity on the bond. Specifically, as is explained below, the shorter the time remaining to maturity, the closer a bond’s price is to its face value. Also, the further a bond is from maturity, the more sensitive the price of the bond as interest rates change. Finally, the relationship between bond price sensitivity and maturity is not linear. As the time remaining to maturity on a bond increases, price sensi- tivity increases but at a decreasing rate. Table 3–5 presents the bond information we will be using to illustrate these relationships. In Table 3–5, we first list the fair present values of the bonds analyzed in Example 3–4. We then repeat the present value calculations using three bonds with identical characteristics except for the time to maturity: 12 years versus 14 years versus 16 years.

Maturity and Security Prices

Table 3–5 lists the present values of 10 percent (compounded semiannually) coupon bonds with a $1,000 face value and 12 years, 14 years, and 16 years, respectively, remaining to maturity. We calculate the fair present value of these bonds using an 8 percent, 10 percent, and 12 percent required rate of return. Notice that for each of these bonds, the closer the bond is to maturity, the closer the fair present value of the bond is to the $1,000 face value. This is true regardless of whether the bond is a premium, discount, or par bond. For example, at an 8 percent required rate of return, the 12-year, 14-year, and 16-year bonds have present values of $1,152.47, $1,166.63, and $1,178.74, respectively. The intuition behind this is that nobody would pay much more than the face value of the bond and any remaining (in this case semiannual) coupon payments just prior to maturity since these are the only cash flows left to be paid on the bond. Thus, the time value effect is reduced as the maturity of the bond approaches. Many people call this effect the pull to par—bond prices and fair values approach their par values (e.g., $1,000) as time to maturity declines towards zero.

Maturity and Security Price Sensitivity to Changes in Interest Rates

The Percentage Price Change columns in Table 3–5 provide data to examine the effect time to maturity has on bond price sensitivity to interest rate changes. From these data we see that the longer the time remaining to maturity on a bond, the more sensitive are bond prices to a given change in interest rates. (Note again that all bonds in Table 3–5 have a 10 percent coupon rate and a $1,000 face value.) For example, the fair present value of the 12-year bond falls 13.23 percent [i.e., ($1,000 − $1,152.47)/$1,152.47 = −0.1323 = −13.23%] as the required rate of return increases from 8 percent to 10 percent. The same 2 percent increase (from 8 percent to 10 percent) in the required rate of return produces

price sensitivity The percentage change in a bond’s present value for a given change in interest rates.

TABLE 3–5 The Impact of Time to Maturity on the Relation between a Bond’s Fair Present Value and Its Required Rate of Return

12 Years to Maturity 14 Years to Maturity 16 Years to Maturity

Required Rate of Return

Fair Price*

Price Change

Percentage Price

Change Fair

Price* Price

Change

Percentage Price

Change Fair

Price* Price

Change

Percentage Price

Change

8% $1,152.47 $1,166.63 $1,178.74 −$152.47 −13.23% −$166.63 −14.28% −$178.74 −15.16%

10% 1,000.00 1,000.00 1,000.00 − 125.50 −12.55 −134.06 −13.41 −140.84 −14.08

12% 874.50 865.94 859.16

*The bond pays interest semiannually, and has a face value of $1,000.

Final PDF to printer

74 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 74 07/19/17 04:27 PM

a larger 14.28 percent drop in the fair present value of the 14-year bond, and the 16-year bond’s fair present value drops 15.16 percent. This same trend is demonstrated when the required rate of return increases from 10 percent to 12 percent—the longer the bond’s maturity, the greater the percentage decrease in the bond’s fair present value.

The same relationship occurs when analyzing expected rates of return (or yields to maturity) and the current market price of the bond—the longer the time to maturity on a bond, the larger the change in the current market price of a bond for a given change in yield to maturity.

Incremental Changes in Maturity and Security Price Sensitivity to Changes in Interest Rates. A final relationship we can examine from Table 3–5 is that between incremental changes in time remaining to maturity and incremental changes in security price sensitivity to a given change in interest rates. Specifically, notice that the maturity effect described above is not linear. For example, a 2 percent increase in the required rate of return (from 8 percent to 10 percent) on the 12-year bond produces a 13.23 percent [i.e., ($1,000 − $1,152.47)/$1,152.47 = −0.1323 = −13.23%] decrease in the bond’s fair present value. The same 2 percent increase (from 8 percent to 10 percent) in the required rate of return on the 14-year bond pro- duces a 14.28 percent decrease in the fair present value. The difference, as we move from a 12-year to a 14-year maturity, is 1.05 percent (14.28% − 13.23%). Increas-

ing the time to maturity two more years (from 14 years to 16 years) produces an increase in price sensitivity of 0.88 percent [−14.28% − (−15.16%)]. While price sensitivity for a given increase in interest rates increases with maturity, the increase is nonlinear (decreasing) in maturity. We illustrate this relationship in Figure 3–2, as the required rate of return increases from 8 percent to 10 percent.

D O YO U U N D E R S TA N D :

10. What happens to a bond’s price as it approaches maturity?

11. What happens to a bond’s price sensitivity for a given change in interest rates as its time to maturity increases? decreases?

Figure 3–2 The Impact of a Bond’s Maturity on Its Price Sensitivity

Time to Maturity

Absolute Value of Percentage Change in a Bond' s Price

for a Given Change in Interest Rates

12 14 16

13.23%

14.28%

15.16%

IMPACT OF COUPON RATES ON SECURITY VALUES Another factor that affects the degree to which the price sensitivity of a bond changes as interest rates change is the bond’s coupon rate. Specifically, the higher the bond’s coupon rate, the higher its present value at any given interest rate. Also, the higher the bond’s coupon rate, the smaller the price changes on the bond for a given change in interest rates.

LG 3-5

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 75

sau19714_ch03_058-092.indd 75 07/19/17 04:27 PM

These relationships hold when evaluating either required rates of return and the resulting fair present value of the bond or expected rates of return and the current market price of the bond. To understand these relationships better, consider again the bonds in Example 3–4. Table 3–6 summarizes the bond values and value changes as interest rates change.

Coupon Rate and Security Price

In Table 3–6, we first list the fair present values of the bonds analyzed in Example 3–4. We then repeat the present value calculations using a bond with identical characteristics except for the coupon rate: 10 percent versus 12 percent. Notice that the fair present value of the 10 percent coupon bond is lower than that of the 12 percent coupon bond at every required rate of return. For example, when the required rate of return is 8 percent, the fair value of the 10 percent coupon bond is $1,152.47 and that of the 12 percent coupon bond is $1,304.94.

Coupon Rate and Security Price Sensitivity to Changes in Interest Rates

Table 3–6 also demonstrates the effect a bond’s coupon rate has on its price sensitivity to a given change in the required rate of return. The intuition behind this relation is as fol- lows. The higher (lower) the coupon rate on the bond, the larger (smaller) is the portion of the required rate of return paid to the bond holder in the form of coupon payments. Any security that returns a greater (smaller) proportion of an investment sooner is more (less) valuable and less (more) price volatile.

To see this, notice in Table 3–6 that the higher the bond’s coupon rate, the smaller the bond’s price sensitivity for any given change in interest rates. For example, for the 10 percent coupon bond, a 2 percent increase in the required rate of return (from 8 percent to 10 percent) results in a 13.23 percent decrease in the bond’s fair present value. A further 2 percent increase in the required rate of return (from 10 percent to 12 percent) results in a smaller 12.55 percent decrease in the fair present value.

For the 12 percent coupon bond, notice that the 2 percent increase in the required rate of return (from 8 percent to 10 percent) results in a 12.79 percent decrease in the bond’s

fair present value, while an increase in the required rate of return from 10 percent to 12 percent results in a lower 12.13 percent decrease in the bond’s fair pres- ent value. Thus, price sensitivity on a bond is negatively related to the level of the coupon rate on a bond. The higher the coupon rate on the bond, the smaller the decrease in the bond’s fair present value for a given increase in the required rate of return on the bond.

We illustrate this relationship in Figure 3–3. The high coupon-paying bond is less susceptible to interest rate changes than the low coupon-paying bond. This is represented in Figure 3–3 by the slope of the line representing the relation between interest rates and bond prices. The sensitivity of bond prices is smaller (the slope of the line is flatter) for high-coupon bonds than for low-coupon bonds.

LG 3-5

TABLE 3–6 The Impact of Coupon Rate on the Relation between a Bond’s Fair Present Value and Its Required Rate of Return

10 Percent Coupon Bond 12 Percent Coupon Bond

Required Rate of Return

Fair Price*

Price Change

Percentage Price Change

Fair Price*

Price Change

Percentage Price

Change

8% $1,152.47 $1,304.94 −$152.47 −13.23% −$166.95 −12.79%

10% 1,000.00 1,137.99 − 125.50 −12.55 − 137.99 −12.13

12% 874.50 1,000.00

*The bond pays interest semiannually, has 12 years remaining to maturity, and has a face value of $1,000.

D O YO U U N D E R S TA N D :

12. Whether a high or low coupon rate bond experiences a larger price change if interest rates increase?

13. Whether a high or low coupon rate bond experiences a larger price change if interest rates decrease?

Final PDF to printer

76 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 76 07/19/17 04:27 PM

The estimation of the effect of maturity and coupon rates on the sensitivity of bond prices to changes in interest rates, as discussed in the previous section, is complex and using these relationships as the basis for decision making is difficult in dealing with multiple bonds. Duration, on the other hand, provides a simple measure that allows for a straightforward calculation of a bond’s price sensitivity to changes in interest rates. In this section, we show that the price sensitivity of a bond, or the percentage change in the bond’s value, for a given change in interest rates (either required rate of return or yield to maturity) can be more directly measured by a concept called duration (or Macaulay’s duration). We also show that duration produces an accurate measure of the price sensi- tivity of a bond to interest rate changes for relatively small changes in interest rates. The duration measure is a less accurate measure of price sensitivity the larger the change in interest rates. Duration is the weighted-average time to maturity on a financial security using the relative present values of the cash flows as weights. On a time value of money basis, duration measures the weighted average of when cash flows are received on a security. In addition to being a measure of the average life of an asset or liability, dura- tion also has economic meaning as the sensitivity, or elasticity, of that asset or liability’s value to small interest rate changes (either required rate of return or yield to maturity). Duration describes the percentage price, or present value, change of a financial security for a given (small) change in interest rates. That is, rather than calculating present value changes resulting from interest rate changes, as we did in the previous sections, the duration of a financial security can be used to directly calculate the price change. Thus, for investors and financial managers duration is a tool that can be used to estimate the change in the value of a portfolio of securities or even firm value for a given change in interest rates.

In this section, we present the basic arithmetic needed to calculate the duration of an asset or liability. Then we analyze the economic meaning of the number we calculate for duration and explain why duration, as a measure of price sensitivity to changes in interest rates, is most accurate only for small changes in interest rates. Appendix 3A to this chapter (available through Connect or your course instructor) looks at how duration can be used to immunize an asset or liability against interest rate risk.

A Simple Illustration of Duration

Duration is a measure that incorporates the time of arrival of all cash flows on an asset or liability along with the asset or liability’s maturity date. To see this, consider a bond with one year remaining to maturity, a $1,000 face value, an 8 percent coupon rate (paid

LG 3-6

duration The weighted-average time to maturity on an investment using the rela- tive present values of the cash flows as weights.

elasticity The percentage change in the price of a bond for a given change in interest rates.

Figure 3–3 The Impact of a Bond’s Coupon Rate on Its Price Sensitivity

Interest Rate

Bond Value

Low-Coupon Bond

High-Coupon Bond

DURATION

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 77

sau19714_ch03_058-092.indd 77 07/19/17 04:27 PM

semiannually), and an interest rate (either required rate of return or yield to maturity) of 10 percent. The promised cash flows from this bond are illustrated in Figure 3–4. The bond holder receives the promised cash flows (CF) from the bond issuer at the end of one-half year and at the end of one year.

CF1/2 is the $40 promised payment of (semiannual) coupon interest ($1,000 × 8% × ½) received after six months. CF1 is the promised cash flow at the end of year 1; it is equal to the second $40 promised (semiannual) coupon payment plus the $1,000 promised pay- ment of face value. To compare the relative sizes of these two cash flow payments—since duration measures the weighted-average time to maturity of a bond—we should put them in the same dimensions, because $1 of principal or interest received at the end of one year is worth less to an investor in terms of time value of money than is $1 of principal or interest received at the end of six months. Assuming that the current rate of return (either required or expected) is 10 percent per year, we calculate the present values (PV) of the two cash flows (CF) as:

C F 1/2

$40

P V 1/2

$40 / (1.05) = $38.10

C F 1 = $1, 040 P V 1 = $1,040 (1.05) 2 = $943.31

P V 1/2 + P V 1 =

$981.41

Note that since CF1/2, the cash flow received at the end of one-half year, is received earlier, it is discounted at (1 + R/2) (where R is the current rate of return on the bond); this discount factor is smaller than the discount rate applied to the cash flow received at the end of the year (1 + R/2)2. Figure 3–5 summarizes the PVs of the cash flows from the bond.

The bond holder receives some cash flows at one-half year and some at one year (see Figure 3–5). Intuitively, duration is the weighted-average maturity on the portfolio of zero- coupon bonds, one that has payments at one-half year and at the end of the year (year 1) in this example. Specifically, duration analysis weights the time at which cash flows are received by the relative importance in present value terms of the cash flows arriving at each point in time. In present value terms, the relative importance of the cash flows arriv- ing at time t = ½ year and time t = 1 year are as follows:

Time (t) Weight (X) ½ year

X 1/2 = P V 1/2 __________

P V 1/2 + P V 1 =

38.10 ______

981.41 = 0.0388 = 3.88%

1 year X 1 =

P V 1 __________ P V 1/2 + P V 1

= 943.31

______ 981.41

= 0.9612 = 96.12%

1.0 100%

Figure 3–5 Present Value of the Cash Flows from the Bond

0 1 Year

CF1 = $1,040PV1 = $943.31 CF1/2 = $40PV1/2 = $38.10

1/2 Year

Figure 3–4 Promised Cash Flows on the One-Year Bond

1/20 Year 1 Year

CF1 = $40 + $1,000CF1/2 = $40

Final PDF to printer

78 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 78 07/19/17 04:27 PM

In present value terms, the bond holder receives 3.88 percent of the cash flows on the bond with the first coupon payment at the end of six months (t1/2) and 96.12 percent with the second payment of coupon plus face value at the end of the year (t1). By definition, the sum of the (present value) cash flow weights must equal 1:

X 1/2 + X 1 = 1 0.0388 + 0.9612

= 1

We can now calculate the duration (D), or the weighted-average time to maturity of the bond, using the present value of its cash flows as weights:

D L

= X 1/2 × ( t 1/2 ) + X 1 × ( t 1 )

= 0.0388 × ( 1 __

2 ) + 0.9612 ×

(1)

= 0.9806 years

Thus, although the maturity of the bond is one year, its duration or average life in a cash flow sense is only 0.9806 years. Duration is less than maturity because in present value terms, 3.88 percent of the cash flows are received during the year.

A General Formula for Duration

You can calculate the duration for any fixed-income security that pays interest annually using the following formula:

D = ∑ t = 1

C F t × t ______ (1 + r) t

_________

∑ t = 1

C F t ______

(1 + r) t =

∑ t = 1

P V t × t _________

∑ t = 1

P V t

where

Duration measured in years

1 to T, the period in which a cash flow is received

N = Number of period to maturity C F t

= Cash flow received on the security at end of period t

Current required rate of return (r) or yield to maturity (ytm) on the investment

P V t

Present value of the cash flow received at the end of the period t

For bonds that pay interest semiannually, the duration equation becomes:13

D = ∑ t = 1/2

C F t × t ________

(1 + r / 2) 2t ____________

∑ t = 1/2

C F t ________

(1 + r / 2) 2t

where t = ½, 1, 1½, . . . , N. Notice that the denominator of the duration equation is the present value of the cash

flows on the security. The numerator is the present value of each cash flow received on the security multiplied or weighted by the length of time required to receive the cash flow. To help you fully understand this formula, we look at some examples next.

13. In general, the duration equation is written as:

D = ∑ t = 1/m

C F t × t _________

(1 + r / m) mt ______________

∑ t = 1/m

C F t _________

(1 + r / m) mt

where m = number of times per year interest is paid.

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 79

sau19714_ch03_058-092.indd 79 07/19/17 04:27 PM

EXAMPLE 3–12 The Duration of a Four-Year Bond Paying Annual Interest

Suppose that you have a bond that offers a coupon rate of 10 percent paid annually. The face value of the bond is $1,000, it matures in four years, its current yield to maturity (rb) is 8 percent, and its current price is $1,066.24. See Table 3–7 for the calculation of its dura- tion. As the calculation indicates, the duration, or weighted-average time to maturity, on this bond is 3.50 years. In other words, on a time value of money basis, the initial invest- ment of $1,066.24 is recovered after 3.50 years.

TABLE 3–7 Duration of a Four-Year Bond with 10 Percent Coupon Paid Annually and 8 Percent Yield

t CFt 1 ________

( 1 + 8% ) t

C F t ________ ( 1 + 8% ) t

C F t × t ________

( 1 + 8% ) t

1 100 0.9259 92.59 92.59 2 100 0.8573 85.73 171.47 3 100 0.7938 79.38 238.15 4 1,100 0.7350 808.53 3,234.13

1,066.24 3,736.34

3,736.34

________ 1,066.24

= 3.50 years

EXAMPLE 3–13 The Duration of a Four-Year Bond Paying Semiannual Interest

Suppose that you have a bond that offers a coupon rate of 10 percent paid semiannually (or 5 percent paid every 6 months). The face value of the bond is $1,000, it matures in four years, its current rate of return (rb) is 8 percent, and its current price is $1,067.34. See Table 3–8 for the calculation of its duration. As the calculation indicates, the dura- tion, or weighted-average time to maturity, on this bond is 3.42 years. In other words, on a time value of money basis, the initial investment of $1,067.34 is recovered after 3.42 years.

