Short on time? This page is the recap. For explanations and worked examples, use the full study guide.
Recap
- A financial asset is a claim to future payments. The three classes in this topic are money, bonds and stocks.
- The most liquid forms of money are cash and demand deposits (checking accounts).
- A bond is an interest-bearing loan to a government or firm. A stock is a share of ownership (equity).
- Liquidity: how easily an asset can be spent or turned into money without losing value. Rate of return: the gain as a percentage of the cost. Risk: the chance the return differs from what you expected, including losses.
- More liquid assets pay less. Higher expected returns usually come with more risk.
- The interest on an existing bond is fixed, so its price adjusts when market rates change.
- The opportunity cost of holding money is the interest forgone on other assets, such as bonds.
Key relationships
| Relationship | Statement or formula | Use it to |
|---|---|---|
| Liquidity ranking | cash, demand deposits (highest) → bonds, stocks | compare assets |
| Return and risk | higher expected return ↔ higher risk | explain why people hold several assets |
| Bond price and interest rate | inverse: market rate ↑ ⇒ price of existing bonds ↓ | predict capital gains and losses |
| One-year bond price | payment at maturity ÷ (1 + market rate) | calculate a bond price |
| Opportunity cost of money | amount held as money × interest rate on bonds | find the cost of holding money |
| Interest rate ↑ | holding money costs more ⇒ people hold less money | link to money demand (Topic 4.5) |
Assumptions behind the numbers
- Cash and demand deposits pay no interest unless the question says otherwise. If they pay some, the opportunity cost is the difference in interest.
- The bond issuer is expected to pay in full; the price changes come from market interest rates.
- Bond calculations use one year to maturity so that one division gives the price.
Mistakes to avoid
- Saying bond prices and interest rates move together. They move in opposite directions.
- Thinking the interest payment on an existing bond changes. The price changes.
- Calling a stock a loan. It is ownership.
- Giving inflation as the opportunity cost of holding money. The answer is interest forgone.
- Mixing up liquidity with return or safety.
- Forgetting that a bondholder who sells after rates rise takes a capital loss.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- A bond will pay VD 840 in one year. The market interest rate is 5%. What is its price today? (VD 800)
- Market interest rates fall. What happens to the price of a previously issued bond? (It rises.)
- You keep VD 12,000 as cash when bonds pay 3%. What is the yearly opportunity cost? (VD 360)
- Which is more liquid: a demand deposit or a share of stock? (The demand deposit.)
Next: practice questions.