fnce 4070: financial markets and institutions lecture 1: introduction to financial markets

50
FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 1: Introduction to Financial Markets Professor Michael Palmer Professor of Finance University of Colorado at Boulder Summer 2012

Upload: honorato-cantu

Post on 01-Jan-2016

64 views

Category:

Documents


0 download

DESCRIPTION

FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 1: Introduction to Financial Markets. Professor Michael Palmer Professor of Finance University of Colorado at Boulder Summer 2012. Where is this Financial Center?. NYSE. - PowerPoint PPT Presentation

TRANSCRIPT

Page 1: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 1: Introduction to Financial Markets

Professor Michael PalmerProfessor of FinanceUniversity of Colorado at BoulderSummer 2012

Page 2: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Where is this Financial Center?

Page 3: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

NYSE

New York Stock Exchange: Traced back to 1790; Trading in Federal Government Bonds issued to finance the Revolutionary War. In 2007, merged with Euronext (NYSE-Euronext). In 2008, acquired the American Stock Exchange. About 2,800 companies, with a combined market capitalization of about $18 trillion, are listed on the NYSE, trading approximately 1.46 billion shares each day. World’s largest stock exchange by market capitalization.

Page 4: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Federal Hall

Site of Federal Hall built in 1700. Home to the first U.S. Congress, Supreme Court, and Executive Branch. George Washington’s inauguration took place here. U.S. Bill of Rights introduced in Federal Hall.

Page 5: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Beginning Quotes For Course“May you live in interesting times.”

Reputed to be an ancient Chinese proverb and curse

“The only certainty in financial markets is uncertainty”

Credit Suisse, August 16, 2007 (Switzerland's second largest bank)

“Markets are constantly in a state of uncertainty and flux and money is made by

discounting the obvious and betting on the unexpected.”

George Soros (Hedge fund manager and philanthropist)

“People should be more concerned with the return of their principal than the

return on their principal.”

Will Rogers (Popular American humorist, early 20th century)

“I used to be scared of uncertainty; now I get a high out of it.”

Jensen Ackles (Actor. TV; Smallville, Dawson’s Creek, and Supernatural)

Page 6: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Your Understanding of Financial Markets? What is a central bank (e.g., the Federal Reserve)

responsible for? What the difference between monetary and fiscal policy? What do we mean by quantitative easing (QE)?

How does a central bank attempt to influence economic activity? How can we measure economic activity?

Who is the current chairman of the Federal Reserve and who were the two previous chairs of the Federal Reserve? Bank of England? European Central Bank?

What is the EU and what is the Euro-zone? Which countries make up the; G7; PIIGS; BRICS Which country, among the following: currently has the

highest (lowest) interest rate? United States, United Kingdom, Japan, Germany, Australia, or Switzerland.

Page 7: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Ben Bernanke: The 14th Chairman of the Federal Reserve Board Ben Bernanke replaced Alan Greenspan on February 1,

2006 Greenspan had served since August 1987.

Background: The Chairman of the Federal Reserve Board is named by the President and is confirmed by the U.S. Senate. They serve a term of four years, and can be reappointed.

The Federal Reserve is responsible for the conduct of monetary policy, which means: Setting interest rates and promoting money supply growth,

in pursuit of maximum employment, stable prices (now defined as 2%), and moderate long-term interest rates.

See Appendix 1 for some insights into Bernanke and Appendix 2 for previous Fed Chairs

Page 8: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Ben Bernanke (?) in Song Columbia Business School's YouTube Video parody of

Dean Glenn Hubbard (Note: he is not the real Dean) singing about Ben Bernanke.

http://www.youtube.com/results?search_query=ben+bernanke+every+breath+you+take&aq=0 (link to Ben Bernanke Every Breath you Take video)

http://youtu.be/3u2qRXb4xCU (this may work as well).

As you watch and listen take note of the following terms: 1. Change of rate (i.e., interest rates) 2. Stagflate (aka, stagflation – a recession with inflation) 3. BPS (basis points, a measure of interest rates) 4. Yield curve flips (yield curve going from upwards sweeping to

downward sweeping as a signal of a future recession) 5. Interest rate policies (monetary policy used by central banks) 6. Models break (i.e., econometric models used to assess the

impact of monetary policy changes on the economy)

Page 9: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Federal Funds Rate The Fed Funds Rate is the short term (generally

overnight) interest rate in the U.S. interbank market for lending/borrowing “excess” bank reserves. What are excess reserves?

