money banking & finance [doyle]

8/2/2019 Money Banking & Finance [Doyle]

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IOU, or a liability of the issue

Securities=> the titles to future payments

Everything in this course has to do with: iy=nEi=1(Payments)n

(1+i)n

9780073375908

1/21/11

-The value of anything depends on more than just its location in space it also depends on its

location in time

The location of something in time effects its value (present value)

How much are things in the future worth today

Time has value

People are generally risk averse

A tradeoff in financial markets, Risk/Return Tradeoff

= variability or volatility of expected returns

Risk:

$1 million=> probability (100%)

Expected return = probability * the different amounts= 1*1 mill ion= $1m

Strategy 1:

Coin toss

Heads:$2million

50% probabil ity => $0

-expected return= $1m

50% probabil ity => $2

Tails: nothing

Strategy 2:

People get more pain by losing more than the joy they would gain for the same

amount

Diminishing marginal utility

Ex. Choice

The fundamental tradeoff in financial theory

Ch1:

What is money?

Money is that class of assets that may or less function as a median of exchange in an

economic context

Measured at a point in time

Money is a stock variable:

Something measured over a particular time period

NOT a Flow Variable:

Income is found over a particular time period

NOT income

Wealth is a broader category (only a portion of wealth is in money)

NOT wealth

What is money not?

Reduces transactions costsa)

Barter=> a mutual coincidence of wants would have to occur for any exchange

to take place

b)

Medium of exchange1)

Reduces transactions costsa)

Unit of account2)

Problematic because the real value of money = Money/Price value=> so if P^ =>

(m/p)V => people who are storing their wealth in the form of money become

less wealthy in real terms

a)

Store of value3)

Money is the only asset whose future value in terms of money can be known with

certainty.

Functions:

Functions of Money

Ch. 2

Money Banking & FinanceWednesday, January 19, 2011

1:58 PM

Money Banking and Finance Page 1
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Medium of exchange

Unit of Account

Store of value,

standard of differed payment

Functions of Money They wouldn't because there is no interest paid

However money has a unique quality money is always worth itself

Why would anyone want to store their wealth in money?

Adjectival form- Liquidity is a way of talking about the ease with which an asset can be

converted or sold into money. The qualitative measure of the money -ness of an asset.

Noune form-Money/cash

Liquidity:

Currency in the hands of the public, checkable deposits, non bank issue travelers

checks

-

M1= narrowly defined money

M2=M1+various types of "near monies" ; savings deposi ts, Money market deposit accounts,

overnight repos, CD's, Eurodollars

M3=M2+??? Even less l iquid

In descending order of liquidity the major monetary aggregates are:

Measuring Money

Assets Liabilities

What you own What you owe

+500 k (house) +500k (mortgage)

-250k bonus from uncle rino (mortgage)

250k (mortgage)

250k (equity)

A=L

A-L=goes on the liability side as "equity"

T accounts:

Repo agreements

A L

Reserves 1billion 1 billion Checkable deposit

$1 billion $1 Billion

T-bills, 1 billion Repo 1 billion

Capital

Theory of Ci rcumventive financial innovation:

Giro banking

Eurodollars= deposits anywhere outside the US

1/28/11

Gold standard: you would have to fix the price of gold in terms of money.1)

U.S. Gold content of $

1oz gold= $100Buy gold from government for $100/oz then take it to the gold market and sell it for

$200

Government will have to devalue the dol lar by increasing the gold's price bc they will

be running out of gold. (or they have to make i t illegal to buy and sell gold)

To make a commodity standard work you have to fix the price then make it il legal to

buy and sell the commodity

2)

Using commodities as a median of exchange: gold, salt, shark teeth etc.i.

Commodity Money1)

Paper money: An offi cial government proclamation. Its not backed by anything so the

central bank can print as much as they want.

i.

In order for this to work well money has to be relatively scarce. Otherwise the value of

money can become worthless

ii.

Fiat Money2)

Monetary system in which the liabilities (IOU's) of private fi nancial institutions serve as thei.

Credit Money System3)

Types of Money

Gold market: P^ to $200/oz



3/24

primary medium of exchange

Value of money is backed by the productive capacity of the US economy. Your money is worth

what it can buy and it depends on the productive capacity.

