Chapter 1

● Why study Financial Markets and Institutions?

○ Financial markets are crucial in our economy
■ Channel funds from savers to investors, promoting economic efficiency
■ Market activity affects: personal wealth, business firms, and economy
○ Well functioning financial markets are key factors in producing high economic
growth
● Debt Markets and Interest Rates
○ Debt markets allow gov’ts, corporations, and individuals to borrow
○ Borrowers issue a security, called a bond, offering interest and principal over
time.
○ The interest rate is the cost of borrowing
■ Many types of market interest rates:
● Mortgage rates
● Car loan rates
● Credit card rates
■ Level of these rates are important
● Ex: Mortgage rates in the early part of 1983 exceeded 13%
■ Understanding the history of interest rates is beneficial
● Bond Market and Interest Rates
○ Ex: interest rates on selected bonds, 1950-2013

■
● The Stock Market
○ The stock market is the market where common stock (or just stock) are traded
○ Companies initially sell stock (in the primary market) to raise money
■ After that, the stock is traded among investors
○ The stock market receives the most attention from the media
○ Ex: stock prices as measured by the Dow Jones Industrial Average, 19050-2013
 ■
○ Companies, not just individuals, also watch the market
■ Often seeking additional funding
■ The success of SEOs (Secondary Equity Offerings) is dependent on the
company’s stock
● The Foreign Exchange Market
○ The foreign exchange market is where int’l currencies trade and exchange rates
are set
○ Although most people know little about this market, it has a daily volume nearing
$3 trillion
○ Ex: Exchange Rate of the US Dollar, 1970-2013

■
■ These fluctuations matter!
● US consumers have found that vacationing in Europe is
expensive, due to a weakening dollar relative to the Euro
● How we study Financial Markets and Institutions
○ Basic analytical framework
■ Simplified models are constructed, explained, and then manipulated to
illustrate various phenomena
■ “Practicing Manager” cases are used to tie theoretical and empirical
aspects
○ Other features
■ Case studies
■ Applications and numerical examples
■ Special interest boxes
■ Hundreds of analytical end-of-chapter problems
■ Predicting the Future problems

Chapter 2-Overview of the Financial System

● Function of Financial Markets
○ Channels funds from person or business w/out investment opportunities (i.e.
“Lender-Savers”) to one who has them (i.e. “Borrower-Spenders”)
○ Improves economic efficiency
○ Lender-Savers
■ Households
■ Business firms
■ Government
■ Foreigners
○ Borrower-Spenders
■ Business firms
■ Government
■ Households
■ Foreigners
○ Segments of Financial Markets
■ Direct Finance
● Borrowers borrow directly from lenders in financial markets by
selling financial instruments which are claims on the borrower’s
future income or assets
■ Indirect Finance
● Borrowers borrow indirectly from lenders via financial
intermediaries (est to source both loanable funds and loan
opportunities) by issuing financial instruments which are claims on
the borrower’s future income or assets
○ Ex: Flows of Funds Through the Financial System
 ■
● Importance of Financial Markets
○ This is important
■ Ex: if you save $1000, but there are no financial markets, then you can
earn no return on this
● Might as well put the money under your mattress
● However, if a carpenter could use that money to buy a new saw
(increasing her productivity), then she is willing to pay you some
interest for the use of the funds
○ Financial markets are critical for producing an efficient allocation of capital,
allowing funds to move from people who lack productive investment opportunities
to people who have them
○ Financial markets also improve the well-being of consumers, allowing them to
time their purchases better
● Structure of financial markets
○ It helps to define financial markets along a variety of dimensions (not necessarily
mutually exclusive)
○ Debt markets:
■ Short-Term (maturity < 1 year)
■ Long-Term (maturity > 10 years)
■ Intermediate term (maturity in-between)
■ Represented $38.2 trillion at the end of 2012
○ Equity markets:
■ Pay dividends, in theory forever
 ■ Represents an ownership claim in the firm
■ Total value of all US equity was $18.7 trillion at the end of 2012
○ Primary market:
■ New security issues sold to initial buyers
■ Typically involves an investment bank who underwrites the offering
○ Secondary market:
■ Securities previously issued are bought and sold
■ Examples include both the NYSE and the Nasdaq
■ Involves both brokers and dealers (do you know the difference?)
■ Even though firms don’t get any money, per se, from the secondary
market, it serves two important functions:
● Provides liquidity, making it easy to buy and sell the securities of
the companies
● Establishes a price for the securities (useful for company
valuation)
■ We can further classify secondary markets as follows:
● Exchanges-
○ Trades conducted in central locations
○ E.g. New York Stock Exchange, CBT
● Over-the-Counter Markets
○ Dealers at different locations buy and sell
○ Best example is the market for Treasury Securities
● Classifications of Financial Markets
○ We can also classify markets by the maturity of the securities:
■ Money market: Short-Term (maturity < 1 year)
■ Capital market: Long-Term (maturity > 1 year) plus equities (no maturity)
● Internationalization of Financial Markets
○ The internationalization of markets is an important trend
■ The US no longer dominates the world stage
○ International Bond Market & Eurobonds
■ Foreign bonds
● Denominated in a foreign currency
● Targeted at a foreign market
■ Eurobonds
● Denominated in one currency, but sold in a different market
● Now larger than US corporate bond market
● Over 80% of new bonds are Eurobonds
○ Eurocurrency Market
■ Foreign currency deposited outside of home country
■ Eurodollars are US dollars deposited, say, London
■ Gives US borrowers an alternative source for dollars
○ World Stock Markets
 ■ US stock markets are no longer always the largest- at one point, Japan’s
was larger
○ The number of int’l stock market indexes is quite large

