econ 303 final notes

8/6/2019 ECON 303 Final Notes

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The Fed and September 11

The attacks on the World Trade Center and the Pentagon immediately interrupted the payments system. Sinceairplanes were grounded, checks stopped traveling among banks. In addition, the attacks knocked out electronic

communications in Manhattans financial district. Many banks could not make electronic payments that they hadpromised.

Consequently, some banks did not receive payments they expected and ran short of money. This could have had adomino effect. When banks are worried about a money shortage, they are reluctant to send money elsewhere;they delay payments and refuse to make loans. This means that other banks dont receive expected funds.

Everybody starts hoarding money, and the payments system can break down.

Without a payments system, people cant buy or sell goods and services. So a serious breakdown in paymentscould have disrupted the whole economy, slowing growth and raising unemployment. The Fed took several actions

to prevent this outcome.

y The Fed adjusted the rules governing payments. Normally, the Fed charges overdraft fees to banks with negative

balances in their Fed accounts. These fees were suspended from September 11 to September 21. This policy

encouraged banks to keep making payments even if incoming funds were delayed, pushing their balances negative.y The Fed acted as a lender of last resort. At 11:45 on September 11, 3 hours after the initial attack, it issued a

press release saying, The Federal Reserve System is open and operating and ready with emergency loans. Lots

were needed: on September 12 the Fed had $45 billion of loans out to banks, about 200 times the normal level.y The Fed relaxed bank regulations. It allowed loans that it would normally prohibit. For example, the Fedencouraged banks to lend to securities dealers, which it usually considers risky. Many dealers needed money

because, like banks, they didnt receive expected payments.

Besides disrupting payments, the 9/11 attacks threatened the economy in other ways. A higher demand for money

raises interest rates. Banks scramble for money could have raised rates, which in turn would have slowedeconomic growth. However, starting on September 11, the Fed increased the money supply to match money

demand. This action kept interest rates stable.

On Monday, September 17, the Fed went a step farther. It decided the economy needed not stable interest rates,but lowerrates. It decided to push short-term rates from 3.5 percent to 3 percent, which it accomplished by

increasing the money supply.

The Fed acted because it feared a decline in economic growth. Growth was threatened by problems in certain

industries, such as airlines and travel, and by reduced consumer spending caused by general uncertainty. Lowerinterest rates encouraged consumers and firms to spend, helping to offset the factors reducing growth

With interest-rate targets, raising rates means announcing higher targets. Volcker preferred to announce areduction in money growth, which sounds less objectionable. Lowering money growth raises interest rates, but the

public doesnt fully understand this effect. It is less obvious that the Fed is intentionally raising rates and slowingthe economy.

Open-market operations change the money supply, which affects the overall level of interest rates. Rates on many

types of bonds and loans respond to open-market operations. However, some rates are affected more quickly and

directly than others. The federal funds rate is especially responsive to open-market operations, which is one reason

the Fed targets this rate.

The Fed trades bonds with about 25 financial institutions known as primary dealers. These dealers are major

commercial and investment banks, such as JP Morgan Chase and Goldman Sachs. When the Fed wants to make atrade, it notifies all primary dealers electronically, giving them 10 or 15 minutes to respond with bids. For example,

the Fed might say it wants to sell Treasury bonds with a certain maturity, and primary dealers say what prices theyare willing to pay. The Fed accepts the most favorable bids.

The Fed performs two kinds of trades. In an outright open-market operation, it simply buys or sells bonds. This

transaction permanently changes bank reserves and the monetary base. In a temporary open-market operation,the Fed makes a repurchase agreement with a bond dealer. This means the Fed buys or sells bonds with an

agreement to reverse the transaction in a certain number of days (see Section 9.1). This action temporarilychanges bank reserves. The Fed uses this approach to offset temporary shifts in the supply and demand for federal

funds.


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A central bank can practice money targeting, in which it chooses a level for the money supply. Alternatively, it can

practice interest-rate targeting, in which it chooses a level for the interest rate and adjusts the money supply to hitthis target.

