Notes on Chapter 1: The Role of Financial Markets and Institutions

1. Overview of Financial Markets

● Purpose: Facilitate the transfer of funds from surplus units (investors) to deficit units
(corporations, governments).
● Roles:
1. Corporate Finance Activity: Corporations issue securities to obtain funds for
operations and expansion.
2. Investment Management: Investors allocate funds to various securities for
returns.

2. Types of Financial Markets

● Primary Markets: Facilitate the issuance of new securities (e.g., IPOs).

● Secondary Markets: Allow trading of existing securities (e.g., stock exchanges).

3. Securities in Financial Markets

● Money Market Securities (Short-term):

○ Examples: Treasury bills, commercial paper, negotiable CDs.
● Capital Market Securities (Long-term):
○ Examples: Bonds, stocks, mortgages, mortgage-backed securities.
● Derivative Securities:
○ Contracts derived from underlying assets.
○ Purposes: Speculation and risk management.
○ Valuation: Based on expected cash flows, discounted for uncertainty.

4. Security Valuation

● Factors Influencing Valuation:

○ Economic conditions, industry trends, firm-specific factors.
○ Behavioral finance: Psychological biases can misprice securities.
○ Uncertainty: Higher uncertainty increases risk.

5. Financial Regulations

● Ensure accurate financial disclosures to aid proper valuation.

● Key Acts:
○ Securities Act of 1933
○ Securities Exchange Act of 1934
○ Sarbanes-Oxley Act of 2002

6. International Financial Markets

 ● Integration: Market conditions in one region (e.g., EU) affect others (e.g., US).
● Foreign Exchange Markets: Facilitate currency exchange across countries.

7. Financial Institutions

● Roles:
○ Act as intermediaries, channeling funds from surplus to deficit units.
○ Monitor publicly traded firms.
● Types:
○ Depository Institutions:
■ Accept deposits, provide credit.
■ Examples: Commercial banks, savings institutions, credit unions.
○ Non-depository Institutions:
■ Generate funds via other means.
■ Examples: Finance companies, mutual funds, insurance companies,
pension funds.
● Structure of Financial Conglomerates:
○ Diversify risk and revenue streams across banking, thrift, consumer finance,
mutual funds, securities, and insurance.

8. Systemic Risk

● Definition: Financial instability spread among institutions, leading to system collapse.

● Example: 2008-2009 credit crisis:
○ Mortgage defaults → Decline in mortgage-backed securities → Financial
instability.

9. Financial Technology (Fintech)

● Definition: Innovative products/services improving or replacing traditional financial

methods.
● Examples: Venmo, PayPal, Apple Pay, cryptocurrencies.
● Applications:
○ Banking, investment management, compliance, and more.
● Advantages: Accessible, efficient, low-cost alternatives to traditional services.

Key Takeaways

● Financial Markets:
 ○ Transfer funds, classified into primary (new securities) and secondary (existing
securities) markets.
○ Trade money market (short-term) and capital market (long-term) securities.
● Financial Institutions:
○ Facilitate fund flow and ensure market efficiency.
○ Include both depository (banks) and non-depository (mutual funds, insurance
companies) institutions.
● Systemic Risk: A major challenge, exemplified by the 2008 financial crisis.
● Fintech: Disrupts traditional finance, offering modern, cost-effective solutions.
Notes on Chapter 2: Determination of Interest Rates

1. Key Learning Objectives

1. Understand the loanable funds theory to explain interest rate changes.

2. Identify factors affecting interest rate movements.
3. Learn methods to forecast interest rates.

2. Loanable Funds Theory

● Definition: Market interest rates are determined by supply and demand for loanable
funds.
● Demand for Loanable Funds:
○ Households:
■ Borrow for housing, automobiles, and household items.
■ Demand more funds at lower interest rates (inverse relationship).
○ Businesses:
■ Borrow for investments in long-term assets.
■ Demand increases when interest rates are low.
○ Government:
■ Borrow when expenditures exceed revenues (e.g., through bonds or
treasury securities).
■ Federal government demand is interest inelastic (unaffected by rates).
○ Foreign Sector:
■ Foreign entities borrow based on interest rate differentials.
■ Demand increases when U.S. interest rates are lower than foreign rates.
● Aggregate Demand (DA):
○ Sum of demand by all sectors:
DA=Dh+Db+Dg+Dm+DfDA = D_h + D_b + D_g + D_m +
D_fDA=Dh​+Db​+Dg​+Dm​+Df​
○ Inversely related to interest rates.

