Economics 434: The Theory of Financial Markets Professor Burton Fall 2016 Sept 13, 2016

Readings Through The End of This Week Chapters 7 and 8 Now in all, first 8 chapters Sept 13, 2016

Default Free Securities – An Example US Treasury Market Bills (one year or less original maturity) Notes and Bonds (more than one year of original maturity) Notes are 2, 3, 5,7, and 10 year maturities (anything more than one year and not more than 10 years in original maturity Bonds are anything with more than 10 years original maturity – currently just the 30 year bond Auctioned on a regular basis Calculating yields Bills different than Notes and Bonds Sept 13, 2016

Use the Web for Latest Treasury Information http://www.treasurydirect.gov/indiv/products/products.htm http://www.treasurydirect.gov/govt/reports/pd/mspd/2016/2016_aug.htm http://www.treasury.gov/resource-center/data-chart-center/quarterly-refunding/documents/auctions.pdf http://www.treasurydirect.gov/NP/debt/current http://research.stlouisfed.org/fred2/release?rid=263 https://www.treasurydirect.gov/instit/annceresult/annceresult.htm Sept 13, 2016

Maturity: What Does It Mean? That’s the last of the treasury securities life On that day, it pays the “principal” of the security Bills -- $ 1,000,000 Coupon Issues (notes and bonds) -- $ 100,000 For bills, that is the only payment For coupon issues, the final interest (coupon) payment is made on the maturity date Sept 13, 2016

Treasury Bills Anything issued with less than 1 year in original maturity Everything else is a note or a bond Three main types 4 week bill (30 day bill) 3 month (90 day bill) 6 month (180 day bill) Year bill (360 day bill) Also, from time to time Cash management bills

Key facts about treasury bills Always have “original maturity” less than one year Quotes are “discounts” Year is assumed to be 360 days long Actual annual yield higher than quote because Quote is a discount Year has more days than 360

Example: The Year Bill Assume the quote is 0.40 % Assume the principal amount is $ 1 million (always assume this in this class for treasury bills) What is the price of this bill? Discount is .004 times $ 1 million = $ 4,000 Price then must be $ 996,000 What is the annual yield of this bill? Yield for 360 days is 4/996 = .004016 % Yield for 365 days is 365/360 times .004016 % or .004072 or .4072 percent

To calculate annual yield General Principles To calculate annual yield First calculate the amount of the discount Quote times t/360 times $ 1 million where is t is the days remaining to maturity Then note that the amount of the discount is your profit and $ 1 million minus the discount is your cost, so that the yield for t days is: Yield for t days = discount/($ 1milion – discount) Then annualize: Annual yield = (365/t) times (Yield for t days)

US Treasury Notes and Bonds Assume that principal (payoff) amount is $100,000, paid at maturity date of bond Two payments annually, approx. six months apart If coupon is 10 percent, each payment is $ 5,000; if coupon is 1 percent, each payment is $ 500 Name is: coupon (plus) maturity date For example: 2 1/4s of Aug ‘46

2 1/4’s of August 2046 Pays $ 100,000 on Aug 15, 2046 Also pays $ 1,125 on Feb 15, 2017 and Aug 15, 2017 Similarly for every year until payment of $ 1,125 on Aug 15, 2013 plus the $ 100,000 payment on that same date Was auctioned on Aug 11,2016

There is a 30 year auction today Competitive Bids Due in by 1 PM EST $ 12 billion “Reopening” of the 2 1/4s of Aug ’46 $ 16 billion already outstanding Also 4 week and 52 week auction Settlement is Thursday, the 15th Sept 13, 2016

Sept 13, 2016