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Lecture 6

BUSI 3410U Lecture Notes - Lecture 6: Swedish National Bank, Risk Premium, Liquidity Premium

Course Code
BUSI 3410U
Bin Chang

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Lecture 6: Fixed Income Securities
Financial Institutions
Four types of Credit Market Instruments → Siple loa, Fied paet loa,
- Coupon Bond
o The yield to maturity is the interest rate that equates the PV of the CF payments received from a
debt instrument with its value today
o The price of a coupon bond and the YTM are negatively related
1. Sold at pa→ he the oupo od is pied at its FV, YTM euals the oupo ate
2. Sold at disout→ YTM is geate tha the oupo ate he the od pie is elo its FV
3. Sold at Peiu→ YTM is less tha the oupo ate hen the bond price is above its F
o Cosole → od ith o atuit date that does ot pa piipal ut pas fied oupos foee
- Discount Bond: one year bond
o Bond without coupons
o YTM equals the increase in price over the year divided by the initial price
o Yield on a Discount Basis
idb = (F P) /P x 365/(days to maturity)
Negative Interest Rates in Japan
- Nov 1998, interest rates on Japanese 6-months T-bills = - 0.004% with investors paying more for the bills
- Weakness of Jap economy and a negative inflation rate drove interest rates to low levels; 2 factors cannot
explain negative rates
- Reaso→ lage iestos foud it oe oeiet to hold theses 6o ills as a stoe of alue athe tha
holding cash
o Bills are denominated in large amounts and can be stored electronically
o Convenience of T-bills result in interest rates changing slightly (below)
Negative interest rate Sweden July 2009
- Riksbank fixed interest rates at -0.25% on certain deposits kept by the commercial banks at the central bank
- Negatie ate, aks ae effetiel fied if the hoad uused fuds i the etal ak’s offes
o Way to punish them for a conservative lending policy at a time when authorities want to ensure the
economy gets easy credit
- Banks are usually paid interest on these deposits
Interest Rate Risk
- Risk that a od’s pie ill hage eause iteest ates hage
- Volatile refers to the % change of price
- Prices for LT bonds are more volatile than those for ST bonds
- Prices for low-coupon bonds are more volatile than those for high-coupon bonds
- There is no interest-rate risk for any bond whose time to maturity matches the holding period
Determining the Quantity Demanded of an Asset
- Wealth→ total esoues oed  the idiidual, including all assets ( both increases)
- Epeted etu→ E  oe the et peiod o oe asset elatie to alteatie assets ( both increases)
- Risk→ degee of uetait assoiated ith etu o oe asset elatie to alteatie assets (negatively
- Liuidit→ ease/speed which asset can be turned into cash relative to alternative assets (both increases)
Supply and Demand for Bonds
- At lower prices(higher interest rates), the quantity demanded of bonds is higher an inverse relationship
- At loe pies highe iteest ates, the uatit supplied  ods is loe → a positie elatioship
Market Equilibrium
- When Bd = Bs euiliiu
- When Bd > Bs → eess dead; pies ill ise, ad iteest ates ill fall
- When Bd < Bs → eess supply; price will fall and interest rates will rise
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