3. Supply of Loanable Funds

● Definition: Funds supplied to financial markets, primarily by savers.

○ Households: Largest supplier.
○ Other Suppliers: Some governments (budget surplus) and businesses (cash
flow surplus).
● Aggregate Supply (SA):
 ○ Sum of supply by all sectors:
SA=Sh+Sb+Sg+Sm+SfSA = S_h + S_b + S_g + S_m +
S_fSA=Sh​+Sb​+Sg​+Sm​+Sf​
○ Directly related to interest rates (upward-sloping curve).

4. Equilibrium Interest Rates

● Definition: The rate where aggregate demand equals aggregate supply.

● Dynamics:
○ Low interest rates: DA>SADA > SADA>SA (excess demand).
○ High interest rates: SA>DASA > DASA>DA (excess supply).
○ Equilibrium: Balances borrowers and savers.

5. Factors Affecting Interest Rates

1. Economic Growth:
○ Expansion: DADADA shifts right, increasing interest rates.
○ Slowdown: DADADA shifts left, lowering interest rates.
2. Inflation:
○ Raises borrowing demand (DADADA) and reduces saving supply (SASASA),
increasing rates.
3. Budget Deficit:
○ Increased government borrowing shifts DADADA outward, increasing rates.
4. Federal Reserve Policies:
○ Money Supply:
■ Reduced supply increases rates (upward pressure).
■ Increased supply decreases rates (downward pressure).
5. Foreign Exchange Rates:
○ Interest rates vary between currencies based on economic size and market
dynamics.

6. Forecasting Interest Rates

● Net Demand for Funds (ND):

○ ND=DA−SAND = DA - SAND=DA−SA
○ Positive ND: Upward pressure on rates.
○ Negative ND: Downward pressure on rates.
○ Magnitude of NDNDND determines the extent of rate adjustments.
● Key Factors in Forecasting:
○ Household borrowing capacity (e.g., consumer credit data).
 ○ Business expansion plans and economic conditions.
○ Government deficits influenced by tax revenues and unemployment.
○ Foreign interest rate trends and currency dynamics.

7. Key Takeaways

● Loanable Funds Framework: Explains equilibrium interest rate based on aggregate

supply and demand.
● Interest Rate Movements:
○ Influenced by economic growth, inflation, budget deficits, monetary policy, and
foreign exchange conditions.
● Forecasting: Requires analyzing changes in supply and demand schedules to
anticipate rate adjustments.
Chapter 3: Structure of Interest Rates - Key Notes

1. Overview of Debt Security Yields

● Variation in Yields: Interest rates differ among debt securities due to various influencing
factors.
● Key Determinants of Yields:
○ Credit/Default Risk: Higher risk requires higher yields as compensation.
○ Liquidity: Less liquid securities offer higher yields to attract investors.
○ Tax Status: Taxable securities need higher pre-tax yields to match tax-exempt
securities.
○ Term to Maturity: Yields vary based on the duration of the investment.

2. Factors Affecting Yields

1. Credit Risk:
○ Assessed through bond ratings from agencies like Moody's and S&P.
○ Ranges from high-quality (AAA) to low-quality (C/D).
○ Ratings are opinions and may change with issuer or economic conditions.
○ Regulated by the Office of Credit Ratings (established by the Financial Reform
Act of 2010).
2. Liquidity:
○ High Liquidity: Short-term securities or active secondary markets; offers lower
yields.
○ Low Liquidity: Longer-term or inactive markets; offers higher yields.
3. Tax Status:
○ Investors value after-tax income more than pre-tax.
○ Formula for after-tax yield: Yat=Ybt×(1−T)Y_{\text{at}} = Y_{\text{bt}} \times (1 -
T)Yat​=Ybt​×(1−T)
○ Formula for before-tax yield: Ybt=Yat(1−T)Y_{\text{bt}} = \frac{Y_{\text{at}}}{(1 -
T)}Ybt​=(1−T)Yat​​
○ Tax-exempt securities benefit high-tax-bracket investors the most.
4. Term to Maturity:
○ Defines the relationship between maturity length and annualized yield, keeping
other factors constant.