■
● Global perspective: Relative decline of US Capital Markets
○ The US has lost its dominance in many industries
■ Ex: automobiles and consumer electronics
○ A similar trend appears at work for US financial markets, as London and Hong
Kong compete
■ Many US firms use these markets over the US
○ Why?
■ New tech in foreign exchanges
■ 9/11 made US regulations tighter
■ Greater risk of lawsuit in the US
■ Sarbanes-Oxley has increased the cost of being a US-listed public
company
● Function of Financial Intermediaries: Indirect Finance
○ Instead of savers lending / investing directly w/ borrowers, a financial
intermediary (such as a bank) plays as the middleman:
■ The intermediary obtains funds from savers
■ The intermediary then makes loans / investments w/ borrowers
○ This process, called financial intermediation, is actually the primary means of
moving funds from lenders to borrowers
■ More important source of finance than securities markets (such as stocks)
■ Needed because of transactions costs, risk sharing, and asymmetric
information
○ Transaction costs:
■ Financial intermediaries make profits by reducing transactions costs
■ Reduce transactions costs by developing expertise and taking advantage
of economies of scale
 ■ Financial intermediary’s low transactions costs mean it can provide its
customers w/ liquidity services, services that make it easier for customers
to conduct transactions
● Banks provide depositors w/ checking accounts that enable them
to pay their bills easily
● Depositors can earn interest on checking and savings accounts
and yet still convert them into goods and services whenever
necessary
○ The importance of financial intermediaries relative to securities markets
■ Studies show that firms in the US, Canada, the UK, and other developed
nations usually obtain funds from financial intermediaries, not directly
from capital markets
■ In Germany and Japan, financing from financial intermediaries exceeds
capital market financing 10-fold
■ However, the relative use of bonds vs equity does differ by country
○ Another benefit made possible by the FI’s low transaction costs is that they can
help reduce the exposure of investors to risk, through a process known as risk
sharing
■ FIs create and sell assets w/ lesser risk to one party on order to buy
assets w/ greater risk from another party
● This process is referred to as asset transformation, because in a
sense risky assets are turned into safer assets for investors
○ Financial intermediaries also help by providing the means for individuals and
businesses to diversify their asset holdings
■ Low transactions costs allow them to buy a range of assets, pool them,
and then sell rights to the diversified pool to individuals
○ Another reason FIs exist is to reduce the impact of asymmetric info
■ One party lacks crucial info about another party, impacting
decision-making
■ We usually discuss this problem along two fronts: adverse selection and
moral hazard
● Adverse selection:
○ Before transaction occurs
○ Potential borrowers most likely to produce adverse
outcome are ones most likely to seek a loan
○ Similar problems occur w/ insurance where unhealthy
people want their known medical problems covered
● Moral hazard:
○ After transaction occurs
○ Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely that
won’t pay loan back
 ○ Again, w/ insurance, people may engage in risky activities
only after being insured
○ Another view is a conflict of interest
○ Economies of scope and conflicts of interest
■ FIs are able to lower the production cost of information by using the info
for multiple services- bank accounts, loans, auto insurance, retirement
savings, etc
● This is called economies of scope
■ But, providing multiple services may lead to conflicts of interest, perhaps
causing the FI to hide or conceal info from another area (or the economy
as a whole)
● May actually make financial markets less efficient
○ Types of financial intermediaries:

■
■
■ Depository Institutions (Banks): accept deposits and make loans
● These include commercial banks and thrifts
● Commercial banks (11,343 at end of 2012)
○ Raise funds primarily by issuing checkable, savings, and
time deposits which are used to make commercial,
consumer and mortgage loans
○ Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset portfolios
■ Thrifts: S&Ls & Mutual Savings Banks (918) and Credit Unions (905)
● Raise funds primarily by issuing savings, time, and checkable
deposits which are most often used to make mortgage and
consumer loans, w/ commercial loans also becoming more
prevalent at S&Ls and Mutual Savings Banks
● Mutual savings banks and credit unions issue deposits as shares
and are owned collectively by their depositors, most of which at
credit unions belong to a particular group
○ E.g. a company’s workers
■ Contractual Savings Institutions (CSIs)
● All CSIs acquire funds from clients at periodic intervals on a
contractual basis and have fairly predictable future payout
requirements
○ Life Insurance Companies- receive funds from policy
premiums, can invest in less liquid corporate securities and
mortgages, since actual benefit payouts are close to those
predicted by actuarial analysis
 ○ Fire and Casualty Insurance Companies- receive funds
from policy premiums, must invest most in liquid gov’t and
corporate securities, since loss events are harder to predict
○ Pension and Government Retirement Funds- hosted by
corporations and state and local governments acquire
funds through employee and employer payroll
contributions, invest in corporate securities, and provide
retirement income via annuities
■ Finance Companies- sell commercial paper (a short-term debt instrument)
and issue bonds and stocks to raise funds to lend to consumers to buy
durable goods, and to small businesses for operations
■ Mutual Funds- acquire funds by selling shares to individual investors
(many of whose shares are held in retirement accounts) and use the
proceeds to purchase large, diversified portfolios of stocks and bonds
■ Money Market Mutual Fund- acquire funds by selling checkable
deposit-like shares to individual investors and use the proceeds to
purchase highly liquid and safe short-term money market instruments
■ Investment Banks- advise companies on securities to issue, underwriting
security offerings, offer M&A assistance, and act as dealers in security
markets
● Regulatory Agencies
○ Principal regulatory agencies of the US financial system
 ■

