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Money, banking and fnancial markets
March 30
Marketability: ability to sell something
Liquidity: ability to sell quickly at little or no loss of principle
Monetary Policy: credit; money supply
Fiscal Policy: taxes; state budget
Five core principles o Money and Banking
1. Time has value
. isk requires compensation
3. !normation is the basis for decisions
!. Markets determine prices and allocate resources
". "tability improves #elfare
Purposes o money
1. Means of payment. $nit of account
3. %tore of value
&uture of money 'o di(erent units of account
%tore of value on the #ay out → advances in )nancial markets.
Means of payment: secure systems virtually* no money at all.
M+',- %$/- → is a group of safe assets that households andbusinesses can use to make payments or to hold as short-term investments. &or example* $.%. currency and balances held inchecking accounts and savings accounts are included in many
measures of the money supply.
http:###.federalreserve.goveleases2currentdefault.htm
M# → is the most liquid* dollar value of phsysical cash and coin.
M$ and M% → 4he monetary base is de)ned as the sum of currencyin circulation and reserve balances.
M$ → sum of currency &eld by t&e public and transaction
deposits at depository institutions. 3 trillion dollars.
o 4raveler5s 6hecks
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http://www.federalreserve.gov/Releases/H6/current/default.htmhttp://www.federalreserve.gov/Releases/H6/current/default.htm
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o 7emand 7epositso +ther checkable deposits
M% → M1 8 savings deposits* small denomination time deposits
and retail money market. 1*!3 trillion dollars. 4he &,7 makes
ad9ustments in the season of the money supply.o %mall denomination time deposits
o %avings deposits and money market deposits accountso etail money market mutual fund shares
pril 0
Markets
• ,uro #ent up a /ittle tiny bit to 1.1!
• -en continues to strengthens
•
+il →
3.<→
1.
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o %#apso +ptions
!ndirect fnance → you give money to a )nancial institution and the)nancial institutions lend #ith your money.
4ypes of )nancial institutions
1. epository @nstitutions→ deposit taking institutions. Banksare the most common depository institutions.
a. 6ommercial banks → take money and generate loans andinvestments.
b. %avings banks and loans associations
c. 6redit union → is like a bank* takes deposits and makesmortgage loans. 6redit unions don5t pay any income tax*so they could give a loan at a lo#er interest rate thanbanks.
. *ontractual !nstitutions→ you pay money like a premium toa company and you receive a product or service in return. 4hemost common is the insurance companies:
a. Lie insurance companyb. -on lie insurance company Chome* car* apartments* )reD
c. Pension unds are something they you and youremployer put in to a pension fund and it accumulates and#hen you retire you get the bene)t of the money. @f you
put the money into a pension fund* it is ta./ree.3. !ntermediary !nstitutions
a. Mutual funds → are in the middle of contractual or
intermediary institutions → Mutual fund is a pull of moneyrun by a professional money manager. -ou pay the moneymanager to invest. Mutual funds spread out the risk.Mutual funds have di(erent investments.
b. &inance companies→ )nance cars. 4hey borro# money
on the capital markets.
c. @nvestment banks→
?olden %acks* Morgan %tanley. 4heyprovide assistance to companies needing )nancing.
!. 0overnment "ponsor 1nterprise 20"13 → mortgage
)nancing.
Financial markets → #here you buy and sell product and services.
4hree main functions of )nancial markets Cpage "
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. rovide good inormation → derive a lot of information of thatmarket. Eith the @nternet the amount of information isexponential. @nternet.
3. "&ares t&e risk → a lot of people are doing the same thing.
4ypes of )nancial markets Bank loans
Bonds
2ome mortgages
%tocks
sset=backed securities
*&apter 4
Future value → is the value sometime in the future of an investment
made today.
F5 6 P5 7 2$8i3 -
9ield → is the return you get on something.
Present value → is the value today of a payment that is promised inthe future.
