stock market powerpoint

Financial Markets and Institutions

Anthony Saunders • Marcia Millon Cornett

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The dawning of a new era in markets and institutions

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Financial Markets and Institutions

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Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

FINANCIAL MANAGEMENT

Block, Hirt, and Danielsen Foundations of Financial Management Fourteenth Edition

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

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

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

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Sixth Edition

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

Cornett, Adair, and Nofsinger M: Finance First Edition

DeMello Cases in Finance Second 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 Tenth Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Ninth Edition

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

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

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

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Eighth Edition

Bodie, Kane, and Marcus Investments Ninth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

Jordan and Miller Fundamentals of Investments: Valuation and Management Sixth Edition

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

Sundaram and Das Derivatives: Principles and Practice First Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins Bank Management and Financial Services Eighth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

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

Saunders and Cornett Financial Markets and Institutions Fifth Edition

INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Sixth Edition

Robin International Corporate Finance First Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

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

FINANCIAL PLANNING AND INSURANCE

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition

Altfest Personal Financial Planning First Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills Third Edition

Kapoor, Dlabay and Hughes Personal Finance Tenth Edition

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

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f i f 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

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FINANCIAL MARKETS AND INSTITUTIONS, FIFTH EDITION

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2012, 2009, and 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 The McGraw-Hill Companies, Inc., 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.

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Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Executive editor: Michele Janicek Executive director of development: Ann Torbert Editorial coordinator: Kaylee Putbrese Vice president and director of marketing: Robin J. Zwettler Marketing director: Brad Parkins Senior marketing manager: Melissa S. Caughlin Marketing specialist: Jennifer M. Jelinski Vice president of editing, design, and production: Sesha Bolisetty Lead project manager: Harvey Yep Senior buyer: Michael R. McCormick Lead media project manager: Rachel Townsend Media project manager: Suresh Babu, Hurix Systems Pvt. Ltd. Lead Designer: Matthew Baldwin Interior Designer: Matthew Baldwin Cover Designer: Laurie Entringer Cover Image: ©Getty Images Typeface: 10/12 Times Roman Compositor: Cenveo Publisher Services Printer: Quad Graphics

Library of Congress Cataloging-in-Publication Data

Saunders, Anthony, 1949- Financial markets and institutions / Anthony Saunders, Marcia Millon Cornett.—5th ed.

p. cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-803466-4 (alk. paper) ISBN-10: 0-07-803466-3 (alk. paper) 1. Securities—United States. 2. Stock exchanges—United States. 3. Financial institutions—

United States. 4. Rate of return—United States. 5. Interest rates—United States. I. Cornett, Marcia Millon. II. Title.

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To Marty Gruber: a mentor and friend. —TONY SAUNDERS

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

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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 Saunders

received his Ph.D. from the London

School of Economics and has

taught both undergraduate and

graduate level courses at NYU

since 1978. Throughout his

academic career, his teach-

ing and research have special-

ized 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 University of

Melbourne.

Professor Saunders holds or has held positions on the Board of

Academic Consultants of the Federal Reserve Board of Gover-

nors 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 Monetary Fund. He is editor of the Journal

of Financial Markets, 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 jour-

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

his textbook, with Dr. Marcia Millon Cornett, Financial Institu-

tions Management: A Risk Management Approach for McGraw-

Hill (seventh edition) as well as a third edition of his book on

credit risk measurement for John Wiley & Sons. Professor Saun-

ders was ranked the 16th most prolific author out of more than

5,800 who have published in the seven leading Finance aca-

demic journals from 1953 to 2002 and was ranked first in the

top 16 journals (“Prolific Authors in the Financial Literature: A

Half Century of Contributions,” Journal of Finance Literature,

Volume 1, Winter 2005).

Marcia Millon Cornett

Marcia Millon Cornett is currently a professor of finance in the

School of Management at Bentley University. She received her

B.S. degree in economics from Knox College in Galesburg,

Illinois, and her M.B.A. and Ph.D. degrees in finance from Indi-

ana University in Bloomington, Indiana. Dr. Cornett has written

and published several articles in the areas of bank performance,

bank regulation, corporate finance, and investments. Articles

authored by Dr. Cornett have appeared in such academic jour-

nals as the Journal of Finance, the Journal of Money, Credit, and

Banking, the Journal of Financial Economics, Financial Man-

agement, and the Journal of Banking and Finance. In 2008, she

was 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 (John M.

Schiff Professor of Finance and for-

mer chair of the Department of

Finance at the Stern School of

Business at New York Univer-

sity), Dr. Cornett has recently

completed work on the seventh

edition of Financial Institu-

tions Management (McGraw-Hill/

Irwin). With Troy A. Adair, Jr. (Wilkes

University) and John Nofsinger (Washington State University),

she has also recently completed work on the second edition of

Finance: Applications and Theory and the first edition of M:

Finance (McGraw-Hill/Irwin). Professor Cornett serves as an

associate editor for the Journal of Financial Services Research,

the Review of Financial Economics, Financial Review, and Mul-

tinational Finance Journal. Dr. Cornett has served as a mem-

ber of the Board of Directors, the Executive Committee, and the

Finance Committee of the SIU Credit Union. Dr. Cornett has also

taught at Southern Illinois University at Carbondale, the Univer-

sity of Colorado, Boston College, Southern Methodist Univer-

sity, and Boston University. She is a member of the Financial

Management Association, the American Finance Association,

and the Western Finance Association.

ABOUT THE AUTHORS

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PREFACE

he last 20 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 competition became increasingly global in nature. Many forces contributed to this break-

down 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 Depression. 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 finan- cial markets, 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 Mar- kets and Institutions provides a broad application of this important perspective. This book recognizes that domestic and foreign financial markets are becoming increasingly inte- grated 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.

T

INTENDED AUDIENCE Financial Markets and Institutions is aimed at the first course in financial markets and institutions at both the undergraduate and M.B.A. 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 located at the book’s Web site ( www.mhhe.com/sc5e ).

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, as well as their past, present, and expected future movements. We then review

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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 pol- icy 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 ), foreign 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 analyze 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, at the effect of recent changes in regulation.

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

Part 5 concludes the text by examining the risks facing a modern FI and FI man- agers 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 corporations. Chapter 21 covers liquidity risk in financial institutions. This chap- ter 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.

viii Preface

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NEW FEATURES Key changes to this edition include the following: • Discussion of the 2008–2009 fi nancial crisis has been added throughout the book. Virtually every chapter includes new material detailing how the fi nancial crisis affected risk management in fi nancial institutions. • Appendix 1A describes events leading up to the fi nancial crisis, events occurring at the peak of the crisis, and events associated with the aftermath of the fi nancial crisis, in- cluding changes to fi nancial institutions, the impact on U.S. and world economies, federal fi nancial and fi scal rescue efforts, and regulatory changes. • Major changes proposed and implemented for the regulation of fi nancial markets and institutions are included where appropriate throughout the book. • New boxes highlighting “Notable Events from the Financial Crisis” have been added to chapters throughout the book. • New end-of-chapter problems have been included in several chapters. • Chapter 4 includes much discussion of the actions taken by the Federal Reserve and other international central banks during and after the fi nancial crisis. • Chapters 5 through 10 highlight the effects of the fi nancial crisis on various fi nancial markets and include discussions of the freezing of the commercial paper markets, the municipal default crisis, the mortgage market meltdown, and the role of credit derivatives in the fi nancial crisis. • Chapter 7 reviews the process that led to the conservatorship and proposed disman- tling of Fannie Mae and Freddie Mac. • Chapter 13 provides a synopsis of the Wall Street Reform and Consumer Protection Act of 2010 and the new deposit insurance coverage and premium rules, as well as an examination of the FDIC’s attempts to deal with the liquidity crisis, a discussion of the TARP Capital Purchase Program and stress tests on the major commercial banks in 2009, and a review of the new international capital standards being implemented for depository institutions worldwide. • Several chapters include discussions of major fi rms that have been lost or dramati- cally altered as a result of the fi nancial crisis (e.g., the failure of Bear Stearns, Lehman Brothers, and AIG; conversions of Goldman Sachs, Morgan Stanley, GMAC, and CIT Group to bank holding companies; the failure of Primary Reserve Money Market Funds; and the failure of CIT Group). • Chapters 22 through 24 discuss the role of derivative securities in the fi nancial crisis, including the roles of swaps (especially credit default swaps), collateralized mortgage, and collateralized debt obligations (CMOs and CDOs). • Tables and fi gures in all chapters have been revised to include the most recent data available.

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.

Preface ix

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Arabinda Basistha West Virginia University

Deanne Butchey Florida International University

Lucy Chernykh Bowling Green State University

Jon Chesbro Montana Tech

Wan-Jiun Paul Chiou Shippensburg University

Lee M. Dunham Creighton University

Donald Flagg University of Tampa

Victoria Geyfman Bloomsburg University of Pennsylvania

Lin Guo Suffolk University

William W. Hall, Jr. The University of North Carolina Wilmington

Wei He Mississippi State University

Taewon Kim California State University, Los Angeles

Adam Y. C. Lei Midwestern State University

D. K. Malhotra Philadelphia University

Khawaja Mamun Sacred Heart University

Christine Mooney Queensborough Community College

Ohannes G. Paskelian University of Houston-Downtown

Mitchell Ratner Rider University

Thomas W. Secrest Coastal Carolina University

John Thornton Kent State University

Wenyuh Tsay California State University San Marcos

Ying Wang University at Albany—SUNY

K. Matthew Wong St. John’s University

Sehyun Yoo Belmont University

We would like to thank the staff at McGraw-Hill for their help and guidance, especially Michele Janicek, executive editor; Kaylee Putbrese, editorial coordinator; Harvey Yep and Jill Eccher, project managers; Melissa Caughlin, marketing manager; Jennifer Jelinski, marketing specialist; Michael McCormick, senior buyer; Matthew Baldwin, lead designer; and Rachel Townsend and Suresh Babu, media project managers. We are also grateful to our secretaries and assistants, Alex Fayman, Jamie John McNutt, Sharon Moore, and Brenda Webb.

Anthony Saunders

Marcia Millon Cornett

x Preface

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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 snap- shot view of what they can expect to learn from each chapter’s discussion.

LEARNING GOALS Learning goals (LG) have been added at the beginning of each chapter to serve students as 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 and a marginal glossary.

PERTINENT WEB SITE ADDRESSES Web site addresses are referenced in the margins throughout each chapter, providing additional resources to aid in the learning process.

WALKTHROUGH

Chapter Features

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“DO YOU UNDERSTAND:” BOXES These boxes allow students to test themselves on the main concepts presented within each major chapter section. Solutions are provided on the book Web site at www.mhhe.com/sc5e .

Pedagogical Features

IN-CHAPTER EXAMPLES These examples provide numerical demonstrations of the analytical material described in many chapters.

NOTABLE EVENTS FROM THE FINANCIAL CRISIS These boxes use articles pertaining to events during the recent 2008–2009 financial crisis to elaborate on chapter material.

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

“IN THE NEWS …” BOXES These boxes demonstrate the application of chapter material to real current events.

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EXCEL PROBLEMS These are featured in selected chapters and are denoted by an icon. Spreadsheet templates are available on the book’s Web site, at www.mhhe.com/sc5e .

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.

END-OF-CHAPTER PROBLEMS AND QUESTIONS New to this edition, problems and questions in the end-of-chapter material now appear in separate sections. These newly defined sections allow instructors to choose whether they prefer students to engage in quantitative or qualitative analysis of the material. Selected problems also appear in McGraw-Hill’s Connect Finance online assessment product.

WALKTHROUGH

End-of-Chapter Features

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SUPPLEMENTS

FOR THE INSTRUCTOR

Instructors will have access to teaching support such as electronic files of the ancillary materials, described below, as well as other useful materials on the Online Learning Center at www.mhhe.com/sc5e .

• Instructor’s Manual Prepared by Tim Manuel, University of Montana, the Instructor’s Manual includes detailed chapter contents and outline, additional exam- ples for use in the classroom, and extensive teaching notes. • Test Bank Prepared by Jamie McNutt, Southern Illinois University, the Test Bank includes nearly 1,000 additional problems to be used for test material. • EZ Test Online A comprehensive bank of test questions is provided within a computerized test bank powered by McGraw-Hill’s fl exible electronic testing program EZ Test Online ( www.eztestonline.com ). EZ Test Online allows you to create tests or quizzes in this easy to use program.

Instructors can select questions from multiple McGraw- Hill test banks or author their own, and then either print the test for paper distribution or give it online. This user- friendly program allows instructors to sort questions by format, edit existing questions or add new ones, and scramble questions for multiple versions of the same test. Sharing tests with colleagues, adjuncts, and TAs is easy! Instant scoring and feedback are provided and EZ Test’s grade book is designed to easily export to your grade book.

• Solutions Manual Prepared by coauthor Marcia Millon Cornett, worked out solutions to the end-of- chapter questions are provided. Author involvement ensures consistency between the solution approaches presented in the text and those in the manual. • PowerPoint Developed by Tim Manuel, University of Montana, the PowerPoint presentation includes full- color slides featuring lecture notes, fi gures, and tables. The slides can be easily downloaded and edited to better fi t your lecture.

FOR THE STUDENT

A wealth of information is available at this book’s Online Learning Center at www.mhhe.com/sc5e ! Students will have access to study materials specifically created for this text, interactive quizzes, excel templates, and much more!

MCGRAW-HILL CONNECT FINANCE

Less Managing. More Teaching. Greater Learning. McGraw-Hill Connect Finance is an online assignment and assessment solution that connects students with the tools and resources they need to achieve success.

McGraw-Hill Connect Finance helps prepare students for their future by enabling faster learning, more efficient studying, and higher retention of knowledge.

McGraw-Hill Connect Finance Features Connect Finance offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Finance, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. Connect Finance offers you the features described below.

Simple assignment management

With Connect Finance, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to:

• Create and deliver assignments easily with selectable end-of-chapter questions and test bank items.

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• Streamline lesson planning, student progress report- ing, and assignment grading to make classroom manage- ment more effi cient than ever. • Go paperless with the eBook and online submission and grading of student assignments.

Smart grading

When it comes to studying, time is precious. Connect Finance helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time is also precious. The grading function enables you to:

• Have assignments scored automatically, giving stu- dents immediate feedback on their work and side-by-side comparisons with correct answers. • Access and review each response; manually change grades or leave comments for students to review. • Reinforce classroom concepts with practice tests and instant quizzes.

Instructor library

The Connect Finance Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture.

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 perform- ance relative to learning objectives. • Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

McGraw-Hill Connect Plus Finance

McGraw-Hill reinvents the textbook learning experience for the modern student with Connect Plus Finance. A

seamless integration of an eBook and Connect Finance, Connect Plus Finance provides all of the Connect Finance features plus the following:

• An integrated eBook, allowing for anytime, any- where access to the textbook. • Dynamic links between the problems or questions you assign to your students and the location in the eBook where that problem or question is covered. • A powerful search function to pinpoint and connect key concepts in a snap.

In short, Connect Finance offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on course content, teaching, and student learning. Connect Finance also offers a wealth of content resources for both instructors and students. This state-of-the-art, thoroughly tested system supports you in preparing students for the world that awaits.

For more information about Connect Finance , go to www.mcgrawhillconnect.com , or contact your local McGraw-Hill sales representative.

TEGRITY CAMPUS: LECTURES 24/7

Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture in a searchable format for students to review when they study and complete assignments. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac.

Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. This search helps students

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efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students’ study time into learning moments immediately supported by your lecture.

To learn more about Tegrity Campus, watch a two- minute Flash demo at http://tcgritycampus.mhhe.com.

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CONTENTS IN BRIEF

Preface vii

part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1

1 Introduction 1

2 Determinants of Interest Rates 36

3 Interest Rates and Security Valuation 72

4 The Federal Reserve System, Monetary Policy, and Interest Rates 106

part 2 SECURITIES MARKETS 141 5 Money Markets 141

6 Bond Markets 176

7 Mortgage Markets 213

8 Stock Markets 244

9 Foreign Exchange Markets 285

10 Derivative Securities Markets 310

part 3 COMMERCIAL BANKS 348 11 Commercial Banks: Industry Overview 348

12 Commercial Banks’ Financial Statements and Analysis 374

13 Regulation of Commercial Banks 406

part 4 OTHER FINANCIAL INSTITUTIONS 449

14 Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies 449

15 Insurance Companies 476

16 Securities Firms and Investment Banks 500

17 Mutual Funds and Hedge Funds 523

18 Pension Funds 554

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 575

19 Types of Risks Incurred by Financial Institutions 575

20 Managing Credit Risk on the Balance Sheet 59 5

21 Managing Liquidity Risk on the Balance Sheet 627

22 Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 650

23 Managing Risk off the Balance Sheet with Derivative Securities 677

24 Managing Risk off the Balance Sheet with Loan Sales and Securitization 707

References 733

Index 735

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CONTENTS

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 3 Money Markets versus Capital Markets 6 Foreign Exchange Markets 8 Derivative Security Markets 9 Financial Market Regulation 10

Overview of Financial Institutions 10 Unique Economic Functions Performed

by Financial Institutions 12 Additional Benefits FIs Provide to Suppliers

of Funds 15 Economic Functions FIs Provide to the

Financial System as a Whole 15 Risks Incurred by Financial Institutions 16 Regulation of Financial Institutions 17 Trends in the United States 17

Globalization of Financial Markets and Institutions 20

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

2 Determinants of Interest Rates 36

Interest Rate Fundamentals: Chapter Overview 36

Loanable Funds Theory 37 Supply of Loanable Funds 38 Demand for Loanable Funds 39 Equilibrium Interest Rate 40 Factors That Cause the Supply and Demand

Curves for Loanable Funds to Shift 42

Movement of Interest Rates Over Time 45

Determinants of Interest Rates for Individual Securities 45

Inflation 46 Real Interest Rates 46 Default or Credit Risk 47 Liquidity Risk 49

Special Provisions or Covenants 49 Term to Maturity 50

Term Structure of Interest Rates 51 Unbiased Expectations Theory 52 Liquidity Premium Theory 53 Market Segmentation Theory 56

Forecasting Interest Rates 57

Time Value of Money and Interest Rates 58 Time Value of Money 58 Lump Sum Valuation 61 Annuity Valuation 64 Effective Annual Return 67

3 Interest Rates and Security Valuation 72

Interest Rates as a Determinant of Financial Security Values: Chapter Overview 72

Various Interest Rate Measures 73 Coupon Rate 73 Required Rate of Return 73 Expected Rate of Return 74 Required versus Expected Rates of Return:

The Role of Efficient Markets 76 Realized Rate of Return 76

Bond Valuation 77 Bond Valuation Formula Used to Calculate

Fair Present Values 77 Bond Valuation Formula Used to Calculate

Yield to Maturity 79

Equity Valuation 80 Zero Growth in Dividends 82 Constant Growth in Dividends 83 Supernormal (or Nonconstant) Growth in

Dividends 84

Impact of Interest Rate Changes on Security Values 85

Impact of Maturity on Security Values 86 Maturity and Security Prices 87 Maturity and Security Price Sensitivity to

Changes in Interest Rates 87

Impact of Coupon Rates on Security Values 88 Coupon Rate and Security Price 88 Coupon Rate and Security Price Sensitivity to

Changes in Interest Rates 89

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Duration 90 A Simple Illustration of Duration 90 A General Formula for Duration 92 Features of Duration 95 Economic Meaning of Duration 96 Large Interest Rate Changes and Duration 98

Appendix 3A: Duration and Immunization (at www.mhhe.com/sc5e)

Appendix 3B: More on Convexity (at www.mhhe .com/sc5e)

4 The Federal Reserve System, Monetary Policy, and Interest Rates 106

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview 106

Structure of the Federal Reserve System 107 Organization of the Federal Reserve

System 107 Board of Governors of the Federal Reserve

System 109 Federal Open Market Committee 109 Functions Performed by Federal Reserve

Banks 110 Balance Sheet of the Federal Reserve 114

Monetary Policy Tools 118 Open Market Operations 119 The Discount Rate 122 Reserve Requirements (Reserve Ratios) 125

The Federal Reserve, the Money Supply, and Interest Rates 129

Effects of Monetary Tools on Various Economic Variables 129

Money Supply versus Interest Rate Targeting 131

International Monetary Policies and Strategies 133

Systemwide Rescue Programs Employed During the Financial Crisis 134

part 2 SECURITIES MARKETS 141 5 Money Markets 141

Definition of Money Markets: Chapter Overview 141

Money Markets 142

Yields on Money Market Securities 143 Bond Equivalent Yields 143 Effective Annual Return 144 Discount Yields 144 Single-Payment Yields 145

Money Market Securities 147 Treasury Bills 147 Federal Funds 153

Repurchase Agreements 155 Commercial Paper 158 Negotiable Certificates of Deposit 162 Banker’s Acceptances 164 Comparison of Money Market Securities 164

Money Market Participants 165 The U.S. Treasury 166 The Federal Reserve 166 Commercial Banks 166 Money Market Mutual Funds 166 Brokers and Dealers 166 Corporations 167 Other Financial Institutions 167 Individuals 167

International Aspects of Money Markets 167 Euro Money Markets 169

Appendix 5A: Single versus Discriminating Price Treasury Auctions (at www.mhhe.com/sc5e)

Appendix 5B: Creation of a Banker’s Acceptance (at www.mhhe.com/sc5e)

6 Bond Markets 176

Definition of Bond Markets: Chapter Overview 176

Bond Market Securities 177 Treasury Notes and Bonds 177 Municipal Bonds 188 Corporate Bonds 194 Bond Ratings 200 Bond Market Indexes 203

Bond Market Participants 204

Comparison of Bond Market Securities 205

International Aspects of Bond Markets 205 Eurobonds, Foreign Bonds, and Sovereign

Bonds 208

7 Mortgage Markets 213

Mortgages and Mortgage-Backed Securities: Chapter Overview 213

Primary Mortgage Market 215 Mortgage Characteristics 216 Mortgage Amortization 221 Other Types of Mortgages 226

Secondary Mortgage Markets 229 History and Background of Secondary

Mortgage Markets 230 Mortgage Sales 230 Mortgage-Backed Securities 231

Participants in the Mortgage Markets 238

International Trends in Securitization 240

Appendix 7A: Amortization Schedules for No- Points versus Points Mortgages in Example 7–4 (at www.mhhe.com/sc5e)

Contents xix

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8 Stock Markets 244

The Stock Markets: Chapter Overview 244

Stock Market Securities 246 Common Stock 246 Preferred Stock 249

Primary and Secondary Stock Markets 251 Primary Stock Markets 251 Secondary Stock Markets 256 Stock Market Indexes 266

Stock Market Participants 271

Other Issues Pertaining to Stock Markets 272 Economic Indicators 272 Market Efficiency 273 Stock Market Regulations 276

International Aspects of Stock Markets 278

Appendix 8A: The Capital Asset Pricing Model (at www.mhhe.com/sc5e)

Appendix 8B: Event Study Tests (at www.mhhe .com/sc5e)

9 Foreign Exchange Markets 285

Foreign Exchange Markets and Risk: Chapter Overview 285

Background and History of Foreign Exchange Markets 286

Foreign Exchange Rates and Transactions 290 Foreign Exchange Rates 290 Foreign Exchange Transactions 290 Return and Risk of Foreign Exchange

Transactions 294 Role of Financial Institutions in Foreign

Exchange Transactions 299

Interaction of Interest Rates, Inflation, and Exchange Rates 303

Purchasing Power Parity 304 Interest Rate Parity 305

Appendix 9A: Balance of Payment Accounts (at www.mhhe.com/sc5e)

10 Derivative Securities Markets 310

Derivative Securities: Chapter Overview 310

Forwards and Futures 312 Spot Markets 312 Forward Markets 313 Futures Markets 315

Options 322 Call Options 322 Put Options 324 Option Values 326 Option Markets 328

Regulation of Futures and Options Markets 334

Swaps 335 Interest Rate Swaps 335 Currency Swaps 338 Credit Swaps 339 Swap Markets 340

Caps, Floors, and Collars 341

International Aspects of Derivative Securities Markets 343

Appendix 10A: Black–Scholes Option Pricing Model (at www.mhhe.com/sc5e)

part 3 COMMERCIAL BANKS 348 11 Commercial Banks: Industry

Overview 348

Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview 348

Definition of a Commercial Bank 351

Balance Sheets and Recent Trends 351 Assets 351 Liabilities 354 Equity 355 Off-Balance-Sheet Activities 355 Other Fee-Generating Activities 358

Size, Structure, and Composition of the Industry 358

Bank Size and Concentration 360 Bank Size and Activities 362

Industry Performance 364

Regulators 366 Federal Deposit Insurance Corporation 366 Office of the Comptroller of the Currency 367 Federal Reserve System 368 State Authorities 368

Global Issues 368 Advantages and Disadvantages of International

Expansion 368 Global Banking Performance 370

12 Commercial Banks’ Financial Statements and Analysis 374

Why Evaluate the Performance of Commercial Banks? Chapter Overview 374

Financial Statements of Commercial Banks 376

Balance Sheet Structure 377 Off-Balance-Sheet Assets and Liabilities 383 Other Fee-Generating Activities 386 Income Statement 387 Direct Relationship between the Income

Statement and the Balance Sheet 391

Financial Statement Analysis Using a Return on Equity Framework 391

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Return on Equity and Its Components 392 Return on Assets and Its Components 394 Other Ratios 399

Impact of Market Niche and Bank Size on Financial Statement Analysis 400

Impact of a Bank’s Market Niche 400 Impact of Size on Financial Statement

Analysis 401

13 Regulation of Commercial Banks 406

Specialness and Regulation: Chapter Overview 406

Types of Regulations and the Regulators 407 Safety and Soundness Regulation 407 Monetary Policy Regulation 409 Credit Allocation Regulation 410 Consumer Protection Regulation 410 Investor Protection Regulation 410 Entry and Chartering Regulation 411 Regulators 411

Regulation of Product and Geographic Expansion 412

Product Segmentation in the U.S. Commercial Banking Industry 412

Geographic Expansion in the U.S. Commercial Banking Industry 416

Bank and Savings Institution Guarantee Funds 417

FDIC 418 The Demise of the Federal Savings and Loan

Insurance Corporation (FSLIC) 419 Reform of Deposit Insurance 419 Non-U.S. Deposit Insurance Systems 421

Balance Sheet Regulations 421 Regulations on Commercial Bank

Liquidity 421 Regulations on Capital Adequacy

(Leverage) 422 Off-Balance-Sheet Regulations 427

Foreign versus Domestic Regulation of Commercial Banks 428

Product Diversification Activities 429 Global or International Expansion

Activities 429

Appendix 13A: Calculating Deposit Insurance Premium Assessments 436

Appendix 13B: Calculating Risk-Based Capital Ratios 440

Appendix 13C: Primary Regulators of Depository Institutions (at www.mhhe.com/sc5e)

Appendix 13D: Deposit Insurance Coverage for Commercial Banks in Various Countries (at www.mhhe.com/sc5e)

Appendix 13E: Calculating Minimum Required Reserves at U.S. Depository Institutions (at www.mhhe.com/sc5e)

part 4 OTHER FINANCIAL INSTITUTIONS 449

14 Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies 449

Other Lending Institutions: Chapter Overview 449

Savings Institutions 450 Size, Structure, and Composition of the

Industry 450 Balance Sheets and Recent Trends 453 Regulators 455 Savings Institution Recent Performance 456

Credit Unions 457 Size, Structure, and Composition of the

Industry 458 Balance Sheets and Recent Trends 460 Regulators 463 Industry Performance 463

Finance Companies 464 Size, Structure, and Composition of the

Industry 464 Balance Sheets and Recent Trends 466 Industry Performance 471 Regulation 472

Global Issues 473

15 Insurance Companies 476

Two Categories of Insurance Companies: Chapter Overview 476

Life Insurance Companies 477 Size, Structure, and Composition of the

Industry 477 Balance Sheets and Recent Trends 481 Regulation 484

Property–Casualty Insurance Companies 485 Size, Structure, and Composition of the

Industry 485 Balance Sheets and Recent Trends 487 Regulation 495

Global Issues 496

16 Securities Firms and Investment Banks 500

Services Offered by Securities Firms versus Investment Banks: Chapter Overview 500

Size, Structure, and Composition of the Industry 502

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Regulation 569

Global Issues 571

Appendix 18A: Calculation of Growth in IRA Value during an Individual’s Working Years (at www.mhhe.com/sc5e)

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 575

19 Types of Risks Incurred by Financial Institutions 575

Why Financial Institutions Need to Manage Risk: Chapter Overview 575

Credit Risk 576

Liquidity Risk 579

Interest Rate Risk 580

Market Risk 582

Off-Balance-Sheet Risk 584

Foreign Exchange Risk 586

Country or Sovereign Risk 588

Technology and Operational Risk 589

Insolvency Risk 590

Other Risks and Interaction Among Risks 591

20 Managing Credit Risk on the Balance Sheet 595

Credit Risk Management: Chapter Overview 595

Credit Quality Problems 596

Credit Analysis 599 Real Estate Lending 599 Consumer (Individual) and Small-Business

Lending 603 Mid-Market Commercial and Industrial

Lending 603 Large Commercial and Industrial Lending 612

Calculating the Return on a Loan 616 Return on Assets (ROA) 616 RAROC Models 618

Appendix 20A: Loan Portfolio Risk and Management 624

21 Managing Liquidity Risk on the Balance Sheet 627

Liquidity Risk Management: Chapter Overview 627

Causes of Liquidity Risk 628

Liquidity Risk and Depository Institutions 629 Liability Side Liquidity Risk 629 Asset Side Liquidity Risk 632

Securities Firm and Investment Bank Activity Areas 504

Investment Banking 504 Venture Capital 506 Market Making 507 Trading 508 Investing 509 Cash Management 509 Mergers and Acquisitions 510 Other Service Functions 511

Recent Trends and Balance Sheets 511 Recent Trends 511 Balance Sheets 515

Regulation 516

Global Issues 519

17 Mutual Funds and Hedge Funds 523

Mutual Funds and Hedge Funds: Chapter Overview 523

Size, Structure, and Composition of the Mutual Fund Industry 524

Historical Trends 524 Different Types of Mutual Funds 527

Mutual Fund Returns and Costs 531 Mutual Fund Prospectuses and Objectives 531 Investor Returns from Mutual Fund

Ownership 532 Mutual Fund Costs 535

Mutual Fund Balance Sheets and Recent Trends 538

Long-Term Funds 538 Money Market Funds 539

Mutual Fund Regulation 540

Mutual Fund Global Issues 543

Hedge Funds 545 Types of Hedge Funds 546 Fees on Hedge Funds 549 Offshore Hedge Funds 550 Regulation of Hedge Funds 550

18 Pension Funds 554

Pension Funds Defined: Chapter Overview 554

Size, Structure, and Composition of the Industry 555

Defined Benefit versus Defined Contribution Pension Funds 555

Insured versus Noninsured Pension Funds 557 Private Pension Funds 558 Public Pension Funds 565

Financial Asset Investments and Recent Trends 566

Private Pension Funds 566 Public Pension Funds 567

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Measuring a Bank’s Liquidity Exposure 633 Liquidity Risk, Unexpected Deposit Drains, and

Bank Runs 639 Bank Runs, the Discount Window, and Deposit

Insurance 640

Liquidity Risk and Insurance Companies 644 Life Insurance Companies 644 Property–Casualty Insurance Companies 644 Guarantee Programs for Life and Property–

Casualty Insurance Companies 645

Liquidity Risk and Investment Funds 646

Appendix 21A: New Liquidity Risk Measures Implemented by the Bank for International Settlements (at www.mhhe.com/sc5e)

Appendix 21B: Sources and Uses of Funds Statement: Bank of America, June 2010 (at www.mhhe.com/sc5e)

22 Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 650

Interest Rate and Insolvency Risk Management: Chapter Overview 650

Interest Rate Risk Measurement and Management 651

Repricing Model 651 Duration Model 659

Insolvency Risk Management 666 Capital and Insolvency Risk 667

23 Managing Risk off the Balance Sheet with Derivative Securities 677

Derivative Securities Used to Manage Risk: Chapter Overview 677

Forward and Futures Contracts 678 Hedging with Forward Contracts 679 Hedging with Futures Contracts 680

Options 684 Basic Features of Options 684 Actual Interest Rate Options 687 Hedging with Options 687 Caps, Floors, and Collars 688

Risks Associated with Futures, Forwards, and Options 689

Swaps 690 Hedging with Interest Rate Swaps 690 Hedging with Currency Swaps 693 Credit Swaps 694 Credit Risk Concerns with Swaps 697

Comparison of Hedging Methods 698 Writing versus Buying Options 698 Futures versus Options Hedging 700 Swaps versus Forwards, Futures, and

Options 701

Derivative Trading Policies of Regulators 702

Appendix 23A: Hedging with Futures Contracts (at www.mhhe.com/sc5e)

Appendix 23B: Hedging with Options (at www .mhhe.com/sc5e)

Appendix 23C: Hedging with Caps, Floors, and Collars (at www.mhhe.com/sc5e)

24 Managing Risk off the Balance Sheet with Loan Sales and Securitization 707

Why Financial Institutions Sell and Securitize Loans: Chapter Overview 707

Loan Sales 708 Types of Loan Sales Contracts 710 The Loan Sales Market 710 Secondary Market for Less Developed

Country Debt 713 Factors Encouraging Future Loan Sales

Growth 714 Factors Deterring Future Loan Sales

Growth 715

Loan Securitization 715 Pass-Through Security 716 Collateralized Mortgage Obligation 722 Mortgage-Backed Bond 726

Securitization of Other Assets 728

Can all Assets be Securitized? 728

References 733

Index 735

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1

Introduction and Overview of Financial Markets part one

Introduction

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.

WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? CHAPTER OVERVIEW In the 1990s, financial markets in the United States boomed. The Dow Jones Industrial Index—a widely quoted index of the values of 30 large corporations (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 else- where, 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 escalated to a full blown financial crisis and the worst recession in the United States since the Great Depression. The Dow Jones Industrial Arerage (DJIA) fell to 6,547 in March 2009 before recovering, along with the economy, to over 11,000 in April 2010.

While security values in U.S. financial markets rose dramatically in the 1990s, markets in Southeast Asia, South America, and Russia were much more volatile. The Thai baht, for example, fell nearly 50 percent in value relative to the U.S. dollar on July 2, 1997. More recently, in 2002, as U.S. markets surged in value, Argentina’s economic and financial

c hap t e r

1 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

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2 Part 1 Introduction and Overview of Financial Markets

system collapsed and its currency fell more than 30 percent in value relative to the U.S. dollar as the government relaxed the peso’s one-to-one parity peg to the dollar. During the financial crisis of 2008–2009, however, 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).

Meanwhile, the financial institutions (FIs) industry has gone through a full histori- cal cycle. Originally the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock investing, insurance provision, etc.). In the early 1930s, the economic and industrial col- lapse resulted in the separation of some of these activities. In the 1970s and 1980s new, relatively unregulated financial services industries sprang up (e.g., mutual funds, broker- age funds) that separated the financial service functions even further.

The last 20 years have been particularly dramatic for the financial institutions indus- try. 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 service firm under the umbrella of a financial services holding company. For example, J. P. Morgan Chase operates a commercial bank (J. P. Morgan Chase Bank), an investment bank (J. P. Morgan Securities, which also sells mutual funds), and an insur- ance company (J. P. Morgan Insurance Agency). During the financial crisis, this finan- cial services holding company purchased a savings institution, Washington Mutual, and several investment banks, including Bear Stearns. 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 ninth largest bank holding company, operating in 60 countries.

Then came the late 2000s when the United States, and indeed the world, experienced a collapse of financial markets second only to that experienced during the Great Depres- sion. The financial crisis produced a major reshaping of all FI sectors and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most prominent invest- ment 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 have either failed, been merged, or become bank holding companies.

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 securiti- zation, derivative securities, and internationalization of financial services also receive spe- cial emphasis. Further, as the United States and the world 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 vari- ous 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.

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Chapter 1 Introduction 3

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.

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 2010. The 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 market transactions in the United States are arranged through financial institutions called invest- ment banks—for example, Morgan Stanley or Bank of America Merril Lynch—that serve as intermediaries between the issuing corporations (fund users) and investors (fund sup- pliers). 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 securi- ties 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 discussion below). Figure 1–1 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 .

OVERVIEW OF FINANCIAL MARKETSOVERVIEW OF FINANCIAL MARKETS

financial markets The arenas through which funds flow.

financial markets The arenas through which funds flow.

LG 1-1LG 1-1

primary markets Markets in which cor- porations raise funds through new issues of securities.

primary markets Markets in which cor- porations raise funds through new issues of securities.

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

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.

TABLE 1–1 Types of Financial Markets

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

*Through first quarter.

Security Type 2000 2005 2007 2008 2009 2010 *

All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,171.2 $259.8 Bonds 944.8 2,323.7 2,220.3 861.2 946.9 231.1 Stocks 311.9 115.3 1,168.8 206.8 224.3 28.7 Private placements 196.5 24.6 20.1 16.2 11.2 n.a.

IPOs 97.0 36.7 46.3 26.4 16.6 2.9

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4 Part 1 Introduction and Overview of Financial Markets

Rather than a public offering (i.e., an offer of sale to the investing public at large), a primary market sale can take the form of a private placement. With a private placement, the securities issuer (user of funds) seeks to find an institutional buyer—such as a pension fund—or group of buyers (suppliers of funds) to purchase the whole issue. Privately placed securities have traditionally been among the most illiquid securities, with only the very largest financial institutions or institutional investors being able or willing to buy and hold them. We discuss the benefits and costs of privately placed primary market sales in detail in Chapter 6 .

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 May 28, 2010, Toys ‘R’ Us announced an $800 million IPO of its common stock. The company’s stock was underwritten by several investment banks, including Goldman Sachs.

Primary market securities also include the issue of additional equity or debt instru- ments of an already publicly traded firm. For example, on March 18, 2010, Genpact Lim- ited announced the sale of an additional 38,640,000 shares of common stock underwritten by investment banks such as Morgan Stanley, Goldman Sachs, and Citigroup Global Markets.

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 June 22, 2010, 23.7 million shares of ExxonMobil were traded in the second- ary stock market. Buyers of secondary market securities are economic agents (consumers,

initial public offerings (IPOs) The first public issue of financial instruments by a firm.

initial public offerings (IPOs) The first public issue of financial instruments by a firm.

secondary market A market that trades financial instruments once they are issued.

secondary market A market that trades financial instruments once they are issued.

Figure 1–1 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 offered for sale)

Secondary Markets

(Where financial instruments, once issued, are traded)

Financial instruments flow

Funds flow

Initial Suppliers of Funds

(Investors)

Financial Markets

(Investors)

Securities Brokers

Other Suppliers of Funds

(Investors)

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Chapter 1 Introduction 5

businesses, and governments) with excess funds. Sellers of secondary market financial instruments are economic agents in need of funds. Secondary markets provide a central- ized marketplace where economic agents know they can transact quickly and efficiently. These markets therefore save economic agents the search and other costs of seeking buy- ers or sellers on their own. Figure 1–1 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 Schwab acting as an inter- mediary 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 Automated Quota- tion (NASDAQ) 2 system are two well-known examples of secondary markets for trading stocks. 3 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 are linked to other, previously issued [or underlying] primary 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, the derivative securities markets are among the newest of the financial security markets. However, the financial crisis clearly illustrates the magnitude of the risk that derivatives can impose on a FI and even the world’s financial system. Indeed, at the very heart of the financial crisis were losses associated with off-balance-sheet derivative securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs (e.g., the investment banks Lehman Brothers, Bears Stearns, and Merrill Lynch; the savings institution Washington Mutual; the insurance company AIG; the commercial bank Citigroup; the finance company Countrywide Financial; and the gov- ernment sponsored agencies Fannie Mae and Freddie Mac) and a near meltdown of the world’s financial and economic systems.

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).

Trading volume in secondary markets can be large. For example, on October 28, 1997, NYSE trading volume exceeded 1 billion shares for the first time ever and trading of this magnitude and higher has occurred several times since. Indeed, on October 10, 2008 (at the height of the financial crisis), trading volume topped 7.3 billion shares, the highest level to date. In contrast, during the mid-1980s, a NYSE trading day involving 250 million shares was considered to be heavy.

Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into cash quickly—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

derivative security A financial security whose payoffs are linked to other, previously issued securities.

derivative security A financial security whose payoffs are linked to other, previously issued securities.

3 Most bonds are not traded on floor-based exchanges. Rather, FIs trade them over the counter (OTC) using tele- phone and computer networks (see Chapter 6 ). For example, less than 1 percent of corporate bonds outstanding are traded on organized exchanges such as the NYSE.

2 In the fall of 2008, the NYSE, the world’s largest stock market and the American Stock Exchange (AMEX), at the time the nation’s second largest floor-based exchange, merged.

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6 Part 1 Introduction and Overview of Financial Markets

initially in the primary market. Further, the existence of centralized markets for buying and selling financial instruments allows investors to trade these instruments 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 1–2 ). In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money market 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 19 on interest rate risk). In the United States, money mar- kets do not operate in a specific location—rather, transactions occur via telephones, 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 corpo- rations 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 1–3 shows outstanding amounts of money market instruments in the United States in 1990, 2000, and 2010. Notice that in 2010 negotiable CDs, followed by Treasury bills, federal funds and repurchase agreements, and commercial paper, had the largest amounts outstanding. Money market instruments and the operation of the money markets are described and discussed in detail in Chapter 5 .

Capital Markets. Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year (see Figure 1–2 ). The major suppliers of capital market securities (or users of funds) are corporations and governments. Households are the major suppliers of funds for these securities. Given their longer matu- rity, these instruments experience wider price fluctuations in the secondary markets in which they trade than do money market instruments. 4 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 each capital market security. Figure 1–4 shows their outstanding amounts by dollar market value. Notice that in both 2000 and 2010, corporate stocks or equities represent the largest capital market instrument, followed by securitized mortgages and corporate bonds. Securitized mortgages are those mortgages that FIs have packaged together and sold as bonds backed by mortgage cash

LG 1-2LG 1-2

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

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, trans- actions occur via tele- phones, wire transfers, and computer trading.

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

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

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

4 For example, their longer maturities subject these instruments to both higher credit (or bankruptcy) risk and interest rate risk than money market instruments.

Figure 1–2 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

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Chapter 1 Introduction 7

TABLE 1–3 Money and Capital Market Instruments

Figure 1–3 Money Market Instruments Outstanding

*As of the end of the first quarter.

Source : Federal Reserve Board, “Flow of Fund Accounts,” Statistical Releases , Washington, DC, various issues. www.v.gov

1990 $2,056 b.

outstanding

2000 $4,510 b.

outstanding

2010* $6,477.1 b. outstanding

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

18.1%

25.7% 26.6%

2.6%

35.6% 26.5%

14.4%

23.3%0.2%

0.0%

27.1% 16.7%

29.1%

25.6%

28.6%

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 certificate of deposit —bank-issued time deposit that specifies an interest rate and maturity date and is negotiable, (i.e., can be sold by the holder to another party). Banker’s acceptance —time draft 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. Treasury. State and local government bonds —long-term bonds issued by state and local governments. U.S. government agencies —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.

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8 Part 1 Introduction and Overview of Financial Markets

flows (such as interest and principal repayments—see Chapters 7 and 24 ). It was these securities that were at the very heart of the recent financial crisis. The relative size of the market value of capital market instruments outstanding depends on two factors: the num- ber of securities issued and their market prices. 5 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 sectors 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 1 ½ years, larger than the decline during the market crash of 1929 when it fell 49 percent. However, 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 operations 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, a currency and economic crisis in Argentina in the early 2000s, adversely impacted some U.S. markets and firms. Coca-Cola Co., which derived about 2 percent of its sales from Argentina, attributed a 5 percent decline in its operating profits to unfavorable currency movements between the Argentinian peso and the U.S. dollar.

LG 1-3LG 1-3

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

Figure 1–4 Capital Market Instruments Outstanding

*As of the end of the first quarter.

Source : Federal Reserve Board, “Flow of Fund Accounts,” Statistical Releases , Washington, DC, various issues. www.federalreserve.gov

20.9%

31.3%

16.8%9.0%

11.4%

4.2%

6.4%

1990 $14,933 b. outstanding

2000 $40,621 b. outstanding

2010* $67,922.3 b. outstanding

Corporate stocks Mortgages Corporate bonds

State and local government bonds U.S. government agencies Bank and 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%

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Chapter 1 Introduction 9

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 exam- ple, 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 depreci- ates (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 ter- minated), 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 and supply of 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 such as foreign exchange (FX) futures, options, and swaps, are discussed in Chapter 23 .

Derivative Security Markets

Derivative security markets are the markets in which derivative securities trade. A deriv- ative security is a financial security (such as a futures contract, option contract, swap con- tract, or mortgage-backed security) whose payoff is linked to another, previously issued security such as a security traded in the 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 value of the underlying security to be exchanged changes, the value of the derivative security changes. While derivative securities have been in existence for centu- ries, 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 2010.

As major markets, the 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 associ- ated with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Signs of significant problems in the U.S. economy first arose in late 2006 and the first half of 2007 when home prices plummeted and defaults held by subprime mortgage

LG 1-4LG 1-4

derivative security markets The markets in which derivative securities trade.

derivative security markets The markets in which derivative securities trade.

derivative security An agreement between two parties to exchange a standard quantity of an asset at a predeter- mined price on a speci- fied date in the future.

derivative security An agreement between two parties to exchange a standard quantity of an asset at a predeter- mined price on a speci- fied date in the future.

DO YOU UNDERSTAND:

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?

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

*As of the first quarter.

S ource : Office of the Comptroller of the Currency Web site, various dates. www.occ.treas.gov

1992 2000 2010 *

Futures and forwards $4,780 $ 9,877 $ 26,493 Swaps 2,417 21,949 142,011 Options 1,568 8,292 30,267 Credit — 426 14,036 Total $8,765 $40,544 $212,807

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10 Part 1 Introduction and Overview of Financial Markets

borrowers began to affect the mortgage lending industry as a whole, as well as other parts of the economy. Mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 through 2008 as homeowners, who had stretched themselves financially to buy a home or refinance a mortgage in the early 2000s, fell behind on their loan payments. As mortgage borrowers defaulted on their mortgages, financial institu- tions that held these mortgages and credit derivative securities (in the form of mortgage- backed securities) started announcing huge losses on them. 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, acquisition, or bailout of some of the largest FIs and the near collapse of the world’s financial and economic systems.

