Money Banking & Finance

Wednesday, January 19, 2011 1:58 PM

Everything in this course has to do with: Securities=> the titles to future payments IOU, or a liability of the issue

i y =nEi=1(Payments) n (1+i) n 9780073375908

1/21/11 Ch1: Time has value -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 The fundamental tradeoff in financial theory A tradeoff in financial markets, Risk/Return Tradeoff People are generally risk averse Risk: = variability or volatility of expected returns

Ex. Choice Strategy 1: $1 million=> probability (100%) Expected return = probability * the different amounts= 1*1 million= $1m
Strategy 2: Coin toss Heads:$2million Tails: nothing 50% probability => $0 50% probability => $2 -expected return= $1m Diminishing marginal utility People get more pain by losing more than the joy they would gain for the same amount Ch. 2 Functions of Money What is money? What is money not? Money is that class of assets that may or less function as a median of exchange in an economic context Money is a stock variable: Measured at a point in time NOT a Flow Variable: Something measured over a particular time period NOT income Income is found over a particular time period NOT wealth Wealth is a broader category (only a portion of wealth is in money) Functions: 1) Medium of exchange a) Reduces transactions costs b) Barter=> a mutual coincidence of wants would have to occur for any exchange to take place 2) Unit of account a) Reduces transactions costs 3) Store of value a) 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 Money is the only asset whose future value in terms of money can be known with certainty.

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1/26/11 Functions of Money Medium of exchange Unit of Account Store of value, standard of differed payment

Why would anyone want to store their wealth in money? They wouldn't because there is no interest paid However money has a unique quality money is always worth itself

Measuring Money Liquidity: 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

In descending order of liquidity the major monetary aggregates are: M1= narrowly defined money - Currency in the hands of the public, checkable deposits, non bank issue travelers checks M2=M1+various types of "near monies" ; savings deposits, Money market deposit accounts, overnight repos, CD's, Eurodollars M3=M2+??? Even less liquid
T accounts: Assets What you own Liabilities 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"

Eurodollars= deposits anywhere outside the US

Theory of Circumventive financial innovation: Repo agreements A L Giro banking Reserves 1billion 1 billion Checkable deposit

$1 billion
T-bills, 1 billion

$1 Billion
Repo 1 billion Capital

1/28/11 Types of Money 1) Commodity Money i. Using commodities as a median of exchange: gold, salt, shark teeth etc. 1) Gold standard: you would have to fix the price of gold in terms of money. U.S. Gold content of $ Gold market: P^ to $200/oz 1oz gold= $100 Buy gold from government for $100/oz then take it to the gold market and sell it for $200 Government will have to devalue the dollar by increasing the gold's price bc they will be running out of gold. (or they have to make it illegal to buy and sell gold) 2) To make a commodity standard work you have to fix the price then make it illegal to buy and sell the commodity 2) Fiat Money i. Paper money: An official government proclamation. Its not backed by anything so the central bank can print as much as they want. ii. In order for this to work well money has to be relatively scarce. Otherwise the value of money can become worthless 3) Credit Money System i. Monetary system in which the liabilities (IOU's) of private financial institutions serve as the primary medium of exchange

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i. 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. Equation of Exchange MV=PY - Money * the velocity of money = real GDP %M +%V= %P + %Y

Quantity Theory of Money If real GDP in the long run is determined by Y=AF(K,L) And if velocity is constant than the price level is 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

V= PY/m (nominal GDP/ money)

Velocity: Demand for money When V^ that suggests that the demand for MV. When V V that suggests that Md^
The Cambridge version of the equation of exchange: k=1/v M=kPY 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*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 velocity. What would that symbolize about people's opinion of money ? V V=> 1/v^ - People have lost confidence in securities Ch. 3 Direct Finance vs. Indirect Finance Direct Finance: Flow of funds Lenders -> borrowers Indirect Finance Lenders => financial intermediaries=>borrowers

