Corporate Finance - Study Session 11

Review Notes:

• Know the relationship between BDY, BEY, HPY and EAY well i.e. what the drawbacks are of each and which gives higher or lower results relative to the others.
• Know how to calculate BDY, BEY, HPY and EAY very well
• The money market yield (MMY) is the holding period yield (HPY) times 360/t and is always greater than the discount yield (BDY) which is the actual discount from face value times 360/t, since the holding period yield is always greater than the percentage discount from face value. A security’s BDY and MMY always <>, and its EAY always > BEY.
• So EAY > BEY > MMY > BDY
• For pricing debt or equity, use market price rather than face value or book value
• weak on finding the Beta for a project calculation - probably just a brute for memorization

LOS 44b - Discuss the basic principles of capital budgeting, including the choice of the proper cash flows

Capital budgeting includes 5 key principles:

1. Decisions are based on cash flows, not accounting income; so take into account incremental cash flows; do not consider sunk costs such as market research into a potential new product; consider negative externalities such as cannibalisation and positive ones which may boost another product.
   
   conventional cash flow pattern = negative first cash flow, positive cash flows from then on
   unconventional cash flow pattern = sign on the cash flow changes more than once
2. Cash flows are based on opportunity costs e.g. account for the cost of the company-owned land that a proposed new building would occupy
3. Timing of cash flows - earlier cash flows are more valuable than later ones
4. cash flows are analysed on an after-tax basis - we want to know what we keep from the project
5. financing costs are already reflected in the required rate of return i.e. the discount rate used in the capital budgeting analysis takes account of the firms cost of capital; only projects expected to return more than the cost of capital needed to fund them will increase the value of the firm

LOS 44c - Explain how the following project interactions affect the evaluation of a capital project:

1. Independent versus Mutually Exclusive Projects Independent projects are unrelated to one another and can be evaluated based on their own profitability. Mutually exclusive projects = only one project in a set of projects can be accepted.
2. Project Sequencing Just as it sounds. the order of projects is important. choosing a certain project now may provide opportunities for other projects if profitable. If unprofitable, it precludes the other project.
3. Unlimited Funds versus Fund Rationing If you have unlimited money, choose the projects which will make more than the cost of capital. With constraints on money, you will have to prioritise projects and ration money to those projects that make the most monetary sense.

LOS 44d - Calculate and interpret the results using each of the following to evaluate a single capital project: NPV, IRR, payback period, discounted payback period, and profitability index (PI)

NPV is the sum of all the present values (including any initial negative outlay) of the expected incremental after-tax cash flows if a project is undertaken, discounted at the firm's cost of capital (adjusted for risk). A positive NPV is expected to increase shareholder wealth and vice versa. For independent projects, the NPV decision rule is to accept any project with a positive NPV

IRR is the discount rate that makes the after tax PV of all the cash flows (discounted at the firm's cost of capital) equal to the initial cost of the project i.e. makes PV(inflows)=PV(outflows) and therefore is the discount rate that makes the NPV = 0. IRR Decision Rule (1) determine required rate of return for a project (usually firm's cost of capital adjusted for risk) and (2) if IRR > cost of capital then accept.

Payback Period (PBP) is the number of years it takes to recover the initial cost. You may be given a Cumulative Net Cash Flows (NCF) table which is a running total of how much you have paid down on the initial cost or how much profit you have made. If the breakeven point is between two years, divide the NCF at the start of the year by the next cash inflow (the next year) e.g. -400/1200 will give you 0.333 of a year.

PBP Decision rule Payback period is about liquidity i.e. when will i have the money back so i can do something else with it. It is not for accept/reject because it does not take into account time value of money or cash flows beyond the payback period (so terminal/salvage value wouldn't be included).

Discounted Payback Period = # of years it takes to pay back intial outlay in PV terms and therefore is always greater than non-discounted PBP. Addresses TMV drawback of PBP but does not address the other concerns.

Profitability Index (PI) = the PV of a project's future cash flows divided by the initial cash outlay. i.e. PI = PV of future cash flows including intial cash flow/initial cash flow = CF0 + NPV/CFo

If NPV is positive then PI will be greater than one. Therefore, if PI > 1.0 accept the project.

• So if NPV is positive, IRR will be greater than cost of capital and PI will be > 1.0

LOS 44e: Explain the NPV profile, compare and contrast the NPV and the IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods

• NPV profile depicts the NPV of (multiple) projects at varying costs of capital. The cost of capital is along the x axis so the IRR will be where the NPV profile intersects the x axis i.e. where NPV = 0
• NPV profiles intersect where their NPV's are equal (the crossover rate); in the below profile, project 1 has a higher NPV at discount rates lower than 7.2% and project 2 has higher NPV at discount rates higher than 7.2% (so the discount rate determines which project has a higher NPV)
• The NPV profiles intersect because of the timing of their cash flows; the NPV of a project (e.g. project 1) will fall faster if it has later cash flows than another project (project 2)

key advantage of NPV = direct measure of the expected increase in shareholder value (therefore, preferred method). disadvantage = does not tell you the size of the project e.g. a project that cost a $1,000,000 but has a positive NPV of $10 is probably not a wise investment

key advantage of IRR is that it solves the latter problem; measures profitability as a percentage i.e. return on each dollar invested. We can tell how far the project has to fall before it becomes uneconomical/ distadvantage: (1) can produce different rankings than NPV approach for same projects (2) possibility that there are multiple IRR's or no IRR for a project (due to unconventional cash flows for projects with positive NPV)

when in doubt (for mutually exclusive projects) use NPV IRR can be huge for a very small project e.g. investing $10 and making $100 might give you an IRR of 85% but only increases shareholder value by $90 whereas a large investment of a smaller IRR (say 20% IRR on a million bucks) is obviously a better investment.

NPV implicitly assumes that the money made could be reinvested at the discount rate used which is realistic whereas IRR implies it could be reinvested at the IRR rate which is not realistic.

LOS 44f: Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price

Capital budgeting method varies according to:

Location European countries tend to use PBP method as much as IRR/NPV

Sophistication - the more sophisticated the company (size/education/private) the more likely the IRR/NPV method is used

Relationship between NPV and Stock Price

in theory, a positive NPV should cause a proportionate increate in a company's stock price. e.g.

• if share price is $10 with 1000 shares outstanding then value = $10,000
• if NPV of new project is $2000 then new value of company = $12,000
• new share price = 12,000/1000 = $12

in reality, share price is more function of expectations about earnings so announcement of NPV positive project may cause share price to drop if NPV is less than expect or it might rise disportionately if the project signals other projects or expectations

LOS 45a: Calculate and interpret the weighted average cost of capital (WACC) of a company

Calculate WACC = (wd)[kd(1 - t)] + (wps)(kps) + (wce)(kce)

where:

• wd = weight of debt
• kd = cost of debt
• t = marginal tax rate
• wps = weight preferred stock
• kps = cost of preferred stock
• wce = weight common equity
• kce = cost of common equity

WACC gives you the opportunity cost of capital or the discount rate for discounting future cash flows when capital budgeting

• For any given project, your IRR should be higher than your WACC in order to approve the project
• If your project is riskier than the risk of the projects that make up the firm, the WACC may need to be revised upward or vice versa

LOS 45b: describe how taxes affect the cost of capital from different capital sources

Interest paid on debt is often tax deductible hence the debt is often discounted by 1-t (which decreases the cost of debt by the marginal tax rate). Other sources of capital (ps and ce) are not typically tax deductible so they are not discounted.

LOS 45c: Describe alternative methods of calculating the weights used in the WACC, including the use of the company's target capital structure

• WACC should be based on firm's target capital structure - the weights (based on market values) of debt, ps, and ce the firm expects to achieve over time
• if no info is available, use firms current structure
• if there is a trend (e.g. firm has been increasing debt) then follow that trend in your weighting system
• otherwise use industry average capital structure as target structure for firm

LOS 45d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget

• Company creates wealth for shareholders by earning more on its investment in its assets than is required by those who provide capital to the firm (the WACC)
• Marginal Cost of Capital (cost of raising capital) generally increases as larger amounts are invested - hence the upward sloping marginal cost of capital curve
• Expected returns (IRR's) of potential projects can be ordered from highest IRR to lowest IRR to create a downward sloping investment opportunity schedule
• where the MCC curve intersects the investment opp schedules is the optimal capital budget which makes sense because the firm should take on all projects with an IRR greater than the cost of capital

LOS 45e: Explain the marginal cost of capital's role in determining the NPV of a project

• WACC is the appropriate discount rate for projects with the same level of risk as the firm's existing projects; WACC's should be adjusted up/down for higher/lower risk projects
• implicit assumption that capital structure of a firm will remain the same over the span of the project
• NPV should be calculated using the WACC/Marginal Cost of Capital and those projects with a positive after tax NPV should be accepted

LOS 45f: Calculate and interpret the cost of fixed rate debt capital using the YTM approach and the debt rating approach

• After-tax cost of debt is the rate, kd(1 - t) is the interest rate at which firms can issue new debt net of the tax savings
• Cost of debt is the market interest rate (YTM) of new (marginal) debt, not coupon rate on firm's existing debt
• if YTM is not available (e.g. debt is not publicly traded), analyst may use the rating and maturity of the firm's existing debt e.g. if firm's debt is rated AA with maturity of 15 yrs, you can use yield curve for AA rates debt with maturity of 15 yrs
• if anything (e.g. covenants, seniority) affect the yeidl, adjust appropriately
• for firms with floating rate debt, estimate the longer-term cost of the firm's debt using the current yield curve (term structure for the appropriate rating category)