Under money targeting, shifts in money demand cause the interest rate to change. Under interest-rate

targeting, shifts in money demand do not affect the interest rate. Because of this difference, the Fed targetsinterest rates rather than money.

open-market operations: Purchases or sales of bonds by a central bank.

Aggregate expenditure can be broken into four components, which you probably recall from your principles ofeconomics course:

y Consumption (C) covers purchases of goods and services by individualseverything from loaves of bread to cars

to haircuts.

y Investment (I) means purchases of physical capital, such as new factories, machines, and houses.y Government purchases (G) includes roads, military jets, and the salaries of government workers (which

economists interpret as purchases of the workers services).

y Net exports (NX) is exports minus imports. It measures net purchases of a countrys goods and services by

foreigners

These four components sum to aggregate expenditure. We assume that output, Y, equals AE:

Anything that affects one of the spending components affects aggregate expenditure, and therefore affects output

Securitization involves pooling loans with similar characteristics and selling them to investors.the GAO, it is a process that "packages relatively illiquid individual financial assets, such as

loans, leases or receivables with common features, and converts them to interest-bearing, asset-backed securities with characteristics marketable to capital market investors."

The primary benefit of securitizing a pool of loans is the increased liquidity provided to the

originator. Lenders who sell loans to a secondary market source do not have to hold the loans ontheir books, and are able to increase loan activity, thereby increasing the flow of credit to

community development organizations and generating more earned income. For CED lenderswho have deployed much or all of their available funds, selling loans can be an effective

recapitalization strategy.

securitization benefits lenders by efficiently reallocating and reducing portfolio risk. For example,

lenders who want greater diversification in their loan portfolios can use securitizationeither the ability

to sell or to purchase loansas a means to achieve it. Plus the ability to sell loans in a securitized form

reduces the potential impact of interest rate risk on the institution. Securitization benefits borrowers by

increasing the amount of credit that lending institutions make available to the community.investor

interest in the purchase of securities can lead to lower borrowing costs for the original borrower. The

ability to purchase particular types of securities benefits investors in two ways. First, securities provide


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5. 5. The multiplier is the reciprocal of the leakage rate.

B.B. The general model: the role of autonomous taxes, income taxes, and imports

1. 1. Autonomous taxes shift the AE schedule.

2. 2. Income taxes and imports flatten the slope of the AE schedule.

3. 3. The flatter the AE schedule the lower the income multiplier.

4. 4. Savings, income taxes, and imports are leakages that determine the value of theincome multiplier.

IV. VII. Aggregate Expenditures and Aggregate Demand

A. A.

The effect of a price change on the AEschedule.

1. 1. A higher price level lowers consumption, investment, and net exports resultingin lower aggregate expenditures.

2. 2. Lower aggregate expenditures results in lower equilibrium output at a higherprice level. This is, in fact, the aggregate demand schedule of the economy.

3. 3. Factors other than a price change that affect aggregate expenditures result in ashift in the aggregate demand schedule.

Example: A change in one of these factors can shift the net export function. Suppose the valueof the dollar decreases relative to foreign currency (fall in the dollars exchange value). With the

dollar worth less on world markets, foreign products become more expensive for Americans, andU.S. products become cheaper for foreigners. What happens to net exports?

Imports decrease and e

exports increase. Net exports = Exports Imports increase.What is the effect of an increase in the dollars exchange value?

The financial crisis in Thailand has unfolded after many years of outstanding

economic performance. The causes of the Thai financial crisis were created

by several factors such as the burst of bubble economy, the financial

liberalisation policy, the fixed exchange rate, the high domestic interest rate

policy, the ignorance of control and investigation in financial institutions, the


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structural and managerial erosion of finance and securities, the economic

recession, and the political limitation and decision making process. These

factor details are as follows.

