5. Bonds and interest rates Flashcards
“Is There a Zero Lower Bound?”
Explain what the corporate channel of monetary policy is and how it works?
- Negative rates increase the cost of holding cash – discourage the corporate savings
- Firms rebalance their assets and expand their investments – economic growth
- Firms who are associated with banks who charge negative rates and are more exposed to negative rates via higher liquidity, experience higher fixed asset growth (more investment) and a decrease in liquidity (they finance it with excess cash they had before)
- Stronger effect for smaller firms (they rely more on their relationship with banks for credit, so they can’t leave easily)
“Is There a Zero Lower Bound?”
Explain what the corporate channel of monetary policy is and how it works?
- Negative rates increase the cost of holding cash – discourage the corporate savings
- Firms rebalance their assets and expand their investments – economic growth
- Firms who are associated with banks who charge negative rates and are more exposed to negative rates via higher liquidity, experience higher fixed asset growth (more investment) and a decrease in liquidity (they finance it with excess cash they had before)
- Stronger effect for smaller firms (they rely more on their relationship with banks for credit, so they can’t leave easily)
“Is There a Zero Lower Bound?”
Why are investment-grade banks more effective in monetary policy implementation in a negative interest rate environment?
1) Corporate treasurers are advised to deposit liquidity in banks whose deposits have high ratings (if something happens, the money does not disappear-> linked to the safe asset idea)
2) Strong relationships with safe banks may be good insurance for firms in case their financing needs increase in the future.
3) Healthy banks are better able to transfer negative rates onto deposits
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the main conclusion of the article?
The positive effects of the NIRP on the economy are stronger if banks are healthy and can charge negative rates on deposits.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What are the findings on monetary policy transmission (effectiveness of the monetary policy depending on the current interest rate)?
- Above the ZLB, all banks pass on most of the policy interest rate cut to commercial deposits (MECHANISM WORKS);
- Around the ZLB, little pass through, even after a year only 20% of the original cut is reflected (MECHANISM IS WEAK – support for HARD ZLB);
- Below the ZLB, pass through increases but only for financially sound banks
(MECHANISM WORKS FOR SOUND BANKS; WEAK BANKS – MONETARY PASS-THROUGH IS NOT HAPPENING).
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the paper about?
The paper:
- examines how effective the monetary policy is in a low and negative interest rate environment
- describes how these effects are transferred unto the economy
- describes how banks and firms are affected by negative interest rate policies.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the reasoning behind the paper? Why is it needed now?
Recently (in the past decades) many economies have entered a low interest rate environment, with some even deploying negative interest rate policies.
The authors examine how it occurs, and what are the consequences.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
When does zero lower bound (ZLB) occur?
It occurs when interest rates are very low
=> rates cause liquidity trap
=> monetary policy is severely limited
=> and CB’s cannot stimulate demand by lowering r
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How do negative interest rate policies (NIRP) work?
Negative rates reduce banks’ profits and lead them to reduce lending.
NIRP provides stimulus to the economy through firms’ asset rebalancing. Firms with high cash holdings linked to banks charging negative rates increase their investment and decrease their cash-holdings to avoid the costs associated with negative rates.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How does NIRP reflect on sound banks?
- sound banks are more likely to charge negative rates once ECB does so
- banks do not experience a decrease in deposits even if they charge negative rates
=> for sound banks that tend to offer negative rates when ECB does as well, the deposits increase
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the main finding of this paper?
When banks are sound, the NIRP can effectively
stimulate the real economic activity by influencing the behavior of both banks and firms.
Explanation:
1) sound banks pass the negative rates on the corporate depositors
2) the transmission mechanism is enhanced by the fact that firms whose deposits are more exposed to negative rates decrease their liquid asset holdings and start investing more in fixed assets (both tangible and intangible)
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What happens to firms that have relationships with banks that offer negative rates?
They are more exposed to negative rates if they hold a lot of cash. These firms lengthen the maturity of the assets to improve their profitability. Thus, they decrease their short-term assets and cash and increase their fixed investment.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
When does a zero lower bound (ZLB) arise?
How does it affect sound banks?
ZLB arises only if agents lack confidence in the banking system and deposits shrink when the interest rate approaches zero.
For sound banks, the transmission mechanism appears to be unaffected even when interest rates turn negative.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
Which banks are more likely to charge negative rates?
Banks in non-stressed countries are more likely to charge negative rates on corporate deposits.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How does the health of the bank impact the amount of pass-through?
Conventionally weaker banks used to pass most of the effect, as they could lend more.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Which one - ETF or mutual fund - interacts directly with the capital markets
Mutual Fund. ETF does not interact with capital markets directly. ETF manager is in legal contract with Authorized Participant (large financial institutions who interacts with the market instead of them)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
At what prices shares trade for ETFs?
Trades occur at MARKET determined PRICES
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
At what prices shares trade for mutual funds?
Trades occur at the end of the day at NET ASSET VALUE (NAV)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe and compare transaction costs for ETFs vs. mutual funds
ETF - externalized (because of no interaction with the capital markets) -> reduced transaction costs
Mutual Fund - Investors bear transaction costs incurred by participants
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe and compare transparency for ETFs vs. mutual funds
ETF - much transparency. Investment strategies specified in advance, holdings listed daily
Mutual Funds - Less transparency. Holdings listed quarterly.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
In which one - ETF or mutual fund - can investors short sell, buy on margin or lend shares?
ETF. Mutual funds cannot do that
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe 3 potential issues for ETFs
1) Investors may have POOR FINANCIAL KNOWLEDGE to distinguish between the types of ETFs (e.g. levered funds)
2) Intraday liquidity can cause “TOO MUCH” TRADING. Investors who trade actively suffer lower returns than those who trade less.
