Financial Analytics

Intro to Finance

Introduction to Finance

FIN-3134 Financial Analytics Fall 2020 4.7 Monetary Policy Objectives • Goals are speciﬁed via Congressional acts that give the Fed its power. • Monetary policy promotes maximum employment (i.e., near the natural rate of employment), stable prices (roughly 2% inﬂation in the long-run), and moderate long-term interest rates . • The Fed prefers 2% inﬂation as opposed to 0% because any deﬂation can cause large problems particularly for debtors because the real burden of debt increases. Inﬂation decreases in recessions which can have catastrophic snowball e ↵ ects (e.g., the Great Depression). • 2020 Long-Run Goals – Targets an average 2% inﬂation rate over time in contrast to aiming for 2% at any given time. – Following periods when inﬂation persists below 2%, the Fed strives for inﬂation o be moderately above 2% for some time. 4.8 Federal Funds Market & Rate Targeting • The Fed has substantial inﬂuence over the money supply, but they cannot control it perfectly. The following are not under Fed-control: – Bank Behavior ( rr ) – Consumer Behavior ( cr ) • In the 1970s, the Fed had goals for money supply growth, but it had mixed results. It was subsequently abandoned in favor of interest rate targeting . – Interest rate targeting refers to when the central bank announces a target rate (or range of rates) for a benchmark interest rate and conducts monetary policy actions in order to achieve that target. – The Fed typically targets the federal funds rate which is the interest rate in the federal funds market. ∗ THIS RATE IS NOT SET BY THE FED. ∗ It is a market rate determined by the standard forces of supply and demand. 4.9 Traditional Tools of Monetary Policy– Old School Tools 4.9.1 Reserve Requirements • These are largely irrelevant at the moment since the current reserve requirement is 0%. • The Fed has the authority to set the required ratio of deposits that must be held as reserves. • Changing this immediately alters the extend of the excess reserves in the system. As a result, it is rarely changed. – It was roughly 10% for nearly three decades. – In March 2020, it was lowered to 0% because the Fed thinks it is operating in ”ample reserves environment”–lots of excess reserves held. • Historically, it was important in generating demand for federal funds in order to comply with reserve requirements. FIN-3134 Financial Analytics Fall 2020 4.9.2 Discount Rate • Unlike the federal funds rate, the DISCOUNT RATE IS SET BY THE FED . • Interest is charged by a Reserve Bank for institutions to borrow funds on a short-term basis. • It is a primary source of funds during disruptions (i.e., ﬁnancial crises). • It alters the amount of reserves in banking systems and alters the quantity of reserves. • If the Fed decreases the discount rate, the monetary base increases. 4.9.3 Open Market Operations • Buying/selling Treasury bills • Historically, it was the primary monetary tool. When the Fed buys or sells securities, it inﬂuences the quantity of excess reserves available for lending in the federal funds market (i.e., it shifts the supply curve). • Buying securities creates new reserves (expansionary policy). – When the Fed buys Treasury bills, it shifts outward the supply of non-borrowed reserves leading to a reduction in the equilibrium federal funds rate (if on the downward-sloping portion of demand). • Selling securities results in less reserves (contractionary policy/money tightening). – When the Fed sells Treasury bills, it shifts inward the supply of non-borrowed reserves leading to a increase in the equilibrium federal funds rate (if on the downward-sloping portion of demand).

FIN | 3134 | Financial Analytics | lecture notes | FIN-3134 Financial Analytics F

