Lecture 1

Chapter 1: Understanding Financial Markets

1.1 Why Study Financial Markets

 Financial markets are markets in which funds are transferred from people who have an
excess of available funds to people who have a shortage.
 A security or financial instrument is a claim on the issuer’s future income or assets (any
financial claim or piece of property that is subject to ownership).
 A bond is a debt security that promises to make payments periodically for a specified period
of time.
 Interest rates are determined in the bond market, which is the cost of borrowing or the price
paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year).
 Interest rate includes car loan interest, mortgage interest, bond interest etc.
 Interest rate is important at both individual level and government level.
 A common stock (called stock) represents a share of ownership in a corporation. Simply
called the market for stock market.
 The foreign exchange market is where the conversion of funds from one currency to the
other takes place, and so it is instrument in moving funds between countries.

1.2 Why Study Banking and Financial Institutions

 Financial institutions include banks, insurance companies, mutual funds, finance

companies and investment banks, which are heavily regulated by the governments.
 Financial intermediaries have an important effects on the performance of the economy as
a whole.
 Financial intermediaries are institutions that borrow funds from other people who have
saved and in turn make loans to others.
 Banks are financial institutions that accept deposits and make loans. They include
commercial banks, savings and loans associations, mutual savings banks and credit
unions.
  E-finance is how the dramatic improvements in information technology have led to a new
means of delivering financial services electronically.

1.3 Why Study Money and Monetary Policy

 Money or money supply is defined as anything that is generally accepted in payment for
goods and services or in the repayment of debts.
 Money is linked to economic variables that affect everyone.
 Total production of goods and services is called aggregate output.
 Unemployment is the percentage of available labour force unemployed.
 Money plays an important role in generally business cycles such as recession, boom,
recovery etc.
 Average price of goods and services is called aggregate price level.
 Inflation is continual increase in the aggregate price level.
 Monetary policy is the management of money and interest rate, which is a responsibility
of central bank.
 Fiscal policy involves decisions about government spending and taxation.
 Budget deficit is excess of government expenditure over revenue and budget surplus is
the excess of government revenue over expenditure.

1.4 Defining Aggregate Output, Income, Price Level and Inflation Rate

 Measures of aggregate output is GDP, which is the market value of all final goods and
services produced in a country during the course of the year.
 Aggregate income is the total income of factors of production (land, labour and capital)
from producing goods and services in the economy during the year.
 Measure of price level is GDP deflator, which is normal GDP divided by real GDP.
𝑋𝑡−𝑋𝑡−1
 Growth rate is measured using growth rate of real GDP, which is x100.
𝑋𝑡−1
 Chapter 2: Overview of Financial System

 Financial markets (bond and stock market) and financial intermediaries (banks,
insurance companies, pension funds) have basic function of getting people who have
shortage of funds and who have a surplus of funds to meet and satisfy their needs.

2.1 Functions of Financial Markets

 Financial markets perform the essential economic function of channeling funds from
households, firms and government that have saved surplus funds by spending less than
their income to those that have a shortage of funds because they wish to spend more than
their income.

 Financial market enables to transfer funds from a person who has no investment
opportunities to one who has them.
 Without financial market, both parties may be stuck without investment and benefit
 Financial market promotes economic efficiency.
 Financial market are critical for producing an efficient allocation of capital, which
contributes to higher production and efficiency for overall economy. J
 Well-functioning financial markets also directly improve the well-being of consumer by
allowing them to time their purchases better. They provide funds to young people who
could afford later.
2.2 Structure of Financial Markets

