Mishkin Ppt04

8/11/2019 Mishkin Ppt04

1/21

1.Wealth

2.Expected Return

3.Risk

4.Liquidity

Asset a piece of property that is a store of value

Pearson Prentice HallFinancial Markets and Institutions 4 - 1

Determinants of Asset Demand


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1. Wealth- total resources owned, including all assets

2. Expected Return - return expected over the nextperiod) on one asset relative to alternative assets

3. Risk- degree of uncertainty associated with the return

4. Liquidity- the ease & speed with which an asset can beturned into cash




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Ceteris paribus -

1.Wealth- an increase in wealth raises the quantity demandedof an asset

2.Expected Return - weighted average of all possiblereturns, where the weights are the probabilities ofoccurrence of that return: Re= p1R1+ p2R2+. . . + pnRn

an increase in an assets expected return relative to that

of an alternative asset, raises the quantity demanded of

the asset




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Ceteris paribus

3.Risk- the degree of uncertainty associated with the return;a measure of risk called the standard deviation (). The

standard deviation of returns on an asset is calculated as: Square root of the weighted squared deviations from

the expected return (Re)

=

p1(R1- Re

)2

+ p2(R2- Re

)2

+. . . +pn(Rn- Re

)2

if an assets risk RISES relative to that of alternative

assets, its quantity demanded will FALL




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Ceteris paribus

4.Liquidity- the ease and speed with which an asset can beturned into cash

An asset is liquid if the market in which it is traded has depthand breadth, i.e., if the market has many buyers and sellers

Treasury bill- a highly liquid asset; well-organized market

The more liquid an asset is relative to alternativeassets, the more desirableit is, and the greaterwill bethe quantity demanded




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Summary response:

Change in Change in

Variable Quantity Demanded

1. Wealth

2. Expected Return

3. Risk i

4. Liquidity




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Example:

1-yr Discount Bond,Face vale, $1000

Holding Pd: 1 yr

Re= i = F P

P


Demand & Supply Curves

Equilibrium Pt


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Demand Curve Bd : downward slope, indicating that atLOWER prices of the bond, ceteris paribus, the quantitydemanded is HIGHER

Supply Curve Bs : upward slope, indicating that as the priceincreases, ceteris paribus, the quantity supplied is INCREASES

Market Equilibrium :Quantity Demanded = Quantity Supplied

or Market-Clearing Price Bd = Bs


Demand & Supply Curves


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Market Implications

When the PRICE of bonds is set too HIGH: Bs > Bd : Excess Bs

people want to SELLmore bonds than others want to buy,the price of the bonds will FALL;

as long as price is above equilibrium, it will continue to fall

When the PRICE of bonds is set too LOW: Bs


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Movements along the Curve vs Shifts in the Curve

ALONGthe Curve:

rQty due torPRICE orrInterest Rate (i)

SHIFTin the Curve:

r Qty at each given PRICE or Interest Rate

- in response torin some factors beside PRICE or i


Changes in Equilibrium Interest Rates


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Shifts in the Demand for Bonds

1. Wealth

2. Expected returns on bonds relative to alternativeassets

3. Risk of bonds relative to alternative assets

4. Liquidity of bonds relative to alternative assets




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If h, h

Economy is growing rapidly,

expansion & wealth isincreasing, the demand curve

shifts to the RIGHT;

Recession: income & wealth

are falling, the demand for

bonds falls, and the demand

curve shifts to the LEFT.



Shifts in the Demand for Bonds: WEALTH


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If h, i

Higher expected interest

rates in the future itheexpected return for LT bonds,

ithe Bd, and shift the curve to

the LEFT; Lower expected interest

rates: RIGHT.



Shifts in the Demand for Bonds: Expected Returns


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If h, i

Higher expected inflation

rates in the future itheexpected return for LT bonds,


the LEFT; Lower expected inflation

rates: RIGHT.



Shifts in the Demand for Bonds: Expected Inflation


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If h, i

Increase in riskiness ithe

bonds become less attractive,


the LEFT;



Shifts in the Demand for Bonds: RISK


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If h, h

More people started trading in

the bond market, and as a resultit became easier to sell bonds

quickly; hliquidity of bonds

results in an hBd, the demand

curve shifts to the RIGHT; hliquidity of ALTERNATIVE

ASSETSiBd, shifts the demand

curve to the LEFT.



Shifts in the Demand for Bonds: LIQUIDITY


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Shifts in the Supply for Bonds

1. Expected profitability of investment opportunities

2. Expected inflation

3. Government budget




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If h, h

Economy is growing rapidly,

business cycle expansion,Bsisincreasing, the supply curve


Recession: fewer expected

profitable investment

opportunities, and the supply

curve shifts to the LEFT.



Shifts in the Supply for Bonds: PROFITABILITY


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If h, h

Real cost of borrowing i,

business cycle expansion,Bsisincreasing, the supply curve

shifts to the RIGHT

FISHER EFFECT:

When expected inflation

rises, interest rates will rise



Shifts in the Supply for Bonds: Expected Inflation


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If h, h

Deficit: Government borrows

by issuing Treasury Bonds, Bsis increasing, the supply curve


Surplus: supply curve shifts to

the LEFT.



Shifts in the Supply for Bonds: GOVERNMENT BUDGET


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Analysis assumptions:

1. Examine the effect of a variable change, remember thatwe are assuming that all other variables are unchanged;that is, we are making use of the ceteris paribusassumption

2. INTEREST RATEis negativelyrelated to the BONDPRICE,

so when the equilibrium bond price rises, the equilibriuminterest rate falls. Conversely, if the equilibrium bondprice moves downward, the equilibrium interest raterises.



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