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Financial markets are markets in which funds are transferred from people who have an
excess of available funds to people who have a shortage.
A security or financial instrument is a claim on the issuer’s future income or assets (any
financial claim or piece of property that is subject to ownership).
A bond is a debt security that promises to make payments periodically for a specified period
of time.
Interest rates are determined in the bond market, which is the cost of borrowing or the price
paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year).
Interest rate includes car loan interest, mortgage interest, bond interest etc.
Interest rate is important at both individual level and government level.
A common stock (called stock) represents a share of ownership in a corporation. Simply
called the market for stock market.
The foreign exchange market is where the conversion of funds from one currency to the
other takes place, and so it is instrument in moving funds between countries.
Money or money supply is defined as anything that is generally accepted in payment for
goods and services or in the repayment of debts.
Money is linked to economic variables that affect everyone.
Total production of goods and services is called aggregate output.
Unemployment is the percentage of available labour force unemployed.
Money plays an important role in generally business cycles such as recession, boom,
recovery etc.
Average price of goods and services is called aggregate price level.
Inflation is continual increase in the aggregate price level.
Monetary policy is the management of money and interest rate, which is a responsibility
of central bank.
Fiscal policy involves decisions about government spending and taxation.
Budget deficit is excess of government expenditure over revenue and budget surplus is
the excess of government revenue over expenditure.
1.4 Defining Aggregate Output, Income, Price Level and Inflation Rate
Measures of aggregate output is GDP, which is the market value of all final goods and
services produced in a country during the course of the year.
Aggregate income is the total income of factors of production (land, labour and capital)
from producing goods and services in the economy during the year.
Measure of price level is GDP deflator, which is normal GDP divided by real GDP.
𝑋𝑡−𝑋𝑡−1
Growth rate is measured using growth rate of real GDP, which is x100.
𝑋𝑡−1
Chapter 2: Overview of Financial System
Financial markets (bond and stock market) and financial intermediaries (banks,
insurance companies, pension funds) have basic function of getting people who have
shortage of funds and who have a surplus of funds to meet and satisfy their needs.
Financial markets perform the essential economic function of channeling funds from
households, firms and government that have saved surplus funds by spending less than
their income to those that have a shortage of funds because they wish to spend more than
their income.
Financial market enables to transfer funds from a person who has no investment
opportunities to one who has them.
Without financial market, both parties may be stuck without investment and benefit
Financial market promotes economic efficiency.
Financial market are critical for producing an efficient allocation of capital, which
contributes to higher production and efficiency for overall economy. J
Well-functioning financial markets also directly improve the well-being of consumer by
allowing them to time their purchases better. They provide funds to young people who
could afford later.
2.2 Structure of Financial Markets
Traditional instrument in the international bond market known as foreign bonds, which
are sold in a foreign country and are denominated in that country’s currency
Eurobond is a bond denominated in a currency other than that of a country in which it is
sold
Eurocurrencies are a variant of Eurobond, where foreign currencies deposited in banks
outside home country is included.
Yield to maturity is the most accurate measure of interest rate, the yield to maturity is
measured and examine alternative (but less accurate) ways in which interest rates are
quoted.
Bond’s interest rate does not necessarily indicate how good an investment the bond is
because what it earns (its rate of return) does not necessarily equal its interest rate.
The concept of present value (or present discounted value) is based on the common sense
notion that a dollar paid to you one year from now is less valuable to you than a dollar a
dollar paid to you today. This is true because one can deposit a dollar in savings account
that earns interest and have more than a dollar in one year.
The simple kind of debt instrument is called simple loan.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
The measure of simple interest rate is i = x100.
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
In terms of timing of their payment, there are four basic types of credit market instrument
d. A discount bond (zero-coupon bond) is bought at a price below its face value (at
discount) and the face value is repaid at the maturity date. Unlike coupon bond,
discount bond does not make any interest payments, it just pays off the face value.
Example; a discount bond with a face value $1000 might be bought for $900 in a
year’s time the owner would be repaid the face value of $1000.
For simple loans, the simple interest rate equals the yield to maturity.
