Demand and Supply for Financial Assets Essay Example

Demand and Supply for Financial Assets Essay Demand and Supply for Financial Assets Mishkin ch. 5: Bonds †¢ Motivation: Monetary policy works primarily by manipulating interest rates. Interest rates are determined by the demand and supply for bonds. Demand and supply for other financial assets are determined similarly. †¢ Perspectives on the bond market: 1. Bonds as financial assets = Determinants of Asset Demand. †¢ Bond demand affected by relative risk, relative liquidity, and wealth. †¢ Asset pricing (Finance) issues. Instantaneous responses to news. 2. Saving and Borrowing = Real Factors. Bond market matches savers and borrowers, affected by their behavior. †¢ Macro issues: Real savings/investment. Takes time. 3. Liquidity Preference †¢ View bonds as alternative to holding money. Affected by monetary changes. †¢ Special issues: Flexible versus â€Å"sticky† prices. DEFER. †¢ Application: Money Interest Rates †¢ Mishkin provides survey. Needs more analysis – Star t reading the lecture notes. [Mishkin ch. 5 P. 1] Perspective #1: Bonds as Financial Assets †¢ General Finance Question: What determines the demand for financial assets? . Expected return (+) 2. Risk (-) 3. Liquidity (+) 4. Wealth (+) Applies to all financial assets. Bonds as example. †¢ The Demand Curve for Bonds †¢ Remember â€Å"High price Low yield†. Implies downward sloping demand function. †¢ Demand function shifts if bonds’ risk or liquidity change. †¢ Demand is relative shifts if return, risk, or liquidity on other assets change. †¢ Note: Bond market responds quickly to financial news, to any news relevant for determining the return, risk, or liquidity of bonds relative to other assets. Time horizon: Instantaneous (within seconds). [Mishkin ch. 5 P. 2] Demand for other financial assets †¢ Same arguments as for bonds: Downward sloping, because â€Å"higher Price lower expected return† logic applies to all financial assets, provided the asset’s payment stream remains unchanged. Shifting down/left when risk increases. Shifting up/right when liquidity increases. Examples: Stocks, mutual funds, real estate, gold, investments abroad. Similar for equity-type assets, except future payments are uncertain New element: Unexpected new information about payments shift the demand curve †¢ Example: Stock with expected value next year $100 More demand now at $80 than at $90 = Downward sloping demand curve. Suppose the expected value next year rises to $120: Demand at $96 (20% discount) is similar to previous demand at $80 = Shift right/up in the demand curve †¢ Special factor for long-term bonds: Rising interest rate before maturity would reduce the price = Reduce the return = Expected increases in interest rates reduce the demand for long-term bonds. Mishkin ch. 5 P. 3] Wealth as Demand Factor: Caution †¢ Basic point: More wealth = More demand for all financial assets. †¢ Co ntrast wealth with the demand factors that affect relative values: Demands for different financial assets are negatively related when relative returns, relative risks, and relative liquidity levels shift. Demands for different financial assets are positive related when wealth changes. †¢ Wealth can change in two ways: 1. New savings. 2. Re-valuation. Re-valuation is a distraction (or even misleading): Not a source of new demand. Example: Hold 100 bonds @100 = $10,000 wealth. If price rises to $110 = Wealth $11,000. Will demand increase? Demand from existing wealth is still 100 bonds. New savings must come from real activity = Surplus of income over spending. New savings take time: NOT an instantaneous factor = Creates dynamics. Purchasing power of wealth is eroded by inflation = Real returns (after inflation) determine the incentives to save †¢ Lessons for applications: Source of wealth changes is savings. Savings raise all asset demands. Quantity axis in diagrams = Number of securities or their face value (not $ value). [Mishkin ch. 5 P. 4] The supply of bonds and other financial assets †¢ Simple: the supplier/issues of securities defines the market! Treasury bond market = supply by U. S. Treasury Market for Microsoft stock = supply by Microsoft †¢ Supply incentives in the primary market: 1. Need for funds: Private: Profitability of capital investments. Public: Level of government bu dget deficits. 2. Cost of borrowing: Borrow more if the cost is low = upward-sloping supply curve. Inflation reduces the real value of debt = Real returns (after inflation) determine the incentives to issue securities †¢ Secondary market: Fixed supply except for buyback/new issues. = Steep or vertical supply curve. †¢ Mishkin’s demand supply diagrams: generic up/down slopes [Mishkin ch. 5 P. 5] Demand Supply = Equilibrium Price and Volume †¢ For bonds: Exact price-yield relationship (Example: F=1000) †¢ For all financial assets: High price tends to imply low future returns. [Mishkin ch. 5 P. 6] We will write a custom essay sample on Demand and Supply for Financial Assets specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Demand and Supply for Financial Assets specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Demand and Supply for Financial Assets specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Applications: Predict the Effect of Changes †¢ Reasons why bond