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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
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-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
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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
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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
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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
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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 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:
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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
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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
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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:
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=-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)
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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
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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
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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)
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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:
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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:
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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
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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
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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 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
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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:
*
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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:
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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
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+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