When the coupon bond is priced at its face value, the yield to maturity equals the coupon
rate
The price of a coupon bond and the yield to maturity are negatively related; that is as the
yield to maturity rises, the price of the bond falls
The yield to maturity is greater than the coupon rate when the bond price is below the its
face value
Consol or a perpetuity is a perpetual bond with no maturity date and no repayment of
principal that makes fixed coupon payments of $C forever. The formula for the price of
the consol P is C/i
𝐹−𝑃
For one year discount bond the yield to maturity can be written as i =
𝑃
Yield on Discount Basis
o Also called discount yield
o Usually understated as it considers 360 days in a year rather than 365 days.
For a bill which is selling for $900 and has a face value of $1000, the yield on
discount basis would be as follows
Price and returns for long-term bonds are more volatile than those for shorter-term
bonds.
Changes in interest rate make investments in the long-term bonds quite risky. Indeed
the riskiness of an asset’s return that result from interest rate changes is so important
that it has been given a special name, interest-rate risk.
Duration and Interest Rate Risk
Chapter 5: The Behavior of Interest Rates
9.2 Liabilities
1. Checkable Deposits: these are bank accounts that allow the owner of the
account to write checks to third parties, which includes all accounts on which
checks can be drawn. Checkable deposits and money deposits are payable on
demand that is if a depositor shows up at the bank and requests payment by
making a withdrawal. It is an assets for the depositor as it is part of his or her
wealth.
2. Non-transactional Deposits: these are the primary source of bank funds.
Owners cannot write checks on non-transactional deposit, but the interest rates
are usually higher than those on checkable deposits. This can be of two types
Savings accounts
In these type of accounts, funds can be added or from which
funds can be withdrawn
Transactions and interest payments are recorded in a monthly
statement or in a small book (the passbook) held by the owner
of the account
Time deposits or certificate of deposits (CDs)
These have fixed maturity length, ranging from several months
to over five years, and have substantial penalties for early
withdrawal
Small denomination time deposits (less than $100,000) are less
liquid for the depositor than passbook savings, earn higher
interest rates and are more costly source of funds for the banks
3. Borrowings:
Banks obtain funds by borrowing from the Federal Reserve system,
the Federal Home Loan Banks, other banks and corporations.
Borrowings from the Fed are called discount loans/advances
4. Bank Capital
The bank’s net worth, which equals the differences between total
assets and liabilities.
The funds are raised by selling new equity or from retained earnings.
9.3 Assets
1. Reserves: these are deposits plus currency that is physically held by banks
(called vault cash). Banks hold reserves for two reasons
a. Some reserves called required reserves are held because of reserve
requirement by the regulation (required reserve ratio)
b. Banks hold excess reserves because they are the most liquid of all
bank assets and can be used by a bank to meet its obligations when
funds are withdrawn either directly by a depositor or indirectly when a
check is written on an account.
2. Cash Items in Process of Collection: checks that are not received or
collected from the other bank
3. Deposits at Other Banks: deposits in other larger banks in exchange for a
variety of services, including check collection, foreign exchange transactions,
and help with securities purchases
4. Securities: a bank’s holding of securities are an important income-earning
assets.
5. Loans: Banks make their profits primarily by issuing loans.
6. Other Assets: the physical capital (bank building, computers, and other
equipment) owned by the banks
o To keep enough cash on hand, the bank must engage in liquidity management,
which is the acquisition of sufficiently liquid assets to meet the bank’s obligations
to depositors
o Bank manager must pursue an acceptably low level of risk by acquiring assets
that have a low rate of default and by diversifying asset holdings (asset
management)
o Banks must acquire funds at a low cost (liability management)
o Banks must manage credit risk, the risk arising because borrowers may default
and how it manages interest rate risk, the riskiness of earnings and returns on
bank assets that result from the interest rate changes.
o Liquidity Management and the Role of Reserves
If a bank has ample reserves, a deposit outflow does not necessitate
change in other parts of its balance sheet
Ways to eliminate shortage in reserves, bank has 4 options
1. Acquire reserves to meet a deposit outflow by borrowing from
other banks in the federal funds market or by borrowing from
corporation
2. Sell some of its securities to help cover the deposit outflow
3. Acquire reserves by borrowings from the Fed.
4. Reduce its loans by this the same amount of required deposits
o Asset Management
Banks try to find borrowers how will pay high interest rates and are
unlikely to default on their loans. They seek out loans business by
advertising their borrowing rates and by approaching corporations directly
to solicit loans
Banks try to purchase securities with high returns and low risk.