We discuss the tremendous growth of 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 purposes or dealers (such as banks) that act as counterpar- ties 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 mar- kets since the passage of the Securities Act of 1934—as well as the exchanges (if any) on which the instruments are traded. For example, the main emphasis of SEC regulations (as stated in the Securities 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 regis- ter 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. 6 The SEC also monitors trading on the major exchanges (along with the exchanges themselves) to ensure that stockhold- ers and managers do not trade on the basis of inside information about their own firms (i.e., information prior to its public release). SEC regulations 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 deci- sions. The SEC has also imposed regulations on financial markets in an effort to reduce excessive price fluctuations. For example, the NYSE operates under a series of “circuit breakers” that require the market to shut down for a period of time when prices drop by large amounts during any trading day. The details of these circuit breaker regulations are listed in Chapter 8 .

www.sec.gov www.sec.gov

www.nyse.com www.nyse.com

6 Those issues not offered to the public at large but rather sold to a few large investors are called private place- ments and are not subject to SEC regulations (see Chapter 6 ).

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 oper- ation of financial markets, imagine a simple world in which FIs did 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

financial institutions Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages 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 1-5LG 1-5

OVERVIEW OF FINANCIAL INSTITUTIONSOVERVIEW OF FINANCIAL INSTITUTIONS

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Chapter 1 Introduction 11

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 securities) to finance the gap between their investment expenditures and their internally generated savings such as retained earnings. As shown in Figure 1–5 , 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.

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

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

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

TABLE 1–5 Types of Financial Institutions

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. Mutual funds —financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets. Hedge funds —financial institutions that pool funds from a limited number (e.g., less than 100) of wealthy (e.g., annual incomes of more than $200,000 or net worth exceeding $1 million) individuals and other investors (e.g., commercial banks) and invest these funds on their behalf, usually keeping a large proportion (commonly 20 percent) of any upside return and charging a fee (2%) on the amount invested. 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 a pension fund are exempt from current taxation.

Figure 1–5 Flow of Funds in a World without FIs

Users of Funds (Corporations)

Financial Claims (equity and debt instruments)

Cash

Suppliers of Funds (Households)

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12 Part 1 Introduction and Overview of Financial Markets

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, since this would lower the chances of being repaid and/or earning a positive return on their investment (such as through the receipt of dividends or interest). 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 investment. 7 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, cor- porate 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. In addition, the secondary market trading of securi- ties involves various transaction costs. The price at which investors can sell a security 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 valua- tion 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. 8

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. 9 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 hold the financial claims issued by FIs rather than those directly issued by the ultimate users of funds. Consider Figure 1–6 , which is a closer representation than Figure 1–5 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.

liquidity The ease with which an asset can be converted into cash at its fair mar- ket value.

liquidity The ease with which an asset can be converted into cash at its fair mar- ket value.

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

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

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

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

7 Failure to monitor exposes fund suppliers to “agency costs,” that is, the risk that the fund users will take actions with the fund supplier’s money contrary to the promises contained in the financing agreement. Monitoring costs are part of overall agency costs. That is, agency costs arise whenever economic agents enter into contracts in a world of asym- metric or incomplete information and thus information collection is costly. The more difficult and costly it is to collect information, the more likely it is that contracts will be broken. In this case, the fund suppliers could be harmed by the actions taken by the fund users. As discussed below, one solution to this agency problem is for a large number of fund suppliers to place their funds with a single FI who acts as a “delegated” monitor.

8 On organized exchanges such as the NYSE, the price difference between a buy and sell price is called the bid- ask spread.

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

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Chapter 1 Introduction 13

Figure 1–6 Flow of Funds in a World with FIs

TABLE 1–6 Services Performed by Financial Intermediaries

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.

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 above, 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. In turn the FI invests in the direct financial claims issued by fund users. This aggrega- tion of funds by fund suppliers in a financial institution resolves a number of problems.

LG 1-6LG 1-6

Cash Cash

Financial Claims (Equity and debt securities)

Financial Claims (Deposits and insurance policies)

FI (Brokers)

FI (Asset

transformers)

Suppliers of FundsUsers of Funds

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14 Part 1 Introduction and Overview of Financial Markets

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 exam- ple, full-service securities firms such as Morgan Stanley carry out investment research on new issues and make investment recommendations for their retail clients (or investors), while commercial banks collect deposits from fund suppliers and lend these funds to ulti- mate users such as corporations. An important part of these FIs’ functions is their ability and incentive to monitor ultimate fund users.

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 deposits, insurance policies, or other secondary securities .

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., savings 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 inves- tors. 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 by writing a check. Even life insur- ance 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? Indeed, 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 .) Indeed, experiments have shown that diversifying across just 15 securities can bring significant diversification benefits to FIs and portfolio managers. Further, for equal investments in different securities, as the number of securities in an FI’s asset portfolio increases, portfolio risk falls, albeit at a diminishing rate. What is really going on here is that FIs can exploit the law of large num- bers 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. A good example of this is a bank’s ability to offer highly liquid, instantly withdrawable demand deposits as liabilities while investing in risky, nontradable, and often illiquid loans as assets. As long as an FI is large enough to gain from diversification and monitoring on the asset side of its balance

delegated monitor An economic agent appointed to act on behalf of smaller inves- tors in collecting informa- tion and/or investing funds on their behalf.

delegated monitor An economic agent appointed to act on behalf of smaller inves- tors in collecting informa- tion and/or investing funds on their behalf.

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

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

diversify The ability of an eco- nomic agent to reduce risk by holding a num- ber of securities in a portfolio.

diversify The ability of an eco- nomic agent to reduce risk by holding a num- ber of securities in a portfolio.

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Chapter 1 Introduction 15

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 directly investing themselves.

Nevertheless, as a result of technological advances, the costs of direct access to finan- cial markets by savers are ever falling and the relative benefits to the individual savers of investing through FIs are narrowing. An example is the ability to reduce transactions costs with an etrade on the Internet rather than using a traditional stockbroker and paying bro- kerage fees (see Chapter 8 ). Another example is the private placement market, in which corporations such as General Electric sell securities directly to investors, often without using underwriters. In addition, a number of companies allow investors to buy their stock directly without using a broker. Among well-known companies that have instituted such stock purchase plans are AT&T, Microsoft, Marathon Oil, IBM, and Walt Disney Co.

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 mismatching, FIs can produce new types of contracts such as long-term 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 19 ), a large FI is better able than a small investor to manage this risk through its superior 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 because they provide services 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 savers (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 gener- ate 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 .

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

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

etrade Buying and selling shares on the Internet.

etrade Buying and selling shares on the Internet.

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16 Part 1 Introduction and Overview of Financial Markets

10 The Federal Reserve is the U.S. central bank charged with promoting economic growth in line with the economy’s potential to expand, and in particular, stable prices.

11 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.

The Transmission of Monetary Policy. The highly liquid nature of bank and thrift depos- its 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 sup- ply (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 and the rate of inflation, 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). 10 Because depository institu- tions are instrumental in determining the size and growth of the money supply, they have been designated as the primary conduit through which monetary policy actions by the Fed- eral Reserve impact the rest of the financial sector and the economy 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 num-

ber of other countries such as the United Kingdom have identified residential real estate as 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 associations and savings banks must emphasize mortgage lend- ing. Sixty-five percent of their assets must be mortgage related for these thrifts to maintain their charter status (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. 11

Intergenerational Wealth Transfers or Time Intermediation. The ability of savers to transfer wealth from their youth to old age as well as across gen- erations is also of great importance to a country’s social well-being. Because of this, special taxation relief and other subsidy mechanisms encourage invest- ments by savers in life insurance, annuities, and pension funds. For example, pension funds offer savings plans through which fund participants accumu- late 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 special in that the efficiency with which they provide payment services directly benefits the economy. Two important payment services are check-clearing and wire transfer services. For example, on any given day, over $3 trillion of payments are directed through Fedwire and CHIPS, the two largest whole- sale payment wire network systems in the United States. Any breakdowns in

these systems would likely produce gridlock to the payment system, with resulting harm- ful effects to the economy.

Risks Incurred by Financial Institutions

As financial institutions perform the various services described above, 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

www.federal reserve.gov www.federal reserve.gov

LG 1-7LG 1-7

DO YOU UNDERSTAND:

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?

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Chapter 1 Introduction 17

both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mis- match 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 opera- tional risk because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services). 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. 12 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 sectors 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 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. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sud- den drops in income upon retirement. In addition, individual 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 pro- vided 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 more 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 the regulations (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 1860 to 2010. 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 55.9 percent in 1948 to 30.6 percent in 2010. Further, the share of thrifts (savings banks, savings associations, and credit unions) fell from 12.3 to 4.6 percent over the same period. 13 Similarly, insurance

LG 1-8LG 1-8

12 As discussed in Chapter 12 , the capital reserves of an FI insulate it against the losses that may occur as a result of its risk exposure.

13 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.

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18

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Chapter 1 Introduction 19

companies also witnessed a decline in their share, from 24.3 to 13.3 percent. The most dra- matic trend involves the increasing share of pension funds and investment companies. Pen- sion funds (private plus state and local) increased their asset share from 3.1 to 22.2 percent, while investment companies (mutual funds and money market mutual funds) increased their share from 1.3 to 20.8 percent over the 1948 to 2010 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, the U.S. Congress passed the Financial Services Modernization (FSM) Act, which repealed the 1933 Glass-Steagall barriers between com- mercial 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. Thus, after 70 years of partial or complete separation between insurance, investment banking, and commercial banking, the Financial Services Modernization Act of 1999 opened the door for the creation of full-service financial insti- tutions in the U.S. 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 finan- cial 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 system, 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 con- sumers. 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 liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model in which they originated or warehoused loans and then quickly sold them. Indeed, most large banks organized as financial services holding companies to facilitate these new activities. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the finan- cial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and interest rate risks of traditional banking, they had little incentive to screen and monitor the activities of borrowers to whom they originated loans. Thus, FIs failed to act as special- ists in risk measurement and management.

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 money market rate that banks and other finan- cial institutions pay in the federal funds market and even made lender-of-last-resort funds available to nonbank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by the central bank resulted in a rapid expansion

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20 Part 1 Introduction and Overview of Financial Markets

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. More- over, 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 adjustable rate mortgages (ARMs). These teaser rates provided exceptionally low ini- tial 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. Under the traditional, “origi- nate 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-to-distribute model of banking, asset securitization 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 con- sumer and corporate leverage.

Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates in the money market as it began to fear inflation. Since many of the subprime mortgages that originated in the 2001–2005 period had float- ing rates, the cost of meeting mortgage commitments rose to unsustainable levels for many low-income households. 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 fore- closures that only reinforced the downward trend in housing 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 apparently anticipated by the rat- ing agencies who set their initial subprime mortgage securitizations ratings. These effects built throughout 2006 and through the middle of 2007. By February 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 number of subprime mort- gages that were more than 60 days behind on their payments was 17.1 percent in June 2007 and over 20 percent in August 2007. As borrowers had difficulty repaying their existing mortgages, they found it impossible to refinance their existing loans prior to the higher step-up interest rate kicking in. Thus, the financial crisis began. As previously mentioned, Appendix 1A provides a detailed discussion of the causes of, the major events during, and the regulatory and industry 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.

Financial markets and institutions in the United States have their counterparts in many foreign countries. Table 1–8 lists U.S. dollar equivalent values of money market and debt securities outstanding in countries throughout the world from 1996 through 2010. Notice that U.S. markets dominate the world debt markets. For example, in 2010 over 26 percent of the world’s debt securities were issued in the United States. The next two most active issuers combined (Germany and the United Kingdom) had fewer debt securities outstand- ing than the U.S. market. While U.S. financial markets have historically been much larger in value, size, and trading volume than any foreign market, financial markets became

GLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONSGLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONS

LG 1-9LG 1-9

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Chapter 1 Introduction 21

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. 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 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. Given the size of the “euro-economies,” the euro is fast becoming one of the world’s most important currency for international transactions, chal- lenging the U.S. dollar’s traditional role in international trade. Finally, deregulation in many foreign countries has allowed international investors greater access and allowed the

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

*As of the end of the first quarter.

Source : Bank for International Settlements, “International Banking and Financial Market Developments,” Quarterly

Review , various issues. www.bis.org

Money Market Long-Term Debt Securities

Country 1996 2000 2010 * 2000 2010 *

Argentina $ 29.0 $ 68.1 $ 51.3 $ 0.4 $ 0.1 Australia 77.4 94.1 538.6 17.9 23.0 Austria 62.5 82.2 338.7 9.3 14.7 Belgium 42.1 65.3 559.3 12.4 25.7 Brazil 23.1 48.9 142.3 3.5 2.6 Canada 177.8 202.8 574.4 5.8 5.8 China n.a. 17.6 49.6 0.2 0.9 France 204.4 346.5 1,849.0 12.7 109.0 Germany 319.8 769.8 2,682.7 104.4 120.0 Hong Kong 15.9 28.4 77.6 2.5 0.3 Ireland 20.0 32.0 533.8 4.1 38.8 Italy 88.6 198.1 1,273.9 12.6 41.3 Japan 325.6 274.2 370.8 7.4 18.8 Luxembourg 8.4 16.4 87.8 5.4 5.1 Mexico 41.5 63.7 100.7 2.9 0.8 Netherlands 112.2 267.2 1,177.8 26.2 85.8 Norway 19.5 39.1 182.5 1.8 11.4 South Korea 38.9 48.7 122.4 0.8 0.0 Spain 44.2 137.0 1,666.9 11.3 85.7 Sweden 99.6 90.6 351.9 7.5 51.1 Switzerland 39.5 89.3 449.8 8.1 10.4 United Kingdom 258.7 519.2 2,938.9 48.1 127.9 United States 372.4 1,662.7 6,695.3 40.9 74.3 Total private sector debt $2,982.5 $5,907.7 $25,670.8 $370.1 $944.9

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22 Part 1 Introduction and Overview of Financial Markets

deregulating countries to expand their investor bases (e.g., until 1997, foreign investors faced severe restrictions on their ability to buy Korean stocks). As a result of these factors, the overall volume of investment and trading activity in foreign securities is increasing, as is the integration of U.S. and foreign financial markets.

Table 1–9 shows the extent of the growth in foreign investment in U.S. financial mar- kets. From 1992 through 2010, foreign investors’ holdings of U.S. financial market debt securities outstanding increased 700 percent, from $989.3 billion to $7,921.9 billion, while foreign financial market debt securities held by U.S. investors increased 560 percent, from $315.8 billion to $2,084.2 billion. From these data it should be evident that 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 economies. In turn, the success of other economies depends to a significant extent on their financial market development. Fur- ther, 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 1–10 lists the 10 largest banks in the world, measured by total assets, as of 2010. Only two of these are U.S. banks.

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

TABLE 1–9 Financial Market Securities Holdings ( in billions of dollars )

1992 1996 2000 2010 *

U.S. Financial Market Instruments Held by Foreign Investors

Open market paper $ 12.9 $ 57.9 $ 114.3 $ 192.5 U.S. government securities 595.0 1,293.9 1,462.8 5,218.3 U.S. corporate bonds 251.5 453.2 1,073.6 2,325.1 Loans to U.S. corporate businesses 129.9 126.2 117.3 186.0

Total 989.3 1,931.2 2,768.0 7,921.9 U.S. corporate equities held 329.0 656.8 1,643.2 2,980.8 Total financial assets held $2,247.0 $4,133.2 $6,746.0 $15,625.3

Foreign Financial Market Instruments Held by U.S. Investors

Commercial paper $ 78.4 $ 67.5 $ 120.9 $ 384.7 Bonds 147.2 347.7 572.7 1,580.7 Bank loans 23.9 43.7 70.5 97.0 U.S. government loans 55.1 50.1 47.2 21.8 Acceptance liabilities to banks 11.3 9.9 3.1 0.0

Total 315.8 518.8 814.4 2,084.2 Foreign corporate equities held 314.3 876.8 1,852.8 4,157.3 Total financial assets held $1,712.3 $3,117.0 $3,562.3 $ 7,358.1

*As of the end of the first quarter.

Source : Federal Reserve Board, “Flow of Fund Accounts,” Statistical Releases , various issues. www.federal

reserve.gov

DO YOU UNDERSTAND:

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

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stock markets followed, with U.K stock markets falling 4.1 percent and German markets by 2.4 percent. The selling continued in the United States, with the Dow Jones Industrial Average falling more than 300 points at the beginning of trading on Thursday, August 16.

As the crisis spread and intensified in 2008–2009, world stock markets saw huge swings in value as investors tried to sort out the extent of the crisis. Markets from Russia to Europe were forced to suspend trading as stock prices plunged. Additionally, banks worldwide saw losses driven by their portfolios of structured finance products and secu- ritized exposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets for those instruments. In Europe, the general picture of bank performance in 2008 was similar to that in the United States. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerland, and the United Kingdom had net losses for the year. Banks in Ireland, Spain, and the United Kingdom were especially hard hit as they had large investments in mortgages and mortgage-backed securities, both U.S. and domestic. For example, one of the largest banks in the United Kingdom, the Royal Bank of Scotland (SBC), had to be nationalized by the government. Because they focused on domestic retail banking, French and Italian banks were less affected by losses on mortgage-backed securities. Continental European banks, in contrast to U.K. banks, partially cushioned losses through an increase in their net interest margins.

TABLE 1–10 The Largest (in Total Assets) Banks in the World ( in trillions of dollars )

Bank Country Total Assets

1. BNP Paribas France $3.21 2. Royal Bank of Scotland United Kingdom 2.99 3. Barclays Bank United Kingdom 2.54 4. Deutsche Bank Germany 2.43 5. HSBC Holdings United Kingdom 2.42 6. Credit Agricole France 2.30 7. Bank of America United States 2.25 8. Mitsubishi UFJ Financial Japan 2.07 9. J. P. Morgan Chase United States 2.02 10. UBS Group Switzerland 1.80

Source : Authors’ research.

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 services 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 functions 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.

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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

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

4. Which of the money market instruments has grown the fastest since 1990? ( LG 1-2 )

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

6. Which of the capital market instruments has grown the fastest since 1990? ( 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., corporations) 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 to 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. Why are FIs regulated? ( LG 1-8 )

18. What events resulted in banks’ shift from the traditional banking model of “originate and hold” to a model of “originate and distribute?” (LG 1-6, LG 1-7, LG 1-8)

19. 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)

20. What countries have the most international debt securities outstanding? ( LG 1-8 )

21. What countries have the largest commercial banks? ( LG 1-8 )

Go to the New York Stock Exchange Web site at www.nyse.com and find the latest figures for top NYSE volume days.

Click on “Investor Relations.” Click on “Financials.” Click on “Transaction/Statistics.” Click on “Data Library.” Click on “NYSE Statistics Archive.” Under “NYSE Daily Share Volume in NYSE Listed Issues,” click on the most recent date. Click on “Interactive Viewer.” 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 2.4 billion shares traded on

June 18, 2010.

SEARCH THE SITE

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

In the late 2000s, the United States, and indeed the world, experienced the worst financial crisis since the 1930s and the Great Depression. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less than 1½ year’s time, larger than the decline during the market crash of 1937–1938, when it fell 49 percent. Home foreclosures reached record highs in late 2008 and continued to rise through 2009, with 1 in 45 households (2.8 million properties) in default on their home mortgage in 2009. The investment banking industry saw the failure or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley) and these two firms converted to commer- cial bank holding companies. AIG, one of the largest insurance companies in the United States, survived only because of a federal government bailout. Commercial banking giant Citigroup required a massive government guarantee against losses and an injection of cash to prevent failure. The three major U.S. automakers faced imminent danger of bankruptcy without a federal bailout, and even with the bailout, Chrysler and General Motors declared Chapter 11 bankruptcy in May and June 2009, respectively. As of October 2009, the U.S. unemployment rate was over 10 percent, the highest level since 1983. Events associated with the financial crisis impacted financial institutions and the way they do business for- ever. In this appendix, we review the major events both leading up to and throughout the financial crisis. Throughout the text, we explore the root causes of and changes brought about by the financial crisis as they apply to specific areas of risk measurement and man- agement within FIs.

The Beginning of the Collapse

Signs of significant problems in the U.S. economy first arose in late 2006 and the first half of 2007, when home prices plummeted and defaults by subprime mortgage borrow- ers began to affect the mortgage lending industry as a whole, as well as other parts of the economy. Mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 through 2008 as homeowners, who stretched themselves financially to buy a home or refinance a mortgage in the early 2000s, fell behind on their loan payments. Foreclosure filings jumped 93 percent in July 2007 over July 2006. Between August 2007 and October 2008, an additional 936,439 homes were lost to foreclosure.

As mortgage borrowers defaulted on their mortgages, financial institutions that held these mortgages and mortgage-backed securities started announcing huge losses on them. These securitized loans and, particularly, securitized subprime mortgage loans led to huge financial losses and possibly were even the root cause of the weakness of the U.S. econ- omy in the mid- to late 2000s. Losses from the falling value of subprime mortgages and securities backed by these mortgages reached over $400 billion worldwide through 2007. In 2007, Citigroup, Merrill Lynch, and Morgan Stanley wrote off a combined $40 billion, due mainly to bad mortgage loans. Bank of America took a $3 billion write-off for bad loans in just the fourth quarter of 2007, while Wachovia wrote off $1.2 billion. UBS Secu- rities took a loss of $10 billion, Morgan Stanley wrote off $9.4 billion, Merrill Lynch wrote down $5 billion, and Lehman Brothers took a loss of $52 million—all because of losses on investments in subprime mortgages or assets backed by subprime mortgages. Even mortgage-backed security insurers felt the losses. In February 2008, MBIA Inc.—one of the largest insurers of mortgage-backed securities credit risk—reported a $2.3 billion loss for the fourth quarter of 2007, due mainly to declines in the values of mortgage-backed securities it insured.

Early on, some large financial institutions were unable to survive the mortgage crisis. For example, Countrywide Financial, the country’s largest mortgage issuer, nearly failed in the summer of 2007 due to defaults by its subprime mortgage borrowers. In an effort to add liquidity, Countrywide drew down its entire $11.5 billion line of credit with other

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financial institutions. Such an enormous and sudden drawdown sent Countrywide’s shares down $3.17 to $21.29 (and down 50 percent for the year) and the DJIA down 2.83 percent on fears of an increasing degradation of the mortgage markets and potential contagion to other financial markets. Only a $2 billion equity investment by Bank of America in 2007 and then an acquisition offer in 2008 kept Countrywide alive.

Another early casualty of the financial crisis was IndyMac Bank, the ninth largest mort- gage lender in the United States in 2007, which was seized by the FDIC in July of 2008. In 2007, IndyMac had over $32 billion in assets, making it one of the largest savings insti- tutions in the United States. In late 2007 and early 2008, with mounting defaults on its mortgages, IndyMac was desperate for more capital, but could not find investors willing to put new funds into what appeared to be a failing institution. In the summer of 2008, despite FDIC insurance coverage, spooked depositors withdrew a total of $1.3 billion and the FDIC stepped in to rescue the institution. At a cost to the FDIC of between $8.5 billion and $9.4 billion, IndyMac represented the largest depository institution failure in over 20 years.

The Failure of Bear Stearns

Investment banks and securities firms were major purchasers of mortgages and mortgage- backed securities in the early 2000s, which allowed them to increase their business of packaging the loans as securities. As mortgage borrowers defaulted on their mortgages, investment banks were particularly hard hit, with huge losses on the mortgages and the securities backing them. A prime example of the losses incurred is that of Bear Stearns. In the summer of 2007, two Bear Stearns funds suffered heavy losses on investments in the subprime mortgage market. The two funds filed for bankruptcy in the fall of 2007. Bear Stearns’s market value was hurt badly by these losses. The losses became so great that in March 2008 J. P. Morgan Chase and the Federal Reserve stepped in to rescue the then fifth largest investment bank in the United States before it failed or was sold piecemeal to vari- ous financial institutions. J. P. Morgan Chase purchased Bear Stearns for $236 million, or $2 per share. The stock was selling for $30 per share three days prior to the purchase and $170 per share less than a year earlier.

Along with brokering the sale of Bear Stearns to J. P. Morgan Chase, in the spring of 2008 the Fed took a series of unprecedented steps. First, for the first time, the Fed lent directly to Wall Street investment banks 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. Second, the Fed cut interest rates sharply, including one cut on a Sunday night in March 2008. The widening regulatory arm of the Fed came amid criticism aimed at the SEC (traditionally the main regulator of investment banks) and its oversight of Bear Stearns before its collapse. The Fed was acting as a lender to various financial institutions beyond depository institutions.

The Crisis Hits

September 2008 marked a crucial turning point in the financial crisis. On September 8, the U.S. government seized Fannie Mae and Freddie Mac, taking direct responsibility for the firms that provided funding for about three-quarters of new home mortgages written in the United States. Fannie Mae and Freddie Mac were particularly hard hit by the sub- prime mortgage market collapse in the mid-2000s as these government-sponsored agencies are deeply involved in the market that securitizes subprime mortgages. The two agencies recorded approximately $9 billion in losses in the last half of 2007 related to the market for subprime mortgage-backed securities. With the seizure, the two companies were put under a conservatorship and continue to operate with management under the control of their pre- vious regulator, the Federal Housing Finance Agency.

Then on Monday, September 15, Lehman Brothers (the 158-year-old investment bank) filed for bankruptcy, Merrill Lynch, rather than face bankruptcy, was bought by Bank of America, AIG (one of the world’s largest insurance companies) met with federal regulators to raise desperately needed cash, and Washington Mutual (the largest savings institution in

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the United States) was looking for a buyer to save it from failing. A sense of foreboding gripped Wall Street. As news spread that Lehman Brothers would not survive, FIs moved to disentangle trades made with Lehman. The Dow fell more than 500 points, the largest drop in over seven years. Figure 1–7 shows the movement in the Dow Jones Industrial Average from October 2007 (when it hit its all-time high of 14,164.53 on October 9, 2007) through January 25, 2010 (including March 9, 2009, when the DJIA closed at a low of 6,547.05).

By Wednesday, September 17, tension mounted around the world. Stock markets saw huge swings in value as investors tried to sort out who might survive. Meanwhile, markets from Russia to Europe were forced to suspend trading as stock prices plunged. Money market mutual fund withdrawals skyrocketed—fund investors pulled out a record $144.5 billion through Wednesday (redemptions during the week of September 8 totaled just $7.1 billion) as investors worried about the safety of even these safest investments. Money market mutual funds participated heavily in the $1.7 trillion commercial paper mar- ket, which provided the bulk of the short-term funds to corporations. As investors pulled their money from these funds, the commercial paper market shrank by $52.1 billion for the week (through Wednesday). Without these funds available to meet short-term expenses, factories faced the real possibility of shutting down and laying off employees. Likewise, without these short-term funds, banks faced the inability to fund short-term lending units (such as credit card units). Given this turmoil, the two largest U.S. investment banks, Gold- man Sachs and Morgan Stanley, sought Federal Reserve and government protection by converting to bank holding company status.

By mid-September 2008, financial markets froze and banks stopped lending to each other at anything but exorbitantly high rates. The overnight London Interbank Offered Rate (a benchmark rate that reflects the rate at which banks lend to one another) more than doubled (see Figure 1–8 ). Banks generally rely on each other for cash needed to meet their daily needs. Interest rates on this interbank borrowing are generally low because of the confidence that the financial institutions will pay each other back. But confidence had bro- ken down since August of 2007 and had never been completely restored. Without funding, banks became reluctant to lend at all and credit markets froze further.

The Rescue Plan

Evident that a financial crisis was on hand, on Thursday, September 18, 2008, the Federal Reserve and central banks around the world invested $180 billion in global financial markets in an attempt to unfreeze credit markets. Further, then Treasury Secretary Henry Paulson met with congressional leaders to devise a plan to get bad mortgage loans and mortgage- backed securities off the balance sheets of financial institutions. After two weeks of debate

Figure 1–7 The Dow Jones Industrial Average, October 2007–January 2010

Date

DJIA

14000

12000

10000

8000

6000

10 /1

/0 7

1/ 1/

08

4/ 1/

08

7/ 1/

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(and one failed vote for passage), a $700 billion rescue plan was passed and signed into law by then President Bush on October 3, 2008. The bill established the Troubled Asset Relief Program (or TARP) that gave the U.S. Treasury funds to buy “toxic” mortgages and other securities from financial institutions. The federal government was mandated to take an equity stake and executive compensation was limited in the companies that took part in the TARP program. The bill also called for the administration to develop a plan to ease the wave of home foreclosures by modifying loans acquired by the government and increased FDIC deposit insurance to $250,000 from $100,000.

The Crisis Spreads Worldwide

As the U.S. government debated the 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 larg- est mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed deposits and debt of its six major financial institutions. Iceland rescued its third largest bank with a $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. How- ever, 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 19 billion euros. 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 banking sys- tems 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 midsize businesses with short-term funding. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets.

After the Rescue Plan

In the two months after the rescue plan was enacted in the United States, the financial crisis deepened as the world assessed the possibility that the initial attempts to rescue the world’s financial system would not be sufficient. Worldwide, stock market values plunged. By mid-October, the Dow had dropped 24.7 percent in less than a month, the

Figure 1–8 Overnight London Interbank Offered Rate (LIBOR), 2001–2010

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

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Shanghai Composite dropped 30.4 percent, and the various markets in Europe fell between 20 and 30 percent. By mid-November, the Dow fell to a 5½ year low and the S&P 500 index erased its gains from the previous 10 years. Third quarter GDP in the United States declined to 0.3 percent (later revised to −2.7 percent). Indeed, some measures of eco- nomic activity found the United States entered a recession as early as December 2007. The United Kingdom and Germany also saw growth decline by 0.5 percent in the third quarter of 2008. Countries across the world saw companies scrambling for credit and cutting their growth plans. Additionally, consumers worldwide reduced their spending. Even China’s booming economy slowed faster than had been predicted, from 10.1 percent in the second quarter of 2008 to 9.0 percent in the third quarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmed hopes that Chinese demand could help keep world economies going. In late October 2008, the global crisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bank rescue in the oil-rich Gulf. Until this time, the area had been relatively immune to the world financial crisis. However, plummeting oil prices (which had dropped over 50 percent between July and October) left the area’s economies suddenly vulnerable.

Between January and November 2008, 22 U.S. banks had failed, up from 3 in 2007. The FDIC reported that it added 54 banks to its list of troubled institutions in the third quarter, a 46 percent increase over the second quarter. The additions to the list reflected the escalating problems in the banking industry. However, it should be noted that the 171 banks on the FDIC’s problem list represented only about 2 percent of the nearly 8,500 FDIC-insured institutions. Still, the increase from 117 troubled banks in the second quar- ter was the largest seen since late 1995. Further, proving that some banks are too big to fail, commercial banking giant Citigroup required a massive government guarantee against losses (up to $306 billion) and a $20 billion injection of cash to prevent failure.

By the middle of November it became apparent that the rescue plan enacted in early October would not be sufficient as a growing number of distressed financial and nonfi- nancial companies and consumers called for assistance. Among the largest companies in need of a bailout were the Big Three automobile manufacturers (General Motors, Ford, and Chrysler). The leaders of these companies painted a grim picture of their financial position during two days of congressional hearings, warning that the collapse of the auto industry could lead to the loss of three million jobs nationwide. Both General Motors and Chrysler said they could collapse in weeks. However, automakers ran into resistance from House lawmakers, who chastised the executives for fighting tougher fuel-efficiency standards in the past and questioned their use of private jets while at the same time seek- ing government handouts. Fearing that the Big Three would take any bailout money and continue to make the same “stupid” decisions they had been making for 25 years, the U.S. Senate canceled plans for a vote on a bill to take $25 billion in new auto industry loans out of the $700 billion TARP rescue fund. Lawmakers gave the three automakers until mid-December to come back with substantial business plans outlining what they would do with any federal funds that might be lent and how they would restructure and improve the efficiency in their respective companies. After more days of testimony in mid-December, the U.S. Senate again failed to vote on a bailout for the automakers. General Motors and Chrysler stated that they did not have sufficient funds to continue operations through the end of December. Then on December 19, 2008, President George W. Bush announced that $13.4 billion in federal loans would be made immediately available to General Motors and Chrysler.

By the end of December, nearly $7 trillion of loans or commitments had been made. (Table 1–11 outlines the major commitments, loans, and investments made by the U.S. government through 2009.) The U.S. Treasury had used the first $362 billion of the $700 billion TARP rescue fund: $250 billion to inject capital into banks ($125 billion of which went to the 9 largest banks), another $40 billion to further stabilize insurer AIG, $25 billion to stabilize Citigroup, $20 billion to stabilize Bank of America, $20 billion used by the Fed to stabilize other lending institutions, and $24.9 billion lent to the auto industry. Note that the Treasury had dropped the original plans to use the TARP bailout

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TABLE 1–11 Federal Government Rescue Efforts through December 2009

Program Committed Invested Description

TARP $700.0 billion $356.2 billion Financial rescue plan aimed at restoring liquidity to financial markets AIG 70.0 b 69.8 b Auto industry financing 80.1 b 77.6 b Capital Purchase Program 218.0 b 204.7 b Public-Private Investment Program 100.0 b 26.7 b Targeted investments to Citigroup and Bank of America 52.5 b 45.0 b

Amount repaid $118.5 billion

Federal Reserve Rescue Efforts $6.4 trillion $1.5 trillion Financial rescue plan aimed at restoring liquidity to financial markets Asset-backed commercial paper money market mutual fund liquidity facility

unlimited $0.0

Bear Stearns bailout 29.0 b 26.3 b Commercial paper funding facility 1.8 t 14.3 b Foreign exchange dollar swaps unlimited 29.1 b GSE (Fannie Mae and Freddie Mac) debt purchases

200.0 b 149.7 b

GSE mortgage-backed securities purchases 1.2 t 775.6 b Term asset-backed securities loan facility 1.0 t 43.8 b U.S. government bond purchase 300.0 b 295.3 b

Federal Stimulus Programs $1.2 trillion $577.8 billion Programs designed to save or create jobs Economic Stimulus Act 168.0 b 168.0 b Student loan guarantees 195.0 b 32.6 b American Recovery and Reinvestment Act 787.2 b 358.2 b

American International Group $182.0 billion $127.4 billion Bailout to help AIG through restructuring and to get rid of toxic assets Asset purchases 52.0 b 38.6 b Bridge loan 25.0 b 44.0 b TARP investment 70.0 b 44.8 b

FDIC Bank Takeovers $45.4 billion $45.4 billion Cost to FDIC to fund deposit losses on bank failures 2008 failures 17.6 b 17.6 b 2009 failures 27.8 b 27.8 b

Other Financial Initiatives $1.7 trillion $366.4 billion Other programs designed to rescue the financial sector NCUA bailout of U.S. Central Credit Union 57.0 b 57.0 b Temporary Liquidity Guarantee Program 1.5 t 308.4 b

Other Housing Initiatives $745.0 billion $130.6 billion Other programs intended to rescue the housing market and prevent home foreclosures Fannie Mae and Freddie Mac bailout 400.0 b 110.6 b FHA housing rescue 320.0 b 20.0 b

Overall Total $11.0 trillion $3.0 trillion

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money to buy troubled mortgage assets from financial institutions, stating that it was no longer the most effective way to restart credit markets. Rather, plans were to take equity stakes in financial institutions.

Some Bright Spots

While the economy remained in crisis, some positive things occurred between September and December 2008. Oil, which rose to over $142 per barrel in July, had dropped to below $40 in late 2008. As a result, gas prices, which rose to over $4.00 per gallon in the sum- mer of 2008, had fallen to a national average of $1.65 in December. Led by a federal government push, many banks moved to restructure delinquent mortgage loans rather than foreclose and Fannie Mae and Freddie Mac suspended foreclosures on 16,000 homes over the 2008 holiday period while they evaluated whether the borrowers would qualify for the new loan modification programs. Fannie and Freddie’s modification plan allowed mortgage restructuring, rather than foreclosure, for homeowners whose mortgages were held by one of the two companies, were at least three months behind on their payments, and whose mortgage payments were no more than 38 percent of the homeowner’s pretax monthly income. The Federal Reserve’s attempt to stabilize the housing market resulted in a drop in long-term mortgage rates (30-year fixed-rate mortgage rates dipped to below 5.0 percent in late November). In a historic move, on December 17, 2008, the Fed unex- pectedly announced that it would drop its target fed funds rate to a range between zero and one-quarter percent and lower its discount window rate to one-half percent, the lowest level since the 1940s (see Figure 1–9 ). Along with this announcement, the Fed announced that

Figure 1–9 Federal Funds Rate and Discount Window Rate—January 1971 through January 2010

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it would continue to use all its available tools to promote economic growth and preserve price stability. This was followed by interest rate cuts in many other countries, including Japan, the United Kingdom, Hong Kong, and the European Central Bank.

The Crisis Continues in 2009

Despite the many efforts of regulators to stem the tide of the growing recession, the U.S. and world economies deteriorated further at the start of 2009. The DJIA and the S&P 500 index had their worst January ever, falling 8.84 percent and 8.57 percent, respectively. Unemployment in January hit 7.6 percent, the highest level since September 1992. Also in January, employers cut 589,000 jobs, the highest monthly job losses in over 34 years. Since December 2007 (as the recession began), the U.S. economy lost 3.6 million jobs, half of which were lost in the period from November 2008 through January 2009. Gross domestic product growth was announced, showing a drop of 3.8 percent in the fourth quarter of 2008 (later revised to −5.4 percent). New vehicle sales in the United States fell 37 percent in January, the industry’s worst month since 1982 and the worst January since 1963. For the first time ever, more vehicles were sold in China than in the United States.

Worldwide, central governments tried to grapple with the building recession. The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries to pass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its target interest rates to a record low of 1 percent hoping to help the British economy out of a recession. The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interest rates to 1 percent or below.

The U.S. Stimulus Plan. With the U.S. economy deteriorating at its swiftest rate in his- tory, President Obama made good on his pre-election promise to have an economic stimu- lus plan approved and enacted shortly after his election. The House passed its version of an $819 billion stimulus package on January 28, 2009. The Senate passed an $827 billion version of a stimulus plan on February 10, 2009. After more debate and compromise, both arms of Congress agreed on and passed the Economic Stimulus Plan, called the American Recovery and Reinvestment Act, on February 13, 2009. The plan devoted $308.3 billion to appropriations spending, including $120 billion on infrastructure and science and more than $30 billion on energy-related infrastructure projects. Another $267 billion went for direct spending, including increased unemployment benefits and food stamps. Finally, $212 billion was set aside for tax breaks for individuals and businesses (Table 1–12 lists some of the major items in the stimulus plan).

Financial Rescue Plan. In addition to the overall economic stimulus plan, the Obama administration, including new Treasury Secretary Geithner, announced a separate plan that focused on the stabilization of the financial system. Early 2009 saw a plunge in the DJIA (falling to a low of 6,547.05 on March 9, 2009) and, particularly, the market values of financial institutions. Banks such as Citigroup, Bank of America, and J. P. Morgan Chase traded at less than their book values as investors had little confidence in the value of their assets. Through February 13, 2009, 13 U.S. banks had already failed in 2009, while 25 had failed in all of 2008 (the highest annual total since 1993). The financial rescue plan, announced on February 10, 2009, involved a number of initiatives, including injecting capital into banks, offering federal insurance to banks against losses on bad assets, buying distressed mortgages from banks, helping homeowners avoid foreclosure, giving the FDIC power to help troubled financial firms other than depository institutions, and expanding the Fed’s Term Asset-Backed Securities Loan Facility (TALF). The TALF combined capital provided by the TARP with funding from the Federal Reserve in order to promote lending by increasing investor demand for securitized loans. The TALF significantly expanded the availability and reduced the cost of term financing for investors in derivative securities. The goal of TALF was to stimulate demand for these securities and thereby allow originators of securitized loans to lower the cost and increase the availability of credit to consumers and

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businesses. The Fed’s TALF program initially provided financing for investors to purchase securities backed by consumer loans. The Treasury wanted to expand this beyond consumer loans. For homeowners, the banking plan called for the creation of national standards for loan modifications and for the use of tax dollars to give mortgage companies an incentive to modify mortgage loans. Further, along with the expanded TALF program, the Treasury, working with the Federal Reserve, FDIC, and private investors, created the Public-Private Investment Fund (PPIF) to acquire real estate–related off-balance-sheet assets. By selling to PPIF, financial institutions could reduce balance sheet risk, support new lending, and help improve overall market functioning.

Finally, in late February 2009, the Obama administration announced that it would con- duct a “stress test” of the 19 largest U.S. banks, which would measure the ability of these banks to withstand a protracted economic slump (the unemployment rate above 10 percent and home prices dropping another 25 percent). Results of the stress test showed that 10 of the 19 banks needed to raise a total of $74.6 billion in capital. Within a month of the May 7, 2009, release of the results, the banks had raised $149.45 billion of capital.

The Economy Begins to Recover. Through the spring of 2009, the federal government continued to take actions to combat the stagnant economy. These actions included passage of the Job Creation Through Entrepreneurship Act (in May 2009), to help small businesses access capital and credit markets, and the wildly popular Cash for Clunkers Program (in June 2009), to stimulate automobile sales. Further, a variety of regulatory changes were proposed to prevent a recurrence of such a catastrophic collapse of financial markets and the financial institutions that operate them. These included the establishment of resolution procedures for closing troubled financial institutions (such as investment banks and hedge funds), restricting the leverage that financial institutions can assume, requiring executive compensation to be tied more closely to long-term performance, reinstating the separation of commercial and investment banking established by the Glass-Steagall Act in 1933 and repealed in 1999 by the Financial Services Modernization Act, breaking up institutions that are “too big to fail” to limit systemic risk, ensuring that any financial institution has the necessary capital to support its financial commitments, regulating credit derivatives and ensuring that they are traded on well-capitalized exchanges to limit counterparty risk, requiring financial institutions to maintain sufficient “contingent capital” (i.e., pay insur- ance premiums to the government during boom periods, in exchange for payments during a downturn), and regulating institutions that “act like banks” similarly to banks. (However, as of spring 2010, many of these had not yet to be implemented.)

By the summer and fall of 2009, the economy slowly began to recover. Pending home sales and residential construction both posted significant increases in September. September marked the eighth consecutive monthly increase in pending home sales, which was the

TABLE 1–12 Major items in the $787 Billion Stimulus Program as Passed by the U.S. Congress, February 13, 2009

$116.1 b. for tax cuts and credits to low- and middle-income workers 69.8 b. for middle-income taxpayers to get an exemption from the alternative minimum tax 87.0 b. in Medicaid provisions 27.0 b. for jobless benefits extension to a total of 20 weeks in addition to regular

unemployment compensation 17.2 b. for increases in student aid 40.6 b. for aid to states 30.0 b. for modernization of electric grid and energy efficiency 19.0 b. for payments to hospitals and physicians who computerize medical record systems 29.0 b. for road and bridge infrastructure construction and modernization 18.0 b. for grants and loans for water infrastructure, flood prevention, and environmental

cleanup

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longest such streak since 1991, when these data began to be tracked. Home sales rose at an annual rate of 6.1 percent in September and were 21.2 percent ahead of their September 2008 level. Meanwhile, the Commerce Department reported that residential construction spend- ing increased at a 3.9 percent annual rate in September. It was the third consecutive monthly increase in residential construction. The National Association of Realtors announced that the number of signed contracts increased for the ninth consecutive month—31.8 percent higher than September 2008 and the biggest year-over-year gain in the history of the index. These signs of life in the construction industry were an indication that the first-time home- buyer tax credit put in place as part of the American Recovery and Reinvestment Act was working. Indeed, in November 2009, President Obama signed into law an expanded Home- buyer Tax Credit that extended a tax credit of up to $8,000 for qualified first-time home buyers and $6,500 for repeat home buyers purchasing a principal residence.

Third quarter 2009 GDP increased by 2.2 percent and fourth quarter GDP rose 5.7 percent. The third-quarter increase was the first since the second quarter of 2008. The increases were the result of consumer spending, which increased significantly. Spending on new cars and trucks was a big contributor (adding 1.45 percent to the third quarter change), reflecting the federal Cash for Clunkers Program in effect in July and August. The increase in GDP in the fourth quarter primarily reflected increases in private inventory investment, exports, and personal consumption expenditures. Automobile output continued to do well, adding 0.61 percent to the fourth-quarter change in GDP.

With the positive economic news, on October 14, 2009, the DJIA reached 10,000 for the first time in a year. However, unemployment countinued to lag, topping 10 percent in October. This greater-than-10-percent rate was short lived, as the unemployment rate dropped to 10 percent in November 2009 and job losses dramatically declined, with only 11,000 American jobs lost in November 2009, compared to 741,000 jobs lost in December 2008. Further, in 2009, there were 140 failures of banks with assets totaling $170.9 billion. The five largest bank failures were BankUnited ($12.8 billion in assets), Colonial Bank ($25 billion in assets), Guaranty Bank ($13 billion in assets), United Commercial Bank ($11.2 billion in assets), and AmTrust Bank ($12 billion in assets). The cost to the FDIC for resolving these failures was $27.8 billion. In comparison, in 2008 there were 25 bank failures with assets totaling $373.6 billion.

In December 2009, the Obama administration announced that the long-term cost of the Troubled Asset Relief Program would be at least $200 billion less than previously projected, which would help bring down the projected federal budget deficit. At the end of 2009, while the economy was still fragile and had certainly not fully recovered from the extreme financial crisis, it was stabilizing.

Finally, in July 2010, the U.S. Congress passed, and President Obama signed, the 2010 Wall Street Reform and Consumer Protection Act, which sought to prevent a repeat of the market meltdown. Touted as the most extensive proposal for the overhaul of financial rules since the Great Depression, this bill proposed a sweeping overhaul of the nation’s financial system and the rules that govern it. The bill called for the Federal Reserve to receive new oversight powers and to impose conditions designed to discourage any type of financial institution from getting too big. The proposals put the Federal Reserve in charge of moni- toring the country’s biggest financial firms—those considered critical to the health of the system as a whole. Those firms also face new, stiffer requirements on how much capital and liquidity they must keep in reserve. The overhaul also provides unprecedented powers to the Fed to step into any financial institutions—such as insurance giant AIG (whose main regulators include the New York State Department of Insurance and the Office of Thrift Supervision)—that are facing imminent collapse, in order to force an orderly bankruptcy and thereby protect the wider economy.

More specifically, the bill sets forth reforms to meet five key objectives:

1. Promote robust supervision and regulation of financial firms by establishing (i) a new Financial Services Oversight Council of financial regulators (chaired by Treasury and including the heads of the principal federal financial regulators as members) to identify

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emerging systemic risks and improve interagency cooperation, (ii) a new authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks, (iii) stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms, (iv) a new National Bank Supervisor to supervise all federally chartered banks, (v) elimina- tion of the federal thrift charter for thrifts not dedicated to mortgage lending and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve, and (vi) the registration of advisers of hedge funds and other private pools of capital with the SEC.