P5 6 F5 2$8i3 -
!;; Cinternal rate of returnD → @f the expected return of aninvestment is bigger than the @... of that investment* you shouldprobably considering doing that investment.
elations&ip bet(een bond prices and interest rates
When interest rates rise, bond prices fall. Ehen interest rates fall*bond prices rise.
Bond → is a piece of debt issued by a company Cborro# moneyD froman investor. Bonds pay interest.
Maturity → is the length of time of a )nancial instrument.
4reasury bills are generally F0 or 1
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4he price of the bond #ill al#ays ad9ust to over the yield. @f @n themarket the rate of interest goes do#n* the bond #ill ad9ust the price#hen the yield equals the ne# rate of return.
o( to reduce risk?
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7iversi)cation → holdings* the maturity* the type of investment*
etc.
2edging → for#ard contracts* future contracts* s#aps and
options are used to hedge risk. Buy another investment that #ill
o(set the risk of that. ?oing in opposite directions from #hereyou are.
If you have risk:
1. @dentify the risk
. 4ry to measure the risk
3. 7eal #ith the risk* generally by hedging.
Bond prices
Most corporations need to borro# money in order to operate* so theysell bonds to the market.
$% Bond market → is three times the stock market.
$% ?overnment → has 1F trillion dollars of debt.
4he bond market has a relationship #ith interest rates. @nterest rate isvery important.
bond is a loan made by a company that needs to borro# money.
! kinds of bonds
1. @ero/coupon Bond → they are sold at a discount. @f the bondpays at maturity 100 dollars* the price could be F< dollars Cthedi(erence bet#een the t#o numbers is the pro)tD. 4reasury billsare liquid and safe.
. Fi.ed payment loan → is the most common type of bond.
CMortgagesD
3. *oupon bond → bond that pays I percent of interest.
!. *A-"AL bond → is a bond that has no maturity date; there isno promise for paying a principal.
*ommercial paper sold on a discount basis* they promise to paysomething and you pay less. 6ommercial aper market is at veryshort term C1 day* " days* etc.D 4he interest rate is very lo#.6ommercial paper is an unsecured short term borrowing by
corporations. Eho is the lenderJ @nsurance companies* corporations
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that have extra money and #ant to buy some commercial paper andlend money.
7efault → is #hen you don5t meet your obligations.
Bond yield → is the return over the price you pay. Ehen the bond isselling at the oar value* the yield equals the coupon rate.eturnprice.
@f the rate of interest of the market rate goes do#n* the bond heldstays the same* but the market changes* so that bond #ill increase.
9ield to maturity takes into account the return of income from #hatyou paid and #hat you get paid at maturity. Ehen the bond is sold atpar* the yield equals the coupon rate.
&actors that inKuence the supply of bonds
• ?overnment expenditure→ the more the government borro#s*the greater quantity a bond is required.
• Business conditions
• ,xpected @nKation → current inKation and expected inKation.
• 4axation → there are taxable and tax free bonds Cstates andmunicipal bond marketsD.
&actors that inKuence the demand of bonds
• ealt&
• ,xpected inCation → big impacts on ho# you manage yourportfolio.
• ,xpected returns and interest rates
• isk relative to alternatives
• Liquidity relative to alternatives
• Business cicle
&y bonds are risky?
1. 7efault risk → the risk that the bond issuer doesn5t payo( in thetimely manner as promised principal and interest. 4his is thema9or risk of a bond.
. @nKation risk → an investor can5t be sure of #hat the real valueof the payments #ill be. @nKation may turn out to be higher than
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expected* reducing the real return on holding the bond. @nKationdestroys the value of )xed income investments.
3. @nterest rate risk → arises from a bond investment horiAon*#hich may be shorter than the maturity of demand. @nterest
rates may rise bet#een the time the bond is purchased and thetime it is sold reducing the bond5s price.