 Two main ways that an individual or firm obtain funds

1. Debt Instrument
 Debt instrument includes bonds and mortgage
 Debt and mortgage are contractual agreement by the borrower to pay the
holder of the instrument fixed dollar amounts at regular intervals (interest
and principal payment) until a specified date (maturity date).
 Maturity date of a debt instrument is the number of years (term) until that
instrument’s expiration date.
 Debt instrument can be of;
 Short-term (if less than one year)
 Intermediate-term (if one to ten years)
 Long-term (if more than ten years)
2. Issuing Equities
 Equities often make periodic payments called dividends
 Considered as long term securities
 Primary and Secondary Markets
o Primary Market is a financial market in which new issues of a security such as a
bond, or stock are sold to initial buyers by the corporation or government agency
borrowing the funds.
o Primary markets are not well known to public as they happen behind the closed
doors
o Secondary market is a financial market in which securities that have been
previously issued can be resold.
o Important financial institution assisting initial sale of securities is investment
bank, where it does this by underwriting securities.
o Securities brokers and agents are crucial to a well-functioning secondary market.
o Brokers are agents of investors who match buyers with sellers of securities.
o Dealers link buyers and sellers buying and selling securities at stated prices.
o In secondary market, the corporation does not receive any new funds.
o Two important functions of secondary markets are;
  Liquidity
 Makes it easier and quicker to sell financial instruments to raise
cash
 Makes it more desirable and easier for the issuing firm to sell in
the primary market
 Determine the price of the security that the issuing firm sells in the
primary market
 The higher the price of security in the secondary market, the higher
will be the price that the issuing firm will receive for a new
security in the primary market, hence the greater the amount of
financial capital it can raise
 Exchange and Over-The-Counter Markets
o Secondary markets can be organized in two ways;
 Exchanges; where buyers and sellers of securities meet in one central
location
 OTC markets; which dealers at different location who have an inventory
of securities stand ready to buy and sell securities ‘over the counter’ to
anyone who comes to them and is willing to accept their prices, which is
also the most common method.
 Money and Capital Market
o Based on maturity of securities traded, markets can be distinguished to;
 Money market
 Short-term debt instrument traded
 Generally less than one year
 Usually more widely traded and is more liquid
 Corporations and banks actively use money market to earn interest
on surplus funds
 Capital market
 Long-term debt and equity instruments are traded
 Generally more than one year
 Often held by financial intermediaries
2.3 Internationalization of Financial Markets

 Traditional instrument in the international bond market known as foreign bonds, which
are sold in a foreign country and are denominated in that country’s currency
 Eurobond is a bond denominated in a currency other than that of a country in which it is
sold
 Eurocurrencies are a variant of Eurobond, where foreign currencies deposited in banks
outside home country is included.

2.4 Functions of Financial Intermediaries

 Borrows funds from lender-savers

 Lends to borrower-spenders
 The process of indirect finance using financial intermediaries called financial
intermediation, is the primary route for moving funds from lenders to borrowers
 Transaction costs
o Transaction costs are the time and money in carrying out financial transactions,
and are a major problem for people who have excess funds to lend.
o Financial intermediaries substantially reduce transaction costs as they have
developed expertise in lowering them, due to their scale, called economies of
scale.
o Can provide funds indirectly to people
o Can provide customers with liquidity services, making it easier for customer to
conduct transactions
 Risk sharing
o Financial intermediaries create and sell assets with risk characteristics that people
are comfortable with and the intermediaries then use the funds they acquire by
selling these assets to purchase other assets that may have far more risk
o Enable asset transformation
o Enables individual to diversify
o Collection of assets (portfolio) managed by financial intermediaries
  Asymmetric information
o Information about the other parties could be incomplete or unknown
o Moral hazard is the problem created by asymmetric information after the
transaction occurs.
o It is the risk (hazard) that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of view, because they make it less
likely that the loan will be paid back.
o Financial intermediaries reduce the chances of asymmetric information by
clearing the investment opportunities and details.
o Can lead to financial panic, called the wide spread collapse of financial
intermediaries which means, not able to assess the soundness of financial
intermediaries

2.5 Financial Intermediaries

 Financial intermediaries are highly regulated

o Limits on competition
o Restricts on entry
o Restricting interest rate
o Deposit insurance; government insuring
o Restrictions on assets and activities
 The following are different types of financial intermediaries and their characteristics

