Chapter 3 & 4 Flashcards
The 2 types of Monetary aggregates
- M1
- M2
Most M1 is characterised by
- Most liquid
- Shorter in time
- Higher accessibility to be transformed into cash
- Non-limited checks writing ability
M2 is
M1+Quasi Money
Quasi Money are characterized by
- Least liquid
- Longer time
- Lower accessibility to be transformed into cash
- Limited checks Writing ability
M1 (most liquid assets) =
currency + traveler’s checks + demand deposits + other checkable deposits
Which monetary aggregate construction differ from one country to another
M2
M2 is composed of
= M1 + small denomination time deposits + savings deposits
and money market deposit accounts + money market mutual fund shares
Currency refer to
A component of M1
Paper money & coins in the hands of public & does not include cash held at ATM
Any Cash that is traded out of the banking system
Traveler’s checks refer to
A component of M1
Prepaid fixed amount that operates like cash that a purchaser can use to buy goods or services when traveling
A customer can exchange a traveler’s check anywhere for cash
Why the use of traveler’s check has been declining
Their use has been in decline since the1990s but Why?
A variety of more convenient alternatives, such as credit cards, Debit cards and Automated Teller Machines “ATM”, became more widely available and were easier for travelers to use
Demand deposits includes
A Component of M1
Business checking accounts that do not pay interest & can be withdrawn at any time from the Depository institutions
Other checkable deposits consists of
A component of M1
Any Demand deposits account against which checks or drafts of any kind may be written, it is called interest bearing checking account
You get a small interest like simple saving accounts
Small denomination time deposits
M2 component
A deposit “<100,000 $ ” at a bank that has a fixed return and a fixed maturity without ability to write checks on it
Depositor does not have access to the funds until maturity
Depositor does not have access to the funds until maturity in Small denomination time deposits but he benefits from
a higher interest rate
Saving deposits is
An M2 component
a non-transaction Deposit that can be added to or taken out at any time.
Money market Deposit Account are
similar to money market mutual funds but are issued by banks
Money market mutual fund shares are
Retail accounts on which households can write checks.
Egyptian Monetary Aggregates are
List the 2 Egyptian Monetary aggregates
- M1
- M2
In Egyptian Monetary Aggregates, M1 is equal to
Currency in circulation + demand deposits in local currency
In Egyptian Monetary Aggregates, M2 is equal to
M1 + demand deposits in foreign currency + time and savings deposits in local and foreign currency
M1 + quasi-money
In Egyptian Monetary Aggregates, M2 is equal to
M1 + demand deposits in foreign currency + time and savings deposits in local and foreign currency
M1 + quasi-money
When Does it not matter which measure of money is considered?
When M1 and M2 move in same direction
If M1 and M2 move in different directions then the government should
Put eyes on both, investigating the problem and find reason behind the differences.
Define money
Any thing that is generally accepted as payment of goods or services or in the repayment of debts
Checks and saving deposits can be considered as money because
Could be
accepted for payment
Which concept is broader Currency or Money
Money
Wealth is
The total collection of pieces of property that serve to store value, it includes not only money but other different types of assets.(bonds-cars-land…….)
Income is
Flow of earnings per unit of time
(a flow concept)
Money is a what concept
money is a stock concept refers to a certain amount in a given point of time.
The 3 functions of money
- Medium of exchange
- Unit of Account
- Store of value
Medium of Exchange refers to
The money used to pay for goods and services
The advantages of having a medium of exchange
- Eliminates the trouble of finding a double coincidence of needs in the barter economy
- Promotes efficiency of economy by lowering transaction costs and minimizing time
- Promotes specialization by eliminating much of time
needed to exchange goods and services.
Double coincidence of needs in the barter economy refers to
Finding someone who needs my good and offer what I want
A medium of exchange must:
- be easily standardized.
- be widely accepted.
- be divisible.
- be easy to carry.
- not deteriorate quickly.
