Week-1 Into to Money and Bankingand Basic Overview of U.S. Fin.docx

Week-1 Into to Money and Banking
and Basic Overview of U.S. Financial System
Money and Banking Econ 311
Instructor: Thomas L. Thomas
Financial markets transfer funds from people who have excess
available funds to people who have a shortage.
They promote grater economic efficiency by channeling funds
from people who do not have a productive use for them to those
who do.
Well functioning financial markets are a key factor in producing
economic growth, where as, poor functioning financial markets
are a major reason many countries in the world remain poor.
Financial Markets

A security or financial instrument is a claim on the issuer’s
future income or assets.
A bond is a debt security (IOU) that promises to make payments
periodically for a specified period of time.
The bond market is especially important economic activity
because it enables businesses and the government to borrow and
finance their activities and because it is where interest rates are
determined.
An interest rate is the cost of borrowing money or the price to
rent (use someone else’s) funds.
Because different interest rates tend to move in unison,
economist frequently lump interest rates together and refer to
the “interest rate”.
Interest rates are important on a number of levels:
High interest rates retard borrowing
High interest rates induce saving.
Lower interest rates induce borrowing
Lower Interest rates retard saving
Information Asymmetry and Information costs
Why Financial Intermediaries
In the neo-classical world economists have argued financial
intermediaries are not necessary. Savers (investors) could
manage their risks through diversification.
The logic rests on the perfect market assumption – that is

investors can always through their own borrowing and lending
compose their portfolios as they see fit, without costs. In such a
world there are no bankruptcy costs.
In such a world if taken to the extreme, perfect and complete
markets imply that there is no need for financial institutions to
intermediate in the financial (capital markets) as every investor
(saver) has complete information and can contract with the
market at the same terms as banks. E.g. Information
Asymmetry
Why Financial Intermediaries Bonds
A common stock (usually called stock) represents a share of
ownership in a corporation.
It is usually a security that is a claim on the earnings and assets
of the corporation.
Issuing stock and selling it to the public (called a public
offering) is a way for corporations to raise the funds to finance
their activities.
The stock market is the most widely followed financial market
in almost every country that has one – that is why it is generally
called the market – here “Wall Street.”
The stock market is also an important factor in business
investment decisions, because the price of shares affects the
amount of funds that can be raised by selling newly issued stock
to finance investment spending. (Note impact examples.)
Why Financial Intermediaries Stock Market

Banking and other financial institutions are what make the
markets work. Without them financial markets could not move
funds from people who save (investors) and people who have
productive investment opportunities.
The financial system is complex comprising may different type
of private sector institutions including banks, insurance
companies, mutual funds, finance companies, and investment
banks.
If a saver wanted to make a loan to IBM of GM for example, he
or she would not go directly to the president of the company
and offer the company a loan. Rather he or she would lend the
money through a financial intermediary.
Why Financial Intermediaries Financial Institutions
Banks are financial institutions that accept deposits and make
loans.
Included under the term banks are firms such as commercial
banks, savings and loan associations, mutual savings banks, and
credit unions.
Banks are the financial intermediaries that the average person

interacts with most frequently.
Because banks are the largest financial institutions in our
economy, the deserve the most careful study.
Banks
The first and most important issue with this view is incomplete
information which comprises several components:
Search Cost – finding all the people willing to make a funds
exchange – matching lenders (savers) to borrowers (spenders) –
Real cost and Nominal Costs
Transaction Cost – paying for enforceable contracts, accounting
costs, collection costs, etc.
Asymmetric Information – default / losses.
Information & Transaction Costs
Asymmetric Information – the lender does not know enough
about the borrower to make a accurate decision – “the borrower
always knows better how well he can pay back the loan.”
Adverse selection is a problem created when there is

asymmetric information before a transaction occurs. It occurs
when borrowers who are most likely to default are the ones
most actively seeking to obtain loans and are thus selected.
Moral hazard occurs – after the transaction occurs.
The problems created by by adverse selection and moral hazard
are an important impediment to well functioning financial
markets - and cause systemic fall in confidence e.g. most
recent financial market crisis.
Asymmetric Information – Moral Hazard
In such a situation when there are numerous defaults lenders
may not make loans even though there are good credit risks
(borrowers) in the market place. Government regulation can
lead to this situation also – retail mortgage – capital
requirements Dodd /Frank Act – expand on it.
Note – poor credit borrowers – are not necessarily deceitful.
Note, adjustable loan market and subprime lending as an
example.
9
Moral hazard in the financial markets is the risk or hazard that
the borrower might engage in activities that are undesirable
(immoral) from the lenders point of view.
Strategic default is one example – people walk away from their
mortgage because their home value has declined below that
outstanding balance on the loan.

Moral hazard can also occur from the lending perspective where
management engages in activities that benefit themselves at the
expense of the owners shareholders – this is called the
separation theorem.
This is often referred to as conflicts of interest. Conflicts of
interest are a moral hazard that occur when a person or
institution has multiple objectives (interests), and as a result,
have conflicts between those objectives.
Moral Hazard
example.
10
Financial Innovation the development of any new financial
products and services is an important force making the financial
market more efficient.
For example dramatic improvements in technology have lead to
new products and the ability to deliver financial services
electronically like e-finance and the ATM (POS).

It also has a dark side and can lead to moral hazards, and
financial crises like the most recent one.
When the financial system sizes up (liquidity dries up) it may
produce a financial crisis.
A financial crisis is characterized by sharp declines in asset
prices, the failure of numerous financial institutions and rising
unemployment.
Financial Innovation
example.
11
The Dialectic Process was developed by the German
Philosopher Georg Wilhelm Fredric Hegel (1770-1831).
According to Hegel society is burdened with contradictions and
tensions.
Through these contradictions and tensions one goes through a
process (dialectic) to discover what he called the “absolute idea

or absolute knowledge.
Professor Edward Kane applied this term to banking in the
1970’s
It carries the idea that baking regulation is cyclical interaction
between opposing economic and political forces.
Such rules foster a cat and mouse gam benefiting particular
institutions thereby motivating other institutions to find
loopholes in the system.
Management’s goals become finding ways to circumvent
restrictions in order to capture key markets.
Now if a number of institutions are successful in such
avoidance, than the regulations are changed and a new dialectic
cycle begins.
Regulation& Dialectic Process
example.
12

Money also referred to as the money supply is defined as
anything that is generally accepted in payment for goods or
services or in the repayment of debt.
Money is linked to changes in economic activity and variables
that affect all of us and are important to the heath of the
economy.
When an economy undergoes pronounced fluctuations evidence
suggest that money plays an important role in generating a
business cycle.
Monetary theory relates the quantity of money and monetary
policy to changers in aggregate economic activity.
Money and Monetary Policy
example.
13
The average price of goods and services in the economy is
called the aggregate price level.
Inflation is a continual increase in the price level, affecting

individuals, business, and governments.
The price level and money supply generally rise together
(Why?)
Milton Friedman, a Nobel Laureate in Economics made the
famous statement “Inflation is always and everywhere a
monetary phenomenon.”
In addition to inflation, money plays an important role in
interest rate fluctuations.
Money & Inflation
example.
14
Because money can affect many different economic variables,
policymakers often concentrate on the conduct of monetary
policy which is the management of money and interest rates.
The organization that is responsible for conducting monetary
policy is the central bank. For the United States the central bank
is the Federal Reserve System (12 banks).
Fiscal policy involves decisions around government spending

and taxation.
A budget deficit is the excess of government expenditures over
tax revenues for a particular time period.
A budget surplus arises when tax revenues exceed government
expenditures.
The government must finance deficit by borrowing in the
financial markets.
Monetary Policy and Fiscal Policy
example.
15
Transaction Costs – the time and money spent carrying out
financial transactions are the major problems faced by
individual lenders.
Financial intermediaries can substantially lower transaction cost
because their size allows them to take advantage of economies
of scale.
For example banks and insurance companies have large staffs of
lawyers who can produce airtight contracts that can be used
over and over again.

