FIN 408 E1
Demand for Loanable Funds
"Demand for loanable funds" describes the total net demand for funds by fund users. •In general, the quantity of loanable funds demanded is higher as interest rates fall. •Household demand reflects financing purchases of homes, durable goods, and nondurable goods ($16.05t in 2019). •Businesses demand funds to finance investments in long-term assets and for short-term working capital needs ($66.46t for nonfinancial and $111.87t for financial in 2019). •Governments also borrow heavily ($28.86t in 2019). •Foreign participants, mostly from the business sector, borrow in U.S. financial markets ($20.81t in 2019).
Supply of Loanable Funds
"Supply of loanable funds" describes funds provided to the financial markets by net suppliers of funds: •Generally, the quantity of loanable funds supplied increases as interest rates rise. •Household sector (consumer sector) is one of the largest suppliers of loanable funds in the U.S. ($84.66t in 2019). •Business sector often has excess cash that it can invest for short periods of time ($28.06t for nonfinancial and $98.47t for financial business in 2019). •Governments may supply loanable funds ($5.66t in 2019). •Foreign investors view U.S. markets as alternatives to their domestic financial markets ($27.20t in 2019). Higher interest rate = loan more, and vise versa.
Types of Financial Institutions
-commercial banks -thrifts -insurance companies -securities firms and investment banks -finance companies -investment funds -pension funds -FinTechs
Functions Performed by Federal Reserve Banks (F R Bs)
1.Assistance in the conduct of monetary policy. •Set and change the discount rate. •Loans transacted through each F R Bs discount window. 2.Supervision and regulation. •Each F R B has supervisory and regulatory authority over the activities of state-chartered member banks and bank holding companies located in their districts. 3.Consumer protection and community affairs. •Possess authority to implement federal laws intended to protect consumers in credit and other financial transactions. 4.Government services. •Serves as the commercial bank for the U.S. Treasury. 5.New currency issue. •Responsible for the collection and replacement of currency (paper and coin) from circulation. 6.Check clearing. •Operates a central check clearing system for U.S. banks, routing interbank checks to D Is on which they are written and transferring the appropriate funds from one bank to another. Only about 10% is in currency. 7.Wire transfer services. •F R Bs and member banks are linked electronically through the Federal Reserve Communications System. 8.Research services. •Each F R B uses professional economics to conduct research.
Characteristics of Convexity
1.Convexity is desirable. •The greater the convexity of a security or portfolio of securities, the more insurance or interest rate protection an investor or FI manager has against rate increases and the greater the potential gains after interest rate falls. 2.Convexity increases the error in duration as an investment criterion. •The larger the interest rate changes and the more convex a fixed-income security or portfolio, the greater the error in using just duration (and duration matching) to immunize exposure to interest rate shocks. 3.All fixed-income securities are convex. •That is, as interest rates change, bond prices change at a nonconstant rate.
Systemwide Rescue Programs Employed during the Financial Crisis
1.Expansion of retail deposit insurance was widely used during the crisis to ensure continued access to deposit funding. 2.Capital injections by central governments were the main mechanism used to directly support bank balance sheets. 3.Debt guarantees allowed banks to maintain access to reasonably priced, medium-term funding. •They also reduced liquidity risk and lowered overall borrowing costs for banks. 4.Asset purchases/guarantees removed distressed assets from bank balance sheets. At the heart of the efforts were 11 countries, which accounted for the bulk of the rescue programs: Australia, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Switzerland, the United Kingdom, and the United States.
Structure of the Federal Reserve System
12 Federal Reserve Banks in cities throughout the U.S. •Each acts as a depository institution for the banks in its district. •Operate under general supervision of the Board of Governors. •Each has its own 9-member board of directors. •Nationally chartered banks are required to become members of the F R S. 7-member Board of Governors in Washington, D.C. •Each member appointed by the president of the U.S. and must be confirmed by the Senate. •Members serve a nonrenewable, 14-year term. •Primary responsibilities are the formulation and conduct of monetary policy and the supervision and regulation of banks. Most banks are not federally chartered, they are state. Usually still have FDIC insurance. Not more power, but fed banks have my control over the people in fed positions. More laws, less money, less restrictive state > federal. 1st: New York- District 2- Most assets regulated because Wall Street there. 2nd: Chicago 3rd: Dallas NYC vice chair always FOMC. Other 4 rotate between districts, J. Powell. Voting members
price sensitivity
A bond's price sensitivity is measured by the percentage change in its present value for a given change in interest rates. •The shorter the time remaining to maturity, the closer a bond's price is to its face value. •The further a bond is from maturity, the more sensitive the price of the bond as interest rates change. •Relationship between bond price sensitivity and maturity is not linear. •As the time remaining to maturity on a bond increases, price sensitivity increases but at a decreasing rate.
