ECOS2004 MONEY AND BANKING LECTURE SUMMARIES

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1 ECOS2004 MONEY AND BANKING LECTURE SUMMARIES TABLE OF CONTENTS WEEK TOPICS 1 Chapter 1: Why Study Money, Banking, and Financial Markets? Chapter 2: An Overview of the Financial System 2 Chapter 3: What is Money? Chapter 4: The Meaning of Interest Rates 3 Chapter 5: The Behaviour of Interest Rates + Interest Rates: The Modern Central Banking View 4 Chapter 6: The Risk and Term Structure of Interest Rates Chapter 9: Banking and the Management of Financial Institutions 5 The Conduct and Strategy of Monetary Policy (1): The Adoption of Inflation Targets (2): Issues in Inflation Targeting 6 Mid Term 1 7 The Global Financial Crisis (1): Causes and Transmission of the Crisis (2): Economic Effects and Regulatory Response 8 The Current Policy Environment: Global 9 The Current Monetary Policy Environment: Australia 10 Mid Term 2 11 The Murray Inquiry into the Australian Financial System 12 Central Banks and Financial Stability Policy 13 Wrap-Up Lecture

2 WEEK 1 Chapter 1: Why Study Money, Banking, and Financial Markets? Chapter 2: An Overview of the Financial System Financial markets: Markets in which funds are transferred from people and firms who have an excess of available funds to people and firms who have a need of funds - Promotes efficiency by producing an efficient allocation of capital, which increases production - Directly improve the well-being of consumers by allowing them to schedule purchases better Security: Claim on issuer s future income or assets Bond: Debt security that promises to make payments periodically for specified period of time. Principal returned to lender at maturity Interest Rate: Cost of borrowing or price of credit Stock (Equity): Share of ownership in a corporation Share of Stock: Claim on net earnings and assets of corporation Financial Intermediaries: Institutions that borrow funds from people who have saved and in turn make loans to other people - E.g. Banks Accept deposits and make loans, Insurance companies Financial Innovation: Development of new financial products and services Financial Crises: Major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures (or government rescues) of many financial and nonfinancial firms Aggregate Price Level: Average price of goods and services in an economy Inflation: Sustained rise in price level - Inflation Rate: Percentage increase in aggregate price level Monetary Policy: Management of interest rates and the central bank balance sheet - Conducted by Fed in US, RBA in Aus Fiscal Policy: Government spending and taxation - Budget Surplus: Revenues > Expenditures - Budget Deficit: Expenditures > Revenues - Any deficit must be financed by borrowing or money creation Foreign Exchange Market: Funds converted from one currency into another Foreign Exchange Rate: Price of one currency in terms of another currency - In a floating rate system, the market determines the foreign exchange rate Gross Domestic Product (GDP): Market value of all final goods and services produced in a country during the course of a year - Most commonly reported measure of aggregate output - E.g. Total of aggregate income, total income of factors of production Nominal Variable: Any variable whose scale is proportional to the general price level - E.g. CPI, nominal interest rate, nominal GDP, money supply Real Variable: Any variable whose scale does not depend on the general price level - E.g. Real interest rate, real GDP, quantity of output Direct Finance: Borrowers borrow funds directly from lenders in financial markets by selling them securities Indirect Finance: Intermediary such as a bank stands between the borrower and lender

3 Debt and Equity Markets - Debt instruments (maturity) - Equities (dividends) Primary and Secondary Markets - Investment banks underwrite securities in primary markets - Brokers and dealers work in secondary markets Exchanges and Over-the-Counter Markets - Exchanges: Market with formal location, i.e. Stock exchange - OTC Markets: Dealers decentralized and linked electronically, i.e. Foreign exchange Money and Capital Markets - Money Markets: Deal in short-term debt instruments - Capital Markets: Deal in longer-term debt and equity instruments Function of Financial Intermediaries - Lower Transaction Costs: Economies of scale, liquidity services - Reduce exposure of investors to risk: Risk sharing, asset transformation, diversification - Dealing with adverse selection: Avoiding the risky borrower by gathering information about them - Dealing with moral hazard: Ensuring borrower will not engage in activities that will prevent him/her from repaying the loan - Allows small savers and borrowers to benefit from the presence of financial markets Regulation of Financial System - Increase information available to investors - Reduce adverse selection and moral hazard problems - Reduce insider trading and related violations - Ensure soundness of financial intermediaries: Restrictions on entry, assets and activities, deposit insurance to avoid bank runs, limits on competition Regulation of Australian Financial System - Council of Financial Regulators: Coordinating body for Australia s main financial regulatory agencies - Comprises RBA, APRA etc. - Discuss regulatory issues and coordinate responses to potential threats to financial stability Australia Prudential Regulation Authority (APRA): Prudential regulator of banks, insurance companies and superannuation funds, credit unions, building societies in Australia Australia Securities and Investments Commission: Australia s corporate markets and financial services regulator