In addition, they have the resources to develop data systems and
expertise to determine a borrowers credit worthiness. This is
often referred to as economies of scope.
Economies of scope lower the cost of information production
for each service by applying one information source to to many
different services.
Function of Financial Intermediaries – Transaction Costs
example.
16
Financial intermediaries bring numerous transaction partners
together by creating assets (products) with risk characteristics
that people are comfortable with.
In addition, the lower transaction costs and risk sharing enable
the financial intermediaries to earn a profit (spread) between the
return they earn on a risky asset, and payments they make on
the assets they have sold.
Financial intermediaries also promote risk sharing by helping
individuals diversify the amount of risk they are exposed.

Diversification entails investing in a collection (portfolio) of
assets whose assets do not always move together, thereby
reducing the over all risks compared to that of individual
investments. (Note Mutual Funds and Loan Portfolios)
Function of Financial Intermediaries – Risk Sharing
example.
17
18
Individual Investment – An Economic Perspective
Savings and investment is an intertemporal choice between
current consumption and future consumption.
The individual will save and consume at level that gives
him/her the highest level of satisfaction (utility) depicted by
curves U1 through U4 for a given level of income (budget).
The highest attainable level of utility is point C1 where U3 is

tangent to the individual’s budget line.
Current Consumption at time t
Future Consumption at time t+1
U3
U2
U1
U4
Budget Line
C1
A
B
O
Current
Consumption
Future Consumption
Savings
D

19
Individual Investment – An Economic Perspective Continued
We can apply this same analysis to the owner of a single firm
who can either:
consume the firm’s present earnings by liquidating the assets
(points O,A)
Or save / invest into future returns (points A, D)
Note the production frontier acts like a budget constraint.
In this case the production frontier represents the combinations
of savings and consumption that is used to produce wealth /
utility.
Note the curved shape of the frontier is due to the law of
diminishing returns.
The level of consumption and investment also equal to the point
of highest utility at point C1.
U3
Production Frontier
C1
A
B
O

Consumption
Future Returns
Investment
D
20
Introducing the capital market allows us to examine investment
decisions where there are many owners (shareholders) – this is
called the Separation Theorem.
The capital investment decision becomes the company
(managers) undertake physical investment until the return from
the investment = the market rate of return/interest at point P.
This level of investment results in some dividend flow or
appreciation of wealth to the shareholders.
Shareholders make their financial decision by either borrowing
or lending in the capital market until their individual time value
of money = the capital market return.
This results in the highest aggregate utility at point C2
indifference curve U2.
Total Investment
With CML

A
B
O
1+r
D
E
C1
C2
U1
U2
Capital Market Investment Line (CML)
Required rate
Of Return
F
P

Old
Investment
Old Future
Returns
Total Returns
With CML
A firm or individual can obtain funds in the financial market in
two ways.
The most common way is to issue a debt instrument (IOU) such
as a bond or mortgage which is contractual agreement to pay the
holder some dollar amount at regular intervals (interest and
principal) over a specified time period.
Maturity is the number of years months, etch until final
payment is made.
A short-term instrument is less than one year.
A long-term instrument has a maturity greater than a year.
Debt & Equity Markets

example.
21
The second method for a firm to raise money is by issuing
equities such as common stock.
Equities are a claim against the firm’s income and assets. If
you own one share out of a 100 shares then you have a 1 percent
claim against the company’s income and assets.
You make money either through dividend payment – sharing the
income to the share holders or
By selling the shares for a profit base on the market
appreciation of the company’s assets and projected income
stream.
Debt & Equity Markets

example.
22
A primary market is one where new issues of a security such as
a bond or stock are sold to initial buyers (individuals or
corporations).
A secondary market is a financial market in where securities
that have been previously issued are resold.
Primary markets for securities are generally closed to the public
and are conducted behind closed doors (not underwriting)
Investment banks are the primary intermediary for primary
security sales.
They do this by underwriting the securities – buying the issue
guaranteeing the price to the issuer and selling the securities to
corporations for a margin. The corporations then sell the issues
to the public.
Primary and Secondary Markets

example.
23
The New York Stock Exchange and NASDAQ are examples of
the secondary market.
Securities brokers and dealers are an integral part of the
secondary market.
Brokers are agents of investors who match buyers and sellers.
Dealers link buyers and sellers by buying and selling securities
at state prices (note bid ask spread).
Secondary Markets
example.
24

Secondary Markets are organized in tow ways: exchanges and
over the counter (OTC) transactions.
Organized exchanges are locations where buyers and sellers (or
their agents or brokers) meet to conduct trades. The Chicago
Board of Trade where commodities are like corn or silver etc. is
one example.
OTC trades are done by different dealers at different locations
who have inventory of securities to buy and sell over the
counter willing to pay or receive the bid ask spread (Note
Money Desk)
Exchanges and Over the Counter Markets
example.
25
Another way to distinguish markets is base on the maturity of
the securities traded.
The money market is a financial market in which only short-
term debt instruments are traded.
The capital market is the market in where longer-term debt and

equity instruments are traded.
Money market securities are usually more widely traded and
tend to be more liquid.
Liquid refers to the ability to sell the instrument on the market
quickly to raise cash.
Money and Capital Markets
example.
26
Because of their short-term maturities these debt instruments
are considered less risky (Why?)
U.S Treasury Bills – These are short-term government
instruments issued on one, two, three, and six month maturities.
(Considered risk-free –why?)
US Treasury bills are the most liquid of all money market
instruments because they are the most actively traded.
Money Market Instruments

example.
27
Negotiable CDs – A certificate of deposit (CD) is a debt
instrument sold by banks to depositors that pay annual interest
of a given amount at maturity pays back principal. Negotiable
CDs are those sold in the secondary market (why would a bank
sell a CD and how is it priced?)
Commercial paper – is a short-term debt instrument issued by
large banks and well-know corporations.
Repurchase agreements (repos) are effectively short-term loans
for which another instrument serves as collateral. How do they
work? What happens if the borrower defaults?
What additional risk is present other than default?
Federal Funds (FED Funds) are typically overnight loans
between banks of their deposits at the Federal Reserve. Why
would banks barrow funds from other banks who hold deposits
and the Federal Reserve. Why would banks loan funds to other
banks?
The fed funds rate the interest paid on fed funds borrowing is a
closely watched rate. It is a barometer of how tight is the credit
market (why?)

example.
28
Capital Market instruments are debt and equity instruments with
maturities greater than a year ( why is equity considered a long-
term instrument?
Stocks are equity claims on the net assets and income of a
corporation. Stocks are divided into common shares and
preferred shares.
Mortgages are loans to house holds or firms to purchase land
buildings etc. The land or buildings serve as collateral to the
loan – what does that mean and how is it important.
Mortgage backed securities are bond like debt instruments
backed by the individual mortgages which are collected together
whose principal and interest payments are collectively paid to
the bond holder. (Discuss Structure).
Corporate bonds are long-term bonds issued by corporations
with very strong credit ratings. The typical bond send the
holder semi-annual interest payments and pays the face value

(principal) at maturity – may be sold in the secondary market at
par, loss or gain.
Capital Markets
example.
29
Week- 5 Interest Rates and Stock Market
Thursday 7 - 9:45

Response over Time to an Increase in Money Supply Growth
2
Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due
to:
Default risk
Liquidity
Tax considerations

Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System,
Banking and Monetary Statistics, 1941–1970; Federal Reserve;
www.federalreserve.gov/releases/h15/data.htm.
4
Risk Structure of Interest Rates (cont’d)
Default risk: probability that the issuer of the bond is unable or
unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government
can raise taxes).
Risk premium: the spread between the interest rates on bonds
with default risk and the interest rates on (same maturity)
Treasury bonds

5
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
6
Liquidity: the relative ease with which an asset can be
converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal
income taxes.

Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may
have different interest rates because the time remaining to
maturity is different
Yield curve: a plot of the yield on bonds with differing terms to
maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above
short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates
Must Explain
Interest rates on bonds of different maturities move together

over time
When short-term interest rates are low, yield curves are more
likely to have an upward slope; when short-term rates are high,
yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
9
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first
two
Liquidity premium theory combines the two theories to explain
all three facts

10
Expectations Theory
The interest rate on a long-term bond will equal an average of
the short-term interest rates that people expect to occur over the
life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over
another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be
perfect substitutes
11

Expectations Theory: Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next
year.
Then the expected return for buying two one-year bonds
averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be
willing to purchase it.
12
Expectations Theory (cont’d)
Explains why the term structure of interest rates changes at
different times
Explains why interest rates on bonds with different maturities
move together over time (fact 1)
Explains why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates are high
(fact 2)
Cannot explain why yield curves usually slope upward (fact 3)

13
Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over
another
If investors generally prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why yield curves
usually slope upward (fact 3)

14
Liquidity Premium & Preferred Habitat Theories
short-term interest rates expected to occur over the life of the
long-term bond plus a liquidity premium that responds to supply
and demand conditions for that bond
Bonds of different maturities are partial (not perfect) substitutes
15
Liquidity Premium Theory

16
Preferred Habitat Theory
Investors have a preference for bonds of one maturity over
another
They will be willing to buy bonds of different maturities only if
they earn a somewhat higher expected return
Investors are likely to prefer short-term bonds over longer-term
bonds
17

The Relationship Between the Liquidity Premium (Preferred
Habitat) and Expectations Theory
18
Common Stock is the principal way that corporations raise
equity capital
Stockholders those who own stock – own an interest in the
corporation proportional to the shares they own.
The most important rights are the right to vote and to be a
residual claimant of al the funds flowing into the firm (cash
flows). (What do we mean by residual)

Dividends are payments made periodically (usually quarterly to
the stockholders (shareholders).
Stock
A basic principal of finance is that the value of any investment
is found by computing the present value of all cash flows that
the investment will generate over its life. (How do we measure
a corporation’s life from an investor’s point of view?)
Similar to the net present value formula in chapter 4 the
discounted cash flows on equity consists of one dividend
payments and the final sales price.
=
Where P0 = the current price of the stock at the present
Div1 = dividend paid at the end of year 1
= the required return on an equity investment
P1 = the price of the stock at the end of the period or the
predicted sales price of the stock
Example assume the current price for a share of stock is $50.
Also assume that the required return is 12% the dividend is
$0.16 and the forecasted sales price is $60.00
= = $0.14 + $53.57 = $53.71
Would you buy the stock?
One Period Valuation

The Generalized Dividend Valuation Model
22
The Gordon Growth Model

23
The Required Return (k)
Depends on
the risk-free rate (rf),
the return on the market (rm), and
the stock's beta.
24
Relationship Between Risk and Required Return
2.0
1.5
1.0
0.5

20
15
10
5
k=3.5% +(10% - 3.5%)ß
B
A
Required Return (%)
Risk ß
1.8
0.8
8.7
15.2
Substitution of Cash Flow for Earnings and Dividends
Emphasis on firm’s ability to generate cash
May be applied when firm does not pay a dividend

26
How the Market Sets Prices
The price is set by the buyer willing to pay the highest price
The market price will be set by the buyer who can take best
advantage of the asset
Superior information about an asset can increase its value by
reducing its perceived risk
Information is important for individuals to value each asset.
When new information is released about a firm, expectations
and prices change.
Market participants constantly receive information and revise
their expectations, so stock prices change frequently
27
Application: The Global Financial Crisis and the Stock Market
Financial crisis that started in August 2007 led to one of the
worst bear markets in 50 years.

Downward revision of growth prospects: ↓g.
Increased uncertainty: ↑ke
Gordon model predicts a drop in stock prices.
Explain why the formula suggests a drop in prices?
The Theory of Rational Expectations
Adaptive expectations:
Expectations are formed from past experience only.
Changes in expectations will occur slowly over time as data
changes.
However, people use more than just past data to form their
expectations and sometimes change their expectations quickly.
Expectations will be identical to optimal forecasts using all
available information
Even though a rational expectation equals the optimal forecast
using all available information, a prediction based on it may not
always be perfectly accurate
It takes too much effort to make the expectation the best guess
possible
Best guess will not be accurate because predictor is unaware of
some relevant information
This is due to What???????

Formal Statement of the Theory
30
Rationale Behind the Theory
The incentives for equating expectations with optimal forecasts

are especially strong in financial markets. In these markets,
people with better forecasts of the future get rich.
The application of the theory of rational expectations to
financial markets (where it is called the efficient market
hypothesis or the theory of efficient capital markets) is thus
particularly useful
Implications of the Theory
If there is a change in the way a variable moves, the way in
which expectations of the variable are formed will change as
well
Changes in the conduct of monetary policy (e.g. target the
federal funds rate)
The forecast errors of expectations will, on average, be zero and
cannot be predicted ahead of time.

32
The Efficient Market Hypothesis:
Rational Expectations in Financial Markets
33
The Holding Period Return (HPR)
The percentage earned on an investment during a period of time
HPR = P1 + D - P0
P0

34
The Efficient Market Hypothesis: Rational Expectations in
Financial Markets (cont’d)
At the beginning of the period, we know Pt and C.
Pt+1 is unknown and we must form an expectation of it.
The expected return then is
Expectations of future prices are equal to optimal forecasts
using all currently available information so
Supply and Demand analysis states Re will equal the
equilibrium return R*, so Rof = R*

Why the Efficient Market Hypothesis Does Not Imply that
Financial Markets are Efficient
Some financial economists believe all prices are always correct
and reflect market fundamentals (items that have a direct impact
on future income streams of the securities) and so financial
markets are efficient
However, prices in markets like the stock market are
unpredictable- This casts serious doubt on the stronger view
that financial markets are efficient
The Efficient Market Hypothesis
Hard to beat the market on a risk-adjusted basis consistently
Earning a higher return is not necessarily outperforming the
market.
Considering risk is also important.
37

Assumptions Concerning Efficient Markets
Large number of competing participants
Information is readily available.
Transaction costs are small.
38
Random Walk
Another term for efficient markets
Does not imply security prices are randomly determined.
Implies day-to-day price changes are random

39
Random Walk
Successive prices changes are independent.
Today's price does not forecast tomorrow's price.
Current price embodies all known information.
Prices quickly change in response to new information
By the time most investors know the information, the price
change has already occurred
40
Rationale Behind the Hypothesis

41
Implications of Efficient Markets
Security prices embody known information.
The playing field is level.
Specifying financial goals may be more important than seeking
undervalued stocks.
42
Degree of Market Efficiency
The forms of the efficient market hypothesis:
the weak form
the semi-strong form
the strong form

43
The Weak Form
Studying past price and volume data will not lead to superior
investment results.
While the weak form suggests that using price data will not
produce superior results, using financial analysis may produce
superior returns.
44
The Semi-Strong Form
Studying economic and accounting data will not lead to superior
investment returns.
Studying inside information may lead to superior returns.

