UNIT II:MARKETS
CLASS OUTLINE
- Interest rates
These are the basis of all financial markets
All finance is a series of footnotes to compounding and discounted present value”.
- Basic principles of interest rates & fixed-income markets:
- Time preference
- Time value of money
- Future value (compounding)
- Present value (discounting)
- Time preference and the time value of money
People prefer consumption now to consumption later.
if they defer consumption – if they SAVE – they require something additional in future THAT IS THE RATE OF INTEREST
REMEMBER THAT 10% MEANS 0.10 – that’s what we use in calculations.
- Future value (compounding)
If you invest $1 for one year at a rate of r percent, the “future value” of that $1 is what you get back – the $1 plus interest – after one year.
Same thing for $x:
e.g.
For longer or shorter periods:
e.g. FV($100,2 years,5%) =
FV($100,6 months = 0.5 year,5%) =
- Present value (discounting)
This is the INVERSE of future value: If you know you will receive $1.10 one year from now, and the interest rate is 10%, what is that expected amount worth now?
That is “present value”
In general:
So, the present value of $x to be received afterT years discounted r%:
e.g.
Present Value is used to compute the price of all bonds, short-term and long-term.
For short-term markets there is only one payment; for long-term markets there are many payments of both interest and principal.
NOTE: PV and interest rate move inversely:
asi rises, PV declines; as i declines, PV rises.
compare PV of $100 to be received in 2 years, discounted (a) 10% (b) 5%
- Where do interest rates come from? LOANABLE FUNDS THEORY
Basic supply and demand:
- Demand comes from . . .
- Supply comes from . . .
- Equilibrium determination of interest rate
NOTE: this is the supply and demand for credit; its price is the interest rate. Once that is known, you can calculate the present value of a bond, etc.
- Factors that affect interest rates
- Economic Growth:
- Inflation: if prices are rising
(1) credit demanders (deficit units)
(2) credit suppliers (surplus units
— together these increasethe interest rate
terms: nominal interest rate : the actual rate in a transaction
real interest rate : the interest rate adjusted for inflation
if the borrower pays 5% per annum but expected inflation is 4%, the “real” interest rate is 5% – 4% = 1%
this is the “Fisher Effect”:
or
Here, the real interest rate is the difference between the blue and red lines:
- Monetary policy:
- Fiscal policy:
- Foreign demand and supply: the same things but from foreign sources.
Recent history of U.S. short-term interest rates
- Securities
- Financial markets primarily buy and sell securities
- Primary market
- Secondary market
After a security is issued in the primary market it can be sold to someone else. (This is most of what you see in the daily trading of stocks and bonds.)
- Valuation of securities
- Information is the key.
- Securities regulation tries to be sure all relevant information is public.
- Cash flows are crucial to valuation.
- “Efficient markets hypothesis” – that the market price reflects all relevant information so no one can reliably earn higher-than-market returns.
HIGHLY CONTROVERSIAL
NAME: ____________________________ ________POINTS _______ PERCENT
5 problems on FUTURE VALUE and PRESENT VALUE (2 points each) (show work for possible partial credit)
- PRESENT VALUE of $10,000, at 2.3%, 2 years
- FUTURE VALUE of $10,000, at 1.25%, 1 year
- FUTURE VALUE of $1,000, at 3.5%, 4 years
- PRESENT VALUE of $1,000,000, at 0.5%, 6 months
- FUTURE VALUE of $750, at 0.75%, 9 months
- This graph shows an initial equilibrium in the Market for Loanable Funds.
- Show the changes in the graph if the fiscal authorities (i.e. Congress and the President) increase government spending substantially. (6 points)
- In this case the equilibrium interest rate (choose one) . . .
- increases
- decreases
- In this case the equilibrium quantity of loans (choose one) . . .
- increases
- decreases
- If the Market for Loanable Funds shows a nominal interest rate of 7%, use the Fisher Equation — i_{nominal}= E(INF) + r_{real} — to find the real rate of interest if expected inflation is 3%. (2 points)
- For each of the following, indicate whether it takes place in the primary market or the secondary market for securities. (circle the correct answers) (2 points)
- A successful startup corporation decides to issue shares to the public for the first time. (primary/secondary)
- You buy 100 shares of Apple Inc., which is listed on the NASDAQ exchange (primary/secondary)
Last Updated on September 12, 2018 by Essay Pro