Essentially, the Federal Funds rate is the interest rate at which one commercial bank will lend excess reserves to another commercial bank.

The Federal Funds Rate is regarded as a key (i.e., “benchmark”) short interest rate in the United States because the Federal Reserve sets this rate so as to implement monetary policy. So we (financial market participants) get important

signals from this rate (and changes in the rate).

Page 10: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Federal Funds Rate Since 1982, the Fed has announced a “target” for

the federal funds rate. However beginning in December 2008 the

target has actually been a range (upper and lower limit).

In addition to the Fed Funds target, another important overnight interbank rate is the “effective federal funds rate.” This is the actual rate at which banks are

lending excess reserves to one another. It will generally parallel the target, but when it

doesn’t it too provides us with important signals as to conditions in financial markets.

Page 11: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

How Does the Fed Affect the Federal Funds Rate? Through open market operation:

The buying and selling of government securities. Buying government securities increases bank

excess reserves. An increase in the supply of bank reserves (everything

else equal) will put downward pressure on the Federal funds rate.

Selling government securities reduces bank excess reserves. A decrease in the supply of bank reserves (everything

else equal) will put upward pressure on the Federal funds rate.

Page 12: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Demand and Supply Model of Bank Excess Reserves: Impact on Fed Funds RateFed buying government securities; increasing bank excess reserves S1 S2FedFundsRate (%) Demand

Excess Reserves

Fed selling government securities; reducing bank excess reserves

S2 S1

FedFunds Rate Demand (%)

Excess Reserves

Page 13: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

U.S. Federal Funds Target Rate: Sep 1982 (first used) to Dec 2008 Note: Fed targeted money supply from 1979 to 1993, but, in the

1982, it started shifting policy towards the fed funds rate; in 1995 it formally announced a fed funds target

Page 14: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

U.S. Federal Funds Target Rate Range: Dec 2008 to the Present Beginning in December 2008 (Dec 16th) the Federal Reserve

announced a range for the Fed Funds Rate (0.00% to 0.25%).

Page 15: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Effective Federal Funds Rate Historical high (Daily data): April 10, 1980, 19.53%.

Historical low: Dec 30, 2011 – January 2, 2012, 0.04%

Page 16: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Relationship of Target to Effective Rate Note: An official fed funds target was first announced in1995,

although minutes from the FOMC suggests the Fed was targeting this rate from 1982 on.

Page 17: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Monitoring the Effective Federal Funds Rate As noted, the effective federal funds rate

follows the target (or range) and thus it would appear that we can monitor this rate as an indicator of the stance (and changes in the direction) of Fed policy.

http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND

We can also evaluate the effective rate in relation to the target or range as indicators (signals) as to conditions in financial markets.

Page 18: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Assessing Financial Market Conditions in 2008

Page 19: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Assessing Financial Market Conditions with the Fed Funds Range, Dec 2008 to the Present Recall, beginning on December 16, 2008 the Federal Reserve

announced a range for the Fed Funds Rate

Page 20: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Why is the Fed Funds Rate (Potentially) So Important? Fed Funds rate is set (or influenced) by

U.S. central bank and thus it carries important signals for the market. It tells us what the central bank thinks

about the economy and the direction of the economy.

These signals, in turn, will affect how the market sets its interest rates.

Bottom line: Other money market rates are probably influenced by the direction and level of the Fed Funds Rate.

Page 21: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Prime Interest Rate Prime Rate: Interest rate commercial banks

will charge their best customers (i.e., high grade corporates) on loans to borrow short term (one year or less) funds.

By convention, the prime rate is tied to the Federal Funds Rate (with the Fed funds rate the casual rate). Banks scale up from this “cost of funds” rate. Prime rate is generally around 300 basis points

higher than fed funds rate Currently: 3.25%. (January 2008: 7.25%)

Page 22: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Fed Funds Rate and Prime Rate

Page 23: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Prime Interest Rate, 1955 - Present Historical high (daily data): December 16, 1980 – January 1, 1981,

21.50%. Historical low: December 16, 2008 – Present, 3.25% (matching August 1955)

Page 24: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Fed Funds Rate and Other Money Market Rates

Page 25: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Fed Funds Rate and Capital Market Rates

Page 26: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Fed Funds Rate and Equities

Page 27: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Measures of Economic Activity Important measures of economic activity:

Economic output (Business Activity). GDP (changes in real GDP)

Business Cycles: Traditional recession definition: 2 consecutive quarters

decline in real GDP Current definition: incorporates more analysis.

