Popular in Finance Money and Capital markets
Popular in Finance
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
This 24 page Study Guide was uploaded by Layan Notetaker on Monday February 15, 2016. The Study Guide belongs to FINA 3301 at George Washington University taught by Hwang in Spring 2016. Since its upload, it has received 174 views. For similar materials see Finance Money and Capital markets in Finance at George Washington University.
Reviews for FINA 3301
Please tell me you're going to be posting these awesome notes every week..
-Mr. Zechariah Bernier
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 02/15/16
Study Guide – Midterm 1 Chapter 1: Financial Markets and Institutions - A financial system is necessary in order to avoid wasting or inefficiently utilizing excess funds that may be present within the economy - Funds flow through financial markets that are classified in three ways 1. Primary – Secondary markets 2. Money – Capital markets 3. Exchange – Overthecounter markets Primary markets are markets in which corporations raise funds through new issues of securities Secondary markets are markets that trade financial instruments once they are issued Money markets are markets that trade debt securities or instrument (CDs and Treasury Bills) with maturities of less than one year – with a little to no risk of capital loss yet low returns Capital markets are markets that trade debt and equity instruments (Notes, bonds, and stocks) with maturities of more than one year – with a substantial risk of capital loss yet higher promised returns Overthecounter markets are markets where majority of trading takes place and do not operate in a specific fixed location – rather; transactions occur via telephones, wire transfers, and computer trading. The potential buyers & sellers individually communicate with a dealer & negotiate over transaction [Include: fixed income, foreign exchange, and derivatives markets] Central exchanges are markets in which securities are traded through centralized communications (NYSE) and those transactions can be done electronically or by voice Financial market regulations include: The Securities Act of 1933 and The Securities Exchange Act of 1934; enforcing full and fair disclosure and securities registration, as well as making the SEC the main regulator of securities markets, respectively Financial institutions act as the middleman that performs the essential function of (indirectly) channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds) o E.g. commercial and savings banks, credit unions, insurance companies, mutual funds. Financial institutions are distinguished by: whether or not they accept insure deposits (commercial banks, thrifts), and whether or not they receive contractual payments from customers (insurance companies, pension funds) o Commercial banks: depository institutions whose major assets are loans (broadly range) and whose major liabilities (include subordinate notes and debentures) are deposits. o Thrifts: depository institutions in the form of savings associations, savings banks, and credit unions. [Difference with commercial: concentrate their loans in one segment] o Insurance companies: financial institutions that protect individuals and corps from adverse events. o Securities firms and investment banks: financial institutions that help firms issue securities and engage in related activities (brokerage and trading of securities) o Finance companies: financial intermediaries that make loans to both individuals and businesses. [Difference with depository institutions: do not accept deposits but instead rely on short and longterm debt for funding] o Investment funds: financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets o Pension funds: financial institutions that offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years [exempt of taxation] Since the direct transfer of funds is difficult due to various problems such as asymmetric information and transaction costs, financial institutions are involved in a process called financial intermediation which is actually the primary means of moving funds from lenders to borrowers Financial institutions face the following risks: Credit risk/ interest rate risk/ liquidity risk/ insolvency risk The way in which FIs resolve these cost and risk issues: * Financial institutions perform services that benefit the suppliers of funds: o Monitoring costs – aggregation of funds in a FI provides greater incentive to collect a firm’s information and monitor actions (at a lower average cost) o Liquidity and price risk – the provision of financial claims to household savers with superior liquidity attributes and with lower price risk o Transaction cost services – economies of scale in transaction costs o Maturity intermediation – FIs can better bear the risk of mismatching the maturities of their assets and liabilities o Denomination intermediation – FIs allow small investors to overcome constraints to buying assets imposed by large minimum denomination size * Financial institutions perform services that benefit the overall economy: o Money supply transmission – Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general o Credit allocation – FIs are often viewed as the major, and sometimes only, source of financing for a particular sector of the economy. o Intergenerational wealth transfers = FIs provide savers with the ability to transfer wealth from one generation to the next o Payment services – the efficiency with which depository institutions provide payment services directly benefits the economy FIs are heavily regulated to protect society at large from market failures. Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation The Hammurabi Code (1780 B.C.) refers to the role played by merchants in advancing capital to the landowners and to merchants; the law fixes the interest rate at 20%/year Asymmetric information: o All parties to a transaction or a contract do not have the same information o Rises mainly in two forms 1. Adverse Selection [before the transaction occurs, one party has better information than the other and the market will most likely produce adverse outcomes for the uninformed party] 2. Moral Hazard [after the transaction occurs, one party has an incentive to behave differently and the informed party will engage in activities that are harmful for the uninformed party’s interests] – Insurance markets Agency theory: the analysis of how asymmetric information problems affect behavior These two forms of asymmetric information have an influence on financial transactions and financial institutions How adverse selection influences financial structure: o Lemons Problem in Securities Markets If we cannot distinguish between good & bad securities, we are willing to pay only average of good and bad securities’ value The result is that good securities will be undervalued and won’t be issued, while bad securities will be overvalued with too many to be issued o Lemons Problem in Financial Institutions If banks cannot distinguish between good and bad borrowers The result is that banks will be left with bad borrowers To solve this adverse selection problem: 1. Private Production and Sale of Information ─ Freerider problem interferes with this solution 2. Government Regulation to Increase Information ─ For example, annual audits of public corporations 3. Financial Intermediation Avoid freerider problem by making private loans Large firms are more likely to use direct instead of indirect financing 4. Collateral and Net Worth Moral hazard problems in financial structure: o Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount Example: If a firm owes $100 in interest, but only has $90, it is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash To solve these moral hazard problems: 1. Net Worth and Collateral 2. Monitoring and Enforcement of Restrictive Covenants. Covenants that discourage undesirable behavior; encourage desirable behavior; keep collateral valuable; provide information 3. Financial Intermediation Chapter 2: Interest Rates (1) An interest rate is the rental price for money, and serves to allocate resources, and is expressed in terms of annual rates. o For borrowers the cost for using the fund in advance o For lenders the reward for putting off using the fund into future Various types of interest rates: o Federalfunds rate o Prime rate o Money market interest rate o CD o 30year mortgage, fixed o Fiveyear adj. mortgage (ARM) o Loans o HELOC Loanable funds theory is a model that is commonly used to explain interest rates and interest rate movements – it views the level of interest rates in financial markets as resulting from factors that affect supply and demand for loanable funds o Supply of loanable funds All sources of funds available to invest in financial claims Quantity of loanable funds supplied increases as interest rates rise o Demand for loanable funds All uses of funds raised from issuing financial claims Quantity of loanable funds demanded is higher as interest rates fall o Equilibrium interest rate Equates aggregate supply of and aggregate demand for loanable funds Factors that cause supply and demand curves to shift: As wealth and income increase, funds suppliers are more willing to supply funds to markets – resulting in lower interest rates As the risk of an investment increases, funds suppliers are less willing to purchase the claim – resulting in higher interest rates As current spending needs increase, funds suppliers are less willing to invest – resulting in higher interest rates As the central bank increases the supply of money in the economy, this directly increases the supply of funds available for lending – resulting in lower interest rates With stronger economic growth, wealth and income rises, increasing the supply of funds available. As U.S. economic strength improves relative to the rest of the world, foreign supply of funds is also increased. Business demand for funds increases as more projects are profitable – resulting in an indeterminate effect on interest rates, but at more rapid growth rates interest rates tend to rise As loan or bond covenants become more restrictive, borrowers reduce their demand for funds – resulting in lower interest rates Taxes on interest and capital gains reduce the returns to savers and the incentive to save. The tax deductibility of interest paid on debt increases borrowing demand –resulting in higher interest rates An increase in expected inflation implies that suppliers will be repaid with dollars that will have less purchasing power than originally anticipated. Suppliers lose purchasing power and borrowers gain more than originally anticipated. This implies that supply will be reduced and demand increased – resulting in higher interest rates Real rate of interest The most fundamental component of interest rates The true cost of borrowing The financial market balances savings and investments from producers and households by coming up with the equilibrium real rate of interest. Equilibrium interest rate o When competitive forces operate in financial sector, the laws of supply and demand bring rates to equilibrium o Equilibrium is temporary or dynamic: any force that shifts supply or demand will tend to change interest rates Inflation and interest rates o Borrowers benefit from unanticipated inflation, at expense of the lenders o Lenders benefit from unanticipated deflation, at expense of the borrowers o Lenders change added interest to offset