● Regulations of Financial Markets

○ Main reasons for Regulation
■ Increase information to investors
■ Ensure the soundness of financial intermediaries
○ Increase investor info
■ Asymmetric info in financial markets means that investors may be subject
to adverse selection and moral hazard problems that may hinder the
efficient operation of financial markets and may also keep investors away
from financial markets
■ The Securities and Exchange Commission (SEC) requires corporations
issuing securities to disclose certain information about their sales, assets,
and earnings to the public and restricts trading by the largest stockholders
(known as insiders) in the corporation
 ■ Such gov’t regulation can reduce adverse selection and moral hazard
problems in financial markets and increase their efficiency by increasing
the amount of info available to investors
● The SEC has been particularly active recently in pursuing illegal
insider trading
○ Ensure Soundness of Financial Intermediaries
■ Providers of funds (depositors, like you) to financial intermediaries may
not be able to assess whether the institutions holding their funds are
sound or not
■ If they have doubts about the overall health of financial intermediaries,
they may want to pull their funds out of both sound and unsound
institutions, which can lead to a financial panic
● Such panics produces large losses for the public and causes
serious damage to the economy
■ To protect the public and the economy from financial panics, the gov’t has
implemented six types of regulations:
● Restrictions on entry
● Disclosure
● Restrictions on assets and activities
● Deposit insurance
● Limits on competition
● Restrictions on interest rates
■ Restrictions on entry:
● Regulators have created tight regulations as to who is allowed to
set up a financial intermediary
● Individuals or groups that want to est a financial intermediary,
such as a bank or an insurance company, must obtain a charter
from the state or the federal gov’t
○ Only if they are upstanding citizens w/ impeccable
credentials and a large amount of initial funds will they be
given a charter
■ Disclosure:
● There are stringent reporting requirements for financial
intermediaries
○ Their bookkeeping must follow certain strict principles
○ Their books are subject to periodic inspection
○ They must make certain information available to the public
■ Restriction on Assets and Activities
● There are restrictions on what financial intermediaries are allowed
to do and what assets they can hold
● Before you put your funds into a bank or some other similar
institution, you want to know that your funds are safe and that the
financial intermediary will be able to meet its obligations to you
 ○ One way of doing this is to restrict the financial
intermediary from engaging in certain risky activities
○ Another way is to restrict financial intermediaries from
holding certain risky assets, or at least from holding a
greater quantity of these risky assets than is prudent
■ Deposit Insurance:
● The gov’t can insure people’s deposits to a financial intermediary
from any financial loss if the financial intermediary should fail
● The Federal Deposit Insurance Corporation (FDIC) insures each
depositor at a commercial bank or mutual savings bank up to a
loss of $250,000 per account
● Similar government agencies exist for other depository institutions:
○ The National Credit Union Share Insurance Fund
(NCUSIF) provides insurance for credit unions
■ Limits on Competition
● Evidence is weak showing that competition among financial
intermediaries promotes failures that will harm the public
○ Such evidence has not stopped the state and federal
government from imposing many restrictive regulations
● In the past, banks were not allowed to open branches in other
states, and in some states banks were restricted from opening
additional locations
■ Restrictions on Interest Rates
● Competition has also been inhibited by regulations that impose
restrictions on interest rates that can be paid on deposits
○ These regulations were instituted because of the
widespread belief that unrestricted interest-rate
competition helped encourage bank failures during the
Great Depression
○ Later evidence did not support this view, and restrictions
on interest rates have been abolished
■ Improve Monetary Control
● Because banks play a very important role in determining the
supply of money (which in turn affects many aspects of the
economy), regulation of these financial intermediaries is intended
to improve control over the money supply
○ One example is reserve requirements, which make it
obligatory for all depository institutions to keep a certain
fraction of their deposits in accounts w/ the Federal
Reserve System (the Fed), the central bank in the US
○ Reserve requirements help the Fed exercise more precise
control over the money supply
● Financial Regulation Abroad
 ○ Those countries w/ similar economic systems also implement financial regulation
consistent w/ the US model:
■ E.g. Japan, Canada, and Western Europe
■ Financial reporting for corporations is required
■ Financial intermediaries are heavily regulated
○ However, US banks are more regulated along dimensions of branching and
services than their foreign counterparts

