One attribute of a bond that influences its interest is its default risk. The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn to be willing to hold a risky bond.
Another attribute of a bond that influences its interest rate is its liquidity. US treasury bonds are the most liquid of all long-term bonds because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low. A bond with low liquidity is not as desirable as the one with higher liquidity, with all other conditions being equal. Thus people demand a liquidity premium, that is an extra amount of interest to hold them.
Interest payments on municipal bonds are exempt from federal income taxes.
Summary: more risk---higher interest rate, less liquid---higher interest rate, exemption from tax payment----lower interest rate
Yield curves can be classified as upward-sloping, flat and downward-sloping
(1) When yield curves are upward-sloping
the long-term interest rates are above the short-term interest rates
(2) Flat
short- and long-term interest rates are the same
(3) Inverted
Short-term interest rates are higher than the long-term interest rates
The expectation hypothesis: The interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond. The explanation provided by the expectation theory for why interest rates on bonds of different maturities differ is that short-term interest rates are expected to have different values at future dates. The key assumption is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.
The preferred habitat theory: interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bonds plus a liquidity premium that responds to supply and demand conditions for that bond. The key assumption is that bonds of different maturities are not perfect substitutes.
Three facts of yield curves:
(1) interest rates on bonds of different maturities tend to move together over time
(2) yield curves usually slope upward
(3) when short-term interest rates are low, yield curves are most likely to have a steep upward slope
3/05/2013
Banking notes 3/5/2013
Why do yields change over time
(1) real interest rate changes (supply and demand curve in loanable funds market)
(2) credit risk
*(3) inflation and expected inflation rate
Fisher equation: real interest rate = nominal interest rate - inflation rate
interest rate changes because people's expected inflation changes all the time
Why different bonds have different yields
(1) credit risks
concern of default
people would demand a higher interest rate for to compensate the potential loss
risk premium
AAA has the highest safety
government treasures are nominally risk-free
junk bond and traditional bond
Revolving credit cards come branded with two important numbers - the maximum available credit
and the interest rate. The credit line tells you how much money that
you can borrow at once without paying off the balance. The interest rate
is the portion of the balance that gets charged to your account as a
financing fee when you have not paid off the balance in full at the end
of every month.
Credit cards are unsecured, meaning that there is no collateral for your borrowing.
The interest rate of credit card is high
Suppose a bank loans you $100, interest rate is 10%, and 4.5% of the loan is never paid back.
Bank needs 110$ next year, but statistically the bank can get back 110*(1-4.5%) = 105.56
So the bank will have to increase the interest rate to get it back.
Suppose the interest rate imposed is A, then 100*(1+A)*(1-4.5%) = 110
a kind of negative externalities
(2) liquidity
Liquidity premium:
A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.
People are willing to pay a higher price and demand a lower interest rate for liquid bonds and stocks. US treasury securities are one of the most liquid securities on earth, that is the major reason why Fed actually use them to conduct the open market operations. We don't want interest rate be fluctuated greatly.
(3) taxes
if tax on interest is low, then interest rate is low
The reasons why municipal bond has higher interest rate than US treasury bonds are that (1) municipal bond are more illiquid (2) US treasury bonds are exempt from tax payment
One reason not to tax the rich: some people gain wealth from buying stocks and bonds, and if government tax on securities, it will have to have higher interest rate and these payment will be paid by the poor.
(4) maturity
Why is the yield curve normally upward sloping: expectation and preferred habitat
lenders are concerned about a potential default (or rising rates of inflation), so they offer long-term loans for higher interest rates than they offer for shorter-term loans.
Expectation theory: The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates. Another term-structure theory, preferred habitat theory, expands on expectations theory to explain why longer-term bonds tend to pay more interest than two shorter-term bonds that add up to the same maturity. It says that investors prefer short-term bonds and are only interested in longer-term bonds if they pay a risk
premium. While expectations theory assumes that investors only care
about yield, preferred habitat theory assumes they care about maturity
as well as yield.
Preferred habitat: A term structure theory suggesting that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk
premium for the maturity range is available. The theory also suggests
that when all else is equal investors prefer to hold short-term bonds in
place of long-term bonds and that the yields on longer term bonds
should be higher than shorter term bonds.\
If expected inflation rate is high, then the inverse yield curve will occur, if there is no inflation rate, then the yield curve will be flat.