anticipated decreases in purchasing power o The Fisher Effect shows that expected inflation is embodied in nominal interest rates The fisher effect o , Where i is the observed nominal interest rate; r is the real interest rate; and Pe is the expected annual inflation rate o The lender gets compensated for anticipated loss of purchasing power on both the principal and the interest Realized vs. expected inflation o Actual rate of return can be quite different from the expected rate of return o Expected returns are hardly negative whereas actual returns are often negative Term structure of interest rates The relationship between bonds termtomaturity and yieldtomaturity o Loans: maturity can be as short as overnight (federal funds) to as long as 30yr (mortgage) o Bonds: different maturities = different interest rates o The yield curve is a graphical plot of term structure of interest rates Term structure facts 1. Interest rates for different maturities tend to move together 2. Yield curves tend to have: steeper upward slope when short rates are low flatter upward slope when short rates are high 3. Yield curve is typically upward sloping Three theories of term structure 1. Unbiased Expectations Theory Explains 1 and 2, but not 3 2. Market Segmentation Theory Explains 3, but not 1 and 2 3. Liquidity Premium Theory Solution: Combines features of above theories, and explains all facts Unbiased expectations theory o At a given point in time, the yield curve reflects the market’s current expectations of future shortterm rates o If future oneyear rates are expected to rise each successive year into the future, then the yield curve will slope upwards o Key assumptions: investors only care about expected returns; bonds of different maturities are perfect subsitutes o Implication: A longterm interest rate is an average of future shortterm interest rates Expectations theory o To illustrate what this means, consider two alternative investment strategies for a two year time horizon. 1. Invest $1 into oneyear bond, and when it matures, invest into another oneyear bond with the proceeds from the first investment. 2. Buy $1 of twoyear bond and hold it. Unbiased expectations theory o Expected return from strategy (1) o Expected return from strategy (2) o The two returns should be equal Therefore: Approximation: More generally: Unbiased Expectations Theory and Term Structure Facts o Explains why yield curve has different slopes When short rates are expected to rise in future, the average of future short rates is above today’s short rate; therefore yield curve is upward sloping When short rates expected to stay same in future, average of future short rates is the same as today’s, and yield curve is flat. Only when short rates expected to fall will yield curve be downward sloping. o Explains fact 1 Short rate rises are persistent If 11 today, then (21) , (31) etc. average of future expected rates (1 ) Therefore: (11) (1 ) (i.e., short and long rates move together) o Explains fact 2; When short rates are low, they are expected to rise to normal level, and long rate average of future short rates will be well above today's short rate; yield curve will have steep upward slope. When short rates are high, they will be expected to fall in future, and long rate will be below current short rate; yield curve will have downward slope. o Doesn’t explain fact 3; Short rates are as likely to fall in future as rise, so average of expected future short rates will not usually be higher than current short rate: therefore, yield curve will not usually slope upward. Market segmentation theory o Argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium) o Key assumptions: Securities of different maturities are NOT substitutes o Implication: Markets are completely segmented; interest rates at each maturity are determined separately o Explains fact 3; investors typically prefer short holding periods and thus have higher demand for shortterm bonds, which have higher prices and lower interest rates than longterm bonds o Does not explain facts 1 or 2 because it assumes longterm and shortterm rates are determined independently Liquidity premium theory o Based on the idea that investors will hold longterm maturities only if they are offered at a premium to compensate for future uncertainty in a security’s value, which increases with an asset’s maturity o Key assumption: bonds of different maturities are substitutes but not perfect subsitutes o Implication: modifies the first theory with the second one o Investors prefer shortterm rather than longterm bonds – (higher demand) o This implies that prices of shortterm bonds are higher and prices of longterm bonds are lower o Investors must be paid positive liquidity premium, , to hold long term bonds. o Resulting in this equation, where Ln is the liquidity premium Liquidity premium theory: term structure facts o Explains all 3 facts #3: that usual upwardly sloping yield curve by liquidity premium for longterm bonds #1, #2: same explanations as pure expectations theory because it has average of future short rates as determinant of long rate Default risk o The risk that a security issuer will default on making its promised interest and principal payments to the buyer of a security. o The higher the default risk, the higher the interest rate demand by buyer of security to compensate for default risk exposure o Therefore, interest rates on bonds with default risks are higher than those on “riskfree” bonds o Default does not mean everything is lost! Through the bankruptcy process, some part of principal/interest may be recovered o Default risk premium: DRP = i i rf The difference between the nominal rate and the yield on a comparable (same term) riskless security (treasury