Money and Banking Study Guide Chapter 1-5

Chapter 1- Why study Money, Banking and Financial Markets? Why are Financial Markets Important? Financial markets are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Well functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets, vice versa. Financial markets and intermediaries have the basic function of getting people together by moving funds from those who have a surplus of funds to those who have a shortage of funds. The Importance of Interest Rates On a personal level, high interest rates can deter you from buying a house or a car because the cost of financing would be too high. Conversely, they could encourage you to save because you earn more interest by putting your money aside in savings. ON a more general level, interest rates affect the overall health of the economy because they affect not only consumers’ willingness to spend but also businesses’ investment decisions. High interest rates for example might cause a corporation to postpone building a new plant that would provide more jobs. The Importance of Stocks On a personal level the fluctuations in stock prices affect the size of people’s wealth and as a result may affect their willingness to spend. On a general level, it affects business investment decisions since the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm’s shares means that it can raise a larger amount of funds, which it can use to buy production facilities and equipment. A higher price means it can raise a larger amount of funds, which it can use to buy production facilities and equipment. Role of Financial Intermediaries Financial intermediaries are institutions that borrow funds from people who have saved and in turn make loans to others. Banks are included in this category. They accept deposits and make loans. These include commercial banks, savings and loan associations, mutual savings banks and credit unions. Investment banks are, insurance companies, mutual funds etc. are a different category. Money growth and Inflation Inflation may be tied to continuing increases in the growth rate of the money supply. Countries with the highest inflation are those with the highest money growth rates. Questions: – Quantitative easing is done by the Federal Reserve buying more bonds. This is how they decrease the interest rate. Therefore, since the Federal reserve said they will be keeping the interest rate close to zero for the next two years, is this not considered QE3? – How many shares of stock are too much? Can’t a company infinitely raise money than? Like when does it become a problem in terms of ownership? When 51% is in the hands of the public? Are stock profits considered cash flow for a company? Chapter 2- An Overview of the Financial System Indirect Finance vs. Direct Finance In direct finance borrowers borrow funds directly from lenders in financial markets by selling them securities that are claims on the borrower’s future income or assets. In indirect finance, lender-savers provide funds to financial intermediaries, who provide funds to borrower and spenders, as well as into financial markets. This financial intermediary borrows funds from the lenders savers and then using these funds make loans to borrower-spenders. This process is called financial intermediation. It is more feasible for them to do this because of their economies of scale and ability to shy off transaction costs. Also it provides liquidity services, and risk sharing. This process of risk sharing is also sometimes referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors. Firm and Individual Ways to Obtain Funds First way is to issue a debt instrument such as a bond or a mortgage. Second is by raising funds through issuing equities, such as common stock. Primary vs. Secondary Market Primary is where new issues of a security such as a bond or sock are sold to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a financial market in which securities that have been previously issued can be resold. An investment bank assists in the initial sale of securities in the primary market by underwriting the securities: it guarantees a price for a corporation’s securities and then sells them to the public. A corporation acquires new funds only when its securities are first sold in the primary market. Importance of Secondary markets Although they don’t directly increase corporations stock they nonetheless serve two important functions. (1) they make it easier and quicker to sell these financial instruments to raise cash; that is they make the it more liquid. This increased liquidity then makes them more desirable and thus easier for issuing firm to sell in the primary market. (2), the secondary market determines the price of the security that the issuing firm sells in the primary market. The investors buying in the primary will pay the corporation no more than the price they think the secondary market will set for the security. Brokers vs. Dealers Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices. A dealer is a person who will buy and sell securities on their account. On the other hand, a broker is one who will buy and sell securities for their clients. When dealing with securities, dealers make all decisions in respect of purchases. On the other hand, a broker will only make purchases as per the client’s wishes. While dealers have all the rights and reedom regarding the buying and selling of securities, brokers seldom have this freedom and these rights. Money Market vs. Markets The money market is a financial market in which only short-term debt instruments are traded. The capital market is the market in which longer-term debt instruments and equity instruments are traded. Money markets are usually more widely traded so tend to be more liquid. Short-term securities are also less volatile in p rices than long-term securities, making them more safer investments. Certificate