Download M1 = currency + traveler`s checks + demand deposits + other

M1
M1 = currency + traveler's checks + demand deposits + other
checkable deposits
M2
M2 = M1 + overnight RP's + overnight Eurodollars + money market
mutual funds + money market deposit accounts + savings deposits +
small time deposits
M3
M3 = M2 + large time deposits + term RP's + term Eurodollars +
institutional money market mutual funds
Desirable Characteristics of Money
The only necessary characteristic of money is general acceptability. If
everyone regards an item as money and is willing to accept it as payment for
goods and services, that item is money.
desirable physical characteristics
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portable
divisible
durable
easily recognizable
Classifying Different Kinds of Money
The different kinds of money can be classified by their cost of production
and circulation.
Full-bodied money is money whose cost of production and circulation is as
great as its value as money. For example, the amount of gold in a $20 gold
piece was purchased from metal dealers for $20.
Fiat money is produced and maintained at zero cost. The nearest example is
the Susan B. Anthony dollar coin. For practical purposes, our money is fiat
money.
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According to Gresham's Law (bad money drives out good), money that is
more than full-bodied does not remain in circulation long. If the value of
copper in a penny was more than 1 cent, people would melt pennies down
for other uses, e.g. electrical wires.
So, if our money is fiat money, what backs our money? The money supply
is backed by the assets of the banking system since money is debt. Currency
is backed by government debt and government debt is ultimately backed by
the ability of the government to print more currency.
Dollar bills have value because
1. the demand for them is greater than the supply (scarcity)
2. general acceptability
legal tender
an item that creditors must accept in payment of debts
From Last Time
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You do need to memorize the items that make up M1, M2, and M3.
The M probably refers to Monetary Aggregate. Don't worry about L.
Full-bodied money has a value in another use equal to its value as
money, e.g. if there was 1 cent worth of copper in a penny, it would
be full-bodied money. Gresham's Law says that if there are two types
of money (say, those copper pennies and zinc pennies) in circulation,
the one with the smaller value in another use (the zinc pennies) will
stay in circulation as money while the good money will be hoarded.
Pure fiat money is costless to produce. Its only value comes from
what it can be used to purchase. It has no value as anything other than
money. The Susan B. Anthony dollar was the closest thing we've had
to money that was costless to produce and keep in circulation.
Advantages of Fiat Money
The fundamental defect of full-bodied money, from society's point of view,
is that it requires the use of real resources to add to the stock of money.
People must work hard to dig something out of the ground in one place, say
to dig gold out of the ground in south Africa, in order to rebury it in Fort
Knox.
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Seignorage is the profits earned by producing money. With full-bodied
money, there is no seignorage. But, fiat money enables the government to
acquire resources and provide society with services equal to the real value of
the money created. We can have money without any sacrifice. By switching
from full-bodied money like gold coins to fiat paper money, the government
can now hire miners and mining equipment to build us a subway system
rather than mine gold.
Evolution of Payments System
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until several hundred years ago, the payments system in all advanced
countries was based on gold or silver
then came the introduction of paper currency convertible into a
quantity of gold or silver
this was eventually replaced by fiat money not convertible into
anything
major drawbacks of currency are that it is easily stolen and costly to
transport in large quantities
the invention of checks; but checks take time to clear and are costly to
process
electronic payments
Why Study Banks?
1. provide a link between those who want to save and those who want to
invest
2. play a role in determining the quantity of money in the economy
3. source of financial innovation expanding the ways to invest savings
Why Study Financial Markets?
Financial markets are markets in which funds are transferred from those
who have excess funds (savers, lenders) to those who have a shortage
(investors, borrowers).
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bond market - determines interest rates
stock market - influences wealth and business decisions
foreign exchange market - affects prices of imports and exports
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Financial markets improve social welfare by allowing funds to move from
those without productive investment opportunities to those with such
opportunities. Consumers also benefit by being allowed to make purchases
when they need them the most.
kinds of financial markets:
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debt v. equity
primary v. secondary
exchanges v. over-the-counter markets
money v. capital markets
Financial Intermediaries
Financial intermediaries acquire funds by issuing liabilities such as deposits
and then use these funds to acquire assets by purchasing securities or
making loans.
types:
1. banks
2. contractual savings institutions
3. invesmtment intermediaries
Government Regulation of Financial Markets and Intermediaries
purposes:
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provide information to investors
ensure a sound financial system
improve control of monetary policy
encourage home ownership
Internationalization of Financial Markets
Eurobonds (a bond denominated in a currency other than that of the country
in which it is sold, e.g. a bond denominated in U.S. dollars sold in Tokyo)
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account for 80% of new issues in the world bond market. They have now
passed the U.S. corporate bond market as a source of new funds.
In the late 1980's, the Japanese stock market at times exceeded the value of
stocks traded in the U.S.
Lecture 4 - Present Value
from last time
basics of debt instruments
simple loan
discount bond
coupon bond
fixed payment loan
present value
Basics of Debt Instruments
debt Instruments
promises by a borrower to repay principal plus interest to a lender
principal
amount of the loan
interest
fee for using the funds
maturity
date repayment is due
Simple Loan
E.g., a 2 year loan of $1000 at 10% interest
Discount Bond
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With a discount bond, the borrower pays the lender the amount of the loan
(face or par value) at maturity but receives less than the face value initially.
Coupon Bond
A coupon bond gives the lender periodic interest payments plus final
repayment of the face value at maturity. A coupon bond specifies the
maturity date, face value, issuer, and coupon rate (the coupon payment
divided by the face value).