3. Modeling Yield for Debt Securities

● Formula for annualized return of an nnn-year debt security: Yn=Rfn+CP+LP+TAY_n =

R_{\text{fn}} + CP + LP + TAYn​=Rfn​+CP+LP+TA
 ○ RfnR_{\text{fn}}Rfn​: Yield on nnn-year risk-free security.
○ CPCPCP: Credit Risk Premium.
○ LPLPLP: Liquidity Premium.
○ TATATA: Tax Adjustment.
● Yield changes over time due to variations in the factors above.

4. Theories Behind Term Structure of Interest Rates

● Definition: Term structure explains the relationship between yields and the term to
maturity.

Key Theories:

1. Pure Expectations Theory:

○ Yield curve shape is driven by expectations of future interest rates.
○ Rising Rates:
■ Short-term yields drop, long-term yields rise.
■ Result: Upward sloping yield curve.
○ Falling Rates:
■ Short-term yields rise, long-term yields drop.
■ Result: Downward sloping yield curve.
2. Liquidity Premium Theory:
○ Investors prefer shorter maturities for higher liquidity.
○ Longer-term securities must compensate with a liquidity premium.
○ Adds upward pressure to the yield curve.
3. Segmented Markets Theory:
○ Maturity preferences align with cash needs (e.g., pension funds prefer long-term
securities).
○ Each maturity market functions independently, but shifts occur if cash needs
change.

5. Combined Impact on Yield Curve

● Example with three conditions:

1. Expectations of rising interest rates → Upward slope (Expectations Theory).
2. Borrowers need long-term funds; investors prefer short-term → Reinforces
upward slope (Segmented Markets Theory).
3. Liquidity premium on long-term securities → Steeper upward slope.
● Final yield curve reflects combined effects of Expectations + Segmented Markets +
Liquidity Premium.
6. Applications of Yield Curves

● Forecasting: Interest rates and economic conditions (e.g., recessions).

● Investment Decisions: Helps assess market expectations.
● International Variations:
○ Yield curves vary across countries due to different interest rate levels and
economic conditions.

7. Summary

1. Factors Influencing Debt Yields:

○ Credit risk, liquidity, tax status, term to maturity.
2. Modeling Yields:
○ Base on risk-free treasury yields with adjustments for specific factors.
3. Term Structure Theories:
○ Pure Expectations, Liquidity Premium, and Segmented Markets theories explain
yield curve shapes.
Chapter Four: Functions of the Federal Reserve (Fed)

Key Learning Objectives

1. Organizational Structure of the Fed

○ Five Major Components:
■ Federal Reserve District Banks: Clearing checks, replacing old
currency, and providing loans to depository institutions.
■ Member Banks: National banks must be members; state-chartered
banks have the option to join.
■ Board of Governors: Sets margin requirements, revises reserve
requirements.
■ Federal Open Market Committee (FOMC): Oversees monetary policy to
achieve economic stability and low inflation.
■ Advisory Committees: Provide recommendations on banking, economic
issues, and financial service needs of various populations.
2. Fed’s Control of the Federal Funds Rate
○ Monetary Policy Goals: Full employment, low inflation, and moderate long-term
interest rates.
○ Monetary Policy Implementation:
■ Targets money supply growth and interest rates.
■ Administered rates:
■ Interest Rate on Reserve Balances (IORB): Interest paid to
banks on reserves.
■ Overnight Reserve Repo Facility (ONRRP): Interest for other
institutions like money market funds.
○ Money Supply Measures:
■ M1: Currency + checking deposits.
■ M2: M1 + savings accounts, small time deposits, money market accounts.
■ M3: M2 + large time deposits and other items.
3. Fed’s Response to Economic Crises
○ 2008 Credit Crisis:
■ Funded Bear Stearns to prevent bankruptcy and stabilize financial
transactions.
■ Quantitative Easing: Purchased mortgage-backed securities to stabilize
the housing market and increase liquidity.
■ Created Term Asset-Backed Security Loan Facility (TALF) to encourage
consumer loans.
■ Purchased commercial paper to reduce long-term interest rates.
○ COVID-19 Pandemic (2020):
■ Reduced federal funds rate to zero.
■ Restarted buying U.S. treasury and mortgage-backed securities.
■ Introduced lending facilities:
 ■ Paycheck Protection Program Liquidity Facility: Supported
small business payrolls.
■ Main Street Lending Program: Assisted small and mid-sized
businesses.
4. Global Monetary Policy
○ Each country’s central bank conducts monetary policy to achieve economic
stability.
○ European Central Bank (ECB) manages monetary policy for eurozone
countries, limiting individual nations’ control over local economic issues.

