Five Parts of The Financial System: Text and Reference Material & The Primary Textbook For The Course Will Be

TEXT AND REFERENCE MATERIAL &
FIVE PARTS OF THE FINANCIAL SYSTEM

The Primary textboo !or the "o#r$e %i&& be
Money, Banking and Financial Markets by Stephan G. Cecchetti
International Edition, McGraw ill !"blishers, ISB# $%$&%'''()(%*
Re!ere'"e boo$ %i&& be
+he Econo,ics o- Money, Banking and Financial Markets, by Fredrick
S. Mishkin
&th Edition .ddison /esley 0ong,an !"blishers
!rinciples o- Money, Banking and Financial Markets by 0awrence S.
1itter, /illai, 0. Silber and
Gregory F. 2dell, .ddison /esley 0ong,an !"blishers
Co#r$e Co'te't$
Mo'ey a'( the Fi'a'"ia& Sy$tem
Money and the !ay,ents Syste,
Financial Instr",ents, Financial Markets, and Financial Instit"tions
I'tere$t rate) *'a'"ia& i'$tr#me't$ a'( *'a'"ia& maret$
F"t"re 3al"e, !resent 3al"e and Interest 1ates
2nderstanding 1isk
Bonds, !ricing and 4eter,ination o- Interest 1ates
+he 1isk and +er, Str"ct"re o- Interest 1ates
Stocks, Stock Markets and Market E5iciency
Fi'a'"ia& I'$tit#tio'$
Econo,ics o- Financial Inter,ediation
4epositary Instit"tions6 Banks and bank Manage,ent
Financial Ind"stry Str"ct"re
1eg"lating the 7nancial syste,
Ce'tra& +a'$) Mo'etary Po&i"y a'( Fi'a'"ia& $tabi&ity
Str"ct"re o- central banks
Balance sheet and Money S"pply process
Monetary policy
E8change rate policy
Mo(er' Mo'etary E"o'omi"$
Money growth and Money 4e,and
.ggregate de,and
B"siness Cycle
9"tp"t and in:ation in the short r"n
Mo'ey a'( +a'i', i' I$&am
Monetary and 7nancial policy and str"ct"re -or an Interest%-ree econo,y
Isla,ic Banking in the conte,porary world
Fi-e Part$ o! the Fi'a'"ia& Sy$tem
Money
Financial Instr",ents
Financial Markets
Financial Instit"tions
Central Banks
./ Mo'ey
+o pay -or p"rchases
+o store wealth
E;ol;ed -ro, gold and sil;er coins to paper ,oney to today<s electronic
-"nds trans-ers
= Copyright 3irt"al 2ni;ersity o- !akistan 1
Money > Banking ? MG+@'' V0
+raditional !aycheck syste, ;s. .+M /ithdrawals and Mailed
transactions ;s. E%banking
1/ Fi'a'"ia& I'$tr#me't$
+o trans-er wealth -ro, sa;ers to borrowers
+o trans-er risk to those best eA"ipped to bear it.
9nce in;esting was an acti;ity reser;ed -or the wealthy
Costly indi;id"al stock transactions thro"gh stockbrokers
In-or,ation collection was not so easy
#ow, s,all in;estors ha;e the opport"nity to p"rchase shares in ,"t"al
-"nds.
2/ Fi'a'"ia& Maret$
+o b"y and sell 7nancial instr",ents A"ickly and cheaply
E;ol;ed -ro, co5eeho"ses to trading places BStock e8changesC to
electronic networks
+ransactions are ,"ch ,ore cheaper now
Markets o5er a broader array o- 7nancial instr",ents than were a;ailable
e;en ($ years ago
3/ Fi'a'"ia& I'$tit#tio'$
!ro;ide access to 7nancial ,arkets
Banks e;ol;ed -ro, 3a"lts and de;eloped into deposits% and loans%agency
+oday<s banks are ,ore like 7nancial s"per,arkets o5ering a h"ge
assort,ent o- 7nancial
prod"cts and ser;ices -or sale.
.ccess to 7nancial ,arkets
Ins"rance
o,e% and car%loans
Cons",er credit
In;est,ent ad;ice
4/ Ce'tra& +a'$
Monitors 7nancial Instit"tions
StabiliDes the Econo,y
Initiated by Monarchs to 7nance the wars
+he go;t. treas"ries ha;e e;ol;ed into the ,odern central bank
Control the a;ailability o- ,oney and credit in s"ch a way as to ens"re
0ow in:ation,
igh growth, and
+he stability o- the 7nancial syste,
State Bank o- !akistan www.sbp.org.pk
S#mmary
Fi-e Part$ o! the Fi'a'"ia& Sy$tem
Money
Financial Markets
Central Banks
Le$$o' 1
FIVE CORE PRINCIPLES OF MONEY AND +AN5IN6
./ Time ha$ Va&#e
+i,e a5ects the ;al"e o- 7nancial instr",ents.
Interest pay,ents e8ist beca"se o- ti,e properties o- 7nancial
instr",ents
Exam7&e
.t )E interest rate, @ year loan o- F'$,$$$ -or a car
1eA"ires @G ,onthly install,ents o- FHI( each
+otal repay,ent J FHI( 8 @G J F'',HG$
F'',HG$ K F'$,$$$ B+otal
repay,entC B.,o"nt o- loanC
1eason6 yo" are co,pensating the lender -or the ti,e d"ring which yo"
"se the -"nds
1/ Ri$ Re8#ire$ Com7e'$atio'
In a world o- "ncertainty, indi;id"als will accept risk only i- they are
co,pensated in so,e -or,.
+he world is 7lled with "ncertaintyL so,e possibilities are welco,e and
so,e are not
+o deal e5ecti;ely with risk we ,"st consider the -"ll range o-
possibilities6
Eli,inate so,e risks,
1ed"ce others,
!ay so,eone else to ass",e partic"larly onero"s risks, and
M"st li;e with what<s le-t
In;estors ,"st be paid to ass",e risk, and the higher the risk the higher
the reA"ired pay,ent
Car ins"rance is an e8a,ple o- paying -or so,eone else to sho"lder a risk
yo" don<t want to take.
Both parties to the transaction bene7t
4ri;ers are s"re o- co,pensation in the e;ent o- an accident
+he ins"rance co,panies ,ake pro7t by pooling the ins"rance pre,i",s
and in;esting the,
#ow we can "nderstand the ;al"ation o- a broad set o- 7nancial
instr",ents
E.g., lenders charge higher rates i- there is a chance the borrower will not
repay.
2/ I'!ormatio' i$ the ba$i$ !or (e"i$io'$
/e collect in-or,ation be-ore ,aking decisions
+he ,ore i,portant the decision the ,ore in-or,ation we collect
+he collection and processing o- in-or,ation is the basis o- -o"ndation o-
the 7nancial syste,.
So,e transactions are arranged so that in-or,ation is #9+ needed
Stock e8changes are organiDed to eli,inate the need -or costly
in-or,ation gathering and th"s
-acilitate the e8change o- sec"rities
9ne way or another, in-or,ation is the key to the 7nancial syste,
3/ Maret$ $et 7ri"e$ a'( a&&o"ate re$o#r"e$
Markets are the core o- the econo,ic syste,L the place, physical or
;irt"al,
/here b"yers and sellers ,eet
/here 7r,s go to iss"e stocks and bonds,
/here indi;id"als go to p"rchase assets
Financial ,arkets are essential to the econo,y,
Channeling its reso"rces
Mini,iDing the cost o- gathering in-or,ation
Making transactions
/ell%de;eloped 7nancial ,arkets are a necessary precondition -or healthy
econo,ic growth
+he role o- setting prices and allocation o- reso"rces ,akes the ,arkets
;ital so"rces o-
in-or,ation
Markets pro;ide the basis -or the allocation o- capital by attaching prices
to di5erent stocks or
bonds
Financial ,arkets reA"ire r"les to operate properly and a"thorities to
police the,
+he role o- the go;t. is to ens"re in;estor protection
In;estor will only participate i- they percei;e the ,arkets are -air
4/ Stabi&ity im7ro-e$ %e&!are
+o red"ce risk, the ;olatility ,"st be red"ced
Go;t. policy,akers play pi;otal role in red"cing so,e risks
. stable econo,y red"ces risk and i,pro;es e;eryoneNs wel-are.
By stabiliDing the econo,y as whole ,onetary policy,akers eli,inate
risks that indi;id"als can<t
and so i,pro;e e;eryone<s wel-are in the process.
StabiliDing the econo,y is the pri,ary -"nction o- central banks
. stable econo,y grows -aster than an "nstable one
Fi'a'"ia& Sy$tem Promote$ E"o'omi" E9"ie'"y
+he Financial Syste, ,akes it Easier to +rade
Facilitate !ay,ents % bank checking acco"nts
Channel F"nds -ro, Sa;ers to Borrowers
Enable 1isk Sharing % Classic e8a,ples are ins"rance and -orward
,arkets
./ Fa"i&itate Payme't$
Cash transactions B+rade ;al"e -or ;al"eC. Co"ld hold a lot o- cash on
hand to pay -or things
Financial inter,ediaries pro;ide checking acco"nts, credit cards, debit
cards, .+Ms
Make transactions easier.
1/ Cha''e& F#'($ !rom Sa-er$ to +orro%er$
0ending is a -or, o- trade B+rade ;al"e -or a pro,iseC
Gi;e "p p"rchasing power today in e8change -or p"rchasing power in the
-"t"re.
Sa;ers6 ha;e ,ore -"nds than they c"rrently needL wo"ld like to earn
capital inco,e
Borrowers6 need ,ore -"nds than they c"rrently ha;eL willing and able to
repay with interest in the
-"t"re.
/hy is this i,portantO
A: .llows those witho"t -"nds to e8ploit pro7table in;est,ent opport"nities.
Co,,ercial loans to growing b"sinessesL
3ent"re capitalL
St"dent loans Bin;est,ent in h",an capitalCL
In;est,ent in physical capital and new prod"ctsPprocesses to pro,ote
econo,ic growth
+: Financial Syste, allows the ti,ing o- inco,e and e8pendit"res to be
deco"pled.
o"sehold earning potential starts low, grows rapidly "ntil the ,id ($s,
and then declines with age.
Financial syste, allows ho"seholds to borrow when yo"ng to prop "p
cons",ption Bho"se loans,
car loansC, repay and then acc","late wealth d"ring ,iddle age, then li;e
o5 wealth d"ring
retire,ent.
Fi,#re; Cha''e& F#'($ !rom Sa-er$ to +orro%er$
2/ E'ab&e Ri$ Shari',
+he world is an "ncertain place. +he 7nancial syste, allows trade in risk.
B+rade ;al"e -or a
pro,iseC
+wo principal -or,s o- trade in risk are ins"rance and -orward contracts.
S"ppose e;eryone has a 'P'$$$ chance o- dying by age @$ and one wo"ld
need F' ,illion to
replace lost inco,e to pro;ide -or their -a,ily.
/hat are yo"r options to address this riskO
S#mmary
Fi;e Core !rinciples o- Money and Banking
+i,e has 3al"e
1isk 1eA"ires Co,pensation
In-or,ation is the basis -or decisions
Markets set prices and allocate reso"rces
Stability i,pro;es wel-are
Financial Syste, !ro,otes Econo,ic E5iciency
Facilitate !ay,ents
Channel F"nds -ro, Sa;ers to Borrowers
Enable 1isk Sharing
= Copyright 3irt"al 2ni;ersity o- !akistan
Consumption
Income
$
TimRetirement e
Begins
Dissavings Dissavings
Savings
5
Le$$o' 2
MONEY & THE PAYMENT SYSTEM
Money
Characteristics o- Money
0iA"idity
!ay,ent syste,
Co,,odity ;s. Fiat Money
CheA"es
9ther -or,s o- pay,ents
F"t"re o- Money
Mo'ey
Money is an asset that is generally accepted as pay,ent -or goods and
ser;ices or repay,ent o-
debt.
#ot the sa,e as wealth or inco,e
Money is a co,ponent o- wealth that is held in a readily% spend able -or,
Money is ,ade "p o-
Coin and c"rrency
CheA"ing acco"nt balances
9ther assets that can be t"rned into cash or de,and deposits nearly
instantaneo"sly, witho"t risk
or cost BliA"id wealthC
Di$ti'"tio'$ amo', Mo'ey) <ea&th) a'( I'"ome
/hile ,oney, inco,e and wealth are all ,eas"red in so,e c"rrency "nit,
they di5er signi7cantly in
their ,eaning.
!eople ha;e ,oney i- they ha;e large a,o"nts o- c"rrency or big bank
acco"nts at a point in ti,e.
BStock ;ariableC
So,eone earns inco,e Bnot ,oneyC -ro, work or in;est,ents o;er a
period o- ti,e. BFlow
;ariableC
!eople ha;e wealth i- they ha;e assets that can be con;erted into ,ore
c"rrency than is necessary
to pay their debts at a point in ti,e. BStock ;ariableC
Chara"teri$ti"$ o! Mo'ey
. ,eans o- pay,ent
. "nit o- .cco"nt
. Store o- 3al"e
A mea'$ o! 7ayme't
+he pri,ary "se o- ,oney is as a ,eans o- pay,ent.
Money is accepted in econo,ic e8changes.
Barter is an alternati;e to "sing ,oney b"t it doesn<t work ;ery well.
Barter reA"ires a do"ble coincidence o- wants, ,eaning that in order
-or trade to take place both
parties ,"st want what the other has.
Money 7naliDes pay,ents so that b"yers and sellers ha;e no -"rther clai,
on each other.
.s econo,ies ha;e beco,e ,ore co,ple8 and physically dispersed the
need -or ,oney has grown.
M"st as the di;ision o- labor and specialiDation allow -or e5icient
prod"ction, ,oney allows -or
e5icient e8change.
A #'it o! A""o#'t
/e ,eas"re ;al"e "sing r"pees and paisas.
Money is the "nit o- acco"nt that we "se to A"ote prices and record debts.
Money can be re-erred to as a standard o- ;al"e.
2sing ,oney ,akes co,parisons o- ;al"e easy
2nder barter the general -or,"la -or n goods, we will ha;e n Bn % 'C P H
prices
+wo goods ' price
I goods I prices
'$$ goods @,Q($ prices
'$,$$$ goods ($ ,illion prices
A Store o! Va&#e
For ,oney to -"nction as a ,eans o- pay,ent it has to be a store o- ;al"e
too beca"se it ,"st
retain its worth -ro, day to day.
+he ,eans o- pay,ent has to be d"rable and capable o- trans-erring
p"rchasing power -ro, one
day to the ne8t.
Money is not the only store o- ;al"eL wealth can be held in a n",ber o-
other -or,s.
9ther stores o- ;al"e can be pre-erable to ,oney beca"se they pay
interest or deli;er other ser;ices.
owe;er, we hold ,oney beca"se it is liA"id, ,eaning that we can "se it
to ,ake p"rchases.
0iA"idity is a ,eas"re o- the ease with which an asset can be t"rned into
a ,eans o- pay,ent
Bna,ely ,oneyC.
+he ,ore costly an asset is to t"rn into ,oney, the less liA"id it is.
Constantly trans-or,ing assets into ,oney e;ery ti,e we wish to ,ake a
p"rchase wo"ld be
e8tre,ely costlyL hence we hold ,oney
Li8#i(ity
0iA"idity is a ,eas"re o- the ease an asset can be t"rned into a ,eans o-
pay,ent, na,ely ,oney
.n asset is liA"id i- it can be easily con;erted into ,oney and illiA"id i- it
is costly to con;ert.
Cash is per-ectly liA"id.
Stocks and bonds are so,ewhat less liA"id.
0and is least liA"id.
The Payme't$ Sy$tem
+he pay,ent syste, is a web o- arrange,ents that allows -or the
e8change o- goods and ser;ices,
as well as assets a,ong di5erent people
Money is at the heart o- pay,ent syste,R
Ty7e$ o! Mo'ey
Co,,odity Money ? +hings that ha;e intrinsic ;al"e
Fiat Money ? 3al"e co,es -ro, go;ern,ent decree Bor 7atC
Commo(ity Mo'ey
+he 7rst ,eans o- pay,ent were things with intrinsic ;al"e like silk or
salt.
S"ccess-"l co,,odity ,onies had the -ollowing characteristics
+hey were "sable in so,e -or, by ,ost peopleL
+hey co"ld be ,ade into standardiDed A"antitiesL
+hey were d"rableL
+hey had high ;al"e relati;e to their weight and siDe so that they were
easily transportableL and
+hey were di;isible into s,all "nits so that they were easy to trade
For ,ost o- h",an history, gold has been the ,ost co,,on co,,odity
,oney
Fiat Mo'ey
+oday we "se paper ,oney that is 7at ,oney, ,eaning that its ;al"e
co,es -ro, go;ern,ent
decree Bor 7atC.
. note costs abo"t $.$@E its worth to prod"ce.
+hese notes are accepted as pay,ent -or goods or in settle,ent o- debts
-or two reasons6
/e take the, beca"se we belie;e we can "se the, in the -"t"re.
+he law says we ,"st accept the,L that is what the words legal tender
printed on the note
,eans.
.s long as the go;ern,ent stands behind its paper ,oney, and doesn<t
iss"e too ,"ch o- it, we will
"se it. In the end, ,oney is abo"t tr"st.
Fiat or Commo(ity Mo'ey=
4oes ,oney need to be backed by a co,,odity at allO
+he logical answer to this A"estion is no.
I- the ,onetary syste, is stable and -"nctions e5ecti;ely, backing is
e8pensi;e, incon;enient, and
"nnecessary.
+oday, ,oney is only backed by con7dence that go;ern,ent will
responsibly li,it the A"antity o-
,oney to ens"re that ,oney in circ"lation will hold its ;al"e.
A(-a'ta,e$ o! Fiat Mo'ey
Fewer reso"rces are "sed to prod"ce ,oney.
+he A"antity o- ,oney in circ"lation can be deter,ined by rational h",an
S"dg,ent rather than by
disco;ering -"rther ,ineral depositsTlike gold or dia,onds
Di$a(-a'ta,e
. corr"pt or press"red go;ern,ent ,ight iss"e e8cessi;e a,o"nts o-
,oney, thereby "nleashing
se;ere in:ation.
Che8#e$
CheA"es are another way o- paying -or things, b"t
+hey are not legal tender
+hey are not e;en ,oney.
CheA"es are instr"ctions to the bank to take -"nds -ro, yo"r acco"nt and
trans-er those -"nds to
the person or 7r, whose na,e is written in the !ay to the 9rder o- line.