of Deposit (CD) Is a debt instrument sold generally by commercial banks that pay annual interest of a given amount and at maturity pays back the original purchase price. They are sold in the secondary market. Repurchase Agreements (Repos) These are effectively short-term loans usually with a maturity of less than two weeks, for which treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan. A large corporation for example may have some idle funds in its bank account say $1 million that it would like to lend for a week. Microsoft uses this excess $1mil to buy Treasury bills from a bank, which agrees to repurchase them the next week at a price slightly above Microsoft’s purchase price. The effect is that Microsoft makes a loan of $1 million ot the bank and holds $1 million of the bank’s treasury bills until the bank repurchase the bills to pay off the loan. Federal Funds and Federal Funds rate These are confusing because the federal funds designation is not to be confused with loans made by the federal government. It is rather by banks to other banks. One reason they might borrow from other banks is to meet the amount required by regulators. The federal funds rate is a closely watched barometer of the tightness of credit market conditions in the banking system. Its the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight. When high that means banks are strapped for funds, when low, banks credit needs are low. Thus with a high federal funds rate banks require more money reserve in their vaults and thus can’t issue out loans as regularly. Asymmetric Information: Adverse Selection and Moral Hazard When one party often does not know enough about the other party to make accurate decisions. For example a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked than the lender does. Lack of information creates problems on two fronts: before the transaction is entered into and after. Adverse Selection The problem created by asymmetric information before the transaction occurs. It occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome –the bad credit risks- are the ones who most actively seek out al oan are are thus most likely to be selected. Moral Hazard The problem created by asymmetric information after the transaction occurs. It is the risk and hazard that the borrower might engage in activities that are undesirable from the lender’s point of view; because they make it less likely that the loan will be paid back. When you make a loan, it is usually by trust that they do what they say they’ll do with the money. Depository Institutions Commercial banks, Savings and loan Associations, Mutual Savings Banks, Credit Unions. These are financial intermediaries, referred to as simply banks in the text, that accept deposits from individuals and institutions and make loans. Thrift Institutions are all of these minus commercial banks. Commercial Banks Raise funds primarily by issuing checkable deposits, savings deposits, they then use these funds to make commercial, consumer, and mortgage loans and to buy US government securities and municipal bonds. They are the largest financial intermediary and have the most diversified portfolios of assets. Savings and Loan Associations and Mutual Savings Banks Obtain funds primarily through savings deposits often called shares and time checkable deposits. Over time they have been less constrained and are turning into commercial banks. Credit Unions Usually very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds form deposits called shares and primarily make consumer loans. Contractual Savings Institutions Financial intermediaries that acquire funds at periodic intervals on a contractual basis, since they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years. Liquidity is not as important. Involve life insurance companies, fire and casualty insurance companies, and pension and government retirement funds. Finance Companies Raise funds by selling commercial paper and by issuing stocks and bonds. They lend funds to consumers who make purchases of items and to small businesses. Some are organized by parent corporations to help sell its product. Mutual Funds Acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. Money Market Mutual Funds Similar to a mutual fund but they also function to an extent as a depository institution. They sell shares to acquire funds that are then used to buy money market instruments that are both safe and liquid. A key feature is that shareholders can write checks against the value of their shareholdings. Investment Banks It is not a bank or a financial intermediary in the ordinary sense; that is, it does not take in deposits and then lend them out. Instead, an Investment Bank is a different type of intermediary that helps a corporation issue securities. First it advises the corporation on which type of securities to issue (stocks or bonds) then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. They also act as deal makers and earn enormous fees by helping corporations acquire other companies through mergers and acquisitions. Regulations involved Restrictions on entry, only those who have impeccable credentials and a large amount of initial funds are given a charter as a financial intermediary. Stringent reporting requirements for financial intermediaries. Restrictions on certain assets and activities. Deposit Insurance, Limits on Competition. Also, there is a restriction on interest rates that can be paid on deposits. These regulations were instituted because of the widespread believe that unrestricted interest-rate compensation helped encourage bank failures during the Great Depression. In terms of regulation abroad, the major differences between financial regulation in the US vs. Abroad relate to bank regulation as in the past the US was the only industrialized country to subject banks to restrictions on branching which limited banks size. Questions: