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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

1

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!