Chapter

1 Direct finance- lender-savers and borrower-spender by and sell securities in financial markets Indirect- there is a financial intermediary that helps transfer funds What is a security- a financial instrument o Bonds o Stocks(equity) Bond market is important bc its where interest rates are determined Money market- only 4 short term debt secutries (bonds) Capital market- for debt with maturities greater than one year and equity instrumets Financial intermediation why important??- reduce transaction costs which causes: o Provide liquidity services o Risk sharing Asymmetric information: lack of information FI reduce transaction costs because they can take advantage of economies of scale The process of risk sharing is also referred as asset transformation Assest transf. can be seen from 3 view points: o Convenience of denomination: banks then simply play the role of intermediaries by collecting the small deposits and invest the proceeds into large loans o Quality transformation: small investor cannot diversify its portfolio or banks have better info o Maturity transf. transfor. Securities with short maturities, like deposits, into securities with long maturities, like loans Adverse Selection occurs before transaction and moral hazard occurs after Chapter 2 Money how to measure it: o M1: currency + checking accounts deposits + traveler checks o M2: M1+ small time deposits + saving deposits and money market deposit accounts + money market mutual fund shares Chapter 3 Compound interest rate: $100 x (1 + i)n The process of calculating todays value of dollars received in the future is called discounting the future PV = CF / (1 + i)n Simple loan- repaid at the maturity date along with and additional payment of interest Fixed payment loan: the repayment involves the same payment every period, like auto loans or mortgages

Coupon bond: issuer pays the owner of the bond a fixed interest payement (called coupon payment) every year until maturity date, when a specified final amount ( called face value) is repaid. Coupon Rate: yearly coupon payment expressed as a percentage of the face value. Like US treasury nods or corporate bonds Discount bond: bought at a price below its face value. No interest payments Yield to maturity: the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today Fixed payment loan: o LV(loan value) = FP (fixed yearly payment)/ (1 + i)n Coupon bond: o P(price of coupon bond) = C(yearly coupon payment)/ (1 + i)n Price of a coupon bond and the yield to maturity are negatively related RET ( rate of return) = (C/Pt) + ((Pt+1 Pt)/(Pt)) o RET = return from holding the dong from time t to time t+1 o Pt =Price of bond a time t o Pt+1 = Price of bond at time t +1 o C= coupon payment o C/Pt = Current yield = ic o ((Pt+1 Pt)/(Pt))= rate of capital gain = g 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 holding period) The more distant a bonds maturity, the greater the size of the % price change associ. With an interest rate change The more distant the bonds maturity, the lower the rate of return occurs as a result of an increase in the interest rate In LR bond prices are more volatile Nominal Interest rate does not take in interest rate Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing Fisher Equiation: o i = ir + e o i = nominal interest rate o ir = real interest rate o e = expected inflation rate when the real interest rates are low, there are greater incenctives to borrow and fewer incentives to lend. The real interest rate is a better indicatior of the incentives to borrow and lend. Factors that shift demand curve for bonds: o Weath- increase then shift right o Expected interest rates affect exp. Returns: o Expected returns on other assets o Expected inflation affect exp. Returns. o Risk of bonds or relative risk o Liquidity of bonds or relative liquidity

Factors that shift supply curve for bonds: o Expected inflation: o Government Budget Fisher effect: o Exp inflation increases which Demand: demand for bonds fall (other assets are more attractive) Supply: supply increases (real cost of borrowing increases) o Which; Fisher effect: when expected inflation rises, interest rates will rise Quantity is ambiguous The liquidity preference framework: o Demand for money: as the interest rate on bonds rise, the opportunity cost of holding money rises, thus money is less desirable and their demand fall o Other assumption is that money supply is fixed Factors that shift the demand curve for money o Income effect o Price-level effect Main conclusion of LPF model: an increase in money supply will lower interest rates ( liquidity effect)

