Slides - Principles of Financial Markets PDF

PRINCIPLES
OF FINANCIAL MARKETS
Instructor: Phu Hoang-Tho
phuht@uel.edu.vn
Course Goals
Level of
Goals Descriptions
competence
Students shall be able to comprehend
G1 and apply knowledge of financial 4
system and financial institutions.
Students shall be able to analyze,
synthesize and assess problems
G2 relating to financial markets, financial 4
institutions, interest rates and foreign
exchanges.
Students shall be able to apply
G3 teamwork skills and critical thinking to 4
solve problems in finance.
Course Learning Outcomes

Teach.
CLOs Descriptions
Modes
G1.1 Understand financial system T
G1.2 Apply interest rates and foreign exchanges T, U
G2.1 Possess knowledge of financial institutions T
Able to analyze, synthesize and assess
G2.2 problems relating to financial markets, financial T, U
institutions, interest rates and foreign exchanges
Establish, organize, collaborate and manage
G3.1 U
team
G3.2 Discuss, debate and criticize in groups U
Analyze, synthesize, report and present in
G3.3 U
groups.
1
Course Assessment
Assessment
Assessment Components %
Types
A1.1 Participation (Activeness, attitude
during lessons; Bonus points 5%
A1. Ongoing accumulated through the course)
assessment
A1.2 Exercise 10%
A1.3 Group assignment 15%
A2. Mid-term Open personal written essay and/or
20%
exam Tests
Multiple choices test, including some
A3. Final difficult questions to test critical thinking,
50%
exam analysis and synthesis problems ability.
Total time: 60 minutes.
Course Content
No.
Content Periods
session
An overview of the financial
1,2 Lesson 1 6
system
3,4,5 Lesson 2 Financial Institutions 9
6 Lesson 3 Basic of money 3
Central Banking and the
7 Lesson 4 3
Conduct of Monetary Policy
8,9,10,11 Lesson 5 Understanding interest rates 12
12 Lesson 6 Theory of Asset Demand 3
13,14.15 Lesson 7 The Foreign Exchange Market 9
Text Book
1. F. S Mishkin The Economics
of Money, Banking and
Financial Markets (9 ed.) –
Addison-Wesley, 2010
2. Lloyd B. Thomas Money,
Banking and Financial
Markets – Thomson, 2006
3. Website: www.investorwords.com
2
The process of learning
• If you read (or hear) something, you
will know it.
• If you write it down you will remember
it.
• If you can explain it to someone else
you will understand it.
Q&A
3
Lesson 1A
(Chapter 1)
Why Study
Money, Banking,
and Financial
Markets?
Why Study Money, Banking, and

Financial Markets
• To examine how financial markets

such as bond, stock and foreign
exchange markets work
• To examine how financial institutions
such as banks and insurance
companies work
• To examine the role of money in
the economy
Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-11
Financial Markets
• Markets in which funds are transferred

from people who have an excess of
available funds to people who have a
shortage of funds
4
The Bond Market and Interest Rates
• A security (financial instrument) is a

claim on the issuer’s future income
or assets
• A bond is a debt security that promises
to make payments periodically for a
specified period of time
• An interest rate is the cost of borrowing
or the price paid for the rental of funds
The Stock Market
• Common stock represents a share of

ownership in a corporation
• A share of stock is a claim on the
earnings and assets of the corporation
5
The Foreign Exchange Market
• The foreign exchange market is where

funds are converted from one currency
into another
• The foreign exchange rate is the
price of one currency in terms of
another currency
• The foreign exchange market
determines the foreign exchange rate
6
Banking and Financial Institutions
• Financial Intermediaries—institutions that

borrow funds from people who have saved
and make loans to other people
• Banks—institutions that accept deposits and
make loans
• Other Financial Institutions—insurance
companies, finance companies, pension
funds, mutual funds and investment banks
• Financial Innovation—in particular, the advent
of the information age and e-finance
Money and Business Cycles
• Evidence suggests that money

plays an important role in generating
business cycles
• Recessions (unemployment) and booms
(inflation) affect all of us
• Monetary Theory ties changes in the
money supply to changes in aggregate
economic activity and the price level
7
Money and Inflation
• The aggregate price level is the

average price of goods and services in
an economy
• A continual rise in the price level
(inflation) affects all economic players
• Data shows a connection between the
money supply and the price level
8
Money and Interest Rates
• Interest rates are the price of money

• Prior to 1980, the rate of money growth
and the interest rate on long-term
Treasure bonds were closely tied
• Since then, the relationship is less clear
but still an important determinant of
interest rates
Monetary and Fiscal Policy
• Monetary policy is the management of the

money supply and interest rates
 Conducted in the U.S. by the Federal Reserve
Bank (Fed)
• Fiscal policy is government spending
and taxation
 Budget deficit is the excess of expenditures over
revenues for a particular year
 Budget surplus is the excess of revenues over
expenditures for a particular year
 Any deficit must be financed by borrowing
9
How We Will Study Money, Banking,

and Financial Markets
• A simplified approach to the demand
for assets
• The concept of equilibrium
• Basic supply and demand to explain behavior
in financial markets
• The search for profits
• An approach to financial structure based on
transaction costs and asymmetric information
• Aggregate supply and demand analysis
10
Lesson 1B
(Chapter 2)
An Overview
of the Financial
System
11
Function of Financial Markets
• Perform the essential function of channeling

funds from economic players that have
saved surplus funds to those that have a
shortage of funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production
• Directly improve the well-being of consumers
by allowing them to time purchases better
Structure of Financial Markets
• Debt and Equity Markets

• Primary and Secondary Markets
 Investment Banks underwrite securities in primary markets
 Brokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets

• Money and Capital Markets
 Money markets deal in short-term debt instruments
 Capital markets deal in longer-term debt and
equity instruments
12
Internationalization
of Financial Markets
• Foreign Bonds—sold in a foreign country and
denominated in that country’s currency
• Eurobond—bond denominated in a currency
other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited
in banks outside the home country
 Eurodollars—U.S. dollars deposited in foreign
banks outside the U.S. or in foreign branches of
U.S. banks
• World Stock Markets
13
Function of Financial Intermediaries:
Indirect Finance
• Lower transaction costs
 Economies of scale
 Liquidity services
• Reduce Risk
 Risk Sharing (Asset Transformation)
 Diversification
• Asymmetric Information
 Adverse Selection (before the transaction)—more likely to
select risky borrower
 Moral Hazard (after the transaction)—less likely borrower will
repay loan
14
Regulation of the Financial System
• To increase the information available to investors:

 Reduce adverse selection and moral hazard problems
 Reduce insider trading
• To ensure the soundness of financial intermediaries:
 Restrictions on entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition
 Restrictions on Interest Rates
15
Lesson 2A
(Chapter 8)
An Economic
Analysis of
Financial Structure
16
Eight Basic Facts
1. Stocks are not the most important sources of

external financing for businesses
2. Issuing marketable debt and equity securities
is not the primary way in which businesses
finance their operations
3. Indirect finance is many times more important
than direct finance
4. Financial intermediaries are the most
important source of external funds
Eight Basic Facts (cont’d)
5. The financial system is among the most

heavily regulated sectors of the economy
6. Only large, well-established corporations
have easy access to securities markets to
finance their activities
7. Collateral is a prevalent feature of
debt contracts
8. Debt contracts are extremely complicated
legal documents that place substantial
restrictive covenants on borrowers
Transaction Costs
• Financial intermediaries have evolved to

reduce transaction costs
 Economies of scale
 Expertise
17
Asymmetric Information
• Adverse selection occurs before

the transaction
• Moral hazard arises after the transaction
• Agency theory analyses how
asymmetric information problems affect
economic behavior
Adverse Selection:
The Lemons Problem
• If quality cannot be assessed, the buyer is
willing to pay at most a price that reflects the
average quality
• Sellers of good quality items will not want to
sell at the price for average quality
• The buyer will decide not to buy at all because
all that is left in the market is poor quality items
• This problem explains fact 2 and partially
explains fact 1
Adverse Selection: Solutions
• Private production and sale of information

 Free-rider problem
• Government regulation to increase information

 Fact 5
• Financial intermediation
 Facts 3, 4, & 6
• Collateral and net worth

 Fact 7
18
Moral Hazard in Equity Contracts
• Called the Principal-Agent Problem

• Separation of ownership and control
of the firm
 Managers pursue personal benefits and
power rather than the profitability of the firm
Principal-Agent Problem: Solutions
• Monitoring (Costly State Verification)

 Free-rider problem
 Fact 1
• Government regulation to increase information
 Fact 5
• Financial Intermediation
 Fact 3
• Debt Contracts
 Fact 1
Moral Hazard in Debt Markets
• Borrowers have incentives to take on

projects that are riskier than the lenders
would like
19
Moral Hazard: Solutions
• Net worth and collateral

 Incentive compatible
• Monitoring and Enforcement of Restrictive
Covenants
 Discourage undesirable behavior
 Encourage desirable behavior
 Keep collateral valuable
 Provide information
• Financial Intermediation
 Facts 3 & 4
Conflicts of Interest
• Type of moral hazard problem caused by economies

of scope
• Arise when an institution has multiple objectives and,
as a result, has conflicts between those objectives
• A reduction in the quality of information in financial
markets increases asymmetric information problems
• Financial markets do not channel funds into productive
investment opportunities
• The economy is not as efficient as it could be
20
Why Do Conflicts of Interest Arise?
• Underwriting and Research in

Investment Banking
 Information produced by researching companies is
used to underwrite the securities. The bank is
attempting to simultaneously serve two client
groups whose information needs differ.
 Spinning occurs when an investment bank
allocates hot, but underpriced, IPOs to executives
of other companies in return for their companies’
future business
Why Do Conflicts
of Interest Arise? (cont’d)
• Auditing and Consulting in Accounting Firms

 Auditors may be willing to skew their judgments
and opinions to win consulting business
 Auditors may be auditing information systems or
tax and financial plans put in place by their
nonaudit counterparts
 Auditors may provide an overly favorable audit to
solicit or retain audit business
Conflicts of Interest: Remedies
• Sarbanes-Oxley Act of 2002 (Public

Accounting Return and Investor
Protection Act)
 Increases supervisory oversight to monitor and
prevent conflicts of interest
 Establishes a Public Company Accounting
Oversight Board
 Increases the SEC’s budget
 Makes it illegal for a registered public accounting
firm to provide any nonaudit service to a client
contemporaneously with an impermissible audit
21
Conflicts of Interest:
Remedies (cont’d)
• Sarbanes-Oxley Act of 2002 (cont’d)

 Beefs up criminal charges for white-collar
crime and obstruction of official
investigations
 Requires the CEO and CFO to certify
that financial statements and disclosures
are accurate
 Requires members of the audit committee
to be independent
Conflicts of Interest:
Remedies (cont’d)
• Global Legal Settlement of 2002
 Requires investment banks to sever the link
between research and securities underwriting
 Bans spinning
 Imposes $1.4 billion in fines on accused
investment banks
 Requires investment banks to make their analysts’
recommendations public
 Over a 5-year period, investment banks are
required to contract with at least 3 independent
research firms that would provide research to their
brokerage customers
Financial Crises
and Aggregate Economic Activity
• Crises can be caused by:

 Increases in interest rates
 Increases in uncertainty
 Asset market effects on balance sheets
 Problems in the banking sector
 Government fiscal imbalances
22
Lesson 2B
(Chapter 9)
Banking and
the Management
of Financial
Institutions
23
Basic Banking—Cash Deposit
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100

Cash deposits deposits
• Opening of a checking account leads to an

increase in the bank’s reserves equal to the
increase in checkable deposits
Basic Banking—Check Deposit
First National Bank When a bank receives

Assets Liabilities additional deposits, it
Cash items +$100 Checkable +$100 gains an equal amount of reserves;
in process deposits when it loses deposits,
of collection
it loses an equal amount of reserves
First National Bank Second National Bank

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits
24
Basic Banking—Making a Profit
First National Bank Second National Bank

Required +$100 Checkable +$100 Required +$100 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves
• Asset transformation-selling liabilities with one set of

characteristics and using the proceeds to buy assets
with a different set of characteristics
• The bank borrows short and lends long
Bank Management
• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
Liquidity Management:
Ample Excess Reserves

Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M
• If a bank has ample excess reserves, a

deposit outflow does not necessitate changes
in other parts of its balance sheet
25
Shortfall in Reserves

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M
• Reserves are a legal requirement and the

shortfall must be eliminated
• Excess reserves are insurance against the
costs associated with deposit outflows
Liquidity Management: Borrowing
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
• Cost incurred is the interest rate paid on the

borrowed funds
Securities Sale
Assets Liabilities
Loans $90M Bank Capital $10M
Securities $1M
• The cost of selling securities is the brokerage

and other transaction costs
26
Federal Reserve
Assets Liabilities
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M
• Borrowing from the Fed also incurs interest

payments based on the discount rate
Liquidity Management: Reduce Loans
Assets Liabilities
Loans $81M Bank Capital $10M
Securities $10M
• Reduction of loans is the most costly way of

acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a
substantial discount
Asset Management: Three Goals
• Seek the highest possible returns on

loans and securities
• Reduce risk
• Have adequate liquidity
27
Asset Management: Four Tools
• Find borrowers who will pay high

interest rates and have low possibility
of defaulting
• Purchase securities with high returns
and low risk
• Lower risk by diversifying
• Balance need for liquidity against
increased returns from less liquid assets
Liability Management
• Recent phenomenon due to rise of

money center banks
• Expansion of overnight loan markets and
new financial instruments (such as
negotiable CDs)
• Checkable deposits have decreased in
importance as source of bank funds
Capital Adequacy Management
• Bank capital helps prevent bank failure

• The amount of capital affects return for
the owners (equity holders) of the bank
• Regulatory requirement
28
Capital Adequacy Management:
Preventing Bank Failure When
Assets Decline
High Bank Capital Low Bank Capital

Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital

Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
Capital Adequacy Management:

Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
 
equity capital assets equity capital
ROE = ROA  EM
Capital Adequacy
Management: Safety
• Benefits the owners of a bank by making

their investment safe
• Costly to owners of a bank because the
higher the bank capital, the lower the
return on equity
• Choice depends on the state of the
economy and levels of confidence
29
Credit Risk: Overcoming Adverse
Selection and Moral Hazard
• Screening and information collection
• Specialization in lending
• Monitoring and enforcement of
restrictive covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
Interest-Rate Risk
First National Bank

Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
• If a bank has more rate-sensitive liabilities than assets, a rise in

interest rates will reduce bank profits and a decline in interest
rates will raise bank profits
Interest Rate Risk: Gap Analysis

Basic Gap Analysis:
(rate-sensitive assets  rate sensitive liabilities)

  interest rates =  in bank profits
Maturity Bucket Approach

measures the gap for several maturity subintervals
Standardized Gap Analysis
accounts for differing degrees of rate sensitivity
30
Interest Rate Risk: Duration Analysis
Duration Analysis:
% market value of security 

percentage point  interest rate  duration in years
Uses the weighted average duration of

a financial institution's assets and of its liabilities
to see how net worth responds to a change in
interest rates
Off-Balance-Sheet Activities
• Loan sales (secondary loan

participation)
• Generation of fee income
• Trading activities and risk management
techniques
 Futures, options, interest-rate swaps,
foreign exchange
 Speculation
Off-Balance-Sheet Activities (cont’d)
• Trading activities and risk management

techniques (cont’d)
 Principal-agent problem
 Internal Controls
• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk
• Stress testing
31
Lesson 2C
(Chapter 10)
Banking Industry:
Structure and
Competition
Evolution of the Banking Industry
• Financial innovation is driven by the desire

to earn profits
• A change in the financial environment will
stimulate a search by financial institutions for
innovations that are likely to be profitable
 Responses to change in demand conditions
 Responses to changes in supply conditions
 Avoidance of regulations
32
U.S. Has a Dual Banking System
• State banks chartered by state

governments
• National banks chartered by federal
government beginning in 1863
Primary Supervisory Responsibility of

Bank Regulatory Agencies
• Comptroller of the Currency—national banks
• Federal Reserve and state banking
authorities—state banks that are members
of the Federal Reserve System
• Fed also regulates bank holding companies
• FDIC—insured state banks that are not
Fed members
• State banking authorities—state banks without
FDIC insurance
Responses to Changes in Demand

Conditions: Interest Rate Volatility
• Adjustable-rate mortgages
 Flexible interest rates keep profits high
when rates rise
 Lower initial interest rates make them
attractive to home buyers
• Financial Derivatives
 Ability to hedge interest rate risk
 Payoffs are linked to previously
issued securities
33
Responses to Changes in Supply
Conditions: Information Technology
• Bank credit and debit cards
 Improved computer technology lowers the transaction costs
• Electronic banking
 ATM
 Home banking
 ABM
 Virtual banking
• Junk bonds
• Commercial paper market
• Securitization
Avoidance of Regulations:
Loophole Mining
• Reserve requirements act as a tax

on deposits
 Sweep accounts
• Restrictions on interest paid on deposits

led to disintermediation
 Money market mutual funds
Decline of Traditional Banking
• As a source of funds for borrowers,

market share has fallen
• Share of total financial intermediary
assets has fallen
• No decline in overall profitability
• Increase in income from off-balance-
sheet activities
34
Decline of Traditional Banking
• Decline in cost advantages in acquiring funds

(liabilities)
 Rising inflation led to rise in interest rates and
disintermediation
 Low-cost source of funds, checkable deposits, declined in
importance
• Decline in income advantages on uses of funds
(assets)
 Information technology has decreased need for banks to
finance short-term credit needs or to issue loans
 Information technology has lowered transaction costs for
other financial institutions, increasing competition
Banks’ Responses
• Expand into new and riskier areas

of lending
 Commercial real estate loans
 Leveraged buyouts
 Corporate takeovers
• Pursue off-balance-sheet activities
 Non-interest income
 Concerns about risk
35
Branching
• McFadden Act and state branching

regulations prohibited branching across
state lines and forced all national banks
to conform to the branching regulations
of the state in which they were located
• Bank holding companies and automated
teller machines are responses to
these regulations
36
Bank Consolidation
• The number of banks has declined over the

last 25 years
 Bank failures
 Consolidation
 Deregulation—Riegle-Neal Interstate Banking
and Branching Efficiency Act of 1994
 Economies of scale and scope from
information technology
• Results may be not only a smaller number
of banks but a shift in assets to much
larger banks
Benefits and Costs

of Bank Consolidation
• Benefits
 Increased competition, driving inefficient banks out
of business
 Increased efficiency also from economies of scale and scope
 Lower probability of bank failure from more diversified
portfolios
• Costs
 Elimination of community banks may lead to less lending to
small business
 Banks expanding into new areas may take increased risks
and fail
37
Separation of Banking and Other
Financial Services
• Glass-Steagall Act of 1933

 Prohibited commercial banks from underwriting
corporate securities or engaging in
brokerage activities
 Section 20 loophole was allowed by the Federal
Reserve enabling affiliates of approved commercial
banks to underwrite securities as long as the
revenue did not exceed a specified amount
 U.S. Supreme Court validated the Fed’s action
in 1988
Separation of Banking and Other

Financial Services (cont’d)
• Gramm-Leach-Bliley Financial Services

Modernization Act of 1999
 Abolishes Glass-Steagall
 States regulate insurance activities
 SEC keeps oversight of securities activities
 Office of the Comptroller of the Currency
regulates bank subsidiaries engaged in
securities underwriting
 Federal Reserve oversees bank holding companies
Three Basic World Frameworks
• Universal banking
 No separation between banking and
securities industries
• British-style universal banking
 May engage in security underwriting
• Separate legal subsidiaries are common
• Bank equity holdings of commercial firms are
less common
• Few combinations of banking and
insurance firms
38
Three Basic
World Frameworks (cont’d)
• Some legal separation
 Allowed to hold substantial equity stakes in
commercial firms but holding companies are illegal
Thrift Industry:
Regulation and Structure
• Savings and Loan Associations
 Chartered by the federal government or by states
 Most are members of Federal Home Loan Bank
System (FHLBS)
 Deposit insurance provided by Savings Association Insurance
Fund (SAIF), part of FDIC
 Regulated by the Office of Thrift Supervision
• Mutual Banks
 Approximately half are chartered by states
 Regulated by state in which they are located
 Deposit insurance provided by FDIC or state insurance
Thrift Industry:
Regulation and Structure (cont’d)
• Credit Unions
 Tax-exempt
 Chartered by federal government or by states
 Regulated by the National Credit Union
Administration (NCUA)
 Deposit insurance provided by National Credit
Union Share Insurance Fund (NCUSIF)
39
International Banking
• Rapid growth
 Growth in international trade and
multinational corporations
 Global investment banking is very profitable
 Ability to tap into the Eurodollar market
Eurodollar Market
• Dollar-denominated deposits held in

banks outside of the U.S.
• Most widely used currency in
international trade
• Offshore deposits not subject
to regulations
• Important source of funds for U.S. banks
Structure of U.S. Banking Overseas
• Shell operation
• Edge Act corporation
• International banking facilities (IBFs)
 Not subject to regulation and taxes
 May not make loans to domestic residents
40
Foreign Banks in the U.S.
• Agency office of the foreign bank