E.g., a $1000, 2 year bond with a 10% coupon rate
Fixed Payment Loan
Under a fixed payment loan the borrower makes periodic payments on both
interest and principal. There is no lump-sum payment of principal at
maturity.
Present Value
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We want to compare the rates of return for the four types of investments.
The rate of return just equals the annual percentage return.
The problem is that they make payments to lenders in different amounts at
different times and dollars received in the future are not as valuable as
today's dollars. The concept of present value is used to compare dollars
amounts received/spent at different points in time.
Present value is the value today of some amount to be received in the future.
If I put $100 in the bank and receive 5% interest, I will have $105 in 1 year.
So, the present value of $105 to be received in 1 year is $100. $100 now is
the same as getting $105 1 year from now because $100 will grow into $105
in a year.
present value
of $1 to
be received
in n years
=
$1
------------n
(1 + i)
where i = interest rate
For example, the present value of $100 to be received next year (with i =
5%) equals ($100)/(1 + 0.05) = ($100)/(1.05) = $95.
Lecture 5 - Yield to Maturity
from last time
yield to maturity
bond prices and interest rates
bond prices and yield to maturity
real interest rates
From Last Time
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The difference between the 4 types of loans (simple loans, discount
bonds, coupon bonds, and fixed payment loans) is simply the
repayment schedule.
Yield to Maturity
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The yield to maturity is the interest rate that equates the present value of an
asset's payments with its value today. The interest rate that answers the
question "If I pay a price P for a set of future payments, at what interest rate
could I invest P and get the same future payments?" is the yield to maturity.
To find the yield to maturity, set today's value equal to the present value of
the stream of payments and solve for the interest rate.
Bond Prices and Interest Rates
Suppose you hold a bond that you paid $1000 for that pays you $80 a year
in interest. The interest rate on that bond is 8%.
Suppose that now a bond that costs $1000 pays $100 per year in interest.
The interest rate is 10%. What does this do to the value of your bond?
If you want to sell it, the purchaser will want to receive a 10% interest rate
because that's what new bonds are paying. So, she will pay $800 for your
bond because ($80/$800) = 10%.
So, the value of your bond falls when interest rates rise.
Bond Prices and Yield to Maturity
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discounting future payments at a higher interest rate reduces the
present value of the payments and bond prices
a lower yield to maturity raises the present value of the future
payments and the price of the bond
the longer the maturity of a bond, the larger will be the price change
in response to a change in the yield to maturity
yield to maturity = f(current yield, F - P)
1. when F = P, yield to maturity (i) = current yield(C/P)
2. when P < F, i > C/P
3. when P > F, I < C/P
Real Interest Rates
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The market interest rate can be divided into a required real rate of return and
the expected inflation rate over the period. Market interest rates are nominal
rates, measured in current dollars; but investors are concerned about their
real, or inflation- adjusted returns. As a result, investors demand nominal
returns that are high enough to protect them against expected inflation and
still yield a real return that makes lending attractive.
nominal interest rate = real interest rate + expected inflation rate
Lecture 6- Portfolio Allocation
from last time
determinants of asset demand
diversification
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Why would anyone pay more for a bond than its face value? Well,
suppose you have a bond that has a face value of $1000 and pays $80
a year interest. The interest rate on your bond is 8%. Suppose a new
bond is issued for $1000 that pays just $50 a year interest. What
happens to the value of your bond? People will be willing to pay
more than $1000 for your bond because it pays higher interest than
newly issued bonds with the same face value. Your bond rises in
value to $1600. The person who buys your bond for $1600 receives
$80 a year in interest plus $1000 when the bond matures. Their yield
to maturity is less than the 8% coupon rate of the bond because of the
capital loss they will suffer. The yield to maturity depends on both the
bond's coupon rate and any capital gain/loss the holder receives.
The inflation rate will be negative when the average price level falls.
An inflation rate of -7% means that prices have fallen 7% on average.
If you plan to hold a bond to maturity, changes in interest rates will
have no effect on you.
The real interest rate is the nominal or market interest rate adjusted
for inflation.
Determinants of Asset Demand
An asset is a piece of property that is a store of value, e.g. money, bonds,
stocks, art, land, houses, farm equipment, comic books, manufacturing
machinery, etc.
A portfolio is a collection of assets.
1. wealth
Wealth is the total resources available to the individual. When wealth goes
up, there are more resources available to purchase assets.
2. expected return on assets
Expected return on an asset is equal to the sum over i of the probability of
return i times return i.
Given two otherwise similar assets, pick the one with the higher expected
return.
3. risk associated with asset returns
This is the chance that the actual return will differ from the expected return.
Consider two shares of stock: TWA, which has a 50% chance of a 15%
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return and a 50% chance of a 5% return and Martz, which gives a sure
return of 10%. There is more uncertainty associated with TWA returns.
Therefore, TWA stock has a greater risk.
Our measure of risk will measure how much the returns fluctuate. We will
use the standard deviation, s.
The greater the standard deviation, the greater the risk.
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risk averse
risk neutral
risk loving
4. liquidity
Liquidity refers to how quickly and easily the asset can be turned into cash.
5. information costs
Information costs are the resources spent obtaining and analyzing data on an
asset.
Diversification
Holding more than one asset reduces the overall risk an investor faces.
Consider two assets:
1. Good Times, Inc.: 15% when economy is strong; 5% when weak
2. Bad Times, Ltd.: 5% when economy is strong; 15% when weak
Assume there is a 50% chance of a strong economy. Both have an expected
return of 10%, but there is uncertainty about the returns. If you put half your
savings into each stock, you get a sure 10% return no matter what economic
conditions are. So, diversification provides the same expected return as
holding just one stock with less risk.
You receive no benefits from diversification when the returns on the two
securities move together.
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