LOS 45g: Calculate and interpret the cost of non-callable, non-convertible preferred stock

• cost of preferred stock (kps) = Dps/P
• where Dps is preferred dividends and P is market price

LOS 45h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the divident discount model approach, and the bond-yield-plus risk-premium approach

All of these approaches measure the required rate of return on the firm's common stock - the opportunity cost of capital i.e. the firm can lower some of this part of the WACC by using retained earnings to buy back shares (lowering cost of common stock outstanding)

Hence all of these approaches are ways of valuing the cost of common stock

1) CAPM = RFR + B[E(Rm) - RFR]

• RFR = Risk free rate
• E(Rm) = expected return on the market
• Beta is the stock's risk measure
• this is another formula that makes sense when you break it down. it is the risk free rate plus the risk premium multiplied by the market risk

2) Dividend discount model approach

• Po = D1/(kce - g)

where:

• D1 = next year's dividend
• kce = the required rate of return on common equity
• g = the firm's expected constant growth rate

Rearranging the terms you can solve for kce = (D1/P0) + g

Use the growth rate projected by security analysts or estimate growth using:

• g = (retention rate)(return on equity) = (1 - payout rate)(ROE)

this is also intuitive; the growth rate is the amout of ROE the firm will keep

3) Bond yield plus risk premium approach

ballpark figure constructed by adding a risk premium (3-5%) to the market yield on the firm's long term debt

• kce = bond yield + risk premium of 3-5%

LOS 45i: Calculate and interpret the beta and cost of capital for a project

Project's beta = systematic or market risk; use project's beta to adjust for differences between a specific project's risk adn the average risk fo a firm's projects

Pure-play method = find a publicly traded firm purely engaged in the same biz as the project and begin with that firm's beta and then unlever it (to adjust for the company's dependence on debt financing) and then relever it based on the financial structure of the company evaluating the project. Then use this equity beta to calculate the cost of equity to be used in evaluating the project.

To get asset beta for publicly traded firm, discount the equity beta for the form by the after tax debt-to-equity ratio

• ΒASSET = ΒEQUITY[1/1+(1(1-t)D/E)]

to get equity beta for the project, use the subject firm's tax rate and debt-to-equity ratio and re-lever the beta so...

• BPROJECT = BASSET[1+((1-t)D/E)]

issues for this method:

• beta is estimated using historical returns which may be sensitive to the length of time used
• estimate is affected by the index chosen to represent market return
• betas are believe the revert to 1 over time - need to account for this
• estimates of betas for small cap firms may include a risk premium for risk of smaller firm not captured by usual estimation methods

LOS 45j: Explain the country equity risk premium in the estimation of the cost of equity for a company located in a developing market

CAPM is problematic in developing countries because Beta does not capture country risk premium

general risk of developing country is reflected in its sovereign yield spread (the difference between yields of sovereign debt and similar maturity Treasuries)

we must also adjust the sovereign yield spread by the ratio of the volatility of equities in dev country/volatility of sovereign bonds for that country (for bonds denominated in developed market's currency)

so revised CAPM: kce = B[E(Rmkt)-RFR+CRP]

where CRP is:
country risk premium = sovereign yield spread * (volatility dev. equities/ volatility dev. bonds in US$)

LOS 45k: Describe the marginal cost of capital schedule, explain why it may be upward sloping with respect to additional capital, and calculate and interpret its break points

• marginal cost of capital schedule tends to be upward sloping because as a firm raises more and more capital , the costs of different sources of financing will increase
• e.g. cost of debt may rise due to increased risk, convenant protecting seniority of earlier debt issues, flotation costs of issuing new stock
• marginal cost of capital schedule shows the WACC for different amounts of financing
• break points occur any tiem the cost of one of the components of the company's WACC changes and is calculated thusly:

break point =
amt of capital at which a component's cost of capital changes
weight of the component in the capital structure

LOS 45l: Explain and demonstrate the correct treatment of flotation costs

• Flotation costs are a fixed one-off costs and should rightly be accounted for as part of the initial cost of the project and NOT as part of WACC in any way

Problem set issues:

• calculate Marginal Cost of Capital
• calculate ke using dividend discount approach

Reading 46: Working Capital Management

LOS 46a. describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position;

• primary sources of liquidity are the sources of cash the company usese in its day-to-day operations e.g. cash balances from sales of goods and services, collecting receivables and investment income. Short term funding includes trade credit from vendors and lines of credit from banks
• secondary sources of liquidity indicates trouble e.g. liquidating short-term or long-lived assts, renegotiating debt agreements, filing for bankruptcy and restructured
• drags and pulls drags on liquidity are things that delay/reduce cash inflows (bad debts, incollected receivables, obsolete inventory, etc.) pulls are things that accelerate cash outflows e.g. paying vendors sooner than is optimal

LOS 46b. compare a company’s liquidity measures with those of peer companies;

most of the comparisons are performed comparing the following ratios to industry norms

• current ratio = current assets/current liabilities high ratio means better ability to pay short term bills; less than one means trouble
• quick ratio = (cash + marketable securities + receivables)/current liabilities i.e. same as current ratio but only using the most liquid assets

Measures of how well a company is managing its working capital include:

• receivables turnover = credit sales/average receivables
• number of days of receivables = 365/receivables turnover
• inventory turnover = COGS/average inventory
• number of days of inventory = 365/inventory turnover
• payables turnover = purchases/average trade payables
• number of days of payables = 365/payables turnover
• NB all of these are measures of turnover i.e. the item/average of the opposite measure e.g. COGS/avg inventory and the number of days is just 365/turnover
• NB you want these to mostly be close to industry norms

LOS 46c. evaluate overall working capital effectiveness of a company, using the operating and cash conversion cycles, and compare its effectiveness with other peer companies;

• operating cycle = number of days it takes to turn raw materials into cash proceeds from sales
• operating cycle = days of inventory + days of receivables
• cash conversion cycle or net operating cycle is the length of time it takes to turn the firm's cash investment in inventory back into cash, in teh form of collections from the sales of that inventory
• cash conversion cycle = (avg days of receivables) + (avg days of inventory) + (avg days of payables)
• NB high cash conversion cycles are undesirable - implies too much investment in working capital
• NB understand what the ratios are saying about the business

LOS 46d. identify and evaluate the necessary tools to use in managing a company’s net daily cash position;

Need to ensure there is sufficient cash without letting it sit idle; answer is to keep much of it highly liquid, low risk securities etc. such as:

• Treasuries
• Bank COD's
• Banker's Acceptances
• Repurchase Agreements
• Commercial Paper
• Money Market Mutual Funds
• Adjustable-rate preferred stock = stock which resets quarterly to current market yields and has tax advantage

LOS 46e. compute and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines;

• % discount from face value = (face value - price)/face value
• discount basis yield (or BDY) = % discount * (360/t)
• money market yield = ((face value - price)/price)* (360/t) = HPY * (360/t)
• bond equivalent yield = HPY * (365/t)

returns on firm's short term securities investments should be stated as BEY's. Return on portfolio should be expressed as weighted average of those yields

LOS 46f. assess the performance of a company’s accounts receivable, inventory management, and accounts payable functions against historical figures and comparable peer company values;

• A firm's inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time, and by comparing them to industry averages or averages for a group of peer companies.
• A receivables aging schedule and a schedule of weighted average days of receivables can each provide additional detail for evaluating receivables management.

LOS 46g. evaluate the choices of short-term funding available to a company and recommend a financing method.

Choices for short term borrowing depends on firm's size and credit-worthiness; options (in order of decreasing firm creditworthiness and increasing cost):

• commercial paper
• bank lines of credit
• collateralised borrowing
• nonbank financing
• factoring (of receivables)

FINANCIAL STATEMENT ANALYSIS

LOS 47: Demonstrate the use of pro forma income and balance sheet statements

• Pro forma income and balance sheet statements are forward-looking financial statements constructed based on specific assumptions about future business conditions and firm performance.
• process begins with making an assumption about which variable is the overall driver (e.g. sales) of income and balance sheet items
• e.g. if sales are forecast to increase by 10% then we could forecast that COGS, fixed assts, total assets, debt and interest expense etc. could increase by 10%
• i.e. that the percentage of each relative to sales will be maintained

Constructing a sales-driven pro forma financial statement:

1. Estimate the relation between change in sales and the changes in sales-driven income statement and balance sheet items
2. Estimate the future tax rate, interest rate on debt, lease payements, etc.
3. Forecast sales for the period of interest
4. Estimate fixed operating costs and fixed financial costs
5. Integrate these estimates into pro forma financial statements for the period of interest

To calculate future sales, you can:

• calculate average compound growth rate of sales over 5 or 10 year period and use that rate to forecast future sales
• regression analysis to estimate relationship between GDP growth and growth in sales and use economists' estimates of future GDP growth to forecast (assumes correlation)
• economic cycles, seasonality of sales, specific events, changes in regulation/tax rate etc. can also be incorporated into model

We can move the financial statements through iterations based on "what if" scenarios such as what if the company decided not to pay dividends and yielded a surplus. Then what if this surplus was used to pay down debt? Interest payments would come down and more money would come in from the savings there... etc. etc.

The Corporate Governance of Listed Companies: A Manual For Investors

LOS 48a: Define and describe corporate governance

Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the appropriate rights, roles, and responsibilities of the management, the board of directors, and shareholders within an organisation. It is the firm's checks and balances.