 Can lend and transfer fund in the U.S.
 Cannot accept deposits from
domestic residents
 Not subject to regulations
• Subsidiary U.S. bank
 Subject to U.S. regulations
 Owned by a foreign bank
Foreign Banks in the U.S. (cont’d)
• Branch of a foreign bank

 May open branches only in state designated as
home state or in state that allow entry of out-of-
state banks
 Limited-service may be allowed in any other state
• Subject to the International Banking Act
of 1978
• Basel Accord (1988)
 Example of international coordination of
bank regulation
 Sets minimum capital requirements for banks
41
Lesson 2D
(Chapter 11)
Economic
Analysis of
Banking
Regulation
Asymmetric Information
and Bank Regulation
• Government safety net: Deposit insurance and
the FDIC
 Short circuits bank failures and contagion effect
 Payoff method
 Purchase and assumption method
• Moral Hazard
 Depositors do not impose discipline of marketplace
 Banks have an incentive to take on greater risk
• Adverse Selection
 Risk-lovers find banking attractive
 Depositors have little reason to monitor bank
Too Big to Fail
• Government provides guarantees of

repayment to large uninsured creditors
of the largest banks even when they are
not entitled to this guarantee
• Uses the purchase and assumption
method
• Increases moral hazard incentives for
big banks
42
Financial Consolidation
• Larger and more complex banking

organizations challenge regulation
 Increased “too big to fail” problem
 Extends safety net to new activities,
increasing incentives for risk taking in
these areas
Restrictions on Asset Holding

and Bank Capital Requirements
• Attempts to restrict banks from too much

risk taking
 Promote diversification
 Prohibit holdings of common stock
 Set capital requirements
• Minimum leverage ratio
• Basel Accord: risk-based capital requirements
• Regulatory arbitrage
Bank (Prudential) Supervision:

Chartering and Examination
• Chartering (screening of proposals to open new
banks) to prevent adverse selection
• Examinations (scheduled and unscheduled) to monitor
capital requirements and restrictions on asset holding
to prevent moral hazard
 Capital adequacy
 Asset quality
 Management
 Earnings
 Liquidity
 Sensitivity to market risk
• Filing periodic ‘call reports’
43
Assessment of Risk Management
• Greater emphasis on evaluating soundness of

management processes for controlling risk
• Trading Activities Manual of 1994 for risk management
rating based on
 Quality of oversight provided
 Adequacy of policies and limits
 Quality of the risk measurement and monitoring systems
 Adequacy of internal controls
• Interest-rate risk limits
 Internal policies and procedures
 Internal management and monitoring
 Implementation of stress testing and Value-at risk (VAR)
Disclosure Requirements
• Requirements to adhere to standard

accounting principles and to disclose
wide range of information
• Eurocurrency Standing Committee of the
G-10 Central Banks also recommends
estimates of financial risk generated by
the firm’s internal monitoring system be
adapted for public disclosure
Consumer Protection
• Truth-in-lending mandated under the

Consumer Protection Act of 1969
• Fair Credit Billing Act of 1974
• Equal Credit Opportunity Act of 1974,
extended in 1976
• Community Reinvestment Act
44
Restrictions on Competition
• Justified by moral hazard incentives to

take on more risk as competition
decreases profitability
 Branching restrictions (eliminated in 1994)
 Glass-Steagall Act (repeated in 1999)
• Disadvantages
 Higher consumer charges
 Decreased efficiency
45
International Banking Regulation
• Similar to U.S.
 Chartered and supervised
 Deposit insurance
 Capital requirement
• Particular problems
 Easy to shift operations from one country
to another
 Unclear jurisdiction lines
Regulation
• Applies to a moving target

 Calls for resources and expertise
• Details are important
• Political pressures
46
1980s S&L and Banking Crisis
• Financial innovation and new financial

instruments increasing risk taking
• Increased deposit insurance led to
increased moral hazard
• Deregulation
 Depository Institutions Deregulation and
Monetary Control Act of 1980
 Depository Institutions Act of 1982
1980s S&L
and Banking Crisis (cont’d)
• Managers did not have expertise in
managing risk
• Rapid growth in new lending, real estate
in particular
• Activities expanded in scope; regulators at
FSLIC did not have expertise or resources
• High interest rates and recession increased
incentives for moral hazard
47
1980s S&L and Banking Crisis:
Later Stages
• Regulatory forbearance by FSLIC
 Insufficient funds to close insolvent S&Ls
 Established to encourage growth
 Did not want to admit agency was in trouble
• Zombie S&Ls taking on high risk projects and
attracting business from healthy S&Ls
• Competitive Equality in Banking Act of 1987
 Inadequate funding
 Continued forbearance
Principal-Agent Problem
for Regulators and Politicians
• Agents for voters-taxpayers
• Regulators
 Wish to escape blame (bureaucratic gambling)
 Want to protect careers
 Passage of legislation to deregulate
 Shortage of funds and staff
• Politicians
 Lobbied by S&L interests
 Necessity of campaign contributions for expensive
political races
The Financial Institutions Reform,

Recovery, and Enforcement Act of 1989
• Regulatory apparatus restructured

 Federal Home Loan Bank Board relegated
to the OTS
 FSLIC given to the FDIC
 RTC established to manage and resolve
insolvent thrifts
• Cost of the bailout approximately $150 billion
• Re-restricted asset choices
48
The Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (cont’d)
• Increased core-capital leverage requirements

• Imposed same risk-based capital standards as
those on commercial banks
• Enhanced enforcement powers of regulators
• Did not focus on underlying moral hazard and
adverse selection problems
Federal Deposit Insurance

Corporation Improvement Act of 1991
• Recapitalize the Bank Insurance Fund
 Increase ability to borrow from the Treasury
 Higher deposit insurance premiums until the loans
could be paid back and reserves of 1.25% of
insured deposits maintained
• Reform the deposit insurance and regulatory
system to minimize taxpayer losses
 Too-big-to-fail policy substantially limited
 Prompt corrective action provisions
 Risk-based insurance premiums
49
50
Deja Vu
• It is the existence of a government safety

net that increases moral hazard
incentives for excessive risk taking on
the part of banks
Lesson 3
(Chapter 3)
What Is Money?
Meaning of Money
• Money (money supply)—anything that is

generally accepted in payment for goods
or services or in the repayment of debts;
a stock concept, not the same with
wealth (stock) or income (flow)
• Wealth—the total collection of pieces of
property that serve to store value
• Income—flow of earnings per unit
of time
51
Functions of Money
• Medium of Exchange—promotes economic efficiency

by minimizing the time spent in exchanging goods
and services
 Must be easily standardized
 Must be widely accepted
 Must be divisible
 Must be easy to carry
 Must not deteriorate quickly
• Unit of Account—used to measure value in
the economy
 # of trading ratios under a barter system = N x (N-1) / 2
• Store of Value—used to save purchasing power; most
liquid of all assets but loses value during inflation
• Standard of deferred payments
Evolution of the Payments System
• Commodity Money (precious metals:

gold and silver…)
• Paper Currency (fiat money)
• Checks
• Electronic Payment
• E-Money (Debit cards, Stored-value
cards, Smart cards, E-cash…)
Stocks vs. Flows