Primary Markets vs. Secondary Markets Primary Markets: are a place where borrowing and lending takes place Secondary markets are places of liquidity - Flying papers on wall street - They have already been bought and sold at least once Money Markets Securities with a term to maturity of less than 1 year Much more liquid than capital market securities

Bonds vs. Stocks

Bonds are evidence of borrowing and debt Stock is evidence of ownership Bonds =>Debt=> IOU Stock=>ownership=>corporate shares

Bonds=debt instrument, securities Stock=an ownership share in a corporation

Every security is a title ship to an income stream

Bonds=interest Stock=net earnings

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stream Bonds=>interest Stock=>dividends (net earnings)

Bond Holders= creditors => they get paid first (businesses pay their debt first before they pay themselves) Stock holders= owners => residual claimants Primary Markets Secondary Markets: Markets of liquidity

Over the counter Markets (OTC's) vs. Organized exchanges - Organized exchange (men buying in selling in person) - OTC (consists of a network of relationships) NASDAQ-keeps track of different securities samples

Bonds
Two types: Coupon Bonds 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) Pure Discount (zero coupon bonds)

Bonds can sell at a discount or premium PB>face value = premium PB<face value= a discount
Key Money Market Securities 1) T-Bills - Always coupon bonds Government likes to finance their debt using short term loans - The interest rate in US Government Securities has usually been considered the benchmark default risk free interest rate

2) Negotiable Bank CD's - They can be legally bought ant sold

3) Commercial Paper - Short term debt (30-90 days) 4) Bankers acceptances - Short term securities guarantied by bankers 5) Repurchasing Agreements 6) Fed Funds Market - Overnight loans among banks - Buying and selling bank reserves 7) Eurodollars - Dollar denominated deposits located outside of the USA Capital Market Instruments 1. Stock 1) Preferred Stock a) Stock holders guarantied a certain pay out b) Cumulative i) Legally the corp must pay all back dividends to you before anyone else c) Noncumulative i) It never has to get caught up it just goes on until the next year d) No voting rights 2) Common Stock a) Bottom of the hierarchy b) Gets to vote for board of directors and other things within the company etc. c) Pro-rata share of the companies corporate earnings i) Pro rata= shares/outstanding shares

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Mortgages - Long term loan issued for the purpose of real estate - Collateral The property one uses to ensure a loan and which the lender taked possession of in the event of default "The bank owns the house" no they its only when the loan is defaulted - Increases Securitization of retail loans 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 liquidity Lowers every type of risk for individual investors - CDO Collateralized debt obligations - Reinvestment risk The variability of returns. When a loan is paid off early and you cant pay off the interests as high as it was before Municipal Bonds Tax free! Should be lower interest rates than bonds because of its tax free -ness Two Types: 1) General Obligation a) Paid out of tax revenues b) Less risky than the other municipal bond 2) Revenue Bond a) Usually used for a particular project (like building a bridge) b) Paid off of the revenue of the final project

Convertibility When a bond can be converted into stock under certain circumstance at the initiative of the lender Call feature or prevision Many bonds are callable which means they can be repaid by the borrower before the maturity date whether the lender likes it or not

3 Major types of Financial Risk 1- Market or interest rate risk i. The price volatility in interest rates 2- Default Risk i. Borrower wont serve the loan in a timely fashion 3- Reinvestment Risk i. Tax Free Bonds The interest rate on taxable bonds=3% " " nontaxable " = 1%
Tax bracket= 25% It=3% Im=1% You after tax = (1-t)i t= .75(3%)= 2.25%

Tax free municipal bonds are only worth it to the people in the highest tax bracket
How would a decrease in the highest tax rate affect the spread between municipal and nominal bond yeilds? Municipal bond should grow smaller or narrower Im^ => less desirable => Dmd V =>P$ V => im^ It v

Derivatives
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Derivatives
Derivatives are securities that derive their value from the value of some other underlying asset - Their value is based on the value of something else - Black Scholes option premium pricing model Their major advantage to the economic system as a whole it enables hedge strategies Held by two type of investors 1- Hedgers a) Try to reduce risk 2- Speculators a) They are willingly taking on additional risk to make higher returns Time Value of Money Time preference: Evaluation of things based on their location in time (rather than space) - 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

