Money, banking and financial markets

March 30
Marketability: ability to sell something
Liquidity: ability to sell quickly at little or no loss of principle
Monetary Policy: credit; money supply
Fiscal Policy: taxes; state budget
Five core principles of Money and Banking
1. Time has value
2. Risk requires compensation
3. Information is the basis for decisions
4. Markets determine prices and allocate resources
5. Stability improves welfare
Purposes of money
1. Means of payment
2. Unit of account
3. Store of value
Future of money
No different units of account
Store of value on the way out advances in financial markets.
Means of payment: secure systems virtually, no money at all.
MONEY SUPPLY is a group of safe assets that households and
businesses can use to make payments or to hold as shortterm investments. For example, U.S. currency and balances held in
checking accounts and savings accounts are included in many
measures of the money supply.
http://www.federalreserve.gov/Releases/H6/current/default.htm
M0 is the most liquid, dollar value of phsysical cash and coin.
M1 and M2 The monetary base is defined as the sum of currency
in circulation and reserve balances.
M1 sum of currency held by the public and transaction
deposits at depository institutions. 3 trillion dollars.
o Travelers Checks

o Demand Deposits
o Other checkable deposits
M2 M1 + savings deposits, small denomination time deposits
and retail money market. 12,43 trillion dollars. The FED makes
adjustments in the season of the money supply.
o Small denomination time deposits
o Savings deposits and money market deposits accounts
o Retail money market mutual fund shares
April 06
Markets

Euro went up a Little tiny bit to 1.14

Yen continues to strengthens
Oil 37.8 1.80 growth. The oil went up and so the market
went up.
10-year treasury 1.75% low
German bonds are down almost to 0, low interest rates.
Commodities markets are down.
Chinese economy is restructuring.
Interest rates are really low.

US borrow in 3 types
1. 1 day to 1-year Treasury bill
2. 1 year to 10 years Treasury notes
3. 10 years to 30 years Treasury bonds
Crowd funding provides a platform for people to lend money.
Chapter 3
Financial intermediaries transfer value from one place to another,
usually money. Example: crow funding
Financial instruments are the things we use to transfer value.
They should be standardized. In addition to the purposes of
money, financial instruments enable people to transfer risk.
Basic financial instruments:
o Checks standardized, certain maturity and payment.
o Stocks and bonds
Derivative financial instruments value arises from
something else. Are used to transfer risk and also to
speculate. You get them for something else.
o Forward contracts
o Future contracts

o Swaps
o Options
Indirect finance you give money to a financial institution and the
financial institutions lend with your money.
Types of financial institutions
1. Depository Institutions deposit taking institutions. Banks
are the most common depository institutions.
a. Commercial banks take money and generate loans and
investments.
b. Savings banks and loans associations
c. Credit union is like a bank, takes deposits and makes
mortgage loans. Credit unions dont pay any income tax,
so they could give a loan at a lower interest rate than
banks.
2. Contractual Institutions you pay money like a premium to
a company and you receive a product or service in return. The
most common is the insurance companies:
a. Life insurance company
b. Non life insurance company (home, car, apartments, fire)
c. Pension funds are something they you and your
employer put in to a pension fund and it accumulates and
when you retire you get the benefit of the money. If you
put the money into a pension fund, it is tax-free.
3. Intermediary Institutions
a. Mutual funds are in the middle of contractual or
intermediary institutions Mutual fund is a pull of money
run by a professional money manager. You pay the money
manager to invest. Mutual funds spread out the risk.
Mutual funds have different investments.
b. Finance companies finance cars. They borrow money
on the capital markets.
c. Investment banks Golden Sacks, Morgan Stanley. They
provide assistance to companies needing financing.
4. Government Sponsor Enterprise (GSE) mortgage
financing.
Financial markets where you buy and sell product and services.
Three main functions of financial markets (page 58)
1. Provide liquidity ability to sell something quickly with
minimal or no loss of principal. Low cost of the transaction.

2. Provide good information derive a lot of information of that

market. With the Internet the amount of information is
exponential. Internet.
3. Shares the risk a lot of people are doing the same thing.
Types of financial markets

Bank loans
Bonds
Home mortgages
Stocks
Asset-backed securities

Chapter 4
Future value is the value sometime in the future of an investment
made today.
FV = PV * (1+i)

Yield is the return you get on something.