Derivative Security Markets
A derivative security is a financial security (for example, future, option, swap, or mortgage-backed security) whose payoff is linked to another, previously issued security, such as a security traded in capital or foreign exchange markets. •Derivatives are traded in derivative security markets. •Generally involves agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified future date. •Derivative markets are the newest of financial security markets and are also potentially the riskiest security. Value of derivative changes as value of underlying asset changes. Riskiest instruments. Derivative activity: •Tremendous growth between 19 92 to 20 13. •Large drop from 20 13 to 20 19, due largely to the 20 14 implementation of the Volcker Rule. The Volcker Rule prohibits bank holding companies from engaging in proprietary trading.
Real Risk-Free Rate
A real risk-free rate is the interest rate that would exist on a risk-free security if no inflation were expected over the holding period of a security. •The higher society's preference to consume today, the higher the real risk-free rate (R F R).
Monitoring Costs
A supplier of funds who directly invests in a fund user's financial claims faces a high cost of monitoring the fund user's actions in a timely and complete fashion. •A solution is for many small investors to group their funds together by holding the claims issued by a F I (that is, aggregation of funds).
Additional Benefits and Functions of FIs
Additional benefits FIs provide to suppliers of funds: •Reduced transaction cost. •Maturity intermediation. Denomination intermediation. Economic functions FIs provide to the financial system as a whole: •Transmission of monetary policy. •Credit allocation. •Intergenerational wealth transfers or time intermediation. •Payment services.
Bond Valuation
Bond valuation employs time value of money concepts. •Fair value of a bond reflects the present value of all cash flows promised or projected to be received on that bond discounted at the required rate of return (rb). •Expected rate of return, E(rb), is the interest rate that equates the current market price of the bond with the present value of all promised cash flows received over the life of the bond.
Capital Markets
Capital markets trade debt (bonds) and equity (stocks) instruments with maturities of more than one year. •Wider price fluctuations than money market instruments.
International Monetary Policies and Strategies
Central banks guide the monetary policy in virtually all countries. Independence of a central bank generally means that the bank is free from pressure from politicians who may attempt to enhance economic activity in the short term at the expense of long-term economic growth. •Other independent central banks, like the Federal Reserve: •European Central Bank (E C B) is the central bank for the E U. •Bank of England is the central bank of the U K. •Banks with less independence: •People's Bank of China. •Reserve Bank of India. Central Bank of Brazil.
Default risk
Default risk is the risk that a security issuer will fail to make its promised interest and principal payments to the buyer of a security. •The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure.
Large Interest Rate Changes and Duration
Duration accurately measures the price sensitivity of financial securities only for small changes in interest rates of the order of one or a few basis points. •A basis point is equal to one-hundredth of 1 percent. Duration misestimates the change in the value of a security following a large change (either positive or negative) in interest rates. •As a result of convexity, the capital loss effect of large rate increases tends to be smaller than the capital gain effect of large rate decreases. •Convexity is the degree of curvature of the price-interest rate curve around some interest rate level.
Features of Duration
Duration and coupon interest. •The higher the coupon or promised interest payment on the bond, the shorter its duration. •The larger the coupon or promised interest payment, the more quickly investors receive cash flows on a bond and the higher are the present value weights of those cash flows in the duration calculation. Duration and rate of return. •Duration decreases as the rate of return on the bond increases. Duration and maturity. •Duration increases with maturity, but at a decreasing rate. In addition to being a measure of the average life of a bond, duration is also a direct measure of its price sensitivity to changes in interest rates, or elasticity. For small changes in interest rates, bond prices move in an inversely proportional manner based on the size of D.
duration
Duration is the weighted-average time to maturity on an investment using the relative present values of the cash flows as weights. •Produces an accurate measure of the price sensitivity of a bond to interest rate changes for relatively small changes in interest rates. •Less accurate measure of price sensitivity the larger the change in interest rates. •In addition to being a measure of the average life of an asset or liability, duration also has economic meaning as the sensitivity, or elasticity, of that asset or liability's value to small interest rate changes (either required rate of return or yield to maturity).
