Published on April 27, 2014
Financial Institution Module Handbook Presented to BBA-8 Presented by Muhammad Bilal (FA10-BBA-149) Khizar Nawaz (FA10-BBA--___) Submitted to Sir wajid Shakeel Dated: 04-03-2014
CHAPTER # 1 (WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS)
Financial markets: Any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees and market forces determining the prices of securities that trade. Some financial markets only allow participants that meet certain criteria, which can be based on factors like the amount of money held, the investor's geographical location, knowledge of the markets or the profession of the participant. Debt and interest rate: A security (also referred to as a monetary instrument) may be a claim on the issuer’s future income or assets (any monetary claim or piece of property that's subject to ownership). A bond may be a debt security that guarantees to form payments sporadically for a nominal amount of your time.1 Debt markets, additionally typically brought up generically because the bond market, square erasure particularly necessary to economic activity as a result of the permit companies and governments to borrow so as to finance their activities; the bond market is additionally wherever interest rates square measure determined. Associate degree charge per unit is that the price of borrowing or the value procured the rental of funds (usually expressed as a proportion of the rental of $100 per year). There square measure several interest rates within the economy—mortgage interest rates, automobile loan rates, and interest rates on many alternative types of bonds. Interest rates square measure necessary on variety of levels. On a private level, high interest rates might deter you from shopping for a house or automobile as a result of the price of finance it would be high. Conversely, high interest rates might encourage you to avoid wasting because you'll earn a lot of interest financial gain by putt aside a number of your earnings as savings. On a lot of general level, interest rates have a sway on the general health of the economy as a result of they have an effect on not solely consumers’ disposition to pay or save however additionally businesses’ investment choices. High interest rates, for instance, might cause a company to put over building a replacement plant that may offer a lot of jobs. Stock market: A common stock (typically simply referred to as a stock) represents a share of possession in a corporation. It’s a security that's a claim on the earnings and assets of the corporation. Issuing stock and merchandising it to the general public may be a manner for companies to boost funds to finance their activities. The securities market, during which claims on the earnings of companies (shares of stock) area unit listed, is that the most
generally followed monetary market in nearly each country that has one; that’s why it's usually referred to as merely ―the market.‖ A big swing within the costs of shares within the securities market is usually a significant story on the evening news. Folks usually speculate on wherever the market is heading and obtain terribly excited once they will brag regarding their latest ―big killing,‖ however they become depressed when they suffer a giant loss. The eye the market receives will most likely be best explained by one straightforward fact: it's an area wherever folks will get rich—or poor—quickly. Foreign Exchange Market: The markets in which participants are able to buy, sell, exchange and speculate on currencies. Foreign exchange markets are made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. The forex market is considered to be the largest financial market in the world Financial Intermediary: An entity that acts as the middleman between two parties in a financial transaction. While a commercial bank is a typical financial intermediary, this category also includes other financial institutions such as investment banks, insurance companies, broker-dealers, mutual funds and pension funds. Financial intermediaries offer a number of benefits to the average consumer including safety, liquidity and economies of scale. Managing risk in financial institutions: In recent years, the economic environment has become an increasingly risky place. Interest rates have fluctuated wildly, stock markets have crashed both here and abroad, speculative crises have occurred in the foreign exchange markets, and failures of financial institutions have reached levels unprecedented since the Great Depression. To avoid wild swings in profitability (and even possibly failure) resulting from this environment, financial institutions must be concerned with how to cope with increased risk. Conclusion: Activities in financial markets have direct effects on individuals’ wealth, the behavior of businesses, and the efficiency of our economy. Three financial markets deserve particular attention: the bond market (where interest rates are determined), the stock market (which has a major effect on people’s wealth and on firms’ investment decisions), and the foreign exchange market (because fluctuations in the foreign exchange rate have major consequences for the U.S. economy). Because monetary policy affects interest rates, inflation, and business cycles, all of which have an important impact on financial markets and
institutions, we need to understand how monetary policy is conducted by central banks in the United States and abroad. Assignment Financial Innovation Introduction: State Bank of Pakistan is implementing the Financial Inclusion Program (FIP), sponsored by the UK Aid, with the aim to improve access to financial services in Pakistan. FIP has adopted a multi-pronged approach towards tackling the problem of financial exclusion by combining market forces and public sector principles. A notable tool of this approach is to accelerate on innovations to widen the reach of financial services in Pakistan. FIP has kept GBP 10 million pound in grants under the Financial Innovation Challenge Fund (FICF) to help the financial sector reach the excluded with use of innovations. Specifically, FICF will foster innovations to test new markets, lower cost of delivery, enable systems and procedures to be more efficient and provide new ways of meeting the unmet demand for financial services. The fund will hold specialized challenge rounds focusing on innovations that market wishes to undertake to alter the scope and reach of financial services. Hence, FICF will be open to both bank and non-bank financial institutions, telecoms, NGOs, and academic organizations. Objectives The following are the objective of FICF: a) Spur innovation and innovative practices that increase access to financial services by the unbanked or the financially excluded. The fund will provide support for pilots and for up- scaling financial services vis-à-vis seed capital and a platform for knowledge sharing. b) Leverage FICF funds to attract private investment. Additional capital will help create a bridge between pilot and roll-out of an innovation. c) Create relations between successful projects with other funds under FIP and beyond to ensure that pilots can be brought to scale through donor and private sector coordination.
