Ch 2 The Financial System investment purchase of physical capital Structure of the nancial system Financial system Financial Markets Direct Finance equity stock markets debt bond markets foreign exchange markets Financial intermediaries Indirect nance banks S L s insurance companies mutual funds Monetary theory examines role of money in economy Monetary policy use of money and interest rates to minimize in ation and unemployment Function and structure of nancial markets function and types of nancial intermediaries regulation of nancial system Role of nancial system 1 provide individuals rms governments funds to do things today they couldn t otherwise afford at a price 2 storing protecting providing pro table uses for excess capital 3 4 speculation insuring against risk Structure of nancial markets 1 debt equity markets 2 primary and secondary markets 3 exchange and over the counter markets 4 money and capital markets Debt and equity markets debt securities promises to repay principal and interest at speci ed date primary source of direct nance BONDS debt security maturity describes length of time until nal payment is made short term 1 year intermediate term 1 year maturity 10 years long term 10 years equity securities represent ownership of corporation and entitle stockholder to rm s earnings assets Primary and secondary markets primary newly issued debt equity securities sold to initial buyers secondary previously issued securities are bought sold Types of secondary markets 1 exchanges buying selling takes place in centralized location 2 OTC buying selling takes place through computerized trading Money and capital markets short term securities traded in money markets equity securities and longer term securities traded in capital markets Example of money market instruments 1 commercial paper unsecured corporate debt issued to nance short term working capital 2 needs repurchase agreements repos sale of securities with simultaneous agreement to repurchase securities at agreed upon future date at an agreed upon future price Functions of nancial intermediaries nancial intermediation is process of indirect nance using nancial intermediaries nancial intermediaries provide route for moving funds for savers lenders to investors borrowers because they reduce transaction costs information costs Transaction costs time money spent carrying out transaction economies of scale average cost of transactions falls as number of transactions increases information cost arise from asymmetric information problems adverse selection and moral hazard interest and interest rates interest amount lenders receive for extending credit or amount borrowers pay for obtaining Ch 3 Understanding Interest Rates credit ex interest rates re ect amount of interest paid in relation to amount lent borrowed interest rates re ect trade off between present future consumption interest rates re ect price of capital Calculating interest rates concepts present value yield to maturity ex Principal 10 000 Repay 15 000 Interest 5 000 10 years 5 000 10 5 per year Present value Yield to maturity interest rate that requires price of an asset today with the present value of all future payments associated with that asset YTM is the interest rate i that equates the 2 sides of the equations 4 credit market instruments 1 simple loan commercial bank loan 2 discount bond US T bill zero coupon bond 3 coupon bond U S Treasury Bond corporate bond 4 xed payment loan car loan mortgage Simple loan borrower receives principal and repays principal plus interest at maturity YTM on a simple loan interest rate Discount bond borrower repays face value of bond at maturity but initially receives less than face value Coupon bond borrower initially receives face value of bond then makes payments of interest at regular intervals and repays face value at maturity if coupon issued at Par face value then coupon rate YTM Fixed payment loan borrower makes regular period payments of equal size Each payment includes both principal and interest Calculating YTM bond prices and interest rates are negatively related YTM vs ROR if bond is held until it matures then ROR YTM For a bond held t to t 1 If bond is held to maturity then ROR always equals YTM if interest rate goes up then price of bond goes down longer term bonds are affected more by change in interest rates long term bonds higher interest rate risk if interest rate goes up tomorrow buy long term today if interest rate goes down tomorrow buy short term today Real vs nominal interest rates real interest rate nominal minus rate of in ation Ex post vs ex ante real interest rates ex post nominal minus actual rate of in ation for the past ex ante nominal minus expected in ation rate to predict future real interest rate Ch 4 Behavior of Interest Rates 2 approaches to determination of interest rates 1 bond market framework 2 liquidity preference framework both rely on theory of asset demand Theory of asset demand other things equal how will change in any of the following affect one s decision to buy particular asset wealth asset s expected return relative to other assets asset s risk relative to other assets asset s liquidity relative to other assets Demand for asset X will increase other things equal as result of increase in wealth of buyers increase in expected return of asset x relative to expected return on other assets a decrease in riskiness of asset x relative to riskiness of other assets increase in liquidity of asset x relative to liquidity of other assets A model market for bonds assume only type of kind and only one interest rate in the economy Bond supply positive relationship between bond prices and quantity of bonds supplied Equilibrium quantity supplied quantity demanded at the going price Factors that increase demand for bonds increase in wealth decrease in expected future interest rates if expected future interest rates fall expected future bond price will rise decrease in expected future in ation decrease in riskiness of bond relative to riskiness of other assets increase in liquidity of bonds relative to liquidity of other assets Factors that increase supply of bonds increase in expected pro tability of business investments increase in expected in ation increase in government budget de cit Real interest rate nominal rate minus expected in ation rate Real interest rate real cost of borrowing money ex If expected in ation increases what happens to interest rates Fisher effect increase in expected