(1) real interest rate changes (supply and demand curve in loanable funds market)
(2) credit risk
*(3) inflation and expected inflation rate
Fisher equation: real interest rate = nominal interest rate - inflation rate
interest rate changes because people's expected inflation changes all the time
Why different bonds have different yields
(1) credit risks
concern of default
people would demand a higher interest rate for to compensate the potential loss
risk premium
AAA has the highest safety
government treasures are nominally risk-free
junk bond and traditional bond
Revolving credit cards come branded with two important numbers - the maximum available credit
and the interest rate. The credit line tells you how much money that
you can borrow at once without paying off the balance. The interest rate
is the portion of the balance that gets charged to your account as a
financing fee when you have not paid off the balance in full at the end
of every month.Credit cards are unsecured, meaning that there is no collateral for your borrowing.
The interest rate of credit card is high
Suppose a bank loans you $100, interest rate is 10%, and 4.5% of the loan is never paid back.
Bank needs 110$ next year, but statistically the bank can get back 110*(1-4.5%) = 105.56
So the bank will have to increase the interest rate to get it back.
Suppose the interest rate imposed is A, then 100*(1+A)*(1-4.5%) = 110
a kind of negative externalities
(2) liquidity
Liquidity premium:
A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates
to rise.People are willing to pay a higher price and demand a lower interest rate for liquid bonds and stocks. US treasury securities are one of the most liquid securities on earth, that is the major reason why Fed actually use them to conduct the open market operations. We don't want interest rate be fluctuated greatly.
(3) taxes
if tax on interest is low, then interest rate is low
The reasons why municipal bond has higher interest rate than US treasury bonds are that (1) municipal bond are more illiquid (2) US treasury bonds are exempt from tax payment
One reason not to tax the rich: some people gain wealth from buying stocks and bonds, and if government tax on securities, it will have to have higher interest rate and these payment will be paid by the poor.
(4) maturity
Why is the yield curve normally upward sloping: expectation and preferred habitat
lenders are concerned about a potential default (or rising rates of inflation), so they offer long-term loans for higher interest rates than they offer for shorter-term loans.
Expectation theory: The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates. Another term-structure theory, preferred habitat theory, expands on expectations theory to explain why longer-term bonds tend to pay more interest than two shorter-term bonds that add up to the same maturity. It says that investors prefer short-term bonds and are only interested in longer-term bonds if they pay a risk
premium. While expectations theory assumes that investors only care
about yield, preferred habitat theory assumes they care about maturity
as well as yield.Preferred habitat: A term structure theory suggesting that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk
premium for the maturity range is available. The theory also suggests
that when all else is equal investors prefer to hold short-term bonds in
place of long-term bonds and that the yields on longer term bonds
should be higher than shorter term bonds.\If expected inflation rate is high, then the inverse yield curve will occur, if there is no inflation rate, then the yield curve will be flat.
3/04/2013
Banking regulation
Depositors lack information about the quality of these private loans.Unable to learn if bank managers were taking too much risk or were outright crooks, depositors would be reluctant to put money in the bank, thus making banking institutions less viable.
A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection fro the depositors, it can overcome reluctance to put funds ion the banking system. One form is deposit insurance.
The most serious drawback of the government safe net stems from moral hazard, the incentives of one party to a transaction to engage in activities detrimental to the other party. Depositor won't monitor the bank. Banks may have more risky investment.
One problem with the too-big-too-fail policy is that it increases the moral hazard incentives for big banks. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.
Nonbank financial institutions
Insurance company:
Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance company can accurately predict what their payouts to policyholders will be in the future. Consequently, they hold long term assets that are not particularly liquid.
Insurance companies use the premiums paid on policies to invest in assets such as bonds, stocks, mortgages and other loans; the earnings from these assets are then used to pay out claims on the policies.