/hen yo" gi;e so,eone a CheA"e in e8change -or a good or ser;ice, it is
not a 7nal pay,entL
. series o- transactions ,"st still take place that lead to the 7nal pay,ent
Following are the steps in the process
.> Uo" hand a paper cheA"e -ro, yo"r bank to a ,erchant in e8change -or
so,e good
1> +he ,erchant deposits the cheA"e into ,erchant<s bank and ,erchant<s
acco"nt is credited
2> +he ,erchant<s bank sends the cheA"e to the local central bank
3> +he Central Bank
?a: Credits the ,erchant<s bank<s reser;e acco"nt
?b: 4ebits yo"r bank<s reser;e acco"nt
B+his step in;ol;es ,oneyC
4> +he Central Bank ret"rns the cheA"e to yo"r bank
@> Uo"r bank debits yo"r CheA"ing acco"nt by the a,o"nt o- the cheA"e
+he whole process is ti,e cons",ing and e8pensi;eL
+ho"gh cheA"e ;ol",es ha;e beg"n to -all, paper CheA"es are still with
"s beca"se a cancelled
cheA"e is legal proo- o- pay,ent
Other Form$ o! Payme't$
4ebit Cards
Credit Cards
Electronic F"nds trans-ers
Stored 3al"e Cards
Le$$o' 3
OTHER FORMS OF PAYMENTS
Debit Car(
+he ,oney in yo"r acco"nt is "sed -or pay,ents
/orks like a cheA"e and there is "s"ally a -ee -or the transaction
Cre(it "ar(
It is a pro,ise by a bank to lend the cardholder ,oney with which to
,ake p"rchases.
/hen the card is "sed to b"y ,erchandise the seller recei;es pay,ent
i,,ediately
+he ,oney that is "sed -or pay,ent does not belong to the b"yer
1ather, the bank ,akes the pay,ent, creating a loan that the b"yer ,"st
repay.
So, they do not represent ,oneyL rather, they represent access to
so,eone else<s ,oney
E&e"tro'i" F#'($ Tra'$!er
Mo;e -"nds directly -ro, one acco"nt to another.
Banks "se these trans-ers to handle transactions a,ong the,sel;es
Indi;id"als ,ay be -a,iliar with s"ch trans-ers thro"gh direct deposit o-
their paycheA"es and the
pay,ent o- their "tility bills, etc
E>mo'ey
2sed -or p"rchases on the Internet.
Uo" open an acco"nt by trans-erring -"nds to the iss"er o- the e%,oney
/hen shopping online, instr"ct the iss"er to send yo"r e%,oney to the
,erchant
It is really a -or, o- pri;ate ,oney.
Store(>-a&#e "ar(
1etail b"sinesses are e8peri,enting with new -or,s o- electronic
pay,ent
!repaid cell"lar cards, Internet scratch cards, calling cards etc
The F#t#re o! Mo'ey
+he ti,e is rapidly approaching when sa-e and sec"re syste,s -or
pay,ent will "se ;irt"ally no
,oney at all
/e will also likely see
Fewer ;arieties o- c"rrency, Ba sort o- standardiDation o- ,oneyC and
. dra,atic red"ction in the n",ber o- "nits o- acco"nt
Money as a store o- ;al"e is clearly on the way o"t as ,any 7nancial
instr",ents ha;e beco,e
highly liA"id.
Mea$#ri', Mo'ey
4i5erent 4e7nitions o- ,oney based "pon degree o- liA"idity. Federal
1eser;e Syste, de7nes
,onetary aggregates.
Changes in the a,o"nt o- ,oney in the econo,y are related to changes in
interest rates, econo,ic
growth, and ,ost i,portant, in:ation.
In:ation is a s"stained rise in the general price le;el
/ith in:ation yo" need ,ore ,oney to b"y the sa,e basket o- goods
beca"se it costs ,ore.
In:ation ,akes ,oney less ;al"able
+he pri,ary ca"se o- in:ation is the iss"ance o- too ,"ch ,oney
Beca"se ,oney growth is related to in:ation we need to be able to
,eas"re how ,"ch ,oney is
circ"lating
Money as a ,eans o- pay,ents
/e ,eas"re the A"antity o- ,oney as the A"antity o- c"rrency in
circ"lation ? an "nrealistically
li,ited ,eas"re, since there are other ways o- pay,ents
.lternati;ely, broadly categoriDe 7nancial assets and sort the, by the
degree o- liA"idity
Sort the, by the ease with which they can be con;erted into a ,eans o-
pay,ents
.rrange the, -ro, ,ost liA"id to least liA"id
4raw a line and incl"de e;erything on one side o- the line in the ,eas"re
o- the ,oney
/here to draw the lineO
In reality, we draw line at di5erent places and co,p"te se;eral ,eas"res
o- ,oney called the
,onetary aggregates
M', MH, and MI
M' is the narrowest de7nition o- ,oney and incl"des only c"rrency and
;ario"s deposit acco"nts
on which people can write CheA"es.
C"rrency in the hands o- the p"blic,
+ra;eler<s CheA"es,
4e,and deposits and
9ther cheA"eable deposits
MH incl"des e;erything that is in M' pl"s assets that cannot be "sed
directly as a ,eans o- pay,ent
and are di5ic"lt to t"rn into c"rrency A"ickly,
S,all%deno,ination ti,e deposits,
Money ,arket deposit acco"nts,
Money ,arket ,"t"al -"nd shares
MH is the ,ost co,,only A"oted ,onetary aggregate since its
,o;e,ents are ,ost closely related
to interest rate and econo,ic growth.
MI adds to MH other assets that are i,portant to large instit"tions
0arge%deno,ination ti,e deposits,
Instit"tional ,oney ,arket ,"t"al -"nd shares,
1ep"rchase agree,ents and
E"rodollars
A Symbo& A$$et$ i'"&#(e(
C C"rrency
M' C V de,and deposits, tra;elers< CheA"es,
other cheA"eable deposits
MH M' V s,all ti,e deposits, sa;ings deposits,
,oney ,arket ,"t"al -"nds, ,oney ,arket deposit acco"nts
MI MH V large ti,e deposits, rep"rchase agree,ents, instit"tional ,oney
,arket
,"t"al -"nd balances
= Copyright 3irt"al 2ni;ersity o- !akistan 1!
Mo'etary A,,re,ate$ Fi,#re$ i' mi&&io'$ a$ o! Mar"h 1BB4
./ C"rrency iss"ed &'',QQ&
1/ C"rrency held by SB! I,'GG
2/ C"rrency in tills o- Sched"led Banks @I,Q'@
3/ C"rrency in circ"lation B' ? H ? IC ))@,GQ(
4/ Sched"led Banks de,and deposits QI,H&H
@/ 9ther 4eposits with SB! @,GH)
C/ M' B@V(V)C ',)$H,@HI
D/ Sched"led Banks +i,e 4eposits ',$I&,)&G
E/ 1esident Foreign C"rrency 4eposits '&H,$&@
.B/ +otal Monetary .ssets BMHC H,G'H,'&(
../ MI I,GII,)G)
So#r"e; State +a' o! Pai$ta'
Tab&e ; The Mo'etary A,,re,ate$
Mo'etary A,,re,ate$ Va&#e a$ o! A#,#$t 1BB3 ?0/S/F bi&&io':
M.J C"rrency in the hands o- the p"blic
V +ra;eler<s checks
V 4e,and deposits
V 9ther checkable deposits
Tota& M.
)G).H
&.)
I'(.I
IHG.(
.)22C/@
M1JM'
V S,all%deno,ination ti,e deposits
V Sa;ings deposits incl"ding ,oney ,arket deposit
acco"nts
V 1etail ,oney ,arket ,"t"al -"nd shares
Tota& M1
&Q@.&
I@'(.I
&I(.(
@)1D2/.
M2JMH
V 0arge%deno,ination ti,e deposits
V Instit"tional ,oney ,arket ,"t"al -"nd shares
V 1ep"rchase agree,ents
V E"rodollars
Tota& M2
',$I).I
','$@.&
(').)
I@@.(
E)1D4/1
Fi,#re; 6ro%th Rate$ i' Mo'etary A,,re,ate$
"5
!
5
1!
15
2!
25
3!
35
4!
11
12
13
14
15
16
17
18
1
2!!!
2!!1
2!!2
2!!3
2!!4
#1
#2
#3
!
5
1!
15
2!
25
3!
1!"1
11"2
12"3
13"4
14"5
15"6
16"7
17"8
18"
1"!!
2!!!"!1
2!!1"!2
2!!2"!3
2!!3"!4
$ears
%
Mea$#re$ o! I'Gatio'
Fi8ed%weight Inde8 % C!I
4e:ator ? G4! or !ersonal Cons",ption E8pendit"re 4e:ator
Co'$#mer Pri"e I'(ex ?CPI:
Meas"re o- the o;erall le;el o- prices "sed to
+rack changes in the typical ho"sehold<s cost o- li;ing
.llow co,parisons o- dollar 7g"res -ro, di5erent years
S"r;ey cons",ers to deter,ine co,position o- the typical cons",er<s
basket o- goods.
E;ery ,onth, collect data on prices o- all ite,s in the basketL co,p"te
cost o- basket
C!I in any ,onth eA"als
Fi,#re; Mo'ey 6ro%th a'( I'Gatio'
12
Cost o& 'as(et in t)at mont)
1!!
Cost o& 'as(et in 'ase perio*

Exam7&e;
+he basket contains H$ piDDas and '$ co,pact discs.
Pri"e$
Year$ PiHHa CD$
H$$H F'$ F'(
H$$I F'' F'(
H$$@ F'H F')
H$$( F'I F'(
Fro, this table, we can calc"late the in:ation rate as6
Year$ Co$t o! +a$et CPI I'Gatio' rate
H$$H FI($ '$$.$ n.a.
H$$I I&$ '$(.& (.&E
H$$@ @$$ ''@.I G.'E
H$$( @'$ ''&.' H.(E
6DP DeGator
+he G4! de:ator, also called the i,plicit price de:ator -or G4!, ,eas"res
the price o- o"tp"t relati;e to
its price in the base year. It re:ects what<s happening to the o;erall le;el o-
prices in the econo,y
G4! 4e:ator J B#o,inal G4! P 1eal G4!C W'$$
Year$ Nom/ 6DP Rea& 6DP 6DP DeGator I'Gatio' Rate
H$$' 1s@), H$$ 1s@), H$$ '$$.$ n.a.
H$$H (',@$$ ($,$$$ '$H.G H.GE
H$$I (G,I$$ (H,$$$ ''H.' Q.'E
Le$$o' 4
FINANCIAL INTERMEDIARIES
Financial Inter,ediaries
2ses
Characteristics
3al"e
E8a,ples
Fi'a'"ia& I'terme(iarie$
+he in-or,al arrange,ents that were the ,ainstay o- the 7nancial syste,
cent"ries ago ha;e since
gi;en way to the -or,al 7nancial instr",ents o- the ,odern world
+oday, the international 7nancial syste, e8ists to -acilitate the design,
sale, and e8change o- a broad
set o- contracts with a ;ery speci7c set o- characteristics.
/e obtain the 7nancial reso"rces we need -ro, this syste, in two ways6
4irectly -ro, lenders and
Indirectly -ro, 7nancial instit"tions called 7nancial inter,ediaries.
I'(ire"t Fi'a'"e
. 7nancial instit"tion Blike a bankC borrows -ro, the lender and then
pro;ides -"nds to the
borrower.
I- so,eone borrows ,oney to b"y a car, the car beco,es his or her asset
and the loan a liability.
Dire"t Fi'a'"e
Borrowers sell sec"rities directly to lenders in the 7nancial ,arkets.
Go;ern,ents and corporations 7nance their acti;ities this way
+he sec"rities beco,e assets to the lenders who b"y the, and liabilities
to the borrower who sells
the,
Fi'a'"ia& a'( E"o'omi" De-e&o7me't
Financial de;elop,ent is ine8tricably linked to econo,ic growth
o +here aren<t any rich co"ntries that ha;e ;ery low le;els o- 7nancial
de;elop,ent.
Fi,#re; Fi'a'"ia& a'( E"o'omi" De-e&o7me't
Fi'a'"ia& I'$tr#me't$
. 7nancial instr",ent is the written legal obligation o- one party to
trans-er so,ething o- ;al"e ?
"s"ally ,oney ? to another party at so,e -"t"re date, "nder certain
conditions, s"ch as stocks,
loans, or ins"rance.
/ritten legal obligation ,eans that it is s"bSect to go;ern,ent
en-orce,entL
+he en-orceability o- the obligation is an i,portant -eat"re o- a 7nancial
instr",ent.
+he party re-erred to can be a person, co,pany, or go;ern,ent
+he -"t"re date can be speci7ed or can be when so,e e;ent occ"rs
Financial instr",ents generally speci-y a n",ber o- possible
contingencies "nder which one party
is reA"ired to ,ake a pay,ent to another
Stocks, loans, and ins"rance are all e8a,ples o- 7nancial instr",ents
0$e$ o! Fi'a'"ia& I'$tr#me't$
./ Means o- !ay,ent !"rchase o- Goods or Ser;ices
1/ Store o- 3al"e +rans-er o- !"rchasing !ower into the -"t"re
2/ +rans-er o- 1isk +rans-er o- risk -ro, one person or co,pany to another
Chara"teri$ti"$ o! Fi'a'"ia& I'$tr#me't$
StandardiDation
StandardiDed agree,ents are "sed in order to o;erco,e the potential
costs o- co,ple8ity
Beca"se o- standardiDation, ,ost o- the 7nancial instr",ents that we
enco"nter on a day%to%day
basis are ;ery ho,ogeneo"s
Co,,"nicate In-or,ation
S",,ariDe certain essential in-or,ation abo"t the iss"er
4esigned to handle the proble, o- asy,,etric in-or,ation,
Borrowers ha;e so,e in-or,ation that they don<t disclose to lenders
C&a$$e$ o! Fi'a'"ia& I'$tr#me't$
2nderlying Instr",ents B!ri,ary or !ri,iti;e Sec"ritiesC
E.g. Stocks and bonds
Financial 4e;elop,ent is
,eas"red by the co,,only
"sed ratio o- broadly de7ned
,oney to G4!. Econo,ic
de;elop,ent is ,eas"red by
the real G4! per capita.
! 5! 1!! 15! 2!! 25!
5!!!
1!!!!
15!!!
2!!!!
+inancia, #ar(et Deve,opment
25!!!
-er Capita Rea, .D-
/orea
#a,a0sia
Corre,ation1!262
3ong /ong
C)ina
44
4
444
4
4
4
4
4
44
4
4
4
15
4eri;ati;e Instr",ents
3al"e and payo5s are deri;ed -ro, the beha;ior o- the "nderlying
instr",ents
F"t"res and options
Va&#e o! Fi'a'"ia& I'$tr#me't$
SiDe o- the pro,ised pay,ent
!eople will pay ,ore -or an instr",ent that obligates the iss"er to pay the
holder a greater s",.
+he bigger the siDe o- the pro,ised pay,ent, the ,ore ;al"able the
7nancial instr",ent
/hen the pay,ent will be recei;ed
+he sooner the pay,ent is ,ade the ,ore ;al"able is the pro,ise to ,ake
it
+he likelihood the pay,ent will be ,ade BriskC.
+he ,ore likely it is that the pay,ent will be ,ade, the ,ore ;al"able the
7nancial instr",ent
+he conditions "nder which the pay,ent will be ,ade
!ay,ents that are ,ade when we need the, ,ost are ,ore ;al"able than
other pay,ents
Va&#e o! Fi'a'"ia& I'$tr#me't$
./ SiDe !ay,ents that are larger are ,ore ;al"able
1/ +i,ing !ay,ents that are ,ade sooner are ,ore ;al"able
2/ 0ikelihood !ay,ents that are ,ore likely to be ,ade are ,ore ;al"able
3/ Circ",stances !ay,ents that are ,ade when we need the, ,ost are
,ore ;al"able
Le$$o' @
FINANCIAL INSTR0MENTS & FINANCIAL MAR5ETS
E8a,ples
Financial Markets
1oles
Str"ct"re
Exam7&e$ o! Fi'a'"ia& I'$tr#me't$
Primari&y Store$ o! Va&#e
Bank 0oans
. borrower obtains reso"rces -ro, a lender i,,ediately in e8change -or
a pro,ised set o-
pay,ents in the -"t"re
Bonds
. -or, o- a loan, whereby in e8change -or obtaining -"nds today a
go;ern,ent or corporation
pro,ises to ,ake pay,ents in the -"t"re
o,e Mortgages
. loan that is "sed to p"rchase real estate
+he real estate is collateral -or the loan,
It is a speci7c asset pledged by the borrower in order to protect the
interests o- the lender in the
e;ent o- nonpay,ent.
I- pay,ent is not ,ade the lender can -oreclose on the property.
Stocks
.n owner o- a share owns a piece o- the 7r, and is entitled to part o- its
pro7ts.
Primari&y to tra'$!er ri$
Ins"rance Contracts
+he pri,ary p"rpose is to ass"re that pay,ents will be ,ade "nder
partic"lar Band o-ten rareC
circ",stances
F"t"res Contracts
.n agree,ent to e8change a 78ed A"antity o- a co,,odity, s"ch as wheat
or corn, or an asset,
s"ch as a bond, at a 78ed price on a set -"t"re date
It is a deri;ati;e instr",ent since its ;al"e is based on the price o- so,e
other asset.
It is "sed to trans-er the risk o- price :"ct"ations -ro, one party to
another
9ptions
4eri;ati;e instr",ents whose prices are based on the ;al"e o- so,e
"nderlying assetL
+hey gi;e the holder the right Bb"t not the obligationC to p"rchase a 78ed
A"antity o- the
"nderlying asset at a predeter,ined price at any ti,e d"ring a speci7ed
period.
Fi'a'"ia& Maret$
Financial Markets are the places where 7nancial instr",ents are bo"ght
and sold.
Enable both 7r,s and indi;id"als to 7nd 7nancing -or their acti;ities.
!ro,ote econo,ic e5iciency by ens"ring that reso"rces are placed at the
disposal o- those who can
p"t the, to best "se.
/hen they -ail to -"nction properly, reso"rces are no longer channeled to
their best possible "se
and the society s"5ers at large
Ro&e o! Fi'a'"ia& Maret$
0iA"idity Ens"re that owners o- 7nancial instr",ents can b"y and sell the,
cheaply and easily
In-or,ation !ool and co,,"nicate in-or,ation abo"t the iss"er o- a
7nancial instr",ent
1isk Sharing !ro;ide indi;id"als with a place to b"y and sell risk, sharing
the, with indi;id"als
Financial ,arkets need to be designed in a way that keeps transactions
costs low
Str#"t#re o! Fi'a'"ia& Maret$
Primary -$/ Se"o'(ary Maret$
In a pri,ary ,arket a borrower obtains -"nds -ro, a lender by selling
newly iss"ed sec"rities.
Most co,panies "se an in;est,ent bank, which will deter,ine a price
and then p"rchase the
co,pany<s sec"rities in preparation -or resale to clientsL this is called
"nderwriting.
In the secondary ,arkets people can b"y and sell e8isting sec"rities
Ce'tra&iHe( Ex"ha',e$ -$/ O-er>the>"o#'ter Maret$
In the centraliDed e8change Be.g. Xarachi Stock E8change
www.kse.co,.pk C, the trading is done
on the :oor
O-er>the>"o#'ter ?or OTC:
9+C ,arket are electronic networks o- dealers who trade with one
another -ro, where;er they are
located
Debt a'( E8#ity -$/ Deri-ati-e Maret$
EA"ity ,arkets are the ,arkets -or stocks, which are "s"ally traded in the
co"ntries where the
co,panies are based.