Enterprise Risk Management
Enterprise risk management. •Recognizes the importance of managing the combined impact of the full spectrum of risks as an interrelated risk portfolio. •Seeks to embed risk management as a component in all critical decisions throughout F I. •Popularity rose as a result of the failure of advanced risk measurement and management systems to detect exposures that led to the financial crisis. Stresses importance of building strong risk culture.
Effects of Monetary Tools on Various Economic Variables
Expansionary Activities. Open market purchases of securities. All else constant, reserve accounts of banks increase Discount rate decreases. •All else constant, interest rates in the economy decrease. Reserve requirement ratio decreases. •All else constant, bank reserves increase. Contractionary Activities. Open market sales of securities. •All else constant, reserve accounts of banks decrease. Discount rate increases. •All else constant, interest rates in the open market increase. Reserve requirement ratio increases. •All else constant, bank reserves decrease.
Risks Incurred by Financial Institutions
F Is face various types of risks: •Default risk (that is, credit risk). •Foreign exchange risk and country (that is, sovereign) risk. •Interest rate risk. •Market risk, or asset price risk. •Off-balance sheet risk. *investing in risky markets •Liquidity risk. •Technology and operational risk. •Insolvency risk.
Federal Open Market Committee (F O M C)
F O M C is the major monetary policy-making body of the Federal Reserve System. •Required to meet at least four times each year in Washington, D.C., but typically meet more often. (usually every 6 weeks) •Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, an da sustainable pattern of international trade. •Set guidelines regarding open market operations, the purchase and sale of U.S. government and federal agency securities, as the main policy tool to achieve monetary targets. •Beige Book summarizes information on current economic conditions by Federal Reserve district. All open market operations occur in Manhattan. 4 reasons why NYC is important.
Factors That Affect the Supply of and Demand for Loanable Funds for a Financial Security
Factors that cause the demand curve for loanable funds to shift include the following: 1.As the utility derived from an asset purchased with borrowed funds increases (decreases), the demand for loanable funds increases (decreases). 2.As the restrictiveness of nonprice conditions on borrowed funds decreases (increases), the demand for loanable funds increases (decreases). •Nonprice conditions may include fees, collateral, or requirements or restrictions on the use of funds (that is, restrictive covenants). 3.When domestic economic conditions result in a period of growth (stagnation), the demand for funds increases (decreases). A "direct" impact on equilibrium interest rates means that as the "factor" increases (decreases) the equilibrium interest rate increases (decreases). An "inverse" impact means that as the factor increases (decreases) the equilibrium interest rate decreases (increases). Factors That Affect the Supply of Loanable Funds for a Financial Security Interest rate, Movement along the supply curve, Direct Total wealth, Shift supply curve, Inverse Risk of financial security, Shift supply curve, Direct Near-term spending needs, Shift supply curve, Direct Monetary expansion, Shift supply curve, Inverse Economic conditions, Shift supply curve, Inverse Factors That Affect the Demand for Loanable Funds for a Financial Security Interest rate, Movement along the demand curve, Direct Utility derived from assets purchased with borrowed funds, Shift demand curve, Direct Restrictiveness of nonprice conditions, Shift demand curve, Inverse Economic conditions, Shift demand curve, Direct
Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift
Factors that cause the supply curve of loanable funds to shift, at any given interest rate: A shift in the supply or demand curve occurs when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate. 1.As wealth of fund suppliers increases (decreases), the supply of loanable funds increases (decreases). 2.As risk of the financial security increases (decreases), the supply of loanable funds decreases (increases). 3.As near-term spending needs increase (decrease), the supply of loanable funds increases (decreases). 4.When monetary policy objectives allow the economy to expand (restrict expansion), the supply of loanable funds increases (decreases). 5.As economic conditions improve in a domestic (foreign) country, the supply of funds increases (decreases).