When a company issues a secondary IPO, is it in the primary market or secondary market? Chapter 3 – What is Money? What are the requirements for Money? (1) Must be easily standardized making it simple to ascertain its value (2) It must be widely accepted (3) It must be divisible so that it easy to make change (4) It must be easy to carry and (5) It must not deteriorate quickly. Examples have included strings of beds used by Indians, to tobacco, and whiskey, to cigarettes. Functions of Money Money is used as (1) a medium of exchange to pay for goods and services (2) a unit of account used to measure value in the economy (3) a store of value used to save purchasing power from the time income is received until the time it is spent. Commodity Money Money made up of precious metals or another valuable commodity is called commodity money. Problem is that it is hard to transport. Fiat Money Paper Currency. It has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is trusting in the authorities that issue it and if printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult. Major drawbacks are that they are easily stolen and can be expensive to transport in large amounts because of their bulk. To combat this there has been the invention of checks. Monetary Aggregates M1 = Currency + Traveler’s Checks + Demand deposits + Other checkable deposits. M2 = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares. M1 is the most liquid while M2 is money including assets that have check-writing features and other assets that can be turned into cash quickly at little cost, but are not as liquid. Chapter 4 – Understanding Interest Rates Simple Loan PV = CF/(1+i)^n, there’s not payments in between, it’s just the lender provides the borrower with an mount of funds (principal) which is then repaid back to lender at the end of the maturity (can be any amount of years) as well as an interst. Fixed Payment Loan Lender provides borrower with an amount of funds which must be repaid by making the same payment every period consisting of part principal and part interest. Coupon Bond Your normal type of bond, pays interest by coupon payment, price changes, principal at end. Corporate bonds, treasury bonds, all are coupon bonds. Discount Bond Zero-Coupon Bond, this is a type of coupon bond where it is bought at a price below its face value and the face value is repaid at the end of the maturity date. However it does not make any interest payments. It’s coupon rate = 0. YTM = F-P / P Perpetuity Type of coupon bond that is a perpetual bond and has no maturity date where it repays a principal amount. P = C/i Current Yield With long-term bonds or perpetuities, I = C/P and this just equals the current yield. Distinction Between Interest Rates and Returns A lender is not better off if the interest rate rises. How well a person does by holding a bond or any other security depends on their assets return. Here for a bond, the return is defined as the payments to the owner plus the change in its value, expressed as a fraction of its price. R = C+P2-P1 / P1. R = i + g.. = Coupon rate + rate of capital gain. Greater fluctuations with Long Term Bonds When interest rates rise, long-term bonds bear the worse effect since their present values are taken into far far into the future, therefore their prices are more drastically changing. The more distant a bond’s maturity the greater the size of the percentage price change associated with an interest rate change. It’s all because of the change in capital growth. Interest Rate Risk Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. The riskiness of an assets return that results form interest rate changes is called interest-rate risk. Bonds with a maturity that is as short as the holding period have no interest rate risk. This is true only for discount bonds and zero-coupon bonds. The key is to recognize that the price at the end of the holding period is already fixed at face value, the change in interest rates then have no effect on the price at the end of the holding period for thos bonds, and the return will therefore be equal to the yield to maturity. Fisher Equation Nominal interest rate always equals the real interest rate + the expected rate of inflation. Chapter 5 – The Behavior of Interest Rates Determinants of Asset Demand 1) Wealth – Increasing wealth creates more resources available with which to purchase assets and therefore quantity of assets we demand increases. (2) Expected Returns – An increase in an asset’s expected return relative to alternative assets raises the quantity of assets we demand. (3) Risk – The degree of risk or uncertainty of an asset’s ret urns also affects the demand for the asset. Increasing risk decreasing the quantity of assets demanded. (4) Liquidity – The more liquid an asset is relative to alternative assets, the more desirable it is and greater the quantity demanded. What determines interest rates? There’s two theories: the Bond Market Framework and the Money Market framework called the Liquidity Preference. The best Theory is the combination of the two. Demand Curve in the Bond Market As the interest rate rises, or prices of the bonds decrease, people or willing to lend out more money therefore increase their quantity of buying bonds. This explains the negative slope of the bond demand curve. Supply Curve in the Bond Market As the interest rates rise, or prices of the bonds decrease, people are less willing to borrow by selling bonds considering that their interest payments are higher. Therefore as interest rates increases, quantity of bonds decrease thereby explaining the positive slope of the supply curve. Shifts in the Demand for Bonds The theory of asset demand demonstrated before provides factors which cause the demand curve for bonds to shift. Therefore these four parameters are included: (1) Wealth – Increase in wealth increases demand for bonds. This is because with higher wealth, there is a growing business expansion, and therefore people are willing to lend out money more. Also, propensity to save, if households save more, wealth increases and demand for bonds rises. 