Good corporate governance seeks to ensure that:

• the board of directors protects shareholders interests
• the firm acts lawfully and ethically in dealings with shareholders
• the rights of shareholders are protected and shareholders have a voice in governance
• the board acts independently from management
• proper procedures and controls cover management's day-to-day operations
• the firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner

LOS 48b: Discuss and critique characteristics and practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection

Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. Good corporate governance practices ensure that the board of directors is independent of management and that firm and its managers act lawfully.

LOS 48c: Describe board independence and explain the importance of independent board members in corporate governance

Majority of board should be independent but experienced enough to advise management and review its activities.

LOS 48d: Identify factors that indicate a board and its members possess the experience required to govern the company for the benefit of its shareholders

experience with:

• the products or services the firm produces
• financial operations, accounting, and auditing
• legal issues
• strategies and planning
• firm's business and financial risks

LOS 48e: Explain the provisions that should be included in a strong corproate code of ethics and the implications of a weak code of ethics with regard to related-party transactions and personal use of company assets

• code of ethics - practice what you preach;
• comply with corp gov standards in home country and stock exchange;
• no advantages to outsiders that are not available to shareholders;
• have someone responsible for corp governance

LOS 48f: State the key areas of responsibility for which board committees are typically created and explain the criteria for assessing whether each committee is able to adequately repesent shareholder interests

• Audit committee - proper account procedures, external independent auditor, free commuincations
• Compensation committee - ensure fair and appropriate (not excessive) compensation which is linked to long term profitability; shareholder approval for share based compensation (dilution issues); be transparent about compensation
• Nominations committee - recruitment of new, qualified board members; review existing board members; succession planning

LOS 48g: Evaluate, from a shareholder's perspective, company policies related to voting rules, sharehodler sponsored proposals, commons stock classes, and takeover defenses

• don't make it difficult to vote proxies
• confidence voting and remote proxy voting are good
• takeover defenses are generally not in the shareholders' best interest

rules of thumb:

• independence is good; promoting rights and interests of shareholders is good
• any conflict of interest e.g.tie to management, consulting fees, personal loans from company, long-serving board members, family ties, cross-directorships, unreasonable compensation packages, chairman is also CEO = bad

The Out-of-whack order

OK. In case, anyone is actually reading this, let me explain the messy postings: I've decided to move FRA to last so that I can spend the required time on it (and i'm going to do the "real" reading for that i.e. CFAI books). I started it as you can see but quickly realised i need time to internalise it and become more fluent in the fundamentals and learn more depth so it is now last where it can expand a little without the pressure of getting to other books.

Because i want ~one month to revise and take practice tests, it means i am about three behind schedule (fun!). So my plan is to try and study corporate finance/portfolio management/equity investments (book 4) in the evening and study the rest of the derivates/alternative investments during my lunch hour at work to try and make up the time. We'll see how well that works out considering today was day one of the new schedule and i studied zero hours during the day.

General Thoughts on Formulas and Mistakes

1. many mistakes I make are on the small things e.g. not reading the question correctly, forgetting to do something simple like divide the interest rate or coupon by the number of periods etc.
2. to reinforce the above: underline key data in a question including putting a big circle around words like least likely or most appropriate etc. - getting these right could easily improve my scores by 5-10% and are a stupid-ass reason to lose points.

Understanding Formulas
Several formula seem to crop up again and again in various guises so I'm going to try and explain generally what they are useful for and how they work:

1. weighted average - whenever you are trying to find an average (e.g. expected return) on a set of outcomes that are not equally represented in the set
2. powers - raising returns/yields to a power of n represents compounding that yield over n periods
3. geometric mean - when the return/yield is different for each of n periods and you need an average, multiply all the returns/yields together and take the nth root
4. percentage change between two periods e.g. Holding period return, change in bond price after interest rate change etc. is the (final period value - original value)/original value NB this not the way you would do it when calculating change in price say for the elasticity calc - that would be P1-P0/(avg P1,P0)
5. discounting - discounting cash flows or even interest rates (unsurprisingly) happens a lot and is usually happening over several periods so you are undoing compounding of interest etc. so: value to be discounted/(1+I/Y)ⁿ
6. spot versus forward rates spot rates are the one interest rate for the period of the loan e.g. a 3 yr spot rate would be the discount rate for the entire three years whereas a forward rate would be used for each of the periods to discount the cash flows. So for two periods if you have 1 yr spot of 5% and fwd of 5% and 2yr spot of 6% and fwd of 6% then to calc PV of cash at the end of two years using spot rate, you would use 6% as your discount. To calc PV of cash at the end of two years using forward rate, you would discount year one at 5% and yr 2 cash flow at 6% then 5%
7. Increasing or decreasing an amount by a certain percentage (e.g. finding next/last dividend, profit on a stock portfolio based on growth rate, etc.): increase = amt*(1+x), decrease = amt*(1-x)

Valuing a security
most valuations involve a PV of the expected cash flows
expected return can be compared against required return to decide buy or sell

Conducting any analysis tends to consist of these kinds of steps:

• set the objective or goal
• collect the relevant data
• process the data to get usable numbers
• analyse and interpret the data
• recommendation based on data
• monitor and update the analysis

this appears to be true of individual company analysis, financial statement analysis, hypothesis testing, etc.

when conducting the analysis, work from general to specific e.g. economic analysis, industry analysis, firm analysis, firm security analysis.

Study Session 15 - Readings 60-65 Fixed Income

Fixed Income

Notes:

• The duration of a floating rate bond is equal to the time until the next coupon payment takes place. As the coupon rate changes semi-annually with the level of the interest rate, a floating rate bond has the same duration as a pure discount bond with time to maturity equal to the time to the next coupon payment of the floating rate bond.
• duration for fixed rate bonds is Duration = Price Yield Down – Price Yield Up / 2 * (initial price) *change in yield in decimals
  

LOS 61a - Explain the risks associated with investing in bonds

Interest rate risk - approximated by measure call duration; when interest rates rise, bonds fall

• Yield Curve Risk - change in shape of yield curve means that yields change by different amounts for bonds with different maturities
  
• Call Risk - risk of issuer calling back the bond, investor must reinvest at a lower rate


• Prepayment Risk - increase in interest rate volatility (like with call risk) causes prepayment; investor must reinvest at lower rate


• Reinvestment Risk - when market rates fall, cash flows (principal and coupon) from bond must be reinvested at lower rate


• NB Investor can be faced with choice between reinvestment risk and price risk e.g. non-callable zero coupon bond has no reinvestment risk (no cash flows to reinvest) but has more interest rate risk than a coupon bond of same maturity) and vice versa


• Credit Risk - if creditworthiness of issuer declines, required return increases, decreasing security's value


• Liquidity Risk - if bond is not very liquid, may have trouble selling it and sell for discount


• Exchange-rate risk e.g. foreigner investing in T-bills will risk relative value of home currency to dollar
  
• Inflation Risk - uncertainty about future purchasing power of cash flows


• Volatility Risk - with embedded options (call/put/prepayment) interest rate volatility affect value of the options and therefore the value of the security


• Event Risk - events outside of the financial market e.g. catastrophe, corporate takeover


• Sovereign Risk - risk of changes in government attitudes and policies toward repayment and servicing of debt; also change in Sovereign's ability to pay, etc.

LOS 61b - Identify the relations among a bond's coupon rate, the yield required by the market, and the bond's price relative to par value (i.e., discount, premium or equal to par)

• Bonds tend to be issued with the coupon rate of similar bonds so they initially trade at par


• they trade at a discount to par when they become more risky (e.g. credit issues with issuer) or less desirable relative to other assets (interest rate rises)


• if required yield falls, bondy trades at a premium

LOS 61c - Explain how features of a bond (e.g. maturity, coupon, and embedded options) and the level of a bond's yield affect the bond's interest rate risk
Interest rate risk = duration = sensitivity of a bond's price to a change in yield (inverse relationship) = similar to elasticity except inverse i.e. bond yield goes up, price goes down

• ceteris paribus longer maturity = higher duration


• ceteris paribus higher coupon rate = lower duration

both of these are intuitive: with longer maturity, you are locked in to a particular coupon until maturity, so the value of your bond will be sensitive to returns on other securities. with higher coupon rate, the percentage different between your coupon and the yields of other investments would be smaller

• callable bond will have lower duration because the upside for the investor is capped at the call price; when interest rates decline, bond price will rise but (almost) never above the call price
  
• putable bond will have lower duration as well because downside for the invest is capped at put price; when interest rates rise, bond price will fall but (alomst) never below put price
  
• This is also intuitive; embedded options limit the price movement of a bond because the privileged part will either put or call the bond at the strike price


• maturity up = interest rate up = higher interest rate sensitivity/duration
  
• coupon up = interest rate down = lower interest rate sensitivity/duration
  
• add a call = interest rate down = lower interest rate sensitivity/duration
  
• add a put = interest rate down = lower interest rate sensitivity/duration

NB remember duration is basically sensitivity to changes in yield

LOS 61d - Indentify the relationship among the price of a callable bond, the price of an option-free bond, and the price of the embedded call option

• call option favours issuer, put option favours bondholder
  
• call option decreases value of bond compared to option-free bond

callable bond = value of option-free bond-value of embedded call option

difference between value of option-free bond and callable bond will be greater at lower yields because price will rise as yield declines but as price gets closer to call price...

LOS 61e - Explain the interest rate risk of a floating-rate security and why such a securities prcie may differ from par value

floating rate is an imperfect insurance against interest rate risk; it is imperfect because the coupon does not float fluidly with market yields but instead is reset at particular dates (and should return to par value).