First, the bubble economy has begun in the real estate market after 1985

and in the stock market after 1987. This cause leads to the financial

instituted problems because the asset pricing is greater than its productivity.

Hence, the financial institutions can lend to the asset owners more than the

productivity. When the bubble economy burst, the borrowers cannot pay

their borrowing back. As a result, the financial institutions faced non-

performance loan (NPL) problem. Moreover, Thai purchasing power

degenerated and led to the decline of national income.

Second, the Bank of Thailand started the financial liberalisation policy in

1990 which is an appropriate period. This is because Thai economy has

stability and high growth rate. From this reason the policy seem to be

correct. Afterwards, the Bank of Thailand accelerated to use the Bangkok

international Banking facilities (BIBF) policy in 1993, but ignored the

sequencing; therefore, the decision and the management mechanism loose,

and the lack of tools policy. The financial crisis appeared not only cannot

solved the problems but also duplicate the situation even worse.

Third, the Bank of Thailand proceeded the fixed exchange rate system and

the financial liberalisation policy which cannot be carry out together, but the

Bank of Thailand needed to make a certainty for international businesses

and remained low inflation rate. Eventually, the problems happened with

Thai international reserve because of these two policies.

Forth, the high domestic interest rate policy has been used because the

Bank of Thailand needed to accumulate the international reserve to get rid of

the excess demand for dollars in the foreign exchange market by attracted


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international investors transfer foreign capital to Thailand. Most of the

capital mobility at that time has been invested in the security market and

the real estate market. Afterwards, there is oversupply in real estate market

which has an asymmetric information problem.

Fifth, the basic idea of financial institutions cannot be bankrupt led to the

ignored control and investigation of the financial institutions. This idea

seemed to be promoting the stability of financial institutions, but there are a

lot of risk-lover executive which still produce instability problems in the basic

step.

Sixth, the structural and managerial erosion of financial and securities due to

the Thai economy has been growth since 1987, the finance and securities

expanded according to economic system and the bubble economy situation.

At that period, there are a lot of new branch of finance and securities. This is

a cause of lack and inexperience of executive management. Therefore, the

adverse selection problems appear by the risk-lover of new executive

management.

Seventh, the economic recession has started since 1996 which duplicate the

financial crisis. In addition, the economic recession decreased the payable of

borrowers due to the reduction of revenue and profit. Moreover, the

economic recession affected the value of asset which used for the guarantee

credit. Furthermore, the economic recession made the international financial

institutions reduced the confidence about the loan payable of Thai economic

system.

Eight, some economic stable problems such as inflation and unemployment

are the political agenda because people who are in trouble may act as

complainant force to solve the problem, but some problems such as the

trade the balance deficit, the current account deficit, and the international


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balance of payment deficit are not the political agenda because nobody

suffers from these problems. Therefore, there is not any complainant force

to solving the problems. At that moment, the political leaders try to gain

economic rent from the policy decision process. So, the political limitation

and decision making process are among the most important influence

factors.

Thai financial crisis in 1996 is the most severe in Thai economy after the

Second World War. These factors have been disclosed and are able to

categorise into three groups as follows.

The first group is the macroeconomic mismanagement which is the cause of

the bubble economy growth, using of the financial liberalisation by

unchanging the controlling and investigation of financial institutions,

organising the tools policy for any new situation, the fixed exchange rate

system, and the high domestic interest rate policy. These are not only worse

for economic prosperity but also repeating the economic recessions.

The second group is the structural and managerial of finance and securities.

On the one hand, the structure of staff comprises of risk-lover investors. On

the other hand, the financial management which is not rigid in risk analysis

of project, the less of strict in revising credit and reducing value of asset that

use for guarantee credit, and concealing of non performance loan (NPL).