Ways to reduce moral hazards and adverse selection:
(1) information collection (reduce adverse selection)
(2) risk-based premiums, risk classification (reduce adverse selection)
(3) restrictive provisions (reduce moral hazard)
(4) prevention of fraud (reduce moral hazard)
(5) deductibles: the fixed amount by which the insured's loss is reduced when a claim is paid off. A 250$ deductible on an auto policy means that if you suffer a loss of 1000$ because of an accident, the insurance company will pay you only 750$. (reduce moral hazard)
(6) coinsurance: works exactly the same as deductible
(7) limits on the amount of insurance
Pension funds:
Because the benefits paid out of the pension fund each year are highly predictable, pension funds invest in long term securities,with the bulk of their asset holdings in bonds, stocks, and long term mortgages.
Private pension funds are administered by a bank, a life insurance company or a pension fund manager.
Public pension plans: social securities. Unlike a private pension plan, paid-out benefits are not tied closely to a participant's past contributions, so typically they are paid out from current contributions. This "pay-as-you-go" system can leads to great underfunding, which means that a person's contribution and earnings do not cover what he gets from the pension fund.
Mutual funds:
financial intermediaries that pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Mutual funds allow the small investors to obtain the benefits of lower transactions costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held.
Federal Credit Agency:
Housing sector: Ginne Mae, Fannie Mae, Freddie Mac
Farm: Farmer Mae
Student loans: Sallie Mae
Government loan guarantees; acts like insurance: it insures the lender from any loss if the borrower defaults.
Housing: FHA, Veterans Administrations, Urban Development
Farm and education
Securities market institutions:
Investment banks: When a corporation wishes to borrow funds, it hires the services of an investment bank to help sell its securities.
(1) They advise the corporation whether it should issue bond or stock
(2) underwriters--investment banks that guarantee the corporation a price on the securities and then sell them to the market
Securities brokers and dealers: conduct trading in secondary market.
Brokers: match buyers with sellers (don't own securities themselves)
Dealers: link buyers and sellers by standing ready to buy and sell securities at given prices, They hold inventories of securities and make their living by selling these securities for a slightly higher price than they paid for them.
Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance company can accurately predict what their payouts to policyholders will be in the future. Consequently, they hold long term assets that are not particularly liquid.
Insurance companies use the premiums paid on policies to invest in assets such as bonds, stocks, mortgages and other loans; the earnings from these assets are then used to pay out claims on the policies.
Ways to reduce moral hazards and adverse selection:
(1) information collection (reduce adverse selection)
(2) risk-based premiums, risk classification (reduce adverse selection)
(3) restrictive provisions (reduce moral hazard)
(4) prevention of fraud (reduce moral hazard)
(5) deductibles: the fixed amount by which the insured's loss is reduced when a claim is paid off. A 250$ deductible on an auto policy means that if you suffer a loss of 1000$ because of an accident, the insurance company will pay you only 750$. (reduce moral hazard)
(6) coinsurance: works exactly the same as deductible
(7) limits on the amount of insurance
Pension funds:
Because the benefits paid out of the pension fund each year are highly predictable, pension funds invest in long term securities,with the bulk of their asset holdings in bonds, stocks, and long term mortgages.
Private pension funds are administered by a bank, a life insurance company or a pension fund manager.
Public pension plans: social securities. Unlike a private pension plan, paid-out benefits are not tied closely to a participant's past contributions, so typically they are paid out from current contributions. This "pay-as-you-go" system can leads to great underfunding, which means that a person's contribution and earnings do not cover what he gets from the pension fund.
Mutual funds:
financial intermediaries that pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Mutual funds allow the small investors to obtain the benefits of lower transactions costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held.
Federal Credit Agency:
Housing sector: Ginne Mae, Fannie Mae, Freddie Mac
Farm: Farmer Mae
Student loans: Sallie Mae
Government loan guarantees; acts like insurance: it insures the lender from any loss if the borrower defaults.
Housing: FHA, Veterans Administrations, Urban Development
Farm and education
Securities market institutions:
Investment banks: When a corporation wishes to borrow funds, it hires the services of an investment bank to help sell its securities.
(1) They advise the corporation whether it should issue bond or stock
(2) underwriters--investment banks that guarantee the corporation a price on the securities and then sell them to the market
Securities brokers and dealers: conduct trading in secondary market.