The longer the reset period the greater the interest rate risk at any reset date; the closer you are to a reset date, the lower the interest rate risk

Coupon resets may not return the bond to par value due if one or both of the following factors are present:

• caps - if interest rates rise above the bond's yield cap, the floating rate security will trade at a discount (cap risk)
  
• fixed margin - e.g. LIBOR plus 2% - the 2% margin reflects liquidity and credit risk of issuer; if these improve, the security will trade at above part; even if firm's creditworthiness remains constant, a chance in the market's required yield premium for the firm's risk level will cause the value of the floater to differ from par

LOS 61f - Computer and interpret the duration and dollar duration of a bond

duration = approximation of the percentage change in security price for a 1% change in yield (so yield is denominator)

• duration = -(% change in bond price/yield change in %)
  
• minus sign because it is an inverse relationship; price goes up, yield goes down
  
• duration of a zero coupon bond will be ~years to maturity;
  
• duration of floater = fraction of a year until the next reset date

NB if you are given the duration, remember inverse relation between price and yield. If you are given a duration of 2 and a yield increase of 5 then you would expect the price to go down by 2*5 = 10% decrease

• percentage price change = -duration * (yield change in %)

dollar duration = approx. price change in dollars in response to a 1% change in yield e.g.with a duration of 5.2 and bond value of $1.2 million, dollar duration is 5.2% * $1.2 million = $62,400 which make sense since duration tells you the movement in price per 1% change in yield

LOS 61g - Describe yield-curve risk and explain why duration does not account for yield-curve risk for a portfolio of bonds

• OK. So a yield curve illustrates the relationship between bond maturity and yield;
  
• the yield curve risk is the changes in the shape of the yield curve that are not captured by the duration
  
• portfolio's duration is just the market-weighted average of the individual bond's durations and will capture parallel shifts in the yield curve i.e. the curve remains the same shape but moves up or down so yields on all maturity lengths are affected equally
  
• non-parallel shifts change the shape of the curve e.g. short maturity bonds have different sensitivities to change in yield than longer ones
  
• to estimate impact of these non-parallel shifts, use key rate durations i.e. measure sensitivity of portfolio's value to changes in yields for specific maturities (or portions of the yield curve)

LOS 61h - Explain the disadvantages of a callable or prepayable security to an investor

This is intuitive, the disadvantages are:

• you cannot benefit from a decline in interest rates (and corresponding increase in value of your asset) beyond the strike price of call option and similarly your benefits are capped if the issuer prepays
  
• there is less security to your cash flows because your issuer may pay back the principal thereby stopping coupon payments
  
• All of this will likely happen when interest rates are low and your opportunities to reinvest will be in a low interest market

LOS 61i - Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortising securities expose investors to greater reinvestment risk than nonamortising securities

NB lower coupon increases (duration) interest rate risk but decrease reinvestment risk (since your return was lower to begin with) ceteris paribus

A security has more reinvestment risk when:

• coupon is higher so that interest cash flows are higher
  
• call feature is present
  
• it is amortising
  
• it contains a prepayment option (this also adds risk/uncertainty)

because with each you may be stuck with your principal and no more cash flows at a time when interest rates are low and investment opportunities suck.

LOS 61j - Describe the various forms of credit risk and describe the meaning and role of credit risk

rating indicates probability of default so lower rated bonds have more default risk

difference between yield on Treasuries and lower rated bond of similar maturity is credit spread

yield on a risky bond = yield on a default free bond + credit spread

Credit Spread Risk = default risk premium required in market can increase even when there is no change in similar Treasuries; increase in credit spread risk decreases value of the bond

Downgrade Risk = risk of rating downgrade which would increase required return and decrease price

Bonds issued by the same company may have different ratings depending on capital and priority of bondholder's claims

S&P's ratings:

• AAA = least risk
  
• AAA through BBB- are investment grade
  
• BB and below are speculative (junk bonds or high yield bonds)
  
• D are currently in default

LOS 61k - Explain liquidity risk and why it might be important to investors even if the expect to hold a security to the maturity date

Investors prefer more liquidity to less; low liquidity decreases the number of buyers for my asset so I must sell at a lower (possibly discount) rate

bid-ask spread is an indication of liquidity - highly liquid assets have a very low bid-ask spread

low liquidity = high liquidity risk

• even if you are holding to maturity, liquidity can still be an issue when you have to mark to market at lower price because of decrease in liquidity/widening of bid-ask spread
  
• MTM is done for portfolio performance reporting
  
• MTM also affect repurchase agreements to ensure that collateral value is adequate to support the funds being borrowed; lower valuation = higher cost of funds and decreasing portfolio returns
  

LOS 61l - Describe the exchange rate risk an investor faces when a bond makes payments in foreign currency

• Exchange-rate risk e.g. foreigner investing in T-bills will risk relative value of home currency to dollar

LOS 61m - Explain Inflation Risk

• Inflation Risk - uncertainty about future purchasing power of cash flows

LOS 61n - Explain how yield volatility affects the price of a bond with an embedded option and how changes in volatility affect the value of a callable bond and a putable bond

Without any volatility in interest rates, call provision and put provision have little value ceteris paribus.

• value of a callable bond = value of option-free bond - value of embedded call option
  
• value of a putable bond = value of option-free bond + value of embedded put option


• the value of either option is increased by an increase in yield volatility but look at the formulas to determine effect on the bond price
  
• since the call is subtracted from the value of the bond and the put is added (better for investor), yield volatility will decrease value of callable bond and increase value of putable bond


• fluctation in interest rates affects these in opposite ways


• volatility risk for callable bonds is risk that interest rate volatility will increas


• volatility risk for putable bonds is risk that interest rate volatility will decrease

LOD 61o - Describe the various forms of event risk

Event risk = something significant happening to a company or market segment e.g

• disasters impair the ability of corporation to meet debt obligations if disaster reduces cash flow
  
• corporate restructurings [spin-offs, leveraged buy outs, mergers]may affect cash flows, value of collateral assets, etc.
  
• regulatory issues e.g. clean air requirements may reduce cash available to bondholders and result in downgrade

Problem Set Issues

• if you know the duration and the change in yield then multiple the change in yield by the duration (to get the new duration?) and multiple this by the price.
• e.g. a bond with a 7.3% has a duration of 5.4 and is trading at $985. If yield decreases to 7.1%, the new bond price is -5.4*(-0.2) = 1.08%. New price is 1.0108 * 985 = $995.64
• the value of an embedded put option is the difference between the price of the putable bond and the price of the straight bond (not the face value of the bond)
• zero coupon bond will have the greatest duration and therefore subject to greatest interest rate risk
• Treasury bond pays semi-annual coupon and therefore has reinvestment risk
• AAA bonds can lose their AAA rating and therefore have downgrade risk
• Bond with a call feature has volatility risk even when call cannot be exercised immediately
  

READING 62

Caution:

• Remember for TIPS the coupon is fixed (divide by 2 for semi-annual) but the face value upon which the coupon is based fluctuates based on the inflation rate. For $100,000 worth of TIPS trading at par with a 4% coupon and annula inflation rate at 2.5% what is the inflation adjusted principal value of the bond after 6 months.
  
• It pays the product of the par value, half the coupon, and half the inflation rate so:


• coupon payment = ($100,000 * 1.0125) * (0.04/2) = $2025

Measuring Return With Yield
Coupon is not yield. Yield is essentially your return based as a ratio of the value of the bond. Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Why is yield inversely related to price?
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Yield to maturity (YTM)
YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium). The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.

If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.

When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

Government Bonds
In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:

• Bills - debt securities maturing in less than one year.
  
• Notes - debt securities maturing in one to 10 years.
  
• Bonds - debt securities maturing in more than 10 years

READING 63

63e - Computer, compare, and contrast the various yield spread measures

• Yield Spread = Yield on Bond A – Yield on Bond B (doesn't capture interest rate movements if they both move in unison)
  
• Relative Yield Spread =Yield on bond A- Yield on Bond B/ Yield on Bond B
  
• Yield Ratio = Yield on Bond A / Yield on Bond B

Even though the way most investors discuss spreads is based on a Treasury security with the same maturity as the one it is being compared to, an investor can also talk about spreads between any two bonds with the following measures:

1. Absolute Yield Spread
This is the way most spreads are measured in the market. This spread measures the difference in spread between two bonds in terms of basis points.

• Yield Spread = Yield on Bond A – Yield on Bond B

2.Relative Yield Spread
This ratio measures the yield spread relative to the reference bond.

• Relative Yield Spread =Yield on bond A- Yield on Bond B/ Yield on Bond B

3.Yield Ratio
This is just the ratio of the yields between the two bonds.

• The equation is: Yield on Bond A / Yield on Bond B

Market convention is to use the on-the-run government security as the reference yield or bond. So in the above equations, one would replace Bond B with the comparable government security.

Example: Yield Ratios
We want to compare an IBM five-year bond with a yield of 4.5 % and the on- the-run government five-year with a yield of 3.75%

Answer:

• Absolute Yield Spread = 4.5% - 3.75% = .75% or 75 basis points
  
• Relative Yield Spread = 4.5%- 3.75% / 3.75% = .20 = 20%
  
• Yield Ratio = 4.5% / 3.75% = 1.20

Why Relative Spreads Are Better
Investors may find relative spreads a better measure because they measure the magnitude of the yield spread and the way it is affected by interest-rate levels. While absolute spread may be maintained as rates change, relative spreads will move in or out depending on the level of rates.