45
The Strong Form
Using inside information will not lead to superior investment
returns.
46
Anomalies
Empirical results generally support:
the weak form, and
the semi-strong form.
Possible exceptions to the efficient market hypothesis, called
anomalies, appear to exist.
47
Anomalies and Returns
Empirical evidence of the existence of an anomaly does not

mean the individual can take advantage of the anomaly.
The anomaly can still exist and the market be effectively
efficient from the individual investor's perspective.
48
How Valuable are Published Reports by Investment Advisors?
Information in newspapers and in the published reports of
investment advisers is readily available to many market
participants and is already reflected in market prices
So acting on this information will not yield abnormally high
returns, on average
The empirical evidence for the most part confirms that
recommendations from investment advisers cannot help us
outperform the general market
Efficient Market Prescription for the Investor
Recommendations from investment advisors cannot help us
outperform the market

A hot tip is probably information already contained in the price
of the stock
Stock prices respond to announcements only when the
information is new and unexpected
A “buy and hold” strategy is the most sensible strategy for the
small investor
int =
it + it+1
e + it+2
e + ...+ it+( n−1)
e
n
+ lnt
where lnt is the liquidity premium for the n-period bond at time
t
lnt is always positive
Rises with the term to maturity
i

nt
=
i
t
+i
t+1
e
+i
t+2
e
+...+i
t+(n-1)
e
n
+l
nt
where l
nt
is the liquidity premium for the n-period bond at time t
l
nt
is always positive
12
0
12
0
0
1
The value of stock today is the present
value of all future cash flows
...
(1)(1)(1)(1)
If is far in the future, it will not a
ffect
(1)

The price of the
nn
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DP
DD
P
kkkk
PP
D
P
k
¥
=
=++++
++++
=
+
å
stock is determined only by the present
value of
the future dividend stream
P0 =
D0 (1+ g )
(ke − g )
=
D1

(ke − g )
D0 = the most recent dividend paid
g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate
forever
The growth rate is assumed to be less than the required return
on equity
P
0
=
D
0
(1+g)
(k
e
-g)
=
D
1
(k
e
-g)
D
0
= the most recent dividend paid
g = the expected constant growth rate in dividends
k
e
= the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate

forever
The growth rate is assumed to be less than the required return
on equity
expectation of the variable that is bei
ng forecast
= optimal forecast using all available
information
eof
e
of
XX
X
X
=
=
1
Recall
The rate of return from holding a securi
ty equals the sum of the capital
gain on the security, plus any cash paym
ents divided by the
initial purchase price of the security.
= the r
tt
t
PPC
R
P
R
+
-+
=
1
ate of return on the security
= price of the security at time + 1, t
he end of the holding period

= price of the security at time , the b
eginning of the holding period
= cash payment (coupon
t
t
Pt
Pt
C
+
or dividend) made during the holding per
iod
t
t
e
t
e
P
C
P
P
R
+
-
=
+
1
of
e
of
t
e
t
R
R
P
P

=
Þ
=
+
+
1
1
Rof > R* ⇒ Pt ↑⇒ R
of ↓
Rof < R* ⇒ Pt ↓⇒ R
of ↑
until
Rof = R*
In an efficient market, all unexploited profit opportunities will
be eliminated
R
of
>R
*
ÞP
t
-ÞR
of
¯
R
of
<R
*

ÞP
t
¯ÞR
of
-
until
R
of
=R
*
In an efficient market, all unexploited profit opportunities will
be eliminated
Week- 4 Interest Rates and Interest Rate Behavior
Thursday 7 - 9:45
Determinants of Asset Demand
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 with the return on
Liquidity: the ease and speed with which an asset can be turned
into cash relative to alternative assets
2
Theory of Portfolio Choice
Holding all other factors constant:
The quantity demanded of an asset is positively related to
wealth
The quantity demanded of an asset is positively related to its
expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the
risk of its returns relative to alternative assets
liquidity relative to alternative assets

3
Supply and Demand in the Bond Market
At lower prices (higher interest rates), ceteris paribus, the
quantity demanded of bonds is higher: an inverse relationship
quantity supplied of bonds is lower: a positive relationship
4

Supply and Demand for Bonds
5
Factors That Shift the Demand Curve for Bonds
6
Shifts in the Supply of Bonds
Expected profitability of investment opportunities: in an
expansion, the supply curve shifts to the right
Expected inflation: an increase in expected inflation shifts the
supply curve for bonds to the right
Government budget: increased budget deficits shift the supply
curve to the right

7
Factors That Shift the Supply of Bonds
8
Response to a Change in Expected Inflation

9
Figure 5 Expected Inflation and Interest Rates (Three-Month
Treasury Bills), 1953–2011
Source: Expected inflation calculated using procedures outlined
in Frederic S. Mishkin, “The Real Interest Rate: An Empirical
Investigation,” Carnegie-Rochester Conference Series on Public
Policy 15 (1981): 151–200. These procedures involve estimating
expected inflation as a function of past interest rates, inflation,
and time trends.
10
Response to a Business Cycle Expansion
11

Business Cycle and Interest Rates (Three-Month Treasury
Bills), 1951–2011
Source: Federal Reserve:
www.federalreserve.gov/releases/H15/data.htm.
12
Supply and Demand in the Market for Money: The Liquidity
Preference Framework
13

Equilibrium in the Market for Money
14
Demand for Money in the Liquidity Preference Framework
As the interest rate increases:
The opportunity cost of holding money increases…
The relative expected return of money decreases…
…and therefore the quantity demanded of money decreases.
Changes in Equilibrium Interest Rates in the Liquidity
Preference Framework

Shifts in the demand for money:
Income Effect: a higher level of income causes the demand for
money at each interest rate 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 at each interest rate to increase and the demand curve
to shift to the right
16
Shifts in the Supply of Money
Assume that the supply of money is controlled by the central
bank
An increase in the money supply engineered by the Federal
Reserve will shift the supply curve for money to the right

17
Factors That Shift the Demand for and Supply of Money
18
Price-Level Effect and Expected-Inflation Effect
A one time increase in the money supply will cause prices to
rise to a permanently higher level by the end of the year. The
interest rate will rise via the increased prices.
Price-level effect remains even after prices have stopped rising.
A rising price level will raise interest rates because people will
expect inflation to be higher over the course of the year. When
the price level stops rising, expectations of inflation will return
to zero.
Expected-inflation effect persists only as long as the price level
continues to rise.

19
Does a Higher Rate of Growth of the Money Supply Lower
Interest Rates?
Liquidity preference framework leads to the conclusion that an
increase in the money supply will lower interest rates: the
liquidity effect.
Income effect finds interest rates rising because increasing the
money supply is an expansionary influence on the economy (the
demand curve shifts to the right).

20
Does a Higher Rate of Growth of the Money Supply Lower
Interest Rates? (cont’d)
Price-Level effect predicts an increase in the money supply
leads to a rise in interest rates in response to the rise in the
price level (the demand curve shifts to the right).
Expected-Inflation effect shows an increase in interest rates
because an increase in the money supply may lead people to
expect a higher price level in the future (the demand curve
shifts to the right).
Response over Time to an Increase in Money Supply Growth

22
Money Growth (M2, Annual Rate) and Interest Rates (Three-
Month Treasury Bills), 1950–2011
Sources: Federal Reserve:
www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
What happed here?
23
Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due
to:
Default risk
Liquidity
Tax considerations

Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System,
Banking and Monetary Statistics, 1941–1970; Federal Reserve;
www.federalreserve.gov/releases/h15/data.htm.
25
Default risk: probability that the issuer of the bond is unable or
unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government
can raise taxes).
Risk premium: the spread between the interest rates on bonds
with default risk and the interest rates on (same maturity)
Treasury bonds

26
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
27
Liquidity: the relative ease with which an asset can be
converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal
income taxes.

Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may
have different interest rates because the time remaining to
maturity is different
Yield curve: a plot of the yield on bonds with differing terms to
maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above
short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates

Must Explain
Interest rates on bonds of different maturities move together
over time
When short-term interest rates are low, yield curves are more
likely to have an upward slope; when short-term rates are high,
yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
30
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first
two
Liquidity premium theory combines the two theories to explain
all three facts

31
Expectations Theory
the short-term interest rates that people expect to occur over the
life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over
another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be
perfect substitutes
32

Expectations Theory: Example
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next
year.
Then the expected return for buying two one-year bonds
averages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be
willing to purchase it.
33
Expectations Theory (cont’d)
Explains why the term structure of interest rates changes at
different times
Explains why interest rates on bonds with different maturities
move together over time (fact 1)
Explains why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates are high
(fact 2)
Cannot explain why yield curves usually slope upward (fact 3)

34
Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over
another
If investors generally prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why yield curves
usually slope upward (fact 3)

35
Liquidity Premium & Preferred Habitat Theories
short-term interest rates expected to occur over the life of the
long-term bond plus a liquidity premium that responds to supply
and demand conditions for that bond
Bonds of different maturities are partial (not perfect) substitutes
36
Liquidity Premium Theory

37
Preferred Habitat Theory
Investors have a preference for bonds of one maturity over
another
They will be willing to buy bonds of different maturities only if
they earn a somewhat higher expected return
Investors are likely to prefer short-term bonds over longer-term
bonds
38

