Money and Banking
Money and Banking
Be able to identify which activity involves direct or indirect finance: indirect finance involves financial intermediaries
financial intermediation, involves the movement of funds from individuals or businesses that have surplus funds but lack investment opportunities (such as lenders or savers) to those who have investment opportunities but lack funds (such as borrowers or spenders)
Financial intermediaries – 3rd parties (intermediate player) between business that have SURPLUS funds but LACK INVESTMENT to ppl who have INVESTMENT opportunities but LACK FUNDS (ppl who want to open a business)
Distinguish three types of debt market (short-term(money markets) vs long-term(bond stocks), intermediate-term)
Short term: maturity < 1yr
Long term: maturity > 10 yrs
Intermediate term: maturity in between
Distinguish money market (treasury CD’s) vs capital market (stocks)
Understand the difference between
over-the-counter what most companies do
exchange trading Most common stocks are traded over-the-counter, although the largest corporations have their shares traded at organized stock exchanges such as the New York Stock Exchange.
Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid
Understand the difference between primary and secondary market: issuers acquire funds from primary markets
Primary market- company raising money
secondary market- exchange between investors
Primary Market
u New security issues sold to initial buyers
u Typically involves an investment bank who underwrites the offering
Secondary Market
u Securities previously issued are bought and sold
u Examples include the NYSE and Nasdaq
u Involves both brokers and dealers (do you know the difference?)
Understand the difference among foreign bond, Eurobond, Eurodollars, Eurocurrencies
u International Bond Market & Eurobonds
u Foreign bonds
u Eurobonds
u Denominated in one currency, but sold in a different market
u Now larger than U.S. corporate bond market
u Over 80% of new bonds are Eurobonds
u Eurocurrency Market
u Foreign currency deposited outside of home country
u Eurodollars are U.S. dollars deposited, say, London.
u Gives U.S. borrows an alternative source for dollars.
u World Stock Markets
u U.S. stock markets are no longer always the largest—at one point, Japan’s was larger
Understand the three functions of financial intermediaries:
· Cost saving through economies of scale
· Risk sharing: increase its own risk and reduce the risks of its customers
· Alleviation of information asymmetry problem
Ø Adverse selection: ex ante; potential borrowers who are most likely to default are ones most likely to seek a loan
Ø Moral hazard: ex post; once a borrower gets the loan, he may shift to a more risky project.
Understand the three types of financial intermediaries and able to identify a financial institution belong to which type.
· Depository institutions (banks)
o Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts.
o Commercial banks (about 5,000 at end of 2015)
o Raise funds primarily by issuing checkable, savings, and time deposits which are used to make commercial, consumer and mortgage loans
o Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios
o Thrifts: S&Ls & Mutual Savings Banks and Credit Unions (around 900 of each)
· Contractual savings institutions (savings/loans)
o All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements.
o Life Insurance Companies
o Fire and Casualty Insurance Companies
o Pension and Government Retirement Funds
· Investment intermediaries (JP Morgan, Goldman Sachs)
o Finance Companies
o Mutual Funds
o Money Market Mutual Funds
o Hedge Funds
o Investment Banks
Chapter 3
Understand the definition of interest rate (yield to maturity) and distinguish among interest rate, current yield, coupon rate, real interest rate
Risk premium- difference between “growth return – risk free rate if risk free rate goes up then the risk premium SHRINKS expected value will then be less attractive
Investment vs Debt
Debit- bank investment in you (interest rate you pay is THEIR RETURN)
if you get a loan for a house (mortgage) in mortgage agreement theres a “money term” + non-money terms
Money term- the actual money your going to be paying
Amount of the loan
the interest rate your going to pay
how long your going to make payments (maturity)
What is the actual payment
u Yield to maturity = interest rate that equates today’s value with present value of all future payments
What are the 5 variables related to the time value of money: present value, future value, interest rate, time, payment
Ø Present Value (money you invest today, the amount loan you pay)
Ø Future Value (The expected money you will receive or pay in the future)
Ø Interest Rate- Growth of your money
Ø Growth rate: Future value – Present value / present value
Ø 120-100/100= 20%
Ø Discount Rate- discount of the future value (backwards way to look at growth rate)
Ø Holding Period Return (HPR)- the actual return on your investment
Ø Simple Loans require payment of one amount which equals the loan principal plus the interest.
