Introduction to Finance and the Financial System

Financial System and Regulation

Financing Transactions: - Direct Financing: Borrowers borrow funds directly from lenders in financial markets by selling them securities. - Indirect Financing: Involves a financial intermediary (e.g., a bank) between the lender/saver and the borrower/spender. This is the primary focus of most discussions.
Regulation Goals: There are two fundamental objectives of financial market regulation: 1. Better Information for Investors: Reducing asymmetric information. 2. Ensuring Soundness: Maintaining the stability of financial institutions and intermediaries.

Bond Mechanics and Volatility

Hold to Maturity vs. Holding Period: - Return on Bond ( $R$ ): Equals the Yield to Maturity ( $YTM$ ) only when the maturity is equal to the holding period. - If you buy a $10$ rd year bond with a $10\,\%$ coupon and hold it for $10$ years, your return is locked at $10\,\%$ . - Holding More or Less than Maturity: If held for less than maturity, changes in interest rates affect the price. - Interest Rates $\uparrow$ $\rightarrow$ Price $\downarrow$ . - Interest Rates $\downarrow$ $\rightarrow$ Price $\uparrow$ .
Maturity and Price Sensitivity: - The longer the maturity, the greater the price change (volatility). - Example: A $30$ rd year bond loses significantly more value than a $2$ rd year bond if sold after one year following a rate hike. A $1$ rd year bond held for one year loses nothing because it matures.

Supply and Demand for Bonds

Graphing Bonds: - Demand Curve: Downward sloping ( $x-axis$ : Quantity of Bonds, $y-axis$ : Price). - Supply Curve: Upward sloping. - Inverse Relationship: As Price drops, Interest Rates increase.
Market Equilibrium: - Above Equilibrium: Supply > Demand ( $Excess\,Supply$ ). - Below Equilibrium: Demand > Supply ( $Excess\,Demand$ ). - Shifting Curves: A decrease shifts the curve to the Left; an increase shifts the curve to the Right.
The Fisher Effect: - When expected inflation rates increase, demand for bonds goes down (investors want higher rates later) and the supply of bonds goes up (issuers want to lock in low rates now). - Result: Bond prices fall and interest rates unambiguously go up.
Flight to Quality: - Occurs during credit crises (e.g., corporate bond market trouble). - Demand for corporate bonds $\downarrow$ , prices $\downarrow$ , yields $\uparrow$ . - Demand for Treasury bonds $\uparrow$ , prices $\uparrow$ , yields $\downarrow$ . - This causes the Credit Spread (gap between corporate and risk-free rates) to widen.

Term Structure of Interest Rates

Theories: 1. Expectations Theory: Long-term rates are the average of expected future short-term rates. 2. Market Segmentation Theory: Bonds of different maturities are not substitutes. 3. Liquidity Premium Theory: Combines the first two. Explains why the yield curve is typically upward sloping by adding a positive liquidity/term premium.
Mathematical Application: Long-term interest rates are the summation of expected future short-term rates.

Money and Capital Markets

Money Market Instruments: - Characteristics: Low risk, low return, short duration, and high liquidity.
Bond Calculations (Semi-annual): - Number of Periods ( $n$ ): Multiply annual years by $2$ . - Yield/Return: Always quoted annually; divide by $2$ for semi-annual calculations. - Coupon Payment ( $PMT$ ): Divide annual payment by $2$ . - Example: A $10\,\%$ coupon bond with a $\$1{,}000$ face value pays $\$50$ semi-annually.
Bond Types: - Callable Bonds: The issuer has the right to repurchase the bond before maturity. - Convertible Bonds: These can be converted into shares of common stock.

Stock Valuation and Mutual Funds

Gordon Growth Model: A simplified version of the Dividend Discount Model. - Crucial Differentiation: Ensure the formula uses the correct dividend—Current ( $D_0$ ) vs. Next Year ( $D_1$ ).
Mutual Funds: - How most households access the stock market via pooled assets. - Net Asset Value ( $NAV$ ): Total Net Assets divided by Shares Outstanding ( $NAV = \frac{\text{Net Assets}}{\text{Shares Out}}$ ).

Foreign Exchange Markets

Definitions: - Spot Rates: Immediate currency exchange. - Forward Rates: Exchange at a future date.
Impact of Appreciation: - Domestic Consumers: Happy (domestic currency buys more foreign goods). - Domestic Businesses: Unhappy (foreign earnings translate to fewer domestic dollars).
Law of One Price and PPP: - Big Mac Index: A Big Mac should cost the same everywhere. - Tariffs: Make foreign goods more expensive. This increases demand for domestic goods, which strengthens the domestic exchange rate.

