Module: Financial Markets and Monetary Policy Yield to Maturity (YTM)

Chapter 3: Interest Rates and Security Valuation The return or yield the bondholder will earn if they buy the bond at its current market price, receive all promised
payments, and hold the bond until maturity.
Various Interest Rate Measures
Equity Valuation
Coupon Rate
The valuation of equity instruments involves calculating the present value of an infinite series of cash flows
The interest rate on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the (dividends) discounted at an appropriate interest rate. Dividends are portions of a firm’s earnings paid to stockholders,
bondholder. while retained earnings are reinvested to generate future income and dividends. The fair price of stocks is conceptually
the present value of all current and future dividends.
Required Rate of Return
Factors Affecting Security Prices and Price Volatility
The interest rate an investor should receive on a security given its risks. The required rate of return is used to calculate
the fair present value of a security. Interest Rate Impact

Expected Rate of Return There is an inverse relationship between interest rates and security prices. As interest rates increase, security prices
decrease at a diminishing rate.
The interest rate an investor expects to receive on a security if they buy it at its current market price, receive all
expected payments, and sell the security at the end of their investment horizon. Time to Maturity

Realized Rate of Return The shorter the time to maturity, the closer the price is to the face value. Longer time to maturity results in larger price
changes due to interest rate fluctuations.
The actual interest rate earned on an investment in a financial security. The realized rate of return is a historical (ex-
post) measure of the interest rate. Coupon Rate

Required vs. Expected Rates of Return and Efficient Markets Higher coupon rates reduce the price change for a given interest rate change.

Once an expected rate of return E(r) on a financial security is calculated, the market participant compares this expected Duration and Convexity
rate of return to its required rate of return (r). If E(r) > r, the projected cash flows on the security exceed the amount
required to compensate for the risk. The required rate of return is used to calculate a fair present value, while the Duration
expected rate of return serves as a discount rate with the current market price. Market efficiency ensures that financial
security prices adjust to new equilibrium levels when interest rates or security-specific characteristics change. Duration is the weighted-average time to maturity using the relative present values of cash flows as weights. It
measures a bond’s sensitivity to interest rate changes.
Bond Valuation
Convexity
Types of Bonds
Convexity measures the curvature of the price-interest rate relationship. Higher convexity provides better protection
1. Coupon Bonds – Bonds that pay interest based on a stated coupon rate, with generally constant interest against rate changes.
payments over their lifetime.
2. Zero-Coupon Bonds – Bonds that do not pay periodic interest but are issued at a discount and redeemed at
face value.
Chapter 4: The Federal Reserve System and Monetary Policy
Bond Categories
Overview of the Federal Reserve System
• Premium Bond: When the coupon rate is greater than the required rate of return, the fair present value is
greater than the bond's face value. The Federal Reserve (Fed) is the central bank of the United States, created by the Federal Reserve Act of 1913. It
• Discount Bond: When the coupon rate is less than the required rate of return, the fair present value is less operates independently but is subject to congressional oversight.
than the bond's face value.
• Par Bond: When the coupon rate equals the required rate of return, the fair present value equals the bond's
face value.
Functions of the Federal Reserve System Contractionary Policy

1. Conducting Monetary Policy • Raising the discount rate increases interest rates, making borrowing expensive.
2. Supervising and Regulating Depository Institutions • Increasing reserve requirements limits loan availability, reducing spending.
3. Maintaining Financial Stability
4. Providing Financial Services Systemwide Rescue Programs during the Financial Crisis

Board of Governors 1. Retail Deposit Insurance Expansion

2. Capital Injections
The seven-member board headquartered in Washington, D.C., formulates monetary policy and supervises banks. 3. Debt Guarantees
4. Asset Purchases or Guarantees
Federal Open Market Committee (FOMC)
Conclusion Effective financial risk management ensures stability and success in financial markets. Understanding
The primary monetary policy-making body that formulates policies for economic stability and growth. interest rates, security valuation, and monetary policy is crucial for making informed investment and policy decisions.

Functions of Federal Reserve Banks

• Assisting in monetary policy implementation Module: Money Markets and Bond Markets
• Supervising financial institutions
• Providing government services Chapter 5: Money Markets
• Issuing currency
• Clearing checks Introduction to Money Markets
• Wire transfer services
• Conducting economic research
Money markets facilitate short-term borrowing and lending, usually for periods of one year or less. These markets
provide high liquidity and are used by businesses, governments, and financial institutions.
Major Liabilities of the Federal Reserve
Yields on Money Market Securities
• Reserves: Depository institutions’ reserves at the Fed.
• Monetary Base: Currency in circulation and reserves held at the Fed. Returns on money market securities are measured and quoted in ways that may not align directly with time value of
money calculations.
Major Assets of the Federal Reserve
Bond Equivalent Yields (BEY)
• Treasury Securities: U.S. government securities held by the Fed.
• Government Agency Securities A rate used to calculate the present value of an investment. For money market securities, BEY is derived as the product
• Gold and Foreign Exchange of the periodic rate and the number of periods in a year.

