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 better Primary lender avers are households Primary borrower spender are businesses 1 Direct Finance 2 Indirect Finance Main financial instruments Debt instruments such as bond or mortgage Equities such as a common stock Structure of Financial Markets 1 Debt Markets 2 Equity Market Structure of Financial Markets 1 Primary Market 2 Secondary Market a Exchanges b Over the counter Markets Structure of Financial market 1 Money Market Short term 2 Capital Market Long term Financial intermediation is actually the primary Function of financial intermediaries Asymmetric information Adverse selection Economies of scope Types of Financial Intermediaries Banks Contractual savings institution Investment intermediaries Finance Companies Mutual Funds Contractual saving institutions Life insurance companies Fire and casualty Insurance companies Investment Intermediaries Money Market Mutual Funds Hedge Funds Investment Bank Regulation of Financial Markets 1 2 Increase Information to Investors Improve monetary control 3 Ensure the soundness of financial intermediaries Chapter 3 Time value money money today is worth more than money in the future due to inflation Fixed Payment Loan loan principal and interest are repaid in several payments Simple loan PV CF 1 i n Coupon Bond P C i i C P Discount Bond Yield curve interest measured at different maturity lengths Rate of return Return Current Yield Capital Gain Yield Risk averse person prefers a less risky asset given the same return Risk lover person who loves risk Equilibrium point where demand equals supply Excess supply occurs when the amount that people are willing to sell is greater than the amount people are willing to buy Excess demand vice versa Determinants of Asset demand 1 Wealth 2 Expected return 3 Risk 4 Liquidity Shifts in the demand for bonds 1 Wealth more wealth they have the more they need to deploy for investments 2 Expected returns higher expected interest rates decrease demand for long term bonds 3 Risk higher risk reduces demand 4 Liquidity increased liquidity leads to increased demand for bond Changes in interest rates is called shifting demand or supply curve Shifts in the supply of Bonds 1 Expected profitability of Investment opportunities 2 Expected inflation an increase in expected inflation causes the supply of bonds to increase 3 Government Activities Higher government deficit increase the supply of bonds Fisher Effect if expected inflation increases expected return of bonds decreases causes lower equilibrium price Factors affecting risk structure Default Risk Default risk occurs when you cant make payments Investment grade A bond BBB or higher Liquidity Income Taxes Ability to turn asset into cash quickly Term structure of interest rates Different maturities tend to have different rates How to explain yield curve 1 Interest rates for different maturities move together 2 Yield curve tend to have a steep upward when short rates are slow and a downward slopes when short rates are high 3 Yield curve tends to slope up Three theories of term structure Expectations Theory same Explains fact 2 Market Segmentation Theory Bonds of different maturity lengths are perfect substitutes The important point is that if expectations theory is correct your expected wealth is the Bonds of different maturities are not substitutes Liquidity Premium Theory Bonds of different maturities are substitutes but are not perfect substitutes Explains all 3 facts Zero coupon bond has a duration of 30 years Fear of centralized power and distrust of moneyed interests guided central bank activities in the Origins and structure of fed 19th century Federal reserve act 1913 Checks and balances Founders decided against concentrating federal banking system Economic goals of fed 1 Maximum sustainable employment 2 Stable prices 3 Moderate long term interest rates Fed dual mandate price stability and long term employment Keeping interest rates low or raising interest rate to keep market stable 12 federal reserve banks Board of Governers THREE POLICY TOOLS 1 Open market operations 2 Discount rate 3 Reserve requirement Twelve Districts Fed is both private and public Setup like private corporations Establish the discount rate aar which bank members might borrow Federa reserve bank function Similar function to normal banks Print money New Yorrk Fed Largest financial institution headquartered in manhattan Houses the open market desk Chairman of New York only permanent member of FOMC Board of Governors Set margin requirements for stock purchases Federal open market committee supply FOMC meetings 8 times a year National economic forecasts Discuss monetary policies Open market operations are the most important tool that the fed has for controlling the money Post meetings announcements Green book National forecast next two years Blue Book projections of monetary aggregates Th Books Beige Book Research staff Fed is Free Instrument Independence Goal Independence President has indirect control over the fed Controls who becomes part of the fed Case for independence Political pressure will tend to add inflationary bias to monetary policy Wants the economy to expand fast during short term for presidency Political business cycle Treasury may try to finance the government through bonds this may lead to inflationary bias Some view independence as undemocratic a group of people running important part of Case against Independence economy without accountability No checks and balances Central Bank behavior Public interest view the central bank serves public inteerest Theory of Bureaucratic behavior central bank will seek to maximize its own welfare Fed likes to keep its actions hidden European central bank Founded in 1999 treaty between European central bank and european system of central banks 17 members attend monthly meetings Long term goal as price stability Most instrument and goal independent central bank Monetary Policy Conventional marketing tools 1 Open market operation 2 Discount policy and lendor of last resort 3 Reserves requirement and interest on reserves Two types of reserves Required reserves Excess reserves Purchase of bonds increases money supply Making discount loans increases the money supply The federal funds rate is the rate banks charge each other for night loans The discount window is facility in which