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Financial markets and

institutions
Lecturer: Dr Nguyen Kim Thu
Part 1: Introduction
• Why study financial markets and
institutions?
• Overview of the financial system
• Financial markets are markets in which
funds are transferred from people who
have an excess of available funds to
people who have a shortage
• Greater economic efficiency
• Direct effect on personal wealth, the
behavior of businesses and consumers,
and the overall performance of the
economy
Debt markets and interest rates
• A bond is a debt security that promises to
make payments periodically for a specified
period of time.
• Interest rate is the cost of borrowing or the
price paid for the rental of funds.
• Interest rates affect the saving and
investment decisions, affect the
profitability and value of financial
institutions
The stock market
• A stock is a security that represents a
share of ownership in a corporation. It is a
claim on the earnings and assets of the
corporation.
The foreign exchange market
• The foreign exchange market is where the
currency of one country is converted to the
currency of another country; and is where
the foreign exchange rate (the price of one
country’s currency in terms of another’s) is
determined
Financial institutions
• Financial institutions are what make
financial markets work, enabling financial
markets to move funds from people who
save to people who have productive
investment opportunities.
• Central banks
• Financial intermediaries: commercial
banks, savings and loan associations,
insurance companies, mutual funds…
Overview of the financial system
• Function of financial markets
-Channeling funds from savers to investors
• Structure of financial markets
-Debt and equity markets
-Primary and secondary markets
-Exchanges and the OTC markets
-Money and capital markets
• Structure of financial intermediaries
-Stand between the lender and the borrower
and helps transfer funds from one to the
other.
-The indirect finance using financial
intermediaries is far more important
source of financing for corporations than
securities markets, since they reduce
transaction costs for lenders.
Asymmetric information
• One party does not know enough about the other party
to make accurate decisions
e.g: the borrower who takes out a loan has better
information about the investment project than the lender
does
• Adverse selection
-the problem created by asymmetric information before the
transaction occurs
-occurs when the potential borrowers who are the most
likely to produce an undesirable outcome are the ones
who most actively seek out a loan and are thus most
likely to be selected. Therefore, lenders may decide not
to make any loans even though to good credit borrowers
• Moral hazard: is the problem created by
asymmetric information after the
transaction occurs.
-is the risk that the borrower might engage in
activities that are undesirable/risky
-because moral hazard lowers the
probability that the loan will be repaid,
lenders may decide not to make a loan
• Financial intermediaries can deal with the
asymmetric information problem.
-better equipped to screen out good from
bad credits
-expertise in monitoring the parties they lend
to
Part 2: Fundamentals of interest
rates
• Measuring interest rates
-A simple loan: pay at maturity date the principal plus the
interest
-A fixed-payment loan: making the same payment every
month, consisting of part of the principal and interest.
-A coupon bond: pays the owner of the bond a fixed
interest payment (coupon payment) every year until the
maturity date, and the face value (par value) is repaid at
the maturity date
-A discount bond: is bought at a price below its face value ,
and the face value is repaid at the maturity date.
How can you decide which of these instruments provides
you with more income?
Present value
• The value today of a future payment (FV)
received n years from now when the
simple interest rate is i:
• PV = FV/(1+i)n
Yield to maturity (YTM)
• Yield to maturity is considered the most
accurate measure of interest rates
• It is the interest rate that equates the
present value of payments received from a
debt instrument with its value today.
• Simple loan: for simple loans, the simple
interest rate equals YTM
• Fixed-payment loan:
LV = FP/ (1+i) + FP/(1+i)2 + …+ FP/(1+i)n
LV: loan value
FP: fixed yearly payment
n: number of years until maturity
• Coupon bond:
P = C/(1+i) + C/(1+i)2 + …+ C/(1+i)n +
F/(1+i)n
P: Price of coupon bond
C: Yearly coupon payment
F: Face value of the bond
n: years to maturity date
• Three interesting facts
-When P = F, YTM = Coupon rate
-P and YTM are negatively related
-YTM>Coupon rate when P<F
• Perpetuity: is a perpetual bond with no
maturity date, no repayment of principal,
makes fixed coupon payments of $C
forever.
• P = C/i
P: Price of the perpetuity
C: Yearly payment
So i = C/P or YTM = C/P
• Discount bond: for any one-year discount
bond, YTM is
i = (F-P)/P
F: face value of the discount bond
P: current price of the discount bond
Other measures of interest rates
• YTM is the most accurate measure of
interest rates and is what financial
economists mean when they use the term
interest rate. However, because YTM is
sometimes difficult to calculate, people
often use other, less accurate measures of
interest rates, like the current yield and the
yield on a discount basis
• Current yield
ic = C/P
ic : current yield
P: price of the coupon bond
C: yearly coupon payment
-The current yield approximates the YTM better
when the bond price is nearer to the bond’s par
value and the maturity is longer.
-A change in the current yield always signals a
change in the same direction of the YTM
• Yield on a discount basis
idb = [(F-P)/F]* (360/Days to maturity)
idb : yield on a discount basis
F: face value of the discount bond
P: purchase price of the discount bond
-The yield on a discount basis always understates
the YTM and this understatement becomes
more severe the longer the maturity of the
discount bond.