Regulation of Financial Institutions
Failures of FIs can cause widespread panic and withdrawal runs on institutions. •The 2008 increase in the deposit cap (to $250,000 per person per bank) was intended to instill confidence in the banking system. FIs are regulated to prevent market failures, as well as associated costs on the economy and society at large.
Money Supply versus Interest Rate Targeting 1
Federal Reserve can successfully target only one of these two variables (money supply or interest rates) at any one moment. •If the money supply is the target variable used to implement monetary policy, interest rates must be allowed to fluctuate relatively freely. •If an interest rate (for example, fed funds rate) is the target, bank reserves and the money supply must be allowed to fluctuate relatively freely. Fed announced that it would use interest rates—the federal funds rate—as the main target variable to conduct monetary policy in 19 93. •Guiding principle used by the Fed to set short-term interest rates is the Taylor rule, which states short-term interest rates should be determined by three conditions: 1.Where actual inflation is relative to the Fed's targeted level. 2.The extent to which the economy is above or below its full employment level. What short-term interest rates should be to achieve full employment •Under the current regime, the Fed simply announces whether the federal funds rate target has been increased, decreased, or left unchanged after every monthly F O M C meeting.
Financial institutions
Financial institutions perform the essential function of channelling funds from those with surplus funds to those with shortages of funds. In a world without FIs, the level of funds flowing between suppliers and users would likely be quite low due to the following reasons: •Monitoring costs. •Liquidity costs. •Price risk.
Financial Market Regulation
Financial instruments are subject to regulations imposed by regulatory agencies, such as the Securities and Exchange Commission (S E C). •Main emphasis of S E C regulations is on full and fair disclosure of information on securities issues to actual and potential investors. •S E C monitors trading on the major exchanges to ensure stockholders and managers do not trade on inside information about their own firms.
Financial Markets
Financial markets are structures through which funds flow. Financial markets can be distinguished along two major dimensions: •Primary versus secondary markets. Money versus capital markets.
Foreign exchange risk
Foreign exchange risk is the sensitivity of the value of cash flows on foreign investments to changes in the foreign currency's price in terms of dollars. •U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. Imported-> get billed in foreign currency, must exchange your money. Exchange rate impacts foreign trade. Invest in a currency that appreciates relative to other currencies. Borrow in currency that depreciates.
fiscal policy
Government policy that attempts to manage the economy by controlling taxing and spending.
monetary policy
Government policy that attempts to manage the economy by controlling the money supply and thus interest rates. Federal Reserve uses the following to implement monetary policy: •Open market operations. (usually uses, most effective) •Discount rate. •Reserve requirements. Major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves. Federal Reserve's monetary policy seeks to influence either the demand for, or supply of, excess reserves at depository institutions and in turn the money supply and the level of interest rates. Depository institutions trade excess reserves held at their local Federal Reserve Banks among themselves. •Rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the fed funds rate. Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay interest on reserve balances. •Interest on excess reserves (I O E R) and required reserves (I O RR). Federal Reserve can take one of two basic approaches to affect the market for banks' excess reserves. 1.Target the quantity of reserves in the market. 2.Target the interest rate on those reserves (the fed funds rate).
Inflation
Inflation is the continual increase in the price level of a basket of goods and services: •T he higher the level of actual or expected inflation, the higher will be the level of interest rates. •In the U.S., inflation is measured using indexes. •Consumer price index (C P I). •Producer price index (P P I).
Balance Sheet of the Federal Reserve
Liabilities. •Major liabilities on the Fed's balance sheet are currency in circulation and reserves, the sum of which is referred to as the Fed's monetary base or money base. •Total reserves can be classified into two categories: •Required reserves are those the Fed requires banks to hold by law. (usually 10% now it's 0% because of pandemic) •Excess reserves are additional over and above required reserves. Assets. •Major assets are Treasury and government agency (that is Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange. •Interbank loans are a small portion of total assets, but they plan an important role in implementing monetary policy. In pandemic, feds had 9 million in us treasuries. Now selling them off.
Liquidity risk
Liquidity risk is the risk that a security can be sold at a predictable price with low transaction costs on short notice: •A highly liquid asset is one that can be sold at a predictable price with low transaction costs, and thus can be converted into its full market value at short notice. •If a security is illiquid, investors add a liquidity risk premium (L R P) to the interest rate on the security that reflects its relative liquidity. •L R P might also be thought of as an "illiquidity" premium. •L R P may also exist if investors dislike long-term securities because their prices (present values) are more sensitive to interest rate changes than short-term securities.
