Financial markets and

institutions
Lecturer: Dr Nguyen Kim Thu

Part 1: Introduction
Why study financial markets and
institutions?
Overview of the financial system

 Financial markets are markets in which

funds are transferred from people who
have an excess of available funds to
people who have a shortage
Greater economic efficiency
Direct effect on personal wealth, the
behavior of businesses and consumers,
and the overall performance of the
economy

Debt markets and interest rates

A bond is a debt security that promises to
make payments periodically for a specified
period of time.
Interest rate is the cost of borrowing or the
price paid for the rental of funds.
Interest rates affect the saving and
investment decisions, affect the
profitability and value of financial
institutions

The stock market

A stock is a security that represents a
share of ownership in a corporation. It is a
claim on the earnings and assets of the
corporation.

The foreign exchange market

The foreign exchange market is where the
currency of one country is converted to the
currency of another country; and is where
the foreign exchange rate (the price of one
countrys currency in terms of anothers) is
determined

Financial institutions
Financial institutions are what make
financial markets work, enabling financial
markets to move funds from people who
save to people who have productive
investment opportunities.

 Central banks
Financial intermediaries: commercial
banks, savings and loan associations,
insurance companies, mutual funds

Overview of the financial system

Function of financial markets
-Channeling funds from savers to investors
Structure of financial markets
-Debt and equity markets
-Primary and secondary markets
-Exchanges and the OTC markets
-Money and capital markets

 Structure of financial intermediaries

-Stand between the lender and the borrower
and helps transfer funds from one to the
other.
-The indirect finance using financial
intermediaries is far more important
source of financing for corporations than
securities markets, since they reduce
transaction costs for lenders.

Asymmetric information
One party does not know enough about the other party
to make accurate decisions
e.g: the borrower who takes out a loan has better
information about the investment project than the lender
does
Adverse selection
-the problem created by asymmetric information before the
transaction occurs
-occurs when the potential borrowers who are the most
likely to produce an undesirable outcome are the ones
who most actively seek out a loan and are thus most
likely to be selected. Therefore, lenders may decide not
to make any loans even though to good credit borrowers

 Moral hazard: is the problem created by

asymmetric information after the
transaction occurs.
-is the risk that the borrower might engage
in activities that are undesirable/risky
-because moral hazard lowers the
probability that the loan will be repaid,
lenders may decide not to make a loan

 Financial intermediaries can deal with the

asymmetric information problem.
-better equipped to screen out good from
bad credits
-expertise in monitoring the parties they lend
to

Part 2: Fundamentals of interest

rates
Measuring interest rates
-A simple loan: pay at maturity date the principal plus the
interest
-A fixed-payment loan: making the same payment every
month, consisting of part of the principal and interest.
-A coupon bond: pays the owner of the bond a fixed interest
payment (coupon payment) every year until the maturity
date, and the face value (par value) is repaid at the
maturity date
-A discount bond: is bought at a price below its face value ,
and the face value is repaid at the maturity date.
How can you decide which of these instruments provides
you with more income?

Present value
The value today of a future payment (FV)
received n years from now when the
simple interest rate is i:
PV = FV/(1+i)n

Yield to maturity (YTM)

Yield to maturity is considered the most
accurate measure of interest rates
It is the interest rate that equates the
present value of payments received from a
debt instrument with its value today.

 Simple loan: for simple loans, the simple

interest rate equals YTM
Fixed-payment loan:
LV = FP/ (1+i) + FP/(1+i)2 + + FP/(1+i)n
LV: loan value
FP: fixed yearly payment
n: number of years until maturity

 Coupon bond:
P = C/(1+i) + C/(1+i)2 + + C/(1+i)n + F/
(1+i)n
P: Price of coupon bond
C: Yearly coupon payment
F: Face value of the bond
n: years to maturity date

 Three interesting facts

-When P = F, YTM = Coupon rate
-P and YTM are negatively related
-YTM>Coupon rate when P<F

 Perpetuity: is a perpetual bond with no

maturity date, no repayment of principal,
makes fixed coupon payments of $C
forever.
P = C/i
P: Price of the perpetuity
C: Yearly payment
So i = C/P or YTM = C/P

 Discount bond: for any one-year discount

bond, YTM is
i = (F-P)/P
F: face value of the discount bond
P: current price of the discount bond

Other measures of interest rates

YTM is the most accurate measure of
interest rates and is what financial
economists mean when they use the term
interest rate. However, because YTM is
sometimes difficult to calculate, people
often use other, less accurate measures of
interest rates, like the current yield and the
yield on a discount basis

 Current yield
ic = C/P
ic : current yield
P: price of the coupon bond
C: yearly coupon payment
-The current yield approximates the YTM better
when the bond price is nearer to the bonds par
value and the maturity is longer.
-A change in the current yield always signals a
change in the same direction of the YTM

 Yield on a discount basis

idb = [(F-P)/F]* (360/Days to maturity)
idb : yield on a discount basis
F: face value of the discount bond
P: purchase price of the discount bond
-The yield on a discount basis always understates
the YTM and this understatement becomes
more severe the longer the maturity of the
discount bond.
-The yield on a discount bond always moves in the
same direction with YTM

Real and nominal interest rates

i = ir + e
or ir = i - e
i: nominal interest rate
ir: real interest rate
e expected inflation rate
When real interest rate is low, there are
greater incentives to borrow and fewer
incentives to lend

Interest rates and returns

The return on a bond held from time t to
time t+1 can be written as
R = (C + Pt+1 Pt)/Pt
R: return from holding the bond from time t to
time t+1
Pt : price of bond at time t
Pt+1: price of bond at time t+1
C: Coupon payment

 R= C/Pt + (Pt+1-Pt)/Pt = current yield+rate

of capital gain = ic + g

 If time to maturity = holding period, then return =

the initial YTM
When holding period<terms to maturity, a rise in
interest rates is associated with a fall in bond
prices, resulting in capital losses on bonds
The more distant a bonds maturity, the greater
the size of the price change associated with an
interest-rate change
Even though a bond has a substantial initial
interest rate (high YTM), its return can be
negative if interest rate rises.