Table 3–9 shows that if the annual coupon rate is lowered to 6 percent, the duration of the bond rises to 3.60 years. Since 6 percent annual coupon payments are smaller than 10 percent coupon payments, it takes longer to recover the initial investment with the 6 percent coupon bond. In Table 3–10, duration is calculated for the original 10 percent coupon bond, assuming that its rate of return (rb) increases from 8 percent to 10 percent. Now duration falls from 3.42 years (in Table 3–8) to 3.39 years. The higher the rate of return on the bond, the more the investor earns on reinvested coupons and the shorter the time needed to recover his or her initial investment. Finally, as the maturity on a bond decreases, in this case to 3 years in Table 3–11, duration falls to 2.67 years (i.e., the shorter the maturity on the bond, the more quickly the initial investment is recovered).

Most bonds pay interest semiannually rather than annually as in Example 3–12. Thus, we next look at the duration on a bond that pays interest semiannually.

Final PDF to printer

80 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 80 07/19/17 04:27 PM

TABLE 3–8 Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Rate of Return

t CFt 1 _________

( 1 + 4% ) 2t

C F t _________ ( 1 + 4% ) 2t

C F t × t _________

( 1 + 4% ) 2t

½ 50 0.9615 48.08 24.04 1 50 0.9246 46.23 46.23 1½ 50 0.8890 44.45 66.67 2 50 0.8548 42.74 85.48 2½ 50 0.8219 41.10 102.75 3 50 0.7903 39.52 118.56 3½ 50 0.7599 38.00 133.00 4 1,050 0.7307 767.22 3,068.88

1,067.34 3,645.61

D = 3, 645.61

________ 1,067.34

= 3.42 years

TABLE 3–9 Duration of a Four-Year Bond with 6 Percent Coupon Paid Semiannually and 8 Percent Rate of Return

t CFt 1 _________

( 1 + 4% ) 2t

C F t _________ ( 1 + 4% ) 2t

C F t × t _________

( 1 + 4% ) 2t

½ 30 0.9615 28.84 14.42 1 30 0.9246 27.74 27.74 1½ 30 0.8890 26.67 40.00 2 30 0.8548 25.64 51.28 2½ 30 0.8219 24.66 61.65 3 30 0.7903 23.71 71.13 3½ 30 0.7599 22.80 79.80 4 1,030 0.7307 752.62 3,010.48

932.68 3,356.50

D = 3,356.50

________ 932.62

= 3.60 years

TABLE 3–10 Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 10 Percent Rate of Return

t CFt 1 _________

( 1 + 5% ) 2t

C F t _________ ( 1 + 5% ) 2t

C F t × t _________

( 1 + 5% ) 2t

½ 50 0.9524 47.62 23.81 1 50 0.9070 45.35 45.35

1½ 50 0.8638 43.19 64.78 2 50 0.8227 41.14 82.28

2½ 50 0.7835 39.18 97.95 3 50 0.7462 37.31 111.93

3½ 50 0.7107 35.53 124.36 4 1,050 0.6768 710.68 2,842.72

1,000.00 3,393.18

D = 3,393.18

________ 1,000.00

= 3.39 years

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 81

sau19714_ch03_058-092.indd 81 07/19/17 04:27 PM

The Duration of a Zero-Coupon Bond. Zero-coupon bonds sell at a discount from face value and pay their face value (e.g., $1,000) on maturity. These bonds have no intervening cash flows, such as coupon payments, between issue and maturity. The current price that an investor is willing to pay for such a bond, assuming semiannual compounding of inter- est, is equal to the present value of the single, fixed (face value) payment on the bond that is received on maturity (here, $1,000):

P = 1,000 / (1 + r b / 2) 2 T ZC where

r b

Required semiannually compounded rate of return or yield

T zc = Number of years to maturity

Price

Because the only cash flow received on these securities is the final payment at matu- rity (time Tzc), the following must be true:

D zc = T zc

That is, the duration of a zero-coupon bond equals its maturity. Note that it is only for zero- coupon bonds that duration and maturity are equal. Indeed, for any bond that pays some cash flows prior to maturity, its duration will always be less than its maturity.

TABLE 3–11 Duration of a Three-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Rate of Return

t CFt 1 _________

( 1 + 4% ) 2t

C F t _________ ( 1 + 4% ) 2t

C F t × t _________

( 1 + 4% ) 2t

½ 50 0.9615 48.08 24.04 1 50 0.9246 46.23 46.23 1½ 50 0.8890 44.45 66.67 2 50 0.8548 42.74 85.48 2½ 50 0.8219 41.10 102.75 3 1,050 0.7903 829.82 2,489.46

1,052.42 2,814.63

D = 2,814.63

________ 1,052.42

= 2.67 years

EXAMPLE 3–14 The Duration of a Zero-Coupon Bond Suppose that you have a zero-coupon bond with a face value of $1,000, a maturity of four years, and a current rate of return of 8 percent compounded semiannually. Since the bond pays no interest, the duration equation consists of only one term—cash flow at the end of year 4:

or duration equals the maturity of the zero-coupon bond.

t CF4

1 ____________

(1 + 8% / 2) 2×4

C F 4 ____________ (1 + 8% / 2) 2×4

C F 4 × 4 ____________

(1 + 8% / 2) 2×4

4 $1,000 0.7307 730 2,923 D = 2,923/730 = 4 years

Final PDF to printer

82 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 82 07/19/17 04:27 PM

Features of Duration

The preceding examples suggest several important features of duration relating to the time remaining to maturity, rate of return, and coupon interest of the underlying bond being analyzed. These features are summarized in Table 3–12.

Duration and Coupon Interest. A comparison of Tables 3–8 and 3–9 indicates that the higher the coupon or promised interest payment on the bond, the shorter its duration. This is due to the fact that the larger the coupon or promised interest payment, the more quickly investors receive cash flows on a bond and the higher are the present value weights of those cash flows in the duration calculation. On a time value of money basis, the investor recoups his or her initial investment faster when coupon payments are higher.

Duration and Rate of Return. A comparison of Tables 3–8 and 3–10 also indicates that duration decreases as the rate of return on the bond increases. This makes intuitive sense since the higher the rate of return on the bond, the lower the present value cost of waiting to receive the later cash flows on the bond. Higher rates of return discount later cash flows more heavily, and the relative importance, or weights, of those later cash flows decline when compared to cash flows received earlier.

Duration and Maturity. A comparison of Tables 3–8, 3–11, and 3–13 indicates that duration increases with the maturity of a bond, but at a decreasing rate. As maturity of a 10 percent coupon bond decreases from four years to three years (Tables 3–8 and 3–11), duration decreases by 0.75 year, from 3.42 years to 2.67 years. Decreasing maturity for an additional year, from three years to two years (Tables 3–11 and 3–13), decreases duration by 0.81 year, from 2.67 years to 1.86 years. Notice too that for a coupon bond, the longer the maturity on the bond the larger the discrepancy between maturity and duration. Spe- cifically, the two-year maturity bond has a duration of 1.86 years (0.14 year less than its maturity), while the three-year maturity bond has a duration of 2.67 years (0.33 year less than its maturity), and the four-year maturity bond has a duration of 3.42 years (0.58 year less than its maturity). Figure 3–6 illustrates this relation between duration and maturity for our 10 percent coupon (paid semiannually), 8 percent rate of return bond. The In the News box describes how this relation between maturity and duration can result in poten- tially large losses when bonds are purchased during a period of falling interest rates.

LG 3-7

TABLE 3–12 Features of Duration

1. The higher the coupon or promised interest payment on a security, the shorter is its duration. 2. The higher the rate of return on a security, the shorter is its duration. 3. Duration increases with maturity at a decreasing rate.

TABLE 3–13 Duration of a Two-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Rate of Return

t CFt 1 _________

( 1 + 4% ) 2t

C F t _________ ( 1 + 4% ) 2t

C F t × t _________

( 1 + 4% ) 2t

½ 50 0.9615 48.08 24.04 1 50 0.9246 46.23 46.23 1½ 50 0.8890 44.45 66.67 2 1,050 0.8548 897.54 1,795.08

1,036.30 1,932.02

D = 1,932.02

________ 1, 036.30

= 1.86 years

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 83

sau19714_ch03_058-092.indd 83 07/19/17 04:27 PM

Economic Meaning of Duration

So far we have calculated duration for a number of different bonds. In addition to being a measure of the average life of a bond, duration is also a direct measure of its price sensi- tivity to changes in interest rates, or elasticity.14 In other words, the larger the numerical value of duration (D), the more sensitive the price of that bond (ΔP/P) to (small) changes

LG 3-8

14. In Chapter 22, we also make the direct link between duration and the price sensitivity of an asset or liability or of an FI’s entire portfolio (i.e., its duration gap). We show how duration can be used to immunize a security or portfolio of securities against interest rate risk.

Figure 3–6 Discrepancy between Maturity and Duration on a Coupon Bond

Maturity (years)

Years

1 2 3 4 5

Duration

Maturity

Gap = Maturity – Duration

Investors looking for big returns in government bonds could have found them in 2015 with bonds issued by Japan. With global interest rates extraordinarily low, and borrowers issuing long-term debt, duration shot up. Duration implies risk. As discussed in the chapter, a one percentage- point change in interest rates implies a change in the bond’s price equal to the duration. A bond with a dura- tion of 25 years will rise in price by 25 percent if interest rates fall by one percentage point and fall 25 percent in price if rates rise by one percent- age point.

Japanese debt is a prime example and highlights a quiet risk in bond markets in an era of low and even

Duration Risk in Bond Markets

I N T H E N E W S

negative interest rates: duration. In 2015, Japan issued 40-year bonds with a coupon of 1.4 percent. Rates fell in Japan and bond prices rose 34 percent. However, the long maturity is troublesome given that as durations got longer, interest rate risk increased. If rates rise in the next few years, a bond yielding 0.49 percent becomes unattractive, and an investor must take a poten- tially large loss to sell it.

Usually, to account for dura- tion risk, the yield curve is relatively steep. Thus, to compensate an investor for facing considerable uncertainty, bonds with long maturi- ties have considerably higher yields. However, in Japan yield curves in

2015 were flattening. Investors who usually would have bought shorter maturity government bonds in Japan purchased longer-term maturi- ties. However, the yield on 40-year Japanese bonds declined from above 2 percent in late 2012 to around 1.5 percent at the end of 2015. At the beginning of 2016, it fell to below 0.5 percent.

Few are predicting a turnaround in Japanese rates any time soon. However, 40 years is a long time to wait, and if and when rates turn up, investors holding these long-term bonds could be forced to take heavy losses—even though Japan’s govern- ment debt is regarded as some of the world’s safest.

Final PDF to printer

84 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 84 07/19/17 04:27 PM

or shocks in interest rates Δrb/(1 + rb). The specific relationship between these factors for securities with annual compounding of interest is represented as:15

ΔP / P __________

Δ r b / (1 + r b ) = − D

For securities with semiannual receipt (compounding) of interest, it is represented as:

ΔP / P ___________

Δ r b / (1 + r b / 2) = − D

The economic interpretation of this equation is that the number D is the elasticity, or sen- sitivity, of the bond’s price to small interest rate (either required rate of return or yield to maturity) changes. The negative sign in front of the D indicates the inverse relationship between interest rate changes and price changes. That is, −D describes the percentage value decrease—capital loss—on the security (ΔP/P) for any given (discounted) small increase in interest rates [Δrb/(1 + rb)], where Δrb is the change in interest rates and 1 + rb is 1 plus the current (or beginning) level of interest rates.

The definition of duration can be rearranged in another useful way for interpretation regarding price sensitivity:

ΔP

___ P

= − D [ Δ r b _____

1 + r b ]

ΔP

___ P

= − D [ Δ r b ______

1 + r b / 2 ]

for annual and semiannual compounding of interest, respectively. This equation shows that for small changes in interest rates, bond prices move in an inversely proportional manner according to the size of D. Clearly, for any given change in interest rates, long duration securities suffer a larger capital loss (or receive a higher capital gain) should interest rates rise (fall) than do short duration securities.16

The duration equation can be rearranged, combining D and (1 + rb) into a single vari- able D/(1 + rb), to produce what practitioners call modified duration (MD). For annual compounding of interest:

ΔP

___ P

= − MD × Δ r b

where

MD = D _____

1 + r b

For semiannual compounding of interest:

ΔP

___ P

= − MD × Δ r b

15. In what follows, we use the Δ (change) notation instead of d (derivative notation) to recognize that interest rate changes tend to be discrete rather then infinitesimally small. For example, in real-world financial markets the smallest observed rate change is usually one basis point, or 1/100 of 1 percent.

16. By implication, gains and losses under the duration model are symmetric. That is, if we repeated the above exam- ples but allowed interest rates to decrease by one basis point annually (or ½ basis point semiannually), the percentage increase in the price of the bond (Δ P/P) would be proportionate with D. Further, the capital gains would be a mirror image of the capital losses for an equal (small) decrease in interest rates.

modified duration Duration divided by 1 plus the initial interest rate.

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 85

sau19714_ch03_058-092.indd 85 07/19/17 04:27 PM

where

MD = D ______

1 + r b / 2

This form is more intuitive than the Macaulay’s duration because we multiply MD by the simple change in interest rates rather than the discounted change in interest rates as in the general duration equation. Thus, the modified duration is a more direct measure of bond price elasticity. Next, we use duration to measure the price sensitivity of different bonds to small changes in interest rates.

EXAMPLE 3–15 Four-Year Bond Consider a four-year bond with a 10 percent coupon paid semiannually (or 5 percent paid every 6 months) and an 8 percent rate of return (rb). According to calculations in Table 3–8, the bond’s duration is D = 3.42 years. Suppose that the rate of return increases by 10 basis points (1/10 of 1 percent) from 8 to 8.10 percent. Then, using the semiannual compounding version of the duration model shown above, the percentage change in the bond’s price is:

ΔP

___ P

− (3.42) [

0.001 _____

1.04 ]

− 0.00329

= − 0.329%

The bond price had been $1,067.34, which was the present value of a four-year bond with a 10 percent coupon and an 8 percent rate of return. However, the duration model predicts that the price of this bond will fall by 0.329 percent, or by $3.51, to $1,063.83 after the increase in the rate of return on the bond of 10 basis points.17

With a lower coupon rate of 6 percent, as shown in Table 3–8, the bond’s duration, D, is 3.60 and the bond price changes by:

ΔP

___ P

= − (3.60) ( 0.001

_____ 1.04

) = − 0.00346

= − 0.346%

for a 10-basis-point increase in the rate of return. The bond’s price drops by 0.346 percent, or by $3.23, from $932.68 (reported in Table 3–8) to $929.45. Notice again that, all else held constant, the higher the coupon rate on the bond, the shorter the duration of the bond and the smaller the percentage decrease in the bond’s price for a given increase in interest rates.

17. That is, a price fall of 0.329 percent in this case translates into a dollar fall of $3.51. To calculate the dollar change in value, we can rewrite the equation as ΔP = (P )(−D)((Δ rb)/(1 + rb/2)) = ($1,067.34)(−3.42)(0.001/1.04) = $3.51.

Large Interest Rate Changes and Duration

It needs to be stressed here that duration accurately measures the price sensitivity of finan- cial securities only for small changes in interest rates of the order of one or a few basis points (a basis point is equal to one-hundredth of 1 percent). Suppose, however, that inter- est rate shocks are much larger, of the order of 2 percent or 200 basis points or more. While such large changes in interest rates are not common, this might happen in a financial

Final PDF to printer

86 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 86 07/19/17 04:27 PM

crisis or if the central bank (see Chapter 4) suddenly changes its monetary policy strategy. In this case, duration becomes a less accurate predictor of how much the prices of bonds will change, and therefore, a less accurate measure of the price sensitivity of a bond to changes in interest rates. Figure 3–7 is a graphic represen- tation of the reason for this. Note the difference in the change in a bond’s price due to interest rate changes according to the proportional duration measure (D), and the “true relationship,” using the time value of money equations of Chapter 2 (and discussed earlier in this chapter) to calculate the exact present value change of a bond’s price in response to interest rate changes.

Specifically, duration predicts that the relationship between an interest rate change and a security’s price change will be proportional to the security’s D (duration). By precisely calculating the exact or true change in the security’s price using time value of money calculations, however, we would find that for large interest rate increases, duration overpredicts the fall in the security’s price, and for large interest rate decreases, it underpredicts the increase in the secu- rity’s price. Thus, duration misestimates the change in the value of a security following a large change (either positive or negative) in interest rates. Further, the duration model predicts symmetric effects for rate increases and decreases on a bond’s price. As Figure 3–7 shows, in actuality, the capital loss effect of large rate increases tends to be smaller than the capital gain effect of large rate

decreases. This is the result of a bond’s price–interest rate relationship exhibiting a prop- erty called convexity rather than linearity, as assumed by the simple duration model. Intuitively, this is because the sensitivity of the bond’s price to a change in interest rates depends on the level from which interest rates change (i.e., 6 percent, 8 percent, 10 percent, 12 percent). In particular, the higher the level of interest rates, the smaller a bond’s price sensitivity to interest rate changes.

convexity The degree of curvature of the price–interest rate curve around some interest rate level.

D O YO U U N D E R S TA N D :

14. When the duration of an asset is equal to its maturity?

15. What the denominator of the duration equation measures?

16. What the numerator of the duration equation measures?

17. What the duration of a zero- coupon bond is?

18. Which has the longest duration: a 30-year, 8 percent yield to maturity, zero-coupon bond, or a 30-year, 8 percent yield to maturity, 5 percent coupon bond?

19. What the relationship is between the duration of a bond and its price elasticity?

EXAMPLE 3–16 Calculation of the Change in a Security’s Price Using the Duration versus the Time Value of Money Formula

To see the importance of accounting for the effects of convexity in assessing the impact of large interest rate changes, consider the four-year, $1,000 face value bond with a 10 percent coupon paid semiannually and an 8 percent rate of return. In Table 3–8 we found this bond has a duration of 3.42 years, and its current price is $1,067.34. We represent this as point A in Figure 3–8. If rates rise from 8 percent to 10 percent, the duration model predicts that the bond price will fall by 6.577 percent; that is:

ΔP

___ P

= − 3.42 (0.02 / 1.04) = − 6.577%

or from a price of $1,067.34 to $997.14 (see point B in Figure 3–8). However, using time value of money formulas to calculate the exact change in the bond’s price after a rise in rates to 10 percent, we find its true value is:

V b = 50

⎡

⎢ ⎣ 1 −

1 ______________

[ 1 + ( 0.10 / 2 ) ] 2 ( 4 ) __________________

0.10 / 2

⎤

⎥ ⎦ + 1,000 / [ 1 + ( 0.10 / 2 ) ] 2 ( 4 ) = $1,000 This is point C in Figure 3–8. As you can see, the true or actual fall in price is less than the duration predicted fall by $2.86. The reason for this is the natural convexity to the price– interest rate curve as interest rates rise.