LOS 63f - Describe a credit spread and discuss the suggested relation between credit spreads and the well-being of the economy

• A credit spread is difference in yields between two issues that are similar in all respects except for credit rating
  
• these spreads show effect of credit quality on yields and reveal risk-return tradeoff investor can expect
  
• during expanding economy, more companies are flush and credit spreads tighten
  
• during contracting economy, credit spreads widen and investors tend toward "flight to quality" such as Treasuries

LOS 63g - Identify how embedded options affect yield spreads

• Yield spreads against a benchmark such as Treasuries will be greater for a callable bond than a similar non-callable bond to compensate the bondholder for reinvestment risk


• Similarly, mortgage passthrough securities which have a prepayment option will have higher yield spreads to compensate boldholder for reinvestment risk
  
• Putable options will have lower yield spreads than otherwise similar option free bonds to compensate issuer for risk of having the bonds sold back to them
  
• important b/c this tells us that spreads for bonds with embedded options are not purely premiums for credit risk, liquidity differences, and maturity (duration) risk

LOS 63h - Explain how the liquidity or issue size of a bond affects its yield spread relative to risk free securities and relative to other securities

• Bonds that have less liquidity have higher spreads
  
• Larger issues tend to be more liquid
  
• Issues with greater size tend to be more liquid and tend therefore to have lower yield spreads

LOS 63i - Computer the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security

• After-tax yield = taxable yield * (1 - marginal tax rate)

Tax exempt securities can offer lower yields due to the tax savings. to compare between taxable and non-taxable yields, use the taxable equivalent yield i.e. the yield an investor must make on a taxable bond to have the same after tax return they would on a tax exempt issue (rearrange the after tax yield formula).

• taxable-equivalent yield = tax-free yield/(1-marginal tax rate)

LOS 63j - define LIBOR and explain its importance to funded investors who borrow short term

• London Interbank Offered Rate - the most important reference rate for floating-rate debt securities and short term lending
  
• A funded investor is borrowing at LIBOR + x to fund investments; his profits depend on his ability to earn more than LIBOR + x

READING 64

If the discount rate is higher than the coupon rate the PV will be less than par. If the discount rate is lower than the coupon rate, the PV will be higher than par value.

How Does a Bond’s Price Change as it Approaches its Maturity Date?
As a bond moves closer to its maturity date, its price will move closer to par. The break down on the three scenarios is as follows:

1.If a bond is at a premium, the price will decline over time towards its par value.
2.If a bond is at a discount, the price will increase over time towards its par value
3.If a bond is at par, its price will remain the same

watch out for:
confusing yield price with coupon payment percentage
read carefully for semi-annual versus annual

LOS 65a - Explain the sources of return from investing in a bond

1. coupon interest payments


2. recovery of principal


3. income from reinvesting the periodic coupon payments

LOS 65b - Computer and interpret the traditional yield measures for fixed-rate bonds and explain their limitations and assumptions

1. current yield expresses only bond's annual interest income - ignores capital gains/losses or investment income:

• current yield = annual cash coupon payment/bond price

2. yield to maturity = annualised IRR based on price and promised cash flows. For bond with semiannual coupon payments, YTM is stated as two times the semiannual IRR implied by the bond's price. The formula that relates the bond price (including accrued interest) to YTM for semi-annual coupon is:

[insert clearer version of bond price formula]
bond price = (CPN1/(1+YTM/2)) + (CPN2/(1+YTM/2)²)+...+(CPN_2N+PAR/(1+YTM/2)^2N)

where:
bond price = full price including accrued interest
CPNt = the semi-annual coupon payment rec'd after t periods
N = number of years to maturity
YTM = Yield to Maturity

YTM and price give the same information i.e. given YTM you can calc. price and given price you can calc. YTM (but not easily in the latter case)

To compute YTM compute as if you were calculating IRR remembering:

• first cash flow is negative and is the bond price


• payments are usually semi-annual so divide coupon payment by two and


• double the number of periods (minus one payment)


• final payment is PAR + semi-annual coupon payment


• multiply the final figure by 2 to get the annual payment

or calculate as if it were an annuity:

• PMT = semi-annual coupon


• PV = neg. bond price


• FV = PAR value


• N = 2 * number of years


• CPT I/Y = semi-annual YTM (so multiply by two)

YTM will be the discount rate you will use to find the price i.e. the YTM/2 will be the discount rate to discount the semi-annual cash flows and the recovered principal to get the bond's price.

if price = par then coupon rate = current yield = YTM

if price <>

if price > par then coupon rate > current yield > YTM

bond equivalent yield = semi-annual pay YTM's (mult. by two to get annual pay YTM). This is the discount rate using semi-annual interest, double the periods, etc. If you were to calculate it on annual interest and annual payments it would just be called the annual pay YTM

the bond equivalent yield is the non-compounded annual rate received from a security that pays semi-annually with only simple interest. So to get an annual pay rate from a BEY you would to:

1. get the semi-annual payment rate (so divide by two)
2. then compound the semi-annual payment rate over two periods

example: what is the annual-pay yield for a bond with a BEY of 5.6%?
answer: [(1+(0.056/2))²-1

BEY/semi-annual pay YTM example: for a semi-annual pay bond, you can calculate the YTM if you know price (PV), par value (FV), number of years (N*2) and then CPT the I/Y and multiply by two i.e. you are trying to find the semi-annual discount rate that would make $1000 become the current price of $768

to find the annual pay YTM you would use the same above except number of years would just be N and not N*2 (gives a slightly higher number obviously). This is the number that would make $1000 become the current price of $768 when discounted annually instead of semi-annually

Yield To Call simply substitutes the call price for the par value and the number of periods until the call date is substituted for the number of periods until maturity

Yield to First Call simple subsitutes the call price for the par value and the number of periods until the first call date is subbed for the number of periods until maturity

Yield to Worst is the worst outcome of all possible provisions of the bond, so find worst case scenario (e.g. Yield to First Call) and calculate; usually the first date on which the money is repaid in some form (e.g. call, refunding, repayment)

Yield to Refunding is same calc as YTM or YTC but here the YTRefunding would use the call price but the date is the date when refunding protection ends

Yield to Put is used for bonds with embedded puts which are selling at a discount. Yield would likely be higher than YTM (advantage investor). The YTP calc is just like YTM but number of semi-annual periods until put date is N and put price is FV

NB Don't forget to:

• N = ensure this multiplied by 2 or kept whole as appropriate
• PMT = ensure divided by 2 or kept whole as appropriate
• I/Y = don't forget to multiple by two as appropriate
• take it easy when you input the numbers, the time will pay off

NB Bonds trading at a discount to par value, YTC will be higher than YTM; bond yields quoted on a yield to call basis when the YTC is less than the YTM which can only be the case for bonds trading at a premium to the call price

Cash Flow Yield (CFY) is used for mortgage backed securities and other amortising asset-backed securities. Amount of principal repayment can be greater than the amount required to amortise the loan over its life. Once cash flows are projected, calculate CFY as a monthly IRR based on the market price of the security.

Primary LIMITATION of YTM is that it does not consider the rate of return we might receive on the reinvested coupon payments i.e. assumes that everything appreciates at the same rate (YTM) whereas in real life the investor might reinvest the coupon payments in a riskier, higher yielding security and may not hold the bond until maturity.

The realised yield is usually computed at the end of the investment horizon (when all the reinvestment rates are known) and captures the reinvestment rate of the coupon payments. If the coupons are invested at a rate equal to YTM then the YTM = realised yield

LOS 65c - Explain the importance of reinvestment income in generating the yield computed at the time of purchase, calculate the amount of income needed to generate that yield and discuss factors that affect reinvestment risk

• The realised yield will always be between the YTM and the (assumed) reinvestment rate


• Once we calculate the total amount needed for a particular level of compound return over a bond's life, we can subtract the principal and coupon payments to determine the amoutn of reinvestment income necessary to achieve the target yield.

So, to calculate the required reinvestment income needed to get a compound return of X:
1. calculate the FV of the par based on the required rate of return
2. subtract the principal payment (plus any discount/premium from par) plus the coupon payments e.g. 180.61 - 100 - 60 = $20.61

LOS 65d - Compute and interpret the BEY of an annual pay bond and the annual pay yield of a semi-annual pay bond

i.e. turn a semi-annual return into an annual return and vice versa

• BEY = [ (1+ annual pay YTM)^1/2 -1] * 2


• EAY = (1+ semi-annual pay YTM/2)² -1

NB must nail down relationship between BEY and YTM. BEY converts annual YTM to what it would be at semi-annual compounding and allows for the comparisons with semi-annual compounding securities. EAY does the opposite i.e. "converts" a semi-annual paying YTM to annualised so it can be compared to annual paying securities.

LOS 65e - Describe the methodology for computing the theoretical Treasury spot rate curve and compute the value of a bond using spot rates

1. begin with the 6 month spot rate


2. set the value of the 1 year bond equal to the present value of the cash flows with the 1 year spot rate divided by 2 as the only unknown


3. solve for the 1 year spot rate


4. use the 6 month and 1 year spot rates and equate the present value of the cash flows of the 1.5 year bond equal to its price, with teh 1.5 year spot rate as the only unknown


5. solve for the 1.5 year spot rate

Valuing a bond using spot rates

sum the discounted value for each of the cash flows at the appropriate rate/2 and number of periods e.g. for the second coupon payment, discount it at the 1 yr spot rate/2; the final payment (at 1.5 years) would be the discounted value of final payment plus the coupon rate using the spot rate for 1.5 years divided by 2 and the number of periods would be 3

LOS 65f - Differentiate between the nominal spread, the zero-volatility spread and the option-adjusted spread

nominal spread = YTM for bond minus YTM for Treasury of similar maturity
nominal spread suffers from same limitations as YTM and ignores the shape of the spot curve (assumes it is flat)

zero-volatility spread = in order to value a bond correctly, we have to increase each of the Treasury spot rates by some equal amount so that the PV of the risky bond's cash flows discounted at the (increased) spot rates equals the market value of the bond.