4ebt instr",ents can be categoriDed as
Money ,arket B,at"rity o- less than one yearC or Bond ,arkets B,at"rity
o- ,ore than one yearC
Chara"teri$ti"$ o! a %e&&>r#' *'a'"ia& maret
0ow transaction costs.
In-or,ation co,,"nicated ,"st be acc"rate and widely a;ailable
I- not, the prices will not be correct
!rices are the link between the 7nancial ,arkets and the real econo,y
In;estors ,"st be protected.
. lack o- proper sa-eg"ards da,pens people<s willingness to in;est
Fi,#re; Maret $iHe a'( i'-e$tor$ 7rote"tio'
"225 "125 "!25 !25 125
!25
12!
125
22!
#easure o& investor protection
225
Stoc( mar(et re,ative to .D-
.reece
4-ortuga,
5/
4
6or7a0
4
44
4444
4444
4
4
4
44
4
4
"325
!
32!
325
5S
4
8ess #ore
1
Le$$o' C
FINANCIAL INSTIT0TIONS
Str"ct"re o- Financial Ind"stry
+i,e 3al"e o- Money
Fi'a'"ia& I'$tit#tio'$
Financial instit"tions are the 7r,s that pro;ide access to the 7nancial
,arketsL
+hey sit between sa;ers and borrowers and so are known as 7nancial
inter,ediaries.
Banks, ins"rance co,panies, sec"rities 7r,s and pension -"nds
. syste, witho"t 7nancial instit"tions wo"ld not work ;ery well -or three
reasons
Indi;id"al transactions between sa;er%lenders and borrower%spenders
wo"ld be e8tre,ely
e8pensi;e.
0enders need to e;al"ate the creditworthiness o- borrowers and then
,onitor the,, and
indi;id"als are not eA"ipped to do this.
Most borrowers want to borrow long ter,, while lenders -a;or short%ter,
loans
Ro&e o! Fi'a'"ia& I'$tit#tio'$
1ed"ce transactions cost by specialiDing in the iss"ance o- standardiDed
sec"rities
1ed"ce in-or,ation costs o- screening and ,onitoring borrowers.
C"rb in-or,ation asy,,etries, helping to ens"re that reso"rces :ow into
their ,ost prod"cti;e
"ses
Make long%ter, loans b"t allow sa;ers ready access to their -"nds.
!ro;ide sa;ers with 7nancial instr",ents B,ore liA"id and less risky than
the indi;id"al stocks and
bondsC that sa;ers wo"ld p"rchase directly in 7nancial ,arkets
Fi,#re; F&o% o! !#'($ thro#,h Fi'a'"ia& I'$tit#tio'$; A""e$$ to
Fi'a'"ia& Maret$
8en*ers9Savers
:-rimari,0 3ouse)o,*s;
Borro7ers9Spen*ers
:-rimari,0 .overnments
an* +irms;
+inancia, Institutions t)at
act as Bro(ers
+inancia, Institutions t)at
trans&orm assets
Bonds & Stocks
Funds
8en*ers9Savers
:-rimari,0 3ouse)o,*s;
Borro7ers9Spen*ers
:-rimari,0 .overnments
an* +irms;
+inancia, Institutions
t)at act as Bro(ers
+inancia, Institutions
t)at trans&orm assets
Bon*s < Stoc(s
+un*s +un*s
Bon*s < Stoc(s
8oans= Bon*s=
Stoc(s an* Rea,
>state
+un*s
Deposits < Insurance
-o,icies
+un*s
I'(ire"t Fi'a'"e
The $im7&i*e( +a&a'"e Sheet o! a Fi'a'"ia& I'$tit#tio'
A$$et$ Liabi&itie$
Bonds
Stocks
0oans
1eal estate
4eposits
Ins"rance policies
The $tr#"t#re o! the *'a'"ia& i'(#$try
+he str"ct"re o- the 7nancial ind"stry6
Financial instit"tions or inter,ediaries can be di;ided into two broad
categories
De7o$itory i'$tit#tio'$ % take deposits and ,ake loans.
BCo,,ercial banks, sa;ings banks, and credit "nionsC
No'(e7o$itory i'$tit#tio'$
Ins"rance co,panies, sec"rities 7r,s, ,"t"al -"nd co,panies, 7nance
co,panies, and pension
-"nds
I'$#ra'"e "om7a'ie$
.ccept pre,i",s, which they in;est in sec"rities and real estate in ret"rn
-or pro,ising
co,pensation to policyholders sho"ld certain e;ents occ"rs Blike death,
property losses, etc.C
Pe'$io' !#'($
In;est indi;id"al and co,pany contrib"tions into stocks, bonds and real
estate in order to pro;ide
pay,ents to retired workers.
Se"#ritie$ *rm$
+hey incl"de brokers, in;est,ent banks, and ,"t"al -"nd co,panies
Brokers and in;est,ent banks iss"e stocks and bonds to corporate
c"sto,ers, trade the,, and
ad;ise clients.
M"t"al -"nd co,panies pool the reso"rces o- indi;id"als and co,panies
and in;est the, in
port-olios o- bonds, stocks, and real estate.
6o-er'me't S7o'$ore( E'ter7ri$e$;
Federal credit agencies that pro;ide loans directly -or -ar,ers and ho,e
,ortgages, as well as
g"arantee progra,s that ins"re the loans ,ade by pri;ate lenders.
BFC, Y+B0, Xh"shhali bank, SME Bank
+he go;ern,ent also pro;ides retire,ent inco,e and ,edical care to the
elderly Band disabledC
thro"gh Social Sec"rity and Medicare.
Fi'a'"e Com7a'ie$;
1aise -"nds directly in the 7nancial ,arkets in order to ,ake loans to
indi;id"als and 7r,s.
+he ,onetary aggregates are ,ade "p o- liabilities o- co,,ercial banks,
so clearly the 7nancial
str"ct"re is tied to the a;ailability o- ,oney and credit.
Le$$o' D
TIME VAL0E OF MONEY
+i,e 3al"e o- Money
F"t"re 3al"e Concepts
!resent ;al"e
.pplication in 7nancial en;iron,ent
Time Va&#e o! Mo'ey
Credit is one o- the critical ,echanis,s we ha;e -or allocating reso"rces.
E;en the si,plest 7nancial transaction, like sa;ing so,e o- yo"r paycheck
each ,onth to b"y a
car, wo"ld be i,possible.
Corporations, ,ost o- which s"r;i;e -ro, day to day by borrowing to
7nance their acti;ities,
wo"ld not be able to -"nction.
Uet e;en so, ,ost people still take a di, ;iew o- the -act that lenders
charge interest.
+he ,ain reason -or the end"ring "npop"larity o- interest co,es -ro, the
-ail"re to appreciate the
-act that lending has an opport"nity cost.
+hink o- it -ro, the point o- ;iew o- the lender.
E8tending a loan ,eans gi;ing "p the alternati;es. /hile lenders can
e;ent"ally reco"p the s",
they lend, neither the ti,e that the loan was o"tstanding nor the
opport"nities ,issed d"ring that
ti,e can be gotten back.
So interest isnNt really Zthe breeding o- ,oney -ro, ,oney,NN as .ristotle
p"t itL itNs ,ore like a
rental -ee that borrowers ,"st pay lenders to co,pensate the, -or lost
opport"nities.
ItNs no s"rprise that in todayNs world, interest rates are o- enor,o"s
i,portance to ;irt"ally
e;eryone
Indi;id"als, b"sinesses, and go;ern,ents
+hey link the present to the -"t"re, allowing "s to co,pare pay,ents
,ade on di5erent dates.
Interest rates also tell "s the -"t"re reward -or lending today, as well as
the cost o- borrowing now
and repaying later.
+o ,ake so"nd 7nancial decisions, we ,"st learn how to calc"late and
co,pare di5erent rates on
;ario"s 7nancial instr",ents
F#t#re Va&#e
F"t"re 3al"e is the ;al"e on so,e -"t"re date o- an in;est,ent ,ade
today.
+o calc"late -"t"re ;al"e we ,"ltiply the present ;al"e by the interest
rate and add that a,o"nt o-
interest to the present ;al"e.
!3 V Interest J F3
!3 V !3[i J F3
F'$$ V F'$$B$.$(C J F'$(
!3 J !resent 3al"e
F3 J F"t"re 3al"e
i J interest rate Bas a percentageC
+he higher the interest rate Bor the a,o"nt in;estedC the higher the
-"t"re ;al"e.
F#t#re Va&#e i' o'e year
F3 J !3[B'ViC
#ow we need to 7g"re o"t what happens when the ti,e to repay,ent
;aries
/hen we consider in;est,ents with interest pay,ents ,ade -or ,ore
than one year we need to
consider co,po"nd interest, or the -act that interest will be paid on interest
F#t#re Va&#e i' t%o year$
F'$$VF'$$B$.$(C VF'$$B$.$(C V F(B$.$(C JF''$.H(
!resent 3al"e o- the Initial In;est,ent V Interest on the initial in;est,ent in
the 'st Uear V Interest on the
initial in;est,ent in the Hnd UearV Interest on the Interest -ro, the 'stUear
in the Hnd Uear
J F"t"re 3al"e in +wo Uears
General For,"la -or co,po"nd interest ? F"t"re ;al"e o- an in;est,ent o-
!3 in n years at interest rate i
B,eas"red as a deci,al, or (E J .$(C
F3n J !3[B'ViC n
Tab&e; Com7#ti', the F#t#re Va&#e o! F.BB at 4I a''#a& i'tere$t
rate
Year$ i'to !#t#re Com7#tatio' F#t#re -a&#e
' F'$$B$.(C F'$(.$$
H F'$$B$.(CH F''$.H(
I F'$$B$.(CI F''(.&)
@ F'$$B$.(C@ F'H'.((
( F'$$B$.(C( F'H&.)I
'$ F'$$B$.(C'$ F')H.GQ
Note;
Both n and i ,"st be ,eas"red in sa,e ti,e "nitsTi- i is ann"al, then n
,"st be in years, so -"t"re ;al"e o-
F'$$ in 'G ,onths at (E is
F3 J '$$ [B'V.$(C'.(
ow "se-"l it isO
I- yo" p"t F',$$$ per year into bank at @E interest, how ,"ch wo"ld yo"
ha;e sa;ed a-ter @$
yearsO
+aking help o- -"t"re ;al"e concept, the acc","lated a,o"nt thro"gh the
sa;ing will be FQG,GH) ?
,ore than twice the F@$,$$$ yo" in;ested
ow does it workO
+he 7rst F',$$$ is deposited -or @$ years so its -"t"re ;al"e is
F',$$$ 8 B'.$@C@$ J @,G$'.$H
+he Hnd F',$$$ is deposited -or IQ years so its -"t"re ;al"e is
F',$$$ 8 B'.$@CIQ J @,)').I&
.nd so on\.."p to the F',$$$ deposited in the @$th year
.dding "p all the -"t"re ;al"es gi;es yo" the a,o"nt o- FQG,GH)
Pre$e't Va&#e
!resent 3al"e B!3C is the ;al"e today Bin the presentC o- a pay,ent that is
pro,ised to be ,ade in
the -"t"re. 91
!resent 3al"e is the a,o"nt that ,"st be in;ested today in order to
realiDe a speci7c a,o"nt on a
gi;en -"t"re date.
+o calc"late present ;al"e we in;ert the -"t"re ;al"e calc"lationL
/e di;ide -"t"re ;al"e by one pl"s the interest rate Bto 7nd the present
;al"e o- a pay,ent to be
,ade one year -ro, nowC.
Sol;ing the F"t"re 3al"e EA"ation
F3 J !3[B'ViC
!resent 3al"e o- an a,o"nt recei;ed in one year.
Exam7&e;
F'$$ recei;ed in one year, iJ(E
!3JF'$$P B'V.$(C J FQ(.H@
#ote6
F3 J !3[B'ViC J FQ(.H@[B'.$(C J F'$$
For pay,ents to be ,ade ,ore than one year -ro, now we di;ide -"t"re
;al"e by one pl"s the
interest rate raised to the nth power where n is the n",ber o- years
!resent 3al"e o- F'$$ recei;ed n years in the -"t"re6
Exam7&e
!resent 3al"e o- F'$$ recei;ed in H ] years and an interest rate o- GE.
!3 J F'$$ P B'.$GCH.( J FGH.($
Note;
F3 JFGH.($ [ B'.$GCH.( J F'$$
Le$$o' E
APPLICATION OF PRESENT VAL0E CONCEPTS
.pplication o- !resent 3al"e Concept
Co,po"nd .nn"al 1ate
Interest 1ates ;s. 4isco"nt 1ate
Internal 1ate o- 1et"rn
Bond !ricing
Im7orta't Pro7ertie$ o! Pre$e't Va&#e
Pre$e't Va&#e i$ hi,her;
+he higher the -"t"re ;al"e BF3C o- the pay,ent
+he shorter the ti,e period "ntil pay,ent BnC
+he lower the interest rate BiC
The $iHe o! the 7ayme't ?FV':
4o"bling the -"t"re ;al"e o- the pay,ent Bwitho"t changing ti,e o- the
pay,ent or interest rateC,
do"bles the present ;al"e
.t (E interest rate, F'$$ pay,ent has a !3 o- FQ$.&$
4o"bling it to FH$$, do"bles the !3 to F'G'.@$
Increasing or decreasing F3n by any percentage will change !3 by the
sa,e percentage in the sa,e
direction
The time #'ti& the 7ayme't i$ ma(e ?':
Contin"ing with the pre;io"s e8a,ple o- F'$$ at (E, we allow the ti,e to
go -ro, $ to I$ years.
+his process shows "s that the !3 pay,ent is worth F'$$ i- it is ,ade
i,,ediately, b"t grad"ally
declines to FHI -or a pay,ent ,ade in I$ years
Fi,#re; Pre$e't -a&#e o! F.BB at 4I i'tere$t rate
The r#&e o! C1
For reasonable rates o- ret"rn, the ti,e it takes to do"ble the ,oney, is
gi;en appro8i,ately by
t J &H P iE
I- we ha;e an interest rate o- '$E, the ti,e it takes -or in;est,ent to
do"ble is6
t J &H P '$ J &.H years
+his r"le is -airly applicable to disco"nt rates in (E to H$E range.
The I'tere$t rate ?i:
igher interest rates are associated with lower present ;al"es, no ,atter
what siDe or ti,ing o- the
pay,ent
.t any 78ed interest rate, an increase in the ti,e "ntil a pay,ent is ,ade
red"ces its present ;al"e
Tab&e; Pre$e't Va&#e o! a F.BB 7ayme't
Payme't (#e i'
I'tere$t rate . Year 4 Year$ .B Year$ 1B Year$
'E FQQ.$' FQ(.'( FQ$.(I FG'.Q(
HE F2/CC FQG.$@ FQ$.(& F1E/.3 FGH.$I F)&.I$
IE 3I FQ&.$Q FG).H) 21I F&@.@' F((.I&
@E FQ).'( FGH.'Q F)&.() F@(.)@
(E FQ(.H@ F&G.I( F)'.IQ FI&.)Q
)E FQ@.I@ F&@.&I F((.G@ FI'.'G
&E FQI.@) F&'.I$ F($.GI FH(.G@
GE FQH.(Q F)G.$) F@).IH FH'.@(
QE FQ'.&@ F)@.QQ F@H.H@ F'&.G@
'$E FQ$.Q' F)H.$Q FIG.(( F'@.G)
''E FQ$.$Q F(Q.I( FI(.HH F'H.@$
'HE FGQ.HQ F().&@ FIH.H$ F'$.I&
'IE FGG.($ F(@.HG FHQ.@) FG.)G
'@E FG&.&H F('.Q@ FH).Q& F&.HG
'(E FG).Q) F@Q.&H FH@.&H F).''
Fi,#re; The re&atio'$hi7 bet%ee' Pre$e't -a&#e a'( I'tere$t Rate$
Com7o#'( A''#a& Rate$
Co,paring changes o;er days, ,onths, years and decades can be ;ery
di5ic"lt.
+he way to deal with s"ch proble,s is to t"rn the ,onthly growth rate
into co,po"nd%ann"al rate.
.n in;est,ent whose ;al"e grows $.(E per ,onth goes -ro, '$$ at the
beginning o- the ,onth to
'$$.( at the end o- the ,onth6
/e can ;eri-y this as -ollowing
'$$ B'$$.( % '$$C J ^B'$$.(P'$$C ? '_ J $.(E
'$$
/hat i- the in;est,ent<s ;al"e contin"ed to grow at $.(E per ,onth -or
ne8t 'H ,onthsO
/e cant si,ply ,"ltiply $.( by 'H
Instead we need to co,p"te a 'H ,onth co,po"nd rate
So the -"t"re ;al"e o- '$$ at $.( EB $.$$(C per ,onth co,po"nded -or 'H
,onths will be6
F3n J !3 B'ViC n J '$$B'.$$(C'H J '$).'&
.n increase o- ).'&E which is greater than )E, had we ,"ltiplied $.(E
by 'H
+he di5erence between the two answers grows as the interest rate grows
.t 'E ,onthly rate, 'H ,onth co,po"nded rate is'H.)GE
.nother "se -or co,po"nding is to co,p"te the percentage change per
year when we know how
,"ch an in;est,ent has grown o;er a n",ber o- years
+his rate is called a;erage ann"al rate
I- an in;est,ent has increased H$E, -ro, '$$ to 'H$ o;er ( years
Is a;erage ann"al rate is si,ply di;iding H$E by (O
+his way we ignore co,po"nding e5ect
Increase in Hnd year ,"st be calc"lated as percentage o- the in;est,ent
worth at the end o- 'st year
+o calc"late the a;erage ann"al rate, we re;ert to the sa,e eA"ation6
F3n J !3 B'ViC n
'H$ J '$$B' V iC (
Sol;ing -or i
i J ^B'H$P'$$C'P( % '_ J $.$I&'
( consec"ti;e ann"al increases o- I.&'E will res"lt in an o;erall increase
o- H$E
I'tere$t Rate a'( Di$"o#'t Rate
+he interest rate "sed in the present ;al"e calc"lation is o-ten re-erred to
as the disco"nt rate
beca"se the calc"lation in;ol;es disco"nting or red"cing -"t"re pay,ents to
their eA"i;alent ;al"e
today.
.nother ter, that is "sed -or the interest rate is yield
Sa;ing beha;ior can be considered in ter,s o- a personal disco"nt rateL
!eople with a low rate are ,ore likely to sa;e, while people with a high
rate are ,ore likely to
borrow
/e all ha;e a disco"nt rate that describes the rate at which we need to be
co,pensated -or
postponing cons",ption and sa;ing o"r inco,e
I- the ,arket o5ers an interest rate higher than the indi;id"al<s personal
disco"nt rate, we wo"ld
e8pect that person to sa;e Band ;ice ;ersaC
igher interest rates ,ean higher sa;ing
A77&yi', Pre$e't Va&#e
+o "se present ;al"e in practice we need to look at a seA"ence or strea,
o- pay,ents whose
present ;al"es ,"st be s",,ed. !resent ;al"e is additi;e.