!. e=@nvestment risk → #hen you have the capital but the marketis so lo# that you cannot re invest your capital for the samereturn. Ehen interest rates go do#n* the company can call thebonds and short the bonds issued in an interest rate higher andthey have to payo( all their bonds.
s interest rates change* the price of bonds changes. The longerthe maturity of the bond would be exacerbated by the change
of interest rate.
pril 0
*&apter D isk and interest ates
atings → evaluate the riskiness of bonds. C%tandard and poors*MoodiesD. 4hey have evoluted over the last years. 4he lo#er therating* the highest the interest that you pay.
Maturity → is a measure of time. 4he /onger the time* the higher the
risk. s interest rates change* if you are holding a 0 or 30=year bond*the price of that bond #ill change so much. 4he longer the bond youhold* as interest rate change* it #ill a(ect so much a long=term bondthan a shorter one. 4he yield goes up* as time goes out Cpag# 13D. -ield goes up* risk goes up.
Ta.es → municipal bonds are tax free* you don5t pay federal incometax in the $%. 4ax advantage in a municipal bond.
) types o yield curves:
1. 4ime increases* the interest goes up→ normal economy and
typical curve.
. &lat interest rates→ di(erent maturities #hatever the prices
3. 7o#n #ard slope
*&apter E "tocks
6ommon stock → shares in a rms ownership. )rm that issues
stock sells part of itself* so that the buyer becomes a part o#ner.
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-ou cannot be prosecuted for o#ning stock of a fraud company.
!nitial public oering 2!PA3 → #hen a company goes public andthen the public can buy shares.
Trading stocks !nde.es → is #hat you look out to see ho# thestocks are doing.
G )#
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• /ong position → you o#n the asset.
• %quare → even. -ou don5t have a position.
• %hort position → sold #ithout o#ning.
MB% → is a security made by individual mortgage securities.
! basic derivative instruments:
1. For(ard contracts → to hedge risk for a future obligation. for#ard contract is an agreement bet#een a buyer and a sellerto exchange a commodity or )nancial instrument for a speci)edamount of cash on a prearranged future date. &or#ard contractsare private agreements bet#een t#o parties generally one isthe bank. Because they are customiAed* for#ard contract are
diNcult to resell to someone else.
. Future contracts → calls for the delivery of something at acertain time and date. isadvantages: 4he amounts are very
)xed. Idvantages → standardiAed amounts.
a; T&e maturity day is f.ed
b; T&e last trading day is t(o day priors to e.port
c; Borro( stock at margin
d. Is t&e price c&anges, t&e value o t&e contract
c&anges M?@' 6$H,
e; 9ou do &ave to put collateral
3. "(aps → are contracts that allo# traders to transfer risk. %#apis #hen you exchange one thing for another. 'otional amount:amount that the transaction #ill be based on. 4#o parties to as#ap.
a. !nterest rate s(aps allo# one s#ap party* for a fee*to alter the stream of payments it makes or receives. @finterest=Koating liabilities increase is a bad thing.
b. Foreign currency s(aps → they s#ap the payments.
4hey are s#apping the cash Ko#s of the obligations.
!. Aptions → n option is a contract that gives you the right butnot the obligation to do something. ,xamples of options:&oreign exchange options* stock options* commodity.
a. 6all if you think that a stock #ill go up* you might buy acall option* #hich gives you the right but not the
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obligation to buy something. merican options are dueany time* that means buy or sell at any time at theclosing day. ,uropean options can only be exercised in theclosing day.
i; *overed #hen you do a call option and you o#nthe stock.
ii; -aked #hen you do the call option* but youdon5t o#n the call.
b. ut if you think that a stock #ill go do#n* you might
buy a put option* #hich gives you the right but not theobligation to sell something.
4hree di(erent prices
i; 'nderlined price current price of the asset
ii; "trike price ,xercise price
iii; Premium is #hat you pay for the option.
Foreign e.c&ange markets
&at is foreign exchangeJ Buy one currency and sell another. 4heforeign exchange market moves ! to " trillion dollars a day globally.
