Financial Markets & Economics Review

Flashcards covering core principles of finance, money and inflation, discounting, bonds, stocks, and foreign exchange, based on lecture notes.

Time has value

A core principle: Money available now is more valuable than the same amount in the future due to its potential earning capacity.

Risk requires compensation

A core principle: Investors expect to be rewarded for taking on greater risks.

Information is the basis for decisions

A core principle: Financial decisions are made based on available information, which influences prices.

Markets determine prices and allocation of resources

A core principle: Financial markets efficiently allocate capital and set prices based on supply and demand.

Stability improves welfare

A core principle: A stable financial system and economy are beneficial for overall well-being and are a basis for monetary policy.

Financial Instrument

A contract that represents a claim on future cash flows or resources (e.g., stocks, bonds, foreign currency).

Financial Institutions

An organization that provides financial services (e.g., insurance companies, banks).

Financial Intermediaries

A specific type of financial institution that connects savers with borrowers and helps reduce information asymmetry (e.g., banks).

Financial Market

A system or place where financial instruments are bought and sold, facilitating the flow of funds between savers and borrowers (e.g., New York Stock Exchange).

Regulatory Agency

A government body that oversees financial markets and institutions to ensure fairness, transparency, and stability (e.g., Securities and Exchange Commission - SEC).

Central Bank

The primary monetary authority of a country that manages money supply, interest rates, and financial stability (e.g., Federal Reserve).

Roles of Money

Means of payment, unit of account, and store of value.

Commodity money

Currency that has inherent non-money value to everyone and cannot be easily created (e.g., gold, shells, cigarettes in prison).

Fiat Money

Currency with no inherent value, deriving its worth from the belief that others will accept it; can be easily created (e.g., USD, Japanese Yen, Euro).

Monetary Policy

The management of money supply and interest rates by a central bank to stabilize the economy, control inflation, and promote maximum employment and stable growth.

Gold Standard

A monetary system where paper currency is backed by a fixed amount of gold, which was rigid and couldn't provide economic flexibility.

Liquidity

How quickly an asset can be converted to cash without significant loss of value.

Gross Domestic Product (GDP)

The total expenditure during a time period on new domestically produced final goods and services.

REAL GDP

GDP calculated using base year prices, which removes the impact of inflation.

NOMINAL GDP

GDP calculated using current prices and quantities.

GDP Deflator

A price index (Nominal GDP / Real GDP * 100) that measures inflation for all goods and services produced in an economy, including investment goods, government purchases, and exports, but ignoring imports.

Producer Price Index (PPI)

Measures the average change over time in the selling prices received by domestic producers for their output; typically wholesale prices of physical goods pre-markup, ignoring imports.

Consumer Price Index (CPI)

A price index based on a typical consumption basket of goods and services, used to measure inflation for consumer goods and services.

Personal Consumption Expenditure (PCE) price index

A price index based on the prices of all goods in personal consumption, ignoring investments, and is often considered more accurate as it reflects changes in consumption patterns over time.

Core PCE

The PCE price index that excludes volatile food and energy components, used by the Federal Reserve to forecast underlying inflation trends.

Headline Inflation

The overall inflation rate for all items in the consumer basket; can be very volatile.

Core Inflation

Inflation that excludes food and energy prices to show a smoother, underlying trend, less distorted by short-term price swings.

Discount Factor ("β")

The proportion of value retained as one waits for a future payment, reflecting an individual's patience or impatience.

Personal Real Interest Rate (ri)

The highest rate at which an individual would borrow or the lowest rate at which they would lend, calculated as (1/"β") - 1.

Real Loanable Funds Market

A market where real interest rates are determined by the patience of investors (supply of lenders with high "β") and the desire to borrow (demand from borrowers with low "β").

Fisher Equation

Nominal Interest Rate = Real Interest Rate + Expected Inflation. It explains the relationship between nominal and real interest rates and inflation.

Nominal Interest Rate

The stated interest rate on a loan or bond, not adjusted for inflation.

Real Interest Rate

The inflation-adjusted return on an investment, indicating how much purchasing power actually grows.

Future Value (FV)

The value of an investment at a future date, calculated as Present Value (PV) * (1 + interest rate)^n.

Present Discounted Value (PDV)

The current value of a future sum of money or stream of cash flows, discounted at a specific rate.

Internal Rate of Return (IRR)

The interest rate that equates the present discounted value of an investment's expected cash inflows to its initial cost; used to evaluate the profitability of potential investments.

Arbitrage

The process of exploiting price differences in different markets to make a risk-free profit, which tends to equalize interest rates or prices across those markets.