security) Default risk premium p o − = ( 1−p ) × (1 + f– ) is the promised interest rate, the risk free interest rate, the probability of default and the recovery rate. o DRP increases in periods of economic contraction (recession) and decreases in periods of economic expansion. DRP tend to peak near the end of a recession o In good times, risky security prices are bid up; yields move closer to those of riskless securities. Chapter 3: Interest Rates (2) Most of longterm bonds or loans provide some form of interim payments until maturity – these interim payments are often coupon payments (with bonds) or interest payments (with loans) Bond o A form of a loan – a debt security obligating a borrower to pay a lender principle and interest o Borrower (issuer) promises contractually to make periodic payments to lender (investor or bondholder) over given number of years At maturity, holder (lender) receives face value (par value or principal). Periodically before maturity, holder receives coupon (interest) payments determined by coupon rate, original interest rate promised as percentage of par on face of bond. o The main difference between loan and bond is that bonds are public securities while loans are private contracts. Public securities are available for transaction in public markets and subject to more regulations. Bond Pricing: Present Value o Bonds are usually sold at face value at issuance, market value = face value. o However, its market value fluctuates as market interest rates change. o The value (price) of a bond is the present value of the future cash flows promised, discounted at the market rate of interest (the required rate of return on this risk class in today’s market). o We can “back out” the market interest rate for the bond using its market value. Valuation Method 1: , where = price of bond (present value of promised payments); = coupon payment in period t, where t = 1, 2, 3…T; = par value (principal amount) due at maturity; = market interest rate (discount rate or market yield); and = number of periods to maturity. Valuation Method 2: ; The sign of PV should be opposite to FV and PMT Bond Pricing: Principles o Cash flows are assumed to flow at end of the period and to be reinvested at . Bonds typically pay interest semiannually o Increasing decreases price (PB); decreasing increases price; thus bond prices and interest rates move inversely. o If market rate equals coupon rate, the bond trades at par. o If coupon rate exceeds market rate, the bond trades above par (premium). o If market rate exceeds coupon rate, bond trades below par (discount) o There are four components in bond valuation: 1. Price 2. Coupon 3. FV 4. Interest rate Zero coupon bonds o Bonds that do not pay coupon interest (no periodic coupon payments) o The face or par value of the bond, is a lump sum payment received by the bond holder when the bond matures – single payment of par value at maturity Yield to maturity o A measure of return ideally capturing impact of coupon payment, income from reinvestment of coupons, and any capital gain or loss o The return or yield the bond holder will earn on the bond if he or she buys it at its current market price, recieves all coupon and principal payments as promised, and holds the bond until maturity o The discount rate at which bond price equals discounted PV of expected payments o The longer the time until maturity, the less valid the reinvestment assumption Compounding frequency o Since many bonds or debt contracts pay interest payments more than once a year (bond is semiannual and a mortgage is monthly): The periodic interest rate = annual interest rate / compounding frequency What does yield to maturity (YTM) represent o YTM is the rate of return on an investment if all the coupon payments are reinvested at the same rate of return. o Rate of Return is defined as o The above definition can be easily extended to multiperiod investment as long as there are no interim cash flows… o For example, if the payoffs are given k periods later, then we have o The periodic return is simply (1+R ) t+k 1/k o It gets a little more complicated when there are interim cash flows… o Assume all the cash flows are reinvested at the same rate as the discount rate. o Consider a 3year bond that pays an annual coupon of C. Then, its cash flows are Year 1: C – Year 2: C – Year 3: C + FV o First, when you receive C at the end of the first year, invest it at for two years. o Second, when you receive C at the end of the second year, 2vest it a1 for a year. o Now in year 3, you have total cash flows of C (1+i) , C (1+i) , C+FV o To get the price, discount with the same interest rate with (1+ ) 3 o Then you have o YTM is a discount rate o YTM is a rate of return, and it is assumed that all interim cash flows are reinvested at the same rate. o The concept of YTM is widely used, and one example is “internal rate of return” A coupon bond can be viewed as a portfolio of zero coupon bonds; this portfolio would have the exact same payoffs as the coupon bond and therefore its value must equal the value of the coupon bond. Bond price volatility o Percentage change in price for given change in interest rates: , Where: %∆ = percentage change in price; = new price in period t; −1= bond’s price one period earlier Interest rate risk and duration o Price risk The variabiliy in bond prices caused by their inverse relationship with interest rates o Reinvestment risk The variability in realized yield caused by changing market rates at which coupons can be reinvested o Duration as a risk management tool Price risk vs. reinvestment risk o Price risk and reinvestment risk work against each other. o As interest rates fall – bond prices rise– coupons are reinvested at lower return. o As interest