Banking Sector

Bank Balance Sheet: - Banks take liabilities (deposits) and transform them into assets (loans). - Profit is the margin between income earned on assets and interest paid on liabilities.
Risk Management: - Areas: Liquidity, Asset Management, Liability Management, and Capital Adequacy.
Capital Adequacy Trade-off: - High capital makes a bank safer and more resistant to write-offs but lowers the Return on Equity ( $ROE$ ) ( $ROE = \frac{\text{Net Profits}}{\text{Equity Capital}}$ ). - Regulators prefer high capital; greedy shareholders prefer low capital for higher returns.

Mortgage Markets and Financial Crisis

Securitization: - Pooling mortgages to provide diversification benefits. - Ginnie Mae: Government-owned; insured/safe. - Freddie Mac: Government Sponsored Entity ( $GSE$ ). Introduced Collateralized Mortgage Obligations (CMOs).
CDOs and Tranches: - Mortgage pools are sliced into sections called "tranches" based on risk and duration. - These became overly complex and opaque leading up to the crisis.
Subprime Crisis Contributors: - NINJA Loans: No Income, No Job, No Assets. - No-Doc Loans: No verification of income/assets. - Bubble Mechanics: High leverage and low initial payments that reset higher. Once housing prices stopped rising, mass defaults occurred.
Academic Framework: Crises occur when asymmetric information and financial frictions increase, gumming up the flow of information. - Stage 1: Friction increase. - Stage 2: Lending freeze and economic decline. - Stage 3 (Great Depression): Debt deflation.

The Federal Reserve (The Fed)

Structure: - Board of Governors: Significant media focus. - Federal Open Market Committee (FOMC): Meets $8$ times a year to set policy.
Monetary Policy Regimes: - Limited Reserves (Pre-2008): Managed by shifting money supply via open market operations. - Ample Reserves (Current): Due to Quantitative Easing ( $QE$ ), supply is so high that the Fed uses the Interest on Reserve Balances ( $IORB$ ) to set the funds rate.
Independence: The Fed must stay independent to make long-term decisions without political pressure for low rates, which risks hyperinflation.
Monetary Policy Tools: 1. Open Market Operations. 2. Discount Rate Lending. 3. Reserve Requirements. 4. Interest on Reserve Balances ( $IORB$ ).
Acronym: INVEST: - Buying Securities = Expansionary. - Selling Securities = Tightening/Contractionary.
Dual Mandate: Price Stability and Maximum Employment.

Advanced Regulation and Insurance

Regulation Types (Chapter 18): - Capital Requirements: Basel Accords (unfinalized after $25$ years). - CAMVIS: Charter examination acronym. - Value at Risk (VAR): Standard industry tool for assessing risk.
Legislation: - Sarbanes-Oxley Act (2002): Focused on financial statement disclosure quality. - Dodd-Frank Reform (2010): Post-crisis broad reform; includes the Volcker Rule (limiting risky activities) and derivatives regulation.
Insurance: - Term Life: Temporary, insurance coverage only, terminates after a period. - Whole Life: For late life, includes a cash value account. - Annuities: Longevity insurance; a guaranteed income stream for life.
Pensions: - Defined Benefit (DB): Employer bears investment risk; guaranteed payment. - Defined Contribution (DC): Employee bears investment risk; employee manages the account.
Social Security: The largest public pension fund.

Questions & Discussion

Question: Why not pop all bubbles?
Response: The "Greenspan Doctrine" states bubbles are hard to identify. Asset bubbles (like the $2000$ tech bubble) cause pain but not calamity, unlike credit-driven bubbles (like the $2008$ mortgage crisis) which are systemic and painful.
Question: Who were the winners/losers of the Big Short?
Response: Slimy bankers sold Credit Default Swaps ( $CDS$ ) while little investors saw the corruption and profited from the collapse. The film illustrates how $CDS$ became gambling without insurable interest, likened to a blackjack game where bystanders bet on the players.
Concluding Remarks: Professor expressed gratitude to the class, mentioned that Chapter 5 is for informational benefit only and will not be on the final exam. Kevin Walsh is predicted to be confirmed as the next Fed Chairman relatively quickly.