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Overall, though, calculating relative expected returns is sticky business that is best addressed in more
specialized financial books and courses. FREE BANKING BOOKS If you want an introduction, investigate the capital asset
pricing model (CAPM)
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and the arbitrage pricing theory (APT).
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As we learned in Chapter 4
"Interest Rates", calculating return is not terribly FREE BANKING BOOKS PDF difficult and neither is comparing returns among a
variety of assets. What’s tricky is forecasting future returns and making sure that assets are
comparable by controlling for risk, among other things. Risk is the uncertainty of an asset’s returns. It
comes in a variety of flavors, all of them unsavory, so as it increases, the quantity demanded of an asset
decreases, ceteris paribus. In Chapter 4 "Interest Rates", we encountered two types of risk: default
risk (aka credit risk), the chance that a financial contract will not be honored, and interest rate risk,
the chance that the interest rate will rise and hence decrease FREE BANKING BOOKS DOWNLOAD PDF a bond or loan’s price. An offsetting risk
is called reinvestment risk, which bites when the interest rate decreases because coupon or other
interest payments have to be reinvested at a lower yield to maturity. To be willing to take on more
risk, whatever its flavor, rational investors must expect a higher relative return. Investors who require
a much higher return for assuming a little bit FREE BANKING STUDY MATERIALS of risk are called risk-averse. Those who will take on
much risk for a little higher return are called risk-loving, risk-seekers, or risk-tolerant. (Investors
who take on more risk without compensation are neither risk-averse nor risk-tolerant, but rather
irrational in the sense discussed in Chapter 7 "Rational Expectations, Efficient Markets, and the
Valuation of Corporate Equities".) Risks can be idiosyncratic; that is, they can be pertinent to a
particular company, sectoral (pertinent to an entire industry, like trucking or restaurants), or
systemic (economy-wide). Liquidity risk occurs when an asset cannot be sold as quickly or cheaply as
expected, be it for idiosyncratic, sectoral, or systemic reasons. This, too, is a serious risk because
liquidity, or (to be more precise) liquidity relative to other assets, is the third major determinant of asset
demand. Because investors often need to change their BANKING BOOKS 2017-2018 investment portfolio or dis-save (spend some of
their wealth on consumption), liquidity, the ability to sell an asset quickly and cheaply, is a good
thing. The more liquid an asset is, therefore, the higher the quantity demanded, all else being equal.
During the financial crisis that began in 2007, the prices of a certain type of bond collateralized by
subprime mortgages, long-term loans collateralized with homes and made to relatively risky
borrowers, collapsed. In other words,BANKING STUDY MATERAILS their yields had to increase markedly to induce investors to
own them. They dropped in price after investors realized that the bonds, a type of asset-backed
security (ABS), had much higher default rates and much lower levels of liquidity than they had
previously believed. Figure 5.4 "Variables that influence demand for bonds" summarizes the chapter
discussion so far.

Stop and Think Box
You are a copyeditor for Barron’s. What, if anything, appears wrong in the following sentence? How do
you know?
“Recent increases in the profitability of investments, inflation expectations, and government surpluses
will surely lead to increased bond supplies in the near future.”
Government deficits, not surpluses, lead to increased bond supplies.
The expectation of higher inflation, other factors held constant, will cause borrowers to issue more
bonds, driving the supply curve rightward, and bond prices down (and yields up). The Fisher
Equation, ir = i –
1
, explains this nicely. If the inflation expectation term
increases while nominal
interest rate i stays the same, the real interest rate ir must decrease. From the perspective of
borrowers, the real cost of borrowing falls, which means that borrowing becomes more attractive. So
they sell bonds. {GOOGLEADS}
1
Borrowing also becomes more attractive when general business conditions become more favorable, as
when taxes and regulatory costs decrease or the economy expands. Although individuals sometimes
try to borrow out of financial weakness or desperation, relatively few such loans are made because
they are high risk. Most economic entities borrow out of strength, to finance expansion and engage in
new projects they believe will be profitable. So when economic prospects are good, taxes are low, and
regulations are not too costly, businesses are eager to borrow, often by selling bonds, shifting the
supply curve to the right and bond prices down (yields up). Figure 5.5 "Variables that determine the
supply of bonds" summarizes the chapter discussion so far.