+o see how this is applied we will look at internal rate o- ret"rn and the
;al"ation o- bonds
I'ter'a& Rate o! Ret#r'
+he Internal 1ate o- 1et"rn is the interest rate that eA"ates the present
;al"e o- an in;est,ent with
it cost.
It is the interest rate at which the present ;al"e o- the re;en"e strea,
eA"als the cost o- the
in;est,ent proSect.
In the calc"lation we sol;e -or the interest rate
. ,achine with a price o- F',$$$,$$$ that generates F'($,$$$Pyear -or '$
years
1 2 3 :1 ;1!
222222 $15!=!!!
:1 ;
$15!=!!!
:1 ;
$15!=!!!
:1 ;
$1=!!!=!!! $15!=!!!
i i i + i
+ +
+
+
+
+
+
=
Sol;ing -or i, iJ.$G'@ or G.'@E
+he internal rate o- ret"rn ,"st be co,pared to a rate o- interest that
represents the cost o- -"nds
to ,ake the in;est,ent.
+hese -"nds co"ld be obtained -ro, retained earnings or borrowing. In
either case there is an
interest cost
.n in;est,ent will be pro7table i- its internal rate o- ret"rn e8ceeds the
cost o- borrowing
Le$$o' .B
+OND PRICIN6 & RIS5
Bond !ricing
1eal 3s #o,inal Interest 1ates
1isk
Characteristics
Meas"re,ent
+o'( Pri"i',
. bond is a pro,ise to ,ake a series o- pay,ents on speci7c -"t"re date.
It is a legal contract iss"ed as part o- an arrange,ent to borrow
+he ,ost co,,on type is a co"pon bond, which ,akes ann"al pay,ents
called co"pon pay,ents
+he percentage rate is called the co"pon rate
+he bond also speci7es a ,at"rity date BnC and has a 7nal pay,ent BFC,
which is the principal, -ace
;al"e, or par ;al"e o- the bond
+he price o- a bond is the present ;al"e o- its pay,ents
+o ;al"e a bond we need to ;al"e the repay,ent o- principal and the
pay,ents o- interest
Va&#i', the Pri'"i7a& Payme't
. straight-orward application o- present ;al"e where n represents the
,at"rity o- the bond
3al"ing the Co"pon !ay,ents6
1eA"ires calc"lating the present ;al"e o- the pay,ents and then adding
the,L re,e,ber, present
;al"e is additi;e
3al"ing the Co"pon !ay,ents pl"s !rincipal
Means co,bining the abo;e
Payme't $to7$ at the mat#rity (ate/ ?':
. pay,ent is -or the -ace ;al"e BFC or principle o- the bond
Co"pon Bonds ,ake ann"al pay,ents called, Co"pon !ay,ents BCC, based
"pon an interest rate,
the co"pon rate BicC, CJic[F
. bond that has a F'$$ principle pay,ent in n years. +he present
3al"e B!B!C o- this is now6
BP n n i i
P F
:1 ;
$1!!
:1 ; +
=
+
=
I- the bond has n co"pon pay,ents BCC, where CJ ic [ F, the !resent
3al"e B!C!C o- the co"pon
pay,ents is6
CP n i
C
i
C
i
C
i
P C
:1 ;
222222
:1 ;1 :1 ;2 :1 ;3 +
+ +
+
+
+
+
+
=
!resent 3al"e o- Co"pon Bond B!CBC J !resent ;al"e o- Uearly Co"pon
!ay,ents B!C!C V !resent 3al"e o-
the !rincipal !ay,ent B!B!C
CB CP BP n n i
F
i
C
i
C
i
C
i
P P P C
:1 ; :1 ;
222222
:1 ;1 :1 ;2 :1 ;3 +
+
+
+ +
+
+
+
+
+
= + =
Note;
+he ;al"e o- the co"pon bond rises when the yearly co"pon pay,ents rise
and when the interest
rate -alls
0ower interest rates ,ean higher bond prices and ;ice ;ersa.
+he ;al"e o- a bond ;aries in;ersely with the interest rate "sed to
disco"nt the pro,ised pay,ents
Rea& a'( Nomi'a& I'tere$t Rate$
So -ar we ha;e been co,p"ting the present ;al"e "sing no,inal interest
rates BiC, or interest rates
e8pressed in c"rrent%dollar ter,s
B"t in:ation a5ects the p"rchasing power o- a dollar, so we need to
consider the real interest rate
BrC, which is the in:ation%adS"sted interest rate.
+he Fisher eA"ation tells "s that the no,inal interest rate is eA"al to the
real interest rate pl"s the
e8pected rate o- in:ation
Fisher EA"ation6
i J r V e
9r
r J i % `e
Fi,#re; Nomi'a& I'tere$t rate$) I'Gatio') a'( rea& i'tere$t rate$
1 185 1 1 14
"5
!
5
1!
"1!
15
2!
17 17 2!!! 2!!3
3!
Fi,#re; I'Gatio' a'( Nomi'a& I'tere$t Rate$) A7ri& 1BB3
Ri$
E;ery day we ,ake decisions that in;ol;e 7nancial and econo,ic risk.
ow ,"ch car ins"rance sho"ld we b"yO
Sho"ld we re7nance the ho,e loan now or a year -ro, nowO
Sho"ld we sa;e ,ore -or retire,ent, or spend the e8tra ,oney on a new
carO
Interestingly eno"gh, the tools we "se today to ,eas"re and analyDe risk
were 7rst de;eloped to
help players analyDe ga,es o- chance.
For tho"sands o- years, people ha;e played ga,es based on a throw o- the
dice, b"t they had little
"nderstanding o- how those ga,es act"ally worked
Since the in;ention o- probability theory, we ha;e co,e to realiDe that
,any e;eryday e;ents,
incl"ding those in econo,ics, 7nance, and e;en weather -orecasting, are
best tho"ght o- as
analogo"s to the :ip o- a coin or the throw o- a die
Still, while e8perts can ,ake ed"cated g"esses abo"t the -"t"re path o-
interest rates, in:ation, or
the stock ,arket, their predictions are really only thatTg"ess.
.nd while ,eteorologists are -airly good at -orecasting the weather a day
or two ahead, econo,ists,
7nancial ad;isors, and b"siness g"r"s ha;e dis,al records.
So "nderstanding the possibility o- ;ario"s occ"rrences sho"ld allow
e;eryone to ,ake better
choices. /hile risk cannot be eli,inated, it can o-ten be ,anaged e5ecti;ely.
Finally, while ,ost people ;iew risk as a c"rse to be a;oided whene;er
possible, risk also creates
opport"nities.
+he payo5 -ro, a winning bet on one hand o- cards can o-ten erase the
losses on a losing hand.
+h"s the i,portance o- probability theory to the de;elop,ent o- ,odern
7nancial ,arkets is hard
to o;ere,phasiDe.
!eople reA"ire co,pensation -or taking risks. /itho"t the capacity to
,eas"re risk, we co"ld not
calc"late a -air price -or trans-erring risk -ro, one person to another, nor
co"ld we price stocks and
bonds, ,"ch less sell ins"rance.
+he ,arket -or options didnNt e8ist "ntil econo,ists learned how to
co,p"te the price o- an option
"sing probability theory
/e need a de7nition o- risk that -oc"ses on the -act that the o"tco,es o-
7nancial and econo,ic
decisions are al,ost always "nknown at the ti,e the decisions are ,ade.
1isk is a ,eas"re o- "ncertainty abo"t the -"t"re payo5 o- an in;est,ent,
,eas"red o;er so,e
ti,e horiDon and relati;e to a bench,ark.
5 1! 15 2! 25
5
1!
15
2!
25
3!
! 3!
Tur(e0 45? ,ine
4
Bra@i,
4 Russia
4
Sout) A&rica
5/ 5S
InBation :%;
6omina, Interest Rate :%;
31
Chara"teri$ti"$ o! ri$
1isk can be A"anti7ed.
1isk arises -ro, "ncertainty abo"t the -"t"re.
1isk has to do with the -"t"re payo5 to an in;est,ent, which is "nknown.
9"r de7nition o- risk re-ers to an in;est,ent or gro"p o- in;est,ents.
1isk ,"st be ,eas"red o;er so,e ti,e horiDon.
1isk ,"st be ,eas"red relati;e to so,e bench,ark, not in isolation.
I- yo" want to know the risk associated with a speci7c in;est,ent
strategy, the ,ost appropriate
bench,ark wo"ld be the risk associated with other in;esting strategies
Mea$#ri', Ri$
Mea$#ri', Ri$ re8#ire$;
0ist o- all possible o"tco,es
Chance o- each one occ"rring
+he tossing o- a coin
/hat are possible o"tco,esO
/hat is the chance o- each one occ"rringO
Is coin -airO
!robability is a ,eas"re o- likelihood that an e;en will occ"r
Its ;al"e is between Dero and one
+he closer probability is to Dero, less likely it is that an e;ent will occ"r.
#o chance o- occ"rring i- probability is e8actly Dero
+he closer probability is to one, ,ore likely it is that an e;ent will occ"r.
+he e;ent will de7nitely occ"r i- probability is e8actly one
!robabilities can also be e8pressed as -reA"encies
Tab&e; A Sim7&e Exam7&e; A&& Po$$ib&e O#t"ome$ o! a Si',&e Coi' To$$
Po$$ibi&itie$ Probabi&ity O#t"ome
a' 'PH eads
aH 'PH +ails
/e ,"st incl"de all possible o"tco,es when constr"cting s"ch a table
+he s", o- the probabilities o- all the possible o"tco,es ,"st be ', since
one o- the possible
o"tco,es ,"st occ"r Bwe S"st don<t know which oneC
+o calc"late the e8pected ;al"e o- an in;est,ent, ,"ltiply each possible
payo5 by its probability
and then s", all the res"lts. +his is also known as the ,ean.
Ca$e .
.n In;est,ent can rise or -all in ;al"e. .ss",e that an asset p"rchased -or
F'$$$ is eA"ally likely to -all to
F&$$ or rise to F'@$$
Tab&e; I'-e$ti', F.)BBB; Ca$e .
Po$$ibi&itie$ Probabi&ity PayoJ PayoJ KProbabi&ity
a' 'PH F&$$ FI($
aH 'PH F',@$$ F&$$
E8pected 3al"e J S", o- B!robability ti,es !ayo5C J F',$($
E8pected 3al"e J ] BF&$$C V ] BF'@$$C J F'$($
Ca$e 1
+he F',$$$ in;est,ent ,ight pay o5
F'$$ BprobJ.'C or
FH$$$ BprobJ.'C or
F&$$ BprobJ.@C or
F'@$$ BprobJ.@C
Tab&e; I'-e$ti', F.)BBB; Ca$e 1
Po$$ibi&itie$ Probabi&ity PayoJ PayoJ KProbabi&ity
a' $.' F'$$ F'$
aH $.@ F&$$ FHG$
aI $.@ F',@$$ F()$
a@ $.' FH,$$$ FH$$
Ex7e"te( Va&#e L S#m o! ?Probabi&ity time$ PayoJ: L F.)B4B
In;est,ent payo5s are "s"ally disc"ssed in percentage ret"rns instead o-
in dollar a,o"ntsL this
allows in;estors to co,p"te the gain or loss on the in;est,ent regardless o-
its siDe
+ho"gh both cases ha;e the sa,e e8pected ret"rn, F($ on a F'$$$
in;est,ent, or (E, the two
in;est,ents ha;e di5erent le;els or risk.
. wider payo5 range indicates ,ore risk.
Le$$o' ..
MEAS0RIN6 RIS5
Meas"ring 1isk
3ariance and Standard 4e;iation
3al"e at 1isk B3.1C
1isk .;ersion > 1isk !re,i",
Mea$#ri', Ri$
Most o- "s ha;e an int"iti;e sense -or risk and its ,eas"re,entL
+he wider the range o- o"tco,es the greater the risk
. 7nancial instr",ent with no risk at all is a risk%-ree in;est,ent or a
risk%-ree assetL
Its -"t"re ;al"e is known with certainty and
Its ret"rn is the risk%-ree rate o- ret"rn
I- the risk%-ree ret"rn is ( percent, a F'$$$ risk%-ree in;est,ent will pay
F'$($, its e8pected ;al"e,
with certainty.
I- there is a chance that the payo5 will be either ,ore or less than F'$($,
the in;est,ent is risky.
/e can ,eas"re risk by ,eas"ring the spread a,ong an in;est,ent<s
possible o"tco,es. +here are
two ,eas"res that can be "sed6
3ariance and Standard 4e;iation
Meas"re o- spread
3al"e at 1isk B3.1C
Meas"re o- riskiness o- worst case
Varia'"e
+he ;ariance is de7ned as the probability weighted a;erage o- the
sA"ared de;iations o- the
possible o"tco,es -ro, their e8pected ;al"e
To "a&"#&ate the -aria'"e o! a' i'-e$tme't) !o&&o%i', $te7$ are
i'-o&-e(;
Co,p"te e8pected ;al"e
S"btract e8pected ;al"e -ro, each possible payo5
SA"are each res"lt
M"ltiply by its probability
.dd "p the res"lts
Com7#te the ex7e"te( -a&#e;
BF'@$$ 8 ]C V BF&$$ 8 ]C J F'$($.
S#btra"t thi$ !rom ea"h o! the 7o$$ib&e 7ayoJ$;
F'@$$%F'$($J FI($
F&$$%F'$($J ?FI($
S8#are ea"h o! the re$#&t$;
FI($H J 'HH,($$BdollarsCH and
B?FI($CH J 'HH,($$BdollarsCH
M#&ti7&y ea"h re$#&t time$ it$ 7robabi&ity a'( a(($ #7 the re$#&t$;
] ^'HH,($$BdollarsCH_ V ] ^'HH,($$BdollarsCH_
J 'HH,($$BdollarsCH
More co,pactlyL
3ariance J ]BF'@$$%F'$($CH V ]BF&$$%F'$($CH
J 'HH,($$BdollarsCH
Sta'(ar( De-iatio'
+he standard de;iation is the sA"are root o- the ;ariance, or6
Standard 4e;iation Bcase 'C JFI($
Standard 4e;iation Bcase HC JF(HG
+he greater the standard de;iation, the higher the risk
It ,ore "se-"l beca"se it is ,eas"red in the sa,e "nits as the payo5s
Bthat is, dollars and not
sA"ared dollarsC
+he standard de;iation can then also be con;erted into a percentage o-
the initial in;est,ent,
pro;iding a baseline against which we can ,eas"re the risk o- alternati;e
in;est,ents
Gi;en a choice between two in;est,ents with the sa,e e8pected payo5,
,ost people wo"ld
choose the one with the lower standard de;iation beca"se it wo"ld ha;e less
risk
Va&#e at Ri$
So,eti,es we are less concerned with the spread o- possible o"tco,es
than we are with the ;al"e
o- the worst o"tco,e.
+o assess this sort o- risk we "se a concept called ;al"e at risk.
3al"e at risk ,eas"res risk at the ,a8i,", potential loss
Ri$ A-er$io'
Most people don<t like risk and will pay to a;oid itL ,ost o- "s are risk
a;erse
. risk%a;erse in;estor will always pre-er an in;est,ent with a certain
ret"rn to one with the sa,e
e8pected ret"rn, b"t any a,o"nt o- "ncertainty.
B"ying ins"rance is paying so,eone to take o"r risks, so i- so,eone
wants "s to take on risk we
,"st be paid to do so
Ri$ Premi#m
+he riskier an in;est,ent ? the higher the co,pensation that in;estors
reA"ire -or holding it ? the
higher the risk pre,i",
1iskier in;est,ents ,"st ha;e higher e8pected ret"rns
+here is a trade%o5 between risk and e8pected ret"rnL
Uo" can<t get a high ret"rn witho"t taking considerable risk.
Fi,#re; The Tra(e>oJ bet%ee' Ri$ a'( Ex7e"te( Ret#r'
+he higher the risk, the higher
the e8pected ret"rn. +he risk
pre,i", eA"als the e8pected
ret"rn on the risky in;est,ent
,in"s the risk%-ree ret"rn.
>Cpecte* Return
Ris(
Ris(" +ree Return
Ris( -remium
3ig)er Ris(13ig)er >Cpecte* Return
36
Le$$o' .1
EVAL0ATIN6 RIS5
So"rces o- 1isk
Idiosyncratic
Syste,atic
1ed"cing 1isk thro"gh 4i;ersi7cation
edging 1isk
Spreading 1isk
Bond and Bond !ricing
Ho% to E-a&#ate Ri$
0ets go back to o"r pre;io"s e8a,ple where F',$$$ yields either F',@$$
and F&$$ with eA"al
probability
I- we think abo"t this in;est,ent in ter,s o- gains and losses, this
in;est,ent o5ers an eA"al
chance o- gaining F@$$ or loosing FI$$
Sho"ld yo" take the riskO
Tab&e; E-a&#ati', the Ri$ o! a F.)BBB i'-e$tme't
A/ The 6ai'
PayoJ Probabi&ity
V F@$$ ]
F$ ]
+/ The Lo$$
PayoJ Probabi&itie$
F$ ]
% FI$$ ]
De"i(i', i! a ri$ i$ %orth tai',
0ist all the possible o"tco,es or payo5s
.ssign a probability to each possible payo5
4i;ide the payo5s into gains and losses
.sk how ,"ch yo" wo"ld be willing to pay to recei;e the gain
.sk how ,"ch yo" wo"ld be willing to pay to a;oid the loss
I- yo" are willing to pay ,ore to recei;e the gain than to a;oid the loss,
yo" sho"ld take the risk
So#r"e$ o! Ri$
1isk is e;erywhere. It co,es in ,any -or,s and -ro, al,ost e;ery
i,aginable place
1egardless o- the so"rce, risks can be classi7ed as either idiosyncratic or
syste,atic
Idiosyncratic, or "niA"e, risks a5ect only a s,all n",ber o- people.
Syste,atic risks a5ect e;eryone.
In the conte8t o- the entire econo,y,
igher oil prices wo"ld be an idiosyncratic risk and
Changes in general econo,ic conditions wo"ld be syste,atic risk.
Re(#"i', Ri$ thro#,h Di-er$i*"atio'
1isk can be red"ced thro"gh di;ersi7cation, the principle o- holding ,ore
than one risk at a ti,e.
olding se;eral di5erent in;est,ents red"ces the o;erall risk that an
in;estor bears
. co,bination o- risky in;est,ents is o-ten less risky than any one
indi;id"al in;est,ent
+here are two ways to di;ersi-y yo"r in;est,ents6
Uo" can hedge risks or
Uo" can spread the, a,ong the ,any in;est,ents
He(,i', Ri$
edging is the strategy o- red"cing o;erall risk by ,aking two
in;est,ents with opposing risks.