MV=PY

Money * the velocity of money = real GDP-

%M +%V= %P + %Y

V= PY/m (nominal GDP/ money)

Equation of Exchange

If real GDP in the long run is determined by Y=AF(K,L)

And if velocity is constant than the price level i s proportionate to the

money supply

Inflation is the result of too much money chasing after too few goods

The quantity of money determines the level of prices as a whole

Quantity Theory of Money

Demand for money

When V^ that suggests that the demand for MV. When VV that suggests that Md^

Velocity:

k=1/v

Money= the proportion of peoples income that they want to hold in the form of money =K=

1/ux their nominal income (PY)

M=$1t

V=$3

P=$1

Y=$3t

M=kPY

The Cambridge version of the equation of exchange:

M*V=

P*Y=

$1t*3= $3t*1

If v=3, k=1/3

Money is critical because it reduces transaction cost

What if there is a huge increase in ve locity. What would that symbolize about people's opinion of

money ?

People have lost confidence in securities-

VV=> 1/v^

Ch. 3

Flow of funds Lenders -> borrowers

Direct Finance:

Lenders => financial intermediaries=>borrowers

Indirect Finance

Direct Finance vs. Indirect Finance

Primary Markets: are a place where borrowing and lending takes place

Flying papers on wall street-

They have already been bought and sold at least once-

Secondary markets are places of liquidi ty

Primary Markets vs. Secondary Markets

Securities with a term to maturity of less than 1 yearMuch more l iquid than capital market securities

Money Markets

Bonds vs. Stocks

Bondsare evidence ofborrowing and debt

Stock is evidence ofownership

Bonds=debt instrument, securities

Stock=an ownership share in a corporation

Every security is a title ship to an income

Bonds =>Debt=> IOU

Stock=>ownership=>corporate shares

Bonds=interest

Stock=net earnings



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Bonds=>interest

Stock=>dividends (net earnings)

stream

Bond Holders= creditors => they get paid first (businesses pay their debt first before they pay

themselves)

Stock holders= owners => residual claimants

Primary Markets

Markets of liquidi ty

Secondary Markets:

Organized exchange (men buying in sell ing in person)-

NASDAQ-keeps track of different securities samples

OTC (consists of a network of relationships)-

Over the counter Markets ( OTC's) vs. Organized exchanges

Pay a semi annual, biannual, etc coupon payment (fixed annual dollar amount)

10 year coupon bond: over ten years payments are made, then at the end you are

paid the principle (face value=hat the bond is worth when it matures)

Coupon Bonds

PB>face value = premium

PB


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Long term loan issued for the purpose of real estate-

"The bank owns the house" no they its only when the loan is defaulted

The property one uses to ensure a loan and which the lender taked possession of in the

event of default

Collateral-

Increases liquidity

Lowers every type of risk for individual investors

Taking a bunch of small retail loans (loans to small borrowers by banks) create one big

security that can be bought and sold in secondary markets.

Increases Securitizationof retail loans-

Collateralized debt obligations

CDO-

The variability of returns. When a loan is paid off early and you cant pay off the interests as

high as it was before

Reinvestment risk-

Tax free!

Should be lower interest rates than bonds because of its tax free -ness

Municipal Bonds

Paid out of tax revenuesa)

Less risky than the other municipal bondb)

General Obligation1)

Usually used for a particular project (like building a bridge)a)

Paid off of the revenue of the final projectb)

Revenue Bond2)

Two Types:

Mortgages

When a bond can be converted

into stock under certain

circumstance at the initiative

of the lender

Convertibility

Many bonds are callable which

means they can be repaid by

the borrower before the

maturity date whether the

lender likes it or not

Call feature or prevision

The price volatility in interest ratesi.

Market or interest rate risk1-

Borrower wont serve the loan in a timely fashioni.

Default Risk2-

i.

Reinvestment Risk3-

3 Major types of Financial Risk

The interest rate on taxable bonds=3%

" " nontaxable " = 1%

Tax bracket= 25%

It=3%

Im=1%

You after tax = (1-t)it=

.75(3%)= 2.25%

Tax free municipal bonds are only worth it to the people in the highest tax bracket

Im^ => less desirable => DmdV =>P$ V => im^

It v

Municipal bond should grow smaller or narrower

How would a decrease in the highest tax rate affect the spread between municipal and nominal

bond yeilds?

