1 Money and Banking Introduction

Week 1 Learning Goals By the end of the week, you should … Be familiar with the different types of financial instruments and markets Be aware of the different types businesses that make up the financial system Be able to distinguish between direct and indirect finance Understand the reason for regulation in the financial system Be able to distinguish between monetary and fiscal policy 2

3 Financial Instruments Legal contracts specifying the payment of cash flows

4 Some Distinctions Primary vs. secondary markets Exchanges vs. over-the-counter markets Money markets vs. capital markets

5 Exchanges: Single Location Larger older companies trade on New York Stock Exchange.

6 OTC (over the counter) markets: organized networks of dealers Newer and small companies trade on NASDAQ National Association of Securities Dealers Automated Quotation System

7 1. Fixed Income Securities (Bonds) Corporate Municipal Treasury Which ones have the highest and lowest yields?

2. Equities (Stocks) Represents ownership with limited liability 8

9 Dow Jones Industrial Average

NASDAQ 10

11 Debt (bonds) Fixed cash flows (interest). Principal to be repaid. Default leads to bankruptcy. Equity (stock) Cash flows tied to profits (dividends). No principal to be repaid. Investors are residual claimants.

12 3. Money market instruments Less than a year in maturity. Low risk. High denomination. Examples: Treasury bills, commercial paper, bankers acceptances, repurchase agreements.

4. Derivatives a)Futures/forwards b)Options c)Swaps By combining these building blocks, an endless number of complex derivatives can be created. 13

14 Eurodollar Futures trading at Chicago Mercantile Exchange

15 In sum … Four Major Financial Instruments Bonds (debt, fixed income securities) Stock (equities) Money market instruments Derivatives

16 Why do we need a financial system? Coordination problem facing savers and businesses requiring capital. Transactions costs.

17 Financial Intermediaries (Indirect Finance) Depository institutions Contractual savings institutions (insurance companies, pension funds) Investment intermediaries (finance companies, mutual funds)

Indirect finance characterized by asset transformation Liquidity transformation Maturity transformation 18

19 Broker-Dealers (Direct Finance) Sell and buy securities on behalf of clients (brokers) Sell and buy for firm’s own account (dealers) Issuing securities for corporations (investment banking)

“Wall Street” Broker-dealers (e.g., Goldman Sachs) Private equity firms (e.g., Blackstone) Hedge funds (e.g., Bridgewater) 20

Private Equity : Corporate Raider Rebranded 21

22 Function of Financial Markets...

Problems in Financial Markets 1. Asymmetric information Adverse selection Moral hazard 2. Instability of indirect finance 23

Government’s role in financial markets Force disclosure – to deal with problem of asymmetric information Lender of last resort – to deal with instability of indirect finance Monetary policy—to keep system on an even keel 24

Fiscal vs. Monetary Policy Fiscal Policy Taxing & spending. Borrow if spending exceeds tax revenue. Responsibility of the Treasury. Monetary Policy Affecting money supply and interest rates. Responsibility of central bank—the Federal Reserve. 25

26 Fed funds rate: rate of interest that large banks charge one another for short-term loans. Transactions flow through their accounts at the Fed— hence the term. Determined by supply and demand. Discount rate: rate of interest that the Fed charges banks for short-term loans. Set 1% above Fed funds target Fed funds versus the discount rate