Reversing the experiment reveals that the duration model would predict the bond’s price to rise by 6.577 percent if yields were to fall from 8 percent to 6 percent, resulting

Final PDF to printer

Chapter 3 Interest Rates and Security Valuation 87

sau19714_ch03_058-092.indd 87 07/19/17 04:27 PM

Figure 3–8 Price–Interest Rate Curve for the Four-Year 10 Percent Coupon Bond

Rate of Return (%)

Price (Vb)

6 8

$1,140.39

$1,137.54

$1,067.34

$1,000.00

$997.14

Figure 3–7 Duration Estimated versus True Bond Price

True Relationship

Duration Model

Error

P P

–D

∇

rb (1 + rb)

An important question for managers of financial institutions and individual savers is whether the error in the duration equation is big enough to be concerned about. This depends on the size of the interest rate change and the size of the portfolio under manage- ment. Clearly, for a large portfolio the error will also be large.

Note that convexity is a desirable feature for an investor or FI manager to capture in a portfolio of assets. Buying a bond or a portfolio of assets that exhibits a lot of convexity or curvature in the price–interest rate relationship is similar to buying partial interest rate risk insurance. Specifically, high convexity means that for equally large changes of interest rates up and down (e.g., plus or minus 2 percent), the capital gain effect of a rate decrease more than offsets the capital loss effect of a rate increase.

in a predicted price of $1,137.54 (see point D in Figure 3–8). By comparison, the true or actual change in price can be computed, using time value of money formulas and a 6 percent rate of return, as $1,140.39 (see point E in Figure 3–8). The duration model has underpredicted the true bond price increase by $2.85 ($1,140.39 − $1,137.54).

Final PDF to printer

88 Part 1 Introduction and Overview of Financial Markets

sau19714_ch03_058-092.indd 88 07/19/17 04:27 PM

So far, we have established the following three characteristics of convexity:

1. Convexity is desirable. The greater the convexity of a security or portfolio of securities, the more insurance or interest rate protection an investor or FI manager has against rate increases and the greater the potential gains after interest rate falls.

2. Convexity diminishes the error in duration as an investment criterion. The larger the interest rate changes and the more convex a fixed-income security or portfolio, the greater the error the investor or FI manager faces in using just duration (and duration matching) to immunize exposure to interest rate shocks.

3. All fixed-income securities are convex. That is, as interest rates change, bond prices change at a nonconstant rate.

To illustrate the third characteristic, we can take the four-year, 10 percent coupon, 8 percent rate of return bond and look at two extreme price–interest rate scenarios. What is the price on the bond if rates fall to zero, and what is its price if rates rise to some very large number such as infinity? Where rb = 0:

V b = 50 ______

( 1 + 0 ) 1 +

50 ______

( 1 + 0 ) 2 + . . . +

1,050 ______

( 1 + 0 ) 8 = $1,400

The price is just the simple undiscounted sum of the coupon values and the face value of the bond. Since interest rates can never go below zero, $1,400 is the maximum possible price for the bond. Where rb = ∞:

V b = 50 ________

( 1 + ∞ ) 1 +

50 ________

( 1 + ∞ ) 2 + . . . +

1,050 ________

( 1 + ∞ ) 8 = $0

As interest rates go to infinity, the bond price falls asymptotically toward zero, but by definition a bond’s price can never be negative. Thus, zero must be the minimum bond price (see Figure 3–9). In Appendix 3B to this chapter (available through Connect or your course instructor) we look at how to measure convexity and how this measure of convexity can be incorporated into the duration model to adjust for or offset the error in the predic- tion of security price changes for a given change in interest rates.

Figure 3–9 The Natural Convexity of Bonds

∞0

Price $1,400

Price–Interest Rate Curve Convexity

Rate of Return (r )

SUMMARY

This chapter applied the time value of money formulas presented in Chapter 2 to the valu- ation of financial securities such as bonds and equities. With respect to bonds, we included a detailed examination of how changes in interest rates, coupon rates, and time to maturity affect their price and price sensitivity. We also presented a measure of bond price sensi- tivity to interest rate changes, called duration. We showed how the value of duration is affected by various bond characteristics, such as coupon rates, interest rates, and time to maturity.

Final PDF to printer

sau19714_ch03_058-092.indd 89 07/19/17 04:27 PM

Chapter 3 Interest Rates and Security Valuation 89

CHAPTER NOTATION

required rate of return

C F t

cash flow received on a security at end of period t

number of periods in the investment horizon

present value of a security

E(r)

expected rate of return

P or P ‾

current market price for a security

RC F t

realized cash flow in period t

r −

realized rate of return

V b

the price on a bond

M = par or face value of a bond INT

annual interest payment on a bond

number of years until a bond matures

r b

annual interest rate used to discount cash flows on a bond

r s

interest rate used to discount cash flows on equity

Di v t

dividend paid at the end of year t

constant growth rate in dividends each year

duration on a security measured in years

last period in which the cash flow is received or number of periods to maturity

modified duration = D / (1 + r)

QUESTIONS 1. What is the difference between a required rate of return and

an expected rate of return? (LG 3-1) 2. What is the relation between the expected rate of return and

the required rate of return as they pertain to the fair market price and the current market price of a security? (LG 3-1)

3. What is the difference between a zero-coupon bond and a coupon bond? (LG 3-2)

4. For each of the following situations, identify whether a bond would be considered a premium bond, a discount bond, or a par bond. (LG 3-2) a. A bond’s current market price is greater than its face value. b. A bond’s coupon rate is equal to its yield to maturity. c. A bond’s coupon rate is less than its required rate of return. d. A bond’s coupon rate is less than its yield to maturity. e. A bond’s coupon rate is greater than its yield to maturity. f. A bond’s fair present value is less than its face value.

5. How does equity valuation differ from bond valuation? (LG 3-3)

6. What happens to the fair present value of a bond when the required rate of return on the bond increases? (LG 3-4)

7. All else equal, which bond’s price is more affected by a change in interest rates, a short-term bond or a long-term bond? Why? (LG 3-5)

8. All else equal, which bond’s price is more affected by a change in interest rates, a bond with a large coupon or a small coupon? Why? (LG 3-5)

9. How is duration related to the price elasticity of a fixed- income security? What is the relationship between duration and the price of a fixed-income security? (LG 3-6)

10. What is the relation between the coupon rate on a bond and its duration? (LG 3-7)

11. Which has the longest duration: a 30-year, 8 percent yield to maturity, 5 percent coupon bond or a 30-year, 10 percent yield to maturity, 5 percent coupon bond? (LG 3-7)

12. What is the economic meaning of duration? (LG 3-8)

PROBLEMS 1. You bought a bond five years ago for $935 per bond. The

bond is now selling for $980. It also paid $75 in interest per year, which you reinvested in the bond. Calculate the real- ized rate of return earned on this bond. (LG 3-1)

2. Refer again to the bond information in Problem 1. You expect to hold the bond for three more years, then sell it for $990. If the bond is expected to continue paying $75 per

year over the next three years, what is the expected rate of return on the bond during this period? (LG 3-1)

3. Johnson Motors’s bonds have 10 years remaining to matu- rity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon rate is 8 percent. The bonds have a yield to maturity of 9 percent. What is the current market price of these bonds? (LG 3-2)

Final PDF to printer

sau19714_ch03_058-092.indd 90 07/19/17 04:27 PM

90 Part 1 Introduction and Overview of Financial Markets

4. Using a Spreadsheet to Calculate Bond Values. What is the value of a $1,000 bond

with a 12-year maturity and an 8 percent coupon rate (paid semiannually) if the required rate of return is 5 percent, 6 percent, 8 percent, and 10 percent? (LG 3-2)

Face Value

Number of Payments

Periodic Coupon

Payment, $ Required Return ⇒

The Bond Value

Will Be

$1,000 12 × 2 = 24 1,000(0.08)/2 =40 5% $1,268.27 1,000 24 40 6 1,169.36 1,000 24 40 8 1,000.00 1,000 24 40 10 862.01

5. A 10-year, 12 percent semiannual coupon bond, with a par value of $1,000 sells for $1,100. What is the bond’s yield to maturity? (LG 3-2)

6. Using a Spreadsheet to Calculate Yield to Maturity. What is the yield to maturity on the

following bonds; all have a maturity of 10 years, a face value of $1,000, and a coupon rate of 9 percent (paid semi- annually). The bonds’ current market values are $945.50, $987.50, $1,090.00, and $1,225.875, respectively. (LG 3-2)

Market Value

Number of Payments

Periodic Coupon

Payment, $ Face Value ⇒

The Yield to Maturity

Will Be

945.50 10 × 2 = 20 1,000(0.09)/2 = 45 $1,000 9.87% 987.50 20 45 1,000 9.19

1,090.00 20 45 1,000 7.69 1,225.875 20 45 1,000 5.97

7. BSW Corporation has a bond issue outstanding with an annual coupon rate of 7 percent paid quarterly and four years remaining until maturity. The par value of the bond is $1,000. Determine the fair present value of the bond if mar- ket conditions justify a 14 percent, compounded quarterly, required rate of return. (LG 3-2)

8. You have just been offered a bond for $863.73. The coupon rate is 8 percent payable annually, and the yield to maturity on new issues with the same degree of risk are 10 percent. You want to know how many more interest payments you will receive, but the party selling the bond cannot remem- ber. If the par value is $1,000, how many interest payments remain? (LG 3-2)

9. A bond you are evaluating has a 10 percent coupon rate (compounded semiannually), a $1,000 face value, and is 10 years from maturity. (LG 3-4) a. If the required rate of return on the bond is 6 percent,

what is its fair present value? b. If the required rate of return on the bond is 8 percent,

what is its fair present value? c. What do your answers to parts (a) and (b) say about the

relation between required rates of return and fair values of bonds?

10. Calculate the yield to maturity on the following bonds: (LG 3-2) a. A 9 percent coupon (paid semiannually) bond, with a

$1,000 face value and 15 years remaining to maturity. The bond is selling at $985.

b. An 8 percent coupon (paid quarterly) bond, with a $1,000 face value and 10 years remaining to maturity. The bond is selling at $915.

c. An 11 percent coupon (paid annually) bond, with a $1,000 face value and 6 years remaining to maturity. The bond is selling at $1,065.

11. Calculate the fair present values of the following bonds, all of which pay interest semiannually, have a face value of $1,000, have 12 years remaining to maturity, and have a required rate of return of 10 percent. (LG 3-5) a. The bond has a 6 percent coupon rate. b. The bond has a 8 percent coupon rate. c. The bond has a 10 percent coupon rate. d. What do your answers to parts (a) through (c) say about

the relation between coupon rates and present values? 12. Repeat parts (a) through (c) of Problem 11 using a required rate

of return on the bond of 8 percent. What do your calculations imply about the relation between the coupon rates and bond price volatility? (LG 3-5)

13. Calculate the fair present value of the following bonds, all of which have a 10 percent coupon rate (paid semiannually), face value of $1,000, and a required rate of return of 8 per- cent. (LG 3-5) a. The bond has 10 years remaining to maturity. b. The bond has 15 years remaining to maturity. c. The bond has 20 years remaining to maturity. d. What do your answers to parts (a) through (c) say about

the relation between time to maturity and present values? 14. Repeat parts (a) through (c) of Problem 13 using a required

rate of return on the bond of 11 percent. What do your cal- culations imply about the relation between time to maturity and bond price volatility? (LG 3-5)

15. A $1,000 par value bond with five years left to maturity pays an interest payment semiannually with a 6 percent cou- pon rate and is priced to have a 5 percent yield to maturity. If interest rates surprisingly increase by 0.5 percent, by how much will the bond’s price change? (LG 3-4)

16. A $1,000 par value bond with seven years left to maturity has a 9 percent coupon rate (paid semiannually) and is sell- ing for $945.80. What is its yield to maturity? (LG 3-2)

17. Calculate the fair present value on a stock that pays $5 in dividends per year (with no growth) and has a required rate of return of 10 percent. (LG 3-3)

18. A preferred stock from Duquesne Light Company (DQU- PRA) pays $2.10 in annual dividends. If the required rate of return on the preferred stock is 5.4 percent, what is the fair present value of the stock? (LG 3-3)

19. A preferred stock from Hecla Mining Co. (HLPRB) pays $3.50 in annual dividends. If the required rate of return on the preferred stock is 6.8 percent, what is the fair present value of the stock? (LG 3-3)

20. Financial analysts forecast Safeco Corp. (SAF) growth for the future to be 10 percent. Safeco’s recent dividend was $1.20. What is the fair present value of Safeco stock if the required rate of return is 12 percent? (LG 3-3)

21. Financial analysts forecast L Brands (LB) growth for the future to be 12.5 percent. LB’s most recent dividend was

Final PDF to printer

sau19714_ch03_058-092.indd 91 07/19/17 04:27 PM

Chapter 3 Interest Rates and Security Valuation 91

$0.60. What is the fair present value of L Brands’s stock if the required rate of return is 14.5 percent? (LG 3-3)

22. A stock you are evaluating just paid an annual dividend of $2.50. Dividends have grown at a constant rate of 1.5 percent over the last 15 years and you expect this to continue. (LG 3-3) a. If the required rate of return on the stock is 12 percent,

what is its fair present value? b. If the required rate of return on the stock is 15 percent,

what should the fair value be four years from today? 23. You are considering the purchase of a stock that is currently

selling at $64 per share. You expect the stock to pay $4.50 in dividends next year. (LG 3-3) a. If dividends are expected to grow at a constant rate of

3 percent per year, what is your expected rate of return on this stock?

b. If dividends are expected to grow at a constant rate of 5 percent per year, what is your expected rate of return on this stock?

c. What do your answers to parts (a) and (b) say about the impact of dividend growth rates on the expected rate of return on stocks?

24. A stock you are evaluating is expected to experience super- normal growth in dividends of 8 percent over the next six years. Following this period, dividends are expected to grow at a constant rate of 3 percent. The stock paid a dividend of $5.50 last year and the required rate of return on the stock is 10 percent. Calculate the stock’s fair present value. (LG 3-3)

25. Ecolap Inc. (ECL) recently paid a $0.46 dividend. The divi- dend is expected to grow at a 14.5 percent rate. At a current stock price of $44.12, what return are shareholders expect- ing? (LG 3-3)

26. Paychex Inc. (PAYX) recently paid a $0.84 dividend. The dividend is expected to grow at a 15 percent rate. At a cur- rent stock price of $40.11, what return are shareholders expecting? (LG 3-3)

27. Consider a firm with a 9.5 percent growth rate of divi- dends expected in the future. The current year’s dividend was $1.32. What is the fair present value of the stock if the required rate of return is 13 percent? (LG 3-3)

28. A company recently paid a $0.35 dividend. The dividend is expected to grow at a 10.5 percent rate. At a current stock price of $24.25, what return are shareholders expecting? (LG 3-3)

29. a. What is the duration of a two-year bond that pays an annual coupon of 10 percent and has a current yield to maturity of 12 percent? Use $1,000 as the face value. (LG 3-6)

b. What is the duration of a two-year zero-coupon bond that is yielding 11.5 percent? Use $1,000 as the face value.

c. Given these answers, how does duration differ from maturity?

30. Consider the following two banks: Bank 1 has assets composed solely of a 10-year,

12 percent coupon, $1 million loan with a 12 percent yield to maturity. It is financed with a 10-year, 10 percent coupon, $1 million CD with a 10 percent yield to maturity.

Bank 2 has assets composed solely of a 7-year, 12 percent, zero-coupon bond with a current value of

$894,006.20 and a maturity value of $1,976,362.88. It is financed with a 10-year, 8.275 percent coupon, $1,000,000 face value CD with a yield to maturity of 10 percent.

All securities except the zero-coupon bond pay inter- est annually. (LG 3-4) a. If interest rates rise by 1 percent (100 basis points), how do

the values of the assets and liabilities of each bank change? b. What accounts for the differences between the two

banks’ accounts? 31. Two bonds are available for purchase in the financial mar-

kets. The first bond is a two-year, $1,000 bond that pays an annual coupon of 10 percent. The second bond is a two- year, $1,000, zero-coupon bond. (LG 3-7 ) a. What is the duration of the coupon bond if the current

yield to maturity is 8 percent? 10 percent? 12 percent? b. How does the change in the current yield to maturity

affect the duration of this coupon bond? c. Calculate the duration of the zero-coupon bond with a

yield to maturity of 8 percent, 10 percent, and 12 percent. d. How does the change in the yield to maturity affect the

duration of the zero-coupon bond? e. Why does the change in the yield to maturity affect the

coupon bond differently than it affects the zero-coupon bond?

32. What is the duration of a five-year, $1,000 Treasury bond with a 10 percent semiannual coupon selling at par? Selling with a yield to maturity of 12 percent? 14 percent? What can you conclude about the relationship between duration and yield to maturity? Plot the relationship. Why does this relationship exist? (LG 3-7)

33. Consider a 12-year, 12 percent annual coupon bond with a required rate of return of 10 percent. The bond has a face value of $1,000. (LG 3-4) a. What is the fair present value of the bond? b. If the required rate of return rises to 11 percent, what is

the fair present value of the bond? c. What has been the percentage change in the fair present

value? d. Repeat parts (a), (b), and (c) for a 16-year bond. e. What do the respective changes in bond values

indicate? 34. Consider a five-year, 15 percent annual coupon bond with

a face value of $1,000. The bond is trading at a rate of 12 percent. (LG 3-4) a. What is the price of the bond? b. If the rate of interest increases 1 percent, what will be the

bond’s new price? c. Using your answers to parts (a) and (b), what is the

percentage change in the bond’s price as a result of the 1 percent increase in interest rates?

d. Repeat parts (b) and (c) assuming a 1 percent decrease in interest rates.

e. What do the differences in your answers indicate about the price–interest rate relationships of fixed-rate assets?