• use trial and error to solve this.


• Discount each of the cash flows by the spot rate plus some fixed estimated amount until you hit the amount that will discount the cash flows such that they equal the price of the bond


• NB the nominal spread assumes the spot rate curve is flat, therefore, if the spot rate curve is upward sloping, the zero volatility spread (which is based on the spot rate curve) will be higher than the nominal spread and if it is downward sloping the zero volatility spread will be lower than the nominal spread


• NB similarly, if the bond is amortising such as an MBS the diff. between the nominal and the zero volatility spread will be higher than regular bond; also, the earlier the principal is paid off, the greater the difference between the two spread measures

the option adjusted spread (OAS) This is a measurement tool for evaluating price differences between similar products with different embedded options.

• A larger OAS implies a greater return for greater risks. This measure removes the effect of options or prepayment on the spread and allows for comparison between products.


• The OAS is the spread for non-option characteristics such as credit risk, liquidity risk, and interest rate risk.

LOS 65g - Describe how the option-adjusted spread accounts for the option cost in a bond with an embedded option

• option cost in percent = Z-spread - OAS


• A callable bond: option cost > 0 (investor is compensated) and OAS > Z-spread


• A puttable bond: option cost <>
  

LOS 65h - Explain a forward rate and compute spot rates from forward rates, forward rates from spot rates, and the value of a bond using forward rates

Borrowing for X years at the Xyear rate should cost the same as borrowing for 1 yr periods, X years in succession. So the spot rate for 3 years will be the same as the geometric mean of the three separate forward rates.

uses forward rate notation such that _xf_y is the forward rate for an x year loan to be made y years from now so...

1. (1+S₃)³ = (1 + ₁f₀)(1+₁f₁)(1+₁f₂) for finding a forward rate three periods from now


2. S₃ = [(1 + ₁f₀)(1 + ₁f₁)(1 + ₁f₂)]^1/3 - 1 for finding a spot rate equivalent to forwards for three periods

The latter is familiar - it is the geometric mean b/c you are finding the single return that creates the same PV of the cash flows as the single rate in the X year loan.

A spot rate for a maturity of N periods is the geometric mean of forward rates over N periods. The same relation can be used to solve for a forward rate given spot rates for two different periods.

To find a forward rate from a spot rate use the first formula and isolate the unknown on one side of the equation e.g. say we know the spot rate for a two year bond is 8% and we know the current 1 period spot rate is 4% then we can calulate the missing 2nd year forward rate using (1+0.08)² = (1 + 0.04)(1+₁f₁) minus one
divide both sides by 1.04 to isolate the unknown:

• (1.08)²/1.04 = (1+₁f₁) and we get 1.1664/1.04
• or 1.12154 = 1+ 1f1 = 1.12154-1 = 12.154%

why do we want to do this? to know whether it is better to buy the one period bond or the two period bond. In this case, we know buying a one year bond for 4% and a forward rate one year bond for one year from now at 12.154% is better than buying one 2 year 8% bond

multiple years calculation

if you know the 1, 2 and 3 yr spot rates, you can back out to the 1 yr forward and the 2 yr forward. in the above example, we found the 2 yr foward rate. if we know the 3 yr spot rate is 12% we can do the same thing again except using cube of the three year equal to the product of the known one year forward rates (including the unknown):

(1.12)³ = (1.04)(1.12154)(1 + x)
1.4049/(1.04)(1.12154) = 1 + x
1.4049/1.1664 = 1+x
1.2045-1= x
20.45% = x

Quick and dirty way = is to use a simple average of the spot rates to solve for the forward rate; may come close enough to answer the question

Calculate price of T-note using spot rates use the appropriate spot rate for each cash flow to discount the cash flow over the appropriate number of periods e.g. a cash flow of $20 in the second period when the spot rate is 5% would be N=2, I/Y = 2.5, FV=$20, CPT PV

Calculate implied forward rates for loans for more than one period given spot rates of: 1 yr = 5%, 2 yr = 6%, 3 yr = 7% and 4 yr = 8% we can calculate the implied rate on a two year loan two years from now by:

[(1+S4)⁴/(1+S2)²]^1/2-1 = [1.08⁴/1.06²]^1/2-1 = 10.04%

i.e. raise the larger year spot rate to the power of the number of years in the future and divide by the smaller of the years raised to the power of the number of year in the future and then take the x root where x is the duration of the loan in years

Computing a bond value using forward rates

Discount each cash flow by the relevant periods and sum them together. e.g. if one of the cash flows takes place two years from now, discount it by the two year forward rate and then again by the one year current rate.

So if 1 yr rate is 4%, 2 yr forward is 5% and 3 yr forward is 6% and we want to find the value of a 3yr 5% coupon bond with face value of $1000 then we do the following:

(50/1.04) + (50/(1.04)(1.05)) + (1050/(1.04)(1.05)(1.06)) = $1000.98

READING 66

Please let me get to the end of these books... it's scary to think how relieved i will be when all i am doing is revising instead of learning. There is so much i feel i don't have a handle on right now.

full valuation or scenario analysis approach to measuring interest rate risk is based on applying the valuation techniques we have learned for a given change in the yield curve. for more complex bonds, a pricing model incorporating yield volatility as well as specific yield curve change scenarios is required to use full valuation approach. if valuation model is sufficiently good, this is the theoretically preferred approach

duration/convexity approach provides approximationof the actual interest rate sensitivity of a bond or bond portfolio -- for parallel shifts in the yield curve

bond characteristics on duration (price sensitivity)

• higher coupon = lower duration (and vice versa)


• longer maturity means higher duration (and vice versa)


• higher market yield = lower duration (and vice versa)

all of these relations are intuitive if you stop to think about it instead of just memorizing them. If my bond is paying me a lot of money in coupons, I'm less concerned about my ability to invest elsewhere and there will be strong demand for my bond. The longer my bond has to maturity, the more sensitive it will be to interest rate changes because you will be locked into the bond for a longer period and if prices change for the worse, you are stuck with an asset that is no longer as attractive relatively. The shorter the maturity, the closer I am to collecting money and the less uncertainty I have about my assets value. if interest rates go down, I will shortly be able to take advantage of them. the higher my market yield, the lower my sensitivity to interest rate changes for similar arguments advanced above about high coupons.

positive convexity
wow. that term sounds like you're smart when it's actually a pretty simple concept:

• yield and prices for bonds are negatively correlated so yield curve is downward sloping


• this inverse relationship is not a simple straight line but a curve bending toward the origin


• the shape shape of this curve determines the severity of a change in price/yield at each level


• the positive convexity will mean that as yields increase, price decreases at a decreasing rate i.e. prices rise faster than they fall for a given change in yield down or up which is a good thing for a bondholder


• for price-yield relationship to be convex, the slope (rate of decrease) of the curve must be decreasing (level out) as move from left to right


• duration = slope of price-yield curve at any given point

Callable Bonds, Prepayable Securities, and Negative Convexity
All of these securities come with enhanced risk/uncertainty for the bondholder because at certain points, the security could be essentially redeemed/paid off and the bondholder has to find a place to reinvest the money (reinvestment risk).

upside price appreciation is limited (price compression) because as interest rates go down, debtors will be more likely to pay off principal and issuers will more likely call the bond in when it hits the call price (so they can refund for a better rate on their debt)

so for callable bonds the curve bulges out on the left hand side up to the call price, so as yields decrease the price increases at a decreasing rate (which makes sense - lower demand as we approach call price) or negative convexity... as move to the right along the curve, the curve returns to positive convexity

• In the above diagram, the *P price is the call price and the yield that matches the call price is *Y


• The curve for yields below *Y will exhibit negative convexity and will eventually flatten out as we approach the call price *P


• Price volatility for lower yields will naturally be lower for a callable bond than an option free bond (more certainty with callable bond around that price-yield area)


• The curve for yields above *Y will exhibit positive convexity


• MBS or similar securities with prepayment risk will exhibit similar behaviour and therefore have greater reinvestment risk, especially as yields fall

Price volatility characteristics of putable bonds

• Less price volatility at higher yields because as the yield rises, price falls and the put becomes more valuable


• Put option is of no value when price is above the putable price and it behaves just like an option free bond

NB all of this information about convexity implies that i should be able to determine whether a bond has call (or prepayment) or a put depending on the % change in price up or down relative to a parallel shift up or down in yield... but it is difficult because an option free bond would still have a price which drops slower than it rises. I guess it would depend where i am on the curve.

Effective Duration

• remember: duration is ratio of % change in price/% change in yield
  
• given convexity, we know price increases faster when rates fall x than price decreases when they rise x

• effective duration uses the average of the price changes in response to equal increases and decreases in yield to account for this fact


• if we have a callable bond trading in the area of negative convexity, the price increase is smaller than the price decrease but using the average still makes sense
• formula effective yield =

(bond price when yields fall - bond price when yields rise)
2*(initial price)*(change in yield in decimal form)

or average price change (difference between the bond prices divided by 2) divided by current price (so it is now average price as a percentage of current price) and then divided by the change in yield in decimal form (to get change in price as a percentage of current price expressed as a precentage of the change in yield)

Looking at the formula step by step helps me remember it. Much watch my fat fingered mistakes on the calculator.

