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FINA 3040B
CENTRAL BANKING AND
REGULATION OF FINANCIAL
INSTITUTIONS
INTEREST RATES, BONDS & THE
FINANCIAL SYSTEM

Dr. Paul M. Kitney

Term 2, 2020-21
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Financial Institutions
• Financial system
• Group of institutions in the economy that help match one person’s
saving with another person’s investment
• Moves the economy’s scarce resources from savers to borrowers

• Financial institutions
• Financial markets – Bond Market and Stock Market
• Financial intermediaries
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Financial Intermediaries

• Financial intermediaries
• Savers can indirectly provide funds to borrowers
• Banks
• Mutual funds
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Financial Intermediaries
• Banks
• Take in deposits from savers
• Banks pay interest
• Make loans to borrowers
• Banks charge interest
• Facilitate purchasing of goods and services
• Checks: medium of exchange
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Financial Intermediaries

• Mutual funds
• Institution that sells shares to the public
• Uses the proceeds to buy a portfolio of stocks and bonds
• Advantages: diversification; professional money managers
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Financial Markets
• The stock market
• Stock: claim to partial ownership in a firm
• A claim to the profits that a firm makes
• Organized stock exchanges
• Stock prices: demand and supply
• Equity finance
• Sale of stock to raise money
• Stock index
• Average of a group of stock prices
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Financial Markets

• The bond market

• Bond: certificate of indebtedness
• Date of maturity, when the loan will be repaid
• Rate of interest, paid periodically until the date of maturity
• Principal, amount borrowed
• Borrowing from the public
• Used by large corporations (Corporates), the federal
government (Sovereigns), or state and local governments
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Credit Markets
• Credit market defines risk of corporate bonds into two categories – High
Yield and Investment Grade
• Credit spreads (risk premium) are higher to compensate for the credit risk
in HY versus IG
• Credit spread (risk premium) = corporate bond yield – risk free rate
• Risk free rate used (although not 100% risk free) is the government bond
or not of the same duration as the corporate bond
• For example, Sony 10 year bond yield is 4% and JGB 10 year bond yield is
0%. Then Sony’s credit spread on this bond is 4-0 =4% or 400 bps
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Perpetuity and Current Yield

• Perpetuity: a bond with no maturity date that does not repay principal
but pays fixed coupon payments forever
P = C / ic
Pc = price of the perpetuity
C = yearly interest payment
Ic = yield to maturity of the perpetuity
can rewrite above equation as this: ic = C/Pc
For coupon bonds, this equation gives the current yield, an easy to calculate
approximation to the yield to maturity
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Discount Bond
For any one year discount bond

F  P
i=
P
F = Face value of the discount bond
P = Current price of the discount bond

The yield to maturity equals the increase in price over the year
divided by the initial price.

As with a coupon bond, the yield to maturity is negatively

related to the current bond price.
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The Distinction Between Interest

Rates and Returns
• Rate of Return:
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P  Pt
RET = + t 1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt 1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt 1  Pt
= rate of capital gain = g
Pt
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The Distinction Between Interest

Rates and Returns
• The return equals the yield to maturity only if the holding period equals
the time to maturity.
• A rise in interest rates is associated with a fall in bond prices, resulting in a
capital loss if time to maturity is longer than the holding period.
• The more distant a bond’s maturity, the greater the size of the percentage
price change associated with an interest-rate change. This is called
“Duration”
• Interest rates do not always have to be positive as evidenced by recent
experience in Japan and several European states.
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The Distinction Between Interest

Rates and Returns

• The more distant a bond’s maturity, the lower the rate of return the
occurs as a result of an increase in the interest rate.
• Even if a bond has a substantial initial interest rate, its return can be
negative if interest rates rise.
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The Distinction Between Interest

Rates and Returns
One-Year Returns on Different-Maturity 10%-Coupon-Rate Bonds When
Interest Rates Rise from 10% to 20%
(1) (2) (3) (4) (5)
Years to Maturity Initial Initial Price Rate of (6)
When Bond Is Current Price Next Capital Gain Rate of Return
Purchased Yield (%) ($) Year* ($) (%) [col (2) + col (5)] (%)
30 10 1,000 503 −49.7 −39.7
20 10 1,000 516 −48.4 −38.4
10 10 1,000 597 −40.3 −30.3
5 10 1,000 741 −25.9 −15.9
2 10 1,000 917 −8.3 +1.7
1 10 1,000 1,000 0.0 +10.0