35. Consider the following. (LG 3-7) a. What is the duration of a five-year Treasury bond with a

10 percent semiannual coupon selling at par?

Final PDF to printer

sau19714_ch03_058-092.indd 92 07/19/17 04:27 PM

92 Part 1 Introduction and Overview of Financial Markets

b. What is the duration of the above bond if the yield to maturity (ytm) increases to 14 percent? What if the ytm increases to 16 percent?

c. What can you conclude about the relationship between duration and yield to maturity?

36. Consider the following. (LG 3-7) a. What is the duration of a four-year Treasury bond with a

10 percent semiannual coupon selling at par? b. What is the duration of a three-year Treasury bond with

a 10 percent semiannual coupon selling at par? c. What is the duration of a two-year Treasury bond with a

10 percent semiannual coupon selling at par? d. Using these results, what conclusions can you draw

about the relationship between duration and maturity? 37. What is the duration of a zero-coupon bond that has eight

years to maturity? What is the duration if the maturity increases to 10 years? If it increases to 12 years? (LG 3-7)

38. Suppose that you purchase a bond that matures in five years and pays a 13.76 percent annual coupon rate. The bond is priced to yield 10 percent. (LG 3-6) a. Show that the duration is equal to four years. b. Show that if interest rates rise to 11 percent next year and

your investment horizon is four years from today, you will still earn a 10 percent yield on your investment.

39. An insurance company is analyzing the following three bonds, each with five years to maturity, annual interest pay- ments, and is using duration as its measure of interest rate risk: (LG 3-6) a. $10,000 par value, coupon rate = 8%, rb = 0.10 b. $10,000 par value, coupon rate = 10%, rb = 0.10 c. $10,000 par value, coupon rate = 12%, rb = 0.10 What is the duration of each of the three bonds?

40. MLK Bank has an asset portfolio that consists of $100 mil- lion of 30-year, 8 percent annual coupon, $1,000 bonds that sell at par. (LG 3-4, LG 3-6) a. What will be the bonds’ new prices if market yields

change immediately by ± 0.10 percent? What will be the new prices if market yields change immediately by ± 2.00 percent?

b. The duration of these bonds is 12.1608 years. What are the predicted bond prices in each of the four cases using the duration rule? What is the amount of error between the duration prediction and the actual market values?

41. You have discovered that when the required rate of return on a bond you own fell by 0.50 percent from 9.75 percent to 9.25 percent, the fair present value rose from $975 to $995. The bond pays interest annually. What is the duration of this bond? (LG 3-8)

Go to the Federal Reserve Board’s website and get the latest rates on 10-year T-bond and Aaa- and Baa-rated corporate bonds using the following steps. Go to www.federalreserve.gov. Click on “Economic Research and Data.” Click on “Selected Interest Rates: −H.15.” Click on the most recent date. This will bring the file onto your computer that contains the relevant data. Questions

1. Calculate the percentage change in the 10-year T-bond and Aaa- and Baa-rated corporate bonds since June 2016. 2. Calculate the current spread of Aaa- and Baa-rated corporate bonds over the 10-year T-bond rate. How have these

spreads changed over the last two years?

S E A R C H T H E S I T E

APPENDIX 3B: More on Convexity

APPENDIX 3A: Duration and Immunization

Appendixes 3A and 3B are available through Connect or your course instructor.

Final PDF to printer

sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM

O U T L I N E

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

Structure of the Federal Reserve System

Organization of the Federal Reserve System

Board of Governors of the Federal Reserve System

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Balance Sheet of the Federal Reserve

Monetary Policy Tools

Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

The Federal Reserve, the Money Supply, and Interest Rates

Effects of Monetary Tools on Various Economic Variables

Money Supply versus Interest Rate Targeting

International Monetary Policies and Strategies

Systemwide Rescue Programs Employed during the Financial Crisis

Challenges Remain after the Crisis

The Federal Reserve System, Monetary Policy, and Interest Rates

L e a r n i n g G o a l s

4 c h a p t e r

LG 4-1 Understand the major functions of the Federal Reserve System.

LG 4-2 Identify the structure of the Federal Reserve System.

LG 4-3 Identify the monetary policy tools used by the Federal Reserve.

LG 4-4 Appreciate how monetary policy changes affect key economic variables.

LG 4-5 Understand how central banks around the world adjusted their monetary policy during the recent financial crisis.

Introduction and Overview of Financial Markets part one

Final PDF to printer

94 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 94 07/07/17 03:10 PM

in line with the economy’s potential to expand, a high level of employment, stable prices, and moderate long-term interest rates.

The Federal Reserve System is an independent central bank in that its decisions do not have to be ratified by the president or another member of the executive branch of the U.S. government. The system is, however, subject to oversight by the U.S. Congress under its authority to coin money. Further, the Federal Reserve is required to work within the framework of the overall objectives of economic and financial policies established by the U.S. government.

The Federal Reserve System has evolved into one of the most powerful economic bod- ies in the world and was critical in implementing policies to address the worldwide finan- cial crisis in 2008–2009. Even the hint of a change in interest rate policy by the Fed can have an impact on markets around the world. Its duties incorporate four major functions: (1) conducting monetary policy; (2) supervising and regulating depository institutions; (3) maintaining the stability of the financial system; and (4) providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

In this chapter, we present an overview of the Federal Reserve System. We start with a basic description, highlighting its organization and structure. We then examine the mon- etary policy tools available to the Fed and how the Fed uses these tools to influence the U.S. money supply and interest rates both domestically and internationally. As part of the discussion, the chapter highlights actions taken by the Fed during the recent financial cri- sis (e.g., expanding its role as a lender of last resort and purchaser/guarantor of distressed assets of banks and other FIs). Finally, we look at the independent and coordinated efforts of central banks around the world as they adjusted their international monetary policies during the financial crisis.

central banks Banks that determine, implement, and control the monetary policy in their home countries.

LG 4-1

STRUCTURE OF THE FEDERAL RESERVE SYSTEM The Federal Reserve System consists of 12 Federal Reserve Banks located in major cities throughout the United States and a seven-member Board of Governors located in Washington, DC. This structure was implemented in 1913 to spread power along regional lines, between the private sector and the government, and among bankers, businesspeo- ple, and the public. Federal Reserve Banks and the Federal Reserve Board of Governors together comprise and operate the Federal Open Market Committee (FOMC), which is responsible for the formulation and implementation of monetary policy.

Organization of the Federal Reserve System

The Federal Reserve System is divided into 12 Federal Reserve districts that are the “oper- ating arms” of the central banking system (see Figure 4–1). Each district has one main Federal Reserve Bank, some of which also have branches in other cities within the district (identified in Figure 4–1). In addition to carrying out the functions for the central banking system as a whole, each Reserve bank acts as a depository institution for the banks in its district. In terms of total assets, the 3 largest Federal Reserve Banks are the New York, San Francisco, and Richmond banks. Together these 3 banks hold over 65 percent of the total assets (discussed later) of the Federal Reserve System. The Federal Reserve Bank of New York (FRBNY) is generally considered the most important of the Federal Reserve Banks because so many of the largest U.S. and international banks are located in the New York district. Further, the Federal Reserve’s Trading Desk, which (as discussed below) carries out all the open market purchases for the Federal Reserve, is located at the FRBNY.

Federal Reserve Banks operate under the general supervision of the Board of Gover- nors of the Federal Reserve based in Washington, DC. Each Federal Reserve Bank has its own nine-member board of directors that oversees its operations: six are elected by mem- ber banks in the district (three are professional bankers and three are businesspeople) and

LG 4-2

www.federalreserve.gov

www.newyorkfed.org

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 95

sau19714_ch04_093-131.indd 95 07/07/17 03:10 PM

three are appointed by the Federal Reserve Board of Governors (directors in this group are prohibited from being employees, officers, or stockholders of a member bank). These nine directors are responsible for appointing the president of their Federal Reserve Bank.

Nationally chartered banks, those chartered by the federal government through the Office of the Comptroller of the Currency (OCC),2 are required to become members of the Federal Reserve System (FRS). State-chartered banks (those not chartered by the OCC) can also elect to become FRS members if they meet the standards set by the FRS.3 The primary advantage of FRS membership is direct access to the federal funds wire transfer network for interbank borrowing and lending of reserves (discussed below). Commercial banks that become members of the FRS are required to buy stock in their Federal Reserve district bank. Thus, Federal Reserve Banks are quasipublic (part private, part government) entities owned by member commercial banks in their district. Their stock, however, is not publicly traded and pays a predetermined dividend (at a maximum rate of 6 percent annu- ally). Approximately 34 percent of all U.S. banks (holding over 84 percent of the total assets in the U.S. banking system) are currently members of the Federal Reserve System.

2. The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks in the United States to ensure a safe, sound, and competitive banking system (see Chapters 11 and 13).

www.occc.treas.gov

3. These state-chartered banks are called state-chartered member banks. State-chartered banks that are not members of the FRS are called state-chartered nonmember banks (see Chapter 11).

Figure 4–1 Federal Reserve Districts

Bu�alo Cincinnati, Pittsburgh Baltimore, Charlotte Birmingham, Jacksonville, Miami, Nashville, New Orleans Detroit

Alaska and Hawaii are part of the

San Francisco District

Board of Governors of the Federal Reserve System, Washington, DC

Federal Reserve Bank city

Federal Reserve Branch city, by District

Little Rock, Louisville, Memphis Helena Denver, Oklahoma City, Omaha El Paso, Houston, San Antonio Los Angeles, Portland, Salt Lake City, Seattle

Board of Governors

Richmond

St. Louis

Chicago

Kansas City San Francisco Philadelphia

New York Boston

Cleveland

Dallas

AtlantaAtlanta

Minneapolis

Source: Federal Reserve Board website, “The Structure of the Federal Reserve System,” May 2016. www.federalreserve.gov

Final PDF to printer

96 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 96 07/07/17 03:10 PM

Board of Governors of the Federal Reserve System

www.occ.treas.gov

www.fdic.gov

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 97

sau19714_ch04_093-131.indd 97 07/07/17 03:10 PM

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Federal Open Market Committee (FOMC) The major monetary policy-making body of the Federal Reserve System.

open market operations Purchases and sales of U.S. government and fed- eral agency securities by the Federal Reserve.

TABLE 4–1 Functions Performed by the Federal Reserve Banks

Assistance in the conduct of monetary policy—Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC). FRBs set and change discount rates.

Supervision and regulation—FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district.

Government services—FRBs serve as the commercial bank for the U.S. Treasury. New currency issue—FRBs are responsible for the collection and replacement of damaged

currency from circulation. Check clearing—FRBs process, route, and transfer funds from one bank to another as checks

clear through the Federal Reserve System. Wire transfer services—FRBs and their member banks are linked electronically through the

Federal Reserve Communications System. Research services—each FRB has a staff of professional economists who gather, analyze, and

interpret economic data and developments in the banking sector in their district and economywide.

Final PDF to printer

sau19714_ch04_093-131.indd 98 07/07/17 03:10 PM

The Financial Crisis: Toward an Explanation and Policy Response

I N T H E N E W S

continued

Final PDF to printer

sau19714_ch04_093-131.indd 99 07/07/17 03:10 PM

Assistance in the Conduct of Monetary Policy. As mentioned, a primary responsibility of the Federal Reserve System is to influence the monetary (and financial) conditions in U.S. financial markets and thus the economy. Federal Reserve Banks conduct monetary policy in several ways. For example, as discussed previously, 5 of the 12 Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC), which determines monetary policy with respect to the open market sale and purchase of government securi- ties and, therefore, interest rates. The Boards of Directors of each Federal Reserve Bank set and change the discount rate (the interest rate on loans made by Federal Reserve Banks to financial institutions). These loans are transacted through each Federal Reserve Bank’s discount window and involve the discounting of eligible short-term securities in return for cash loans. Federal Reserve Bank Boards also have discretion in deciding which banks qualify for discount window loans. As discussed above, any discount rate change must be reviewed by the Board of Governors of the Federal Reserve. For example, in an attempt to stimulate the U.S. economy and prevent a severe economic recession, the Federal Reserve approved 11 decreases in the discount (and federal funds) rate in 2001.

In the spring of 2008, in an attempt to avoid a deep recession and rescue a failing financial system, the Federal Reserve took a series of unprecedented steps in the conduct of monetary policy. First, Federal Reserve Banks cut interest rates sharply, including one cut on a Sunday night in March 2008 (see below). Second, the Federal Reserve Bank of New York brokered the sale of Bear Stearns, the then fifth-largest investment bank in the United States, to J.P. Morgan Chase. Without this deal, Bear Stearns was highly likely to fail (and along with it other investment banks in similar situations as Bear Stearns). To get J.P. Morgan Chase to purchase Bear Stearns, the Fed agreed to take any losses in Bear Stearns’s investment portfolio up to $29 billion. Similarly, in September 2008 AIG (one of the world’s largest insurance companies) met with Federal Reserve officials to ask for desperately needed cash. Concerned about how the firm’s failure would impact the U.S. financial system, the Federal Reserve agreed to lend $40 billion to AIG to prevent its fail- ure. The financial crisis saw the Fed’s widening regulatory arm moving beyond depository institutions to other types of financial institutions. Third, for the first time Federal Reserve Banks lent directly to Wall Street investment banks. In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed.

While the Federal Reserve’s conduct of monetary policy is primarily designed to affect the U.S. economy, in our ever increasing global economy, any policy changes made by the Fed also influence, and are influenced by, international developments. For example, as discussed below and in Chapter 9, the Fed’s monetary policy actions affect the U.S. dollar for foreign currency exchange rates. A change in the foreign exchange value of the dollar affects the foreign currency price of U.S. goods bought and sold on world markets as well as the dollar price of foreign goods purchased by U.S. citizens. These transactions, in turn, affect output and price levels in the U.S. economy. Therefore, it is essential that the Federal Reserve and the FOMC incorporate information about and analysis of interna- tional transactions, movements in foreign exchange rates, and other international develop- ments as well as U.S. domestic influences when formulating appropriate monetary policy.

discount rate The interest rate on loans made by Federal Reserve Banks to financial institutions.

discount window The facility through which Federal Reserve Banks issue loans to financial institutions.

In this way, the discount window became a tool for dampening day-to- day fluctuations in the federal funds rate. In 2006, average weekly lending by the Reserve Banks through the discount window was $59 million.

Since the outset of the widespread market disruptions in the summer of 2007, the Fed has changed the terms of its lending to banks and created new lending facilities. In the first three quarters of 2008, weekly Fed lending

averaged $132.2 billion, and in the fourth quarter of the year, that figure rose to $847.8 billion. Source: Aaron Steelman and John A. Weinberg, Federal Reserve Bank of Richmond Annual Report 2008, April 2009.

I N T H E N E W S CONTINUED

The Financial Crisis: Toward an Explanation and Policy Response

Final PDF to printer

100 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 100 07/07/17 03:10 PM

Supervision and Regulation. Each Federal Reserve Bank has supervisory and regula- tory authority over the activities of state-chartered member banks and bank holding com- panies located in their districts. These activities include (1) the conduct of examinations and inspections of member banks, bank holding companies, and foreign bank offices by teams of bank examiners; (2) the authority to issue warnings (e.g., cease and desist orders should some banking activity be viewed as unsafe or unsound); and (3) the authority to approve various bank and bank holding company applications for expanded activities (e.g., mergers and acquisitions). Further, in the area of bank supervision and regulation, innovations in international banking require continual assessments of, and occasional modifications in, the Federal Reserve’s procedures and regulations.

Notably, after March 2008, as the Fed stepped in to save investment bank Bear Stearns from failure, politicians proposed an expanded role for the Fed as the main supervisor for all financial institutions. In July 2010, the U.S. Congress passed the Wall Street Reform and Consumer Protection Act, which called for the Fed to supervise the most complex financial companies in the United States and gave regulators (including the Fed) author- ity to seize and break up any troubled financial firm whose collapse might cause wide- spread economic damage. Thus, the Fed’s supervision and regulation duties have spread to include commercial banks as well as other types of financial institutions.

Consumer Protection and Community Affairs. The U.S. Congress has assigned the Federal Reserve, through FRBs, with the responsibility to implement federal laws intended to protect consumers in credit and other financial transactions. These responsibilities include writing and interpreting regulations to carry out many of the major consumer protection laws; reviewing bank compliance with the regulations; investigating complaints from the public about state member banks’ compliance with consumer protection laws; addressing issues of state and federal jurisdiction; testifying before Congress on consumer protection issues; and conducting community development activities. Further, community affairs offices at FRBs engage in a wide variety of activities to help financial institutions, community-based organizations, government entities, and the public understand and address financial services issues that affect low- and moderate-income people and geographic regions.

Government Services. As discussed, the Federal Reserve serves as the commercial bank for the U.S. Treasury (U.S. government). Each year government agencies and departments deposit and withdraw billions of dollars from U.S. Treasury operating accounts held by Federal Reserve Banks. For example, it is the Federal Reserve Banks that receive depos- its relating to federal unemployment taxes, individual income taxes withheld by payroll deduction, and so on. Further, some of these deposits are not protected by deposit insur- ance and must be fully collateralized at all times. It is the Federal Reserve Banks that hold collateral put up by government agencies. Finally, Federal Reserve Banks are responsible for the operation of the U.S. savings bond scheme, the issuance of Treasury securities, and other government-sponsored securities (e.g., Fannie Mae, Freddie Mac—see Chapter 7). Federal Reserve Banks issue and redeem savings bonds and Treasury securities, deliver government securities to investors, provide for a wire transfer system for these securities (the Fedwire), and make periodic payments of interest and principal on these securities.