Chapter 4 Bonds with the same maturity have different interest rates ( difference is called spread) due to : o Default risk Risk premium: the spread between the interest rates on bonds with default risk A bond with default risk will always have a positive risk premium and its increase in its default risk will raise the risk premium Credit Rating agencies: credit ratings reflect probability of default on a debt security o Conflicts of interest: Issuers of securities pay a rating firm to have their security rated Debt issuers ask rating agencies to advise them on how to structure their debt issues o SEC prohibited Credit rating agencies to structure the same product they rate Anyone who participates in the rating from negotiating the fee that the issuer pays Gifts from bond-issuer over $25 More disclosure of how credit rating agencies determine their rating

Chapter 5 The required return on investment in equity, as any interest rate that is used to discount future cash flows, usually reflects two things: o Time value of money (approx.. using the risk-free interest rate) o A risk premium (uncertainty about future cash flows) Role of information can increase asset value by reducing its perceived risk Theory of rational expectation: o Xe = Xof Xe= expectation of the variable that is being forecast Xof = optimal forecast using all available information Efficient Markets Hypothesis: o Suppose current equil. Prices (P*) are lower than the optimal forecast of tomorrows price (Pof) will be above its normal level R*, and we identify an unexploited profit oppurt. We will buy the stock, increasing its price until the oppurt. Diaspears (ie until the price is equal to the optimal forecast) Rof>R* Pt (to increase) Rof ( to decrease) Rof<R* Pt (to decrease) Rof ( to increase) Until: Rof = R* o In an efficient market, all unexploited profit oppurt. Will be eliminated o Prices follow random walk for stocks A firm can raise funds by issuing stocks of bonds: their mix is called capital structure Modigliani-Miller theorm: capital structure does not matter, both are equally good ways to raise funds (at the end, in both ways, the company is giving up earning with a PV equal to the amount of funds raised) Diversification: holding many risky assets reduces the overall risk an investor faces, therefore it is beneficial

o Liquidity The more liquid the asset is the more desirable it is o Tax considerations: interest payments form municipal bonds are exempt from federal income taxes Yield Curve: describes the term structure of interest rates for particular types of bonds ( can be upward/ flat/ or downward sloping) Facts theory of the term structure of interest rates must explain o Interest rates on bonds of different maturities move together over time o When SR interest rates are low, yield curves are more likely to have an upward slope; when SR rates are high, yield curves are more likely to slope downward and be inverted o Yield curves almost always slop upwards Expectations Theory o Buyers consider bonds with different maturities to be close subsitutes o Buyers of bonds do not prefer bonds of one maturity over another

Chapter 6 Derivatives are financial securities that derive their economic value from an underlying asset o Intended to allow investors and firms to profit from price movements in the underlying asset o First function: to hedge, or reduce risk o Can serve as a type of insurance against price changes in underlying assets o Second function: to speculate (bets on asset prices) Speculators provide liquidity Hedgers are able to transfer risk to speculators o Forward contracts: Develop. In context of agricultural markets Forward contracts tend to illiquid There is default risk, if one of the parties is unable or unwilling to fulfill the contract: counterparty risk Involve agreement in present to exchange a given amount of a commodity of financial asset at a particular date in the future for a set price o Future contracts Created from forward contracts in order to increase their liquidity and lower their risk o Call option- gives the buyer the right to buy the underlying asset at the strike price, at any time up to the options expiration date o Put option- gives the buyer the right to sell the underlying asset at he strike price Chapter 7 Financial Structure Basic Facts: o Stocks are not the most important source of external financing for business (11% in the US) o Issuing marketable debt and equity securities (43% combined in the US) is not the primary way in which businesses finance their operations o Indirect finance is many times more important than direct finance o Financial intermediaries (57%) are the most important source of external funds used to finance businesses

