money and banking manec 453 acc 453 fall 2007 brian boyer

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Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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Page 1: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Money and Banking

ManEc 453

Acc 453

Fall 2007

Brian Boyer

Page 2: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

What is Money and Banking?INTEREST RATES:

Factors that influence Interest ratesThe Term Structure of Interest ratesDefault RiskForeign Exchange Rates and Purchasing Power parity

RISK MANAGEMENT Duration and Gap AnalysisFuturesOptionsSwaps and Credit Derivatives

FEDERAL RESERVE AND MONETARY POLICYThe Keynsian and Monetariast ViewsStructure of the Federal ReserveBen Bernanke and the Fed Today

Page 3: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Financial Markets and Intermediaries

Firms

Households and Institutional Investors

Goodsand

Services

Primary MarketSecondary 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.

Page 4: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 5: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Direct vs. Indirect Finance

Source: Financial Structure and Economic Growth: Data Disk, MIT

Page 6: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Financing New Projects

Averages for 1970-1994Source: Corbett and Jenkinson “How is Investment Financed?” The Manchester SchoolSupplement, 1997, pp. 69-93

Page 7: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Teaching Assistant

Brian Aimes– Email: [email protected] – Office: TBA– Office Hours: TBA

Page 8: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 9: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

What have your heard about money and banking (ManEc 453)?

What do you hope to get out of money and banking this semester?

Page 10: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 11: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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.

Page 12: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Exams and Grading

Exams in Testing Center

Grade:

Homework assignments15% Quizzes 15% Exam 1 20% Exam 2 20% Exam 3 30%

Exams are in general, cumulative

Page 13: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Understanding Interest Rates

Mishkin, Chapter 4

Page 14: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 15: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 16: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 17: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Net Returns

Net returns are growth rates.

Net returns are simply payoff/price - 1

Net return from buying Cisco:– 110/100 - 1 = 10%– Or 10/100 = 10%– Your investment grows by 10%.

Net returns above 0 are good Net returns below 0 are bad

Page 18: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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?

10505.1100

25.11005.110005.1105 2

76.11505.110005.125.110 3

Page 19: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Future Value In general: FV=P0(1+r)n

– P0= 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)

Page 20: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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.

Page 21: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

2)045.1(X

100)045.1( 2 X

Page 22: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Present Value

Doing some algebra

91.57 is the “present value” of the cash flow from choice #2

57.91)045.1(

100

100)045.1(

2

2

X

X

Page 23: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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.

Page 24: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

2)08.1(X

73.85)08.1/(100,100)08.1( 22 XX

Page 25: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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)

0 (1 )n

FVP

r

Page 26: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

Page 27: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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%

1268.101.11 12

%68.1211

1268.1

Page 28: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

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

24.1)1(1 2 Ar

Page 29: Money and Banking ManEc 453 Acc 453 Fall 2007 Brian Boyer

Growth Rates and Time

Solving for rA gives us

A two-year growth rate of 24% is equivalent to an annual growth rate of 11.35%

24.1)1(1 2 Ar

%35.111)24.1(

)24.1()1(2/1

2/1

A

A

r

r