Chapter 3- What do Interest Rates Mean & What is their Role in Valuation?
● Present Value Introduction
○ Different debt instruments have very different streams of cash payments to the
holder (known as cash flows), w/ very different timing
○ All else being equal, debt instruments are evaluated against one another based
on the amount of each cash flow and the timing of each cash flow
■ This evaluation, where the analysis of the amount and timing of a debt
instrument’s cash flows lead to its ​yield to maturity or interest rate​, is
called present value analysis
● Present Value
○ The concept of present value (or present discounted value) is based on the
commonsense notion that a dollar of cash flow paid to you one year from now is
less valuable to you than a dollar paid to you today
■ Notion is true because you could invest the dollar in a savings account
that earns interest and have more than a dollar in one year
○ The term present value (PV) can be extended to mean the PV of a single cash
flow or the sum of a sequence or group of cash flows
○ Loan principal:
■ The amount of funds the lender provides to the borrower
○ Maturity date:
■ The date the loan must be repaid; the Loan Term is from initiation to
maturity date
○ Interest Payment:
■ The cash amount that the borrower must pay the lender for the use of the
loan principal
○ Simple Interest Rate:
■ The interest payment divided by the loan principal
■ The percentage of principal that must be paid as interest to the lender
■ Convention is to express on an annual basis, irrespective of the loan term
○ Simple Loan
■ Simple loan of $100:
 ■ Previous example reinforces the concept that $100​ ​today is preferable to
$100 a year from now
Today’s $100 could be lent out (or deposited) at 10% interest to be worth
$110 one year from now
● Yield to Maturity
○ Loans
■ Yield to maturity = interest rate that equates today’s value w/ present
value of all future payments
■ Simple Loan Interest Rate (​i​ = 10%)

○ Bonds
■ Coupon Bond (Coupon rate = 10% = C/F)

■ Fixed coupon payments of $C

■ One-Year Discount Bond (P=$900, F=$1000)

● Relationship btwn Price and Yield to Maturity

○
■ Three interesting facts in Table 3.1
When bond is at par, yield equals coupon rate
Price and yield are negatively related
Yield greater than coupon rate when bond price is below par value
 ○ It’s also straight-forward to show that the value of a bond (price) and yield to
maturity (YTM) are negatively related.
■ If ​i​ increases, the PV of any given cash flow is lower; the price of the bond
must be lower
● Global perspective
○ Now, we notice some yields on gov’t bonds are negative
■ Investors are willing to pay more than they would receive in the future
Best explanation is that investors find the convenience of the bills worth
something - more convenient than cash
○ But that can only go so far - the rates are only slightly
negative
● Distinction btwn real and nominal interest rates
○ Real interest rate
■ Interest rate that is adjusted for expected changes in the price level
● ir​ ​ = ​i​ – π e
■ Real interest rate more accurately reflects true cost of borrowing
■ When the real rate is low, there are greater incentives to borrow and less
to lend
■ Usually refer to this rate as the ​ex ante​ real rate of interest because it is
adjusted for the expected level of inflation
● After the fact, we can calculate the ​ex post​ real rate based on the
observed level of inflation
■ Exs:
● If ​i​ = 5% and π e​ = 0% then

○
● If ​i​ = 10% and π e​ = 20% then

○
○ US Real and Nominal Interest Rates

● Distinction btwn interest rates and returns

 ○ Rate of return: we can decompose returns into two pieces:

■
○ Key facts about relationship btwn rates and returns

■
■ Maturity and the volatility of bond returns
● Key findings from Table 3.2
○ Only bond whose return = yield is one w/ maturity =
holding period
○ For bonds w/ maturity > holding period, ​i​ ↑ P​ ↓ implying
capital loss
○ Longer is maturity, greater is price change associated w/
interest rate change
○ The longer the maturity, the more return changes w/
change in interest rate
○ Bond w/ high initial interest rate can still have negative
return if ​i​ ↑
● Conclusion from Table 3.2 analysis
○ Prices and returns more volatile for long-term bonds
because have higher interest-rate risk
○ No interest-rate risk for any bond whose maturity equals
holding period
● Reinvestment Risk
○ Occurs if you hold a series of short bonds over a long holding period
○ i​ at which you reinvest is uncertain
○ As an investor, you gain from ​i​ ↑ , you lose when ​i​ ↓
 Chapter 4- Why Do Interest Rates Change?
● Determinants of Asset Demand
○ An asset is a piece of property that is a store of value
○ Facing the question of whether to buy and hold an asset or whether to buy one
asset rather then another, an individual must consider the following factors:
■ Wealth- the total resources owned by the individual, including all assets
■ Expected return- the return expected over the next period on one asset
relative to alternative assets
■ Risk- the degree of uncertainty associated w/ the return on one asset
relative to alternative assets
■ Liquidity- the ease and speed w/ which an asset can be turned into cash
relative to alternative assets
○ Expected return ex:

■
○ Standard deviation ex:
■ Consider the following two companies and their forecasted returns for the
upcoming year:

●
■ What is the standard deviation of the returns on the Fly-by-Night Airlines
and Feet-on-the-Ground Bus Company, with the return outcomes and
probabilities described on the table? Of these two stocks, which is riskier?
 ■

■ A risk-averse person prefers stock in the Feet-on-the-Ground (the sure

thing) to Fly-by-Night stock (the riskier asset), even though the stocks
have the same expected return, 10%.
● A person who prefers risk is a risk preferrer or a risk lover.
● We assume people are risk-averse, especially in their financial
decisions
○ The quantity demanded of an asset differs by factor
■ Wealth- holding everything else constant, an increase in wealth raises the
quantity demanded of an asset
● Wealth up, quantity demanded up
■ Expected return- an increase in an asset’s expected return relative to that
of an alternative asset, holding everything else unchanged, raises the
quantity demanded of the asset
● Expected return up, quantity demanded up
■ Risk- holding everything else constant, if an asset’s risk rises relative to
that of alternative assets, its quantity demanded will fall
● Risk up, quantity demanded down
 ■ Liquidity- the more liquid an asset is relative to alternative assets, holding
everything else unchanged, the more desirable it is the greater will be the
quantity demanded
● Liquidity up, quantity demanded up
■ Response of the quantity of an asset demanded to changes in wealth,
expected returns, risk, and liquidity