2. Establish comprehensive supervision of financial markets by establishing (i) the regu- lation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and origina- tors retain a financial interest in securitized loans, (ii) comprehensive regulation of all over-the-counter derivatives, and (iii) new authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

3. Protect consumers and investors from financial abuse by establishing (i) a new Consumer Financial Protection Agency to protect consumers across the financial sec- tor from unfair, deceptive, and abusive practices, (ii) stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services, and (iii) a level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank.

4. Provide the government with the tools it needs to manage financial crises by establish- ing (i) a new regime to resolve nonbank financial institutions whose failure could have serious systemic effects and (ii) revisions to the Federal Reserve’s emergency lending authority to improve accountability.

5. Raise international regulatory standards and improve international cooperation by establishing (i) international reforms to support efforts in the United States, including strengthening the capital framework, improving oversight of global financial markets, coordinating supervision of internationally active firms, and enhancing crisis manage- ment tools.

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36

Determinants of Interest Rates

part one Introduction and Overview of Financial Markets

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 Interest 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

Effective Annual Return

chap te r

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

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 .

INTEREST RATE FUNDAMENTALS: CHAPTER OVERVIEW Changes in interest rates influence the performance and decision making for individual inves- tors, businesses, and governmental units alike. Figure 2–1 illustrates the movement in several key U.S. interest rates over the past 40 years: the prime commercial loan rate, the three-month T-bill rate, the high-grade corporate bond rate, and the home mortgage rate. Notice in Figure 2–1 the variability over time in interest rate levels. For example, the prime rate hit highs of over 20 percent in the early 1980s, yet was as low as 4.75 percent in the early 1970s, was well below 10 percent throughout much of the 1990s, 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 2010, 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).

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 securities traded in the money and capital markets, both at home and abroad. As will be

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Chapter 2 Determinants of Interest Rates 37

Figure 2–1 Key U.S. Interest Rates, 1972–2010

Source : Federal Reserve Board Web site, June 2010. www.federalreserve.gov

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discussed later, nominal interest rates affect the relationship between spot and forward foreign exchange rates as well.

This chapter examines the 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 interest 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 financial securities by reviewing time value of money concepts.

nominal interest rates The interest rates actually observed in financial markets.

nominal interest rates The interest rates actually observed in financial markets.

Interest rates play a major part in the determination of the value of financial instruments. For example, when the Federal Reserve unexpectedly increased interest rates in February 2010, financial markets reacted significantly: the Dow Jones Industrial Average (which had previously posted three consecutive days of gains in value) declined 0.9 percent in value,

LOANABLE FUNDS THEORY LOANABLE FUNDS THEORY

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38 Part 1 Introduction and Overview of Financial Markets

the yield on Treasury securities increased (i.e., the yield on two-year T-notes increased from 0.88 percent to 0.92 percent), gold prices dropped $11 to $1,112.70, and the U.S. dollar weakened against foreign currencies (the dollar fell from $1.3613/€ to $1.3518/€). 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 move- ments over time.

One model that is commonly used to explain interest rates and interest rate move- ments is the loanable funds theory . The loanable funds theory of interest rate determi- nation views the level of interest rates in financial markets as resulting from factors that affect the supply (for example, from households; see Chapter 1 ) and demand (for example, from corporations) for loanable funds. This is similar to the way that the prices for goods and services in general are viewed as being the result of the forces of supply and demand for those goods and services. The supply of loanable funds is a term commonly used to describe funds provided to the financial markets by net suppliers of funds. The demand for loanable funds is a term used to describe the total net demand for funds by fund users. The loanable funds framework categorizes financial market participants—suppliers and demanders of funds—as consumers, businesses, governments, and foreign participants.

Supply of Loanable Funds

In general, the quantity of loanable funds supplied 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 partici- pants from U.S. flow of funds data as of June 2010.

The household sector (consumer sector) is the largest supplier of loanable funds in the United States—$45.54 trillion in 2010. Households supply funds when they have excess income or want to reallocate their asset portfolio holdings. For example, during 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 consumer will also gen- erally 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 securities 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.

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

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

LG 2-1LG 2-1

Figure 2–2 Supply of and Demand for Loanable Funds

Quantity of Loanable Funds Supplied and Demanded

Interest Rate

Demand Supply

DemandSupply

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Chapter 2 Determinants of Interest Rates 39

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

Source : Federal Reserve Board Web site, “Flow of Fund Accounts,” June 2010. www.federalreserve.gov

Net Funds Supplied Funds Supplied Funds Demanded (Funds Supplied − Funds Demanded)

Households $45.54 $20.50 $ 25.04 Business—nonfinancial 17.71 41.71 −24.00 Business—financial 43.34 60.10 −16.76 Government units 18.62 12.07 6.55 Foreign participants 15.63 6.46 9.17

Higher interest rates will also result in higher supplies of funds from the U.S. business sector ($17.71 trillion from nonfinancial business and $43.34 trillion from financial busi- ness in 2010), 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 ($18.62 trillion in 2010). 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 con- sumers 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 ($15.63 trillion of funds were supplied to the U.S. finan- cial markets in 2010). When interest rates are higher on U.S. financial securities than they are on comparable securities in their home countries, foreign investors increase their sup- ply 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 coun- tries 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 finan- cial crisis, investors worldwide, searching for a safe haven for their funds, invested huge amounts of funds in U.S. Treasury securities. The amount of money invested in Treasury bills 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

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).

Households (although they are net suppliers of funds) also borrow funds in financial markets ($20.50 trillion in 2010). 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 house- hold’s demand for loanable funds at every level of interest rates.

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40 Part 1 Introduction and Overview of Financial Markets

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 ($41.71 trillion for non- financial businesses and $60.10 trillion for financial businesses in 2010). 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 bor- rowed 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 ($12.07 trillion in 2010). 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 cumulative sum of past deficits is called the national debt, which in the United States in 2011 stood at a record $14.34 trillion. Thus, the national debt and especially the interest payments on the national debt have to be financed in large part by additional government borrowing. 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 ($6.46 trillion in 2010). 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.

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 hold- ing all other factors constant.

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 i L , 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 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.

www.ustreas.gov www.ustreas.gov

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Chapter 2 Determinants of Interest Rates 41

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

*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).

Panel A: The supply of funds

Impact on Equilibrium Factor Impact on Supply of Funds 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

Impact on Equilibrium Factor Impact on Demand for Funds 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

Figure 2–3 Determination of Equilibrium Interest Rates

Quantity of Loanable Funds Supplied and Demanded

Interest Rate

E

i H

i L

i *

Q*

D

DS

S

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42 Part 1 Introduction and Overview of Financial Markets

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.

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, future 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. Accord- ingly, at every interest rate, the supply of loanable funds increases, or the supply curve shifts down and to the right. For example, as the U.S. economy grew in the mid-2000s, total wealth of U.S. investors increased as well. Consequently, the supply of funds avail- able for investing (e.g., in stock and bond markets) increased at every available interest rate. We show this shift (increase) in the supply curve in Figure 2–4(a) as a move from SS to SS ″. The shift in the supply curve creates a disequilibrium between demand and sup- ply. To eliminate the imbalance or disequilibrium in this financial market, the equilibrium interest rate falls, from i * to i *″ , which is associated 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 attractive 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 Figure 2–4(a) . 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 constant, 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 equilibrium quantity of funds loaned (or traded).

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

LG 2-4LG 2-4

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Chapter 2 Determinants of Interest Rates 43

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.

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

www.federal reserve.gov www.federal reserve.gov

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

E

SS''

E''

SS''

i*

i*''

DD

DD

SS

SS

Q* Q*''

(a) Increase in the supply of loanable funds

Quantity of Funds Demanded

Interest Rate

E''

E i*

i*''

Q* Q*''

DD''

DD

DD''

SS

SS

(b) Increase in the demand for loanable funds

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44 Part 1 Introduction and Overview of Financial Markets

in the late 2000s, during the financial crisis), 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 Argentina in the early 2000s 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 loan- able funds at every interest rate and the supply curve shifts down and to the right. Accord- ingly, the equilibrium 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 util- ity 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 Figure 2–4(b) 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 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.

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Chapter 2 Determinants of Interest Rates 45

Restrictiveness of Nonprice Conditions on Borrowed Funds. As the nonprice restrictions put on borrowers as a condition of borrowing decrease, the willingness of market partici- pants 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 restrictive 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 1990s and mid-2000s, market participants are willing to borrow more heavily. For example, state and local gov- ernments 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 equilibrium 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.

DO YOU UNDERSTAND:

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 ?

As discussed in the previous section of this chapter, the loanable funds theory of interest rates is based on the supply and demand for loanable funds as functions of interest rates. The equilibrium interest rate (point E in Figure 2–3 ) is only a temporary equilibrium. Changes in underlying factors that determine the demand and supply of loanable 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 equilibrium interest rate and quantity of funds traded in that market. Refer again to Figure 2–4(a) , which shows the effects of an increase in the supply curve for loanable funds, from SS to SS ″ (and the resulting decrease in the equilibrium interest rate , from i * to i *″ ), while Figure 2–4(b) 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 *″ ).

MOVEMENT OF INTEREST RATES OVER TIMEMOVEMENT OF INTEREST RATES OVER TIME

LG 2-5LG 2-5

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” interest rate, default risk, liquidity risk, special provisions regarding the use of funds raised by a

DETERMINANTS OF INTEREST RATES FOR INDIVIDUAL SECURITIESDETERMINANTS OF INTEREST RATES FOR INDIVIDUAL SECURITIES

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46 Part 1 Introduction and Overview of Financial Markets

security’s issuance, and the term to maturity of the security. We examine each of these fac- tors in this section and summarize them in Table 2–3 .

Inflation

The first factor to affect interest rates is the actual or expected inflation rate in the econ- omy. Specifically, 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. Inflation of the general price index of goods and services (IP) is defined as the (percentage) increase in the price of a standard- ized basket of goods and services over a given period of time. In the United States, infla- tion is measured 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 CPI CPI

CPI t t

t �

� ��1 100

Real Interest Rates

A real interest rate is the interest rate that would exist on a security if no inflation were expected over the holding period (e.g., a year) of a security. The real interest 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 interest rate (RIR) will be.

Fisher Effect. The relationship among the real interest rate (RIR), the expected rate of inflation [Expected (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 rela- tionships early last century. The Fisher effect theorizes that nominal interest 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 forgo- ing present consumption (which reflects the real interest rate discussed above). When an

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

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

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

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

Inflation —the continual increase in the price level of a basket of goods and services. Real Interest Rate —nominal interest 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

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Chapter 2 Determinants of Interest Rates 47

investor purchases a security that pays interest, the nominal interest rate exceeds the real interest rate because of inflation.

i RIR IP RIR IP� � � �Expected Expected( ) [ ( )]

where RIR � Expected ( IP ) is the inflation premium for the loss of purchasing power on the promised nominal interest rate payments due to inflation. For small values of RIR and Expected ( IP ) this term is negligible.

Thus, the Fisher effect formula is often written as:

i RIR IP� � Expected ( ) (2-1)

The approximation formula, in Equation (2-1), assumes RIR � Expected ( IP ) is small. Thus, the nominal interest rate will be equal to the real interest rate only when market par- ticipants expect the inflation rate to be zero—Expected ( IP ) � 0. Similarly, nominal inter- est rates will be equal to the expected inflation rate only when real interest rates are zero. Note that we can rearrange the nominal interest rate equation to show the determinants of the real interest rate as follows:

RIR i IP� � Expected ( ) (2-2)

Example 2–1 Calculations of Real Interest 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 interest rate for 2007 was:

4 53 4 10 0 43. % . % . %� �

The one-year T-bill rate in 2009 was 0.47 percent, while the CPI for the year was 2.70 percent. This implies a real interest rate of −2.23 percent, that is, the real interest rate was actually negative.

Figure 2–5 shows the nominal interest rate (one-year T-bill rate) versus the change in the CPI from 1962 through 2010. Because the expected inflation rate is difficult to estimate accurately, the real interest rate can be difficult to measure accurately as well, since inves- tors’ expectations are not always realized.

Default or Credit Risk

Default risk is the risk that a security issuer will default on making 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 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 poten- tial recovery of the amount loaned. The difference between a quoted interest rate on a

stats.bls.gov/cpi/ home.htm stats.bls.gov/cpi/ home.htm

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

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

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48 Part 1 Introduction and Overview of Financial Markets

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 ( DRP j ). That is:

DRP i ij jt Tt� � (2-3)

where

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

i Tt � 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 8 .)

In August 2010, the 10-year Treasury interest rate, or yield, was 3.31 percent. On Aaa-rated and Baa-rated corporate debt, interest rates were 4.98 percent and 6.23 percent, respectively. Thus, the average default risk premiums on the Aaa-rated and Baa-rated cor- porate debt were:

DRP DRP

Aaa

Baa

� � �

� � �

4 98 3 31 1 67 6 23 3 31 2 92

. % . % . %

. % . % . %%

Figure 2–6 presents these risk premiums from 1977 through 2010. Notice from this figure and Figure 2–5 that default risk premiums tend to increase when the economy is contracting

www.moodys .com www.moodys .com

www.standard andpoors.com www.standard andpoors.com

Figure 2–5 Nominal Interest Rates versus Inflation

Source : Federal Reserve Board Web site and U.S. Department of Labor Web site, June 2010.

www.federalreserve.gov and stats.bls.gov/cpi/home.htm

0

2

4

6

8

10

12

14

16

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

CPI T-bill rate

T-bill rate/ CPI (%)

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Chapter 2 Determinants of Interest Rates 49

and decrease when the economy is expanding. For example, from 2007 to 2008 real inter- est rates (T-bills − CPI in Figure 2–5 ) increased from 0.43 percent to 1.73 percent. Over the same period, default risk premiums on Aaa-rated bonds increased from 1.39 percent to 1.97 percent and on Baa-rated bonds from 2.55 percent to 3.78 percent.

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. The interest rate on a security reflects its relative liquidity, with highly liquid assets carrying the lowest interest rates (all other characteristics remaining the same). Likewise, if a security is illiq- uid, investors add a liquidity risk premium (LRP) to the interest rate on the security. In the United States, liquid markets exist for most government 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 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 selling it early.

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 a security as interest rates change.

Special Provisions or Covenants

Numerous special provisions or covenants that may be written into the contracts under- lying the issuance of a security also affect the interest rates on different securities (see Chapter 6 ). Some of these special provisions include the security’s taxability, convert- ibility, and callability.

For example, for investors, interest payments on municipal securities are free of fed- eral, state, and local taxes. Thus, the interest rate demanded by a municipal bond holder

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

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

Source : Federal Reserve Board Web site, June 2010. www.federalreserve.gov

Figure 2–6 Default Risk Premium on Corporate Bonds

0.0

1.0

2.0

3.0

4.0

5.0

19 77

19 81

19 85

19 89

19 93

19 97

20 01

20 05

20 09

Default Premium (%)

Year

Aaa Risk Premium

Baa Risk Premium

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50 Part 1 Introduction and Overview of Financial Markets

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 general, special provisions that provide benefits to the security holder (e.g., tax-free status and convert- ibility) 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. 1 This relationship is often called the term structure of interest rates or the yield curve. The term structure of interest rates compares the 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 inter- est or yield to maturity curve for U.S. Treasury securities is the most frequently reported and analyzed yield to maturity curve. The shape of the yield curve on Treasury securities has taken many forms over the years, but the three most common shapes are shown in Figure 2–7 . In graph (a), the yield curve on June 8, 2010, 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. Graph (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, graph (c) shows a flat yield curve, reported on June 4, 2007, in which the yield to maturity is virtually unaffected by the term to maturity. 2

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 securi- ties traded at different points along the yield curve. For example, newly issued 20-year Treasury bonds offer a rate of return less than (seasoned issues) 10-year Treasury bonds if investors prefer new (“on the run”) securities to previously issued (“off the run”) securities. Specifically, since (historically) the Treasury only issues new 10-year notes and 20-year bonds at the long end of the maturity spectrum, an existing 10-year Treasury bond would have to have been issued 10 years previously (i.e., it was originally a 20-year bond when it was issued 10 years previously). The increased demand for the newly issued “liquid” 20-year Treasury bonds relative to the less liquid 10-year Treasury bonds can be large enough to push the equilibrium interest rate on the 20-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 to maturity curve.

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 ( j th) financial security:

i f IP RIR DRP LRP SCP MPj j j j j* ( , , , , , )� (2-4)

where

IP � Inflation premium RIR � Real interest rate

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

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

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

2 Yield curves from the last 15 years can be viewed at stockcharts.com/charts/yieldcurve.html . A look at this Web site reveals how infrequently inverted or flat yield curves occur.

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Chapter 2 Determinants of Interest Rates 51

DRP j � Default risk premium on the j th security LRP j � Liquidity risk premium on the j th security SCP j � Special feature premium on the j th security MP j � Maturity premium on the j th security

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

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

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

Yield to Maturity (%) 5.50

4.50

5.00

4.00 Time to Maturity

3- m

on th

6- m

on th

1- ye

ar

2- ye

ar

3- ye

ar

5- ye

ar

7- ye

ar

10 -y

ea r

20 -y

ea r

30 -y

ea r

Yield Curve, June 4, 2007

4.00

3.00

2.00

1.00

0.00

Yield to Maturity (%)

1- m

on th

3- m

on th

6- m

on th

1- ye

ar

2- ye

ar

3- ye

ar

5- ye

ar

7- ye

ar

10 -y

ea r

20 -y

ea r

Yield Curve, June 8, 2010

Time to Maturity

Yield to Maturity (%)

7.00

6.00

5.00

3- m

on th

6- m

on th

1- ye

ar

3- ye

ar

5- ye

ar

7- ye

ar

10 -y

ea r

20 -y

ea r

30 -y

ea r

Yield Curve, November 24, 2000

(c)

(a) (b)

As discussed above 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 premium theory, and the market segmentation theory. Review again Figure 2–7(a) , which presents the Treasury yield curve as of June 8, 2010. As can be seen, the yield curve on this date reflected the normal upward-sloping relationship between yield and maturity.

TERM STRUCTURE OF INTEREST RATESTERM STRUCTURE OF INTEREST RATES

LG 2-7LG 2-7

DO YOU UNDERSTAND:

6 . What the difference is between inflation and real interest 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 ?

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52 Part 1 Introduction and Overview of Financial Markets

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 expecta- tions theory is that if investors have a four-year investment horizon, they could either buy a current, four-year bond and earn the current or spot yield on a four-year bond ( 1 R 4 , if held to maturity) each year, or invest in four successive one-year bonds (of which they only know the current one-year spot rate ( 1 R 1 ), but form expectations of the unknown future one-year rates [ E ( 2 r 1 ), E ( 3 r 1 ), and E ( 4 r 1 )]. Note that each interest rate term has two subscripts, for example, 1 R 4 . 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 maturity on the security, so that 4 represents the purchase of a security with a four-year life. Similarly, E ( 3 r 1 ) 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 hypothesis, if future one-year rates are expected to rise each successive year into the future, then the yield curve will slope upwards. Specifically, the current four-year T-bond rate or return 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. Spe- cifically, the unbiased expectations theory posits that current long-term interest rates ( 1 R N ) are geometric averages of current ( 1 R 1 ) and expected future E ( N r 1 ) short-term interest rates. The mathematical equation representing this relationship is:

( ) ( )( ( )) ( (1 1 1 11 1 1 2 1 1� � � � �R R E r E rN N

N� � � ))) (2-5)

therefore:

1 1 1 2 1 1 11 1 1 1R R E r E rN N

N� � � � �� �( )( ( )) ( ( )) /� � �

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

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

41

(1� R ) 1 1

[1�E ( r )] 2 1

[1�E ( r )] 3 1

[1�E ( r )] 4 1

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Chapter 2 Determinants of Interest Rates 53

Notice that uppercase interest rate terms, 1 R t , are the actual current interest rates on secu- rities purchased today with a maturity of t years. Lowercase interest rate terms, t r 1 , 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 1 2 1 3 1 4 1 94 3 00 3 74R E r E r E r� � �. %, ( ) . %, ( ) . %, ( 11 4 10) . %�

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

1 1

1 2 1 2

1

1 94

1 0194 1 03 1 2 47

R

R

�

� � � � �

. %

[( . )( . )] . %/

RR3 1 3

1

1 0194 1 03 1 0374 1 2 89� � � � � �[( . )( . )( . )] . %/

RR4 1 41 0194 1 03 1 0374 1 041� � � � � �[( . )( . )( . )( . )] / 11 3 19� . %

and the current yield to maturity 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 , 4

3 That is, E ( 4 r 1 ) � E ( 3 r 1 ) � E ( 2 r 1 ) � 1 R 1 .

4 Example 2–2 is somewhat counterintuitive. One can observe zero coupon bond interest rates. Thus, the use of expected future short-term interest rates (which are unobservable) to find zero-coupon bond interest rates (which are observable) is not common. It is much more intuitive for someone to find expected future short-term interest rates given the observed long-term rates today, or the forward rate. We discuss this process in more detail below.

Liquidity Premium Theory

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,

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54 Part 1 Introduction and Overview of Financial Markets

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 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 aver- ages 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 unbiased expectations hypothesis versus the liquidity premium hypothesis. 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 liquid- ity 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

Figure 2–9 Yield Curve under the Unbiased Expectations Hypothesis (UEH) versus the Liquidity Premium Hypothesis (LPH)

Term to Maturity (a)

Yield to Maturity

Upward-Sloping

Term to Maturity (c)

Yield to Maturity

Flat

LPH

LPH UEH

UEH

LPH

UEH

Term to Maturity (b)

Yield to Maturity

Inverted or Downward-Sloping

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Chapter 2 Determinants of Interest Rates 55

increases with maturity fast enough to produce an upward-sloping yield curve. The liquid- ity premium theory may be mathematically represented as:

1 1 1 2 1 2 11 1 1R R E r L E rN N� � � � � �[( )( ( ) ) ( ( )� � � LLN N)] /1 1� (2-6)

where L t � Liquidity premium for a period t

L 2 � L 3 � . . . L N

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 1 2 1 3 1 4 1 1 94 3 00 3 74R E r E r E r� � � �. %, ( ) . %, ( ) . %, ( ) 44 10. %

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

L L L2 3 40 10 0 20 0 30� � �. %, . %, . %

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

1 1

1 2 1 2

1 94

1 0194 1 03 001 1 2 52

R

R

�

� � � � � �

. %

[( . )( . . )] . %/

11 3 1 31 0194 1 03 001 1 0374 002 1R � � � � � � �[( . )( . . )( . . )] / ��

� � � � � �

2 99

1 0194 1 03 001 1 0374 0021 4

. %

[( . )( . . )( . . )R (( . . )] . %/1 041 003 1 3 341 4� � � �

and the current yield to maturity 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 pre- mium 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 .10 percent 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.

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56 Part 1 Introduction and Overview of Financial Markets

Market Segmentation Theory

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). Accordingly, the market segmentation theory does not consider securities with different maturities as perfect sub- stitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. 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 liabilities. Accordingly, 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). The market segmen-

tation theory assumes that investors and borrowers are generally 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 supply curve for short- versus long-term bond segments of the market result in changes in the shape of the yield to maturity curve. Specifically in Figure 2–10 , the higher the yield on securities (the lower the price), the higher the demand for them. 5 Thus, as the supply of securities decreases in the short - term market

www.ustreas.gov www.ustreas.gov

5 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.

DO YOU UNDERSTAND:

9 . What the three explanations are for the shape of the yield curve ? Discuss each and compare them .

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

Time to Maturity

Yield Percent

Yield Curve

S LLong-Term Securities

Yield Percent rL

SL DL

Short-Term Securities

Yield Percent rs

rs

Ss Ds

Time to Maturity

Yield Percent

Yield Curve

S LLong-Term Securities

Yield Percent rL

SL DL

Short-Term Securities

Yield Percent

Ss Ds

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Chapter 2 Determinants of Interest Rates 57

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 down- ward. 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.

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 hypothesis 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 rep- resents the market’s current expectations of future short-term interest rates, the unbiased expectations hypothesis 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 equa- tions representing 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.”

FORECASTING INTEREST RATESFORECASTING INTEREST RATES

LG 2-8LG 2-8

forward rate An expected rate (quoted today) on a security that originates at some point in the future.

forward rate An expected rate (quoted today) on a security that originates at some point in the future.

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

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

1 2 1 1 2 1 1 21 1 1R � � � �[( )( ( ))] /R f

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 1 1 2 2

1 1 1 1 1f R R� � � �[( ) ( )]/

In general, we can find the one-year forward rate for any year, N years into the future, using the following equation:

N N N

N Nf R R1 1 1 1

11 1 1� � � � �

�[( ) ( ) ]/ (2-7)

For example, on May 6, 2011, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:

1 1 1 2 1 3 1 40 205 0 5673 0 9057 1 3899R R R R� � � �. %, . %, . %, . %

DO YOU UNDERSTAND:

10 . What a forward rate is ?

11 . How an implied forward rate can be obtained from current short- and long-term interest rates ?

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58 Part 1 Introduction and Overview of Financial Markets

6 The time value of money concept is a topic that finance students probably studied in introductory financial man- agement courses. However, its use in the valuation of financial instruments created, traded, and held by financial institu- tions is critical to financial managers. 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).

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). Dissavers 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 specifically assumes that any interest or other return earned on a dollar invested over any given period of time (e.g., two, three, four, . . . years) is immediately reinvested—that is, the interest return is compounded. This is in contrast to the concept of simple interest , which assumes that interest returns earned are not rein- vested over any given time period.

TIME VALUE OF MONEY AND INTEREST RATES 6 TIME VALUE OF MONEY AND INTEREST RATES 6

LG 2-9LG 2-9

compound interest Interest earned on an investment is reinvested.

compound interest Interest earned on an investment is reinvested.

simple interest Interest earned on an investment is not reinvested.

simple interest Interest earned on an investment is not reinvested.

Example 2–5 Calculation of Simple and Compounded Interest Returns

CALCULATION OF SIMPLE INTEREST RETURN Suppose you have $1,000 to invest for a period of two years. Currently, default risk-free one-year securities (such as those issued by the U.S. Treasury) are paying a 12 percent interest rate per year, on the last day of each of the two years over your investment horizon.

Using the unbiased expectations theory, one-year forward rates on zero-coupon Treasury bonds for years 2, 3, and 4 as of May 6, 2011, were:

2 1

2

3 1

1 005673 1 00205 1 0 931

1 009

f

f

� � �

�

[( . ) ( . )] . %

[( .

/

0057 1 005673 1 1 586

1 013899 1

3 2

4 1 4

) ( . ) ] . %

[( . ) (

/

/

� �

�f .. ) ] . %009057 1 2 8563 � �

Thus, the expected one-year rate, one year in the future, was 0.931 percent; the expected one-year rate, two years into the future, was 1.586 percent; and the expected one-year rate, three years into the future, was 2.856 percent.

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Chapter 2 Determinants of Interest Rates 59

If you earn simple annual interest on this investment, or you do not reinvest the annual (12 percent) interest earned, the value of your investment at the end of the first year is:

Value in 1 year simple interest Principal( ) � ��

� � �

Interest year 1( ) $ , $ , (. ) $ ,1 000 1 000 12 1 0000 120 1 000 1 12 1 120

�

� �

$ $ , ( . ) $ ,

With simple interest, the $120 in interest earned in year 1 is not reinvested in year 2. Rather, you take the $120 in interest out of the investment account and hold it until the end of year 2. Only the original $1,000 investment is carried forward and earns interest in year 2. Thus, the value at the end of the two-year investment horizon is:

Value in 2 years simple interest Principa( ) � ll Interest year 1 Interest year 2� � �

( ) ( ) $ ,1 0000 1 000 12 1 000 12 1 000 1 000

� �

� �

$ , (. ) $ , (. ) $ , $ , (.112 2 1 240) $ ,�

Panel A of Figure 2–11 illustrates the value of the investment over the two-year investment horizon using simple interest.

CALCULATION OF COMPOUNDED INTEREST RETURN If, instead, the annual interest earned is reinvested immediately after it is received at 12 percent (i.e., interest is compounded), the value of the investment at the end of the first year is:

Value in 1 year compounded interest Princ( ) � iipal Interest year 1� � � �

( ) $ , $ , (. )1 000 1 000 12 $$ , $ $ , ( . ) $ ,

1 000 120 1 000 1 12 1 120

�

� �

Notice that after the first year of the two-year investment horizon, you have $1,120 whether the investment earns simple or compounded interest. With compounded interest, however, the $120 in interest earned in year 1 is reinvested in year 2. Thus, the whole $1,120 is car- ried forward and earns interest in year 2. In this case, the value of the investment at the end of the two-year investment horizon is:

Value in 2 years

compound interest

Principal( )

� �� � Interest year 1

Interest on original prin( ) ccipal year 2

Compounded interest or inte( ) (� rrest on interest received in year 1)

$ ,� 1 000 �� � �

�

$ , (. ) $ , (. ) , (. )(. )

$

1 000 12 1 000 12 1 000 12 12

11 000 1 2 12 12 1 000 1 12 1 25

2 2, (. ) (. ) $ , ( . ) $ ,

� �� � � � 44 40.

Panel B of Figure 2–11 illustrates the value of the investment over the two-year investment horizon using compounded interest. By compounding interest using time value of money principles, an investor increases his or her return compared to the simple interest return. In the example above using a two-year investment horizon, a 12 percent annual interest rate, and an initial investment of $1,000, the investment is worth $1,254.40 at the end of two years under compounded returns rather than $1,240 using simple interest to calculate returns.

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. This is called the invest- ment’s future value ( FV ) and is the same as that in the compounded return example above.

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60 Part 1 Introduction and Overview of Financial Markets

Figure 2–11 Value of a Two-Year Investment Using Simple versus Compounded Interest

Year 0 1 2

Year 0 1 2

Panel A: Investment earns simple interest

Invest $1,000

Receive $1,000(.12) � $120 in interest, which is not reinvested

Value of investment � $1,000 � $1,000(.12) � $1,120

Investment carry forward to year 2 � $1,000

Receive interest on original principal � $1,000(.12) � $120

Value of investment � $1,000 � $1,000(.12) � $1,000(.12) � $1,240

Panel B: Investment earns compounded interest

Invest $1,000

Receive $1,000(.12) � $120 in interest, which is reinvested

Value of investment � $1,000 � $1,000(.12) � $1,120

Investment carry forward to year 2 � $1,000 � $1,000(.12) � $1,120

Receive interest on original principal � compound interest $1,000(.12) � $1,000(.12)(.12) � $134.40

Value of investment � $1,000 � $1,000(.12) � $1,000(.12) � $1,000(.12)(.12) � $1,120 � $134.40 � $1,254.40

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 dollars converted into their equivalent present value or current dollars). We illustrate the FV and PV scenarios in Figure 2–12 . Two forms of time value of money calculations are commonly used in finance for security valuation purposes: the value of a lump sum and the value of annuity payments.

Figure 2–12 Time Value of Money Concepts

$1

Conversion of present values into the future values

FV � Future Value of $1 Paid at Time 0

10

$1

Conversion of future values into the present values

PV � Present Value of $1 Paid at Time 1

10

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61

A lump sum payment is a single cash payment received at the beginning or end of some invest- ment horizon (e.g., $100 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 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 equation used to calculate this value is illustrated in Figure 2–13 and can be represented as follows.

lump sum payment A single cash flow occurs at the beginning and end of the investment horizon with no other cash flows exchanged.

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 investment horizon.

annuity A series of equal cash flows received at fixed intervals over the investment horizon.

IN THE NEWS

The time value of money equations that

are developed in this chapter have been

programmed into some calculators com-

monly known as financial, or business,

calculators. Among many useful financial

shortcuts, these calculators have five

specific financial buttons. The two most

common types of inexpensive financial

calculators are the Hewlett Packard 10b

II Business Calculator and the Texas

Instruments BA II (Plus or Professional).

The relevant financial buttons are the

buttons N (for the number of periods),

I/Y (for the interest rate), PV (for present

value), PMT (for a constant payment

every period), and FV (for future value).

A common, but more sophisticated

and expensive calculator is the TI-83.

This calculator has a menu system that

includes the financial functions as shown

below.

Set up your calculator

Financial calculators come from the fac-

tory with specific settings. It is useful to

change two of these settings. The first

is to set the number of digits shown

after the decimal point on the calculator

display. The factory setting is for two

digits. It is better to set the calculator to

display the number of digits necessary to

show the right number—this is called a

floating-point display. For the HP calcula-

tor, press the color button, then the DISP

button, and finally the decimal (.) button.

To set the display on the TI calculator for

a floating-point decimal, push the 2ND

button, followed by the FORMAT button,

followed by the 9 button, and finally the

ENTER button.

The second change is to set the num-

ber of times the calculator compounds

each period. The settings from the fac-

tory are for compounding 12 times per

period. This should be reset to one time

per period. To change the HP calcula-

tor to compound once per period, push

the 1 button, then the color button, and

finally the P/YR button. On the TI calcula-

tor, simply push the 2ND button, the P/Y

button, the number 1, and the ENTER

button. These new settings will remain in

the calculator until changed or until the

calculator’s batteries are removed.

Using your calculator

Enter the cash flows into the time value

buttons (PV, PMT, and FV) consistent

with the way they are shown in a time

line. In other words, cash inflows should

be positive and cash outflows should be

negative. Interest rates are entered (I/Y)

in the percentage form, not the decimal

form. The number of periods in the

problem is also entered (N). Consider the

future value problem of $100 deposited

for two years earning a 5 percent

interest rate.

• To set the number of years, press 2

and then the N button.

• To set the interest rate, press 5 and

then the I/Y button. (Note that inter-

est rates are in percent format for

using a financial calculator and deci-

mal format for using the equations.)

• To enter the current cash flow: first

press 100, then make it negative by

pressing the �/− button, lastly press

the PV button.

• The PMT button is not used, so enter

0 and then the PMT button.

• To solve for future value, press the

compute button (CPT) [for the TI]

and then the FV button (press the

FV button only for the HP).

• Solution: the display should show

FV � 110.25.

Note that the answer is positive, consis-

tent with an inflow.

Using a Financial Calculator

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62 Part 1 Introduction and Overview of Financial Markets

Present value ( PV ) of a lump sum received at the end of the investment horizon, or future value ( FV ):

PV FV rt t� �/( )1 (2-8)

where

PV � Present value of cash flows FV t � 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 (e.g., 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) 7

7 Time value of money formulas are programmed in business calculators—a tool with which every finance student should be familiar. Because there are several variations of business calculators, we do not apply the problems in the text to any one brand of calculator.

Figure 2–13 Present Value of a Lump Sum ( invested at the rate of r per period )

?

Present value of a lump sum payment of FV (�$10,000) received in t (� 6) periods

Investment Horizon

PV of Lump Sum FV, at Time 0

FV � $10,000

t � 60

Example 2–6 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 (see Figure 2–13 ). If the appropri- ate annual interest rate on the investment is 8 percent compounded annually, the present value of this investment is computed as follows:

PV FV rt t� � � � �/( ) $ , /( . ) $ , (.1 10 000 1 08 10 000 6301706 )) $ , .� 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 12 10 000 506631 5 066 31 6

If the annual interest rate on the investment rises to 16 percent, the present value of this investment becomes:

PV � � � �$ , /( . ) $ , (. ) $ , .10 000 1 16 10 000 410442 4 104 42 6

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 08 10 000 397114 3 971 112 44

CALCULATOR HINTS N � 6 I � 8 FV � 10,000 PMT � 0 CPT FV � �6,301.70

CALCULATOR HINTS N � 6 I � 8 FV � 10,000 PMT � 0 CPT FV � �6,301.70

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Chapter 2 Determinants of Interest Rates 63

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 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 invest- ment 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 fundamental 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 rise by 4 percent, from 8 percent to 12 percent, compared to when they rise from 12 percent to 16 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. 8

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 is illustrated in Figure 2–14 and can be represented as follows:

Future value ( FV ) of a lump sum received at the beginning of the investment horizon:

FV PV rt t� �( )1 (2-9)

8 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 i FV et

n n

in� � � �[ ( )] ( )1 1/ /∞ ∞

where n is the number of years in the investment horizon (period). Thus, in Example 2–6, 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 e� � �� �$ , $ , (. ) $ ,.10 000 10 000 382893 3 816 6( ) 228 93.

Figure 2–14 Future Value of a Lump Sum ( invested at the rate of r per period )

PV � $10,000

Future value of a lump sum payment of PV (� $10,000) at the end of t (� 6) periods

Investment Horizon

FV of Lump Sum PV, at Time t

?

t � 60

Example 2–7 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 (see Figure 2–14 ). 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 r t� � � � � �( ) $ , ( . ) $ , ( . )1 10 000 1 08 10 000 1 5868746 $$ , .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 12 10 000 1 973823 19 738 2 6 33

CALCULATOR HINTS N � 6 I � 8 PV � 10,000 PMT � 0 CPT PV � �15,868.74

CALCULATOR HINTS N � 6 I � 8 PV � 10,000 PMT � 0 CPT PV � �15,868.74

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64 Part 1 Introduction and Overview of Financial Markets

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 . 9 This is because as interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon. This is due to the compounding of interest returns. By con- trast, as stated earlier, as interest rates increase, the present value of an investment decreases at a decreasing rate. These nonlinear relationships are illustrated in Figure 2–15 .

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 illustrated in Figure 2–16 and is represented as follows:

Present value ( PV ) of an annuity stream ( PMT ) received in the future:

PV PMT r j

t j

� � � a

1

1 1[ ( )]/ (2-10)

Figure 2–15 Relation between Interest Rates and Present and Future Values

Interest Rate

Present Value (PV)

Interest Rate

Future Value (FV)

If the annual interest rate on the investment rises to 16 percent, the future value of this investment becomes:

FV � � � �$ , ( . ) $ , ( . ) $ , .10 000 1 16 10 000 2 436396 24 363 96 66

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 08 10 000 2 518170 25 18112 770

9 That is, as rates go from 8 percent to 12 percent (an increase in interest rates of 4 percent), the future value increases by $3,869.49; as interest rates go from 12 percent to 16 percent (an increase in interest rates of 4 percent), the future value increases by $4,625.73.

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Chapter 2 Determinants of Interest Rates 65

Figure 2–16 Present Value of an Annuity ( invested at the rate of r per period )

Present value of an annuity payment of PMT (� $10,000), paid 1 time per year over 6 years (i.e., t � 6)

?PV of Annuity PMT, at Time 0

PMT � $10,000

PMT � $10,000

PMT � $10,000

PMT � $10,000

PMT � $10,000

PMT � $10,000

6 Year0 1 2 3 4 5

6 Payment1 2 3 4 5

Example 2–8 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. We illustrate this investment in Figure 2–16 . If the appropriate annual interest rate on the investment is 8 percent, the pres- ent value of this investment is computed as follows:

PV PMT r

r

t � �

� �

� �

� �

1 1

1

10 000 1

1

1 08

( )

$ , ( .

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

)) .

$ , ( . ) $ , .

6

08

10 000 4 622880 46 228 8

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

� � 00

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; see Figure 2–17 ), the present value of the annu- ity becomes:

PV � � �

�

�

$ , ( . )

.

$ ,

10 000 1

1

1 02 02

10 000

24 ⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

( . ) $ , .18 913926 189 139 26�

CALCULATOR HINTS N � 6 I � 8 FV � 0 PMT � 10,000 CPT PV � �46,228.80

CALCULATOR HINTS N � 6 I � 8 FV � 0 PMT � 10,000 CPT PV � �46,228.80

which can be reduced to the simpler equation:

PV PMT r

r

t � �

� �

1 1

1( ) ⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

where

PMT � Periodic annuity payment received during an investment horizon

Summation sign for ada j

t

�

� 1

ddition of all terms from toj j t� �1

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66 Part 1 Introduction and Overview of Financial Markets

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 illustrated by the example in Figure 2–18 and is represented as follows:

Future value ( FV ) of an annuity payment stream received over an investment horizon: 10

FV PMT rt j

t j� �

�

�

a 0

1

1( ) (2-11)

10 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 2–8, 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 , or, in this example, 9.

Figure 2–17 Present Value of $10,000 Received on the Last Day of Each Quarter for Six Years (i.e., t � 6 � 4 � 24 )

?PV � $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

6 Year0 1/4 1/2 3/4 1 5 3/4

24 Payment1 2 3 4 23

Figure 2–18 Future Value of an Annuity ( invested at the rate of r per period )

PMT � $10,000

PMT � $10,000

PMT � $10,000

PMT � $10,000

PMT � $10,000

? PMT � $10,000

6 Year0 1 2 3 4 5

6 Payment1 2 3 4 5

Future value of an annuity stream of PMT (� $10,000), paid 1 time per year over 6 years (i.e., t � 6)

FV of Annuity PMT, at Time t

If the annuity is paid on the first day of each quarter, 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 becomes:

PV PMT r

r r

t �

� �

�

1 1

1 1

( ) ( )

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

The present value of this investment becomes:

PV � �

� �

�

$ , ( . )

. ( . )10 000

1 1

1 02 02

1 02 24

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

$$ , ( . )( . ) $ , .10 000 18 913926 1 02 192 922 04�

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Chapter 2 Determinants of Interest Rates 67

Effective Annual Return

The annual interest rate, i , used in the time value of money equations in Examples 2–6 through 2–9 is the simple (nominal or 12-month) interest rate on the securities. However, if interest is paid or compounded more than once per year, the true annual rate earned or paid will differ from the simple annual rate. The effective or equivalent annual return ( EAR ) is the return earned or paid over a 12-month period taking any within-year compounding of interest into account. Specifically, the EAR can be written as follows:

EAR r c� � �( )1 1 (2-12)

where c � number of compounding periods per year. In Example 2–6, the EAR on the 16 percent simple return compounded semiannually

(i.e., r � 16%/2 � 8% and c � 2) is computed as:

EAR � � � �( . ) . %1 08 1 16 642

and in Example 2–8 the EAR on the 8 percent simple return compounded quarterly (i.e., r � 8%/4 � 2% and c � 4) is computed as:

EAR � � � �( . ) . %1 02 1 8 244

effective or equivalent annual return Rate earned over a 12-month period taking the compounding of interest into account.

effective or equivalent annual return Rate earned over a 12-month period taking the compounding of interest into account.

Example 2–9 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 (as in Figure 2–18 ). If the interest rate on the investment is 8 percent, the future value of your investment in six years is computed as follows:

FV � � �

�

$ , ( . )

. $ , ( .

10 000 1 08 1

08 10 000 7 33592

6⎡

⎣ ⎢

⎤

⎦ ⎥

99 73 359 29) $ , .�

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:

FV � � �

�

$ , ( . )

. $ , ( .

10 000 1 02 1

02 10 000 30 421

24⎡

⎣ ⎢

⎤

⎦ ⎥

8862 304 218 62) $ , .�

If the annuity is paid on the first day of each quarter, an extra interest payment would be earned on each $10,000 investment. Thus, the time value of money equation for the future value of an annuity becomes:

FV PMT r

r r

t

� � �

� ( )

( ) 1 1

1 ⎡

⎣ ⎢

⎤

⎦ ⎥

Thus, the future value of this investment becomes:

FV � � �

�

�

$ , ( . )

. ( . )

$ ,

10 000 1 02 1

02 1 02

10 000

24⎡

⎣ ⎢

⎤

⎦ ⎥

(( . ) $ , .31 030300 310 303 00�

CALCULATOR HINTS N � 6 I � 8 PV � 0 PMT � 10,000 CPT FV � �73,359.29

CALCULATOR HINTS N � 6 I � 8 PV � 0 PMT � 10,000 CPT FV � �73,359.29

which can be reduced to the simpler equation:

FV PMT r

r t

t

� � � �( )1 1⎡

⎣ ⎢

⎤

⎦ ⎥

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w w

w .m

h h e .c

o m

/s c 5

e 68 Part 1 Introduction and Overview of Financial Markets

Thus, for each dollar invested at the beginning of the year, at 16 percent (com- pounded semiannually) and 8 percent (compounded quarterly), respectively, you would have earned $0.1664 and $0.0824 at the end of the year. Accordingly, the EAR provides a more accurate measure of annual returns in time value of money calculations.

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. 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 )

6. How does the liquidity premium theory of the term structure 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 )

7. What is the difference between simple interest and com- pound interest? ( LG 2-9 )

DO YOU UNDERSTAND:

12 . The difference between simple interest and compounded interest ?

13 . What should happen to the future value of an annuity stream of cash flows as interest rates increase ?

14 . How an EAR differs from a simple rate of return ?

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 interest rate is 3.5 percent. The security’s liquid- ity risk premium is .25 percent and maturity risk premium is .85 percent. The security has no special covenants. Calcu- late 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 one-year T-bills 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 interest 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. The current one-year Treasury-bill rate is 5.2 percent and the expected one-year rate 12 months from now is 5.8 percent. According to the unbiased expectations theory, what should be the current rate for a two-year Treasury security? ( LG 2-7 )

4. 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 1 2 1 3 1 4 1 6 7 7 5 7 85R E r E r E r� � � �%, ( ) %, ( ) . %, ( ) . %

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 )

5. 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 )

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e Chapter 2 Determinants of Interest Rates 69

6. Suppose we observe the following rates: 1 R 1 � 8%, 1 R 2 � 10%. If the unbiased expectations theory of the term struc- ture of interest rates holds, what is the one-year interest rate expected one year from now, E ( 2 r 1 )? ( LG 2-7 )

7. Suppose we observe the three-year Treasury security rate ( 1 R 3 ) 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 )

8. 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 hypotheses, what does the market expect the one-year Treasury rate to be four years from today, E ( 5 r 1 )? ( LG 2-7 )

9. A recent edition of The Wall Street Journal reported inter- est 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 note yields, respectively. According to the unbi- ased 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 )

10. 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 1

2 1 2

3 1

5 65 6 75 0 05 6 85

R E r L E r L

� � � �

. % ( ) . % . % ( ) . % 33 4 1 4

0 10 7 15 0 12

� � �

. % ( ) . % . %E r L

Using the liquidity premium hypothesis, 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 )

11. Suppose we observe the following rates: 1 R 1 � .10, 1 R 2 � .14, and E ( 2 r 1 ) � .10. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2? ( LG 2-7 )

12. 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. According to the liquidity premium hypotheses, what is the liquidity pre- mium on the four-year Treasury security, L 4 ? ( LG 2-7 )

13. 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 hypothesis? ( LG 2-8 )

Maturity Yield One day 2.00% One year 5.50 Two years 6.50 Three years 9.00

14. You note the following yield curve in The Wall Street Journal. According to the unbiased expectations hypothesis, 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

15. 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:

1R1 � 4.75%, 1R2 � 4.95%, 1R3 � 5.25%, 1R4 � 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 )

16. 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 hypothesis, 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 )

17. 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 )

18. Calculate the present value of $5,000 received five years from today if your investments pay ( LG 2-9 ) 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?