Coupon Bond

A bond that pays fixed interest (coupon payments) at regular intervals until maturity, at which point the face value is repaid.

Risk

A measure of uncertainty about the future payoff of an investment, relative to a benchmark expected value.

Expected Value

The weighted average of all possible outcomes, where the weights are the probabilities of each outcome.

Variance

The sum of the average squared differences of individual outcomes from the expected value, measuring the spread of possible returns.

Standard Deviation

The square root of the variance, providing a measure of the typical deviation of returns from the expected value, often used as a measure of risk.

Hedging

Reducing risk by buying assets that move in opposite directions, resulting in a negative correlation.

Spreading

Reducing idiosyncratic risk by buying assets that move independently, resulting in zero correlation.

Leverage

Using borrowed money (debt) to invest, which can amplify both returns and losses, thereby increasing risk.

Idiosyncratic risk

Individual or unique risk specific to a single asset or small group of assets, which can be removed through diversification (spreading).

Systematic risk

Economy-wide risk that affects all assets, such as a recession or inflation, and cannot be diversified away.

Systemic risk

The risk of an entire financial system collapsing, often due to the interconnectedness of institutions.

Risk Premium

The extra return investors demand for taking on a riskier asset compared to a risk-free asset, reflecting their risk aversion.

Risk Free-Rate

The return on an investment that has no risk of default, serving as the baseline cost of money in the economy.

Default Risk

The risk that a borrower might fail to repay their debt.

Inflation Risk

The risk that higher-than-expected inflation will erode the real returns on an investment.

Interest rate risk

The risk that changes in market interest rates will cause the price of a bond to fall if it is sold before maturity, making existing bonds with lower coupon rates less attractive.

Term Structure

Stylized facts about the yield curve: rates of bonds with different maturities move together, short-term yields are more volatile, and long-term yields are typically higher.

Expectations Hypothesis

A theory suggesting that the shape of the yield curve reflects investors' expectations about future short-term interest rates.

Liquidity Premium Theory (Term Premium)

A theory stating that long-term bond yields are higher than short-term yields due to increased interest rate and inflation risk associated with longer maturities, requiring a premium for liquidity.

Common Stock (Equity)

Shares representing ownership in a company, typically with voting rights, limited liability, and a claim on residual earnings (after bondholders are paid).

Dow Jones Industrial Average

A price-weighted stock market index comprising 30 large, publicly owned companies.

Standards & Poor’s 500 (S&P 500)

A value-weighted stock market index comprising 500 of the largest U.S. publicly traded companies.

NASDAQ Composite

A value-weighted stock market index heavily weighted towards technology and growth companies.

Wilshire 5000

A market-capitalization-weighted index that aims to measure the performance of all publicly traded companies in the United States.

Efficient Market Hypothesis (EMH)

The theory that all available information is already reflected in market prices, making it impossible to consistently 'beat the market' through active trading without taking on extra risk or using insider information.

Equity Premium Puzzle

The empirical observation that stocks (equity) have historically earned significantly higher returns than bonds (debt), posing a puzzle because while stocks are riskier, the historical premium seems too large to be explained by conventional risk aversion models.

Depreciation (currency)

The loss of value of a country's currency relative to another currency, meaning it buys fewer units of the foreign currency.

Appreciation (currency)

The gain in value of a country's currency relative to another currency, meaning it buys more units of the foreign currency.

Foreign Exchange (FX) Market

The global marketplace where currencies are bought and sold, determining the nominal exchange rate in the short run based on supply and demand.

Uncovered Interest Parity (UIP)

A condition stating that the expected returns of investing in domestic and foreign assets should be equal after accounting for expected changes in exchange rates, assuming no hedging of currency risk.

Nominal Exchange Rate

The sticker price of one currency in terms of another, without adjusting for inflation (e.g., 1 USD = 1.15 Euros).

Real Exchange Rate

The nominal exchange rate adjusted for differences in price levels (inflation) between countries, indicating the relative price of goods and services between two countries.

Law of One Price (LoOP)

The principle that identical goods sold in different places should have the same price once exchange rates, transportation costs, and trade barriers are accounted for.

Purchasing Power Parity (PPP)

An extension of the Law of One Price, suggesting that exchange rates between currencies should adjust so that the same basket of goods costs the same in different countries, especially in the long run.

Absolute PPP

A strict form of PPP where the exchange rate should equal the ratio of general price levels between two countries (Exchange Rate = Price Ratio). It often does not hold due to non-traded goods, transportation costs, and differing consumption baskets.

Relative PPP

A form of PPP that focuses on changes over time, stating that the percentage change in the exchange rate between two countries should equal the difference in their inflation rates.