Maturity and the volatility of bond

returns: Interest rate risk
Prices and returns for long-term bonds are
more volatile than those for shorter-term
bonds
Interest rate risk is the riskiness of an
assets return that results from interest
rate changes
Bonds with a maturity that is as short as
the holding period have no interest-rate
risk, because return = YTM.

Reinvestment risk
Reinvestment risk occurs because the
proceeds from the short-term bond need
to be reinvested at a future interest rate
that is uncertain.

The behavior of interest rates

Interest rates are negatively related to the
price of bonds, so if we can explain why
bond prices change, we can also explain
why interest rates fluctuate.

Determinants of asset demand

An asset is a piece of property that is a
store of value.
Whether to buy one asset rather another,
consider
-Wealth
-Expected return
-Risk
-Liquidity

 Wealth: more wealth means more

resources to buy assets, so other things
being constant, an increase in wealth
raises the quantity demanded of an asset
Expected returns: an increase in an
assets expected return relative to that of
an alternative asset, holding everything
else unchanged, raises the quantity
demanded of the asset

 Risk: everything else constant, if an

assets risk rises relative to that of
alternative assets, its quantity demanded
will fall
Liquidity: The more liquid an asset is
relative to alternative assets, the greater
will be the quantity demanded.

Benefits of diversification
Diversification reduces the overall risk an
investor faces, except in the extreme case
where returns on securities move perfectly
together
The less the returns on two securities
move together, the more benefit (risk
reduction) there is from diversification

Loanable funds framework:supply

and demand for bonds
Loanable funds framework: Approach the
analysis of interest-rate determination by
studying the supply of and demand for
bonds.

 Factors that cause a shift in the

demand curve for bonds
-Wealth
-Expected returns on bonds relative to
alternative assets
-Risk of bonds relative to alternative assets
-Liquidity of bonds relative to alternative
assets

 Wealth: As wealth increases, bond demand

curve shift to the right
Expected returns: higher expected interest rates
in the future decrease the demand for long-term
bonds and shift the demand curve to the left
-If expected returns on stock increase, demand
curve for bonds shift to the left
-If expected inflation increases, expected returns
on real assets (cars, houses) increase, and
demand for bonds fall

 Risk: an increase in the riskiness of bonds

causes the demand for bonds to fall and the
demand curve to shift to the left
An increase in the riskiness of alternative assets
causes the demand for bonds to rise and the
demand curve to shift to the right.
Liquidity: increased liquidity of bonds results in
an increased demand for bonds, and the
demand curve shifts to the right. Increased
liquidity of alternative assets lowers the demand
for bonds and shifts the demand curve to the left

 Factors that cause a shift in the supply curve

of bonds
-Expected profitability of investment opportunities:
in a business cycle expansion, the supply of
bonds increases and the supply curve shifts to
the right.
-Expected inflation: when expected inflation
increases, the real cost of borrowing decreases,
and the quantity of bonds supplied increases

-Government activities:
Higher government deficits increase the
supply of bonds and shift the supply curve
to the right.

Changes in expected inflation: the

Fisher effect
When expected inflation increases,
demand curve for bonds shift to the left
and supply curve for bonds shift to the
right, resulting in a fall in bond price and a
rise in interest rates

Business cycle expansion

As the economy expands, wealth increases, the
demand for bond increases. Also, supply of
bonds increases. Both demand curve and supply
curve shift to the right.
Depending on whether the supply curve shifts
more than the demand curve or vice versa, the
new equilibrium interest rate can either rise or
fall
However, in reality, interest rate rises in business
cycle expansion and falls in recession.

Liquidity preference framework:

supply and demand for money
Liquidity preference framework:
determines the equilibrium interest rate
using the supply of and demand for
money.

 Assume there are two main categories of

assets that people use to store their
wealth: money and bonds.
Quantity of bonds and money supplied
must equal the quantity of bonds and
money demanded:
Bs + Ms = Bd + Md
Bs Bd = Md - Ms

 If the market for money is in equilibrium, the

bond market is also in equilibrium
The liquidity preference framework is equivalent
to the loanable funds framework, which relates
the money market with the bond market
The loanable funds framework is easier to use
when analyzing the effects from changes in
expected inflation; and the liquidity preference
framework provides a simpler analysis of the
effects from changes in income, the price level,
and the supply of money.

 Money includes currency and checking

account deposits
Other things constant, interest rate and
the quantity of money demanded are
negatively related.
Quantity of money supplied is a vertical
line
Equilibrium interest rate at: Md = Ms

Shift in the demand for money

Income effect: a higher level of income
causes the demand for money to increase
and the demand curve to shift to the right
Price-level effect: a rise in the price level
causes the demand for money to increase
and the demand curve to shift to the right.

Shift in the supply of money

An increase in the money supply will shift
the supply curve for money to the right

Does a higher rate of growth of the money

supply lower interest rates?
Liquidity effect: rising money supply leads to an
immediate decline in the equilibrium interest rate.
Increasing money supply takes time to raise the
price level and income , which in turn raise
interest rates.
The expected-inflation effect, which also raises
interest rates, can be slow or fast, depending on
whether people adjust their expectations of
inflation slowly or quickly when the money
growth rate is increased
Three possibilities (p107)

The risk and term structure of

interest rates

Risk structure of interest rates