Unit of Account is used to measure
Value in an economy
In case of barter economy we can calculate number of prices needed for traded goods by the formula:
Number of P= N(N-1)/2
Show how when introducing money will decrease transaction costs
In case of 10 goods you need only 10 prices when money is introduced in the economy instead of 45 prices in case of barter economy which will be much more easily
Which function of the money grows as economy becomes more complex
Unit of account
Store of Value is used to
Save purchasing power over time
This sentence is associated with which function of money:
“ from the time you receive your income till the time you spent it” , you are not in need to spend it immediately
Store of value
How Other assets also serve as a store of value
They often pay the owner a higher interest rate than money
Liquidity is
the relative ease and speed by which the asset could be
converted to a medium of exchange.
Money is the most liquid of all assets because
it does not have to be converted into anything else in order to make purchases
Which type of assets involve Transaction costs
Land or property
Evolution of the Payment System involve how many phases
5
List the Evolution of the Payment System phases
- Commodity money
- Fiat money
- Checks
- Electronic payments
- E-money
Define Commodity money
The object “commodity” that clearly has value to everyone ,
accepted as a medium of exchange could serve as money , that is what we call commodity money
Commodity money should be
valuable, easily standardized , divisible commodities and universally accepted in payment of goods & services
E.g. precious metals
Which type of money was in primitive societies
Commodity money
Major drawbacks of commodity money
- Very heavy
- Very hard to transport from one place to another
Fiat money is
paper currency decreed by governments as legal tender
Define Legal tender
Is a medium of payment recognized by a legal system to be valid for meeting a financial obligation
Initially, paper currency carried a guarantee that it was
convertible into coins &
precious metal
Fiat Money could be trusted only if
There some trust in the authorities issued it.
Advantages of using fiat money
It’s not heavy and more lighter compared to commodity money
Major drawbacks of Fiat money
- Easily stolen
- Expensive to be transported in large amounts in order to assure security for these great amounts
Checks are
An instruction from you to your bank to transfer money from
your account to someone’s else account when he/she deposits the check
Advantages of Checks:
- Lowering the transaction cost and risk of transporting money which leads to improve efficiency and economic growth.
- Could be written in any amount up to the balance account.
- Loss from theft is greatly reduced
Checks major drawbacks:
- Delay in executing the process of transferring money via checks that might extend to several business days especially if it will be in other country rather than the one at which the check is issued
- Wasted resources as paper required to process checks is costly
The cost of processing checks in the US is
10 billions $ in US
Example of an electronic Payment
online bill pay
How does the spread of internet help in the evoloution of electronic payment
- Make it cheap to pay bills electronically
- Saves alot of time and effort
How Electronic payment systems provided by banks is made easier
Instead recurring bills can be deducted automatically from your bank account
Define Electronic money
Money that only exist in
electronic form
Debit card enables consumers to
purchase goods and
services by electronically transferring funds from bank
account to merchant account directly
Stored-value card
(Smart card) is
such as prepaid phone card
A card that contains a computer chip that allows it to be loaded with digital cash from the owner’s bank account whenever needed
Creating an account in bank that is connected to internet and easily transferring cash to your personal computer is an example of
E-Cash
Several factors work against
the disappearance of the paper system such as:
- social embeddedness “Habits & traditions
- Security and privacy concerns
- high cost of having electronic system
- some institutional arrangements
Importance of Interest rates
- Personal decisions
- Economic decisions
- Differences between debt instruments need to be compared before measuring interest rates
Why a pound paid to you one year from now is less valuable than a pound paid to you today?
A pound deposited today can earn interest and become 1 x (1+i) LE one year from today
Let i = 0.10
In one year
$100 X (1+ 0.10) = $110 then in two years the $110 becomes
$110 X (1 + 0.10) = $121
or 100 X (1 + 0.10)^2
In n years, $100 deposited brings
$100 X (1 + i )^n
$100 denotes the PV
PV stands for
Today’s (present) value
CF
Future cash flow (payment)
PV =
CF/(1+i)^n
Given a certain interest rate, we could determine today value (price) of a credit (debt) market instrument just by
Adding up the individual present
values of all the future payments received
What is the present value of 250 pounds to be paid in two years if the interest rate is 15%?
