Finc 381 Study Notes PDF

LECTURE 01 // MONEY Chapter 1 -​ Definition of cash and the 3 parts -​ Fiat money -​ What is money of aggregate money -​ Do not need to remember small bullet points under M1 but know M1 = currency + demand deposits -​ Inflation and how to calculate Money: anything this is gene...

LECTURE 01 // MONEY Chapter 1 -​ Definition of cash and the 3 parts -​ Fiat money -​ What is money of aggregate money -​ Do not need to remember small bullet points under M1 but know M1 = currency + demand deposits -​ Inflation and how to calculate Money: anything this is generally accepted as payment for goods and services or repayment of debts -​ 3 roles 1.​ Medium of exchange (vs trade or barter) 2.​ Unit of account (measurements) 3.​ Store of value (can be stored and used at later time) Fiat money = government issued currency not backed by a metal or tangible asset -​ checks all 3 roles of money off Checkable deposits = bank transfers Is this money? -​ Salvadoran colon → yes but not widely used -​ USD → yes but not widely used -​ Wealth → not the same concept -​ Bitcoin →not yet, volatile value and therefore low acceptance for payment -​ Central bank digital currency → not yet Money Aggregate = broad categories used to measure circulation of money -​ Allows better understanding of liquidity, inflation, etc -​ M0 → M1 → M2 → M3 (narrow money to broad money) The Fed measures the US money supply from narrower to broader definitions -​ more liquid → less liquid, narrow money to broad money (M0 → M1 → M2 → M3) -​ Loose control over M1 money supply Narrow M1 = currency + deposits Supply = The Fed has loose control over M1 money supply Demand = convenience vs return on other assets Inflation: rate of increase in economy-wide prices over a given period Deflation: rate of decrease in economy-wide prices over a given period Disinflation: deceleration in the rate of inflation Consumer Price Index (CPI) is most widely used measure of inflation -​ Measured annually -​ Measures changes in price of a fixed basket of representative consumer goods Inflation based on CPI is realized, backward looking measure Breakeven inflation: market-based measure of expected inflation ​ ​ = Treasury rate - TIPS rate Price distortions = -​ distortions to consumption/savings/investments -​ erosion of fixed incomes/nominal wages/purchasing power -​ redistribution from savers to borrowers -​ hyperinflation (rates >50% per MONTH) -​ Byproduct of political actions Computing inflation: 1.​ Choose aggregate price level = CPI 2.​ (current price - previous price) / (previous price level) 3.​ Multiply by 100 → % LECTURE 02 // FINANCIAL SYSTEM Chapter 2 -​ Flow of funds chart -​ Review graph -​ Debt vs equity -​ Bond vs shares -​ Maturity threshold = 1 year -​ Do not need to know international -​ Information frictions, what problems they cause -​ How indirect financing and business institutions are helping resolve those problems -​ Financial institution -​ Rough idea … -​ Don't need to know table or charts/ slides about banks -​ Don't memorize blue chart about banks -​ Regulation not covered Flow of Funds -​ Channeling funds from savers to spends → better use / investment opportunity → enjoy good ahead of time Lender savers: ​ →​ Financial Markets ​ →​ ​ borrow spenders: 1.​ Households ​ ​ (DIRECT FINANCE)​ ​ ​ 1. Business Firms 2.​ Business firms ​ ​ or​ ​ ​ ​ ​ 2. Government 3.​ Government ​ ​ Financial intermediaries​ ​ ​ 3. households 4.​ Foreigners ​ ​ (INDIRECT FINANCE)​ ​ ​ 4. Foreigners ​ ​ ​ ​ ​ ^^^^^ -​ Direct finance = raise funds directly from savers -​ in financial markets selling securities -​ Indirect finance = raise money indirectly from -​ savers via financial intermediaries -​ Intermediaries find funds and opportunities to get and give money to Debt → bonds: issuer pays buyer fixed periodic pmts until maturity Equity → shares: claims of shares of the net income of the business -​ Debt and equity can be long term -​ Both involve a claim on issuer’s income -​ Bondholders get paid before stockholders Stocks = ownership -​ Residual claims: bond holders have senior claim = upside gains and downside losses -​ Long term securities (no maturity) -​ Voting rights Bonds = borrowing -​ Short term (maturity threshold = 1yr) // money markets -​ Long term // capital markets (+equity) -​ Intermediate term Primary market: new security issues sold to initial buyers -​ Typically investment bank underwrites the offering Secondary market: securities previous issued are traded -​ Liquidity -​ Price discovery -​ Feedback to corporate governance -​ Ways to organize -​ Exchanges: traded in central locations) -​ Over-the-counter (OTC): dealers at different locations Indirect finance: credit intermediation between investors and borrowers -​ Includes credit transformation, maturity transformation, & liquidity transformation -​ Banks provide liquidity services -​ All financial institutions are heavily regulated by the government -​ Rapid growth in financial intermediation PROBLEM = Adverse selection: problem created by asymmetric information between parties before the transaction occurs -​ Adverse = bad borrowers SOLUTION = financial intermediaries have advantage in collecting info to make better credit choices, provide secured lending (collateral), and have credit rationing PROBLEM = Moral hazard: problem created by asymmetric information after the transaction occurs -​ Asymmetric info: cannot identify bad behaviours from bad lucks  -​ Ex: guaranteed exam grades, risky activities after insurance SOLUTION = intermediaries monitor and make sure you follow covenants Setting up contracts with intermediaries is costly … -​ Delegated monitoring → monitoring every carl is very expensive -​ So …. Give the deposits to the bank and the risk decreases due to diversification -​ Reused info source for various services Economies of scale (scope): lowering cost of production by producing many related goods/services Financial institutions: 1.​ Depository institutions (commercial banks) 2.​ Contractual savings institutions (insurance companies) 3.​ Investment intermediaries (mutual funds and hedge funds) Commercial banking: deposit-taking and lending -​ Retail banking: taking relatively small deposits from private individuals -​ Wholesale banking: providing banking services to medium and larger corporate clients, fund managers, and other financial institutions Investment banking: assisting companies in raising debt and equity, providing advice on mergers and acquisitions, major corp restructuring, etc US takes out more nonbank loans than bank loans Insurance companies provide protection against adverse events (life insurance, property-casualty insurance, health insurance) -​ Pension plan: insurance arranged by a company for its employees which provide employees with income for the rest of their life after they retire Mutual funds serve needs of relatively small investors -​ Subject to more regulation -​ Required to explain their investment policies -​ Use of leverage is limited Hedge funds seek to attract funds from wealthy individuals and large investors such as pension funds -​ Less regulation -​ Wider range of trading strategies -​ More secretive about what they do LECTURE 3 // INTEREST RATES -​ definition of YTM and how to calculate it -​ Relationship between YTM and coupon rate -​ Fisher equation application -​ Rates of return/ holding period return -​ Calculate -​ Practice in class problem and quiz -​ Interest rate risk and various relationships between maturity of bonds and direction of market rate changes -​ Do calculations in duration Time value of money -​ Real (inflation-adjusted) interest rate = interest rate - inflation increase -​ If the Fed lowers interest rates, is it worth refinancing? Only if the money saved outweighs the cost to refinance Present discounted value (“present value”): today’s valuation of future CFs 4 basic debt instruments 1.​ Simple loan 2.​ Fixed payment loan 3.​ Coupon bond 4.