Type of Intermediary Primary Liabilities Primary Assets (Uses

(Sources of Funds) of Funds)
Business and
consumer loans,
Depository
Commercial banks Deposits mortgage, government
Institutions
securities and
(Banks)
municipal bonds
Savings and loan Deposits Mortgages
 associations
Mutual saving banks Deposits Mortgages
Credit unions Deposits Consumer loans
Life insurance Corporate bonds and
Premium from policies
companies mortgages
Municipal bonds,
Contractual Fire and casualty corporate bonds, and
Premium from policies
Savings insurance companies stock, government
Institutions securities
Pension funds, Employer and
Corporate bonds and
government employee
stock
retirement funds contributions
Commercial paper, Consumer and
Finance companies
stocks, bonds business loans
Investment
Mutual funds Shares Stocks, bonds
Intermediaries
Money market Money market
Shares
mutual funds instrument
 Chapter 4: Understanding Interest Rates

 Yield to maturity is the most accurate measure of interest rate, the yield to maturity is
measured and examine alternative (but less accurate) ways in which interest rates are
quoted.
 Bond’s interest rate does not necessarily indicate how good an investment the bond is
because what it earns (its rate of return) does not necessarily equal its interest rate.
 The concept of present value (or present discounted value) is based on the common sense
notion that a dollar paid to you one year from now is less valuable to you than a dollar a
dollar paid to you today. This is true because one can deposit a dollar in savings account
that earns interest and have more than a dollar in one year.
 The simple kind of debt instrument is called simple loan.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
 The measure of simple interest rate is i = x100.
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

 Present value of a future value is calculated as follows

 In terms of timing of their payment, there are four basic types of credit market instrument

a. A simple loan (Present Value = Future value/1+i) or (i = P-F/F)

b. A fixed-payment loan (fully amortized loan) in which the lender provides the
borrower with an amount of funds, which must be repaid by making the same
payment every period such as a month, consisting of part of principal and interest
for a set number of years. Borrowing $1000 requiring to pay $126 every year for
25 years. Example, installment loans such as auto loans and mortgages
 c. A coupon bond pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity date, when a specified final amount (face
value or par value) is repaid. The coupon payment is so named because the bond-
holder used to obtain payment by clipping a coupon off the bond and sending it to
bond issuer, who then sent the payment to the holder. A coupon bond with $1000
might pay a coupon payment of $100 per year for ten years, and at the maturity
date, repay the face value amount of $1000. A coupon bond is identified by three
pieces of information
i. Corporate or government agency issuing the bond
ii. Maturity date of the bond
iii. Bond’s coupon rate

d. A discount bond (zero-coupon bond) is bought at a price below its face value (at
discount) and the face value is repaid at the maturity date. Unlike coupon bond,
discount bond does not make any interest payments, it just pays off the face value.
Example; a discount bond with a face value $1000 might be bought for $900 in a
year’s time the owner would be repaid the face value of $1000.
 For simple loans, the simple interest rate equals the yield to maturity.
 When the coupon bond is priced at its face value, the yield to maturity equals the coupon
rate
 The price of a coupon bond and the yield to maturity are negatively related; that is as the
yield to maturity rises, the price of the bond falls
 The yield to maturity is greater than the coupon rate when the bond price is below the its
face value
 Consol or a perpetuity is a perpetual bond with no maturity date and no repayment of
principal that makes fixed coupon payments of $C forever. The formula for the price of
the consol P is C/i

𝐹−𝑃
 For one year discount bond the yield to maturity can be written as i =
𝑃

 Other Measures of Interest Rate

o Current Yield: is an approximation of the yield to maturity on coupon bonds that
is often reported, because in contrast to the yield to maturity, it is easily
calculated. It is defined as the yearly coupon payment divided by the price of
security
𝑌𝑒𝑎𝑟𝑙𝑦 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 (𝐶)
 Coupon Yield (ic) =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑏𝑜𝑛𝑑 (𝑃)


 Yield on Discount Basis
o Also called discount yield
o Usually understated as it considers 360 days in a year rather than 365 days.

