1. Money & Banking
Week 1
1/24/2006

2. Function of Financial Markets
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3. Direct Finance: Financial Markets & Instruments
Debt (Fixed Income Securities)
Fixed cash flows (interest).
Principal to be repaid.
Default leads to bankruptcy.
Equity
Cash flows tied to profits (dividends).
No principal to be repaid.
Investors are residual claimants.

4. Financial engineering leads to …
Derivatives
Securities whose value derives from the value of an underlying asset, index, currency or commodity.
Asset-backed securities
Securities that are constructed from cash flows from assets such as mortgages.
A type of fixed income security.

5. Equity Markets
Exchanges
NYSE
AMEX
Over-the-counter
NASDAQ

6. Primary vs. secondary markets

7. Brokers vs. dealers

8. Dividend Valuation Model

9. Gordon Growth Model

10. Rational Expectations
Optimal forecasts (the best guess of the future) using all available information.
Application to inflationary expectations.
Relation to adaptive expectations.

11. Efficient Markets Hypothesis
“You can’t beat the market.”

12. Weak Form of EMH There are no repeating patterns in stock prices.
Technical analysis does not work.

13. Strong Form of EMH
All publicly available information is immediately incorporated into the price of the stock.
Fundamental analysis does not work.

14. Evidence in Favor of EMH
Performance of investment analysts and mutual funds.
Earnings announcements have no effect on stock prices.
Stock prices follow a “random walk.”

15. Evidence Against EMH “Anomalies”
Small-Firm Effect
January Effect
Market Overreaction
Excessive Volatility
Mean Reversion
New Information Slow to be Absorbed