Midterm

Midterm Review for Ch1-7, 14
Winter 2012 Jin Man Lee

DePaul University
ECO315 Introduction to Money and Banking
Jin Man Lee (DePaul)
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Outline
1 2 3 4 5 6 7 8
CH1: Introduction CH2: Financial System CH3: What is Money? CH4: Interest Rates CH5: The behavior of Interest Rates CH6: The Risk and Term Structure of Interest Rates CH7: Stock Market CH14: Financial Derivatives
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CH1: Introduction
Figure 4. Goods and Service Markets with Financial Market
GOODS and SERVICE MARKETS
FINANCIAL MARKET D P SAVING (S) P INVESTMENT (I) WAGE(W) CONSUMERS LABOR(L) PRODUCERS S
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CH1: Introduction
Money Demand and Supply

Interest Rate (i) Money Demand(MD) Money Supply (MS) Interest Rate (i)
Loan Demand and Supply (Saving and Investment)

Investment (i) Saving (S)
Money (M)
Loan (L)
Figure1-5: Determination of Interest Rates from Money and Loan Markets

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CH1: Introduction
Market (Economy) Performance Market Index: GDP or Real GDP GDP = C + I + G + N X (1)
W here : C I G NX
= = = =
household consumption expenditures gross private domestic investment government consumption and gross investment expenditures gross exports - gross imports of goods and services
Real GDP means Price Adjusted GDP Measure of Health of Goods and Service Market: GDP Growth Rate GDP GDP Deator or Consumer Price Index (CP)
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Real GDP = RGDP =

(2)
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CH2: Financial System
Figure 2-1: Flows of Funds Through the Financial System
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Financial Market and Financial Intermediaries Financial Market are the markets where net lenders can lend their funds directly to net borrowers. Financial Intermediaries are rms that provide nancial services to net lenders and net borrowers. The nancial intermediaries by bank, saving and loan association, and credit unions serve as go-betweens to link up net lenders and net borrowers.
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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. Direct nance: borrowers borrow funds directly from lenders in nancial markets by selling them securities. Promotes economic eciency by producing an ecient allocation of capital, which increases production. Directly improve the well-being of consumers by allowing them to time purchases better
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Structure of Financial Markets Primary and Secondary Markets

Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets: NYSE, NASDAQ
Exchanges and Over-the-Counter (OTC) Markets

Exchanges: NYSE, Chicago Board of Trade OTC Markets: Foreign exchange, Federal funds
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Structure of Financial Markets (continued) Debt and Equity Markets

Debt instruments (maturity with xed payments) : bond or mortgage Equities (dividends): common stock
Money and Capital Markets

Money markets deal in short-term debt instruments : mostly short term, least price uctuations and the least risky investment Capital markets deal in longer-term debt and equity instruments: greater than one year, wider price uctuations than money market instruments and fairly risk investment
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Money Market Instruments US T-bills Negotiable Bank Certicates of Deposit Commercial Paper Repurchase Agreement Federal Funds Money Market Data in WSJ: http://online.wsj.com/mdc/public/page/2 3020-moneyrate.html
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Capital Market Instruments Stocks Mortgage Corporate Bonds Government Securities Government Agency Securities State and Local Government Bonds Consumer and Bank Commercial Loans Money Market Data in WSJ: http://online.wsj.com/mdc/public/page/2 3021-bondyield.html
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Figure2-8: Money Market vs. Capital Market Instruments
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Advantages of Financial Intermediaries (Indirect Finance) Financial intermediaries allow small savers and borrowers to benet from the existence of nancial markets. Lower transaction costs (time and money spent in carrying out nancial transactions).
Economies of scale Liquidity services
Reduce the exposure of investors to risk

Risk Sharing (Asset Transformation) Diversication
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Financial Intermediaries Instruments Depository Institutions

Commercial Banks Saving and Loan (S&Ls) and Mutual Saving Banks Credit Unions
Contractual Saving Institutions