Flow Stock
More examples:
stock flow
a person’s wealth a person’s saving
# of people with # of new college
college degrees graduates
the govt. debt the govt. budget deficit
52
M1
• M1 = narrowest definition of money

supply, containing only those items that
satisfy the definition of money
• M1 = Currency + travelers’ checks
+demand deposits + other checkable
deposits
• Credit cards? Not money.
M2 and M3
• M2 = M1 + small-denomination time
deposits and repurchase agreements +
savings deposit balances +
Noninstitutional money market mutual
fund shares
• M3 = M2 + large-denomination time
deposits and repurchase agreements +
institution-only money market mutusal
fund shares + Eurodollars
53
How Reliable are the Money Data?
• Revisions are issued because:

 Small depository institutions report infrequently
 Adjustments must be made for seasonal variation
• We probably should not pay much attention to

short-run movements in the money supply
numbers, but should be concerned only with
longer-run movements
54
Lesson 4A
(Chapter 12)
Structure of
Central Banks
and the Federal
Reserve System
Origins of
the Federal Reserve System
• Resistance to establishment of a central bank
 Fear of centralized power
 Distrust of moneyed interests
• First U.S. experiments with a central bank terminated
in 1811 and in 1836
• No lender of last resort
 Nationwide bank panics on a regular basis
 Panic of 1907 so severe that the public was convinced a
central bank was needed
• Federal Reserve Act of 1913
 Elaborate system of checks and balances
 Decentralized
55
Federal Reserve District Banks
• Quasi-public institution owned by private commercial

banks in the district that are members of the
Fed system
• One main bank in each district, total of 12 district
banks
• Federal Reserve Bank of NY – holds 25% of Fed’s
assets
• Federal Reserve Banks of New York, Chicago, and
San Francisco hold over 50% of the Fed’s assets
• In each district bank, the nine (class A, B, and C)
directors appoint the president of the district bank
subject to approval by Board of Governors
• Federal Reserve District Bank Directors:

 Member banks elect six directors (A and B) for
each district; three (C) more are appointed by the
Board of Governors
 Three A directors are professional bankers
 Three B directors are prominent leaders from
industry, labor, agriculture, or consumer sector
 Three C directors appointed by the Board of
Governors
are not allowed to be officers, employees, or
stockholders
of banks
 Designed to reflect all constituencies of the public
56
Functions of
the Federal Reserve District Banks
• Clear checks
• Issue new currency
• Withdraw damaged currency from circulation
• Administer and make discount loans to banks in their
districts
• Evaluate proposed mergers and applications for banks
to expand their activities
• Act as liaisons between business community and the
Fed
• Collect data on business conditions
• Conduct economic research
Functions of
the Federal Reserve Banks (cont’d)
• Act as liaisons between the business
community and the Federal Reserve System
• Examine bank holding companies and state-
chartered member banks
• Collect data on local business conditions
• Use staffs of professional economists to
research topics related to the conduct of
monetary policy

and Monetary Policy
• Directors “establish” the discount rate in their
region (role taken over by the Board of Governors)
• Decide which banks can obtain discount loans
• Directors select one commercial banker from each
district to serve on the Federal Advisory Council
which consults with the Board of Governors and
provides information to help conduct monetary
policy
• FRB of New York and other four of the rest 11
FRB presidents have a vote on the Federal Open
Market Committee (FOMC)
57
Member Banks
• All national banks are required to be members

• Commercial banks chartered by states are not
required but may choose to be members
• Depository Institutions Deregulation and
Monetary Control Act of 1980
 subject all banks to the same reserve requirements
as member banks
 gave all banks access to Federal Reserve facilities,
e.g., discount loans and Fed check clearing
Board of Governors
• Seven members headquartered in Washington,
D.C.
• Appointed by the president and confirmed by
the Senate
• 14-year non-renewable term
• Required to come from different districts
• Chairman is chosen from the governors and
serves four-year term
Duties of the Board of Governors
• Votes on conduct of open market operations

• Sets reserve requirements
• Sets margin requirements
• Controls the discount rate through “review and
determination” process
• Sets salaries of president and officers of each
Federal Reserve Bank and reviews each
bank’s budget
58
Duties of the Board of Governors
• Approves bank mergers and applications for new

activities
• Supervises and regulates the banking system
• Specifies the permissible activities of bank holding
companies
• Supervises the activities of foreign banks
operating in the U.S.
• Over time, the power to conduct monetary policy
has been centralized in the Board of Governors.
Chairman of the Board of Governors
• Advises the president on

economic policy
• Testifies in Congress
• Speaks for the Federal Reserve System
to the media
• May represent the U.S. in negotiations
with foreign governments on
economic matters
Federal Open Market Committee (FOMC)
• Meets eight times a year

• 12-member consists of seven members of the
Board of Governors, the president of the
Federal Reserve Bank of New York and the
presidents of four other Federal Reserve
banks
• Chairman of the Board of Governors is also
chair of FOMC
• Issues directives to the trading desk at the
Federal Reserve Bank of New York
59
FOMC Meeting
• Report by the manager of system open market

operations on foreign currency and domestic open
market operations and other related issues
• “Green Book” forecast
 Go-round
• Current monetary policy and domestic policy directive
 “Blue book”
• Presentation on relevant Congressional actions
• Public announcement about the outcome of
the meeting
Chairman Runs the Show
• Spokesperson for the Fed and

negotiates with Congress and
the President
• Sets the agenda for meetings
• Speaks and votes first about
monetary policy
• Supervises professional economists
and advisers
60
How Independent is the Fed?
• Instrument independent
• Goal independent
• Independent revenue
• Structured by legislation from Congress and
accountable for its actions
• Presidential influence
 Influence on Congress
 Appoints members
 Appoints chairman although terms are
not concurrent
European Central Bank
• Patterned after the Federal Reserve

• Central banks from each country play
similar role as Fed banks
• Executive Board
 President, vice-president and four
other members
 Eight year, nonrenewable terms
• Governing Council
Differences
• National Central Banks control their own

budgets and the budget of the ECB
• Monetary operations are not centralized
• Does not supervise and regulate
financial institutions
61
Governing Council
• Monthly meetings at ECB in

Frankfurt, Germany
• Twelve National Central Bank heads and
six Executive Board members
• Operates by consensus
• ECB announces the target rate and takes
questions from the media
• To stay at a manageable size as new
countries join, the Governing Council will
be on a system of rotation
ECB Independence
• Most independent in the world

• Long terms
• Determines own budget
• Less goal independent
 Price stability
• Charter cannot by changed by legislation;
only by revision of the Maastricht Treaty
Central Bank Behavior
• Theory of bureaucratic behavior—

objective is to maximize its own welfare
which is related to power and prestige
 Fight vigorously to preserve autonomy
 Avoid conflict with more powerful groups
• Does not rule out altruism
62
Case for Independence
• Political pressure would impart an inflationary

bias to monetary policy
• Political business cycle
• Could be used to facilitate Treasury financing
of large budget deficits—accommodation
• Too important to leave to politicians—the
principal-agent problem is worse for politicians
Case Against Independence
• Undemocratic
• Unaccountable
• Difficult to coordinate fiscal and
monetary policy
• Has not used its independence
successfully
Lesson 4B
(Chapter 15)
Tools of
Monetary Policy
63
Tools of Monetary Policy
• Open market operations

 Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves

 Affect the monetary base
• Changes in reserve requirements

 Affect the money multiplier
• Federal funds rate—the interest rate on overnight

loans of reserves from one bank to another
 Primary indicator of the stance of monetary policy
Demand in the Market for Reserves
• What happens to the quantity of reserves demanded,

holding everything else constant, as the federal funds
rate changes?
• Two components: required reserves and
excess reserves
 Excess reserves are insurance against deposit outflows
 The cost of holding these is the interest rate that could have
been earned
• As the federal funds rate decreases, the opportunity
cost of holding excess reserves falls and the quantity
of reserves demanded rises
• Downward sloping demand curve
Supply in the Market for Reserves
• Two components: non-borrowed and

borrowed reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing
from other banks
• If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow more and more
at id, and re-lend at iff
• The supply curve is horizontal (perfectly elastic) at id
64
Affecting the Federal Funds Rate
• An open market purchase causes the

federal funds rate to fall; an open market
sale causes the federal funds rate to
rise shifting the supply curve
• If the intersection of supply and demand
occurs on the vertical section of the
supply curve, a change in the discount
rate will have no effect on the federal
funds rate
Affecting
the Federal Funds Rate (cont’d)
• If the intersection of supply and demand
occurs on the horizontal section of the supply
curve, a change in the discount rate shifts that
portion of the supply curve and the federal
funds rate may either rise or fall depending on
the change in the discount rate
• When the Fed raises reserve requirement, the
federal funds rate rises and when the Fed
decreases reserve requirement, the federal
funds rate falls shifting the demand curve
65
66
Open Market Operations
• Dynamic open market operations

• Defensive open market operations
• Primary dealers
• TRAPS (Trading Room Automated
Processing System)
• Repurchase agreements
• Matched sale-purchase agreements
Advantages of
Open Market Operations
• The Fed has complete control over

the volume
• Flexible and precise
• Easily reversed
• Quickly implemented
Discount Policy
• Discount window
• Primary credit—standing lending facility
• Secondary credit
• Seasonal credit
• Lender of last resort to prevent
financial panics
 Creates moral hazard problem
67
Advantages and
Disadvantages of Discount Policy
• Used to perform role of lender of

last resort
• Cannot be controlled by the Fed; the
decision maker is the bank
• Discount facility is used as a backup
facility to prevent the federal funds rate
from rising too far above the target
Reserve Requirements
• Depository Institutions Deregulation and

Monetary Control Act of 1980 sets the
reserve requirement the same for all
depository institutions
• 3% of the first $48.3 million of checkable
deposits; 10% of checkable deposits over
$48.3 million
• The Fed can vary the 10% requirement
between 8% to 14%
68
Disadvantages
of Reserve Requirements
• No longer binding for most banks

• Can cause liquidity problems
• Increases uncertainty
• Recommendations to eliminate
The Channel/Corridor System
• Sets up a standing lending facility (lombard

facility) and stands ready to loan overnight any
amount banks ask for at a fixed interest rate
(lombard rate)
• The supply of reserves is infinitely elastic at
this interest rate
• Another standing facility is set up that pays
banks a fixed interest rate on any deposits
they would like to keep at the central bank
The Channel/Corridor System (cont’d)
• The supply of reserves is also infinitely

elastic at this interest rate
• In between these two interest rates
the quantity supplied is equal to the
non-borrowed reserves
• The demand curve has its usual
downward slope
69
Monetary Policy Tools

of the European Central Bank
• Open market operations

 Main refinancing operations
• Weekly reverse transactions
 Longer-term refinancing operations
• Lending to banks
 Marginal lending facility/marginal
lending rate
 Deposit facility
Monetary Policy Tools

of the European Central Bank (cont’d)
• Reserve Requirements
 2% of the total amount of checking deposits and
other short-term deposits
 Pays interest on those deposits so cost of
complying is low
70
Lesson 4C
(Chapter 16)
What Should
Central Banks Do?
Monetary Policy
Goals, Strategy,
and Tactics
The Price Stability Goal
• Low and stable inflation

• Inflation
 Creates uncertainty and difficulty in planning
for future
 Lowers economic growth
 Strains social fabric
• Nominal anchor
• Time-inconsistency problem
Other Goals of Monetary Policy
• High employment
• Economic growth
• Stability of financial markets
• Interest-rate stability
• Foreign exchange market stability
71
Should Price Stability be the
Primary Goal?
• In the long run there is no conflict

between the goals
• In the short run it can conflict with
the goals of high employment and
interest-rate stability
• Hierarchical mandate
• Dual mandate
Monetary Targeting
• Flexible, transparent, accountable

• Advantages
 Almost immediate signals help fix inflation
expectations and produce less inflation
 Almost immediate accountability
• Disadvantages
 Must be a strong and reliable relationship
between the goal variable and the targeted
monetary aggregate
Inflation Targeting I
• Public announcement of medium-term

numerical target for inflation
• Institutional commitment to price stability as
the primary, long-run goal of monetary policy
and a commitment to achieve the inflation goal
• Information-inclusive approach in which many
variables are used in making decisions
• Increased transparency of the strategy
• Increased accountability of the central bank
72
Inflation Targeting II
• Advantages
 Does not rely on one variable to achieve target
 Easily understood
 Reduces potential of falling in
time-inconsistency trap
 Stresses transparency and accountability
• Disadvantages
 Delayed signaling
 Too much rigidity
 Potential for increased output fluctuations
 Low economic growth during disinflation
73
Implicit Nominal Anchor
• Forward looking and preemptive

• Advantages
 Uses many sources of information
 Avoids time-inconsistency problem
 Demonstrated success
• Disadvantages
 Lack of transparency and accountability
 Strong dependence on the preferences, skills, and
trustworthiness of individuals in charge
 Inconsistent with democratic principles
74
Tactics:
Choosing the Policy Instrument
• Tools
 Open market operation
 Reserve requirements
 Discount rate
• Policy instrument (operating instrument)
 Reserve aggregates
 Interest rates
 May be linked to an intermediate target
• Interest-rate and aggregate targets
are incompatible
75
Criteria for
Choosing the Policy Instrument
• Observability and Measurability

• Controllability
• Predictable effect on Goals
The Taylor Rule, NAIRU,

and the Phillips Curve
Federal funds rate target =

inflation rate  equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
• An inflation gap and an output gap

 Stabilizing real output is an important concern
 Output gap is an indicator of future inflation as shown by
Phillips curve
• NAIRU
 Rate of unemployment at which there is no tendency for
inflation to change
76
Lesson 5A
(Chapter 4)
Understanding
Interest Rates
Present Value
• A dollar paid to you one year from now

is less valuable than a dollar paid to
you today
Discounting the Future
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10)2
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i )n
77
Simple Present Value
PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i ) n
Four Types
of Credit Market Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
Yield to Maturity
• The interest rate that equates the

present value of cash flow payments
received from a debt instrument with
its value today
78
Simple Loan—Yield to Maturity
PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
Fixed Payment Loan—