For a bill which is selling for $900 and has a face value of $1000, the yield on
discount basis would be as follows

 Capital Asset Pricing Model (CAPM)

o CAPM assumes that investors can borrow and lend as much as they want at
risk-free rate of interest, Rf. By lending at the risk-free rate, the investors
earns an expected return of Rf and his investment has a zero standard
deviation because it is risk-free.
o The equation of CAPM represents security market line
 o Rate of Return: defined as the payments to the owner plus the change in its value,
expressed as a fraction of its purchase price.
 The return on a bond will not necessarily equal the interest rate on that
bond

 Price and returns for long-term bonds are more volatile than those for shorter-term
bonds.
 Changes in interest rate make investments in the long-term bonds quite risky. Indeed
the riskiness of an asset’s return that result from interest rate changes is so important
that it has been given a special name, interest-rate risk.
 Duration and Interest Rate Risk
Chapter 5: The Behavior of Interest Rates

 Determinants of Asset Demand

o Wealth
 Holding everything else constant, an increase in wealth raises the quantity
demanded for an asset
 In a business cycle expansion with growing wealth, the demand for bonds rises
and the demand curve for bonds shifts to the right
 In a recession, when income and wealth are falling, the demand for bonds falls
and the demand curve shifts to the left
o Expected return
 An increase in an asset’s expected return relative to that of an alternative asset,
holding everything else unchanged, raises the quantity demanded of the asset
 Higher expected interest rates in the future lower the expected return for long
term bonds, decrease the demand and shift the demand curve to the left
 Lower expected interest rates in the future increase the demand for long-term
bonds and shift the demand curve to the right.
 An increase in the expected rate of inflation lowers the expected return for
bonds, causing their demand to decline and the demand curve to shift to the left.
o Risk
 Holding everything else constant, if an asset’s risk rises relative to that of an
alternative assets, its quantity demanded will fall.
 An increase in the riskiness of bonds causes the demand for bonds to fall and the
demand curve to shift to the left.
 An increase in the riskiness of alternative assets causes the demand for bonds to
rise and the demand curve to shift to the right.
o Liquidity
 The more liquid an asset is relative to alternative assets, holding everything else
unchanged, the more desirable, it is, and the greater will be the quantity
demanded
 Increased liquidity of bonds results in an increased demand for bonds, and the
demand curve shifts to the right
 Increased liquidation of alternative assets lowers the demand for bonds and
shifts the demand curve to the left.
Chapter 9: Banking and the Management of Financial Institutions

9.1 The Bank Balance Sheet

9.2 Liabilities
1. Checkable Deposits: these are bank accounts that allow the owner of the
account to write checks to third parties, which includes all accounts on which
checks can be drawn. Checkable deposits and money deposits are payable on
demand that is if a depositor shows up at the bank and requests payment by
making a withdrawal. It is an assets for the depositor as it is part of his or her
wealth.
2. Non-transactional Deposits: these are the primary source of bank funds.
Owners cannot write checks on non-transactional deposit, but the interest rates
are usually higher than those on checkable deposits. This can be of two types
 Savings accounts
  In these type of accounts, funds can be added or from which
funds can be withdrawn
 Transactions and interest payments are recorded in a monthly
statement or in a small book (the passbook) held by the owner
of the account
 Time deposits or certificate of deposits (CDs)
 These have fixed maturity length, ranging from several months
to over five years, and have substantial penalties for early
withdrawal
 Small denomination time deposits (less than $100,000) are less
liquid for the depositor than passbook savings, earn higher
interest rates and are more costly source of funds for the banks
3. Borrowings:
 Banks obtain funds by borrowing from the Federal Reserve system,
the Federal Home Loan Banks, other banks and corporations.
 Borrowings from the Fed are called discount loans/advances
4. Bank Capital
 The bank’s net worth, which equals the differences between total
assets and liabilities.
 The funds are raised by selling new equity or from retained earnings.

