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 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

Financial Markets and Intermediaries Firms Households and Institutional Investors 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.

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

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

Financing New Projects Averages for Source: Corbett and Jenkinson “How is Investment Financed?” The Manchester School Supplement, 1997, pp

Teaching Assistant Brian Aimes – – Office:TBA – Office Hours: TBA

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

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

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

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.

Exams and Grading Exams in Testing Center Grade: Homework assignments15% Quizzes 15% Exam 120% Exam 220% Exam 330% Exams are in general, cumulative

Understanding Interest Rates Mishkin, Chapter 4

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

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

Gross Returns Gross returns measure what you get back as a percentage 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

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

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?

Future Value In general: FV=P 0 (1+r) n – P 0 = 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)

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.

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

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

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.

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

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 = net return on investment of similar risk as payoff – pmt=coupons paid before end of each period (0)

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

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%

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 r A = the annual growth rate If I invest $1 in this account in two years I have

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