Final Flashcards
ch1: financial market 9s () finance
what does it do
- suppliers and demanders of funds interact
2. set prices for financial assets
4 financial organizations in financial market
financial market
savers (assets)
borrower’s IOU
intermediaries
4 functions of the financial system
- matches savers with borrowers
- liquidity (allow people to hold financial claims + increases liquidity by providing trading systems)
- information cost
- risk-sharing (diversity portfolios)
primary markets
- what does it trade
- enhance/create liquidity
- newly issued claims
- creates
- does not provide other services
secondary markets
1. enhance/create liquidity
- enhance liquidity; risk sharing, promoting liquidity and information
capital markets include () and ()
short-term instrument w/ m<1 is traded in ()
- auction market (competitive bidding)
- OTC (computerized & NASDAQ)
- MONEY MARKET
fin institutions
- how does it make money
- how does it enhance liquidity
- interest rate spread
2. checking accounts
fin. institutions
1. how does it make money
2. how does it enhance liquidity
- interest rate spread
2. checking accounts
ch2: what 5 criteria define money 1. common medium of exchange (4 criteria) 2. unit of account 3. store of value 4. the standard of deferred payment
what does money enable (specialization)
- acceptable + standard quality + durable + valuable relative to weight + divisible
what determines acceptability
- universal faith (fulfilling expectations)
what is inflation? (hyperinflation –> Zimb)
deflation?
- decrease in the purchasing power of money
2. increase in the purchasing power of money
payment system
1. definitive $
(physical goods + system)
- fiat money vs. legal tender
- checks
- setting and clearing transactions (electronic funds)
- money that does not have to be converted to a more basic medium of exchange
measuring the money supply
1. M1
- M2(best measure of money supply + increases more rapidly than M1)
- M3
- liquid assets (checkable deposits + cash + traveler’s checks)
- M1 + short-term investment account
CH3
IR must cover oppor.cost
- inflation
- default risk
- opportunity cost
yld (def)
- yield = PV of return == PV today
when YTM < Coupon
premium
when YTM = couplon
par
YTM > coupon
discount
capital gain/ loss formula
FV - P
current yld
- C/P move in the same direction as YLD
C/P
increase in P, decrease in CY
F = P –> capital gain/ loss = () –> coupon rate = () –> current yld =()
- 0, current yld, ytm
F<p> capital () –> coupon rate () current yild )_ ytm</p>
loss, >, >
F>P –> capital() –> coupon rate () current yld () YTM
gain,
the longer the time until a bond matures, the () the potential price change caused by a change in YTM
GREATER
the negative impact of a () in i on P increases with n
rise
TIPS
pays () a year at a fixed rate
offers low return
TIPS
pays () a year at a fixed rate
offers a low return
Jeremy Siegal
- why are TIPS bad investment
- when are TIPS an awful investment
- when inflation is high
- according to the Fisher equation, inflation can be a sign of economic growth –> increase in real rate –> decrease in PV of TIPS
how does the treasury benefit from issuing TIPS
- avoid having to pay inflation risk premium
2. provide useful reading of interest rates
drawbacks of tips
- difficulty adjusting to a new asset class
- low liquidity
- supply trends
drawbacks of tips
- difficulty adjusting to a new asset class
- low liquidity
- supply trends
pros of strips
- no periodic cost
2. match information
5 determinants of portfolio choice
- wealth
- exp. return
- liquidity
- risk
- cost to acquire information
for every p that clears the () market, there is an equivalent () that clears the () market
- demand in B == () in LF
- Supply in B == () in LF
- bond, i, loanable funds
5 factors that affect D in Bond mkt and S in LF mkt
- wealth (w increases, Db & Slf shifts out)
- expected return & exp. inflation (increase in expected inflation and return cause Db and Slf to shift in
- risk
- liquidity
- information cost
4 factors that affect the supply of bonds and demands of loanable funds
- exp profitability (increase in prof. increase in supply of bonds / demand of lf)
- business taxes (same as profitability)
- expected inflation (high expected inflation means low real interest rate in borrowing –> supply of bonds and demand of lf shifts out)
- government borrowing (increased deficit –> more savings –> shifts supply of bonds out
why are interest rates low during recession
- in the beginning of a recession –> the demand of bonds shifts () because economic activities are reduced.
- meanwhile, the supply of the bonds also fall because shrinking business activities
- ultimately the second effect would be > the first effect, causing interest rate to fall
- in
2. snow ball effect
what happens to the loanable funds and bond mkts when expected inflation is high
- demand of bonds falls
- supply of bonds increases
- interest rate increases
pros of strips
people who buy strips are (receive certain amount at a specific date, not concerned about receiving current income, do not want to worry about finding an appropriate reinvestment opportunity)
- a promise at a certain date with reduced purchase price
2. provide safety of principal
cons of securities
- interest rate risk (only gains and losses if strips are sold before maturity)
2 .less liquid - inflation risk
the negative impact of a rise in i on p increases with n, because()
- the change in present value is larger and further out into the future
explain why increased liquidity premium would precede a recession
- before recession –> economic activities slow down (less investment etc) –> higher default risk -> less demand for bonds –> lower Pbonds & higher i
- people demand treasury bonds –> increase Dt-bills –> higher Pbills & lower i
- premium = bondi - t-bill i > than before
risk structure () maturity with differences in () factors
- same
2. liquidity, risk, info cost, tax
term structure (only for government bonds) ()maturity with () factors
- different
2. same
interest carry trade strategy and difficulty
- expectation theory suggests that interest carry trade is not an ordinary road to riches
1. institutional investors can do this (i.e borrow at 1% and invest at 3%; however if expectation theory is applied, the short-term interest rate would rise. By the time the bond is matured, all profits are wiped out + interest rate risk )
- the gap between the interest rate and the rate you can borrow can be small or negative
reasons why yield curve is a good forecasting tool
- predictive ability + supplement models
- quick and simple
- takes future and current monetary policy into account
the required return on equity (Re)
- expected return necessary to compensate for the risk of investing in stocks
assumptions of GGM
- receive dividend during the same period
- dividend is constant
- Re > g
adaptive expectations vs. rational
- make expectations based on past events
under rational expectation, the expectation of an asset’s future price = optimal price forecast, Pf
the random error still exists
EMH
1. Under EMH, how does a price forecast translate into prices
- equilibrium price of an asset = optimal forecast of its fundamental value
- Self-interests drive the price to reach its fundamental value (Microsoft & 50 per share)
adverse selection
- in bond market
- in stock market
- higher interest rate attract high default risk borrowers –> credit rationings
- lemon problem ( the cost of equity financing is higher)
moral hazard
- in bond market
- in stock market
- high-risk investments by managers because they can keep the additional profit (restrictive covenants = solution)
- principal agent problem (publication of financial statements = solution)
moral hazard
- in bond market
- in stock market
- high-risk investments by managers because they can keep the additional profit (restrictive covenants = solution)
- principal agent problem (publication of financial statements = solution)
securitization
- higher liquidity
- spreading risk
- specialization
- involves the process of a sale of loans by the lender to a new agency who later sell the securities to investors. Putting smaller loans into standard debt and sell them to investors