The third group is the basic philosophy and the control and invested

mechanisms of the financial institutions, the idea of the financial institutions

cannot bankrupt, the unchanged mechanism of ruling the controlling and

investigation of the financial institutions beneath the new financial

liberalisation, the less of development and improve efficiency of

investigation, and the ignorance of using authority to solve the problems

when a few financial institutions obtained the problems of instability


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According to the expectations hypothesis, if future interest rates are

expected to rise, then the yield curve slopes upward, with longer

term bonds paying higher yields. However, if future interest rates

are expected to decline, then this will cause long term bonds to

have lower yields than short-term bonds, resulting in an inverted

yield curve.

1.The change in yields of different term

bonds tends to move in the same

direction.

2.The yields on short-term bonds are more

volatile than long-term bonds.

3.The yields on long-term bonds tend to be

higher than short-term bonds.

4. The expectations hypothesis (EH) of the term structure of interest ratesthe5. proposition that the long-term rate is determined by the markets expectation of the

shortterm

6. rate over the holding period of the long-term asset plus a constant risk premium7. has been tested extensively using a wide variety of interest rates, over a variety of time8

. periods and monetary policy regimes.

In finance, a hedge is a position established in one market in an attempt to offset exposure to price

fluctuations in some opposite position in another market with the goal of minimizing one's exposure to

unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies,

forward contracts, swaps, options, many types ofover-the-counter and derivative products, and

perhaps most popularly, futures contracts. Public futures markets were established in the 1800s to allow

transparent, standardized, and efficient hedging ofagricultural commodity prices; they have since

expanded to include futures contracts for hedging the values ofenergy, precious metals, foreign

currency, and interest rate fluctuations.

A typical hedger might be a commercial farmer. The market values of wheat and other cropsfluctuate constantly as supply and demand for them vary, with occasional large moves in eitherdirection. Based on current prices and forecast levels at harvest time, the farmer might decide

that planting wheat is a good idea one season, but the forecast prices are only that: forecasts.Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual


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price of wheat rises greatly between planting and harvest, the farmer stands to make a lot ofunexpected money, but if the actual price drops by harvest time, he could be ruined.

If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting

time, he effectively locks in the price ofwheat at that time: the contract is an agreement to

deliver a certain number of bushels of wheat to a specified place on a certain date in the futurefor a certain fixed price. He has hedged his exposure to wheat prices; he no longer cares whetherthe current price rises or falls, because he is guaranteed a price by the contract. He no longer

needs to worry about being ruined by a low wheat price at harvest time, but he also gives up thechance at making extra money from a high wheat price at harvest times.

A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues

and expenses

In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in

the economy (Y) at a given time andprice level[1]

. It is the amount of goods and services in the

economy that will be purchased at all possible price levels.[2]

This is the demand for the grossdomestic product of a country when inventory levels are static. It is often called effectivedemand, though at other times this term is distinguished.

It is often cited that the aggregate demand curve is downward sloping because at lower pricelevels a greater quantity is demanded. While this is correct at the microeconomic, single good

level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downwardsloping as a result of three distinct effects; Pigou's wealth effect, the Keynes' interest rate effect

and the Mundell-Fleming exchange-rate effect

What Does Real Interest Rate Mean?

An interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to

the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflationrate.

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)

Investopedia explains Real Interest Rate

The real interest rate is the growth rate of purchasing power derived from an investment. By adjusting the nominal interest rate to

compensate for inflation, you are keeping the purchasing power of a given level of capital constant over time.

An asset-backed security is a security whose value and income payments are derived from and

collateralized (or "backed") by a specified pool of underlying assets. The pool of assets istypically a group of small and illiquid assets that are unable to be sold individually. Pooling the

assets into financial instruments allows them to be sold to general investors, a process calledsecuritization, and allows the risk of investing in the underlying assets to be diversified because

each security will represent a fraction of the total value of the diverse pool of underlying assets.The pools of underlying assets can include common payments from credit cards, auto loans, and

mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movierevenues.