The Relationship Between the Liquidity Premium (Preferred
Habitat) and Expectations Theory
39
Keynesian model that determines the equi
librium interest rate
in terms of the supply of and demand for
money.
There are two main categories of assets
that people use to store

their wealth: money and bo
ssdd
sdsd
sd
sd
nds.
Total wealth in the economy = B M = B+ M
Rearranging: B- B = M - M
If the market for money is in equilibriu
m (M = M),
then the bond market is also in equilibr
ium (B = B).
+
int =
it + it+1
e + it+2
e + ...+ it+( n−1)
e
n
+ lnt
where lnt is the liquidity premium for the n-period bond at time
t
lnt is always positive
i
nt

=
i
t
+i
t+1
e
+i
t+2
e
+...+i
t+(n-1)
e
n
+l
nt
where l
nt
is the liquidity premium for the n-period bond at time t
l
nt
is always positive
Week-3 Into to Interest Rates
Tuesdays 7 - 9:45

Measuring Interest Rates
Present Value:
A dollar paid to you one year from now is less valuable than a
dollar paid to you today
Why?
A dollar deposited today can earn interest and become $1 x
(1+i) one year from today.
2
Discounting the Future

3
Simple Present Value
4
Time Line

$100
$100
Year
0
1
PV
100
2
$100
$100
n
100/(1+i)
100/(1+i)2
100/(1+i)n
Cannot directly compare payments scheduled in different points
in the time line

Four Types of Credit Market Instruments
Simple Loan
Fixed Payment Loan
Coupon Bond
Discount Bond
6
Yield to Maturity
The interest rate that equates the
present value of cash flow payments received from a debt
instrument with
its value today

7
Simple Loan
8
Fixed Payment Loan

10
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in Ten Years (Face Value = $1,000)
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
The yield to maturity is greater than the coupon rate when the
bond price is below its face value
11
Microsoft Excel Example
Consol or Perpetuity
A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever

For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
13
Discount Bond

14
The Distinction Between Interest Rates and Returns
Rate of Return:
15
The Distinction Between Interest Rates and Returns (cont’d)
The return equals the yield to maturity only if the holding
period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices,
resulting in a capital loss if time to maturity is longer than the
holding period
The more distant a bond’s maturity, the greater the size of the
percentage price change associated with an interest-rate change

(also referred to as duration)
16
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%
17
Interest-Rate Risk
Prices and returns for long-term bonds are more volatile than
those for shorter-term bonds
There is no interest-rate risk for any bond whose time to

maturity matches the holding period
18
Interest Risk - Duration
Duration - is the weighted average time over which he cash
flows form an investment are expected, where the weights are
the relative present values of the cash flows.
Focusing on maturity ignore the fact that some cash benefits are
received before maturity (can be reinvested) and the benefits
may be substantial.

Higher yields lead to lower durations. As the yield increases the
present value of the distant cash flows gets exponentially
smaller thus the weight given to distant time periods in the
numerator get smaller lowering the duration.
The duration of any instrument is positively related to maturity,
except for maturities in excess of 50 years. The duration of a
bond increases as yield (coupon) increases.

Why is this important? The answer: for a given change in
market yields, the percentage change in an asset’s price (PV)
are proportional to the asset’s duration.
Hence longer duration instruments are subject to greater price
changes (exhibit greater price elasticity).
This is expressed by the following formula:
-Duration × [Di ÷(1+i)]
Examples:
The Distinction Between Real and Nominal Interest Rates
Nominal interest rate makes no allowance for inflation

Real interest rate is adjusted for changes in price level so it
more accurately reflects the cost of borrowing
Ex ante real interest rate is adjusted for expected changes in the
price level
Ex post real interest rate is adjusted for actual changes in the
price level
23
Fisher Equation

24
Figure 1 Real and Nominal Interest Rates (Three-Month
Treasury Bill), 1953–2011
Sources: Nominal rates from
www.federalreserve.gov/releases/H15 and inflation from
ftp://ftp.bis.gov/special.requests/cpi/cpia.txt. The real rate is
constructed using the procedure outlined in Frederic S. Mishkin,
“The Real Interest Rate: An Empirical Investigation,” Carnegie-
Rochester Conference Series on Public Policy 15 (1981): 151–
200. This procedure involves estimating expected inflation as a
function of past interest rates, inflation, and time trends and
then subtracting the expected inflation measure from the
nominal interest rate.
25
Determinants of Asset Demand
Wealth: the total resources owned by the individual, including
all assets
Expected Return: the return expected over the next period on

Risk: the degree of uncertainty associated with the return on
Liquidity: the ease and speed with which an asset can be turned
into cash relative to alternative assets
26
Theory of Portfolio Choice
Holding all other factors constant:
The quantity demanded of an asset is positively related to
wealth
expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the
risk of its returns relative to alternative assets
liquidity relative to alternative assets

27
Supply and Demand in the Bond Market
quantity demanded of bonds is higher: an inverse relationship
quantity supplied of bonds is lower: a positive relationship
28
Supply and Demand for Bonds

29
Changes in Equilibrium Interest Rates
Shifts in the demand for bonds:
Wealth: in an expansion with growing wealth, the demand curve
for bonds shifts to the right
Expected Returns: higher expected interest rates in the future
lower the expected return for long-term bonds, shifting the
demand curve to the left
Expected Inflation: an increase in the expected rate of inflations
lowers the expected return for bonds, causing the demand curve
to shift to the left
Risk: an increase in the riskiness of bonds causes the demand
curve to shift to the left
Liquidity: increased liquidity of bonds results in the demand
curve shifting right

30
Factors That Shift the Demand Curve for Bonds
31
Shifts in the Supply of Bonds
Expected profitability of investment opportunities: in an
expansion, the supply curve shifts to the right
Expected inflation: an increase in expected inflation shifts the
supply curve for bonds to the right
Government budget: increased budget deficits shift the supply
curve to the right

32
Factors That Shift the Supply of Bonds
33
2
3
Let = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10)
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)
In years
$100 X (1 + )
n
i
n
i
n
PV = today's (present) value
CF = future cash flow (payment)

= the interest rate
CF
PV =
(1 + )
i
i
1
PV = amount borrowed = $100
CF = cash flow in one year = $110
= number of years = 1
$110
$100 =
(1 + )
(1 + ) $100 = $110
$110
(1 + ) =
$100
= 0.10 = 10%
For simple loans, the simple interest ra
te equ
n
i
i
i
i
als the
yield to maturity
23
The same cash flow payment every period
throughout
the life of the loan
LV = loan value
FP = fixed yearly payment
= number of years until maturity
FPFPFPFP
LV = . . . +

1 + (1 + )(1 + )(1 + )
n
n
iiii
+++
23
Using the same strategy used for the fix
ed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
= years to maturity date
CCCCF
P = . . . +
1+(1+)(1+)(1+)(1
n
n
iiii
++++
+)
n
i
consol
the
of
maturity
to
yield
payment
interest
yearly
consol
the

of
price
/
=
=
=
=
c
c
c
i
C
P
i
C
P
c
c
P
C
i
/
:
this
as
equation
above
rewrite
can
=
F

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there are greater incentives to borrow a
nd fewer incentives to lend.
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e
r
r
e
ii
i
i
p
p
=+
est rate is a better indicator of the in
centives to
borrow and lend.

Week-2 Into to Money and Banking
and Basic Overview of U.S. Financial System & Interest Rates
The first and most important issue with this view is incomplete
information which comprises several components:
Search Cost – finding all the people willing to make a funds
exchange – matching lenders (savers) to borrowers (spenders) –
Real cost and Nominal Costs
Transaction Cost – paying for enforceable contracts, accounting
costs, collection costs, etc.
Asymmetric Information – default / losses.
Information & Transaction Costs

Asymmetric Information – the lender does not know enough
about the borrower to make a accurate decision – “the borrower
always knows better how well he can pay back the loan.”
Adverse selection is a problem created when there is
asymmetric information before a transaction occurs. It occurs
when borrowers who are most likely to default are the ones
most actively seeking to obtain loans and are thus selected.
Moral hazard occurs – after the transaction occurs.
The problems created by by adverse selection and moral hazard
are an important impediment to well functioning financial
markets - and cause systemic fall in confidence e.g. most
recent financial market crisis.
Asymmetric Information – Moral Hazard
example.