2) Expected Returns – Increase in expected returns on bonds relative to alternative assets increases demand for bonds. (through expected interest rates and expected inflation) a. Interest Rates E – Higher expected interest rates in the future, say 10% to 20%, would lead toa sharp decline in price and a very large negative turn. Therefore if people expect higher interest r ates next year, the demand for bonds will decrease. b. Inflation Rate E – An increase in the expected rate of inflation lowers the expected return for bonds. This is because a change in expected inflation is likely to increase the return on physical assets relative to bonds, therefore leading to a fall in relative return on bonds therefore decreasing asset demand. (3) Risk – Increasing risk of bonds relative to alternative assets decreases demand for bonds. (4) Liquidity – Increasing liquidity of bonds relative to alternative assets increases demand for bonds. Shifts in the Supply Curve (1) Profitability of Investment Greater economic expansions yield increases in supply of bonds. The more profitable plant and equipment investments that a firm expects it can make, the more willing will borrow. When the economy is growing rapidly, investment opportunities that are expected to be profitable abound, and the quantity of bonds supplied at any given bond price will increase. (2) Expected Inflation – When inflation is expected to rise, the real cost of borrowing is more accurately measured by the real interest rate which is the nominal rate minus the expected inflation rate, thus real cost of borrowing falls hence quantity of bonds supplied increases. 3) Government Budget – Higher government deficits increase the supply of bonds and shift the supply curve to the right. Government surpluses however do the opposite. Fisher Equation WHEN EXPECTED INFLATION RISES – INTEREST RATES WILL RISE Changes in the Interest Rate due to a Business Expansion In an expansion, the amount of goods and services produced in the economy increase so the national income increases and therefore wealth increases. Therefore demand for bonds increases. At the same, opportunities that are profitable also increase and supply for bonds increase as people want to borrow more. Therefore what happens? Theoretically, nothing, quantity of bonds increases but price/interest rate can go either way. According to data though, usually the supply effect > demand effect as more people invest in new opportunities. Therefore interest rates generally rise during an economic expansion. Business Cycles and Interest Rates Data shows that interest rates rise during business cycle expansions and fall during contractions. Focusing into the Money market now. Liquidity Preference Framework says that the analysis of the money market is the same as the analysis of the bond market. Bs – Bd = Md – Ms. The reason that we approach both in the determination of interest rates with both frameworks is that the bond supply and demand framework is easier to use when analyzing the effects from changes in expected inflation, whereas the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of money. Demand Curve for Money REMEMBER THAT FOR THE MONEY MARKET THE Y AXIS IS INTERST RATE ICNREASING. As interest rates rise, the opportunity cost of holding money increases therefore quantity demanded for money decreases. The Federal reserve controls the amount of money supplied therefore they are able to cause it into equilbirum. Liquidity Preference Framework: Shifts in Demand for Money (1) Income – A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift right. People want to hold more money. Thus interest rates will rise. (2) Price-Level Effect – When price level rises the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their holdings of money in real terms to its former level people want to hold more money. Therefore increasing the price level increases the demand for money. Thus interest rates will rise. Liquidity Preference Framework: Shifts in Supply of Money (1) Only changes by the federal reserve. Now Combining Liquidity Preference and Bond Framewor When we Increase the MS (1) Income Effect – Because an increasing money supply is an expansionary influence on the economy, it should raise national income and wealth. Both the LP and BSD framwork indicate that interest rates will then rise. Thus the income effect of an increase in the money supply is a rise in interest rates. (2) Price – Level Effect – An increase in the money supply causes verall price level in the economy to rise. The liquidity preference framework indicates that this will lead to a rise in interest rates. (3) Expected Inflation Effect – The higher inflation rate that results from an increase in the MS also affects interest rates by affecting the expected inflation rate. The Bond Supply fr amework believes this leads to higher levels of interest rates. But does a higher rate of Growth of the Money Supply Lower Interest Rates? Of all the effects, only the liquidity effect indicates that a higher rate of money growth will cause a decline in interest rates. In contrast, the income, price level and expected inflation effects indicate that interest rates will rise when money growth is higher. Generally the liquidity effect from the greater money growth takes effect immediately because the rising money supply leads to an immediate decline in the equilbrium interest rate. The income and price level effects take tim to work because it takes time for the increase money supply to raise the price level and income which in turn raise interest rates. The expected inflation rate can be slow or fast depnding on wether or not people adjust expcations quik enough.