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Often a separate institution, called a special purpose vehicle, is created to handle thesecuritization of asset backed securities. The special purpose vehicle, which creates and sells the

securities, uses the proceeds of the sale to pay back the bank that created, or originated, theunderlying assets. The special purpose vehicle is responsible for "bundling" the underlying assets

into a specified pool that will fit the risk preferences and other needs of investors who might

want to buy the securities, for managing credit riskoften by transferring it to an insurancecompany after paying a premiumand for distributing payments from the securities. As long asthe credit risk of the underlying assets is transferred to another institution, the originating bank

removes the value of the underlying assets from its balance sheet and receives cash in return asthe asset backed securities are sold, a transaction which can improve its credit rating and reduce

the amount of capital that it needs. In this case, a credit rating of the asset backed securitieswould be based only on the assets and liabilities of the special purpose vehicle, and this rating

could be higher than if the originating bank issued the securities because the risk of the assetbacked securities would no longer be associated with other risks that the originating bank might

bear. A higher credit rating could allow the special purpose vehicle and, by extension, theoriginating institution to pay a lower interest rate (that is, charge a higher price) on the asset-

backed securities than if the originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from theirbalance sheet by having another institution assume the credit risk, so that they (the banks)

receive cash in return. This allows banks to invest more of their capital in new loans or otherassets and possibly have a lower capital requirement.

Expectations Hypothesis

The expectations hypothesis states that different term bonds can

be viewed as a series of 1-period bonds, with yields of each period

bond equal to the expected short-term interest rate for that

period. For example, compare buying a 2-year bond with buying 2

1-year bonds sequentially. If the interest rate for the 1st year is 4%

and the expected interest rate for the 2nd year is 6%, then one can

be either buy a 1-year bond that yields 4%, then buy another bond

yielding 6% after the 1st one matures for an average interest rate of

5% over the 2 years, or he can buy a 2-year bond yielding 5%

both options are equivalent: (4%+6%) / 2 = 5%. Hence, the

sequential 1-year bonds are equivalent to the 2-year bond.


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Note that this relationship must hold in general, for if the sequential

1-year bonds yielded more or less than the equivalent long-term

bond, then bond buyers would buy either one or the other, and

there would be no market for the lesser yielding alternative. For

instance, suppose the 2-year bond paid only 4.5% with the

expected interest rates remaining the same. In the 1st year, the

buyer of the 2-year bond would make more money than the 1st year

bond, but he would lose more money in the 2nd yearearning only

4.5% in the 2nd year instead of 6% that he could have earned if he

didnt tie up his money in the 2-year bond. Additionally, the price ofthe 2-year bond would decline in the secondary market, since bond

prices move in opposition to interest rates, so selling the bond

before maturity would only decrease the bond's return.

According to the expectations hypothesis, if future interest rates are

expected to rise, then the yield curve slopes upward, with longer

term bonds paying higher yields. However, if future interest rates

are expected to decline, then this will cause long term bonds to

have lower yields than short-term bonds, resulting in an inverted

yield curve.

The expectations hypothesis helps to explain 2 of the 3

characteristics of the term structure of interest rates:

1.The yield of bonds of different terms tend to move together.

2.Short-term yields are more volatile than long-term yields.


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However, the expectations hypothesis does not explain why the

yields on long-term bonds are usually higher than short-term bonds.

This could only be explained by the expectations hypothesis if the

future interest rate was expected to continually rise, which isnt

plausible nor has it been observed, except in certain brief periods.

Liquidity Premium Theory

The liquidity premium theory has been advanced to explain the 3rd

characteristic of the term structure of interest rates: that bonds

with longer maturities tend to have higher yields.

There are 2 risks with holding bonds that increases with the term of

the bond: inflation risk and interest rate risk. Both the inflation rate

and the interest rate become more difficult to predict farther into

the future. Inflation risk reduces the real return of the bond.

Interest rate risk is the risk that bond prices will drop if interest

rates rise, since there is an inverse relationship between bond prices

and interest rates. Of course, interest rate risk is only a real risk if

the bondholder wants to sell before maturity, but it is also an

opportunity cost, since the long-term bondholder forfeits the higher

interest that could be earned if the bondholders money was not tied

up in the bond. Therefore, a longer term bond must pay a higher

risk premium to compensate for the bondholder for the greater

risk.


