Function of Financial Markets● Allows efficient allocation of capital● Channels funds from person/business to one who has them● Allowing them to time their purchases betterPrimary lender-avers are householdsPrimary borrower-spender are businesses1. Direct Finance2. Indirect FinanceMain financial instruments● Debt instruments- such as bond or mortgage● Equities-such as a common stockStructure of Financial Markets1. Debt Markets2. Equity MarketStructure of Financial Markets1. Primary Market2. Secondary Marketa. Exchangesb. Over-the-counter MarketsStructure of Financial market1. Money Market- Short term2. Capital Market-Long termFinancial intermediation- is actually the primaryFunction of financial intermediaries● Asymmetric information-● Adverse selectionEconomies of scope-Types of Financial Intermediaries● Banks● Contractual savings institution● Investment intermediaries○ Finance Companies○ Mutual FundsContractual saving institutions● Life insurance companies ● Fire and casualty Insurance companiesInvestment Intermediaries● Money Market Mutual Funds● Hedge Funds● Investment BankRegulation of Financial Markets1. Increase Information to Investors2. Improve monetary control3. Ensure the soundness of financial intermediariesChapter 3Time value money- money today is worth more than money in the future due to inflationSimple loan- PV=CF/(1+i)^nFixed Payment Loan- loan principal and interest are repaid in several paymentsCoupon Bond- P=C/i i=C/PDiscount BondYield curve- interest measured at different maturity lengthsRate of return- Return= Current Yield + Capital Gain Yield Risk-averse- person prefers a less risky asset given the same returnRisk-lover- person who loves riskEquilibrium point where demand equals supplyExcess supply-occurs when the amount that people are willing to sell is greater than the amountpeople are willing to buyExcess demand- vice versaDeterminants of Asset demand1. Wealth2. Expected return3. Risk4. LiquidityShifts in the demand for bonds1. Wealth- more wealth they have the more they need to deploy for investments2. Expected returns- higher expected interest rates decrease demand for long term bonds3. Risk- higher risk reduces demand4. Liquidity-increased liquidity leads to increased demand for bondChanges in interest rates is called shifting demand or supply curveShifts in the supply of Bonds1. Expected profitability of Investment opportunities2. Expected inflation- an increase in expected inflation causes the supply of bonds to increase3. Government Activities- Higher government deficit increase the supply of bondsFisher Effect- if expected inflation increases expected return of bonds decreases causes lower equilibrium priceFactors affecting risk structureDefault Risk● Default risk occurs when you cant make payments● Investment grade A bond BBB or higherLiquidity● Ability to turn asset into cash quicklyIncome TaxesTerm structure of interest rates● Different maturities tend to have different ratesHow to explain yield curve1. Interest rates for different maturities move together2. Yield curve tend to have a steep upward when short rates are slow and a downward slopes when short rates are high3. Yield curve tends to slope upThree theories of term structureExpectations Theory● Bonds of different maturity lengths are perfect substitutes● The important point is that if expectations theory is correct, your expected wealth is the same● Explains fact 2Market Segmentation Theory● Bonds of different maturities are not substitutesLiquidity Premium Theory● Bonds of different maturities are substitutes, but are not perfect substitutes● Explains all 3 factsZero coupon bond has a duration of 30 yearsOrigins and structure of fedFear of centralized power and distrust of moneyed interests guided central bank activities in the 19th centuryFederal reserve act 1913Checks and balancesFounders decided against concentrating federal banking systemEconomic goals of fed1. Maximum sustainable employment2. Stable prices3. Moderate long-term interest ratesFed dual mandate price stability and long term employmentKeeping interest rates low or raising interest rate to keep market stable12 federal reserve banksBoard of GovernersTHREE POLICY TOOLS1. Open market operations2. Discount rate3. Reserve requirementTwelve DistrictsFed is both private and public● Setup like private corporationsFedera reserve bank functionEstablish the discount rate aar which bank members might borrowSimilar function to normal banksPrint moneyNew Yorrk FedLargest financial institution headquartered in manhattanHouses the open market deskChairman of New York only permanent member of FOMCBoard of GovernorsSet margin requirements for stock purchasesFederal open market committeeOpen market operations are the most important tool that the fed has for controlling the money supplyFOMC meetings8 times a yearNational economic forecastsDiscuss monetary policiesPost meetings announcementsTh BooksGreen book- National forecast next two yearsBlue Book - projections of monetary aggregatesBeige BookResearch staffFed is FreeInstrument IndependenceGoal IndependencePresident has indirect control over the fedControls who becomes part of the fedCase for independencePolitical pressure will tend to add inflationary bias to monetary policy● Wants the economy to expand fast during short term for presidency● Political business cycleTreasury may try to finance the government through bonds this may lead to inflationary biasCase against IndependenceSome view independence as “undemocratic” a group of people running important part of economy without accountabilityNo checks and balancesCentral Bank behaviorPublic interest view -the central bank serves public inteerestTheory of Bureaucratic behavior- central bank will seek to maximize its own welfareFed likes to keep its actions hiddenEuropean central bankFounded in 1999 treaty between European central bank and european system of central banks17 members attend monthly meetingsLong-term goal as price stabilityMost instrument and goal independent central bankMonetary PolicyConventional marketing tools1. Open market operation2. Discount policy and lendor of last resort3. Reserves requirement and interest on reservesTwo types of reservesRequired reservesExcess reservesPurchase of bonds increases money supplyMaking discount loans increases the money supplyThe federal funds rate is the rate banks charge each other for night loansThe