Most recent U.S. cycle: Recession: December 2007 - June 2009

Price levels Inflation (Consumer and producer prices)

Page 28: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

U.S. Business Cycles, June 1854 – June 2009 (NBER Data)Cycle Dates Average Recession

(Months)Average Expansion (Months)

1854 – 2009 (33 cycles) 16 months 42 months

1854- 1919 (16 cycles) 22 months 27 months

1919 – 1954 (6 cycles) 18 months 36 months

1945 – 2009 (11 cycles) 11 months 59 months

Great Depression: August 1929 – March 1933

43 months

Longest Expansion: November 2001 – December 2007

120 months

Page 29: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Recent U.S. Cycles

Page 30: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Federal Funds Rate and Business Activity: Response of Federal Reserve

Page 31: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Equities and Business Cycles

Page 32: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Corporate Profits and Equities

Page 33: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Effective Federal Funds Rate and Price Changes (Inflation)

Page 34: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Federal Reserve Discount Rate Federal Reserve Discount Rate: Interest rate the

Federal Reserve will charge member banks and other depository institutions to borrow short term (overnight) reserves. Administratively set by the Federal Reserve Currently: .75% (January 2008: 4.75%) Historically called the Discount Rate, now called the

Primary Credit Rate. This market is important as it represents a

“safety” net for financial institutions. Also carries potentially important signals as to

future fed policy directions. The relationship of this rate to the Federal Funds

rate has changed since January 2003.

Page 35: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Relationship of Discount Rate (Primary Credit Rate) to Fed Funds Rate

Page 36: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Cross Country Comparisons: 10-Year Gov’t Rates, May 2012Country 10-Year Gov’t

Bonds (in local currency)

Country 10-Year Gov’t Bonds (in local currency)

United States 1.76% Italy 5.98%

Switzerland 0.65% Spain 6.28%

Japan 0.83% South Africa 7.78%

Hong Kong 1.12% Ireland 8.21%

Germany 1.46% India 8.52%

Singapore 1.46% Turkey 9.31%

Canada 1.92% Portugal 12.39%

United Kingdom 1.94% Brazil 12.55%

China 2.80% Pakistan 14.23%

France 2.88% Greece 28.41%

Australia 3.23%

http://www.tradingeconomics.com/bonds-list-by-country

Page 37: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Why the Differences in Rates? Differences in cross country government bond

interest rates reflect: Relative differences in economic growth (where countries

are in their business cycles). Relative differences in rates of inflation (generally the

higher the rate of inflation, the higher the interest rate). Relative differences in the “accommodative” stance of each

country’s central bank (generally the more accommodative, the lower the interest rate)

Relative differences in the market’s assessment about the risk associate with a sovereign borrower.

Impact of flight to safe havens as markets become risk adverse (movement into “safer” countries during regional and global uncertainty will drive down yields).

One quick way to observe and measure these differences is through “spreads” to major country bond rates.

Page 38: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Inflation and Long Term Interest Rates

Page 39: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Safe Haven Effect: U.S. Dollar and U.S. 10-Year Bond RatesEURO Exchange Rate (in USD)

10-Year Bond Rate (1919-2012 average = 6.6%)

Page 40: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Gov’t Rates: Spreads Over Benchmark Rates

Country Latest Yield

Spread Versus Bund

Spread Versus T-Bond

Country Latest Yield

Spread Versus Bund

Spread Versus T-Bond

United States

1.75% +0.30 ------- France 2.86% + 1.42 + 1.11

Germany 1.45% -------- -0.30 Australia 3.18% + 1.73 + 1.43

Switzerland 0.65% -0.80 -1.10 New Zealand

3.59% + 2.14 + 1.84

Japan 0.88% -0.57 -0.87 Italy 5.96% + 4.51 + 4.20

Denmark 1.33% -0.12 -0.43 Spain 6.28% + 4.83 + 4.53

United Kingdom

1.85% +0.40 +0.10 Portugal 12.39% +10.94 +10.64

Canada 1.90% +0.45 +0.15 Greece 28.90% +27.45 +27.15

http://markets.ft.com/RESEARCH/Markets/Government-Bond-Spreads

Page 41: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

What Do Spread Differences Tell Us? Given that the spreads are relative to the two major

default free sovereign borrowers (Germany and the U.S.), perhaps we can use these spreads as a market measure of risk of default (certainly the case of Italy, Spain, Portugal and Greece).