Pv=CF/(1+i)^n= (250/(1+0.15)^2)=189.04 pounds
Four Types of Credit Market Instruments in terms of the timing of their cash flow payments
- Simple Loan
- Fixed Payment Loan
- Coupon Bond
- Discount Bond
Simple Loan involves
Lender providing the borrower with an amount of funds, which must be repaid at the maturity date along with an additional payment of interest
E.g. Commercial Loans
Fixed Payment Loan involves
Full amortized loan
Lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period, consisting of part of the principal and interest for a set number of years
E.g installment loans and mortgages
Define Coupon Bond
It pays the owner of the bond fixed interest payments every year until maturity date, when a specified final amount ( face/par value) is repaid
Coupon bond is identified by 4 pieces of information
- Face value
- Issuer
- Coupon rate
- Maturity date
Eg. Treasury bonds – corporate bonds
Discount Bond involves
Buying at prices below its face value and the face value is repaid at the maturity date
Which Credit market instrument doesnt make interest payments
Treasury bills
Simple loans and discount bonds make payments only at
Their maturity dates
Simple loans and discount bonds make payments only at
Their maturity dates
Fixed payment loans and coupon bonds make payments
periodically until maturity
the most accurate way of calculating interest rates is
Yield to maturity
Yield to maturity involves
The interest rate that equates the
present value of cash flow payments received from a debt instrument with its value today
What is the most accurate way to calculate interest rates
Yield to Maturity
Name the type of Loan:
Lender provides the borrower with an amount of funds, which must be repaid at the maturity date along with an additional
payment of interest.
Simple Loan
E.g Comercial loans to businesses
Name the type of Loan:
Lender provides the borrower with an amount of funds, which must be repaid at the maturity date along with an additional
payment of interest.
Simple Loan
E.g Comercial loans to businesses
Application: Yield to Maturity on a simple loan
If Ahmed borrows 100 L.E. from his sister and next year she wants 110L.E. back from him, what is the yield to maturity on this loan?
PV= amount borrowed =100
CF= Cash flow in one year period = 110
n= number of years= 1
100= 110/ (1+i)^1
Solve for i we get i equal to 0.10 i.e 10%
Which type of loan:
The simple interest rate equal to yield to maturity
Simple Loan
Which type of Loan:
Lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period,
consisting of part of the principal and interest for a set number of years.(equal installments)
Fixed Payment Loan (Fully amortized Loan)
E.g. Installment Loans (auto Loans) and mortgages
Which Type of Loan:
Makes the same cash flow payment every period throughout the lifetime of the loan
Fixed Payment Loan
Application: Yield to Maturity & Yearly Payment on a Fixed-Payment Loan
You decide to purchase a new home and need a 100,000L.E. mortgage. You take out a loan from the bank that has an interest rate of 7%. What is the yearly payment to the bank to pay off the loan in 20 years?
LV=FP /(1+i)1+FP /(1+i)2 +…….+FP /(1+i)^n
LV=100,000 FP=? i=0.07
n=20 years
100,000=FP/(1+0.07)^1 +FP/(1+0.07)^2
+………..+FP/(1+0.07) ^20
FP= 9,439.29
LV = Loan Value
FP = Fixed Yearly period
n = Number of years until maturity
Which Type of Bond:
Pays the owner of the bond fixed interest payments every year until maturity date, when a specified final amount is repaid
Coupon Bond
Coupn Bond is identified by 4 pieces of Information
- Face Value
- Issuer
- Coupon Rate (% of Face value)
- Maturity Date
Give an Example:
Coupon Bond
Treasury Bonds - Corporate Bonds
Application: Yield to Maturity and the Bond Price for a Coupon Bond
Find the price of a 10% coupon bond with a face value of 1000L.E., a 12.25% yield to maturity and 8 years to maturity.