Brokers: match buyers with sellers (don't own securities themselves)
Dealers: link buyers and sellers by standing ready to buy and sell securities at given prices, They hold inventories of securities and make their living by selling these securities for a slightly higher price than they paid for them.
Managing credit risk and interest risk
Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; that is, those who are most likely to produce an adverse outcome are the most likely to be selected.
Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders' point of view.
Ways to prevent the above two problems:
(1) Screening and monitoring:
Lenders should screen out the bad credit risks from the good ones so that loans are profitable to them.
Information collection
Specialization in some market loans makes banks easier to collect relative information
(2) Long-term customer relationships
(3) Loan commitments:
a loan commitment is a bank's commitment (for a special future period of time) to provide a firm with loans up to given amount at an interest that is tied to some market interest rate.
(4) Collateral and compensating balances:
a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank
(5) Credit rationing:
Lenders refuse to make loans even though borrowers are willing to pay the state interest rate or even a higher rate.
Two forms
(a) a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate
(b) a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like
Managing interest risk:
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits.
We can use gap analysis (in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets) to measure the sensitivity of bank profits to changes in interest rates
Duration analysis: examines the the sensitivity of the market value of the bank's total assets and liabilities to changes in interest rates.
% change in market value of security = -% change in interest rate * duration in yrs
Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders' point of view.
Ways to prevent the above two problems:
(1) Screening and monitoring:
Lenders should screen out the bad credit risks from the good ones so that loans are profitable to them.
Information collection
Specialization in some market loans makes banks easier to collect relative information
(2) Long-term customer relationships
(3) Loan commitments:
a loan commitment is a bank's commitment (for a special future period of time) to provide a firm with loans up to given amount at an interest that is tied to some market interest rate.
(4) Collateral and compensating balances:
a firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank
(5) Credit rationing:
Lenders refuse to make loans even though borrowers are willing to pay the state interest rate or even a higher rate.
Two forms
(a) a lender refuses to make a loan of any amount to a borrower, even if the borrower is willing to pay a higher interest rate
(b) a lender is willing to make a loan but restricts the size of the loan to less than the borrower would like
Managing interest risk:
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits.
We can use gap analysis (in which the amount of rate-sensitive liabilities is subtracted from the amount of rate-sensitive assets) to measure the sensitivity of bank profits to changes in interest rates
Duration analysis: examines the the sensitivity of the market value of the bank's total assets and liabilities to changes in interest rates.
% change in market value of security = -% change in interest rate * duration in yrs
Strategues for managing bank capital
To lower the amount of capital relative to assets and raise the equity multiplier (that is ASSETS / EQUITY CAPITAL), do three things
(1) reduce the amount of bank capital by buying back some of the bank's stocks
(2) reduce the bank's capital by paying out higher dividends to its stockholders, thereby reducing its retained earnings
(3) keep bank capital constant but increase the bank's assets by acquiring new funds, say, by issuing CDs, and then seeking out loan business or purchasing more securities with these new funds.
To increase the amount of capital, do the reverse.
Equity multiplier:
EM = assets / equity capital
Return on assets (ROA) :
ROA = net profits after taxes / assets
Return on equity (ROE) :
ROE = net profits after taxes / equity capital
ROE = ROA * EM
(1) reduce the amount of bank capital by buying back some of the bank's stocks
(2) reduce the bank's capital by paying out higher dividends to its stockholders, thereby reducing its retained earnings
(3) keep bank capital constant but increase the bank's assets by acquiring new funds, say, by issuing CDs, and then seeking out loan business or purchasing more securities with these new funds.
To increase the amount of capital, do the reverse.
Equity multiplier:
EM = assets / equity capital
Return on assets (ROA) :
ROA = net profits after taxes / assets
Return on equity (ROE) :
ROE = net profits after taxes / equity capital
ROE = ROA * EM
The banking firm and the management of financial institutions
The bank balance sheet:
Total assets = total liabilities + capital
Liabilities (sources if funds)
(1) checkable deposits:
bank accounts that allow the owner of the account to write checks to third parties. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to to a liquid asset that can be used to make purchases.
(2) Non-transaction deposits
owners cannot write checks on them, but the interest rates are usually higher than those on checkable deposits.