rates rise – bond prices fall– coupons are reinvested at higher return. The effects of interest rate change Then you have Measuring Interest Rate Risk It measures a percentage change in bond price when (1+) interest rate changes by 1 percent Duration o The weightedaverage time to maturity on a financial security using the relative present values of the cash flows as weights o Gives a fairly accurate measure when the interest rate changes by a small amount o A measure that incorporates the time of arrival of all cash flows on an asset or liability along with the asset or liability’s maturity date o Duration equals term to maturity for zero coupon securities o The higher the coupon or promised interest payment on a security, the shorter its duration [less price volatility] o The higher the rate of return on a security, the shorter its duration o Duration increases with maturity at a decreasing rate Longer maturities = longer durations = greater price volatility The larger the numerical value of duration, the more sensitive the price of that bond to small changes or shocks in interest rates. Modified duration can be used to predict price changes for nonannual payment loans or securities o It is a more direc measure of bond price elasticity o MD = D / (1 + i period) where i period = APR / n o To predict price changes: Change in Price / Price = MD x i annual Convexity measures the change in slope of the priceyield curve around interest rate level R o It is the degree of curvature of the priceinterest rate curve around some interest rate level o It incorporates the curvature of the priceyield curve into the estimated percentage price change of a bond given an interest rate change: o By second order approximation: Convexity (CX) calculation Porfolio duration calculation ; Where: = proportion of bond in portfolio; = duration of bond . Chapter 4: Federal Reserve System The Federal Reserve is an independent institution that is the central bank of the United States, and was founded by congress in 1913 Its decisions do not have to be ratified by administration Still subject to oversight by congress Main functions 1. Conducting monetary policy 2. Maintaining the stability of financial system 3. Supervising and regulating depository institutions (banks) 4. Providing payment and other financial services to the gov, public, fin. Instutions, and foreign official institutions Origins of the Federal Reserve System o Fear of centralized power and distrust of moneyed interests guided central bank activities in the 19th century The First Bank of the U.S. was disbanded in 1811 The Second Bank of the U.S. was disbanded in 1836 when President Andrew Jackson vetoed its renewal o As a result, banking panics became regular events, absent a lender of last resort, culminating in the panic of 1907 o Widespread bank failures and depositor losses convinced the U.S. that a central bank was needed Federal Reserve Act of 1913 o Fear of a “central authority” was rampant—people worried that powerful Wall Street interests would manipulate the system. o Questions arose as to whether such a monetary authority would be private or a government institution. o The Federal Reserve Act of 1913 was a compromise that created the Federal Reserve System, including elaborate checks and balances. Structure of the Federal Reserve System o The design was intended to diffuse power along the following dimensions: Regions of the U.S. Government and private sector interests Needs of bankers, businesses, and the public o Consists of 12 Federal Reserve Banks and sevenmember Board of Governors o Implemented in 1913 to spread power along regional lines, between the private sector and the government, and among bankers, business people, and the public o Federal Reserve Banks and Board of Governors together comprise and operate the Federal Open Market Committee (FOMC) – responsible for the formulation and implementation of monetary policy o Member banks – 2,400 banks (40% of all U.S. banks) with 80% of total assets Nationally chartered banks State chartered banks 12 Federal Reserve Banks o Operating arms of the central banking system o Each of the 12 districts has one main Federal Reserve Bank which acts as a depository institutions for the banks in the district o The Federal Reserve Banks are quasipublic (part private, part government) entities owned by member commercial banks in their district. However, their stock is not publically traded and pays a predetermined dividend o Operate as nonprofit organizations Generate income primarily from three sources 1. Interest earned on government securities acquired in the course of the Federal Reserve open market transactions 2. Interest earned on reserves that banks are required to deposit at the Fed 3. Fees from the provision of payment and other services to member depository institutions o Each Federal Reserve Bnks has its own ninemember Board of Directors that oversees its operations: six elected by member banks in the district (3 are professional bankers, 3 are business people) and three are appointed by the Federal Reserve Board of Governors – these 9 directors are responsible for appointing the president of their Federal Reserve Bank Functions of the Federal Reserve Bank o Assist in the conduct of monetary policy Set and change the discount rate (must be approved by the Board of Governors) Make discount window loans to depository institutions o Supervise and regulate FRS member banks Conduct examinations and inspections of member banks Issue warnings when banking activity is unsafe or unsound Approve bank mergers and acquisitions o Provide government services Act as the commercial banks of the U.S. Treasury o Issue new currency Collect and replace currency in circulation as