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Unformatted text preview: Economics 310 Money and Banking Topic 4(a) Bond Markets and Interest Rates 2 Lecture 1 Reading Bond Market and Interest Rates Chapters 4 and 5 Exam First Exam: Wednesday, February 10 In class Practice exam available No calculators, electronic devices or blue book Assignment Assignment 2 available Due for submission Monday, 5:00pm Questions 4, 5, 6, 8 &amp; 10 3 Lecture 1 The Bond Market and Interest Rates We have discussed OMOs as an instrument of monetary policy Central bank buys or sells any asset Controls the money supply Usually involves sale or purchase of Treasury Bonds Modern monetary practice focuses on interest rates as the instrument of policy Bond holders receive interest Is there a connection between central banks operations in the bond market (OMOs) and its efforts to set interest rates? 4 Lecture 1 What is a bond? Firms or organizations issue bonds as a way to borrow money The price at which the bond sells is the amount borrowed The loan is repaid according to specified sequence of payments that will be made to the bond holder over the life of the bond An alternative to offering interest on a deposit account The principal is the amount borrowed The loan is of unspecified length, but earns interest at a specified rate 5 Lecture 1 Let: P = principal V = future value of the account i = interest rate (paid annually) n = number of years the account is held Then The compounding deposit account V=P(1+i) n or P=V/(1+i) n 6 Lecture 1 The Discount Bond Promises the bearer a single lumpsum payment at the maturity of the bond Characteristics of the bond 1. The term to maturity Equivalent to length of time a deposit account is held 2. The face value (i.e. the size of the lumpsum payment) Equivalent to the future value of the deposit account. 3. The price Equivalent to the principal of the deposit account 7 Lecture 1 The Discount Bonds Interest Rate Deposit account: V = P(1+i) n or P = V/(1+i) n The deposit account and the discount bond are equivalent ways to borrow (or save) P = price of the bond V = face value of the bond n = term to maturity The implicit interest rate: i = (P/V)n 1 The interest rate offered on an account that would allow a $P deposit to grow into $V in n years 8 Lecture 1 Example: The Discount Bond Consider the discount bond with Face value: V = $121 Term to maturity: n = 2 Price: P = $100 If V = P(1+i) n Then 121 = 100(1+i) 2 And i = (121/100)...
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This note was uploaded on 09/28/2010 for the course ECON 310 taught by Professor Hogan during the Winter '08 term at University of Michigan.
 Winter '08
 Hogan
 Economics

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