Tag Archives: Bonds

A2 Economics – Liquidity Preference Curve

With mock exams this week here is something on Liquidity Preference – included is a mind map that has been modified from Susan Grant’s CIE revision book.

Demand for money

TRANSACTIONS DEMAND – T – this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual’s income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. (note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES – P – this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

SPECULATIVE BALANCES – S – this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑.

If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by the summation of the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

 

 

Keynes v Monetarist – Powerpoint download

Here is a powerpoint on “Keynesian and Monetarist Theory” that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

Stockmarkets v 10 Year Government Bonds

Stockmarket v BondsHere are some statistics that I got from the New Zealand Herald that show investment in the stockmarket has been outperforming 10 year government bonds. The table below shows Bond rates v stockmarket dividend yields over the last 12 months to May 2013. Investors seem to be more comfortable about European economies as they don’t have to offer higher yields on Bonds to attract investors. The countries that have seen a significant drop in rates are Greece, Portugal, Spain and Ireland. Also note the very low interest rates which threatens a liquidity trap. This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.

Bond Yields before and after Bailouts

I quite like this graphic from the WSJ showing bond yields before and after the bailout. Remember that a 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.

Say an American Treasury (government) bond with an 8.125% coupon rate payable at $100 (par value) was trading at $103. In return for the $103 outlay, a buyer would receive the coupon payment of $8.125 (that’s 8.125/103 = 7.8% current yield). What usually holds is that:

Discount rate (price below par) – Coupon Rate less than Current Yield
Premium rate (price above par) – Coupon Rate greater than current Yield
Par Value (price = par) – Coupon Rate = Current Yield

So let’s apply this to the graph below. Because the risk associated with buying Greek Bonds, the trading price is very low which means that its current yield is correspondingly high. Notice that the current yield on Irish bonds has started to fall as the market believes its austerity measures – including dropping the minimum wage – is working.

The Bond Market

Have had a few discussions with my classes about the bond market and how the issue of government bonds are so vital to fund their current spending. There is also an earlier post on Bonds – Bond Prices and Interest Rates

Bonds are essentially a form of debt. Companies and Governments sell bonds to raise money, promising to pay those who buy the bonds a return on their investment, which usually comes in the form of interest payments. The term, or duration, of a bond is important in understanding its risk. A ten-year government bond promises the buyer that it will return the original investment of the bond, plus pay a fixed interest rate, or coupon. So, say you wanted to buy a $1,000 in ten-year bonds (in the US $1,000 is the minimum purchase amount). You would expect to get an annual return which in recent years has been about 4 – 5%, plus the original $1,000 at the end of ten years. Since the interest rate is set for life investors are betting that the return they get is greater than inflation.

Once a bond has been issued they can be traded like any other security. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity – and these are the fears which have been pushing down Irish bond prices.

European Countries and Bond Yields
Because of the poor financial condition that many Europen countries are in they have had to issue bonds in order to raise finance. However because of the risk associated with the loan they have had to offer much higher yields than is normally the case. Take for instance Greece and Ireland – they have had to offer returns of 11.8% and 9.1 respectively – see below.

Economics in 2010 – DRINKBONDS, ALKIBONDS and PUKEBONDS

Here is something I got which was doing the rounds on email – very amusing.
________________________________________________________________________________________________________

I was asked to explain the Economic crisis in Ireland here is an example
as I understand it….( passed on of course !!)

Mary is the proprietor of a bar in Dublin . She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Mary’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Mary’s bar. Soon she has the largest sales volume for any bar in Dublin. By providing her customers’ freedom from immediate payment demands, Mary gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Mary’s gross sales volume increases massively. A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Mary’s borrowing limit. He sees no reason for any undue concern, since he has the debts of unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Mary’s bar. He so informs Mary. Mary then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Mary cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Mary’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion euro no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Mary’s bar.

Now, do you understand economics in 2010?

NZ$ falls with S&P rating and Korean clash

The NZ$ dropped to its lowest level for 4 weeks against the US$ – now at US$0.76 from a high of US$0.79. Two main reasons for this:

1. New Zealand has the second-highest possible rating, AA+, but Standard & Poors (credit rating agency) has revised its outlook from stable to negative – one-in-three chance that NZ will be downgraded. It is New Zealand’s external position that is the main issue – kiwis borrow more than other kiwis are willing to lend. Net international liabilities of the country (as distinct from the Government) at the end of June were $164 billion. S&P said it seemed likely that as the economy strengthened, the problem of big deficits and ever-rising overseas debt would return, “and possibly with a vengeance”. This information for foreign currency dealers means that there is more risk attached to holding NZ$’s therefore you tend to see a sell-off on the market – supply curve to the right = price drops.

2. The clash between North and South Korea has brought about instability in the area and also made investors risk averse to regional currencies including the Aus$. Most of them have returned to the relative safety of American and Japanese bonds or even the US$. With the turmoil in Ireland and the concern that the rescue package from the IMF and the EU won’t be enough investors are tucking for cover. Additionally other countries with high levels of debt, in particular Portugal and Spain, may also have to seek financial help.

“Getting a Haircut?”

With the last posting on the bond market I thought it appropriate to continue this theme with the expression “Getting a Haircut”. In order to raise finance governments issue sovereign bonds and the total amount owed to the holders of the sovereign bonds is called sovereign debt.

Argentina – 2001
In 2001 an economic crisis in Argentina meant that the government could no longer service its debts and decided to default. Then in 2004 it offered to swap its defaulted bonds, worth $81 billion, for new ones worth only $35 billion. The bonds were held by financial institutions at home and abroad, as well as by many individual investors in Japan and Europe. Most accepted the offer and thus lost around half their money – know as ‘taking a haircut’. Others, who held around $20 billion worth refused the deal. As a result Argentina’s name remains mud in interenational capital markets and has had to rely on other governments such as Venezuela, who by mid-2008 had bought $7 billion in Argentinean bonds, the latest of which had to pay interest rates of 15%.

Ireland – 2010?
Ireland’s sovereign debt crisis has been the focus of talks between the biggest EU economies meeting at the G20 summit in the South Korean capital, Seoul. The relentless pressure on Irish sovereign bonds has seen the yield on Ireland’s ten-year government bond nearing 9% on November 10th, 6.2 percentage points above the yield on safe German Bunds (see chart); Portugal’s topped 7%. There is real concern that unless there is a major EU bailout plan Ireland could go bankrupt. The majority of global investors predict Ireland will default on its sovereign debt, showing that weeks of efforts by the government of the onetime “Celtic Tiger” haven’t allayed concerns about its creditworthiness.

Bond Prices and Interest Rates

This topic normally comes up in A2 as a multiple-choice question or as part of an essay on the money markets. It is something that my A2 students have found difficult to understand. Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑

Say you buy a 10 year Treasury Bond is issued for $1,000 for five years with a coupon (interest rate) of 5% per annum, meaning it pays $50 per year in interest. You decide to sell your Bond on the secondary market to get your money back. However, the RBNZ has raised interest rates and 10 year Treasury Bonds are being issued with a 7% coupon rate (interest rate). Therefore these new Bonds are sold at $1,000 and pay $70 per year in interest. If you now want to sell your Bond you will have lower its price to around $714. Your Bond still pays $50 per year in interest, as stipulated in the Bond’s contract. However, the new owner buys it for $714 and receives $50 per year in interest, which calculates to a 7% interest rate (50÷0.07 = 714). The actual coupon payment has not changed ($50) but the ratio of that coupon payment to the price has changed.