New Currency Issue. Federal Reserve Banks are responsible for the collection and replacement of currency (paper and coin) from circulation. They also distribute new cur- rency to meet the public’s need for cash. For example, at the end of 1999 the Fed increased the printing of currency to meet the estimated $697 billion demand for currency result- ing from the Y2K scare, in which it was feared that computers worldwide (incapable of recognizing the year 2000) would cease to function on January 1, 2000. Afraid that bank accounts would be lost, depositors withdrew funds in record amounts. More recently, beginning in 2011, there was talk of the Treasury minting a $1 trillion platinum coin as a way of addressing the U.S. debt ceiling crisis. A few, otherwise intended, sentences in the 1997 Omnibus Consolidated Appropriations Act allowed such a minting as long as the

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 101

sau19714_ch04_093-131.indd 101 07/07/17 03:10 PM

coin was platinum. Advocates argued that minting the $1 trillion coin to pay off some of the national debt was a better option than the continued fighting by political leaders over raising the U.S. debt ceiling. However, talk of this solution was relatively short-lived, as in January 2013 the Federal Reserve announced that if the Treasury did mint the coin and present it for payment, the Fed would not accept it.

Check Clearing. The Federal Reserve System operates a central check clearing system for U.S. banks, routing interbank checks to depository institutions on which they are writ- ten and transferring the appropriate funds from one bank to another. All depository insti- tutions have accounts with the Federal Reserve Bank in their district for this purpose. Table 4–2 shows the number and value of checks collected by the Federal Reserve Banks from 1920 through 2015.

The number of checks cleared through the system peaked in 1990, with 18.60 billion checks cleared. For several reasons, this fell to 5.45 billion by 2015. Industry consolida- tion and greater use of electronic products has resulted in a reduction in the number of checks written and thus cleared through the Federal Reserve System. Further, in October 2004, the Check 21 Act, enacted by the Congress and the Federal Reserve, allowed banks to destroy checks after taking a digital image that is then processed electronically. The act begins the process of moving to a paperless environment. Check 21 authorizes the use of a substitute check (Image Replacement Document) for settlement. The new law is designed to encourage the adoption of electronic check imaging. It was prompted partly by the September 11 attacks, which grounded the cargo airplanes that flew 42 billion checks a year around the United States, threatening to disrupt the financial system. The switch to electronic processing of checks has saved as much as $3 billion a year for the banking industry. For customers, the implications are mixed. Because checks are processed much more quickly, check writers have lost the “float” of several days between the time checks are deposited and when they are debited from the account.

Wire Transfer Services. The Federal Reserve Banks and their member banks are linked electronically through the Federal Reserve Communications System. This network allows these institutions to transfer funds and securities nationwide in a matter of minutes. Two elec- tronic (wire) transfer systems are operated by the Federal Reserve: Fedwire and the Auto- mated Clearinghouse (ACH). Fedwire is a network linking more than 7,300 domestic banks with the Federal Reserve System. Banks use this network to make deposit and loan payments, to transfer book entry securities among themselves, and to act as payment agents on behalf of

TABLE 4–2 Number and Value of Checks and Electronic Transactions Processed by the Federal Reserve

Checks Cleared Fedwire Transactions Processed ACH Transactions Processed

Year Number

(in billions)

Value (in trillions of dollars)

Number (in billions)

Value (in trillions of dollars)

Number (in billions)

Value (in trillions of dollars)

1920 0.42 $ 0.15 0.5 $ 0.03 n.a. n.a. 1930 0.91 0.32 2.0 0.20 n.a. n.a. 1940 1.18 0.28 0.8 0.09 n.a. n.a. 1950 1.96 0.86 1.0 0.51 n.a. n.a. 1960 3.42 1.15 3.0 2.43 n.a. n.a. 1970 7.16 3.33 7.0 12.33 n.a. n.a. 1980 15.72 8.04 43.0 78.59 227 $ 0.29 1990 18.60 12.52 62.6 199.07 1,435 4.66 2000 16.99 13.85 108.3 379.76 4,651 14.02 2005 12.23 15.68 132.4 518.50 8,303 15.96 2010 7.71 8.81 125.1 608.32 11,455 21.37 2015 5.45 8.11 142.8 834.60 13,856 25.62

Final PDF to printer

102 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 102 07/07/17 03:10 PM

large corporate customers.6 Fedwire transfers are typically large dollar payments (averaging $5.85 million per transaction). The ACH was developed jointly by the private sector and the Federal Reserve System in the early 1970s and has evolved as a nationwide method to elec- tronically process credit and debit transfers of funds. Table 4–2 shows the number and dollar value of Fedwire and ACH transactions processed by Federal Reserve Banks from 1920 through 2015. In contrast to the falling volume of checks cleared by the Federal Reserve, electronic Fedwire and ACH transactions processed have grown significantly in recent years.

Research Services. Each Federal Reserve Bank has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sec- tor as well as the overall economy. These research projects are often used in the conduct of monetary policy by the Federal Reserve. Research papers are freely accessible to the public, are of very high quality, and are quite readable. This makes them one of the best resources for economists, investors, FI managers, and any other individual interested in the operations and performance of the financial system.

Balance Sheet of the Federal Reserve

Table 4–3 shows the balance sheet for the Federal Reserve System for various years from 2007 through 2016. The conduct of monetary policy by the Federal Reserve involves changes in the assets and liabilities of the Federal Reserve System, which are reflected in the Federal Reserve System’s balance sheet.

6. A second major wire transfer service is the Clearing House Interbank Payments System (CHIPS). CHIPS operates as a private network, independent of the Federal Reserve. At the core of the CHIPS system are approximately 50 large U.S. and foreign banks acting as correspondent banks for smaller domestic and international banks in clearing mostly international transactions in dollars.

TABLE 4–3 Balance Sheet of the Federal Reserve (in billions of dollars)

Assets 2007 2008 2010 2013 2016 Percentage of

Total, 2016

U.S. official reserve assets $ 34.2 $ 35.7 $ 37.0 $ 34.5 $ 30.5 0.7% SDR certificates 2.2 2.2 5.2 5.2 5.2 0.1 Treasury currency 38.7 38.7 43.5 45.0 47.6 1.0 Federal Reserve float −0.0 −1.5 −1.4 −0.6 −0.0 −0.0 Interbank loans 48.6 559.7 0.2 0.0 0.1 0.0 Security repurchase agreements 46.5 80.0 0.0 0.0 0.0 0.0 U.S. Treasury securities 740.6 475.9 1,021.5 1,796.0 2,461.6 54.2 U.S. government agency securities 0.0 19.7 1,139.6 1,143.4 1,780.4 39.2 Miscellaneous assets 40.5 1,060.2 207.6 220.3 216.8 4.8 Total assets $ 951.3 $ 2,270.6 $ 2,453.2 $ 3,243.8 $ 4,542.2 100.0%

Liabilities and Equity

Depository institution reserves $ 20.8 $ 860.0 $ 968.1 $ 1,790.4 $ 1,977.2 43.5% Vault cash of commercial banks 55.0 57.7 52.7 59.7 74.2 1.6 Deposits due to federal government 16.4 365.7 340.9 79.4 333.7 7.4 Deposits due to government agencies 1.7 21.1 13.5 20.2 31.1 0.7 Currency outside banks 773.9 832.2 930.0 1,117.3 1,350.8 29.7 Security repurchase agreements 44.0 88.4 59.7 105.5 712.4 15.7 Miscellaneous liabilities 2.5 3.4 35.3 16.2 23.3 0.5 Federal Reserve Bank stock 18.5 21.1 26.5 27.6 29.5 0.7 Equity 18.5 21.0 26.5 27.5 10.0 0.2 Total liabilities and equity $ 951.3 $ 2,270.6 $ 2,453.2 $ 3,243.8 $ 4,542.2 100.0%

Source: Federal Reserve Board, “Flow of Fund Accounts,” Monetary Authority, June 2016, p. L.109. www.federalreserve.gov

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 103

sau19714_ch04_093-131.indd 103 07/07/17 03:10 PM

Liabilities. The major liabilities on the Fed’s balance sheet are currency in circulation and reserves (depository institution reserve balances in accounts at Federal Reserve Banks plus vault cash on hand at commercial banks). Their sum is often referred to as the Fed’s monetary base or money base. We can represent these as follows:

Reserves—depository institution reserve balances at the Fed plus vault cash. Money base—currency in circulation plus reserves.

For example, in March 2016 the monetary base totaled $3.90 trillion, of which $2.46 trillion was reserves and $1.44 trillion was currency in circulation. As we show below, changes in these accounts are the major determinants of the size of the nation’s money supply—increases (decreases) in either or both of these balances (e.g., currency in circula- tion or reserves) will lead to an increase (decrease) in the money supply (see below for a definition of the U.S. money supply).

Reserve Deposits. The largest liability on the Federal Reserve’s balance sheet (43.5 percent of total liabilities and equity) is depository institution reserves. All banks hold reserve accounts at their local Federal Reserve Bank. These reserve holdings are used to settle accounts between depository institutions when checks and wire transfers are cleared (see above). Reserve accounts also influence the size of the money supply (as described below).

Total reserves can be classified into two categories: (1) required reserves (reserves that the Fed requires banks to hold by law) and (2) excess reserves (additional reserves over and above required reserves) that banks choose to hold themselves. Required reserves are reserves banks must hold by law to back a portion of their customer transaction accounts (deposits). For example, the Federal Reserve currently requires up to 10 cents of every dollar of transaction deposit accounts at U.S. commercial banks to be backed with reserves (see Chapter 13). Thus, required reserves expand or contract with the level of transaction deposits and with the required reserve ratio set by the Federal Reserve Board. Because these deposits earn little interest, banks try to keep excess reserves to a minimum. Excess reserves, on the other hand, may be lent by banks to other banks that do not have sufficient reserves on hand to meet their required levels.

As the Federal Reserve implements monetary policy, it uses the market for excess reserves. For example, in the fall of 2008, the Federal Reserve implemented several mea- sures to provide liquidity to financial markets that had frozen up as a result of the financial crisis. The liquidity facilities introduced by the Federal Reserve in response to the crisis created a large quantity of excess reserves at depository institutions (DIs). Specifically, in October 2008 the Federal Reserve began paying interest on excess reserves for the first time.7 Further, during the financial crisis, the Fed set the interest rate it paid on excess reserves equal to its target for the federal funds rate (see below). This policy essentially removed the opportunity cost of holding reserves. That is, the interest banks earned by holding excess reserves was approximately equal to what was previously earned by lending to other FIs. As a result, banks drastically increased their holdings of excess reserves at Federal Reserve Banks. Because the U.S. economy was slow to recover from the financial crisis, the Fed kept the fed funds rate at historic lows into 2016. Thus, banks continued to hold large amounts of excess reserves. Note in Table 4–3 that depository institution reserves were 43.5 percent of total liabilities and equity of the Fed in 2016, up from 37.9 percent in 2008. This in turn was up from 2.2 percent in 2007, prior to the start of the financial crisis.

Some observers claim that the large increase in excess reserves implied that many of the policies introduced by the Federal Reserve in response to the financial crisis were inef- fective. Rather than promoting the flow of credit to firms and households, critics argued that the increase in excess reserves indicated that the money lent to banks and other FIs

reserves Depository institutions’ vault cash plus reserves deposited at Federal Reserve Banks.

monetary base Currency in circulation and reserves (depository institution reserves and vault cash of commercial banks) held by the Federal Reserve. Also referred to as money base.

required reserves Reserves the Federal Reserve requires banks to hold.

excess reserves Additional reserves banks choose to hold.

7. On October 1, 2008, the Board of Governors amended its rules governing the payment of interest on excess reserves so that the interest rate on excess balances was set at 25 basis points.

Final PDF to printer

104 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 104 07/07/17 03:10 PM

Currency Outside Banks. The second-largest liability, in terms of percentage of total liabilities and equity, of the Federal Reserve System is currency in circulation (29.7 percent of total liabilities and equity in 2016). At the top of each Federal Reserve note ($1 bill, $5 bill, $10 bill, etc.) is the seal of the Federal Reserve Bank that issued it. Federal Reserve notes are basically IOUs from the issuing Federal Reserve Bank to the bearer. In the United States, Federal Reserve notes are recognized as the principal medium of exchange and therefore function as money (see Chapter 1).

D O YO U U N D E R S TA N D :

1. What the main functions of Federal Reserve Banks are?

2. What the main responsibilities of the Federal Reserve Board are?

3. How the FOMC implements monetary policy?

4. What the main assets and liabilities of the Federal Reserve are?

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 105

sau19714_ch04_093-131.indd 105 07/07/17 03:10 PM

Miscellaneous Assets. Generally, miscellaneous assets are a small portion of the Fed’s total assets (e.g., 4.8 percent in 2016). However, during the financial crisis, the Fed under- took a number of measures to support various sectors of the financial markets. For exam- ple, as mentioned above (and below), during the financial crisis, the Fed provided AIG with a loan to prevent its failure; lent funds (for the first time ever) through its discount window to brokers and dealers; and committed over $1 trillion of loans to support the com- mercial paper market. These temporary programs were recorded as miscellaneous assets and, as a result, this item rose to 46.7 percent of total assets in 2008.

MONETARY POLICY TOOLS In the previous section of this chapter, we referred briefly to tools or instruments that the Federal Reserve uses to implement its monetary policy. These included open market oper- ations, the discount rate, and reserve requirements. In this section, we explore the tools or instruments used by the Fed to implement its monetary policy strategy.8 Figure 4–2 illus- trates the monetary policy implementation process that we will be discussing in more detail below. Regardless of the tool the Federal Reserve uses to implement monetary pol- icy, the major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves (required and excess reserves held as depository institution reserve balances in accounts at Federal Reserve Banks plus the vault cash on hand of commercial banks). Specifically, the Federal Reserve’s monetary policy seeks to influence either the demand for, or supply of, excess reserves at depository institutions and in turn the money supply and the level of interest rates. As we describe in the next section, a change in excess reserves resulting from the implementation of mone- tary policy triggers a sequence of events that affect such economic factors as short-term interest rates, long-term interest rates, foreign exchange rates, the amount of money and credit in the economy, and ultimately the levels of employment, output, and prices. Some of the specific economic variables the Federal Reserve works to affect as it implements monetary policy are listed in Table 4–4. These economic variables are referred to as the index of leading indicators. A leading indicator is a measurable economic factor that changes before the economy starts to follow a particular pattern or trend, and, as such, can be used to predict future economic trends.

LG 4-3

8. In addition to the tools described here, the Fed (as well as the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) can indirectly affect the money supply by signaling to bankers to tighten or loosen credit availability. Further, changes in other types of regulations such as capital requirements can affect the money sup- ply. Finally, the U.S. Congress and the U.S. Treasury can use fiscal policy (the use of government expenditure and reve- nue collection through taxation) to affect the level of aggregate demand in the economy to achieve economic objectives.

Figure 4–2 Federal Reserve Monetary Policy Activities

Extensions Add

Reserves

Securities Purchases

Add Reserves

Securities Sales Drain

Reserves

Repayment Drains

Reserves

Discount Window Loans

Banks with Excess Reserves

Federal Reserve

Open Market Operations

Banks That Want Reserves

Total Reserves in the

Banking System

Trade Reserves

Source: Federal Reserve Board website, “Purposes & Functions.” www.federalreserve.gov

Final PDF to printer

106 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 106 07/07/17 03:10 PM

Depository institutions trade excess reserves held at their local Federal Reserve Banks among themselves. Banks with excess reserves—whose reserves exceed their required reserves—have an incentive to lend these funds (generally overnight) to banks in need of reserves since excess reserves held in the vault or on deposit at the Federal Reserve earn little or no interest. The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate, which is used in the United States to guide monetary policy. The fed funds rate is a function of the supply and demand for federal funds among banks and the effects of the Fed’s trading through the FOMC.

Further, the Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay interest on reserve balances held by depository institutions effective October 1, 2011. Because of the severity of the financial crisis and the need by the Fed to have as many tools available to fight off the crisis, the Emergency Economic Stabilization Act of 2008 moved the effective date to October 1, 2008. The interest rate on required reserves (IORR) is determined by the Fed and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions (see Chapter 13). The interest rate on excess reserves (IOER) is also determined by the board and gives the Fed- eral Reserve an additional tool for the conduct of monetary policy. Specifically, during monetary policy normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the IOER rate. As indi- cated in the minutes of the March 2015 FOMC meeting, the Federal Reserve intends to set the IOER rate equal to the top of the target range for the federal funds rate. Thus, as of December 2015, both the IORR and the IOER rates were set at 0.50 percent.

In implementing monetary policy, the Federal Reserve can take one of two basic approaches to affect the market for banks’ excess reserves: (1) it can target the quantity of reserves in the market based on the FOMC’s objectives for the growth in the monetary base (the sum of currency in circulation and reserves) and, in turn, the money supply (see below); or (2) it can target the interest rate on those reserves (the fed funds rate). The actual approach used by the Federal Reserve has varied according to considerations such as the need to combat inflation or the desire to encourage sustainable economic growth (we dis- cuss the various approaches below). Since 1993, the FOMC has implemented monetary policy mainly by targeting interest rates (mainly using the fed funds rate as a target).

As mentioned earlier, to reduce the effects of an economic slowdown in the United States, the Fed decreased the fed funds rate 11 times in 2001. This was done to soften the effects of the collapse of the dot-com bubble and the September 2001 terrorist attacks, as well as to combat the perceived risk of deflation. Even into August 2003 the FOMC took the unusual step of foreshadowing its future policy course by announcing that the histori- cally low interest rates could be maintained for a considerable period. Although the FOMC did not specify the length of the considerable period, it was not until the summer of 2004 that the Fed increased the fed funds rate (initially by 0.25 percent). It has been argued that this lowering of interest rates was a contributing factor to the rise in housing prices. From 2000 to 2003, the Federal Reserve lowered the fed funds target from 6.5 percent to

fed funds rate The interest rate on short- term funds transferred between financial institu- tions, usually for a period of one day.

TABLE 4–4 List of Leading Economic Indicators

Average number of weekly hours worked by manufacturing workers Average number of initial applications for unemployment insurance Number of manufacturers’ new orders for consumer goods and materials Speed of delivery of new merchandise to vendors from suppliers Number of new orders for capital goods unrelated to defense Number of new building permits for residential buildings S&P 500 stock index Inflation-adjusted monetary supply (M2) Spread between long- and short-term interest rates Consumer sentiment

Final PDF to printer

107

sau19714_ch04_093-131.indd 107 07/07/17 03:10 PM

1.0 percent. The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low. However, some have argued that the Fed’s interest rate pol- icy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bub- ble. Low interest rates and the increased liquidity provided by the central bank resulted in a rapid expansion in mortgage financing as demand for residential mortgages rose dramati- cally, especially among those who had previously been excluded from participating in the market because of their poor credit ratings.

