FINANC 3000 1st Edition Lecture 9 Outline of Last Lecture I. Financial MarketsII. Money Market InstrumentsIII. Capital MarketsIV. Financial InstitutionsOutline of Current Lecture I. Financial InstitutionsII. Federal ReserveIII. Interest RateIV. InflationV. RiskVI. Yield CurveVII. TheoriesCurrent LectureFederal Reserve- Fed was founded in 1913 by act of Congress- Congress originally intended to act as a “lender of last resort” in the case of financial panics- Over time, Congress gave it more responsibilitieso To promote full employmento To maintain low inflation rateThe Federal Reserve SystemThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- Advisory Boardso Board of Governors 7 members appointed by the President; approved by the Senateo Federal Open Market Committee 12 members (7 board of governors & 5 District Bank Presidents)o Federal Reserve District Banks 12 Regional Districtso Member Banks Private banks that hold stock in their district banksFederal Reserve District Banks- Assist in the conduct of monetary policyo Set and change the discount rate (must be approved by the board of governors)o Make discount window loans to depository institutions- Supervise and regulate FRS member bankso Conduct examinations and inspections of member bankso Issue warnings when banking activity is unsafe or unsoundo Approve bank mergers and acquisitions- Provide Government serviceso Act as the commercial banks of the U.S. Treasury- Issue new currencyo Collect and replace currency in circulation as nessecary- Clear Checkso Act as a central clearing system for U.S. bankso Clear ~25% of all checks written in the U.S.- Prove wire transfer serviceso Fedwireo Automated clearing house (ACH)- Perform banking sector and economic research o Used in the formulation of monetary policyInterest Rate- Different rates apply to different financial products- Nominal rate quoted most ofteno Interest rate actually observed in Financial Market- Interest rate affect the price of securitieso Financial manager spend a lot of time trying to predict future rate- Interest rate affects rate for mortgages and other loans- Factors that affect nominal interest rate for a securityo Inflationo Real interest rateo Default and liquidity risko Provisions of security issuero Term to maturityInflation- A continual increase in the price level of a basket of goods and services throughout the economy as a whole- Inflation is measured using the consumer price index (CPI) or producer price index (PPI)- Actual or expected inflation rateo Interest rates increase in response to inflation- Investors require higher interest rate from securities when inflation is higherReal Interest Rate- Rate that exists on default free security if no inflation were expected- Measures society’s relative time preference for consuming today rather than tomorrow- Fisher Effecto Nominal interest rates compensate investors for: Any inflation related reduction in purchasing power on loans An additional premium above the expected rate of inflation for forgoing present consumption- i= Expected IP +RIRDefault or Credit Risk- Risk that issuer fails to pay promised interest and principal o Investors demand higher interest with higher default risko U.S. Treasury securities are generally considered to be free of default risk- Rating agencies evaluate potential risk on corporate bonds and some government and municipal bondso- Ex. Default Risko Interest rate for 10 year Treasury Bond in 2010 – 3.31%o Aaa Corporate Bond interest rate – 4.98%o Baa Corporate Bond interest rate – 6.23%Other risks- Liquidity risko The risk that a security can’t be sold at a predictable price with low transaction costs on short notice. Highly liquid assets carry lowest interest rate- Interest rate price risko The risk of capital losses to which investors are exposed because of changing interest rates- Price risko Risk of losing capital value- Maturity Risk Premiumo A premium that reflects interest rate price risk; bonds with longer maturities have greater interest rate price risk thus greater MRPsInterest Rate on Debt- i= iRF +RP = RIR + IP + (DRP + LP + MRP)o i = nominal interest rateo iRF = risk free interest rateo RIR = real interest rateo IP = inflation premiumo RP = Risk premiumo DRP = default risk premiumo MRP = maturity risk premiumo LP = liquidity premiumYield Curve- Term structure of interest rates or Yield Curve – a comparison of market yields on securities, assuming all characteristics except maturity are the same- Yield curve can take three shapes:o Upward sloping- market expects interest rates to be higher in the future (“normal”)o Downward sloping – rare, market expects interest rate to be lower in the future (“abnormal”)o Flat Yield Curve – yield to maturity not affected by term to maturityUnbiased Expectations Theory- Yield curve reflects the market’s current expectations of future short-term rates- One 4 year bond interest rate = four 1 year bond interest rateso Can roll forward bond every year- Reflects the investors’ expectations about future inflation, real rates don’t change very muchLiquidity Premium Theory- Uncertainty or risk increases with maturity of a securityo Uncertainty with future inflation rate and interest rateso Short term securities provide more marketability (liquidity) and less price risk than long term securities -> investors prefer securities with short maturityo To compensate investor for increased risk, there is a liquidity premium added for longer maturity securitieso Because longer maturities on securities mean greater market and liquidity risk, the liquidity premium increases as maturity increases- Ex. Liquidity Premiumo Even when according to unbiased expectations theory yield curve should be downward sloping or flat, by adding liquidity premium the yield curve can become upward slopingMarket Segmentation Theory- Investors have different preferred maturitieso Banks hold deposits, prefer short term securitieso Insurance companies sell life insurance, prefer long term securitieso To hold different than preferred maturity, investors demand higher interest rate (maturity premium)o Markets can then be segmented into unrelated long term markets and short term markets where interest rate is determined by