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A bonds yield can theoretically be divided into a risk-free yield and

the risk premium. The risk-free yield is simply the yield calculated

by the formula for the expectation hypothesis. The risk premium is

the liquidity premium that increases with the term of the bond.

Hence, the yield curve slopes upward, even if future interest rates

are expected to remain flat or even decline a little, and so the

liquidity premium theory of the term structure of interest rates

explains the generally upward sloping yield curve for bonds of

different maturities.

Besides the liquidity premium theory, 2 other factors also explain

the upward sloping yield curve. The 1st factor is that both the credit

risk and default risk of corporate bonds increases with time. While it

is generally accepted that there is no credit or default risk for

Treasuries, most corporate bonds do have a credit rating that can

change in time because of changing business or economic

conditions, which can also increase default risk.

The 2nd reason why bonds with longer maturities pay a higher yield

is that most issuers would rather issue long-term bonds than a

series of short-term bonds, since it costs money to issue bonds

regardless of maturity.

Inverted Yield Curve

There are times, however, when short-term bonds do actually pay a

higher yield than long-term bonds, and that is when short-term


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rates are expected to decline sharply. This was the situation in

1980-1982, when interest rates were much higher than normal.

Because they were so high, it was expected that they would decline

to more normal values and this is what happened.

Investors expect a fair rate of return from bonds, based on

prevailing interest rates, term length of the bonds, and their credit

rating. Since prevailing interest rates change continually, there is

interest rate risk in holding bolds if the investor wants to sell the

bonds before their maturity. For instance, if a bond, with a $1,000

par value, is issued with a nominal interest rate of 5% when bonds

with similar risk and terms are also at 5%, then the bond can be

sold for $1,000. But if interest rates rise to 6%, then the price of

the bond is going to drop so that the bond's $50 interest payment

per year will have a yield to maturity (YTM) of 6%. So there are

capital gains and losses associated with bonds if they are sold

before maturity, so even with securities that are considered risk-

free in terms of default, such as U.S. Treasuries, there is still

interest rate risk.

Another way to look at bond prices and yields is to note that theprice of a bond is equal to the sum of the present values of the

coupon payments and the principal.

Bond Value = Present Value of Coupon Payments + Present Value of

Par Value


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Formula for Relating Bond Price to Present Value of Future Cash Flow

B =

T

t=1

Ct

+

P

(1+r)t (1+r)T

B= current bond price

C = coupon payment

P = par value of bond

t = time until payment

r= interest rate per payment period

When interest rates change, then the present value of those

payments changes, also, causing the price of the bond to change

with it. Note that since the interest rate factor is in the

denominator, it is inversely related to the bond price.

The relationship between bond prices and prevailing interest rates is

neither simple nor linear. How much bond prices rise or fall depends

on the terms of the bonds, the current bond yield, and whether thebonds have embedded options, such as being callable or putable.

Burton G. Malkiel has described most of the important general

relationships between interest rates and bond prices.

y The most obvious relationship, easily seen in the graph below,

is that when interest rates rise, then bond prices fall,

increasing the YTM to the current market interest rate for

bonds of equal term length and credit rating, and vice versa.

y An increase in a bond's yield to maturity results in a smaller

bond price change than a decrease of equal magnitude. As you


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is further into the future for long-term bonds, and, thus,

is more affected by interest rates.

o The change in bond price per change in interest rate

increases as the term of the bond increases, but at a

proportionately lesser rate.

The bond-yield curve for an option-free bond is said to exhibit negative

convexity. The increase in price of a callable bond is limited by its call

option. When interest rates drop low enough, the issuer will call the bond,

and issue new bonds at the lower interest rate. However, at lower prices and

higher yields, the callable bond has price-yield characteristics similar to the

option-free bond. Similarly, a putable bond will not drop below the put price,

which is usually par value, since the bondholder can sell the bond back to

the issuer for the put price. At higher prices and lower yields, the putable

bond has a price-yield relationship that is similar to the option-free bond.


