FIN435 Class Web Page, Spring '25

Jacksonville University

Instructor: Maggie Foley

 

The Syllabus      Overall Grade calculator     Risk Tolerance Test

Exit Exam Questions (will be posted in week 10 on blackboard)

Term Project (on efficient frontier, updated, due with final)
 

Weekly SCHEDULE, LINKS, FILES and Questions 

Week

Coverage, HW, Supplements

-       Required

 

Reading Materials

Week

1

Marketwatch Stock Trading Game (Pass code: havefun)

1.     URL for your game: 
https://www.marketwatch.com/game/fin435-25spring    

2.   Password for this private game: havefun.

·       Click on the 'Join Now' button to get started.

·       If you are an existing MarketWatch member, login. If you are a new user, follow the link for a Free account - it's easy!

·       Follow the instructions and start trading!

3.   Game will be over on 4/25/2025

 

4.     Risk Tolerance Test (FYI)

 

5.    Game

 

·       Mutual Fund Selection Game (FYI)

·       Order Type Explained Game (FYI)

 

6.    Youtube Instructions

·       How to Use Finviz Stock Screener  (youtube, FYI)

·       How To Win The MarketWatch Stock Market Game (youtube, FYI)

·       How Short Selling Works (Short Selling for Beginners) (youtube, FYI)

 

 

~ Tariff  (FYI) ~

 

Now, let’s work on this survey about tariffs. Tariff Survey

 

Game: Tariff Trade Simulation   A simple game

 

 

 

 

 

Chapter 6 Interest rate

 

Chapter summary

1)     Shape of Yield Curve

i)      Inverted Yield Curve Indicates Recession: The shape of the yield curve, particularly when inverted, serves as a significant indicator of an impending recession.

2)     Expectation Theory

3)     Interest Rate Breakdown

i)      Breaking down interest rates involves considering various components:

           Real Interest Rate

           Inflation Premium:

           Default Premium:

           Liquidity Premium:

           Maturity Premium:

 

Part 1 - Who Wants to Chair the Fed?   Quiz 1

 

Gamehttps://lewis500.github.io/macro/

 

The Federal Reserve (Fed) often faces the challenging dilemma of balancing economic growth with price stability - commonly referred to as the trade-off between controlling inflation and minimizing unemployment.

1. Inflation vs. Unemployment

  • Raising Interest Rates: Helps control inflation by slowing down spending and investment. However, this can increase unemployment as businesses cut back on hiring or production.
  • Lowering Interest Rates: Boosts economic growth and reduces unemployment by encouraging spending and investment. However, it can lead to rising inflation if demand outpaces supply.

2. Long-term Stability vs. Short-term Relief

  • The Fed must make decisions that sometimes prioritize long-term economic health (e.g., curbing inflation) over short-term relief for the economy (e.g., reducing unemployment), or vice versa.

3. Uncertainty and Lag Effects

  • Monetary policy decisions take time to affect the economy, making it hard to predict their full impact.
  • External factors, such as global economic conditions or supply shocks, add to the complexity.

In the game, you play as the Fed chair and must make interest rate decisions to strike this delicate balance while keeping inflation and unemployment within acceptable ranges. Success depends on how well you manage these competing goals over time.

Factors to Consider:

1.     Current Inflation Rate:

    • Is inflation above or below the Fed’s target (usually 2%)?
    • Lowering interest rates could worsen inflation if it's already too high.

2.     Unemployment Rate:

    • Is unemployment high? If so, a rate cut might stimulate job creation and economic activity.

3.     Economic Growth:

    • Is the economy slowing down? If GDP growth is sluggish or negative, lowering interest rates can help boost investment and spending.

4.     Consumer and Business Confidence:

    • Are businesses and consumers optimistic about the future? A rate cut might encourage more borrowing and spending if confidence is low.

5.     Financial Market Conditions:

    • Are financial markets signaling distress? A lower interest rate could stabilize markets by making borrowing cheaper.

6.     Global Economic Trends:

    • Are there external pressures, such as a global slowdown or trade disruptions, that might justify lowering rates to cushion the economy?

7.     Lag Effects of Monetary Policy:

    • How quickly will the rate cut affect the economy? Policy changes take time, so we should consider the timing of their decision.

8.     Federal Reserves Dual Mandate:

    • The Fed is tasked with promoting maximum employment and stable prices. Which goal is more at risk currently?

In-Class Debate: Should the Fed Reduce Interest Rates Soon, or Is It Better to Wait?

  • Support your decision with evidence based on the factors above.
  • Play the game to help decide.

The next Federal Open Market Committee (FOMC) meeting is scheduled for January 2829, 2025. Let’s wait and see what unfolds leading up to this critical decision.

 

Part II – Who Determines Interest Rates?

 

 

Market data website:

 http://finra-markets.morningstar.com/BondCenter/Default.jsp (FINRA bond market data)

 

Market watch on Wall Street Journal has daily yield curve and interest rate information. 

http://www.marketwatch.com/tools/pftools/

 

 In class Exercise:  Draw the yield curve as of January 16, 2025.

  • Use current data on interest rates across various maturities (e.g., 3-month, 1-year, 10-year Treasury yields).
  • Analyze the shape of the curve to assess market expectations about future economic growth and interest rates.