Summary

● The Fed's monetary policy has a significant influence on interest rates and economic
conditions.
● The ample reserves framework is the current method for influencing the federal funds
rate.
● In crises, the Fed uses innovative tools like quantitative easing and temporary facilities to
stabilize the economy.
● Global integration requires the Fed to consider international economic conditions when
implementing policy.
Chapter 5: Monetary Policy - Notes

Overview

● Focus: Understanding how changes in the money supply affect the economy.
● Key Objectives:
1. Describe inputs used to determine monetary policy.
2. Explain the effects of stimulative monetary policy.
3. Explain the effects of restrictive monetary policy.
4. Discuss trade-offs in monetary policy.
5. Describe financial market participants' response to monetary policy.
6. Explain the global impact on monetary policy.

1. Inputs Used to Determine Monetary Policy

● Fed's Goals: Control economic growth and inflation.

● Indicators:
○ Economic Growth:
■ GDP, national income, unemployment rate.
■ Leading, coincident, and lagging indicators.
○ Inflation:
■ Producer Price Index (PPI), Consumer Price Index (CPI).
■ Wage rates, oil prices, gold prices.

2. Effects of Stimulative Monetary Policy

● Mechanism:
○ Fed increases loanable funds → shifts supply curve outward → reduces interest
rates.
○ Lower interest rates reduce firms' cost of borrowing → increased business
investment.
● Impact:
○ Increased investment boosts economic activity.
○ Cost of capital decreases (due to lower risk-free rate).
○ Limitations:
■ Lagged effects, limited control over long-term rates, inflation risks.
3. Effects of Restrictive Monetary Policy

● Mechanism:
○ Fed decreases loanable funds → shifts supply curve inward → raises interest
rates.
○ Higher interest rates increase borrowing costs → reduced business investment.
● Impact:
○ Slower economic growth reduces inflationary pressures.

4. Trade-Offs in Monetary Policy

● Conflict:
○ Low unemployment vs. Low inflation.
○ Strong economic conditions: Low unemployment but higher inflation.
○ Weak economic conditions: Low inflation but higher unemployment.
● Policy Choices:
○ Example:
■ Loose policy → Point A (9% inflation, 4% unemployment).
■ Tight policy → Point B (3% inflation, 8% unemployment).
■ Compromise → Any point between A and B.
● Influence of Fiscal Policy:
○ Large budget deficits can increase interest rates.
○ Fed may counteract fiscal effects with stimulative policies.

5. Financial Market Participants’ Response

● Impact on Various Sectors:

○ Households: Loan rates, mortgages.
○ Firms: Cost of borrowing, equity financing.
○ Treasury: Budget deficit financing costs.
● Monetary Policy Effects on Markets:
○ Money Market: Secondary values, yields on new securities.
○ Foreign Exchange Market: Currency demand and valuation.

6. Global Monetary Policy Considerations

● Exchange Rates:
○ Weak dollar:
■ Stimulates U.S. exports.
 ■ Reduces U.S. imports.
○ Strong dollar:
■ Reduces inflation but dampens U.S. economy.
● Global Integration:
○ Foreign economic conditions influence U.S. policy.
○ Cross-border investment flows affect U.S. interest rates.
● Global Crowding Out:
○ U.S. budget deficits attract foreign investment → reduces funds in other countries
→ raises global interest rates.

Summary

● Fed uses monetary policy to balance inflation and unemployment.

● Stimulative policy:
○ Expands money supply → boosts economic growth.
● Restrictive policy:
○ Contracts money supply → controls inflation.
● Trade-offs are inevitable, influenced by fiscal policy and global factors.
● Monetary policy impacts interest rates, economic growth, and financial markets globally.
Chapter 6: Money Markets – Summary Notes

Overview:

● Money Markets facilitate the transfer of short-term funds between entities with excess
funds (individuals, corporations, governments) and those with a deficit.
● They provide liquidity for financial market participants.