3) Rapid growth in index investing poses CHALLENGES FOR ORDINARY INVESTORS
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe 3 types Equity ETFs
1) Market Capitalization based ETFs (Equity ETFs based on their SIZE)
2) Sector ETFs: track market-weighted) capitalization benchmark for a sector (e.g. real estate) (Equity ETFs based on their SECTOR)
3) Factor/smart beta ETFs: driven by the desire to outperform the market by focusing on certain factors linked to stock returns (e.g. size factor). It is a
cross between active and passive investment strategies.
(Equity ETFs based on their SMART BETA FACTOR)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
What are Fixed Income ETFs?
Portfolio of investment-grade and government BONDS. (purchased via bank loans and high-yield bonds)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
What are 3 reasons for the recent growth in bond ETFs?
1) Bond ETFs are traded on ELECTRONIC EXCHANGES – CONVENIENT (unlike opaque OTC markets for
traditional bonds)
2) Offer HIGHER TRANSPARENCY - bid/ask quotes are
readily available
3) Offer greater LIQUIDITY and DIVERSIFICATION
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
What are Commodity ETFs?
A commodity ETF is an exchange-traded fund (ETF) invested in physical commodities, such as agricultural goods, natural resources, and precious metals. A commodity ETF is usually focused on either a single commodity—holding it in physical storage—or is focused on investments in futures contracts.
Commodity ETF is often viewed as a hedge against
inflation or a source of diversification.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the concern about closure prices of ETFs.
When an ETF closes, its price SHOULD converge to its NAV and underlying assets may be returned in kind (relatively safe)
HOWEVER, in case of exchange-traded unsecured debt obligations issued by Lehman Brothers in 2008, there were no underlying assets to be returned to investors when the bank declared bankruptcy
Implication: investors need to distinguish between various exchange-traded products
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the concern around short selling of ETFs
May cause bankruptcy of the fund if the aggregate long and synthetic long positions exceeds the total actual number of outstanding ETF shares (number of simultaneous redemptions would exceed available assets to be redeemed)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the concern around securities lending by ETF
May pose a THREAT TO INVESTORS but it is very UNLIKELY due to the presence of different safeguards on lending of securities by ETFs. Moreover, it enhances short-selling, which leads to improved price liquidity and efficiency.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the potential Flash Crash of ETFs and why it may be a misconception
ETFs were represented among the securities most affected with prices diverging from their NAVs
– could cause the Flash Crash, yet most likely flash events are not driven by structural problems
with ETFs (e.g. a lot of trading venues, fragmented market)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the concern about liquidity mismatch for ETFs
Liquidity in the primary market refers to the ability of Authorized Participants (APs) to acquire the underlying assets and transfer them to the ETF. The chance that an AP steps away in a crisis may pose SYSTEMATIC RISK. Yet, if a particular AP stops its activities, remaining
APs continue providing liquidity. (If Diana and Dana are transacting, and Dana steps out, Katrina will take over and help Diana)
THIS IS ONLY A PROBLEM FOR SMALL ETFs WHO HAVE VERY LITTLE APs.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe the concern about the impact on the underlying market (from ETFs)
1) Index trackers are typically based on market capitalization-weighted schemes -> pricing errors in underlying stocks might feed on themselves
2) Index funds are price-takers, not price-makers
But, the IMPACT of a “basket” security on liquidity and distortion of prices of the underlying market is UNCLEAR
However, in practical terms, the relative scale of index investing is still small (20% of global equities)
“FREE MARKETS TO FED MARKETS:
HOW MODERN MONETARY POLICY IMPACTS EQUITY MARKETS”
Talis J. Putnins
What is the paper about?
During the COVID crisis, the economy suffers, while S&P500 gained 31%, effectively taking it back to pre-COVID levels.
This paper examines the role of FED played by them intervening in the markets through asset purchasing programs.
“FREE MARKETS TO FED MARKETS:
HOW MODERN MONETARY POLICY IMPACTS EQUITY MARKETS”
Talis J. Putnins
What is the effect of FED intervention?
Once FED intervenes, there is a positive reaction from the stock market.
If stocks plummet, FED responds with a lag to them. Likewise, market responds with a lag from the FED intervention as well.
“FREE MARKETS TO FED MARKETS:
HOW MODERN MONETARY POLICY IMPACTS EQUITY MARKETS”
Talis J. Putnins
What are the channels by which the FED’s asset purchases impact stock markets?
1) Through long-term bond yields
2) Quantitative easing (buying bonds to push up their prices and bring down long-term interest rates), resulting in increased economy activity (Increase money supply in the market -> spur economic activity)
3) By buying ETFs (if needed) -> directly affecting the stock market.
“FREE MARKETS TO FED MARKETS:
HOW MODERN MONETARY POLICY IMPACTS EQUITY MARKETS”
Talis J. Putnins
What does Tālis hypothesise about what did the FED do during the Covid?
Stock markets decline.
Pre-covid: FEDs 10% balance sheet expansion translates to 8.2% increase in stock market returns
Post-covid: FEDs 10% balance sheet expansion translates to 9.1% increase in stock market returns
Conclusion - FED might have bought corporate bonds, therefore indirectly influencing equity market
“FREE MARKETS TO FED MARKETS:
HOW MODERN MONETARY POLICY IMPACTS EQUITY MARKETS”
Talis J. Putnins
What is the conclusion from the paper?
FED actions are responsible for about 1/3 or 1/2 of the rebound of stock market.
When the economy looks grim, the stock market falls, however, while the economy was not great, stocks grew.
Tālis concludes, that FEDs intervention is one of the drivers of the disconnect.