Subjective rate of time preference: This determines the types of behaviors you want to and dont want to engage in 60 years old Good health = $100,000 PV of good health 40 years hence = $100K (1+d) 40 0<d<1 The higher is "d" (your personal rate of positive time preference), the lower will be the Present Value People with high rates of time preference are more likely to abuse things like alcohol, drugs etc. The process of discounting is the process of finding out how much something in the future is valued in the present Discounting is when you take something in the future and plug in the discount rate and find the present value
PV= v En=1(payments) n (1+d) n What future income stream is "worth" in the present

When discount ^ => PV V

Discount rate should represent what? Use dUS, PV US> PV B (using discount bonds)
Bonds do not trade on interest rates they trade on price: 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

Present Value Come from the concept of Future Value What is the future value of $100 one year of today at 10% FV=$100*(1+i) 1=$100(1.1)=$110
PV=$100/(1+i) 1= $100

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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 & Interest rates 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 => i V - When the interest rate goes up the PV of all income streams its being used to discount V=>asset prices V
PV of 100 a) 1 year at 5% b) 10years at 5% c) 30 years at 5%

a) At 5%=95.24 b) At 5=61.39 c) At5%=23.14

a) At10%=90.91 b) At 10=38.55 c) At 10%=5.73 P B1V by 4.33/9.524=0.4546 P B10V by 61.39-38.55/61.39=-37.2% P B30 V by 23.14-5.73/23.14=75%

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

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 fluctuate by more than long term rates The best measure of a bond we have is Yield To Maturity: the discount rate that equates the bonds stream of income Change of interest rate effect on a bond. Pure discount bond: P10= Principle (face value)/ (1+i) 10 PN=P/(1+i) N
Long term bonds have less interest rate risk than short term bonds i R push cart < i us bond Good deal? 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
Internal rate of return trick: 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 IRR of a stock = 1/price earnings ratio = 1/ p/e= 1/5=0.2
2 basic types of stock funds: Growth funds Value funds Interest Rates vs. Returns

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Interest Rates vs. Returns The returns from holding a bond can be considerably more or less than the interest rate on the bond If your holding period is different from the bond's term to maturity

Discounting: Returns: Bond returns can be very different than the interest rate. Coupon Rate = the annual coupon payment the bond's face value Suppose the coupon rate =%10 and the bond is selling at a premium (price of bond>than face value) but CR=C/FV Will i< CR? Because interest rate and price are inversely related PB>FV <= coupons/discount rate=I -interest rate must be lower than the coupon rate Issue a billion $ of 6% coupon rate bonds for 10 years? The Paul Street Inc 6% of 2031 are selling at a considerable premium in the secondary market What does that mean should you be upset or happy? You should be mad because you could have sold at a lower yield, and borrowed at a lower interest rate Try to sell at the highest possible price and buy at lowest possible interest rate
Current Yield = Annual Coupon Payment Price of Bond If price of a bond increases above the face value the coupon payment doesnt change but the current yield on the bond decreases The current yield is a better interpretation than the interest rate on the bond Return for holding a bond is partially the yield What is the return on a bond? Return on a bond = % rate of return you get on your investment strategy Return on bond per year= Coupon + PB t+1-PBT PBT PBT 5% +(-10%)=-5% Exante interest rate= nominal interest rate - expected rate of inflation (i -e) Expost interest rate= i- Nominal interest Rate= r++risk premium () Bond Market Framework Bond Market & Money Market Connection: Supply of financial wealth= supply of bonds + supply of money Demand of financial wealth= demand for bonds + demand for money - So when financial markets are in general equillibrium the Supply of financial wealth=demand for financial wealth Ws=WD=>Bs+MS=Bd+Md => Ms-Md=Bd-Bs 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<Md=Bd<Bs What exactly is being bought and sold in the Bond market? In the labor market: labor is being bought and sold -> not jobs In the bond market people use money as a way of facilitating exchange Bonds trade on price not interest rates The Bond Market Framework