Tax Free Bonds



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Their value is based on the value of something else-

Derivatives are securities that derive their value from the value of some other underlying

asset

Black Scholes option premium pricing model-

Their major advantage to the economic system as a whole it enables hedge strategies

Try to reduce riska)

Hedgers1-

They are willi ngly taking on additional risk to make higher returnsa)

Speculators2-

Held by two type of investors

Derivatives

Evaluation of things based on their location in time (rather than space)

Time preference:

Most people have some degree of positive time preference with respect to most things which

means everything else held constant the thing is more valuable in the present than in the future.

(the further you project a thing in the future the less valuable it is in the present)

-

Delaying gratification is not what most people want (no one likes to wait)-

People value present goods more highly than future goods-

Time Value of Money

This determines the types of behaviors you want to and dont want to engage in

PV of good health 40 years hence = $100K

0 PVB (using discount bonds)

Subjective rate of time preference:

If we know the price of the bond we can calculate the interest of that bond with the same formula

PB=VEn=1(payments)n

(1+i)

n

The yield to maturity on a bond(the interest rate) is the discount rate that

equates the expected stream of payments back to the bonds current price

i=$10 = 10%

$100

Bonds do not trade on interest rates they trade on price:

What future income stream is

"worth" in the present

What is the future value of $100 one year of today at 10%

FV=$100*(1+i) 1=$100(1.1)=$110

Come from the concept ofFuture Value

Present Value



7/24

PV=$100/(1+i)1= $100

PB=$100

PBT+1=$110

i=?

$100=$100/(1+i)=> $100=$110/1+i= 100(1+i)=110 => i=110-100/100= 10%

Bond prices and yields are negatively related.

When PB^, the discount rate that equates the PV of its income stream to its P B goes down => iV-

When the interest rate goes up the PV of all income streams its being used to discount V=>asset

prices V-

Bond prices & Interest rates

1 year at 5%a)

10years at 5%b)

30 years at 5%c)

At 5%=95.24a)

At 5=61.39b)

At5%=23.14c)

At10%=90.91 PB1V by 4.33/9.524=0.4546a)

At 10=38.55 PB10V by 61.39-38.55/61.39=-37.2%b)

At 10%=5.73 PB30V by 23.14-5.73/23.14=75%c)

*The more future weighted an income stream is the more its price wil l change the following agiven change in interest rates. Ie long term bonds exhibit much more price volatility than short

term bonds

PV of 100

For a given change in bond prices, short term interest rates will change by less than long term interest

rates

Short term interest rates tend to fl uctuate by more than long term rates

P10= Principle (face value)/ (1+i) 10

PN=P/(1+i)N

Pure discount bond:

Long term bonds have less interest rate risk than short term bonds

Change of interest rate effect on a bond.

The best measure of a bond we have is Yield To Maturity: the discount rate that equates the bonds

stream of income

Bad deal?

Suppose you use the interest rate on the US bond to calculate the present value of the hotdog

push cart.

Pvpush cart < Ppush cart=bad deal

iR push cart < ius bond Good deal?

Suppose AMR stock = $5 per share

GE stock= 60$ per share

A stocks price earning ratio

If price of stock is $5 per share => $5/$1 =5

= 1/ p/e= 1/5=0.2

IRR of a stock = 1/price earnings ratio

Internal rate of return trick:

Growth funds

Value funds

2 basic types of stock funds:



8/24

The returns from holding a bond can be considerably more or less than the interest rate on the

bond If your holding period is dif ferent from the bond's term to maturity

Interest Rates vs. Returns

Bond returns can be very dif ferent than the interest rate.

Returns:

= the annual coupon payment

the bond's face value

Suppose the coupon rate =%10 and the bond is sel ling at a premium (price of bond>thanface value) but CR=C/FV

Because interest rate and price are inversel y related

-interest rate must be lower than the coupon rate

PB>FV Ms-Md=Bd-Bs

So when financial markets are in general equillibrium the Supply of financial

wealth=demand for financial wealth

-

If Bs=Bd then Md=Ms and the same interest rate that clears the bond market, clears

the money market

Ms>Md=Bd>Bs and Ms


9/24

Bonds

D(lenders)

S(borrowers)Price supply of bonds come from borrowing

Demand of bonds comes from lenders

Supply and demand determines the price of bonds.

