Financial assets and markets
Another way to categorize assets is by what is given up. There is always a transfer of value to the borrower, most often cash, so from this view we concern ourselves with what the lender gets in return. Debt transactions are where the repayment, usually involving interest, is purely financial. Equity transactions include a permanent transfer of ownership, often without an obligation for financial repayment. Financial instruments need not strictly be either debt or equity, but for now we will focus on items that do neatly fit into a single category.
The simplest loan example is a personal loan from a friend. You agree to give your friend $20 today in exchange for $25 next week. For you this is an asset, your friend owes you, but for your friend it is a liability, a requirement to make a payment in the future. This distinction will be especially critical when our discussion turns towards banks.
Loans often have specific legal terms designed to match the needs and ability to pay of the borrower. The possibility of default contributes to loans having relatively high transaction costs, due to the frequent need to negotiate terms and verify items such as credit history and ability to pay.
Many loans involve collateral, assets pledged as security for a loan. In the case of a default the lender takes possession of the collateral and can sell it to recover losses. For example, this is a near universal feature of mortgages and car loans for consumers. The ability to provide collateral reduces risk for a lender and can increase access to credit for borrowers. Loans without collateral are called non-secured loans.
The other primary form of debt are bonds. In a way bonds are the reverse of loans. Loans are generally individuals or businesses seeking funds from financial institutions. Bonds generally involve businesses or governments seeking funds from investors and are non-secured.
The benefit bonds have over loans is that they are standardized, so every unit sold is identical upon being issued. If there are any differences, they count as a separate issue and trade in their own market.
The contrast to debt finance is equity finance, where ownership is given up in exchange for funds. The major example of this is issuing of stock, which is primarily used by companies. During any offering, the company issues shares, selling slices of ownership in exchange for funds. Any time the stock is traded after that initial time, referred to as a secondary sale the company receives no funds directly.
There are many other assets types beyond loans, bonds and stock. One of the most important is derivatives. Derivatives are contracts whose value depends on the value of an underlying asset or a target event. A common example is options, which give the right to buy or sell 100 shares of a specified stock on a specific date for a specific price.
Other derivatives act like insurance. For example utilities buy derivatives, disaster or catastrophe bonds, that pay out when specific weather events occur, such as extreme temperatures or a natural disaster.
More complex financial products do play a key role in modern finance. Deeper discussion of other examples and details of how they work is best left for a course with a heavier finance component.
Imagine that a firm wants to raise funds for a new investment, such as the development of a new product or building a new factory. They have a number of options to raise desired funds. They can issue new stock shares, giving up ownership and reducing the value (even if slightly) of existing shares. If they prefer to take out a loan, they can go to a bank or secure a private loan or they could issue bonds.
Why a firm would choose one option over another is a complex question, that depends on the size of the firm, their credit rating, the riskiness of their intended use of funds and the opportunity cost (availability of alternate financing). As an example, large public firms in the United States often issue bonds, because they have favorable credit ratings and can obtain large amounts of funding near the prime rate.
The demand for investment comes from firms wishing to raise funds, regardless of exactly how they do it. Purchases of a new issue bond or newly issued stock both give firms funds, even though they have different implications for the borrowers.
The stock market is mostly a secondary market. New firms being added usually involves an initial public offering (IPO) and sometimes existing firms issue new shares. So while stock market movements matter for household wealth and consumption, they are technically not connected to investment.
Bond markets
For bonds it is important to add some definitions and details. Discount bonds are bonds where the fixed payment is zero. They are generally sold at a price below face value, and that “discount” is where the name comes from. For this type of bonds, the amount of the discount implies a total return and can be converted into an appropriate annual nominal interest rate.
US Government bonds have special names, depending upon the duration of their maturity.
All are issued by the Federal government and sold via auctions by the Federal Reserve Bank of New York. After that they can be traded on secondary markets.
The most important of these for our discussions are T-bills, as they are considered the risk-free asset, are the most liquid financial instrument that is not immediately spendable. They are also what the Federal Reserve uses to conduct monetary policy. The total market for US Government debt is the second largest in the world, averaging just over $900 billion in daily trading volume
Elements of bond pricing
You are not expected to know exact formulas for bond pricing at this level. What you are responsible for, is understanding the general reasoning of how bond prices are impacted by key factors, the coupon payment and the term (or duration). Raising either leads to more money being paid out for a bond, holding all else equal, so each factor has a positive relationship to a bond’s price.
Our factor with a less obvious effect is interest rates. Recalling our basic one period present value formula, we know that increasing interest rates reduces the value of future payments. Thus increasing interest rates is equivalent to making bond payments worth less, and that makes the price of bonds sold in previous periods go down.
The longer the term of a bond, the more sensitive it is to interest rates. Put another way, the price of a longer duration bond will change more than a shorter duration one for the same change in interest rates.
Other than interest rates, bond demand depends on a number of factors. These include credit quality of the borrower, inflation expectations, market sentiment and economic stability, length to maturity, liquidity, tax treatment (e.g. some US bonds are exempt from federal or state taxation), and political stability. Each of these can be imagined to impact the desired interest rate or likelihood of default.
Remember that in the market for loanable funds it is interest rates, not prices on the y-axis. So factors that decrease demand for loanable funds make interest rates fall, which makes the price of existing bonds rise. Factors that make the supply of bonds increase, will have a similar effect.
The inverse relationship between interest rates and bond prices is the most frequently tested piece of macroeconomic finance. It is often included as part of a FRQ. It is important to state specifically the connection to interest rates and what specific change happens in bond prices is, instead of simply saying “bond prices change”.