 

Part III: Shapes of Yield Curve

For class discussion: What factors contributed to the shifts in yield curve shapes in 2023?

https://www.jufinance.com/fin435_25s/yield_curve_1_15_2025.html

 

Date

1 Mo

3 Mo

6 Mo

1 Yr

2 Yr

3 Yr

5 Yr

7 Yr

10 Yr

20 Yr

30 Yr

1/6/2020

1.54

1.56

1.56

1.54

1.54

1.56

1.61

1.72

1.81

2.13

2.28

1/6/2021

0.09

0.09

0.09

0.11

0.14

0.2

0.43

0.74

1.04

1.6

1.81

1/6/2022

0.04

0.1

0.23

0.45

0.88

1.15

1.47

1.66

1.73

2.12

2.09

1/6/2023

4.32

4.67

4.79

4.71

4.24

3.96

3.69

3.63

3.55

3.84

3.67

1/5/2024

5.54

5.47

5.24

4.84

4.4

4.17

4.02

4.04

4.05

4.37

4.21

1/15/2025

4.40

4.35

4.26

4.19

4.27

4.34

4.45

4.70

4.66

5.06

4.88

 

In Class Exercise

Create your own yield curve by visiting https://www.jufinance.com/game/yield_curve.html.

Year

Key Observations

Implications

2020

·       The curve slopes upward.

·       Indicates expectations of steady economic growth.

·       Short-term rates (~1.54% for 1-month) are lower than long-term rates (~2.28% for 30-year).

·       Investors demand higher yields for longer maturities due to the risk of inflation and uncertainty over time.

 

·       Typical of a healthy economy.

2021

o   Rates are near zero for short-term maturities (~0.09% for 1-month) and remain low for long-term maturities (~1.81% for 30-year).

o   Reflects the Federal Reserve’s accommodative monetary policy in response to the COVID-19 pandemic.

o   The curve remains upward-sloping but is relatively flat.

o   Low rates aimed to stimulate borrowing, investment, and consumption.

 

o   Suggests muted growth.

2022

·       Short-term rates rise slightly (~0.04% for 1-month to ~0.10% for 3-month), but long-term rates remain subdued (~2.09% for 30-year).

·       Indicates modest economic recovery as the pandemic's impact wanes.

·       The curve steepens slightly compared to 2021.

·       Rising yields for longer maturities suggest improving growth expectations.

2023

o   Short-term rates (~4.32% for 1-month) and long-term rates (~3.67% for 30-year) increase sharply.

o   Reflects aggressive Federal Reserve rate hikes to combat high inflation.

o   The curve inverts for intermediate maturities (e.g., 2-year yield at 4.24% > 10-year yield at 3.55%).

o   The inversion of the curve signals potential recession risks, as short-term borrowing costs exceed long-term borrowing costs.

2024

·       Rates peak at short maturities (~5.54% for 1-month), with long-term rates slightly lower (~4.21% for 30-year).

·       Suggests that the Federal Reserve may pause rate hikes as inflation shows signs of slowing.

·       The curve flattens across all maturities.

·       A flat curve reflects uncertainty about future growth and potential recession risks.

2025

o   Short-term rates decrease slightly (~4.40% for 1-month), while long-term rates increase slightly (~4.88% for 30-year).

o   Reflects that inflation is moderating, and the Fed may consider lowering rates in the future.

o   The curve shows a mild upward slope, indicating normalization.

o   Investors are cautious but anticipate moderate economic growth over the long term.

 

General Observations

1.     Shifts in Monetary Policy:

    • The Fed's aggressive rate hikes in 20222023 are evident in the steep rise in short-term rates.
    • The slight decline in short-term rates in 2025 suggests that the Fed may be nearing the end of its tightening cycle.

2.     Inversions and Recession Signals:

    • The inverted curve in 2023 is a classic recession indicator, suggesting economic slowdown concerns.
    • The normalization in 2025 reflects improved market confidence but still warrants caution.

3.     Market Expectations:

    • The long-term rates have remained relatively stable compared to short-term rates, reflecting subdued inflation expectations over the long term.

Conclusion

The yield curves highlight the economic shifts from pre-pandemic growth (2020) to pandemic-driven lows (2021), recovery (2022), inflation-driven tightening (2023), and cautious normalization (2025). The curve as of 2025 suggests that while economic pressures are easing, uncertainties around growth and inflation persist.

Understanding the yield curve (video)

Introduction to the yield curve (khan academy)

 

Who Determines Interest Rates?

https://www.investopedia.com/ask/answers/who-determines-interest-rates/

 

By NICK K. LIOUDIS  Updated Aug 15, 2019

 

Interest rates are the cost of borrowing money. They represent what creditors earn for lending you money. These rates are constantly changing, and differ based on the lender, as well as your creditworthiness. Interest rates not only keep the economy functioning, but they also keep people borrowing, spending, and lending. But most of us don't really stop to think about how they are implemented or who determines them. This article summarizes the three main forces that control and determine interest rates.

KEY TAKEAWAYS

  • Interest rates are the cost of borrowing money and represent what creditors earn for lending money.
  • Central banks raise or lower short-term interest rates to ensure stability and liquidity in the economy.
  • Long-term interest rates are affected by demand for 10- and 30-year U.S. Treasury notes.
  • Low demand for long-term notes leads to higher rates, while higher demand leads to lower rates.
  • Retail banks also control rates based on the market, their business needs, and individual customers.

 

Short-Term Interest Rates: Central Banks

In countries using a centralized banking model, short-term interest rates are determined by central banks. A government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so the supply of money within the economy is neither too large, which causes prices to increase, nor too small, which can lead to a drop in prices.

In the U.S., interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates. The actions of central banks like the Fed affect short-term and variable interest rates.

If the monetary policymakers wish to decrease the money supply, they will raise the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money.