Present value is the value today of a payment that is promised in
the future.
PV = FV / (1+i)

I.R.R (internal rate of return) If the expected return of an

investment is bigger than the I.R.R. of that investment, you should
probably considering doing that investment.
Relationship between bond prices and interest rates
When interest rates rise, bond prices fall. When interest rates fall,
bond prices rise.
Bond is a piece of debt issued by a company (borrow money) from
an investor. Bonds pay interest.
Maturity is the length of time of a financial instrument.
Treasury bills are generally 90 or 180 days.
Coupon rate is the amount of interest that the bond
promises to pay. Known as the interest rate. Coupon rate and
yield is the same at the moment of issue. Rate of interest that
the company must pay for people who buys its bonds.
Par value most bonds are issue at either 100 or 1000
dollars. The par value is the full face value as issued. By the
time the bond price will value.
Face value is the issued price.

The price of the bond will always adjust to over the yield. If In the
market the rate of interest goes down, the bond will adjust the price
when the yield equals the new rate of return.
5% (interest of the bond)/price = 4% (new interest market
rate)
Long-term bonds are very volatile because interests changes
all the time.
April 13th
Risk
The higher the risk, the higher should be the reward.

Risk is a measure of uncertainty about the future payoff to an

investment.
Can be quantified probability: is the measure of the like
hood of something happening. Example: standard deviation.
Is measured against some benchmark for example bonds
are measured against US Treasury securities.
Risk free treasury interest rate US bond. It is a safe investment.
The T Bill (short term) is considered a risk free asset.
Measures of risk
Variance mathematical.
Standard deviation positive square root of the variance. The
SD is a measure of risk. The lower the standard deviation,
the less risky the security.
Value at risk (VaR) is a measure of what might happen in the
worst possible case. The American banks regulators use VaR
in order to inspect the degree of loss that a company would
have. The stress test for a financial institution analyzes the
impact of interest rate risk in your portfolio.
Two types of risk
1. Idiosyncratic only affects your company
2. Systematic affects the whole the economy.
How to reduce risk?
5

 Diversification holdings, the maturity, the type of investment,

etc.
Hedging forward contracts, future contracts, swaps and
options are used to hedge risk. Buy another investment that will
offset the risk of that. Going in opposite directions from where
you are.
If you have risk:
1. Identify the risk
2. Try to measure the risk
3. Deal with the risk, generally by hedging.
Bond prices
Most corporations need to borrow money in order to operate, so they
sell bonds to the market.
US Bond market is three times the stock market.
US Government has 19 trillion dollars of debt.
The bond market has a relationship with interest rates. Interest rate is
very important.
A bond is a loan made by a company that needs to borrow money.
4 kinds of bonds
1. Zero-coupon Bond they are sold at a discount. If the bond
pays at maturity 100 dollars, the price could be 98 dollars (the
difference between the two numbers is the profit). Treasury bills
are liquid and safe.
2. Fixed payment loan is the most common type of bond.
(Mortgages)
3. Coupon bond bond that pays X percent of interest.
4. CONSOL bond is a bond that has no maturity date; there is
no promise for paying a principal.
Commercial paper sold on a discount basis, they promise to pay
something and you pay less. Commercial Paper market is at very
short term (1 day, 5 days, etc.) The interest rate is very low.
Commercial paper is an unsecured short term borrowing by
corporations. Who is the lender? Insurance companies, corporations

that have extra money and want to buy some commercial paper and
lend money.
Default is when you dont meet your obligations.
Bond yield is the return over the price you pay. When the bond is
selling at the oar value, the yield equals the coupon rate.
Return/price.
If the rate of interest of the market rate goes down, the bond held
stays the same, but the market changes, so that bond will increase.
Yield to maturity takes into account the return of income from what
you paid and what you get paid at maturity. When the bond is sold at
par, the yield equals the coupon rate.
Factors that influence the supply of bonds

Government expenditure the more the government borrows,

the greater quantity a bond is required.

Business conditions

Expected Inflation current inflation and expected inflation.