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The interest rate risk of a bond portfolio, or other similar fixed-rate

security, can only be assessed if the risk can be quantified. There

are 2 methods of ascertaining interest rate risk: the full-valuation

approach and the duration/convexity approach.

Full-Valuation Approach (aka Scenario Analysis)

The price of a bond in regard to interest rates is the sum of its

future cash flows discounted by the interest ratein other words,

the sum of the present value of those cash flows. Hence, one way to

calculate interest rate risk is to calculate what actual bond prices


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would be after a change in interest ratesthe full-valuation

approach. A bond portfolio manager would typically calculate the

bond prices for a number of interest rates. Since bond prices only

decline if interest rates rise, the manager would mostly be

interested in the value of the portfolio if the interest rate rises by

specific increments, such as 100, 200, or 300 basis points. By

calculating the value of the bond portfolio for each increment, the

manager can determine the actual interest rate risk if the interest

rates rise by the calculated amount. Because interest rate risk is

determined for specific scenarios, the full-valuation approach is also

known as scenario analysis.

Example Scenario Analysis

The table below lists bond prices and the corresponding price changes for bonds

with a coupon rate of 5% for several different market interest rates and bonds

of different terms.

Interest Rate Term Bond Price Price Change YTM

6.0% 1 Year $990.43 -0.96% 6.00%

6.0% 5 Years $957.35 -4.27% 6.00%

6.0% 10 Years $925.61 -7.44% 6.00%

6.0% 20 Years $884.43 -11.56% 6.00%

7.0% 1 Year $981.00 -1.90% 7.00%7.0% 5 Years $916.83 -8.32% 7.00%

7.0% 10 Years $857.88 -14.21% 7.00%

7.0% 20 Years $786.45 -21.36% 7.00%

8.0% 1 Year $971.71 -2.83% 8.00%


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8.0% 5 Years $878.34 -12.17% 8.00%

8.0% 10 Years $796.15 -20.39% 8.00%

8.0% 20 Years $703.11 -29.69% 8.00%

The full-valuation approach works well for option-free bonds, but

the analysis becomes more complicated if the bonds have

embedded options, such as being callable or putable. For instance, if

the bonds are callable, then any price increases are going to be

capped by the call price and the price increase of the bond will slow

as the call price is approached. If the bond is putable, then

decreases in the bond price will have a floor at the putable price,

which is usually par value. If the bond's price falls below this, then

the bondholder can sell the bond back to the issuer for the put

price. Hence, the price decline slows as the put price is approached,

then levels off at the put price.

Floating rate securities also have complications. The floating rate

is usually a specified number of basis points above a benchmark,

such as a U.S. Treasury. The rate is reset at specific time intervals,

such as every month or every 6 months, and there is usually a cap

on the interest rate of the security, which is the maximum amount

of interest that can be earned. While the interest rate is below the

cap, a given change in interest rates will result in larger price

changes the more time that is left until the reset date. The market

may also demand a greater basis point spread than is being offered

by the security, resulting in lower prices. Finally, there is cap risk,


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where any increases in interest rate above the cap price will cause

the bond price to decline just as with an ordinary bond.

Picking which scenarios to analyze depends on the investment

objective of the manager, and possibly regulations. For instance,

depositary institutions are often required to test a portfolio for a

1%, 2%, and 3% increase in interest rates. Highly leveraged

portfolios, such as those managed by hedge funds, may test

extreme scenariosstress testingsince even small changes in

interest rates can result in large losses in highly leveraged

portfolios.

With a large bond portfolio, the full-valuation approach becomes

computationally intensive, hence statistical models that can be

performed more quickly and cover more scenarios have been

developed to calculate interest rate risk.

econ 303 final notes

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