The Fed then raised the fed funds rate significantly between July 2004 and August 2006; it increased the rate by 0.25 percent for 17 straight meetings. As a result, the fed funds rate rose from a 46-year low of 1 percent in July 2004 to 5.25 percent in August 2006. This contributed to an increase in one-year and five-year adjustable-rate mortgage (ARM) rates and triggered resets of rates on existing ARMs, making ARM interest pay- ments more expensive for homeowners. This also may have contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.

Then, on December 16, 2008, as the U.S. economy faced a severe financial cri- sis and fell into its deepest recession since the Great Depression, the Fed, in a historic move, unexpectedly announced that it would drop its target fed funds rate to a range between 0 and one-quarter of 1 percent and lowered its discount window rate (see below) to one-half percent, the lowest level since the 1940s (see the In the News box in this section). The overall reduction in the federal funds rate between late 2007 and December 2008 was dramatic, going from 5.26 percent in September 2007 to a range

In an effort to prevent a worsening recession, in December of 2008 the U.S. Federal Reserve made the unprecedented decision to cut its benchmark interest rates to as low as zero. According to a Fed spokes- person, “The Federal Reserve will employ all available tools to promote the resumption of sustainable eco- nomic growth and to preserve price stability.” In a historic move, the Fed lowered its target for the benchmark federal funds rates from 1.0 percent to a record low range of zero to 0.25 percent.

The Fed also mentioned that it was considering additional ways to support and boost the faltering economy, including expanding a plan to purchase large amounts of debt issued or guaranteed by government-sponsored mort- gage agencies and purchasing

Fed Cuts Rates to Record Low

I N T H E N E W S

longer-term U.S. Treasury debt. According to the Fed, “The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market oper- ations and other measures that sus- tain the size of the Federal Reserve’s balance sheet at a high level.”

In an article from Reuters, Michael Woolfolk, senior currency strategist at the Bank of New York- Mellon in New York, said, “It’s a highly unorthodox and creative step. We think it’s the best possible move for the U.S. consumer and for the financial market.” Even with a large and varied number of new initiatives planned to encourage lending by banks, as of late 2008, U.S. authorities had been unable to stop the recession from worsening. They increased their efforts after

the increased economic disruption and confusion that accompanied the failure of Lehman Brothers in Sep- tember of 2008.

In the fall of 2008, the Fed also injected huge amounts of money into credit markets, increasing the size of its balance sheet from $887 billion to $2.2 trillion over just three months. According to Ian Shephard- son, chief U.S. economist for High Frequency Economics in Valhalla, New York, the decision “is a reflec- tion of an utterly desolate economic picture, which will persist for the foreseeable future as the wrenching adjustment in household finances continues.”

Source: Mark Felsenthal, “Fed Cuts Rates to Record Low,” Reuters, December 16, 2008, http://www. reuters.com/article/us-usa-fed-preview- idUSN1550484520081216.

Final PDF to printer

108 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 108 07/07/17 03:10 PM

Open Market Operations

www.newyorkfed.org

Federal Reserve Board Trading Desk Unit of the Federal Reserve Bank of New York through which open market opera- tions are conducted.

policy directive Statement sent to the Fed- eral Reserve Board Trading Desk from the FOMC that specifies the daily amount of open market purchases or sales to transact.

9. As of June 2016, there were 23 primary securities dealers trading, on average, $0.82 trillion of securities per day.

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 109

sau19714_ch04_093-131.indd 109 07/07/17 03:10 PM

Note the Federal Reserve’s purchase of Treasury securities has increased the total sup- ply of bank reserves in the financial system. This in turn increases the ability of banks to make new loans and create new deposits. For example, in March 2009 the Federal Reserve announced that it would buy $300 billion of long-term Treasury securities over the next six months in order to try and get credit flowing to the financial markets. This program was eventually referred to as the Fed’s Quantitative Easing 1 (QE1) program. The Fed gener- ally conducts open market operations using short-term Treasury bills (to set the fed funds rate) and generally does not intervene in long-term Treasury markets (allowing the market to set long-term rates). In fact, the Fed had not purchased long-term Treasury securities since the 1960s. In November 2010, the Fed followed up its QE1 program with QE2, in which it purchased $600 billion of long-term Treasury securities between November 2010 and June 2011. In September 2012 the Fed announced the beginning of QE3, an open- ended program involving the purchase of $40 billion of Treasury securities per month. QE3 ended in October 2014. The results of the QE programs can be seen on the Federal Reserve’s balance sheet in Table 4–3. Treasury securities totaled $2.46 trillion in 2016, up from $741 billion in 2007, while depository institution reserves were $1.98 trillion in 2016, up from $21 billion in 2007. The message to the financial markets from these actions was that the Fed was willing to do whatever was necessary to stabilize the economy until it had sufficiently recovered from the financial crisis.

banks) in turn deposit these payments in their accounts held at their local Federal Reserve Bank. As a result of these purchases, the Treasury securities account balance of the Federal Reserve System is increased by $500 million and the total reserve accounts maintained by these banks and dealers at the Fed are increased by $500 million. We illustrate these changes to the Federal Reserve’s balance sheet in Table 4–5. In addition, there is also an impact on commercial bank balance sheets. Total reserves (assets) of commercial banks will increase by $500 million due to the purchase of securities by the Fed, and demand deposits (liabilities) of the securities dealers (those who sold the securities) at their banks will increase by $500 million.10 We also show the changes to commercial banks’ balance sheets in Table 4–5.

10. In reality, not all of the $500 million will generally be deposited in demand deposit accounts of commercial banks, and commercial banks will not generally hold all of the $500 million in reserve accounts of Federal Reserve Banks. We relax these simplifying assumptions and look at the effect on total reserves and the monetary base later in the chapter.

TABLE 4–5 Purchase of Securities in the Open Market

Change in Federal Reserve’s Balance Sheet

Assets Liabilities Treasury securities + $500m Reserve account of

securities dealers’ banks + $500m

Change in Commercial Bank Balance Sheets

Assets Liabilities Reserve accounts

at Federal Reserve + $500m Securities dealers’ demand

deposit accounts at banks + $500m

EXAMPLE 4–2 Sale of Securities by the Federal Reserve Suppose the FOMC instructs the FRBNY Trading Desk to sell $500 million of securities. Traders at the FRBNY call government securities dealers who provide a list of securi- ties they are willing to buy, including the price on each security. FRBNY traders sell

Final PDF to printer

110 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 110 07/07/17 03:10 PM

Note that the Federal Reserve’s sale of Treasury or other government securities has decreased the total supply of bank reserves in the financial system. This in turn decreases the ability of banks to make loans and create new deposits.

While the Federal Reserve conducts most of its open market operations using Treasury securities, other government securities can be used as well. For example, in addition to the purchase of Treasury securities, the QE programs of the Federal Reserve also involved the purchase of over $1 trillion Fannie Mae and Freddie Mac mortgage-backed securities and bonds. The purchase of these securities is evident on the Fed’s balance sheet in Table 4–3. In 2016, the Fed’s holding of U.S. government agency securities was $1.78 trillion, up from $0 in 2007. Treasury securities are used most, however, because the secondary mar- ket for such securities is highly liquid and there is an established group of primary dealers who also trade extensively in the secondary market. Thus, the Treasury securities market can absorb a large number of buy and sell transactions without experiencing significant price fluctuations.

The Discount Rate

The discount rate is the second monetary policy tool or instrument used by the Federal Reserve to control the level of bank reserves (and thus the money supply or interest rates). As defined previously, the discount rate is the rate of interest Federal Reserve Banks charge on loans to financial institutions in their district. The Federal Reserve can influence the level and price of reserves by changing the discount rate it charges on these loans.

Specifically, changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy. For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary mon- etary conditions and lower interest rates in general.

For two reasons, the Federal Reserve has rarely used the discount rate as a monetary policy tool. First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. There is no guarantee that banks will borrow more (less) at the discount window in response to a decrease (increase) in the discount rate. Thus, the exact direct effect of a discount rate change on the money supply is often uncertain. The In the News box in this section demonstrates how in August 2007, the Fed’s lowering of the discount rate to calm financial markets battered by deteriorating conditions in the mortgage and other debt markets resulted in little effect on the borrowing by banks. However, the Fed’s lowering of the fed funds rate less than a month later resulted in a surge in discount window borrowing.

securities to these dealers at the highest prices possible until they have sold $500 million. The FRBNY then notifies its government bond department to deliver the securities to, and receive payment from, the buying security dealers. The securities dealers pay for these securities by drawing on their deposit accounts at their commercial banks. As a result of this sale, the Treasury securities account balance for the Federal Reserve System is decreased by $500 million (reflecting the sale of $500 million in Treasury securities) and the reserve accounts maintained at the Fed by commercial banks that handle these securi- ties transactions for the dealers are decreased by $500 million. The changes to the Fed- eral Reserve’s balance sheet in this case would have the opposite sign (negative) as those illustrated in Table 4–5. In addition, total reserves of commercial banks have decreased by $500 million due to the purchase of securities from the Fed, and demand deposits of the securities dealers at their banks have decreased by $500 million (reflecting the payments for the securities by the securities dealers). Commercial banks’ balance sheet changes would have the opposite sign as those illustrated in Table 4–5 for a purchase of securities.

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 111

sau19714_ch04_093-131.indd 111 07/07/17 03:10 PM

Second, because of its “signaling” importance, a discount rate change often has great effects on the financial markets. For example, the unexpected decrease in the Fed’s discount rate (to 0.50 percent) on December 16, 2008, resulted in a 359.61 point increase in the Dow Jones Industrial Average, one of the largest one-day point gains in the his- tory of the Dow and one of a handful of up days during the height of the financial cri- sis. Moreover, virtually all interest rates respond in the same direction (if not the same amount) to the discount rate change. For example, Figure 4–3 shows the correlation in four major U.S. interest rates (discount rate, prime rate [the rate banks charge to large corporations for short-term loans], three-month CD rate, and three-month T-bill rate) from 1990 through June 2016.

In general, discount rate changes are used only when the Fed wants to send a strong message to financial markets to show that it is serious about wanting to implement new monetary policy targets. For example, Federal Reserve Board members commented that the December 16, 2008, discount rate change was taken in light of a deterioration in labor market conditions and a decline in consumer spending, business investment, and industrial production. Further, financial markets remained quite strained and credit con- ditions tight. The board commented that overall, the outlook for economic activity had weakened further. Thus, this drop in the discount rate was intended to signal the Fed’s strong and persistent intention to allow the money supply to increase and to stimulate economic growth. The discount rate stayed at this historical low until February 2010, when the Fed raised the rate to 0.75 percent.

Historically, discount window lending was limited to depository institutions (DIs) with severe liquidity needs. The discount window rate, which was set below the fed funds rate, was charged on loans to depository institutions only under emergency or special liquidity

Figure 4–3 Various U.S. Interest Rates

Ja n-

9 0

Ja n-

9 1

Ja n-

9 2

Ja n-

9 3

Ja n-

9 4

Ja n-

9 5

Ja n-

9 6

Ja n-

9 7

Ja n-

9 8

Ja n-

9 9

Ja n-

0 0

Ja n-

0 1

Ja n-

0 2

Ja n-

0 3

Ja n-

0 4

Ja n-

0 5

Ja n-

0 6

Ja n-

0 7

Ja n-

0 8

Ja n-

0 9

Ja n-

1 0

Ja n-

1 1

Ja n-

1 5

Ja n-

1 6

Ja n-

1 2

Ja n-

1 3

Ja n-

1 4

Year

Interest Rate

Prime

Discount

T-bill

Source: Federal Reserve Board website, “Research and Data.” www.federalreserve.gov

Final PDF to printer

112

sau19714_ch04_093-131.indd 112 07/07/17 03:10 PM

situations (see Figure 4–3, 1990–2002). However, in January 2003 the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Fed’s discount window. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Primary credit may be used for any purpose, including financ- ing the sale of fed funds. Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to deposi- tory institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Fed- eral Reserve’s seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is avail- able to depository institutions that can demonstrate a clear pattern of recurring intrayearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer-term funds from the dis- count window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending.

With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below, as it generally was in the period preceding January 2003. Note in Figure 4–3 the jump in the discount window rate in January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were intended not to change the Fed’s use of the discount window to

In August of 2007, top banks in the United States, including Citigroup and Bank of America, borrowed $2 billion from the U.S. Federal Reserve. This rare move was designed to sta- bilize and reassure U.S. markets and change the perceived stigma around receiving assistance from the central bank. Traditionally, borrowing funds from the Fed can be perceived as a sign of financial weakness, but three large banks, J.P. Morgan Chase & Co, Bank of America, and Wachovia Corp. claim that they made the choice in the interest of helping the financial system. According to Reuters, “All four banks have emphasized that they have access to other, cheaper funds.”

After the transactions occurred, U.S. shares rose, though bank stocks’

Top Four Banks Tap Fed Discount Window

I N T H E N E W S

performance continued to be mixed because of persistent concerns about worsening mortgage and mortgage backed securities markets. Neverthe- less, the banks’ choice to borrow from the Fed signaled credit markets may be starting to heal. Other banks may also start to follow the lead of their larger counterparts. Robert Albertson, chief strategist at Sandler O’Neill in New York, says, “The psychology is, if a bank needs to borrow from the dis- count window, and they think there’s a stigma attached to it, they can say, ‘Citi has done it, too.’”

Traditionally, banks tend to hesi- tate to borrow funds from the Fed’s discount window. In the past, it has been seen as a sign that a bank is in distress. Discount window borrowing

also often resulted in additional regulation and oversight. Borrowing from the Fed no longer requires addi- tional federal supervision, but “the stigma remains,” according to Richard DeKaser, chief economist at National City Corp. in Cleveland.

Across the world, central banks are adapting to the financial crisis by pumping liquidity into the global economy. The losses in the U.S. subprime mortgage market continue to make credit difficult to obtain in a range of markets such as commercial paper and junk bonds.

Source: Dan Wilchins, “Top Four Banks Tap Fed Discount Window,” Reuters, August 22, 2007, http://www.reuters. com/article/us-banks-federalreserve- idUSN2243173420070822.

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 113

sau19714_ch04_093-131.indd 113 07/07/17 03:10 PM

implement monetary policy, but to significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks’ use of the discount win- dow as a source of funding, the Fed hoped to reduce volatility in the fed funds market as well. The change also allowed healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrow- ing. With the changes, the Fed lends to all banks, but the subsidy of below fed fund rate borrowing is gone.

The Fed took additional unprecedented steps, expanding the usual function of the dis- count window, to address the financial crisis. While the discount window had traditionally been available only to DIs, in the spring of 2008 (as Bear Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer Credit Facility (PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. The largest expansion of the discount window’s availability to all FIs occurred in the wake of the Lehman Brothers’s failure, as a series of actions were taken in response to the increasingly fragile state of financial markets.

During the financial crisis, the Fed also significantly reduced the spread (premium) between the discount rate and the federal funds target to just one-quarter of a point, bring- ing the discount rate down to one-half percent. With lower rates at the Fed’s discount window and interbank liquidity scarce as many lenders cut back their lending, more finan- cial institutions chose to borrow at the discount window. The magnitude and diversity of nontraditional lending programs and initiatives developed during the crisis were unprec- edented in Federal Reserve history. The lending programs were all designed to “unfreeze” and stabilize various parts of the credit markets, with the overall goal that parties receiving credit via these new Fed programs would, in turn, provide funding to creditworthy indi- viduals and firms.

Reserve Requirements (Reserve Ratios)

The third monetary policy tool available to the Federal Reserve to achieve its monetary targets is depository institution reserve requirements. As defined previously, reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Federal Reserve Banks) that depository institutions must maintain by law to back transaction deposit accounts (e.g., demand deposits and interest-bearing checking accounts) held as liabilities on their balance sheets. This requirement is usually set as a ratio of transaction accounts—for example, 10 percent (see Chapter 13 for a detailed description of the process used by depository institutions to calculate required reserves). A decrease in the reserve requirement ratio means that depository institutions may hold fewer reserves (vault cash plus reserve deposits at the Fed) against their transaction accounts (deposits). Consequently, they are able to lend out a greater percentage of their deposits, thus increasing credit availability in the economy. As new loans are issued and used to finance consumption and investment expenditures, some of these funds spent will return to depository institutions as new deposits by those receiving them in return for supplying consumer and investment goods to bank borrowers. In turn, these new depos- its, after deducting the appropriate reserve requirement, can be used by banks to create additional loans, and so on. This process continues until the banks’ deposits have grown sufficiently large such that banks willingly hold their current reserve balances at the new lower reserve ratio. Thus, a decrease in the reserve requirement results in a multiplier increase in the supply of bank deposits and thus the money supply. The multiplier effect can be written as follows:

Change in bank deposits

(1 / New reserve requirement)

× Increase in reserves created by reserve requirement change

Conversely, an increase in the reserve requirement ratio means that depository institu- tions must hold more reserves against the transaction accounts (deposits) on their balance

Final PDF to printer

114 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 114 07/07/17 03:10 PM

sheet. Consequently, they are able to lend out a smaller percentage of their deposits than before, thus decreasing credit availability and lending, and eventually, leading to a multiple contraction in deposits and a decrease in the money supply. Now the multiplier effect is written as:

Change in bank deposits

(1 / New reserve requirement)

× Decrease in reserves created by reserve requirement change

EXAMPLE 4–3 Increasing the Money Supply by Lowering Banks’ Reserve Requirements on Transaction Accounts

City Bank currently has $400 million in transaction deposits on its balance sheet. The current reserve requirement, set by the Federal Reserve, is 10 percent. Thus, City Bank must have reserve assets of at least $40 million ($400 million × 0.10) to back its deposits. In this simple framework, the remaining $360 million of deposits can be used to extend loans to borrowers. Table 4–6, Panel A, illustrates the Federal Reserve’s and City Bank’s balance sheets, assuming City Bank holds all of its reserves at the Fed (i.e., City Bank has no vault cash).

