1. AP/ECON 3430 3.0 A MONETARY ECONOMICS I: FINANCIAL MARKETS AND INSTITUTIONS Fall 2016 Topic 5: Financial Instruments Session 5B Course Director: Prof. Brenda Spotton Visano © Brenda Spotton Visano 2016

2. General Characteristics of Financial Contracts Type of Financial Contract Type/Nature of Income Issuer of the contract Term to Maturity Liquidity Marketability Risks

3. Structuring Debt Contracts How might one structure the terms of a debt contract? 1.Set a Face Value and a Term to Maturity - negotiate the Current Price of the contract (i.e., the amount to be loaned) 2.Set a Face Value, a Term to Maturity, and a Periodic Payment – negotiate the Current Price of the contract 3.Specify a fixed Periodic Payment in perpetuity – negotiate the Current Price of the contract 4.Set a Current Price and a Periodic Payment – negotiate the Annual Interest Rate and Future Value of the contract

4. Negotiating the Current Price As a saver/lender – How do you decide how much you would be willing to pay today for a contract that promises to pay you $100 in 1 year’s time? As a capital owner/investor - How do you decide how much you would be willing to sell a contract for today that commits you to a payment of $100 in 1 year’s time?

5. Considerations Present Value formulas for 1 year Discount Bonds (Treasury Bills), Coupon Bonds, Consols, and Fixed Payment Loans Opportunity Costs Inflation Capital Gains/Losses Degree of Certainty/Uncertainty

6. Bond Prices & Present Value Calculations One period discount debt contract: –Present Value (PV) = $100/(1+i) Paying for a stream of income in perpetuity: –Present Value = $100/(i) (…the formula that emerges from the convergence of an infinite sum) Demand and Supply in competitive markets (should) ensure that the Price of the debt contract = PV

7. Vocabulary of Financial Returns 1.$100 today is worth how much in 1 year if the interest rate = 6%? 2.$106 to be paid in 1 year is worth how much today if the discount rate is 6%? 3.A contract with a market price of $100 today delivers $106 in 1 year. What is the internal rate of return? 4.You buy a contract that pays you $6 every year, in perpetuity. The price of that contract on the market = $100. What is the yield on this asset? 5.Apple Inc.’s Price-Earnings ratio is ~16. What is the expected earnings yield on Apple shares? 6.If the expected inflation rate is 2% per year, what is the real rate of return in all of the above? 7

8. Supply of Bonds As the Price of Bonds rises, why or under what conditions would you expect the Quantity of Bonds Supplied to increase? If the Government of Canada paid off all of its debt, what might happen to the Price of Your Company Bond? During a boom in business, what might happen to the Price of Your Company Bond? If inflation is expected to increase to 3% over the next year, what might happen to the Price of Your Company Bond today?

9. Demand for Bonds As the Price of Bonds rises, why or under what conditions would you expect the Quantity of Bonds Demanded to decrease? If inflation is expected to increase to 3% over the next year, what might happen to bond prices today? If Bond A is riskier than Bond B, what might be the relationship between the Price of Bond A and the Price of Bond B, everything else equal. (What makes a bond “risky”?)

10. Types or Sources of Risk Default or credit risk Liquidity risk Inflation - unanticipated Interest rate risk