Ch1

Financial Market Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Debt Market A security is a claim on the issuers future income or security A bond is a debt security that promises to make payments periodically for a specified period of time. Debt market, also often referred to generically as the bond market, are especially important to economic activity because the enable corporations and governments to borrow to finance their activities and because they are where interest rates are determined. Stock Market A common stock represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. The stock market is the most widely followed financial market in almost every country that has one. Foreign Exchange Market

Ch2
Direct Finance Borrowers borrow funds directly from lenders in financial market by selling them securities Indirect finance Debt and Equity Market A debt instrument is short-term if its maturity is less than a year and long-term if its maturity is ten years or longer. Debt instruments with a maturity between one and ten years are said to be intermediate-term. Primary and Secondary Markets A primary market is a financial market in which new issues of a security. A secondary market is a financial market in which securities that have been previously issued can be resold. In primary market, investment banks assist in the initial sale of security. It does this by underwriting. Brokers are agents of investors who match buyers with sellers of securities. Dealers link buyers and sellers by buying and selling security at stated prices. Exchange and Over-the-Counter Market Exchanges are where buyers and sellers of securities meet in one central location to conduct trades. In over-the-Counter Market, dealers at different locations who have an inventory of security stand ready to buy and sell securities over the counter to anyone who comes to them and is willing to accept their prices

Money and Capital Market The money market is a financial market in which only debt instruments with original maturity of less than one year. The capital market is the market in which debt with maturity of one year or greater and equity instruments are traded. International Bond Market, Eurobonds, and Eurocurrencies Foreign bonds are sold in a foreign country and are denominated in that countrys currency. Eurobond is a bond denominated in a currency other than that of the country in which it is sold. Eurocurrencies are foreign currencies deposited in banks outside the home country. Eurodollars are US dollars deposited in foreign banks outside the US or in foreign branches of US banks. Financial Intermediation Reduce transaction costs through economies of scale. Financial intermediaries also do risk sharing. This process is also referred to asset transformation. They also promote risk sharing by diversification. Asymmetric Information cause adverse selection and moral hazard. Moral hazard problem also leads to conflict of interest. Types of Financial Intermediaries Depository Institutions include: commercial banks, saving and loan associations, mutual saving banks and credit unions. Contractual saving institutions include: life insurance companies, fire and casualty insurance companies, pension funds and government retirement funds Investment Intermediaries include: finance companies, mutual funds, money market mutual finds and investment banks.

Ch3
simple loan Principal + Interest T=10

fixed-payment loan Fixed repayment during all periods

T=1

........

T=10 coupon bond Coupon + Face value (at the maturity date) T=10

Fixed coupon in periods before maturity T=1 ........

discount bond Only Face value (at the maturity date) ........ T=10

Yield to maturity It is the interest rate that equates the present value of cash flows received from a debt instrument with its value today.

P=

C C C C F + + + ... + + (1+ i ) (1 + i)2 (1+ i )3 (1+ i )n (1 + i )n

When the coupon bond is priced at its face value, the YTM equals the coupon rate The price of a coupon bond and the YTM are negatively related The YTM is greater than the coupon rate when the bond price is below its face value The YTM of a consol bond is the current yield

P=
-

C i

i=

C P

Real and Nominal Interest Rates

ir = i e

Rate of return The return on a bond will not necessarily equal the interest rate on that bond The return on a bond is the current yield plus the rate of capital gain.

Return =

C + Pt +1 Pt = ic + g Pt

Reinvestment risk It occurs because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain Interest Rate Risk Price and returns for long-term bonds are more volatile than those for shorter-term bonds Duration Duration is a weighted average of the maturities of the cash payments

CPt DUR = t t 1 t =1 ( + i)

CPt (1 + i)t t =1

The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. The longer the term to maturity of a bond, the greater its duration When interest rates rise, the duration of a coupon bond falls. The higher the coupon rate on the bond, the shorter the bonds duration.

%P DUR

i 1 +i

Ch4
Determinants of Asset Demand Wealth: An increase in wealth raises the quantity demanded of an asset Expected return : An increase in an assets expected return relative to that of an alternative asset, raises the quantity demanded of the asset Risk: if an assets 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 Determinants of Supply of Bond Expected profitability of Investment Opportunities: more expected profitable investment opportunities, the supply of bonds increase Expected Inflation: An increase in expected inflation causes the supply of bonds to increase Government Budget: Higher government deficits increase the supply of bonds Market Equilibrium Bd=Bs Equilibrium price and quantity are determined. Then equilibrium interest rate can be calculated base on the price. Asset market approach: the analysis here is that supply and demand are always in terms of stocks of assets, not in terms of flows.