​ Discount bond (1)​ Simple loan: one repayment of entire principle + interest at maturity -​ Ex: short maturity loans, commercial loans -​ BEGIN OR END MODE -​ Bond prices and interest rates are inversely related (2)​ Fixed payment loan: fixed pmt covering interest and principal is made every principal until paid off at maturity -​ Ex: Mortgages, auto loans  (3)​ Coupon bond: coupon pmt, pmt interval, FV, maturity, price, and YTM -​ Face value (par value) of bond is repaid at maturity -​ Borrower receives fixed coupon payment every interval until maturity -​ Coupon rate = % of $1,000 FV bond -​ YTM: interest rate = price to cash flows -​ Ex: treasury bonds, corporate bonds -​ Treasury bonds have two semi-annual coupon payments a year (4)​ Discount bond (zero-coupon bond): FV, maturity, and price -​ Bond is bought at a discount and pay full face value at maturity -​ Ex: US Treasury bills Example question PV of 15 annual CF payments of $5000 at discounted 4% interest rate? ​ ​ N: 15​ i: 4%​ pv: _55591_ ​ pmt: 5000​ fv: 0 YTM (yield to maturity): interest rate that = the PV of CFs received from debt with it’s value today (annualized) -​ 1 year discount bond → YTM = (Face value- current price)/currentprice Q1: borrow $25000, repaid in 5 annual pmts = $6000, what is YTM? A1: N: 5​ i: _6.4%_​ pv: 25000​ pmt: -6000​ fv: 0 Q2: coupon bond with $10000 fv, 20 year life, coupon rate = 5% → $500, price = $9000 A2: ​ N:20 ​ i:_5.86%_​ pv: -9000​ pmt: 500​ FV: 10000​ Relationships between price & FV / YTM & coupon rate: 1.​ When coupon bond is priced at face value, YTM = coupon rate 2.​ Price of coupon bond and YTM are inversely related 3.​ YTM > coupon rate when bond price < face value 4.​ YTM < coupon rate when bond price > face value Fisher equation: real interest rate = nominal interest rate - inflation rate -​ Real interest rate: inflation-adjusted yield rate -​ The amount the your purchasing power is actually growing -​ Nominal interest rate: given rate -​ Inflation rate: average rate of inflation during the period -​ Expected over the life of the contract TIPS (treasury inflation protected securities) -​ Face value of bond is adjusted to track inflation, held constant in real teams -​ When bond matures, holder is paid the adjusted principal or original principle (whichever is greater) = protected against inflation and deflation -​ Coupon pmt rises/falls with inflation due to inflation-adjusted principal (coupon rate % is unchanged) -​ YTM on TIPS are essentially a measure of real interest rates Breakeven inflation: spreads between TIPS vs unindexed treasuries are a way to back out inflation expectations from the bond market -​ Break even inflation = yield on nominal treasury - yield on TIPS -​ Ex: 10 year treasury bonds yield 4% while TIPS yield 1.5% → Breakeven inflation rate = 2.5% → bond mkt expects inflation to inc on average 2.5% per year over the next 10 years Rate of return = current yield + capital gain -​ Current yield = coupon pmt/ t price of bond -​ Capital gain = price of bond at time (t+1) - t price) / t price Q: 20 year treasury bond with face value = $10000 and coupon rate 4% bought at par Q1: bond is sold at $9500 a year later, rate of return on holding this bond for one year? A1: 400/10000 + (9500-10000)/10000 = -0.01 = -1% Q2: yield increases by 1% (=5%) a year later when you sell the bond, the rate of return? A2: price of bond at t=1 → n:29, i:5%, pv:_8485_,pmt:400, FV:10000 400/10000 + (8485-10000)/10000 = -0.111 = -11% Prices and returns for long-term bonds are more volatile than shorter-term bonds Interest rate risk: possible reduction in returns associated with changes in interest rates -​ Longer maturity bonds have greater interest rate risk -​ No uncertainty about return if holding to maturity because maturity = holding period (no capital gain or loss) Short term bones face reinvestment risk (reinvest at uncertain future interest rate) Interest rates are important to financial institutions because increasing interest rates → inc cost of acquiring funds → dec income from assets Duration: average lifetime of a debt security’s stream of payments (weighted average of cash payments’ maturities) -​ Gives info on bond sensitivity to interest rate change and risk %△P = (P(t+1)-P1)/P1 = capital gain rate i = appropriate interest rate for discounting CF -​ Inverse relationship with interest rates -​ Ex: every 1% increase in interest rates, bond price will decrease by 3% -​ The longer the time to maturity → the higher the duration -​ more uncertainty of interest rates further in the future -​ Larger the coupon rate → the lower the duration -​ The sooner you receive your money back, less uncertainty on money