Taxation there are taxable and tax free bonds (states and
municipal bond markets).

Factors that influence the demand of bonds

Wealth

Expected inflation big impacts on how you manage your

portfolio.

Expected returns and interest rates

Risk relative to alternatives

Liquidity relative to alternatives

Business cicle

Why bonds are risky?

1. Default risk the risk that the bond issuer doesnt payoff in the
timely manner as promised principal and interest. This is the
major risk of a bond.
2. Inflation risk an investor cant be sure of what the real value
of the payments will be. Inflation may turn out to be higher than
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expected, reducing the real return on holding the bond. Inflation

destroys the value of fixed income investments.
3. Interest rate risk arises from a bond investment horizon,
which may be shorter than the maturity of demand. Interest
rates may rise between the time the bond is purchased and the
time it is sold reducing the bonds price.
4. Re-Investment risk when you have the capital but the market
is so low that you cannot re invest your capital for the same
return. When interest rates go down, the company can call the
bonds and short the bonds issued in an interest rate higher and
they have to payoff all their bonds.
As interest rates change, the price of bonds changes. The longer
the maturity of the bond would be exacerbated by the change
of interest rate.
April 20
Chapter 7 Risk and interest Rates
Ratings evaluate the riskiness of bonds. (Standard and poors,
Moodies). They have evoluted over the last years. The lower the
rating, the highest the interest that you pay.
Maturity is a measure of time. The Longer the time, the higher the
risk. As interest rates change, if you are holding a 20 or 30-year bond,
the price of that bond will change so much. The longer the bond you
hold, as interest rate change, it will affect so much a long-term bond
than a shorter one. The yield goes up, as time goes out (pagw 173).
Yield goes up, risk goes up.
Taxes municipal bonds are tax free, you dont pay federal income
tax in the US. Tax advantage in a municipal bond.
3 types of yield curves:
1. Time increases, the interest goes up normal economy and
typical curve.
2. Flat interest rates different maturities whatever the prices
3. Down ward slope
Chapter 8 Stocks
Common stock shares in a firms ownership. A firm that issues
stock sells part of itself, so that the buyer becomes a part owner.

You cannot be prosecuted for owning stock of a fraud company.

Initial public offering (IPO) when a company goes public and
then the public can buy shares.
Trading stocks Indexes is what you look out to see how the
stocks are doing.
DJ 30
S+P 500
NASDAQ
Wilshire 5000
Influences in stock prices

Company's past performance

Future performance companies are required to offer some

kind of information about the future

Perception what do people think about

Fundamentals price to earnings.

Stock markets role

Risk

Savings

Pension funds

Every country is different. In America, a fairly high percent of

corporate needs are raised through stock markets.
End chapter 7: 2, 8, 14
End if chapter 8: 2, 15.
April 27th
Chapter 9 Derivatives
Derivatives have become very important. It is a financial
instrument, whose value is based from something else. They are used
to transfer risk.
Positions

Long position you own the asset.

Square even. You dont have a position.

Short position sold without owning.

MBS is a security made by individual mortgage securities.

4 basic derivative instruments:
1. Forward contracts to hedge risk for a future obligation. A
forward contract is an agreement between a buyer and a seller
to exchange a commodity or financial instrument for a specified
amount of cash on a prearranged future date. Forward contracts
are private agreements between two parties generally one is
the bank. Because they are customized, forward contract are
difficult to resell to someone else.
2. Future contracts calls for the delivery of something at a
certain time and date. Disadvantages: The amounts are very
fixed. Advantages standardized amounts.
a. The maturity day is fixed
b. The last trading day is two day priors to export
c. Borrow stock at margin
d. As the price changes, the value of the contract
changes MARGIN CURVE
e. You do have to put collateral
3. Swaps are contracts that allow traders to transfer risk. Swap
is when you exchange one thing for another. Notional amount:
amount that the transaction will be based on. Two parties to a
swap.
a. Interest rate swaps allow one swap party, for a fee,
to alter the stream of payments it makes or receives. If
interest-floating liabilities increase is a bad thing.
b. Foreign currency swaps they swap the payments.
They are swapping the cash flows of the obligations.
4. Options An option is a contract that gives you the right but
not the obligation to do something. Examples of options:
Foreign exchange options, stock options, commodity.
a. Call if you think that a stock will go up, you might buy a
call option, which gives you the right but not the
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obligation to buy something. American options are due