&ereJ @s basically an interbank marketJ London Cbecause of thetime AoneD is the biggest foreign exchange market* then 'e# -ork and 4okyo. /ondon is the only place in the #orld that can trade #ith siaand the rest of the #orld in the same day. /ondon regulators areeasier than $% regulations and sian egulations.
&yJ 4he main purpose of the foreign exchange market is tofacilitate international trade and investment. &acilitate shipping* traveland speculation.
&oJ 6ommercial banks and governments* corporations. Brokers.@mportersexporters.
>o(J
,nd chapter F: exercises * 1
,nd chapter 10: exercises 1* 1
Bank positions ,very bank has lending positions. bank mustsend a limit.
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7irect → home currency price
@ndirect quotes → one unit of foreign currency per one unit of homecurrency.
T&ings t&at aect oreign e.c&ange market
• @nKation
• 4rade balances
• 4rade and foreign exchange barriers
eserves → country stock of foreign currency* because it has tradesurplice. 6hina has the biggest foreign exchange.
May 1<
$% Banking 2istory → has a terrible banking history. @t didn5t have a
6entral Bank sin 1F1!.
'on=depository institutions → insurance companies life and non=life.
egulation → its necessary to have it in order to create a publictrust. Banks are important to the running of any economy.
6hallenges of regulation:
!ncreasing comple.ity of )nancial institutions → di(erent
products* services* and businesses.
0lobali+ation → #hat happens in one country impacts on the
others. ?lobaliAation is a(ecting the banking business.
o Trade → movement of product and services. ?lobaliAationis reducing the fees of trading.
o Movement of people → globaliAation reduces the barriers
of the movement of people.
o Movement of capital and money. ?lobaliAation is
reducing barriers on the movements of capital.
"&uttle banking → non=bank companies start lending money.
@t is a kind of banking but it is not regulated.
4oo big to fail C4B4&D→ banks in a particular countries are so bigthat becomes a systemic threat for the economy.
May "th
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Banking "ystem egulation
egulation → the #ay the la# is #ritten.
EhyJ
• %afety of the banks
• void bank runs
• rovide a government safety net
"upervision → checking and making sure that the la# is beingenforced.
egulations
sset holding requirements → 6apital to asset atio* 4ests →
risk ratios
7isclosure requirements
ctual examination → most banks are examined one a year but
ne# ones t#ice a year.
* → 6apital adequacy. 4he bank should have suKcient capital.
→ sset Luality. 4hey look at the loan portfolio if they are healthyor not.
M → Management. 2o# is created and distributed.
, → ,arnings
/ → /iquidity. Banks have to keep extra resources* you can5t meetdeposit #ithdra#s
% → %ensitivity. 4he impact of the interest rate c&anges in thebanks.
*entral Banks → is a vital part of any country controlled by thegovernment and serves to the monetary policy Cdetermines theprice and availability of the moneyD.
6entral bank key roles
• /ending in times of stress to )nancial institutions.
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• Manage the payment system of the money Cho# the money istransfer* collected* etc.D
6entral Banks ?oals
• Maintain lo( and stable inCation
• olicies that provides economic gro(t&
• olicies for stable fnancial markets
• romote stable interest rates
• romote policies that promote stable e.c&ange rates
• romote policies that promote lo( unemployment
6haracteristics of a good central bank
ccountable
Must #ork #ell #ith the Ministry of )nance C4reasuryD.
'e# challenges for the regulators and the central banks
1. ?ro#ing comple.ity of the )nancial system
. "&uttle banking → non=bank companies start lending money.@t is a kind of banking but it is not regulated.
4he 7oddO&rank Eall %treet eform and 6onsumer rotection ct ;commonly referred to as 7odd=&rankD #as signed into federal la# byresident +bama on 010.
%@&@ → they don5t #ant to be too big )nancial institions because theyare diNcult to regulate.
1!