/hen one does poorly, the other does well, and ;ice ;ersa.
So while the payo5 -ro, each in;est,ent is ;olatile, together their
payo5s are stable.
Tab&e; PayoJ$ o' T%o Se7arate I'-e$tme't$ o! F.BB
PayoJ !rom O%'i', O'&y
Po$$ibi&ity A+C E&e"tri" XYM Oi& Probabi&ity
9il price rises F'$$ F'H$ 'PH
9il price -alls F'H$ F'$$ 'PH
0et<s co,pare three strategies -or in;esting F'$$, gi;en the relationships
shown in the table6
In;est F'$$ in .BC Electric
In;est F'$$ in *UY 9il
In;est hal- in each co,pany ? F($ in .BC and F($ in *UY
Tab&e; Re$#&t$ o! Po$$ib&e I'-e$tme't Strate,ie$;
He(,i', Ri$) I'itia& I'-e$tme't L F.BB
I'-e$tme't Strate,y Ex7e"te( PayoJ Sta'(ar( De-iatio'
.BC 9nly F''$ F'$
*UY 9nly F''$ F'$
] and ] F''$ F$
ABCDs
S)are
ABCDs
S)are
I*ios0ncratic Ris(
ABCDs
S)are
S0stematic Ris(
ABCDs s)are o&
eCisting mar(et
s)rin(s
Tota, Automo'i,e mar(et
38
S7rea(i', Ri$
In;est,ents don<t always ,o;e predictably in opposite directions, so yo"
can<t always red"ce risk
thro"gh hedging
Uo" can lower risk by si,ply spreading it aro"nd and 7nding in;est,ents
whose payo5s are
co,pletely "nrelated
+he ,ore independent so"rces o- risk yo" hold the lower yo"r o;erall risk
.dding ,ore and ,ore independent so"rces o- risk red"ces the standard
de;iation "ntil it beco,es
negligible.
Consider three in;est,ent strategies6
a/ .BC Electric only,
b/ EFG So-t only, and
"/ al- in .BC and hal- in EFG
+he e8pected payo5 on each o- these strategies is the sa,e6 F''$.
For the 7rst two strategies, F'$$ in either co,pany, the standard
de;iation is still '$, S"st as it was
be-ore.
B"t -or the third strategy, F($ in .BC and F($ in EFG, the analysis is
,ore co,plicated.
+here are -o"r possible o"tco,es, two -or each stock
Tab&e; PayoJ$ !rom I'-e$ti', F4B i' ea"h o! t%o Sto"$
I'itia& I'-e$tme't L F.BB
Po$$ibi&itie$ A+C EF6 So!t Tota& PayoJ Probabi&ity
a' F)$ F)$ F'H$ b
aH F)$ F($ F''$ b
aI F($ F)$ F''$ b
a@ F($ F($ F'$$ b
Tab&e; Re$#&t$ o! Po$$ib&e I'-e$tme't Strate,ie$;
S7rea(i', Ri$
I'itia& I'-e$tme't L F.BB
I'-e$tme't Strate,y Ex7e"te( PayoJ Sta'(ar( De-iatio'
.BC F''$ F'$
EFG So-t F''$ F'$
] and ] F''$ F&.'
Le$$o' .2
+ONDS & +ONDS PRICIN6
Bond > Bond pricing
Yero Co"pon Bond
Fi8ed !ay,ent 0oan
Co"pon Bonds
Consols
Bond Uield
Uield to Mat"rity
C"rrent Uield
+o'($
3irt"ally any 7nancial arrange,ent in;ol;ing the c"rrent trans-er o-
reso"rces -ro, a lender to a
borrower, with a trans-er back at so,e ti,e in the -"t"re, is a -or, o- bond.
Car loans, ho,e ,ortgages, e;en credit card balances all create a loan
-ro, a 7nancial inter,ediary
to an indi;id"al ,aking a p"rchase
Go;ern,ents and large corporations sell bonds when they need to borrow
+he ease with which indi;id"als, corporations, and go;ern,ents borrow is
essential to the
-"nctioning o- o"r econo,ic syste,.
/itho"t this -ree :ow o- reso"rces thro"gh the bond ,arkets, the
econo,y wo"ld grind to a halt.
istorically, we can trace the concept o- "sing bonds to borrow to
,onarchsN al,ost insatiable
appetite -or reso"rces.
+he 4"tch in;ented ,odern bonds to 7nance their lengthy war o-
independence
+he British re7ned the "se o- bonds to 7nance go;ern,ent acti;ities.
+he practice was soon pop"lar a,ong other co"ntries
. standard bond speci7es the 78ed a,o"nt to be paid and the e8act dates
o- the pay,ents
ow ,"ch sho"ld yo" be paying -or a bondO
+he answer depends on bond<s characteristics
+o'( Pri"e$
Mero>"o#7o' bo'($
!ro,ise a single -"t"re pay,ent, s"ch as a +reas"ry bill.
Fixe( 7ayme't &oa'$
Con;entional ,ortgages.
Car loans
Co#7o' +o'($
Make periodic interest pay,ents and repay the principal at ,at"rity.
+reas"ry Bonds and ,ost corporate bonds are co"pon bonds.
Co'$o&$
Make periodic interest pay,ents -ore;er, ne;er repaying the principal
that was borrowed.
Mero>Co#7o' +o'($
+hese are p"re disco"nt bonds since they sell at a price below their -ace
;al"e
+he di5erence between the selling price and the -ace ;al"e represents the
interest on the bond
+he price o- s"ch a bond, like a +reas"ry bill Bcalled +%billC, is the
present ;al"e o- the -"t"re
pay,ent
!rice o- a F'$$ -ace ;al"e Dero%co"pon bond
:1 i;n
$1!!
+
=
/here
i is the interest rate in deci,al -or, and
n is ti,e "ntil the pay,ent is ,ade in the sa,e ti,e "nits as the interest
rate
Gi;en n, the price o- a bond and the interest rate ,o;e in opposite
directions
+he ,ost co,,on ,at"rity o- a +%bill is ) ,onthsL the +reas"ry does not
iss"e the, with a
,at"rity greater than ' year
+he shorter the ti,e "ntil the pay,ent is ,ade the higher the price o- the
bond, so ) ,onth +%bills
ha;e a higher price that a one%year +%bill
Exam7&e$; .ss",e iJ@E
!rice o- a 9ne%Uear +reas"ry bill
$6215
:1 !2!4;
1!! =
+
=
!rice o- a Si8%Month +reas"ry bill
$82!6
:1 !2!4;
1!!
19 2 =
+
=
+he interest rate and the price -or the +%bill ,o;e in;ersely.
I- we know the -ace ;al"e and the price then we can sol;e -or the interest
rate
Fixe( Payme't Loa'$
+hey pro,ise a 78ed n",ber o- eA"al pay,ents at reg"lar inter;als
o,e ,ortgages and car loans are e8a,ples o- 78ed pay,ent loansL
+hese loans are a,ortiDed, ,eaning that the borrower pays o5 the
principal along with the interest
o;er the li-e o- the loan.
Each pay,ent incl"des both interest and so,e portion o- the principal
+he price o- the loan is the present ;al"e o- all the pay,ents
3al"e o- a Fi8ed !ay,ent 0oan J
Co#7o' +o'(
+he ;al"e o- a co"pon bond is the present ;al"e o- the periodic interest
pay,ents pl"s the present ;al"e o-
the principal repay,ent at ,at"rity
+he latter part, the repay,ent o- the principal, is S"st like a Dero%co"pon
bond.
n i
FixedPaymen
i t
FixedPayment
i
FixedPayment
:1 ; :1 ;2 :1 + ;
+ +
+
+
+
E
CB n i n
FaceValue
i
CouponPayment
i
CouponPayment
i
P CouponPayment
:1 ; :1 ;
222222
:1 ;1 :1 ;2 +
+

+
+ +
+
+
+
=
Co'$o&$
. consol o5ers only periodic interest pay,entsL the borrower ne;er
repays the principal
+here are no pri;ately iss"ed consols beca"se only go;ern,ents can
credibly pro,ise to ,ake
pay,ents -ore;er
+he price o- a consol is the present ;al"e o- all the -"t"re interest
pay,ents, which is a bit
co,plicated beca"se there are an in7nite n",ber o- pay,ents
+o'( Yie&($
#ow that we know how to price a bond while interest rate is knownL we
now ,o;e to other
direction and calc"late the interest rate or ret"rn to an in;estor
So co,bining in-or,ation abo"t the pro,ised pay,ents with the price to
obtain what is called the
yield ? a ,eas"re o- cost o- borrowing or reward -or lending.
Interest rate and yield are "sed interchangeably
Yie&( to Mat#rity
+he ,ost "se-"l ,eas"re o- the ret"rn on holding a bond is called the
yield to ,at"rity BU+MC.
+his is the yield bondholders recei;e i- they hold the bond to its ,at"rity
when the 7nal principal
pay,ent is ,ade
It can be calc"lated -ro, the present ;al"e -or,"la
!rice o- 9ne%Uear ( percent Co"pon Bond J
+he ;al"e o- i that sol;es this eA"ation is the yield to ,at"rity
I- the price o- the bond is F'$$, then the yield to ,at"rity eA"als the
co"pon rate.
Since the price rises as the yield -alls, when the price is abo;e F'$$, the
yield to ,at"rity ,"st be
below the co"pon rate.
Since the price -alls as the yield rises, when the price is below F'$$, the
yield to ,at"rity ,"st be
abo;e the co"pon rate.
Uield to Mat"rity
Considering (E co"pon bond
I- U+M is (E then price is
I- U+M is @E then price is
I- U+M is )E then price is
Generally
I- the yield to ,at"rity eA"als the co"pon rate, the price o- the bond is the
sa,e as its -ace ;al"e.
I- the yield is greater than the co"pon rate, the price is lowerL
I- the yield is below the co"pon rate, the price is greater
$ 1!!
:1 ;
$5
.05
+
+ :1 +.05;
1 $1!!
$1!!
:1 ;
$5
.04
+
+ :1+.04;
1 $1!!26
$ 1!!
:1 ;
$5
.06
+
+ :1+.06;
1 $2!6
42
:1 ;
$1!!
:1 ;
$5
i + i
+
+
Le$$o' .3
YIELD TO MAT0RIRY
Uield to Mat"rity
C"rrent Uield
olding !eriod 1et"rns
Bond S"pply > 4e,and
Factors a5ecting Bond S"pply
Factors a5ecting Bond 4e,and
Yie&( to Mat#rity; 6e'era& Re&atio'$hi7$
General 1elationships
I- the yield to ,at"rity eA"als the co"pon rate, the price o- the bond is the
sa,e as its -ace ;al"e.
I- the yield is greater than the co"pon rate, the price is lowerL
i- the yield is below the co"pon rate, the price is greater
I- yo" b"y a bond at a price less than its -ace ;al"e yo" will recei;e its
interest and a capital gain,
which is the di5erence between the price and the -ace ;al"e.
.s a res"lt yo" ha;e a higher ret"rn than the co"pon rate
/hen the price is abo;e the -ace ;al"e, the bondholder inc"rs a capital
loss and the bond<s yield to
,at"rity -alls below its co"pon rate.
Tab&e; Re&atio'$hi7 bet%ee' Pri"e a'( Yie&( to Mat#rity
YTM o' a .BI Co#7o' rate bo'( mat#ri', i' te' year$ ?Fa"e Va&#e L
F.)BBB:
Pri"e o! +o'( ?F: Yie&( to Mat#rity ?I:
',H$$ &.'I
','$$ G.@G
',$$$ '$.$$
Q$$ ''.&(
G$$ 'I.G'
Three I'tere$ti', Fa"t$ i' the abo-e Tab&e
./ /hen bond is at par, yield eA"als co"pon rate
1/ !rice and yield are negati;ely related
2/ Uield greater than co"pon rate when bond price is below par ;al"e
C#rre't Yie&(
C"rrent yield is a co,,only "sed, easy%to%co,p"te ,eas"re o- the
proceeds the bondholder
recei;es -or ,aking a loan
It is the yearly co"pon pay,ent di;ided by the price
+he c"rrent yield ,eas"res that part o- the ret"rn -ro, b"ying the bond
that arises solely -ro, the
co"pon pay,entsL
It ignores the capital gain or loss that arises when the bond<s price di5ers
-ro, its -ace ;al"e
0et<s ret"rn to '%year (E co"pon bond ass",ing that it is selling -or FQQ.
C"rrent yield is (PQQ J $.$($( or (.$(E
U+M -or this bond is calc"lated to be ).$)E thro"gh the -ollowing
calc"lations
I- yo" b"y the bond -or FQQ, one year later yo" get not only the F( co"pon
pay,ent b"t also a
g"aranteed F' capital gain, totaling to F)
:1 ;
$1!!
:1 ;
$5
i + i
+
+
1 $
43
-rice -ai*
Current $ie,* = $ear,0 Coupon -a0ment
1epeating this process -or the bond selling -or F'$', c"rrent yield is
@.Q(E and U+M is I.Q)E
+he c"rrent yield ,o;es in;ersely to the priceL
I- the price is abo;e the -ace ;al"e, the c"rrent yield -alls below the
co"pon rate.
/hen the price -alls below the -ace ;al"e, the c"rrent yield rises abo;e
the co"pon rate.
I- the price and the -ace ;al"e are eA"al the c"rrent yield and the co"pon
rate are eA"al.
Since the yield to ,at"rity takes acco"nt o- capital gains Band lossesC,
/hen the bond price is less than its -ace ;al"e the yield to ,at"rity is
higher than the c"rrent yield,
I- the price is greater than -ace ;al"e, the yield to ,at"rity is lower than
the c"rrent yield, which is
lower than the co"pon rate
1elationship between a Bond<s !rice and its Co"pon 1ate, C"rrent Uield and
Uield to Mat"rity
Bond !rice c Face 3al"e6
Co"pon 1ate c C"rrent Uield c Uield to Mat"rity
Bond !rice J Face 3al"e6
Co"pon 1ate J C"rrent Uield J Uield to Mat"rity
Bond !rice K Face 3al"e6
Co"pon 1ate K C"rrent Uield K Uield to Mat"rity
Ho&(i', Perio( Ret#r'$
+he in;estor<s ret"rn -ro, holding a bond need not be the co"pon rate
Most holders o- long%ter, bonds plan to sell the, well be-ore they
,at"re, and beca"se the price
o- the bond ,ay change in the ti,e since its p"rchase, the ret"rn can di5er
-ro, the yield to
,at"rity
+he holding period ret"rn ? the ret"rn to holding a bond and selling it
be-ore ,at"rity.
+he holding period ret"rn can di5er -ro, the yield to ,at"rity
+he longer the ter, o- the bond, the greater the price ,o;e,ents and
associated risk can be
Exam7&e$;
Uo" pay -or F'$$ -or a '$%year )E co"pon bond with a -ace ;al"e o- F'$$,
yo" intend to hold the
bond -or one year, i.e. b"y a '$ year bond and sell a Q year bond an year
later
I- interest rate does not change yo"r ret"rn will be F)P'$$ J $.$) J )E
I- interest rate -alls to (E o;er the year then thro"gh "sing bond pricing
-or,"la we can see that
Uo" bo"ght a '$%year bond -or F'$$ and sold a Q%year bond -or F'$&.''
#ow the one year holding ret"rn has two parts
F) co"pon pay,ent and
F&.'' capital gain
So now, one year holding !eriod ret"rn J
9r 'I.''E
I- the interest rate in one year is &E...
1312 1
$1!!
$13211
$1!!
$1!7211 $1!!
$1!!
$6 + = =
9ne year holding !eriod ret"rn J
9r %$.(HE
GeneraliDing, '%year holding ret"rn is
+o'( Maret a'( I'tere$t Rate$
+o 7nd o"t how bond prices are deter,ined and why they change we need
to look at the s"pply
and de,and in the bond ,arket.
0et<s consider the ,arket -or e8isting bonds at a partic"lar ti,e Bthe
stock o- bondsC and consider
prices and not interest rates.
9ne Uear Yero%co"pon Bdisco"ntC Bond
+o'( S#77&y) Dema'( a'( E8#i&ibri#m
+o'( S#77&y
+he Bond s"pply c"r;e is the relationship between the price and the
A"antity o- bonds people are
willing to sell, all other things being eA"al.
Fro, the point o- ;iew o- in;estors, the higher the price, the ,ore
te,pting it is to sell a bond they
c"rrently hold.
Fro, the point o- ;iew o- co,panies seeking 7nance -or new proSects, the
higher the price at
which they can sell bonds, the ,ore ad;antageo"s it is to do so.
For a F'$$ one%year Dero%co"pon bond, the s"pply will be higher at FQ(
than it will be at FQ$, all
other things being eA"al.
+o'( Dema'(
+he bond de,and c"r;e is the relationship between the price and
A"antity o- bonds that in;estors
de,and, all other things being eA"al.
.s the price -alls, the reward -or holding the bond rises, so the de,and
goes "p
+he lower the price potential bondholders ,"st pay -or a 78ed%dollar
pay,ent on a -"t"re date, the
,ore likely they are to b"y a bond
+he Dero%co"pon bond pro,ising to pay F'$$ in one year will be ,ore
attracti;e at FQ$ than it will
at FQ(, all other things being eA"al.
2!!52
$1!!
$252
$1!!
$3248 $1!!
$1!!
$6 + = =
-rice o& t)e Bon*
C)ange in -rice o& t)e Bon*
-rice -ai*
= $ear,0 Coupon -a0ment +
= Current $ie,* + Capita, .ain :as a %;
-
or i $1!! -
1 i
- $1!! =
+
=
Fi,#re; S#77&y) (ema'( a'( e8#i&ibri#m i' the bo'( maret
EA"ilibri", in the bond ,arket is the point at which s"pply eA"als
de,and.
I- the price is too high Babo;e eA"ilibri",C the e8cess s"pply o- bonds will
p"sh the price back
down.
I- the price is too low Bbelow eA"ilibri",C the e8cess de,and -or bonds
will p"sh it "p
9;er ti,e the s"pply and de,and c"r;es can shi-t, leading to changes in
the eA"ilibri", price
Fa"tor$ that $hi!t +o'( S#77&y
Cha',e$ i' ,o-er'me't borro%i',
.ny increase in the go;ern,ent<s borrowing needs increases the A"antity
o- bonds o"tstanding,
shi-ting the bond s"pply c"r;e to the right.
+his red"ces price and increases the interest rate on the bond.
Cha',e$ i' b#$i'e$$ "o'(itio'$
B"siness%cycle e8pansions ,ean ,ore in;est,ent opport"nities,
pro,pting 7r,s to increase their
borrowing and increasing the s"pply o- bonds
.s b"siness conditions i,pro;e, the bond s"pply c"r;e shi-ts to the right.
