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9.1: Portfolio choices between money and other assets

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    A financial portfolio is a collection of financial assets. It might include money balances, bonds, equities, mortgages, and mutual funds. The structure of a portfolio, the proportion held in each type of asset, reflects two main characteristics of the assets involved:

    1. The returns paid by different financial assets
    2. The risks arising from changes in the market prices of assets

    Wealth holders and institutional portfolio managers for pension funds and insurance companies like their portfolios to pay high returns with low risk. To achieve this, they hold mixed portfolios of money and other financial assets.

    Suppose you win $10 million in a lottery. Now that you have wealth, what are you going to do with it? You will no doubt spend some and give some away. That is a wealth effect, but what about the balance of your winnings? You have to make a portfolio choice. Will you hold your wealth as money in the bank? Will you put your money in the stock market? Will you put your money in the bond market?

    If you consult a financial planner, he or she will probably recommend a mixed portfolio made up of money, bonds, and equities. That recommendation will be based on your intention to increase your wealth and draw income from it while protecting it from losses in financial markets.

    Money holdings are an important part of the portfolio. Money is the medium of exchange. It can be used directly to make payments for goods and services or to settle debts. Other assets, for example bonds, cannot be used as a means of payment. Furthermore, money has a fixed nominal price. It is a "safe asset." Wealth held as money does not rise or fall with the rise or fall in financial asset prices on stock and bond markets. However, money is exposed to the risk that inflation will lower its real purchasing power.

    Other financial assets differ from money in three respects. First, they cannot be used as a means of payment. To use them to make a payment you would first have to sell them for money, at their current market price, and then use the money to make the payment. Second, they offer a return in the form of an interest payment, a dividend payment, or a rise in price that provides income to the portfolio holder. Third, because the prices of financial assets like bonds or stocks fluctuate daily on financial markets, these assets carry the risk that their values may decline significantly from time to time.

    Portfolio management recognizes these differences between assets by trading some return for lower risk and greater convenience in the mix of assets held. Money in the portfolio offers the convenience of the means of payment, providing low risk but zero return. Other assets offer a flow of interest and dividend income, and possible capital gains if asset prices rise, but the risk of capital loss if prices fall.

    This portfolio choice between money balances and other assets is the basis for our discussion of the demand for money balances in the remainder of this chapter.

    Bond prices, yields and interest rates

    The demand for money comes from an understanding of the relationship between interest rates, bond coupons, the prices of financial assets, and yields on financial assets. To keep the examples simple assume only one type of financial asset, a bond. However, the prices and yields of other financial assets are related to interest rates in the same way as bond prices.

    Several basic concepts and definitions are important. A bond is an asset that makes one or more fixed money payments to its holder each year until its maturity date. On its maturity date, it also repays its principal value. Governments and businesses issue and sell bonds on financial markets to raise funds to finance expenditures.

    Bond: a financial contract that makes one or more fixed money payments at specific dates in the future.

    The interest rate is the current market rate, expressed as a percentage, paid to lenders or charged to borrowers.

    Interest rate: the current market rate paid to lenders or charged to borrowers.

    A bond coupon is the fixed money payment made annually to the holders of the bond from the date of issue until the date of maturity. The coupon rate is a fixed percentage of the principal value of the bond at the time of issue. For example a 3% bond pays $3.00 annually per $100 of principal until its maturity date.

    Bond coupon: the annual fixed money payment paid to a bond holder.

    The price of a marketable bond is the current price at which it can be bought or sold on the open bond market at any time between its date of issue and its maturity date.

    Price of a marketable bond: the current price at which the bond trades in the bond market.

    The yield on a bond is the return to a bond holder expressed as an annual percentage rate, which is a combination of the coupon payments and any change in the market price of the bond during the period in which it is held.

    Yield on a bond: the return to a bond holder expressed as an annual percentage.

    Bond prices depend on current market interest rates. The current price of a bond is the present value of the future payments it will provide. The present value is the discounted value of those future payments. It recognizes that money payments in the future are worth less than money payments today.

    Bond price: the present value of future payments of interest and principal.

    Present value is the discounted value of future payments.

    To help understand present value, ask the following question: If someone promises to give you $1,000, would you rather have it today or a year from today? Notice that $1,000 lent at an interest rate of 3% (i.e. 3/100=0.03) would give you a sum of:

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    one year from today. In the same way, the amount of money you need to lend today to have $1,000 one year from today is:

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    When the market rate of interest is 3 percent, the present value of $1,000 to be received one year in the future is $970.87.

    Experimenting with different interest rate assumptions in this present value calculation illustrates that the present value of $1,000 to be paid one year from today changes with the rate of interest. Higher interest rates reduce present values while lower rates increase them. For example, if the current market rate is 5% the present value of $1,000 to be received one year from today is:

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    This relationship is the key to understanding bond prices and how they fluctuate over time. A rise in market interest rates lowers the present value of fixed future payments. A fall in market rates increases present values of fixed future payments.

    In general, because the future payments offered by bonds are fixed in dollar terms, the prices of marketable bonds vary inversely to market rates of interest. Rising interest rates mean falling bond prices, and falling interest rates mean rising bond prices. There are many types of bonds that differ by coupon, maturity date, frequency of future payments, and in other ways. However, the relationship between prices, yields, and interest rates remains the same. Because bond prices are the present value of future payments, prices and interest rates move in opposite directions.

    Furthermore, the size of the change in the price of a bond as a result of a change in the interest rate depends on the bond's term to maturity. The prices of longer-term bonds are more volatile than those of shorter-term bonds. This an important consideration for bond portfolio managers concerned with trade-offs between risk and return.

    Asset markets like the bond market are very active. Large volumes of bonds are bought and sold every business day. Example Box 9.1 at the end of the chapter gives a more detailed example of the relationship between market interest rates and bond prices. You can find a long list of outstanding bonds and see their coupons, term to maturity and current prices and yields at:

    http://www.globeinvestor.com/servlet/Page/document/v5/data/bonds/


    This page titled 9.1: Portfolio choices between money and other assets is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) .

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