If the Federal Reserve decreases the reserve requirement from 10 percent to 5 percent, City Bank’s minimum reserve requirement decreases by $20 million, from $40 million to $20 million ($400 million × 0.05). City Bank can now use $20 million of its reserves at its local Federal Reserve Bank (since these are now excess reserves that earn little interest) to make new loans. Suppose, for simplicity, that City Bank is the only commercial bank (in practice, the multiplier effect described below will work the same except that deposit growth will be spread over a number of banks). Those who borrow the $20 million from the bank will spend the funds on consumption and investment goods and services and those who produce and sell these goods and services will redeposit the $20 million in funds received from their sale at their bank (assumed here to be City Bank). We illustrate this redeposit of funds in Figure 4–4. As a result of these transaction deposits, City Bank’s balance sheet changes to $420 million (shown in Panel B of Table 4–6). Because of the $20 million increase in transaction account deposits, City Bank now must increase its reserves held at the Federal Reserve Bank by $1 million ($20 million × 0.05) but still has $19 million in excess reserves with which to make more new loans from the additional deposits of $20 million (see row 2 in Figure 4–4).

Assuming City Bank continues to issue new loans and that borrowers continue to spend the funds from their loans, and those receiving the loanable funds (in exchange for the sale of goods and services) redeposit those funds in transaction deposits at City Bank, City Bank’s balance sheet will continue to grow until there are no excess reserves held by City Bank (Panel C in Table 4–6). The resulting change in City Bank’s deposits will be:

Change in bank deposits = (1 / 0 . 05) × (40m − 20m) = $400m

For this to happen, City Bank must willingly hold the $40 million it has as reserves. This requires City Bank’s balance sheet (and its deposits) to double in size as a result of the reserve require- ment decrease from 10 percent to 5 percent (i.e., $800 million deposits × 0.05 = $40 million).

While the deposit multiplier effect has been illustrated here using the example of a change in reserve requirements, it also holds when other monetary policy tools or instruments are changed as well (e.g., open market operations). For example, suppose the FOMC instructs the FRBNY Trading Desk to purchase $200 million in U.S. Treasury securities. If the reserve requirement is set at 10 percent, the $200 million open market purchase will result in an increase in bank reserves of $200 million, and ultimately, via the multiplier (1/0.1), an increase in bank deposits and the money supply of $2 billion:

1/0.1 × $200 million = $2,000 million = $2 billion

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 115

sau19714_ch04_093-131.indd 115 07/07/17 03:10 PM

We have made some critical assumptions about the behavior of banks and borrow- ers to simplify our illustration of the impact of a change in open market operations and reserve requirements on bank deposits and the money supply. In Example 4–3 we assume that City Bank is the only bank, that it converts all (100 percent) of its excess reserves into loans, that all (100 percent) of these funds are spent by borrowers, and that all are returned to City Bank as “new” transaction deposits. If these assump- tions are relaxed, the overall impact of a decrease in the reserve requirement ratio, or increase in excess reserves from an open market purchase, on the amount of bank depos- its and the money supply will be smaller than illustrated, albeit still a multiplier simi- lar to that above, and the precise effect of a change in the reserve base on the money supply is less certain. For example, in Example 4–3, if only 90 percent of any funds lent by City Bank are returned to the bank in the form of transaction deposits and 10 percent is held in cash, then the resulting change in City Bank’s deposits will be:

TABLE 4–6 Lowering the Reserve Requirement

Panel A: Initial Balance Sheets

Federal Reserve Bank

Assets Liabilities Securities $ 40m Reserve accounts $ 40m

City Bank

Assets Liabilities Loans $ 360m Transaction deposits $ 400m Reserve deposits at Fed

(10% of deposits) 40m

Panel B: Balance Sheet Immediately after Decrease in Reserve Requirement Federal Reserve Bank

Assets Liabilities Securities $ 21m Reserve accounts $ 21m

City Bank

Assets Liabilities Loans $ 380m Transaction deposits $ 420m Reserve deposits at Fed (5% of deposits) 21m Cash (from liquidated reserves) 19m

Panel C: Balance Sheet after All Changes Resulting from Decrease in Reserve Requirement Federal Reserve Bank

Assets Liabilities Securities $ 40m Reserve accounts $ 40m

City Bank

Assets Liabilities Loans $ 760m Transaction deposits $ 800m Reserve deposits at Fed (5% of deposits) 40m

Final PDF to printer

116 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 116 07/07/17 03:10 PM

Change in bank deposits

[1 / (New reserve requirement + c) ]

× Change in reserves created by reserve requirement change

where c = the public’s cash-to-deposit ratio or preference for holding cash outside banks relative to bank deposits = 0.1 (or 10/100). Thus, City Bank’s change in deposits = [1/ (0.05 + 0.1)] × (40m – 20m) = $133.33 million.

Nevertheless, as long as some portion of the excess reserves created by the decrease in the reserve requirement are converted into loans and some portion of these loans after being spent are returned to the banking system in the form of transaction deposits, a decrease in reserve requirements will result in a multiple (that is, greater than one) increase in bank deposits, the money supply, and credit availability.

Conversely, if the Federal Reserve increases reserve requirement ratios, depository institutions must convert some of the loans on their balance sheets back into reserves held at their local Federal Reserve Bank. The overall result is that an increase in the reserve requirements will result in a multiple decline in credit availability, bank deposits, and the money supply (i.e., the multi- plier effect described above will be reversed). Again, the overall effect on the money supply is not fully predictable.

Because changes in reserve requirements can result in unpredictable changes in the money supply (depending on the amount of excess reserves

held by banks, the willingness of banks to make loans rather than hold other assets such as securities, and the predictability of the public’s willingness to redeposit funds lent at banks instead of holding cash—that is, whether they have a stable cash-deposit ratio or not), the reserve requirement is very rarely used by the Federal Reserve as a monetary policy tool.

Figure 4–4 Deposit Growth Multiplier

Producers of Goods and Services Receive $20 Million

Producers of Goods and Services Receive $19 Million

Banks Use $20 Million in Excess Reserves to Make Loans

Borrowers Spend $20 Million in Loans on Goods and Services

Producers Redeposit $20 Million in Bank

Producers Redeposit $19 Million in Bank

Bank Deposits Increase by $20 Million: Assets Increase; $1 Million in Reserves and $19 Million in Loans

Borrowers Spend $19 Million in Loans on Goods and Services

Bank Deposits Increase by $19 Million: Assets Increase; $0.95 Million in Reserve Deposits and $18.05 Million in Loans

THE FEDERAL RESERVE, THE MONEY SUPPLY, AND INTEREST RATES As we introduced this chapter, we stated that the Federal Reserve takes steps to influence monetary conditions—the money supply, credit availability, interest rates, and ultimately security prices—so it can promote price stability (low inflation) and other macroeconomic objectives. We illustrate this process in Figure 4–5. Historically, the Fed has sought to influence the economy by directly targeting the quantity of bank reserves in the market

LG 4-4

D O YO U U N D E R S TA N D :

5. What the major policy tools used by the Federal Reserve to influence the economy are?

6. What the impact is on credit availability and the money supply if the Federal Reserve purchases securities?

7. Why the Federal Reserve is unique in its ability to change the money supply through monetary policy tools?

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 117

sau19714_ch04_093-131.indd 117 07/07/17 03:10 PM

based on the FOMC’s objectives for growth in the monetary base, and in turn the money supply or interest rates. In this section, we take a look at the ultimate impact of monetary policy changes on key economic variables. We also look at the Fed’s choice of whether to target the money supply or interest rates in order to best achieve its overall macroeconomic objectives.

Effects of Monetary Tools on Various Economic Variables

The examples in the previous section illustrated how the Federal Reserve and bank balance sheets change as a result of monetary policy changes. Table 4–7 goes one step further and looks at how the money supply, credit availability, interest rates, and security prices are affected by these monetary policy actions. To do this, we categorize monetary policy tool changes into expansionary activities versus contractionary activities.

Figure 4–5 The Process of Monetary Policy Implementation

Open Market Operations Discount Rate Changes Reserve Requirement Ratio Changes

Monetary Policy Tools

Financial Markets

A na

ly si

s an

d Fe

ed ba

Objectives

Change in Bank Reserves Change in Money Supply Change in Credit Availability Change in Interest Rates Change in Borrowing Change in Security Prices Change in Foreign Exchange Rates

Price Stability Economic Growth Low Inflation Full Employment Sustainable Pattern of International Trade

Money Supply (bank reserves) Interest Rates (fed funds rate)

Targets

TABLE 4–7 The Impact of Monetary Policy on Various Economic Variables

Expansionary Activities (open market purchases

of securities, discount rate decreases, reserve requirement

ratio decreases)

Contractionary Activities (open market sales of securities,

discount rate increases, reserve requirement ratio

increases)

Impact on: Reserves ↑ ↓ Money supply ↑ ↓ Credit availability ↑ ↓ Interest rates ↓ ↑ Security prices ↑ ↓

Final PDF to printer

118 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 118 07/07/17 03:10 PM

Expansionary Activities. We described earlier the three monetary policy tools that the Fed can use to increase the money supply: open market purchases of securities, discount rate decreases, and reserve requirement ratio decreases. All else held constant, when the Federal Reserve purchases securities in the open market, the reserve accounts of banks increase. When the Fed lowers the discount rate, this generally results in a lowering of interest rates in the economy. Finally, a decrease in the reserve requirements, all else con- stant, results in an increase in bank reserves.

In two of the three cases (open market operations and reserve requirement changes), an increase in reserves results in an increase in bank deposits and the money supply. One immediate effect of this is that interest rates fall and security prices start to rise (see Chapters 2 and 3). In the third case (a discount rate change), the impact of a lowering of interest rates is more direct. Lower interest rates encourage borrowing from banks. Eco- nomic agents spend more when they can get cheaper funds. Households, businesses, and governments are more likely to invest in fixed assets (e.g., housing, plant, and equipment). Households increase their purchases of durable goods (e.g., automobiles, appliances). State and local government spending increases (e.g., new road construction, school improvements). Finally, lower domestic interest rates relative to foreign rates can result in a drop in the (foreign) exchange value of the dollar relative to other currencies.11 As the dollar’s (foreign) exchange value drops, U.S. goods become relatively cheaper compared to foreign goods. Eventually, U.S. exports increase. The increase in spending from all of these market participants results in economic expansion, stimulates additional real pro- duction, and may cause the inflation rate (defined in Chapter 2) to rise. Ideally, the expan- sionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price infla- tion. However, when the Fed undertakes expansionary activities, the resulting increase in demand for goods and services tends to push wages and other costs higher and can lead to inflation. Indeed, price stabilization (low inflation) can be viewed as a primary policy objective of the Fed.

Contractionary Activities. We also described three monetary policy tools that the Fed can use in a contractionary fashion: open market sales of securities, discount rate increases, and reserve requirement ratio increases. All else constant, when the Federal Reserve sells securities in the open market, reserve accounts of banks decrease. When the Fed raises the discount rate, interest rates generally increase in the open market, making borrowing more expensive. Finally, an increase in the reserve requirement ratio, all else constant, results in a decrease in excess reserves for all banks and limits the avail- ability of funds for additional loans.

In all three cases, interest rates will tend to rise. Higher interest rates discourage credit availability and borrowing. Economic participants spend less when funds are expensive. Households, businesses, and governments are less likely to invest in fixed assets. House- holds decrease their purchases of durable goods. State and local government spending decreases. Finally, an increase in domestic interest rates relative to foreign rates may result in an increase in the (foreign) exchange value (rate) of the dollar. As the dollar’s exchange rate increases, U.S. goods become relatively expensive compared to foreign goods. Even- tually, U.S. exports decrease.

Money Supply versus Interest Rate Targeting

Table 4–8 shows how the Federal Reserve has varied between its use of the money sup- ply and interest rates as the target variable used to control economic activity in the United States. Panel a of Figure 4–6 illustrates the targeting of money supply, while Panel b of Figure 4–6 shows the targeting of interest rates. For example, letting the demand curve for money be represented as MD in Panel a of Figure 4–6, suppose the FOMC sets the target

11. See the discussion of the interest rate parity theorem in Chapter 9.

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 119

sau19714_ch04_093-131.indd 119 07/07/17 03:10 PM

money supply (currency and bank reserves) at a level that is consistent with 5 percent growth, line MS in Panel a of Figure 4–6. At this MS level, the FOMC expects the equilib- rium interest rate to be i*. However, unexpected increases or decreases in production, or changes in inflation, may cause the demand curve for money to shift up and to the right, MD

′, or down and to the left, MD″. Accordingly, interest rates will fluctuate between i′ and i″. Thus, targeting the money supply can lead to periods of relatively high volatility in interest rates.

TABLE 4–8 Federal Reserve Monetary Policy Targets

Target Years

Fed funds rate targeted using bank reserves to achieve target 1970–October 1979

Nonborrowed reserves targeted October 1979–October 1982 Borrowed reserves targeted October 1982–July 1993 Fed funds rate targeted (rate announced) July 1993–present

Figure 4–6 Targeting Money Supply versus Interest Rates

Interest Rate

Quantity of Money (in billions of dollars)Ms

MD'

MD''

Ms i' = 8%

i* = 6%

i' ' = 4%

(a) Targeting Money Supply

MsM s'

Quantity of Money (in billions of dollars)Ms

MD'

MD''

iT = 6%

i' ' = 5%

M s'

Interest Rate

(b) Targeting Interest Rates

Source: Bank for International Settlements, BIS Papers, No. 48, July 2009. www.bis.org

Final PDF to printer

120 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 120 07/07/17 03:10 PM

In Panel b of Figure 4–6, suppose instead the FOMC targets the interest rate, iT = 6 percent. If the demand for money falls, to MD″, interest rates will fall to i″ = 5 percent with no intervention by the Fed. In order to maintain the target interest rate, the FOMC has to conduct monetary policy actions (such as open market sales of U.S. securities) to lower bank reserves and the money supply (to MS′). This reduction in the money supply will maintain the target interest rate at iT = 6 percent. As should be obvious from these graphs and the discussion, the Federal Reserve can successfully target only one of these two variables (money supply or interest rates) at any one moment. If the money supply is the target variable used to implement monetary policy, interest rates must be allowed to fluctuate relatively freely. By contrast, if an interest rate (such as the fed funds rate) is the target, then bank reserves and the money supply must be allowed to fluctuate rela- tively freely.

In the 1970s, the Fed, and then chairs Arthur Burns and G. William Miller, imple- mented its monetary policy strategy by targeting the federal funds rate. However, during the 1970s interest rates rose dramatically (Figure 4–7). The Fed responded to these inter- est rate increases by increasing the money supply, which led to historically high levels of inflation (e.g., over 10 percent in the summer of 1979). With rapidly rising inflation, Paul Volcker (chair of the Federal Reserve Board from 1979 to 1987) felt that interest rate targets were not doing an appropriate job in constraining the demand for money (and the inflationary side of the economy). Thus, on October 6, 1979, the Fed chose to com- pletely refocus its monetary policy, moving away from interest rate targets toward tar- geting the money supply itself, and in particular bank reserves—so-called nonborrowed reserves, which are the difference between total reserves and reserves borrowed through the discount window (see the earlier discussion in this chapter).

Growth in the money supply, however, did not turn out to be any easier to control. For example, the Fed missed its money supply growth rate targets in each of the first three years in which reserve targeting was used. Further, in con- trast to expectations, volatility in the money supply growth rate grew as well (Figure 4–7). Thus, in October 1982, the Federal Reserve abandoned its policy of targeting nonborrowed reserves for a policy of targeting borrowed reserves (those reserves banks borrow from the Fed’s discount window).

The borrowed reserve targeting system lasted from October 1982 until 1993, when the Federal Reserve, and then chair Alan Greenspan, announced that it would no longer target bank reserves and money supply growth at all. At this time, the Fed announced that it would use interest rates—the federal funds rate—as the main target variable to conduct monetary policy (initially setting the target rate at a constant 3 percent). A guiding principle used by the Fed to set short-term inter- est rates during this period is the Taylor rule, a formula developed by economist John Taylor. The rule states that short-term interest rates should be determined by three conditions: (1) where actual inflation is relative to the Fed’s targeted level, (2) the extent to which the economy is above or below its full employment level, and (3) what short-term interest rates should be to achieve full employment. The rule recommends that the Fed increase interest rates when inflation is above its target or when the economy is above the full employment level and decrease inter- est rates when inflation is below its target or when the economy is below the full employment level. Although the Fed does not follow the Taylor rule unequivo-

cally in conducting monetary policy, the rule closely describes how monetary policy actu- ally has been conducted since 1993.

Under the current regime, and contrary to previous tradition such as in the 1970s, the Fed simply announces whether the federal funds rate target has been increased, decreased, or left unchanged after every monthly FOMC meeting—previously, the federal funds rate change had been kept secret. This announcement is watched very closely by financial mar- ket participants who react quickly to any change in the fed funds rate target. As a result of this regime, there has been relatively small volatility in interest rates since the late 1980s (see Figure 4–7).

D O YO U U N D E R S TA N D :

8. What actions the Federal Reserve can take to promote economic expansion? Describe how each affects money supply, credit availability, interest rates, and security prices.

9. What actions the Federal Reserve can take to contract the U.S. economy? Describe how each affects money supply, credit availability, interest rates, and security prices.

