Financial Market - Assignment Example

Financial Market Table of Contents Random walk behaviour of consumption 3 Methodology 4 Bond, bill and stock 5 Bonds 5 Bills 6 Stock 6 Difference between bill and bond 7 Difference between bond and stock 7 The concept of Bond 7 Holding Period Yield 8 Spot Yield 8 Yield to Maturity (YTM) 9 Hypothesis of term structure interest rates 10 The pure expectation hypothesis 10 The liquidity preference hypothesis 11 Relationship analysis 11 References 13 Random walk behaviour of consumption The multiplier µ is defined as Where mpc is marginal propensity to consume out of income. The random walk behaviour of consumption constitutes permanent-income hypothesis. A simplified version of permanent income hypothesis is given as C=kYp where C is consumption, Yp is expected or permanent income and k is the propensity to consume out of permanent income which is under the conditions of certainty approximately equals to unity. Permanent consumption represents steady level of consumption to be maintained by consumer over its lifetime given its income flows and initial assets over lifetime. The real rate of interest is the key determinant of k whose value in the long run is assumed constant. The random walk behaviour of macroeconomic aggregates can be produced by a wide variety of complicated behaviour at microeconomic level. If income follows a random walk process, any innovation in income or a change in income due to an economic shock is an unexpected change in permanent income affecting consumption growth. The predictive ability of unexpected permanent or actual growth in income is consistent with permanent income hypothesis (PIH). Within the framework of time-series modelling, it was suggested that the standard test is biased towards finding excess sensitivity when disposable income follows a random walk process. If income follows a random walk, the permanent income equals current income. Assuming that permanent income hypothesis is true and consumption equals income, since series contain a unit root, the procedures of standard testing are not valid. If both consumption and income are de-trended, spurious cycles would be exhibited by both series. Since consumption tracks income perfectly over these transitory cycles, it can be concluded that consumption is excessively sensitive to contemporaneous income. Excess sensitivity of consumption does not provide evidence against the permanent income hypothesis unless the income is shown as not to have properties of random walk. The random walk process is followed by the real disposable income. Actual real disposable income approximates real permanent disposable income which determines household consumption. The origins of random walk process of real disposable income are on the supply side including factors of capital market restrictions, changes in trade, capital accumulation, technological adaptation and innovation, climatic and weather change etc. These supply side shocks have long term impact on income and consumption. They also impact productivity changes across the longer term so the growth in consumption is linked to unpredictable innovations in permanent income. Predictable measures of monetary and fiscal policy have transitory effects on income with low downstream impact on consumption. Methodology Using the function of quadratic utility which allows linear marginal utility, current marginal utility has been regressed on its past value in the context of the model. The model tells that β = 1, so that consumption follows a random walk. The tests of random walk are notoriously difficult as failure to reject null hypothesis that β = 1, very little is known. The data are not inconsistent with random walk. Statistically, this is not same saying β = 1. This test is severely limited as it does not allows to distinguish this theory from other theories of consumption. Bond, bill and stock Bonds A bond is an instrument of indebtedness of bond issuer to holders. It is a debt security under which the issuer owes a debt to the holders. The issuer is obliged to pay them interest and is required to repay the principal at a maturity date. The interest is payable at fixed intervals. The bond is negotiable. Its ownership can be transferred in the secondary market. A bond has the following features. Principal, nominal, face or par amount is the amount on which interest is paid by issuer and it has to be repaid at the end of term. Some structured bonds have redemption amount which differs from face amount and is linked to performance of particular assets like commodity or stock index. The nominal amount is to be repaid by the issuer on the date of maturity. After meeting all the due payments, the issuer has no further obligation to bond holders after the date of maturity. Usually, the bonds have a term of up to 30 years. The interest rate paid by the issuer to bondholder is called coupon. This rate is usually fixed throughout the life of bond. The rate of return received from investment in bond is called yield. It includes current yield and yield to maturity. The credit quality is associated with bond which refers to the probability of receiving the promised amount by bondholders at due dates. A tradable bond’s market price will be influenced by currency, amount, quality of bond, timing of interest payment etc. There are commonly three kinds of bonds, treasury notes, treasury bills and treasury bonds. Bills For investing in bonds for short term, treasury bills are the type of bonds to be made investment. These are having maturity dates of 6 months, 3 months or one year. Treasury bills are sold by government and money generated by the government is utilized immediately. It is not kept for funding the