Why Study Financial Markets and Institutions?
Markets and institutions are primary channels through which capital is allocated in our society. •Investment and financing decisions require managers and individual investors to understand the flow of funds throughout the economy. •Managers and individuals must also understand the operation and structure of domestic and international financial markets.
Money Market
Money markets trade debt securities or instruments with maturities of one year or less. •Most U.S. money markets are over-the-counter (O T C) markets.
Interest Rate Fundamentals
Nominal interest rates are the interest rates actually observed in financial markets: •Directly affect the value (price) of most securities traded in the money and capital markets. •Changes in interest rates influence the performance and decision making for individual investors, businesses, and governmental units. Interest rate is promised yield, expected return Observations on interest rates: Vary widely over time, can be volatile. Tend to go together, all graphs show similar shape. Highly correlated. Yield curve usually upward sloping (relationship between time to maturity and yield is positive) but not rn.
Open Market Operations
Open market operations. •When a targeted monetary aggregate or interest rate level is determined by the F O M C, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (F R B N Y) through a statement called the policy directive. •Manager of Trading Desk uses policy directive to instruct traders on daily amount of open market purchases or sales to transact. Open market operations are the primary determinant of changes in bank excess reserves in the banking system. •Directly impact the size of the money supply and/or the level of interest rates (for example, the fed funds rate). Open market operations are primarily conducted using Treasury securities, but others can be used as well.
Discount Rate
Recall, the discount rate is the rate of interest Federal Reserve Banks charge on loans to FIs in their district. •Raising the discount rate signals a desire to see a tightening of monetary conditions and higher interest rates in general. •Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general. Federal Reserve has rarely used the discount rate as a monetary policy tool for the following reasons: 1.It is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. 2.Because of its "signaling" importance, a discount rate change often has great effects on the financial markets. Historically, discount window lending was limited to depository institutions (D Is) with severe liquidity needs. •Fed made changes to discount window lending that increased the cost of borrowing but eased the terms in January 2003. •Three lending programs are now offered through the Fed's discount window: •Primary credit is available to generally sound D Is on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee's target rate for federal funds. •Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. •Seasonal credit is available to D Is that can demonstrate a clear pattern of recurring intrayearly swings in funding needs.
Reserve Requirements (Reserve Ratios)
Reserve requirements determine the minimum amount of reserve assets that D Is must maintain by law to back transaction deposit accounts held as liabilities on their balance sheets. •Requirement is usually set as a ratio of transaction accounts. •Very rarely used by the Federal Reserve as a monetary policy tool. A(n) decrease (increase) in the reserve requirement ratio means that D Is may hold fewer (must hold more) reserves against their transaction accounts, allowing them to lend out a greater (smaller) percentage of their deposits and increasing (decreasing) credit availability in the economy. Decrease in the reserve requirement results in a multiplier increase in the supply of bank deposits and thus the money supply. Increase in the reserve requirement results in a multiple contraction in deposits and a decrease in the money supply.
Special Provisions or Covenants
Special provisions or covenants that may be written into the contract underlying a security also affect the interest rates on different securities: •Some of these provisions include the security's taxability, convertibility, and callability. •For investors, interest payments on municipal securities are free of federal, state, and local taxes. •A convertible (special) feature of a security offers the holder the opportunity to exchange one security for another type of the issuer's securities at a preset price. •In general, special provisions that provide benefits to the security holder (for example, tax-free status and convertibility) are associated with lower interest rates. SPC Sometimes increases YTM, sometimes doesn't. Can impact tax treatment if bought. Municipal bonds are high marginal tax rate, illiquid. Federal income tax free. May have to pay state or local taxes.