The Fed funds rate affects the prime ratethe rate banks charge their best customers, many of whom have the highest credit rating possible. It's also the rate banks charge each other for overnight loans.

The U.S. prime rate remained at 3.25% between Dec. 16, 2008 and Dec. 17, 2015, when it was raised to 3.5%.

 

Long-Term Interest Rates: Demand for Treasury Notes

Many of these rates are independent of the Fed funds rate, and, instead, follow 10- or 30-year Treasury note yields. These yields depend on demand after the U.S. Treasury Department auctions them off on the market. Lower demand tends to result in high interest rates. But when there is a high demand for these notes, it can push rates down lower.

If you have a long-term fixed-rate mortgage, car loan, student loan, or any similar non-revolving consumer credit product, this is where it falls. Some credit card annual percentage rates are also affected by these notes.

These rates are generally lower than most revolving credit products but are higher than the prime rate.

 

Many savings account rates are also determined by long-term Treasury notes.

 

Other Rates: Retail Banks

Retail banks are also partly responsible for controlling interest rates. Loans and mortgages they offer may have rates that change based on several factors including their needs, the market, and the individual consumer.

For example, someone with a lower credit score may be at a higher risk of default, so they pay a higher interest rate. The same applies to credit cards. Banks will offer different rates to different customers, and will also increase the rate if there is a missed payment, bounced payment, or for other services like balance transfers and foreign exchange.

Summary: Who Determines Interest Rates?

Key Influences on Interest Rates

1.     Short-Term Interest Rates: Central Banks

    • Central banks, like the Federal Reserve in the U.S., set short-term interest rates to manage the money supply and ensure price stability.
    • The Federal Open Market Committee (FOMC) meets eight times a year to adjust monetary policy and set the Federal Funds Rate, influencing rates like the prime rate (the rate banks charge their best customers).
    • Higher rates reduce borrowing and spending, while lower rates encourage borrowing and stimulate the economy.

2.     Long-Term Interest Rates: Treasury Notes

    • Long-term rates are tied to the yields on 10- and 30-year U.S. Treasury notes, determined by demand during Treasury auctions.
    • Higher demand for Treasury notes lowers their interest rates, while lower demand increases them.
    • Fixed-rate loans like mortgages, car loans, and student loans, as well as savings account rates, are influenced by these yields.

3.     Other Rates: Retail Banks

    • Retail banks determine rates for consumer loans and mortgages based on factors like market conditions, their business needs, and individual customer creditworthiness.
    • Borrowers with lower credit scores face higher rates due to increased default risk.
    • Rates may also change due to missed payments or specific services, such as balance transfers.

Part IV – Breaking Down of Interest Rates of Treasury and Corporate Bonds  

 

Quiz 2           Game - Interest Rate Explorer  

1.      Compare Treasury and Corporate Bonds:

Feature

Treasury Bonds

Corporate Bonds (e.g., Microsoft)

Issuer

U.S. Government

Corporations (e.g., Microsoft)

Risk Level

Risk-free (backed by the U.S. government)

Some risk (default and liquidity risk)

Return/Yield

Lower returns

Higher returns to compensate for risks

Liquidity

Highly liquid

Less liquid compared to Treasuries

Default Risk

None

Depends on the company’s credit rating

Purpose

Fund government operations

Fund corporate projects or operations

2.      Breaking Down of Interest Rates:   Play this game bond_yield_breakdown game! ( https://www.jufinance.com/game/bond_yield_break_down.html)

 

Component

Definition

Explanation (Simple Analogy)

Real Rate

The true return after removing inflation.

"It’s like growing your savings without losing purchasing power."

Inflation Premium

Compensation for the rise in prices over time.

"If inflation is 3%, lenders want at least 3% to break even."

Default Risk Premium

The chance the borrower won’t pay back.

"Treasuries have 0% default risk. Corporate bonds have some, even for Microsoft."

Liquidity Premium

Compensation for the ease of selling the bond.

"Treasuries are highly liquid, but corporate bonds may take time to sell."

Maturity Premium

The added risk for lending over a long period.

"Longer bonds mean more uncertainty, so investors demand higher yields."

image004.jpg

 

 

Interest Rate

Short-Term

Long-Term

Short-Term

Long-Term

Parameter

Treasuries

Treasuries

Corporate

Corporate

r*

X

X

X

X

IP

X

X

X

X

MRP

 

X

 

X

DRP

 

 

X

X

LP

 

 

X

X

 

 

Maturity

Treasury Security Yield (%)

Microsoft Bond Yield (%)

Corporate Spread

 

1 Month

4.43

N/A

N/A

3 Month

4.34

N/A

N/A

6 Month

4.28

N/A

N/A

 

2 Year

4.27

4.01

-0.26

5 Year

4.42

4.44

0.02

10 Year

4.61

4.48

-0.13

20 Year

4.91

5.08

0.17

30 Year

4.84

5.3

0.46

https://www.finra.org/finra-data/fixed-income/corp-and-agency (corporate bonds)

https://www.finra.org/finra-data/fixed-income/treasuries (Treasury Securities)

 

Maturity

Treasury Yield (%)

Microsoft Yield (%)

Corporate Spread (%)

Real Rate (%)

Inflation Premium (%)

Maturity Premium (%)

Corporate Spread (Default + Liquidity) (%)

2 Year

4.27

4.01

-0.26

1

3.17

0.100

-0.26

5 Year

4.42

4.44

0.02

1

3.02

0.400

0.02

10 Year

4.61

4.48

-0.13

1

2.71

0.900

-0.13

20 Year

4.91

5.08

0.17

1

2.01

1.900

0.17

30 Year

4.84

5.3

0.46

1

0.94

2.900

0.46

Note:

  • Microsoft Yields > Treasury Yields:
    • Corporate bonds compensate for default and liquidity risks.
  • Longer-Term Yields are Higher:
    • Reflects maturity risk for both Treasuries and Microsoft bonds.