Ch5
Risk structure (similar payment streams) Default Risk The spread between the interest rates on bonds with default risk and default-free bonds called the risk premium (ic - iT) Bonds with relatively low risk of default are called investment grade security. Bonds have higher default risk are called junk bond. Liquidity Income Tax Considerations: Municipal bonds have income tax exemption

Term structure (different maturities) Expectations Theory Key Assumption: Bonds of different maturities are perfect substitutes

int =

it + it +1 + it + 2 + ... + it + (n1) n
or

(Spot rate)

e t +n

(1+ in+1t ) = n (1 + int )

n +1

1 (Forward rate)

Market Segmentation Theory Key Assumption: Bonds of different maturities are not substitutes at all Liquidity Premium Theory Key Assumption: Bonds of different maturities are substitutes, but are not perfect substitutes

int =

it + ite+1 + ite+ 2 + ... + ite+ ( n1) n

or

+ l nt

e t +n

(1+ in+1t l n +1t )n+1 = 1 n (1+ int l nt )

* Remember

Ch6
Efficient Market Hypothesis It states that the prices of securities in financial markets fully reflect all available information. Current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return. In an efficient market, all unexploited profit opportunities will be eliminated by arbitrage. Under stronger version of the efficient market hypothesis, in an efficient market, all prices are always correct and reflect market fundamentals. Evidence on the Efficient Market Hypothesis Poor performance of Investment Analysts and Mutual Funds Stock prices reflect publicly available information Random-walk behavior of stock prices Technical Analysis Evidence against Efficient Market Hypothesis Small-firm effect January effect Market overreaction Excessive volatility Mean reversion New information is not always immediately incorporated into stock prices

Ch13
Exchange rate E = (no.of foreign currency / 1 unit of domestic currency) domestic currency appreciates domestic goods prices abroad, foreign goods prices in home country Factors Affecting Exchange Rates in Long Run Relative price levels E= (Pforeign / Pdomestic) Tariffs and quotas (trade barriers) more trade barriers, domestic currency appreciates Preferences for domestic v. foreign goods people prefer domestic goods, domestic currency appreciates Productivity relative productivity increases, domestic currency appreciates Exchange Rates in the Short Run Expected returns are the same in both domestic and foreign assets

Ete+1 Et i =i Et
D F

(Interest parity condition)

iD domestic currency to appreciate iF domestic currency to depreciate Ete+ domestic currency to appreciate 1

Ch25
Long position purchased or owned an asset hedge risk by taking short position Short position sell or deliver an asset to a third party hedge risk by taking long position Forward contracts agreements by two parties to engage in a financial transaction at a future point in time Pros: Flexible; Cons: Lack of liquidity, Subject to default risk Futures contracts Specifies delivery of type of security at future date Micro hedge hedging the value of a specific asset. Macro hedge - hedging the entire value of a portfolio. No. of contract for the hedge = Value of the Asset / Value of each Contract T-bond future (assume $100,000 principal): gain/loss = (change in price of bond * 1000) * no. of contract Hedging FX risk: gain/loss = (change in exchange rate * value of contract) * no. of contract Stock Index futures: gain/loss = (change in index * $250) * no. of contract Options Right to buy (call option) or sell (put option) an instrument at the exercise (strike) price up until expiration date or on expiration date Disadvantage: pay premium; Advantage: protected if i increases, gain Maximum loss = premium Interest-Rate Swaps Advantages: Reduce risk, Longer term Disadvantages : Lack of liquidity, Subject to default risk Credit Derivatives Credit options : payoffs are tied to changes in credit conditions Credit swaps : swapping actual payments on similar-sized loan portfolios Credit-linked notes : combining a bond and a credit option

Ch8
Central Banks Balance Sheet Assets : Government Securities, Discount Loans Liabilities : Currency in Circulation, Reserves Tools of Monetary Policy: Open Market Operation : (Purchase) Monetary Base expands Discount Lending : (Lower Discount rate) Monetary Base expands Reserve Requirement

id iff BR

Rs

Rd Rd NBR Iff = federal funds rate, the interest rate of interbank loans Id = discount rate, cost of borrowing from Fed NBR = Nonborrowed reserves, amount of reserves supplied in the banking system BR = Borrowed reserves, amount of reserves borrowed from Fed Monetary Targeting Results observable almost immediately Helps avoid the time-inconsistency trap Link between inflation goal and money target must exist! Hitting target does not guarantee goal achieved Communication is complicated by trying to explain the assumed relationship Inflation targeting : Announcing a medium-term inflation target Commitment to monetary policy to achieve the target Inclusion of many variables to make monetary policy decisions Increasing transparency through public communication of objectives Increasing accountability for missed targets Policy Instrument

reserve aggregates and short-term interest rates Observable and Measurable Controllable Predictable effect on goals

Ch14
Foreign exchange interventions Unsterilized International Reserve (change), Monetary Base (change) Exchange rate (change) Sterilized International Reserve (change), Government Bonds (change), Monetary Base (no change) Exchange rate (no change) Balance of payments Current Account + Capital Account = Net Change in Governmental International Reserves Fixed exchange rate regime Anchor currency Overvalued, Undervalued Currency boards Dollarization Floating exchange rate regime

