Chapter 6
Risk Structure : same maturity have different interest rates
1. Default Risk : Unable or unwilling to make interest payments or pay off the face value
2. Liquidity : Assets can be converted into cash ( Cost of selling bonds & No of buyers/seller in a bond market)
3. Income Tax Considerations : Interest payments on municipal bonds are exempt from federal income taxes
Term Structure of Interest Rates : Bonds with identical risk, liquidity, and tax characteristics have different interest rates
because the time remaining to maturity is different.
1. Yield Curve : A plot of yield bonds with different terms of maturity but same risk, liquidity and tax ( Upward sloping : Long
term rates above short term rates; Inverted : Long term rates below short term rates; Flat : Long term equal to short term).
Interest rates on bonds of different maturities move together over time.When short-term interest rates are low, yield curves
are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and
be inverted. Yield curves almost always slope upward.
Expectation Theories :
1. Interest of long term = Interest of Short term
2. Will not hold any quantity of bond if expected return is less than that of another bond with different maturity.
3. Bond holders consider bonds with different maturities to be perfect substitutes
Segmented Markets Theory :
Bonds of different maturities are not substitutes at all. The interest rate for each bond with a different maturity is determined
by the demand for and supply of that bond. Investors have preferences for bonds of one maturity over another. If investors
generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually
slope upward (fact 3).
Liquidity Premium & Preferred Habitat Theories :
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the
long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond. Bonds of different
maturities are partial (not perfect) substitutes. Interest rates on different maturity bonds move together over time; explained
by the first term in the equation. Yield curves tend to slope upward when short-term rates are low and to be inverted when
short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the
second case. Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens.
Chapter 7 :
The Gordon Model To count stock price.
P=Present value;D0 =Present dividend; D1
D (1 g) D1
P0 0 = Future Dividend
(ke g) (ke g) The present value determines if the
company can perform in the future.The
D0 = the most recent dividend paid price is set by the buyer willing to pay the
g = the expected constant growth rate in dividends highest price.The market price will be set
by the buyer who can take best
ke = the required return on an investment in equity advantage of the asset. Superior
Dividends are assumed to continue growing at a constant rate forever information about an asset can increase
its value by reducing its perceived risk.
The growth rate is assumed to be less than the required return on equity (most important when buying stock)
Theory of Rational Expectations :
Adaptive expectations:
Expectations are formed from past experience only. Changes in expectations will occur slowly over time as data changes.
However, people use more than just past data to form their expectations and sometimes change their expectations quickly.
Expectations will be identical to optimal forecasts using all available information. Even though a rational expectation equals
the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate (It takes
too much effort to make the expectation the best guess possible. Best guess will not be accurate because predictor is
unaware of some relevant information.)
X e X of Xof = might not even be equal to 30% of the true
information.
X expectation of the variable that is being forecast
e
X of = optimal forecast using all available information
Rationale behind the theory :
The incentives for equating expectations with optimal forecasts are especially strong in financial markets. In these markets,
people with better forecasts of the future get rich. The application of the theory of rational expectations to financial markets
(where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful
Implications of the Theory :
If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well
(Changes in the conduct of monetary policy (e.g. target the federal funds rate). The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time.
Chapter 8
Asymmetric Information
Adverse selection occurs before the transaction. Moral hazard arises after the transaction. Agency theory analyses how
asymmetric information problems affect economic behavior.
To solve Adverse Selection : Private production and sale of information(Free-rider problem)
Government regulation to increase information(Not always works to solve the adverse selection problem, explains Fact 5.)
Financial intermediation (Indirect finance is many times more important than direct finance. Financial intermediaries,
particularly banks, are the most important source of external funds used to finance businesses. Only large, well-established
corporations have easy access to securities markets to finance their activities).
Collateral and net worth (Collateral is a prevalent feature of debt contracts for both households and businesses.)
Moral Hazard :
Called the Principal-Agent Problem(Principal: less information (stockholder) Agent: more information (manager)
Separation of ownership and control of the firm( Managers pursue personal benefits and power rather than the profitability
of the firm)
To solve Moral Hazard : Net worth and collateral(Incentive compatible) Monitoring and Enforcement of Restrictive Covenants
(Discourage undesirable behavior,Encourage desirable behavior, Keep collateral valuable,Provide information)
“Financial repression” created by an institutional environment characterized by:
Poor system of property rights (unable to use collateral efficiently) Poor legal system (difficult for lenders to enforce
restrictive covenants) Weak accounting standards (less access to good information) Government intervention through
directed credit programs and state owned banks (less incentive to proper channel funds to its most productive use).
Chapter 5 :