 

3. Visualize the Yield Curves

 

image049.jpg

 

 

4. Simplify the Yield Spread Formula

Objective: Break down the difference between Treasury and corporate bonds.

·        Formula:
Corporate Yield Treasury Yield = Default Risk Premium + Liquidity Premium.

·        Example for 30-Year Bond:

    • Microsoft: 5.30%
    • Treasury: 4.84%
    • Spread: 0.46% = DRP + LP.

Concept

Real-Life Analogy

Explanation

Treasury Bond

Lending to Your Parents

Safe and reliable; you know they will always pay you back.

Corporate Bond

Lending to a Business Friend

Trustworthy, but there’s a small chance they might not repay you.

Yield Spread

Extra Payment for Taking the Risk

"Would you charge your business friend a bit more for the risk? That’s the spread."

 

In Class Exercise

  • Activity 1: Create Your Own Yield Curve
    • Find yield data (Treasury and Intel).
    • Graph both curves on paper or a digital tool.
  • Activity 2: Calculate the Spread
    • Give specific bond yields and ask students to calculate spreads.
  • Activity 3: Group Debate
    • "Why do corporate bonds pay more than Treasuries?"

Key Takeaways

  • Treasuries are risk-free and more liquid, so they pay lower yields.
  • Corporate bonds offer higher yields to compensate for risks like default and liquidity.
  • The spread shows the extra compensation investors demand for corporate bonds.

 

 

Part V – Expectation Theory            Quiz

 

Scenario: "Which Investment Should You Choose?"

You have $10,000 to invest and three simple options:

·       Option 1: Invest for 1 year at 5%, then reinvest each year for the next 4 years at the rates below:

·       Option 2: Lock your money in for 3 years at a fixed rate of 4.5% per year.

  • Option 3: Lock your money in for 5 years at a fixed rate of 4% per year.

Based on your results, which option is better if you plan to use the money after 5 years?

 

Online Calculator

image020.jpg

 

Question for discussion: If a% and b% are both known to investors, such as the bank rates, how much is the future interest rate, such as c%?

 

(1+a)^N = (1+b)^m *(1+c)^(N-M)

 

Either earning a% of interest rate for N years,

or b% of interest rate for M years, and then c% of interest rate for (N-M) years,

investors should be indifferent. Right?

 

Then,

 (1+a)^N = (1+b)^m *(1+c)^(N-M)è c = ((1+a)^N / (1+b)^m)^(1/(N-M))-1

 

Or approximately,

N*a = M*b +(N-M)*(c)è c = (N*a M*b) /(N-M)

 

 

What Is Expectations Theory   

Expectations theory attempts to predict what short-term interest rates will be in the future based on current long-term interest rates. The theory suggests that an investor earns the same amount of interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today. The theory is also known as the "unbiased expectations theory.

Understanding Expectations Theory

The expectations theory aims to help investors make decisions based upon a forecast of future interest rates. The theory uses long-term rates, typically from government bonds, to forecast the rate for short-term bonds. In theory, long-term rates can be used to indicate where rates of short-term bonds will trade in the future (https://www.investopedia.com/terms/e/expectationstheory.asp)

Example: Given that the current 2-year rate is 4.1% and the 1-year rate is 4.3%, what is the expected 1-year rate one year from now? (Answer: 3.9%. Why?)

image006.jpg

 

 

Chapter 6 In class exercise  

 

Interest Rate

Short-Term

Long-Term

Short-Term

Long-Term

Parameter

Treasuries

Treasuries

Corporate

Corporate

r*

X

X

X

X

IP

X

X

X

X

MRP

 

X

 

X

DRP

 

 

X

X

LP

 

 

X

X

 

1 You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:

    • Inflation premium = 3.25%
    • Liquidity premium = 0.6%
    • Maturity risk premium = 1.8%
    • Default risk premium = 2.15%

On the basis of these data, what is the real risk-free rate of return?  (answer: 2.25%)

 

Solution:

 

General equation: Rate = r* + Inflation + Default + liquidity + maturity

30-day T-bills = short term Treasury Security è Default = liquidity = maturity = 0

So 30-day T-bills = 5.5% = r* + inflation =r* + 3.25%

 

 2 The real risk-free rate is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?(answer: 6%, 6.33%)

 

Solution:

General equation: Rate = r* + Inflation + Default + liquidity + maturity

2-year T-notes = intermediate term Treasury Security è Default = liquidity = 0, maturity=0 as given

Inflation = average of inflations from year 1 to year 2 = (2% + 4%)/2 = 3%

So 2-year T-notes =   r* + inflation  = 3% + 3% = 6%

 

3-year T-notes = short term Treasury Security è Default = liquidity = 0, maturity=0 as given

Inflation = average of inflations from year 1 to year 2 = (2% + 4% +4%)/3 = 3.33%

So 2-year T-notes =   r* + inflation  = 3% + 3.33% = 6.33%

 

 

 

 3 A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?  (answer: 1.5%)

 

Solution:

General equation: Rate = r* + Inflation + Default + liquidity + maturity

10 year T-notes = intermediate term Treasury Security è Default = liquidity = 0, maturity is not zero

So 10-year T-notes =   r* + inflation + maturity = 6%

 

10 year corporate bond  rate = r* + Inflation + Default + liquidity + maturity = 8%

Its liquidity = 0.5%, its maturity = 10-year-notes’ maturity.