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Price

S(borrowers)

supply of bonds come from borrowing Demand of bonds comes from lenders

D(lenders)
Bonds Supply and demand determines the price of bonds. Bond prices and yields are negatively related The main factors that affect the Bond Supply: 1) The government budget deficit: ^Gov deficit=> ^ borrowing=> S B^=> PBV and Q^ =>i^ Basis point: 100 basis point= a 1%age point change in the interest rate 2) Improvement in general business Expected future marginal product of capital (the animal spirits) of the business community Most of the time, (^MPKf=> Y^ and MPK V=>YV)

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

Interest rates are prociclycle moving with the business cycle Risk: -

what is it? Measure Examples Reduce

Example Stocks: a) Company (Russia) 1) $1 in Succeed 1/2 the time $3 per every dollar spent Return--> $2 Fail $0 Loss-->-1 b) Company (Germany) 1) $1 in Succeed 1/2 the time 2.50 Return$1.50 Fail $.50 Loss -0.5 Expected Value: How much can I expect to get back from that investment Mean weighted average Russia: E(a)=.5(2)+.5(-1)= 1-.5=0.5 Probabilities should add up to one Germany: E(b)=.5(1.5)+.5(-.5)=0.5 They both give the same value of return I would go with Germany because the gains are the same however the potential loss in Germany is less than russia Measure Risk - Standard deviation (variance) - Value of risk Total potential losses

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Value of risk Total potential losses Standard deviation Russia: Mean=.5 How far from mean: 2<->0.5 =(1.5)2=2.25 -1<->-0.5=-(1.5) 2=2.25 Variance .5(2.25)+.5(2.25)=2.25

-1

-.5

.5

1.5

Risk Free Assets: Investment C US Bonds: $1->1.2 back

Standard deviation=variance
Germany: E(b)=0.5 1.5-0.5=1 2->1 -0.5-0.5=-12->1 Variance=1 Standard deviation=1

The risk of investing in Russia > risk of investing in Germany

Two Different Investments: X-> +$1000 (50%) -$1000 (50%) Y-> +500 (45%) -100 (45%) -1800 (10%)

The Value at Risk: How much could I possibly lose? X: Variance=1 Y: Variance=0.441

Two Investments: E(R )=E(G)--> V(R ) > V(G) R2 - 2.5 Expected return(R2)=.5(2.5)+.5(-.5)= 1 - -0.5

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

Returns Risk premium Risk free investment Risk The higher the interest rate they have to pay= the higher the risk Source Risk: 2 kinds of Risk: - Idiosyncratic Firm specific - Systematic The whole market

Avoiding Risk: Hedging Buying insurance Example: Oil +20 -20 Look at opposite Buy stocks that are opposite: buy ford stock when you invest in oil -

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Buy stocks that are opposite: buy ford stock when you invest in oil Correlation= 1 (move together) =-1 (move opposite directions) =0 (not related) When hedging you look for things that move in opposite direction to ensure your investment Spreading Spreading your investments 2 Stocks The investments are not related so that you have a better chance to succeed in one a. $2 industry over another. b. $0 - Half $ 1 0 Events: 1 0 1,1/4 1, 1/4 0 1 2

1
0

0,1/4
0,1/4

Spreading reduces value or risk

Get Notes For March 2nd and 4th Supply and Demand Bond prices and Interest rates Increase in GDP will effect the bond market During a period of rapid economic growth the demand and supply of bonds will increase Increase in supply predominates The Fisher Effect When e^ => ^I s.t. r (i.e. e^I => e^ st r 1) Inflation Risk (devaluing of money) - Price of bonds will change to cause capital losses or gains - Volatility in real returns Bc bond return is fixed 2) Interest Rate Risk (market rate risk) i. Valatility of bonds - 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 3) Default Risk - The interest will 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?