Ch15
Facts of Financial Structure 1. Stocks are not the most important source of external financing for businesses. 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. 5. The financial system is among the most heavily regulated sectors of economy. 6. Only large, well-established corporations have easy access to securities markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

Asymmetric information Adverse selection Occurs when one party in a transaction has better information than the other party Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected Moral hazard Occurs when one party has an incentive to behave differently once an agreement is made between parties After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Lemons Problem Good securities undervalued and firms won't issue them; bad securities overvalued so too many issued Tools to Help Solve Adverse Selection (Lemons) Problems Private Production and Sale of Information Government Regulation to Increase Information Financial Intermediation Collateral and Net Worth Tools to Help Solve the Principal-Agent Problem Production of Information: Monitoring Government Regulation to Increase Information Financial Intermediation (e.g, venture capital) Debt Contracts Tools to Help Solve Moral Hazard in Debt Contracts Net Worth Monitoring and Enforcement of Restrictive Covenants Financial Intermediationbanks and other intermediaries have special advantages in monitoring Factors Causing Financial Crises Problems in banking sector Government Fiscal Imbalances Balance of payments problems Burst of asset bubbles

Ch16
economies of scope conflicts of interest arise as the concealment of information to the dissemination of misleading information

Types of Conflicts of Interest Underwriting and research in investment banking Auditing and consulting in accounting firms Credit assessment and consulting in credit-rating agencies Universal banking Sarbanes-Oxley Act of 2002 Established Public Company Accounting Oversight Board to supervise accounting firms. Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing. Members of the boards audit committee must be independent increases SECs budget to supervise securities markets Increased the charges for white-collar crimes and obstruction. requires corporations CEOs and CFOs to certify that periodic financial statements and disclosures of firms Global Legal Settlement of 2002 Firms must severe the link between underwriting and research activities. Spinning is banned. Firms must make public analyst recommendations and target prices Brokerage firms required to obtain third-party, independent research for their clients. $1.4 billion in fines

Ch18
Historical Development of the Banking Industry The modern commercial banking industry began when the Bank of North America was chartered in Philadelphia in 1782 Financial Innovation Response to Changes in Demand Conditions Major change is huge increase in interest-rate risk starting in 1960s Response to Changes in Supply Conditions Major change is improvement in computer technology Bank Credit and Debit Cards Automatic Teller Machines (ATMs) virtual banks on the internet Electronic money, or stored cash Junk Bonds Commercial Paper Market Securitization Treasury STRIPS Avoidance of Regulation Reserve requirements

Deposit-rate ceilings (Reg Q) Eurodollars Money Market Mutual Funds Sweep Accounts Decline in Traditional Banking Decline in Cost Advantages in Acquiring Funds (Liabilities) Decline in Income Advantages on Uses of Funds (Assets) Expand lending into riskier areas Expand into off-balance sheet activities Bank Consolidation Loophole mining reduced effectiveness of branching restrictions Development of super-regional banks Riegle-Neal Act of 1994 Glass-Steagall allowed commercial banks to sell on-the-run government securities, but prohibited underwriting and brokerage services Erosion of Glass-Steagall Gramm-Leach-Bliley Act of 199 International Banking 100 American bank branches abroad, with over $1.3 trillion in assets Eurodollar market Regulation K Foreign Banks in U.S. are setup as : an agency office of a foreign bank a sub of a U.S. bank a branch of a foreign bank

Ch20
Deposit Insurance and the FDIC failed banks in one of two ways: the payoff method, and the purchase and assumption method creates moral hazard : banks to take on greater risk than they otherwise would because of the lack of market discipline on the part of depositors creates adverse selection : those who can take advantage of (abuse) the insurance are mostly likely to find banks attractive Too Big to Fail : increases the moral hazard problem for big banks and reduces the incentive for large depositors to monitor the bank Restrictions on Asset Holdings Bank Capital Requirements Bank Supervision: Chartering and Examination

Assessment of Risk Management Disclosure Requirements Consumer Protection Restrictions on Competition The 1980s U.S. Banking Crisis Decreasing profitability: banks take risk to keep profits up Financial innovation creates more opportunities for risk taking Innovation of brokered deposits enables circumvention of $100,000 insurance limit Failures and risky loans Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 DoddFrank Wall Street Reform and Consumer Protection Act A bill that aims to increase government oversight of trading in complex financial instruments such as derivatives Basel III refers to a new update to the Basel Accords that is under development tighter definitions of Common Equity; banks must hold 4.5% by January 2015, then a further 2.5%, total 7% the introduction of a leverage ratio, a framework for counter-cyclical capital buffers, measures to limit counterparty credit risk, and short and medium-term quantitative liquidity ratios