Bond prices and yields are negatively related

^Gov deficit=> borrowing=> SB^=> PBV and Q^ =>i^

Basis point: 100 basis point= a 1%age point change in the interest rate

The government budget deficit:1)

Expected future marginal product of capital (the animal spirits) of the business community

Most of the time, (^MPKf=> Y^ and MPKV=>YV)

MPKf^=>higher investment demand=>^borrowing=> S B

Interest rates are prociclycle moving with the business cycle

Improvement in general business2)

The main factors that affect the Bond Supply:

what is it?-

Measure-

Examples-

Reduce-

Risk:

1/2 the time

Return--> $2

$3 per every dollar spent

Succeed

Loss-->-1$0

Fail

$1 in1)

Company (Russia)a)

1/2 the time

Return$1.50

2.50

Succeed

Loss -0.5

$.50

Fail

$1 in1)

Company (Germany)b)

Stocks:

How much can I expect to get back from that investment

Mean weighted average

Probabilities should add up to one

E(a)=.5(2)+.5(-1)= 1-.5=0.5

Russia:

E(b)=.5(1.5)+.5(-.5)=0.5

Germany:

Expected Value:

I would go with Germany because the gains are the same however the potential loss in

Germany is less than russia

They both give the same value of return

Standard deviation (variance)-

Value of risk-

Measure Risk

Example



10/24

Total potential losses

Standard deviation

-1 -.5 .5 1.5 2

Mean=.5

How far from mean:

20.5 =(1.5)2=2.25

-1-0.5=-(1.5)2=2.25

Variance

.5(2.25)+.5(2.25)=2.25

Standard deviation=

variance

Russia:

US Bonds: $1->1.2 back

Investment C

Risk Free Assets:

E(b)=0.5

1.5-0.5=1 2->1

-0.5-0.5=-12->1

Variance=1

Standard deviation=1

Germany:

The risk of investing in

Russia > risk of investing

in Germany

X-> +$1000 (50%)

-$1000 (50%)

Y-> +500 (45%)

-100 (45%)

-1800 (10%)

Two Different Investments:

How much could I possibly lose?X:

Variance=1

Y:

Variance=0.441

The Value at Risk:

E(R )=E(G)--> V(R ) > V(G)

Two Investments:

2.5-

-0.5-

R2

E(R2)-E(G)=>Risk premium

Expected return(R2)=.5(2.5)+.5(-.5)= 1

Risk free investment

Returns

Risk premium

Risk

The higher the interest rate they

have to pay= the higher the risk

Firm specific

Idiosyncratic-

The whole market

Systematic-

2 kinds of Risk:

Source Risk:

Buying insurance

+20

-20

Oil

Look at opposite

Example:

Buy stocks that are opposite: buy ford stock when you invest in oil -

Hedging

Avoiding Risk:



11/24

=-1 (move opposite directions)

=0 (not related)

Correlation= 1 (move together)

When hedging you look for things that move in opposite direction to ensure your

investment

Spreading your investments

$2a.

Half $ 1-

0

$0b.

2 Stocks

Spreading

The investments are not related so that you have a better chance to succeed in one

industry over another.

Events:

1 1,1/4

0 1, 1/4

1 0,1/4

0 0,1/4

0 1 2

Spreading reduces value or risk

Get Notes For March 2nd and 4th

Increase in supply predominates

During a period of rapid economic growth the demand and supply of bonds will

increase

Increase in GDP will effect the bond market

Whene^ => I s.t. r

(i.e. e^I => e^ st r

The Fisher Effect

Bond prices and Interest rates

(devaluing of money)

Price of bonds wil l change to cause capital losses or gains-

Bc bond return is fixed

Volatil ity in real returns-

Inflation Risk1)

Valatili ty of bondsi.

Applies to situations whence the holding period > term to maturity-

If holding period on a bond is = term to maturity : yield to maturity =current yield=

coupon/PB

Interest Rate Risk (market rate risk)2)

The interest wil l not be paid on a timely fashion-

Or the principal payment wont be paid at all-

How do we capture default risk in the bond amrket fraimwork?