Market Porfolio: the total of all risky assets that is included in the portfolio o They also have risk: Systematic risk ( recessions can decrease price as a whole) Not the unique risk, as they are called: Idiosyncratic risk ( or nonsystematic risk) Total asset risk = systematic risk + nonsystematic risk

o The financial system is among the most heavily regulated sectors of the economy (provide information, soundness of the system) o Only large, well-established corporations have easy access to securities market to finance their activities o Collateral (property pledged to a lender to guarantee payment in event of default) is a prevalent feature of debt contracts for both households and businesses. We call this type of debt Collateralized debt o Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers. The restrictive covenants are provisions that restrict and specify certain activities that the borrower can engage in Transaction Costs: o Influence financial structure o How financial intermediaries reduce transaction costs? Economies of scale: the more transactions, the lower the cost per transaction. For example: Mutual Funds Expertise at lowering transaction costs Asymmetric Info: o Adverse Selection: is the problem created by asymmetrical info before the transaction occurs Problem to distinguish low-risk borrowers from high-risk borrowers o Moral hazard: is the problem after the transaction Is the risk that a borrower may engage in undesirable activities Adverse Selection in the Stock Market: o Tools to help solve?? Private production of information: S&Ps, Moodys, etc. information on balance sheet positions and investment activities and sell to subscribers Free-Rider Problem: ppl who do not pay for information take advantage of the information that other ppl have paid for Govt Regulation: SEC requires firms to disclosure info using certain standards (independent audits on sales, assets, liabilities, earnings) Despite this, firms still have more info than investors Financial intermediation: an FI, like a bank, becomes an expert in producing info about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors to lend them to good firms. Bank or FI avoids free-rider prob making private loans rather than purchasing securities in an open market; its key to success in reducing asymm. Info

Chapter 8 1933 Glass-Steagall Act: restricted the scope of banks activities (forbidden to engage in the business of securities).

Collateral and net worth: if there is collateral, the consequences of default are reduced. Hence, lenders are more willing to make loans secured by collateral. Net Worth is the difference between firms assets and its liabilities, perform a similar role to collateral. More net worth, the less likely firm will default. Moral hazard in the Stock market: o Managers (the agents) pursuing their own interests rather than those of the shareholders (the principles) o Tools to help solve?? Production of information-monitoring: auditing firms frequently and checking on what the management is doing is known as costly state verification. Make equity contracts less desirable. Monitoring is subject to free-rider prob Govt Regulation: required to release info and impose criminal penalties on ppl who commit fraud of hiding or stealing profits Financial Intermediation: venture capitalist firms pool the resources of their partners and use funds to help budding entrepreneurs start new businesses Have positions in board of directors. Equity is not marketable to anyone besides them, eliminates free-rider prob Moral hazard in debt markets: o The less frequent need to monitor the firm, and thus the lower cost of state verification, explain why debt contracts are used more frequently than equity contracts o Still subject to moral hazard o Tools to help solve??? Net worth and collateral: if net worth is high or the collateral is highly valuable, the risk of the moral hazard is reduced (b/c the borrowers has a lot to lose). In this way you make the debt contract incentive-compatible Monitoring and enforcement of restrictive covenants: you can make sure that the money will be used for the purpose you want by writing provisions. Financial intermediation: restrictive covenants reduce the risk of moral hazard, but it is not possible to write a covenant for every possible risky situation. The problem with them is they require monitoring(free-rider prob again) and enforcement(legal costs). FIs avoid the free-rider prob as long as they make private loans.

o Fully repealed by congree in 1999 o When the act was repealed, it allowed for the creation of financial holding companies (FHC), conglomerates than own groups of financial institutions. Ex: Citigroup owns Citibank and other financial institutions Securitization: o Steps: Borrowers take out loans Lenders sell loans to securitizer Securitizer creates derivative securities backed by pools of loans Securities sold to financial institutions Balance Sheet of banks: o Assets: Reserves and cash items Require reserves (required reserve ratio) and excess reserves Securities Loans Less liquid and higher prob of default Other assets (ie physical assets) o Liabilities: Checkable deposits Nontransaction deposits Small denomination time deposits (<$100,000) Savings deposits Large denomination time deposits Borrowings Borrowings from FED: which are discount loans Borrowings (overnight) from other banks is the federal funds rate Financial holding companies issue bonds not the bank Bank capital Or equity = net worth Off Balance Sheet activities: o Does not affect the level of assets and liabilites o Lines of credit o Letter of credit: issued by banks, in order to guarantee some payment promised by a firm. In return of the fee, the banks agrees to make the payment if the firm does not o Asset Management: manages assets (small pension fund, wealthy guy) o Derivatives: banks can trade future contracts and options on stocks bonds and currencies o Investment banking: underwriting securities and advising on mergers and acquisitions (since 1999)

