money and banking manec 453 acc 453 fall 2007 brian boyer
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Money and Banking
ManEc 453
Acc 453
Fall 2007
Brian Boyer
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What is Money and Banking?INTEREST RATES:
Factors that influence Interest ratesThe Term Structure of Interest ratesDefault RiskForeign Exchange Rates and Purchasing Power parity
RISK MANAGEMENT Duration and Gap AnalysisFuturesOptionsSwaps and Credit Derivatives
FEDERAL RESERVE AND MONETARY POLICYThe Keynsian and Monetariast ViewsStructure of the Federal ReserveBen Bernanke and the Fed Today
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Financial Markets and Intermediaries
Firms
Households and Institutional Investors
Goodsand
Services
Primary MarketSecondary Market
Primary Market: A financial market in which new issues of a security are sold to initial buyers.
Secondary Market: A financial market securities that have been previously issued can be resold.
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Financial Markets
Financial Intermediary– Institutions that help channel funds from people who have
saved to those who need capital.
Direct Finance– Borrowers sell securities to lenders in financial markets.
Indirect Finance– A bank borrows money from lenders and loans it to
borrowers
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Direct vs. Indirect Finance
Source: Financial Structure and Economic Growth: Data Disk, MIT
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Financing New Projects
Averages for 1970-1994Source: Corbett and Jenkinson “How is Investment Financed?” The Manchester SchoolSupplement, 1997, pp. 69-93
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My History
Grew up in Central California BYU after high school Mission in Sao Paulo Brazil Undergrad at BYU (economics) Federal Reserve in D.C. (two years) PhD at University of Michigan
Married with three children
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What have your heard about money and banking (ManEc 453)?
What do you hope to get out of money and banking this semester?
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Course Materials
You are not required to buy a text for this course
Readings are posted on course reserve (electronically) from four texts– The Economics of Money Banking and Financial Markets, Mishkin, 8th ed– Money, Banking, and Financial Markets, Cecchetti– Essentials of Investments, Bodie, Kane, and Marcus 6th ed– Options, Futures, and Other Derivatives, Hull, 6th ed
Hard Copies of these texts will also be placed in the reserve library
The course schedule specifies which readings are required for each lecture.
You will need a financial calculator
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Workload and Class Structure
Do assigned reading
Expectation: 6 hours per week of outside work
Homework due every class period.
Quizes every Wednesday.
Wall Street Journal reading assignments
Tour of class web page.
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Exams and Grading
Exams in Testing Center
Grade:
Homework assignments15% Quizzes 15% Exam 1 20% Exam 2 20% Exam 3 30%
Exams are in general, cumulative
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Understanding Interest Rates
Mishkin, Chapter 4
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Measuring Performance: Price, Payoff, and Return
1 Share of Cisco Stock– You buy it now for $100– In three months you sell it for $110
1 Share of Apache Stock– You buy it now for $200– In three months you sell it for $215
What is the correct “measuring stick?”– Payoff– Profit– Return
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Returns
Returns are the “growth rate” of your investment
Investment in Cisco “grew” by 10% (110/100-1)
Investment in Apache “grew” by 7.5%
Instead of buying Apache for $200 buy two shares of Cisco for the same price
– Profit is $20
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Gross Returns Gross returns measure what you get back as a percentage of
the initial price.
Gross returns are simply payoff/price
Gross return from buying Cisco:– 110/100 = 110%– By investing in Cisco, you get back 110% of what you
initially invested. Gross returns above 100% are good Gross returns below 100% are bad
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Net Returns
Net returns are growth rates.
Net returns are simply payoff/price - 1
Net return from buying Cisco:– 110/100 - 1 = 10%– Or 10/100 = 10%– Your investment grows by 10%.
Net returns above 0 are good Net returns below 0 are bad
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Growth rates and Future Value
Example: – Investment with net return of 5% per year.– Initial Investment: $100
After first year, what is the value of investment?
After second year, what is the value of investment?
After third year, what is the value of investment?
10505.1100
25.11005.110005.1105 2
76.11505.110005.125.110 3
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Future Value In general: FV=P0(1+r)n
– P0= initial principal invested– r = net return on investment– N = number of time periods
Financial Calculator– N=number of time periods– PV = -initial principal (remember “-” sign)– r = net return on investment– pmt=coupons paid before end of each period (0)
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Present Value
Suppose you are given the choice of two flows– Choice #1: Receive $X now– Choice #2: Receive $100 two years from now
The present value of the cash flow from choice #2 is the amount, $X, that would make you indifferent between the two choices.
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Present Value Case #1:
– Suppose the cash flow from choice #2 is risk free– Risk-free accounts pay a net return of 4.5% per year– If you get $X now, you can invest it risk free and in two
years get
– For you to be indifferent between the two choices
2)045.1(X
100)045.1( 2 X
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Present Value
Doing some algebra
91.57 is the “present value” of the cash flow from choice #2
57.91)045.1(
100
100)045.1(
2
2
X
X
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Present Value Case #2
– What if the cash flow from investment #2 is not risk-free? That is, on average you expect to get paid $100, but it could be more or less.
– Choice #1: Receive $X now– Choice #2: Receive $100 two years from now with some
uncertainty.
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Present Value
Suppose an account exists with “similar risk” as choice #2 that pays an interest rate of 8%
– Must be higher than 4.5% (risk-free rate) because of additional risk.
– If you get $X now, you can invest it in the account and in two years and get
– For you to be indifferent between the two choices
2)08.1(X
73.85)08.1/(100,100)08.1( 22 XX
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Present Value
In general:
– FV= payoff at the end of year n– r = return on investment of similar risk as FV– N = number of time periods until money is received
Financial Calculator– N=number of time periods– FV=payoff – r = net return on investment of similar risk as payoff– pmt=coupons paid before end of each period (0)
0 (1 )n
FVP
r
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Growth Rates and Time
Net returns (growth rates) are attached to a unit of time.
How can we transform growth rates to different units of time?
Example:– Account pays 1% per month– What is the growth rate per year?– Hint: the answer is not 12%!– Reason: we earn interest on interest
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Growth Rates and Time
If I invest $1 in this account the money has grown to
Over one year, the net return is
A monthly growth rate of 1% is equivalent to an annual growth rate of 12.68%
1268.101.11 12
%68.1211
1268.1
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Growth Rates and Time
Example:– Account pays 24% per 2 years– What is the growth rate per year?– Hint: the answer is not 12%!
Let rA = the annual growth rate If I invest $1 in this account in two years I have
24.1)1(1 2 Ar
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Growth Rates and Time
Solving for rA gives us
A two-year growth rate of 24% is equivalent to an annual growth rate of 11.35%
24.1)1(1 2 Ar
%35.111)24.1(
)24.1()1(2/1
2/1
A
A
r
r