Default Risk3)

Supply and Demand

P

Q

S

D

D'

^ default risk=> Dv

=> Dv, Pv and i^ until the default risk premium uses by enough to clear the market

Applies to situations where

the holding period > term to

maturity

-

Reinvestment Risk4)



12/24

T-Bills

S

D

P

QQ*

p*

Ie^ and short term bonds 1 year hence=> Dv => Pv to P' and i^ in the present

D'

Gov Bonds:

S

D

P

QQ*

P*S'

^ G=> budget def icit which must be financed by borrowing=> S to S' =>>Pv to P', i^

Two bonds, A+B => RETca=> vDB

Corprate Bonds

S

D

P

QQ*

P*

vD corporate bonds=> vP and I

Bonds and IR move together

All securities are substitutes for each other

vRisk of holding a particular type of bond

S

D

P

QQ* Q'

P*

The invention of a credit default swap=>

^D=>^P=>iv

D'

p'

^ liquidity of Bonds



13/24

S

D

P

QQ*

P*

^Liquidity=>^D B=>^P and iV

D'

Bond yields=> interest rates-

One period returns from holding a bond :

RETT+1= C + PBT-1-PT

= C+PBT+1-PTPBT

N period return:

PB PBT

RETT+n= Ent-1 CT+PT-n-PTPT

Returns vs Yields

n

CH7: Three ways to understand the relation of interest rates:

How default risk effects different interest rates-

Default risk structure

Moodies and Standard and fords

Moodies uses small letters-

Standard and fords uses capital letters-

US government-

Exxon Mobile-

Microsoft-

AAA bonds have lowest risk of default

GE-

Procter and Gamble-

Spain-

AA

2 Major Bond rating agencies:

Should there be an interest rate differential?

Buy GE bc they are paying a high interest rate to their riskiness

Compare interest rates between Microsoft and GE debt according to Moodies and Standard and Fords:

Some bonds are exempt from taxation

Tax Structure of interest rates:

Yield curve

*the term structure of interest shows the relationship between yields and bonds that differ

onlyin terms of term to maturity==> yiel d curve

The relationship between interest rates on bonds with different terms of maturity

Yield Curve:

Term Structure of Interest rates:

t(term to maturity)

i

Normal (long term interest rates are higher than short)

Flat

Inverted



14/24

The current relationship between short term interest rates and long term interest rates

Interest rates tend to move together1-

Short term yields tend to be more volatile than long term yields2-

Any correct theory of the term structure must either explain or be in accordance with three facts:

Why is the yield curve normally upward sloping3-

*Bonds that differ only in terms of term to maturity are

perfect substitutes.

Pure expectations theoryof the term structure:

iT,1=2%ieT+1=2%

Buy a 1 year bond today and a 1 year bond 1 year hence1)

iT,2=5%

Buy a 2 year bond2)

2 year holding period:

Why the pure expectations theory

should be correct in a world of

perfect rationality

A random walk down wallstreet-

Burtan Malkiel

Which investment strategy promises he highest

Average annual interst return?

2%+2% = 4%=2%1)

2 2

5% = 2.5%2)

2

Investment Strategy #2 is most desire

Term structure

Supply and demand for

bonds

General abstract theory

Long term interest rate = average of short and long term interest rates

It doesnt explain the last of the three major things: Why are yield curves upward sloped?

Pure expectation theory:

Bonds that differ in terms of maturity are not substitutes at all for one another, they are

completely segmented

Borrows prefer to borrow long and lender want to lend short

There is a separate supply and demand for bonds with different maturities

Here is the problem: if bond markets are completely separate then how do we explain why the

levels of interest rates tend to move together?

Segmented Market approach:

People can be induced to part from their preferences if they are offered sufficient

compensation

The idea that lender prefer to lend short and borrowers borrow long-- the key word is prefer

Higher yields on the long end of the maturity spectrum is like tuna fish for a cat.

This would make the yield curve to be upward sloping -- the distance would get wider

as term to maturity increases

The long term interest rate is the average of the short term interest rate plus a premium

The Liquidity premium theory of the term structure of interest rates: (the prefered habitat theory of

the structure)



15/24

If yie ld curves become inverted then its a sign that there is going to be an expected down tern in the

market

He suggested that stock prices follow a random walk-

Variables do not behave in a way that is predictable-

"A random walk Down Wall street" by Burton Malkiel

Entitles one to a prorated share in the issuing corporations net earnings(whatever is

left over after everyone is paid)

Common Stock:

Assumes the risk to guarantee a payment to get them to work for his idea

The entrepreneur gets to keep everything made because he is the residual claimant

Entrepreneur:

Stock holders are a companies residual claimants

Stock: a share of stock entitles a person to an income stream

Bond holders get interest

Stock holders get net earnings called dividends

Book value of a stock= Assets - Liabilities = Equity

There is an inexplicable price increase of an assets beyond the fundamental theory of

the price of that asset

Stock bubble:

Income:

NYSE

DOW

The worth of a company is what its stock is currently selling for

Market Capitalization

S&P 500

Stock indexes:

Consists of 500 different corporations. But their weight depends on market

capitalization relative to the S+P 500 total market capitalization

Market Capitali zation C1 .S+P 500 Total Market Capitalization

S+P 500 fund

Stock index Mutual Fund:

Theory of how stock markets work:

Discount rate of future income to present value - expected rate of growth

Gordon Growth Model

PS=DE/ d-g

d=dVF+drisk-g

Risk free interest rate + Discount rate that has to do with risk - expected growth rate of dividends

Price of a companies stock= dividend today * (1+expected rate of growth)

C1=company 1

What is the optimal forcast of a variable?

People rationally expect all of the available rational information interpreted through

the lens of economic theory that relates to the behavior of that variable

The optimal forecast of a variable is always correct-

Rational expectations dont have to be correct- but it would be wrong if they were

irrational

-

Xe=XOF-

The Theory of Rational expectations

When things change the way that people form expectations change as well1)

Two major implications of the theory:

Fish and Capital Theory:



16/24

Xe=X

=0

Expectations on average wil l be zero2)

People do not make systematic mistakes in the economic part of life (f ish and capital theory)

Systematically- making the same kind of mistake over and over again

Market participants neither systematicallyoverestimate or underestimate the future value

of the variable

Financial markets do not underestimate or overestimate the variables

PT

ReT=PT+1-PT+C

PT

ReT=PeT+1-PT+C

The one period return from holding a bond

How a fi sh and capital markets theory causes security prices to change?

=> the expected return on the bond equals the expected forecast of the bond (expected

return is the best forecast)

PeT+1=PoF=P*T+1= Rof=R*

The expected future price of a bond is the optimal forecast of the price of the bond

Rationality requires that the expected price of the bond in the future=the optimal forcast of a

bond in the future.

In a world of expectations will immediately illuminate any extreme variability of loss

Arbitrage

Bb bond upgraded to Aaa

Optimal forecast of price of the bond > equil ibrium (R*) [^P eT+1 s.t. the expected rate of

appreciation in the bonds price is higher than the equilibrium rate of appreciation]

DB^=>PT^ until ROFT+1V(optimal forecast)=R*

You cant get rich unless you know something other people dont know

Initially optimal forecast of a bond = the equil ibrium price

Long term bonds and you have access to information unemployment decreased from 9.5%

to 5% => ^(inflation goes up)=> i^ =>PeT+1(POFT+1)V ROFT+1DB V=> PT V ROFT+1 unitl ROFT+1=R*

Initially ROF=R*

Fish and capital market are extremely efficient to capitalize future price to current price

This suggests that on average the best you can do i s earn the competitive market equilibrium rate of

returns

Whenever an opportunity to earn a little bit the opportunity is immediately arbitraged away

A way of critiquing current fiscal policy

Rebuilding stuff thats destroyed doesnt make us better off its just cleaning up a mess

It is a way GDP overstates economic well being-- it includes clean up costs

The fallacy is not taken into account the opportunity cost of what could have been spent in order

to fix a problem

Broken Window Fallacy

*The competitive rate of return can be quite high

*you can get rich

Fish and Capital Markets Theory:

The correctness of the securities prices determined in financial markets

Strong Version

Forecast using rational expectations is the optimal forecast

Weak Version

Problems:



17/24

Public announcement- 1 billion in net earnings for Q:1 2011

GM decreases to $18

Example- GM sells for $20 per share1)

People expected the price to be higher earnings so the stock price can decline

How can you reconcile this with the fi sh and capital market?

Its not irrational to think that asset prices will rise

Sometimes the only rational thing to conclude is to think people are irrational

Rof>R* bc POFT+1^=>PT^

--weak version

Are bubbles a sign of markets running irrationally?