demand may shift †¢ Reasons why bond supply may shift †¢ Scenarios that involve shifts in demand and supply: Business cycles Inflation: The Fisher Effect †¢ In each case: Task: Determine the impact on prices and quantities. Ask additional questions: What’s the time horizon? What’s the likely impact on other markets, e. g. , the stock market? †¢ Alternative view: Loanable Funds analysis (see Online Appendix5#1) Supply of securities = Demand for financing Demand for securities = Supply of funds to financial markets. Helpful way to think about markets, but not required for exams. [Mishkin ch. 5 P. 7] Summary: Factors that shift the Demand for Bonds [Mishkin ch. 5 P. 8] Summary: Factors that shift the Supply for Bonds [Mishkin ch. 5 P. 9] Notes on Mishkin’s Examples (1) †¢ About higher expected interest rates: Higher yield expected = Lower expected return = Declin e in demand = Reduced price = Yield rises immediately. Lesson: Rational investors act on expectations. Markets move when information arrives that changes investor expectations. About the slopes of demand and supply curves: Demand: Depends on how easily investors can go elsewhere when prices rise: For a specific bond relative to others: Essentially horizontal/very flat. For bonds as an asset class: Elastic/flat. Investors can substitute to stocks etc. For bonds as reflecting the supply of savings: Quite inelastic/steep. Consumptionsavings decisions are not highly sensitive to interest rates. Supply: usually inelastic/steep. New issues are small relative to outstanding quanties of identical or similar securities. Relevance of slopes: Steeper vs. flatter Larger vs. smaller price changes. [Exam: Generic slopes okay. But remember for real-world applications. ] [Mishkin ch. 5 P. 10] Notes on Mishkin’s Examples (2) †¢ About the time horizon and level of aggregation: Ins tructive to separate two sets of issues: 1. Allocation of existing financial assets: Instantaneous: Supply is well-approximated by a vertical line. Pricing is relative to other financial assets. Economic arguments involve relative return, risk, liquidity (nothing else). In equilibrium, all financial assets must attract investors = Must offer the same risk- and liquidity-adjusted return. 2. Flows of savings and capital investment: Takes time: New demand and supply more important relative to existing financial assets the more time passes. Savings are unspecific: Savers will invest in any savings vehicles that pays the equilibrium return: Markets clear at the aggregate level. Equilibrium return must match aggregate flow of funds into financial markets with total demand for funds from issuers of securities. [Mishkin ch. 5 P. 11] Scenario: Business Cycle Expansion †¢ Shifts in Demand and Supply: Higher incomes. Real capital investment is more profitable. [Caution: Distinguish real and financial investments! ] †¢ Questions: What causes business cycles? How do we know that supply shifts more than demand? = Macroeconomic issues. [Mishkin ch. 5 P. 12] Scenario: Increase in Expected Inflation †¢ Lower real cost of borrowing = More security issues (supply). †¢ Lower real return = Less savings (demand). Conclude: Fisher effect. †¢ Questions: What causes higher expected inflation? = Macroeconomic issue. Mishkin ch. 5 P. 13] Evidence on the Fisher Effect (Fits the data at least in the long-run) [Mishkin ch. 5 P. 14] Collect Open Questions †¢ Why does expected inflation change? Leading answer: Money growth. Not an exogenous disturbance. = Needs analysis. Topic: Money and Inflation. †¢ What causes business cycles? Many causes. Among them: â€Å"Mistakes† in monetary policy . = Needs analysis. Topic: Money and Output. †¢ Agenda: 1. Reinforce the lessons on demand and supply: More examples. 2. Examine how monetary policy influences inflation and output. 3. Return to the interest rates – remainder of Mishkin ch. 5 [Mishkin ch. 5 P. 15] Applications of Asset Demand Supply Analysis 1. A Classic: The â€Å"Flight to Quality† (Lesson: Asset demand is relative) Stock Market Price Supply Price Bond Market Supply Demand Stocks Demand Bonds 1987 stock market crash: stocks - flight to bonds 1994 Mexican Peso crisis: emerging market stocks - to US stocks and bonds 1997 Asian crisis: Asian stocks and bonds - to US and Europeans stocks and bonds 1998 Russian default: risky bonds (foreign and US low quality) - to US Treasury bonds . The Term Structure of interest rates: (Mishkin ch. 6, part 2) Defer discussion, raises macro issues. [Mishkin ch. 5 P. 16] 3. The Risk-structure of interest rates: (Mishkin ch. 6, part 1) Good measures of riskiness: Bond Ratings Good measures of promised return: Yield to maturity. Find: (1) Changes in risk = Changes in relative yields (2) Holding risk constant, yields move together 4. The Stock Marke t Crash of 1987 Can we always assume that demand is downward sloping? . The Market for Foreign Exchange (Mishkin ch. 17. Much improved in 8ed. ) Exchange rate = Relative price of different country’s financial assets Demand = Function of relative return, risk, and liquidity Supply = Fixed in short run (apart from official interventions – later) More later if time – for now, note one key point: High US interest rates relative to foreign interest rates increase the demand for dollar assets = Stronger dollar [Mishkin ch. 5 P. 17]