10. Why the simultaneous targeting of the money supply and interest rates is sometimes impossible to achieve?

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 121

sau19714_ch04_093-131.indd 121 10/09/17 06:22 PM

In addition, following its meeting in January 2012, the FOMC issued a statement announcing that it would adopt a strategy of inflation targeting. The FOMC noted in its statement that inflation at the rate of 2 percent is most consistent over the longer run with the Federal Reserve’s statutory mandate. By communicating an inflation goal the Fed hoped to clearly keep longer-term inflation expectations firmly anchored, thereby fostering price

Figure 4–7 Federal Funds Rates and Annualized Money Supply Growth Rates, 1977–2016

A pr

-7 7

A pr

-7 9

A pr

-8 1

A pr

-8 3

A pr

-8 5

A pr

-8 7

A pr

-8 9

A pr

-9 1

A pr

-9 3

A pr

-9 5

A pr

-9 7

A pr

-9 9

A pr

-0 1

A pr

-0 3

A pr

-0 5

A pr

-0 7

A pr

-0 9

A pr

-1 1

A pr

-1 3

A pr

-1 5

Year

Federal Funds Rate

-6

-4

-2

A pr

-7 9

A pr

-8 1

A pr

-8 3

A pr

-8 5

A pr

-8 7

A pr

-8 9

A pr

-9 1

A pr

-9 3

A pr

-9 5

A pr

-9 7

A pr

-9 9

A pr

-0 1

A pr

-0 3

A pr

-0 5

A pr

-0 7

A pr

-0 9

A pr

-1 1

A pr

-1 3

A pr

-1 5

Year

Money Supply Growth Rate

A pr

-7 7

Source: Federal Reserve Board website, “Research and Data,” June 2016. www.federalreserve.gov

Final PDF to printer

122

sau19714_ch04_093-131.indd 122 07/07/17 03:10 PM

stability and moderate long-term interest rates and enhancing the FOMC’s ability to pro- mote maximum employment.

Finally, in 2013 the Fed altered the purpose of its Summary of Economic Projections (SEP). Historically, the SEP contained information on FOMC meeting participants’ fore- casts of the unemployment rate, the change in real GDP, inflation, and core inflation rate at different points in time under appropriate monetary policy. However, since January 2012 the Fed started to disclose its members’ views on the future path of the target interest rate under appropriate monetary policy as well. For example, in conjunction with the FOMC meeting held on March 16, 2016, meeting participants submitted their projections of the most likely outcomes for real output growth, the unemployment rate, inflation, and the fed- eral funds rate for each year from 2016 to 2018 and over the longer run. The Industry Per- spectives box shows the SEP for March 16, 2016. Each participant’s projection is based on information available at the time of the meeting together with his or her assessment of appropriate monetary policy and assumptions about the factors likely to affect economic outcomes. The longer-run projections represent each participant’s assessment of the value to which each variable would be expected to converge, over time, under “appropriate mon- etary policy” and in the absence of further shocks to the economy. Appropriate monetary policy is defined as the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpre- tation of the Federal Reserve’s objectives of maximum employment and stable prices.

At the March 2016 FOMC meet- ing, participants generally expected that, under appropriate monetary policy, growth in real gross domestic product (GDP) would be at or some- what above their individual estimates of the longer-run growth rate in 2016 and 2017 and would converge toward the longer-run rate in 2018 (see table). All participants projected that by the

Minutes of the Federal Open Market Committee

I N T H E N E W S

end of the current year, the unem- ployment rate would decline to, or fall below, their individual estimates of the longer-run normal unemploy- ment rate—that is, their projected unemployment gaps would be zero or negative—and that these zero or negative gaps would persist through 2018, even though many partici- pants reduced their estimates of the

longer-run normal rate. All partici- pants projected that inflation, as mea- sured by the four-quarter change in the price index for personal consumption expenditures (PCE), would pick up in 2016 and 2017 from the very low rate seen in 2015. Participants gener- ally projected inflation to be either at or just slightly below the committee’s 2 percent objective by the end of 2018.

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, March 2016 (percentage)

Median Central Tendency Range

Variable 2016 2017 2018 Longer 2016 2017 2018 Longer 2016 2017 2018 Longer

Change in real GDP 2.2 2.1 2.0 2.0 2.1–2.3 2.0–2.3 1.8–2.1 1.8–2.1 1.9–2.5 1.7–2.3 1.8–2.3 1.8–2.4 December projection 2.4 2.2 2.0 2.0 2.3–2.5 2.0–2.3 1.8–2.2 1.8–2.2 2.0–2.7 1.8–2.5 1.7–2.4 1.8–2.3 Unemployment rate 4.7 4.6 4.5 4.8 4.6–4.8 4.5–4.7 4.5–5.0 4.7–5.0 4.5–4.9 4.3–4.9 4.3–5.0 4.7–5.8 December projection 4.7 4.7 4.7 4.9 4.6–4.8 4.6–4.8 4.6–5.0 4.8–5.0 4.3–4.9 4.5–5.0 4.5–5.3 4.7–5.8 PCE inflation 1.2 1.9 2.0 2.0 1.0–1.6 1.7–2.0 1.9–2.0 2.0 1.0–1.6 1.6–2.0 1.8–2.0 2.0 December projection 1.6 1.9 2.0 2.0 1.2–1.7 1.8–2.0 1.9–2.0 2.0 1.2–2.1 1.7–2.0 1.7–2.1 2.0 Core PCE inflation 1.6 1.8 2.0 1.4–1.7 1.7–2.0 1.9–2.0 1.4–2.1 1.6–2.0 1.8–2.0 December projection 1.6 1.9 2.0 1.5–1.7 1.7–2.0 1.9–2.0 1.4–2.1 1.6–2.0 1.7–2.1 2.0 Memo: Projected appropriate policy path

Federal funds rate 0.9 1.9 3.0 3.3 0.9–1.4 1.6–2.4 2.5–3.3 3.0–3.5 0.6–1.4 1.6–2.8 2.1–3.9 3.0–4.0 December projection 1.4 2.4 3.3 3.5 0.9–1.4 1.9–3.0 2.9–3.5 3.3–3.5 0.9–2.1 1.9–3.4 2.1–3.9 3.0–4.0

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 123

sau19714_ch04_093-131.indd 123 07/07/17 03:10 PM

Systemwide Rescue Programs Employed during the Financial Crisis

LG 4-5

Final PDF to printer

124

sau19714_ch04_093-131.indd 124 10/10/17 06:22 PM

TABLE 4–9 Central Bank Actions, September 2008–June 2009

Source: Bank for International Settlements, BIS Papers, No. 48, July 2009. www.bis.org *Indicates the size of government exposure for the various interventions

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 125

sau19714_ch04_093-131.indd 125 07/07/17 03:10 PM

countries. The programs can be categorized into four general areas: expansion of retail deposit insurance, capital injections, debt guarantees, and asset purchases/guarantees.12 Figure 4–8 summarizes deposit insurance coverage in various countries before versus after the start of the financial crisis, and Table 4–10 provides a more detailed overview of the

12. For a detailed summary of each of these, see BIS Quarterly Review, December 2008, www.bis.org.

Figure 4–8 Deposit Insurance Coverage for Commercial Banks in Various Countries (USD equivalents, at current exchange rates, as of mid-September and early December 2008)

400,000 600,000 800,000 1,00,000200,0000

Unlimited

Australia

Austria

Denmark

Germany

Hong Kong, China

Iceland

Ireland

Singapore

Slovak Republic

New Zealand

Norway

United States

Italy

Belgium

Greece

Luxembourg

Netherlands

Portugal

Spain

Mexico

Japan

France

Switzerland

Canada

United Kingdom

Czech Republic

Finland

Hungary

Poland

Sweden

Korea

Turkey

Russia

544,000

281,000

250,000

133,000

129,000

121,000

108,000

90,000

83,000

79,000

74,000

64,000

61,000

35,000

32,000

25,000

mid September 2008 early December 2008

Source: “Financial Crisis: Deposit Insurance and Financial Safety Net Aspects,” Organization for Economic Co-operation and Development working paper, December 2008. www.oecd.org

Final PDF to printer

126 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 126 07/07/17 03:10 PM

commitments and outlays associated with capital injections, debt guarantees, and asset purchases/guarantees made by various countries.

Expansion of Retail Deposit Insurance Increased retail bank deposit insurance cover- age was widely used during the crisis to ensure continued access to deposit funding. As shown in Figure 4–8, the amounts covered by deposit insurance varied substantially across countries, with some countries extending unlimited guarantees of retail deposits.

Capital Injections Direct injections of capital by central governments were the main mechanism used to directly support bank balance sheets. Governments increased banks’ capital by injecting combinations of common shares, preferred shares, warrants, subordi- nated debt, mandatory convertible notes, or silent participations. These capital injections improved banks’ abilities to absorb additional losses and strengthened protection for banks’ uninsured creditors. Further, because they relieved balance sheet constraints, the capital injections allowed banks to increase their lending.

Countries varied in the capital instruments they used and the conditions of their capital injections. Some countries (e.g., the United States) also imposed restrictions on executive compensation and/or dividend payments to common stockholders. As seen in Table 4–10, countries also varied in the amounts of capital injected into the banking sys- tem. The Netherlands made commitments totaling 6.2 percent of the country’s GDP, the United Kingdom made commitments worth 3.4 percent of its GDP, and Switzerland made commitments worth 1.1 percent of its GDP.

Debt Guarantees As financial markets froze, so did the wholesale funding market used by banks to support lending activities. In response to these events, governments announced state guarantees on bank wholesale debt. Specifically, governments provided explicit guarantees against default on uninsured bank liabilities. These programs allowed banks to maintain access to reasonably priced, medium-term funding. They also reduced liquidity risk and lowered overall borrowing costs for banks.

Countries varied in the range of liabilities covered and the fee structures associated with these programs (e.g., some charged a flat fee, while others linked fees to bank credit default swap spreads). Further, as seen in Table 4–10, countries committed significantly larger amounts to the debt guarantee programs than to the capital injection programs. Many countries (e.g., Australia, Canada, Italy, and Switzerland) committed unspecified amounts for debt guarantees, the Netherlands committed an amount totaling 33.6 percent of the country’s GDP, the United Kingdom made commitments worth 17.2 percent of its GDP, and Spain made commitments worth 9.1 percent of its GDP.

Asset Purchases or Guarantees Asset purchase programs removed distressed assets from bank balance sheets. Thus, bank liquidity was improved and capital relief was provided (particularly if purchase prices were higher than book values). Asset guarantee programs left the distressed assets with the banks. However, the central banks assumed part or all of the risk of the portfolio of distressed or illiquid assets from the banks. Asset purchase and guarantee programs were not used extensively. A main reason for this is that it was diffi- cult to determine the price at which the central bank would purchase the distressed assets. A purchase price set too close to par effectively amounted to a covert recapitalization of the

bank. Further, there was a debate regarding the range of eligible assets. To have a significant and immediate impact on market confidence, the programs would have to cover all distressed assets, which would require large programs. As seen in Table 4–10, the United Kingdom used asset guarantees extensively (commitments amounted to 33.4 percent of the country’s GDP). Beyond this, Germany commit- ted an unspecified amount for asset purchases and an amount totaling 8.0 percent of the country’s GDP for asset guarantees, while the United States committed 1.0 percent of its GDP for asset purchases and an amount totaling 2.5 percent of the country’s GDP for asset guarantees.

D O YO U U N D E R S TA N D :

11. The monetary policy measures taken by central banks to address the recent worldwide financial crisis? What were they?

Final PDF to printer

127

sau19714_ch04_093-131.indd 127 10/10/17 06:22 PM

TA B

LE 4

–1 0

um m

ar y

of C

en tr

al B

an k

P ro

gr am

Final PDF to printer

128 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 128 07/07/17 03:10 PM

Challenges Remain after the Crisis

While the worst of the financial crisis subsided in the United States in the last half of 2009, throughout the spring of 2010 Greece struggled with a severe debt crisis. Early on, the European Central Bank (ECB) and some of the healthier European countries tried to step in and assist the debt-ridden country. Specifically, in March 2010 the ECB, Germany, and France began formulating a plan to bail out Greece with as much as $41 billion in aid. However, in late April, Greek bond prices dropped dramatically as traders determined that a debt default was inevitable, even if the country received a mas- sive bailout. The selloff was the result of still more bad news for Greece, which showed that the 2009 budget deficit was worse than had been previously reported. As a result, politicians in Germany began to voice opposition to a Greek bailout. Further, Moody’s Investors Service downgraded Greece’s debt rating and warned that additional cuts could be on the way. However, the ECB stated that it would continue to support Greece regard- less of the country’s credit rating.

The problems in the Greek bond market then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. As a result, in May the ECB, Euro-zone countries, and the International Monetary Fund, seeking to halt a widening European debt crisis that had now threatened the stability of the euro, agreed to extend to Greece an unprecedented $147 billion rescue in return for huge budget cuts. Additional rescue pack- ages and promises of further austerity measures intended to cut the burgeoning Greek defi- cit occurred through 2012. Yet the European debt crisis continued. While Greece had not yet missed a bond payment, in March the International Swaps and Derivatives Association (ISDA)13 declared that Greece had undergone a “restructuring credit event” which trig- gered insurance policy payments. The restructuring event was a forced swap of old debt held by some of its private bond holders for new debt. The swap forced a 74 percent haircut on those creditors that held out, triggering the effective default.

At one point, Greece seemed unable to form a government and the leader of one party rejected the country’s bailout commitments. It seemed increasingly conceivable that Greece might have to leave the Euro zone. Economists estimated that a Greek exit from the Euro zone would cost the European Union $1 trillion, or about 5 percent of the Union’s annual economic output. Yet, the leaders of EU countries, particularly Germany and France, continued to work to keep Greek reform on track and the EU together. Further, the ECB stated that it would do whatever it took to protect the euro; the ECB prepared to move forcefully into bond markets in tandem with Europe’s rescue funds and concentrated on buying shorter-term debt. Through June 2012, the cost of bailouts required to do so totaled over $480 billion and, while calmer, the crisis in the EU was not over as Spain and Italy required bailouts as well. Fear arose that, in their efforts to keep the European Union together and the euro intact, sound countries would be drawn into their own crises as they were called upon to bail out unhealthy countries.

The situation in Greece and the European Union stabilized after 2012. However, a major debt payment was due from Greece to its creditors on June 30, 2015, a payment required to continue to receive rescue funds from the EU. Knowing that they could not make the payment, Greek officials met with Euro-zone leaders in an attempt to get a better deal. Greece, however, was unwilling to agree to more spending cuts and other concessions requested by the EU and talks broke down. Greece would be the first devel- oped country to default on its debt and faced the real possibility that it would be forced to leave the European Union. With its financial system near collapse and a debt payment due to the ECB on July 20, Greece was forced to continue negotiations with its credi- tors. A deal was reached on July 13 that essentially required Greece to surrender to all of its creditors’ demands including tax increases, pension reform, and the creation of a fund (under European supervision) that would hold some €50 billion in state-owned

13. The ISDA is the trade group that oversees the market for credit default swaps. Credit default swaps are essentially insurance policies against bond defaults (see Chapter 10).

Final PDF to printer

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 129

sau19714_ch04_093-131.indd 129 07/07/17 03:10 PM

assets earmarked to be privatized or liquidated (with the proceeds to be used to pay off Greece’s debt and help recapitalize its banks).

Underscoring both the importance and limits of monetary policy in a global economy, in the mid-2010s, beleaguered by painfully slow growth and anxious financial markets well after the financial crisis that began in 2008, central banks around the world went to new lengths to boost their economies. For example, in early 2016 the Bank of Japan (BOJ) set its key short-term interest rate below zero. Specifically, the BOJ charged a 0.10 percent- age point penalty on excess reserves that banks keep on deposit at the BOJ. In theory, the increasingly radical steps would encourage Japan’s commercial banks to circulate more money in the economy, where it can be used for investment and growth. The move fol- lowed three years of aggressive monetary easing by the BOJ, in which the central bank purchased ¥80 trillion ($660.8 billion) in government bonds a year, an amount equal to one-fifth of the size of Japan’s economy. As a result, by 2016 the BOJ owned nearly one- third of the Japanese government bond market and 43 percent of Tokyo’s exchange-traded stock fund market.

The move by the BOJ came a week after the European Central Bank indicated that it was ready to begin additional monetary stimulus.The central bank, trying to stimulate growth and hold off deflation in the wake of the global financial crisis, announced it would be lowering rates and buying increasing amounts of assets to get cash into their economies. The ECB set negative interest rates on some bank reserves in 2014. But the announcement indicated that the ECB would cut rates even further into negative terri- tory in coming months. Economists predicted that Canada, Australia, Norway, and even China would also set their policy rates negative should macroeconomic conditions turn out even weaker than expected.

Negative rates have had powerful effects, in particular by driving down currencies, which helped boost inflation and exports. However, this comes at the expense of other countries to some extent. These countries often respond with easier money policies of their own. For example, between 2014 and 2016, China authorized six interest rate cuts and sev- eral reductions in required bank reserves and approved hundreds of infrastructure projects aimed at halting its economic downturn. But even with these efforts, China’s economic slowdown has proved deeper than expected. In 2015, the economy grew by 6.9 percent, its slowest pace in 25 years.The People’s Bank of China’s decision to devalue the yuan in January 2016 was driven in part by the need to lower its own interest rates to stimulate growth. Going full circle, the lower yuan, in turn, put pressure on China’s trading partners, including Japan, to ease monetary policy.

Challenges to central banks became even bigger in June 2016 when the people of the United Kingdom voted to leave the EU after 43 years (Brexit). The shock from the UK’s surprise vote to leave the EU swept across global markets, triggering steep drops in stock markets and the British pound, and a flight into safe assets such as U.S. bonds and gold. The pound fell more than 11 percent to its lowest point since 1985. The DJIA dropped 610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008, while Japan’s Nikkei Stock Average declined 7.9 percent. Bonds also sold off sharply, pushing UK government borrowing costs sharply higher as traders and investors grappled with the market implications of Brexit. The UK had its credit rating outlook cut to “negative” by the ratings agency Moody’s. Less than an hour after the markets opened in London, the governor of the Bank of England stood in front of television cameras to announce that the central bank had earmarked ₤250 billion (about $344 billion) to release as needed for stability. The Bank of England faces an extraordinarily tricky situation as it attempts to navigate Brexit. It simultaneously must plan for a possible recession caused by Brexit uncertainty and for higher inflation because of the drop in the currency value and outflow of capital. It can fight one of those problems, but it cannot fight both at once. So a decline in business confidence and a rise in uncertainty, paired with limited responses by central banks, makes a recession a major risk in Britain and something of a risk in the rest of Europe and the United States.The vote to leave raised the prospect of sustained anxiety in the global economy as investors struggle to surmise what is happening.