9.3 Assets

1. Reserves: these are deposits plus currency that is physically held by banks
(called vault cash). Banks hold reserves for two reasons
a. Some reserves called required reserves are held because of reserve
requirement by the regulation (required reserve ratio)
b. Banks hold excess reserves because they are the most liquid of all
bank assets and can be used by a bank to meet its obligations when
funds are withdrawn either directly by a depositor or indirectly when a
check is written on an account.
 2. Cash Items in Process of Collection: checks that are not received or
collected from the other bank
3. Deposits at Other Banks: deposits in other larger banks in exchange for a
variety of services, including check collection, foreign exchange transactions,
and help with securities purchases
4. Securities: a bank’s holding of securities are an important income-earning
assets.
5. Loans: Banks make their profits primarily by issuing loans.
6. Other Assets: the physical capital (bank building, computers, and other
equipment) owned by the banks

9.4 Bank Management

o To keep enough cash on hand, the bank must engage in liquidity management,
which is the acquisition of sufficiently liquid assets to meet the bank’s obligations
to depositors
o Bank manager must pursue an acceptably low level of risk by acquiring assets
that have a low rate of default and by diversifying asset holdings (asset
management)
o Banks must acquire funds at a low cost (liability management)
o Banks must manage credit risk, the risk arising because borrowers may default
and how it manages interest rate risk, the riskiness of earnings and returns on
bank assets that result from the interest rate changes.
o Liquidity Management and the Role of Reserves
 If a bank has ample reserves, a deposit outflow does not necessitate
change in other parts of its balance sheet
 Ways to eliminate shortage in reserves, bank has 4 options
1. Acquire reserves to meet a deposit outflow by borrowing from
other banks in the federal funds market or by borrowing from
corporation
2. Sell some of its securities to help cover the deposit outflow
 3. Acquire reserves by borrowings from the Fed.
4. Reduce its loans by this the same amount of required deposits
o Asset Management
 Banks try to find borrowers how will pay high interest rates and are
unlikely to default on their loans. They seek out loans business by
advertising their borrowing rates and by approaching corporations directly
to solicit loans
 Banks try to purchase securities with high returns and low risk.
 Banks must attempt to lower risk by diversifying, by purchasing many
different types of assets, both short term and long term
 Banks must manage the liquidity of its assets so that it can satisfy its
reserve requirements without bearing huge costs, meaning that it will hold
liquid securities even if they earn a somewhat lower return than other
assets.
o Liquidity Management
 Management of liabilities by large banks (money center banks) lead to an
expansion of overnight loan markets, such as federal funds market, and the
development of new financial instruments such as negotiable CDs, which
enabled money center banks to acquire funds quickly
o Capital Adequacy Management
 Banks have to make decision about the amount of capital they need to
hold for three reasons
1. Bank capital helps prevents bank failure, a situation in which the
bank cannot satisfy its obligations to pay its depositors and other
creditors and so goes out of business
2. The amount of capital affects returns for the owners (equity
holders) of the bank
o Return on Assets (ROA) = net profit after taxes/assets
o Return on Equity (ROE) = net profit after taxes/equity
capital
o Equity Multiplier (EM) = Assets/Equity Capital
 3. A minimum amount of bank capital (bank capital requirement) is
required by regulatory authorities
o Managing Credit Risk
 Must overcome the adverse selection and moral hazard problems that make
loans defaults more likely
1. Screening and Monitoring
o Screening and monitoring by collecting reliable information
from prospective borrowers
o Specialization in lending: specialize in lending to local firms or to
firms in particular industries, such as energy. However, the bank
is not diversifying. It is easier for banks to collect information
about local firms and determine their creditworthiness than to
collect comparable information on firms that are far away
o Monitoring and enforcing on restrictive covenants: once a loan
has been made, the borrower has an incentive to engage in
risky activities that make it less likely that the loan will be paid
off. Financial institutions must adhere to the principle for
management credit risk that a lender should write provisions
(restrictive covenants) into loan contracts that restrict borrower
from engaging in risky activities.
2. Long-term customer relationships
o Having a long term relationship to identify more information
about the customer could be helpful
o Long-term relationships benefit the customers as well as the
bank
o No bank can think of every contingency when it writes a
restrictive covenant into a loan contract, there will always be
risky borrower activities that are not ruled out. However, if the
borrowers wants to preserve a long-term relationship with a
bank, because it will be easier to get future loans at low interest
rates
3. Loan Commitment
 o Banks also create long-term relationship and gather information
by issuing loan commitment to commercial customers.
o A loan commitment is a bank’s commitment (for a specific
future period of time) to provide a firm with loans up to a given
amount at an interest rate that is tied to some market interest
rate.
o Majority of commercial and industrial loans are made under the
loan commitment arrangement
4. Collateral and Compensating Balances
o Collateral requirements for loans are important credit risk
management tools.
o One particular form of collateral required when a bank makes
commercial loans is called compensating balances, which is the
firm receiving a loan keeping a required minimum amount of
funds in a checking account at the bank.
5. Credit Rationing
o Credit rationing is refusing to make loans even though
borrowers are willing to pay the stated interest rate or even a
higher rate.
o Managing Interest Rate Risk
 If a bank has more rate-sensitive liabilities than assets, a rise in interest rate will
reduce bank profits and a decline in interest rates will raise bank profits
 With the increased volatility of interest rates that occurred in the 1980s,
financial institutions because more concerned about their exposure to interest
rate risk.
 Financial institutions manage their interest-rate risk by modifying their balance
sheets but can also use strategies involving financial derivatives.

