ECOS2004
MONEY AND
BANKING
WEEK 1: INTRODUCTION
MISKIN CH 1: WHY STUDY MONEY, BANKING AND FINANCIAL MARKETS
WHY STUDY FINANCIAL MARKETS?
• Financial markets: are markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have need of funds
o Can be a source OR amplifier of instability
o World economic conditions are still being affected by aftermath of GFC
THE BOND MARKET AND INTEREST RATES
• Security: financial instrument = a claim on the issuer’s future income or assets
• Bond: debt security promising to make coupon payments periodically for a specified period of time o Principal is returned to lender at maturity
o Important for corporations + Govs who borrow money to finance their activities o Where IR are determined
• Interest rate: the cost of borrowing or the price of credit (the price paid for the rental of funds)
POLICY INTEREST RATES
• SIDE GRAPHS: policy interest rates of major advanced economies à all have similar systems w/ cash rates o Periods of BOTH rapid movement + long stability à E.g. Instability in 2007 pre-GFC
o Extremely unusual period for rates to be so close to 0 (NOW)
§ Japan below 0 à i.e. paying someone to hold your money for you
• BOTTOM: IR in Australia à GFC impact in Aus was not as severe as overseas = IR weren’t cut so low
• Housing rates + the cash rate:
o GRAPH RIGHT: mortgage rate
§ Correlates reasonably closely w/ cash rate
§ Margin creates profit margins for banks (not perfectly)
§ Change of cash rate has an almost immediate effect on lending rates à such a large component of the economy
WEEK 2: MONEY AND THE PAYMENT SYSTEM, UNDERSTANDING INTEREST RATES
MISHKIN CH 3: WHAT IS MONEY?
• Money: anything generally accepted as payment for G+S or in the repayment / settlement of debts
• Currency: notes, coins
• Distinction between a stock and flow:
o Stock units: measured at a POINT IN TIME o Flow units: expressed PER UNIT OF TIME
• Money (a stock concept) is different from both:
o Wealth: total set of assets (property, money and securities) that serve to store value
§ Is a stock but is much broader than money o Income: flow of earnings per unit of time
FUNCTIONS OF MONEY 1. Medium of exchange
o Promotes economic efficiency by minimising transaction costs (i.e. time spent exchanging G+S)
§ Don’t have to satisfy a ‘double coincidence of wants’ like in a barter economy o Promotes specialisation in production / labour services
o MOE must be:
§ Easily standardised = simple to ascertain value
§ Widely accepted
§ Divisible à to make exact payment, also easy to ‘provide change’
§ Portable
§ Durable
2. Unit of account: money is used to measure value in the economy
o Reduces transaction costs à facilitates comparison of relative values rather than bartering 3. Store of value: used to save purchasing power over time
o Also served by other assets (e.g. securities) – can have greater advantages through higher interest payments
§ Money is THE MOST liquid asset à a dollar of any type of money can be reliably converted into a dollar of currency at any time
o Money, therefore has fixed nominal value à unlike securities
§ BUT money loses real value (purchasing power) during periods of inflation EVOLUTION OF THE PAYMENTS SYSTEM
• Payments system: the method of conducting transactions in the economy
• Commodity money: an object universally accepted, valuable, easily standardised and divisible o Value = based on the item itself à E.g. precious metals, cigarettes in prison
• Coins: standardised metallic commodity money
• Paper bank notes: certificates of claim on metallic commodity money (gold or silver)
• Fiat money: paper money decreed by Govs as a legal tender
• Cheques: an instruction to your bank to transfer money from your deposit account to another
• Electronic payment: e.g. online bill-pay and electronic deposit transfers
• E-money: debit card, stored-value card, e-cash
• Are we headed for a cashless society?
o E-money might be more + and efficient than paper-based payments system
o Use of e-money will likely still increase in future
MEASURING MONEY
UNITED STATES DEFINITIONS
• M1: currency + traveller’s cheques + demand deposits + other checkable deposits o Contains the most liquid assets
• M2: M1 + small-denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund (MMMF) shares
o Shares for MMMFs are basically cashable at original value
• M1 vs. M2:
o M1 and M2 can move different directions in short run à GRAPH o Choice of monetary aggregate can lead to a range of different conclusions
§ One reason monetary aggregates have become less useful as a policy indicator
AUSTRALIAN DEFINITIONS:
• Currency: notes and coins in circulation
• M1: currency + current deposits with commercial banks
o Usefulness reduced by fact that deposits in M1 no longer have clear distinctions from those not included in M1
• M2: no longer in use in Aus
• M3: M1 + all bank deposits
• Broad money: M3 + deposits with non-bank depository institutions
• LEFT GRAPH: trends shift due to preferences
o GFC: people lost faith in banks and decided to hold currency (cash) rather than in bank deposits = large fall in M3 and parallel growth in currency
• MIDDLE GRAPH: correlation b/c banks can only issue the amount of credit they hold
• RIGHT: see some correction post-GFC when banks tried to reduce lending
CHAPTER 4: THE MEANING OF INTEREST RATES MEASURING INTEREST RATES
PRESENT VALUE
• Present value: the present value of a payment to be received in the future taking into account the time value of money o A dollar today is more valuable than a dollar tomorrow
• qrst'% Fu)%+%v) = #w ∗ (1 + r)1 o E.g. $100 today is worth:
§ Y1: 100 ∗ (1 + 0.1) = $110
§ Y2: 100 ∗ (1 + 0.1)I= $121 etc.