Ø Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the loan term.
Ø Intermingle interest + principal together
Ø Installment Loans, such as auto loans and home mortgages are frequently of the fixed-payment type.
Distinguish among fixed payment loan, coupon bond and zero coupon bond
Be able to calculate the future value of an investment
Be able to calculate the present value (price) of a zero coupon bond
Be able to calculate the yield to maturity for a simple loan
Be able to calculate the present value (price) of a coupon bond
Be able to calculate the real interest rate based on the nominal interest rate (yield to maturity) and (expected) inflation rate
Be able to calculate the one year return on bond investment and distinguish between return and interest rate
Understand reinvestment risk: holding period longer than the term to maturity of a bond
Understand interest rate risk: bond price will change when interest rate changes. The longer the maturity of the bond, the higher the interest rate risk and the more volatile of the bond price and bond return.
Chapter 4
3 Factors BEFORE you invest
Measure expected return
Quantify risk (what risk are you willing to take)
Set time (exit)
Be able to tell how the factors determine the demand of an asset ( a bond). Factors include: wealth, expected return, risk and liquidity
• asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:
1. Wealth, the total resources owned by the individual, including all assets
Wealth increases = more resources = more purchases
Expected return (the return expected over the next period) on one asset relative to alternative assets
Gain for holding an asset (base on interest)
Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets
High Standard Deviation = High Risk
Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets
Converting asset to cash
Be able to calculate expected return and the standard deviation of a bond
Understand what is demand curve: price and quantity demanded
Understand what is supply curve and what causes it to shift: investment opportunities, expected inflation rate, government activities (deficits)
Understand what is equilibrium, excess demand, excess supply and how the bond price will change with excess demand or excess supply
Again we are applying basic economics—more people will offer (supply) the bonds if the expected return (cost) is lower
Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price
Trading level
Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price
sell more than willing to buy
Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price
Buy more than willing to sell
Be able to tell how the demand curve of a bond will shift when some economic fundamentals affect the factors: economic expansion, expected interest rate in the future, expected inflation
rate, expected return on other asset markets (e.g. stock market), liquidity of stock market, (very important)
Demand Curve Shifts
Wealth / saving
Economy up-à wealth up (right)
Economy downà wealth down (left)
Expected returns on bonds
Risk
Liquidity: more liquidity more demand, less liquidity less demand
The Fisher effect, Business cycle effect (figure 4.4, 4.6 homework questions);
Chapter 5
Figure 5.1: the interest rates among 4 types of bonds
Understand what risk premium is and how it changes with the change of the factors: default risk, liquidity and income tax consideration (Very important)
Risk of default- when the issuer of the bond is unable or unwilling to make interest payments when promoted
Risk premium- how much additional interest ppl must earn in order to be willing to hold that risky bond
Figure 5.2 : how change of corporate default risk shifts the demand curve for corporate bond and the demand curve for government bond (Very important)
Yield curve- plots interest rates at different maturieis (a snapshot)
Interest rates for different maturities move together
Yield curves tend to have steep upward slope when short rates are low and downward slope when short rates are high
Yield curve is typically upward sloping
Effect of subprime mortgage market collapse on the demand of corporate vs Treasury bonds and the risk premium
Effect of an increase of marginal tax rates on the demand for municipal bonds vs government bonds
The three facts of the yield curve
Expectation theory: Understand the meaning and the explanation for the yield curve facts ( what it can explain and what it fails to explain). Be able to calculate the interest with the formula
Assumption: bonds of different maturies are perfect substitutes
EX: Expectation that a one year bond is priced the same as a 2 or 3 year bond
Explains that yield curves tend to have a steep slope + that short and long rates move together
Market Segmentation theory: Understand the meaning and the explanation for the yield curve facts
Assumption: bonds of different maturies are not substitutes at all
Yield curve is usually upward sloping
Liquidity premium theory: Understand the meaning and the explanation for the yield curve facts
Implicit forward rate: Be able to calculate it with the formula.
Assumption: bonds of different maturies are substitutes but are not perfect substitutes