Exam 1 Economics 330 (notes on Chapters 1-7)

Chapter 1 o Financial markets: markets in which funds are transferred from people who have an excess of funds to people who have a shortage o Security: (financial instrument) claim on issuers future income/assets o Bond: debt security that promises to make payments periodically for a specific period of time o Interest rate: cost of borrowing/renting funds o Common stock: share of ownership in a corporation o Foreign exchange market: where conversion of funds takes place o Financial intermediaries: institutions that borrow funds from people who have saved and in turn make loans to others o Banks: institutions that accept deposits and make loans o E finance: means of delivering financial services electronically o Money: anything that is generally accepted in payment for goods/services or the prepayment of debt o Aggregate output: total production of goods and services o Business cycle: upward and downward movement of aggregate output produced in the economy o Monetary theory: theory that relates changes in the quantity of money to changes in aggregate economic activity and price level o Aggregate price level: average price of goods and services in an economy (aka price level) o Monetary policy: management of money and interest rates o Federal Reserve System: USs central bank (responsible for the conduct of the nations monetary policy) o Fiscal policy: involves decisions about government spending and taxation o GDP: gross domestic product measurement of aggregate output, market value of all final goods and service produced during the course of one year o GDP deflator: nominal GDP/real GDP o Factors of production: land, labor, and capital o Nominal: current prices o Real: fixed prices o CPI: basket of goods and services Chapter 2 o Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities (claims on borrowers future income or assets) o Maturity: number of years (term) until the debt instruments expiration date (short term < 1 year; intermediate 1-10 years; long term > 10 years) o Equity: raising funds by issuing common stock (long-term) o Dividends: periodic payments to shareholders

o Residual claimant: the corporation must pay all its debt holders before it pays its equity holders o Primary market: financial marketing which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds o Secondary market: financial market in which securities that have been previously issued can be resold o Underwriting: investment bank does this by guaranteeing a price for a corporations securities and then sells them to the public o Broker: agents of investors who match buyers with sellers of securities o Dealers: link buyers and sellers by buying and selling securities at stated prices o Liquid: the ease and quickness by which one can sell financial instruments to raise cash o Exchange: an organization of a secondary market where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades o OTC market: over the counter market (another organization of a secondary market) in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices o Money market: financial market in which only short-term debt instruments are traded (more widely traded; more liquid) o Capital market: market in which longer-term debt (>1 year) and equity instruments are traded o US Treasury Bills: issued in one, three, and six-month maturities to finance the federal government no interest payments/set at discount o Default: a situation in which the party issuing the debt is unable to pay it off o CD: certificate of deposit; sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price o Commercial paper: short-term debt instrument issued by large banks and wellknown corporations o Banker acceptance: bank draft (similar to check) issued by firm, payable at some future date, and guaranteed for a fee by the bank that stamps it accepted, short term o Repurchase agreements: effectively short-term loans (< 2 weeks) for which treasury bills serve as collateral o Federal funds: overnight loans between banks for their deposits at the Federal Reserve (loans made by banks to other banks) o Stocks: equity claims on the net income and assets of a corporation o Mortgages: loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans o Municipal bonds: long-term debt instruments issued by state and local governments to finance expenditures of schools, roads and other large programs

o Corporate bond: issued by corporations with very strong credit ratings; sends the holder an interest payment twice a year and pays off the face value when the bond matures o Foreign bonds: traditional instruments in the international bond markets o Eurobond: a bond denominated in a currency other than that of the country in which it is sold o Financial intermediation: the primary route for moving funds from lenders to borrowers o Transaction costs: the time and money spent in carrying out financial transactions o Economies of scale: the reduction in transaction costs per dollar of transactions as the size of transactions increases o Liquidity services: services that make it easier for customers to conduct transactions o Risk: uncertainty about the returns investors will earn on assets o Risk sharing: financial intermediaries create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk (aka asset transformation) o Diversification: investing a collection (portfolio) of assets whose returns do not always move together the risk is lower than for individual assets o Asymmetric information: one party often does not know enough about the other party to make informative decisions o Adverse selection: the problem created by asymmetric information before the transaction occurs o Moral hazard: the problem created by asymmetric information after the transaction occurs the risk that the borrower might engage in activities that are undesirable form the lenders point of view, because they make it less likely that the loan will be paid back o Thrift institution: savings and loan association, mutual saving banks and credit unions o Commercial banks: raise funds primarily by issuing checkable deposits, savings deposits, and time deposits; largest financial intermediary o Savings and Loan Associations (S & Ls) and mutual savings banks: obtain funds primarily through saving deposits (shares) and time and checkable deposits o Credit unions: very small cooperative lending institutions organized around a particular group acquire funds from shares o Contractual savings institutions: (ex. insurance companies and pension funds) financial intermediaries that acquire funds at periodic intervals on a contractual basis o Finance companies: raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds

o Mutual funds: acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds o Money market mutual funds: have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposittype accounts shareholders can write checks against the value of their shareholdings o Underwrite: selling securities by purchasing them from the corporation at a predetermined price and reselling them in the market o SEC: Securities and Exchange Commission; requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders o Financial panic: widespread collapse of financial intermediaries (caused by asymmetric information) Chapter 3 o Currency: consists of dollar bills and coins o Wealth: the total collection of pieces of property that serve to store value o Income: a flow of earnings per unit of time o Medium of exchange: used to pay for goods and services o Transaction cost: the time spent trying to exchange goods or services o Unit of account: used to measure value in the economy o Store of value: a repository of purchasing power over time o Liquidity: the relative ease and speed with which an asset can be converted into a medium of exchange o Hyperinflation: periods of extreme inflation o Payments system: the method of conducting transaction in the economy o Commodity money: money made up of precious metals or another valuable commodity o Fiat money: paper currency decreed by governments as legal tender but not convertible into coins or precious metal o M1: narrowest measure of money includes currency, checking account deposits and travelers checks o M2: adds to M1 other assets that have check-writing features (money market deposit accounts and money mutual fund shares) and other assets (savings deposits and small-denomination time deposits) that are extremely liquid, because they can be turned into cash quickly at very little cost Chapter 4 o Present value: based on the common-sense notion that a dollar paid to you one year from now is less valuable to you than a dollar paid to you today o Simple loan: the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with additional payment for the interest

o Fixed payment loan: the lender provides the borrower with an amount of funds, which must be repaid by making the same payment for every period o Coupon bond: pays the owner of the bond a fixed interest payment every year until the maturity date, when a specified final amount is repaid o Discount bound: bought at a price blow its face value and the face value is repaid at the maturity date o Yield to maturity: the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today for simple loans, the simple interest rate equals the yield to maturity o Consol/perpetuity: a perpetual bond with no maturity date and no prepayment of principal that makes fixed coupon payments of $C forever o Basis point: a hundredth of a percentage point o Return/rate of return: how well a person does by holding a bond or any other security over a particular time period; the return on a bond will not necessarily equal the yield to maturity on that bond o Rate of capital gain: the change in the bonds price relative to the initial purchase price Chapter 5 o Holding everything else constant, an increase in wealth raises the quantity demanded of an asset o An increase in a assets expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset o Holding everything else constant, if an assets risk rises relative to that of alternative assets, its quantity demanded will fall o The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, the greater will be the quantity demanded o Market equilibrium: occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) o Asset market approach: emphasizes stocks of assets rather than flows in determining asset prices; the dominant methodology used by economists, because correctly conducting analyses in terms of flows is tricky o In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right o Higher expected interest rates in the future lower the expected return for longterm bonds, decrease the demand, and shift the demand curve to the right o Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right o An increase in expected rate of inflation lowers the expected return for bonds, causing their demand to decline and the fucking demand curve to shift to the left o An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left; an increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right

o Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the left o In business cycle expansion, the supply of bonds increases and supply curve shifts to the right o An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right o Higher government deficits increase the supply of bonds and shift the supply curve to the right o Fisher Effect: when expected inflation rises, interest rates will rise o Liquidity preference framework: when income is rising during a business cycle expansion (holding other economic variables constant), interest rates will rise o 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 o 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 o Expected inflation effect: the rise in expected inflation rate will lead to a rise in interest rates o An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right o When the price level increases, with the supply of money and other economic variables held constant, interest rates will rise o When the money supply increases, interest rates will decline Chapter 6 o Risk structure of interest rates: relationship among the interest rates (bonds with the same term to maturity have different interest rates) o Term structure of interest rates: relationship among interest rates on bonds with different terms to maturity o Default: occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures o Risk premium: the spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity (indicates how much additional interest people must earn to be willing to hold that risky bond) a bond with default risk will always have a positive risk premium and in increase in its default risk will raise the risk premium o Credit rating agencies: investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default o Investment grade: bonds with relatively low risk of default (Baa/BBB or above) o Junk bonds: bonds with a higher risk of default (Ba/BB through C/D) o Income tax considerations: interest payments on municipal bonds are exempt from federal income taxes so you are willing to hold the riskier and less liquid

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municipal bond even though it has a lower interest rate than the US Treasury bond Yield curve: a plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations Inverted yield curve: downward sloping yield curve FACT 1: interest rates on bonds of different maturities move together over time FACT 2: when short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted FACT 3: yield curves almost always slope upward 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 (PERFECT SUBSTITUTES) explains facts 1 & 2 Segmented markets theory: sees markets fro different-maturity bonds as completely separate and segmented; not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity explains fact 3 Liquidity premium theory: 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 longterm bond plus a liquidity premium (aka preferred habitat theory) explains facts 1, 2, & 3