• #w ={2<| }3.~
(J0)Ä
o E.g. What is the present value of $250 to be paid in two years if the interest rate is 15%?
§ #w =(J0)=ÅÄ=(JÉ.JÇ)IÇÉ Ñ= $189.04
• Cannot directly compare payments scheduled in different points in the time line
YIELD TO MATURITY
• Yield to maturity: interest rate that equates the present value of the total cash flow payments received from a debt instrument with its value today
o Direct relationship between YTM and current interest rate
FOUR TYPES OF CREDIT-MARKET INSTRUMENTS
1 – SIMPLE LOAN:
• Simple loan: lender provides borrower with funds that must be repaid to the lender at maturity, along with an additional payment for interest
• E.g. PV = $100, CF Y1 = $110, n = 1
o 100 =(J0)JÉÉS à (1 + r) =JJÉJÉÉ à r = 10%
2 – FIXED PAYMENT LOAN:
• Fixed-payment loan: loan repaid by making the same payment, consisting of part of principal and interest, every period for a set number of years
• âw = Å6
(J0)S+ Å6
(J0)Ñ+ ⋯ + Å6
(J0)Ä
o LV = loan value
o FP = fixed yearly payment o N = number of years to maturity
• E.g. Loan is $1,000 and payment is $126 every year for 25 years o $1000 = JIã
(J0)S+ JIã
(J0)Ñ+ JIã
(J0)å+ ⋯ + JIã
(J0)Ä
§ r = 7% à must use a financial calculator or program
• E.g. You decide to purchase a home and need a $100,000 mortgage. You take out a loan from the bank with an interest rate of 7%. What is the yearly payment to the bank if you wish to pay off the loan in 20 years?
o $100,000 = 6
(JÉ.Éè)S+ 6
(JÉ.Éè)Ñ+ 6
(JÉ.Éè)å+ ⋯ + 6
(JÉ.Éè)Ñê
§ # = $9,439.29
3 – COUPON BOND:
• Coupon bond: pays owner of the bond a fixed interest payment (coupon) every year until maturity, when a specified final amount (face value) is repaid
• # = =
(J0)S+ =
(J0)Ñ+ ⋯ + =
(J0)Ä+ Å
(J0)Ä
o P = price of coupon bond o C = yearly coupon payment o F = face value of bond o n = years to maturity
• Relationship between bond prices and YTM: negative relationship
o Change in IR has a MODEST impact on near-term cashflows à GREATER IMPACT on distant cashflows
§ Premium: Coupon rate > yield à price > face value (100)
§ Discount: Coupon rate < yield à price < face value (100)
§ Par: Coupon rate = yield à price = face value (100)
4 – PERPETUITY:
• Consol or perpetuity: a bond with no maturity date, does not repay principal but pays fixed coupon payments forever o
#
==
0=î
• E.g. Telstra pays half yearly dividends of around $0.155 (around $0.22 including tax effects). If this is expected to continue indefinitely, and the share market is expected to return 14.84% p.a. compounded 6-monthly, what is the value of Telstra?
o 14.84% p.a. is equivalent to 7.42% per half year o #w =;{=É.ÉèïIÉ.II = $2.96
o BUT Telstra is currently trading around $3.36
5 – DISCOUNT BOND (ZERO-COUPON BOND):
• Discount bond (zero-coupon bond): bought at a price below its face value (at discount) and face value is repaid at maturity à no interest payments, just face value
• For any one-year discount bond: r =ÅQ6
#
o F = face value of the discount bond o P = current price of that discount bond
• E.g. What is the yield to maturity of a one year, $1000 Treasury bill with a current price of $900?
o #w = =Å
(J0)Ä
§ $900 =(J0)JÉÉS à r = 11.1%
THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS
• Rate of return: payments to owner plus change in value expressed as a fraction of the purchase price o ó:ò = =
6P+6PôSQ6P
#) à ó == 6PôSQ6P
#)
§ RET = return from holding the bond from time (t) to time (t+1)
§ Pt = price of bond at time t
§ C = coupon payment
§ C/Pt = current yield = ic
§ 6PôSQ6P
#) = rate of capital gain = g
o E.g. $1,000 bond with coupon rate of 10%, bought for $1,000 and held for one year and then sold for $1,200
§ Coupon of $100
§ Change in bond value of $200
§ ó:ò =$JÉÉ$IÉÉ$JÉÉÉ = 30%
• The return on a bond will not necessarily equal the yield to maturity on that bond o Return = YTM only if holding period is equal to time to maturity
• Rise in IR associated with fall in bond prices = capital loss if time to maturity is longer than holding period
• Further away bond’s maturity = greater % price change associated w/ IR change
o More years until a bond matures = more years initial coupon is low in relation to market = new buyers willing to pay a low price for it
o Even if a bond has a substantial initial IR, its return can be negative if IR rise
• SO: yield (and hence price) of a bond today depends on the expected yield and price tomorrow
• Maturity + volatility of bond returns: interest-rate risk
o Prices and returns for long term bonds are more volatile than those for shorter-term bonds THE DISTINCTION BETWEEN INTEREST REAL AND NOMINAL INTEREST RATES
• Nominal interest rate: the actual reported interest rate, with no adjustment for inflation
• Real interest rate: adjusted for changes in price level (inflation) so it more accurately reflects the true cost of borrowing o Ex ante real IR: adjusted for expected changes in price level
o Ex post real IR: adjusted for actual changes in price level
• örvℎ%+ :õú()r*u: r = r;+ û8 o i = nominal interest rate o ir = real interest rate
o pe = expected inflation rate