19. Calculate the future value in five years of $5,000 received today if your investments pay ( LG 2-9 ) 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?

20. Calculate the present value of the following annuity streams: ( LG 2-9 ) a. $5,000 received each year for 5 years on the last day of

each year if your investments pay 6 percent compounded annually.

b. $5,000 received each quarter for 5 years on the last day of each quarter if your investments pay 6 percent com- pounded quarterly.

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e 70 Part 1 Introduction and Overview of Financial Markets

c. $5,000 received each year for 5 years on the first day of each year if your investments pay 6 percent compounded annually.

d. $5,000 received each quarter for 5 years on the first day of each quarter if your investments pay 6 percent com- pounded quarterly.

21. Calculate the future value of the following annuity streams: ( LG 2-9 ) a. $5,000 received each year for 5 years on the last day of

each year if your investments pay 6 percent compounded annually.

b. $5,000 received each quarter for 5 years on the last day of each quarter if your investments pay 6 percent com- pounded quarterly.

c. $5,000 received each year for 5 years on the first day of each year if your investments pay 6 percent compounded annually.

d. $5,000 received each quarter for 5 years on the first day of each quarter if your investments pay 6 percent com- pounded quarterly.

22. For each of the following, compute the future value: ( LG 2-9 )

Present Value Years Interest Rate Future Value

$ 2,250 4 18% 9,310 9 6 76,355 15 12 183,796 21 8

23. e celx Using a Spreadsheet to Calculate Future Values. What is the future value of $100,000 invested for 12 years at 5 percent, 6 percent, 8 percent, and 10 percent, compounded annually? ( LG 2-9 )

Present Interest The Answer Value Periods Rate ⇒ Will Be

$100,000 12 5% $179,585.63 100,000 12 6 201,219.65 100,000 12 8 251,817.01 100,000 12 10 313,842.84

24. For each of the following, compute the present value: ( LG 2-9 )

Present Value Years Interest Rate Future Value

6 4% $ 15,451 8 12 51,557 16 22 886,073 25 20 550,164

25. e celx Using a Spreadsheet to Calculate Present Values. What is the present value of $100,000 invested for 12 years at 5 percent, 6 percent, 8 percent, and 10 percent compounded annually? ( LG 2-9 )

Future Interest The Answer Value Periods Rate ⇒ Will Be

$100,000 12 5% $55,683.74 100,000 12 6 49,696.94 100,000 12 8 39,711.38 100,000 12 10 31,863.08

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 )

Future Value Future Value (Payment (Payment made on made on Interest last day first day Payment Years Rate of period) of period)

$ 123 13 13% 4,555 8 8 74,484 5 10 167,332 9 1

27. e celx Using a Spreadsheet to Calculate Future Value of Annuities. What is the future value of $1,000 invested each month for 10 years at 5 percent, 6 percent, 8 percent, and 10 percent, compounded monthly? ( LG 2-9 )

Annuity Interest The Answer Payment Periods Rate ⇒ Will Be

$1,000 10 � 12 � 120 5% $155,282.28 1,000 120 6 163,879.35 1,000 120 8 182,946.04 1,000 120 10 204,844.98

28. 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 )

Present Value Present Value (Payment (Payment made on made on Interest last day) first day Payment Years Rate of period) of period)

$ 678.09 7 13% 7,968.26 13 6 20,322.93 23 4 69,712.54 4 31

29. e celx Using a Spreadsheet to Calculate Present Values. What is the present value of $100,000 invested for 12 years at 5 percent, 6 percent, 8 percent, and 10 percent, compounded semiannually? ( LG 2-9 )

Future Interest The Answer Value Periods Rate ⇒ Will Be

$100,000 12 � 2 � 24 5% $55,287.54 100,000 24 6 49,193.37 100,000 24 8 39,012.15 100,000 24 10 31,006.79

30. What is the future value of $950 paid on the last day of each 6 months for 12 years assuming an interest rate of 11 percent compounded semiannually? ( LG 2-9 )

31. 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 )

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e Chapter 2 Determinants of Interest Rates 71

32. 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 )

33. What is the value of a $5,500, 4 year cash flow moved to year 8 when interest rates are 10 percent? ( LG 2-9 )

34. If an ounce of gold, valued at $700, increases at a rate of 7.5 percent per year, how long will it take to be valued at $1,000? ( LG 2-9 )

35. If a house valued at $150,000 grows to a value of $270,000 in seven years, what annual return did it earn? ( LG 2-9 )

36. What is the present value of annual $500 payments made for the next 15 years if interest rates are 11 percent? ( LG 2-9 )

37. 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 )

38. At retirement, you have saved $800,000 in your employer’s savings plan. They have offered to convert this money to an annual payment of $70,000 for the next 30 years. What is the interest rate of this annuity? ( LG 2-9 )

39. 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 )

40. You have borrowed $4,000 from your parents after gradu- ation to get settled into your career. If they charge you 6 percent compounded monthly and you can pay them $100 per month, how long will it take to pay them back? ( LG 2-9 )

41. Calculate the effective annual return on an investment offering a 12 percent interest rate, compounded monthly. ( LG 2-9 )

42. A car dealer is advertising a loan with monthly payments and a 9.9 percent nominal rate. What is the loan’s EAR? ( LG 2-9 )

43. You are considering using one of two loans. The terms of the two loans are equivalent with the exception of the interest rates. Loan A offers a rate of 8.10 percent compounded daily. Loan B offers a rate of 8.25 percent compounded semiannu- ally. Loan _____ is the better offer because______. ( LG 2-9 )

Go to the United States Treasury Web site and find the latest information available on the size of the U.S. national debt.

Go to the U.S. Treasury’s Treasury Direct Web site at www.treasurydirect.gov . Click on “Debt to the Penny.” This will bring up the relevant tables. For example, on June 24, 2010, the size of the national debt was $13.04 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 June 24, 2010.

SEARCH THE SITE

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72

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 the 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., its coupon rate and remaining time

part one Introduction and Overview of Financial Markets

Interest Rates and Security Valuation

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 .

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 (at www.mhhe.com/sc5e ) Appendix 3B: More on Convexity (at www.mhhe.com/sc5e )

chap te r

3

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Chapter 3 Interest Rates and Security Valuation 73

to maturity) also influence a financial security’s price. 1 We conclude the chapter with an 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 .

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 the 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 interest 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 con- tractually 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, includ- ing 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 on in this chapter, this process involves the discounting of all projected cash flows

VARIOUS INTEREST RATE MEASURESVARIOUS INTEREST RATE MEASURES

LG 3-1LG 3-1

coupon interest rate Interest rate used to cal- culate the annual cash flow the bond issuer promises to pay the bond holder.

coupon interest rate Interest rate used to cal- culate the annual cash flow the bond issuer promises to pay the bond holder.

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. Therefore, 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.

TABLE 3–1 Various Interest Rate Measures

Coupon rate —interest rate on a bond instrument used to calculate the annual cash flows 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.

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74 Part 1 Introduction and Overview of Financial Markets

( CF s) 2 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

CF

r

CF

r

CF

r

CF

r n

n� � �

� �

� � �

� 1

1 2

2 3

31 1 1 1( ) ( ) ( ) ( ) �

where

r � 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 .

Example 3–1 Application of Required Rate of Return

A 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:

PV � �

� �

� �

� 100

1 1125

100

1 1125

100

1 1125

10 1 2 3( . ) ( . ) ( . )

00 960

1 1125

935 31

4

�

�

�

( . )

$ . Given the current selling price of the 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 par- ticipant expects to earn by buying the security at its current market price ( P ), receiving all the projected cash flow payments ( C F s) on the security, and selling the security when the security matures 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

required rate of return The interest rate an investor should receive on a security, given its risk.

required rate of return The interest rate an investor should receive on a security, given its risk.

CALCULATOR HINTS N � 4 I � 11.25 PMT � 100 FV � 960 CPT PV � 935.31

CALCULATOR HINTS N � 4 I � 11.25 PMT � 100 FV � 960 CPT PV � 935.31

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.

expected rate of return The interest rate an investor expects 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 secu- rity, and sell the security at the end of his or her investment horizon.

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Chapter 3 Interest Rates and Security Valuation 75

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 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

CF

E r

CF

E r

CF

E r

CFn� �

� �

� �

� �1 1 2

2 3

31 1 1[ ( )] [ ( )] [ ( )] [ �

11 � 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 .

Example 3–2 Application of Expected Rate of Return

Refer to information in Example 3–1 describing a 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

100

1

100

1

100 1 2 3� �

� �

� �

� �

[ ( )] [ ( )] [ ( )]E r E r E r

9960

1

11 607

4[ ( )]

( ) . %

�

�

E r

E r⇒ 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.

CALCULATOR HINTS N � 4 PMT � 100 FV � 960 PV � �925 CPT I � 11.607%

CALCULATOR HINTS N � 4 PMT � 100 FV � 960 PV � �925 CPT I � 11.607%

TABLE 3–2 The Relation between Required Rate of Return and Expected Rate of Return

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.

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.

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76 Part 1 Introduction and Overview of Financial Markets

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 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. How- ever, when an event occurs that unexpectedly changes interest rates or a characteristic 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. Con- versely, 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 ( RCF 1 , RCF 2 , . . . , RCF n ), 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

RCF

r

RCF r

RCF r n

n� � �

� � �

� 1

1 2

21 1 1( ) ( ) ( ) �

where

RCF 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.

Example 3–3 Application of Realized Rate of Return

Consider again the bond investment described in Examples 3–1 and 3–2. Using your origi- nal purchase price, $890, and the current market price on this bond, the realized rate of return you have earned on this bond over the last two years is calculated as follows:

890 100

1

100 925

1

13 08

1 2� � �

�

�

�

( ) ( )

. %

r r

r⇒

market efficiency The process by which financial security prices move to a new equilibrium when interest rates or a security- specific characteristic changes.

market efficiency The process by which financial security prices move to a new equilibrium when interest rates or a security- specific characteristic changes.

realized rate of return The actual interest rate earned on an investment in a financial security.

realized rate of return The actual interest rate earned on an investment in a financial security.

CALCULATOR HINTS N � 2 PMT � 100 FV � 925 PV � �890 CPT I � 13.08%

CALCULATOR HINTS N � 2 PMT � 100 FV � 925 PV � �890 CPT I � 13.08%

DO YOU UNDERSTAND:

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 ?

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Chapter 3 Interest Rates and Security Valuation 77

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 ( r b ). Similarly, the expected rate of return, E(r b ) , 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 realized 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 (are fixed) over the life of the bond. 5 Thus, the fixed interest payment is essen- tially 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. The face or par value of the bond, on the other hand, 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.

Using time value of money formulas, and assuming that the bond issuer makes its promised semiannual coupon and principal payments, the present value of the bond can be written as: 6

V INT

r

INT

r

INT

r b

b b b �

� �

� � �

�

/2

1 /2

/2

1 /2

/2

1 /21 21 2 1 2 1� 22 1 2 a b 1 2

2 21 /2

/2 1 /2

T b

T

bt

T t

b

M

r

INT r

M

r

� �

� �

� ��2

1

1 1

2

∑ 22

2

2

1 1

1 2 2

1

1

T

b T

b b

INT r r

M r

� �

� �

�( ) ( )

( /

/

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

//2 2) T ⎡ ⎣ ⎢

⎤ ⎦ ⎥

where

V b � Present value of the bond M � 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 T � Number of years until the bond matures r b � Annual interest rate used to discount cash flows on the bond

BOND VALUATIONBOND VALUATION

LG 3-2LG 3-2

coupon bonds Bonds that pay interest based on a stated coupon rate. The interest, or coupon, payments per year are generally constant over the life of the bond.

coupon bonds Bonds that pay interest based on a stated coupon rate. The interest, or coupon, payments per year are generally constant over the life of the bond.

zero-coupon bonds Bonds that do not pay interest.

zero-coupon bonds Bonds that do not pay interest.

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. Both these types of bonds, therefore, can have variable interest payments.

6 More generally for bonds that pay interest other than semiannually:

V INT

m

r m

r m M

r m b

b mT

b b

�

� �

� �

1 1

1 1

1

( )

( )

/

/ /

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

mmT

⎡

⎣ ⎢

⎤

⎦ ⎥

where m � Number of times per year interest is paid.

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78 Part 1 Introduction and Overview of Financial Markets

Example 3–4 Calculation of the Fair Value of a Coupon Bond

You are considering the purchase of a $1,000 face value bond that pays 10 percent coupon interest per year, with the coupon paid semiannually (i.e., $50 (� 1,000(.1)/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 ( r b ) 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:

Vb � �

�1 000 1

2

1 1

1 08 2 08 2

2 12, (. ) [ (. )] .

( )/ /

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥⎥ ⎥

� �

� �

1 000 1 08 2

50 15 24696 1 000

2 12, [ (. )]

( . ) , (.

( )/ /

339012 1 152 47) $ , .� or an investor would be willing to pay no more than $1,152.47 for this bond. 7 , 8

If the required rate of return on this bond is 10 percent, the market value of the bond is calculated as follows:

Vb � �

�1 000 1

2

1 1

1 10 2 10 2

2 12, (. ) [ (. )] .

( )/ /

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥⎥ ⎥

� �

� �

1 000 1 10 2

50 13 79864 1 000

2 12, [ (. )]

( . ) , (.

( )/ /

331007 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:

Vb � �

�1 000 1

2

1 1

1 12 2 12 2

2 12, (. ) [ (. )] .

( )/ /

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥⎥ ⎥

� �

� �

1 000 1 12 2

50 12 55036 1 000

2 12, [ (. )]

( . ) , (.

( )/ /

224698 874 50) $ .� or an investor would be willing to pay no more than $874.50 for this bond.

In the preceding example, notice that when the required rate of return ( r b ) on the bond is 8 percent, the value of the bond, $1,152.47, is greater than its face value of $1,000. When this relationship between the value and the face value of a bond exists, the bond is referred to as a bond that should sell at a premium. This premium occurs because the coupon rate on the bond is greater than the required rate of return on the bond (a 10 percent coupon rate versus an 8 percent required rate of return in our example). To achieve the required rate of return on the bond, the bond holder experiences a loss on the difference between the purchase price of the bond and the face value received at maturity. When the required rate of return on the bond is 12 percent, the present value of the bond is less than its face value, and the bond is referred to as a bond that should sell at a discount. This discount occurs

premium bond A bond in which the present value of the bond is greater than its face value.

premium bond A bond in which the present value of the bond is greater than its face value.

discount bond A bond in which the present value of the bond is less than its face value.

discount bond A bond in which the present value of the bond is less than its face value.

7 If the bond paid interest once per year (i.e., m � 1) rather than twice, the bond’s fair market value would be calculated as:

Vb �

� �

�1 000 1 1

1

1 08 08

1 000 12

, (. ) ( . )

. , (

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

/ 11 08 1 150 7212� �. ) $ , . .

8 These pricing formulas are programmed in business calculators. Because there are several variations of business

calculators, we do not apply the problems in the text to any one brand of calculator.

CALCULATOR HINTS N � 12(2) � 24 I � 4.00 PMT � 50 FV � 1,000 CPT PV � �1,152.47

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Chapter 3 Interest Rates and Security Valuation 79

because the coupon rate on the bond is less than the required rate of return on the bond. To achieve the required rate of return on the bond, 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 required rate of return on the bond is 10 percent, the present value of the bond is equal to its face value, and the bond is referred to as a bond that should sell at par. This par 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 purchase price of the bond and the face value received at maturity. We summarize the scenarios for premium, discount, 9 and par bonds in Table 3–3 .

It should be noted that the designation as a premium, discount, or par bond does not necessarily assist a bond holder in the decision to buy or sell a bond. This decision is made on the basis of the relationship between the present value and the actual current market price of the bond. Rather, premium, discount, and par bonds are descriptive designations regarding the relationship between the present value of the bond and its face value. As stated 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 security’s value.

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(r b ) , 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 prin- cipal payments as promised, and holds the bond until maturity). The yield to maturity calcu- lation 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. 10

Rewriting the bond valuation formula, where V b 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(r b ) ):

V INT

ytm

INT

ytm

INT

yt b �

� �

� � �

�

/

/

/

/

/2

1 2

2

1 2

2

11 2( ) ( ) ( �

mm

M

ytm

INT ytm ytm

T T

T

/ /

/ /

2 1 2

2

1 1

1 2 2

2 2

2

) ( )

( )

� �

�

� �

⎡

⎣

⎢ ⎢⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

� �1 1 2 2[ ( )]ytm T/

par bond A bond in which the present value of the bond is equal to its face value.

par bond A bond in which the present value of the bond is equal to its face value.

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.

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.

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 value —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.

9 The term discount bond is also used to denote a zero-coupon bond.

10 As discussed in Appendix 3A to this chapter (located at the book’s Web site, www.mhhe.com/sc5e ), 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 ).

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80 Part 1 Introduction and Overview of Financial Markets

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(.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(r b ) is calculated as follows:

931 176 1 000 11

2

1 1

1 2 2

2 15

. , (. ) ( ) ( )

�

� � ytm ytm

/ /

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤⎤

⎦

⎥ ⎥ ⎥ ⎥

� �1 000 1 2 2 15, ( ) ( )/ /ytm

Solving for ytm , 11 the yield to maturity (or expected rate of return) on the

bond is 12 percent. 12 Equivalently, you would be willing to buy the bond only if the required rate of return ( r ) was no more than 12 percent.

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 stockholders. 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. 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, dividend growth, and stock value (price) will generally be highly correlated.

We begin by defining the variables we will use to value an equity:

D t � Dividend paid out 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.

Example 3–6 Calculation of Realized Rate of Return on a Stock Investment

Suppose you owned a stock for the last two years. You originally bought the stock two years ago for $25 ( P 0 ) and just sold it for $35 ( P 2 ). The stock paid an annual dividend of

LG 3-3LG 3-3

CALCULATOR HINTS N � 15(2) � 30 PV � �931.176 PMT � 110/2 � 55 FV � 1000 CPT I � 6.0 @ 6 months 6.0 2 � 12.0 @ year

11 Business calculators are programmed to easily solve for the yield to maturity on a security.

12 The yield to maturity is the nominal return on the bond. Its effective annual return is calculated as (see Chapter 2 ):

EAR ytm� � � � � � �( ) ( . ) . %1 2 1 1 12 2 1 12 362 2/ /

DO YOU UNDERSTAND:

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 ?

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Chapter 3 Interest Rates and Security Valuation 81

$1( D ) on the last day of each of the past two years. Your realized rate of return on the stock investment can be calculated using the following time value of money equation:

P D r

r P rs

s s0

2

2 2

1 1

1 1�

� �

� �/ ( )

( )

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

or

25 1 1

1

1 35 1

2 2�

� � �

−⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

( ) ( )

r r

rs s

s/

Solving for r s , your annual realized rate of return on this investment was 22.02 percent.

25 1 1 4912 35 0 6716� �( . ) ( . )

The expected rate of return, E(r s ) , 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 investment horizon.

Example 3–7 Calculation of Expected Rate of Return on a Stock Investment

You are considering the purchase of a stock that you expect to own for the next three years. The current market price of the stock is $32 ( P 0 ) and you expect to sell it for $45 in three years’ time (P 3 ). You also expect the stock to pay an annual dividend (D) of $1.50 on the last day of each of the next three years. Your expected return on the stock investment can be calculated using the following time value of money equation:

P D E r

E r P E rs

s s0

3

3

1 1

1 1�

� �

� � [ ( )]

( ) [ ( )]

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

/ 33

or

32 1 50 1

1

1 45 1

3

�

� �

� �. [ ( )]

( ) [ (

E r E r

E rs s

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

/ ss )] 3

Solving for E(r s ), your annual expected rate of return on this investment is 16.25 percent.

Finally, the required rate of return ( r s ) 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 dis- counted at the required rate of return ( r s )—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

D

rs 0

2 21 1

� �

� �

� � �

1 11

. . . ( ) ( ) ( )

D

r D

rs s

CALCULATOR HINTS N � 2 PV � �25 PMT � 1 FV � 35 CPT I � 22.02%

CALCULATOR HINTS N � 3 PV � �32 PMT � 1.50 FV � 45 CPT I � 16.25%

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82 Part 1 Introduction and Overview of Financial Markets

The price or value of a stock is equal to the present value of its future dividends (Dt) , 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 r s 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) nonconstant 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, D 0 � D 1 � D 2 � . . . � D � D . Accordingly, the equity valuation formula can be written as follows:

P

D

r

D

r

D

r D

rs s s s 0

1 1

2 21 1 1

1

1 �

� �

� � �

� �

�

( ) ( ) ( ) . . . a btt

t�

1 ∑

where

D0 � Current (time 0) value of dividends D t � Value of dividends at time t � 1, 2, . . . ,

or 13

P D rs0 � /

This formula can be generalized as follows:

P D rt 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 ( r s ) is applied to the formula, the price we solve for is the fair market price. If the expected return E(r s ) 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, P 0 .

14

r D Ps � / 0

If the fair market price is applied to this formula, the return we solve for is the required rate of return ( r s ). If the current market price is applied to the formula, the price we solve for is the expected return E(r s ). 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 market value.

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 expected rate of return, E(r s ) , on the stock is 12 percent. The current market value (or price) of this stock is calculated as follows:

P0 5 0 12 41 67� �/ . $ .

13 Remember that, in the limit:

1 1

1

1

1

1

1

11

1 2

� �

� �

� � �

� �

�

x x x x

t

t

⎛ ⎝⎜

⎞ ⎠⎟∑ a b a b a b� 11x

Thus:

a b1

1

1

1 � �

�

r rs

t

t s ∑

14 This is also referred to as the current dividend yield on a stock.

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Chapter 3 Interest Rates and Security Valuation 83

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, D 1 � D 0 (1 � g )

1 , D 2 � D 0 (1 � g ) 2 , . . . , D �

D 0 (1 � g ) . Accordingly, the equity valuation formula can now be written as follows:

P

D g

r

D g

r

D g

s s 0

0 1

1 0

2

2 01

1

1

1

1

1 �

�

� �

�

� � �

� ( )

( )

( )

( )

( )

( �

�� �

�

� �

r D

g

rs s

t

t)

( )

( )0 1

1

1 a b∑

or 15

P

D g

r g

D

r gs s 0

0 1

11� �

� �

�

( )

This formula can be generalized as follows:

P

D g

r g

D

r g t

t

s

t

s �

�

� �

� �0 11( )

If the required rate of return ( r s ) is applied to the formula, the price we solve for is the fair market price. If the expected return, E(r s ), 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 P 0 :

r

D g

P g

D

P gs �

� � � �0

0

1

0

1( )

If the fair market price is applied to the formula, the return we solve for is the required rate of return ( r s ). If the current market price is applied to the formula, the price we solve for is the expected return E(r s ) .

Example 3–9 Calculation of Stock Price with Constant Growth in Dividends

A stock you are evaluating 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 required rate of return (r s ) on the stock is 10 percent. The fair present value (or price) of this stock is calculated as follows:

P0

3 50 1 02

10 02 44 625�

�

� �

. ( . )

. . $ .

The investor would be willing to pay no more than $44.625 for this stock.

Example 3–10 Calculation of the Expected Rate of Return, E(r s ), on a Stock with Constant Growth in Dividends

A stock you are evaluating 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 this stock is calculated as follows:

E rs( )

. ( . ) . . %�

� � �

4 80 1 0175

52 0175 11 14

15 Remember that in the limit:

a b ° ¢1 1

1

1 1

1

1 1

�

� � �

�

� �

�

��

�

g

r r g

g

g

r gs

t

t

s

t

t s ∑ ∑

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84 Part 1 Introduction and Overview of Financial Markets

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 dividend growth, we calculate the present value of dividends during the two different growth peri- ods. A three-step process is used as follows:

Step 1: Find the present value of the dividends during the period of supernormal (nonconstant) 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

A stock you are evaluating is expected to experience supernormal growth in dividends of 10 percent, g s , 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 the stock is calculated as follows:

Step 1: Find the present value of the dividends during the period of supernormal growth.

Year Dividends ( D 0 (1 � g s ) t ) 1/(1 � .15) t Present Value

1 4(1 � .1) 1 � 4.400 .8696 3.826 2 4(1 � .1) 2 � 4.840 .7561 3.659 3 4(1 � .1) 3 � 5.324 .6575 3.500 4 4(1 � .1) 4 � 5.856 .5718 3.349 5 4(1 � .1) 5 � 6.442 .4972 3.203

Present value of dividends during supernormal growth period $17.537

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

D

r g

D g g

r gs

s

s 5

6 0 5 1 5 11 1 4 1 1 1 04

� �

� � �

� �

� �( ) ( ) ( . ) ( . )

.115 04 60 906

� �

. $ .

b. Find present value of constant growth dividends:

P P0 5 51 15 60 906 4972 30 283� � � �/( . ) . (. ) $ .

Step 3: Find present value of stock � Value during supernormal growth period � Value during normal growth period:

$ . $ . $ .17 537 30 283 47 820� �

DO YOU UNDERSTAND:

6. How stock valuation differs from bond valuation ?

7 . The difference between constant growth in dividends and supernormal growth in dividends ?

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Chapter 3 Interest Rates and Security Valuation 85

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, the fac- tors that affect financial security prices include interest rate changes, the time remaining to maturity, and the coupon rate. We evaluate next the impact of each of these factors as they affect bond prices. 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 � .1323 � 13.23%). Similarly, when the required rate of return increased from 10 percent to 12 percent, 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 .

IMPACT OF INTEREST RATE CHANGES ON SECURITY VALUESIMPACT OF INTEREST RATE CHANGES ON SECURITY VALUES

LG 3-4LG 3-4

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.

Figure 3–1 Relation between Interest Rates and Bond Values

Bond Value

Interest Rate

874.50 1,000 1,152.47

12%

10%

8%

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86 Part 1 Introduction and Overview of Financial Markets

Notice too from the earlier example that the inverse relationship between bond prices and interest rates is not linear. Rather, the percentage change in the present value of a bond to a given change in interest rates 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, investment 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 liabilities). 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.

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 matu- rity on the bond. A bond’s price sensitivity is measured by the percentage change in its present value for a given change in interest rates. The larger the percentage change in the bond’s value for a given interest rate change, the larger the bond’s price sensitivity. Specifi- cally, 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 (fair or current) 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 sensitivity 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 pres- ent value calculations using three bonds with identical characteristics except for the time to maturity: 12 years versus 14 years versus 16 years.

IMPACT OF MATURITY ON SECURITY VALUESIMPACT OF MATURITY ON SECURITY VALUES

LG 3-5LG 3-5

price sensitivity The percentage change in a bond’s present value for a given change in interest rates.

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 Percentage Percentage Percentage Rate of Fair Price Price Fair Price Price Fair Price Price Return Price* Change Change Price* Change Change Price* Change 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 10% coupon interest compounded semiannually and has a face value of $1,000.

DO YOU UNDERSTAND:

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 ?

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Chapter 3 Interest Rates and Security Valuation 87

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, remain- ing 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 interest rate, 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 � �.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 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 incre- mental 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 � �.1323 � �13.23%) decrease in the bond’s fair pres- ent value. The same 2 percent increase (from 8 percent to 10 percent) in the 14-year bond produces 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%). Increasing 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.

DO YOU UNDERSTAND:

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 ?

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88 Part 1 Introduction and Overview of Financial Markets

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. 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 two bonds with identical characteristics

IMPACT OF COUPON RATES ON SECURITY VALUESIMPACT OF COUPON RATES ON SECURITY VALUES

LG 3-5LG 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 Percentage Percentage Rate of Fair Price Price Fair Price Price Return Price* Change Change Price* Change 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.

Figure 3–2 The Impact of a Bond’s Maturity on Its Interest Rate Sensitivity

Time to Maturity

Absolute Value of Percent Change in a Bond's Price

for a Given Change in Interest Rates

12 14 16

13.23%

14.28%

15.16%

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Chapter 3 Interest Rates and Security Valuation 89

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 interest rates. The intuition behind this relation is as follows. 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 price. 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 price.

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 price, 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 price. 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 price 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.

Figure 3–3 The Impact of a Bond’s Coupon Rate on Its Interest Rate Sensitivity

Interest Rate

Bond Value

Low-Coupon Bond

High-Coupon Bond

DO YOU UNDERSTAND:

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 ?

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90 Part 1 Introduction and Overview of Financial Markets

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 straight- forward calculation of a bond’s interest rate sensitivity. In this section, we show that the price sensitivity of a bond, or the percent change in the bond’s fair present value, for a given change in interest rates (as discussed above) can be more directly measured by a concept called duration (or Macauley’s duration). We also show that duration produces an accurate measure of the price sensitivity 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, duration 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). 16 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 calculat- ing 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 interest rate sensitivity, is most accu- rate only for small changes in interest rates. Appendix 3A to this chapter, located at the book’s Web site ( www.mhhe.com/sc5e ), 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 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.

CF 1/2 is the $40 promised payment of (semiannual) coupon interest ($1,000 8% ½) received after six months. CF 1 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 payment

DURATIONDURATION

LG 3-6LG 3-6

duration The weighted-average time to maturity on an investment using the relative present values of the cash flows as weights.

duration The weighted-average time to maturity on an investment using the relative 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.

elasticity The percentage change in the price of a bond for a given change in interest rates.

16 In this sense, duration is to bonds what beta is to stocks. That is, beta is the change in the price of a security for a given change in the rate of return on a market portfolio. Thus, both duration and beta are measures of systematic risk.

Figure 3–4 Promised Cash Flows on the One- Year Bond

1/20 Year 1 Year

CF1 � $40 � $1,000CF1/2 � $40

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Chapter 3 Interest Rates and Security Valuation 91

of face value. To compare the relative sizes of these two cash flow payments—since dura- tion 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 interest rate is 10 percent per year, we calculate the present values ( PV ) of the two cash flows ( CF ) as:

CF PV

CF PV

1 2 1 2

1 1

40 40 1 05 38 10

1 040

/ /$ $ /( . ) $ .

$ , $

� � �

� � 11 040 1 05 943 31

981 41

2

1 2 1

, ( . ) $ .

$ ./

/ �

� �PV PV

Note that since CF 1 / 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 annual interest rate on the bond); this dis- count 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. 17

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:

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

17 Here we use the Treasury formula for calculating the present values of cash flows on a security that pays cash flows semiannually. We use 1/(1 � ½ R ) 2 to discount the one-year cash flow rather than 1/(1 � R ). This approach is more accurate, since it reflects the semiannual payment and compounding of interest on the bond.

Time ( t ) Weight ( X )

½ year X PV

PV PV1 2 1 2

1 2 1

38 10

981 41 0388 3 88/ � �

� � �/

/

.

. . . %

1 year X

PV

PV PV1 1

1 2 1

943 31

981 41 9612

1 0

96 12� �

� � � /

.

. .

.

. %%

%100

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 ( t 1 / 2 ) and 96.12 percent with the second payment of coupon plus face value at the end of the year ( t 1 ). By definition, the sum of the (present value) cash flow weights must equal 1:

X X1 2 1 1 0388 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 X t X tL � � � �

1 2 1 2 1 1 1

20388 9612 1 / /( ) ( )

. ( ) . ( ) �� .9806 years

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92 Part 1 Introduction and Overview of Financial Markets

Thus, although the maturity of the bond is one year, its duration or average life in a cash flow sense is only .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

CF t

r

CF

r

PV t

PV

t t

t

N

t t

t

N

t t

N

t t

�

�

�

�

�

�

�( )

( )

1

1

1

1

1 ∑

∑

∑

��1

N

∑ where

D � Duration measured in years t � 1 to T, the period in which a cash flow is received N � Number of periods to maturity CF t � Cash flow received on the security at end of period t r � Current required rate of return ( r ) or yield to maturity ( ytm ) on the investment PV 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: 18

D

CF t

r

CF

r

t t

t

N

t t

t

N�

�

�

�

�

( )

( )

/ 1 2

1 2

2 1 2

2 1 2

/

//

∑

∑

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 (which in an efficient market will be equal to the current market price). The numerator is the present value of each cash flow received on the security multi- plied 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.

Example 3–12 The Duration of a Four-Year Bond

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 3–7 for the calculation of its duration. As the calculation indicates, the duration, 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.

18 In general, the duration equation is written as:

D

CF t

r m

CF

r m

t mt

t m

N

t mt

t m

N�

�

�

�

�

( )

( )

/

/

1

1

1

1

/

/

∑

∑

where m � number of times per year interest is paid.

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Chapter 3 Interest Rates and Security Valuation 93

Table 3–8 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 3–9 , duration is calculated for the original 10 percent cou- pon bond, assuming that its rate of return ( r b ) increases from 8 percent to 10 percent. Now duration falls from 3.42 years (in Table 3–7 ) 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 3–10 , duration falls to 2.67 years (i.e., the shorter the matu- rity on the bond, the more quickly the initial investment is recovered).

The Duration of a Zero-Coupon Bond. Zero-coupon bonds sell at a discount from face value on issue 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 interest, 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 rb Tzc� �1 000 1 2 2, ( )/ /

where

r b � Required semiannually compounded rate of return or yield Tzc � Number of years to maturity

P � 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 Tzc 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 3–7 Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Yield

t CF t 1

(1 4%)� 2t

CFt 2t(1 4%)�

CF tt

2t

�

�(1 4%)

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

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94 Part 1 Introduction and Overview of Financial Markets

TABLE 3–10 Duration of a Three-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Yield

t CF t 1

(1 4%)� 2t

CFt 2t(1 4%)�

CF tt

2t

�

�(1 4%)

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

TABLE 3–9 Duration of a Four-Year Bond with 10 Percent Coupon Paid Semiannually and 10 Percent Yield

t CF t 1

(1 5%)� 2t

CFt 2t(1 5%)�

CF tt

2t

�

�(1 5%)

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

TABLE 3–8 Duration of a Four-Year Bond with 6 Percent Coupon Paid Semiannually and 8 Percent Yield

t CF t 1

(1 4%)� 2t

CFt 2t(1 4%)�

CF tt

2t

�

�(1 4%)

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 68

, .

. .3 60 years

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Chapter 3 Interest Rates and Security Valuation 95

Example 3–13 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 flows at the end of year 4:

t CF4 1

(1 8%/ 2)2 4� � CF4

2 4(1 8%/ 2)� � CFt �

� � 4

(1 8%/ 2)2 4

4 $1,000 0.7307 730 2,923

D � �2 923 730, / 4 years

or duration equals the maturity of the zero-coupon bond.

Features of Duration

The preceding examples suggest several important features of duration relating to the time remaining to maturity, yield to maturity, and coupon interest of the underlying bond being analyzed. These features are summarized in Table 3–11 .

Duration and Coupon Interest. A comparison of Tables 3–7 and 3–8 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 3–7 and 3–9 also indicates that duration decreases as rate of return 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 3–7 , 3–10 , and 3–12 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 3–7 and 3–10 ), duration decreases by 0.75 years, from 3.42 years to 2.67 years. Decreasing maturity for an additional year, from three years to two years ( Tables 3–10 and 3–12 ), decreases duration by 0.81 years, 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 years less than its maturity), while the three-year maturity bond has a duration of 2.67 years (0.33 years less than its maturity), and the four-year maturity bond has a duration of 3.42 years (0.58 years less than its maturity). Figure 3–6 illustrates this relation between duration and maturity for our 10 percent coupon (paid semiannually), 8 percent yield bond.

LG 3-7LG 3-7

TABLE 3–11 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.

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96 Part 1 Introduction and Overview of Financial Markets

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 interest rate sensitivity, or elasticity. 19 In other words, the larger the numerical value of duration ( D ), the more sensitive the price of that bond to (small) changes or shocks in interest rates. The specific relationship between these factors for securities with annual compounding of interest is represented as: 20

�

�

P P

r r D

b b

/

/( )1 � � �

LG 3-8LG 3-8

TABLE 3–12 Duration of a Two-Year Bond with 10 Percent Coupon Paid Semiannually and 8 Percent Yield

t CF t 1

(1 + 4%)2t

CFt 2t(1 4%)�

CF tt

2t

�

�(1 4%)

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

19 In Chapter 22 , we also make the direct link between duration and the interest rate 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.

20 In what follows, we use the � (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.

Figure 3–6 Discrepancy between Maturity and Duration on a Coupon Bond

Maturity (years)

Years

1 2 3 4 5

5

4

3

2

1

0

Duration

Maturity

Gap � Maturity � Duration

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Chapter 3 Interest Rates and Security Valuation 97

For securities with semiannual receipt (compounding) of interest, it is represented as:

�

�

P P

r r D

b b

/

/ /( )1 2� � �

The economic interpretation of this equation is that the number D is the interest elas-

ticity, or sensitivity, 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 fair or current value decrease —capital loss—on the security (� P / P ) for any given (discounted) small increase in interest rates (� r b /(1 � r b )), where � r b is the change in interest rates and 1 � r b 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 interest sensitivity:

� � �

�

�

P

P D

r

r b

b1

⎡ ⎣ ⎢

⎤ ⎦ ⎥

or

�

� � �

�

P

P D

r

r b

b1 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. 21

The duration equation can be rearranged, combining D and (1 � r b ) into a single vari- able D /(1 � r b ), to produce what practitioners call modified duration ( MD ). For annual compounding of interest:

� � � �

P

P MD rb

where

MD D

rb �

�1

For semiannual compounding of interest:

� � � �

P

P MD rb

where

MD D

rb �

�1 2/

This form is more intuitive than the Macauley’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.

modified duration Duration divided by 1 plus the interest rate.

modified duration Duration divided by 1 plus the interest rate.

21 By implication, gains and losses under the duration model are symmetric. That is, if we repeated the above examples but allowed interest rates to decrease by one basis point annually (or ½ basis point semiannually), the per- centage increase in the price of the bond (� 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.

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98 Part 1 Introduction and Overview of Financial Markets

The Interest-Paying Bond.

Example 3–14 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 (r b ). According to calculations in Table 3–7 , 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:

� � �

� �

P

P ( . )

.

.

.

3 42 001

1 04

00329

⎡ ⎣⎢

⎤ ⎦⎥

or

� �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. 22

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:

� � � � �

P

P ( . )

.

. .3 60

001

1 04 00346⎡

⎣⎢ ⎤ ⎦⎥

or

� �0 346. % for a 10-basis-point increase in the rate of return for each semiannual period. 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 a bond’s price for a given increase in interest rates.

Large Interest Rate Changes and Duration

It needs to be stressed here that duration accurately measures the price sensitiv- ity of financial 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 interest 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 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 representation of the reason for this. Note the difference in the change in a bond’s price due to inter- est 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.

22 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 � P � ( P )(� D )((� r b )/(1 � r b /2)) � ($1,067.34)(�3.42)(.001/1.04) � $3.51.

DO YOU UNDERSTAND:

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 interest elasticity ?

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Chapter 3 Interest Rates and Security Valuation 99

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, 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 security’s price. Thus, duration misestimates the final 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 property called convexity rather than linearity , as assumed by the simple duration model. Intuitively, this is because the sensi- tivity 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.

Example 3–15 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 3–7 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:

� � � � �

P

P 3 42 02 1 04 6 577. (. . ) . %/

or from a price of $1,067.34 to $997.14 (see point B in Figure 3–8 ). However, calculating the exact change in the bond’s price after a rise in rates to 10 percent, we find its true value is:

Vb � �

� �50

1 1

1 10 2 10 2

1 000 2 4[ (. )]

. ,

( )/ /

/

⎡

⎣

⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥

[[ (. )] $ ,( )1 10 2 1 0002 4� �/

convexity The degree of curvature of the price–interest rate curve around some interest rate level.

convexity The degree of curvature of the price–interest rate curve around some interest rate level.

Figure 3–7 Duration Estimated versus True Bond Price

True Relationship

Duration Model

Error

Error

P P

�D

�

rb (1 � rb)

�

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100 Part 1 Introduction and Overview of Financial Markets

This is point C in Figure 3–8 . As you can see, the true or actual fall in price is less than the predicted fall by $2.86. The reason for this is the natural convexity to the price-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 fell from 8 percent to 6 percent, resulting 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 as $1,140.39 by estimating the present value of the bond’s coupons and its face value with a 6 percent rate of return (see point E in Figure 3–8 ). The duration model has underpredicted the bond price increase by $2.85 ($1,140.39 � $1,137.54).

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–rate relationship is similar to buying partial interest rate risk insur- ance. 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.

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 non-constant rate zero.

To illustrate the third characteristic, we can take the four-year, 10 percent coupon, 8 percent yield bond and look at two extreme price–rate scenarios. What is the price on the

Figure 3–8 Price-Rate Curve for the Four-Year 10 Percent Coupon Bond

Rate (%)

Price (Vb)

6 8

E

D

A

B

C

10

$1,140.39

$1,137.54

$1,067.34

$1,000.00

$997.14

0

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Chapter 3 Interest Rates and Security Valuation 101

bond if rates fall to zero, and what is its price if rates rise to some very large number such as infinity? Where r b � 0:

Vb �

� �

� � �

� �

50

1 0

50

1 0

1 050

1 0 1 4001 2 8( ) ( )

,

( ) $ ,�

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 r b � ∞:

Vb �

� �

� � �

� �

50

1

50

1

1 050

1 01 2 8( ) ( )

,

( ) $�

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, located at the book’s Web site ( www.mhhe.com/sc5e ), 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 prediction of security price changes for a given change in interest rates.

Figure 3–9 The Natural Convexity of Bonds

�0

Price $1,400

Price–rate curve convexity

Yield (r)

SUMMARY This chapter applied the time value of money formulas presented in Chapter 2 to the valu- ation of financial securities such as equities and bonds. 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.

CHAPTER NOTATION

r � required rate of return CF t � cash flow received on a security at end of period t n � number of periods in the investment horizon PV � present value of a security E(r) � expected rate of return P or P � current market price for a security RCF t � realized cash flow in period t

w w

w .m

h h e .c

o m

/s c 5

e

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w w

w .m

h h e .c

o m

/s c 5

e 102 Part 1 Introduction and Overview of Financial Markets

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 T � 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 D t � dividend paid at the end of year t D � duration on a security measured in years N � last period in which the cash flow is received or number of periods to

maturity MD � modified duration � D /(1 � r )

QUESTIONS

1. 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.

2. What is the economic meaning of duration? ( LG 3-8 )

3. How is duration related to the interest elasticity of a fixed- income security? What is the relationship between duration and the price of a fixed-income security? ( 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 )

4. e celx Using a Spreadsheet to Calculate Bond Val-ues. What is the value of a $1,000 bond with a 12-year maturity and an 8 percent coupon rate (paid semi- annually) if the required return is 5 percent, 6 percent, 8 percent, and 10 percent? ( LG 3-2 )

Periodic The Bond Face Total Coupon Required Value Value Payments Payment Return ⇒ Will Be $1,000 12 2 � 24 1,000(.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. e celx 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 )

Periodic The Yield Market Total Coupon Face to Maturity Value Payments Payment Value ⇒ Will Be

945.50 10 2 � 20 1,000(.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 market con- ditions 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 interest rates 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

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e Chapter 3 Interest Rates and Security Valuation 103

the party selling the bond cannot remember. 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 cal- culations 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 semiannu- ally), face value of $1,000, and a required rate of return of 8 percent. ( 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 would 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 present value on a stock that pays $5 in divi- dends 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 return on the preferred stock is 5.4 percent, what is the 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 return on the pre- ferred stock is 6.8 percent, what is the 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 value of Safeco stock if the required return is 12 percent? ( LG 3-3 )

21. Financial analysts forecast Limited Brands (LTD) growth for the future to be 12.5 percent. LTD’s most recent divi- dend was $0.60. What is the value of Limited Brands’s stock when the required 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 is its expected price 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 expected rate of returns 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 return is 13 percent? ( LG 3-3 )

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e 104 Part 1 Introduction and Overview of Financial Markets

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: ( LG 3-4 ) 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 by 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. 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 return of 10 percent. The bond has a face value of $1,000. ( LG 3-4 ) a. What is the price of the bond? b. If interest rates rise to 11 percent, what is the price of the

bond? c. What has been the percentage change in price? d. Repeat parts (a), (b), and (c) for a 16-year bond. e. What do the respective changes in bond prices 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-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? 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 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, and is using dura- tion as its measure of interest rate risk: ( LG 3-6 ) a. $10,000 par value, coupon rate � 8%, r b � .10 b. $10,000 par value, coupon rate � 10%, r b � .10 c. $10,000 par value, coupon rate � 12%, r b � .10

What is the duration of each of the three bonds?

40. MLK Bank has an asset portfolio that consists of $100 million of 30-year, 8 percent 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 return of a bond you own fell by 0.50 percent from 9.75 percent to 9.25 percent, the price rose from $975 to $995. What is the duration of this bond? ( LG 3-8 )

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e Chapter 3 Interest Rates and Security Valuation 105

Go to the Federal Reserve Board’s Web site and get the latest rates on 10-year T-bond and Aaa- and Baa-rated corporate bonds.

Go to the Federal Reserve’s Web site at www.federalreserve.gov . Click on “Economic Research and Data.” Click on “Statistical Releases and Historical Data.” Click on “Selected Interest Rates: Weekly.” 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 2010. 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?

SEARCH THE SITE

APPENDIX 3A: Duration and Immunization

View this appendix at www.mhhe.com/sc5e

APPENDIX 3B: More on Convexity

View this appendix at www.mhhe.com/sc5e

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e Chapter 3 Interest Rates and Security Valuation 1

APPENDIX 3A: Duration and Immunization

In the body of the chapter, you learned how to calculate duration and came to understand that the duration measure has economic meaning because it indicates the interest sensitiv- ity or elasticity of an asset or liability’s value. For FIs, the major relevance of duration is as a measure for managing interest rate risk exposure. Also important is duration’s role in allowing an FI to hedge or immunize its balance sheet or some subset on that balance sheet against interest rate risk. The following sections consider two examples of an FI’s use of the duration measure for immunization purposes. The first is its use by insurance company and pension fund managers to help meet promised cash flow payments to policyholders or beneficiaries at a particular time in the future. The second is its use in immunizing or insulating an FI’s balance sheet against interest rate risk.

Duration and Immunizing Future Payments

Frequently, pension fund and life insurance company managers face the problem of structuring their asset investments so they can pay a given cash amount to policyholders in some future period. The classic example of this is an insurance policy that pays the holder some lump sum when the holder reaches retirement age. The risk to the life insurance company manager is that interest rates on the funds generated from investing the holder’s premiums could fall. Thus, the accumulated returns on the premiums invested could not meet the target or promised amount. In effect, the insurance company would be forced to draw down its reserves and net worth to meet its payout commitments. (See Chapter 15 for a discussion of this risk.)