On the other hand, spreads may simply represent differences in inflation rates (Japan and U.K.), economic activity (Australia), or central bank accommodation (Switzerland).

Finally, differences between the Bund and T-Bill probably reflect differences in global market demand stemming from regional and global safe haven effects.

Page 42: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Comparing Cross Country Interest Rates In comparing government bonds cross country,

the 2 most common comparison rates are either yields to maturity on 10-year U.S. Treasuries (T-Bonds) and 10-year German Treasuries (Bunds). We assume both of these are “default-free.”

Thus we can compare other sovereigns to these (and to one another) to assess : Risk of default (credit risk). Inflation risk. Overall country risk (including political and exchange

rate risk) See: http://markets.ft.com/markets/bonds.asp

Page 43: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Central Bank Overnight Interest Rate Targets, January 2008 and May 2012Country January

2008May 2012 Country January

2008May 2012

United States 4.25% 0 – 0.25% India 9.00% 8.00%

Japan 0.50% 0.10 Egypt 11.50% 9.25%

Switzerland 2.75% 0.00% Brazil 13.75% 9.00%

Canada 4.00% 1.00% Turkey 16.75% 5.75%

Euro-zone 4.00% 1.00%

United Kingdom 5.50% 0.50%

Australia 6.75% 3.75%

China 7.20% 6.56%

New Zealand 8.25% 2.50%

http://www.fxstreet.com/fundamental/interest-rates-table

Page 44: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Cross Country Comparisons: Money Market Rates (3 Month Government Rates) May 2012Country Interest Rate (in

local currency)Country Interest Rate (in

local currency)

United States 0.07% Australia 3.28%

Germany 0.06% Brazil 8.44%

Japan 0.11% Greece 25.40%

United Kingdom 0.26%

Canada 1.00%

Page 45: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Useful Web Sites For current U.S. interest rate data see:

http://www.federalreserve.gov/releases/h15/update For Effective Fed Funds Rate see:

http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND

For other key rates: http://www.bloomberg.com/markets/rates-bonds/key-

rates/ For cross country comparisons on 10-Year

Government bonds: http://www.tradingeconomics.com/bonds-list-by-country

Page 46: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Appendix 1

Ben Bernanke’s View of the Role of Central Banks:The following slides present a brief sketch of Bernanke and offer possible insights into his approach regarding the role of the U.S. central bank.

Page 47: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Ben Bernanke

Ben Bernanke was born on December 13, 1953, in Augusta, Georgia. He received a B.A. in economics in 1975 from Harvard University (summa cum laude) and a Ph.D. in economics in 1979 from the Massachusetts Institute of Technology.

Before becoming a member of the Federal Reserve Board, Dr. Bernanke was the Howard Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs and Chair of the Economics Department at Princeton University (1996-2002). Dr. Bernanke had served as a Professor of Economics and Public Affairs at Princeton since 1985.

Page 48: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Bernanke’s Views on Central Banking Bernanke, whose academic studies have focused on the

Great Depression, has written that during that era the U.S. central bank allowed banks to fail, prices to fall and the money supply to contract, which contributed to the protracted slump. In essence, he blames the Fed for not acting in a proactive

manner. In addition, Bernanke has been quoted as follows: "We

now know the lessons from that” [the Depression]. "We are certainly going to make sure that the financial system remains in good functioning order.“

Conclusion: It appears that Bernanke will follow a very aggressive proactive approach to monetary policy in the U.S.

Page 49: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Appendix 2

Changing Fed Chairs being introduced by the President

Page 50: FNCE 4070: FINANCIAL MARKETS  AND INSTITUTIONS  Lecture 1: Introduction to Financial Markets

Changing Fed Chairs

Volcker to Greenspan, August 1987

Greenspan to Bernanke, February 2006