Yield to Maturity
The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =    ...+
1 + i (1 + i ) 2 (1 + i )3 (1 + i ) n
Coupon Bond—Yield to Maturity
Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=   . . . + 
1+i (1+i ) 2 (1+i )3 (1+i ) n (1+i ) n
79
• When the coupon bond is priced at its face value, the
yield to maturity equals the coupon rate
• The price of a coupon bond and the yield to maturity
are negatively related
• The yield to maturity is greater than the coupon rate
when the bond price is below its face value
Consol or Perpetuity
• A bond with no maturity date that does not repay

principal but pays fixed coupon payments forever
Pc  C / ic
Pc  price of the consol

C  yearly interest payment
ic  yield to maturity of the consol
Can rewrite above equation as ic  C / Pc
For coupon bonds, this equation gives current yieldÑ

an easy-to-calculate approximation of yield to maturity
Discount Bond—Yield to Maturity
For any one year discount bond

F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
80
Yield on a Discount Basis
Less accurate but less difficult to calculate

F-P 360
idb = X
F days to maturity
idb = yield on a discount basis
F = face value of the Treasury bill (discount bond)
P = purchase price of the discount bond
Uses the percentage gain on the face value
Puts the yield on an annual basis using 360 instead of 365 days
Always understates the yield to maturity
The understatement becomes more severe the longer the maturity
Following the Financial News:

Bond Prices and Interest Rates
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P -P
RET = + t1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt
81
Rate of Return
and Interest Rates
• The return equals the yield to maturity only if

the holding period equals the time to maturity
• A rise in interest rates is associated with a fall
in bond prices, resulting in a capital loss if time
to maturity is longer than the holding period
• The more distant a bond’s maturity,
the greater the size of the percentage
price change associated with an
interest-rate change
Rate of Return
and Interest Rates (cont’d)
• The more distant a bond’s maturity, the lower

the rate of return the occurs as a result of an
increase in the interest rate
• Even if a bond has a substantial initial
interest rate, its return can be negative if
interest rates rise
82
Interest-Rate Risk
• Prices and returns for long-term

bonds are more volatile than those for
shorter-term bonds
• There is no interest-rate risk for any
bond whose time to maturity matches
the holding period
Real and Nominal Interest Rates
• Nominal interest rate makes no allowance

for inflation
• Real interest rate is adjusted for changes in
price level so it more accurately reflects the
cost of borrowing
• Ex ante real interest rate is adjusted for
expected changes in the price level
• Ex post real interest rate is adjusted for actual
changes in the price level
Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
83
Lesson 5B
(Chapter 6)
The Risk and

Term Structure
of Interest Rates
Risk Structure of Interest Rates
• Default risk—occurs when the issuer of the

bond is unable or unwilling to make interest
payments or pay off the face value
 U.S. T-bonds are considered default free
 Risk premium—the spread between the interest
rates on bonds with default risk and the interest
rates on T-bonds
• Liquidity—the ease with which an asset can be
converted into cash
• Income tax considerations
84
85
Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax

characteristics may have different interest rates
because the time remaining to maturity is different
• Yield curve—a plot of the yield on bonds with differing
terms to maturity but the same risk, liquidity and tax
considerations
 Upward-sloping  long-term rates are above
short-term rates
 Flat  short- and long-term rates are the same
 Inverted  long-term rates are below short-term rates
Facts Theory of the Term Structure

of Interest Rates Must Explain
1. Interest rates on bonds of different

maturities move together over time
2. When short-term interest rates are low,
yield curves are more likely to have an
upward slope; when short-term rates
are high, yield curves are more likely to
slope downward and be inverted
3. Yield curves almost always
slope upward
86
Three Theories
to Explain the Three Facts
1. Expectations theory explains the first

two facts but not the third
2. Segmented markets theory explains
fact three but not the first two
3. Liquidity premium theory combines the
two theories to explain all three facts
Expectations Theory
• The interest rate on a long-term bond will

equal an average of the short-term interest
rates that people expect to occur over the life
of the long-term bond
• Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a
different maturity
• Bonds like these are said to be perfect
substitutes
87
Expectations Theory—Example
• Let the current rate on one-year bond be 6%.

• You expect the interest rate on a one-year
bond to be 8% next year.
• Then the expected return for buying two one-
year bonds averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be
7% for you to be willing to purchase it.
Expectations Theory—In General
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

(cont’d)
Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
88
(cont’d)
If two one-period bonds are bought with the $1 investment

(1  it )(1  ite1 )  1
1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
e
it (i ) is extremely small
t 1
Simplifying we get
it  ite1

(cont’d)
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it  ite1  ite 2  ...  ite ( n 1)
int 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
Expectations Theory
• Explains why the term structure of interest

rates changes at different times
• Explains why interest rates on bonds with
different maturities move together over time
(fact 1)
• Explains why yield curves tend to slope up
when short-term rates are low and slope down
when short-term rates are high (fact 2)
• Cannot explain why yield curves usually slope
upward (fact 3)
89
Segmented Markets Theory
• Bonds of different maturities are not substitutes at all

• The interest rate for each bond with a different
maturity is determined by the demand for and supply
of that bond
• Investors have preferences for bonds of one maturity
over another
• If investors have short desired holding periods and
generally prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why
yield curves usually slope upward (fact 3)
Liquidity Premium &

Preferred Habitat Theories
• The interest rate on a long-term bond will

equal an average of short-term interest
rates expected to occur over the life of
the long-term bond plus a liquidity
premium that responds to supply and
demand conditions for that bond
• Bonds of different maturities are
substitutes but not perfect substitutes
Liquidity Premium Theory
it  it1
e
 it2
e
 ... it(
e
int   lnt n1)
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
90
Preferred Habitat Theory
• Investors have a preference for bonds of

one maturity over another
• They will be willing to buy bonds of
different maturities only if they earn a
somewhat higher expected return
• Investors are likely to prefer short-term
bonds over longer-term bonds
Liquidity Premium and Preferred Habitat

Theories, Explanation of the Facts
• Interest rates on different maturity bonds move

together over time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term
rates are low and to be inverted when short-term rates
are high; explained by the liquidity premium term in
the first case and by a low expected average in the
second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
91
Lesson 6
(Chapter 5)
The Behavior of
Interest Rates
92
Determining the
Quantity Demanded of an Asset
• Wealth—the total resources owned by the individual,
including all assets
• Expected Return—the return expected over the next
period on one asset relative to alternative assets
• Risk—the degree of uncertainty associated with the
return on one asset relative to alternative assets
• Liquidity—the ease and speed with which an asset
can be turned into cash relative to alternative assets
Theory of Asset Demand
Holding all other factors constant:

1. The quantity demanded of an asset is positively
related to wealth
related to its expected return relative to
alternative assets
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to
alternative assets
related to its liquidity relative to alternative assets
93
Supply and Demand for Bonds
• At lower prices (higher interest rates),

ceteris paribus, the quantity demanded
of bonds is higher—an inverse
relationship
• At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is lower—a positive relationship
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
• When Bd = Bs  the equilibrium (or market
clearing) price and interest rate
• When Bd > Bs  excess demand  price will
rise and interest rate will fall
• When Bd < Bs  excess supply  price will
fall and interest rate will rise
94
Shifts in the Demand for Bonds
• Wealth—in an expansion with growing wealth, the
demand curve for bonds shifts to the right
• Expected Returns—higher expected interest rates in
the future lower the expected return for long-term
bonds, shifting the demand curve to the left
• Expected Inflation—an increase in the expected rate
of inflations lowers the expected return for bonds,
causing the demand curve to shift to the left
• Risk—an increase in the riskiness of bonds causes
the demand curve to shift to the left
• Liquidity—increased liquidity of bonds results in the
demand curve shifting right
95
Shifts in the Supply of Bonds
• Expected profitability of investment

opportunities—in an expansion, the
supply curve shifts to the right
• Expected inflation—an increase in
expected inflation shifts the supply curve
for bonds to the right
• Government budget—increased budget
deficits shift the supply curve to the right
96
97
98
The Liquidity Preference Framework
Keynesian model that determines the equilibrium interest rate

in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs  M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).
Shifts in the Demand for Money
• Income Effect—a higher level of income

causes the demand for money at each
interest rate to increase and the demand
curve to shift to the right
• Price-Level Effect—a rise in the price
level causes the demand for money at
each interest rate to increase and the
demand curve to shift to the right
99
Shifts in the Supply of Money
• Assume that the supply of money is

controlled by the central bank
• An increase in the money supply
engineered by the Federal Reserve
will shift the supply curve for money to
the right
100
Everything Else Remaining Equal?
• Liquidity preference framework leads to the conclusion

that an increase in the money supply will lower interest
rates—the liquidity effect.
• Income effect finds interest rates rising because
increasing the money supply is an expansionary
influence on the economy.
• Price-Level effect predicts an increase in the money
supply leads to a rise in interest rates in response to
the rise in the price level.
• Expected-Inflation effect shows an increase in interest
rates because an increase in the money supply may
lead people to expect a higher price level in the future.
Price-Level Effect
and Expected-Inflation Effect
• A one time increase in the money supply will cause
prices to rise to a permanently higher level by the
end of the year. The interest rate will rise via the
increased prices.
• Price-level effect remains even after prices have
stopped rising.
• A rising price level will raise interest rates because
people will expect inflation to be higher over the
course of the year. When the price level stops rising,
expectations of inflation will return to zero.
• Expected-inflation effect persists only as long as the
price level continues to rise.
101
Lesson 7
(Chapter 17)
The Foreign
Exchange Market
102
Foreign Exchange I
• Exchange rate—price of one currency in terms

of another
• Foreign exchange market—the financial
market where exchange rates are determined
• Spot transaction—immediate (two-day)
exchange of bank deposits
 Spot exchange rate
• Forward transaction—the exchange of bank
deposits at some specified future date
 Forward exchange rate
Foreign Exchange II
• Appreciation—a currency rises in value

relative to another currency
• Depreciation—a currency falls in value relative
to another currency
• When a country’s currency appreciates, the
country’s goods abroad become more
expensive and foreign goods in that country
become less expensive and vice versa
• Over-the-counter market mainly banks
103
Exchange Rates in the Long Run
• Law of one price

• Theory of Purchasing Power Parity
 Assumes all goods are identical in
both countries
 Trade barriers and transportation costs
are low
 Many goods and services are not traded
across borders
Factors that Affect Exchange Rates

in the Long Run
• Relative price levels

• Trade barriers
• Preferences for domestic versus
foreign goods
• Productivity
104
Exchange Rates in the Short Run
• An exchange rate is the price of domestic

assets in terms of foreign assets
• Using the theory of asset demand—the most
important factor affecting the demand for
domestic (dollar) assets and foreign (euro)
assets is the expected return on these assets
relative to each other
Comparing Expected Returns I
Dollar assets pay an interest rate of i D and do not have any capital gain
Foreign assets have an interest rate of i F and there is no capital gain
To compare the expected returns on dollar assets and foreign assets
the returns must be converted into the currency unit used
Et  the spot exchange rate
Et+1  the exchange rate for the next period
e
Et+1 - Et
 the expected rate of appreciation for the dollar
Et
105
Comparing Expected Returns II
The expected return on dollar assets R D in terms of foreign currency

is the sum of the interest rate on dollar assets
plus the expected appreciation of the dollar
e
Et1  Et
R D in term of euros = i D 
Et
The expected return on foreign assets R F is i F
e
Et1  Et
Relative R D  i D  i F 
Et
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
Comparing Expected Returns III

The expected return on foreign assets R F in terms of dollars
is the interest rate on foreign assets i F plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar
e
Et1  Et
R F in terms of dollars = i F 
Et
The expected return on the dollar assets R D is i D
e
Et1  Et E e  Et
Relative R D  i D  (i F  )  i D  i F  t1
Et Et
Which is the same as previously
Relative expected return on dollar assets is the same whether it is
calculated in terms of euros or in terms of dollars
As the relative expected return on dollar assets increases, both foreigners and
domestic residents will want to hold more dollar assets
Interest Parity Condition

e
Et1  Et
iD  iF 
Et
• Capital mobility with similar risk and liquidity 
the assets are perfect substitutes
• The domestic interest rate equals the foreign
interest rate minus the expected appreciation of the
domestic currency
• Expected returns are the same on both domestic and
foreign assets
• An equilibrium condition
106
Demand and Supply
for Domestic Assets
• Demand
 Relative expected return
 At lower current values of the dollar
(everything else equal), the quantity
demanded of dollar assets is higher
• Supply
 The amount of bank deposits, bonds,
and equities in the U.S.
 Vertical supply curve
107
108
109
Exchange Rate Overshooting
• Monetary Neutrality
 In the long run, a one-time percentage rise in the
money supply is matched by the same one-time
percentage rise in the price level
• The exchange rate falls by more in the short

run than in the long run
 Helps to explain why exchange rates exhibit so
much volatility
The Dollar and Interest Rates
• While there is a strong correspondence

between real interest rates and the
exchange rate, the relationship between
nominal interest rates and exchange rate
movements is not nearly as pronounced
110
Thank You!
phuht@uel.edu.vn
0903 846 236
111

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PRINCIPLES

Course Learning Outcomes

Why Study Money, Banking, and

• To examine how financial markets

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• Markets in which funds are transferred

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• A security (financial instrument) is a

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The Stock Market

• Common stock represents a share of

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The Foreign Exchange Market

• The foreign exchange market is where

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• Financial Intermediaries—institutions that

Money and Business Cycles

• Evidence suggests that money

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• The aggregate price level is the

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• Interest rates are the price of money

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Monetary and Fiscal Policy

• Monetary policy is the management of the

How We Will Study Money, Banking,

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• Perform the essential function of channeling

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Structure of Financial Markets

• Debt and Equity Markets

• Exchanges and Over-the-Counter (OTC) Markets

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• To increase the information available to investors:

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1. Stocks are not the most important sources of

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Eight Basic Facts (cont’d)

5. The financial system is among the most

• Financial intermediaries have evolved to

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• Adverse selection occurs before

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Adverse Selection: Solutions

• Private production and sale of information

• Government regulation to increase information

• Collateral and net worth