-The yield on a discount bond always moves in the
same direction with YTM
Real and nominal interest rates
• i = ir + πe
or ir = i - πe
i: nominal interest rate
ir: real interest rate
πe expected inflation rate
When real interest rate is low, there are
greater incentives to borrow and fewer
incentives to lend
Interest rates and returns
• The return on a bond held from time t to
time t+1 can be written as
R = (C + Pt+1 – Pt)/Pt
R: return from holding the bond from time t to
time t+1
Pt : price of bond at time t
Pt+1: price of bond at time t+1
C: Coupon payment
• R= C/Pt + (Pt+1-Pt)/Pt = current yield+rate
of capital gain = ic + g
• If time to maturity = holding period, then return =
the initial YTM
• When holding period<terms to maturity, a rise in
interest rates is associated with a fall in bond
prices, resulting in capital losses on bonds
• The more distant a bond’s maturity, the greater
the size of the price change associated with an
interest-rate change
• Even though a bond has a substantial initial
interest rate (high YTM), its return can be
negative if interest rate rises.
Maturity and the volatility of bond
returns: Interest rate risk
• Prices and returns for long-term bonds are
more volatile than those for shorter-term
bonds
• Interest rate risk is the riskiness of an
asset’s return that results from interest
rate changes
• Bonds with a maturity that is as short as
the holding period have no interest-rate
risk, because return = YTM.
Reinvestment risk
• Reinvestment risk occurs because the
proceeds from the short-term bond need
to be reinvested at a future interest rate
that is uncertain.
The behavior of interest rates
• Interest rates are negatively related to the
price of bonds, so if we can explain why
bond prices change, we can also explain
why interest rates fluctuate.
Determinants of asset demand
• An asset is a piece of property that is a
store of value.
• Whether to buy one asset rather another,
consider
-Wealth
-Expected return
-Risk
-Liquidity
• Wealth: more wealth means more
resources to buy assets, so other things
being constant, an increase in wealth
raises the quantity demanded of an asset
• Expected returns: an increase in an
asset’s expected return relative to that of
an alternative asset, holding everything
else unchanged, raises the quantity
demanded of the asset
• Risk: everything else constant, if an
asset’s risk rises relative to that of
alternative assets, its quantity demanded
will fall
• Liquidity: The more liquid an asset is
relative to alternative assets, the greater
will be the quantity demanded.
Benefits of diversification
• Diversification reduces the overall risk an
investor faces, except in the extreme case
where returns on securities move perfectly
together
• The less the returns on two securities
move together, the more benefit (risk
reduction) there is from diversification
Loanable funds framework:supply
and demand for bonds
• Loanable funds framework: Approach the
analysis of interest-rate determination by
studying the supply of and demand for
bonds.
• Factors that cause a shift in the
demand curve for bonds
-Wealth
-Expected returns on bonds relative to
alternative assets
-Risk of bonds relative to alternative assets
-Liquidity of bonds relative to alternative
assets
• Wealth: As wealth increases, bond demand
curve shift to the right
• Expected returns: higher expected interest rates
in the future decrease the demand for long-term
bonds and shift the demand curve to the left
-If expected returns on stock increase, demand
curve for bonds shift to the left
-If expected inflation increases, expected returns
on real assets (cars, houses) increase, and
demand for bonds fall
• Risk: 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.
• Liquidity: increased liquidity of bonds results in
an increased demand for bonds, and the
demand curve shifts to the right. Increased
liquidity of alternative assets lowers the demand
for bonds and shifts the demand curve to the left
• Factors that cause a shift in the supply curve
of bonds
-Expected profitability of investment opportunities:
in a business cycle expansion, the supply of
bonds increases and the supply curve shifts to
the right.
-Expected inflation: when expected inflation
increases, the real cost of borrowing decreases,
and the quantity of bonds supplied increases
-Government activities:
Higher government deficits increase the
supply of bonds and shift the supply curve
to the right.
Changes in expected inflation: the
Fisher effect
• When expected inflation increases,
demand curve for bonds shift to the left
and supply curve for bonds shift to the
right, resulting in a fall in bond price and a
rise in interest rates
Business cycle expansion
• As the economy expands, wealth increases, the
demand for bond increases. Also, supply of
bonds increases. Both demand curve and supply
curve shift to the right.
• Depending on whether the supply curve shifts
more than the demand curve or vice versa, the
new equilibrium interest rate can either rise or
fall
• However, in reality, interest rate rises in
business cycle expansion and falls in recession.
Liquidity preference framework:
supply and demand for money
• Liquidity preference framework:
determines the equilibrium interest rate
using the supply of and demand for
money.
• Assume there are two main categories of
assets that people use to store their
wealth: money and bonds.
• Quantity of bonds and money supplied
must equal the quantity of bonds and
money demanded:
• Bs + Ms = Bd + Md
• Bs – Bd = Md - Ms
• If the market for money is in equilibrium, the
bond market is also in equilibrium
• The liquidity preference framework is equivalent
to the loanable funds framework, which relates
the money market with the bond market
• The loanable funds framework is easier to use
when analyzing the effects from changes in
expected inflation; and the liquidity preference
framework provides a simpler analysis of the
effects from changes in income, the price level,
and the supply of money.
• Money includes currency and checking
account deposits
• Other things constant, interest rate and the
quantity of money demanded are
negatively related.
• Quantity of money supplied is a vertical
line
• Equilibrium interest rate at: Md = Ms
Shift in the demand for money
• Income effect: a higher level of income
causes the demand for money 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 to increase
and the demand curve to shift to the right.
Shift in the supply of money
• An increase in the money supply will shift
the supply curve for money to the right
Does a higher rate of growth of the money
supply lower interest rates?
• Liquidity effect: rising money supply leads to an
immediate decline in the equilibrium interest
rate.
• Increasing money supply takes time to raise the
price level and income , which in turn raise
interest rates.
• The expected-inflation effect, which also raises
interest rates, can be slow or fast, depending on
whether people adjust their expectations of
inflation slowly or quickly when the money
growth rate is increased
• Three possibilities (p107)
The risk and term structure of
interest rates
Risk structure of interest rates

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