Suppose that it is 2012 and the insurer must make a guaranteed payment to an inves- tor in five years, 2017. For simplicity, we assume that this target guaranteed payment is $1,469, a lump-sum policy payout on retirement, equivalent to investing $1,000 at an annually compounded rate of 8 percent over five years. Of course, realistically, this pay- ment would be much larger, but the underlying principles of the example do not change by scaling up or down the payout amount.

To immunize or protect itself against interest rate risk, the insurer needs to determine which investments would produce a cash flow of exactly $1,469 in five years, regardless of what happens to interest rates in the immediate future. By investing either in a five-year maturity and duration zero-coupon bond or a coupon bond with a five-year duration, the FI would produce a $1,469 cash flow in five years, no matter what happens to interest rates in the immediate future. Next we consider the two strategies: buying five-year deep-discount bonds and buying five-year duration coupon bonds.

Buy Five-Year Deep-Discount Bonds. Given a $1,000 face value and an 8 percent yield and assuming annual compounding, the current price per five-year discount bond is $680.58 per bond

P � �680 58 1 000

1 08 5 .

,

( . ) If the insurer buys 1.469 of these bonds at a total cost of $1,000 in 2012, these invest-

ments would produce $1,469 on maturity in five years. The reason is that the duration of this bond portfolio exactly matches the target horizon for the insurer’s future liability to its policyholders. Intuitively, since the issuer of the zero-coupon discount bonds pays no inter- vening cash flows or coupons, future changes in interest rates have no reinvestment income effect. Thus, the return would be unaffected by intervening interest rate changes.

Buy a Five-Year Duration Coupon Bond

Suppose that no five-year discount bonds exist. In this case, the portfolio manager may seek to invest in appropriate duration coupon bonds to hedge interest rate risk. In this exam- ple, the appropriate investment is in five-year duration coupon-bearing bonds. Consider a

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e 2 Part 1 Introduction and Overview of Financial Markets

six-year maturity bond with an 8 percent coupon paid annually, an 8 percent yield and $1,000 face value. The duration of this six-year maturity bond is computed as 4.993 years, or approximately 5 years (see Table 3–13 ). By buying this six-year maturity, five-year dura- tion bond in 2012 and holding it for five years until 2014, the term exactly matches the insurer’s target horizon. We show in the next set of examples that the cash flow generated at the end of five years is $1,469 whether interest rates stay at 8 percent or instantaneously (immediately) rise to 9 percent or fall to 7 percent. Thus, buying a coupon bond whose dura- tion exactly matches the investment time horizon of the insurer also immunizes the insurer against interest rate changes.

Example 3–16 Interest Rates Remain at 8 Percent

Assuming interest rates stay at 8 percent throughout the five years, the cash flows received by the insurer on the bond are as follows:

Coupons, 5 � $80 $ 400 Reinvestment income 69 Proceeds from sale of bond at end of the fifth year 1,000

$1,469

We calculate each of the three components of the insurer’s income from the bond invest- ment as follows:

Coupons. The $400 from coupons is simply the annual coupon of $80 received in each of the five years. Reinvestment income. Because the coupons are received annually, they can be rein- vested at 8 percent as they are received, generating an additional cash flow of $69. To understand this, consider the coupon payments as an annuity stream of $80 invested at 8 percent at the end of each year for five years. The future value of the annuity stream is calculated as $80 [[(1 � .08) 5 � 1]/.08] � 80(5.867) � $469. Subtracting the $400 of invested coupon payments leaves $69 of reinvestment income. Bond sale proceeds. The proceeds from the sale are calculated by recognizing that the six-year bond has just one year left to maturity when the insurance company sells it at the end of the fifth year (i.e., year 2014). That is:

↓ Sell $1,080

Year 5 Year 6 (2017) (2018)

1. 2. 3.

1.

2.

3.

TABLE 3–13 The Duration of a Six-Year Bond with 8 Percent Coupon Paid Annually and an 8 Percent Yield

t CFt 1

(1 8%)� t CFt

t(1 8%)� CF tt

t

× (1 8%)�

1 80 0.9259 74.07 74.07

2 80 0.8573 68.59 137.18

3 80 0.7938 63.51 190.53

4 80 0.7350 58.80 235.20

5 80 0.6806 54.45 272.25

6 1,080 0.6302 680.58 4,083.48

1,000.00 4,992.71

D � 4,992.71/1,000.00 � 4.993 years

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e Chapter 3 Interest Rates and Security Valuation 3

What fair market price can the insurer expect to receive upon selling the bond at the end of the fifth year with one year left to maturity? A buyer would be willing to pay the present value of the $1,080—final coupon plus face value—to be received at the end of the one remaining year, or:

P5

1 080

1 08 1 000� �

.

. $ .

Thus the insurer would be able to sell the one remaining cash flow of $1,080, to be received in the bond’s final year, for $1,000.

Next we show that since this bond has a duration of five years, matching the insur- er’s target period, even if interest rates were to instantaneously fall to 7 percent or rise to 9 percent, the expected cash flows from the bond still would sum exactly to $1,469. That is, the coupons plus reinvestment income plus principal received at the end of the fifth year would be immunized. In other words, the cash flows on the bond are protected against interest rate changes.

Example 3–17 Interest Rates Fall to 7 Percent

In this example with falling interest rates, the cash flows over the five years are as follows:

Coupons, 5 � $80 $ 400 Reinvestment income 60 Bond sale proceeds 1,009 $1,469

Thus, the amount of the total proceeds over the five years is unchanged from proceeds gen- erated when interest rates were 8 percent. To see why this occurs, consider what happens to the three parts of the cash flow when rates fall to 7 percent:

Coupons. These are unchanged, since the insurer still receives five annual coupons of $80 ($400). Reinvestment income. The coupons can now be reinvested only at the lower rate of 7 percent. Thus, at the end of five years $80 [[(1.07) 5 � 1]/.07] � 80(5.751) � $460. Subtracting the $400 in original coupon payments leaves $60. Because interest rates have fallen, the investor has $9 less in reinvestment income at the end of the five-year planning horizon. Bond sale proceeds. When the six-year maturity bond is sold at the end of the fifth year with one cash flow of $1,080 remaining, investors would be willing to pay more:

P5

1 080

1 07 1 009� �

,

. $ ,

That is, the bond can be sold for $9 more than when rates were 8 percent. The reason is that investors can get only 7 percent on newly issued bonds, but this older bond was issued with a higher coupon of 8 percent.

A comparison of reinvestment income with bond sale proceeds indicates that the decrease in rates has produced a gain of $9 on the bond sale proceeds. This offsets the loss of reinvestment income of $9 as a result of reinvesting at a lower interest rate. Thus, total cash flows remain unchanged at $1,469.

1. 2. 3.

1.

2.

3.

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e 4 Part 1 Introduction and Overview of Financial Markets

Example 3–18 Interest Rates Rise to 9 Percent

In this example with rising interest rates, the proceeds from the bond investment are as follows:

Coupons, 5 � $80 $ 400 Reinvestment income 80 [[[(1.09) 5 � 1]/.09] � 400] 78 Bond sale proceeds (1,080/1.09) 991

$1,469

Notice that the rise in interest rates from 8 to 9 percent leaves the final terminal cash flow unaffected at $1,469. The rise in rates has generated $9 extra reinvestment income ($78 � $69), but the price at which the bond can be sold at the end of the fifth year has declined from $1,000 to $991, equal to a capital loss of $9. Thus, the gain in reinvestment income is exactly offset by the capital loss on the sale of the bond.

The preceding examples demonstrate that matching the duration of a coupon bond to the FI’s target or investment horizon immunizes it against instantaneous shocks to interest rates. The gains or losses on reinvestment income that result from an interest rate change are exactly offset by losses or gains from the bond proceeds on sale.

1. 2. 3.

APPENDIX 3B: More on Convexity

In the main text of this chapter, we explained why convexity is a desirable feature for assets. In this appendix we then ask: Can we measure convexity? And can we incorporate this measurement in the duration model to adjust for or offset the error in prediction due to its presence? The answer to both questions is yes.

Theoretically speaking, duration is the slope of the price–rate curve, and convexity, or curvature, is the change in the slope of the price–rate curve. Consider the total effect of a change in interest rates on a bond’s price as being broken into a number of separate effects. The precise mathematical derivation of these separate effects is based on a Taylor series expansion that you might remember from your math classes. Essentially, the first-order effect ( dP/dr ) of an interest rate change on the bond’s price is the price–rate curve slope effect, which is measured by duration. The second-order effect ( dP 2 / d 2 r ) measures the change in the slope of the price–rate curve; this is the curvature or convexity effect. There are also third-, fourth-, and higher-order effects from the Taylor series expansion, but for all practical purposes these effects can be ignored.

We have noted that overlooking the curvature of the price–rate curve may cause errors in predicting the interest sensitivity of a portfolio of assets and liabilities, especially when interest rates change by large amounts. We can adjust for this by explicitly recognizing the second-order effect of interest rate changes by measuring the change in the slope of the price–rate curve around a given point. Just as D (duration) measures the slope effect ( dP/dr ), we introduce a new parameter ( CX ) to measure the curvature effect ( dP 2 / d 2 r ) of the price–rate curve.

The resulting equation, predicting the change in a security’s price (� P / P ), is:

� � �

�

� � �

P

P D

r

r CX r

( ) ( )

1

1

2 2

(1)

or:

� � � � �

P

P MD r CX r

1

2 2( )�

(2)

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e Chapter 3 Interest Rates and Security Valuation 5

The first term in Equation 1 is the simple duration model that over- or underpredicts price changes for large changes in interest rates, and the second term is the second-order effect of interest rate changes, that is, the convexity or curvature adjustment. In Equation 1, the first term D can be divided by 1 � r to produce what we called earlier modified dura- tion (MD). You can see this in Equation 2. This form is more intuitive because we multiply MD by the simple change in r (� r ) rather than by the discounted change in r (� r /(1 � r )). In the convexity term, the numbers 1/2 and (� r ) 2 result from the fact that the convexity effect is the second-order effect of interest rate changes while duration is the first-order effect. The parameter CX reflects the degree of curvature in the price–rate curve at the current interest rate level, that is, the degree to which the capital gain effect exceeds the capital loss effect for an equal change in rates up or down. At best, the FI manager can only approximate the curvature effect by using a parametric measure of CX. Even though calculus is based on infinitesimally small changes, in financial markets the smallest change in interest rates normally observed is one basis point, or a 1/100 of 1 percent change. One possible way to measure CX is introduced next.

As just discussed, the convexity effect is the degree to which the capital gain effect more than offsets the capital loss effect for an equal increase and decrease in interest rates at the current interest rate level. In Figure 3–10 we depict rates changing upward by one basis point ( r �.01%) and downward by one basis point ( r � .01%). Because convexity measures the curvature of the price–rate curve around the rate level r percent, it intuitively measures the degree to which the capital gain effect of a small rate decrease exceeds the capital loss effect of a small rate increase. 23 By definition, the CX parameter equals:

CX � Scaling

factor

The capital

loss from a one- basiss-point rise

in rates negative effect

The capi

( )

�

ttal

gain from a

one-basis-point

fall in rates pos( iitive effect)

⎡

⎣

⎢ ⎢ ⎢ ⎢ ⎢ ⎢ ⎢

⎤

⎦

⎥ ⎥ ⎥ ⎥ ⎥ ⎥ ⎥

The sum of the two terms in the brackets reflects the degree to which the capital gain effect exceeds the capital loss effect for a small one-basis-point interest rate change down and up. The scaling factor normalizes this measure to account for a larger 1 percent change

Figure 3–10 Convexity and the Price–Rate Curve

P+

P

P–

Price

Capital gain

Capital loss

r–.01% r % r+.01% Interest rate

23 We are trying to approximate as best we can the change in the slope of the price-rate curve at r percent. In theory, the changes are infinitesimally small ( dr ), but in reality, the smallest yield change normally observed is one basis point (� r ).

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in rates. Remember, when interest rates change by a large amount, the convexity effect is important to measure. A commonly used scaling factor is 10 8 so that: 24

CX

P

P

P

P �

� � �

� � 108 ⎡

⎣⎢ ⎤ ⎦⎥

Calculation of CX. To calculate the convexity of an 8 percent coupon, 8 percent rate of return, six-year maturity Eurobond that has a price of $1,000: 25

CX � �

� �

10 999 53785 1 000

1 000

1 000 46243 1 008 . ,

,

, . , 00

1 000, ⎡ ⎣⎢

⎤ ⎦⎥

Capital loss from

a one-basis-pooint

increase in rates

Capital gain from

a o� nne-basis-point

decrease in rates

CX � 10 0 008[ . 0000028 28

] CX �

This value for CX can be inserted into the bond price prediction Equation 2 with the convexity adjustment:

� � � � � �

P

P MD r rb b

1

2 28 2( )

Assuming a 2 percent increase in r b (from 8 percent to 10 percent):

� � � �

� �

P

P

4 993

1 08 02

1

2 28 02

0925

2.

. . ( )(. )

.

⎡ ⎣⎢

⎤ ⎦⎥

�� � � �. . . %0056 0869 8 69or The simple duration model (the first term) predicts that a 2 percent rise in interest rates

will cause the bond’s price to fall 9.25 percent. However, for large changes in rates, the dura- tion model overpredicts the price fall. The duration model with the second-order convexity adjustment predicts a price fall of 8.69 percent; it adds back 0.56 percent due to the convexity effect. This is much closer to the true fall in the six-year, 8 percent coupon bond’s price if we calculated this using 10 percent to discount the coupon and face value cash flows on the bond. The true value of the bond price fall is 8.71 percent. That is, using the convexity adjustment reduces the error between the predicted value and true value to just a few basis points. 26

In Table 3–14 we calculate various properties of convexity, where:

T � Time to maturity r b � Rate of return or yield C � Annual coupon D � Duration CX � Convexity

Part 1 of Table 3–14 shows that as the bond’s maturity ( T ) increases, so does its convex- ity ( CX ). As a result, long-term bonds have more convexity—which is a desirable property— than do short-term bonds. This property is similar to that possessed by duration. 27

24 This is consistent with the effect of a 1 percent (100 basis points) change in rates.

25 You can easily check that $999.53785 is the price of the six-year bond when rates are 8.01 percent and $1,000.46243 is the price of the bond when rates fall to 7.99 percent. Since we are dealing in small numbers and con- vexity is sensitive to the number of decimal places assumed, use at least five decimal places in calculating the capital gain or loss. In fact, the more decimal places used, the greater the accuracy of the CX measure.

26 It is possible to use the third moment of the Taylor series expansion to reduce this small error (8.71 percent versus 8.69 percent) even further. In practice, few people do this.

27 Note that the CX measure differs according to the level of interest rates. For example, we are measuring CX in Table 3–14 when rates are 8 percent. If rates were 12 percent, the CX number would change. This is intuitively rea- sonable, as the curvature of the price–rate curve differs at each point on the price–rate curve. Note that duration also changes with the level of interest rates.

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e Chapter 3 Interest Rates and Security Valuation 7

Part 2 of Table 3–14 shows that coupon bonds of the same maturity ( T ) have less convexity than do zero-coupon bonds. However, for coupon bonds and discount or zero- coupon bonds of the same duration, part 3 of the table shows that the coupon bond has more convexity. We depict the convexity of both in Figure 3–11 .

Finally, before leaving convexity, we might look at one important use of the concept by managers of insurance companies, pension funds, and mutual funds. Remembering that con- vexity is a desirable form of interest rate risk insurance, FI managers could structure an asset portfolio to maximize its desirable effects. As an example, consider a pension fund manager with a 15-year payout horizon. To immunize the risk of interest rate changes, the manager purchases bonds with a 15-year duration. Consider two alternative strategies to achieve this:

Strategy 1: Invest 100 percent of resources in a 15-year deep-discount bond with an 8 percent rate of return.

Strategy 2: Invest 50 percent in the very short-term money market (federal funds) and 50 percent in 30-year deep-discount bonds with an 8 percent rate of return.

The duration ( D ) and convexities ( CX ) of these two asset portfolios are:

Strategy 1: D � 15, CX � 206 Strategy 2: 28 D � ½ (0) � ½(30) � 15, CX � ½(0) � ½(797) � 398.5

28 The duration and convexity of one-day federal funds are approximately zero.

TABLE 3–14 Properties of Convexity

1. Convexity Increases with Bond Maturity 2. Convexity Varies with

Coupon

3. For Same Duration, Zero-Coupon Bonds Are

Less Convex than Coupon Bonds

Example Example Example

A B C A B A B

T � 6 T � 18 T � � T � 6 T � 6 T � 6 T � 5

rb � 8% rb � 8% rb � 8% rb � 8% rb � 8% rb � 8% rb � 8%

C � 8% C � 8% C � 8% C � 8% C � 0% C � 8% C � 0%

D � 5 D � 10.12 D � 13.5 D � 5 D � 6 D � 5 D � 5

CX � 28 CX � 130 CX � 312 CX � 28 CX � 36 CX � 28 CX � 25.72

ΔP P

–MD = –D = –4.62 1 + rb

0

Coupon bond

Discount bond

Δrb

Figure 3–11 Convexity of a Coupon versus a Discount Bond with the Same Duration

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e 8 Part 1 Introduction and Overview of Financial Markets

Strategies 1 and 2 have the same durations, but strategy 2 has a greater convexity. Strategy 2 is often called a barbell portfolio, as shown in Figure 3–12 by the shaded bars. 29 Strategy 1 is the unshaded bar. To the extent that the market does not price (or fully price) convexity, the barbell strategy dominates the direct duration matching strategy (number 1). 30

More generally, an FI manager may seek to attain greater convexity in the asset port- folio than in the liability portfolio, as shown in Figure 3–13 . As a result, both positive and negative shocks to interest rates would have beneficial effects on the FI’s net worth. 31

Figure 3–12 Barbell Strategy

100%

50%

Percent of portfolio

0 15 30 Duration

29 This is called a barbell because the weights are equally loaded at the extreme ends of the duration range or bar as in weight lifting.

30 In a world in which convexity is priced, the long-term 30-year bond’s price would rise to reflect the competition among buyers to include this more convex bond in their barbell asset portfolios. Thus, buying bond insurance—in the form of the barbell portfolio—would involve an additional cost to the FI manager. In addition, to be hedged in both a duration sense and a convexity sense, the manager should not choose the convexity of the asset portfolio without seek- ing to match it to the convexity of its liability portfolio.

31 Another strategy would be for the FI to issue callable bonds as liabilities. Callable bonds have limited upside capital gains because if rates fall to a low level, then the issuer calls the bond in early (and reissues new lower coupon bonds). The effect of limited upside potential for callable bond prices is that the price–rate curve for such bonds exhib- its negative convexity. Thus, if asset investments have positive convexity and liabilities have negative convexity, then interest rate shocks (whether positive or negative) are likely to produce net worth gains for the FI.

Figure 3–13 Assets Are More Convex than Liabilities

Asset, Liability, Equity Value ($)

Interest Ratesrb+2%rb�2% rb%

Assets

Liabilities

Equity

Equity Equity

{ }

}

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106

MAJOR DUTIES AND RESPONSIBILITIES OF THE FEDERAL RESERVE SYSTEM: CHAPTER OVERVIEW The Federal Reserve (the Fed) is the central bank of the United States. Founded by Con- gress under the Federal Reserve Act in 1913, the Fed’s original duties were to provide 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) and the last decades of the 19th century. As time passed, additional legislation, including the Banking Act of 1935, the Full Employ- ment 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 objec- tives of the Federal Reserve System. These objectives included economic growth in line with the economy’s potential to expand, a high level of employment, stable prices, and moderate long-term interest rates.

part one Introduction and Overview of Financial Markets

The Federal Reserve System, Monetary Policy, and Interest Rates

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

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.

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

chap te r

4

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 107

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 bodies in the world and was critical in implementing policies to address the worldwide financial 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 func- tions: (1) conducting monetary policy, (2) supervising and regulating depository institu- tions, (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 for- eign 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 crisis (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.

The Federal Reserve System consists of 12 Federal Reserve Banks located in major cit- ies throughout the United States and a seven-member Board of Governors located in Washington, D.C. This structure was implemented in 1913 to spread power along regional lines, between the private sector and the government, and among bankers, business peo- 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 bank- ing system as a whole, each Reserve bank acts as a depository institution for the banks in its district. In terms of total assets, the three largest Federal Reserve Banks are the New York, Chicago, and San Francisco banks. Together these three banks hold over 50 percent of the total assets (discussed later) of the Federal Reserve System. The New York Federal Reserve Bank 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.

Federal Reserve Banks operate under the general supervision of the Board of Gov- ernors of the Federal Reserve based in Washington, D.C. Each Federal Reserve Bank has its own nine-member Board of Directors that oversees its operations: six are elected by member banks in the district (three are professional bankers and three are business- people) and 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.

LG 4-1LG 4-1

STRUCTURE OF THE FEDERAL RESERVE SYSTEMSTRUCTURE OF THE FEDERAL RESERVE SYSTEM

LG 4-2LG 4-2

www. federalreserve .gov

www. federalreserve .gov

www.newyorkfed .org www.newyorkfed .org

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108 Part 1 Introduction and Overview of Financial Markets

Nationally chartered banks, those chartered by the federal government through the Office of the Comptroller of the Currency (OCC), 1 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. 2 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 40 percent of all U.S. banks (holding over 80 percent of the total assets in the U.S. banking system) are currently members of the Federal Reserve System.

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

www.occ.treas .gov www.occ.treas .gov

Figure 4–1 Federal Reserve Districts

1 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 ).

2 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 ).

Source : Federal Reserve Board Web site, “The Structure of the Federal Reserve System,” July 2010. www

.federalreserve.gov

Buffalo 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, D.C.

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

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 109

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, D.C. 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. 3 Board members are often individuals with Ph.D. 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 chairman and vice chairman 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 government 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 conduct of monetary policy and the supervision and regulation of banks. All seven Board members 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 Fed- eral 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). 4 The Fed also shares supervisory and regu- latory responsibilities with state supervisors 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, com- mercial lending subsidiaries, and representative offices of foreign banks in the United States. The Board approves member bank mergers and acquisitions and specifies permis- sible 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).

The chairman of the Federal Reserve Board, currently Ben Bernanke, often advises the president of the United States on economic policy and serves as the spokesperson for the Federal 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.

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 above, 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

www.occ.treas .gov www.occ.treas .gov

www.fdic.gov www.fdic.gov

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

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

3 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.

4 An Edge Act corporation is a subsidiary of a federally chartered domestic bank holding company that generally specializes 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.

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110 Part 1 Introduction and Overview of Financial Markets

(on a rotating basis). The chairman 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, D.C. 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, not only do its actions affect 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 functions. These include assistance in the conduct of monetary policy, supervision and reg- ulation of member banks, consumer protection, and the provision of services such as new currency issue, check clearing, wire transfer, and research services to the federal govern- ment, 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 extraordi- nary services in many of these areas in response to the recent financial crisis.

Assistance in the Conduct of Monetary Policy. As mentioned above, 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. Furthermore, in an increasingly global economy, activities of the Federal Reserve and the international economy influence each other. Therefore, when deciding on an appropriate monetary policy for achieving basic economic goals, the Fed considers the record of U.S. international transactions, movements

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

open market operations Purchases and sales of U.S. government and federal 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 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.

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111

IN THE NEWS

In the first half of 2007, as the extent of

declining home prices became apparent,

banks and other financial market partici-

pants started to reassess the value of

mortgages and mortgage-backed securi-

ties that they owned, especially those in

the subprime segment of the housing mar-

ket. 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 reluc-

tance to lend to one another for terms

much longer than overnight. This reluc-

tance was reflected in a dramatic rise in

the London Interbank Offered Rate (LIBOR)

at most maturities greater than overnight.

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 volatility, with many interest rate

spreads at historically high levels.

In response to this turbulence, the Fed

and the federal government have taken a

series of dramatic steps. As 2007 came

to a close, the Federal Reserve Board

announced the creation of a Term Auction

Facility (TAF), in which fixed amounts of

term funds are auctioned to depository

institutions against any collateral eligible

for discount window loans. So while the

TAF substituted an auction mechanism for

the usual fixed interest rate, this facility

can be seen essentially as an extension

of more conventional discount window

lending. 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 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 unavailable in the mar-

ket, to institutions (the primary dealers)

beyond those banks that typically borrow

at the discount window. . .

In the fall of 2008, financial markets

worldwide experienced another round of

heightened volatility and historic changes:

Lehman Brothers filed for Chapter 11

bankruptcy protection; 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 purchased National City

Corporation; and the American Interna-

tional 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 tremen-

dous 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

last two years has taken the form of

expanded lending by the Fed and central

banks in other countries. The exten-

sion 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 supply at the

time the Fed was created. Over time, open

market operations, in which the Fed buys

and sells securities in transactions with

market participants, have become the main

tool for managing the money supply. Lend-

ing has became 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.

In this way, the discount window became

a tool for dampening day-to-day fluctua-

tions 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 wide-

spread 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: Federal Reserve Bank of Rich-

mond Annual Report 2008 , April 2009,

by Aaron Steelman and John A. Weinberg.

The Financial Crisis: Toward an Explanation and Policy Response

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112 Part 1 Introduction and Overview of Financial Markets

in foreign exchange rates, and other international economic developments. Federal Reserve Banks conduct monetary policy in several ways. For example, as discussed above, 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 securities and, therefore, interest rates. 5 The Boards of Directors of each Fed- eral Reserve Bank set and change the discount rate (the interest rate on loans made by Federal Reserve Banks to depository 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 dis- count 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 reces- sion, the Federal Reserve approved 11 decreases in the discount (and federal funds) rate in 2001. Additionally, as noted in the In the News box and as discussed in detail below, during the financial crisis, the Fed dropped the discount rate (and the fed funds rate) to historic lows, changed the terms of its discount window lending to banks, and created new lending facilities.

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. 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.

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, innova- tions in international banking require continual assessments of, and occasional modifica- tions 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 a financial regulation overhaul bill (the Wall Street Reform and Consumer Protection Act) which called for the Fed to super- vise the most complex financial companies in the United States and gave regulators (includ- ing the Fed) authority to seize and break up any troubled financial firm whose collapse might cause widespread 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

discount rate The interest rate on loans made by Federal Reserve Banks to deposi- tory institutions.

discount rate The interest rate on loans made by Federal Reserve Banks to deposi- tory institutions.

discount window The facility through which Federal Reserve Banks issue loans to depository institutions.

discount window The facility through which Federal Reserve Banks issue loans to depository institutions.

5 The president of the New York Federal Reserve Bank always sits on the FOMC. The other four positions are allocated to the other Federal Reserve districts on a rotating annual basis.

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 113

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, commu- nity affairs offices at FRBs engage in a wide variety of activities to help financial institu- tions, community-based organizations, government entities, and the public understand and address financial services issues that affect low and moderate-income people and geo- graphic regions.

Government Services. As discussed above, the Federal Reserve serves as the com- mercial 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 deposits relating to federal unemployment taxes, individual income taxes with- held by payroll deduction, and so on. Further, some of these deposits are not protected by deposit insurance 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 secu- rities, 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 resulting from the Y2K scare.

Check Clearing. Over 30 billion checks are written in the United States each year. About 15 billion of these checks are deposited in the same institution on which the check was written (called “on-us” checks). The Federal Reserve System operates a central check clearing system for U.S. banks, routing interbank checks to depository institutions on which they are written and transferring the appropriate funds from one bank to another. About 30 percent of these interbank checks, over 8.5 billion per year, are processed by this system. 6 Table 4–2 shows the number and value of checks collected by the Federal Reserve Banks from 1920 through 2009. The number of checks cleared through the system peaked in 1990, with over 18 billion checks cleared. However, industry consolidation 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. All depository institutions have accounts with the Federal Reserve Bank in their district for this purpose.

In October 2004, new legislation allowed banks to destroy checks after taking a digital image that is then processed electronically. The Check 21 Act, enacted by Congress and the Federal Reserve, 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 fly 42 billion checks a year around the United States, threatening to disrupt the financial system. Further, the decline in overall check volume, caused by industry consolidation and greater use of electronic products, has brought a rise in processing costs. As banks look

6 The remainder are processed through private check-clearing systems.

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114 Part 1 Introduction and Overview of Financial Markets

for ways to reduce operating costs, switching to electronic processing of checks will save as much as $3 billion a year for the banking industry. For customers, the implications are mixed. Because checks will be processed much more quickly, check writers will lose 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 Systems. This network allows these institutions to transfer funds and securities nationwide in a matter of minutes. Two electronic (wire) transfer systems are operated by the Federal Reserve: Fedwire and the Automated Clearinghouse (ACH). Fedwire is a network linking more than 9,000 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 large corporate customers. 7 Fedwire transfers are typically large dollar payments (averaging almost $3.0 million per transaction). Table 4–3 shows the number and dollar value of Fedwire transactions processed by Federal Reserve banks from 1920 through 2009. The Automated Clearinghouse (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 electronically process credit and debit transfers of funds. Table 4–4 shows the number and dollar value of ACH transactions processed by Federal Reserve Banks from 1975 through 2009.

Research Services. Each Federal Reserve Bank has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sector as well as the overall economy. These research projects are often used in the conduct of monetary policy by the Federal Reserve.

Balance Sheet of the Federal Reserve

Table 4–5 shows the balance sheet for the Federal Reserve System as of March 2010. 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.

TABLE 4–2 Number and Value of Checks Cleared by the Federal Reserve

Number of Checks Cleared Value of Checks Cleared Year (in billions) (in trillions of dollars)

1920 0.42 $ 0.15 1930 0.91 0.32 1940 1.18 0.28 1950 1.96 0.86 1960 3.42 1.15 1970 7.16 3.33 1980 15.72 8.04 1990 18.60 12.52 2000 16.99 13.85 2005 12.23 15.68 2009 8.58 13.76

Source : Federal Reserve Board Web site, “Payment Systems,” various dates. www.federalreserve.gov

7 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.

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 115

TABLE 4–3 Number and Value of Fedwire Transactions Processed by the Federal Reserve

Number of Transactions Value of Transactions Year (in millions) (in trillions of dollars)

1920 0.5 $ 0.03 1930 2.0 0.20 1940 0.8 0.09 1950 1.0 0.51 1960 3.0 2.43 1970 7.0 12.33 1980 43.0 78.59 1990 62.6 199.07 2000 108.3 379.76 2005 132.4 518.50 2009 124.7 631.10

Source : Federal Reserve Board Web site, “Payment Systems,” various dates. www.federalreserve.gov

TABLE 4–4 Number and Value of ACH Transactions Processed by the Federal Reserve

Number of Transactions Value of Transactions Year (in millions) (in trillions of dollars)

1975 6 $ 0.09 1980 227 0.29 1990 1,435 4.66 2000 4,651 14.02 2005 8,303 15.96 2009 11,161 19.72

Source : Federal Reserve Board Web site, “Payment Systems,” various dates. www.federalreserve.gov

TABLE 4–5 Balance Sheet of the Federal Reserve ( in billions of dollars)

Assets

Gold and foreign exchange $ 35.4 1.5% SDR certificates 5.2 0.2 Treasury currency 42.7 1.8 Federal Reserve float −1.6 −0.0 Federal Reserve loans to domestic banks 11.5 0.5 Security repurchase agreements 0.0 0.0 U.S. Treasury securities 776.7 33.2 U.S. government agency securities 1,237.7 52.9 Miscellaneous assets 231.1 9.9 Total assets 2,338.7 100.0%

Liabilities and Equity

Depository institution reserves $1,053.9 45.1% Vault cash of commercial banks 51.9 2.2 Deposits due to federal government 216.7 9.3 Deposits due to government agencies 19.3 0.8 Currency outside banks 882.7 37.7 Security repurchase agreements 57.8 2.5 Miscellaneous liabilities 4.1 0.2 Federal Reserve Bank stock 26.3 1.1 Equity 26.0 1.1 Total liabilities and equity $2,338.7 100.0%

Source : Federal Reserve Board, “Flow of Fund Accounts,” Monetary Authority, June 2010, p. L.108.

www.federalreserve.gov

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116 Part 1 Introduction and Overview of Financial Markets

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.

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 circulation 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 (45.1 percent of total liabilities and equity) is commercial bank reserves (depository institution reserves and vault cash of commercial banks). 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 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, 8 banks try to keep excess reserves to a minimum. 9 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 DIs. Specifically, in October 2008 the Federal Reserve began paying interest on excess reserves for the first time. Further, during the finan- cial crisis, the Fed set the interest rate it paid on excess reserves equal to its target for the fed- eral 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. For example, in March 2010, depository institution reserves were 45.1 percent of total liabilities and equity of the Fed. This was up from 3.5 percent in June 2008, 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

reserves Depository institutions’ vault cash plus reserves deposited at Federal Reserve Banks.

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 Fed- eral Reserve.

monetary base Currency in circulation and reserves (depository institution reserves and vault cash of commercial banks) held by the Fed- eral Reserve.

required reserves Reserves the Federal Reserve requires banks to hold.

required reserves Reserves the Federal Reserve requires banks to hold.

excess reserves Additional reserves banks choose to hold.

excess reserves Additional reserves banks choose to hold.

8 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.

9 The minimum daily average reserves that a bank must maintain are computed as a percentage of the daily average net transaction accounts held by the bank over the two-week computation period, called the reserve computation period. Transaction accounts include all deposits on which an account holder may make withdrawals (for example, demand deposits, NOW accounts, and share draft accounts—offered by credit unions). Transaction account balances are reduced by demand balances due from U.S. depository institutions and cash items in process of collection to obtain net transaction accounts. Under the current set of regulations, a lag of 30 days exists between the beginning of the reserve computation period and the beginning of the reserve maintenance period (over which deposits at the Federal Reserve Bank must meet or exceed the required reserve target less vault cash).Thus, the bank’s reserve manager knows the value of its target reserves with perfect certainty throughout the reserve maintenance period. See Chapter 13 for more specific details.

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 117

ineffective. 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 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.

Currency Outside Banks. The second largest liability, in terms of percent of total lia- bilities and equity, of the Federal Reserve System is currency in circulation (37.7 percent of total liabilities and equity). 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 ).

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 loans to domestic banks are quite a small portion of the Federal Reserve’s assets, they play an important role in implementing monetary policy (see below).

U.S. Government Agency Securities. In 2010, U.S. government agency securities were the largest asset account on the Fed’s balance sheet (52.9 percent of total assets). However, in June 2008, 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 mar- kets during the financial crisis by buying mortgage-backed securities (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 March 31, 2010. Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial markets.

Treasury Securities. Treasury securities (33.2 percent of total assets) are 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 securi- ties. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply.

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.

Loans to Domestic Banks. As mentioned earlier, depository institutions in need of addi- tional 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) loans to domestic banks are normally a relatively small portion of the Fed’s total assets.

DO YOU UNDERSTAND:

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 in the Federal Reserve System are?

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118 Part 1 Introduction and Overview of Financial Markets

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. 10 Figure 4–2 illustrates 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 reserves 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. Specifically, a change in excess reserves resulting from the implementation of monetary 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.

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.

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 mon- etary base (the sum of currency in circulation and reserves) and, in turn, the money supply

MONETARY POLICY TOOLSMONETARY POLICY TOOLS

LG 4-3LG 4-3

fed funds rate The interest rate on short-term funds trans- ferred between financial institutions, usually for a period of one day.

fed funds rate The interest rate on short-term funds trans- ferred between financial institutions, usually for a period of one day.

10 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 supply.

Figure 4–2 Federal Reserve Monetary Policy Activities

Source : Federal Reserve Board Web site, “Purposes & Functions,” July 2010. www.federalreserve.gov

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

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 119

(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 discuss 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 historically 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 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 policy 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 bubble.

The Fed then raised the fed funds rate significantly between July 2004 and August 2006; the Fed 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 payments 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 crisis 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 Notable Events from the Finan- cial Crisis 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 of 0 percent to 0.25 percent as of December 16, 2008. The rate remained at these historically 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.”

Open Market Operations

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 statement called the policy directive. The manager of the Trading Desk uses the policy directive to instruct traders on the daily amount of open market purchases or sales to transact. Open market operations are the Federal Reserves’s purchases or sales of securities in the U.S. Treasury securities market. This is 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.

www.newyorkfed .org www.newyorkfed .org

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

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

policy directive Statement sent to the Federal Reserve Board Trading Desk from the FOMC that specifies the money supply target.

policy directive Statement sent to the Federal Reserve Board Trading Desk from the FOMC that specifies the money supply target.

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120

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.

NOTABLE EVENTS FROM THE FINANCIAL CRISIS

Fed Cuts Rates Near Zero to Battle Slump

The Federal Reserve cut its target interest rate Tuesday to historic lows between zero and a quarter percentage point and said it could expand a program of unorthodox lending and securities purchases. After two days of discussion among Fed officials, the central bank said it would use every weapon from its arsenal to lift the U.S. from recession. It began by reducing its target interest rate—an overnight bank-lending rate called the federal funds rate—from 1%. Another Fed lending rate, the discount rate, will go to half a percent- age point, a level last seen in the 1940s. The cut was more than many economists expected, and the state- ment that came with it marked the latest signal by the Fed and its chairman, Ben Bernanke, that the central bank was prepared to take aggressive steps to revive the economy.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Fed said in a statement. It added that it expected interest rates to remain “exceptionally” low for some time, a subtle commitment to the current policy that could help bring down longer-term interest rates. In normal times, lower rates reduce the cost of borrowing for households, businesses, and financial institutions, which spurs borrowing and economic activity. Those effects are being muted now, however, because many businesses and households are weighed down by heavy debts . . . A number of official borrowing rates—such as rates on three-month Treasury bills—have tumbled to near

zero, a level they haven’t been near since the Great Depression. . . .

Officials spent much of two days of meetings delib- erating over what other rescue steps the central bank could take as interest rates approach zero. Mr. Bernanke spent much of his academic career studying that and other questions related to financial crises, and the Fed is now employing almost every pre- scription he laid out in the past. The approach carries several risks. It could eventually lead to the opposite of the current problem: higher inflation. It also exposes the independent central bank to political meddling and to losses on loans. Then there’s the risk that it won’t work. The Fed has already started a campaign to lend directly to damaged financial markets and companies— nearly anyone with collateral. Its statement Tuesday said those efforts could “sustain the size of the Federal Reserve’s balance sheet at a high level.” By such lend- ing, officials have effectively concluded that if banks and financial markets won’t extend credit, it will do part of the job for them. . . .

Mortgage rates have been one of the few areas in financial markets where credit costs have fallen in the past few weeks. In its statement, the Fed said it stood ready to expand the program “as conditions warrant.” . . .

Source: The Wall Street Journal , December 17, 2008, p. A1, by Jon Hilsenrath. Reprinted by permission of The Wall Street Journal . © 2008 Dow Jones & Company, Inc. All rights Reserved Worldwide. www.wsj.com

Example 4–1 Purchases of Securities by the Federal Reserve

Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Treasury securities. Traders at the FRBNY call primary government securities dealers of major commercial and investment banks (such as Goldman Sachs and Morgan Stanley), 11 who provide a list of securities they have available for sale, including the denomination,

11 As of July 2010, there were 18 primary securities dealers trading, on average, $846 billion of securities per day.

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 121

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. While the Fed generally conducts open market operations using short-term Treasury bills (to set the fed funds rate), it generally does not intervene in long-term Treasury markets (allowing the market to set long-term rates). The Fed had not purchased long-term Treasury securities since the 1960s. The message to the financial markets from this action was that the Fed was willing to do whatever was necessary to stabilize markets during the financial crisis.

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 securities they are willing to buy, including the price on each security. FRBNY traders sell securi- ties 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 Federal Reserve’s balance sheet would in this case have the opposite sign (negative) as those illus- trated in Table 4–6 . In addition, total reserves of commercial banks will decrease by $500 million due to the purchase of securities from the Fed, and demand deposits of the securi- ties dealers at their banks will decrease 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 4–6 for a purchase of securities.

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.

12 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.

maturity, and the price on each security. FRBNY traders then 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 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 is increased by $500 million. We illus- trate these changes to the Federal Reserve’s balance sheet in Table 4–6 . In addition, there is also an impact on commercial bank balance sheets. Total reserves (assets) of commer- cial 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. 12 We also show the changes to commercial banks’ balance sheets in Table 4–6 .

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122 Part 1 Introduction and Overview of Financial Markets

While the Federal Reserve conducts most of its open market operations using Trea- sury securities, other government securities can be used as well. Treasury securities are used most because the secondary market 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.

At times, the Federal Reserve may want to temporarily increase (or decrease) the aggregate level of bank reserves for reasons other than directly impacting monetary targets or interest rates. For example, holiday deposit withdrawals can create temporary imbal- ances in the level of bank reserves. In this case, the Trading Desk often uses repurchase agreements or repos to offset such temporary shortfalls in bank reserves and liquidity. With a repo, the Fed purchases government securities from a dealer or a bank with an agreement that the seller will repurchase them within a stated period of time (generally 1 to 15 days) as specified in the repurchase agreement.

When a repurchase agreement is used, the level of bank reserves rises as the securi- ties are sold. They are then reduced when the dealers repurchase their securities a few days later. The return to the Fed for letting the dealer borrow funds in exchange for the securities (and the cost to the dealer for borrowing the funds) is the difference between the original prices and the repurchase price of the securities. When the Fed wants to conduct a temporary open market sale, it enters a reverse repurchase agreement (or a matched sale purchase transaction). In this case, the Fed sells securities to the dealer with the agreement to buy them back at a higher price later. The Fed uses repurchase agreements and reverse repurchase agreements to bring about a temporary change in the level of reserves in the system or to respond to some event that the Fed thinks could have a significant but short- lived effect on the economy. The objective of such repurchase agreements is to smooth out fluctuations in bank reserves and thus in the nation’s money supply and to avoid adverse impacts on interest rates.

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 above, 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.

repurchase agreements Open market trans- actions in which the Trading Desk purchases government securities with an agreement that the seller will repurchase them within a stated period of time.

repurchase agreements Open market trans- actions in which the Trading Desk purchases government securities with an agreement that the seller will repurchase them within a stated period of time.

TABLE 4–6 Purchase of Securities in the Open Market

Change in Federal Reserve’s Balance Sheet

Assets Liabilities

Treasury securities �$500m. Reserve account of �$500m. securities dealers’ banks

Change in Commercial Bank Balance Sheets

Assets Liabilities

Reserve accounts �$500m. Securities dealers’ demand �$500m. at Federal Reserve deposit accounts at banks

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

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 FIs 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.

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 dis- count 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 history of the Dow and one of a handful of up days during the height of the financial crisis. 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 1997 through July 2010.

Figure 4–3 Various U.S. Interest Rates

Source : Federal Reserve Board Web site, “Research and Data,” July 2010. www.federalreserve.gov

0

2

4

6

8

10

12

Ja n-

90

Ja n-

91

Ja n-

92

Ja n-

93

Ja n-

94

Ja n-

95

Ja n-

96

Ja n-

97

Ja n-

98

Ja n-

99

Ja n-

00

Ja n-

01

Ja n-

02

Ja n-

03

Ja n-

04

Ja n-

05

Ja n-

06

Ja n-

07

Ja n-

08

Ja n-

09

Ja n-

10

Prime

CD

Discount

T-bill

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124

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 conditions tight. The Board commented that overall, the outlook for economic activity had weakened fur- ther. Thus, this drop in the discount rate was intended to signal the Fed’s strong and per- sistent 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 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 institu- tion. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Federal Reserve’s seasonal credit program is designed to assist small depository institu- tions in managing significant seasonal swings in their loans and deposits. Seasonal credit is

IN THE NEWS

Banks Flock to Discount Window

Borrowing from the Federal Reserve’s

discount window soared in recent days,

which some analysts said may have been

the result of the Fed’s efforts to restore

overnight interest rates to the Fed’s

target level. Discount borrowing under

the Fed’s primary credit program for

banks surged to more than $7.1 billion

outstanding as of Wednesday, up from

about $1 billion a week earlier, the

central banks said yesterday. It was

the highest level since the day after the

Sept. 11, 2001, terrorist attacks.

In August, as liquidity concerns

mounted, the Fed injected money into the

nation’s banking system in a bid to ease

problems in some credit markets. As a

result, the federal funds rate regularly fell

well below the target rate of 5.25 percent.

The Fed also lowered the discount rate by

a half percentage point to 5.75 percent, in

a bid to encourage banks to borrow directly

from the Fed. But the Fed had little success

in spurring the discount window borrow-

ing. Banks typically are reluctant to borrow

from the discount window because they

view it as a source of funding for distressed

institutions. In addition, they have been able

to borrow funds more cheaply from each

other, at the federal funds rate . . .

The surge in discount borrowing

comes ahead of the Fed’s next policy

meeting Tuesday. Fed officials are

expected to cut the federal funds rate

for the first time in four years. Markets

widely expect at least a quarter point cut

to 5 percent, though some analysts say a

half point cut is possible. The smaller cut

might have less effect on financial mar-

kets because it would simply bring the

new target down to where interest rates

had been in recent weeks.

Source : The Wall Street Journal,

September 14, 2007, p. Cl, by Sudeep

Reddy. Reprinted by permission of The Wall

Street Journal. © 2007 Dow Jones &

Company, Inc. All Rights Reserved Worldwide.

www.wsj.com

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 125

available to depository institutions that can demonstrate a clear pattern of recurring intra- yearly 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 discount 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 implement monetary pol- icy, but to significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks’ use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previ- ously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. 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’ failure, as a series of actions were taken in response to the increasingly fragile state of financial markets. After March 2008, several new broad-based lending programs were implemented, providing funding to a wide array of new parties, including U.S. money market mutual funds, commercial paper issuers, insurance companies, and others. These programs rapidly expanded the current lending programs offered via the Fed.

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 commercial bank reserve requirements. As defined above, reserve requirements determine the minimum amount of reserve assets (vault cash plus bank deposits at Fed- eral Reserve Banks) that depository institutions must maintain by law to back transaction deposits 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 increas- ing credit availability in the economy. As new loans are issued and used to finance con- sumption 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 deposits, after deducting the

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126 Part 1 Introduction and Overview of Financial Markets

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 requ� ( iirement increase in reserves created by

) � rreserve 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 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 requ� ( iirement decrease in reserves created by

) � rreserve 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 � .10) to back its deposits. In this simple framework, the remaining $360 million of deposits can be used to extend loans to borrowers. Table 4–7 , Panel A, illustrates the Federal Reserve’s and City Bank’s balance sheets, assum- ing 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 � .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 illus- trate 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 4–7 ). 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 � .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 4–7 ). The resulting change in City Bank’s deposits will be:

Change in bank deposits / 40m 20m� � � �( . ) ( ) $1 05 4400m

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 requirement decrease from 10 percent to 5 percent (i.e., $800 million deposits � .05 � $40 million).

