Key Facts:
Ch. 4:
Present Value PV = CF/(1+i)n
4 Main types of credit market instruments: 1. Simple Loan = borrow money for n years, receive money + interest PV = CF/(1+i)n - for simple loan, interest rate = yield to maturity 2. Fixed Payment Loan = cash payment every period (PV) LV = FP/(1+i)1 + FP/(1+i)2 + ... + FP/(1+i)n 3. Coupon Bond = coupon (%) payment each year, face value and coupon on last year P = C/(1+i)1 + C/(1+i)2 + ... + C+F/(1+i)n 4. Discount Bond = when n=1 P = F/(1+i) i = (F-P)/P - P negatively depends on i 3b. Perpetuity (Consol) = type of coupon bond with no maturity date, no repay principal Price of consol P = C/i ytm = C/P C = yrly interest payment - fixed payments forever
Rate of Return – for selling bonds before maturity date RET = C/Pt + (Pt+1 – Pt)/Pt ↓ ↓ Current yield rate of capital gain - if hold time =maturity then Pt+1 = F - if interest rates ↑ => larger changes in capital gains and RET for larger maturity bonds
Fisher Equation – when real IR is low, greater incentive to borrow, fewer incentive to lend i = ir + πe - i = nominal interest rate - ir = real interest rate - πe = expected inflation rate
Ch. 5:
Liquidity Preference Framework – determines equilibrium interest rate in terms of supply adn demand for money
Total Wealth in Economy: BS + MS = Bd + Md - so.... BS - Bd = MS - Md - if MS = Md then BS = Bd which is equilibrium
Ch. 6:
Expectations Theory – IR on long term bond will equal avg. of short term IRs (expected) - i2t = (it + iet+1)/2 => a 2 period rate, must equal 2 one period rate - longer maturities: int = (it + iet+1 + ... + iet+n-1)/n
Liquidity Premium Theory – IR long term will = avg. of short term IRs plus liquidity premium - Liquidity Premium = changes with supply and demand - int = (it + iet+1 + ... + iet+n-1)/n + Lnt - Lnt is liquidity premium, always positive - liquidity premium rises with term of maturity
Ch. 7:
One Period Model: P0 = Div1/(1+ke) + P1/(1+ke)
Gordon Growth Model: P0 = D1/(ke-g)
Ch.17:
Exchange rate in long run: - real exchange rate (e*) = rate at which goods of 1 country trade for goods of another e* = eP/P* - P is domestic Price - P* is foreign price (in foreign currency) - e is nominal exchange rate (foreign currency per unit of domestic currency) - Purchasing power parity (PPP) = theory that unit of any currency should be able to buy same quantity of goods in all countries - implies that nominal exchange rates adjust to equalize price of basket goods across countries: e = P*/P - under PPP, real exchange e* rate equal to 1 => law of one price - does not always hold because: - many goods cannot be easily traded - foreign and domestic goods are not perfect substitutes
Factors that affect exchange rates in long run: - relative price levels: if ↑ then currency depreciates - trade barriers: if ↑ then currency appreciates - preference for domestic versus foreign goods: if ↑ then currency appreciates - productivity: if ↑ then currency depreciates
- factors move slowly over time
- Note: if factor makes exchange rate appreciate in future (long run), means it will increase expected exchange rate now, in the short run
Factors that affect exchange rates in short run: - exchange rate today, Et = determine demand slope, down slope - domestic interest rate, i = (iD) if ↑ then currency appreciates - when real interest rates rise, called "domestic interest rate" effect - when interest rates rise due to expected increase in inflation, currency depreciates, it's called "relative price level" effect - foreign interest rate, i* = (iF) if ↑ then currency depreciates - expected future exchange rate, Eet+1 = if ↑ then currency appreciates - will also change with changes in long-run determinants