Banks must attempt to lower risk by diversifying, by purchasing many
different types of assets, both short term and long term
Banks must manage the liquidity of its assets so that it can satisfy its
reserve requirements without bearing huge costs, meaning that it will hold
liquid securities even if they earn a somewhat lower return than other
assets.
o Liquidity Management
Management of liabilities by large banks (money center banks) lead to an
expansion of overnight loan markets, such as federal funds market, and the
development of new financial instruments such as negotiable CDs, which
enabled money center banks to acquire funds quickly
o Capital Adequacy Management
Banks have to make decision about the amount of capital they need to
hold for three reasons
1. Bank capital helps prevents bank failure, a situation in which the
bank cannot satisfy its obligations to pay its depositors and other
creditors and so goes out of business
2. The amount of capital affects returns for the owners (equity
holders) of the bank
o Return on Assets (ROA) = net profit after taxes/assets
o Return on Equity (ROE) = net profit after taxes/equity
capital
o Equity Multiplier (EM) = Assets/Equity Capital
3. A minimum amount of bank capital (bank capital requirement) is
required by regulatory authorities
o Managing Credit Risk
Must overcome the adverse selection and moral hazard problems that make
loans defaults more likely
1. Screening and Monitoring
o Screening and monitoring by collecting reliable information
from prospective borrowers
o Specialization in lending: specialize in lending to local firms or to
firms in particular industries, such as energy. However, the bank
is not diversifying. It is easier for banks to collect information
about local firms and determine their creditworthiness than to
collect comparable information on firms that are far away
o Monitoring and enforcing on restrictive covenants: once a loan
has been made, the borrower has an incentive to engage in
risky activities that make it less likely that the loan will be paid
off. Financial institutions must adhere to the principle for
management credit risk that a lender should write provisions
(restrictive covenants) into loan contracts that restrict borrower
from engaging in risky activities.
2. Long-term customer relationships
o Having a long term relationship to identify more information
about the customer could be helpful
o Long-term relationships benefit the customers as well as the
bank
o No bank can think of every contingency when it writes a
restrictive covenant into a loan contract, there will always be
risky borrower activities that are not ruled out. However, if the
borrowers wants to preserve a long-term relationship with a
bank, because it will be easier to get future loans at low interest
rates
3. Loan Commitment
o Banks also create long-term relationship and gather information
by issuing loan commitment to commercial customers.
o A loan commitment is a bank’s commitment (for a specific
future period of time) to provide a firm with loans up to a given
amount at an interest rate that is tied to some market interest
rate.
o Majority of commercial and industrial loans are made under the
loan commitment arrangement
4. Collateral and Compensating Balances
o Collateral requirements for loans are important credit risk
management tools.
o One particular form of collateral required when a bank makes
commercial loans is called compensating balances, which is the
firm receiving a loan keeping a required minimum amount of
funds in a checking account at the bank.
5. Credit Rationing
o Credit rationing is refusing to make loans even though
borrowers are willing to pay the stated interest rate or even a
higher rate.
o Managing Interest Rate Risk
If a bank has more rate-sensitive liabilities than assets, a rise in interest rate will
reduce bank profits and a decline in interest rates will raise bank profits
With the increased volatility of interest rates that occurred in the 1980s,
financial institutions because more concerned about their exposure to interest
rate risk.
Financial institutions manage their interest-rate risk by modifying their balance
sheets but can also use strategies involving financial derivatives.
Asymmetric information analysis explains what types of banking regulations are needed
to reduce moral hazard and adverse selection problems in the banking system
Understanding the theory behind regulation does not mean that regulation and
supervision of the banking system are easy in practice
Getting bank regulations and supervisors to do their job properly in difficult for several
reasons
Financial institutions have strong incentive to avoid existing regulations by loophole
mining.
Regulations applies to a moving target; regulators are continually playing cat-and-mouse
with financial institutions – financial institutions think up clever ways to avoid
regulations, which then causes regulators to modify their regulation activities. Regulators
continually face new challenges in a dynamically changing financial system, and unless
they can respond rapidly to change, they may not be able to keep financial institutions
from taking on excessive risk.