necessary o Clear checks Act as a central clearing system for U.S. banks Clear ~25% of all checks written in the U.S. o Provide wire transfer services Fed wire Automated Clearinghouse (ACH) o Perform banking sector and economic research Used in the formulation of monetary policy The FRB of New York o The most important Federal Reserve Bank. o Being in NYC, the New York Fed is responsible for oversight of some of the largest financial institutions headquartered in Wall Street. o The New York Fed houses the open market desk. All of the Feds open market operations are directed through this trading desk. o The chairman of New York Fed is the only permanent member of the FOMC, serving as the vicechairman of the committee. o The New York Fed is the only member of the Bank for International Settlements. Board of Governors of the Federal Reserve System o A sevenmember board headquarted in Washington, D.C. o Each member is appointed by the president of the U.S. and must be confirmed by the Senate o Board members serve a nonrenewable 14year term o President designated two members of the Board to be the chaiman and vice chairman for fouryear terms o Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks Federal Open Market Committee o The major monetary policymaking body of the Federal Reserve System o Consistes of the 7 members of the Board, the president of the FRB in NY, and the presidents of four other FRBs (on a rotating basis) o Meets eight times each year o Main responsibilities Formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international operations Reports on open market operations (foreign and domestic) National economic forecasts are presented Discussion of monetary policy and directives, including views of each member o Makes decisions regarding open market operations, to influence the monetary base Open market operations are the most important tool that the Fed has for controlling the money supply o All actions are directed at the FRB of NY, where securities are bought & sold as required Chairman of the Federal Reserve System o Spokesperson for the entire system, and supervises the board’s staff o Negotiates, as needed, with Congress and the President of the U.S. o With these, the chairman has effective cotro ove rhte system, even though he doesn’t have legal authority to exercise control over the system and its member banks The Research Staff o The Federal Reserve System employs over 500 research economists. Among them, more than 300 are at the Board. o Offer insight on incoming economic data and interpret where it suggests our economy is heading. o Provide briefs for formal meetings on the economic outlook of the country o Provide support for supervisory staff in decisions about bank mergers, lending activities, and other technical advice. o Produce reports on the developments in major foreign economies. o Public education. Monetary Policy o Goal: Maximum Employment & Price stability (lowest inflation possible) o Monetary policy affects the macroeconomy by influencing the supply and demand for excess bank reserves Influences the level of shortterm and longterm interest rates. Affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices o Three main monetary policy tools Open Market Operations Discount Rate Reserve Requirements Three channels of the transmission process for monetary policy 1) Business investment in real assets Present values of future cash flows from real assets depend significantly on general level of interest rates. Most capital expenditures are debtfinanced; interest expense is thus material in profitability of most businesses. Monetary policy thus always involves material incentives or disincentives for business investment. Fed can manipulate incentives but not compel results. 2) Consumer spending for durable goods and housing Much of consumer spending is on credit, so it tends to vary directly with credit conditions. o Falling interest rates tend to encourage spending. o Rising interest rates tend to discourage spending. Monetary policy can thus often affect aggregate demand to some extent. Fed can encourage/discourage but not necessarily compel consumers don’t necessarily make financial decisions the way businesses do – o Businesses are mostly rational and profit maximizing. o Consumers are partly rational and partly emotional. 3) Net exports Interest rates affect exchange rates. Falling interest rates in a country tend to “weaken” its currency. Rising interest rates in a country tend to “strengthen” its currency. Exchange rates affect imports and exports. As domestic currency weaken: o Domestic demand for imports drops as they become more costly but o Foreign demand for exports rises as they become less costly As domestic currency strengthens: o Domestic demand for imports rises as they become less costly and o Foreign demand for exports drops as they become more costly Monetary policy thus usually affects net exports. Fed can weaken or strengthen dollar, but may do so for any of numerous reasons, related or unrelated to export effects Tools of Monetary Policy o Reserve Requirements o Open Market Operations Fed buys and sells treasury securities directly with dealers, which will affect dealers’ reserves. Supply and demand curves shift in Federal Funds Market o Discount Window Fed allows banks to directly borrow from the Fed Much less common than open market operation Expansionary monetary policy Contractionary monetary policy Open market securities by Fed Purchases Sales Discount rate Decreases Increases Reserve requirement ratio Decreases Increases Reserve Requirements o Depository institutions must reserve set percentage of certain types of deposits. – Most reserves are held as deposit at FRB for that district. Reserves may also be