Saturday, March 6, 2010


TODAY: WE ARE GOING TO LEARNING ABOUT THE MONEY MARKET: This basically let's us understand how the money supply determines the interest rate

BONDS: What are bonds...

Well... Wealth is accumulated purchasing power, and wealth can be held in assets, or "things which you own" -This includes both money and "interest bearing assets"

Any household's financial portfolio includes a combination of money and interest bearing assets- choosing a different investment plan is just a matter of deciding how much of your wealth you wish to hold as money, and how much of it you wish to hold as an asset

Money has no risk of lost value (other than inflation), but also does not give you any returns as an investment

Interest bearing assets include bonds (IOUs from companies or the government), stocks (shares of control of a company) and other things (like real estate). They contain an element of risk, in that they can decrease in value over time and cause you to lose money, but on the other hand, they can generate returns (so you can profit off of investing of interest bearing assets if they increase in value)


So.... Here's a chart

Money: Cash in circulation, as well as deposits held in checking accounts: it has no risk, and generates no returns
Bonds: All other forms of interest bearing assets: it has risk, but can also generate returns
Debt: An interest-earning financial asset: this is a synonym for a bond: when you are a creditor, loaning money to a company, you are effectively buying a debt. There is some risk involved (because there is a chance that the company will go bankrupt and be unable to pay back the loan), but there is also a guaranteed rate of return, as determined by the bond agreement.
Equity: Claims on real capital: This describes stocks, which are a "gift" to companies. Companies may pay dividends to stockholders, but there is no guarantee of this.

BOND TERMINOLOGY: This is dense, awful stuff, so get ready

A BOND: A financial contract to pay fixed amounts at future specified dates, and to repay the principal (a loan agreement or a debt are both synonyms for bonds)
A DEBTOR: A borrower, or someone who sells bonds
A CREDITOR: A lender, or someone who buys bonds
THE INTIAL PRICE OF THE BOND: The original loan value or face value of the bond (ie: the principal)
A COUPON: The dollar value of the fixed returns on the bond
THE COUPON YIELD: Coupon / Initial Price (so, if the bond was valued at $100, and the coupon was $10 for a one-year loan, the coupon yield would be 10%, because 10/100 = 0.10

Initial Price * Coupon Yield = Coupon
100 * 10% = $10 Coupon!

PRICE OF THE BOND (Pb): Originally, this is the face value, or principal of the bond, BUT once the bond is sold, it is the present value of the bond in the market (so the price of the bond can change depending on market conditions)
PRESENT VALUE (PV): A discounted value of all future expected income streams using the MARKET RATE OF INTEREST (the discount rate). The price of the bond which a buyer is willing to pay to receive a future income stream provided by a bond
BOND YIELD: How much money you will make off of the bond- this is determined by a combination of the coupon, plus capital gain (as bonds are a form of asset, and can gain value depending on market conditions)
MARKET YIELD (i): The 'average' interest rate in all money-bearing assets currently in a market: the time-sensative value of money (in other words, the minimum rate on interest which you would impose on debtors to loan them money)
TERM (t): The time it takes to completely pay off a bond (principal and coupons)
JUNK BOND: A riskier, high-yield bond (BBB)

Basic ideas:
-The Present Value is equal to the Price of the Bond, which is equal to the face value of the bond at the time of issuance if the market rate of interest is equal to the coupon yield (which it usually is), because the present value, if you use the market rate, will be the face value
-The Present Value is equal to the Price of the Bond, which is equal to Face Value of the bond at maturity, because the bond has no return at that point: just principal
-As a lender, returns higher than those for the market rate are desirable


There are 3 yields (or rates of return, or interest rates)
-The coupon yield (which is guaranteed, according to the bond agreement)
-The bond yield (which can change depending on market conditions)
The market yield (which is the interest rate of money-bearing assets currently in a market): generally, coupon yields for bonds are set at the market rate for the time when they are issued

demand for money is a function of the NOMINAL rate of interest

Three cases where bonds are sold
Case 1: The bond is price "at par"
Case 2: The bond is sold at a discount (it is worth less in the market than it's face value, so it is sold for less than its face value
Case 3: The bond is sold at a premium (it is worth more in the market than it's face value, so it is sold for more than its face value)

Interest rates affect the present market value of bonds.

The price of bonds varies inversely with interest rates!
R = return one year hence
i = annual market rate of interest (sometimes called the discount rate)
PV = Present value

PV = R/(1 + i)

PV = R/(1 + i)-exponent t (where t is the number of years in the future)

So if the return on a bond one year hence is $110, and the interest rate is 3%, then
PV = 110/(1.03)
PV = $106.80

If the return on a bond is $120 in two years and the interest rate is 10%, then
PV = 120/(1.10)^2
PV = $99.17

The price of a bond is the present value of that future income stream
-The buyer will not pay more than PV for the bond, and the seller will not sell it for less than PV
-The higher the interest rate, the lower the present value of the bond, and vice versa, in order to keep the coupon yield equal to the market interest rate. Basically, we just always fiddle with the present value to make the bond yield equal to the market interest rate (or simply "the" interest rate)

Pb * Bond Yield = Coupon

On most bonds, only the coupon yield is constant.

So, with a given face value, or original bond price of $100, and an original market interest rate of 10%, the issuer of the bond (the borrower) will offer a coupon of $10, or a coupon rate of 10% to compete in the market. This means that the coupon will be $10

Coupon yield = Coupon/Face Value
10/100 = 0.10 = 10%
Bond Yield = The market rate of interest, so there is no capital gain initially...


let's say that the market interest rate jumps to 20%

The present value of the bond falls to around $60
The price of the bond falls to around $60
-The bond yield (including the present value of future payments + capital gain as the bond approaches maturity) rises to market interest rates of 20%

That's all for today!

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