Asset Bubbles:

Overshooting:

S

D

P

QQ*

P*D'

If p*^ bf p=p*

It will overshoot p*

All business cycles are based on central bank misbehavior

In Austrian business cycle theory

The fatal flaw in business cycle theory:

S

D

r

S,IS,I*

r*

r*=the "real" interest rate

When S=I

=>Y=C+I+G

The central bank can never resist to increase the money supply=> nominal

interest rate fal ls=> markets misperceive this decrease in the nominal

interest rate to be a decrease in the real interest rate=>spending is too high

and investment is too high=> I is too high and eventually this cannot be

supported (and investment must decrease)=> Y to decrease

According to the austrian business model people frequently systematically make mistakes

Rights and obligations: for buyers and sel lers

A security that derives its value from some underlying asset

Futures

Options

Swaps

Risk reduction strategy-

Hedging

Speculating

People use derivatives when they are-

Two major types of activities in derivative markets:

Derivatives



18/24

Assuming risk ( in the hopes of being compensated)-

The seller of the futures contract (usually called the short-takign the short

position) has the right andobligationto sell the underlyi ng asset at the pre-

agreed upon price at the expiration of the futures contract

Seller-

The buyer of a futures contract (usually called the long- taking the long position)

has the right and obligationto buy the underlying asset at the pre-agreed upon

price at the expiration of the futures contract

Buyer-

Two sides:

An agreement between two people to buy or sell something in the future at a price they agree

upon today.

Futures Contract:

Forward contract-- they tend to be tailored to the specif ic needs to buy and sell at a certain

date (they are not standardized)

[forward=specific, futures=standardized]

This transfer of gains and losses is called mark to mark settlement

One persons gain always comes at the loss of another party - its a 0 sum game

Futures market-- you have to pay up or be payed at the end of the day.

May 31st light Brent oil futures

1 contract = 1,000 barrels

$100 per barrel

Doyle=the long: buy at $100

Michael=the short : sel l at $100

Suppose there is a big decrease in the supply of oi l from lybia=> expected future price

increases to $110 per barrel

At the end of every day you must settle up

The futures contract increases to $110 bbl

The long (buyer) makes $10,000

The short (seller) pays $10,000

^ the futures price=>the long gains

V the futures price=> the short gains

Oil:

"Go long" in the underlying commodity or security

"Go long" in commodities futures--> buy at the current price => when futures price is

greater than starting price => you get paid PF-P*

If PF you pay PF


19/24

Hedging this risk using futures would involve going sell/ go short in the bond futures market

Short gains when the asset falls in price

If someone was to be harmed by rising fuel prices you should go long andbuy futures

0.=0 $99-661 pf=V

Oil=pp8

Olif Futures =$100bl

Possible to use options in a way tha

Options

The issuer of a call option has the obligation to sell the underlying asset at a pre degreed

upon priece

Call options

The obligation to buy the asset at this price and the buyer has the right to sel l \

Put options

The issuer of options obligation the buyer of options has right

The thing you pay an issuer of an option is called an option premium

Options can never be negativeThey are so desirable because they give you the right to do something but not an obligation

Buying an option-- the option premium is the price you pay

Very actively traded in secondary markets-

Time before option expires

Options strike price

Price of underlying asset

For a put option the intrinsic value = "0" or the difference between the strike price

and the price of the underlying asset (P s-PA)

-

Put option: "In the money"= has some intrinsic market value when the price of the

underlying asset falls below the option's strike price.

Priceing options

EX.IBM Puts w/ strike price of $120, IBM stock=$122 and expires on June 30, 2011

Poption=intrinsic value + time value

A put option will command a higher price the (lower) or ( higher) is the strike price?

The longer the period until the option expires the higher will be its time value.

A call option will command the lower is the strike price

More like options or insurance policy

CDS is an insurance policy (a put option) against a bonds default

Credit default swap= x% which should represent the default risk premium

Interest rate on the cds-qcds=iUS

Credit default swaps:

Options have a-semetric rights and obligations

A contract with two parties where one party pays a fixed interest rate to a party and the other

pays a variable rat eto the fixed rate party.

B: Variable rate payer --> notional principle


20/24


21/24

p=e=F/$1

Q($)

$/1Q

Price = the dollar price of 1 Q

S(domestic resi dents)

D(foreign residents)

Suppose the fed Ms=> V iD =>(V demand or in supply of $) => ei ther way the exchange rate goes down

=> but if the dollar decreases then Q decreases

Increase in supply of dollars results f rom domestic residents buying more foreign securities

Emphasize the "positive" aspect of a transaction: buying as opposed to not buying

When iD^=>^D$=>e^

When iF^=> S$=> eV

Foreign Exchange Rate:

F/$1

$

S

D

^iD or V iF will cause e^

e

$

^Y=> ^spending => ^ imports (maybe Vexports as a result of domestic imports^ when Y )