 

Comparing 10 year T-notes and 10 year corporate bonds, we get default = 8%-6%-0.5%=1.5%

 

r*

inflation

default

liquity

maturity

10 - year- T-notes = 6%

Same

same

0

0

same

10 year corp bonds = 8%

Same

same

?

1.50%

same

 

 

4 The real risk-free rate is 3%, and inflation is expected  to be 3% for the next 2 years. A 2-year Treasury security yields 6.2%. What is the maturity risk premium for the 2-year security? (answer: 0.2%)

 

General equation: Rate = r* + Inflation + Default + liquidity + maturity

2-year T-notes = intermediate term Treasury Security è Default = liquidity = 0, maturity=?

2-year T-notes = 6.2% = r* + inflation + maturity = 3% + 3% + maturity

 

 

5 One-year Treasury securities yield 5%. The market anticipates that 1 year from now, 1-year Treasury securities will yield 6%. If the pure expectations theory is correct, what is the yield today for 2-year Treasury securities? (answer: 5.5%)

 

Or,

 

 

Swiss franc carry trade comes fraught with safe-haven rally risk (FYI)

By Harry Robertson

September 2, 20241:03 AM EDTUpdated 5 months ago

https://www.reuters.com/markets/currencies/swiss-franc-carry-trade-comes-fraught-with-safe-haven-rally-risk-2024-09-02/

 

 

LONDON, Sept 2 (Reuters) - As investors turn to the Swiss franc as an alternative to Japan's yen to fund carry trades, the risk of the currency staging one of its rapid rallies remains ever present.

The Swiss franc has long been used in the popular strategy where traders borrow currencies with low interest rates then swap them into others to buy higher-yielding assets.

Its appeal has brightened further as the yen's has dimmed. Yen carry trades imploded in August after the currency rallied hard on weak U.S. economic data and a surprise Bank of Japan rate hike, helping spark global market turmoil.

 

The Swiss National Bank (SNB) was the first major central bank to kick off an easing cycle earlier this year and its key interest rate stands at 1.25%, allowing investors to borrow francs cheaply to invest elsewhere.

By comparison, interest rates are in a 5.25%-5.50% range in the United States, 5% in Britain, and 3.75% in the euro zone.

"The Swiss franc is back as a funding currency," said Benjamin Dubois, global head of overlay management at Edmond de Rothschild

 

STABILITY

The franc is near its highest in eight months against the dollar and in nine years against the euro , reflecting its status as a safe-haven currency and expectations for European and U.S. rate cuts.

But investors hope for a gradual decline in the currency's value that could boost the returns on carry trades.

Speculators have held on to a $3.8 billion short position against the Swiss franc even as they have abruptly moved to a $2 billion long position on the yen , U.S. Commodity Futures Trading Commission data shows.

 

"There is more two-way risk now in the yen than there has been for quite some time," said Bank of America senior G10 FX strategist Kamal Sharma. "The Swiss franc looks the more logical funding currency of choice."

BofA recommends investors buy sterling against the franc , arguing the pound can rally due to the large interest rate gap between Switzerland and Britain, in a call echoed by Goldman Sachs.

 

The SNB appears set to cut rates further in the coming months as inflation dwindles. That would lower franc borrowing costs and could weigh on the currency, making it cheaper to pay back for those already borrowing it.

Central bankers also appear reluctant to see the currency strengthen further, partly because of the pain it can cause exporters. BofA and Goldman Sachs say they believe the SNB stepped in to weaken the currency in August.

"The SNB will likely guard against currency appreciation through intervention or rate cuts as required," said Goldman's G10 currency strategist Michael Cahill.

 

'INHERENTLY RISKY'

Yet the Swissie, as it is known in currency markets, can be an unreliable friend.

Investors are prone to pile into the currency when they get nervous, thanks to its long-standing safe-haven reputation.

Cahill said the franc is best used as a funding currency at moments when investors are feeling optimistic.

A quick rally in the currency used to fund carry trades can wipe out gains and cause investors to rapidly unwind their positions, as the yen drama showed. High levels of volatility or a drop in the higher-yielding currency can have the same effect.

The SNB and Swiss regulator Finma declined to comment when asked by Reuters about the impact of carry trades on the Swiss currency.

As stock markets tumbled in early August, the Swiss franc jumped as much as 3.5% over two days. The franc-dollar pair has proven sensitive to the U.S. economy, often rallying hard on weak data that causes U.S. Treasury yields to fall.

 

"Any carry trade is inherently risky and this is particularly true for those funded with safe-haven currencies," said Michael Puempel, FX strategist at Deutsche Bank.

"The main risk is that when yields move lower in a risk-off environment, yield differentials compress and the Swiss franc can rally," Puempel added.

A gauge of how much investors expect the Swiss currency to move , derived from options prices, is currently at around its highest since March 2023.

"Considering the central banks, you can see how there may be more sentiment for some carry players to prefer the franc over the yen," said Nathan Vurgest, head of trading at Record Currency Management.

"The ultimate success of this carry trade might still be dependent on how quickly it can be closed in a risk-off scenario," Vurgest said, referring to a moment where investors cut their riskier trades to focus on protecting their cash.

Get the latest news and expert analysis about the state of the global economy with the Reuters Econ World newsletter. Sign up here.