Life Insurance Company Fire and Casualty Insurance Companies Pension Funds and Government Retirement Funds
Investment Intermediaries
Finance Companies Mutual Funds Money Market Mutual Funds Investment Banks
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CH3: What is Money?
Functions of Money Medium of Exchange:

Eliminates the trouble of nding a double coincidence of needs (reduces transaction costs) Promotes specialization
A medium of exchange must

be easily standardized be widely accepted be divisible be easy to carry not deteriorate quickly
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CH3: What is Money?
Functions of Money (continued) Unit of Account:

used to measure value in the economy reduces transaction costs
Store of Value:
used to save purchasing power over time other assets also serve this function oney is the most liquid of all assets but loses value during ination
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CH3: What is Money?
Evolution of the Payment System Checks: an instruction to your bank to transfer money from your account Electronic Payment (e.g. online bill pay). E-Money (electronic money):
Debit card Stored-value card (smart card) E-cash
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CH3: What is Money?
Measuring Money How do we measure money? Which particular assets can be called money? Construct monetary aggregates using the concept of liquidity: M1 (most liquid assets) = currency + travelers checks + demand deposits + other checkable deposits. M2 (adds to M1 other assets that are not so liquid) = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares.
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CH3: What is Money?
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
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CH4: Interest Rates
Four Types of Credit Market Instruments

