Study Guide Financial institutions

Primary Markets

Markets in which users of funds (e.g., corporations) raise funds by issuing new financial instruments (e.g., stocks and bonds).

Secondary Markets

Markets where existing financial instruments are traded among investors (e.g., exchange traded: NYSE and over-the-counter: NASDAQ).

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.

Capital Markets

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.

Derivative Security

A financial security whose payoff is linked to (i.e., "derived" from) another, previously issued security.

Role of Financial Institutions (FIs)

Institutions through which suppliers channel money to users of funds. They provide benefits like reducing monitoring costs, increasing liquidity, reducing transaction costs, providing maturity intermediation, and denomination intermediation.

Nominal Interest Rate

The interest rates actually observed in financial markets. It has two components: the real riskless rate and adjustments for various risks.

Real Risk-Free Interest Rate

The additional purchasing power required to forego current consumption.

Fisher Effect

The theory that nominal interest rates (i) contain a premium for expected inflation (IP). Formally: i ≈ RFR + Expected(IP), where RFR is the real risk-free rate.

Inflation

When people expect prices to rise, lenders demand higher interest rates to compensate for the loss of their money's purchasing power over time.

Loanable Funds Theory

A theory that views the level of interest rates as resulting from factors that affect the supply of and demand for loanable funds.

Interest Rates

Determined by the basic economic forces of supply and demand, balancing the supply of savers and the demand of borrowers.

Default Risk Premium (DRP)

A premium added to the interest rate to compensate for the chance that the borrower will not make the promised payments. DRP = ij - iT, where ij is the rate on a risky security and iT is the rate on a risk-free Treasury security of the same maturity.

Liquidity Risk Premium (LRP)

A premium added to the interest rate to compensate for a security's lack of liquidity, or how quickly and easily it can be sold at a fair price.

Term Structure of Interest Rates (Yield Curve)

The relationship between interest rates (yields) and the time to maturity for a class of similar risk securities, which can be upward sloping, inverted, or flat.

Yield Curve

A graph that shows what interest rates are for loans of different lengths; a normal upward-sloping curve means long-term loans have higher rates than short-term loans.

Unbiased Expectations Theory

The theory that current long-term interest rates are geometric averages of current and expected future short-term interest rates.

Liquidity Premium Theory

A theory that long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity.

Market Segmentation Theory

A theory that the yield curve is determined by distinct supply and demand conditions within each maturity segment, reflecting the preferences of different groups for specific maturities.

Required Rate of Return (r)

The rate you demand to buy a security, based on its risk, used to calculate the Fair Present Value (PV).

Expected Rate of Return (E(r))

The rate you expect to earn based on the security's current market price (P). If E(r) > r, the asset is undervalued (a good buy).

Realized Rate of Return (r̄)

The rate you actually earned on an investment after you have sold it and received all cash flows.

Yield to Maturity (YTM) - Simpler Terms

The total annual return you can expect to earn on a bond if you buy it at today's price and hold it until it matures. It's the most comprehensive measure of a bond's return.

Bond Valuation Principle

A premium bond has a coupon rate greater than the required rate of return (YTM) and its price is greater than its par value. A discount bond has a coupon rate less than the YTM and its price is less than par. A par bond has a coupon rate equal to the YTM and its price equals par.

Duration - Simpler Terms

A measure of a bond's interest rate risk. It tells you approximately how much the price of a bond will change for a 1% change in interest rates. A higher duration means the bond's price is more sensitive to rate changes.

The Three Rules of Duration

Rule 1: Duration and Coupon: The higher the coupon, the shorter the duration. (You get your money back faster with higher coupons).

The Three Rules of Duration - Rule 2

Duration and Yield: The higher the yield-to-maturity, the shorter the duration. (Higher rates reduce the present value of distant cash flows).

The Three Rules of Duration - Rule 3

Duration increases with maturity, but at a decreasing rate. (A 30-year bond has a longer duration than a 10-year bond, but not three times longer).

Modified Duration

A direct measure of a bond's price elasticity. It is calculated as (Macaulay's) Duration / (1 + periodic YTM). The predicted percentage price change ≈ -Modified Duration × Change in Yield.

Modified Duration - Simpler Terms

A tweak to the basic duration formula that makes it easier to directly predict price changes. It's the tool you actually use to estimate how much a bond's price will move.

Convexity - Simpler Terms

Duration assumes a straight-line relationship between price and yield, which isn't perfectly true. Convexity accounts for the curvature. It's a 'second-order' effect that says bond prices increase more when rates fall than they decrease when rates rise by the same amount. It's good for investors.

Federal Reserve (The Fed)

The central bank of the United States, founded in 1913. It is an independent central bank-its decisions do not have to be ratified by the President or Congress, though it is subject to congressional oversight.

Federal Reserve

The institution responsible for managing the U.S. money supply, regulating banks, and promoting economic stability.

The Dual Mandate

The official goals of the Federal Reserve's monetary policy are to promote maximum employment and stable prices.

Federal Open Market Committee (FOMC)

The Fed's major monetary policy-making body consisting of 12 members: the 7 Board of Governors, the president of the NY Fed, and 4 other Reserve Bank presidents on a rotating basis.

Monetary Policy Tools

The various methods used by the Federal Reserve to manage the economy.

Open Market Operations

The primary tool involving the buying and selling of U.S. government securities in the open market to influence the level of bank reserves and the federal funds rate.

Discount Rate

The interest rate Federal Reserve Banks charge on loans to financial institutions.

Reserve Requirements

The reserve assets depository institutions must hold against transaction deposits.

Federal Funds Rate

The interest rate banks charge each other for overnight loans of reserves, which is the Fed's primary target.

Expansionary Policy

Used to fight recession/unemployment by increasing the money supply and lowering interest rates to stimulate borrowing and spending.

Contractionary Policy

Used to fight inflation by decreasing the money supply and increasing interest rates to slow down borrowing and spending.

Monetary Base

The sum of currency in circulation and reserves (vault cash + bank deposits at the Fed).

Challenges in Conducting Monetary Policy

Time lags, the fact that supplying reserves doesn't guarantee banks will lend, and the risk that excessive money creation can lead to inflation.