9.5 Measuring Bank Performance

 Return on Assets (Net income/assets*100)

 Return on equity (net income/capital*100)
 Net interest margin (interest income – interest expenses/assets)
  Capital Adequacy Ratio
 Non-Performing Loan Ratio (non-performing loan/total loans*100)
 Cost to income ratio (operating costs excluding interest/operating income*100)

Chapter 11: Economic Analysis of Banking Regulations

 Asymmetric information analysis explains what types of banking regulations are needed
to reduce moral hazard and adverse selection problems in the banking system
 Understanding the theory behind regulation does not mean that regulation and
supervision of the banking system are easy in practice
 Getting bank regulations and supervisors to do their job properly in difficult for several
reasons
 Financial institutions have strong incentive to avoid existing regulations by loophole
mining.
 Regulations applies to a moving target; regulators are continually playing cat-and-mouse
with financial institutions – financial institutions think up clever ways to avoid
regulations, which then causes regulators to modify their regulation activities. Regulators
continually face new challenges in a dynamically changing financial system, and unless
they can respond rapidly to change, they may not be able to keep financial institutions
from taking on excessive risk.
 This problem can be exacerbated if regulators and supervisors do not have the resources
or expertise to keep up with clever people in financial institutions who think up ways to
hide what they are doing or to get around the existing regulations
 Bank regulations and supervision are difficult for two other reasons. In the regulation and
supervision game, the devil is in the details. Subtle differences in the details may have
unintended consequences; unless regulators get the regulation and supervision just right,
they may be unable to prevent excessive risk taking.
 Regulators and supervisors may be subject to political pressure to not do their jobs
properly.
 So, there is no guarantee that bank regulators and supervisors will be successful in
promoting a healthy financial system.
  Bank regulations and supervision have not always worked well, leading to banking crisis
in the US and throughout the world.
 The concepts of asymmetric information, adverse selection and moral hazard help
explained eight types of banking regulation that we see in the US and other countries, the
government safety net, restrictions on bank asset holdings, capital requirements, bank
supervision, assessment of risk management, disclosure requirements, consumer
protection, and restrictions on competition
 Because asymmetric information problems in the banking industry are a fact of life
throughout the world, bank regulation in other countries is similar to that in the US
 It is particularly problematic to regulate banks engaged in international banking, because
they can readily shift their business from one country to another
 Because of financial innovation, deregulation and a set of historical accidents, adverse
selection and moral hazard problems increased in the 1980s and resulted in huge losses
for the US savings and loan industry and for taxpayers
 Regulators and politicians are subject to the principal-agent problem, meaning that they
may not have sufficient incentives to minimize the costs of deposit insurance to
taxpayers. As a result, regulators and politicians relaxed capital standards, removed
restrictions on holdings of risky assets, and relied on regulatory forbearance.

