FINANCE 305. Financial Markets, Institutions, and Economic Activity Fall 2010

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1 FINANCE 305 Financial Markets, Institutions, and Economic Activity Fall 2010 Course Aims and Objective The objective of this course is to provide students with a better understanding of the financial system and economic environment in which financial management and investment decisions are made. Topics covered include: money and the financial system; financial stability; the regulation of the banking system; money creation and the role of the Federal Reserve; Keynesian theories of aggregate demand and interest rates; New Classical theories of the business cycle; Financial aspects of business cycles; Optimal financial contracting; and Cross country comparisons of law and corporate governance. The course will consider the role of the stock market in shaping the operating decisions (e.g. pricing, production and investment decisions) and financing decisions (e.g. gearing and dividend payout rates) of firms. The course material is fundamental to an understanding of a number of important economic events that have received high media coverage. For example, it should help the student understand the causes, nature and significance of recent financial crises and how they affect the real economy. It should also help the student to evaluate the effectiveness of monetary policy in combating financial crises, inflation, and unemployment. Current events are an extremely important part of the course and students will be expected to read newspapers such as the Financial Times of London or the Wall Street Journal. This will be useful both for exams and the class assignments. Except where noted all reading assignments are in the packet entitled READINGS FOR FINANCE 305 available for purchase in the Business School Copy Center. Class Project The project will consist of formulating a bid for the 13 week and 26 week Treasury bills that are auctioned every Monday throughout the year. Each student will individually write a not more than 3 page (not counting data, appendices, or graphs) double-spaced paper summarizing the logic of their bid, and what they think will happen to short-term interest rates for the remainder of the semester. Your paper must include the following forecasts for both the 13 and 26 week Treasury bills. 1. Discount rates on these two bills for the Monday auction. 2. Price of 13 and 26 week T-bills for the Monday auction. 3. Investment rate for these two bills for the Monday auction. 4. Estimate of the 13 week interest rate for the Monday auction on December 8. The paper is due Thursday, November 12 in class and all estimates will pertain to the auction of Monday, November 16. Papers submitted after November 12 lose 15 points (out of a possible 50 points). This project is designed to evaluate how resourceful you are in carrying out an

2 assignment. Neither I nor the TA will tell you how to make a forecast of these two T-Bill rates. Through your readings of the Financial Times or Wall Street Journal you should be following movements in short-term interest rates, monetary and fiscal policies, and the general economy on a daily basis throughout the semester in order that you get a feel for the supply of and demand for T-bills at the time of the November 16 auction. Formulas that must be used in calculating your answers to (2) and (3) above are as follows. 1. Price based on auction rate for 13-weeks T-Bills R 13 = Rate you forecast for the 13 week T-Bill Price based on auction rate for 26 week T-Bills R 26 = Rate you forecast for the 26 week T-Bill 2. Coupon equivalent (or, investment rate) for 13-week and 26-week T-Bills.

3 This paper must be turned in at the Thursday lecture BEFORE the Monday auction. Auction results can by going to Google typing in Recent Bill Auction Results.

4 Course Outline Course Organizer: Mr. Robert E. Krainer Lecturer: Mr. Robert E. Krainer The Financial System Week 1 I. Financial Institutions A. The Role and Importance of Financial Institutions in the Economy Fabozzi, F. and Modigliani, F Capital Markets: Institutions and Instruments. Englewood Cliffs: Prentice-Hall. Chapter 1, pp.3-33 in Readings. Mishkin, F. and S. Eakins, Financial Markets and Institutions. Reading MA: Addison- Wesley. Chapter 2, pp in Readings. Hoggarth, G., R. Reis, and V. Saporta. Cost of Banking System Instability: Some Empirical Evidence. Bank of England Working Paper, 2001, pp in Readings. B. Banking in the United States Weeks 2-3 Modern Money Mechanics. Federal Reserve Bank of Chicago On reserve in the Business School library. C. The Regulation of Banking Week 4-4 ½ Barth, J., Nolle D. and Rice T Commercial Banking Structure, Regulation and Performance: An International Comparison. Economics Working Paper 97-6, Office of the Comptroller of the Currency, pp in Readings.

5 Barth, J., G. Caprio, and R. Levine The Regulation and Supervision of Banks Around the World. Mimo. Optional reading. On reserve in the Business School Library. Krainer, R Banking in a Theory of the Business Cycle: A Model and Critique of the Basle Accord on Risk-Based Capital Requirements for Banks. International Review of Law and Economics 21, pp , pp in Readings. II. Macroeconomic Theory A. Keynesian Demand Models Weeks 4 ½ - 6 Blanchard, O Macroeconomics. Upper Saddle River, New Jersey. Prentice Hall. Chapters 3-6, pp in Readings. B. New Classical Supply Models Weeks 7-9 Sheffrin, S Inflation and Unemployment in Rational Expectations. Cambridge. Cambridge University Press, pp in Readings. Lucas, R Understanding Business Cycles in Stabilization of the Domestic and International Economy edited by K. Brunner and A. Meltzer. Carnegie-Rochester Conference Series on Public Policy. New York, North-Holland pp. 7-29, pp in Readings. III. Finance and the Economy Weeks A. Theory, Empirical Evidence, and Policy

6 Krainer, R A Theory of Supply Adjustment Over the Business Cycle Chapter 2 in Corporate Finance, Governance, and Business Cycles: Theory and International Comparisons, Amsterdam: North-Holland, pp in Readings. Krainer, R Portfolio and Financing Adjustments for U.S. Banks: Some Empirical Evidence. Journal of Financial Stability, pp in Readings. Krainer, R A Program for Financial Stability. Mimo, pp in Readings. B. Financial Contracting Smith, C. & Warner, J On Financial Contracting: An analysis of Bond Covenants. Journal of Financial Economics, 7, pp , pp in Readings. Krainer, R Financial Contracting and Supply Adjustments, in Finance in a Theory of the Business Cycle. Oxford: Blackwell, pp in Readings. Krainer, R A Contribution to the Theory and Practice of Rational Financial Contracting. Mimo, pp in Readings. C. Cross Country Comparisons of Law and Corporate Governance Franks, J. & Mayer, C Ownership and Control. Mimo. On reserve in the Business School library. Krainer, R Corporate Governance and Business Cycles in the G-7 Countries. Mimo. On reserve in the Business School library. Shleifer A. & Vishny R A Survey of Corporate Governance. Journal of Finance 52, pp , pp in Readings. LaPorta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny Law and Finance. Journal of Political Economy, 106, pp , pp in Readings. IV. Special Topics (if time allows) Weeks 15 Whatever is topical.

7 Course Grading Midterm Final Treasury Auction Paper Course reflections/homework 100 points 100 points 50 points 30 points Course reflections and homework are short type- written assignments (of no more than two double-spaced pages in length) designed to give you some idea of the type of exam questions used in this course. Assignments must be turned in on the due date unless the student is absent on official University business. Those not turned in on the due date will receive 0 points. No make-up will be available. These assignments (except for mathematical equations or T-Accounts) must be typed. The dates for these assignments are the following. 1. October 1. How does a financial crisis turn into a recession? 2. October 15. Practice numerical exam question to be handed out in class on October 13. Dates of Exams First Exam Final Exam October 22, at 5:30-7:00 PM. Place to be announced. December 18 at 12:25-2:25 PM. Place to be announced. The final exam will not be cumulative for those who took the first exam. Students missing the first exam will be required to take a final exam that covers the entire course. All exams are open book and open notes. No computers can be used in the exams. Office: 3110 Grainger Office hours: Tuesday and Thursday 11:00-11:45 and any time my door is open.