4 WEEK 2 Chapter 3: What is Money? Chapter 4: The Meaning of Interest Rates Money/Money Supply/Money Stock: Anything that is generally accepted as payment for goods or services or in the repayment of debts Stock: A unit measured at a point in time Flow: A unit expressed per unit of time Wealth: The total set of assets (i.e. property, money, securities) that serve to store value stock Income: Flow of earnings per unit of time flow Functions of Money 1. Medium of Exchange - Eliminates the trouble of finding a double coincidence of wants (reduces transaction costs) - Promotes specialization in production/labour services - Requirements: Easily standardized, widely accepted, divisible, portable, durable 2. Unit of Account - Used to measure value in the economy - Reduces transaction costs 3. Store of Value - Used to save purchasing power over time - Money is the most liquid of all assets; a dollar of any type of money can be reliably converted into a dollar of currency at any time - Money thus, has fixed nominal value, but loses real value during periods of inflation Payment System 1. Commodity Money: Valuable, easily standardized and divisible commodities 2. Fiat Money: Paper money decreed by governments as legal tender 3. Cheques: Instruction to your bank to transfer money from your deposit account 4. Electronic Payment: Online bill payment, electronic deposit transfers, etc. 5. E-Money: Debit cards, stored-value cards, etc. Measuring Money: U.S Definitions 1. M1 (most liquid assets) = Currency + Traveller s checks + Demand deposits + Other checkable deposits 2. M2 = M1 + Small-denomination time deposits + Savings deposits and money market deposit accounts + Money market mutual fund shares Measuring Money: Australian Definitions 1. Currency: Notes and coins held by non-bank public 2. M1: Currency + Current deposits (transferable deposits) with commercial banks 3. M3: Currency + All bank deposits 4. Broad Money: M3 + Deposits with non-bank depository institutions Present Value: A dollar paid to you one year from now is less valuable than a dollar paid to you today - A dollar deposit today can earn interest and become $1 x (1 + i) one year from today - In not having access to $1 today, you are constraining your opportunities to spend in the next year - E.g. Let i = 10% - In one year: $100 x (100% + 10%) = $110 - In two years: $110 x (100% + 10%) = $121 - In n years: $100 x (1 + i) n

5 Present Value Formula - PV: Today s present value - CF: Future cash flow payment - i: Interest rate - PV = CF / (1 + i) n Credit Market Instruments 1. Simple loan 2. Fixed-payment loan 3. Coupon bond 4. Discount bond (Zero coupon bond) Yield to Maturity: The interest rate that equates the present value of the total cash flow payments received from a debt instrument with its value today Yield to Maturity Simple Loan PV = amount borrowed = $100 CF = cash flow in one year = $110 n = number of years = 1 $100 = $110 (1 + i ) (1 + i) $100 = $110 $110 (1 + i) = $100 i = 0.10 = 10% For simple loans, the simple interest rate equals the yield to maturity 1 Yield to Maturity Fixed payment Loan The same cash flow payment every period throughout the life of the loan LV = loan value FP = fixed yearly payment n = number of years until maturity FP FP FP FP LV = i i i i (1 + ) (1 + ) (1 + ) n Yield to Maturity Coupon Bond Using the same strategy used for the fixed-payment loan: P = price of coupon bond C = yearly coupon payment F = face value of the bond n = years to maturity date C C C C F P = n 1+ i (1+ i) (1+ i) (1+ i) (1 +) n i - When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate - Price of coupon bond and yield to maturity are negatively related - Yield to maturity > Coupon rate, when Bond price < Face value

6 Consol/Perpetuity: A bond with no maturity date; does not repay principal but pays fixed coupon payments forever - P c : Price of consol - C: Yearly interest payment - i c : Yield to maturity of consol - i c = C / P c Yield to Maturity Discount Bond (Zero-Coupon Bond) For any one year discount bond i = F - P P F = Face value of the discount bond P = current price of the discount bond The yield to maturity equals the increase in price over the year divided by the initial price. As with a coupon bond, the yield to maturity is negatively related to the current bond price. Rate of Return The payments to the owner plus the change in value expressed as a fraction of the purchase price RET = C + P - +1 t RET = return from holding the bond from time t to time t + 1 = price of bond at time t +1 = price of the bond at time t + 1 C = coupon payment C = current yield = i c +1 - = rate of capital gain = g Distinction between Interest Rates and Returns - Returns = Yield to maturity, only if the Holding period = Time to maturity - A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period - The more distant a bond s maturity, the greater the size of the percentage price change associated with an interest rate change. - The more distant a bond s maturity, the more negative is the rate of return that arises from an increase in the market interest rate - The more years until a bond matures, the more years its initial interest rate is low in relation to the market rate, and so the lower is the price that new buyers will be willing to pay for that bond - Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rises - The yield and price of a bond today depends on the expected yield and price tomorrow Maturity and Volatility of Bond Returns (Interest Rate Risk) - Prices and returns for long-term bonds are therefore more volatile than those for shorter-term bonds - There is no interest-rate risk for any bond whose time to maturity matches the holding period

International Finance

International Finance FINA 5331 Lecture 2: U.S. Financial System William J. Crowder Ph.D. Financial Markets Financial markets are markets in which funds are transferred from people and Firms who have an