Scope The broad scope of the fund is to facilitate the spread of financial services through innovation. Innovation may come in the following forms: a) A product or service completely new and novel proposed by the applicant; or b) A product or service that has been tested and proved successful somewhere in the world but is new to Pakistan; or c) An innovation that has been tested in Pakistan by organizations and has proved successful and the applicant organization wishes to test it with a new partner or in a different territory.
CHAPTER # 2 (FINANCIAL CRISES)
Financial Crisis A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in changes in the real economy. Types of financial crisis Banking crisis: When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits. it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. An event in which bank runs are widespread is called a systemic banking crisis or banking panic. Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and resulting loan defaults. Speculative bubbles and crashes: A speculative bubble exists in the event of large, sustained overpricing of some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to predict whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur. Black Friday, 9 May 1873, Vienna Stock Exchange. The Panic of 1873 and Long Depression followed. Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices
include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000–2001, and the now-deflating United States housing bubble. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good. International financial crises: When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency because of a speculative attack, this is called a currency crisis or balance of payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight. Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997–98. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds. Wider economic crisis: Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged or severe recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. Declining consumer spending: Some economists argue that many recessions have been caused in large part by financial crises. One important example is the Great Depression, which was preceded in many countries by bank runs and stock market crashes. The subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve, a position supported by Ben Bernanke. Causes and consequences of financial crisis
Strategic complementarities in financial markets: It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. George Soros has called this need to guess the intentions of others 'reflexivity'. Similarly, John Maynard Keynes compared financial markets to a beauty contest game in which each participant tries to predict which model other participants will consider most beautiful. Circularity and self-fulfilling prophecies may be exaggerated when reliable information is not available because of opaque disclosures or a lack of disclosure. Furthermore, in many cases investors have incentives to coordinate their choices. For example, someone who thinks other investors want to buy lots of Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen too. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw too. Economists call an incentive to mimic the strategies of others strategic complementarity. It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crises are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so. Leverage: Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial institution (or an individual) only invests its own money, it can, in the very worst case, lose its own money. But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another. The average degree of leverage in the economy often rises prior to a financial crisis. For example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street Crash of 1929. In addition, some scholars have argued that financial institutions can contribute to fragility by hiding leverage, and thereby contributing to underpricing of risk. Asset-liability mismatch: Another factor believed to contribute to financial crises is asset- liability mismatch, a situation in which the risks associated with an institution's debts and
assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reasons bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Likewise, Bear Stearns failed in 2007–08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities. In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk of sovereign default due to fluctuations in exchange rates. Regulatory failures: Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency: making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, and other limits on leverage. Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the former Managing Director of the International Monetary Fund, Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'. Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis. However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital is scarce, potentially aggravating a financial crisis. International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding (discussed above) and so increasing systemic risk. From this perspective, maintaining diverse regulatory regimes would be a safeguard. Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that
led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in 2008. Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated on September 23, 2008 that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group. Likewise it has been argued that many financial companies failed in the recent crisis because their managers failed to carry out their fiduciary duties. Contagion: Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk. One widely cited example of contagion was the spread of the Thai crisis in 1997 to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.
CHAPTER # 3 (OVER VIEW OF THE FINANCIAL SYSTEM) Function of Financial Markets
They perform very important function by acting as a medium of exchange from funds. Some people who save their income can lend it to others who have good opportunities to invest them and produce more return. Financial market is the place where this can be done. For this purpose there are two ways: Direct finance: In this borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person, who buys them, but they are liabilities (IOUs or debts) for the individual or firm that sells (issues) them. Indirect finance: In this a third party called financial intermediaries is responsible for transfer of funds between borrower and lenders. These include banks, mutual funds, insurance companies etc. these take money from savers and then give it to investors. Financial markets play very important role for economy, this can be understood by an example. Let’s suppose there was a person A, who has saved Rs.100. if he gives it to person B on interest of 10% who want to buy new equipment which will reduce his cost and increase his income. At the end return to A will be Rs.110 and it will help to increase productivity. Without the financial markets it could not be possible. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy Structure of Financial Markets Debt and Equity Markets Most common method used to get fund is to issue bonds or mortgages. By this borrower is bound to pay fixed periodic payments until the maturity date when he loan is returned totally. A debt instrument is short-term if its maturity is less than a year and long-term if its maturity is 10 years or longer. Debt instruments with a maturity between one and 10 years are said to be intermediate-term.