any time, that means buy or sell at any time at the
closing day. European options can only be exercised in the
closing day.
i. Covered when you do a call option and you own
the stock.
ii. Naked when you do the call option, but you
dont own the call.
b. Put if you think that a stock will go down, you might
buy a put option, which gives you the right but not the
obligation to sell something.
Three different prices
i. Underlined price current price of the asset
ii. Strike price Exercise price
iii. Premium is what you pay for the option.
Foreign exchange markets
What is foreign exchange? Buy one currency and sell another. The
foreign exchange market moves 4 to 5 trillion dollars a day globally.
Where? Is basically an interbank market? London (because of the
time zone) is the biggest foreign exchange market, then New York and
Tokyo. London is the only place in the world that can trade with Asia
and the rest of the world in the same day. London regulators are
easier than US regulations and Asian Regulations.
Why? The main purpose of the foreign exchange market is to
facilitate international trade and investment. Facilitate shipping, travel
and speculation.
Who? Commercial banks and governments, corporations. Brokers.
Importers/exporters.
How?
End chapter 9: exercises 6, 16
End chapter 10: exercises 1, 16

Bank positions Every bank has lending positions. A bank must

send a limit.

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Direct home currency price

Indirect quotes one unit of foreign currency per one unit of home
currency.
Things that affect foreign exchange market

Inflation

Trade balances

Trade and foreign exchange barriers

Reserves country stock of foreign currency, because it has trade

surplice. China has the biggest foreign exchange.
May 18
US Banking History has a terrible banking history. It didnt have a
Central Bank sin 1914.
Non-depository institutions insurance companies life and non-life.
Regulation its necessary to have it in order to create a public
trust. Banks are important to the running of any economy.
Challenges of regulation:
Increasing complexity of financial institutions different
products, services, and businesses.
Globalization what happens in one country impacts on the
others. Globalization is affecting the banking business.
o Trade movement of product and services. Globalization
is reducing the fees of trading.
o Movement of people globalization reduces the barriers
of the movement of people.
o Movement of capital and money. Globalization is
reducing barriers on the movements of capital.
Shuttle banking non-bank companies start lending money.
It is a kind of banking but it is not regulated.
Too big to fail (TBTF) banks in a particular countries are so big
that becomes a systemic threat for the economy.
May 25th

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Banking System Regulation

Regulation the way the law is written.
Why?

Safety of the banks

Avoid bank runs

Provide a government safety net

Supervision checking and making sure that the law is being

enforced.
Regulations
Asset holding requirements Capital to asset Ratio, Tests
risk ratios
Disclosure requirements
Actual examination most banks are examined one a year but
new ones twice a year.
C Capital adequacy. The bank should have sufficient capital.
A Asset Quality. They look at the loan portfolio if they are healthy
or not.
M Management. How is created and distributed.
E Earnings
L Liquidity. Banks have to keep extra resources, you cant meet
deposit withdraws
S Sensitivity. The impact of the interest rate changes in the
banks.
Central Banks is a vital part of any country controlled by the
government and serves to the monetary policy (determines the
price and availability of the money).

Central bank key roles

Lending in times of stress to financial institutions.

13

Manage the payment system of the money (how the money is

transfer, collected, etc.)

Central Banks Goals

Maintain low and stable inflation

Policies that provides economic growth

Policies for stable financial markets

Promote stable interest rates

Promote policies that promote stable exchange rates

Promote policies that promote low unemployment

Characteristics of a good central bank

Accountable
Must work well with the Ministry of finance (Treasury).

New challenges for the regulators and the central banks

1. Growing complexity of the financial system
2. Shuttle banking non-bank companies start lending money.
It is a kind of banking but it is not regulated.
The DoddFrank Wall Street Reform and Consumer Protection Act ;
commonly referred to as Dodd-Frank) was signed into federal law by
President Obama on 2010.
SIFI they dont want to be too big financial institions because they
are difficult to regulate.

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