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Money & Banking - MGT411
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TEXT AND REFERENCE MATERIAL &
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TEXT AND REFERENCE MATERIAL &
FIVE PARTS OF THE FINANCIAL SYSTEM
The Primary textbook for the course will be
- “Money, Banking and Financial Markets” by Stephan G. Cecchetti
International Edition, McGraw Hill Publishers, ISBN 0-07-111565-X”
Reference books will be
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FIVE CORE PRINCIPLES OF MONEY AND BANKING
1. Time has Value
- Time affects the value of financial instruments.
- Interest payments exist because of time properties of financial instruments
Example
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MONEY & THE PAYMENT SYSTEM
- Money
- Characteristics of Money
- Liquidity
- Payment system
- Commodity vs. Fiat Money
- Cheques
- Other forms of payments
- Future of Money
Money
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OTHER FORMS OF PAYMENTS
Debit Card
- The money in your account is used for payments
- Works like a cheque and there is usually a fee for the transaction
Credit card
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FINANCIAL INTERMEDIARIES
- Financial Intermediaries
- Financial Instruments
- Uses
- Characteristics
- Value
- Examples
Financial Intermediaries
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FINANCIAL INSTRUMENTS & FINANCIAL MARKETS
- Financial Instruments
- Examples
- Financial Markets
- Roles
- Structure
- Financial Institutions
Examples of Financial Instruments
Primarily Stores of Value
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FINANCIAL INSTITUTIONS
- Financial Institutions
- Structure of Financial Industry
- Time Value of Money
Financial Institutions
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TIME VALUE OF MONEY
- Time Value of Money
- Future Value Concepts
- Present value
- Application in financial environment
Time Value of Money
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APPLICATION OF PRESENT VALUE CONCEPTS
- Application of Present Value Concept
- Compound Annual Rate
- Interest Rates vs. Discount Rate
- Internal Rate of Return
- Bond Pricing
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BOND PRICING & RISK
- Bond Pricing
- Real Vs Nominal Interest Rates
- Risk
- Characteristics
- Measurement
Bond Pricing
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MEASURING RISK
- Measuring Risk
- Variance and Standard Deviation
- Value at Risk (VAR)
- Risk Aversion & Risk Premium
Measuring Risk
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EVALUATING RISK
- Sources of Risk
- Idiosyncratic
- Systematic
- Reducing Risk through Diversification
- Hedging Risk
- Spreading Risk
- Bond and Bond Pricing
How to Evaluate Risk
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BONDS & BONDS PRICING
- Bond & Bond pricing
- Zero Coupon Bond
- Fixed Payment Loan
- Coupon Bonds
- Consols
- Bond Yield
- Yield to Maturity
- Current Yield
Bonds
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YIELD TO MATURIRY
- Yield to Maturity
- Current Yield
- Holding Period Returns
- Bond Supply & Demand
- Factors affecting Bond Supply
- Factors affecting Bond Demand
Yield to Maturity: General Relationships
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SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
- Shifts in Equilibrium in bond market
- Bond and Risk
- Default Risk
- Inflation Risk
- Interest Rate Risk
Shifts in Equilibrium
An increase in expected inflation:
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BONDS & SOURCES OF BOND RISK
- Bonds and Risk
- Default Risk
- Inflation Risk
- Interest Rate Risk
- Bond Ratings
- Bond Ratings and Risk
- Tax Effect
Bonds and Risk
Sources of Bond Risk
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TAX EFFECT & TERM STRUCTURE OF INTEREST RATE
- Tax Effect
- Term Structure of Interest Rate
- Expectations Hypothesis
- Liquidity Premium
Tax Effect
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THE LIQUIDITY PREMIUM THEORY
- Bonds
- Liquidity Premium Theory
- Stocks
- Essential Characteristics
- Process
- Measuring Level of a Stock Market
- Valuing Stocks
The Liquidity Premium Theory
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VALUING STOCKS
- Valuing Stocks
- Fundamental Value and Dividend Discount Model
- Risk and Value of Stocks
Valuing Stocks
- People differ in their opinions of how stocks should be valued
- Chartists believe that they can predict changes in a stock’s price by looking at patterns in its past price movements
- Behavioralists estimate the value of stocks based on their perceptions of investor psychology and behavior
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RISK AND VALUE OF STOCKS
- Stocks
- Risk and the Value of Stocks
- Theory of Efficient Markets
- Investing in Stocks for Long Run
- Stock Markets’ Role in the Economy
- Financial Intermediation
- Role of Financial Intermediaries
Risk and value of stocks
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ROLE OF FINANCIAL INTERMEDIARIES
Role of Financial Intermediaries:
- Pool Savings
- Safekeeping, accounting services and access to the payments system
- Liquidity
- Risk diversification
- Information Services
Role of Financial Intermediaries
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ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED)
Role of Financial Intermediaries (cont)
- Liquidity;
- Risk diversification
- Information Services
- Information Asymmetry and Information Costs
- Adverse Selection
- Moral Hazards
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BANKING
- Banking
- Types of banks
- Balance Sheet of Commercial Banks
- Assets
- Liabilities
Banking
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BALANCE SHEET OF COMMERCIAL BANKS
- Balance Sheet of Commercial Banks
- Assets: uses of funds
- Bank Capital and Profitability
- Off-Balance-Sheet Activities
- Bank Risk
- Liquidity Risk
- Credit Risk
- Interest Rate Risk
- Trading Risk
- Other Risks
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BANK RISK
- Bank Risk
- Liquidity Risk
- Credit Risk
- Interest Rate Risk
- Trading Risk
- Other Risks
Bank Risk
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INTEREST RATE RISK
- Bank Risk
- Interest Rate Risk (Cont.)