Monetary Policy Tools Effective Annual Return (EAR)

1. Open Market Operations (OMO): Buying/selling government securities to regulate money supply. When interest compounds multiple times per year, the true annual return is the EAR, which can be derived from the
2. Discount Rate: Interest rate on Fed loans to financial institutions. BEY for short-term money market securities.
3. Reserve Requirements: Minimum reserves banks must hold.
Discount Yields
Effects of Monetary Policy Tools
Some money market instruments, such as Treasury bills and commercial paper, are sold on a discount basis rather
Expansionary Policy than bearing explicit interest.

• Lowering the discount rate decreases interest rates and increases borrowing. Single Payment Yields
• Reducing reserve requirements increases excess reserves, allowing for more lending.
Securities like negotiable CDs and federal funds pay interest only once at maturity. The single-payment security holder
receives both interest and the face value at maturity.
Money Market Securities Municipal Bonds

Various securities are issued by corporations and governments for short-term financing: Issued by state and local governments:

1. Treasury Bills (T-bills) – Short-term obligations issued by the U.S. government to cover deficits and • General Obligation (GO) Bonds – Backed by the issuer’s full faith and credit.
refinance maturing debt. • Revenue Bonds – Financed by revenue from specific projects.
2. Federal Funds (Fed Funds) – Short-term loans between financial institutions, typically overnight.
3. Repurchase Agreements (Repos) – The sale of securities with an agreement to repurchase them at a Corporate Bonds
specified price on a future date.
4. Commercial Paper – Short-term unsecured promissory notes issued by companies for short-term cash needs.
Long-term debt securities issued by corporations. Key characteristics include:
5. Negotiable Certificates of Deposit (CDs) – Bank-issued time deposits with fixed interest rates and maturity
dates, tradeable in the secondary market.
6. Banker's Acceptances – Time drafts payable to sellers of goods, with payment guaranteed by a bank. • Bearer Bonds – Coupons attached, presented for payment.
• Registered Bonds – Owner recorded by the issuer, payments sent directly.
Money Market Participants • Term Bonds – Mature on a single date.
• Serial Bonds – Mature in installments.
1. U.S. Treasury – Issues T-bills to raise short-term funds. • Debentures – Unsecured bonds backed by issuer creditworthiness.
2. Federal Reserve – Conducts open market transactions using T-bills to regulate money supply. • Subordinated Debentures – Unsecured and lower priority in claims.
3. Commercial Banks – Issue and invest in money market instruments. • Mortgage Bonds – Secured by specific collateral.
4. Money Market Mutual Funds – Invest in money market securities and sell shares to investors. • Convertible Bonds – Can be exchanged for company stock.
5. Brokers and Dealers – Facilitate transactions in money market securities. • Stock Warrants – Provide the option to buy stock at a specified price.
6. Corporations – Issue commercial paper for funding short-term needs. • Callable Bonds – Issuer can repurchase before maturity at a set price.
7. Other Financial Institutions – Property-casualty and life insurance companies require quick access to cash. • Sinking Fund Provisions – Require periodic bond retirement by the issuer.
8. Individuals – Invest directly in money market securities or through mutual funds.
9. International Investors – Engage in U.S. money markets and foreign money markets. Bond Ratings and Interest Rate Spreads

International Aspects of Money Markets • Bond Ratings – Evaluate credit risk of bonds, influencing interest rates.
• Interest Rate Spreads – The difference in interest rates between bonds of varying credit risk.
Global money markets have grown in size and importance, with two major forms of growth:
Bond Market Indexes
• U.S. money market securities are traded by foreign investors.
• Foreign money market securities are traded globally. Indexes track bond performance, helping investors assess market trends.

Bond Market Participants

Chapter 6: Bond Markets Major issuers and buyers of bonds include:

Introduction to Bond Markets 1. Federal, State, and Local Governments – Issue debt to finance public projects.
2. Corporations – Issue bonds for expansion and operations.
Bond markets involve the issuance and trading of long-term debt obligations by corporations and governments. Bonds 3. Households and Businesses – Invest in bonds as long-term financial instruments.
are used to finance large projects and government expenditures. 4. Foreign Investors – Participate in U.S. and global bond markets.

Types of Bonds International Bond Markets

Treasury Notes and Bonds Euro Money Markets

Issued by the U.S. Treasury to finance national debt and government expenditures. Treasury STRIPS (Separate • Eurodollar Market – Trading U.S. dollars outside the U.S., used for international banking.
Trading of Registered Interest and Principal Securities) allow for trading individual interest and principal payments • Eurodollar Certificates of Deposit (CDs) – U.S. dollar-denominated CDs issued in foreign banks.
separately. • Eurocommercial Paper – Unsecured short-term debt issued internationally.