Simple Loan The lender provides the borrower with an amount of funds, which must be repaied to the lander at the maturity date along with additional payment for interest ( Commercial Loan to Business) Fixed Payment Loan Fully amortized loan, the borrower pay a xed amount of funds consisted of part of principal and interest for a set number of years (Mortgages, Installation Loans) Coupon Bond pays xed amount of interest payment every year until maturity and the nal amount(face value) at the maturity Discount Bond zero coupon bonds, which means it pays the face value at the maturity without any coupon payment.
CH4: Interest Rates
Coupon Bond Example 1 Find the price of bond if the face value is $1,000, and coupon payment is $100 per year when the interest rate is 10%. yearly coupon payment(C) = $100 face value of the bond(F ) = $1,000 annual interest rate(i) = 0.1
If the maturity of bond is 1 year: P = C F 100 1000 + = + = 1000 (1 + i) (1 + i) (1 + 0.1) (1 + 0.1) (3)
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CH4: Interest Rates
Example of Perpetuity If a perpetuity bond pays $100 per year with face value of $10,000, then the yield of maturity is
ic = =
C Pc 100 10000
= 0.01
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CH4: Interest Rates
An Example on Rate of Return on Bond A 10% coupon bond with face value of $1,000: The price change from $950 to $920 in a year, then the rate of return is
R =
(Pt+1 Pt ) C + Pt Pt 100 920 950 = + 950 950 = 0.1053 0.0316 = 0.0737
We nd, ic = 10.53% and g = -3.16%
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CH4: Interest Rates
Rate of Return and Interest Rate 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 bonds maturity, the greater the size of the percentage price change associated with an interest-rate change The more distant a bonds 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
CH4: Interest Rates
Real and Nominal Interest Rates Nominal interest rate makes no allowance for ination Real interest rate is adjusted for changes in price level so it more accurately reects 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
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CH4: Interest Rates
Fisher Equation The relationship between the interest rate and the expected ination rate can be expressed by the real interest rate.
i = ir + e ir = i e where, i = nominal interest rate ir = real interest rate e = expected ination rate
(4) (5)
When the real interest rate(ir ), 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.
CH5: The behavior of Interest Rates
Theory of Asset Demand Holding all other factors constant: The quantity demanded of an asset is positively related to wealth The quantity demanded of an asset is positively related to its expected return relative to alternative assets The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
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Figure5-4: Supply and Demand for Bond
the equilibrium bond price and quantity of bond is determined by supply and demand curves. We nd the example shows the current price of bond is $850 and 300 billion dollars of bonds will be traded.
Bond 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 Bd = Bs denes the equilibrium (or market clearing) price and interest rate. When Bd > Bs , there is excess demand, price will rise and interest rate will fall When Bd < Bs , there is excess supply, price will fall and interest rate will rise
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Shifts in the Demand for Bonds Holding all other factors constant: 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 Liquidity: increased liquidity of bonds results in the demand curve shifting right Expected Ination: an increase in the expected rate of ination 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
Shifts in the Supply of Bonds Holding all other factors constant: Expected protability of investment opportunities: in an expansion, the supply curve shifts to the right Expected ination: an increase in expected ination shifts the supply curve for bonds to the right Government budget: increased budget decits shift the supply curve to the right
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Figure5-9: Response to a Change in Expected Ination
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Figure 11: Response to a Business Cycle Expansion
Response to a Business Cycle Expansion
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Figure 13: Equilibrium in the Market for Money
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Shifts in Demand for Money Income Eect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve shift to the right Price-level Eect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to right
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Figure 14: Response to a Change in Income or the Price level
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Shifts in 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.
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Price-Level Eect and Expected-Ination Eect in Money Supply 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 eect remains even after prices have stopped rising. A rising price level will raise interest rates because people will expect ination to be higher over the course of the year. When the price level stops rising, expectations of ination will return to zero. Expected-ination eect persists only as long as the price level continues to rise.
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Figure 17: Interest Rates by Liquidity, Income, Ination, and Expected-Ination Eects
M 0s
M 1s
M 0s
M 1s
M 0s
M 1s
M 0d
M
M 1d
d 0
M 1d M 0d
M
A. Liquidity Effects (negative relationship between money supply and interest rate) B. Liquidity Effects with mild income and inflation effects.
M
C. Liquidity Effects with higher income, inflation, and expected-inflation effects.
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Figure 18: Response over Time to an increase in Money Supply Growth
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CH6: The Risk and Term Structure of Interest Rates
Figure6-5: Response to an Increas in Default Risk on Coporate Bonds
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Figure6-6: Interest Rates on Municipal and Treasury Bonds
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Facts Theory of the Term Structure of Interest Rates Must Explain a plot of the yield on bonds with diering terms to maturity but the same risk, liquidity and tax considerations
1
Interest rates on bonds of dierent maturities move together over time 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 Yield curves almost always slope upward
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Expectations Theory Explains why the term structure of interest rates changes at dierent times Explains why interest rates on bonds with dierent 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)
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Segmented Markets Theory Bonds of dierent maturities are not substitutes at all The interest rate for each bond with a dierent maturity is determined by the demand for and supply of that bond Investors have preferences for bonds of one maturity over another If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
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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.
+
A liquidity premium that responds to supply and demand conditions for that bond Bonds of dierent maturities are partial (not perfect) substitutes
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Figure 12: Yield Curves and the Markets Expectations of Future Short-Term Interest Rates According to the Liquidity Premium (Preferred Habitat) Theory
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CH7: Stock Market
Stock Market Participants Individuals Hedge Funds Brokers and Dealers Investment Banks Other nancial Institutions
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CH7: Stock Market
One-Period Valuation Model P0 = D1 P1 + 1 + ke 1 + ke (6)
P0 = the current price of the stock D1 = the dividend paid at the end of year 1 ke = the required return on investment in equity P1 = the sale price of the stock at the end of the rst period
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CH7: Stock Market
One-Period Valuation Model The value of stock today is the present value of all future cash ows D1 D2 Dn Pn + + ... + + 2 n 1 + ke (1 + ke ) (1 + ke ) (1 + ke )n
P0 =
(7)
If Pn is far in the future, it will not aect P0
P0 =
t=1
Dt (1 + ke )t
(8)
The price of the stock is determined only by the present value of the future dividend stream
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CH7: Stock Market
Gordon Growth Model P0 = D1 D0 (1 + g) = (ke g) (ke g) (9)
P0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on investment in equity
Dividends are assumed to continue growing at a constant rate forever The growth rate is assumed to be less than the required return on equity *Risky Stocks : Higher ke Lower P0 *Higher Growth Expectation: Higher g Higher P0
CH7: Stock Market
Adaptive Expectation Expectations are formed from past experience only. Changes in expectations will occur slowly over time as data changes. However, people use more than just past data to form their expectations and sometimes change their expectations quickly.
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CH7: Stock Market
Theory of Rational Expectations Expectations will be identical to optimal forecasts using all available information Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate
It takes too much eort to make the expectation the best guess possible Best guess will not be accurate because predictor is unaware of some relevant information
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CH7: Stock Market
Ecient Markets Current prices in a nancial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return In an ecient market, a securitys price fully reects all available information
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CH14: Financial Derivatives
Security and Derivatives