held as vault cash. Reserve requirements are the reserve assets depository institutions must keep to “back” transaction deposits o Monetary Control Act of 1980 Subjects all US depository institutions to uniform reserve requirements; Sets limits within which Fed is to specify required reserve ratio. o Reserve requirements are a structural control. Changes in reserve requirements have dramatic effects. Reserve requirements are not useful for “finetuning.” Reserves o Suppose GW bank sells Tbills to Fed for $1,000 Fed will credit $1000 to GW bank’s account at the Fed by increasing their reserve by 1000. GW bank no has $1000 excess reserve o GW decides to make a $1000 loan to a borrower and they don’t have any excess reserve now The borrower deposits $1000 to colonial bank, which keeps a portion of it as reserve and lends out the rest o This process continues o Banks do not want to keep excess reserves since they earn a very small interest, however there might be some situations where banks do want to keep excess reserves Federal Funds Market o A Fedsponsored system in which depository institutions lend and borrow excess reserves among themselves. o Fed Funds Rate, set by market forces as institutions bargain with each other, is a benchmark rate, measuring – Return on bank reserves (most liquid of all assets); Availability of reserves to finance credit demand; Intent and effect of monetary policy. o Fed’s current target rate: 25 bps ~ 50 bps Implementing Monetary Policy: Open Market Operations o Fed directly changes money supply by buying or selling US government securities on open secondary market Pays for “buys” by crediting new reserves to special bank accounts of selected dealers Collects for sales by taking existing reserves back Only the central bank can unilaterally create or retire money in this way o Shortterm interest rates are pressured upward when Fed sells and downward when it buys. o Policy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York o FRBNY acts through the Trading Desk to implement policy directives each business day o Trading Desk manager buys or sells U.S. Treasury securities in the overthecounter (OTC) market, which keeps the fed funds rate near its desired target Operations may be permanent or temporary May use repurchase agreements for temporary increases or decreases in excess reserves Implementing Monetary Policy: Discount window lending o As Fed lends “at the window”, money supply increases. o Changes in discount rate theoretically affect incentives to borrow. o Banks in early 20th century relied on the discount window; now they have other choices for managing liquidity and they are wary of “discount window scrutiny.” o Today, discount rate is more of a signal than direct control. The Federal Reserve’s Balance Sheet o The conduct of monetary policy by the Federal Reserve involves actions that affect its balance sheet. ; Reserves are funded from borrowing from financial institutions which currencies are funded from borrowing from the public o Currency in Circulation + Reserves = Monetary Base The monetary assets of the Fed include: o Government Securities: These are the U.S. Treasury bills and bonds that the Federal Reserve has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply. o Discount Loans: These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply The monetary liabilities of the Fed include: o Currency in circulation: the physical currency in the hands of the public, which is accepted as a medium of exchange worldwide. o Reserves: All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves. The Fed and the Crisis o 2007 Term Auction Facility o 2008 March: Fed facilitates J.P. Morgan Chase purchase of BearStearns Term Securities Lending Facility Primary Dealer Credit Facility: Expands discount window borrowing to investment banks September: Lehman Brothers collapses, GoldmanSachs and Morgan Stanley become commercial banks, Merrill Lynch is bought by Bank of America AssetBacked Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility and the Term AssetBacked Securities Loan Facility (TALF) are created Average weekly lending from the Fed grew from about $59 million in 2006 to almost $850 billion per week in late 2008 The Fed has been aggressively pushing down federal funds rate. August 2006 fed funds rate = 5.25% April 2008 fed funds rate = 2.00% By year end 2008 target fed funds rate between 0 and 0.25% and the discount rate was lowered to 0.5% Quantitative Easing November 2008 The Fed announces it would engage in purchasing up to $600 billion in Treasuries and mortgagebacked securities (quantitative easing) This amount was increased to $1.7 trillion in March 2009. November 2010 the Fed announced a new series of bond buying of up to $600 billion in what has been termed QE2 Quantitative Easing o How can Fed lower longterm interest rates when shortterm interest rates are already at zero? o Recall Long rate = Average short rate + liquidity premium o Forward Guidance: Fed makes a commitment to keep the short rates low for a longer term. o Quantitative Easing: Fed tries to affect liquidity premium by purchasing long term bonds directly o What are the effects of QE on the Fed’s balance sheet? It ballooned the Fed’s balance sheet substantially. o What are the effects of QE on the banks’ reserves? It raised the banks’ reserves equally! o What is the mid term and longterm consequences of QE? Expectation of future inflation Winding down of QE Chapter 5: Money Markets Money is not actually traded in the money markets. Since the securities in the money markets are shortterm with high liquidity – they are close to being money Characteristics of money markets and money market securities: 1. Money market securities are usually sold in