●
● Supply and Demand in the Bond Market
○ How interest rates are determined is different in different bond markets
■ Current supply/demand conditions in the corporate bond market are not
no necessarily the same as, say, in the mortgage market
■ However, because rated tend to move together, we will proceed as if
there is one interest rate for the entire economy
○ The Demand Curve
■ Ex: let’s consider a one-year discount bond w/ a face value of $1000.
● In this case, the return on this bond is entirely determined by price
● The return is, then, the bond’s yield to maturity
○ Derivation of Demand Curve

■
■ Point A: if the bond was selling for $950

●
■ Point B: if the bond was selling for $900

●
■ How do we know the demand ( B d ) at point A is 100 and at point B is
200?
● Well we are making up those number
 ● We are applying basic economics- more people (investors) will
want (demand) the bonds if the expected return is higher
■ To continue:...
● Point C: ​P​ = $850 ​i​ = 17.6% ​Bd​ ​ = 300
● Point D: ​P​ = $800 ​i​ = 25.0% ​Bd​ ​ = 400
​ d​ ​ = 500
● Point E: ​P​ = $750 ​i​ = 33.0% B
● Demand Curve is ​B​d​ in Figure 4.1 which connects points A, B, C,
D, E.
○ Has usual downward slope
■ Figure 4.1- Supply and Demand for Bonds

●
● The supply curve is the line connecting points F,G,C,H, and I
○ The derivation follows the same idea as the demand curve
○ Point F: ​P​ = $750 ​i​ = 33.0% ​B​s​ = 100
○ Point G: ​P​ = $800 ​i​ = 25.0% ​Bs​ ​ = 200
○ Point C: ​P​ = $850 ​i​ = 17.6% ​Bs​ ​ = 300
○ Point H: ​P​ = $900 ​i​ = 11.1% ​Bs​ ​ = 400
○ Point I: ​P​ = $950 ​i​ = 5.3% ​B​s​ = 500
○ Supply Curve is ​Bs​ ​ that connects points F, G, C, H, I, and
has an upward slope
○ More people (investors) will offer (supply) the bonds if the
expected return (cost) is lower
○ Market equilibrium
■ The equilibrium follows what we know from supply-demand analysis:
● Occurs when ​Bd​ ​ = B ​ ​s​, at P
​ ​* = 850, ​i*​ = 17.6%
● When ​P​ = $950, ​i​ = 5.3%, ​B​s​ > ​B​d ​(excess supply): ​P​ ↑ to ​P*​ , ​i​ ↑
​to ​i*​
 ● When ​P​ = $750, ​i​ = 33.0, ​B​d​ > ​B​s ​(excess demand): ​P​ ↑ ​ to ​P​*, ​i​ ↓
to ​i*​
○ Market Condition:
■ Market equilibrium- occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to sell (supply) at a
given price
■ Excess supply- occurs when the amount that people are willing to sell
(supply) is greater than the amount people are willing to buy (demand) at
a given price
■ Excess demand- occurs when the amount that people are willing to buy
(demand) is greater than the amount that people are willing to sell
(supply) at a given price
○ Supply & Demand Analysis
■ We use two different vertical axes-
● One with price, which is high-to-low starting from the top
● One with interest rates, which is low-to-high starting from the top
■ Bond prices and interest rates are inversely related
■ This analysis is an asset market approach based on the stock of bonds
● Another way to do this is to examine the flows
○ The flows approach is tricky, especially with inflation in the
mix
● We will focus on the stock approach
● Changes in equilibrium interest rates
○ We focus on actual shifts in the curves
○ Movements along the curve will be due to price changes alone
○ Factors that shift Demand Curve
 ■

○ How factors shift the demand curve

■ Wealth / saving
● Economy ↑, wealth ↑
● B d ↑, B d shifts out to the right
OR
d d
● B ↑, B shifts out to the right
● Economy ↓, wealth ↓
■ Expected returns on bonds
● i ​ ↓ in future, Re for long-term bonds ↑
● B d shifts out to right
OR
● πe ↓ , relative Re ↑
● B d shifts out to right
■ And expected returns on other assets
 ● ER ​ on other asset (stock) ↑
● Re for long-bonds ↓
● B d shifts out to left
● Closely tied to ​expected interest rate ​and ​ expected inflation
■ Risk
● Risk of bonds ↓, B d ↑
● B d shifts out to right
OR
● Risk of other assets ↑, B d ↑
● B d shifts out to right
■ Liquidity
● Liquidity of bonds ↑, B d ↑
● B d shifts out to right
OR
● Liquidity of other assets ↓, B d ↑
● B d shifts out to right

■
○ Summary of Shifts in the Demand for Bonds
■ Wealth:
● in a business cycle expansion w/ growing wealth, demand for
bonds rises
● In a recession, when income and wealth are falling, demand for
bonds falls
■ Expected returns:
● Higher expected interest rates in the future decrease the demand
for long-term bonds
● Lower expected interest rates in the future increase the demand
for long-term bonds
■ Risk:
● Increase in the riskiness of bonds makes demand for bonds to fall
 ● Increase in riskiness of alternative assets (like stocks) causes the
demand for bonds to rise
■ Liquidity:
● Increased liquidity of the bond market results in an increased
demand for bonds
● Increased liquidity of alternative asset markets (like the stock
market) lowers the demand for bonds
○ Factors That Shift Supply Curve