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 127

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 instru- ments 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/.1), an increase in bank deposits and the money supply of $2 billion:

1 1/ 200 million 2 000 million 2 billion. $ $ , $� � � 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 assumed that City Bank was 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 assumptions are relaxed, the

TABLE 4–7 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.

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128 Part 1 Introduction and Overview of Financial Markets

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 deposits and the money supply will be smaller than illustrated, albeit still a multiplier similar 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:

Change in bank deposits / new reserve req� [ (1 uuirement change in reserves created b

� �

c)] yy reserve requirement change

where c � the public’s cash-to-deposit ratio or preference for holding cash outside banks relative to bank deposits � .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

DO YOU UNDERSTAND:

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?

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

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 129

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.

As we introduced this chapter, we stated that the Federal Reserve takes steps to influence monetary conditions—credit availability, interest rates, the money supply, 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 money supply or interest rates. In this sec- tion, 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 inter- est 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 4–8 goes one step further and

THE FEDERAL RESERVE, THE MONEY SUPPLY, AND INTEREST RATESTHE FEDERAL RESERVE, THE MONEY SUPPLY, AND INTEREST RATES

LG 4-4LG 4-4

Figure 4–5 The Process of Monetary Policy Implementation

*M1 ($1,705.6 billion outstanding in May 2010) consists of (1) currency outside the U.S. Treasury, Federal

Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand

deposits at all commercial banks other than those owed to depository institutions, the U.S. government, and

foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float;

and (4) other checkable deposits (OCDs). M2 ($8,560.5 billion outstanding in May 2010) consists of M1 plus

(1) savings deposits, (2) small time deposits (time deposits in amounts of less than $100,000), and (3) balances

in retail money market mutual funds, less Keogh and IRA balances at money market mutual funds.

Open Market Operations Discount Rate Changes Reserve Requirement Ratio Changes

Monetary Policy Tools

Financial Markets

A na

ly si

s an

d F

ee db

ac k

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 Base (M1 and M2)* Interest Rates (fed funds rate)

Targets

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130 Part 1 Introduction and Overview of Financial Markets

looks at how credit availability, interest rates, the money supply, 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.

Expansionary Activities. We described above 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 improve- ments). 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. 13 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 production, and may cause the inflation rate (defined in Chapter 2 ) to rise. Ideally, the expansionary policies of the Fed are meant to be conducive to real economic expansion (economic growth, full employment, sustainable international trade) without price inflation. Indeed, price stabili- zation (low inflation) can be viewed as the 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 availability of funds for additional loans.

TABLE 4–8 The Impact of Monetary Policy on Various Economic Variables

Expansionary Activities Contractionary Activities

(open market purchases of securities, discount rate

decreases, reserve requirement ratio decreases)

(open market sales of securities, discount rate increases,

reserve requirement ratio increases)

Impact on: Reserves ↑ ↓ Credit availability ↑ ↓ Money supply ↑ ↓ Interest rates ↓ ↑ Security prices ↑ ↓

13 See the discussion of the interest rate parity theorem in Chapter 9 .

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

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

As shown in Table 4–9 , 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 (such as M1), while Panel B of Figure 4–6 shows the targeting of interest rates. For example, letting the demand curve for money be represented as M D in Panel A of Figure 4–6 , suppose the FOMC sets the target M1 money supply (currency and checkable deposits) 14 at a level that is consis- tent with 5 percent growth, line M S in Panel A of Figure 4–6 . At this M S level, the FOMC expects the equilibrium 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 fluctu- ate between i � and i �. Thus, targeting the money supply can lead to periods of relatively high volatility in interest rates.

In Panel B of Figure 4–6 , suppose instead the FOMC targets the interest rate, i T � 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 i T � 6 percent. As should be obvious from these graphs and the discussion, the Federal Reserve can successfully target only one of these two vari- ables (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 relatively freely.

In the 1970s, the Fed, and then chairmen Arthur Burns and G. William Miller, imple- mented its monetary policy strategy by targeting the federal funds rate. However, dur- ing the 1970s, interest rates rose dramatically (see Figure 4–7 ). The Fed responded to these interest 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 (chairman 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

14 Remember that the money base is currency in circulation plus reserves (depository institution reserves balances in accounts at Federal Reserve Banks plus the vault cash on hand of commercial banks). Thus, the money base is a part of the M1 money supply.

TABLE 4–9 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

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132 Part 1 Introduction and Overview of Financial Markets

chose to completely refocus its monetary policy, moving away from interest rate targets toward targeting 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 M1 growth rate targets in each of the first three years in which reserve targeting was used. Further, in contrast to expecta- tions, volatility in the money supply growth rate grew as well (see 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 chairman 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 guide monetary policy (initially setting the target rate at a constant 3 percent). Under the current regime, and contrary to previous tradition such as in the 1970s, the Fed simply announces whether the federal funds

DO YOU UNDERSTAND:

8. What actions the Federal Reserve can take to promote economic expansion? Describe how each affects credit availability, interest rates, money supply, and security prices.

9. What actions the Federal Reserve can take to contract the U.S. economy? Describe how each affects credit availability, interest rates, money supply, and security prices.

10. Why the simultaneous targeting of the money supply and interest rates is sometimes impossible to achieve?

Figure 4–6 Targeting Money Supply versus Interest Rates

Interest Rate

Quantity of Money (in billions of dollars)Ms

MD'

MD''

MD

Ms i ' � 8%

i* � 6%

i '' � 4%

Panel A: Targeting Money Supply

MsM s'

Quantity of Money (in billions of dollars)Ms

MD'

MD''

MD

iT � 6%

i '' � 5%

M s'

Interest Rate

Panel B: Targeting Interest Rates

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 133

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 announce- ment is watched very closely by financial market participants who react quickly to any change in the fed funds rate target. A result of this regime there has been relatively small volatility in interest rates since the late 1980s (see Figure 4–7 ).

As discussed in Chapter 2 , foreign investors are major participants in the financial markets. As such, the Federal Reserve considers economic conditions of other major countries—for example, China—when assessing and conducting its monetary policy for the U.S. econ- omy. The Fed’s actions regarding international monetary policy initiatives are most effec- tive if it coordinates its activities and policies with the central banks of other countries. 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.

The financial crisis first erupted in the United States, with September 2008 mark- ing a crucial turning point. On September 8, the U.S. government seized Fannie Mae and

INTERNATIONAL MONETARY POLICIES AND STRATEGIESINTERNATIONAL MONETARY POLICIES AND STRATEGIES

Figure 4–7 Federal Funds Rates and Annualized Money Supply Growth Rates, 1977–July 2010

Source: Federal Reserve Board Web site,”Research and Data,” July 2010. www.federalreserve.gov

0

2

4

6

8

10

12

14

16

18

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Federal Funds rate

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134 Part 1 Introduction and Overview of Financial Markets

Freddie Mac, taking direct responsibility for the firms that provided funding for about three-quarters of new home mortgages written in the United States. Then on Monday, September 15, Lehman Brothers (the 158-year-old investment bank) filed for bankruptcy, Merrill Lynch, rather than face bankruptcy, was bought by Bank of America, AIG (one of the world’s largest insurance companies) met with federal regulators to raise desperately needed cash, and Washington Mutual (the largest savings institution in the United States) searched for a buyer to save it from failing. As news spread that Lehman Brothers would not survive, FIs 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, 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. Ire- land 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. 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 banking 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 author- ities offered loans and debt guarantees to help small and midsize businesses with short- term funding. Table 4–10 lists some other systemwide support programs and bank-specific actions 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 above mentioned actions by central banks represent steps taken by individual countries, they were just a part of a coordinated effort by major countries to ease the mone- tary 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 res- cue 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 countries. The programs can be categorized into four general areas: expansion of retail deposit insurance, capital injections, debt guarantees, and asset purchases/guarantees. 15 Figure 4–8 summarizes deposit insurance coverage in various countries before versus after the start of the financial crisis, and Table 4–11 provides a more detailed overview of the 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.

LG 4-5LG 4-5

15 For a detailed summary of each of these, see BIS Quarterly Review , December 2008, www.bis.org .

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Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 135

TABLE 4–10 Central Bank Actions, September 2008–June 2009

Source: Bank for International Settlements, BIS Papers , No. 48, July 2009. www.bis.org

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136 Part 1 Introduction and Overview of Financial Markets

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, subor- dinated debt, mandatory convertible notes, or silent participations. These capital injec- tions improved banks’ abilities to absorb additional losses and strengthened protection for

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

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

Unlimited

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

129,000

129,000

129,000

129,000

129,000

121,000

108,000

90,000

83,000

79,000

74,000

64,000

64,000

64,000

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

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137

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138 Part 1 Introduction and Overview of Financial Markets

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 4–11 , countries also varied in the amounts of capital injected into the banking system. 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 4–11 , 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 pro- vided (particularly if purchase prices were higher than book values). Asset guarantee pro- grams 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 dif- ficult 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 sig-

nificant and immediate impact on market confidence, the programs would have to cover all distressed assets, which would require large programs. As seen in Table 4–11 , the United Kingdom used asset guarantees extensively (commitments amounted to 33.4 percent of the country’s GDP). Beyond this, Germany committed 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.

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 insti- tutions. We reviewed the structure under which the Fed provides these functions, the mon- etary policy tools it uses, and the impact of monetary policy changes on credit availability, interest rates, money supply, security prices, and foreign exchange rates.

DO YOU UNDERSTAND:

11. The monetary policy measures taken by central banks to address the recent worldwide financial crisis? What were they?

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QUESTIONS 1. Describe the functions performed by Federal Reserve

Banks. ( LG 4-1 )

2. Define the discount window and the discount rate. ( 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 credit availability, the money supply, 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.

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?

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Go to the Federal Reserve Board Web site and find the latest information available on the prime rate, the three-month CD rate, the discount rate, and the three-month T-bill rate using the following steps.

Go to the Federal Reserve Board’s Web site at www.federalreserve.gov releases. Under “Statisti- cal 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 July 2010.

b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 95 percent of these funds to their banks in the form of transaction 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 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 90 percent of these funds to their banks in the form of transaction deposits?

SEARCH THE SITE

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141

Securities Markets part two

LG 5-1. Define money markets.

LG 5-2. Identify the major types of money market securities.

LG 5-3. Examine the process used to issue Treasury securities.

LG 5-4. List the main participants in money markets.

LG 5-5. Examine the extent to which foreign investors participate in U.S. money markets.

LG 5-6. Understand the major developments in Euro money markets.

DEFINITION OF MONEY MARKETS: CHAPTER OVERVIEW Money markets exist to transfer funds from individuals, corpora- tions, and government units with short-term excess funds (sup- pliers of funds) to economic agents who have short-term needs for funds (users of funds). Specifically, in money markets , short- term debt instruments (those with an original maturity of one year or less) are issued by economic agents that require short-term

funds and are purchased by economic agents that have excess short-term funds. Once issued, money market instruments trade in active secondary markets. Capital markets serve a simi- lar function for market participants with excess funds to invest for periods of time longer than one year and/or who wish to borrow for periods longer than one year. Market partici- pants who concentrate their investments in capital market instruments also tend to invest in some money market securities so as to meet their short-term liquidity needs. The secondary markets for money market instruments are extremely important, as they serve to reallocate the (relatively) fixed amounts of liquid funds available in the market at any particular time.

Money markets played a major role in the financial crisis of 2008–2009. As mortgage and mortgage-backed securities (MBS) markets started to experience large losses, money markets froze and banks stopped lending to each other at anything but high overnight rates. The overnight London Interbank Offered Rate (a benchmark rate that reflects the rate at which banks lend to one another) more than doubled, rising from 2.57 percent on September 29, 2008, to an all-time high of 6.88 percent on September 30, 2009. Fur- ther, commercial paper markets, short-term debt used to finance companies’ day-to-day

chap te r

O U T L I N E

Definition of Money Markets: Chapter Overview Money Markets Yields on Money Market Securities

Bond Equivalent Yields Effective Annual Return Discount Yields Single-Payment Yields

Money Market Securities Treasury Bills Federal Funds Repurchase Agreements Commercial Paper Negotiable Certificates of Deposit Banker’s Acceptances Comparison of Money Market Securities

Money Market Participants The U.S. Treasury The Federal Reserve Commercial Banks Money Market Mutual Funds Brokers and Dealers Corporations Other Financial Institutions

International Aspects of Money Markets

Euro Money Markets Appendix 5A: Single versus Discriminating Price Treasury Auctions (at www.mhhe.com/sc5e ) Appendix 5B: Creation of a Banker’s Acceptance (at www.mhhe.com/sc5e )

Money Markets

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

5

LG 5-1

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142

NOTABLE EVENTS FROM THE FINANCIAL CRISIS

Central Banks Add More Liquidity to Markets

Central banks around the world pumped short-term cash into strained money markets for the second day in a row Tuesday as markets reeled amid a fast-moving crisis that is reshaping the contours of the global finan- cial system. With interest rates on the overnight loans banks make to one another rising sharply on market unease, European policy makers boosted the amount of funds on offer. The European Central Bank (ECB) injected €70 billion ($100.17 billion) in one-day funds into euro-zone money markets, more than double its Monday injection of €30 billion. The Bank of England offered £20 billion ($36.05 billion) in extra two-day funds, atop Monday’s £5 billion in extra three-day funds. The Swiss National Bank also made extra over- night funds available, but a spokesperson declined to say how much. The Bank of Japan injected ¥2.5 trillion ($23.84 billion) into Japanese money markets in two separate operations. Demand surged as commer- cial banks scrambled for short-term cash. Bids from 56 financial institutions totaled more than €102 billion in the ECB’s auction, which set the central bank’s policy rate of 4.25 percent as the minimum bid rate. The Bank of England said bids totaled £58.1 billion, more than triple the £20 billion on offer.

But analysts said Tuesday morning’s moves might not be enough to alleviate deepening market tensions, as global banks remained desperate for dollars. One market participant said the interbank dollar market Tuesday morning was virtually frozen. European banks have drastically increased their dollar-denominated debt in recent years. The U.S. Federal Reserve set up cur- rency swap lines with the ECB and Swiss central banks in December to give European banks access to dollars,

but those auctions only happen every other week. Global markets are swooning in the wake of Lehman Brothers Holdings Inc.’s bankruptcy filing and new fears about the fate of insurer American International Group Inc., whose credit ratings were cut Monday . . . The world’s top central-bank heads agreed Sunday to take steps to calm their respective markets if Lehman’s bankruptcy filing showed signs of sparking liquidity freezes in their respective markets. Tuesday’s moves follow a round of global central-bank interventions Monday. In addition to the ECB and Bank of England injections, the U.S. Federal Reserve Monday pumped reserves into the banking system to keep its targeted rate stable. The central banks of Canada and Australia also added extra short-term funds.

Analysts anticipate central banks may need to continue propping up markets with short-term cash throughout the week, as banks across the globe adjust their books and trades to reflect Lehman’s disappear- ance. Once that repositioning is done, however, the fundamental question of confidence remains. Since the turmoil erupted last August, banks have been reluctant to lend to one another, inclined to hoard cash for their own potential losses and wary of other banks’ credit- worthiness. “We could get back to square one in terms of nobody really knowing what other people’s exposures and risks are,” said Ralf Preusser, senior European rates strategist at Deutsche Bank in London.

Source: The Wall Street Journal, September 16, 2008, p. A13, by Joellen Perry and Alistair Macdonald. Reprinted by permission of The Wall Street Journal. © 2008 Dow Jones & Company, Inc. All Rights Reserved Worldwide. www.wsj.com

operations, shrank by $52.1 billion (from $1.7 trillion in size) in less than a one-week period in mid-September 2008. The Notable Events from the Financial Crisis box high- lights some of the actions taken by central banks around the world to stem the post-2007 crisis in the money markets. In 2010 money markets had over $6.4 trillion in financial claims outstanding, down from over $8 trillion in 2007 before the financial crisis.

In this chapter, we present an overview of money markets. We define and review the various money market instruments that exist, the new issue and secondary market trading process for each, and the market participants trading these securities. We also look at interna- tional money markets and instruments, taking a particularly close look at the Euro markets.

The need for money markets arises because the immediate cash needs of individuals, cor- porations, and governments do not necessarily coincide with their receipts of cash. For example, the federal government collects taxes quarterly; however, its operating and other expenses occur daily. Similarly, corporations’ daily patterns of receipts from sales do not necessarily occur with the same pattern as their daily expenses (e.g., wages and other

MONEY MARKETSMONEY MARKETS

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

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

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Chapter 5 Money Markets 143

disbursements). Because excessive holdings of cash balances involve a cost in the form of forgone interest, called opportunity cost , those economic units with excess cash usually keep such balances to the minimum needed to meet their day-to-day transaction require- ments. Consequently, holders of cash invest “excess” cash funds in financial securities that can be quickly and relatively costlessly converted back to cash when needed with little risk of loss of value over the short investment horizon. Money markets are efficient in perform- ing this service in that they enable large amounts of money to be transferred from suppli- ers of funds to users of funds for short periods of time both quickly and at low cost to the transacting parties. A money market instrument provides an investment opportunity that generates a higher rate of interest (return) than holding cash (which yields zero interest), but it is also very liquid and (because of its short maturity) has relatively low default risk.

Notice, from the description above, that money markets and money market securities or instruments have three basic characteristics. First, money market instruments are gener- ally sold in large denominations (often in units of $1 million to $10 million). Most money market participants want or need to borrow large amounts of cash, so that transactions costs are low relative to the interest paid. The size of these initial transactions prohibits most individual investors from investing directly in money market securities. Rather, indi- viduals generally invest in money market securities indirectly, with the help of financial institutions such as money market mutual funds or short-term funds.

Second, money market instruments have low default risk ; the risk of late or nonpay- ment of principal and/or interest is generally small. Since cash lent in the money markets

must be available for a quick return to the lender, money market instruments can generally be issued only by high-quality borrowers with little risk of default.

Finally, money market securities must have an original maturity of one year or less. Recall from Chapter 3 that the longer the maturity of a debt security, the greater is its interest rate risk and the higher is its required rate of return. Given that adverse price movements resulting from interest rate changes are smaller for short-term securities, the short-term maturity of money market instru- ments helps lower the risk that interest rate changes will significantly affect the security’s market value and price.

For many of the money market securities discussed below, returns are measured and quoted in a manner that does not allow them to be evaluated using the time value of money equations. For example, some securities’ interest rates or returns are based on a 360-day year, while others are based on a 365-day year. It is therefore inappropriate to compare annual interest rates on the various money market securities as well as on short-term and long-term securi- ties without adjusting their interest rates for differences in the securities’ characteristics.

Bond Equivalent Yields

The bond equivalent yield, i bey , is the quoted nominal, or stated, yield on a security. 1 From

Chapters 2 and 3 , the bond equivalent yield is the rate used to calculate the present value of an investment. For money market securities, the bond equivalent yield is the product of the periodic rate and the number of periods in a year. It is calculated as follows:

ibey � [(Pf � P0)/P0](365/h)

where

P f � Face value P 0 � Purchase price of the security h � Number of days until maturity

opportunity cost The forgone interest cost from the holding of cash balances when they are received.

opportunity cost The forgone interest cost from the holding of cash balances when they are received.

LG 5-1LG 5-1

default risk The risk of late or non- payment of principal or interest.

default risk The risk of late or non- payment of principal or interest.

YIELDS ON MONEY MARKET SECURITIESYIELDS ON MONEY MARKET SECURITIES

DO YOU UNDERSTAND:

1. What the three characteristics common to money market securities are?

2. Why it is difficult for individual investors to be involved in the initial sale of a money market security?

1 We describe nominal yields and bond valuation in detail in Chapter 3 .

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144 Part 2 Securities Markets

Effective Annual Return

The bond equivalent yield is a quoted nominal or stated rate earned on an investment over a one-year period. The bond equivalent yield does not consider the effects of compounding of interest during a less than one year investment horizon. Remember from Chapter 2 , that if interest is paid or compounded more than once per year, the true annual rate earned is the effective annual return on an investment. The bond equivalent yield on money market securities with a maturity of less than one year can be converted to an effective annual interest return ( EAR ) using the following equation: 2

EAR i

h bey

h

� � �1 365

1 365

/ ⎛ ⎝⎜

⎞ ⎠⎟

/

Example 5–1 Calculation of EAR on a Money Market Security

Suppose you can invest in a money market security that matures in 75 days and offers a 7 percent nominal annual interest rate (i.e., bond equivalent yield). The effective annual interest return on this security is:

EAR � � � �1

07

365 75 1 7 20

365 75. . %

/

/ ⎛ ⎝⎜

⎞ ⎠⎟

Discount Yields

Some money market instruments (e.g., Treasury bills and commercial paper) are bought and sold on a discount basis. That is, instead of directly received interest payments over the investment horizon, the return on these securities results from the purchase of the security at a discount from its face value ( P 0 ) and the receipt of face value ( P f ) at maturity, as we show in the following time line.

P Pf0 0

____________ Maturity

(days)

Further, yields on these securities use a 360-day year rather than a 365-day year. Interest rates on discount securities, or discount yields ( i dy ), are quoted on a discount basis using the following equation:

i P P P hdy f f� �[( ) ]( )0 360/ /

There are several features of a discount yield that make it difficult to compare with bond equivalent yields on other (nondiscount) securities—for example, U.S. Treasury bonds. Notice the discount yield uses the terminal price, or the security’s face value ( P f ), as the base price in calculating an annualized interest rate. By contrast, bond equivalent yields are based on the purchase price ( P 0 ) of a security. Further, and as already mentioned, discount yields generally use a 360-day rather than a 365-day year to compute interest returns. An appropriate comparison of interest rates on discount securities versus nondis- count securities, adjusting for both the base price and days in the year differences, requires converting a discount yield into a bond equivalent yield in the following manner:

i i P Pbey dy f� ( ) ( )/ /0 365 360

2 This equation assumes that as these short-term securities mature they can be reinvested for the remainder of the year at the same interest rate.

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Chapter 5 Money Markets 145

Example 5–2 Comparison of Discount Yield, Bond Equivalent Yield, and EAR

Suppose you can purchase a $1 million Treasury bill that is currently selling on a discount basis (i.e., with no explicit interest payments) at 97½ percent of its face value. The T-bill is 140 days from maturity (when the $1 million will be paid). Depending on the setting in which you are interested, any one of the following three yields or interest rates could be appropriate:

Discount yield: 1m / 1midy � �[($ . $ , ) $ .](975 000 3660 140 6 43/ Bond equivalent yield:

) . % [(

�

�ibey $$ . $ , ) $ , ]( ) . %1m / /

EAR

� �975 000 975 000 365 140 6 68

:: / /EAR � � � �[ . ( )] . %/1 0668 365 140 1 6 82365 140

Single-Payment Yields

Some money market securities (e.g., jumbo CDs and fed funds) pay interest only once during their lives: at maturity. Thus, the single-payment security holder receives a terminal payment consisting of interest plus the face value of the security, as we show in the follow- ing time line. Such securities are special cases of the pure discount securities that only pay the face value on maturity.

Invest Receive Interest

Maturity days

$ $

(

1

0

1 �

)) Further, quoted nominal interest rates on single-payment securities (or single-payment yield, i spy ) normally assume a 360-day year. In order to compare interest rates on these securities with others, such as U.S. Treasury bonds, that pay interest based on a 365-day year, the nominal interest rate must be converted to a bond equivalent yield in the follow- ing manner:

i ibey spy� ( )365 360/

Further, allowing for interest rate compounding, the EAR for single-payment securities must utilize the bond equivalent yield as follows:

EAR

i

h spy

h

� � �1 365 360

365 1

365( )/

/

/⎡ ⎣⎢

⎤ ⎦⎥

or,

EAR i hbey h

� � �1 365 1 365

/ / /

( )⎡⎣ ⎤⎦

Example 5–3 Comparison of Single-Payment Yield, Bond Equivalent Yield, and EAR

Suppose you can purchase a $1 million jumbo CD that is currently 105 days from maturity. The CD has a quoted annual interest rate of 5.16 percent for a 360-day year. The bond equivalent yield is calculated as:

ibey � �5 16 365 360 5 232. %( ) . %/

The EAR on the CD is calculated as:

EAR � � � �[ (. ) ( )] . %1 05232 365 105 1 5 33365 105/ / /

Table 5–1 lists various money market instruments and their quoted interest rates, as reported in The Wall Street Journal for July 8, 2010. Current market rates (as well as data

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146 Part 2 Securities Markets

on stocks, bonds, foreign exchange, and other securities) can also be found at Bloomberg’s Web site, www.bloomberg.com/markets/rates/index.html . As we proceed with the discussion of the various money market instruments, pay particular attention to the convention used to state returns in the various money markets. For example, Treasury bill rates are stated as discount yields and use a 360-day year. Commercial paper and banker’s acceptance yields are also quoted as discount yields. Federal funds, repurchase agreements,

—52-WEEK— Latest ago High Low

Prime rates U.S. 3.25 3.25 3.25 Canada 2.50 2.50 2.25 Euro zone 1.00 1.00 1.00 Japan 1.475 1.475 1.475 Switzerland 0.56 0.58 0.51 Britain 0.50 0.50 0.50 Australia 4.50 4.50 3.00 Hong Kong 5.25 5.25 5.00

Week —52-WEEK— Latest ago High Low

Week

Overnight repurchase U.S. 0.25 0.31 0.03 U.K. (BBA) 0.532 0.573 0.407 Euro zone 0.43 0.68 0.28

U.S. government rates Discount

0.500.75 0.75

Federal funds

Effective rate 0.19 0.22 0.09 High 0.3800 0.5000 0.3700 Low 0.1000 0.3200 0.0000 Bid 0.1500 0.3800 0.0000 Offer 0.2000 0.8333 0.0200

Treasury bill auction 4 weeks 0.150 0.170 0.000 13 weeks 0.160 0.190 0.040 26 weeks 0.215 0.285 0.130

Bankers acceptances

30 days 60 days 90 days 120 days 150 days 180 days

0.45 0.45 0.21 0.50 0.50 0.23 0.55 0.60 0.25 0.65 0.65 0.26 0.75 0.75 0.31 0.80 0.85 0.35

Commercial paper 60 to 89 days 90 to 119 days 120 to 149 days 150 to 179 days 180 to 209 days 210 to 239 days 240 to 270 days

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

—

Dealer commercial paper 30 days 0.35 0.35 0.20 60 days 0.43 0.43 0.20 90 days 0.53 0.54 0.21

Euro commercial paper 30 day n.a. 0.46 0.10 Two month n.a. 0.50 0.18 Three month 0.56 0.68 0.35 Four month 0.60 0.81 0.40 Five month 0.66 0.88 0.50 Six month 0.77 0.96 0.61

London interbank offered rate, or Libor One month 0.34719 0.35406 0.22813 Three month 0.53331 0.53925 0.24875 Six month 0.75100 0.98750 0.38250 One year 1.17313 1.54875 0.83406

Euro Libor One month 0.461 0.589 0.364 Three month 0.718 0.993 0.576 Six month 1.013 1.235 0.882 One year 1.295 1.431 1.186

BORROWING BENCHMARKS Money Rates July 8, 2010 Key annual interest rates paid to borrow or lend money in U.S. and interna- tional markets. Rates below are a guide to general levels but don’t always represent actual transactions.

Notes on data: U.S. prime rate is effective December 16, 2008. Discount rate is effective February 19, 2010. U.S. prime rate is the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks: Other prime rates aren’t directly comparable; lending practices vary widely by location; Discount rate is the charge on loans to depository institutions by the New York Federal Reserve Banks; Federal-funds rate is on reserves traded among commercial banks for overnight use in amounts of $1 million or more; Call money rate is the charge on loans to brokers on stock-exchange collateral; Dealer commercial paper rates are for high-grade unsecured notes sold through dealers by major corporations; Freddie Mac RNY is the required net yield for the one-year 2% rate capped ARM. Libor is the British Bankers’ Association average of interbank offered rates for dollar deposits in the London market; Libor Swaps quoted are mid-market, semi-annual swap rates and pay the floating 3-month Libor rate. New York Funding Rate is the survey-based average of unsecured bank funding costs.

TABLE 5–1 Various U.S. Money Market Security Rates

DO YOU UNDERSTAND:

3. What characteristics of a discount yield prevent it from being directly compared to a bond equivalent yield?

Source: The Wall Street Journal, July 9, 2010, p. C8. Reprinted by permission of The Wall Street Journal.

© 2010 Dow Jones & Company, Inc. All Rights Reserved Worldwide. www.wsj.com

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Chapter 5 Money Markets 147

and negotiable certificates of deposit are stated on a single payment yield basis. Differ- ences in the convention used to calculate yields must be considered particularly when com- paring returns across various securities.

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 accep- tances. In this section, we look at the characteristics of each of these. Table 5–2 defines each of the money market securities, and Table 5–3 lists the amounts of each outstanding and the interest rate on each of these instruments in 1990 and 2010. As noted in previous chapters, in the late 2000s, as the U.S. economy faced a severe financial crisis 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 zero and one- quarter of 1 percent and lowered its discount window rate to one-half percent, the lowest level since the 1940s. The lowering of the fed funds and discount window rates filtered through to affect all money market rates, dropping them to historic lows as well (as seen in Table 5–3 ). Interest rates remained at these lows through 2010.

Treasury Bills

Treasury bills (T-bills) are short-term obligations of the U.S. government issued to cover current government budget shortfalls (deficits) 3 and to refinance maturing government debt.

MONEY MARKET SECURITIESMONEY MARKET SECURITIES

LG 5-2LG 5-2

Treasury bills Short-term obligations of the U.S. government issued to cover govern- ment budget deficits and to refinance maturing government debt.

Treasury bills Short-term obligations of the U.S. government issued to cover govern- ment budget deficits and to refinance maturing government debt.

TABLE 5–2 Money Market Instruments

TABLE 5–3 Money Market Instruments Outstanding, 1990 and 2010 ( in billions of dollars )

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 to repurchase the securities 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 deposit that specifies an interest rate and maturity date and is negotiable (saleable on a secondary market). Banker’s acceptances —time drafts payable to a seller of goods, with payment guaranteed by a bank.

3 The excess of U.S. government expenditures minus revenues.

Amount Outstanding Rate of Return

1990 2010 1990 2010

Treasury bills $527 $1,856 6.68% 0.16%

Federal funds and repurchase agreements

372 1,656 7.31 0.20

Commercial paper 538 1,083 8.14 0.43

Negotiable certificates of deposit 547 1,822 8.13 0.53

Banker’s acceptances 52 1 7.95 0.55

Source: Federal Reserve Board Web site, May 1991 and June 2010, various tables. www.federalreserve.gov

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148 Part 2 Securities Markets

As discussed in Chapter 4 , Treasury bill purchases and sales are also a main tool used by the U.S. government to implement monetary policy. For example, in the late 2000s, to stimulate the economy and increase the amount of funding available in the economy, the Fed purchased large amounts of Treasury bills. In 2010 there were over $1.8 trillion of Treasury bills outstanding, up from $1 trillion in 2007. T-bills are sold through an auction process (described below). Original maturities are 13 weeks or 26 weeks, and they are issued in denominations of multiples of $1,000. The minimum allowable denomination for a T-bill bid is $1,000. A typical purchase in the newly issued T-bill market is a round lot of $5 million. However, existing T-bills can be bought and sold in an active secondary market through government securities dealers who purchase Treasury bills from the U.S. govern- ment and resell them to investors. Thus, investors wanting to purchase smaller amounts of T-bills can do so through a dealer for a fee.

Because they are backed by the U.S. government, T-bills are virtually default risk free. In fact, T-bills are often referred to as the risk-free asset in the United States. Further, because of their short-term nature and active secondary market, T-bills have little interest rate risk and liquidity risk.

The New Issue and Secondary Market Trading Process for Treasury Bills. The U.S. Treasury has a formal process by which it sells new issues of Treasury bills through its regular Treasury bill auctions . Every week (usually on a Thursday), the amount of new 13-week and 26-week T-bills the Treasury will offer for sale is announced. Bids may be submitted by government securities dealers, financial and nonfinancial corporations, and individuals and must be received by a Federal Reserve Bank (over the Internet [through TreasuryDirect 4 ], by phone, or by paper form) by the deadline of 1 P.M. on the Monday following the auction announcement. Allocations and prices are announced the following morning (Tuesday), and the T-bills are delivered on the Thursday following the auction.

Submitted bids can be either competitive bids or noncompetitive bids. As of 1998, all successful bidders (both competitive and noncompetitive) are awarded securities at the same price, which is the price equal to the lowest price of the competitive bids accepted (as will be explained below). Prior to this, Treasury security auctions were discriminatory auc- tions in that different successful bidders paid different prices (their bid prices). Appendix A to this chapter, located at the book’s Web site ( www.mhhe.com/sc5e ), discusses the rea- sons behind the change and the benefits to the U.S. Treasury from a single price auction.

Competitive bids specify the desired quantity of T-bills and the bid price. The highest bidder receives the first allocation (allotment) of T-bills, and subsequent bids are filled in decreasing order of the bid until all T-bills auctioned that week are distributed. The price paid by all bidders is, then, the lowest price of the accepted competitive bidders. Any competitive bidder can submit more than one bid. However, no bidder can legally receive more than 35 percent of the T-bills involved in any auction. This rule limits the ability of one bidder to “squeeze” the market. In August 1991, Salomon Brothers disclosed that in several recent Treasury auctions, it had improperly purchased substantially more than the 35 percent of an issue that any one firm is allowed to buy. The firm also admitted submit- ting bids in the names of customers who had not authorized it to do so, enabling it to buy more of the securities than allowed. Further, the firm’s president and two other top execu- tives admitted that they had been told four months earlier that the firm had made illegal bids, but failed to report it to the government until mid-August. The illegal trades led to resignations of many of Salomon’s top executives and traders, a loss of $2 billion in equity market value, and substantial fines assessed on the firm by the government.

Competitive bids are generally used by large investors and government securities dealers and make up the majority of the auction market. Table 5–4 shows the results of the Treasury auction on July 6, 2010. At this auction, 23.62 percent and 24.09 percent of the submitted

www .federalreserve .gov

www .federalreserve .gov

LG 5-3LG 5-3

Treasury bill auctions The formal process by which the U.S. Treas- ury sells new issues of Treasury bills.

Treasury bill auctions The formal process by which the U.S. Treas- ury sells new issues of Treasury bills.

www.ustreas.gov www.ustreas.gov

4 TreasuryDirect, operated by the Office of the U.S. Treasury, allows investors to buy and sell Treasury securities directly from the Treasury Department.

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Chapter 5 Money Markets 149

bids were accepted for the 13- and 26-week T-bills, respectively. Figure 5–1 illustrates the T-bill auction for the 13-week T-bills. The highest accepted bid on the 13-week T-bills was 99.969667 percent of the face value of the T-bills. Bids were filled at prices below the high. The lowest accepted bid price was 99.958292 percent. The median accepted bid price was 99.962083 percent. All bidders who submitted prices above 99.958292 percent (categories 1 through 5 in Figure 5–1 ) were awarded in full (winning bids) at a price of 99.958292 percent. Thus, those who submitted a bid at a price greater than 99.958292 percent paid less than their bid price yet received their full allocation of T-bills requested. Bidders who submitted a price below 99.958292 percent (categories 7 and beyond in Figure 5–1 ) received no alloca- tion of the auctioned T-bills. A portion, but not all, of the bids submitted at 99.958292 were filled (category 6 in Figure 5–1 ). Bids submitted at 99.958292 were filled on a pro rata (proportional) basis until the supply available was exhausted.

With noncompetitive bids, the bidder indicates the quantity of T-bills he or she wants to buy and agrees to pay the lowest price of the winning competitive bids. Noncompetitive bidders get a preferential allocation—that is, all these bids are met before the remaining T-bills are allocated to the competitive bidders. Thus, with a noncompetitive bid, the bidder agrees to accept the discount rate determined at auction and is guaranteed to receive the full amount of the bid. Noncompetitive bids are limited to $1 million or less. Noncompeti- tive bids allow small investors to participate in the T-bill auction market without incurring large risks. That is, small investors who are unfamiliar with money market interest rate

13-Week Treasury Bill Auction

26-Week Treasury Bill Auction

Bids tendered (in billions) $127.0 $124.5 Bids accepted (in billions) $30.0 $30.0 Noncompetitive bids (in billions) $1.4 $1.3 Price 99.958292% 99.896361% High Price 99.969667% 99.919111% Low price 99.958292% 99.896361% Median price 99.962083% 99.903944%

TABLE 5–4 Treasury Auction Results, July 6, 2010

Figure 5–1 Treasury Auction Results

Bid Price Noncompetitive Bids

1 2

3

4 5

6 7

99.958292%(PNC) stop-out price

(low bid accepted = price paid by all bidders)

SC ST

$28.6b. $30.0b.

Quantity of T-Bills

99.969667%

Source: Department of Treasury Web site, Bureau of Public Debt, July 9, 2010. www.ustreas.gov

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150 Part 2 Securities Markets

movements can use a noncompetitive bid to avoid bidding a price too low to receive any of the T-bills or bidding too high and paying more than the “fair” market price. Notice, from Table 5–4 , that 4.53 percent ($1.4b./$30.0b.) and 4.27 percent ($1.3b/$30.0b), respectively, of the accepted bids at the July 6, 2010, Treasury auction were noncompetitive for 13- and 26-week T-bills. This resulted in a supply of T-bills available to competitive bidders ( S C ) that is lower than the total supply ( S T ), because of the preferential bidding status of non- competitive bidders (i.e., noncompetitive bidders always receive a 100 percent allocation of their bids).

The secondary market for T-bills is the largest of any U.S. money market security. At the heart of this market are those securities dealers designated as primary government securities dealers by the Federal Reserve Bank of New York (consisting of 18 financial institutions) who purchase the majority of the T-bills sold competitively at auction and who create an active secondary market. In addition, there are many (approximately 500) smaller dealers who directly trade in the secondary market. Primary dealers make a mar- ket for T-bills by buying and selling securities for their own account and by trading for their customers, including depository institutions, insurance companies, pension funds, and so on. T-bill transactions by primary dealers averaged $846 billion per day in June 2010. The T-bill market is decentralized, with most trading transacted over the telephone. Brokers keep track of the market via closed circuit television screens located in the trad- ing rooms of the primary dealers. These television screens display bid and asked prices available at any point in time. Treasury markets are generally open from 9:00 A.M. to 3:30 P.M. EST.

Secondary market T-bill transactions between primary government securities dealers are conducted over the Federal Reserve’s wire transfer service—Fedwire (see Chapter 4 )— and are recorded via the Federal Reserve’s book-entry system. 5 We illustrate a transaction in Figure 5–2 . For example, if J.P. Morgan Chase wants to sell $10 million of T-bills to Bank of New York Mellon, J.P. Morgan Chase would instruct its district Federal Reserve Bank—the Federal Reserve Bank of New York (FRBNY)—to electronically transfer the (book-entry) T-bills, via the Fedwire, from its account to Bank of New York Mellon (also in the district of the FRBNY). The transaction would be recorded in the Fed’s book-entry system with no physical transfer of paper necessary. An individual wanting to purchase $50,000 of T-bills in the secondary market must contact his or her bank or broker. A bank or broker that is not a primary government securities dealer or a secondary market dealer must contact (via phone, fax, or wire) one of these dealers (e.g., J.P. Morgan Chase) to complete the transaction. The T-bill dealer will instruct its local Federal Reserve Bank to increase (credit) its T-bill account at the Fed. In exchange for the investor’s $50,000, these securities are subsequently recorded in the dealer’s book-entry system as an issue held for the investor. T-bill dealers maintain records identifying owners of all Treasury securities held in its account in the book-entry system.

Treasury Bill Yields. As we discussed above, Treasury bills are sold on a discount basis. Rather than directly paying interest on T-bills (the coupon rate is zero), the government issues T-bills at a discount from their par (or face) value. The return comes from the differ- ence between the purchase price paid for the T-bill and the face value received at maturity. During the financial crisis, investors worldwide, searching for a safe haven for their funds, invested huge amounts of funds in U.S. Treasury securities. The amount of money invested in Treasury bills 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 bor- row money.

Table 5–5 lists T-bill rates as quoted in The Wall Street Journal for trading on July 7, 2010. Column 1 in the quote lists the maturity date of the T-bill. Column 2, labeled Bid,

www.newyorkfed .org www.newyorkfed .org

www.newyorkfed .org www.newyorkfed .org

5 With a book-entry system, no physical documentation of ownership exists. Rather, ownership of Treasury securities is accounted for electronically by computer records.

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Chapter 5 Money Markets 151

Figure 5–2 Secondary Market Treasury Bill Transaction

J.P. Morgan Chase

Sell $10m. in T-Bills

Transaction between primary government securities dealers:

Individual

Buy $50,000 in T-Bills

J.P. Morgan Chase

Sell $50,000 in T-Bills

FRBNY

�$50,000 in T-Bills from J.P. Morgan Chase's

Account

�$50,000 T-Bill to Individual

Local Bank or Broker

Phone Call Wire Transfer

Fedwire Transaction

Fedwire

Transaction

Fe dw

ire

Tr an

sa cti

on

Engraved T-BillEngraved T-Bill

Purchase by an individual:

Federal Reserve Bank of New York

Transfers $10m. in T-Bills from J.P. Morgan Chase to Bank of New York Mellon

Transaction Recorded in Fed's Book-Entry System

Bank of New York Mellon

Buy $10m. in T-Bills

is the discount yield (defined below) on the T-bill given the current selling price available to T-bill holders (i.e., the price dealers are willing to pay T-bill holders to purchase their T-bills for them). Column 3, labeled Asked, is the discount yield based on the current pur- chase price set by dealers that is available to investors (i.e., potential T-bill buyers) and is calculated from the settlement date, two days after the quote date. The percentage differ- ence in the ask and bid yields is known as the spread. The spread is essentially the profit the dealers make in return for conducting the trade for investors. It is part of the transaction cost incurred by investors for the trade. Column 4, labeled Chg, is the change in the asked (discount) yield from the previous day’s closing yield. Finally, the last column (column 5), labeled Asked Yield, is the asked discount yield converted to a bond equivalent yield. As discussed above, the discount yield ( dy ) on a T-bill is calculated as follows:

i

P P

P h dy

f

f T-bill, �

� �

0 360

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152 Part 2 Securities Markets

Example 5–4 Calculating a Treasury Bill Asked Discount Yield

Suppose that you purchase the T-bill maturing on November 18, 2010, for $9,993.793. The T-bill matures 133 days after the settlement date, July 9, 2010, and has a face value of $10,000. The T-bill’s asked discount yield is reported as:

i dyT-bill, �

� � �

$ , $ , .

$ , .

10 000 9 993 80

10 000

360

133 0 1668%

Thus, 0.168 percent is the asked discount yield on this T-bill reported in Table 5–5 .

As described above, the discount yield differs from a true rate of return (or bond equivalent yield) for two reasons: (1) the base price used is the face value of the T-bill and not the purchase price of the T-bill, and (2) a 360-day year rather than a 365-day year is used. The bond equivalent yield uses a 365-day year and the purchase price, rather than the

TABLE 5–5 Treasury Bill Rates

Wednesday, July 07, 2010 Treasury bill bid and ask data are representative over-the-counter quotations as of 3 P.M. Eastern time quoted as a discount to face value. Treasury bill yields are to maturity and are based on the asked quote. Asked yields are calculated using a two-day settlement.

Maturity Bid Asked Chg Asked Yield

2010 Jul 15 0.153 0.148 �0.003 0.150 2010 Jul 22 0.155 0.150 unch. 0.152 2010 Jul 29 0.160 0.155 unch. 0.157 2010 Aug 05 0.168 0.163 �0.010 0.165 2010 Aug 12 0.158 0.153 �0.003 0.155 2010 Aug 19 0.165 0.158 unch. 0.160 2010 Aug 26 0.165 0.160 unch. 0.162 2010 Sep 02 0.168 0.160 unch. 0.162 2010 Sep 09 0.160 0.155 �0.003 0.157 2010 Sep 16 0.165 0.155 �0.003 0.157 2010 Sep 23 0.163 0.158 �0.003 0.160 2010 Sep 30 0.160 0.155 �0.005 0.157 2010 Oct 07 0.160 0.155 �0.003 0.157 2010 Oct 14 0.160 0.150 �0.005 0.152 2010 Oct 21 0.163 0.155 �0.003 0.157 2010 Oct 28 0.158 0.150 �0.005 0.152 2010 Nov 04 0.163 0.155 �0.008 0.157 2010 Nov 12 0.175 0.168 unch. 0.170 2010 Nov 18 0.175 0.168 unch. 0.170 2010 Nov 26 0.175 0.168 unch. 0.170 2010 Dec 02 0.170 0.163 �0.002 0.165 2010 Dec 09 0.180 0.175 �0.005 0.178 2010 Dec 16 0.183 0.178 �0.008 0.180 2010 Dec 23 0.193 0.185 �0.012 0.188 2010 Dec 30 0.205 0.198 �0.010 0.200 2011 Jan 06 0.198 0.193 unch. 0.195 2011 Jan 13 0.195 0.185 unch. 0.188

Source: The Wall Street Journal Online, July 8, 2010. Reprinted by permission of The Wall Street Journal.

© 2010 Dow Jones & Company, Inc. All Rights Reserved Worldwide. www.wsj.com

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Chapter 5 Money Markets 153

face value of the T-bill, as the base price. Thus, the formula for a bond equivalent yield on a T-bill, i T-bill, bey , is:

i P P

P h bey

f T-bill, �

� �

0

0

365

For example, the bond equivalent yield (or asked yield reported in Table 5–5 ) in Example 5–4 is calculated as:

i beyT-bill, �

� �

$ , $ , .

$ , .