(a) savings account
(b) time deposits, which are also called certificate of deposit, or CD
(3) Borrowings
funds borrowed from the Fed, other banks and corporations/ Borrowing from the Fed is called discount loans (or advances). They also borrow overnight in federal funds market from other US banks and financial institutions to have enough deposits at the Federal Reserve to meet the amount required by the Fed.
(4) Bank Capital
a cushion against a drop in the value of its assets
Assets (Uses of funds)
(1) reserves
All banks hold some of the funds they acquire as deposits in an account at the Fed. RESERVES are these deposits plus currency that is physically held by banks (called VAULT CASH because it is stored in bank vaults overnight)
The reasons to hold reserves (a) required reserves are mandated by law (b) additional reserves, called excess reserves, are the most liquid of all bank assets and can be used by a bank to meet its obligation when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account.
(2) securities
(3) loans
less liquid than other assets because they cannot be turned into cash until the loan matures.
(4) other assets (physical)
In general terms, banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics. (asset transformation) Transform the saving asset (asset held by the depositor) to a mortgage loan (asset held by the bank)
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses deposits, it loses an equal amount of reserves.
IF a bank has ample reserves, a deposit outflow doesn't necessitate changes in other parts of balance sheets
liquidity management: the acquisition of sufficiently liquid assets to meet the bank's obligation to depositors
asset management: pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings
liability management: acquire funds at low cost (negotiable CDs and federal fund market)
a bank maintains bank capital to lessen the chance that it will become insolvent
net profit after taxes/equity capital = net profit / assets * assets / equity capital
(given the return on assets, the lower the bank capital, the higher the return for the owners of the bank)
bank capital requirements
capital adequacy management: the amount of capital should maintain and capital needed
The reasons why banks hold excess reserve:
When a deposit outflow occurs, holding excess reserves allows the bank to escape the cost of (1) borrowing from other banks or corporations (2) selling securities (3) borrowing from federal (4) selling loans. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold.
Total assets = total liabilities + capital
Liabilities (sources if funds)
(1) checkable deposits:
bank accounts that allow the owner of the account to write checks to third parties. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to to a liquid asset that can be used to make purchases.
(2) Non-transaction deposits
owners cannot write checks on them, but the interest rates are usually higher than those on checkable deposits.
(a) savings account
(b) time deposits, which are also called certificate of deposit, or CD
(3) Borrowings
funds borrowed from the Fed, other banks and corporations/ Borrowing from the Fed is called discount loans (or advances). They also borrow overnight in federal funds market from other US banks and financial institutions to have enough deposits at the Federal Reserve to meet the amount required by the Fed.
(4) Bank Capital
a cushion against a drop in the value of its assets
Assets (Uses of funds)
(1) reserves
All banks hold some of the funds they acquire as deposits in an account at the Fed. RESERVES are these deposits plus currency that is physically held by banks (called VAULT CASH because it is stored in bank vaults overnight)
The reasons to hold reserves (a) required reserves are mandated by law (b) additional reserves, called excess reserves, are the most liquid of all bank assets and can be used by a bank to meet its obligation when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account.
(2) securities
(3) loans
less liquid than other assets because they cannot be turned into cash until the loan matures.
(4) other assets (physical)
In general terms, banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics. (asset transformation) Transform the saving asset (asset held by the depositor) to a mortgage loan (asset held by the bank)
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses deposits, it loses an equal amount of reserves.
IF a bank has ample reserves, a deposit outflow doesn't necessitate changes in other parts of balance sheets
liquidity management: the acquisition of sufficiently liquid assets to meet the bank's obligation to depositors
asset management: pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings
liability management: acquire funds at low cost (negotiable CDs and federal fund market)
a bank maintains bank capital to lessen the chance that it will become insolvent
net profit after taxes/equity capital = net profit / assets * assets / equity capital
(given the return on assets, the lower the bank capital, the higher the return for the owners of the bank)
bank capital requirements
capital adequacy management: the amount of capital should maintain and capital needed
The reasons why banks hold excess reserve:
When a deposit outflow occurs, holding excess reserves allows the bank to escape the cost of (1) borrowing from other banks or corporations (2) selling securities (3) borrowing from federal (4) selling loans. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold.
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