■
■ Profitability of Investment Opportunities
● Business cycle expansion
● Investment opportunities ↑ , B s ↑
● B s shifts out to right
■ Expected Inflation
● πe ↑ , B s ↑
● B s shifts out to right
■ Gov’t Activities
● Deficits ↑ , B s ↑
● B s shifts out to right
 ■
○ Summary of shifts in the supply of bonds
■ Expected profitability of Investment Opportunities
● In business cycle expansion, the supply of bonds increases
● In a recession, when there are far fewer expected profitable
investment opportunities, the supply of bonds falls
■ Expected inflation:
● Increase in expected inflation causes the supply of bonds to
increase
■ Gov’t Activities:
● Higher gov’t deficits increase the supply of bonds
● Gov’t surpluses decrease the supply of bonds
● Special Cases
○ Fisher Effect
■ What if there is only a change in expected inflation?
■ If π e ↑
● Relative Re ↓ , B d shifts in to left
● B s ↑ , B s shifts out to right
● P ↓ , i​ ​ ↑
■ Response to a Change in Expected Inflation

●
 ■ Evidence on the Fisher Effect in the United States
● Expected inflation and interest rates (Three-Month) Treasury Bills,
1953-2013

●
■ Summary of Fisher Effect:
● If expected inflation rises from 5% to 10%, the expected return on
bonds relative to real assets falls and, as a result, the demand for
bonds falls
● The rise in expected inflation also means that the real cost of
borrowing has declined, causing the quantity of bonds supplied to
increase
● When the demand for bonds falls and the quantity of bonds
supplied increases, the equilibrium bond price falls
● Since the bond price in negatively related to the interest rate, this
means that the interest rate will rise
○ Business Cycle Expansion
■ The amount of goods and services for the country is increasing, so
national income is increasing.
● What is the expected effect on interest rates?
■ Response to a Business Cycle Expansion

●
 ■ Wealth ↑ , B d ↑ , B d shifts out to right
■ Investment ↑ , B s ↑ , B s shifts right
■ If B s shifts more than B d then ​P​ ↓ , ​i​ ↑
■ Evidence on business cycle and interest rates
● Business Cycle and Interest Rates (Three-Month Treasury Bills),
1951-2013

●
○ Low Japanese Interest Rates
■ In Nov 1998, Japanese interest rates on 6-month Treasury bills turned
slightly negative
■ Negative inflation lead to B d ↑
● B d shifts out to right
■ Negative inflation lead to ↓ in real rates
● B s shifts out to left
■ Net effect was an increase in bond prices (falling interest rates)
■ Business cycle ​contraction​ lead to ↓ in interest rates
● B s shifts out to left
● B d shifts out to left
■ But the shift in B d is less significant than the shift in B s , so the net effect
was also an increase in bond prices
○ Profiting from Interest-Rate Forecasts
■ Methods for forecasting
● Supply and demand for bonds: use flow of funds accounts and
judgement
● Econometric models: large in scale, use interlocking equations
that assume past financial relationships will hold in the future
■ Make decisions about assets to hold
● Forecast ​i​ ↓ , buy long bonds
● Forecast ​i​ ↑ , buy short bonds
 ■ Make decisions about how to borrow
● Forecast ​i ↓ , borrow short
● Forecast ​i​ ↑ , borrow long
■Financial economists are hired (sometimes for high salaries) to forecast
interest rates
● These predictions help forecast the strength of the economy,
profitability of investments, expected inflation, etc.
● Chapter Summary
○ Determining Asset Demand:
■ We examined the forces that affect the demand and supply of assets
○ Supply and Demand in the Bond Market:
■ We examine those forces in the context of bonds, and examined the
impact on interest rates
○ Changes in Equilibrium Interest Rates:
■ We further examined the dynamics of changes in supply and demand in
the bond market, and the corresponding effect on bond prices and
interest rates.

Chapter 5- Risk & Term Structure

● Risk Structure of Interest Rates
○ First examine the yields for several categories of long-term bonds over the last
90 years
■ Long-Term Bond Yields in the US, 1919-2013

●
● Figure shows two important features of the interest-rate behavior
of bonds:
○ Rates on different bond categories change from one year
to the next
 ○ Spreads on different bond categories change from one
year to the next
○ Factors affecting risk structure of interest rates
■ Default risk
● Occurs when the issuer of the bond is unable or unwilling to make
interest payments when promised
● Bonds w/out default risk are called “default-free bonds”
○ i.e. US Treasury Bonds

○
● Spread btwn the interest rates on bonds w/ default risk and
default-free bonds is the risk premium
○ Indicates how much additional interest people must earn in
order to be willing to hold that risky bond
○ Bond w/ default risk will always have a positive risk
premium
○ Increase in its default risk will raise the risk premium

