Professional Documents
Culture Documents
Introduction
McGraw-Hill/Irwin
Markets and institutions are primary channels to allocate capital in our society
Proper capital allocation leads to growth in: Societal Wealth Income Economic opportunity
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the structure of domestic and international markets the flow of funds through domestic and international markets an overview of the strategies used to manage risks faced by investors and savers
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Financial Markets
Financial markets are one type of structure through which funds flow Financial markets can be distinguished along two dimensions:
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Primary markets
markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq)
Secondary markets
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Do secondary markets add value to society or are they simply a legalized form of gambling?
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Money markets
markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) little or no risk of capital loss, but low return markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year substantial risk of capital loss, but higher promised return
Capital markets
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FX markets
trading one currency for another (e.g., dollar for yen) the immediate exchange of currencies at current exchange rates the exchange of currencies in the future on a specific date and at a pre-specified exchange rate
Spot FX
Forward FX
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Derivative security
a financial security whose payoff is linked to (i.e., derived from) another security or commodity, generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future, the main purpose of the derivatives markets is to transfer risk between market participants.
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Many options, futures contracts Forward contracts Forward rate agreements Swaps Securitized loans
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Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. Mortgage derivatives spread the risk of mortgages to a broader base of investors. Change in banking from originate and hold loans to originate and sell loans.
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Subprime mortgage losses have been quite large, reaching over $700 billion. The Great Recession was the worst since the Great Depression of the 1930s. Trillions $ global wealth lost, peak to trough stock prices fell over 50% in the U.S. Lingering high unemployment in the U.S. Sovereign debt levels in developed economies at alltime highs
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full and fair disclosure and securities registration Securities and Exchange Commission (SEC) is the main regulator of securities markets
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Financial Institutions
institutions through which suppliers channel money to users of funds whether they accept insured deposits, depository versus non-depository financial institutions whether they receive contractual payments from customers.
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INSTITUTION
Commercial Banks Savings Associations Credit Unions Insurance Companies Private Pension Funds Finance Companies Mutual Funds Money Market Mutual Funds
Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds.
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Cash
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Cash
Cash
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Depository institutions:
commercial banks, savings associations, savings banks, credit unions Contractual: insurance companies, pension funds, Non-contractual: securities firms and investment banks, mutual funds.
Non-depository institutions
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Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation
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Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services
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FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and before the financial crisis, recent U.S. regulatory changes were deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation
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Promote robust supervision of FIs Financial Service Oversight Council to identify and limit systemic risk, Broader authority for Federal Reserve (Fed) to oversee non-bank FIs, Higher equity capital requirements, Registration of hedge funds and private equity funds.
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Comprehensive supervision of financial markets New regulations for securitization and over the counter derivatives Additional oversight by Fed of payment systems Establishes a new Consumer Financial Protection Agency
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New methods to resolve non-bank financial crises More oversight of Fed bailout decisions Increase international capital standards and increased oversight of international operations of FIs.
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The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before, Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access, International mutual funds allow diversified foreign investment with low transactions costs, Global capital flows are larger than ever.
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Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) announced by institutions
Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing).
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The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA)
September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points
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Chapter Two
McGraw-Hill/Irwin
Nominal interest rates: the interest rates actually observed in financial markets
Used to determine fair present value and prices of securities Two types of components Opportunity cost Adjustments for individual security characteristics
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What causes differences in nominal and real interest rates? If you wish to earn a 3% real return and prices are expected to increase by 2%, what rate must you charge? Irving Fisher first postulated that interest rates contain a premium for expected inflation.
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Loanable funds theory explains interest rates and interest rate movements Views level of interest rates in financial markets as a result of the supply and demand for loanable funds Domestic and foreign households, businesses, and governments all supply and demand loanable funds
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3. 4.
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Interest rates and tax policy Income and wealth: the greater the wealth or income, the greater the amount saved, Attitudes about saving versus borrowing, Credit availability, the greater the amount of easily obtainable consumer credit the lower the need to save, Job security and belief in soundness of entitlements,
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2. 3. 4.
Relative interest rates and returns on global investments Expected exchange rate changes Safe haven status of U.S. investments Foreign central bank investments in the U.S.
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Foreign Currency Reserves (all $ in billions) $2,847 456 444 382 292
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Federal debt held by the public was at $9.0 trillion at end of 2010 (62% GDP) and is projected to grow to $17.4 trillion by 2020 (76% of projected 2020 GDP, 120% of current GDP)
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Total Federal Debt is currently $14.1 trillion (97% GDP) and is projected to grow to $23.1 trillion by 2020 (64% increase)
o
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DD
SS SS*
DD* DD
SS
E*
Q* Q**
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(a) Upward sloping (b) Inverted or downward sloping (c) Flat (a) (c)
(b)
Time to Maturity
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Long-term interest rates are geometric averages of current and expected future short-term interest rates
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1/ N
1
= actual N-period rate today N = term to maturity, N = 1, 2, , 4, 1R1 = actual current one-year rate today E(ir1) = expected one-year rates for years, i = 1 to N
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Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity
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Individual investors and FIs have specific maturity preferences Interest rates are determined by distinct supply and demand conditions within many maturity segments Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so
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A forward rate (f) is an expected rate on a shortterm security that is to be originated at some point in the future The one-year forward rate for any year N in the future is:
f1 ! [(11 RN ) /(11 RN 1 )
N 1
] 1
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The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date
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Discount future payments using current interest rates to find the present value (PV) PV = FVt[1/(1 + r)]t = FVt(PVIFr,t)
PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIFr,t = present value interest factor of a lump sum
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The future value (FV) of a lump sum received at the beginning of an investment horizon FVt = PV (1 + r)t = PV(FVIFr,t)
FVIFr,t = future value interest factor of a lump sum
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The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
1 (1 i )t PV ! PMT [1/(1 r )] ! PMT v i j !1 PMT = periodic annuity payment
t j
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The future value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
(1 i )t 1 FVt ! PMT (1 r ) ! PMT v i j !0 FVIFAr,t = future value interest factor of an annuity
t 1 j
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Effective or equivalent annual return (EAR) is the return earned or paid over a 12-month period taking compounding into account EAR = (1 + rper period)c 1
c = the number of compounding periods per year
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Financial Calculators
Number of digits shown after decimal point Number of compounding periods per year
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