By the sa,e logic, weak econo,ic growth can lead to rising bond prices
and lower interest rates
Cha',e$ i' ex7e"te( i'Gatio'
Bond iss"ers care abo"t the real cost o- borrowing,
So i- in:ation is e8pected to increase then the real cost -alls and the
desire to borrow rises, res"lting
in the bond s"pply c"r;e shi-ting to the right
Tab&e; Fa"tor$ that i'"rea$e +o'( S#77&y) &o%er +o'( Pri"e$) a'(
Rai$e I'tere$t Rate$
Cha',e EJe"t o' +o'( S#77&y) +o'( Pri"e$) a'(
I'tere$t Rate$
.n increase in the go;ern,ent<s desired e8pendit"re
relati;e to its re;en"e
Bond S"pply shi-ts to the right, Bond prices
decrease and interest rates increase
.n i,pro;e,ent in general b"siness conditions Bond S"pply shi-ts to the
right, Bond prices
.n increase in e8pected in:ation, red"cing the real
cost o- repay,ent
Bond S"pply shi-ts to the right, Bond prices
+he s"pply o- bonds -ro,
the borrowers slopes "p
and the de,and -or bonds
-ro, the lenders slopes
down. EA"ilibri", in the
bond ,arket is deter,ined
by the interaction o-
s"pply and de,and.
S
D
>
Fuantit0 o&
Bon*s
-rice o& Bon*s
Fo
-o
46
Fi,#re; A $hi!t i' the $#77&y o! bo'($
Fa"tor$ that $hi!t +o'( Dema'(
<ea&th
.n increase in wealth shi-ts the de,and -or bonds to the right as
wealthier people in;est ,ore.
+his will happen as the econo,y grows d"ring an e8pansion.
+his will increase Bond !rices and lower yields.
Ex7e"te( i'Gatio'
. -all in e8pected in:ation shi-ts the bond de,and c"r;e to the right,
increasing de,and at each
price and lowering the yield and increasing the Bond<s price.
Ex7e"te( ret#r' o' $to"$ a'( other a$$et$
I- the ret"rn on bonds rises relati;e to the ret"rn on alternati;e
in;est,ents, the de,and -or bonds
will rise.
+his will increase bond prices and lower yields.
Ri$ re&ati-e to a&ter'ati-e$
I- a bond beco,es less risky relati;e to alternati;e in;est,ents, the
de,and -or the bond shi-ts to
the right.
Li8#i(ity o! bo'($ re&ati-e to a&ter'ati-e$
/hen a bond beco,es ,ore liA"id relati;e to alternati;es, the de,and
c"r;e shi-ts to the right
Tab&e; Fa"tor$ that i'"rea$e +o'( (ema'() rai$e +o'( Pri"e$) a'(
&o%er I'tere$t Rate$
Cha',e EJe"t o' +o'( (ema'(
.n increase in wealth increases de,and -or all assets,
incl"ding bonds
Bond de,and shi-ts to the right, Bond prices
increase and interest rates decrease
. red"ction in e8pected in:ation ,akes bonds with 78ed
no,inal pay,ents ,ore desirable
.n increase in e8pected ret"rn on the bond relati;e to the
e8pected ret"rn on alternati;es ,akes bonds ,ore
attracti;e
. decrease in the e8pected -"t"re interest rate ,akes
bonds ,ore attracti;e
. -all in the riskiness o- the bond relati;e to the riskiness
o- alternati;es ,akes bonds ,ore attracti;e.
.n increase in the liA"idity o- the bond relati;e to the
liA"idity o- alternati;es ,akes bonds ,ore attracti;e
/hen borrower<s desire -or
-"nds increases, the bond
s"pply c"r;e shi-ts to the right,
lowering bond prices and
raising interest rates.
So
D
>o
Fuantit0 o&
Bon*s
-rice o& Bon*s
Fo
-
S1
-
>1
47
Fi,#re; A $hi!t i' +o'( Dema'(
/hen there is an increase in
in;estor<s willingness to hold
bonds, the bond de,and c"r;e
shi-ts to the right, increasing bond
prices and red"cing interest rates.
S
Do
>o
Fuantit0 o& Bon*s
-rice o& Bon*s
Fo
D1
>1
-1
-o
48
Le$$o' .4
SHIFTS IN EN0ILI+RI0M IN THE +OND MAR5ET & RIS5
Shi-ts in EA"ilibri", in bond ,arket
Bond and 1isk
4e-a"lt 1isk
In:ation 1isk
Interest 1ate 1isk
Shi!t$ i' E8#i&ibri#m
A' i'"rea$e i' ex7e"te( i'Gatio';
.n increase in e8pected in:ation shi-ts bond s"pply to the right and bond
de,and to the le-t.
+he two e5ects rein-orce each other, res"lting in a lower bond price and a
higher interest rate
Fi,#re; EJe"t o! a' i'"rea$e i' ex7e"te( i'Gatio'
A b#$i'e$$>"y"&e (o%'t#r';
. b"siness%cycle downt"rn shi-ts the bond s"pply to the le-t and the bond
de,and to the le-t.
In this case the bond price can rise or -all, depending on which shi-t is
greater.
B"t interest rates tend to -all in recessions, so bond prices are likely to
increase
So
S1
Do
D1
>o
>1
-o
-1
Fuantit0 o& Bon*s
-rice o& Bon*s
4
Fi,#re; EJe"t o! a b#$i'e$$ "y"&e (o%' t#r'
+o'($ a'( Ri$
So#r"e$ o! +o'( Ri$
4e-a"lt 1isk
In:ation 1isk
Interest%1ate 1isk
S1
So
Do
D1
>o
>1
-o
-1
Fuantit0 o& Bon*s
-rice o& Bon*s
5!
Le$$o' .@
+ONDS & SO0RCES OF +OND RIS5
Bonds and 1isk
4e-a"lt 1isk
In:ation 1isk
Interest 1ate 1isk
Bond 1atings
Bond 1atings and 1isk
+a8 E5ect
+o'($ a'( Ri$
So#r"e$ o! +o'( Ri$
4e-a"lt 1isk
In:ation 1isk
Interest%1ate 1isk
De!a#&t Ri$
+here is no g"arantee that a bond iss"er will ,ake the pro,ised
pay,ents
In;estors who are risk a;erse reA"ire so,e co,pensation -or bearing
riskL the ,ore risk, the ,ore
co,pensation they de,and
+he higher the de-a"lt risk the higher the probability that bondholders
will not recei;e the
pro,ised pay,ents and th"s, the higher the yield
S"ppose risk%-ree rate is (E
YE4E* Corp. iss"es one%year bond at (E
!rice witho"t risk J BF'$$ V F(CP'.$( J F'$$
S"ppose there is '$E probability that YE4E* Corp. goes bankr"pt, get
nothing
+wo possible payo5s6 F'$( and F$
Tab&e; Ex7e"te( Va&#e o! MEDEX +o'( Payme't
Po$$ibi&itie$ PayoJ Probabi&ity PayoJ K Probabi&itie$
F"ll !ay,ent F'$( $.Q$ FQ@.($
de-a"lt F$ $.'$ F$
Ex7e"te( Va&#eL S#m o! PayoJ$ time$ Probabi&itie$ L FE3/4B
E8pected !3 o- YE4E* bond pay,ent J FQ@.(P'.$( J FQ$
I- the pro,ised pay,ent is F'$(, U+M will be F'$(PQ$ ? ' J $.'))& or
').)&E
4e-a"lt risk pre,i", J ').)&E % (E J ''.)&E
I'Gatio' Ri$
Bonds pro,ise to ,ake 78ed%dollar pay,ents, and bondholders are
concerned abo"t the
p"rchasing power o- those pay,ents
+he no,inal interest rate will be eA"al to the real interest rate pl"s the
e8pected in:ation rate pl"s
the co,pensation -or in:ation risk
+he greater the in:ation risk, the larger will be the co,pensation -or it
.ss",ing real interest rate is IE with the -ollowing in-or,ation
Probabi&itie$
I'Gatio' Ca$e I Ca$e II Ca$e III
'E $.($ $.H( $.'$
HE % $.($ $.G$
IE $.($ $.H( $.'$
E8pected In:ation HE HE HE
Standard 4e;iation '.$E $.&'E $.@(E
#o,inal rate J IE real rate V HE e8pected in:ation V co,pensation -or
in:ation risk
I'tere$t>Rate Ri$
Interest%rate risk arises -ro, the -act that in;estors don<t know the
holding period yield o- a longter,
bond.
I- yo" ha;e a short in;est,ent horiDon and b"y a long%ter, bond yo" will
ha;e to sell it be-ore it
,at"res, and so yo" ,"st worry abo"t what happens i- interest rates change
Beca"se the price o- long%ter, bonds can change dra,atically, this can be
an i,portant so"rce o-
risk
+o'( Rati',$
+he risk o- de-a"lt Bi.e., that a bond iss"er will -ail to ,ake a bond<s
pro,ised pay,entsC is one o-
the ,ost i,portant risks a bondholder -aces, and it ;aries a,ong iss"ers.
Credit rating agencies ha;e co,e into e8istence to assess the de-a"lt risk
o- di5erent iss"ers
+he bond ratings are an assess,ent o- the creditworthiness o- the
corporate iss"er.
+he de7nitions o- creditworthiness "sed by the rating agencies are based
on how likely the iss"er
7r, is to de-a"lt and the protection creditors ha;e in the e;ent o- a de-a"lt.
+hese ratings are concerned only with the possibility o- the de-a"lt. Since
they do not address the
iss"e o- interest rate risk, the price o- a highly rated bond ,ay be A"ite
;olatile.
Lo', Term Rati',$ by PACRA
I'-e$tme't 6ra(e$;
AAA; ighest credit A"ality. d...< ratings denote the lowest e8pectation
o- credit risk.
AA; 3ery high credit A"ality. d..< ratings denote a ;ery low e8pectation o-
credit risk.
A; igh credit A"ality. d.< ratings denote a low e8pectation o- credit risk.
+++; Good credit A"ality. dBBB< ratings indicate that there is c"rrently a
low e8pectation o- credit
risk.
S7e"#&ati-e 6ra(e$;
++; Spec"lati;e.
O++P ratings indicate that there is a possibility o- credit risk de;eloping,
+; ighly spec"lati;e. dB< ratings indicate that signi7cant credit risk is
present, b"t a li,ited ,argin
o- sa-ety re,ains.
CCC) CC) C; igh de-a"lt risk. 4e-a"lt is a real possibility.
Short Term Rati',$ by PACRA
A.Q; highest capacity -or ti,ely repay,ent
A.6 Strong capacity -or ti,ely repay,ent
A16 satis-actory capacity -or ti,ely repay,ent ,ay be s"sceptible to
ad;erse econo,ic conditions
A26 an adeA"ate capacity -or ti,ely repay,ent. More s"sceptible to
ad;erse econo,ic condition
+6 ti,ely repay,ent is s"sceptible to ad;erse changes in b"siness,
econo,ic, or 7nancial conditions
C6 an inadeA"ate capacity to ens"re ti,ely repay,ent
D6 high risk o- de-a"lt or which are c"rrently in de-a"lt
+o'( Rati',$ a'( Ri$
+o'( Rati',$
Moody<s and Standard > !oor<s
Rati',$ 6ro#7$
In;est,ent Grade
#on%In;est,ent ? Spec"lati;e Grade
ighly Spec"lati;e
Commer"ia& Pa7er Rati',$
Moody<s and Standard > !oor<s
Rati', 6ro#7$
In;est,ent
Spec"lati;e
4e-a"lt
+o'( ?Cre(it: Rati',$
S & P Moo(yP$ <hat it mea'$
... .aa ighest A"ality and credit worthiness
.. .a Slightly less likely to pay principal V interest
. . Strong capacity to ,ake pay,ents, "pper ,edi", grades
BBB Baa Medi", grade, adeA"ate capacity to ,ake pay,ents
BB Ba Moderate ability to pay, spec"lati;e ele,ent, ;"lnerable
B B #ot desirable in;est,ent, long ter, pay,ent do"bt-"l
CCC Caa !oor standing, known ;"lnerabilities, do"bt-"l pay,ent
CC Ca ighly spec"lati;e, high de-a"lt likelihood, known reasons
C C 0owest rated class, ,ost "nlikely to reach in;est,ent grades
4 .lready de-a"lted on pay,ents
#1 #o p"blic rating has been reA"ested
V 9r % >', H, I /ithin%class re7ne,ent o- .. to CCC ratings
+he lower a bond<s rating the lower its price and the higher its yield.
Fi,#re; The eJe"t o! a' i'"rea$e i' ri$ o' e8#i&ibri#m i' the bo'(
maret
I'"rea$e( Ri$ re(#"e$ +o'( Dema'(
+he res"lting shi-t to the le-t ca"ses a decline in eA"ilibri", price and an
increase in the bond yield.
. bond yield can be tho"ght o- as the s", o- two parts6
+he yield on the +reas"ry bond Bcalled bench,ark bonds beca"se they
are close to being risk-reeC
and
. risk spread or de-a"lt risk pre,i",
I- the bond ratings properly re:ect the probability o- de-a"lt, then lower
the rating o- the iss"er, the
higher the de-a"lt risk pre,i",
So we ,ay concl"de that when +reas"ry bond yields change, all other
yields will change in the sa,e
direction
Increased risk red"ces the de,and -or
the bond at e;ery price, shi-ting the
de,and c"r;e to the le-t -ro, 4o to
4'. +he res"lt is a decline in the
eA"ilibri", price and A"antity in the
,arket. I,portantly, the price -alls
-ro, !o to !', so the yield on the
bond ,"st rise.
S
Do
D1
-o
-1
>o
>1
Fuantit0 o& Bon*s
-rice o& Bon*s
54
Le$$o' .C
TAX EFFECT & TERM STR0CT0RE OF INTEREST RATE
+a8 E5ect
+er, Str"ct"re o- Interest 1ate
E8pectations ypothesis
0iA"idity !re,i",
Tax EJe"t
+he second i,portant -actor that a5ects the ret"rn on a bond is ta8es
Bondholders ,"st pay inco,e ta8 on the interest inco,e they recei;e
-ro, pri;ately iss"ed bonds
Bta8able bondsC, b"t go;ern,ent bonds are treated di5erently
Interest pay,ents on bonds iss"ed by state and local go;ern,ents, called
,"nicipal or ta8e8e,pt
bonds are speci7cally e8e,pt -ro, ta8ation
. ta8 e8e,ption a5ects a bond<s yield beca"se it a5ects how ,"ch o- the
ret"rn the bondholder
gets to keep
+a8%E8e,pt Bond Uield J B+a8able Bond UieldC 8 B'% +a8 1ateC.
Term Str#"t#re o! I'tere$t Rate$
+he relationship a,ong bonds with the sa,e risk characteristics b"t
di5erent ,at"rities is called
the ter, str"ct"re o- interest rates.
. plot o- the ter, str"ct"re, with the yield to ,at"rity on the ;ertical a8is
and the ti,e to ,at"rity
on the horiDontal a8is, is called the yield c"r;e.
Fi,#re; The 0/S/ Trea$#ry Yie&( C#r-e
+he 7g"re plots the
yields on +reas"ry
bills and bonds -or
."g"st H&, H$$@.
! 1 3 6 2 5 1! 3!
12!
22!
32!
42!
52!
62!%
GGGGGGGG #aturit0GGGGGGGG
$T# o& current 'i,,s= notes an* 'on*s
GGG$ester*a0
GGG1 mont) ago
GGG1 0ear ago
#ont)s $ears
55
Fi,#re; The Term Str#"t#re o! Trea$#ry I'tere$t Rate$
Term Str#"t#re RFa"t$S
Interest 1ates o- di5erent ,at"rities tend to ,o;e together
Uields on short%ter, bond are ,ore ;olatile than yields on long%ter,
bonds
0ong%ter, yields tend to be higher than short%ter, yields.
Ex7e"tatio'$ Hy7othe$i$
+he risk%-ree interest rate can be co,p"ted, ass",ing that there is no
"ncertainty abo"t the -"t"re
Since certainty ,eans that bonds o- di5erent ,at"rities are per-ect
s"bstit"tes -or each other, an
in;estor wo"ld be indi5erent between holding
. two%year bond or
. series o- two one%year bonds
Certainty ,eans that bonds o- di5erent ,at"rities are per-ect s"bstit"tes
-or each other
.ss",ing that c"rrent '%year interest rate is (E. +he e8pectations
hypothesis i,plies that the
c"rrent H%year interest rate sho"ld eA"al the a;erage o- (E and '%year
interest rate one year in
-"t"re.
I- -"t"re interest rate is &E, then c"rrent H%year interest rate will be
B(V&C P H J )E
+here-ore, when interest rates are e8pected to rise long%ter, rates will
be higher than short%ter,
rates and the yield c"r;e will slope "p Band ;ice ;ersaC
117
5
17 183 187 11
4
!
8
1!
2
12
14
15 1 2!!171 3
6
16
18
$ie,* :%;
GGG3 mont)s T2Bi,,sGGGGG1! 0ears T"Bon*s
56
Fi,#re; Yie&( C#r-e
Fro, this we can constr"ct in;est,ent strategies that ,"st ha;e the
sa,e yield.
.ss",ing the in;estor has a two%year horiDon, the in;estor can6
In;est in a two%year bond and hold it to ,at"rity
Interest rate will be iHy
In;est,ent will yield B' V iHyC B' V iHyC two years later
In;est in a one%year bond today and a second one a year -ro, now when
the 7rst one ,at"res
Interest rate will be ie
yV'
In;est,ent will yield B' V i'yC B' V ie
yV'C in two years
+he hypothesis tells "s that in;estors will be indi5erent between the two
strategies, so the strategies
,"st ha;e the sa,e ret"rn
+otal ret"rn -ro, H year bonds o;er H years
1et"rn -ro, one year bond and then another one year bond
I- one and two year bonds are per-ect s"bstit"tes, then6
9r
Time to maturit0
$ie,* to maturit0
$ie,* curve 7)en interest rates are eCpecte* to
rise
57
:1 i ;:1 i ; 20 20 + +
:1 i ;:1 i ; :1 i ;:1 e ;
20 20 10 10 + + = + +
2
i i
i
2
10 10
20
+
=
:1 i ;:1 ie ;
10 10 + +
9r in general ter,s
+here-ore the rate on the two%year bond ,"st be the a;erage o- the
c"rrent one%year rate and the
e8pected -"t"re one%year rate
I,plications wo"ld be the sa,e old
Interest rates o- di5erent ,at"rities tend to ,o;e together.
Uields on short%ter, bonds are ,ore ;olatile than those on long%ter,
bonds.
0ong%ter, yields tend to be higher than short%ter, yields
owe;er, e8pectations theory can not e8plain why long%ter, rates are
"s"ally abo;e short ter,
rates
In order to e8plain why the yield c"r;e nor,ally slopes "pward, we need
to e8tend the hypothesis
to incl"de risk
n
i i i i i
e
t n
e
t
e
t t
nt
1 1 1 1 2 1 1 2222 + + + = + + + +
Le$$o' .D
THE LIN0IDITY PREMI0M THEORY
Bonds
0iA"idity !re,i", +heory
Stocks
Essential Characteristics
!rocess
Meas"ring 0e;el o- a Stock Market
3al"ing Stocks
The Li8#i(ity Premi#m Theory
1isk is the key to "nderstanding the slope o- the yield c"r;e
+he yield c"r;e<s "pward slope is d"e to long%ter, bonds being riskier
than short%ter, bonds
Bondholders -ace both in:ation and interest%rate. +he longer the ter,
the greater the in:ation
and interest%rate risk
In:ation risk increases o;er ti,e beca"se in;estors, who care abo"t the
real ret"rn, ,"st
-orecast in:ation o;er longer periods.