Reporting by Harry Robertson; Editing by Dhara Ranasinghe and Alexander Smith

 

Key Insights from the Article:

1.     Swiss Franc as a Funding Currency:

    • The Swiss franc has gained popularity as a funding currency for carry trades due to its low-interest rate (1.25%), particularly as the yen has become less favorable after recent volatility and a surprise rate hike by the Bank of Japan.

2.     Carry Trade Dynamics:

    • Investors borrow currencies with low interest rates (e.g., the Swiss franc) and invest in higher-yielding currencies like the British pound or U.S. dollar.
    • The attractiveness of the Swiss franc is tied to its low borrowing costs and the potential for a gradual decline in its value.

3.     Safe-Haven Risks:

    • The Swiss franc's safe-haven status introduces risk for carry trades. In times of market stress, investors flock to the franc, causing it to rally and potentially wiping out carry trade gains.
    • This was evident when the franc jumped 3.5% over two days in early August during stock market turmoil.

4.     Central Bank Influence:

    • The Swiss National Bank (SNB) is expected to cut rates further, which could lower borrowing costs for the franc and make it cheaper for carry trades.
    • The SNB appears to actively intervene in the currency market to prevent excessive appreciation, supporting exporters and stabilizing the economy.

5.     Strategist Views:

    • Bank of America and Goldman Sachs favor the Swiss franc as a funding currency over the yen due to reduced volatility and predictability.
    • BofA and Goldman Sachs recommend buying higher-yielding currencies like sterling against the franc to benefit from interest rate differentials.

6.     Risks of Swiss Franc Carry Trades:

    • Sudden rallies in the franc (often triggered by safe-haven demand or weak U.S. data) pose significant risks to carry trades.
    • Yield compression in risk-off scenarios can amplify losses for traders.

7.     Investor Sentiment:

    • The success of Swiss franc carry trades depends on investor optimism and the ability to close trades quickly during market stress.
    • Volatility expectations for the franc are currently elevated, reflecting concerns about market risks.

This analysis highlights the opportunities

Chapter six case study (due with first mid term exam)

Optional: Are there any arbitrage opportunities based on the information provided below? Why or why not?

Currency

Interest Rate (%)

Exchange Rate (1 Currency to USD)

Euro (EUR)

2.36

1.04

British Pound (GBP)

4.75

1.23

Norwegian Krone (NOK)

4.5

0.088

Swiss Franc (CHF)

0.5

1.10

 

 

Chapter  7 Bond Valuation

 

 ppt                  Bond_CFO_Decision_Game

 

 

 image149.jpg

 https://www.morningstar.com/portfolios/experts-forecast-stock-bond-returns-2025-edition

 

For discussion:  https://jufinance.com/risk_tolerance.html                  Quiz

 

Bond Type         

 Characteristics                                  

 Suitability                                 

 Risk                                   

 Short-Term Bonds  

Quick maturity, Low risk, Lower returns         

Conservative, Need liquidity               

Reinvestment Risk                      

 Long-Term Bonds   

Higher returns, High risk                       

Long-term, High risk tolerance             

Default Risk; Market interest rate risk

 Corporate Bonds   

Higher yields, Higher risk, Company influence   

Seeking returns, Accepting higher risk     

Default Risk; Market interest rate risk (assuming long maturity)

 Treasury Securities

Low risk, Steady income, Different maturities   

Conservative, Stable income requirement    

Market interest rate risk (assuming long maturity) 

 Municipal Bonds   

Tax advantages, Credit risk                     

Tax-efficient income, Higher tax bracket   

Default Risk; Market interest rate risk (assuming long maturity)

 

 

·       Among the aforementioned bonds, do you have a preference? If so, what factors influence your choice?

 

 

 Untitled-modified (1).jpg

Where to Invest in 2025: Key Takeaways: (self-developed video on youtube)

https://www.morningstar.com/markets/where-investors-can-find-highest-bond-yields-2025-2

 

1.     Cash is No Longer King:

·        Why? Cash yields peaked in 2024 (5.5%) and are now dropping (4.3%-4.4%). Yields on cash reset daily, so returns are no longer guaranteed.

·        Risk: Hoarding cash means missing out on higher returns from other investments, like bonds or stocks.

2.     Interest Rates are Expected to Drop:

·        Forecast: Interest rates may fall to 3% by the end of 2025.

·        The yield curve is flattening, meaning long-term bonds now offer better opportunities.

3.     Move Out of Cash and Into Bonds:

·        Long-Term Bonds: Offer both price appreciation (when rates fall) and steady income. Ideal for a declining interest-rate environment.

·        Short-Term Bonds: Less attractive as their income potential fades with falling rates.

4.     Corporate Bonds are Less Appealing in 2025:

·        High-yield bonds (like junk bonds) now have low yield spreads, meaning the extra return over Treasuries is not enough to justify the risk.

·        Example: High-yield bonds yield 7.2%, but the risk premium is only 2.6%historically very low.

5.     Emerging Market Bonds Offer Higher Yields:

·        Countries like Brazil (14%) and Mexico (10%) offer attractive real yields (returns after inflation).

·        Risks: Currency fluctuations, political instability, and lower liquidity compared to US bonds.

6.     Why Bonds are Important in Portfolios:

·        Treasuries provide stability and hedge against market volatility.

·        Today’s bond yields (~4%) offer positive real returns, which werent possible in past years.

