Finance 141: Money and

Capital Markets
Wednesday, March 25, 2020
Review Questions
• 1. What is inflation risk?
Undermine an investment’s returns through a decline in purchasing power
• 2. What is the Fisher effect?
Describes the relationship between inflation and both real and nominal
interest rates.
Nominal interest rates = real interest rates + premium for expected inflation
• 3. What is the measure of market expectation of future inflation?
• Treasury inflation – protected securities (TIPS)
• 4. What is a callable bond?
• The issuer may redeem before it reaches the stated maturity date
Review Questions (cont.)
• 5. What is an imbedded option?
• Component of a financial security that gives the issuer or the holder the right to take a specified action in the future.
• 6. How does the yield on a callable bond compare to the yield on a non-callable bond by the same issuer with the same maturity?
Why?
• Callable bond high yield than non-callable bond (prepayment/ call risk/ reinvestment risk)
• 7. What other types of bonds contain imbedded options?
• Callable bond
• Puttable bonds
• Sinking fund bonds
• Mortgage bonds
• Convertible bonds
• 8. What are convertible bonds?
• A fixed-income debt security that yields interest payments, but can be converted into a predetermined number of common stock
or equity shares.
Review Questions (cont.)
• 9. How does the yield on a convertible bond compare to that of a
non-convertible bond by the same issuer with the same maturity?
Why?
• Convertible bond offers a better return than a traditional bond.
Interest Rate Risk (cont.)
• Unique Forms of Interest Rate Risk (cont.)

• Prepayment Risk GNMA Mortgage Bond vs. Treasury Bond

YIELD

TIME
Interest Rate Risk (cont.)
• Prepayment risk (cont.)
• Contraction risk
Faced by the holder of fixed income securities.
The risk happens when borrowers increase the rate at which they pay back the
maturity value of the fixed income security.

Happens when borrowers pre-pay thereby reducing the duration of their note.

• Extension risk
Borrowers will defer prepayments due to market conditions.
Exp: if interest rates rise it might discourge homeowners from re-financing their
mortgages, reducing the flow of prepayments. This could extend the duration of the
loans in a mortgage backed security (MBS) beyond what the valuation and risk models
initially predicted.
Other Forms of Risk
• Default risk

• Credit risk
• Consider AA rated bond; 3% coupon; 10 year maturity; price= $1,000 (par).
What is its YTM?
• Bond is downgraded. What will happen?
Other Forms of Risk (cont.)
• Sovereign Risk

• Foreign Exchange Risk

• Event Risk
Liquidity
• What is liquidity in the money and capital markets?

• How is liquidity measured in the money and capital markets?

Liquidity (cont.)
• What is the measure of market expectations of liquidity in the money
and capital markets?
On the Run vs. Off the Run Treasuries

YIELD

TIME
 Transfer of Money in the Economy
• Financial Intermediation – Indirect Finance

Money $ Commercial Money $ Loan

Depositor Bank Borrower
Interest % Interest $
Transfer of Money in the Economy (cont.0
• Benefits of the financial intermediation process

• Size intermediation

• Maturity intermediation

• Liquidity intermediation

• Risk intermediation
Transfer of Money in the Economy: Direct
Finance

Money $

Investor Issuer
Interest %
Transfer of Money in the Economy (cont)
• Direct Finance (cont.)

• Who are the major issuers in the money and capital markets?
• Bond market:
• U.S. government
• Corporations
• municipalities
• Who are the major investors in the money and capital markets?