Interest%rate risk arises when an in;estor<s horiDon and the bond<s
,at"rity do not ,atch. I-
holders o- long%ter, bonds need to sell the, be-ore ,at"rity and interest
rates ha;e increased,
the bonds will lose ;al"e
Incl"ding risk in the ,odel ,eans that we can think o- yield as ha;ing two
parts6
1isk%-ree and
1isk pre,i",
Fi,#re; Re&atio'$hi7 bet%ee' the Li8#i(ity Premi#m a'(
Ex7e"tatio'$ Theorie$
Ri$ 7remi#m P#re ex7e"tatio'$ theory
Time to maturit0
Interest rate
>Cpectations T)eor0 $ie,* curve
:I& s)ort term interest rates are eCpecte* to remain
constant;
8iHui*it0
premium
8iHui*it0 -remium T)eor0 $ie,* curve
5
n
i rp i i i i
e
t n
e
t
e
t t
nt n
1 1 1 1 2 1 1 2222 + + + = + + + + +
.gain, we arri;e at the sa,e three concl"sions abo"t the ter, str"ct"re
o- interest rates
Interest rates o- di5erent ,at"rities tend to ,o;e together.
Uields on short%ter, bonds are ,ore ;olatile than those on long%ter,
bonds.
0ong%ter, yields tend to be higher than short%ter, yields
Sto"$; A' I'tro(#"tio'
Stocks pro;ide a key instr",ent -or holding personal wealth as well as a
way to di;ersi-y, spreading
and red"cing the risks that we -ace
For co,panies, they are one o- se;eral ways to obtain 7nancing.
.dditionally,
Stocks and stock ,arkets are one o- the central links between the
7nancial world and the real
econo,y.
Stock prices are -"nda,ental to the -"nctioning o- a ,arket%based
econo,y
+hey indicate the ;al"e o- the co,panies that iss"ed the stocks and,
+hey allocate scarce in;est,ent reso"rces
+he 7r,s dee,ed ,ost ;al"able in the ,arketplace -or stocks are the
ones that will be able to
obtain 7nancing -or growth. /hen reso"rces :ow to their ,ost ;al"ed "ses,
the econo,y operates
,ore e5iciently
Most people see stock ,arket as a place where -ort"nes are easily ,ade
or lost, and they recoil at its
"n-atho,able boo,s and b"sts.
Great .,erican 4epression B'QHQC
!ost%Septe,ber '', H$$' scenario
!akistan stock ,arket on roller%coaster%ride BMarch H$$(C
/hat happens in realityO
Stock prices tend to rise steadily and slowly, and
Collapse rarely when nor,al ,arket ,echanis,s are o"t o- align,ent
For ,ost people the e8perience o- losing or gaining wealth s"ddenly is
,ore ,e,orable than the
e8perience o- ,aking it grad"ally.
By being preocc"pied with the potential short%ter, losses associated
with crashes, we lose sight o-
the gains we co"ld realiDe i- we took a longer%ter, ;iew
E$$e'tia& Chara"teri$ti"$ o! Commo' Sto"
Stocks, also known as co,,on stock or eA"ity, are shares in a 7r,<s
ownership
Fro, their early days, stocks had two i,portant characteristics that today
are taken -or granted6
+he shares are iss"ed in s,all deno,inations and
+he shares are trans-erable
2ntil recently, stockowners recei;ed a certi7cate -ro, the iss"ing
co,pany, b"t now it is a
co,p"teriDed process where the shares are registered in the na,es o-
brokerage 7r,s that hold
the, on the owner<s behal-
+he ownership o- co,,on stock con;eys a n",ber o- rights
. stockholder is entitled to participate in the shares o- the enterprise, b"t
this is a resid"al clai, i.e.
,eaning the le-to;ers a-ter all other creditors ha;e been paid.
Stockholders also ha;e li,ited liability,
E;en i- a co,pany -ails, the ,a8i,", a,o"nt that the stockholder can
lose is the initial
in;est,ent
Stockholders are entitled to ;ote at the 7r,<s ann"al ,eeting incl"ding
;oting to elect Bor re,o;eC
the 7r,<s board o- directors
Following are so,e salient -eat"res o- stock trading
./ .n indi;id"al share represents only a s,all -raction o- the ;al"e o- the
co,pany that iss"ed
it
1/ . large n",ber o- shares are o"tstanding
2/ !rices o- indi;id"al shares are low, allowing indi;id"als to ,ake relati;ely
s,all
in;est,ents
3/ .s resid"al clai,ants, stockholders recei;e the proceeds o- a 7r,<s
acti;ities only a-ter all
other creditors ha;e been paid
4/ Beca"se o- li,ited liability, in;estor<s losses cannot e8ceed the price they
paid -or the
stockL and
@/ Shareholders can replace ,anagers who are doing a bad Sob
Mea$#ri', the Le-e& o! the Sto" Maret
Stocks are one way in which we choose to hold o"r wealth, so when stock
;al"es rise we get richer
and when they -all we get poorer
+hese changes a5ect o"r cons",ption and sa;ing patterns, ca"sing
general econo,ic acti;ity to
:"ct"ate
/e need to "nderstand the dyna,ics o- the stock ,arket, in order to
Manage o"r personal 7nances and
See the connections between stock ;al"es and econo,ic conditions
Stock ,arket inde8es
4esigned to gi;e "s a sense o- the e8tent to which stock prices are going
"p or down
+ell "s both how ,"ch the ;al"e o- an a;erage stock has changed, and
how ,"ch total wealth has
gone "p or down
!ro;ide bench,arks -or per-or,ance o- ,oney ,anagers, co,paring how
they ha;e done to the
,arket as a whole
E;ery ,aSor co"ntry in the world has a stock ,arket, and each o- these
,arkets has an inde8
For the ,ost part, these are ;al"e%weighted indices
+o analyDe the per-or,ance o- these di5erent ,arkets it is "se-"l to look
at percentage changes,
b"t percentage change isn<t e;erything
+he 4ow Mones Ind"strial .;erage
+he Standard > !oorNs ($$ Inde8
#.S4.e Co,posite inde8
Financial +i,es Stock E8change '$$ Inde8
ang Seng '$$
#ikkei HH(
XSE '$$ Inde8
+he XSE'$$
It contains a representati;e sa,ple o- co,,on stock that trade on the
Xarachi Stock E8change.
+he XSE stocks that co,prise the inde8 ha;e a total ,arket ;al"e o-
aro"nd 1s. ','Q& Billion
co,pared to total ,arket ;al"e o- 1s. ',I)( Billion -or o;er )&Q stocks listed
on the Xarachi Stock
E8change.
+his ,eans that the XSE'$$ Inde8 represents GG percent o- the total
,arket capitaliDation o- the
Xarachi Stock E8change, as o- Febr"ary, H$$@
Le$$o' .E
VAL0IN6 STOC5S
3al"ing Stocks
F"nda,ental 3al"e and 4i;idend 4isco"nt Model
1isk and 3al"e o- Stocks
Va&#i', Sto"$
!eople di5er in their opinions o- how stocks sho"ld be ;al"ed
Chartists belie;e that they can predict changes in a stock<s price by
looking at patterns in its past
price ,o;e,ents
Beha;ioralists esti,ate the ;al"e o- stocks based on their perceptions o-
in;estor psychology and
beha;ior
9thers esti,ate stock ;al"es based on a detailed st"dy o- the
-"nda,entals, which can be analyDed
by e8a,ining the 7r,<s 7nancial state,ents.
In this ;iew the ;al"e o- a 7r,<s stock depends both on its c"rrent assets
and esti,ates o- its -"t"re
pro7tability
+he -"nda,ental ;al"e o- stocks can be -o"nd by "sing the present ;al"e
-or,"la to assess how
,"ch the pro,ised pay,ents are worth, and then adS"sting to allow -or risk
Chartists and Beha;ioralists -oc"s instead on esti,ates o- the de;iation o-
stock prices -ro, those
-"nda,ental ;al"es
F#'(ame'ta& Va&#e a'( the Di-i(e'(>Di$"o#'t Mo(e&
.s with all 7nancial instr",ents, a stock represents a pro,ise to ,ake
,onetary pay,ents on
-"t"re dates, "nder certain circ",stances
/ith stocks the pay,ents are in the -or, o- di;idends, or distrib"tions o-
the 7r,<s pro7ts
+he price o- a stock today is eA"al to the present ;al"e o- the pay,ents
the in;estor will recei;e
-ro, holding the stock
+his is eA"al to
+he selling price o- the stock in one year<s ti,e pl"s
+he di;idend pay,ent recei;ed in the interi,
+h"s the c"rrent price is the present ;al"e o- ne8t year<s price pl"s the
di;idend
I- !today is the p"rchase price o- stock, !ne8t year is the sales price one year
later and 4ne8t year is the siDe
o- the di;idend pay,ent, we can say6
/hat i- in;estor plans to hold stock -or two yearsO
GeneraliDing -or n years6
Next yeanext year r
today i
P
i
P = D:1 + ; + :1 + ;
next year In two
today i
P
i
D
P
:1 ; :1 + ;2
+
+
= In two
i
D
:1 ;2
+
+
62
n
n years rom now
n
n years rom now
next year in two years
today
i
P
i
D
i
D
i
D
P
:1 ; :1 ;
22222
:1 ; :1 ;
G G G G G G
2
G G G
+
+
+
+ +
+
+
+
=
I- a stock does not pay di;idends the calc"lation can still be per-or,edL a
;al"e o- Dero is "sed -or
the di;idend pay,ents
F"t"re di;idend pay,ents can be esti,ated ass",ing that c"rrent
di;idends will grow at a constant
rate o- g per year.
For ,"ltiple periods6
!rice eA"ation can now be re%written as6
.ss",ing that the 7r, pays di;idends -ore;er sol;es the proble, o-
knowing the selling price o-
the stockL the ass",ption allows "s to treat the stock as we did a consol
+his relationship is the di;idend disco"nt ,odel
+he ,odel tells "s that stock price sho"ld be high when
4i;idends are high
4i;idend growth is rapid, or
Interest rate is low
<hy $to"$ are ri$y=
Stockholders recei;e pro7ts only a-ter the 7r, has paid e;eryone else,
incl"ding bondholders
It is as i- the stockholders bo"ght the 7r, by p"tting "p so,e o- their
own wealth and borrowing
the rest
+his borrowing creates le;erage, and le;erage creates risk
I,agine a so-tware b"siness that needs only one co,p"ter costing F',$$$
and p"rchase can be
7nanced by any co,bination o- stocks BeA"ityC and bonds BdebtC. Interest
rate on bonds is '$E.
Co,pany earns F')$ in good years and FG$ in bad years with eA"al
probability
D D :1 !
n years rom now today = + ;n
63
:1 ; G D D ! next year today = +
n
n years rom now
n
n
today
today today
today
i
P
i
D !
i
D !
i
D !
P
:1 ; :1 ;
:1 ;
22222
:1 ;
:1 ;
:1 ;
:1 ;
G G G
2
2
+
+
+
+
+ +
+
+
+
+
+
=
i !
D
P today
today
=
Tab&e; Ret#r'$ (i$trib#te( to (ebt a'( e8#ity ho&(er$ #'(er (iJere't
*'a'"i', a$$#m7tio'$
Per"e't
E8#ity ?I:
Per"e't
Debt ?I:
Re8#ire(
7ayme't$ o'
.BI bo'($
Payme't to
e8#ity
ho&(er$
E8#ity
Ret#r' ?I:
Ex7e"te(
E8#ity
Ret#r' ?I:
St/ De-/ o!
E8#ity Ret#r'
'$$E $ $ FG$%')$ G%')E 'HE @E
($E ($E F($ FI$%''$ )%HHE '@E GE
I$E &$E F&$ F'$%Q$ I.I%I$E ').)&E 'I.IE
H$E G$E FG$ F$%G$ $%@$E H$E H$E
I- the 7r, were only '$E eA"ity 7nanced, shareholders< liability co"ld
co,e into play.
Iss"ing FQ$$ worth o- bonds ,eans FQ$ -or interest pay,ents.
I- the b"siness t"rned o"t to be bad, the FG$ re;en"e wo"ld not be
eno"gh to pay the interest
/itho"t their li,ited liability, stockholders will be liable -or F'$ short-all.
B"t act"ally, they will lose
only F'$$ in;est,ent and not ,ore and the 7r, goes bankr"pt.
Stocks are risky beca"se the shareholders are resid"al clai,ants. Since
they are paid last, they ne;er
know -or s"re how ,"ch their ret"rn will be.
.ny ;ariation in the 7r,<s re;en"e :ows thro"gh to stockholders dollar
-or dollar, ,aking their
ret"rns highly ;olatile
Le$$o' 1B
RIS5 AND VAL0E OF STOC5S
Stocks
1isk and the 3al"e o- Stocks
+heory o- E5icient Markets
In;esting in Stocks -or 0ong 1"n
Stock Markets< 1ole in the Econo,y
Financial Inter,ediation
1ole o- Financial Inter,ediaries
Ri$ a'( -a&#e o! $to"$
+he di;idend%disco"nt ,odel ,"st be adS"sted to incl"de co,pensation
-or a stock<s risk
1et"rn to olding Stock -or 9ne Uear J
Since the "lti,ate -"t"re sale price is "nknown the stock is risky,
+he in;estor will reA"ire co,pensation in the -or, o- a risk pre,i",
1eA"ired Stock 1et"rn BiC J 1isk%-ree 1et"rn Br-C V 1isk !re,i", BrpC
+he risk%-ree rate can be tho"ght o- as the interest rate on a treas"ry
sec"rity with a ,at"rity o-
se;eral ,onths
9"r di;idend disco"nt ,odel beco,es6
Ri$ a'( -a&#e o! $to"$
Stock !rices are high when
C"rrent di;idends are high B4today is highC
4i;idends are e8pected to grow A"ickly Bg is highC
+he risk%-ree rate is low Br- is lowC
+he risk pre,i", on eA"ity is low Brp is lowC
+he S>! ($$ inde8 7nished the year H$$I at S"st o;er ','$$. was this
le;el warranted by
-"nda,entalsO
1isk -ree real interest rate is abo"t HE or r- J $.$H
1isk pre,i", is ass",ed to be @E or rp J $.$@
4i;idend growth rate is aro"nd HE or g J $.$H
+he owner o- a F',$$$ port-olio wo"ld ha;e recei;ed FI$ in di;idends
d"ring H$$I
S"bstit"ting the in-or,ation in o"r adS"sted di;idend disco"nt ,odel6
B"t the act"al stock prices were s"bstantially higher than this calc"lated
7g"re
+his ,ay be d"e to wrong ass",ption on risk pre,i",. +he in;estors ,ay
ha;e been de,anding
lower risk pre,i", in H$$I.
+o co,p"te it, we "se the sa,e eA"ation
0.0" 0.04 0.0"
P $3! today + = = $750
65
today
next year today
today
next year
P
P P
P
D
G + G
r rp !
D
P today
today +
=
+he answer is appro8i,ately H.&(E
The Theory o! E9"ie't Maret$
+he basis -or the theory o- e5icient ,arkets is the notion that the prices
o- all 7nancial
instr",ents, incl"ding stocks, re:ect all a;ailable in-or,ation
.s a res"lt, ,arkets adS"st i,,ediately and contin"o"sly to changes in
-"nda,ental ;al"es
/hen ,arkets are e5icient, the prices at which stocks c"rrently trade
re:ect all a;ailable
in-or,ation, so that -"t"re price ,o;e,ents are "npredictable.
I- the theory is correct then no one can consistently beat the ,arket
a;erageL acti;e port-olio
,anage,ent will not yield a ret"rn that is higher than that o- a broad stock%
,arket inde8
I- ,anagers clai, to e8ceed the ,arket a;erage year a-ter year, it ,ay be
beca"se
+hey ,"st be taking on risk,
+hey are l"cky,
+hey ha;e pri;ate in-or,ation Bwhich is illegalC, or
Markets are not e5icient
I'-e$ti', i' Sto"$ !or the Lo', R#'
Stocks appear to be risky, and yet ,any people hold s"bstantial
proportions o- their wealth in the
-or, o- stock
+his is d"e to the di5erence between the short ter, and the long ter,L
In;esting in stocks is risky only i- yo" hold the, -or a short ti,e
In -act, when held -or the long ter,, stocks are less risky than bonds.
Fi,#re; S&P .>Year Sto" Ret#r'$) .DC. to 1BB2?Ret#r'$ are Rea&)
A(T#$te( !or I'Gatio' #$i', the
CPI:
0.0r " p :0.0"
1=1! $3!
! +
=
1883 185 1 1 131
"4!
!
2!
"6!
4!
6!
1 143 155 167
"2!
:%; age c)ange
1 11 2
$ears
66
Fi,#re; S&P Lo',>R#' Sto" Ret#r'$) .DC. to 1BB2?Ret#r'$ are Rea&)
a(T#$te( !or i'Gatio' #$i',
the CPI:
The Sto" MaretP$ Ro&e i' the E"o'omy
+he stock ,arket plays a cr"cial role in e;ery ,odern capitalist econo,y.
+he prices deter,ined there tell "s the ,arket ;al"e o- co,panies, which
deter,ines the allocation
o- reso"rces.
Fir,s with a high stock ,arket ;al"e are the ones in;estors< priDe, so
they ha;e an easier ti,e
garnering the reso"rces they need to grow.
In contrast, 7r,s whose stock ;al"e is low ha;e di5ic"lty 7nancing their
operations
So long as stock prices acc"rately re:ect -"nda,ental ;al"es, this
reso"rce allocation ,echanis,
works well.
.t ti,es, howe;er, stock prices de;iate signi7cantly -ro, the
-"nda,entals and prices ,o;e in
ways that are di5ic"lt to attrib"te to changes in the real interest rate, the
risk pre,i",, or the
growth rate o- -"t"re di;idends.
The Sto" MaretP$ Ro&e i' the E"o'omy
Shi-ts in in;estor psychology ,ay distort pricesL both e"phoria and
depression are contagio"s
/hen in;estors beco,e "nS"sti7ably e8"berant abo"t the ,arket<s -"t"re
prospects, prices rise
regardless o- the -"nda,entals, and s"ch ,ass enth"sias, creates b"bbles.
+#bb&e$
B"bbles are persistent and e8panding gaps between act"al stock prices
and those warranted by the
-"nda,entals.
+hese b"bbles ine;itably b"rst, creating crashes.