Financial Crisis
The Crisis Hits. •September 8, 20 08: U.S. government seized Fannie Mae and Freddie Mac. •Recorded approximately $9b in losses in the last half of 2007 related to subprime mortgage-backed securities. •Put under a conservatorship and continue to operate under the control of Federal Housing Finance Agency (F H F A). •September 15, 20 08: •Lehman Brothers filed for bankruptcy. •Merrill Lynch was bought by Bank of America. •AIG met with federal regulators to raise cash. Washington Mutual was looking for a buyer. The Rescue Plan. •September 18, 20 08: Federal Reserve and central banks around the world invested $180b in global financial markets to unfreeze credit markets. •Treasury Secretary Henry Paulson met with congressional leaders to devise a plan to get bad mortgage loans and mortgage-backed securities off the balance sheet of financial institutions. •October 3, 20 08: $700b rescue plan was based and signed into law. •Established the Troubled Asset Relief Program (T A R P) that gave the U.LS. Treasury funds to buy "toxic" mortgages and other securities from F Is. Some positive events occurred between September and December 20 08. •Oil dropped to below $40 in late 20 08, leading to falling gas prices. •Many banks restructured delinquent mortgage loans rather than foreclose. •Fed announced it would drop its target fed funds rate and lower its discount window rate. The financial crisis had a significant impact on primary market sales by firms. New issues fell to $1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007, pre-crisis. As of 2018, primary market sales had still not recovered as only $1,725.2 billion new securities were issued for the year. Derivative Security Markets: Indeed, at the center of the recent financial crisis were losses associated with off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Losses from the falling value of subprime mortgages and the derivative securities backed by these mortgages reached $700 billion worldwide by early 2009 and resulted in the failure, acquisition, or bailout of some of the largest FIs and the near collapse of the world's financial and economic systems.
Trends In US
The following trends are evident in the U.S. between 19 48 to 20 19: •Share of depository institutions declined from 62.7% to 30.9%. •Insurance companies also witnessed a decline in their share, from 23.4% to 13.8%. •Investment companies increased their share from 1.1% to 31.0%, while pension funds increased from 9.1% to 13.2%. •Overall assets increased from $0.27t to $75.21t. Investment companies and pension funds differ from banks and insurance companies in that they give savers cheaper access to the direct securities market. Rise of financial services holding companies. •Savers increasingly prefer investments that closely mimic diversified investments in the direct securities markets over the transformed financial claims offered by traditional F Is. Shift away from risk measurement and management and the financial crisis. •Under the traditional originate-and-hold banking model, banks may have been reluctant to so aggressively pursue low-credit-quality borrowers for fear of default.
Market Efficiency
The speed with which financial security prices adjust to unexpected news, to maintain equality with the fair present value of the security, is referred to as market efficiency. •If financial markets are efficient, which tends to be the case most of the time, the current market price of a security tends to equal its fair price present value. •When an event occurs that unexpectedly changes interest rates or a characteristic of a financial security, the current market price of a security can temporarily diverge from its fair present value.
Term to Maturity
The term structure of interest rates is a comparison of market yields on securities, assuming all characteristics except maturity are the same. •Change in required interest rates as the maturity of a security changes is called the maturity premium (M P). •The M P can be positive, negative, or zero.
Time Value of Money
Time value of money is the basic notion that a dollar received today is worth more than a dollar received at some future date. Two forms of time value of money calculations are commonly used in finance for security valuation purposes: 1. Value of a lump sum. •A lump sum payment is a single cash payment received at the beginning or end of some investment horizon. 2. Value of annuity payments. •Annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon.
Globalization of Financial Markets and Institutions
U.S. markets are the world's largest, but international markets have seen rapid growth in recent years as a result of various factors: 1.Pool of savings in foreign countries has increased. 2.International investors have turned to U.S. and other markets to expand their investment opportunities. 3.Information on foreign investments and markets is now more accessible and thorough. 4.Some U.S. F Is offer their customers opportunities to invest in foreign securities and emerging markets at relatively low transaction costs. 5.The euro is having a notable impact on the global financial system. 6.Economic growth in Pacific Basin countries, China, and other emerging countries has resulted in significant growth in their stock markets. 7.Deregulation in many foreign countries has allowed international investors greater access and allowed the deregulating countries to expand their investor base.