large denominations 2. Money market instruments have low default risk 3. Money market securities must have an original maturity of one year or less Money market Money markets involve debt instruments with original maturities of one year or less Money market debt o Issued by highquality (i.e., low default risk) economic units that require shortterm funds o Purchased by economic units that have excess shortterm funds o Little or no chance of loss of principal – low rates of return Most money market instruments have active secondary markets to provide liquidity Many money market instruments are zero coupon (discount) bonds. In principal, the banking industry can provide the same service of intermediation of short term borrowing and short term lending. They have an advantage of handling asymmetric information problem but disadvantage of government regulations. For borrowers with less asymmetric information problems, it would be cheaper to directly access lenders. Lenders in money markets are often “warehousing” surplus funds until they are needed. o Yields do not have to be high as long as they are higher than alternatives (cash, bank) and safe. o Investment advisers, investment funds, financial intermediaries Borrowers need short term funds to bridge cash inflows and outflows o U.S. Government o Large Corporations Money market instruments o Treasury Bills (Tbills): shortterm obligations issued by U.S. government to cover current government budget shortfalls and to refinance maturing government debt o Federal Funds (fed funds): shortterm funds transferred between financial institutions usually for no more than one day No particular collateral is involved; is NOT secure o Repurchase Agreements (repos or RP): agreements involving the sale of securities by one party to another with a promise to repurchase the securities at a specified date and price Essentially a collateralized fed funds loans, with the collateral taking the form of securities – makes the transaction very safe o Commercial Paper (CP): shortterm unsecured promissory notes issued by a company to raise shortterm cash, often to finance working capital requirements Shortterm range – 120 days o Negotiable Certificates of Deposit (CD): bankissued, fixed maturity, interestbearing time deposits that specify an interest rate and maturity date and are negotiable (saleable on a secondary market) For professional investor Has an active secondary market; can always liquidate o Banker’s Acceptances (BA): time drafts payable to a seller of goods, with payment guaranteed by a bank Most important institutions among all participants who are principal issuers or investors are the commercial banks; they are everywhere Money market yields o Money market securities use special rate quoting conventions: Bond equivalent yields (i )beynterest rate is quoted on an annual basis assuming a 365 day year as a percentage of the purchase price Discount yields (i dy Interest rate is quoted on an annual basis assuming a 360 day year as a percent of the redemption price or the face value Single payment yields (i )spynterest rate is quoted on an annual basis assuming a 360 day year as a percent of the purchase price o Each yield can be converted into another. ; ; ; ; U.S. Treasury bill o TBills are shortterm debt obligations issued by the U.S. government o Tbills are virtually default risk free, are highly liquid, and have little interest rate risk o Strong international demand for Tbills as safe haven investment o Characteristics Sold on discount basis. Maturities from 28 days up to one year. Minimum denomination is usually $10,000, but smaller investors can invest in multiples of $1,000 through the Treasury Direct Program offered by the Fed. – Treasury Bill Auctions o 13 and 26week Tbills are auctioned weekly o Bids are submitted by government securities dealers, financial and nonfinancial corporations, and individuals o Bids can be competitive or noncompetitive Competitive bids specify the bid price and the desired quantity of Tbills Noncompetitive bidders get preferential allocation and agree to pay the lowest price of the winning competitive bids Treasury Bill Auctions: Competitive Bids o Specify price and quantity desired. o Minimum $10,000 & in multiples of $5,000 above $10,000. o Mostly professionals dealers & banks. o No more than 35% of an issue is sold under the competitive bidding process in order to ensure a competitive secondary market. Treasury Bill Auctions: Noncompetitive Bids o All noncompetitive bids accepted; specify quantity only. o Maximum $5,000,000. o Mostly individuals & small investors. The Secondary Market for TBill o The secondary market for Tbills is the largest of any U.S. money market instrument o 22 primary dealers “make” a market in Tbills by buying the majority sold at auction and by creating an active secondary market Primary dealers trade for themselves and for customers Tbill purchases and sales are bookentry transactions conducted over Fed wire o TBills are sold on a discount basis TBill Prices o Can be calculated from quotes by rearranging the discount yield equation o Or, by rearranging the bond equivalent yield equation Federal Funds o The federal funds (fed funds) rate is the target rate in the conduct of monetary policy o Fed fund transactions are shortterm (mostly overnight) unsecured loans o Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds o Multimillion dollar loans may be arranged in a matter of minutes o Originally a market for excess reserves Now a source of investment (federal funds sold) and continued financing (federal funds purchased). Repurchase Agreement o A repurchase agreement (repo or RP) is the sale of a security with an agr
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'