Key Learning Objectives:

1. Money Market Securities: Understanding the key features of common money market
securities.
2. Institutional Use: Explaining how institutional investors use money markets.
3. Global Integration: Understanding how money markets have become globally
interconnected.

1. Money Market Securities

● Definition: Debt instruments with a maturity of 1 year or less, issued in the primary
market by governments, corporations, and financial intermediaries.

Common Types of Money Market Securities:

● Treasury Bills (T-Bills):

○ Issued by the U.S. Treasury to fund government spending.
○ Short-term, virtually risk-free due to government backing.
○ Sold at a discount (no interest payments) and redeemed for par value.
○ Investors receive the difference between purchase price and par value as return.
○ Example: A T-bill with a $10,000 par value sold for $9,615.38 would yield 4%
annually.
● Commercial Paper:
○ Short-term, unsecured debt issued by creditworthy corporations.
○ Typically used for liquidity or to finance inventory/accounts receivable.
○ Has a slightly higher yield than T-bills due to credit risk.
○ Subject to credit ratings by agencies like Moody’s, S&P, and Fitch.
● Negotiable Certificates of Deposit (NCDs):
○ Issued by commercial banks as a short-term funding source.
○ Provides return via interest plus potential capital gains if sold in secondary
market.
○ Example: An NCD purchased for $990,000, redeemed for $1 million after one
year with $40,000 interest results in a 5.05% yield.
● Repurchase Agreements (Repos):
○ A party sells securities with an agreement to repurchase them later.
 ○ Often used for short-term borrowing or lending.
○ A reverse repo is the opposite, where securities are purchased with the
agreement to sell them back.
● Federal Funds:
○ Short-term borrowing/lending between depository institutions at the federal funds
rate.
○ Typically, commercial banks are the most active participants.
● Banker's Acceptances:
○ A promise by a bank to pay for a good at a future date.
○ Used in international trade, often discounted and traded in the secondary market.

2. Institutional Use of Money Markets

● Primary Purpose: To earn a return while maintaining liquidity.

● Financial Institutions’ Role:
○ Purchase money market securities for returns and liquidity.
○ Issue money market instruments (e.g., NCDs, commercial paper) to raise funds.
○ Use repos and the federal funds market for cash management.

3. Globalization of Money Markets

● Growth in International Trade & Financing:

○ Money markets have expanded globally, with major hubs in Europe, Asia, and
South America.
○ International banks play a key role in the global money market by facilitating
loans and deposits in different currencies.
● LIBOR (London Interbank Offered Rate):
○ A key benchmark for interest rates in the global money market.
○ Determined by banks reporting the rate they offer to lend to each other.
● Eurodollars:
○ U.S. dollar-denominated deposits held in non-U.S. banks, mainly in Europe.
○ Eurodollar instruments: Eurodollar certificates of deposit, Euro notes, and Euro
commercial paper.
● Foreign Currency Risk:
○ Investments in foreign money market securities can be impacted by exchange
rate fluctuations.
○ Effective Yield is calculated by adjusting for both foreign yield and the exchange
rate effect.
Example:
■ If a U.S. investor in Mexican pesos earns a 9% return and the peso
appreciates by 8%, the effective yield becomes 17.72%.
4. Factors Affecting Money Market Securities

● Risk-Free Interest Rate & Risk Premium:

○ The return on T-bills (considered risk-free) and other money market instruments
are influenced by the risk-free rate and any credit risk premiums.
● Required Return:
○ Driven by the perceived credit risk and interest rates, affecting the prices and
yields of money market securities.

5. Credit Crisis Impact (2008)

● The credit crisis of 2008 significantly impacted money markets, particularly the
commercial paper market.
○ Lehman Brothers' default on commercial paper was a major event as it couldn't
roll over its short-term debt due to declining collateral values (e.g.,
mortgage-backed securities).
○ Repos and other money market instruments became harder to finance as a
result of the reduced liquidity in the system.

Key Takeaways:

● Money Markets are essential for short-term borrowing and lending, ensuring liquidity
across financial institutions.
● Investors use money market instruments like T-bills, commercial paper, and NCDs for
low-risk, liquid investments.
● The global integration of money markets allows for international financing but also
exposes investors to exchange rate risks.
Chapter 7: Bond Markets – Notes

Key Concepts

1. Role of Bonds: Bonds facilitate the flow of long-term debt from investors (surplus units)
to borrowers (deficit units).
2. Types of Bonds:
○ Treasury Bonds: Issued by the U.S. Treasury to finance government
expenditures.
○ Federal Agency Bonds: Issued by federal agencies (e.g., Fannie Mae, Freddie
Mac) to support sectors like housing.
○ Municipal Bonds: Issued by state/local governments to finance public projects.
○ Corporate Bonds: Issued by corporations for funding operations or capital
projects.