P
S D

D'

^ default risk=> Dv => Dv, Pv and i^ until the default risk premium uses by enough to clear the market
4) Reinvestment Risk - Applies to situations where the holding period > term to maturity

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T-Bills P S

p*

D' Q*

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

S
S'

P*

D Q* Q

^ G=> ^ budget deficit which must be financed by borrowing=> ^S to S' =>>Pv to P', i^ Two bonds, A+B =>^RETca=> vD B Corprate Bonds
P S

P*

D Q* Q

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 P S

p' P* D'
D Q* Q' Q The invention of a credit default swap=> ^D=>^P=>iv

^ liquidity of Bonds

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P* D'
D Q* Q

^Liquidity=>^DB=>^P and i V Returns vs Yields - Bond yields=> interest rates One period returns from holding a bond : RETT+1= C + PBT-1-PT PB PBT B -P = C+P T+1 T PBT N period return: RETT+n= Ent-1 CT+PT-n-PT PT

CH7: Three ways to understand the relation of interest rates: Default risk structure - How default risk effects different interest rates

2 Major Bond rating agencies: Moodies and Standard and fords - Moodies uses small letters - Standard and fords uses capital letters
AAA bonds have lowest risk of default - US government - Exxon Mobile - Microsoft

AA
- GE - Procter and Gamble - Spain

Compare interest rates between Microsoft and GE debt according to Moodies and Standard and Fords: Should there be an interest rate differential? Buy GE bc they are paying a high interest rate to their riskiness
Tax Structure of interest rates: Some bonds are exempt from taxation Term Structure of Interest rates: Yield curve The relationship between interest rates on bonds with different terms of maturity *the term structure of interest shows the relationship between yields and bonds that differ only in terms of term to maturity==> yield curve

Yield Curve:
i Inverted

Flat
Normal (long term interest rates are higher than short) t(term to maturity)

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

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The current relationship between short term interest rates and long term interest rates Any correct theory of the term structure must either explain or be in accordance with three facts: 1- Interest rates tend to move together 2- Short term yields tend to be more volatile than long term yields

3- Why is the yield curve normally upward sloping Pure expectations theory of the term structure: *Bonds that differ only in terms of term to maturity are perfect substitutes. Burtan Malkiel - A random walk down wallstreet Why the pure expectations theory should be correct in a world of perfect rationality

2 year holding period: 1) Buy a 1 year bond today and a 1 year bond 1 year hence i T,1=2% i eT+1=2% 2) Buy a 2 year bond Which investment strategy promises he highest i T,2=5% Average annual interst return? 1) 2%+2% = 4%=2% 2 2 2) 5% = 2.5% 2 Investment Strategy #2 is most desire Term structure Supply and demand for bonds General abstract theory Pure expectation 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? Segmented Market approach: 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?

The Liquidity premium theory of the term structure of interest rates: (the prefered habitat theory of the structure) The idea that lender prefer to lend short and borrowers borrow long -- the key word is prefer People can be induced to part from their preferences if they are offered sufficient compensation Higher yields on the long end of the maturity spectrum is like tuna fish for a cat. The long term interest rate is the average of the short term interest rate plus a premium This would make the yield curve to be upward sloping -- the distance would get wider as term to maturity increases

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

Theory of how stock markets work: "A random walk Down Wall street" by Burton Malkiel - He suggested that stock prices follow a random walk - Variables do not behave in a way that is predictable Stock: a share of stock entitles a person to an income stream Common Stock: Entitles one to a prorated share in the issuing corporations net earnings(whatever is left over after everyone is paid) Entrepreneur: 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 Stock holders are a companies residual claimants Income: Bond holders get interest Stock holders get net earnings called dividends

Book value of a stock= Assets - Liabilities = Equity Stock bubble: There is an inexplicable price increase of an assets beyond the fundamental theory of the price of that asset
Stock indexes: NYSE DOW S&P 500 Market Capitalization The worth of a company is what its stock is currently selling for

Stock index Mutual Fund: S+P 500 fund Consists of 500 different corporations. But their weight depends on market capitalization relative to the S+P 500 total market capitalization C1=company 1 Market Capitalization C 1 . S+P 500 Total Market Capitalization