Another way is to issue equities, like common stock, it is claim over income of organization and on assets. For example a firm issue 100 shares and you have bought 30 share then you have 30% ownership of that organization. Some of these shares pay periodically in form of dividends and are considered long term securities as they don’t mature. The main disadvantage of owning a corporation’s equities rather than its debt is that the corporation must pay its equity holders after it pays to all its debt holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset. Debt holders do not share in this benefit, because their dollar payments are fixed. Equity holders also have voting rights to choose directors for organization. Size of the debt market is often substantially larger than the size of the equities market. Primary and Secondary Markets In primary market new securities are issued, such as a bond or a stock and are sold to initial buyers by the corporation or government agency for raising funds. In secondary market previously issued securities can be resold. Exchanges and Over-the-Counter Markets Secondary markets can work in two ways. One method is through exchanges, where buyers and sellers of securities meet in one central location to conduct trades e.g. Stock Exchanges. The other way is to have an over-the counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities ―over the counter‖ to anyone who comes to them and is willing to accept their prices. This is not very much different from stock exchanges but it has high competition. Money and Capital Markets We can distinguish financial markets on the basis of the maturity of the securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded. The capital market is the market in which long term debt (generally with original maturity of one year or greater) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid.
Conclusion The basic function of financial markets is to channel funds from savers who have an excess of funds to spenders who have a shortage of funds. Financial markets can do this either through direct finance, in which borrowers borrow funds directly from lenders by selling them securities, or through indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. This channeling of funds improves the economic welfare of everyone in the society. Because they allow funds to move from people who have no productive investment opportunities to those who have such opportunities, financial markets contribute to economic efficiency. In addition, channeling of funds directly benefits consumers by allowing them to make purchases when they need them most. Financial markets can be classified as debt and equity markets, primary and secondary markets, exchanges and over-the-counter markets, and money and capital markets. Assignment Eurobond: a bond denominated in a currency other than that of the country in which it is sold for example, a bond denominated in U.S. dollars sold in London. Eurocurrencies: these are foreign currencies deposited in banks outside the home country. Eurodollars: which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds.
CHAPTER # 4 (WHAT DO INTEREST RATES MEAN AND WHAT IS THEIR ROLE IN VALUATION) INTRODUCTION: Interest rates are among the most closely watched variables in the economy. Their movements are reported almost daily by the news media because they directly affect our everyday lives and have important consequences for the health of the economy. They affect
personal decisions such as whether to consume or save, whether to buy a house, and whether to purchase bonds or put funds into a savings account. Interest rates also affect the economic decisions of businesses and households, such as whether to use their funds to invest in new equipment for factories or to save their money in a bank. Interest rates are important to understand because due to the fluctuation of interest rate, we make our decisions about personal decisions or business decisions. Personal decisions in term of like if I want to buy a house and want some money borrow, so if interest rate is low that I’d be supposed to pay at the end of the time, then I’d go for borrowing. Same is the case with business decisions, like if a business intends to extend its operations and want some money but due to fluctuation in interest rate it is not possible. Also due to fluctuation in interest rate, the value of your assets decrease and you’d try to sell it out. Here is another concept that when money comes with anyone, different ideas come in mind to rock the world. Investment bankers and brokers need such type of idea to tell to the potential investors that their money won’t be lost. There are different ways to measure the interest rate given below. Present value: present value tells that cash flow paid to you after specific time is less worthy than it’s paid to you today. Through present value, interest rate could be determined. For example, if you made your friend Ali a simple loan of PKR 1000 for one year, you would require him to repay the principal of PKR 1000 in one year’s time along with an additional payment for interest; like PKR 100. In the case of a simple loan, the interest payment divided by the amount of the loan. So simple interest rate, i, is: 100/1000=10% Yield to maturity: it’s most accurate measure of interest rate because it calculates the present value of cash flow received from any debt instrument with its value today. Lets suppose I want to borrow PKR 1000 from Rizwan today and he wants me to give him back PKR 1100 after one month. So here the difference that is of PKR 100 would be calculated by yield to maturity. 1000=1100/(1+i) (1+i) 1000=1100 i=1.10-1=0.10=10% Real and nominal interest rate: nominal interest rate is that interest rate that makes no allowance for inflation. It is different from real interest rate because real interest rate has included inflation with it. The interest rate makes no allowance for inflation, and it is more precisely referred to as the nominal interest rate. We distinguish it from the real interest rate,