- Trading Risk
- Other Risks
- Globalization of Banking
- The Future of Banks
- Non-depository Institutions
- Insurance Companies
- Securities Firms
- Finance Companies
- Government Sponsored Enterprises
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NON- DEPOSITORY INSTITUTIONS
- Non-depository Institutions
- Insurance Companies
- Securities Firms
- Finance Companies
- Government Sponsored Enterprises
Non-depository Institutions
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NON- DEPOSITORY INSTITUTIONS (CONTINUED)
- Securities Firms
- Investment Banks
- Mutual Funds
- Finance Companies
- Government Sponsored Enterprises
- Banking Crisis
- Sources of Runs, Panics and Crisis
- Government Safety Net
- Government: Lender of Last Resort
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THE GOVERNMENT SAFETY NET
- There are three reasons for the government to get involved in the financial system
- To protect investors
- To protect bank customers from monopolistic exploitation
- To ensure the stability of the financial system
- Investor Protection
- Small investors are unable to judge the soundness of financial institutions
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THE GOVERNMENT'S BANK
- The central bank started out as the government’s bank, originally created by rulers to finance wars
- However, the early examples are really the exceptions, as central banking is largely a 20th century phenomenon.
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LOW, STABLE INFLATION
- Many central banks take as their primary job the maintenance of price stability; they strive to eliminate inflation.
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MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
- The boom in the past decade with its associated decrease in volatility may have happened because technology sparked a boom just as central banks became better at their jobs.
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THE MONETARY BASE
- Currency in the hands of the public and the reserves of the banking system are the two components of the monetary base, also called high-powered money.
- Bank Reserves = Vault Cash plus Deposits at the central bank
- The central bank can control the size of the monetary base and therefore the quantity of money
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DEPOSIT CREATION IN A SINGLE BANK
- If the central bank buys a security from a bank, the bank has excess reserves, which it will seek to lend
- The loan replaces the securities as an asset on the bank’s balance sheet
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MONEY MULTIPLIER
- Remember, we discussed that
- Assuming
- No excess reserves are held
- There are no changes in the amount of currency held by the public,
- The change in deposits will be the inverse of the required deposit reserve ratio (rD) times the change in required reserves, or ΔD = (1/rD) ΔRR
- Alternatively
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TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
- The central bank chooses to control the federal funds rate by manipulating the quantity of reserves through open market operations: the central bank buys or sells securities to add or drain reserves as required.
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WHY DO WE CARE ABOUT MONETARY AGGREGATES?
- Every country with high inflation has high money growth; thus to avoid sustained episodes of high inflation, a central bank must be concerned with money growth.
- It is impossible to have high, sustained inflation without monetary accommodation.
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THE FACTS ABOUT VELOCITY
- Fisher’s logic led Milton Friedman to conclude that central banks should simply set money growth at a constant rate.
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THE PORTFOLIO DEMAND FOR MONEY
- Money is just one of many financial instruments that we can hold in our investment portfolios.
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MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
- To shift the focus to inflation, we need to look at changes in the price level.
- Suppose that inflation exceeds money growth (with velocity held constant). Real money balances will fall and so will aggregate demand
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DERIVING THE MONETARY POLICY REACTION CURVE
- To ensure that deviations of inflation from the target are only temporary, monetary policymakers respond to change in inflation by changing the real interest rate in the same direction.
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THE AGGREGATE DEMAND CURVE
- The slope of the aggregate demand curve tells us how sensitive current output is to a given change in current inflation.
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THE AGGREGATE SUPPLY CURVE
- The aggregate supply curve tells us where on the aggregate demand curve the economy will end up, explaining the relationship between inflation and real output in the process.
- The short run aggregate supply curve tells us where the economy will settle at any particular time
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EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
Short-Run Equilibrium
- Short-run equilibrium is determined by the intersection of the aggregate demand curve with the short-run aggregate supply curve.
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SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY
- Changes in potential output shift the long-run aggregate supply curve
- At first the shift has no impact on the short-run aggregate supply curve, so inflation and output remain stable
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