*Calculated with a financial calculator, using the equation introduced in Lecture 2:

C C C C F
P= + 2
+ 3
+. . . + +
1+ i (1+ i ) (1+ i ) (1+ i ) (1+ i )n
n
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Supply and Demand in the Bond Market

• At lower prices (higher interest rates), ceteris paribus, the quantity

demanded of bonds is higher: an inverse relationship

• At lower prices (higher interest rates), ceteris paribus, the quantity

supplied of bonds is lower: a positive relationship
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Supply and Demand for Bonds

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Market Equilibrium

• Occurs when the amount that people are willing to buy (demand) equals
the amount that people are willing to sell (supply) at a given price.
• Bd = Bs defines the equilibrium (or market clearing) price and interest rate.
• When Bd > Bs , there is excess demand, price will rise and interest rate will
fall.
• When Bd < Bs , there is excess supply, price will fall and interest rate will
rise.
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Changes in Equilibrium Interest Rates

• Shifts in the demand for bonds:
• Wealth: in an expansion with growing wealth, the demand curve for bonds
shifts to the right
• Expected Returns: higher expected interest rates in the future lower the
expected return for long-term bonds, shifting the demand curve to the left
• Expected Inflation: an increase in the expected rate of inflations lowers the
expected return for bonds, causing the demand curve to shift to the left
• Risk: an increase in the riskiness of bonds causes the demand curve to shift
to the left
• Liquidity: increased liquidity of bonds results in the demand curve shifting
right
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Shifts in the Demand for Bonds

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Shifts in the Supply of Bonds

• Shifts in the supply for bonds:

• Expected profitability of investment opportunities: in an expansion,

the supply curve shifts to the right

• Expected inflation: an increase in expected inflation shifts the supply

curve for bonds to the right

• Government budget: increased budget deficits shift the supply curve

to the right
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Shifts in the Supply of Bonds

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Response to a Change
in Expected Inflation
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Expected Inflation and Interest Rates (Three-

Month Treasury Bills), 1953–2017

Sources: Federal Reserve Bank of St. Louis FRED

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Response to a Business Cycle Expansion

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Business Cycle and Interest Rates (Three-

Month Treasury Bills), 1951–2017

Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS

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Risk Structure of Interest Rates

• Bonds with the same maturity have different interest rates due to:
• Default risk
• Liquidity – the number of buyers and sellers in the market.
• Tax considerations – US Municipal Bonds tax exempt
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Risk Structure of Interest Rates

• Default risk: probability that the issuer of the bond is unable or unwilling
to make interest payments or pay off the face value
• U.S. Treasury bonds are considered default free (government can
raise taxes).
• Risk premium (credit spread): the spread between the interest rates
on bonds with default risk and the interest rates on (same maturity)
Treasury bonds
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Long-Term Bond Yields, 1919–2017

Sources: Board of Governors of the Federal Reserve System

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Response to an Increase in Default

Risk on Corporate Bonds
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Bond Ratings by Ratings Agencies

Moody’s Rating Agency S&P Fitch Definitions
Aaa AAA AAA Prime Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA Blank
Aa3 AA– AA– Blank
A1 A+ A+ Upper Medium Grade
A2 A A Blank
A3 A– A– Blank
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB Blank
Baa3 BBB– BBB– Blank
Ba1 BB+ BB+ Noninvestment Grade
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and Poor’s, and Fitch

Moody’s Rating Agency S&P Fitch Definitions
Ba2 BB BB Speculative
Ba3 BB– BB– Blank
B1 B+ B+ Highly Speculative
B2 B B Blank
B3 B– B– Blank
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC — In Poor Standing
Caa3 CCC– — Blank
Ca — — Extremely Speculative
C — — May Be in Default
— — D Default
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The GFC & the Baa–AAA Spread

• Starting in August 2007, the collapse of the subprime mortgage market

led to large losses among financial institutions.
• The perceived increase in default risk for Baa bonds made them less
desirable at any given price.
• Second biggest credit sh0ck in the US after the Great Depression
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Term Structure of Interest Rates

• Yield curve: a plot of the yield on bonds with differing terms to maturity
but the same risk, liquidity, and tax considerations
• Upward-sloping: long-term rates are above
short-term rates
• Flat: short- and long-term rates are the same
• Inverted: long-term rates are below short-term rates.
• Inverted Yield Curve as a market predictor of recession. Markets
follow the US 10 year-2year Treasury yield spread, which has
correlated with future recessions
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Trend of US Government Bond Yields

with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/