security
whose payo is explicitly tied to value or price of other nancial security that determines value of derivative is called underlying security
derivatives
Buying asset or commodity in advance to insure against adverse market movements Eective tools for hedging risks designed to enable market participants to eliminate risk. Business dealing with a good faces risk associated with price uctuations. Control that risk through use of derivative securities.
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Example of Forward Contract

You enter a long forward contract at a stock at the price of 50. What is the payo in 6 months for prices of $40, $45, $50, $55, $60? 40 - 50 = -10 45 - 50 = -5 50 - 50 = 0 55 - 50 = 5 60 - 50 = 10 This means the prot for long = Price of Stock at t+1 (Spot Price) - Forward = S - F
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Example of Forward Contract

You enter a short forward contract at a stock at the price of 50. What is the payo in 6 months for prices of $40, $45, $50, $55, $60? 50 - 40 = 10 50 - 45 = 5 50 - 50 = 0 50 - 55 = -5 50 - 60 = -10 This means the prot for Short = Forward - Price of Stock at t+1 (Spot Price) = F - S
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Gain/Loss on Forwards
Long position:
The payo to the long is S - F The prot is also S - F (no initial deposit required)
Short position:
The payo to the short is F - S The prot is also F - S (no initial deposit required)
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Futures Contracts
A contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse. As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.
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Options
Contracts that give the purchaser the option (right) to buy or sell the underlying nancial instrument at a specied price (exercise or strike price) within a specic period of time (term to expiration). The seller is obligated to buy or sell the nancial instrument if the buyer of the option exercises the right to sell or buy. The buyer does not have to exercise the option.
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Options
A premium is paid for the option American option can be exercised at any time up to the expiration date European options can only be exercised on the expiration date Stock options Futures options - More liquid than debt instrument markets Regulated by the SEC (stocks) and the CFTC (futures)
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Dierences Between Options and Futures Contracts
For a futures contract the prots grow by an equal dollar amount for every point increase in the price of the underlying nancial instrument For the option contract prots do not always grow by the same amount for a given change in the price of the underlying nancial instrument because of the protection aorded from losses Initial investment on the contracts dier Money changes hands daily in the futures market; only once for the option contract (when the option is exercised).
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Interest-Rate Swap Contracts
Interest rate swap species Interest rate on the payments that are being exchanged Type of interest payments The amount of notional principal The time period over which the exchanges continue
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Midterm Review for Ch1-7, 14

Winter 2012 Jin Man Lee

ECO315 Introduction to Money and Banking

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

Figure 4. Goods and Service Markets with Financial Market

GOODS and SERVICE MARKETS

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

Money Demand and Supply

Loan Demand and Supply (Saving and Investment)

Figure1-5: Determination of Interest Rates from Money and Loan Markets

Real GDP = RGDP =

Midterm Review for Ch1-7, 14

CH2: Financial System

Figure 2-1: Flows of Funds Through the Financial System

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Structure of Financial Markets Primary and Secondary Markets

Exchanges and Over-the-Counter (OTC) Markets

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Structure of Financial Markets (continued) Debt and Equity Markets

Money and Capital Markets

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Figure2-8: Money Market vs. Capital Market Instruments

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Reduce the exposure of investors to risk

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH2: Financial System

Financial Intermediaries Instruments Depository Institutions

Contractual Saving Institutions

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH3: What is Money?

Functions of Money Medium of Exchange:

A medium of exchange must

Jin Man Lee (DePaul)

Midterm Review for Ch1-7, 14

CH3: What is Money?

Functions of Money (continued) Unit of Account:

Jin Man Lee (DePaul)