Bond Background

● Definition: Long-term debt securities issued by governments or corporations with

maturities of 10-30 years.
● Obligations: Issuers must pay periodic interest (coupons) and repay principal (par
value) at maturity.
● Issuer Types:
○ Treasury Bonds: Issued by the U.S. Treasury.
○ Federal Bonds: Issued by federal agencies like Fannie Mae.
○ Municipal Bonds: Issued by state/local governments.
○ Corporate Bonds: Issued by corporations.

Bond Yields

● Issuer’s Perspective: The cost of financing bonds is measured by the Yield to Maturity
(YTM), which reflects the total annualized return to investors.
● Investor’s Perspective: The Holding Period Return is the return based on the
investor’s actual holding period (not necessarily until maturity).
● Example: A bond with 10 years to maturity, a par value of $1,000, and an 8% coupon
rate purchased for $936 has a YTM of 9%.
● Impact of Interest Rates: Treasury bond yields fluctuate in response to economic
conditions and interest rate changes set by the Federal Reserve.

Types of Bonds

1. Treasury and Federal Agency Bonds

○ Treasury Bonds: Issued by the U.S. Treasury to cover government spending.
Bonds are considered risk-free.
○ TIPS (Treasury Inflation-Protected Securities): Bonds whose returns are
linked to inflation.
 ○ Federal Agency Bonds: Issued by agencies like Fannie Mae and Freddie Mac
to buy mortgages.
2. Municipal Bonds
○ Purpose: Issued by state/local governments to finance public projects.
○ Types:
■ General Obligation Bonds: Backed by the taxing power of the issuer.
■ Revenue Bonds: Backed by revenues from a specific project (e.g., toll
roads).
○ Credit Risk: Municipal bonds carry default risk, and ratings are provided by
agencies like Moody’s, S&P, and Fitch.
○ Tax Exemption: Interest income is generally exempt from federal and state
taxes.
○ Call Provisions: Municipal bonds often include options for issuers to repurchase
bonds early.
3. Corporate Bonds
○ Purpose: Issued by corporations to fund operations, expansion, or capital
restructuring.
○ Tax Deductible Interest: Interest paid on corporate bonds is tax-deductible for
issuers.
○ Risk: Corporate bonds carry default risk. Junk bonds (high-risk) pay higher yields
to compensate for this.
○ Secondary Market: Bonds can be sold in the secondary market, though liquidity
varies based on issuer size and bond volume.

Bond Characteristics

● Bond Indenture: A legal document detailing the rights and obligations of both issuer and
bondholder.
● Sinking Fund: Provision requiring the issuer to retire some bonds annually.
● Call Provision: Allows the issuer to repurchase bonds before maturity, typically at a
premium.
● Secured vs. Unsecured: Some bonds are backed by collateral (secured), while others
are not (unsecured).

Types of Corporate Bonds

1. Low Coupon and Zero Coupon Bonds: Bonds issued at a deep discount, with interest
paid at maturity.
2. Variable-Rate Bonds: Bonds with an interest rate that adjusts periodically based on
benchmark rates.
3. Convertible Bonds: Bonds that can be converted into a specific number of shares of
the issuing company’s stock.

Bond Market Globalization

 ● Cross-Border Investments: Investors increasingly purchase foreign government bonds
(sovereign bonds), contributing to global integration of bond markets.
● Attractive Sovereign Bonds: Foreign bonds are attractive due to the issuing
government’s ability to meet debt obligations.

Other Long-Term Debt Securities

1. Structured Notes: Debt securities where interest and principal payments depend on
market conditions (e.g., stock indices).
2. Exchange-Traded Notes (ETNs): Debt instruments whose returns are based on specific
indexes, after deducting fees.
3. Auction Rate Securities: Bonds with adjustable interest rates, typically auctioned to
investors every 7-35 days.