FIN-3134_-3-3_-_Bond_Pricing.pdf-FIN-3134 Financial Analytics Fall 2020 3.3

FIN-3134 Financial Analytics Fall 2020 3.6 Special Government Bonds 3.6.1 Separate Trading of Registered Interest and Principal of Securities (STRIPS) Characteristics : 1. Zero-coupon bonds that are synthesized out of regular, coupon bearing US Treasury notes and bonds by stripping the notes and bonds into claims to the individual cash ﬂows. 2. They exist due to investor demand for longer maturity zero-coupon government bonds. 3. The price of a STRIP (or of any zero-coupon bond) provides a measure of the discount factor associated with cash received at the maturity data of the corresponding zero-coupon bond (e.g., if a STRIP with a three-year maturity trades for $ 96.42, then the value of $ 1 in three years equals 96.42 cents). • Example : A treasury bond has one year to maturity and pays a 10% coupon semi-annually. If a STRIP with six months to maturity trades at $ 99 and another STRIP with 12 months to maturity trades at $ 97.80, what is the implied price of the treasury bond? The present value of of $ 1 in six months is 99 cents, and the present value of $ 1 in twelve months is 97.8 cents. The bond o ↵ ers the investor $ 5 in six months and $ 105 in twelve months ($100 + $5) , so the price of the bond is (0 . 99 ⇤ $5) + (0 . 975 ⇤ $105) = $107 . 64 . 3.6.2 Treasury Inﬂation Protected Securities (TIPS) Characteristics : 1. Special bonds that help protect investors against inﬂation. They are issued in maturities of 5, 10, or 30 years. 2. The face value is adjusted semiannually for inﬂation based on changes in the Consumer Price Index for Urban Consumers (e.g., at maturity, if the adjusted principal/face value is greater than the par value, the investor receives the adjusted price). • Example : A TIPS note has an original principal amount of $ 100,000 with 10 years till ma- turity, 3% coupon (1.5% semi-annually). Given 1% inﬂation (EPR) in the next six months and 1.4% inﬂation (EPR) in the following six months, determine the adjusted principal for the TIPS and the ﬁrst two adjusted coupon payments. After six months, the principal adjusts to $100 , 000(1 + 1%) = $101 , 000 . The ﬁrst coupon payment equals the adjusted principal amount times the semi-annual coupon rate. $101 , 000 ⇥ 1 . 5% = $1 , 515 After the second six months, the principal adjusts to $101 , 000(1 + 1 . 4%) = $102 , 414 . FIN-3134 Financial Analytics Fall 2020 The second coupon payment then equals $102 , 414 ⇥ 1 . 5% = $1 , 536 . 21 . This process can continue for the remaining life of the bond depending on the realized inﬂation path. Note that the coupons received by the investor maintain a constant real value (purchasing power). TIPS bonds provide a market-based measuring of the real interest rate at various horizons. For example, if US Treasury notes with one year to maturity have a yield of 2%, and a TIPS security with one year to maturity has a yield of 1%, expected inﬂation would be 2% - 1% = 1% according to the approximation to the Fisher equation.

FIN_3104__Lecture_7A__Risk_and_Return_II.pdf-Daniel Eisert FIN-3104: Lecture 7A March

FIN-3134 Financial Analytics Fall 2020 4.10 Unconventional Tools of Monetary Policy– New School Tools 4.10.1 Zero Lower Bound Conventional monetary policy faces a limitation as interest rates approach the zero lower bound (ZLB) . This has occured twice in recent macroeconomic history. 1. 2008 Financial Crisis 2. Coronavirus Crisis (now) At the ZLB, the Fed is unable to rely on conventional monetary policy to further lower rates and stimulate the economy. Only two other options remain: 1. Fiscal policy which is sometimes infeasible. 2. Unconventional monetary policy which is a combination of quantitative easing and forward guidance . 4.10.2 Quantitative Easing (QE) The central bank purchases longer duration ﬁnancial assets in order to inject a certain quantity of money into the economy. The goal of this is to buy longer maturity assets with electronically created reserves. • Push up the price of these assets to decrease yield (interest rates). • This amount to pushing down long end of the yield curve. • Risks – Inﬂation Increases: Similar to conventional monetary expansion, repeated quantitative easing may lead to signiﬁcant inﬂation. – Ine ↵ ectiveness: Banks must ultimately lend out reserves in a way that spurs the economy. 4.10.3 Forward Guidance Fed communication regarding its future policy plans. In particular, its plans for future adjustments to the federal funds target. • Yield Curve: Long-term rates reﬂect expectations of future short-term interest rates. • If the Fed wants to lower longer-term rates (no direct control), they need to convince the public that they will keep the short-term interest rate low in the future. 4.11 Current Policy Implementations The Fed is currently operating in an abundant reserves environment. • Banks reserves vastly in excess of traditional required reserve level. • The Fed recently dropped the required reserve level to zero recognizing that is plays a little role in generating demand for reserves in the current environment. FIN-3134 Financial Analytics Fall 2020 • Traditional open market sales will not increase the federal funds rate because we are on the ”ﬂat part” of the demand curve. • Rather, the target level of the funds can be supported by changing the interest rate paid on reserves that banks hold at the Fed (this started in October 2008; the current rate is 10 basis points ). 4.11.1 Overnight Reverse Repurchase (Repo) Agreement The institutions can buy securities from the Fed, and the Fed buys securities back the next day at a slightly higher price that is agreed upon in advance. • Interest is earned by the institution that bought the securities. This is an implicit form of collateralized loan to the Fed. • Institutions have little incentive to lend in the federal funds market at rates much below what they can earn by participating in a reverse repurchase agreement with the Fed. • By changing the interest rate paid in reverse repurchase agreements (in addition to the rate paid on reserves), the Fed is able to better control the federal funds rate.

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