This problem can be exacerbated if regulators and supervisors do not have the resources
or expertise to keep up with clever people in financial institutions who think up ways to
hide what they are doing or to get around the existing regulations
Bank regulations and supervision are difficult for two other reasons. In the regulation and
supervision game, the devil is in the details. Subtle differences in the details may have
unintended consequences; unless regulators get the regulation and supervision just right,
they may be unable to prevent excessive risk taking.
Regulators and supervisors may be subject to political pressure to not do their jobs
properly.
So, there is no guarantee that bank regulators and supervisors will be successful in
promoting a healthy financial system.
Bank regulations and supervision have not always worked well, leading to banking crisis
in the US and throughout the world.
The concepts of asymmetric information, adverse selection and moral hazard help
explained eight types of banking regulation that we see in the US and other countries, the
government safety net, restrictions on bank asset holdings, capital requirements, bank
supervision, assessment of risk management, disclosure requirements, consumer
protection, and restrictions on competition
Because asymmetric information problems in the banking industry are a fact of life
throughout the world, bank regulation in other countries is similar to that in the US
It is particularly problematic to regulate banks engaged in international banking, because
they can readily shift their business from one country to another
Because of financial innovation, deregulation and a set of historical accidents, adverse
selection and moral hazard problems increased in the 1980s and resulted in huge losses
for the US savings and loan industry and for taxpayers
Regulators and politicians are subject to the principal-agent problem, meaning that they
may not have sufficient incentives to minimize the costs of deposit insurance to
taxpayers. As a result, regulators and politicians relaxed capital standards, removed
restrictions on holdings of risky assets, and relied on regulatory forbearance.
Insurance
o Life insurance
o Property and casualty insurance
Pension Funds
o Private
o Public (state and local government)
Finance Companies
Mutual Funds
o Stock and bond
o Money market
Depository Institutions (Banks)
o Commercial banks
o S&L and mutual savings banks
o Credit unions
Effective insurance management requires several practices, information collection and
screening of potential policyholders, risk-based premiums, restrictive provisions,
prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the
amount of insurance
All these practices reduce moral hazard and adverse selection by making it harder for
policyholders to benefit from engaging in activities that increase the amount and
likelihood of calms.
With smaller benefits available, the poor insurance risks (those who are more likely to
engage in the activities in the first place) see less benefit from the insurance and are thus
less likely to seek it out.
Given the greater demand for risk reduction, the process of financial innovation described
came to the rescue by producing new financial instruments that help financial institution
managers manage risk better. These instruments, called financial derivatives, have
payoffs that are linked to previously issued securities and are extremely useful risk
reduction tools.
Financial derivatives are so effective in reducing in reducing risk because they enable
financial institutions to hedge; that is engage in a financial transaction that reduces or
eliminates risk.
Forward Contracts
o Forward contracts are agreements by two parties to engage in a financial
transaction at a future (forward) point in time.
o Forward contracts that are linked to debt instrument called interest-rate forward
contracts
o Dimensions
Specification of the actual debt instrument that will be delivered at a future
date
Amount of the debt instrument to be delivered
Price (interest rate) on the debt instrument when it is delivered and
Date on which delivery will take place
o Suffers from two problems
It may be very hard for an institution to find another party (called
counterparty) to make the contract with.
They are subject to default risk
Future Contracts
o At the expiration date of a futures contract, the price of what contract is the same
as the price fo the underlying asset to be delivered.
Options
o These are contracts that give the purchase the option or right to buy or sell the
underlying financial instrument at a specified price called the exercise price or
strike price within a specified period of time (the term to expiration)
o The owner or buyer of an option does not have to exercise the option, he or she
can let the option expire without using it.
o The owner of the option is not obligated to take any action, but rather has the right
to exercise the contract if he or she so choses.
o Because the right to buy or sell a financial instrument at a specified price has
value, the owner of an option is willing to pay an amount for it called a premium.
o Two types of options
American options
Can be exercised at any time up to the expiration date of the
contract
European options
Can be exercised only on the expiration date
o A call option is a contract that gives the owner the right to buy a financial
instrument at the exercise price within a specific period of time.
o A put option is a contract that gives the owner the right to sell a financial
instrument at the exercise price within a specific period of time.