Money Banking & Finance [Doyle]

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  • 8/2/2019 Money Banking & Finance [Doyle]


    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




    -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


    $1 million=> probability (100%)

    Expected return = probability * the different amounts= 1*1 mill ion= $1m

    Strategy 1:

    Coin toss


    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


    Diminishing marginal utility

    Ex. Choice

    The fundamental tradeoff in financial theory


    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


    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


    Store of value3)

    Money is the only asset whose future value in terms of money can be known with



    Functions of Money

    Ch. 2

    Money Banking & FinanceWednesday, January 19, 2011

    1:58 PM

    Money Banking and Finance Page 1
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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


    Currency in the hands of the public, checkable deposits, non bank issue travelers



    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=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


    Theory of Ci rcumventive financial innovation:

    Giro banking

    Eurodollars= deposits anywhere outside the US


    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


    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


    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.


    In order for this to work well money has to be relatively scarce. Otherwise the value of

    money can become worthless


    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

    Money Banking and Finance Page 2

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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.


    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^



    Money= the proportion of peoples income that they want to hold in the form of money =K=

    1/ux their nominal income (PY)






    The Cambridge version of the equation of exchange:



    $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


    Stock=net earnings

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    Stock=>dividends (net earnings)


    Bond Holders= creditors => they get paid first (businesses pay their debt first before they pay


    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


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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


    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


    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:


    When a bond can be converted

    into stock under certain

    circumstance at the initiative

    of the lender


    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-


    Reinvestment Risk3-

    3 Major types of Financial Risk

    The interest rate on taxable bonds=3%

    " " nontaxable " = 1%

    Tax bracket= 25%



    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


    Black Scholes option premium pricing model-

    Their major advantage to the economic system as a whole it enables hedge strategies

    Try to reduce riska)


    They are willi ngly taking on additional risk to make higher returnsa)


    Held by two type of investors


    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




    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%


    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




    $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)


    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


    Short term interest rates tend to fl uctuate by more than long term rates

    P10= Principle (face value)/ (1+i) 10


    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:

    Money Banking and Finance Page 7

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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.


    = 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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    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?-





    1/2 the time

    Return--> $2

    $3 per every dollar spent




    $1 in1)

    Company (Russia)a)

    1/2 the time




    Loss -0.5



    $1 in1)

    Company (Germany)b)


    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




    Expected Value:

    I would go with Germany because the gains are the same however the potential loss in

    Germany is less than russia