government in long term. These bonds do not pay interest to its holders. The profit is earned by the investor by increase in price of bond from the time it is purchased to its value at its maturity. Treasury bills carry a minimum investment of $10,000 or more so these are not issued to small investors. These bonds are carried in money market to generate interest for investors. Mutual funds referred as short term bond funds hold a large portion of their portfolio in these bonds. Stock The stock or capital stock of an incorporated business constitutes the equity stake of its owners. It represents the residual assets of company which is due to stockholders after discharging secured and unsecured debt. The stockholder’s equity cannot be withdrawn from company as it is detrimental to creditors of company. The stock of a corporation is partitioned into shares. Additional shares can be authorized by existing shareholders and issued by company. Shares represent a fraction of ownership in business. This ownership of share is documented by issue of stock certificate which a legal document is specifying the amount of share owned by shareholder. Stock in the form of shares can be preferred stock or common stock. Preferred stock differs from common stock in the way that it does not carry voting rights. It is entitled to a certain level of dividend payment before issuing any dividend to other shareholders. Difference between bill and bond Bills are short term obligations which are issued with a term of one year or less. It does not give interest before maturity as it is sold at discount from its face value. The interest is the difference between the purchase price and price paid on maturity. Whereas, bonds hold a fixed rate of interest that is paid semi annually till maturity. Again, bills are priced at a discount from its face value and it does not gives interest before maturity but in bonds, interest is paid semi-annually and its pricing is based on yield to maturity. Difference between bond and stock Both stocks and bonds are securities. However, they differ in the sense that stockholders hold an equity stake in company but the bondholders hold a creditor stake in company. In other words, they are the lenders. It also differentiates in a way that bonds contain a defined term or maturity. After maturity, it is redeemed but the stocks can remain outstanding indefinitely. The concept of Bond Debt instruments are preferred by many investors since it ensures assured return and high interest rate for the investor which is not a characteristic feature of equity. The basic difference between bond market and stock market is that former is fixed income security and involves less risk of investment. It can be further divided into primary and secondary markets. The bond markets also trades Government securities. The participants of bond market are banks, corporates, financial institutions, and individuals. The instruments of bond market are index bonds, government bonds, deep discount bonds, mortgage bonds, money multiplier bonds, educational bonds, unsecured bonds, guaranteed bonds, retirement bonds, and so on. A bond security contract is a security in which authorised issuer owes to the bond holder a certain amount of principal debt which by obligation is to be repaid on maturity along with interest on outstanding debt. Thus, a bond is an intention of understanding between the investor and the issuer to pay a fixed sum along with interest on maturity. The risk associated for investment in bond securities are interest rate risk, default risk, call ability risk, and market ability risk. Holding Period Yield The holding period yield of an investor is based on the concept that if an investor buys a bond and sell it after holding the bond till maturity, then the rate of return for the investor for holding the bond for entire maturity period is calculated using the following formula, Holding period yield = (Price gain or loss during holding period + Coupon interest rate) / (Price at the beginning of holding period) The holding period yield is also known as single period rate of return. In the primary and secondary market it is calculated daily, monthly, or annually basis. If the fall in bond prices is greater than coupon payment, then the holding period yield will be negative. Conversely, when the holding period yield is positive, then it implies that coupon payment for the bond is greater than bond prices in market. Spot Yield It is also known as the current yield. The spot yield is the coupon payment expressed as percentage of current market prices. It is calculated using the following formula, Spot yield = (Annual coupon payment) / (current market price) The importance of current yield or spot yield is that with this measure an investor can get the idea about the true rate of cash flow from their investment every year. The current yield differs from coupon rate since the face value of bond is not equal to the market price of bond. When the market value and the face value of bond is equal due to laws of demand and supply in the market, consequently, the current yield and coupon rate and coupon rate will also be equal. Yield to Maturity (YTM) The concept of YTM is widely acknowledged by investors as a tool for bond management. The YTM is defined as the discount factor which makes the present value of future cash flows of bond equal to the current market price of the bond. Hence, YTM can also be considered as the rate of return which the investor expects to earn if the bond is held till maturity. The assumptions of YTM are as follows: 1. The issuer of bond should not default on or before maturity 2. The principal and coupon should be paid as per initial agreement 3. The investor