=> V net exports => decrease in demand for dollars in the foreign exchange market, supply=> CV (dollar

depreciates)

When Y^=> NXV=> eV

D'

**

Another way of restating the eff icient capital market

1D=1F-(eeT+1-et/et)

eet+1=1 yr domestic interest rate

et= current spot market exchange rate

Whats going to happen is one of these changes

Also explain the equasion in words

Interest Rate Parody Condition

Banking system= system of depository institutions

Bid-ask spread

Bid=buying price

Ask=sell ing price

Assets (owned) Liabilities (owed)

Deposits at fed

Vault cash

Cash items in

process (float)

Reserves

Secondary reserves

(all loans to bank)

Checkable deposits

Share accounts, past book savings accounts, deposits,

small denomination ,large denomination time deposit

Savings deposits

Capital

Bank's Balance Sheet

Bank Firm and Balance Sheet:

*



22/24

T-bills

Liquid securities

Bank borrowers

Retail loans

Real estate holding

Bank reserves are cash- money banks use to make payments amongst themselves

Liquidity management-management of reserves

Balancing act involving tradeoffs

Cost with having liquidity, and a cost with not having enough

Liquidity- managing banks reserves

Asset- making loans with the lowest risk and highest return

Liability- disintermediation: people withdrawing their funds and investing it directly in

financial markets. The more loans it has with people the more loans it can make

When capital =0 the bank is insolvent

Capital- problem because when banks make bad loans, capital takes the hit.

4 types of management:

Bank Owners are only concerned with ROE(return on equity)

1% on sales=> $1.2b/yr=12m

The smaller the ratio of capital to assets the higher the return on equity

100 mi llion in inventory and turns it every month

ROE= net earnings on assets* ratio of its assets /captal

ROA=1/capital/assets= eqiuty multiplies

Capital V=> the euity multipl ier decreases

Roe on equty =10%

The lower the ____ likely to it is that benaks addue moe risk

Portfolio diversification

Risk

Efficient capital market

Foreign exchange

DerivativesLiquidity crisis

Capital crisis

5,8,9,10,12

Test:

Given curetn plitical climate

^^cemand fur chase

9nij,dom`=> sell sets (liqiudity)

Pay V=too much loan lossses ad the result of vP= an d coloe sotether

Risk of insolvency-- holding capital prevents this

ROE=ROA*EMThe less capital the bank has the higher the equity multipl ier: 1/capital/asset

When banks hold less capital the more likely they are to fail -- when banks fail the losses are

spread throughout society

Major type of risk:

Can lead to insolvancy-- mostly to do with a bank running short of reserves

Adverse clearing= net outflow of deposits

A L

Reserves

Securities

Deposites

capital

Liquidity Risk:



23/24

loans

-5 million deposit outflow =>

Sell securities1)

Fail to renew loans2)

Or by borrowing in the fed funds market

Borrow from the FED at the discount rate (rate the fed charges banks)3)

Bank can try to attract deposits: by offering higher interest rates etc.4)

When a bank is faced with a li quidity problem it can do 1 of 4 things:

Risk that a banks own portfolio is going to go bad

Regional diversification enabled by laws that permit branch banking

One way to reduce risk-- diversify loan portfolios

Credit Risk:

Rate sensitive assets vs rate sensitive liabilities

i^=> Gap D of 1,=>CB now has 900k in excess reserves=> CB can affords to make loansup to 900K because they can afford to lose 900k in reserves => ^L by 900k and ^D by 900k

Real Bills Doctrine

A L

+900k

Cash items in process

+900K

+900K R

My doctor banks at BofA VR=adverse clearing

^R=a favorable clearing

When a bank has a crearing that causes a loss in reserves its called an

adverse clearing

Now BofA has 810k in ER=>

D=1/RR*R

Chang in deposites= 1/reserve requirements times the change in the reserve

Money is nothing more than an intellectual and social construct

How the FED makes money:

The main tool the fed uses to control the monetary base is the open market operations

MV but Vv

QE2= 600b open market purchase

Fed

a L

City Bank

A L

+600B revenues 600B deposit



24/24

+600k casj

RR=10%

+600b US gov securities +600 b deposit to cb

600 b deposite

M=10*RR=10*600B=$6T

Senaurage: revenue that governmet recieves fro

money banking & finance [doyle]

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