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Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer. What is Money and Banking?. INTEREST RATES: Factors that influence Interest rates The Term Structure of Interest rates Default Risk Foreign Exchange Rates and Purchasing Power parity RISK MANAGEMENT Duration and Gap Analysis

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Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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  1. Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

  2. What is Money and Banking? • INTEREST RATES: • Factors that influence Interest rates • The Term Structure of Interest rates • Default Risk • Foreign Exchange Rates and Purchasing Power parity • RISK MANAGEMENT • Duration and Gap Analysis • Futures • Options • Swaps and Credit Derivatives • FEDERAL RESERVE AND MONETARY POLICY • The Keynsian and Monetariast Views • Structure of the Federal Reserve • Ben Bernanke and the Fed Today

  3. Financial Markets and Intermediaries Households and Institutional Investors Firms Goods and Services Primary Market Secondary Market Primary Market: A financial market in which new issues of a security are sold to initial buyers. Secondary Market: A financial market securities that have been previously issued can be resold.

  4. Financial Markets • Financial Intermediary • Institutions that help channel funds from people who have saved to those who need capital. • Direct Finance • Borrowers sell securities to lenders in financial markets. • Indirect Finance • A bank borrows money from lenders and loans it to borrowers

  5. Direct vs. Indirect Finance Source: Financial Structure and Economic Growth: Data Disk, MIT

  6. Financing New Projects Averages for 1970-1994 Source: Corbett and Jenkinson “How is Investment Financed?” The Manchester School Supplement, 1997, pp. 69-93

  7. Teaching Assistant • Brian Aimes • Email: brianames139@hotmail.com • Office: TBA • Office Hours: TBA

  8. My History • Grew up in Central California • BYU after high school • Mission in Sao Paulo Brazil • Undergrad at BYU (economics) • Federal Reserve in D.C. (two years) • PhD at University of Michigan • Married with three children

  9. What have your heard about money and banking (ManEc 453)? • What do you hope to get out of money and banking this semester?

  10. Course Materials • You are not required to buy a text for this course • Readings are posted on course reserve (electronically) from four texts • The Economics of Money Banking and Financial Markets, Mishkin, 8th ed • Money, Banking, and Financial Markets, Cecchetti • Essentials of Investments, Bodie, Kane, and Marcus 6th ed • Options, Futures, and Other Derivatives, Hull, 6th ed • Hard Copies of these texts will also be placed in the reserve library • The course schedule specifies which readings are required for each lecture. • You will need a financial calculator

  11. Workload and Class Structure • Do assigned reading • Expectation: 6 hours per week of outside work • Homework due every class period. • Quizes every Wednesday. • Wall Street Journal reading assignments • Tour of class web page.

  12. Exams and Grading • Exams in Testing Center • Grade: • Homework assignments 15% • Quizzes 15% • Exam 1 20% • Exam 2 20% • Exam 3 30% • Exams are in general, cumulative

  13. Understanding Interest Rates Mishkin, Chapter 4

  14. Measuring Performance: Price, Payoff, and Return • 1 Share of Cisco Stock • You buy it now for $100 • In three months you sell it for $110 • 1 Share of Apache Stock • You buy it now for $200 • In three months you sell it for $215 • What is the correct “measuring stick?” • Payoff • Profit • Return

  15. Returns • Returns are the “growth rate” of your investment • Investment in Cisco “grew” by 10% (110/100-1) • Investment in Apache “grew” by 7.5% • Instead of buying Apache for $200 buy two shares of Cisco for the same price • Profit is $20

  16. Gross Returns • Gross returns measure what you get back as apercentage of the initial price. • Gross returns are simply payoff/price • Gross return from buying Cisco: • 110/100 = 110% • By investing in Cisco, you get back 110% of what you initially invested. • Gross returns above 100% are good • Gross returns below 100% are bad

  17. Net Returns • Net returns are growth rates. • Net returns are simply payoff/price - 1 • Net return from buying Cisco: • 110/100 - 1 = 10% • Or 10/100 = 10% • Your investment grows by 10%. • Net returns above 0 are good • Net returns below 0 are bad

  18. Growth rates and Future Value • Example: • Investment with net return of 5% per year. • Initial Investment: $100 • After first year, what is the value of investment? • After second year, what is the value of investment? • After third year, what is the value of investment?

  19. Future Value • In general: FV=P0(1+r)n • P0= initial principal invested • r = net return on investment • N = number of time periods • Financial Calculator • N=number of time periods • PV = -initial principal (remember “-” sign) • r = net return on investment • pmt=coupons paid before end of each period (0)

  20. Present Value • Suppose you are given the choice of two flows • Choice #1: Receive $X now • Choice #2: Receive $100 two years from now • The present value of the cash flow from choice #2 is the amount, $X, that would make you indifferent between the two choices.

  21. Present Value • Case #1: • Suppose the cash flow from choice #2 is risk free • Risk-free accounts pay a net return of 4.5% per year • If you get $X now, you can invest it risk free and in two years get • For you to be indifferent between the two choices

  22. Present Value • Doing some algebra • 91.57 is the “present value” of the cash flow from choice #2

  23. Present Value • Case #2 • What if the cash flow from investment #2 is not risk-free? That is, on average you expect to get paid $100, but it could be more or less. • Choice #1: Receive $X now • Choice #2: Receive $100 two years from now with some uncertainty.

  24. Present Value • Suppose an account exists with “similar risk” as choice #2 that pays an interest rate of 8% • Must be higher than 4.5% (risk-free rate) because of additional risk. • If you get $X now, you can invest it in the account and in two years and get • For you to be indifferent between the two choices

  25. Present Value • In general: • FV= payoff at the end of year n • r = return on investment of similar risk as FV • N = number of time periods until money is received • Financial Calculator • N=number of time periods • FV=payoff • r = netreturn on investment of similar risk as payoff • pmt=coupons paid before end of each period (0)

  26. Growth Rates and Time • Net returns (growth rates) are attached to a unit of time. • How can we transform growth rates to different units of time? • Example: • Account pays 1% per month • What is the growth rate per year? • Hint: the answer is not 12%! • Reason: we earn interest on interest

  27. Growth Rates and Time • If I invest $1 in this account the money has grown to • Over one year, the net return is • A monthly growth rate of 1% is equivalent to an annual growth rate of 12.68%

  28. Growth Rates and Time • Example: • Account pays 24% per 2 years • What is the growth rate per year? • Hint: the answer is not 12%! • Let rA = the annual growth rate • If I invest $1 in this account in two years I have

  29. Growth Rates and Time • Solving for rA gives us • A two-year growth rate of 24% is equivalent to an annual growth rate of 11.35%

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