Summary of Chapter 7

● Bond Issuers: Bonds are issued by governments, agencies, and corporations for
financing purposes.
● Investors: Various financial institutions, including banks and pension funds, are major
investors in bonds.
● Types of Bonds: Bonds can be classified as Treasury, Federal Agency, Municipal, or
Corporate. Each has different risk profiles, yields, and liquidity characteristics.
● Global Integration: Bond markets have become interconnected globally due to
cross-border investments in government bonds.
● Alternative Debt Securities: Structured notes, ETNs, and auction-rate securities offer
specialized investment opportunities.
Chapter 8: Bond Valuation and Risk - Key Concepts and Notes

1. Bond Valuation Process

● The price of a bond reflects the present value of future cash flows (coupon payments
and principal) discounted at the required rate of return (yield to maturity).
● Coupon Payment = Coupon rate × Par value of bond.
● Formula for Bond Price: Use a financial calculator or app for efficiency.
● Example:
○ Par value: $1,000
○ Coupon payment: $100 per year
○ Yield to maturity: 12%
○ Price calculation gives: $951.97.

2. Factors Affecting Bond Prices

● Required rate of return (discount rate): Influenced by the prevailing risk-free rate (e.g.,
U.S. Treasury yield) and the credit risk premium.
● Credit risk premium (Rp): The return required by investors to compensate for the
issuer’s credit risk. A higher risk leads to a higher required rate of return and lower bond
price.
● Maturity: Longer maturity bonds are more sensitive to interest rate changes.
● Timing of Payments: Affects the present value of a bond.
● Interest Rate and Market Movements: Changes in rates and inflation expectations can
affect bond values.

3. Discount, Par, and Premium Bonds

● Discount Bonds: Bonds sold below par value. Occur when the yield is higher than the
coupon rate.
● Par Bonds: Bonds sold at face value. Occur when the yield equals the coupon rate.
● Premium Bonds: Bonds sold above par value. Occur when the yield is lower than the
coupon rate.
● Zero-Coupon Bonds: No periodic interest; sold at a deep discount to provide a return at
maturity.
○ Example: A zero-coupon bond with a 13% yield results in a price of $693.05.

4. Bond Price Movements

● Bond price changes are driven by changes in the required rate of return (k).
● Bond price and required return have an inverse relationship.
● Price changes can be modeled by changes in either:
○ The risk-free rate (Rf), influenced by inflation, economic growth, money supply,
and budget deficits.
 ○ The credit risk premium (Rp), impacted by economic conditions and changes in
the issuer's risk profile.

5. Sensitivity of Bond Prices to Interest Rates

● Bond Price Elasticity: Measures price sensitivity to interest rate changes.

○ Formula: % change in bond price / % change in required return.
● Duration: Measures the bond’s price sensitivity to interest rates.
○ *Modified Duration (DUR)**: Adjusted for interest rate changes; used to estimate
price changes.
● Impact of Interest Rates:
○ Long-term bonds are more sensitive to interest rate changes than short-term
bonds.
○ Zero-coupon bonds are most sensitive to interest rate changes because of their
lump sum payment structure.

6. Bond Investment Strategies

● Matching Strategy: Match bond income to expected periodic expenses.

● Laddered Strategy: Allocate funds across bonds with different maturities.
● Barbell Strategy: Invest in short-term and long-term bonds, avoiding intermediate-term
bonds.
● Interest Rate Strategy: Invest based on interest rate forecasts.

7. International Bonds

● Foreign Interest Rates: Bond values can be affected by changing foreign interest rates.
● Credit Risk: Affects bond prices, with higher risk leading to a higher required rate of
return and lower bond value.
● Exchange Rate Risk: Changes in foreign currency exchange rates can influence the
returns on international bonds.
○ Example: The U.S. dollar-denominated return on a foreign bond can be impacted
by fluctuations in exchange rates (e.g., British pound).
● International Bond Diversification: Helps reduce exposure to risks like interest rate
risk, credit risk, and exchange rate risk by diversifying across countries.

8. Summary of Key Takeaways

● The value of a bond is the present value of its future cash flows, discounted by the
required rate of return.
● Bond prices are influenced by economic factors, interest rates, and credit risk.
● Bond price sensitivity can be measured using bond price elasticity and duration.
● Common bond investment strategies include matching, laddered, barbell, and interest
rate strategies.
● International bonds offer higher returns but are exposed to exchange rate and credit
risks.