As underwriter, an investment bank helps issue new stocks and bonds IPOs Form syndicate with other investment banks using a lead investment bank Syndicate members purchase company stock and resell it immediately to financial institutions (mutual funds) Typically sells stocks for 5-10% more than paid for Basic Banking: o Opening an account with a check from other bank: bank deposit the check in its acct at the FED, and FED collects the funds from the checks bank o Making a profit Assets transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long o Manager has 6 concerns: Bank has enough cash to pay in event of deposit outflow, or liquidity management Search for a low level risk and high level of diversification, or asset management Acquire funds at a low cost, or liability management Decide the appropriate level of capital, or capital adequacy management Overcome the adverse selection and moral hazard problems, or credit risk management Limit the exposure to interest rate rise, or interest rate risk management o If bank has no reserves (which is required) then it has to: Borrow from other banks (cost is the interest rate that has to pay) Borrow from the FED ( cost is the discount rate) Sell securities (costs are brokerage and transaction costs) Reducing loans(calling in short term loans, or sell part of the portfolio to other banks at discount) Excess reserves are insurance against the costs associated with deposit outflows o Liability management: Core deposits: banks inexpensive sources of funds (checking deposits, savings, small time depo) Purchase Funs: expensive source of fund (borrowings and large time deposits) Strategy: 2 step process; first maximize core deposits. Then target the level of purchased funds

o Capital Adequacy management Basel Committee on banking supervision(BCBS) Classified under 4 categories based on risk, then the ratio of banks capital relative to its risk adjusted assets is calculated. Tier 1 capital consists of mostly shareholders equity If: o 6% or greater than cat1 (well capitalized) total cap ratio must be >10% o 4% or greater than cat2 (adequately capitalized) total cap ration must be >8% o less than 4% than cat3 (undercapitalized) total cap <8% o less than 3% than cat4(signfi. Undercapitalized) total cap <6% o less than 2% than cat5 (critically undercapitalized) Tier 2 capital equals the banks loan loss reserves, subordinate debt and other items If Cat1: no restriction o Cat2: restrictions on certain activites o If cat3,4,5 must take actions to raise capital ratios (FDIC makes an agreement regarding actions and deadlings) o If cat5, and capital is not raised immediately, then bank if closed. How to raise? Issue equity Reduce dividends Maintain capital in absolute terms o Leverage: the measure of how much debt an investor assumers making an investment. In the case of banks: ratio= assets/capital o Credit Risk management Screening and monitoring Collateral Credit rationing: higher interest rates make adverse selection problems worse/ moral hazed increase with size of loan o Interest rate risk management: Gap analysis: vulnerability of profits to changes in interest rates Duration analysis: vulnerability of banks capital to changes in interest rate Basic Gap analysis: bankprofit=(interest x (sensitive assets-sensative liabilities))

Duration analysis: duration measures the average life of a securities stream of payments. %change in market value ~~ o (-% change in points of interest rate)*(duration of yrs) banks can reduce interest rate risk using derivatives suppose bank has negative gap(too few sens. Assets) banks can use adjustable rate loans (not easy) can use interest rate swaps: banks agree to exchange, or swap, the payments from a fixed rate loan for the payments of an adjustable rate loan owned by a corp(why? Corporation wants to transfer the interest rate risk to someone else) can use future contracts: if a bank is worried that an increase in interest rate will worsen its position(fixed rate loans and variable rate deposits), it can sell treasury bill futures contracts. If market interest rate rise, the value of the tbill futures contract will fall. Hence if he offset its position he will register a profit.

