Cyprus bankruptcy
If a government cannot pay the debts back, it can:
(1) default
(2) inflate (print more money)
(3) go bankrupt and restructure the contract (low cost to roll over the debt today at the expense of higher interest rate in the future)
Balance sheet of Cyprus bank
Assets Liabilities
Cyprus bonds Deposits
(value decreases) (50% domestic citizens, 50% foreign institutions, especially Russia)
Greek bonds
(value decreases)
Requirements of IMF to bail out
Cyprus should raise some money by itself. Government then imposes taxes from depositors
The cause is that government are borrowing bonds that they cannot pay back
Control of capital flow? Will it work?
Why bonds have different interest rates?
(1) risk
(2) liquidity
(3) tax treatment
(4) maturity
(5) currency risks
(4) maturity
Yield curve
Expectation theory doesn't make perfect sense because it assumes that future inflation expectation will only rise. It also cannot explain why current and future interest rates tend to move up together.
Preferred habitat: based on expectation theory, adds term premium---reward for holding long-term bonds
(a) People care about flexibility
If an amount of money is locked in for a long time, investors demand a premium to compensate for the lack of flexibility
(b) Long -term bonds are prone to more uncertainty, so investors demand a premium for holding the bond
Yield curve
(a) normal curves slope up: expected inflation will rise
(b) inverted curves slope down: expected inflation will decrease. When money supply is tightened, current interest rate goes up and people expect that future inflation will not be high because there isn't much money flowing around.
(c) U-shaped curve
(5) currency risk
Japanese 10 year bond: 0.63%, US 10 year bond: 1.89%
r(US) = r(Japan) +e (expected appreciation of yen against dollar)
Now 1$=93.2yen, and I have 100$ to invest:
Buy 100$ bonds convert to 9320 yen, and after one year
After one year: 101.89% 9320*1.0063=9378.7 yen
9378.7/93.2 = 100.62 <101.89
Based on no-arbitrage principle, yen should appreciate against dollar
different expected inflation in different countries
Interest rate risk and realized (actual) rate of return
2 year zero coupon bond with the par value of $10000. Buy it at $8573 today
8573 = 10000/(1+r)^2; r = 8%
Suppose in one year:
(a) interest rate rises to 10%, PV= 10000/1.1 = 9091
realized return: 9091-8573 / 8573 = 6.04%
(b) interest rate decreases to 6%, PV = 10000/1.06 = 9433
realized return: 9433 - 8573 / 8573 = 10%
If interest rate rises at time when you sell the bond, then you are worse
Buy 30 year zero-coupon bond at par value of $100000, r=8%
PV= 100000 / 1.08^30 = 9938
Suppose one year later, you are forced to sell the bond when interest rate is 10%
PV = 100000/ 1.1^29 = $6304
One year bond, r=8%, Two year bond, r=8%, par value of both bonds are 1000$
PV = 1000/ 1.08 = 925.9 PV = 1000 / 1.08^2 = 857.3
suppose the interest rate rises to 10 %,
PV = 1000 /1.1 = 909.1 PV = 1000 / 1.1^2 = 826.4
Capital loss: 925.9 - 909.1 / 925.9 = 1.8% 857.3 - 826.4 / 857.3 = 3.6%
A bank's balance sheet
Assets Liabilities
loans/mortgages deposits
(long-term) (short-term)
Timing of the coupon payment
front-loaded example back-loaded example
$10000 par value r=10% $10000 par value r=10%
2 year bond, coupon rate 10% 2 year zero-coupon bond
PV= 1000/1.1+1000/1.1^2+10000/1.1^2=10000 PV = 10000/1.1^2 = 8264
interest rate falls to 8%
PV = 10357 PV = 8573
realized return= 10357-10000 / 10000 = 3.57% realized return = 8573-8264 / 8264 = 3.7%
Subject to more interest rate risk
Interest rate risk: maturity, timing of coupon----------durations
Larger the durations, more interest rate risk
Check bank's balance sheet, there is a positive duration gap between assets and liabilities, and assets are more volatile
If interest rate goes up, asset value goes down, but liabilities won't fall much \This means that net equity will fall
Institutions that have negative duration gap: insurance company
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