AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/4/4-1)
Unit 4 · Topic 4.1
4.1 Financial Assets
Besides spending it, you can hold wealth as cash, bank deposits, bonds or stocks, and each choice trades off liquidity, risk and rate of return. The idea the exam leans on most: the prices of bonds already issued move opposite to interest rates. That link connects bonds to the money market and to monetary policy.
Key terms
- liquidity
- rate of return
- risk
- stocks (equity)
- bonds
- opportunity cost of holding money
Three ways to compare assets
A financial asset is a claim on future money, such as a bank deposit, a bond or a share of stock. Economists compare assets on three traits.
- Liquidity: how quickly and cheaply you can turn an asset into spending power without losing value. Cash is perfectly liquid. Checking deposits (also called demand deposits) are almost as liquid. A house is very illiquid: selling it takes weeks and costs money.
- Rate of return: what the asset earns, as a percentage of what you paid. Interest on a bond, dividends on a stock and any rise in the asset's price all count.
- Risk: how uncertain that return is. A stock's price can drop sharply; a government bond's payments are very likely to arrive.
The tradeoff
These traits trade off. Assets that are safer and more liquid usually pay less. Cash pays nothing, so to earn more you have to give up some liquidity, take on some risk, or both.
| Asset | Liquidity | Typical return | Risk |
|---|---|---|---|
| Cash | Highest | None | Very low, though inflation eats its value |
| Checking deposit | Very high | Little or none | Very low |
| Savings deposit or CD | High to medium | Low | Low |
| Bond | Medium | Fixed interest payments | Low to medium |
| Stock | Medium | Dividends plus price changes | Higher |
Stocks and bonds
A stock (also called equity) is a share of ownership in a company. If the company does well, you may get dividends (a share of the profits) and the stock price may rise. If it does badly, the price can fall and you can lose what you paid.
A bond is a loan you make to a company or a government. The borrower promises fixed interest payments and repays the bond's face value (the amount borrowed) on a set date, called maturity. That's why bonds are called interest-bearing assets.
Both can be resold. Once a bond is issued, it trades in the bond market at whatever price buyers will pay, which can be above or below its face value.
Why bond prices and interest rates move opposite
An old bond's payments are locked in when it's issued. Say you own a $1,000 bond that pays $50 a year. Then interest rates in the economy rise, and new $1,000 bonds pay $80 a year. Nobody will pay you $1,000 for $50 a year when $1,000 buys $80 a year elsewhere. To sell your bond, you have to cut its price until its return matches the new bonds. So when interest rates rise, the prices of previously issued bonds fall.
It works the other way too. If rates fall to 3%, your $50-a-year bond looks good, buyers compete for it, and its price rises above $1,000.
The link also runs from prices to rates. When people rush to buy bonds, bond prices rise and the return a new buyer earns (the yield, or interest rate) falls. When people sell bonds, prices fall and yields rise. You'll use this in the money market (4.5) and in open market operations (4.6).
The opportunity cost of holding money
Money is the most liquid asset, but cash earns no interest and checking accounts earn little. The opportunity cost of holding money (what you give up) is the interest you could have earned by holding a bond or other interest-bearing asset instead. The nominal interest rate measures that cost.
When interest rates rise, holding money costs more, so people keep less money and buy more bonds. That's why the money demand curve slopes downward (4.5).
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Pricing an old bond after rates rise
A one-year bond will pay its owner $1,050 in one year: its $1,000 face value plus $50 of interest. It was issued when market interest rates were 5%. Market rates then jump to 10%. About what price would a buyer now pay for this bond?
Show the solutionHide the solution
- Step 1: A buyer now expects a 10% return, the same as a new bond would pay.
- Step 2: Find the price P that grows to $1,050 at a 10% return: P × 1.10 = $1,050.
- Step 3: P = $1,050 ÷ 1.10 ≈ $954.55.
- Step 4: Check the direction: the interest rate rose, and the bond's price fell below $1,000. Price and interest rate moved in opposite directions.
Answer: About $954.55, down from $1,000.
- Example 2
Bond prices rise: what happened to rates? (classic trap)
Over a month, prices of existing government bonds rise sharply. A student says this means interest rates rose. Is the student right?
Show the solutionHide the solution
- Step 1: A bond's payments are fixed. If buyers pay a higher price for the same payments, each dollar they invest earns less.
- Step 2: A lower return on bonds means the interest rate (yield) fell.
- Step 3: The trap is assuming that because both are 'going up' in the news, they move together. They move in opposite directions.
Answer: No. Rising bond prices mean interest rates fell.
- Example 3
Linking a rate increase to money holding
The central bank raises interest rates. What happens to (a) the price of bonds issued last year and (b) the opportunity cost of holding money?
Show the solutionHide the solution
- Step 1: (a) New bonds now pay more than last year's bonds, so last year's bonds must sell at a lower price to attract buyers.
- Step 2: (b) Holding money means giving up the interest a bond would pay. With higher interest rates, you give up more by holding cash, so the opportunity cost rises and people hold less money.
Answer: (a) The price of previously issued bonds falls. (b) The opportunity cost of holding money rises.
Common mistakes
- Saying bond prices and interest rates move together. They move in opposite directions: higher interest rates mean lower prices for bonds already issued.
- Mixing up stocks and bonds. A stock is a share of ownership (equity); a bond is a loan (debt) that pays interest.
- Naming inflation or 'the price of goods' as the opportunity cost of holding money. The course defines it as the interest you give up by not holding bonds or other interest-bearing assets.
- Confusing liquidity with value. A house can be worth a lot and still be illiquid, because turning it into cash takes time and costs money.
On the exam
- Multiple-choice questions often ask what happens to the price of existing bonds when interest rates change, or ask you to rank assets by liquidity. Cash and checking deposits are the most liquid.
- In free-response chains, a bond link earns credit only with the right direction and a reason, for example: 'interest rates rise, so the price of previously issued bonds falls, because new bonds pay more.'
Connected topics
Videos
Check yourself
4 questions on 4.1 Financial Assets. Pick an answer to see if you got it, and why.
Which of the following assets is the most liquid?
Maya owns a bond that pays a fixed $50 in interest each year. Interest rates on newly issued bonds of the same risk then rise from 5 percent to 7 percent. Which of the following is most likely to happen?
Which of the following correctly describes a difference between a stock and a bond?
An investor is comparing three assets: money in a bank savings account, a government bond and shares in a new technology company. Which of the following best describes the usual relationship among these assets?
0 of 4 answered