10 000 9 993 793

9 993 793

365

1333 0 170� . %

Finally, the EAR on the T-bill is calculated as:

EAR � � � �1

00170

365 133 1 1 71

365 133. . %

/

/⎛ ⎝

⎞ ⎠

A Treasury bill’s price (such as that used in the examples above) can be calculated

from the quote reported in the financial press (e.g., The Wall Street Journal ) by rearrang- ing the yield equations listed above. Specifically, for the asked discount yield, the required market ask price would be:

P P i

h Pf dy f0 360

� � � �T-bill, ⎡ ⎣⎢

⎤ ⎦⎥

and for the bond equivalent yield:

P P i h

f bey0 1 365 � � �/ T-bill,

⎛ ⎝

⎞ ⎠

⎡ ⎣⎢

⎤ ⎦⎥

Example 5–5 Calculation of Treasury Bill Price from a Wall Street Journal Quote

From Table 5–5 , the asked (or discount) yield on the T-bill maturing on September 23, 2010 (or 77 days from the settlement date, July 9, 2010), is 0.158 percent. The T-bill price for these T-bills is calculated as:

P0 10 000 00158

77

360 10 000 9 996 62� � � � �$ , . $ , $ , .⎡

⎣⎢ ⎤ ⎦⎥

or using the asked yield (or the bond equivalent yield) on the T-bill, 0.160 percent:

P0 10 000 1 00160

77

365 9 996 62� � � �$ , . $ , ./ ⎛⎝

⎞ ⎠

⎡ ⎣⎢

⎤ ⎦⎥

Federal Funds

Federal funds (fed funds) are short-term funds transferred between financial institutions, usually for a period of one day. For example, commercial banks trade fed funds in the form of excess reserves held at their local Federal Reserve Bank. That is, one commercial bank may be short of reserves, requiring it to borrow excess reserves from another bank that has a surplus. The institution that borrows fed funds incurs a liability on its balance sheet, “federal funds purchased,” while the institution that lends the fed funds records an asset, “federal funds sold.” The overnight (or one day) interest rate for borrowing fed funds is the federal funds rate . The fed funds rate is a function of the supply and demand for federal funds among financial institutions and the effects of the Federal Reserve’s trading through the FOMC (as discussed in Chapter 4 ). For example, as discussed in Chapter 4 , during the

federal funds Short-term funds trans- ferred between financial institutions, usually for a period of one day.

federal funds Short-term funds trans- ferred between financial institutions, usually for a period of one day.

federal funds rate The interest rate for borrowing fed funds.

federal funds rate The interest rate for borrowing fed funds.

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154 Part 2 Securities Markets

height of the financial crisis, the Fed unexpectedly announced that it would drop its target fed funds rate to a range between zero and one-quarter of 1 percent. The rate remained at these historically 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.”

Federal Funds Yields. Federal funds (fed funds) are single-payment loans—they pay interest only once, at maturity. Further, fed funds transactions take the form of short-term (mostly overnight) unsecured loans. Quoted interest rates on fed funds, i ff,spy , assume a 360-day year. Therefore, to compare interest rates on fed funds with other securities such as Treasury bills, the quoted fed funds interest rate must be converted into a bond equiva- lent rate or yield, i ff,bey .

Example 5–6 Conversion of Federal Funds Rate of Interest to a Bond Equivalent Rate

From Table 5–1 , the overnight fed funds rate on July 8, 2010, was 0.20 percent. The con- version of the fed funds rate to a bond equivalent rate is calculated as follows:

i iff bey ff spy, , ( ) . % ( )

�

�

/ /

365 360 0 20 365 360 �� 0 20278. %

Remembering that fed funds are generally lent for one day, The EAR on the fed funds can then be calculated as:

EAR � � � �1

0020278

365 1 1 0 20298

365 1. . %

/

/⎛ ⎝

⎞ ⎠

In addition to being the cost of unsecured, overnight, interbank borrowing, the federal funds rate is of particular importance because, as was discussed in Chapter 4 , it is a focus or target rate in the conduct of monetary policy.

Trading in the Federal Funds Market. The fed funds market is a highly liquid and flexible source of funding for commercial banks and savings banks. Commercial banks, especially the largest commercial banks, conduct the vast majority of transactions in the fed funds market. Fed funds transactions are created by banks borrowing and lending excess reserves held at their Federal Reserve Bank (see Chapter 4 ), using Fedwire, the Federal Reserve’s wire transfer network, to complete the transaction. Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds.

Federal funds transactions can be initiated by either the lending or the borrowing bank, with negotiations between any pair of commercial banks taking place directly over the telephone. Alternatively, trades can be arranged through fed funds brokers (such as Garban-Intercapital and Prebon Yamane), who charge a small fee for bringing the two par- ties to the fed funds transaction together. 6

Figure 5–3 illustrates a fed funds transaction. For example, a bank that finds itself with $75 million in excess reserves (e.g., J.P. Morgan Chase) can call its correspondent banks (banks with which it has reciprocal accounts and agreements) 7 to see if they need overnight reserves. The bank will then sell its excess reserves to those correspondent banks that offer the highest rates for these fed funds (e.g., Bank of America). When a transaction is agreed upon, the lending bank (J.P. Morgan Chase) instructs its district Federal Reserve Bank (e.g., the FRBNY) to transfer the $75 million in excess reserves to the borrowing bank’s (Bank of America) reserve account at its Federal Reserve Bank (e.g., the Federal Reserve Bank of San Francisco). The Federal Reserve System’s wire transfer network, Fedwire, is

correspondent banks Banks with recipro- cal accounts and agreements.

correspondent banks Banks with recipro- cal accounts and agreements.

6 Brokerage fees are often as low as 50 cents per $1 million transacted.

7 Correspondent bank relations are discussed in more detail in Chapter 12 .

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Chapter 5 Money Markets 155

used to complete the transfer of funds. The next day, the funds are transferred back, via Fedwire, from the borrowing bank to the lending bank’s reserve account at the Federal Reserve Bank plus one day’s interest. 8 Overnight fed funds loans will likely be based on an oral agreement between the two parties and are generally unsecured loans.

Repurchase Agreements

A repurchase agreement (repo or RP) is an agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price and on a specified date in the future. Thus, a repurchase agreement is essentially a collateralized fed funds loan, with the collateral (held by the repo seller) taking the form of securities. The securities used most often in repos are U.S. Treasury securities (e.g., T-bills) and govern- ment agency securities (e.g., Fannie Mae). Collateral pledged in a repurchase agreement has a “haircut” applied, which means the collateral is valued at slightly less than market value. This haircut reflects the underlying risk of the collateral and protects the repo buyer against a change in the value of the collateral. Haircuts are specific to classes of collateral. For example, a U.S. Treasury bill might have one haircut rate, while a government agency security might have another haircut rate. A reverse repurchase agreement (reverse repo) is an agreement involving the purchase (buying) of securities by one party from another with the promise to sell them back at a given date in the future.

Because the parties in every repurchase agreement transaction have opposite perspec- tives, the titles repo and reverse repo can be applied to the same transaction. That is, a given transaction is a repo from the point of view of the securities’ seller and a reverse repo from the point of view of the securities’ buyer. Whether a transaction is termed a repo or a reverse repo generally depends on which party initiated the transaction. Most repos have very short terms to maturity (generally from 1 to 14 days), but there is a growing market

repurchase agreement An agreement involving the sale of securities by one party to another with a promise to repur- chase the securities at a specified price and on a specified date.

repurchase agreement An agreement involving the sale of securities by one party to another with a promise to repur- chase the securities at a specified price and on a specified date.

reverse repurchase agreement An agreement involving the purchase of securi- ties by one party from another with the promise to sell them back.

reverse repurchase agreement An agreement involving the purchase of securi- ties by one party from another with the promise to sell them back.

8 Increasingly, participants in the fed funds markets do not hold balances at the Federal Reserve (e.g., commercial banks that do not belong to the Federal Reserve System). In this case, the fed funds transaction is settled in immediately available funds—fed funds on deposit at the lending bank that may be transferred or withdrawn with no delay. A federal funds broker, typically a commercial bank, matches up institutions using a telecommunications network that links federal funds brokers with participating institutions. Upon maturity of the fed funds loan, the borrowing bank’s fed funds demand deposit account at the lending bank is debited for the total value of the loan and the borrowing bank pays the lending bank an interest payment for the use of the fed funds. Most of these fed funds transactions are for more than $5 million (they averaged around $50 million in the 2000s) and usually have a one- to seven-day maturity.

Figure 5–3 Federal Funds Transaction

J. P. Morgan Chase

Today: Takes $75m. from Reserve Account of J.P. Morgan Chase

Tomorrow: Adds $75m. Plus One Day's Interest to Reserve Account of J.P. Morgan Chase

FedwireTransaction

FedwireTransaction

FRBNY

Today: Adds $75m. to Reserve Account of BOA

Tomorrow: Takes $75m. Plus One Day's Interest from Reserve Account of BOA

FRB of San Francisco

Bank of America (BOA)

Borrows (Buys) Fed Funds

Lends (Sells) Fed Funds

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156 Part 2 Securities Markets

for longer-term 1- to 3-month repos. Repos with a maturity of less than one week gener- ally involve denominations of $25 million or more. Longer-term repos are more often in denominations of $10 million.

Many commercial firms, with idle funds in their deposit accounts at banks, use repos as a way to earn a small return until these funds are needed. In this case the firm uses its idle funds to buy T-bills from its bank. The bank then agrees to repurchase the T-bills in the future at a higher price. Other securities may be involved in repos as well. For example, in the mid-2000s Bank of America used repos to reduce (and arguably hide) debt in the form of mortgage-backed securities on its balance sheet. However, most repos are collateralized fed funds transactions entered into by banks. As discussed above, in a fed funds transac- tion, the bank with excess reserves sells fed funds for one day to the purchasing bank. The next day, the purchasing bank returns the fed funds plus one day’s interest reflecting the fed funds rate. Since there is a credit risk exposure to the selling bank in that the purchas- ing bank may be unable to repay the fed funds the next day, the selling bank may seek collateral backing for the one-day loan of fed funds. In a repo transaction, the funds-selling bank receives government securities as collateral from the funds-purchasing bank. That is, the funds-purchasing bank temporarily exchanges securities for cash. The next day, this transaction is reversed, with the funds-purchasing bank sending back the fed funds bor- rowed plus interest (the repo rate); it receives in return, or repurchases, its securities used as collateral in the transaction.

The Trading Process for Repurchase Agreements. Repurchase agreements are arranged either directly between two parties or with the help of brokers and dealers. Figure 5–4 illus- trates a $75 million repurchase agreement of Treasury bonds arranged directly between two parties (e.g., J.P. Morgan Chase and Bank of America). The repo buyer, J.P. Morgan Chase, arranges to purchase fed funds from the repo seller, Bank of America, with an agree- ment that the seller will repurchase the fed funds within a stated period of time—one day.

J.P. Morgan Chase

Buys a $75m. Repo

Today: 2$75m. from Reserve Account of J.P. Morgan Chase; 1$75m. to T-Bond Account of J.P. Morgan Chase

Tomorrow: 1$75m. plus One Day's Interest to Reserve Account of J.P. Morgan Chase; 2$75m. to T-Bond Account of J.P. Morgan Chase

Fedwire (cash) Transaction

Fedwire (T-bond) Transaction

Bank of America (BOA)

Sells a $75m. Repo

Fedwire (cash) Transaction

Fedwire (T-bond) Transaction

FRBNY

Today: 1$75m. to Reserve Account of BOA 2$75m. to T-Bond Account of BOA

Tomorrow: 2$75m. plus One Day's Interest from Reserve Account of BOA 1$75m. to T-Bond Account of BOA

FRB of San Francisco

Figure 5–4 A Repurchase Agreement Transaction

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Chapter 5 Money Markets 157

The repo is collaterolized with T-bonds. In most repurchase agreements, the repo buyer acquires title to the securities for the term of the agreement.

Once the transaction is agreed upon, the repo buyer, J.P. Morgan Chase, instructs its district Federal Reserve Bank (the FRBNY) to transfer $75 million in excess reserves, via Fedwire, to the repo seller’s reserve account. The repo seller, Bank of America, instructs its district Federal Reserve Bank (the FRB of San Francisco) to transfer $75 million from its T-bond account via securities Fedwire to the repo buyer’s T-bond account. Upon maturity of the repo (one day in this example), these transactions are reversed. In addition, the repo seller transfers additional funds (representing one day’s interest) from its reserve account to the reserve account of the repo buyer.

As noted in Chapter 4 , repurchase agreements are used by the Federal Reserve to help it conduct open market operations as part of its overall monetary policy strategy. When monetary adjustments are intended to be temporary (such as smoothing out fluctuations in interest rates or the money supply), the Fed uses repurchase agreements with dealers or banks. The maturities of the repos used by the Federal Reserve are rarely longer than 15 days. Government securities dealers—such as the largest investment and commercial banks—engage in repos to manage their liquidity and to take advantage of anticipated changes in interest rates.

Repurchase Agreement Yields. Because Treasury securities back most repurchase agreements, they are low credit risk investments and have lower interest rates than uncol- lateralized fed funds. 9 The spread between the rate on collateralized repos versus uncollater- alized fed funds has usually been in the order of 0.25 percent, or 25 basis points. The yield on repurchase agreements is calculated as the annualized percentage difference between the initial selling price of the securities and the contracted (re)purchase price (the selling price plus interest paid on the repurchase agreement), using a 360-day year. Specifically:

i

P P

P h RA

f �

� �

0

0

360

where

P f � Repurchase price of the securities (equals the selling price plus interest paid on the repurchase agreement)

P 0 � Selling price of the securities h � Number of days until the repo matures

Example 5–7 Calculation of a Yield on a Repurchase Agreement

Suppose a bank enters a reverse repurchase agreement in which it agrees to buy fed funds from one of its correspondent banks at a price of $10,000,000, with the promise to sell these funds back at a price of $10,000,291.67 ($10,000,000 plus interest of $291.67) after five days. The yield on this repo to the bank is calculated as follows:

iRA spy,

$ , , . $ , ,

$ , , �

� �

10 000 291 67 10 000 000

10 000 000

3660

5 0 21� . %

Because of their common use as a source of overnight funding and the fact that repos are essentially collateralized fed fund transactions, the Federal Reserve generally classifies federal funds and repurchase agreements together in its statistical data. Together, these

9 There is a one-day interest rate risk that may impact credit risk if interest rates suddenly rise so that the market value of the collateral backing the repo falls. To avoid the risk many repo transactions require a securities “haircut” to be imposed at the time of the transaction—more securities are used to back the cash part of the transaction. For exam- ple, Bank A may send $100 million in cash to Bank B. In turn, Bank B sends $105 million in securities as collateral to back the cash loan from A.

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158 Part 2 Securities Markets

amounted to more than $1.6 trillion outstanding in 2010 (see Table 5–3 ). Some notable differences exist, however, between repurchase agreements and fed funds. For example, repurchase agreements are less liquid than fed funds since they can only be arranged after an agreed upon type of collateral is posted (i.e., repos are hard to arrange at the close of the banking day, whereas fed funds can be arranged at very short notice, even a few minutes). Further, nonbanks are more frequent users of repurchase agreements.

Commercial Paper

Commercial paper is an unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements. Commercial paper is one of the largest (in terms of dollar value outstanding) of the money market instruments, with $1.1 trillion outstanding as of 2010. One reason for such large amounts of commer- cial paper outstanding is that companies with strong credit ratings can generally borrow money at a lower interest rate by issuing commercial paper than by directly borrowing (via loans) from banks. Indeed, although business loans were the major asset on bank balance sheets between 1965 and 1990, they have dropped in importance since 1990. This trend reflects the growth of the commercial paper market. Figure 5–5 illustrates the difference between the commercial paper rate and the prime rate for borrowing from banks from 1973 through July 2010. 10 Notice that in the 1990s and 2000s, the spread between the prime rate and commercial paper rate increased relative to the 1970s and 1980s.

Commercial paper is generally sold in denominations of $100,000, $250,000, $500,000, and $1 million. Maturities generally range from 1 to 270 days—the most com- mon maturities are between 20 and 45 days. This 270-day maximum is due to a Securi- ties and Exchange Commission (SEC) rule that securities with a maturity of more than

commercial paper An unsecured short-term promissory note issued by a company to raise short-term cash, often to finance working capital requirements.

commercial paper An unsecured short-term promissory note issued by a company to raise short-term cash, often to finance working capital requirements.

www.sec.gov www.sec.gov

Figure 5–5 Commercial Paper and Prime Rate, 1973–2010

10 It should be noted, however, that the best borrowers from banks can borrow below prime. Prime rate in today’s banking world is viewed as a rate to be charged to an average borrower—best borrowers pay prime rate minus some spread.

0

2

4

6

8

10

12

14

16

18

20

22

7/ 1/

19 73

7/ 1/

19 75

7/ 1/

19 77

7/ 1/

19 79

7/ 1/

19 81

7/ 1/

19 83

7/ 11

9/ 85

7/ 1/

19 87

7/ 1/

19 89

7/ 1/

19 91

7/ 1/

19 93

7/ 1/

19 95

7/ 1/

19 97

7/ 1/

19 99

7/ 1/

20 01

7/ 1/

20 03

7/ 12

00 5

7/ 1/

20 07

7/ 1/

20 09

Prime Com Paper

Interest Rate

Year

Source: Federal Reserve Board Web site, “Selected Interest Rates,” July 2010. www.federalreserve.gov

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Chapter 5 Money Markets 159

Figure 5–6 Direct versus Dealer Placements of Commercial Paper

11 This is partly because any dealer that issues (underwrites) commercial paper of a given company will generally buy back that commercial paper should a buyer wish to sell it. Thus, in general, underwriters act as counterparties in any secondary market trade.

$0

$200,000

$700,000

$1,200,000

$1,700,000

$2,200,000

Ja n-

92

Ja n-

93

Ja n-

94

Ja n-

95

Ja n-

96

Ja n-

97

Ja n-

98

Ja n-

99

Ja n-

00

Ja n-

01

Ja n-

02

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03

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04

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05

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06

Ja n-

07

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08

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09

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10

Year

Dollars (in thousands of $s)

Direct Placements Dealer Placements

Source: Federal Reserve Board Web site, “Research and Data,” July 2010. www.federalreserve.gov

270 days must go through the time-consuming and costly registration process to become a public debt offering (i.e., a corporate bond). As a result, at maturity most commercial paper is rolled over into new issues of commercial paper (again avoiding the SEC registration process). Commercial paper can be sold directly by the issuers to a buyer such as a mutual fund (a direct placement) or can be sold indirectly by dealers in the commercial paper mar- ket. The dollar value (in thousands of dollars) of each method of issue from 1991 through June 2010, is reported in Figure 5–6 .

Commercial paper is generally held by investors from the time of issue until maturity. Thus, there is no active secondary market for commercial paper. 11 Because commercial paper is not actively traded and because it is also unsecured debt, the credit rating of the issuing company is of particular importance in determining the marketability of a com- mercial paper issue. Credit ratings provide potential investors with information regarding the ability of the issuing firm to repay the borrowed funds, as promised, and to compare the commercial paper issues of different companies. Several credit rating firms rate com- mercial paper issues (e.g., Standard & Poor’s, Moody’s, and Fitch IBCA, Inc.). Standard & Poor’s rates commercial paper from A-1 for highest quality issues to D for lowest quality issues, while Moody’s rates commercial paper from P-1 for highest quality issues to “not rated” for lowest quality issues. Virtually all companies that issue commercial paper obtain ratings from at least one rating services company, and most obtain two rating evaluations.

www.standardand poors.com www.standardand poors.com

www.moodys .com www.moodys .com

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160 Part 2 Securities Markets

Commercial paper issuers with lower than prime credit ratings often back their com- mercial paper issues with a line of credit obtained from a commercial bank. In these cases, the bank agrees to make the promised payment on the commercial paper if the issuer can- not pay off the debt on maturity. Thus, a letter of credit backing commercial paper effec- tively substitutes the credit rating of the issuer with the credit rating of the bank. This reduces the risk to the purchasers of the paper and results in a lower interest rate (and higher credit rating) on the commercial paper. In other cases, an issuer arranges a line of credit with a bank (a loan commitment) and draws on this line if it has insufficient funds to meet the repayment of the commercial paper issue at maturity.

In the early 2000s, the slowdown in the U.S. economy resulted in ratings downgrades for some of the largest commercial paper issuers. For example, the downgrade of General Motors and Ford from a tier-one to tier-two commercial paper issuer had a huge impact on the commercial paper markets. The result is that these commercial paper issuers were forced to give up the cost advantage of commercial paper and to move to the long-term debt markets to ensure they would have access to cash. The decrease in the number of eli- gible commercial paper issuers in the early 2000s resulted in a decrease in the size of the commercial paper market for the first time in 40 years (see Figure 5–6 ).

The mid-2000s saw a huge rise in the use of asset-backed commercial paper (ABCP). In July 2007, $1.19 trillion of the total $2.16 trillion commercial paper outstanding was ABCP. ABCP is collateralized by other financial assets of the issuer. The financial assets that serve as collateral for ABCP are ordinarily a mix of many different assets, which are jointly judged to have a low risk of bankruptcy by a ratings agency. In the mid-2000s, the collateralized assets were mainly mortgage-backed securities. However, in 2007–2008 many of these mortgage-backed securities performed more poorly than expected. Billions of dollars of asset-backed commercial paper were tainted because some of the proceeds were used to buy investments tied to U.S. subprime mortgages. Issuers found buyers much less willing to purchase ABCP. The result was another big drop in the dollar value of the commercial paper markets. By June 2010, just $391 billion of ABCP was outstanding (of the total $1.08 trillion commercial paper market).

In addition to the problems in the ABCP market, at the height of the financial crisis, in September 2008, money market mutual funds withdrawals skyrocketed. Fund inves- tors pulled out a record $144.5 billion during the week ending Wednesday, September 17 (redemptions during the week of September 10 totaled just $7.1 billion) as investors wor- ried about the safety of even these safest investments. Money market mutual funds par- ticipate heavily in the commercial paper market. As investors pulled their money from these funds, the commercial paper market shrank by $52.1 billion for the week (through Wednesday). These outflows severely undermined the stability of short-term funding mar- kets, upon which many large corporations rely heavily to meet their short-term borrowing needs. In response, the Federal Reserve Board announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that complemented the Federal Reserve’s exist- ing credit facilities, to help provide liquidity to short-term funding markets. Under the plan, the Federal Reserve stepped in to purchase commercial paper and other short-term debt that financed companies’ day-to-day operations. Despite these actions, however, the commercial paper market failed to reverse its contraction; from over $2.16 trillion at its peak in July 2007, the commercial paper market has fallen to $1.76 trillion in July 2008, $1.21 trillion in July 2009, and just $1.08 trillion in July 2010. These decreases can be seen in Figure 5–6 .

The better the credit rating on a commercial paper issue, the lower the interest rate on the issue. The spread between the interest rate on medium grade commercial paper and prime grade commercial paper is shown in Figure 5–7 . During the 1990s, the spread was generally on the order of 0.22 percent (22 basis points) per year. From June 2001 through June 2003, as the economy slowed, the spread increased to an average of 0.38 percent per year. In the mid-2000s, the spread was at times close to zero. However, as credit markets deteriorated in the summer of 2007 spreads again increased. For example, in August 2007, the spreads surged to 1.25 percent. The situation worsened throughout the financial crisis.

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Chapter 5 Money Markets 161

Figure 5–7 shows that the cost of commercial paper funding skyrocketed for the medium- grade commercial paper following the collapse of Lehman Brothers in the fall of 2008. When the spread between prime versus medium-grade commercial paper hit 1.60 percent in 2007, the market was shocked. However, this became minor when the spread increased to an eight-month high of 3.95 percent in September 2008 after the U.S. House of Repre- sentatives rejected a plan to rescue banks and then rose to an unthinkable 6.15 percent in late 2008. Usually the spread between prime and medium-grade commercial paper reflects a concern for default on the riskier paper. But during the financial crisis the spread also reflected a lack of liquidity in the system: credit markets were essentially locked up waiting for the federal government to present some type of solution or bailout. While the Federal Reserve was able to bring commercial paper rates down during the crisis, the commercial paper market has yet to recover.

The Trading Process for Commercial Paper. Commercial paper is sold to investors either directly (about 50 percent of all issues in 2010—see Figure 5–6 ), using the issuer’s own sales force (e.g., GMAC), or indirectly through brokers and dealers, such as major bank subsidiaries that specialize in investment banking activities and investment banks underwriting the issues. 12 Commercial paper underwritten and issued through brokers and dealers is more expensive to the issuer, usually increasing the cost of the issue by one-tenth to one-eighth of a percent, reflecting an underwriting cost. In return, the dealer guarantees, through a firm commitment underwriting, the sale of the whole issue. To help achieve this goal, the dealer contacts prospective buyers of the commercial paper, determines the appropriate discount rate on the commercial paper, and relays any special requests for the commercial paper in terms of specific quantities and maturities to the issuer. When a

Figure 5–7 Rates on Prime versus Medium-Grade Commercial Paper, 1997–2010

12 Commercial bank subsidiaries have been allowed to underwrite commercial paper only since 1987.

Interest Rate

Ja n-

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Year

Prime Medium Grade

7

6

5

4

3

2

1

0

Source: Federal Reserve Board Web site, “Research and Data,” July 2010. www.federalreserve.gov

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162 Part 2 Securities Markets

company issues commercial paper through a dealer, a request made at the beginning of the day by a potential investor (such as a money market mutual fund) for a particular maturity is often completed by the end of the day.

When commercial paper is issued directly from an issuer to a buyer, the company saves the cost of the dealer (and the underwriting services) but must find appropriate inves- tors and determine the discount rate on the paper that will place the complete issue. When the firm decides how much commercial paper it wants to issue, it posts offering rates to potential buyers based on its own estimates of investor demand. The firm then monitors the flow of money during the day and adjusts its commercial paper rates depending on investor demand.

Commercial Paper Yields. Like Treasury bills, yields on commercial paper are quoted on a discount basis—the discount return to commercial paper holders is the annualized per- centage difference between the price paid for the paper and the par value using a 360-day year. Specifically:

i P P

P h cp dy

f

f , �

� �

0 360

and when converted to a bond equivalent yield:

i P P

P h cp bey

f , �

� �

0

0

365

Example 5–8 Calculation of the Yield on Commercial Paper

Suppose an investor purchases 95-day commercial paper with a par value of $1,000,000 for a price of $990,023. The discount yield ( dy ) on the commercial paper is calculated as:

icp dy,

$ , , $ ,

$ , , .�

� � �

1 000 000 990 023

1 000 000

360

95 0 37002%

and the bond equivalent yield ( bey ) is:

icp bey,

$ , , $ ,

$ , .�

� � �

1 000 000 990 023

990 023

365

95 0 37577%

Finally, the EAR on the commercial paper is:

EAR � � � �1

003757

365 95 1 0 3763

365 95. . %

/

/⎛ ⎝

⎞ ⎠

Negotiable Certificates of Deposit

A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies an interest rate and maturity date and is negotiable (i.e., salable) in the secondary market. As of 2010, there were over $1.8 trillion of negotiable CDs outstanding. A negotiable CD is a bearer instrument —whoever holds the CD when it matures receives the princi- pal and interest. A negotiable CD can be traded any number of times in secondary mar- kets; therefore, the original buyer is not necessarily the owner at maturity. 13 Negotiable CDs have denominations that range from $100,000 to $10 million; $1 million is the most common denomination. The large denominations make negotiable CDs too large for most

negotiable certificate of deposit A bank-issued, fixed maturity, interest-bearing time deposit that speci- fies an interest rate and maturity date and is negotiable.

negotiable certificate of deposit A bank-issued, fixed maturity, interest-bearing time deposit that speci- fies an interest rate and maturity date and is negotiable.

bearer instrument An instrument in which the holder at maturity receives the principal and interest.

bearer instrument An instrument in which the holder at maturity receives the principal and interest.

13 By contrast, retail CDs with face values under $100,000 are not traded. Thus, a negotiable CD is more “liquid” to an investor than a retail CD or time deposit.

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Chapter 5 Money Markets 163

individuals to buy. However, negotiable CDs are often purchased by money market mutual funds (see Chapter 17 ), which pool funds of individual investors and allow this group to indirectly purchase negotiable CDs. Negotiable CD maturities range from two weeks to one year, with most having a maturity of one to four months.

While CDs have been used by banks since the early 1900s, they were not issued in a negotiable form until the early 1960s. Because of rising interest rates in the 1950s and significant interest rate penalties charged on the early withdrawal of funds invested in CDs, large CDs became unattractive to deposit holders. The result was a significant drop in deposits at banks (disintermediation). In 1961, First National City Bank of New York (now known as Citigroup) issued the first negotiable CD, and money market dealers agreed to make a secondary market in them. These negotiable CDs were well received and helped banks regain many of their lost deposits. Indeed, the success of negotiable CDs helped bank managers focus more actively on managing the liability side of their portfolios (see Chapter 21 ).

The Trading Process for Negotiable Certificates of Deposit. Banks issuing negotiable CDs post a daily set of rates for the most popular maturities of their negotiable CDs, nor- mally 1, 2, 3, 6, and 12 months. Then, subject to its funding needs, the bank tries to sell as many CDs to investors who are likely to hold them as investments rather than sell them to the secondary market.

In some cases, the bank and the CD investor directly negotiate a rate, the maturity, and the size of the CD. Once this is done, the issuing bank delivers the CD to a custodian bank specified by the investor. The custodian bank verifies the CD, debits the amount to the investor’s account, and credits the amount to the issuing bank. This is done through the Fedwire system by transferring fed funds from the custodian bank’s reserve account at the Fed to the issuing bank’s reserve account.

The secondary market for negotiable CDs allows investors to buy existing negotiable CDs rather than new issues. While it is not a very active market, the secondary market for negotiable CDs is made up of a linked network of approximately 15 brokers and dealers using telephones to transact. The secondary market is predominantly located in New York City, along with most of the brokers and dealers.

The mechanics of the secondary market are similar to those of the primary market for negotiable CDs. Certificates are physically transported between traders or their custodian banks. The custodian bank verifies the certificate and records the deposit in the investor’s account. Most transactions executed in the morning are usually settled the same day; most transactions executed later in the day are settled the next business day.

Negotiable CD Yields. Negotiable CD rates are negotiated between the bank and the CD buyer. Large, well-known banks can offer CDs at slightly lower rates than smaller, less well-known banks. This is due partly to the lower perceived default risk and greater marketability of well-known banks and partly to the belief that larger banks are often “too big to fail”—regulators will bail out troubled large banks and protect large depositors beyond the explicit ($250,000) deposit cap under the current FDIC insurance program (see Chapter 13 ). Interest rates on negotiable CDs are generally quoted on an interest-bearing basis using a 360-day year.

Example 5–9 Calculation of the Secondary Market Yield on a Negotiable CD

A bank has issued a six-month, $1 million negotiable CD with a 0.72 percent annual inter- est rate. Thus, at maturity (in 182 days) the CD holder will receive:

FV � � �$ . ( . ) $ , ,1 1 0072 2 1 003 600m /

in six months in exchange for $1 million deposited in the bank today.

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164 Part 2 Securities Markets

Immediately after the CD is issued, the secondary market price on the $1 million CD falls to $999,651. As a result, the secondary market yield on the $1 million face value CD increases as follows:

1 003 600 1 2 999 651

0 791

, , ( ) $ ,

.

,

,

/ /� �

�

i

i

CD bey

CD bey=> 66%

Finally, the EAR on the CD is:

EAR � � � �

/

/

1 007916

365 182 1 0 7932

365 182. . %⎛⎝

⎞ ⎠

Banker’s Acceptances

A banker’s acceptance is a time draft payable to a seller of goods, with payment guar- anteed by a bank. Bankers’ acceptances make up an increasingly small part of the money markets. There were less than $1 billion banker’s acceptances outstanding in 2010. Time drafts issued by a bank are orders for the bank to pay a specified amount of money to the bearer of the time draft on a given date.

The Trading Process for Banker’s Acceptances. Many banker’s acceptances arise from international trade transactions and the underlying letters of credit (or time drafts) that are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer). Foreign exporters often prefer that banks act as guarantors for payment before sending goods to domestic importers, particularly when the foreign supplier has not previously done business with the domestic importer on a regular basis. In the United States, a majority of all acceptances are originated in New York, Chicago, and San Francisco. The U.S. bank insures the international transaction by stamping “Accepted” on a time draft written against the letter of credit between the exporter and the importer, signifying its obliga- tion to pay the foreign exporter (or its bank) on a specified date should the importer fail to pay for the goods. Foreign exporters can then hold the banker’s acceptance (the accepted time draft written against the letter of credit) until the date specified on the letter of credit. If they have an immediate need for cash, they can sell the acceptance before that date at a discount from the face value to a buyer in the money market (e.g., a bank). In this case, the ultimate bearer will receive the face value of the banker’s acceptance on maturity. We describe this process in more detail in Appendix B to this chapter located at the book’s Web site ( www.mhhe.com/sc5e ).

Because banker’s acceptances are payable to the bearer at maturity, they can and are traded in secondary markets. Maturities on banker’s acceptances traded in secondary mar- kets range from 30 to 270 days. Denominations of banker’s acceptances are determined by the size of the original transaction (between the domestic importer and the foreign exporter). Once in the secondary markets, however, banker’s acceptances are often bun- dled and traded in round lots, mainly of $100,000 and $500,000.

Only the largest U.S. banks are active in the banker’s acceptance market. Because the risk of default is very low (essentially an investor is buying a security that is fully backed by commercial bank guarantees), interest rates on banker’s acceptances are low. Specifi- cally, there is a form of double protection underlying banker’s acceptances that reduces their default risk. Since both the importer and the importer’s bank must default on the transaction before the investor is subject to risk, the investor is also protected by the value of the goods imported to which he or she now has a debtor’s claim—the goods underlying the transaction can be viewed as collateral. Like T-bills and commercial paper, banker’s acceptances are sold on a discounted basis.

Comparison of Money Market Securities

Having reviewed the different money market securities, it should be obvious that the dif- ferent securities have a number of characteristics in common: large denominations, low

banker’s acceptance A time draft payable to a seller of goods, with payment guaranteed by a bank.

banker’s acceptance A time draft payable to a seller of goods, with payment guaranteed by a bank.

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Chapter 5 Money Markets 165

default risk, and short maturities. It should also be noted that these securities are quite different in terms of their liquidity. For example, Treasury bills have an extensive secondary market. Thus, these money market securities can be con- verted into cash quickly and with little loss in value. Commercial paper, on the other hand, has no organized secondary market. These securities cannot be converted into cash quickly unless resold to the original dealer/underwriter, and conversion may involve a relatively higher cost. Federal funds also have no sec- ondary market trading, since they are typically overnight loan transactions and are not intended as investments to be held beyond very short horizons (thus, the lack of a secondary market is inconsequential). Indeed, longer-horizon holders simply roll over their holdings. Bank negotiable CDs also can be traded on sec- ondary markets, but in recent years trading has been relatively inactive, as most negotiable CDs are being bought by “buy and hold” oriented money market mutual funds, as are banker’s acceptances.

The major money market participants are the U.S. Treasury, the Federal Reserve, com- mercial banks, money market brokers and dealers, corporations, other financial institutions such as mutual funds, and individuals. Table 5–6 summarizes the role (issuer or investor) each of these participants plays in the markets for the various money market securities.

MONEY MARKET PARTICIPANTSMONEY MARKET PARTICIPANTS

LG 5-4LG 5-4

DO YOU UNDERSTAND:

4. How Treasury bills are first issued?

5. What federal funds are?

6. What the two types of federal funds transactions are? Describe each.

7. What securities are mainly used as collateral in repurchase agreements?

8. Why the negotiable CD market was created?

9. What the process is by which a banker’s acceptance is created?

Instrument Principal Issuer Principal Investor

Treasury bills U.S. Treasury Federal Reserve System Commercial banks Mutual funds Brokers and dealers Other financial institutions Corporations Individuals

Federal funds Commercial banks Commercial banks Repurchase agreements Federal Reserve System Federal Reserve System

Commercial banks Commercial banks Brokers and dealers Mutual funds Other financial institutions Brokers and dealers

Other financial institutions Corporations

Commercial paper Commercial banks Brokers and dealers Other financial institutions Mutual funds Corporations Corporations

Other financial institutions Individuals

Negotiable CDs Commercial banks Brokers and dealers Mutual funds Corporations Other financial institutions Individuals

Banker’s acceptances Commercial banks Commercial banks Brokers and dealers Corporations

TABLE 5–6 Money Market Participants

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166 Part 2 Securities Markets

The U.S. Treasury

The U.S. Treasury raises significant amounts of funds in the money market when it issues T-bills. T-bills are the most actively traded of the money market securities. T-bills allow the U.S. government to raise money to meet unavoidable short-term expenditure needs prior to the receipt of tax revenues. Tax receipts are generally concentrated around quarterly dates, but government expenditures are more evenly distributed over the year.

The Federal Reserve

The Federal Reserve is a key (arguably the most important) participant in the money mar- kets. The Federal Reserve holds T-bills (as well as T-notes and T-bonds) to conduct open market transactions—purchasing T-bills when it wants to increase the money supply and selling T-bills when it wants to decrease the money supply. The Federal Reserve often uses repurchase agreements and reverse repos to temporarily smooth interest rates and the money supply. Moreover, the Fed targets the federal funds rate as part of its overall mon- etary policy strategy, which can in turn affect other money market rates. Finally, the Fed operates the discount window, which it can use to influence the supply of bank reserves to commercial banks and ultimately the demand for and supply of fed funds and repos.

Commercial Banks

Commercial banks are the most diverse group of participants in the money markets. As Table 5–6 shows, banks participate as issuers and/or investors of almost all money market instruments discussed above. For example, banks are the major issuers of negotiable CDs, banker’s acceptances, federal funds, and repurchase agreements.

The importance of banks in the money markets is driven in part by their need to meet reserve requirements imposed by regulation. For example, during periods of economic expansion, heavy loan demand can produce reserve deficiencies for banks (i.e., their actual reserve holdings are pushed below the minimums required by regulation). Additional reserves can be obtained by borrowing fed funds from other banks, engaging in a repur- chase agreement, selling negotiable CDs, or selling commercial paper. 14 Conversely, dur- ing contractionary periods, many banks have excess reserves that they can use to purchase Treasury securities, trade fed funds, engage in reverse repos, and so on.

Money Market Mutual Funds

Money market mutual funds purchase large amounts of money market securities and sell shares in these pools based on the value of their underlying (money market) securities (see Chapter 17 ). In doing so, money market mutual funds allow small investors to invest in money market instruments. In 2010 money market mutual funds had $1.5 trillion invested in short- term financial securities—such as repurchase agreements, negotiable CDs, open market paper (mostly commercial paper), and U.S. government securities. Money market mutual funds pro- vide an alternative investment opportunity to interest-bearing deposits at commercial banks. 15

Brokers and Dealers

Brokers’ and dealers’ services are important to the smooth functioning of money markets. We have alluded to various categories of brokers and dealers in this chapter. First are the

www.ustreas.gov www.ustreas.gov

www .federalreserve .gov

www .federalreserve .gov

14 Only bank holding companies such as Citigroup can issue commercial paper. However, funds so borrowed can be lent (downstreamed) to bank subsidiaries such as Citibank. Currently, the Federal Reserve imposes reserve require- ments on such transactions.

15 Indeed, the short maturity of these asset holdings is an objective of these funds so as to retain the deposit- like nature of their liabilities (called shares). The major difference between deposits and money market mutual fund (MMMF) shares is that interest-bearing deposits (below $250,000) are fully insured by the FDIC, whereas MMMF shares are not. Moreover, because of bank regulatory costs (such as reserve requirements, capital adequacy require- ments, and deposit insurance premiums), bank deposits generally offer lower interest rates or returns than noninsured money market mutual funds. Thus, the net gain in switching to a money market mutual fund is a higher return in exchange for the loss of FDIC deposit insurance coverage. Many investors appeared willing to give up FDIC insurance coverage to obtain additional returns in the late 1990s and early 2000s.

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Chapter 5 Money Markets 167

18 primary government security dealers. This group of participants plays a key role in marketing new issues of Treasury bills (and other Treasury securities). Primary govern- ment securities dealers also make the market in Treasury bills, buying securities from the Federal Reserve when they are issued and selling them in the secondary market. Secondary market transactions in the T-bill markets are transacted in the trading rooms of these pri- mary dealers. These dealers also assist the Federal Reserve when it uses the repo market to temporarily increase or decrease the supply of bank reserves available.

The second group of brokers and dealers are money and security brokers. The five major brokers in this group are Cantor Fitzgerald Securities Corp., Garban-Intercapital, Liberty, Prebon Yamane, and Hill Farber. When government securities dealers trade with each other, they often use this group of brokers as intermediaries. These brokers also play a major role in linking buyers and sellers in the fed funds market and assist secondary trading in other money market securities as well. These brokers never trade for their own account, and they keep the names of dealers involved in trades they handle confidential.

The third group of brokers and dealers are the thousands of brokers and dealers who act as intermediaries in the money markets by linking buyers and sellers of money market securities (see Chapter 16 ). These brokers and dealers often act as the intermediaries for smaller investors who do not have sufficient funds to invest in primary issues of money market securities or who simply want to invest in the money markets.

Corporations

Nonfinancial and financial corporations raise large amounts of funds in the money markets, primarily in the form of commercial paper. Because corporate cash inflows rarely equal their cash outflows, they often invest their excess cash funds in money market securities, especially T-bills, repos, commercial paper, negotiable CDs, and banker’s acceptances.

Other Financial Institutions

Because their liability payments are relatively unpredictable, property-casualty (PC) insur- ance companies, and to a lesser extent life insurance companies, must maintain large bal-

ances of liquid assets (see Chapter 15 ). To accomplish this, insurance companies invest heavily in highly liquid money market securities, especially T-bills, repos, commercial paper, and negotiable CDs.

Since finance companies are not banks and cannot issue deposits, they raise large amounts of funds in the money markets (see Chapter 14 ), especially through the issuance of commercial paper.

Individuals

Individual investors participate in the money markets through direct investments in these securities (e.g., negotiable CDs) or through investments in money market mutual funds, which contain a mix of all types of money market securities.

While U.S. money markets are the largest and most active in the world, money markets across the world have been growing in size and importance. Two forms of growth include (1) U.S. money market securities bought and sold by foreign investors and (2) foreign money market securities. As a result of the growth in money markets worldwide, the flow of funds across borders in various countries has grown as international investors move their funds to money markets offering the most attractive yields. Table 5–7 lists the total amounts of various U.S. money market securities held by foreign investors from 1994 through 2010. Figure 5–8 shows the U.S. dollar equivalent amounts of money market instruments traded in international money markets as of March 2010, by the cur- rency of issue and type of instrument issued. Table 5–8 shows the variation in central bank interest rates (discount rates for lender of last resort loans) in several countries in 2007 and 2010.

INTERNATIONAL ASPECTS OF MONEY MARKETSINTERNATIONAL ASPECTS OF MONEY MARKETS

LG 5-5LG 5-5

DO YOU UNDERSTAND:

10. Who the major money market participants are?

11. Which money market securities commercial banks issue?

12. What services brokers and dealers provide for money market participants?

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168 Part 2 Securities Markets

Note from Table 5–7 that foreign investments in U.S. money market securities increased from 1994 through 2007 (before the financial crisis). During the crisis, only foreign investments in Treasury securities increased significantly (from $2.376 trillion in 2007 to $3.936 trillion in 2010). In contrast, foreign investments in repos decreased signifi- cantly (from $1.109 trillion in 2007 to $0.630 trillion in 2010), as did investments in open

1994 1997 2000 2004 2007 2010*

Treasury securities† $633 $1,252 $1,222 $1,814 $2,376 $3,936 Repurchase agreements 47 91 91 665 1,109 630 Negotiable CDs 56 74 107 149 208 219 Open market paper‡ 25 78 111 230 278 192

TABLE 5–7 Foreign Investments in U.S. Money Market Instruments ( in billions of dollars )

Figure 5–8 Worldwide Money Market Instruments Outstanding

* Data as of March 2010.

† Includes Treasury bills, notes, and bonds.

‡ Commercial paper and banker’s acceptances.

Source: Federal Reserve Board Web site, “Flow of Fund Accounts,” June 2010. www.federalreserve.gov

Currency Type

Other Short-Term Paper, $350.2 billion

Commercial Paper, $594.7 billion

Issue Type

Currency Type Issue Type

Corporations 0.2%

Other 0.2%

Financial Institutions

99.6%Other 10.0%

Euro 39.4%

U.S. $ 44.7%

Pound 5.9%

Corporations 5.3%

Other 7.1%

Financial Institutions

87.6% Euro

49.6%

Pound 13.3%

Other 6.4%

U.S. $ 30.7%

Source: Bank for International Settlements, “International Banking and Financial Market Developments,” Quarterly

Review, June 2010. www.bis.org

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Chapter 5 Money Markets 169

market paper (from $0.278 trillion in 2007 to $0.192 trillion in 2010). During the finan- cial crisis, investors worldwide, searching for a safe haven for their funds, invested huge amounts of funds in U.S. Treasury securities, while reducing investments in other money market (and capital market) securities. In addition, while central banks varied in the level of interest rates they set, all countries reduced their interest rates to historic lows during the financial crisis as they took steps to stimulate their local economies (see Table 5–8 ). For example, the United Kingdom lowered its repurchase rate from 5.75 percent in 2007, prior to the crisis, to 0.50 percent in 2010, during the crisis. Japan, whose economy was relatively weak in 2007, set its discount rate at 0.75 percent in 2007 and lowered it even further, to 0.10 percent, during the crisis.

Euro Money Markets

Because of the importance of the U.S. dollar relative to other currencies, many inter- national financial contracts call for payment in U.S. dollars—the U.S. dollar is still the major international medium of exchange (64 percent of the world’s currency reserves are held in U.S. dollars). As a result, foreign governments and businesses have historically held a store of funds (deposits) denominated in dollars outside of the United States. Fur- ther, U.S. corporations conducting international trade often hold U.S. dollar deposits in

foreign banks overseas to facilitate expenditures and purchases. These dollar- denominated deposits held offshore in U.S. bank branches overseas and in other (foreign) banks are called Eurodollar deposits (Eurodollar CDs) and the market in which they trade is called the Eurodollar market. Eurodollars may be held by governments, corporations, and individuals from anywhere in the world and are not directly subject to U.S. bank regulations, such as reserve requirements and deposit insurance premiums (or protection). As a result, the rate paid on Eurodollar CDs is generally higher than that paid on U.S.-domiciled CDs (see below). As an alternative to the Eurodollar market, companies can also obtain

LG 5-6LG 5-6

TABLE 5–8 Selected Central Bank Interest Rates

2007 Rate 2010 Rate

Country/Interest Rate Percent per

Year Applicable

From Percent per Year

Applicable From

1. EU countries Euro area 3 Sept. ’07 1.00 May ’09 Denmark Discount rate 4 June ’07 0.75 Jan. ’10 Sweden Deposit rate 3 Sept. ’07 �0.25 Aug. ’09 Repurchase rate 3.75 Sept. ’07 0.50 July ’10 United Kingdom Repurchase rate† 5.75 July ’07 0.50 Mar. ’09 2. Switzerland Three-month LIBOR target 2.25–3.25 Sept. ’07 0.25 Mar. ’09 3. Non-European countries Canada‡

Discount rate 4.5 July ’07 0.50 June ’10 Japan Discount rate 0.75 Feb. ’07 0.10 Nov. ’08 United States Federal funds rate§ 5.75 Sept. ’07 0.25 Dec. ’08

† Bank of England key rate.