NB if the question shows a parallel yield shift of 50 bps e.g. current rate is 10% and we want to know the price change at 9.5% and 10.5% then the change in yield will be 50 bps or 0.005% because this is the swing either side

Also helpful:

• price increase in response to the 0.005 decrease above would be PYieldDown-InitialPrice/InitialPrice


• price decrease in response to the 0.005 increase above would be PYieldUp-InitialPrice/InitialPrice

The average of the percentage price increase and the percentage price decrease.
If the change in yield was 50 bps, we can find the duration by multiplying the price change by two to get the percent change in price for a 1% change in yield.

Using effective duration
Once you have your effective duration (e.g. -2.5) for say a bond when yield increases by 50bps, you can calculate the new up or down price by:

• percent change in bond price = - effective duration x change in yield in percent
• or -2.5 * 0.005 = 0.0125 = 1.25%
• so if the bond were priced at $100, it would now be worth $98.75

Other types of duration...

Macaulay duration = estimate of bond's interest rate sensitivity based on the time in years until the promised cash flows will arrive; because Macaulay duration is based on the expected cash flows for an option free bond, it is not an appropriate estimate of the price sensitivity of bonds with embedded options

Modified duration = derived from Macaulay duration and is slight improvement b/c it takes the current YTM into account; also based on expected cash flows for option free bond so not good for bonds with embedded options

Effective duration is the most appropriate measure of interest rate risk for bonds with embedded options because effective duration is calculated from expected price changes in response to changes in yield that explicitly take into account a bond's option provisions (i.e. they are the price-yield function used).

Interpreting Duration

1. duration is the slope of the price-yield curve at the bond's current YTM
2. (Macaulay) duration is a weighted average of the time (in years) until each cash flow will be received; the weights are in proportions of the total bond that each cash flow represents
3. duration is the approx. change in price for a 1% change in yield (price sensitivity to a change in yield)

Duration of a portfolio is just the weighted (by market value i.e. market price * par value e.g. 102 * 1,000,000 means 102% of 1,000,000 or 1,020,000) average of the individual bonds within the portfolio

duration is a good measure of the sensitivity of portfolio value to parallel shifts in the yield curve; changes to the shape of the yield curve may affect different securities differently and this will not be captured in the portfolio duration

convexity is a measure of the curvature of the price-yield curve; a straight line has a convexity of zero

duration assumes the price-yield curve is zero (ignores changes in shape) and will underestimate the price of the bond (except when curve is flat)

A bond's approximate percentage price change based on duration and convexity
Combining duration and convexity gives us more of a full picture and a more accurate estimate of the % change in price of a bond - esp. for large changes in yield

percentage change in price = duration effect + convexity effect

= {[-duration * change Y] + [convexity * (changeY)²]} * 100

with changeY entered as a decimal, the *100 is necessary to see it as a percentage

watch out: the duration will be negative when yield rises and positive when yield falls so percentage change in price will be different for a rise than for a fall i.e. will not both rise and fall by x. Say duration is -2% (yield has risen) and convexity is 8% then total change will be 6% but if yield falls and duration is +2% then total change will be 10% (2+8)

when convexity is negative (e.g. low yields cause negative convexity for callable bonds) the convexity adjustment to the duration-only based estimate of the percentage change will be negative for both yield increases and decreases

Effective Convexity takes into account changes in cash flows due to embedded options while modified convexity does not and therefore effective convexity is the appropriate measure for bonds with embedded options just as effective duration is appropriate for measuring bonds with embedded options instead of modified duration

Price value of a basis point (PVBP) is the dollar change in the price/value of a bond or portfolio when the yield changes by one basis point or 0.01%

PVBP = duration * 0.0001 * bond value

This is actually a little more complicated than it looks. Don't forget that semi-annual effective durations will need to be multiplied by 2 to get annualised version. if you want to know the difference in price. It is actually:

PVBP = initial price - price if yield changes by 1bp

calculate the duration (e.g. 5%) and add one basis point (5.01) and redo the calculation using this new rate and then find the difference between the two prices.

Study Session 7 - Financial Reporting and Analysis

Classification of Business Activities

• Operating Activities = day-to-day business activities
• Investing Acvitivies = investment in long term assets (inc. securities/physical plant)
• Financing Activities = borrowing or repaying capital

Within each of these any activity can be classified as (OREAL):

• Owner's Equity = residual claim on the resources of the company, partner's capital
• Revenue* = inflows of economic resources to the company
• Expenses* = outflows of economic resources or increase in liabilities
• Assets = economic resources of a company
• Liabilities = creditors' claims on resources of a company

* Gains and Losses are like Revenue and Expenses but arise from secondary activities outside of operating activities e.g. selling excess equipment for more than its value would be a gain, decline in the value of inventory would be a loss

Accounts are subcategories under each of the OREAL headings e.g. under assets might be the accounts of cash, accounts receivable, inventory etc. These may then be grouped under each of the OREAL headings to further summarise the books.

Actual accounts are set forth in a chart of accounts

contra accounts = accounts that are used to offset other accounts e.g.

• allowance for bad debts offsets trade receivables,
• accumulated depreciation offsets property, plant and equipment,
• sales and allowances offsets revenue and reflects discounts etc. for unsatisfactory goods etc.

COMMON ACCOUNTS

Assets (tend to be listed in the order of liquidity)

• Cash and cash equivalents
• Accounts receivable, trade receivables
• pre-paid expenses
• inventory
• property, plant and equipment - noncurrent
• investment property - noncurrent
• intangible assets (patents, trademarks, licenses, copyright, goodwill) - noncurrent
• financial assets, trading securities, investment securities
• investments accounted for by the equity method
• current and deferred tax assets
• [for banks, loans receivable - b/c that is their business
• noncurrent assets benefit company over extended period of time (over one year)
• current assets expected to be consumed within a year or converted into cash

Liabilities

• Accounts payable, trade payables
• provisions or accrued liabilities
• financial liabilities
• current and deferred tax liabilities
• reserves
• minority interest [equity owned in subsidiaries?]
• unearned revenue
• debt payable
• bonds (payable0
• [for banks, deposits - b/c these are the amounts the bank is 'borrowing']

Owner's Equity

• Capital such as common stock par value
• additional paid-in capital
• retained earnings
• other comprehensive income

Revenue

• Revenue, sales
• Gains
• Investment income (e.g. interest and dividends)

Expenses

• Cost of goods sold
• Selling, general, and administrative expenses (SG&A) e.g. rent, utilities, salaries, advertising
• depreciation
• interest expense
• tax expense
• losses

Accounting Equations

balance sheet

• Assets = Liabilities + Owner's Equity
• Assets - Liabilities = Owner's Equity
• Owner's Equity = Contributed Capital + Retained Earnings
• Expanded: Assets = Liabilities + Contributed Capital + Beginning retained earnings + Revenue - Expenses - Dividends
• A = L + CC + RE(beg) + R - Ex - Div

income statement

• Revenue - Expenses = Net income

ending retained earnings

• ending retained earnings = beg. RE + Net Income - Dividends
• ending retained earnings = beg. RE + (Revenues - Expenses) - Dividends

Retained earnings = the net income retained by the company and not distributed as dividends; usually kept for investment. RE is a component of owner's equity and links the "as of" balance sheet equation with the "activity" equation of the income statement, so

• Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue - Expenses - Dividends
• if asked to calculate this remember Assets = everything else - (expenses + liabilities)

Retained Earnings is the net earnings not distributed as dividends and as such shows up on the Balance Sheet (under shareholder's equity). The income statement will tell you how much net income has increased during a period and the net income will be added to existing retained earnings.

Income Statement and Statement of Retained Earnings show movement over a period (in and out, plus and minus) whereas balance sheet just shows snapshot

Rules of Thumb:

• selling something for x that cost y has two parts:
  • the cash received increases cash (asset) by x and revenue (income) by x and
  • decreases inventory (asset) by y : offset by increase in COGS (expense) by y
  • so in balance sheet cash asset is increased, inventory asset is decreased, difference between the two is profit (retained earnings)
  • in income statement revenue is increased under income and COGs is increased under expenses and difference is reflected in net income
• when you purchase something that will last over multiple periods, you are just converting one asset (cash) into another - so you reduce cash asset and increase the bought asset total
• when you purchase a something that you will consume in the current period, it is an expense
• when you purchase something on credit, the asset is offset in liabilities (accounts payable)
• unearned fees are identical to unearned premiums therefore liabilities which are earned incrementally e.g. each month you might earn one more month's worth of the unearned premiums so liabilities would decrease by one month value and fee revenue would increase by one month value
• contributed capital is both an asset (cash) and owners' equity (since the owners have a claim on this economic resource); liabilities reduce the owners' equity since liabilites represent creditors claims on the resources (which supercede the shareholders)
• Receiving cash for services not yet rendered adds cash to the assets but adds the same amount in liabilities (unearned fees)
• Receiving cash for services rendered counts as revenue (if it is from operations)
• Assets and Liabilities = balance sheet
• Revenues and Expenses = income statement
• Borrowing increases cash and adds liability of bank debt
• pre-paid rent and rent deposits are assets; when rent is paid, pre-paid rent asset is decreased by x and logged as an expense of x
• anything paid before it is billed is recorded as an asset until such time as the bill is received and the money is recorded as an outflow
• wages earned but not paid are recorded in b/s as accrued wages and in income statement as payroll expense
• investment gains are logged as unrealised gains under revenue
• interest income is revenue and asset (investment)
• interest from debt owed is logged as liability (interest payable) and an expense (income statement). If monthly accounts, then annual interest is divided by compounding periods
• equipment is logged as an asset (say $120) and then depreciated over time. Say it has a year's usefulness then depreciation will be $10 per month ($120/12) which will be logged as a contra asset (balance sheet) and an expense (income statement) each month

