Download - Mishkin Ppt04
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1.Wealth
2.Expected Return
3.Risk
4.Liquidity
Asset a piece of property that is a store of value
Pearson Prentice HallFinancial Markets and Institutions 4 - 1
Determinants of Asset Demand
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1. Wealth- total resources owned, including all assets
2. Expected Return - return expected over the nextperiod) on one asset relative to alternative assets
3. Risk- degree of uncertainty associated with the return
4. Liquidity- the ease & speed with which an asset can beturned into cash
Pearson Prentice HallFinancial Markets and Institutions 4 - 2
Determinants of Asset Demand
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Ceteris paribus -
1.Wealth- an increase in wealth raises the quantity demandedof an asset
2.Expected Return - weighted average of all possiblereturns, where the weights are the probabilities ofoccurrence of that return: Re= p1R1+ p2R2+. . . + pnRn
an increase in an assets expected return relative to that
of an alternative asset, raises the quantity demanded of
the asset
Pearson Prentice HallFinancial Markets and Institutions 4 - 3
Determinants of Asset Demand
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Ceteris paribus
3.Risk- the degree of uncertainty associated with the return;a measure of risk called the standard deviation (). The
standard deviation of returns on an asset is calculated as: Square root of the weighted squared deviations from
the expected return (Re)
=
p1(R1- Re
)2
+ p2(R2- Re
)2
+. . . +pn(Rn- Re
)2
if an assets risk RISES relative to that of alternative
assets, its quantity demanded will FALL
Pearson Prentice HallFinancial Markets and Institutions 4 - 4
Determinants of Asset Demand
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Ceteris paribus
4.Liquidity- the ease and speed with which an asset can beturned into cash
An asset is liquid if the market in which it is traded has depthand breadth, i.e., if the market has many buyers and sellers
Treasury bill- a highly liquid asset; well-organized market
The more liquid an asset is relative to alternativeassets, the more desirableit is, and the greaterwill bethe quantity demanded
Pearson Prentice HallFinancial Markets and Institutions 4 - 5
Determinants of Asset Demand
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Summary response:
Change in Change in
Variable Quantity Demanded
1. Wealth
2. Expected Return
3. Risk i
4. Liquidity
Pearson Prentice HallFinancial Markets and Institutions 4 - 6
Determinants of Asset Demand
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Example:
1-yr Discount Bond,Face vale, $1000
Holding Pd: 1 yr
Re= i = F P
P
Pearson Prentice HallFinancial Markets and Institutions 4 - 7
Demand & Supply Curves
Equilibrium Pt
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Demand Curve Bd : downward slope, indicating that atLOWER prices of the bond, ceteris paribus, the quantitydemanded is HIGHER
Supply Curve Bs : upward slope, indicating that as the priceincreases, ceteris paribus, the quantity supplied is INCREASES
Market Equilibrium :Quantity Demanded = Quantity Supplied
or Market-Clearing Price Bd = Bs
Pearson Prentice HallFinancial Markets and Institutions 4 - 8
Demand & Supply Curves
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Market Implications
When the PRICE of bonds is set too HIGH: Bs > Bd : Excess Bs
people want to SELLmore bonds than others want to buy,the price of the bonds will FALL;
as long as price is above equilibrium, it will continue to fall
When the PRICE of bonds is set too LOW: Bs
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Movements along the Curve vs Shifts in the Curve
ALONGthe Curve:
rQty due torPRICE orrInterest Rate (i)
SHIFTin the Curve:
r Qty at each given PRICE or Interest Rate
- in response torin some factors beside PRICE or i
Pearson Prentice HallFinancial Markets and Institutions 4 - 10
Changes in Equilibrium Interest Rates
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Shifts in the Demand for Bonds
1. Wealth
2. Expected returns on bonds relative to alternativeassets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets
Pearson Prentice HallFinancial Markets and Institutions 4 - 11
Changes in Equilibrium Interest Rates
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If h, h
Economy is growing rapidly,
expansion & wealth isincreasing, the demand curve
shifts to the RIGHT;
Recession: income & wealth
are falling, the demand for
bonds falls, and the demand
curve shifts to the LEFT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 12
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: WEALTH
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If h, i
Higher expected interest
rates in the future itheexpected return for LT bonds,
ithe Bd, and shift the curve to
the LEFT; Lower expected interest
rates: RIGHT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 13
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: Expected Returns
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If h, i
Higher expected inflation
rates in the future itheexpected return for LT bonds,
ithe Bd, and shift the curve to
the LEFT; Lower expected inflation
rates: RIGHT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 14
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: Expected Inflation
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If h, i
Increase in riskiness ithe
bonds become less attractive,
ithe Bd, and shift the curve to
the LEFT;
Pearson Prentice HallFinancial Markets and Institutions 4 - 15
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: RISK
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If h, h
More people started trading in
the bond market, and as a resultit became easier to sell bonds
quickly; hliquidity of bonds
results in an hBd, the demand
curve shifts to the RIGHT; hliquidity of ALTERNATIVE
ASSETSiBd, shifts the demand
curve to the LEFT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 16
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: LIQUIDITY
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Shifts in the Supply for Bonds
1. Expected profitability of investment opportunities
2. Expected inflation
3. Government budget
Pearson Prentice HallFinancial Markets and Institutions 4 - 17
Changes in Equilibrium Interest Rates
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If h, h
Economy is growing rapidly,
business cycle expansion,Bsisincreasing, the supply curve
shifts to the RIGHT;
Recession: fewer expected
profitable investment
opportunities, and the supply
curve shifts to the LEFT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 18
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: PROFITABILITY
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If h, h
Real cost of borrowing i,
business cycle expansion,Bsisincreasing, the supply curve
shifts to the RIGHT
FISHER EFFECT:
When expected inflation
rises, interest rates will rise
Pearson Prentice HallFinancial Markets and Institutions 4 - 19
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: Expected Inflation
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If h, h
Deficit: Government borrows
by issuing Treasury Bonds, Bsis increasing, the supply curve
shifts to the RIGHT;
Surplus: supply curve shifts to
the LEFT.
Pearson Prentice HallFinancial Markets and Institutions 4 - 20
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: GOVERNMENT BUDGET
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Analysis assumptions:
1. Examine the effect of a variable change, remember thatwe are assuming that all other variables are unchanged;that is, we are making use of the ceteris paribusassumption
2. INTEREST RATEis negativelyrelated to the BONDPRICE,
so when the equilibrium bond price rises, the equilibriuminterest rate falls. Conversely, if the equilibrium bondprice moves downward, the equilibrium interest raterises.
Pearson Prentice HallFinancial Markets and Institutions 4 - 21
Changes in Equilibrium Interest Rates