‡ Bank of Canada’s ceiling rate for call money.

§ Rate targeted for interbank trade in central bank money.

Source: Author’s research.

DO YOU UNDERSTAND:

13. What the major U.S. money market securities held by foreign investors are?

14. Which currencies most international money market instruments are issued in?

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170 Part 2 Securities Markets

short-term funding by issuing Eurocommercial paper. Eurocommercial paper is issued in Europe but can be held by investors inside or outside of Europe.

The Eurodollar Market. Large banks in London organized the interbank Eurodollar market. This market is now used by banks around the world as a source of overnight fund- ing. The term “Eurodollar market” is something of a misnomer because the markets have no true physical location. Rather, the Eurodollar market is simply a market in which dol- lars held outside the United States (so-called Eurodollars) are tracked among multinational banks, including the offices of U.S. banks abroad, such as Citigroup’s branch in London or its subsidiary in London. 16 For example, a company in Italy needing U.S. dollars for a foreign trade transaction might ask Citigroup’s subsidiary in London to borrow these dollars on the Eurodollar market. Alternatively, a Greek bank needing U.S. dollar funding may raise the required funds by issuing a Eurodollar CD. Most Eurodollar transactions take place in London.

The rate offered for sale on Eurodollar funds is known as the London Interbank Offered Rate (LIBOR). Funds traded in the Eurodollar market are often used as an alter- native to fed funds as a source of overnight funding for banks. 17 As alternative sources of overnight funding, the LIBOR and the U.S. federal funds rate tend to be very closely related. Should rates in one of these markets (e.g., the LIBOR market) decrease relative to the other (e.g., the fed funds market), overnight borrowers will borrow in the LIBOR market rather than the fed funds market. As a result, the LIBOR will increase with this increased demand and the fed funds rate will decrease with the decline in demand. This will make the difference between the two rates quite small, although not equal, as is dis- cussed below. The ease of transacting in both markets makes it virtually costless to use one market versus the other. Indeed, the LIBOR rate is frequently used by major banks in the United States as a base rate on commercial and industrial loans.

The fed funds rate and LIBOR between 1997 and July 2010 are plotted in Figure 5–9 . While they are close substitutes for overnight funding, the fed funds rate is generally lower than the LIBOR. This difference is due to the low-risk nature of U.S. bank deposits versus foreign bank deposits. U.S. bank deposits are covered by deposit insurance up to certain levels. Moreover, there is a perception that large U.S. banks and large U.S. bank depositors are implicitly insured via “too big to fail” (or TBTF) guarantees. Such guarantees lower U.S. bank risk and thus the cost of borrowing in the fed funds market. Foreign banks have no such explicit or implicit guarantees. As a result, LIBOR is generally higher than the fed funds rate, reflecting slightly higher default risk. Further, remember from Chapter 4 that the Federal Reserve sets the fed funds rate as it implements monetary policy. Thus, the fed funds rate is affected not just by the demand for interbank lending, but also by the Fed’s actions.

Note from Figure 5–9 that during the financial crisis the LIBOR rate spiked signifi- cantly, while the fed funds rate did not. The first spike occurred in the summer of 2007. In June and July, two Bear Stearns hedge funds required assistance, and Countrywide, one of the largest subprime mortgage originators, announced unexpectedly large losses. Then in August 2007, the asset-backed securities market dried up when several issuers failed to provide liquidity to support funding of securitized assets financed with short-term com- mercial paper. In response to the decline in asset values and an increase in concerns about bank solvency, the interbank market began to freeze. To prevent trouble in the financial markets, the Fed kept the fed funds rate low. The result was that the LIBOR rate rose especially sharply, while the fed funds rate did not. For example, the spread between the LIBOR and fed funds rates was 0.07 percent in May 2007, 0.50 percent in August 2007, and 0.75 percent in December 2007.

Conditions improved following the bailout of Bear Stearns. The cost of funds to banks fell, as did the spread between the LIBOR and fed funds rates. In the summer of

Eurodollar market The market in which Eurodollars trade.

Eurodollar market The market in which Eurodollars trade.

London Interbank Offered Rate (LIBOR) The rate paid on Eurodollars.

London Interbank Offered Rate (LIBOR) The rate paid on Eurodollars.

16 Estimates indicate that more than twice as many dollars are traded outside than within U.S. borders.

17 Also, the rate paid by banks buying these funds is the London Interbank Bid Rate (LIBID). The spread between LIBOR and LIBID is small, rarely exceeding 12.5 basis points.

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Chapter 5 Money Markets 171

2008, however, mortgage foreclosures continued to rise, leading to further downgrades of mortgage-backed securities by the credit rating agencies and the acceleration of losses to holders of those securities. Losses on mortgages and mortgage-backed securities eventu- ally led to the failure of several financial institutions, most notably during the week of September 15, 2008, in which both AIG (technically) and Lehman Brothers failed. The demise of AIG and Lehman massively increased the demand for funding liquidity across the whole financial system. Panic soon spread globally and overnight borrowing rates jumped. However, the Fed again stepped in and lowered the fed funds rate (to between 0 and 0.25 percent) and expanded insurance on bank deposits. Public capital was also injected into all of the large banks in an attempt to allay fears about insolvency. The result was a huge spike in the spread between the LIBOR and fed funds rates. At the height of the crisis, the spread jumped to about 3 percent.

Note, too, from Figure 5–9 that the fed funds rate sometimes exceeds the LIBOR rate. As noted above, the increased demand for Eurodollars relative to fed funds as a source of overnight funding has, at times, outweighed the effect of the deposit insurance and TBTF guarantees. The result is that the fed funds rate has, at times, risen above the LIBOR rate.

Initially, most short-term adjustable-rate business loans were tied to the U.S. fed funds rate. However, the tremendous growth of the Eurodollar market has resulted in the LIBOR becoming the standard rate by which loan rates are now priced. For example, the commer- cial paper market in the United States now quotes rates as a spread over the LIBOR rate rather than over the Treasury bill rate.

Eurodollar Certificates of Deposit. Eurodollar certificates of deposit (CDs) are U.S. dollar–denominated CDs in foreign banks. Maturities on Eurodollar CDs are less than one year, and most have a maturity of one week to six months. Because these securities are

Eurodollar CDs Dollar-denominated deposits in non-U.S. banks.

Eurodollar CDs Dollar-denominated deposits in non-U.S. banks.

Figure 5–9 Overnight Interest Rates, 1997–2010

Year

Interest Rate

LIBOR Fed Funds

Ja n-

97

Ja n-

98

Ja n-

99

Ja n-

00

Ja n-

01

Ja n-

02

Ja n-

03

Ja n-

04

Ja n-

05

Ja n-

06

Ja n-

07

Ja n-

08

Ja n-

09

Ja n-

10

1

2

3

4

5

6

7

8

0

Source: Federal Reserve Board Web site, “Research and Data,” July 2010, and author’s research.

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172 Part 2 Securities Markets

deposited in non-U.S. banks, Eurodollar CDs are not subject to reserve requirements in the same manner as U.S. deposits (although the reserve requirement on U.S. CDs was set to zero at the beginning of 1991).

Figure 5–10 shows the difference between three-month Eurodollar and U.S. bank– issued CDs from 1971 through 2010. As can be seen in this figure, prior to the 1990s,

the Eurodollar CD paid consistently higher interest rates than U.S. CDs. In the 1990s, after the reserve requirement on CDs was set to zero, it is diffi- cult to distinguish the Eurodollar CD rate from the U.S. CD rate. Indeed, in 2007, the average rate paid on three-month Eurodollar CDs was 5.52 percent and on three-month U.S. CDs the average rate paid was 5.49 percent. Note, however, that during the financial crisis, Eurodollar CD rates rose above U.S. CD rates. In October 2008, the Eurodollar CD rate (5.31 percent) was 0.99 percent higher than the U.S. CD rate (4.32 percent). This difference was again due to the low-risk nature of U.S. bank deposits relative to foreign bank deposits.

Eurocommercial Paper. Eurocommercial paper (Euro-CP) is issued in Europe by dealers of commercial paper without involving a bank. The Eurocommercial paper rate is generally about one-half to 1 percent above the LIBOR rate. Foreign commercial paper markets are new and small relative to U.S. commercial paper markets. Eurocommercial paper is issued in local currencies as well as in U.S. dollars. Table 5–9 lists the amount of Eurocommercial paper outstanding in the international money markets from 1995 through March 2010 by currency and nationality of issuer. Notice that with the introduction of the European Currency Unit in 1999, Eurocommercial paper denominated in euro-area

Eurocommercial paper Eurosecurities issued in Europe by dealers of commercial paper with- out involving a bank.

Eurocommercial paper Eurosecurities issued in Europe by dealers of commercial paper with- out involving a bank.

DO YOU UNDERSTAND:

15. What the differences are between a Eurodollar CD and Eurocommercial paper?

16. What the relation is between the federal funds rate and the LIBOR?

0

2

4

6

8

10

12

14

16

18

20

Ja n-

71

Ja n-

73

Ja n-

75

Ja n-

77

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79

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81

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83

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87

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89

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91

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93

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97

Ja n-

99

Ja n-

01

Ja n-

03

Ja n-

05

Ja n-

07

Ja n-

09

Year

Interest Rate

EuroCDUS CD

Figure 5–10 Three-Month U.S. Bank–Issued versus Eurodollar CD Rates, 1971–2010

Source: Federal Reserve Board Web site, “Research and Data,” July 2010. www.federalreserve.com

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currencies increased significantly. By 2010, 49.6 percent of all Eurocommercial paper out- standing was denominated in euros. In comparison, U.K. (British pound sterling) paper comprised 13.3 percent of all Eurocommercial paper outstanding, while U.S dollar– denominated paper fell to 30.8 percent of the total. Projections are that the Euro money market will only continue to grow.

TABLE 5–9 Eurocommercial Paper Outstanding, 1995–2010 ( in billions of U.S. dollars )

Amount Outstanding

1995 1998 2001 2004 June 2008

March 2010

Eurocommercial paper $87 $133 $243 $415 $807 $595 Currency type U.S. dollar 56 78 103 113 208 183 Euro-area currencies† 9 24 80 209 405 295 Japanese yen 2 4 14 4 19 5 Pound sterling N/A N/A 29 62 122 79 Other currencies 20 27 17 27 53 33

Issuer nationality

Germany 9 14 61 109 94 60 United Kingdom 5 9 26 49 225 149 United States 14 20 30 51 63 40 Japan 12 18 7 17 1 2 Other developed countries 36 56 92 176 377 317 Other 11 16 27 13 47 27

† The BIS used the deutsche mark in 1995.

Source: Bank for International Settlements, “International Banking and Financial Market Developments,” Quarterly

Review, various issues. www.bis.org

SUMMARY In this chapter, we reviewed money markets, which are markets that trade debt securities with original maturities of one year or less. The need for money markets arises because cash receipts do not always coincide with cash expenditures for individuals, corporations, and government units. Because holding cash involves an opportunity cost, holders of excess cash invest these funds in money market securities. We looked at the various money market securities available to short-term investors and the major borrowers and issuers of each. We also outlined the processes by which each of these securities are issued and traded in secondary markets. We concluded the chapter by examining international issues involving money markets, taking a particular look at Euro money markets.

QUESTIONS 1. What are the three characteristics common to money market

securities? (LG 5-1)

2. What is the difference between a discount yield and a bond equivalent yield? Which yield is used for Treasury bill quotes? (LG 5-1)

3. Why can discount yields not generally be compared to yields on other (nondiscount) securities? (LG 5-1)

4. What is the difference between a single-payment yield and a bond equivalent yield? (LG 5-1)

5. Describe the T-bill auction process. (LG 5-3)

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6. What is the difference between a competitive bid and a non- competitive bid in a T-bill auction? (LG 5-3)

7. What are federal funds? How are they recorded on the bal- ance sheets of commercial banks? (LG 5-2)

8. Describe the two types of fed funds transactions. (LG 5-2)

9. What is the difference between a repurchase agreement and a reverse repurchase agreement? (LG 5-2)

10. Why do commercial paper issues have an original maturity of 270 days or less? (LG 5-2)

11. Why do commercial paper issuers almost always obtain a rating of their issues? (LG 5-2)

12. What is the process through which negotiable CDs are issued? (LG 5-2)

13. Describe the process by which a banker’s acceptance is created. (LG 5-2)

14. Who are the major issuers of and investors in money market securities? (LG 5-4)

15. What are Eurodollar CDs and Eurocommercial paper? (LG 5-6)

PROBLEMS 1. What is the discount yield, bond equivalent yield, and effec-

tive annual return on a $1 million Treasury bill that currently sells at 97 3/8 percent of its face value and is 65 days from maturity? (LG 5-1)

2. Calculate the bond equivalent yield and effective annual return on a jumbo CD that is 115 days from maturity and has a quoted nominal yield of 6.56 percent. (LG 5-1)

3. You would like to purchase a Treasury bill that has a $10,000 face value and is 68 days from maturity. The current price of the Treasury bill is $9,875. Calculate the discount yield on this Treasury bill. (LG 5-2)

4. Suppose you purchase a T-bill that is 125 days from maturity for $9,765. The T-bill has a face value of $10,000. (LG 5-2) a. Calculate the T-bill’s quoted discount yield. b. Calculate the T-bill’s bond equivalent yield.

5. You can purchase a T-bill that is 95 days from maturity for $9,965. The T-bill has a face value of $10,000. (LG 5-2) a. Calculate the T-bill’s quoted yield. b. Calculate the T-bill’s bond equivalent yield. c. Calculate the T-bill’s EAR.

6. Refer to Table 5–5 . (LG 5-2) a. Calculate the ask price of the T-bill maturing on

September 30, 2010, as of July 7, 2010. b. Calculate the bid price of the T-bill maturing on

October 28, 2010, as of July 7, 2010.

7. e celx Using a Spreadsheet to Calculate T-bill Prices: What is the bid price of a $10,000 face value T-bill with a bid rate of 2.23 percent if there are 10, 25, 50, 100, and 250 days to maturity? (LG 5-2)

Face Value

Bid Rate

Days to Maturity

� > The Answer Will Be

$10,000 2.23% 10 $9,993.81 10,000 2.23 25 9,984.51 10,000 2.23 50 9,969.03 10,000 2.23 100 9,938.06 10,000 2.23 250 9,845.14

8. A T-bill that is 225 days from maturity is selling for $95,850. The T-bill has a face value of $100,000. (LG 5-2) a. Calculate the discount yield, bond equivalent yield, and

EAR on the T-bill. b. Calculate the discount yield, bond equivalent yield, and

EAR on the T-bill if it matures in 300 days.

9. e celx Using a Spreadsheet to Calculate T-bill Yield: What is the quoted yield of a $10,000 face value T-bill with a market price of $8,885 if there are 10, 25, 50, 100, and 250 days to maturity? (LG 5-2)

Face Value

Market Price

Days to Maturity

� > The Answer Will Be

$10,000 $8,885 10 4.014% 10,000 8,885 25 1.606 10,000 8,885 50 0.803 10,000 8,885 100 0.401 10,000 8,885 250 0.161

10. If the overnight fed funds rate is quoted as 2.25 percent, what is the bond equivalent rate? Calculate the bond equivalent rate on fed funds if the quoted rate is 3.75 percent. (LG 5-2)

11. Suppose a bank enters a repurchase agreement in which it agrees to buy Treasury securities from a correspondent bank at a price of $24,950,000, with the promise to buy them back at a price of $25,000,000. (LG 5-2) a. Calculate the yield on the repo if it has a 7-day maturity. b. Calculate the yield on the repo if it has a 21-day

maturity.

12. You can buy commercial paper of a major U.S. corporation for $495,000. The paper has a face value of $500,000 and is 45 days from maturity. Calculate the discount yield and bond equivalent yield on the commercial paper. (LG 5-2)

13. You have just purchased a four-month, $500,000 negotiable CD, which will pay a 5.5 percent annual interest rate. (LG 5-2) a. If the market rate on the CD rises to 6 percent, what is its

current market value? b. If the market rate on the CD falls to 5.25 percent, what is

its current market value?

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Go to the Bureau of Public Debt Web site at www.treasurydirect.gov and find the latest information on 13-week and 26-week Treasury bill auctions.

Click on “Auction Results.” Click on “13-week Bills” and then “26-week Bills.” Click on “20XX” (most current year). Under the most recent date, click on “Auction/Results.” This will bring up the relevant information.

Questions 1. What are the high, low, and median prices on the most recent issues? 2. What is the dollar value of tendered and accepted bids for the most recent issues? 3. What is the dollar value of noncompetitive bids on the most recent issues?

SEARCH THE SITE

APPENDIX 5A: Single versus Discriminating Price Treasury Auctions

View this appendix at www.mhhe.com/sc5e

APPENDIX 5B: Creation of a Banker’s Acceptance

View this appendix at www.mhhe.com/sc5e

Go to the Federal Reserve Web site at www.federalreserve.gov and find the most recent information on prime versus commercial paper rates using the following steps. Click on “Selected Interest Rates” and then on the most recent date. This will bring up the relevant data (“Commercial Paper, Nonfinancial, 3-Month” and “Bank prime loan”).

Questions 1. By how much have the prime rate and commercial paper rate changed since June 2010? 2. Calculate the average spread between the prime rate and the commercial paper rate over the last

year. How does this compare to the spread seen in the fall of 2008?

SEARCH THE SITE

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APPENDIX 5A: Single versus Discriminating Price Treasury Auctions

The single price auction was fully adopted by the U.S. Treasury in 1998. Under this model, all Treasury security bidders pay the same price for the Treasury security—the lowest price of the competitive bids accepted. Prior to 1998, Treasury security auctions were “discriminating” price auctions in that different successful bidders paid different prices (their bid prices). The Treasury found that single price auctions tend to result in the distribution of auction awards to a greater number of bidders than under discriminating price auctions. Also, the Treasury found that single price auctions result in more aggressive bidding. Successful bidders avoid the so-called winner’s curse, the risk that one bidder will pay more than others. However, the Treasury also found that the more aggressive bidding results in overall higher bid prices and thus increased revenues (or reduced costs) to the Treasury for funding the federal debt. 18

We illustrate this increase in revenue in Figure 5–11 . Panel A in Figure 5–11 shows the Treasury auction results under a discriminating price auction. The revenue to the U.S. Treasury from the auction is represented by the shaded area under the demand curve ( D D ) for the Treasury security being auctioned. Panel B shows the Treasury auction results under a single price auction. In a single price auction, bidders bid higher because they do not pay the price they bid. Thus, there is no penalty (i.e., the bidder pays no more) for bidding a higher price and the demand curve for the security being auctioned shifts up and to the right (to D s ). Even though some of the successful bidders will pay less for the securities, with this shift up in the demand for the security, the revenue (the shaded area under the demand curve ( D s )) to the Treasury may increase.

18 See “Uniform Price Auctions: Update of the Treasury Experience,” Department of Treasury, October 1998.

Figure 5–11 Single Versus Discriminating Price Treasury Auctions

Bid price Noncompetitive bids

1 2

3 4

5 6

7

Quantity of T-bills

DD

High bid

(Stop-out price) Low-bid

accepted

ST

Panel A: Discriminating Price Auction

1 2

3 4

5 6

7

ST

Quantity of T-bills

(Stop-out price) Low-bid

accepted

Noncompetitive bids

Bid price High bid

Panel B: Single Price Auction

DS

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APPENDIX 5B: Creation of a Banker’s Acceptance

19 One might think of the domestic importer being a U.S. firm such as IBM that purchases a fleet of cars for its executive staff. The foreign exporter might be DaimlerChrysler, a German company, that sells the cars to IBM. The U.S. bank used by IBM might be Bank of America and DaimlerChrysler’s bank can be thought of as Deutsche Bank.

Figure 5–12 Creation of a Banker’s Acceptance

Domestic Importer

1 4

Foreign Exporter

U.S. Bank

1. Purchase order sent. 2. Letter of credit requested. 3. Notification of letter of credit and draft authorization. 4. Order shipped. 5. Time draft and shipping papers sent to foreign bank. 6. Time draft and shipping papers sent to U.S. bank; banker’s acceptance created. 7. Payments sent to foreign bank. 8. Payments sent to foreign exporter. 9. Payment to U.S. bank. 10. Shipping papers delivered.

Foreign Bank

6 7

32 9 10 5 8

In this appendix, we describe the process by which an international trade-related banker’s acceptance is created. The process is illustrated in Figure 5–12 . The creation of a banker’s acceptance often begins when a domestic importer, after placing a purchase order from a foreign exporter (1), is asked by the foreign exporter for a guarantee of payment from the domestic importer’s bank before the goods are shipped. 19 In compliance with this request, the domestic importer arranges a letter of credit through its U.S. bank (2). The bank subse- quently notifies the foreign exporter (3) that, upon meeting the delivery requirements, the exporter is entitled to draw a time draft against the letter of credit at the importer’s bank (i.e., withdraw money) for the amount of the transaction. After the export order is shipped (4), the foreign exporter presents the time draft and the shipping papers to its own (foreign) bank (5), who forwards these to the domestic importer’s U.S. bank. The foreign exporter involves the foreign bank so as to act as a repository of funds associated with the time draft. The U.S. bank stamps the time draft as accepted and the draft becomes a banker’s acceptance (6).

At this point, the U.S. bank returns the stamped time draft (now a banker’s acceptance) to the foreign exporter’s bank and payment is made (7) to the foreign exporter’s bank (and implicitly, to the foreign exporter) on the maturity date (e.g., in three months’ time). Alter- natively, if the foreign exporter wants cash payment immediately it can sell or discount the

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acceptance with its (foreign) bank. In this case, the U.S. bank immediately forwards to the foreign exporter’s bank the discounted value of the banker’s acceptance (7). In either case, the foreign bank pays the foreign importer for the goods (8) (either on the maturity date of the banker’s acceptance or immediately, based on a discounted value). At this point, the U.S. bank effectively pays the domestic importer’s bill for the purchases, either through its payment in full on the maturity date or the discounted value immediately. When the banker’s acceptance matures, the domestic importer must pay its U.S. bank for the pur- chases (9), and the U.S. bank sends the domestic importer the shipping papers (10).

If the foreign exporter discounts the banker’s acceptance with its foreign bank before maturity, the foreign bank can either hold the acceptance as an investment until it matures or sell the banker’s acceptance in the secondary market.

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176

DEFINITION OF BOND MARKETS: CHAPTER OVERVIEW Equity (stocks) and debt (notes, bonds, and mortgages) instruments with maturities of more than one year trade in capital markets. In the next several chapters, we look at characteristics of the different capital markets, starting in this chapter with bond markets. 1 In Chapter 7 , we look at the mortgage markets (e.g., mortgage-backed securities, asset- backed securities), and in Chapter 8 , we describe the equity markets. In this Chapter, we look at bond markets.

Bonds are long-term debt obligations issued by corporations and government units. Proceeds from a bond issue are used to raise funds to support long-term operations of the issuer (e.g., for capital expenditure projects). In return for the investor’s funds, bond issu- ers promise to pay a specified amount in the future on the maturity of the bond (the face value) plus coupon interest on the borrowed funds (the coupon rate times the face value of the bond). If the terms of the repayment are not met by the bond issuer, the bond holder (investor) has a claim on the assets of the bond issuer.

Bond markets are markets in which bonds are issued and traded. They are used to assist in the transfer of funds from individuals, corporations, and government units with excess funds to corporations and government units in need of long-term debt funding. Bond markets are traditionally classified into three types: (1) Treasury notes and bonds, (2) municipal bonds, and (3) corporate bonds. Figure 6–1 shows the distribution of each

part two Securities Markets

Bond Markets

O U T L I N E

Definition of Bond Markets: Chapter Overview

Bond Market Securities

Treasury Notes and Bonds

Municipal Bonds

Corporate Bonds

Bond Ratings

Bond Market Indexes

Bond Market Participants

Comparison of Bond Market Securities

International Aspects of Bond Markets

Eurobonds, Foreign Bonds, and Sovereign Bonds

chap te r

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

LG 6-1. Describe the major bond markets.

LG 6-2. Identify the characteristics of the various bond market securities.

LG 6-3. List the major bond market participants.

LG 6-4. Describe the types of securities traded in international bond markets.

1 Although both notes and bonds are issued by agents such as the U.S. government, their characteristics (e.g., coupon rate) other than maturity are generally the same. In this chapter, the term bond will mean bonds and notes in general, except where we distinguish notes by their special maturity features. For example, U.S. Treasury notes have maturities of over one year and up to 10 years. U.S. Treasury bonds have maturities from over 10 years at the time of issue.

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Chapter 6 Bond Markets 177

type outstanding in 1994 and 2010. In this chapter, we look at the characteristics of the various bond securities (including the trading process in bond markets), the participants in the bond markets, and international bond markets and securities.

Government units and corporations are the major bond security issuers. Figure 6–1 shows that the dollar amount of bond securities outstanding by these groups has increased 229 percent, from $6.2 trillion in 1994 to $20.4 trillion in 2010. Much of this increase occurred between 2008 and 2010 during the depths of the financial crisis as bond markets grew by more than $4 trillion. Historically low rates on debt during this period were a major reason for the boom in bond markets. In this section, we look at the bond market securities issued by each of these groups: Treasury notes and bonds, municipal bonds, and corporate bonds.

Treasury Notes and Bonds

Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other federal government expenditures ($6.1 trillion outstanding in June 2010). The national debt ( ND ) reflects the historical accumulation of annual federal gov- ernment deficits or expenditures ( G ) minus taxes ( T ) over the last 200-plus years, as follows:

ND G Tt t t t

N

� � �

( ) 1

∑

Figure 6–2 shows the composition of the U.S. national debt from 1994 through 2010. Notice that over this period, approximately 40 to 50 percent of the U.S. national debt consisted of Treasury notes and bonds. 2 Notice also that as the U.S. economy boomed in the late 1990s and the U.S. budget deficit shrank, the amount of public debt outstanding in the form of U.S. Treasury securities decreased from a year-end high of $3.10 trillion in 1994 (52.5 percent of the U.S. gross domestic product [GDP]) to $2.97 trillion in

LG 6-1LG 6-1

BOND MARKET SECURITIESBOND MARKET SECURITIES

LG 6-2LG 6-2

Treasury notes and bonds Long-term securities issued by the U.S. Treasury to finance the national debt and other federal government expenditures.

Treasury notes and bonds Long-term securities issued by the U.S. Treasury to finance the national debt and other federal government expenditures.

www.ustreas.gov www.ustreas.gov

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

bond markets Markets in which bonds are issued and traded.

bonds Long-term debt obligations issued by corporations and government units.

Figure 6–1 Bond Market Instruments Outstanding, 1994–2010

1994 ($6.2 trillion outstanding)

2010 ($20.4 trillion outstanding)

Corporate Bonds 40.2%

Treasury Bonds 38.2%

Municipal Bonds 21.6%

Treasury Bonds 30.0%

Corporate Bonds 56.1%

Municipal Bonds 13.9%

Source: Federal Reserve Board Web site, “Flow of Funds Accounts,” various issues. www.federalreserve.gov

2 Included as part of the U.S. national debt are government account securities. These include U.S. savings securi- ties, dollar-denominated foreign government securities issued by the U.S. Treasury directly to foreign governments, federal insurance fund securities, federal retirement fund securities, and others.

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178 Part 2 Securities Markets

2000 (29.8 percent of GDP). While the amount of Treasury securities grew through the 2000s, so did economic growth. The level of outstanding U.S. Treasury securities grew to $4.7 trillion by June 2008 (32.9 percent of GDP). During the financial crisis, the U.S. gov- ernment used Treasury securities in its attempts to stimulate the economy (see Chapter 4 ) and the national debt ballooned to $13.05 trillion—$8.10 trillion of which was Treasury securities (representing 55.5 percent of GDP).

Like T-bills, T-notes and bonds are backed by the full faith and credit of the U.S. gov- ernment and are, therefore, default risk free. As a result, T-notes and bonds pay relatively low rates of interest (yields to maturity) to investors. T-notes and bonds, however, are not completely risk free. Given their longer maturity (i.e., duration), these instruments experi- ence wider price fluctuations than do money market instruments as interest rates change (and thus are subject to interest rate risk—see Chapter 22 ). Further, many of the older issued bonds and notes—“off the run” issues—may be less liquid than newly issued bonds and notes—“on the run” issues—in which case they may bear an additional premium for illiquidity risk. Figure 6–3 shows the pattern of 10-year T-note yields versus 3-month T-bill yields from 1980 through 2010.

Figure 6–2 Composition of the U.S. National Debt

*Includes securities held by government trust funds, revolving funds, and special funds such as Social Security and

government pension funds.

†Includes U.S. savings securities, dollar-denominated foreign government securities issued by the U.S. Treasury

directly to foreign governments, and other.

Source: U.S. Treasury Department, Treasury Bulletin, various issues. www.ustreas.gov

1994 ($4.7 trillion)

2000 ($5.6 trillion)

June 2008 ($9.5 trillion)

June 2010 ($13.2 trillion)

Other†

8.2%

Government Account

Securities* 25.8%

T-Bills 14.9%

T-Notes and Bonds 51.1%

Other 6.9%

Government Account

Securities 40.3%

T-Bills 11.5%

T- Notes and Bonds 41.3%

Other 5.3%

Other 3.2%

T-Notes and Bonds 38.3%

Government Account

Securities 45.2%

T-Bills 11.2%

T-Notes and Bonds 47.9%

Government Account

Securities 35.4%

T-Bills 13.5%

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Chapter 6 Bond Markets 179

In contrast to T-bills, which are sold on a discount basis from face value (see Chapter 5 ), T-notes and T-bonds pay coupon interest (semiannually). Further, T-bills have an original maturity of one year or less. Treasury notes have original maturities from over 1 to 10 years, while T-bonds have original maturities from over 10 years. T-notes and bonds are issued in minimum denominations of $1,000, or in multiples of $1,000. The Treasury issues two types of notes and bonds: fixed principal and inflation-indexed. While both types pay interest twice a year, the principal value used to determine the percentage interest payment (coupon) on inflation-indexed bonds is adjusted to reflect inflation (mea- sured by the consumer price index). Thus, the semiannual coupon payments and the final principal payment are based on the inflation-adjusted principal value of the security. 3

Like T-bills, once issued T-notes and T-bonds trade in very active secondary markets. Table 6–1 presents part of a T-note and T-bond (including Treasury STRIPS—see below) clos- ing price/interest yield quote sheet from The Wall Street Journal for trading on July 16, 2010. Column 1 is the date the note or bond matures. Column 2 in the table lists the coupon rate on the Treasury security. Note that coupon rates are set at intervals of 0.125 (or 1⁄8 of 1) percent. Column 3, labeled Bid, is the close of the day selling price (in percentage terms) available to T-note and bond holders (i.e., the price dealers are willing to pay T-note and bond hold- ers for their Treasury securities). Prices are quoted as percentages of the face value on the Treasury security, in 32nds. For example, using a face value of $1,000, the bid price on the 0.875 percent coupon, May 2011 T-note was $1,005.00 (100 16⁄32 % � $1000). Column 4, labeled Asked, is the close of the day purchase price available to investors. Column 5, labeled Chg, is the change in the asked price from the previous day’s close in 32nds—that is, the May 2011 T-note’s price was unchanged from the previous day. Finally, the last column, labeled

Figure 6–3 T-Bill versus T-Note Yields, 1980–2010

Source: Federal Reserve Board Web site, “Research and Data,” July 2010. www.federalreserve.gov

Interest Rate

18

16

14

12

10

8

6

4

2

0 Year

Ja n-

80

Ja n-

82

Ja n-

84

Ja n-

86

Ja n-

88

Ja n-

90

Ja n-

92

Ja n-

94

Ja n-

96

Ja n-

98

Ja n-

00

Ja n-

02

Ja n-

04

Ja n-

06

Ja n-

08

Ja n-

10

T-Bill T-Note

3 For example, a two-year, 10 percent coupon (annual) bond issued with a principal value (face value) of $1,000 will pay a total of $10 and $10 in the first and second years. An indexed (annual) bond when inflation is 10 percent in the first year and the second year will pay a 10 percent coupon based on principal values of $1,000 (1.1) � $1,100 and $1,000 (1.1) 2 � $1,210, respectively. That is, the first year coupon will be 10% � $1,100 � $11 and the second year coupon will be 10% � $1,210 � $12.10.

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180 Part 2 Securities Markets

TABLE 6–1 Treasury Note and Bond Quote

2010 Jul 31 2.750 100:03 100:03 unch. −0.0786 2010 Aug 15 4.125 100:09 100:10 −1 0.0390 2010 Aug 31 2.375 100:08 100:09 −1 0.1008 2010 Sep 15 3.875 100:18 100:19 −2 0.1054 2010 Sep 30 2.000 100:12 100:12 unch. 0.1187 2010 Oct 15 4.250 100:31 101:00 −1 0.1208 2010 Oct 31 1.500 100:12 100:12 unch. 0.1445 2010 Nov 15 4.500 101:13 101:13 −1 0.1600 2010 Nov 30 1.250 100:12 100:13 −1 0.1503 2011 Mar 31 0.875 100:14 100:14 unch. 0.2374 2011 Apr 30 0.875 100:15 100:15 unch. 0.2649 2011 Apr 30 4.875 103:18 103:19 −2 0.2598 2011 May 31 0.875 100:16 100:16 unch. 0.2830 2011 May 31 4.875 103:30 103:31 −1 0.2835 2011 Jun 30 1.125 100:24 100:25 unch. 0.3035 2011 Jun 30 5.125 104:18 104:18 unch. 0.2994 2011 Jul 31 1.000 100:21 100:22 unch. 0.3366 2011 Jul 31 4.875 104:21 104:22 −1 0.3337 2011 Aug 15 5.000 104:31 105:01 −1 0.3205 2011 Aug31 1.000 100:22 100:23 unch. 0.3650 2011 Aug 31 4.625 104:23 104:24 −1 0.3660 2011 Sep 30 1.000 100:23 100:23 unch. 0.3921 2011 Sep 30 4.500 104:30 104:31 −1 0.3513 2011 Oct 31 1.000 100:23 100:24 unch. 0.4221 2011 Oct 31 4.625 105:13 105:14 −1 0.3653 2011 Nov 15 1.750 101:24 101:24 unch. 0.4194 2011 Nov 30 0.750 100:13 100:13 11 0.4513 2011 Nov 30 4.500 105:18 105:19 −1 0.3985 2011 Dec 15 1.125 100:30 100:31 unch. 0.4392 2011 Dec 31 1.000 100:24 100:24 11 0.4743 2011 Dec 31 4.625 106:02 106:03 unch. 0.4115 2013 Nov 15 4.250 110:17 110:19 15 1.0030 2013 Nov 30 2.000 103:01 103:02 15 1.0734 2013 Dec 31 1.500 101:10 101:11 15 1.1017 2014 Mar 31 1.750 101:30 101:31 17 1.2063 2014 Apr 30 1.875 102:09 102:10 16 1.2470 2014 May 15 4.750 113:05 113:06 15 1.2076 2014 May 31 2.250 103:22 103:23 16 1.2633 2014 Jun 30 2.625 105:02 105:03 17 1.2993 2014 Jul 31 2.625 105:00 105:01 17 1.3412 2014 Aug 15 4.250 111:19 111:20 17 1.3105 2014 Aug 31 2.375 103:30 103:31 17 1.3837 2014 Sep 30 2.375 103:27 103:28 17 1.4228 2017 May 31 2.750 102:17 102:18 112 2.3435 2017 Jun 30 2.500 100:29 100:30 112 2.3541 2017 Aug 15 4.750 116:03 116:04 112 2.2697 2017 Nov 15 4.250 112:26 112:27 113 2.3316 2018 Feb 15 3.500 107:11 107:12 113 2.4291 2018 May 15 3.875 109:24 109:25 113 2.4908 2018 May 15 9.125 148:03 148:06 115 2.3462 2018 Aug 15 4.000 110:13 110:14 113 2.5607 2018 Nov 15 3.750 108:06 108:07 112 2.6431 2039 Aug 15 4.500 109:12 109:14 111 3.9519 2039 Nov 15 4.375 107:07 107:09 111 3.9531 2040 Feb 15 4.625 111:20 111:22 111 3.9521 2040 May 15 4.375 107:13 107:14 111 3.9482

Asked Maturity Coupon Bid Asked Chg yield

Treasury note and bond data are representative over-the-counter quotations as of 3pm Eastern time. Figures after colons in bid and ask quotes represent 32nds; 101:26 means 101 26/32, or 101.8125% of face value; 99:01 means 99 1/32, or 99.03125% of face value. For notes and bonds callable prior to maturity, yields are computed to the earliest call date for issues quoted above par and to the maturity date for issues below par.

Friday, July 16, 2010

Treasury Notes & Bonds

Treasury Note, Stripped Principal

Stripped Coupon Interest

2010 Aug 15 99.988 99.998 0.001 0.03 2010 Nov 15 99.943 99.953 0.001 0.14 2015 Feb 15 92.784 92.794 0.229 1.64 2015 Aug 15 91.163 91.173 0.260 1.83 2015 Nov 15 90.166 90.176 0.281 1.95 2016 Feb 15 89.381 89.391 0.293 2.02 2016 May 15 88.258 88.268 0.302 2.15 2016 Aug 15 87.902 87.912 0.300 2.13 2020 Aug 15 71.921 71.931 0.291 3.30 2021 Feb 15 70.241 70.251 0.298 3.37 2021 May 15 69.216 69.226 0.299 3.43 2021 Aug 15 68.329 68.339 0.302 3.47 2021 Nov 15 67.371 67.381 0.304 3.52 2022 Aug 15 65.091 65.101 0.212 3.59 2026 Aug 15 54.032 54.042 0.220 3.87 2026 Nov 15 53.349 53.359 0.221 3.88 2027 Feb 15 52.706 52.716 0.220 3.90 2027 Aug 15 51.374 51.384 0.221 3.94 2027 Nov 15 50.727 50.737 0.243 3.95 2028 Aug 15 49.060 49.070 0.245 3.98 2039 Aug 15 29.725 29.735 0.127 4.22 2039 Nov 15 29.460 29.470 0.127 4.21 2040 Feb 15 29.111 29.121 0.127 4.22 2040 May 15 29.000 29.010 0.126 4.19

2010 Aug 15 99.987 99.997 0.001 0.04 2011 Feb 15 99.879 99.889 0.013 0.19 2011 Aug 15 99.633 99.643 0.007 0.33 2012 Feb 15 99.287 99.297 0.022 0.45 2012 Aug 15 98.873 98.883 0.023 0.54 2016 Nov 15 86.813 86.823 0.349 2.25 2017 Feb 15 85.920 85.930 0.345 2.32 2017 Aug 15 84.582 84.592 0.331 2.38 2017 Nov 15 83.736 83.746 0.368 2.44 2018 Feb 15 82.684 82.694 0.345 2.52 2018 Nov 15 79.512 79.522 0.315 2.77

2010 Aug 15 99.989 99.999 0.001 0.02 2010 Nov 15 99.947 99.957 0.002 0.13 2013 Jul 31 96.924 96.934 0.133 1.03 2013 Aug 15 97.031 97.041 0.134 0.98 2013 Aug 31 96.840 96.850 0.135 1.03 2018 Aug 15 80.314 80.324 0.325 2.73 2018 Nov 15 79.447 79.456 0.332 2.78 2019 Feb 15 78.000 78.010 0.302 2.92 2019 May 15 77.122 77.132 0.307 2.96 2019 Aug 15 75.855 75.865 0.344 3.07 2019 Nov 15 75.041 75.051 0.349 3.10 2020 Feb 15 73.782 73.792 0.284 3.20 2020 May 15 72.760 72.770 0.287 3.26 2020 Aug 15 71.707 71.717 0.290 3.33 2030 May 15 44.435 44.445 0.242 4.13 2030 Aug 15 43.937 43.947 0.220 4.14 2030 Nov 15 43.405 43.415 0.220 4.15 2031 Feb 15 42.873 42.883 0.199 4.16 2036 Aug 15 33.432 33.442 0.130 4.24 2036 Nov 15 33.063 33.073 0.130 4.25 2039 May 15 29.638 29.648 0.126 4.26 2040 Feb 15 28.693 28.703 0.125 4.26

U.S. zero-coupon STRIPS allow investors to hold the interest and principal components of eligible Treasury notes and bonds as separate securities. STRIPS offer no interest payment; investors receive payment only at maturity. Quotes are as of 3 p.m. Eastern time based on transactions of $1 million or more. Yields calculated on the ask quote.

Friday, July 16, 2010

U.S. Treasury Strips

Treasury Bond, Stripped Principal

Maturity Bid Asked Chg Asked yield

Source: The Wall Street Journal Online, July 17, 2010. Reprinted by permission of The Wall Street Journal. © 2010 Dow Jones & Company, Inc.

All Rights Reserved Worldwide. www.wsj.com

Asked yield, is the asked price converted into a rate of return (yield to maturity) on the T-note or T-bond. This yield is calculated using the yield to maturity formulas found in Chapter 3 — it is the interest rate or yield (using semiannual compounding) that makes the price of the security just equal to the present value of the expected coupon and face value cash flows on the bond (where this yield is the single discount rate that makes this equality hold).

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Chapter 6 Bond Markets 181

STRIPs. In 1985, the Treasury began issuing 10-year notes and 30-year bonds 4 to finan- cial institutions using a book-entry system under a program titled Separate Trading of Registered Interest and Principal Securities (STRIPS). A STRIP is a Treasury security in which periodic coupon interest payments can be separated from each other and from the final principal payment. As illustrated in Figure 6–4 , a STRIP effectively creates two sets of securities—one set for each semiannual interest payment and one for the final principal payment. Each of the components of the STRIP are often referred to as “Treasury zero bonds” or “Treasury zero-coupon bonds” because investors in the individual components only receive the single stripped payments (e.g., the third semiannual coupon) in which they invest. Investors needing a lump sum payment in the distant future (e.g., life insurers) would prefer to hold the principal portion of the STRIP. Investors wanting nearer-term cash flows (e.g., commercial banks) would prefer the interest portions of the STRIP. Also, some state lotteries invest the present value of large lottery prizes in STRIPs to be sure that funds are available to meet required annual payments to lottery winners. Pension funds purchase STRIPs to match payment cash flows received on their assets (STRIPs) with those required on their liabilities (pension contract payments).

STRIPs were created by the U.S. Treasury in response to the separate trading of Trea- sury security principal and interest that had been developed by securities firms. Specifi- cally, in the early 1980s, Merrill Lynch introduced Treasury Investment Growth Receipts (TIGRs). Merrill Lynch purchased Treasury securities, stripped them into one security rep- resenting the principal component only and a separate security for each coupon payment, and put these individual securities up for resale. The Treasury’s creation of the STRIP was meant to offer a competitive product to the market.

The U.S. Treasury does not issue STRIPs directly to investors. Rather, stripped Trea- sury notes and bonds may be purchased only through financial institutions and government securities brokers and dealers, who create the STRIP components after purchasing the original T-notes or T-bonds (whole) in Treasury auctions (see below). After the STRIP components have been created, by requesting that the Treasury separate each coupon and face value payment on each bond and recording them as separate securities in its book- entry computer system, they can be sold individually in the secondary markets. 5

Example 6–1 Creation of a STRIP

Suppose the Treasury issues a five-year T-note with a par value of $10,000 and an 8 percent coupon rate (paid semiannually, or $400 is paid to the holder every six months for the next five years) to Citigroup. Citigroup decides to convert the bond into a set of

STRIP A Treasury security in which the periodic interest payment is separated from the final principal payment.

STRIP A Treasury security in which the periodic interest payment is separated from the final principal payment.

www.ml.com www.ml.com

4 The U.S. Treasury stopped issuing 30-year bonds between 2001 and 2006.

5 Once a bond is stripped, if an investor purchases each coupon and face value component at a later time, he or she can ask the Treasury to reconstitute the original bond on its computer system. Thus, the Treasury STRIPs program is highly flexible and STRIPs can be reconstituted as whole bonds.

Figure 6–4 Creation of a Treasury STRIP

. . . 1 1/2C

2

1/2C

3

1/2C

19

1/2C

20

1/2C

21

F

10-Year Bond as a Whole

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182 Part 2 Securities Markets

stripped securities by requesting the Treasury to separate the coupons and face value of the note into separate securities on its computer system (basically giving each coupon and face value a separate I.D. or CUSIP number). This means that Citigroup can then sell 11 different securities: 10 securities associated with each of the semiannual coupon payments of $400 and one that pays $10,000 (the face or principal value) in five years to outside investors. We show the value of each of these securities in Table 6–2 , assuming the yield to maturity on each of the stripped securities is 7.90 percent and is the same as the bond sold “whole.”

Notice that the total present value of the 11 different securities involved with the STRIP is the same as that of the original T-note before it is stripped, $10,040.65. How- ever, in general, the bank (Citigroup) will try to sell the 11 stripped securities for a greater total present value than the bond as a whole. The reason for this is that many investors desire particular maturity zero-coupon bonds to meet investment goals and needs. Such goals and needs (such as duration targets—see below) are often harder to achieve through buying whole T-notes or T-bonds. Consequently, investors are willing to pay a higher price and thus accept a yield lower than 7.90 percent on the stripped investments. As a result, the total price Citigroup would get from selling the 11 STRIPs would exceed $10,040.65.

As mentioned above, STRIPs are attractive investments to investors desiring particular maturity zero-coupon bonds to meet investment goals and needs. For example, STRIPs are used as investment securities for individual retirement accounts, Keogh plans, and pension funds. Frequently, managers of these types of financial institutions face the problem of structuring their asset investments so they can pay a given cash amount to policyholders in some future period. The classic example of this is an insurance policy that pays the holder some lump sum when the holder reaches retirement age. The risk to the life insurance company manager is that interest rates on the funds generated from investing the holder’s premiums could fall. Thus, the accumulated returns on the premiums invested might not meet the target or promised amount. In effect, the insurance company would be forced to draw down its reserves and net worth to meet its payout commitments. (See Chapter 15 for a discussion of this risk.) To immunize or protect itself against interest rate risk, the insurer can invest in Treasury zero-coupon bonds (or STRIPs).

TABLE 6–2 Present Value of STRIP Components of a 5-Year T-Note with an 8 Percent Coupon Rate and 7.90 Percent Yield to Maturity

Maturity on Security (in years)

Cash Flow Received at Maturity