+hey a5ect all o- "s beca"se they distort the econo,ic decisions
co,panies and cons",ers ,ake
I- b"bbles res"lt in real in;est,ent that is both e8cessi;e and ine5iciently
distrib"ted, crashes do
the oppositeL the shi-t to e8cessi;e pessi,is, ca"ses a collapse in
in;est,ent and econo,ic growth
/hen b"bbles grow large eno"gh and res"lt in crashes the stock ,arket
can destabiliDe the real
econo,y
1188
3
185 1 1 131
"4!
!
2!
"6!
4!
6!
143 155 161 7
"2!
:%; age c)ange= Annua, Rate
GGGG1"$ear Returns GGGG25 0ear Returns
1 11 2
67
Fi'a'"ia& I'terme(iatio'
Econo,ic well%being is essentially tied to the health o- the 7nancial
inter,ediaries that ,ake "p the
7nancial syste,.
/e know that 7nancial inter,ediaries are the b"sinesses whose assets
and liabilities are pri,arily
7nancial instr",ents.
3ario"s sorts o- banks, brokerage 7r,s, in;est,ent co,panies, ins"rance
co,panies, and pension
-"nds all -all into this category.
+hese are the instit"tions that pool -"nds -ro, people and 7r,s who sa;e
and lend the, to people
and 7r,s who need to borrow
Financial inter,ediaries -"nnel sa;ersN s"rpl"s reso"rces into ho,e
,ortgages, b"siness loans, and
in;est,ents.
+hey are in;ol;ed in both
4irect 7nanceTin which borrowers sell sec"rities directly to lenders in
the 7nancial ,arkets
Indirect 7nanceTin which a third party stands between those who
pro;ide -"nds and those who
"se the,
Inter,ediaries in;estigate the 7nancial condition o- the indi;id"als and
7r,s who want 7nancing
to 7g"re o"t which ha;e the best in;est,ent opport"nities.
.s pro;iders o- indirect 7nance, banks want to ,ake loans only to the
highest%A"ality borrowers.
/hen they do their Sob correctly, 7nancial inter,ediaries increase
in;est,ent and econo,ic growth
at the sa,e ti,e that they red"ce in;est,ent risk and econo,ic ;olatility
Ro&e o! Fi'a'"ia& I'terme(iarie$
.s a general r"le, indirect 7nance thro"gh 7nancial inter,ediaries is
,"ch ,ore i,portant than
direct 7nance thro"gh the stock and bond ,arkets
In ;irt"ally e;ery co"ntry -or which we ha;e co,prehensi;e data, credit
e8tended by 7nancial
inter,ediaries is larger as a percentage o- G4! than stocks and bonds
co,bined
.ro"nd the world, 7r,s and indi;id"als draw their 7nancing pri,arily
-ro, banks and other
7nancial inter,ediaries
+he reason -or this is in-or,ationL
M"st think o- an online store
Uo" can b"y ;irt"ally E3E1U+I#G ? -ro, F( dinner plates to FI$$,$$$
sports car
B"t yo" will notice an absence o- 7nancial prod"cts, like st"dent loans,
car loans, credit cards or
ho,e ,ortgages
Uo" can not bonds on which iss"er is still ,aking pay,ents, nor can yo"
ha;e the ser;ices o-
checking acco"nt.
/hy s"ch online store does not deal in ,ortgagesO
S"ppose a co,pany needs a ,ortgage o- F'$$,$$$ and the store can Bi- at
allC establish a syste, in
which '$$ people sign "p to lend F',$$$ each to the co,pany
B"t the store has to do ,ore
Collecting the pay,ents
Fig"ring o"t how to repay the lenders
/riting legal contracts
E;al"ating the creditworthiness o- the co,pany and -easibility o- the
,ortgaged proSect
Can it do it allO
Financial inter,ediaries e8ist so that indi;id"al lenders don<t ha;e to
worry abo"t getting answers
to all o- the i,portant A"estions concerning a loan and a borrower
0ending and borrowing in;ol;e transactions costs and in-or,ation costs,
and 7nancial
inter,ediaries e8ist to red"ce these costs
Financial inter,ediaries per-or, 7;e -"nctions6
./ +hey pool the reso"rces o- s,all sa;ersL
1/ +hey pro;ide sa-ekeeping and acco"nting ser;ices as well as access to the
pay,ents
syste,L
2/ +hey s"pply liA"idityL
3/ +hey pro;ide ways to di;ersi-y riskL and
4/ +hey collect and process in-or,ation in ways that red"ce in-or,ation
costs
Le$$o' 1.
ROLE OF FINANCIAL INTERMEDIARIES
1ole o- Financial Inter,ediaries6
!ool Sa;ings
Sa-ekeeping, acco"nting ser;ices and access to the pay,ents syste,
0iA"idity
1isk di;ersi7cation
In-or,ation Ser;ices
Ro&e o! Fi'a'"ia& I'terme(iarie$
.s a general r"le, indirect 7nance thro"gh 7nancial inter,ediaries is
,"ch ,ore i,portant than
direct 7nance thro"gh the stock and bond ,arkets
In ;irt"ally e;ery co"ntry -or which we ha;e co,prehensi;e data, credit
e8tended by 7nancial
inter,ediaries is larger as a percentage o- G4! than stocks and bonds
co,bined
.ro"nd the world, 7r,s and indi;id"als draw their 7nancing pri,arily
-ro, banks and other
7nancial inter,ediaries
+he reason -or this is in-or,ationL
Financial inter,ediaries e8ist so that indi;id"al lenders don<t ha;e to
worry abo"t getting answers
to all o- the i,portant A"estions concerning a loan and a borrower
0ending and borrowing in;ol;e transactions costs and in-or,ation costs,
and 7nancial
inter,ediaries e8ist to red"ce these costs
Financial inter,ediaries per-or, 7;e -"nctions6
+hey pool the reso"rces o- s,all sa;ersL
+hey pro;ide sa-ekeeping and acco"nting ser;ices as well as access to the
pay,ents syste,L
+hey s"pply liA"idityL
+hey pro;ide ways to di;ersi-y riskL and
+hey collect and process in-or,ation in ways that red"ce in-or,ation
costs
International banks handle transactions that cross borders, which ,ay
,ean con;erting c"rrencies
+aking deposits -ro, sa;ers in one co"ntry and pro;iding the, to
in;estors in another co"ntry
Con;erting c"rrencies to -acilitate transactions -or c"sto,ers who do
b"siness or tra;el
Poo&i', Sa-i',$
+he ,ost straight-orward econo,ic -"nction o- a 7nancial inter,ediary is
to pool the reso"rces o-
,any s,all sa;ers
+o s"cceed in this endea;or the inter,ediary ,"st attract s"bstantial
n",bers o- sa;ers
+his is the essence o- indirect 7nance, and it ,eans con;incing potential
depositors o- the
so"ndness o- the instit"tion
Banks rely on their rep"tations and go;ern,ent g"arantees like deposit
ins"rance to ,ake s"re
c"sto,ers -eel that their -"nds will be sa-e
Sa!eee7i',) Payme't$ Sy$tem A""e$$) a'( A""o#'ti',
Golds,iths were the original bankersL
!eople asked the golds,iths to store gold in their ;a"lts in ret"rn -or a
receipt to pro;e it was there
!eople soon realiDed that trading the receipts was easier than trading the
gold itsel-.
E;ent"ally the golds,iths noticed that there was gold le-t in the ;a"lts at
the end o- the day, so it
co"ld sa-ely be lent to others
+oday, banks are the places where we p"t things -or sa-ekeepingL
/e deposit o"r paychecks and entr"st o"r sa;ings to a bank or other
7nancial instit"tion beca"se
we belie;e it will keep o"r reso"rces sa-e "ntil we need the,
Banks also pro;ide other ser;ices, like .+Ms, checkbooks, and ,onthly
state,ents, gi;ing people
access to the pay,ents syste,
Financial inter,ediaries also red"ce the cost o- transactions and so
pro,ote specialiDation and
trade, helping the econo,y to -"nction ,ore e5iciently.
.ccording to the principle o- co,parati;e ad;antage, people and
co,panies concentrate on the
acti;ities
.t which they are the best and
For which their opport"nity cost is lower
+his leads to specialiDation in a partic"lar acti;ity
More specialiDation JK ,ore trading JK ,ore 7nancial transaction JK
calls -or low cost o-
transaction
+he bookkeeping and acco"nting ser;ices that 7nancial inter,ediaries
pro;ide help "s to ,anage
o"r 7nances
!ay%CheA"es
o"se%rents
2tility bills
0oan pay,ents
Food clothing and other e8penses
Sa;ings and retire,ent plans
!ro;iding sa-ekeeping and acco"nting ser;ices as well as access to the
pay,ents syste, -orces
7nancial inter,ediaries to write legal contracts, which are standardiDed
M"ch o- what 7nancial inter,ediaries do takes ad;antage o- econo,ies o-
scale,
+he a;erage cost o- prod"cing a good or ser;ice -alls as the A"antity
prod"ced increases
In-or,ation is also s"bSect to econo,ies o- scale
Le$$o' 11
ROLE OF FINANCIAL INTERMEDIARIES ?CONTIN0ED:
1ole o- Financial Inter,ediaries BcontC
0iA"idityL
1isk di;ersi7cation
In-or,ation Ser;ices
In-or,ation .sy,,etry and In-or,ation Costs
.d;erse Selection
Moral aDards
Pro-i(i', Li8#i(ity
0iA"idity is a ,eas"re o- the ease and cost with which an asset can be
t"rned into a ,eans o-
pay,ent
Financial inter,ediaries o5er "s the ability to trans-or, assets into
,oney at relati;ely low cost
B.+Ms are an e8a,pleC
Financial inter,ediaries pro;ide liA"idity in a way that is e5icient and
bene7cial to all o- "s
By collecting -"nds -ro, a large n",ber o- s,all in;estors, a bank can
red"ce the cost o- their
co,bined in;est,ent, o5ering the indi;id"al in;estor both liA"idity and high
rates o- ret"rn
Financial inter,ediaries o5er depositors so,ething they can<t get -ro,
7nancial ,arkets on their
own
Financial inter,ediaries o5er both indi;id"als and b"sinesses lines o-
credit, which are preappro;ed
loans that can be drawn on whene;er a c"sto,er needs -"nds
Di-er$i!yi', Ri$
Financial inter,ediaries enable "s to di;ersi-y o"r in;est,ents and
red"ce risk
/hile in;esting, don<t p"t all yo"r eggs in one basket
!"tting F' in '$$ stocks is better than in;esting F'$$ in S"st one stock
Financial instit"tions enable "s to di;ersi-y o"r in;est,ent and red"ce
risk.
Banks ,itigate risk by taking deposits -ro, a large n",ber o- indi;id"als
and ,ake tho"sands o-
loans with the,, th"s gi;ing each depositor a s,all stake in each o- the
loans
Bank ,ay collect F',$$$ -ro, each o- one ,illion depositors and then "se
F' billion to ,ake
'$,$$$ loans o- F'$$,$$$ each
+h"s each has a 'P',$$$,$$$ share in each o- the '$,$$$ loans. +his is
di;ersi7cationR
.nd since bank are e8pert at this ga,e, it can ,ini,iDe the cost o- all
s"ch transactions
.ll 7nancial inter,ediaries pro;ide a low%cost way -or indi;id"als to
di;ersi-y their in;est,ents
M"t"al -"nds
I'!ormatio' Ser-i"e$
9ne o- the biggest proble,s indi;id"al sa;ers -ace is 7g"ring o"t which
potential borrowers are
tr"stworthy and which are not
+here is an in-or,ation asy,,etry beca"se the borrower knows whether
or not he or she is
tr"stworthy, b"t the lender -aces s"bstantial costs to obtain the sa,e
in-or,ation
Financial inter,ediaries red"ce the proble,s created by in-or,ation
asy,,etries by collecting and
processing standardiDed in-or,ation
Screen loan applications to g"arantee the creditworthiness
Monitor loan recipients to ens"re proper "sage o- -"nds
I'!ormatio' A$ymmetrie$ a'( I'!ormatio' Co$t$
In-or,ation plays a central role in the str"ct"re o- 7nancial ,arkets and
7nancial instit"tions
Markets reA"ire sophisticated in-or,ation in order to work well, and
when the cost o- obtaining
in-or,ation is too high, ,arkets cease to -"nction
A$ymmetri" i'!ormatio'
Iss"ers o- 7nancial instr",ents ? borrowers who want to iss"e bonds and
7r,s that want to iss"e
stock ? know ,"ch ,ore abo"t their b"siness prospects and their
willingness to work than
potential lenders or in;estors
Sol;ing this proble, is one key to ,aking o"r 7nancial syste, work as
well as it does
0ets take "p o"r online store e8a,ple
B"yers ,"st belie;e that ite, has been described acc"rately and they
,"st be s"re that the seller
will send the ite, in e8change -or their pay,ent
ere sellers ha;e ,"ch ,ore in-or,ation than b"yers ha;e, creating an
in-or,ation asy,,etry
+o resol;e this iss"e,
Ind"ct an ins"rance syste,
4e;ise an in-or,ation syste, collecting data o- p"rchases and deli;ery
.sy,,etric in-or,ation poses two obstacles to the s,ooth :ow o- -"nds
-ro, sa;ers to in;estors6
.d;erse selection, % in;ol;es being able to disting"ish good credit risks
-ro, bad be-ore the
transactionL
Moral haDard, % arises a-ter the transaction and in;ol;es 7nding o"t
whether borrowers will "se the
proceeds o- a loan as they clai, they will.
A(-er$e Se&e"tio'
!otential borrowers know ,ore abo"t the proSects they wish to 7nance
than prospecti;e lenders
0$e( Car$ a'( the Maret !or Lemo'$;
In a ,arket in which there are good cars BpeachesC and bad cars
Ble,onsC -or sale, b"yers are
willing to pay only the a;erage ;al"e o- all the cars in the ,arket.
+his is less than the sellers o- the peaches want, so those cars disappear
-ro, the ,arkets and
only the le,ons are le-t
+o sol;e this proble, ca"sed by asy,,etric in-or,ation, co,panies like
Cons",er 1eports
pro;ide in-or,ation abo"t the reliability and sa-ety o- di5erent ,odels, and
car dealers will certi-y
the "sed cars they sell
A(-er$e Se&e"tio' i' Fi'a'"ia& Maret$;
In-or,ation asy,,etries can dri;e good stocks and bonds o"t o- the
7nancial ,arket
I- yo" can<t tell the di5erence between a 7r, with a good prospects and a
7r, with bad prospects,
yo" will be willing to pay a price based only on their a;erage A"alities
+he stocks o- the good co,pany will be "nder;al"ed so the ,angers o-
these co,panies will keep
the stocks away -ro, the ,arket
+his lea;es only the 7r,s with bad prospects in the ,arket
+he sa,e happens in the bond ,arket
I- a lender can not tell whether a borrower is a good or a bad credit risk,
the de,and -or a risk
pre,i", will be based on the a;erage risk
Borrowers ha;ing good credit risk will not pay higher risk pre,i",s and
wo"ld withdraw -ro, the
,arket
9nly bad credit risk bonds are le-t in the ,arket
So&-i', the A(-er$e Se&e"tio' Prob&em;
+he ad;erse selection proble, res"lting in good in;est,ents not to be
"ndertaken, the econo,y
will not grow as rapidly as it co"ld.
So there ,"st be so,e way o- disting"ishing good 7r,s -ro, the bad
ones
4isclos"re o- In-or,ation
Collateral and #et /orth
Di$"&o$#re o! I'!ormatio';
Generating ,ore in-or,ation is one ob;io"s way to sol;e the proble,
created by asy,,etric
in-or,ation
+his can be done thro"gh go;ern,ent reA"ired disclos"re and the pri;ate
collection and
prod"ction o- in-or,ation
E.g. Sec"rities and E8change Co,,ission reg"lations
1eports -ro, pri;ate so"rces s"ch as rating agencies, brokerage
co,panies and 7nancial analysts
+he cost and credibility o- s"ch in-or,ation are to be kept in ,ind
Co&&atera& a'( Net <orth;
Collateral is so,ething o- a ;al"e pledged by a borrower to the lender in
the e;ent o- borrower<s
de-a"lt
0enders can be co,pensated e;en i- borrowers de-a"lt, and i- the loan is
so ins"red then the
borrower is not a bad credit risk
#et worth is the owner<s stake in the 7r,, the ;al"e o- the 7r, ,in"s the
;ale o- its liabilities
I- a 7r, de-a"lts on loan, the lender can ,ake a clai, against the 7r,<s
net worth
+he sa,e is tr"e -or ho,e loans
+he i,portance o- net worth in red"cing ad;erse selection is the reason
owners o- new b"sinesses
ha;e so ,"ch di5ic"lty borrowing ,oney
Mora& HaHar($
Moral haDard arises when we cannot obser;e people<s actions, and so
cannot S"dge whether a poor
o"tco,e was intentional or S"st a res"lt o- bad l"ck
Moral aDard in EA"ity Finance
/hile p"rchasing stocks o- a co,pany, are yo" s"re that it will "se the
-"nds in a way that is best
-or yo"O
!rincipal%agent proble,
+he separation o- ownership -ro, control
/hen the ,anagers o- a co,pany are the owners, the proble, o- ,oral
haDard in eA"ity 7nancing
disappears.
Moral aDard in 4ebt Finance
Beca"se debt contracts allow owners to keep all the pro7ts in e8cess o-
the loan pay,ents, they
enco"rage risk taking
. good legal contract can sol;e the ,oral haDard proble, that is inherent
in debt 7nance.
Bonds and loans o-ten carry restricti;e co;enants
The Ne,ati-e Co'$e8#e'"e$ o! I'!ormatio' Co$t$
./ A(-er$e Se&e"tio';
0enders can<t disting"ish good -ro, bad credit risks, which disco"rages
transactions -ro, taking
place.
Sol"tions incl"de
Go;ern,ent%reA"ired in-or,ation disclos"re
!ri;ate collection o- in-or,ation
+he pledging o- collateral to ins"re lenders against the borrower<s de-a"lt
1eA"iring borrowers to in;est s"bstantial reso"rces o- their own
1/ Mora& HaHar(;
0enders can<t tell whether borrowers will do what they clai, they will do
with the borrowed
reso"rcesL borrowers ,ay take too ,any risks.
Sol"tions incl"de
Forced reporting o- ,anagers to owners
1eA"iring ,anagers to in;est s"bstantial reso"rces o- their own
Co;enants that restrict what borrowers can do with borrowed -"nds
Fi'a'"ia& I'terme(iarie$ a'( I'!ormatio' Co$t$
+he proble,s o- ad;erse selection and ,oral haDard ,ake direct 7nance
e8pensi;e and di5ic"lt to
get.
+hese drawbacks lead "s i,,ediately to indirect 7nance and the role o-
7nancial instit"tions.
M"ch o- the in-or,ation that 7nancial inter,ediaries collect is "sed to
red"ce in-or,ation costs
and ,ini,iDe the e5ects o- ad;erse selection and ,oral haDard
Screening and Certi-ying to 1ed"ce .d;erse Selection
Monitoring to 1ed"ce Moral aDard

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Money > Banking ? MG+@'' V0

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