Relationships

• Balance sheet contains Assets, Liabilities and Shareholders' Equity
• Cash is broken down in the Statement of Cash Flows
• Income Statement breaks down all cash flows e.g. net income from Owners' Equity Statement, revenues/expenses on statement of cash flows
• Shareholders' Equity is broken down in the Statement of Owners' Equity

Definitions and Purpose of Statements

• Balance Sheet is a snapshot of assets, liabilities and b
• Income Statement shows profitability over time through details of revenue, expense and resulting net income
• Statement of Cash Flows provides info about cash flows over a period from operating, financing and investing activities
• Statement of Owners' Equity provides information about the composition and changes in equity during a period

Accruals

Unearned (deferred) revenue

• originating recorded as cash receipt and as a liability
• adjusting reduce liability while recording revenue

Prepaid Expense

• originating record cash payment and establish an asset
• adjusting reduce asset while recording the expense

Unbilled (accrued) revenue

• originating record revenue, establish an asset
• adjusting when billing occrus, reduce unbilled revenue and increase accounts receivable; when cash is collected, eliminate accounts receivable

Accrued Expenses

• originating establish a liability and record an expense
• adjusting reduce the liability as cash is paid

Accounting Systems

Flow of information in an accounting system:
Journal entries > GL and T-Accounts > Trial Balance > Financial Statements

Cooking books if you want to cook the books, you must find an offset e.g. if you want to report more revenue then you need to create an asset to generate the revenue, if you want to conceal a cost then you need to create a liability to be the cause of that cost

Study Session 5

Just some quick notes:

MRP = the amount of $ you make from the extra stuff you sell because you hired one more guy. This in turn determines demand for labour (or any other productive input). Therefore, MRP equilibrium will always equal the cost of the input (e.g. wage for the worker day) because any more and you would make a loss.

Physical capital is actual stuff you spend money on which helps you make products. The demand for physical capital is also determined by the MRP of that input (e.g. bulldozer) except that the difference here is that your return on investment in physical capital is seen over many periods. The PV of the MRP's derived from investing in that bulldozer determines the value of investing in that item and determines demand. Kind of like IRR for projects?

SAS vs LAS - Short Run Aggregate Supply and Long Run Aggregate Supply
Aggregate supply is the amt of goods and services produced by an economy and is a function of price level (higher prices increase supply).

General Rules

• This is all about regression to the mean. The mean in this case is the level of GDP at full employment.

The swings back and forth are cause by the usual suspects:

• higher prices of goods and services cause more supply
• higher price of inputs (inc. labour) causes marginal cost to rise, supply to fall
• oversupply of labour will cause wages to fall and demand for labour to increase to equilibrium
• oversupply of goods/services will cause prices to fall and demand for goods/services to increase to equilibrium
• if workers' fears of inflation do not (yet) match actual inflation, we temporarily move along the SAS curve and out of equilibrium until workers' expectations are equal with actual inflation i.e. when workers' fear future inflation, they demand higher wages which increases marginal cost of producing and suppliers will produce less at the same price. Fewer workers employed causes downward pressure on wages as more people compete for fewer jobs and with lower wages come lower marginal cost/higher employment/more supply of product and we return to equilibrium

NB note difference between things that cause a move along a curve and things that cause the whole curve to shift.

SAS is the short term fluctuation either side of the equilibrium supply level (LAS). Movements along this curve are caused by worker expectations about inflation as seen above. Shape of the SAS curve comes from supply at different price levels. Supply increases as price rises so curve is upward sloping.

LAS is level of supply of goods and services when economy is operating at full employment (i.e. only structural and frictional unemployment). This is the natural rate of unemployment and produces the real level of GDP (output). Assumes that workers' view of inflation is in line with reality.

Potential output is positively related to (1) the quantity of labour (2) the quantity of capital and (3) the technology that the economy possesses

In the short run, we are holding money wages (and prices of all inputs) and potential GDP constant.

If the wage rate or prices of other productive inputs increases, the SAS curve will shift to the left, a decrease of aggregate supply in the short run.

Two factors influence change in money wage rates (and cause shift in SAS):

1. unemployment
2. inflation expectations

LOS 23b: Explain the components of and the factors that affect real GDP demand, describe the aggregate demand curve and why it slopes downward, and explain the factors that can change aggregate demand.

AD curve shows the relationship between the price level and the real quantity of final goods and services (real GDP) demanded and is made up of:

CIGX = Consumption + Investment + Government Spending + Net eXports

AD is downward sloping as expected because at high price levels, consumption, business investment, and exports will decrease due to the following effects:

1. when price level rises, real wealth declines so people spend less (wealth effect)
2. when price level rises, interest rates rise which decrease investment as well as consumption because borrowing cost is higher; consumers delaying purchases in this case is an intertemporal substitution as consumers substitute consumption later (when it is relatively cheaper) for consumption now (which is relatively expensive)

What shifts the AD curve?

1. Expectations about future incomes, inflation, and profits
   Expectations of inflation will cause current spending to increase (inexpensive compared to future); expectations of higher incomes will increase consumption; increase in expected profits will increase investment
2. Fiscal and monetary policy Gov spending increases G component of demand; decrease in taxes or increase in transfer payments (e.g. Soc Security) will increase demand through increase in consumption (more money in pockets); increase in money supply tends to decrease interest rates and increase consumption and investment
3. world economy - FX rates and countries' incomes affect their ability to consume other countries' goods and services.

LOS 23c. Differentiate between short-run and long-run macroeconomic equilibrium and explain how economic growth, inflation, and changes in aggregate demand and supply influence the macroeconomic equilibrium

• If equilibrium is price = 100 everything is good, full employment, equilibrium output of GDP
• At 115, there is excess supply since aggregate supply has outstripped aggregate demand. This is a recessionary gap and will cause downward pressure on prices as suppliers restrict supply and try to shed excess inventory and will move the price back to equilibrium.
• At 90, aggregate demand has outpaced aggregate supply = upward pressure on prices and increase of supply - the inflationary gap - as businesses experience unanticipated shortages. return to equilibrium price.

As the price level changes, we move back and forth along the AD curve, regressing toward equilibrium.

Shifts in the short run AS curve are part of the process of moving toward equilibrium i.e. the economy can be in short run equilibrium above or below long term equlibrium.

Economic expansion shift in AD/AS curves = AD outpaces LAS = above full employment = upward pressure on prices. Inflation causes real wages to decline which causes workers to demand more $. More demand for workers (we are above full employment) also causes wages to rise. This increases marginal cost of production which decreases demand for workers (pushing employment back to equilibrium) and decreases supply at the current price (since production is more expensive due to wage increase and fewer employed workers means lower AD) which returns supply to equilibrium.

increase in any input/resource price will cause supply of resulting product to decrease at each price level and causes SAS to decrease.

Recession shift in AD and AS curves = AD is less than equilibrium so fewer workers are employed (less than full employment = structural + frictional + cyclical) and output (GDP) is lower than equilibrium = excess supply of labour = wages/input prices fall = marginal cost falls = increase in SAS of goods and services (now cheaper to produce at same price level) = greater supply in short term = lower prices = increase in demand = more demand for labour = return to equilibrium

LOS 23d: Compare and contrast the classical, Keynesian, and monetarist schools of macroeconomic

All are trying to explain deviations from equilibrium.

Classical economists = shifts in both AD and AS driven by changes in technology over time and that economy has a strong tendency toward full employment equilibrium as either recession or over-full employment lead to decreases or increases in the money wage rate. Taxes are impediment and cause inefficiencies in this process.

Keynesian = shifts in AD due to change in expectations and that wages were "downward sticky" (i.e. they refuse to fall at the rate they should) reducing the ability of a decrease in money wages to increase SAS and move econo0my from recession (or depression) back toward full-employment. Keynesians think this can be nudged by increasing money supply (monetary policy) and/or increasing gov spending, decreasing taxes or both (fiscal policy).

Monetarists believe that monetary policy is the key influence over boom and bust i.e. recessions are cause by inappropriate decreases in the money supply so keep the money supply steady with predictable increases.

Monetarists share the Keynesian belief in downward sticky wages and input prices and share the classical view that taxes cause inefficiencies.

LOS 24h: Explain interest rate determination and the short run and long run effects of money on real GDP

• In the short run
  If the Fed increases the money supply (by buying back treasuries and other securities on the open market), this will decrease the interest rate because there is more cash in the hands of banks who compete to supply this now more abundant cash. Multiplier effect as people spend and more people have cash which banks can then lend again.
• Decreased interest rates encourage Investment and Consumption (which increase AD aggregate demand).
• Low interest rates cause foreigners to move money out of the country to places where it can earn more which lowers the FX rate for that currency which makes eXports cheaper and increases net eXports.
• Long run effect = higher price level, same GDP
  Increased demand for goods and services pushes up the price level (inflation) which increases wages and increases MC causing a decrease in SAS to equilibrium GDP of LAS with the price settling at a higher equilibrium price and interest rate returning to equilibrium (because people want to spend less because prices were higher, demand for money is lower).
• contractions in the money supply (by Fed selling securities) would have the opposite effect.