Price of a companies stock= dividend today * (1+expected rate of growth) 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 Fish and Capital Theory: The Theory of Rational expectations - Xe=XOF 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 Two major implications of the theory: 1) When things change the way that people form expectations change as well 2) Expectations on average will be zero

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2) Expectations on average will be zero Xe=X =0 People do not make systematic mistakes in the economic part of life (fish and capital theory) Market participants neither systematically overestimate or underestimate the future value of the variable Systematically- making the same kind of mistake over and over again Financial markets do not underestimate or overestimate the variables How a fish and capital markets theory causes security prices to change? The one period return from holding a bond ReT=PT+1-PT+C PT ReT=PeT+1-PT+C PT

Rationality requires that the expected price of the bond in the future=the optimal forcast of a bond in the future. => the expected return on the bond equals the expected forecast of the bond (expected return is the best forecast)
The expected future price of a bond is the optimal forecast of the price of the bond PeT+1=PoF=P*T+1= Rof=R* Arbitrage In a world of expectations will immediately illuminate any extreme variability of loss Initially optimal forecast of a bond = the equilibrium price Bb bond upgraded to Aaa Optimal forecast of price of the bond > equilibrium (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 ROF=R* Long term bonds and you have access to information unemployment decreased from 9.5% to 5% => ^(inflation goes up)=> i^ =>P eT+1(POF T+1) V ROFT+1<R*=> DB V=> PT V ROFT+1 unitl ROFT+1 =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 is earn the competitive market equilibrium rate of returns Whenever an opportunity to earn a little bit the opportunity is immediately arbitraged away Broken Window Fallacy A way of critiquing current fiscal policy

It is a way GDP overstates economic well being--it includes clean up costs Rebuilding stuff thats destroyed doesnt make us better off its just cleaning up a mess
The fallacy is not taken into account the opportunity cost of what could have been spent in order to fix a problem Fish and Capital Markets Theory: *you can get rich *The competitive rate of return can be quite high Strong Version The correctness of the securities prices determined in financial markets Weak Version Forecast using rational expectations is the optimal forecast Problems: 1) Example- GM sells for $20 per share

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Problems: 1) Example- GM sells for $20 per share Public announcement- 1 billion in net earnings for Q:1 2011 GM decreases to $18 How can you reconcile this with the fish and capital market? People expected the price to be higher earnings so the stock price can decline

Asset Bubbles: Are bubbles a sign of markets running irrationally? 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 POF T+1^=>PT^ --weak version Overshooting:
P S

P*

D' D Q* If p*^ bf p=p* It will overshoot p* Q

The fatal flaw in business cycle theory: All business cycles are based on central bank misbehavior In Austrian business cycle theory r S When S=I =>Y=C+I+G

r*

D S,I* S,I r*=the "real" interest rate The central bank can never resist to increase the money supply=> nominal interest rate falls=> 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 Derivatives Rights and obligations: for buyers and sellers

A security that derives its value from some underlying asset Futures Options Swaps Two major types of activities in derivative markets: People use derivatives when they are Hedging - Risk reduction strategy Speculating Assuming risk (in the hopes of being compensated)

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- Assuming risk (in the hopes of being compensated)

Futures Contract: An agreement between two people to buy or sell something in the future at a price they agree upon today. Two sides: SellerThe seller of the futures contract (usually called the short-takign the short position) has the right and obligation to sell the underlying asset at the preagreed upon price at the expiration of the futures contract BuyerThe buyer of a futures contract (usually called the long- taking the long position) has the right and obligation to buy the underlying asset at the pre-agreed upon price at the expiration of the futures contract Forward contract-- they tend to be tailored to the specific needs to buy and sell at a certain date (they are not standardized) [forward=specific, futures=standardized]

Futures market-- you have to pay up or be payed at the end of the day. 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
Oil: 1 contract = 1,000 barrels May 31st light Brent oil futures $100 per barrel Doyle=the long: buy at $100 Michael=the short : sell at $100

