# Money Banking & Finance [Doyle]

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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

1/21/11

-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

= 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

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

Money Banking and Finance Page 1

http://dealoz.com/9780073375908/eb10http://dealoz.com/9780073375908/eb10
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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

1/28/11

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

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

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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

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

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

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...