Chapter 9 What factors explain a financial crisis?: o Asset market effects on balance sheet Decrease in net worth Increase moral hazard and adverse selection o Deterioration of FIs balance sheets Net worth down, and lending falls lower economic activity o Banking Crisis: Multiple banks fail at once Lending falls Loss of information production o Increases in uncertainty Higher adverse selection Lending falls o Increases in Interest rates Adverse selection Higher ir payments Lower internal funds available o Government Fiscal imbalances Events in a crisis: Stage 1: o Seeds: financial liberalization Increases efficiency Can generate credit boom with an inadequate risk managmt o Govt safety net increases moral hazard incentive for FI

Chapter 10 Low and stable inflation most important goal of monetary policy Inflation o Creates uncertainty o Lowers economic growth

o Bank losses: reduce net worth causes deleveraging, cuts the creation of information, increase info problems, cut lending o Asset bubble are also driven by credit booms Stage 2 o Loss of information Stage 3 o Sharp decline in prices, increasing burden of fixed debt Decline of traditional banking o Shadow banking system: lending via securities market o Financial innovation ARMs Financial derivatives Credit cards Atms and virtual banking Junk bonds Only companies with investment grade or used to have investment grade Securitization Transforming illiquid assets (residential mortgages, auto loans etc.) into marketable capital market securities o Securitization of mortgages Pooling a group of mortgages with similar characterisitics, the removal from balance sheet, and subsequent sale of interests and principal to secondary market investors Origination of mortgage back securities (MBS) Only to prime borrowers Traditional mortages Down payment of 20% of house price Subprime mortgages Lend money to ppl that normally do not qualify for a mortgage o Agency loans: market was dominated by fannie mae and Freddie mac for MBS o Non-agency loans: Other investment banks followed and issued MBS Jumbo: prime borrowers with big principal (>417th) Alt-A: solid credit scores, but some credit issue does not make them prime Subprime: poor credit history

o Strains social fabric Time inconsistency prob: o We have a nice plan that will produce a good outcome, but we find unwilling to follow it consistently over time. The plan is then time- inconsistent o Monetary policy makers face same prob Want to deviate from target policy to make an unexpected monetary expansion to boos econ output or reduce unemployment in SR Other goals of monetary policy: o Frictional unemployment: searches by workers and firms to find suitable matches o Structural unemploy.: mismatch between job requirements and skills of workers o Natural rate of unemployment: consistent with situation in which the SL=DL o Economic growth stability of financial markets o Interest rate stability o Foreign exchange market stability Hierarchical mandate: price stability is the primary mandate(ECB,bankofengland, bankofcanada, reservebankofnewzealand) Dual mandate: Fed reserve system and FOMC shall maintain LR growth of the monetary and credit aggregates commensurate with the economys LR potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate LR interest rates Origins of Federal reserve system: o Resistance to est. a central bank o A lender of last resort o Federal Reserve act of 1913 Checks and balances Decentralized o 12 banks fed reserve banks o member banks elect 6 directors for each district, 3 more are appointed by board of governors o monetary policy: directly (discount loans) and indirectly (membership of fed reserve committees) o seven members in Washington 14yr nonrenewable term o chairman chosen by governors 4yr term can be reappointed monetary policy: affects open market operations, reserve requirements, discount rate FOMC

o Meets 8tmes a yr o 12 members 7 board of governors president of fed bank of NY 4 other fed banks issues directives to buy/sell securities Chapter 11 The money supply process: o Fed Actions (policy tools) Open market operations Discount loans Reserve requirements o Bank decisions Monetary base + Banks balance sheet o Depositors decisions Monetary base + Banks balance sheet o Creation of money o Money supply FEDs balance sheet o Monetary liabilities Currency in circulation: hands of the pubic Reserves: bank deposits at the FED and vault cash o Assets Govt securities: earn interest Discount loans: earn the discount rate o Monetary base: MB= C + R C: currency in circulation R: reserves in the banking system o Money supply= C + checking deposits (D) Open market operations o Fed buys and sells securities Discount Loans o Loans FED makes to other banks o Cannot impose the amount of borrowing form banks Fourmula for multiple deposit creation: o D = (1/r) x R Money Multipler o M=mMB o If multiplier is >1, then MB increases and M increases