○
● Increase in default on corporate bonds
○ Corporate bond market
■ Re on corporate bonds ↓ , Dc ↓ , Dc shifts left
■ Risk of corporate bonds ↑ , Dc ↓ , Dc shifts left
 ■ pc ↓ , ic ↑
○ Treasury bond market
■ Relative Re on treasury bonds ↑ , DT ↑ , DT shifts
right
■ Relative risk of treasury bonds ↓ , DT ↑ , DT shifts
right P T , iT ↑
○ Outcome
■ Risk premium, ic - iT , rises
● Default risk is an important component of the size of the risk
premium
○ Bond investors would like to know as much as possible
about the default probability of a bond
■ One way to do this is to use the measures provided
by credit-rating agencies
● Moody’s, Fitch and S&P

●
● Case: The Global Financial Crisis and the Baa-Treasury Spread
○ Starting in 2007, the subprime mortgage market collapsed,
leading to large losses for financial institutions
○ Because of the questions raised about the quality of Baa
bonds, the demand for lower-credit bonds fell, and a
“flight-to-quality” followed (demand for T-securities
increased)
○ Result: Baa-Treasury spread increased from 185 bps to
545 bps
■ Liquidity factor
● Another attribute of a bond that influences its interest rate is its
liquidity
○ A liquid asset is one that can be quickly and cheaply
converted into cash if the need arises
 ○ The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant
● Corporate Bond becomes less liquid
○ Corporate Bond Market
■ Liquidity of corporate bonds ↓ Dc ↓ , Dc shifts left
■ P c ↓ , ic ↑
○ Treasury Bond Market
■ Relatively more liquid Treasury bonds, DT ↑ , DT
shifts right
■ P T ↑ , iT ↓
○ Outcome
■ Risk premium, ic - iT , rises
○ Risk premium reflects not only corporate bonds’ default
risk but also lower liquidity
● The differences between interest rates on corporate bonds and
Treasury bonds (that is, the risk premiums) reflect not only the
corporate bond’s default risk but its liquidity too
○ This is why a risk premium is sometimes called a ​risk and
liquidity premium
■ Income taxes factor
● An odd feature of Figure 5.1 is that municipal bonds tend to have
a lower rate the Treasuries. Why?
○ Munis certainly can default.
■ Orange County (California) is a recent example
from the early 1990s
■ Munis are not as liquid as Treasuries
● Interest payments on municipal bonds are exempt from federal
income taxes
○ A factor that has the same effect on the demand for
municipal bonds as an increase in their expected return
● Treasury bonds are exempt from state and local income taxes
○ Interest payments from corporate bonds are fully taxable
● Ex: suppose you are in the 35% tax bracket
○ From a 10%-coupon Treasury bond, you only net $65 of
the coupon payment because of taxes
○ From a 8%-coupon muni, you net the full $80
■ For the higher return, you are willing to hold a
riskier muni (to a point)
 ●
○ Municipal bond market
■ Tax exemption raises relative Re on municipal
bonds, Dm ↑ , Dm shifts right
■ Pm ↑
○ Treasury bond market
■ Relative Re on Treasury bonds ↓ , DT ↓ , DT shifts
left
■ PT ↓
○ Outcome
■ im < iT
○ Case: Bush Tax Cut and Obama Repeal on Bond Interest Rates
■ The 2001 tax cut called for a reduction in the top tax bracket, from 39% to
35% over a 10-year period
● This reduces the advantage of municipal debt over T-securities
since the interest on T-securities is now taxed at a lower rate
■ Bush tax cuts were repealed under Obama
● Analysis is reversed
● The advantage of municipal debt increased relative to T-securities,
since the interest on T-securities is taxed at a higher rate
● Term structure of interest rates
○ Now that we understand risk, liquidity, and taxes, we turn to another important
influence on interest rates - maturity
○ Bonds w/ different maturities tend to have different required rates, all else equal
○ Following the News
■ For ex, yahoo.com publishes a plot of the yield curve (rates at different
maturities) for Treasury securities
■ Yield curves:
 ●
○ Term Structure Facts to Be Explained
■ Besides explaining the shape of the yield curve, a good theory must
explain why:
● Interest rates for different maturities move together
■ Movements over time of interest rates on US government bonds w/
different maturities

●
■ Besides explaining the shape of the yield curve, a good theory must
explain why:
● Interest rates for different maturities move together
● Yield curves tend to have steep upward slope when short rates
are low and a downward slope when short rates are high
● Yield curve is typically upward sloping
○ Three theories of term structure
■ Expectations theory
● Pure expectations theory explains 1 and 2, but not 3
 ■ Market Segmentation theory
● Market Segmentation theory explains 3, but not 1 and 2
■ Liquidity Premium theory
● Solution: combine features of both Pure Expectations theory and
Market Segmentation theory to get Liquidity Premium theory and
explain all facts
○ Expectations Theory
■ Key assumption: bonds of different maturities are perfect substitutes
■ Implication: Re on bonds of different maturities are equal
■ To illustrate what this means, consider two alternative investment
strategies for a two-year time horizon
● Buy $1 of one-year bond, and when it matures, buy another
one-year bond w/ your money
● Buy $1 of two-year bond and hold it
● If expectations theory is correct, your expected wealth is the same
(at the start) for both strategies
○ Of course, your actual wealth may differ, if rates change
unexpectedly after a year

■
■ More generally for n-period bond….