holds the bond till maturity 4. All coupon payments should be immediately reinvested at the same interest rate as yield to maturity of bond. Mathematically, YTM is calculated from the following formula, For an investor to make better decisions, it is very crucial to understand the concept of YTM. Any difference in reinvestment rate will change the actual return and YTM. From the concept of YTM, it can be said that the price of bond and bond yield is negatively related. This means that if the current prices of bond rise in the market, it will cause a fall in yield and vice versa. Hypothesis of term structure interest rates The pure expectation hypothesis The bond portfolio manager is concerned with mostly two aspects of bonds’ interest rates namely, the term structure of interest rate and the level of interest rate. The relationship between the time to maturity and the bond yield is called the term structure of bond and it states about the expectation of the investor or the bond holder. The hypothesis states that the long term interest rates can be used to forecast or predict short term rates of future. According to the postulates of expectation theory, an investor can earn the comparable interest by investing in a single period one year bond on current date as the new single period bond a year later. This theory can be explained using the yield curve. In reality the market is not efficient and the bond rates generally remain even when the yield curve of bond is normal. This means that the pure expectation theory over estimates the short term interest rates of bonds in future. The liquidity preference hypothesis The liquidity preference theory was described by the famous economist John Keynes. According to him people value money for transaction as well as savings. Thus, if people sacrifice the interest foregone by not saving and consuming money today the interest rates for the bonds will increase. This means that the bond price would decrease in the market. If this happens then the people will be attracted to save money in banks. As more and more people keep on saving money, the supply of bonds in the market will decrease which will raise the price of bond in the market. It is based on the principal that a bond holder would demand for a premium for security as the maturity of the bond gets longer. This is because with longer maturity, the time value of money decreases with rise in inflation which increases the risk of holding bond. Since an investor would prefer holding bonds with less risk, more emphasis is put on the bonds’ liquidity. This is because the more the bond investment is liquid the easier it would be to sell in the market with full value. Also the interest rates are more volatile over short term period compared to medium or long term period. From the pure expectation theory, it can be said that it will decrease the yield of bond at maturity. Thus, from liquidity preference hypothesis, it can be said that people would be willing to hold more money when interest rates decreases and conversely, hold less money when the interest rates increases so as secure profits. Relationship analysis The term structure of interest rate states the relationship between yields of bonds with different terms to maturity. Plotting of interest rate of such bonds against its terms represents the yield curve. The expectation hypothesis of term structure of interest rate represents that interest rate on long term bond is the average of short term interest rates that is expected to occur over the life of long term bond. Band spectrum regression shows that if y = xβ + ε is a valid model of regression in time domain, it can be transformed into frequency domain by application of Fourier transformation to both independent and dependent variables. The transformed variables denoted as and the regression in frequency domain will be The estimator will be written as Where T is sample size, is periodogram of series in x at each frequency ω and is a vector of cross periodograms. Transfer of regression model into frequency domain benefits by permitting a test of hypothesis that is applied by a specific model to some frequencies. For computing a frequency band is summed over instead of full range of frequencies. Application of model only to a specific frequency band and use of information from all frequencies might obscure the relationship between variables. A conventional F test is used to test the equality of parameters across frequency bands. From such test, it is found that equality of β across frequency bands is rejected for long rates and term spreads with test statistics between F1,230 = 20.47 to F1,230 = 43.38, which exceed the critical value at 5% significance level of 3.89. Testing the expectation hypothesis of term structure of interest rates allows considering different frequency bands. At high frequencies having fluctuation with a periodicity of less than 6 months, a negative relation is found between the term spread and change in long term interest rate. At low frequencies beyond 4 years the relation is positive for short maturities and negative for long maturities (Assenmacher-Wesche and Gerlach, 2008). The expectation hypothesis is rejected due to high frequency fluctuations in data it do better in case of interest rate changes in intermediate frequency bands. High frequency or short run fluctuations in term structure interest rate do not contain much information about future interest rates, so, it should be disregarded. References Assenmacher-Wesche, K. and Gerlach, S., 2008. The Term Structure Of Interest Rates Across Frequencies. No. 976. [pdf]. Available from http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp976.pdf. [Accessed on March 29, 2013]. Read More