At the end of every day you must settle up

Suppose there is a big decrease in the supply of oil from lybia=> expected future price increases to $110 per barrel 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
Speculating with Futures Suppose you wanted to speculate that the prize of oil is going to rise "Go long" in the underlying commodity or security In the futures market: "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<P* => you pay PF<P* Suppose price of oil will go down "Go short" in the underlying commodity or security In the futures market however you agree to sell at P* If PF<P*=> P*-PF= your gains Trading Places: 9 am Duke Brothers have incorrect insider information that will be made publicly available at 9:30 a.m. that next years orange crop harvest is a disaster. Acroid and Murphy have the correct insider info that there will be an abundant orange harvest next year Hedging with futures: You are going to get 1 billion in a yr- what is your risk? Between now and then interest rates could increase in which case P B could decrease

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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 and buy futures

Olif Futures =$100bl 0.=0 $99-661 pf=V

Oil=pp8 Options Possible to use options in a way tha

The issuer of options obligation the buyer of options has right Call options The issuer of a call option has the obligation to sell the underlying asset at a pre degreed upon priece Put options The obligation to buy the asset at this price and the buyer has the right to sell \
The thing you pay an issuer of an option is called an option premium Options have a-semetric rights and obligations They are so desirable because they give you the right to do something but not an obligation Options can never be negative

Buying an option-- the option premium is the price you pay - Very actively traded in secondary markets Priceing options Time before option expires Options strike price Price of underlying asset
Put option: "In the money"= has some intrinsic market value when the price of the underlying asset falls below the option's strike price. - 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)

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

Credit default swaps: 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 Interest Rate Swaps: 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<-- fixed rate payer Fixed rate receiver variable rate receiver

Rules: Hedging with interest rate swaps Risk:

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 Hedging with interest rate swaps - Risk: Rising interest rates will increase your cost of funds; your payments will be adversely affected by change in the interest rate => change in interest rate adversely impacts liability side where asset side is immune => Fixed rate payer and variable rate receiver. Falling interest rates=> whose asset sides would be disproportionately affected by changed in the interest rate=> in other words their reciepts or revenues are adversely affected by change in interest=> variable rate payer and fixed rate receiver Household finance Co.

Assets

Liablities

Short term loans Long term loans

If interest decreases their revenues will be adversely affected

Banks - assets: long term liabilities: short term Foreign Exchange Rate Determination: How they are determined in the long and short run Long run: purchasing power parody Short run: interest rates

PPP: Purchasing Power Parody [long run determination] As a result of international arbitrage in goods and services the value of a countries currency in terms of goods and services should be the same everywhere. Why? Because changes in the nominal exchange rate should result in the real exchange rate tending toward the value of "1" Good predictor of where exchange rates will be heading
When the condition holds one unit of a countries money can buy the same amount of goods and services any where in the world

Nominal exchange rate= e= F/$1 Real exchange rate= = F/$1 * P D/PF PPP is achieved when =1
Ex. Current exchange rate= 1E/1$

domestic price of beer= $5 (6 pack) foreign price of beer= E2 (6pack)

= E1/$1 * P D(5$)/PF(2E)= 2.5 == the price of one unit of domestic goods in terms of foreign goods

Arbitrage opportunity: 1/2.5=0.4 Buy low sell high - Beer is cheap in Europe and expensive in the US ^D$ or ^DE in FE mkt=> ^DE=> ^ in value PPP suggests: ^P D=> Ve=> domestic money depreciates ^PF => ^e=>domestic may appreciate
Dynamic version %e=F-D

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p=e=F/$1

S(domestic residents)

D(foreign residents)
Q($)

Price = the dollar price of 1 Q $/1Q

Suppose the fed ^ Ms=> V i D =>(V demand or ^ in supply of $) => either way the exchange rate goes down => but if the dollar decreases then Q decreases Increase in supply of dollars results from domestic residents buying more foreign securities Emphasize the "positive" aspect of a transaction: buying as opposed to not buying When i D^=>^D$=>e^ When i F^=> ^S$=> e V

Foreign Exchange Rate:

F/$1 e S

^i D or V i F will cause e^ D
D' $

^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=> e V ** * Interest Rate Parody Condition 1D=1F-(e eT+1-e t/et) Another way of restating the efficient capital market

e et+1=1 yr domestic interest rate e t= current spot market exchange rate

Whats going to happen is one of these changes Also explain the equasion in words Bank Firm and Balance Sheet: Banking system= system of depository institutions Bid-ask spread Bid=buying price Ask=selling price Bank's Balance Sheet Assets (owned) Liabilities (owed)

Reserves Deposits at fed Vault cash Cash items in process (float) Secondary reserves T-bills

Checkable deposits (all loans to bank) Savings deposits Share accounts, past book savings accounts, deposits, small denomination ,large denomination time deposit Capital

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Secondary reserves T-bills Liquid securities Bank borrowers Retail loans Real estate holding

Capital

Bank reserves are cash- money banks use to make payments amongst themselves Liquidity management- management of reserves 4 types of management: Liquidity- managing banks reserves Balancing act involving tradeoffs Cost with having liquidity, and a cost with not having enough 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 Capital- problem because when banks make bad loans, capital takes the hit. When capital =0 the bank is insolvent Bank Owners are only concerned with ROE (return on equity) 100 million in inventory and turns it every month 1% on sales=> $1.2b/yr=12m

The smaller the ratio of capital to assets the higher the return on equity
ROE= net earnings on assets* ratio of its assets /captal ROA=1/capital/assets= eqiuty multiplies Capital V=> the euity multiplier decreases Roe on equty =10% The lower the ____ likely to it is that benaks addue moe risk Test: Portfolio diversification Risk Efficient capital market Foreign exchange Derivatives Liquidity crisis Capital crisis 5,8,9,10,12 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

Major type of risk: Risk of insolvency-- holding capital prevents this

The less capital the bank has the higher the equity multiplier: 1/capital/asset ROE=ROA*EM When banks hold less capital the more likely they are to fail -- when banks fail the losses are spread throughout society Liquidity Risk: Can lead to insolvancy-- mostly to do with a bank running short of reserves Adverse clearing= net outflow of deposits A L

Reserves Deposites Securities capital loans

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Securities capital loans -5 million deposit outflow => When a bank is faced with a liquidity problem it can do 1 of 4 things: 1) Sell securities 2) Fail to renew loans 3) Borrow from the FED at the discount rate (rate the fed charges banks) Or by borrowing in the fed funds market 4) Bank can try to attract deposits: by offering higher interest rates etc.

Credit Risk: Risk that a banks own portfolio is going to go bad One way to reduce risk-- diversify loan portfolios Regional diversification enabled by laws that permit branch banking
Interest Rate Risk: How a banks profitability will be affected by change in interest rates Rate sensitive assets vs rate sensitive liabilities i^=> Gap<0

GAP= % assets that are sensitive to invest- % liabilities that are sensitive to the interest rate

The Multiple deposit creation The fed and the Monetary Base The Money multiplier CH17:

Whenever banks make loans they create new money: whenever loans are repaid and not renewed money disappears.
You find 1million Deposit it in the bank Citibank Reserve requirement=10% (set by the fed)

A
R+1m

L
+1m ^Rof 1m=>^D of 1,=>CB now has 900k in excess reserves=> CB can affords to make loans up to 900K because they can afford to lose 900k in reserves => ^^L by 900k and ^D by 900k

L+900K +900K Real Bills Doctrine

My doctor banks at BofA

A L

When a bank has a crearing that causes a loss in reserves its called an adverse clearing V R=adverse clearing ^R=a favorable clearing Chang in deposites= 1/reserve requirements times the change in the reserve D=1/RR*R

+900k +900K Cash items in process

+900K R

Now BofA has 810k in ER=> How the FED makes money: Money is nothing more than an intellectual and social construct 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

City Bank
A L

+600B revenues 600B deposit

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

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+600b US gov securities +600 b deposit to cb 600 b deposite +600k casj RR=10% M=10*RR=10*600B=$6T

Senaurage: revenue that governmet recieves fro

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