P=C /(1+i)^1+C /(1+i)^2 +…….+C /(1+i)^n + F/(1+i)^n
F=1000 ytm=12.25% n=8 c=10%
C=c×F=0.10 × 1000=100 P=?
P=100 /(1+0.1225)^1+100 /(1+0.1225)^2 +…….+ 100/(1+0.1225)^8 + 1000/(1+0.1225)^8 = 889.20
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
Coupon Bnd:
When does the YTM equate the Coupon rate
When the Coupon Bond is priced at its Face value
When does the YTM exceed the coupon rate
When the bond price is below its Face value
T or F:
The price of a coupon bond and the yield to maturity are negatively related.
True
What is this Bond:
A bond with no maturity date that does not repay principal but pays fixed coupon payments forever
Consol or Perpetuity
yield to maturity of the consol is equal to
i_c = C/P_c
For coupon bonds, this equation gives the current yield, an easy way to calculate approximation to the yield to maturity for the case of long term bonds (20 years or more).
The yield-to-maturity calculation for a discount bond is similar to
a simple loan
What is the formula to calculate the yield to maturity for a one-year discount bond?
i =(F - P)/P
What does F and P represent in the yield to maturity formula for a discount bond?
F = Face value of the discount bond
P = current price of the discount bond
How is the yield to maturity related to the increase in price over the year for a discount bond?
The yield to maturity equals the increase
in price over the year divided by the initial price.
Is there a relationship between the current bond price and the yield to maturity of a discount bond, and if so, what is it?
As with a coupon bond, the yield to maturity is
negatively related to the current bond price
What is the relationship between YTM and current bond price for a discount bond?
for a discount bond, the YTM is negatively related to the current bond price.
How does a rise in bond price affect YTM for a discount bond?
The equation shows that a rise in the bond price—
say, from $900 to $950—means that the bond will
have a smaller increase in its price at maturity and
so the YTM will fall, from 11.1% to 5.3% in our
example.
What is the definition of rate of return for a security?
The rate of return is defined as the amount of each payment to the owner plus the change in the security’s value, expressed as a fraction of its purchase price
What does the rate of return measure for a security?
How well a person does financially by holding a bond or any other security over a particular time period is accurately measured by the security’s return
What is the distinction between interest rates and returns when it comes to bond investments?
return on a bond will not necessarily equal the yield to maturity on that bond
Why is the return on a bond more important than the interest rate when evaluating the success of an investment?
The return on a bond that tells how good (or poor ) an investment has been over the holding period
What is the formula for calculating the return on a bond?
The return on a bond is calculated as the sum of coupon payments plus the change in value expressed as a fraction of the purchase price, or
RET = (C/P_t) + ((P_t+1 - P_t)/P_t).
What is the current yield of a bond?
The current yield of a bond is defined as the coupon payment divided by the price of the bond, or
C/P_t = i_c.
What is the rate of capital gain of a bond?
The rate of capital gain of a bond is the change in the bond’s price expressed as a fraction of the purchase price, or (P_t+1 - P_t)/P_t = g
How is the rate of return of a bond calculated?
The rate of return of a bond is calculated as the sum of the current yield and the rate of capital gain, or
R = i+g.
How is the rate of return of a bond calculated?
The rate of return of a bond is calculated as the sum of the current yield and the rate of capital gain, or
R = i+g.
How is the rate of return of a bond calculated?
The rate of return of a bond is calculated as the sum of the current yield and the rate of capital gain, or
R = i+g.
How is the rate of return of a bond calculated?
The rate of return of a bond is calculated as the sum of the current yield and the rate of capital gain, or
R = i+g.
What is the relationship between return and yield to maturity when the holding period equals the time to maturity?
The return equals the yield to maturity
What is the formula for calculating return when the holding period equals the time to maturity?