Chapter 12: Nonbank Finance

 Insurance
o Life insurance
o Property and casualty insurance
 Pension Funds
o Private
o Public (state and local government)
 Finance Companies
 Mutual Funds
o Stock and bond
o Money market
  Depository Institutions (Banks)
o Commercial banks
o S&L and mutual savings banks
o Credit unions
 Effective insurance management requires several practices, information collection and
screening of potential policyholders, risk-based premiums, restrictive provisions,
prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the
amount of insurance
 All these practices reduce moral hazard and adverse selection by making it harder for
policyholders to benefit from engaging in activities that increase the amount and
likelihood of calms.
 With smaller benefits available, the poor insurance risks (those who are more likely to
engage in the activities in the first place) see less benefit from the insurance and are thus
less likely to seek it out.

Chapter 13: Financial Derivatives

 Given the greater demand for risk reduction, the process of financial innovation described
came to the rescue by producing new financial instruments that help financial institution
managers manage risk better. These instruments, called financial derivatives, have
payoffs that are linked to previously issued securities and are extremely useful risk
reduction tools.
 Financial derivatives are so effective in reducing in reducing risk because they enable
financial institutions to hedge; that is engage in a financial transaction that reduces or
eliminates risk.
 Forward Contracts
o Forward contracts are agreements by two parties to engage in a financial
transaction at a future (forward) point in time.
o Forward contracts that are linked to debt instrument called interest-rate forward
contracts
o Dimensions
  Specification of the actual debt instrument that will be delivered at a future
date
 Amount of the debt instrument to be delivered
 Price (interest rate) on the debt instrument when it is delivered and
 Date on which delivery will take place
o Suffers from two problems
 It may be very hard for an institution to find another party (called
counterparty) to make the contract with.
 They are subject to default risk
 Future Contracts
o At the expiration date of a futures contract, the price of what contract is the same
as the price fo the underlying asset to be delivered.
 Options
o These are contracts that give the purchase the option or right to buy or sell the
underlying financial instrument at a specified price called the exercise price or
strike price within a specified period of time (the term to expiration)
o The owner or buyer of an option does not have to exercise the option, he or she
can let the option expire without using it.
o The owner of the option is not obligated to take any action, but rather has the right
to exercise the contract if he or she so choses.
o Because the right to buy or sell a financial instrument at a specified price has
value, the owner of an option is willing to pay an amount for it called a premium.
o Two types of options
 American options
 Can be exercised at any time up to the expiration date of the
contract
 European options
 Can be exercised only on the expiration date
o A call option is a contract that gives the owner the right to buy a financial
instrument at the exercise price within a specific period of time.
 o A put option is a contract that gives the owner the right to sell a financial
instrument at the exercise price within a specific period of time.

Chapter 14: Structure of Banks and Federal Reserve System

Chapter 17: Tools of Monetary Policy

 Market equilibrium (demand and supply for reserves)

 Open market operations

o An open market purchase causes the federal funds rate to fall, where as an open
market sale causes the federal funds rate to rise
o When the fed raises reserve requirements, the federal funds rate raises
o An open market operation (OMO) is an activity by a central bank to give (or
take) liquidity in its currency to (or from) a bank or a group of banks.
o The central bank can either buy or sell government bonds in the open market (this
is where the name was historically derived from) or, which is now mostly the
preferred solution, enter into a repo or secured lending transaction with a
commercial bank: the central bank gives the money as a deposit for a defined
period and synchronously takes an eligible asset as collateral.
o A central bank uses OMO as the primary means of implementing monetary
policy.
o The usual aim of open market operations is - asides from supplying commercial
banks with liquidity and sometimes taking surplus liquidity from commercial
banks - to manipulate the short-term interest rate and the supply of base money in
an economy, and thus indirectly control the total money supply, in
effect expanding money or contracting the money supply.
o This involves meeting the demand of base money at the target interest rate by
buying and selling government securities, or other financial instruments.
Monetary targets, such as inflation, interest rates, or exchange rates, are used to
guide this implementation
o When the central bank is interested in controlling inflation, it sells government
bonds to commercial banks and the public. Banks and the public pay the central
bank in return of the bonds and this reduces excess reserves which in turn reduces
the banks' ability to lend money, thereby decreasing money supply and increasing
interest rates.