3
Moral hazard in the financial markets is the risk or hazard that
the borrower might engage in activities that are undesirable
(immoral) from the lenders point of view.
Strategic default is one example – people walk away from their
mortgage because their home value has declined below that
outstanding balance on the loan.
Moral hazard can also occur from the lending perspective where
management engages in activities that benefit themselves at the
expense of the owners shareholders – this is called the
separation theorem.
This is often referred to as conflicts of interest. Conflicts of
interest are a moral hazard that occur when a person or
institution has multiple objectives (interests), and as a result,
have conflicts between those objectives.
Moral Hazard
example.

4
Financial Innovation the development of any new financial
products and services is an important force making the financial
market more efficient.
For example dramatic improvements in technology have lead to
new products and the ability to deliver financial services
electronically like e-finance and the ATM (POS).
It also has a dark side and can lead to moral hazards, and
financial crises like the most recent one.
When the financial system sizes up (liquidity dries up) it may
produce a financial crisis.
A financial crisis is characterized by sharp declines in asset
prices, the failure of numerous financial institutions and rising
unemployment.
Financial Innovation
example.

5
The Dialectic Process was developed by the German
Philosopher Georg Wilhelm Fredric Hegel (1770-1831).
According to Hegel society is burdened with contradictions and
tensions.
Through these contradictions and tensions one goes through a
process (dialectic) to discover what he called the “absolute idea
or absolute knowledge.
Professor Edward Kane applied this term to banking in the
1970’s
It carries the idea that baking regulation is cyclical interaction
between opposing economic and political forces.
Such rules foster a cat and mouse gam benefiting particular
institutions thereby motivating other institutions to find
loopholes in the system.
Management’s goals become finding ways to circumvent
restrictions in order to capture key markets.
Now if a number of institutions are successful in such
avoidance, than the regulations are changed and a new dialectic
cycle begins.
Regulation& Dialectic Process

example.
6
Money also referred to as the money supply is defined as
anything that is generally accepted in payment for goods or
services or in the repayment of debt.
Money is linked to changes in economic activity and variables
that affect all of us and are important to the heath of the
economy.
When an economy undergoes pronounced fluctuations evidence
suggest that money plays an important role in generating a
business cycle.
Monetary theory relates the quantity of money and monetary
policy to changers in aggregate economic activity.
Money and Monetary Policy

example.
7
The average price of goods and services in the economy is
called the aggregate price level.
Inflation is a continual increase in the price level, affecting
individuals, business, and governments.
The price level and money supply generally rise together
(Why?)
Milton Friedman, a Nobel Laureate in Economics made the
famous statement “Inflation is always and everywhere a
monetary phenomenon.”
In addition to inflation, money plays an important role in
interest rate fluctuations.
Money & Inflation
example.
8

Because money can affect many different economic variables,
policymakers often concentrate on the conduct of monetary
policy which is the management of money and interest rates.
The organization that is responsible for conducting monetary
policy is the central bank. For the United States the central bank
is the Federal Reserve System (12 banks).
Fiscal policy involves decisions around government spending
and taxation.
A budget deficit is the excess of government expenditures over
tax revenues for a particular time period.
A budget surplus arises when tax revenues exceed government
expenditures.
The government must finance deficit by borrowing in the
financial markets.
Monetary Policy and Fiscal Policy
example.
9
Transaction Costs – the time and money spent carrying out

financial transactions are the major problems faced by
individual lenders.
Financial intermediaries can substantially lower transaction cost
because their size allows them to take advantage of economies
of scale.
For example banks and insurance companies have large staffs of
lawyers who can produce airtight contracts that can be used
over and over again.
In addition, they have the resources to develop data systems and
expertise to determine a borrowers credit worthiness. This is
often referred to as economies of scope.
Economies of scope lower the cost of information production
for each service by applying one information source to to many
different services.
Function of Financial Intermediaries – Transaction Costs
example.
10
Financial intermediaries bring numerous transaction partners

together by creating assets (products) with risk characteristics
that people are comfortable with.
In addition, the lower transaction costs and risk sharing enable
the financial intermediaries to earn a profit (spread) between the
return they earn on a risky asset, and payments they make on
the assets they have sold.
Financial intermediaries also promote risk sharing by helping
individuals diversify the amount of risk they are exposed.
Diversification entails investing in a collection (portfolio) of
assets whose assets do not always move together, thereby
reducing the over all risks compared to that of individual
investments. (Note Mutual Funds and Loan Portfolios)
Function of Financial Intermediaries – Risk Sharing
example.
11

12
Individual Investment – An Economic Perspective
Savings and investment is an intertemporal choice between
current consumption and future consumption.
The individual will save and consume at level that gives
him/her the highest level of satisfaction (utility) depicted by
curves U1 through U4 for a given level of income (budget).
The highest attainable level of utility is point C1 where U3 is
tangent to the individual’s budget line.
U3
U2
U1
U4
Budget Line
C1
A
B
O
Current
Consumption

Future Consumption
Savings
D
13
We can apply this same analysis to the owner of a single firm
who can either:
consume the firm’s present earnings by liquidating the assets
(points O,A)
Or save / invest into future returns (points A, D)
Note the production frontier acts like a budget constraint.
In this case the production frontier represents the combinations
of savings and consumption that is used to produce wealth /
utility.
Note the curved shape of the frontier is due to the law of
diminishing returns.
The level of consumption and investment also equal to the point
of highest utility at point C1.
U3
Production Frontier

C1
A
B
O
Consumption
Future Returns
Investment
D
14
Introducing the capital market allows us to examine investment
decisions where there are many owners (shareholders) – this is
called the Separation Theorem.
The capital investment decision becomes the company
(managers) undertake physical investment until the return from
the investment = the market rate of return/interest at point P.
This level of investment results in some dividend flow or
appreciation of wealth to the shareholders.
Shareholders make their financial decision by either borrowing
or lending in the capital market until their individual time value
of money = the capital market return.

This results in the highest aggregate utility at point C2
indifference curve U2.
Total Investment
With CML
A
B
O
1+r
D
E
C1
C2
U1
U2
Capital Market Investment Line (CML)
Required rate

Of Return
F
P
Old
Investment
Old Future
Returns
Total Returns
With CML
Money Market Instruments – because of their short maturities
these traded debt instruments exhibit the least price fluctuations
(called volatility) so are the least risky investments (Why?)
General Types of Money Market instruments include:
U.S Treasury Bills
Negotiable Bank Certificates of Deposit
Commercial Paper
Repurchase Agreements
Federal Funds
Bankers Acceptance

These are short-term debt instruments of the U.S. Government
generally called T-bills.
T-bills are usually issued with one of three original maturities
91 days (13 weeks), 182 days (26 weeks), 364 days (52 weeks).
The minimum denomination is $10,000 sold to the highest
bidder in weekly auctions by the Federal Reserve Bank of New
York.
Bids are expressed in a percentage of the bill’s Par Value
(Face). For example, a bid of 99.55 on a 26 week T-bill means
the buyer is willing to pay a purchase price of 99.55% of the
face value.
Because T-bills are sold at a discount, purchasers make money
by what they pay for the T-bill and Face Value, and on the
maturity of the bill.
U.S. Treasury Bills
A Certificate of deposit is a debt instrument sold by banks to
depositors that pays a stated annual interest and at maturity
pays back principal.
Negotiable CD are CDs sold in the secondary market.
In the 1960s when Regulation Q was in effect it was difficult
for large banks to retain large depositors.