7.     Tips for Investing:

    • Avoid chasing yield blindlyassess risks like creditworthiness and economic conditions.
    • Maintain a diversified portfolio to balance risk and opportunity.
    • Keep a long-term perspective amid potential volatility in 2025 (e.g., geopolitical conflicts, Fed policy changes).

 

 

 

 

 

 Market data website:

FINRA:      https://www.finra.org/finra-data/fixed-income  (FINRA bond market data)

 

 

 

image004.jpg 

 

Relationship between bond prices and interest rates (Khan academy)            

 

 Reading material:

 

·        Interest rate risk When Interest rates Go up, Prices of Fixed-rate Bonds Fall, issued by SEC at https://www.sec.gov/files/ib_interestraterisk.pdf

 

  

 

·        Higher market interest rates è lower fixed-rate bond prices è higher fixed-rate bond yields

·       Lower fixed-rate bond coupon rates è higher interest rate risk

·       Higher fixed-rate bond coupon rates è lower interest rate risk

·       Lower market interest rates è higher fixed-rate bond prices è lower fixed-rate bond yields èhigher interest rate risk to rising market interest rates

·        Longer maturity è higher interest rate risk è higher coupon rate

·       Shorter maturity è lower interest rate risk è lower coupon rate

From https://www.sec.gov/files/ib_interestraterisk.pdf

 

 

Bond Pricing Excel Formula

 

To calculate bond price  in EXCEL (annual coupon bond):

Price=abs(pv(yield to maturity, years left to maturity, coupon rate*1000, 1000)

 

To calculate yield to maturity (annual coupon bond)::

Yield to maturity = rate(years left to maturity, coupon rate *1000, -price, 1000)

 

To calculate bond price (semi-annual coupon bond):

Price=abs(pv(yield to maturity/2, years left to maturity*2, coupon rate*1000/2, 1000)

 

To calculate yield to maturity (semi-annual coupon bond):

Yield to maturity = rate(years left to maturity*2, coupon rate *1000/2, -price, 1000)*2

 

To calculate duration:

DURATION=DURATION(DATE(2025,2,4),DATE(2035,2,4),5%,7%,2,0)=7.80

Interpretation:

·       A duration of 7.80 means that for every 1% increase in interest rates, the bond’s price is expected to decrease by approximately 7.8%. Conversely, if interest rates fall by 1%, the bond’s price would increase by 7.8%.

 

 

In Class Exercise (could be used to prepare for the first midterm exam)

 

Excel Solution                

 

1.     AAA firm’ bonds will mature in eight years, and coupon is $65. YTM is 8.2%. Bond’s market value? ($903.04,  abs(pv(8.2%, 8, 65, 1000))

 

·       Rate   8.2%

·       Nper    8

·       Pmt      65

·       Pv       ? 

·       FV       1000

 

 

2.                  AAA firm’s bonds’ market value is $1,120, with 15 years maturity and coupon of $85. What is YTM?  (7.17%,  rate(15, 85, -1120, 1000))

 

·       Rate   ?

·       Nper    15

·       Pmt      85

·       Pv       -1120

·       FV       1000

 

3.         Sadik Inc.'s bonds currently sell for $1,180 and have a par value of $1,000.  They pay a $105 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100.  What is their yield to call (YTC)? (7.74%, rate(5, 105, -1180, 1100)) What is their yield to maturity (YTM)? (8.35%, rate(15, 105, -1180, 1000))

 

·       Rate   ?

·       Nper    15

·       Pmt      105

·       Pv       -1180

·       FV       1000

 

 

4.         Malko Enterprises’ bonds currently sell for $1,050.  They have a 6-year maturity, an annual coupon of $75, and a par value of $1,000.  What is their current yield? (7.14%,  75/1050)

 

 

5.         Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%.  The bond has a face value of $1,000, and it makes semiannual interest payments.  If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? ($1,105.69,  abs(pv(8.4%/2, 20*2, 9.5%*1000/2, 1000)) )

 

·       Rate   8.4%/2

·       Nper    20*2

·       Pmt      95/2

·       Pv       ?

·       FV       1000

 

 

 6.        Grossnickle Corporation issued 20-year, non-callable, 7.5% annual coupon bonds at their par value of $1,000 one year ago.  Today, the market interest rate on these bonds is 5.5%.  What is the current price of the bonds, given that they now have 19 years to maturity? ($1,232.15,  abs(pv(5.5%, 19, 75, 1000)))

 

·       Rate   7.5%/2

·       Nper    19

·       Pmt      75

·       Pv       ?

·       FV       1000

 

 

 

 7.        McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050.  Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future.  What is the difference between this bond's YTM and its YTC?  (Subtract the YTC from the YTM; it is possible to get a negative answer.) (2.62%, YTM = rate(25, 90, -1250, 1000), YTC = rate(5, 90, -1250, 1050))

 

·       Rate   ?           ------------                ?       

·       Nper    25        -------------               5

·       Pmt      90       ------------                90

·       Pv       -1250   ------------                -1250

·       FV       1000    ------------              1000

 

 

8.         Taussig Corp.'s bonds currently sell for $1,150.  They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50.  Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future.  Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds? (4.2%, rate(5, 63.5, -1150, 1067.5))

 

9.         A 25-year, $1,000 par value bond has an 8.5% annual payment coupon.  The bond currently sells for $925.  If the yield to maturity remains at its current rate, what will the price be 5 years from now? ($930.11, rate(25, 85, -925, 1000), abs(pv( rate(25, 85, -925, 1000), 20, 85, 1000))

 

 

Fixed Income Investor's Reference Guide (FYI)               Quiz

(This guide is based on principles and insights from trusted financial resources, including Investopedia, Morningstar, Bloomberg, and FINRA.)