Challenges Remain after the Crisis
While the worst of the financial crisis subsided in the U.S. in the last half of 2009, throughout the spring of 2010 Greece struggled with a severe debt crisis. •Problems in the Greek bond market then spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. •In August 2018, Greece exited the third bailout program. •In total, Greece now owes the E U and I M F roughly $330 billion, part of a public debt that has climbed to 180 percent of G D P. Challenges to central banks became more pronounced in June 2016 when the people of the United Kingdom voted to leave the E U after 43 years (that is, Brexit). •The pound fell more than 11 percent to its lowest point since 1985. •The D J I A dropped 610.32 points, or 3.4 percent. •The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008. •Japan's Nikkei Stock Average declined 7.9 percent. Bank of England (B o E) unveiled a four-point plan to prevent a post-Brexit recession. •In August 2016, the B o E cut interest rates for the first time in more than seven years to a new record low of 0.25 percent.
perpetuity
a time period lasting through the ages; eternity
Realized rate of return
actual interest rate earned on an investment in a financial security. Realized rate of return is a historical (ex post) measure of the interest rate.
Market segmentation theory
assumes that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. Thus, interest rates are determined by distinct supply and demand conditions within a particular maturity segment (for example, the short end and long end of the bond market). Market segmentation theory 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): •Does not consider securities with different maturities as perfect substitutes. •Individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold (that is, investors have complete risk aversion for securities outside their maturity preferences).
Unbiased expectations theory
at any given point in time, the yield curve reflects the market's current expectations of future short-term rates. According to the unbiased expectations theory, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds (as long as the market is in equilibrium). •At a given point in time, the yield curve reflects the market's current expectations of future short-term rates.
Thrifts
depository institutions in the form of savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans.
Commercial banks
depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial banks' loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. Commercial banks' liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions.
Securities firms and investment banks
financial institutions that help firms issue securities and engage in related activities such as securities brokerage and securities trading.
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. Funds originally invested in and accumulated in pension funds are exempt from current taxation.
Investment funds
financial institutions that pool financial resources of individuals and companies and invest those resources in diversified portfolios of assets.
Insurance companies
financial institutions that protect individuals and corporations (policyholders) from adverse events. Life insurance companies provide protection in the event of untimely death, illness, and retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on.
Finance companies
financial intermediaries that make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits but instead rely on short- and long-term debt for funding.
FinTechs
institutions that use technology to deliver financial solutions in a manner that competes with traditional financial methods In a world without FIs, we have a direct transfer of funds from suppliers of funds to users of funds. Likewise, financial claims would flow directly from users of funds to suppliers of funds. With FIs, we have indirect transfers, a transfer of funds between suppliers and users of funds through a financial intermediary. Financial technology, or fintech, refers to the use of technology to deliver financial solutions in a manner that competes with traditional financial methods. •Includes services such as cryptocurrencies (for example bitcoin) and blockchain. •Fintech risk involves the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and lost revenue. •Supports models of peer-to-peer mass collaboration.
Expected rate of return
interest rate an investor expects to receive on a security if he or she buys the security at its current market price, receives all expected payments, and sells the security at the end of his or her investment horizon.
Required rate of return
interest rate an investor should receive on a security given its risk. Required rate of return is used to calculate the fair present value on a security.
coupon rate
interest rate on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the bond holder.
Liquidity premium theory
long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity risk premiums that increase with the security's maturity. Longer maturities on securities mean greater market and liquidity risk. So, investors will hold long-term maturities only when they are offered at a premium to compensate for future uncertainty in the security's value. The liquidity premium increases as maturity increases. A weakness of the unbiased expectations theory is that it assumes that investors are risk neutral. Liquidity premium theory is an extension of the unbiased expectations theory. •Based on the idea that investors will hold long-term 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. A weakness of both the unbiased expectations and liquidity premium theories is that they assume that investors have no preference when it comes to different maturities and the risks associated with them.
Loanable Funds Theory
suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds. Loanable funds theory views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds. •Categorizes financial market participants - consumers, businesses, governments, and foreign participants - as net suppliers or demanders of funds.
Liquidity and Price Risk
•FIs act as asset transformers, financial claims issued by an F I that are more attractive to investors than the claims directly issued by corporations. •Often claims issued by F Is have liquidity attributes that are superior to those of primary securities. •FIs diversify away some, but not all, of their investment risk.
Primary markets
•Markets in which users of funds (for example, corporations) raise funds through new issues of financial instruments, such as stocks and bonds. •Include issues of equity by firms initially going public, referred to as initial public offerings (IPOs). Primary Market Transactions: IPOs SPACs Direct Listings
Secondary markets
•Markets that trade financial instruments once they are issued.