R = ytm +0 ( as PT+1= PT = FACE value)
What happens to the interest rate and price of a bond when the maturity period is longer than the holding period?
The interest rate will change leading to changes in the price of the bond so the rate of capital gain will change and then the rate of return will change
What happens to bond prices when interest rates rise?
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.
What happens to bond prices when interest rates rise?
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.
What happens to bond prices when interest rates rise?
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.
How does the percentage price change associated with an interest-rate change vary with bond maturity?
The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change.
How does the rate of return vary with bond maturity when interest rates rise?
The more distant a bond’s maturity, the lower the rate of return that occurs as a result of an increase in the interest rate
Can a bond with a high initial interest rate have a negative return?
Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise
What happens to the bondholder when interest rates rise and the price of the bond falls?
The bondholder
experiences a capital loss.
What is a “paper loss” in bond investing?
If the bondholder doesn’t sell the bond, his capital loss is often referred to as a “paper loss.”
When will returns differ from the interest rate?
Returns will differ from the interest rate especially if the price of the bond experiences sizable fluctuations that produce substantial capital gains or losses.
What is interest-rate risk?
It is the riskiness of an asset’s return that results from interest rate changes
Are prices and returns for long-term bonds more or less volatile than those for short-term bonds?
Prices and returns for long-term bonds are
more volatile than those for shorter-term
bonds
Do short-term debt instruments have substantial interest-rate risk?
Although long-term debt instruments have
substantial interest-rate risk, short-term debt
instruments do not.
Is there interest-rate risk for a bond whose time to maturity matches the holding period? Why?
There is no interest-rate risk for any bond whose time to maturity matches the holding period.
That is due that:
1. The price at the end of the holding period is fixed at the face value
2. Any change in interest rate will have no effect on the price at the end of the holding period for the bonds, and the return will be equal to the yield to maturity known at the time the bond is purchased.
Why is interest-rate risk especially important for long-term bonds?
Capital gains and losses can be substantial
Are long-term bonds considered safe assets with a sure return over short holding periods? Why or why not?
Long-term bonds are not considered safe assets with a sure return over short holding periods
How is the real interest rate different from the nominal interest rate?
Real interest rate is adjusted for changes in price level
(inflation) so it more accurately reflects the real cost of borrowing
What does the real return indicate?
Real return indicates the amount of extra goods and
services that can be purchased as a result of holding
the security.
What is the ex ante real interest rate?
Ex ante real interest rate is adjusted for expected changes in the price level (it is what economics mean when they refer to the term real interest rate )
How is the ex-post real interest rate different from the ex ante real interest rate?
Ex post real interest rate is adjusted for actual changes in the price level (it describes how well the lender has done in real terms after the fact)
What is the Fisher Equation?
Fisher Equation
i = i_r +π^e
What does the variable “i” represent in the Fisher Equation?
i = nominal interest rate
What does the variable “i_r” represent in the Fisher Equation?
i_r = real interest rate
What does the variable “π^e” represent in the Fisher Equation?
π^e = expected inflation rate
How does a low real interest rate impact borrowing and lending incentives?
When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
Why is the real interest rate a better indicator of borrowing and lending incentives than the nominal interest rate?
The nominal interest rate does not account for inflation and may be misleading when assessing the cost of borrowing and the return on investment.
What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year?
Mathematically, r = i – π
where i = nominal interest rate = 0.08
π = expected inflation rate = 0.10
Thus , r = 0.08 - 0.10 = -0.02 = -2%.
The result is that you will be able to buy 2% fewer goods at the
end of the year, and you will be 2% worse off in real terms.
What does a negative real interest rate mean for lenders?
A negative real interest rate means that in terms of real goods and services, lenders have earned a negative interest rate and are less eager to make a loan.
What does a negative real interest rate mean for borrowers?
A negative real interest rate means that borrowers will have to pay back less in terms of goods and services, making them quite well at the end of the year and giving them an incentive to borrow.
When the real interest rate is low, are there greater incentives to borrow or to lend?
When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
