FIN 371G Spellman

Important Terms and Concepts

U.S. Treasury Prices Treasuries are debt issued by the U.S. Gov, meaning the Gov borrows principal from the public and pays it back at maturity with interest payments along the way. Treasury prices are determined by the discounted cash flows they provide. Saying a treasury gains in price or the interest rate it pays drops are synonymous as the price of the treasury is pushed up because of high demand, the yield of the bond drops (even though the actual coupon payments stay the same). Typically as the stock market improves, people sell the treasuries they previously owned, lowering their price and raising the effective rates they pay. Mortgage rates are usually correlated to 10 year treasury rates. So if the 10 year treasury rate is high, then it is unattractive to buy houses because they must be financed at a higher rate. High, right now, is all relative because the current mortgage rates we are seeing are near all time lows (~4%) from previous highs of above 15%. The enigma of U.S. treasuries is that they pay a historically low rate right now (meaning there is a high demand for them), despite the fact that the U.S. gov is essentially running a ponzi scheme with their debt; the government doesnt seem to have an intention lowering long-term obligations (Social Security, Medicare). Luckily, other nations have it relatively much worse than us like Europe. Bank Capital Capital is a term used generally to mean an entitys (corporation or person) savings that may be used at the owners discretion. It is also sometimes used very loosely for any type of investable tender (cash, liquid assets). In this class, however, we are concerned mainly the banks capital, capital ratios, and capital requirements. A banks capital is by definition its assets liabilities or its equity. It is a measure of how much of the banks money the bank actually owns (as in is not lent by consumers or the fed). In the past, the banks were overleveraged, meaning they invested a lot of money, but very little of it was actually theirs. When the value of the assets bought with borrowed money dropped significantly, the banks became insolvent because the ratio of capital was too low in relation to the banks risk weighted assets. Banks have trouble lending and restarting the economy right now because they dont have enough capital to meet requirements to lend. Market Flows of Capital In the past year the rise and fall of many national stock markets has been largely the result of capital inflows and outflows to the countries financial system (stocks, banks, bonds, etc.). For example, if the U.S. economy is not offering acceptable rates of returns investors will look elsewhere. I.E. if U.S. treasuries are paying 3% and Australian ones are paying 5%, why buy U.S.? As money flows into an economy, it can be very good because it fuels investments and infrastructure gains. However, it can also be bad because of excess money sloshing around capital markets. The excess money forced into a small economy

can cause high inflation (making the exports expensive bad) and risky speculation (causing bubbles that burst bad). If an extreme event causes money to be pulled out of an economy at a rapid pace, the entire economy can collapse and cause contagion to other linked economies.