When Regulation Q was in effect during times of high interest
rates investors could earn more money by investing directly into
T-bills.
Reg Q Ceilings prohibited banks from paying higher interest
rates. Consequently banks like City Bank of New York (now
Citibank) created Negotiable CDs that had large face values
usually $1 million, that could be sold by the depositor in the
secondary market if the depositor needed cash before maturity.
(Why would this make them more attractive to corporate
customers?)
Negotiable CDs have original maturities of less than one year,
have a coupon or stated rate which is expressed as a percentage
of Par (what does this imply?)
Interest calculations assume a 360 day year – thus the yield is
called a bond yield.
Negotiable CDs
Commercial Paper is a short-term debt instrument issued by
large banks or well known corporations like Microsoft.
Traditionally large well known firms dominated the market –
but smaller highly rated companies began to issue commercial
paper in the 1980s.
Commercial paper has expended into world markets and the
Eurocommercial paper market is centered in London.
While commercial paper can be sold in the secondary market,
due to their short-term nature a secondary market is virtually
nonexistent. Most are held to maturity.
Commercial Paper

Repurchase agreements (Repos) are effectively short-term loans
with maturities less than two weeks.
T-bills and other debt securities are used as collateral.
A large corporation may have idle fund in its bank account for
which it is willing to lend out for a short period. The firm buys
a T-bill from the bank at a discount.
The bank agrees to repurchase the T-bill at par or a price
slightly higher than the price the firm paid for the T-bill in the
original exchange. In effect the firm gave the bank a short-term
loan.
A reverse repo is in the opposite direction and depends on who
is the buyer and who is the seller. Usually repo is designated to
the seller and reverse repo is designated to the purchaser.
Repos have become an important funding source for banks as
well as lending tool since they are not counted as on balance
sheet loans.
Repurchase Agreements
These are overnight loans between banks of their deposits at the
Federal Reserve
Note these are not funds from the federal government.
One reason a bank may borrow FED funds is that it does not

have enough deposits in its Fed Account to meet the minimum
required reserves.
Banks may also find themselves in a position where their loan
demand exceeds their available deposit balances e.g. short on
funding.
Funds are transferred from one bank’s account to the other
bank’s Fed account using the Fed’s wire transfer system.
Fed funds are borrowed either through direct negotiations
between institutions or via Brokers.
Federal (FED) Funds
Are short-term securities of global importance.
They are short-term credit agreements often called time drafts,
through which international trade is financed.
Because merchants or sellers often have difficulty assessing the
credit worthiness of overseas customers, they may be more
comfortable if a bank guarantees payment for the goods ordered.
Suppose an importer orders goods and at the same time goes to
the bank to finance the purchase. Typically the financing is
though a letter of credit (LC). The LC certifies the bank will
standby the importer.
The importer present the LC to the Exporter who now is more
comfortable engaging in the transaction. If the financing is
approved, the bank notifies the exporter’s bank that funds are
forthcoming. Upon guarantee of the payment the exporter ships
the goods and forwards shipping documents and a draft
(authorization for payment) issued with a specific payment date
to his bank. The bank then sends the shipping documents and
the draft for collection to the importer’s bank. At that point the

importer’s bank stamps the draft “Accepted” and the draft
becomes a Bankers Acceptance (BA). The exporter’s bank
ships the funds and receives payment from the importer when
the goods arrive and are confirmed and inspected by the bank
Bankers Acceptance
If the importer’s bank has already advanced the funds and it
wans to recover the funds before the importer repays the short-
term loan it may sell the acceptance to market investors .
At this point, the purchaser of a BA ha s promise of two parties,
the importer and the importer’ s bank that the BA will be paid
on the maturity date. For this reason a BA is sometimes called
two-name paper.
Investors purchase the BA security at a discount form the face
amount where the investor makes a profit by the difference from
what was paid to the investor’s bank to buy the BA and the total
funds that the investor receives at maturity.
Thus, bankers acceptances serve not only as short-term assets to
money market investors, but also as a short-term funding source
for large banks financing international transactions.
Bankers Acceptance Continued

Capital market instruments are debt and equity securities whose
maturities are greater than one year.
The exhibit far wider price fluctuations than money market
instruments and are considered to be fairly risky instruments.
They Include:
Corporate Stocks
Mortgages
Corporate Bonds
U.S. Government Long-term Securities
Government Agency Securities
State and Local Government Bonds
Bank Commercial Loans
Consumer Loans
Capital Markets
Stocks are equity (ownership) claims on the net assets and
income of a corporation.
The total market value of all U.S stocks exceeded $17 trillion at
the end of 2010.
However, the amount of new stock issued any given year is less
than 1% of the total market.
Individuals own around ½ of the value of all shares outstanding
and the other half held by mutual funds, pension funds, and
insurance companies.

Stocks (Equities)
Mortgages are loans to house holds and firms looking to
purchase land buildings, or both where the land and structure or
both serve as collateral on the debt obligation.
Mortgages are by far the largest debt market in the United
States.
Mortgages are provided by Commercial Banks, Savings and
Loans, Mutual Savings Banks, and Insurance Companies.
For certain niche markets government agencies also fund
mortgages like the Federal Farm Home Loan Bank, and the
Veterans Administration.
Mortgages
25
Residential Mortgages used to purchase residential housing
outstanding balances are more than quadruple that of
commercial and farm loans.

Residential mortgages can take the form of Fixed Term Loans,
Hybrids, and Adjustable Rate loans.
Residential Mortgages can be conforming and Non-conforming
transactions.
In 1970 Congress Authorized Fannie Mae to purchase
residential mortgage loans. Fannie Mae worked with Freddie
Mac to develop uniform documents and notional standards that
would be known as a conforming loan.
The Office of Federal Housing Oversight (OFHEO) set the
criteria on what constitutes a Conforming Loan Limit for the
two agencies.
The criteria includes a debt to income ration and documentation
limits.
The maximum Loan Amount is set based on the October-to-
October change in median home prices. Loans above this
maximum price are called Jumbo loans and are “non-
conforming.”
Freddie and Fannie can only buy conforming transactions and
repackage these loans into secondary mortgage backed
securities making the demand for non-conforming loans much
less.
Residential Mortgages
Commercial mortgages are use to finance land buildings, and
premises that can be used for operations or for investment

properties.
Commercial mortgages where the borrower uses the land or
building and resides on the property for operating purposes are
called owner occupied.
Commercial mortgages where the borrower does not occupy the
property and collects rents or is intended for resale are called
investor Properties.
Commercial Mortgages
Under U.S. Federal income tax law, a real estate investment
trust (REIT) is "any corporation, trust or association that acts as
an investment agent specializing in real estate and real estate
mortgages" under Internal Revenue Code section 856.
They sell a security that sells like a stock on the major
exchanges and invests in real estate directly, either through
properties or mortgages. REITs receive special tax
considerations and typically offer investors high yields, as well
as a highly liquid method of investing in real estate.
Equity REITs: Equity REITs invest in and own properties (thus
responsible for the equity or value of their real estate assets).
Their revenues come principally from their properties' rents.
Mortgage REITs: Mortgage REITs deal in investment and
ownership of property mortgages. These REITs loan money for
mortgages to owners of real estate, or purchase existing
mortgages or mortgage-backed securities. Their revenues are
generated primarily by the interest that they earn on the
mortgage loans.
Hybrid REITs: Hybrid REITs combine the investment strategies
of equity REITs and mortgage REITs by investing in both

properties and mortgages.
Real Estate Investment Trusts - REITS
Land Development Loan – when raw land need to be made
construction ready a the borrower obtains a land development
loan. The land may be subdivided and sold in a number of
parcels for commercial or residential use. (phased performance
covenants)
Acquisition and Development Loan is used if the land is ready
for development and needs improvement to infrastructure or
existing buildings.
Mini Perm Loan is a temporary loan used to settle an
outstanding construction or commercial property loan that once
completed will produce income. After three to five years of
generating income the mini perm is replaced with longer-term
financing.
A Takeout Loan replaces financing on projects where a
temporary short-term construction loan currently exists.
(Require guarantees).
Interim Construction Loan pay for the labor and materials to
finish a project.
Commercial Construction Mortgages

Corporate Bonds – Long-term debt instruments issued by
investment grade corporations that pay holders interest
generally bi-annually and the principal at maturity.
Mortgage-backed Securities - are bond like instruments backed
by a bundle of individual mortgages whose interest and
principal are paid to the holders. These are often referred to as
credit derivatives – since they derive their value from other debt
instruments.
U. S. Government Securities - long-term debt instruments issued
by the U.S. Treasury to finance deficits of the Federal
Government. Because they are the most widely traded bonds in
the United States – they exhibit the most liquidity.
U.S. Government Agency Securities are – Long-term bond
issued by government agencies like Ginnie Mae, the Federal
Farm Credit Bank, etc.
State and Local Government Bonds – called municipal bonds
are long-term debt instruments by states and local governments
to finance expenditures on roads, infrastructure, schools, and
large program. (Tax advantage).
Consumer and Commercial Bank Loans – largest debt
instruments to private sector.
Capital Market Instruments Continued

Depository Institutions – are financial intermediaries that
legally accept deposits from individuals and firms and make
loans using a portion of the deposits. Hence they are highly
leveraged institutions.
They include commercial banks, thrift institutions, savings and
loan associations, mutual savings banks, and credit unions.
Because they are involved in the creation of money via deposits
and the money multiplier the study of money and banking
focuses on these financial institutions.
Financial Intermediaries - Depository Institutions
Commercial Banks – raise funds by issuing demand and savings,
and time deposits.
They uses these funds to make commercial, consumer and
mortgage loans.
Banks obtain an operating charter at the federal of state level -
those that are chartered at the federal level are called national
banks.
The regulator for most national banks is the Comptroller of the
Currency (OCC) which was created by the National Banking
Act of 1864.
The National Banking act established standards a bank must
meet before receiving a national charter.
The current duel banking system where both the federal
government and state governments issue bank charters is traced
back to this period.
The Federal Reserve System was created by the Federal Reserve

Act of 1913 to ensure the existence of both a flexible payment
system and as the lender of last resort to banks.
As a result all federally chartered banks must be members of the
Fed and the Fed also provides supervision over federally
chartered banks as well as state chartered banks that join the
Fed. Note virtually all banks now belong to the FED.
Depository Institutions – Commercial Banks
These institutions sometimes called Thrifts, also are chartered
either federally or by states.
The Federal Home Loan Bank Board and the Office of Thrift
and Supervision (OTS) was established in 1932 to oversee and
supervise thrifts.
These institutions are primarily funded through savings deposits
called shares and time and DDA deposits.
In the past these institutions could only make residential
mortgage loans but the regulations have been loosened such
they act as commercial banks. (Note many have actually been
acquired by commercial banks).
Depository Institutions – S&Ls and Mutual Saving Banks

Are smaller co-ops organized around a particular group or union
of members, employees of a firm etc. who basically own the
organization.
They acquire funds form deposits of the members and used
these funds to make consumer loans – most often to its
members.
They are also chartered though either states for the federal
government.
The major regulator for credit unions is the National Credit
Union Administration (NCUA).
Depository Institutions – Credit Union
Finance Companies raise funds by selling commercial paper
and by issuing stock and bonds. They lend the funds to
consumers to purchase consumer durable goods like
automobiles, furniture, and for home improvement where the
goods or homes serve as collateral.
Mutual Funds are financial intermediaries that sell shares to
large groups of individuals and use the funds to purchase
diversified pools portfolios of stocks and bonds. They allow
shareholders to reduce transaction cost by large blocks of stocks
or bonds. They help members hold more diversified portfolios
and make money through management fees.
Money Market Funds are similar to mutual funds but offer
deposit like accounts that pay interest to the depositors. Like
mutual funds they sell shares to acquire money market
instruments and use the instruments to pay interest to their

share deposits.
Investment Banks are not banks but help corporations issues
securities like stock and bonds. They help the corporations
decide what type of security to issue and then underwrite the
security by purchasing the security at a predetermined price and
then selling them in the market. They make money by
underwriting fees and from the difference they pay to the
corporation to obtain the initial offering and what they sell the
stock in the market.
Other Depository Institutions
Economists define money as anything that is generally accepted
in payment for goods, services, or the repayment of debt.
When most people talk about money today they think of coin or
currency.
However to define money as only coin or currency is too narrow
a definition for economist. For example, checks are also
accepted for payment so would they also be considered money?
Money is also confused with wealth. Money is used to make
purchases of goods and services whereas wealth is the total
collection of the individual’s assets which includes money.
Money is also used to describe income. Income on the other
hand is a flow of earnings at a point in time. Whereas money is
a stock – it is a certain amount at a given time by looking at the
total money balances you cannot tell where it came from or
necessarily when it was accumulated. (What is the difference
between nominal and real values?)
Money

In every economy money serves three basic functions:
Medium of exchange – here money is used to pay for goods and
services.
Unit of account – used to measure the relative value of
something ( Market economies and prices help move goods and
services to highest perceived value.
Store of value – where money acts as a repository of
purchasing power to utilized at a future date.
Functions of Money
Medium of exchange – here money is used to pay for goods and

services which promotes economic efficiency by reducing the
time spent in exchanging goods and services (called transaction
cost).
If I want to eat in a barter economy I must find someone who
wants to learn about money and banking and produces the food I
like to eat.
In such an economy transactions only occur between two
individuals if both peoples wants are satisfied. This is called
double coincidence of wants. (Important concept in a market
economy).
The time necessary trying to satisfy all the potential double
coincidences is high in a barter economy. Money reduces the
time to find all the people who will be wiling to trade goods and
services.
Functions of Money – Medium of Exchange

Imagine how difficult it would be trying to find how many
people would trade bread for shoes. Moreover how much bread
equates to a pair of shoes?
If you only had three goods then one would only need to know
only three prices relative to each other to make an exchange.
Now assume that we have 1,000 different goods to trade. Each
item would need 999 different price tags to estimate how much
each of the other goods is necessary to make an exchange.
When we introduce money as a common measure, it is easy to
exchange good s and services in terms of the amount of money
need. This in turn also lowers transaction costs.
Functions of Money – Unit of Account
Money also functions as a store of value – a repository of future
purchasing power. Most of us do not spend all our income all at
once. Rather we purchase goods and services as we need them.
Any asset can act as a store of value. However as we noted in
barter economy exchanging goods and services particularly in

the future is costly.
The ease and speed at which assets can be converted into a
medium of exchange ( or exchanged for that matter) is called
liquidity.
Liquidity is highly desirable and money is the most liquid of
assets because it does not have to be converted into anything
else to make exchanges.
How good money functions as a store of value depends on the
price level. For example if prices double money’s value and
declined by half. This is trued during extreme periods where
the inflation rate exceeds 50%. (Example Germany between
WWI and WWII). Can you think of a modern example today?
Functions of Money – Store of Value
Inflation is a continual increase in aggregate prices that affects
business, individuals and the government.
Substantial evidence exists to suggest that inflation is tied to
increases in the money supply.
Demand pull inflation best known by Americans stating in 1960

and latter sometimes called wage inflation. It occurs when
workers experience wage increase leading to increased demand
the exceeds aggregate out put thus leading individuals to bid up
prices.
Cost push inflation or commodity inflation. It arises from either
(1) increased demand for raw materials that dive up their price
and the price increased is passed along tot the end product or
(2) an interruption in the supply of a commodity that increases
the price of the end product( give examples).
Monetary inflation that was famously seen in Weimar Germany
in the 1920s when the German government when the
government printed billions of marks such that it tool billions
to equal one dollar (note arbitrage and parity effects).
Inflation
By examining the evolution of payment systems we can get a
better picture of the types of money and its functions.
Commodity Money – For thousands of years commodity money
made up of various rare raw material like precious metals
served as the medium of exchange. (what is the problems
associated with this type of money?) (Does it have to be rare
minerals – Egypt).
Fiat Money – paper currency (lighter and easier to store and
protect). Originally paper money carried a guarantee that is was

Week-1 Into to Money and Bankingand Basic Overview of U.S. Fin.docx

Week-1 Into to Money and Bankingand Basic Overview of U.S. Fin.docx

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