Chapter 12 Federal Funds Rate: (from one bank to another bank, not the FED) o Primary instrument of monetary policy o Determined in the market for reserves Reserves= required reserves + excess reserves Taylors Theory: the FED was confused between nominal and real interest rates. Taylor found that each 1 point increase in inflation caused the nominal FFR to rise by 0.8 points ( only in US 70s) Monetary Policy with an Implicit Nominal Anchor o Monetary strategy US has been using the past years o Implicit but not an explicit nominal anchor in the long run (inflation) It involves forward looking behavior in which there is careful monitoring for signs of future inflation Monetary Policy have long lags (upto one yr to affect output, 1.5 or 2 yrs to affect inflation) Inflation becomes harder to control once it has been allowed to gathered momentum, b/c higher inflation expectations become ingrained in LR crontracts and pricing agreements o Best Description: just do it policy Implicit nominal anchor o Advantages: same IT, does not rely on stable money inflation relationship, FED uses many sources of information to makes its decisions (not only monetary ag.), FED forward looking behavior and stress on price stability ameliorates the time-inconsistency problem o Disadvantages: Lack of transparency and accountability. Which leads to time consistency problems. At the end, just do it approach success depends on the preferences, skills and trustworthiness of the individuals in charge of the central bank The Phillips Curve: is the relationship between inflation and GDP, or between inflation and unemployment o Flexible price firms(firms that can change prices today) p = P + a (y yn) o Sticky price firms(firms that cannot change their prices today) p = Pe + a (ye yn^e) since GDP potential is equal to zero p = Pe Taylor Rule: o r = rn + (y yn) + ( t)

Chapter 13 Demand for Money o V = (P x Y)/M o Equation of exchange M x V = P x Y M= the money supply P= the price level Y= aggregate output (income) P x Y = aggregate nominal income (nominal GDP) V = velocity of money(avg number of times per year that dollar is spent) o Quantity Theory (QT) Fisher 1911 Velocity fairly constant in short run Classical economists view wages and prices completely flexible, then output was always at full employment, so output was constant in the short run SR: movement in the price level results solely from change in the quantity of money o Quantity theory for Money demanded: M = (1/V) x PY When money market is in equil.. M = Md Let k = (1/V) So Md = k x PY b/c k is constant PY determines Md the demand for money is not affected by interest rates o Keynes Liquidity Preference theory: Why do ppl hold money? Transactions motive Precautionary motive Speculative motive Distinguishes between real and nominal quatities of money (real money balance) Md/ P = f (i, Y) o where the demand for real money balances is negatively related to the interest rate i, and positively related to real income Y. o rewriting the equation we get o P/Md= 1/ (f(i, Y)) o Multiply both sides by Y and replace Md with M o V= PY/M= Y/f(i, Y) o Where i increases f(i,Y) decreases V increase

Intuition: if interest rate goes up, I demand less real money balances (high oppt cost). With less money in the economy and the same level of income, the rate at which money turns over( velocity) must be higher Aggregate Supply + Demand o AS: P = Pe + k (y yn) If s goes to zero, we have LRAS, if not then SRAS o LRAS is consistent with the level of potential output and the natural rate of of unemployment o SRAS: instead of sticky price firms, stickiness is reflected in cost of production Profitsi = (p * Qi) ( c * Qi) When P increases p increases, then Profitsi/Qi increase = p increase c And Qi increases o Aggregate Demand Yad= C + I + G + NX Price-level effect: an increase in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right Factors that shift AD: Money supply: an increase in MS will decrease interest rates and increase investment Components (C,I,G,NX) in Yad