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Lecture 01
What is basic banking?

¨  Making a profit!

¨  Asset transformation: selling liabilities with one

setting of characteristics and using the proceeds for
buying assets with another set of characteristics

¨  A bank borrows short and lends long

Flow of funds
What’s a commercial bank?

¨  This is a financial institution providing services for businesses,

organisations and individuals. Services include offering current,
deposit and saving accounts as well as giving out loans to
¨  A commercial banks is defined as a bank whose main business
is deposit-taking and making loans.
¨  Commercial banks make their profits by taking small, short-
term, relatively liquid deposits and transforming these into
larger, longer maturity loans. This process of asset
transformation generates net income for the commercial bank.
What’s an investment bank?

¨  Also called merchant bank (particularly in the UK),

¨  A financial institution that deals mainly with corporate
customers and specialises on:
¤  servicesfor companies and large investors, including
underwriting and advising on securities issues and other
forms of capital raising,
¤  trading on capital markets,
¤  research and private equity investments,
¤  asset management,
¤  advisory activities and corporate restructuring such as
mergers and acquisitions, and
¤  trading and investing on its own account.
What determines Asset Demand?
¨  An asset is a piece of property that is a store of value. Facing
the question of whether to buy and hold an asset or whether to
buy one asset rather than another, an individual must consider
the following factors:
1.  Wealth, the total resources owned by the individual, including
all assets
2.  Expected return (the return expected over the next period) on one
asset relative to alternative assets
3.  Risk (the degree of uncertainty associated with the return) on one
asset relative to alternative assets
4.  Liquidity (the ease and speed with which an asset can be turned into
cash) relative to alternative assets
What determines Asset Demand?

¨  The quantity demanded of an asset differs by factor.

1.  Wealth: Holding everything else constant, an increase in wealth raises
the quantity demanded of an asset
2.  Expected return: An increase in an asset’s expected return relative to
that of an alternative asset, holding everything else unchanged,
raises the quantity demanded of the asset
3.  Risk: Holding everything else constant, if an asset’s risk rises relative
to that of alternative assets, its quantity demanded
will fall
4.  Liquidity: The more liquid an asset is relative to alternative assets,
holding everything else unchanged, the more desirable
it is, and the greater will be the quantity demanded
What determines Asset Demand?
What determines Asset Demand?
What determines Asset Demand?
What determines Asset Demand?
What determines Asset Demand?

¨  If πe ↑
1.  Relative Re ↓,
Bd shifts
in to left
2.  Bs ↑, Bs shifts
out to right
3.  P ↓, i ↑
What determines Asset Demand?

1.  Wealth ↑, Bd ↑, Bd
shifts out to right
2.  Investment ↑, Bs ↑,
Bs shifts right
3.  If Bs shifts
more than Bd
then P ↓, i ↑
What determines Asset Demand?

¨  Make decisions about assets to hold

1.  when forecasting i ↓, buy long bonds
2.  when forecasting i ↑, buy short bonds

¨  Make decisions about how to borrow

1.  when forecasting i ↓, borrow short
2.  when forecasting i ↑, borrow long
What’s the Risk Structure
of Interest Rates?

¨  RS: same maturity different interest rates

¨  One attribute of a bond that influences its interest rate

is its risk of default, which occurs when the issuer of
the bond is unable or unwilling to make interest
payments when promised.

¨  U.S. Treasury bonds have usually been considered to

have no default risk because the federal government
can always increase taxes to pay off its obligations
(or just print money). Bonds like these with no default
risk are called default-free bonds.
What’s the Risk Structure
of Interest Rates?
¨  Default Risk

¨  The spread between the interest rates on bonds with

default risk and default-free bonds, called the risk
premium, indicates how much additional interest
people must earn in order to be willing to hold that
risky bond.

¨  A bond with default risk will always have a positive

risk premium, and an increase in its default risk will
raise the risk premium.
What’s the Risk Structure
of Interest Rates?
What’s the Risk Structure
of Interest Rates?
What’s the Risk Structure
of Interest Rates?
¨  Liquidity Risk
¨  Another attribute of a bond that influences its interest rate is its
liquidity; a liquid asset is one that can be quickly and cheaply
converted into cash if the need arises. The more liquid an asset
is, the more desirable it is (higher demand), holding everything
else constant.
¨  The differences between interest rates on corporate bonds and
Treasury bonds (that is, the risk premiums) reflect not only the
corporate bond’s default risk but its liquidity too. This is why a
risk premium is sometimes called a risk and liquidity premium.
What’s the Risk Structure
of Interest Rates?

Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds

What’s the Risk Structure
of Interest Rates?
¨  Income Tax Considerations
¨  Interest payments on municipal bonds are exempt

from federal income taxes, a factor that has the

same effect on the demand for municipal bonds as
an increase in their expected return.
¨  Treasury bonds are exempt from state and local
income taxes, while interest payments from
corporate bonds are fully taxable.
What’s the Risk Structure
of Interest Rates?
What’s the Term Structure
of Interest Rates?
TS: relationship of interest rates for assets with
different maturities
¨  Yield curve: a plot of the yield on bonds with
differing terms to maturity but the same risk, liquidity
and tax considerations
•  Upward-sloping: long-term rates are above short-term
•  Flat: short- and long-term rates are the same
•  Inverted: long-term rates are below short-term rates
What’s the Term Structure
of Interest Rates?
What’s the Term Structure
of Interest Rates?
What’s the Term Structure
of Interest Rates?
¨  Besides explaining the shape of the yield curve, the
theory attempts to explain why:
1.  Interest rates for different maturities move together.
2.  Yield curves tend to have steep upward slope when
short rates are low and downward slope when short
rates are high.
3.  Yield curve is typically upward sloping.
What’s the Term Structure
of Interest Rates?
¨  The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond

it + it +1 + it + 2 + ... + it + (n−1)
int =
What’s the Term Structure
of Interest Rates?
¨  Investors have a preference for bonds of one
maturity over another
¨  They will be willing to buy bonds of different

maturities only if they earn a somewhat higher

expected return
¨  Investors are likely to prefer short-term bonds over
longer-term bonds. This implies that investors must be
paid positive liquidity premium, int, to hold long term
What’s the Term Structure
of Interest Rates?
it + ite+1 + ite+ 2 + ... + ite+ (n−1)
int = + l nt
What’s the Term Structure
of Interest Rates?
¨  Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
¨  Bonds of different maturities are substitutes but not

perfect ones
¨  The interest rate for each bond with a different

maturity is determined by the demand for and supply

of that bond in a segmented fashion
The Practicing Manager:
Forecasting Interest Rates with the Term Structure

¨  Invest £1 in 1-period bonds or in two-period bond

(1 + it )(1 + ite+1 )− 1 = (1+ i2t )(1 + i2t ) − 1
Solve for forward rate, iet+1
e (1 + i2t )
it +1 = −1 (4)
1 + it
Numerical example: i1t = 5%, i2t = 5.5%
(1 + 0.055)2
ite+1 = − 1 = 0.06 = 6%
1 + 0.05
Forecasting Interest Rates
with the Term Structure
¨  Compare 3-year bond versus 3 one-year bonds

(1 + it )(1 + ite+1 )(1 + ite+2 )− 1 = (1 + i3t )(1+ i3t )(1 + i3t ) − 1

Using iet+1 derived in (4), solve for iet+2

e (1 + i3t )
it +2 = 2 −1
(1+ i2t )
Forecasting Interest Rates
with the Term Structure
¨  Generalize to:
n +1
e (1+ in+1t )
t +n = n −1
(1 + int )
Liquidity Premium Theory: int - = same as pure
expectations theory; replace int by int - in (5)
to get adjusted forward-rate forecast

e (1+ in+1t − l n +1t ) (6)
it +n = n −1
(1+ int − l nt )
Forecasting Interest Rates
with the Term Structure
¨  Numerical Example
2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%
(1 + 0.0575 − 0.0025)
ite+1 = − 1 = 0.06 = 6%
(1 + 0.05)
Example: 1-year loan next year
T-bond + 1%, 1t=0 2t = 0 .4%, i1t = 6%, i2t = 7%
(1 + 0.07 − 0.004)
ite+1 = − 1 = 0.072 = 7.2%
(1 + 0.06)
Loan rate must be > 8.2%

Ø  Prepare a brief report on “changes in interest

rates due to expected inflation and how this
may affect the behaviour of banks.”
Ø  Prepare a brief report on how the banking sector
has been affected by “sovereign default risk
and the crisis in the euro area.”
Ø  Prepare a brief report on the benefits and costs of
“low Japanese interest rates” for the banking