the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. This interest rate is more precisely referred to as the ex-ante real interest rate because it is adjusted for expected changes in the price level. The ex-ante real interest rate is most important to economic decisions, and typically it is what financial economists mean when they make reference to the ―real‖ interest rate. The interest rate that is adjusted for actual changes in the price level is called the ex post real interest rate. It describes how well a lender has done in real terms after the fact. The real interest rate is more accurately defined by the Fisher equation, named for Irving Fisher, one of the great monetary economists of the twentieth century. The Fisher equation states that the nominal interest rate i equals the real interest rate is plus the expected rate of inflation. Real interest rate=nominal interest rate + inflation. Credit Market Instruments: A simple loan, in which the lender gives to the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest. A fixed-payment loan in which the lender gives to the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount face value is repaid. A discount bond also called a zero-coupon bond is bought at a price below its face value called as at a discount, and the face value is repaid at the maturity date. For example, a discount bond with a face value of $1,000 might be bought for $900; in a year’s time the owner would be repaid the face value of $1,000. Interest rate risk: prices of longer-maturity bonds respond more dramatically to changes in interest rates helps explain an important fact about the behavior of bond markets: Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Reinvestment Risk: Up to now, we have been assuming that all holding periods are short and equal to the maturity on short-term bonds and are thus not subject to interest-rate risk. However, if an investor’s holding period is longer than the term to maturity of the bond, the investor is exposed to a type of interest-rate risk called reinvestment risk. Reinvestment risk occurs because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain.
CHAPTER # 5 (WHY DO INTEREST RATE CHANGE) Determinants of Asset Demand: An asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing machinery are all assets. Asset demand can be considered with the help of following factors:
1. Wealth, the total resources owned by the individual, including all assets. When wealth increases then ability to demand assets also increases. 2. Expected return (the return expected over the next period) on one asset relative to alternative assets. If there are two companies from which company A’s return was previously 20% but now it is increased to 25% so people will buy its securities more than company B return stayed on 20%. 3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets. For example if company B gives return of 10% for half of life and 5% for other half-life then there is a risk in it as its return is fluctuating. But if company A provides return at constant rate of 10% people will demand its securities more because it has no uncertainty on rate of return. 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets. People prefer short term securities because they are highly liquid i.e. they can be resold easily and quickly then long term securities.
Supply and Demand in the Bond Market: Demand Curve: It shows the relationship between the quantity demanded and the price when all other economic variables are held constant. We can analyse it with the help of a example through following formula: I =Re= F-P/P Where I = interest rate = yield to maturity Re = expected return F = face value of the discount bond P = initial purchase price of the discount bond If the bond sells for $950, the interest rate and expected return are 1000-950/950= 5.3% But At a price of $900, the interest rate and expected return are 1000-900/900= 11.1% So definitely people will buy more at a price of RS.900 as it is giving more return. Demand increases from $100 billion to $200 billion, when price fall from $950- $900. But opposite is the case with supply organizations will supply more when prices are high because it helps them to raise more funds at lower cost of borrowing (interest). So when price increases from 900 to 950, supply goes up by $100 billion.
Equilibrium between supply and demand is gained at price of $850 with interest rate of 17.6%. Equilibrium satisfies both buyers and sellers of securities. Market always move toward equilibrium i.e. when prices are lower than $850 people will demand more as security is cheaper to purchase and provides more return while organizations will supply less as its cost is high and funds are also less, due to more demand and less supply (excess demand) prices will rise until they reach $850. Vice versa in the case when prices are above equilibrium. Shifts in the Demand for Bonds Some factors cause the demand curve for bonds to shift. These factors include changes in four parameters: 1. Wealth: In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. Using the same reasoning, in a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left. Bond price Quantity demand 2. Expected returns on bonds relative to alternative assets: Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left. (Higher interest means lower prices in future which can reduce gain on sale of these securities). 3. Risk of bonds relative to alternative assets: If prices in the bond market become more volatile, the risk associated with bonds increases, and bonds become a less attractive asset. An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. BD1 111 BD2
Bond price & Interest rate Quantity demand 4. Liquidity of bonds relative to alternative assets: Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right. Bond price Quantity demand Shifts in the Supply of Bonds Certain factors can cause the supply curve for bonds to shift, among them these: 1. Expected profitability of investment opportunities: The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment are expected to be profitable, and the quantity of bonds supplied at any given bond price will increase. BD1 111 BD2 BD1 111 BD2
Bond price Quantity supply 2. Expected inflation The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profitable abound, and the quantity of bonds supplied at any given bond price will increase. Bond price Quantity supply BS1 111 BS2 BS1 111 BS2
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