Key Metrics for Bond Analysis

1)     Yield to Maturity (YTM):

·       The total return earned by holding a bond until maturity. Essential for comparing bond values.

2)     Duration:

·       A measure of price sensitivity to interest rate changes. Longer duration = higher sensitivity.

3)     Convexity:

·       Enhances duration analysis by accounting for large interest rate shifts.

4)     Credit Ratings:

·       Assess bond risk via agencies like Moody’s, S&P, and Fitch. Higher ratings = lower risk.

5)     Spread Analysis:

·       Compare bond yields against benchmarks (e.g., Treasuries) to gauge risk and reward.

Types of Bonds

1.     Government Bonds:

·       Low risk, used as market benchmarks (e.g., U.S. Treasuries).

·       Risk: Interest rate risk for long maturities.

2.     Corporate Bonds:

·       Higher yields but increased risk. Categories include investment-grade and junk bonds.

·       Risk: Default and liquidity risks.

3.     Municipal Bonds:

·       Tax-exempt income for high-tax-bracket investors.

·       Risk: Default and interest rate risks.

4.     TIPS (Inflation-Protected Securities):

·       Inflation-adjusted principal protects against rising prices.

5.     Emerging Market Bonds:

·       High yields, but risks include currency fluctuations and political instability.

Key Risks in Fixed Income

1)     Interest Rate Risk: Bond prices drop when rates rise; longer maturities are most affected.

2)     Credit Risk: The possibility of the bond issuer defaulting on payments.

3)     Liquidity Risk: Difficulty in selling bonds quickly at fair prices.

4)     Reinvestment Risk: Falling rates reduce income when reinvesting proceeds.

5)     Inflation Risk: Fixed payments lose purchasing power as inflation increases.

Tools for Bond Investors

1)     Bond Screeners: Platforms like Bloomberg, FINRA, and Morningstar for research and filtering.

2)     Excel: Use Excel to model YTM, duration, and portfolio returns.

3)     Bond Indices: Benchmarks like Bloomberg Barclays Aggregate Index track bond market performance.

4)     Economic Indicators: Stay updated with Fed decisions, inflation rates, and employment reports.

Portfolio Strategies

1)     Laddering: Divide investments across maturities to manage reinvestment and interest rate risks.

2)     Barbell Strategy: Combine short-term and long-term bonds for flexibility and yield.

3)     Core-Satellite Approach: Base your portfolio on stable bonds while adding high-yield options for growth.

Monitoring the Market

1)     Yield Curve Analysis: A normal curve signals growth, while an inverted one predicts economic slowdown.

2)     Credit Spreads: Wider spreads indicate higher risk; narrower spreads suggest stability.

3)     Central Bank Policies: Interest rate changes by the Fed affect bond yields and prices significantly.

Practical Exercises

1)     Bond Trading Simulation: Platforms like Investopedia allow practice in a risk-free environment.

2)     Case Studies: Analyze market events like the 2008 financial crisis to understand bond behavior.

3)     Portfolio Construction: Create mock portfolios tailored to specific investment goals.

Inspirational Stories and Role-Playing

1.     Learn from bond market legends like Bill Gross and their strategies.

2.     Simulate decision-making as a CFO or bond trader to understand market dynamics (Play a simple simulation game here)

Key Takeaways

1)     Always analyze YTM, duration, and credit ratings to make informed decisions.

2)     Diversify with a mix of government, corporate, and municipal bonds to balance risk.

3)     Leverage tools like bond screeners and economic data for insights.

4)     Track the yield curve, credit spreads, and Fed policies to anticipate market trends.

5)     Practice with simulations and real-world scenarios to refine your skills.

 

2025 Global Fixed Income Outlook (FYI)

https://www.morganstanley.com/im/en-us/individual-investor/insights/articles/2025-global-fixed-income-outlook.html

 

 

Category

Key Insights

Macroeconomic Landscape

High inflation (except China), low growth (except U.S.), loose fiscal and tight monetary policy.

U.S. Economic Strength

Strong growth driven by AI, productivity, and consumer spending.

Fed Policy

Fed rate cuts to be smaller than in 2024; ECB expected to cut more.

Bond Market Outlook

U.S. Treasury yields range-bound (4% to 4.75%), favor curve steepening strategies.

Credit Markets

Tight credit spreads but strong fundamentals; preference for securitized credit over corporate credit.

Emerging Markets

Headwinds from strong U.S. dollar and trade uncertainty, but selective opportunities exist.

Currency Trends

U.S. dollar remains strong due to fiscal policy, higher yields, and trade policies.

Major Risks

Risks include geopolitical tensions, inflation resurgence, and aggressive corporate leverage.

Investment Strategy

Favor high-quality credit, shorter-duration bonds, and securitized credit while maintaining flexibility.

 

 

Reference Websites for Spreads and Metrics (FYI)

Spread/Metric

Website

Details

10-Year vs. 2-Year Treasury Spread

https://fred.stlouisfed.org/series/T10Y2Y

Daily yield curve rates for U.S. Treasuries.

FRED (Federal Reserve Economic Data)

Historical yield curve data and economic indicators.

Credit Spreads (Investment-Grade/High-Yield vs. Treasury)

FINRA Bond Center

Provides credit spread data and bond ratings.

Bloomberg

Industry-standard for corporate bond spreads and high-yield bond data (subscription required).

Sector Spreads (e.g., Technology, Energy)