●
● Don’t let this seem complicated. Equation simply states that the
interest rate on a long-term bond equals the average of short rates
expected to occur over life of the long-term bond
○ Numerical example
■ One year interest rate over the next 5 years are
expected to be 5%, 6%, 7%, 8%, and 9%
○ Interest rate on two-year bond today:
■ (5% + 6%)/2 = 5.5%
○ Interest rate for five-year bond today:
■ (5%+6%+7%+8%+9%)/5=7%
○ Interest rate for one- to five-year bonds today:
■ 5%, 5.5%, 6%, 6.5% and 7%
■ Explains why yield curve had different slopes
● When short rates are expected to rise in future, average of future
short rates = int is above today’s short rate; therefore yield curve is
upward sloping
 ● When short rates expected to stay same in future, average of
future short rates same as today’s, and yield curve flat
● Only when short rates expected to fall will yield curve be
downward sloping
■ Pure expectations theory explains fact 1- that short and long rates move
together
● Explains fact 2- that yield curves tend to have steep slope when
short rates are low and downward slope when short rates are high
○ When short rates are low, they are expected to rise to
normal level, and long rate = average of future short rates
will be well above today’s short rate; yield curve will have
downward slope
● Doesn’t explain fact 3- that yield curve usually has upward slope
○ Short rates are as likely to fall in future as rise, so average
of expected future short rates will not usually be higher
than current short rate: therefore yield curve will not usually
slope upward
○ Market Segmentation theory
■ Key assumption: bonds of different maturities are not substitutes at all
■ Implication: markets are completely segmented; interest rate at each
maturity are determined separately
■ Explains fact 3- that yield curve is usually upward sloping
● People typically prefer short holding periods and thus have higher
demand for short-term bonds, which have higher prices and lower
interest rates than long bonds
■ Doesn’t explain fact 1 or 2 because it assumes long-term and short-term
rates are determined independently
○ Liquidity Premium theory
■ Key assumption: bonds of different maturities are substitutes, but are not
perfect substitutes
■ Implication: modifies Pure Expectations theory w/ features of Market
Segmentation theory
■ Investors prefer short-term rather than long-term bonds
● This implies that investors must be paid positive liquidity premium,
int , to hold long term bonds
■ Results in following modification of Expectations Theory, where lnt is the
liquidity premium

●
■ The relationship btwn the Liquidity Premium and Expectations Theories
 ●
■ Numerical example
● One year interest rate over the next five years: 5%, 6%, 7%, 8%,
and 9%
● Investors’ preferences for holding short-term bonds to liquidity
premium for one- to five-year bonds: 0%, .25%, .5%, .75%, and
1%
● Interest rate on the two-year bond:
○ .25% + (5% + 6%)/2 = 5.75%
● Interest rate on the five-year bond:
○ 1% + (5%+6%+7%+8%+9%)/5= 8%
● Interest rates on one- to five-year bonds:
○ 5%, 5.75%, 6.5%, 7.25%, and 8%
● Comparing w/ those for the pure expectations theory, liquidity
premium theory produces yield curves more steeply upward
sloped
■ Explains all 3 facts:
● Explains fact 3- that usual sloped yield curve by liquidity premium
from long-term bonds
● Explains fact 1 and 2 using same explanations theory because it
has average of future short rates as determinant of long rate
■ Market predictions of future short rates
 ●
○ Evidence on the Term Structure
■ Initial research (early 1980s) found little useful information in the yield
curve for predicting future interest rates
■ Recently, more discriminating tests show that the yield curve has a lot of
info about very short-term and long-term rates, but says little about
medium-term rates
○ Case: interpreting yield curves
■ The picture illustrates several yield curves that we have observed for US
Treasury securities in recent years
● What do they tell us about the public’s expectations of future
rates?

■
 ■ The steep downward curve in 1981 suggested that short-term rates were
expected to decline in the near future
● This played-out, with rates dropping by 300 bps in 3 months
● The upward curve in 1985 and 2013 suggested a rate increase in
the near future
■ The moderately upward slopes in 1980 and 1997 suggest that short term
rates were not expected to rise or fall in the near term
■ The steep upward slope in 2013 suggests short term rates in the future
will rise
○ Mini-case: The Term Structure as a Forecasting Tool
■ The yield curve does have info about future interest rates, and so it
should also help forecast inflation and real output production
● Rising (falling) rates are associated w/ economic booms
(recessions)
● Rates are composed of both real rates and inflation expectations
● Chapter summary
○ Risk structure of interest rates: we examine the key components of risk in debt:
default, liquidity, and taxes
○ Term structure of interest rates: we examined the various shapes the yield curve
can take, theories to explain this, and predictions of future interest rates based on
the theories

Chapter 6-Are Financial Markets Efficient?

● Efficient Market Hypothesis
○ Recall from chapter 3 that the rate of return for any position is the sum of the
capital gains (​P​t​+1​ – ​Pt​ )​ plus any cash payments (C):

■
○ At the start of a period, the unknown element is the future price: ​P​t+​ 1​ . But,
investors do have some expectation of that price, thus giving us an expected rate
of return

■
○ The Efficient Market Hypothesis views the expectations as equal to optimal
forecasts using all available information. This implies:

■
○ Assuming the market is in equilibrium:
■ R​e​ = ​R*
○ Put these ideas together: efficient market hypothesis
■ R​of​ = ​R*
■ This equation tells us that current prices in a financial market will be set
so that the optimal forecast of a security’s return using all available info
equals the security’s equilibrium return
■ Financial economists state it more simply: A security’s price fully reflects
all available info in an efficient market
■ Ex: