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The right of a residual claimant: Stockholders have a claim on all

assets and income left over after all other claimants have been satisfied

Valuing common stock:


1-The One-Period Valuation Model: use a simple model, assume you
buy a stock, hold it for one period to get the dividend and then sell it, this
is the one period valuation model.

2-The Generalized Dividend Valuation Model:

Simplified models have been developed like the Gordon growth


model that assumes constant dividend growth.
3-The Gordon Growth Model: Same as the previous model, but it
assumes that dividend grow at a constant rate, g.

If the growth rate is larger than the discount rate demanded


by the holders of the firm equity, the firm will grow
impossibly large in the long run.

The efficient market hypothesis is based on the assumption


that prices of securities reflect all available information

In an efficient market, a securitys price fully reflects all


available information.

People will buy more of this stock which will increase the current
price relative to the expected future price P of t+1 , hence lowering the
expected future return.

--If a corporation announces that it expects quarterly earnings to


increase by 25% and it actually sees an increase of 22%, what
should happen to the price of the corporations stock if the
efficient markets hypothesis holds, everything else held constant?
Answer: The stocks price should fall. The price had adjusted based on the
statement of expected earnings. When the actual number turned out to be
lower than expected, the stock price changes to reflect the additional
information.
-- Your best friend calls and gives you the latest stock market hot
tip that he heard at the health club. Should you act on this
information? Why or why not?
Answer: No, if this information is readily available, it will already be
reflected in the stock price.
--Suppose Barbara looks out in the morning and sees a clear sky
so decides that a picnic for lunch is a good idea. Last night the
weather forecast included a 100% chance of rain by midday but
Barbara did not watch the local news program. Is Barbaras
prediction of good weather at lunch time rational? Why or why
not?
Answer: No, this prediction is not using rational expectations. Although
Barbara based her guess on the information that was available to her at
the time, additional information was readily available that could have been
used to improve her prediction.
What rights does ownership interest give stockholders?
Answer: Stockholders have the right to vote on issues brought before the
stockholders, be the residual claimant , that is, receive a portion of any
net earnings of the corporation, and the right to sell the sto ck.
The bank has four primary concerns:
1. Liquidity management
2. Asset management
Managing credit risk
Managing interest-rate risk
3. Liability management
4. Managing capital adequacy
ROA = Net Profits after taxes/Assets

ROE = Net Profits after taxes/Equity Capital


There is a direct relationship between the ROA and ROE, determined
by the equity multiplier (EM), the amount of assets per dollar
of equity capital:
EM = Assets/Equity Capital

ROE = ROA EM
Capital , EM , ROE
Basic gap analysis to measure the sensitivity of banks profits to changes
in interest rate
(rate sensitive assets - rate sensitive liabilities) x interest rates = in
bank profit
Example: (20millions-50millions)x(5% increase in i)=-1.5million

Duration Analysis:
% in market value of security - percentage point
duration in years.

in interest rate x

Net worth: Assets-liabilities


The Law of One Price states that the price of an identical good will
be the same throughout the world, regardless of which country
produces it.
Purchasing Power Parity PPP suggests that if one countrys price
level rises relative to anothers, its currency should depreciate
(the other countrys currency should appreciate).

The rise in expected domestic inflation leads to a decline in the


expected appreciation of the dollar, which is typically thought to be
larger than the increase in the domestic interest rate iD.
As a result, at any given exchange rate, the relative expected
return on domestic (dollar) assets falls, the demand curve shifts to
the left. The dollar depreciates.

Reserve:
The rise in expected domestic inflation leads to a decline in the
expected appreciation of the dollar, which is typically thought to be
larger than the increase in the domestic interest rate iD.
As a result, at any given exchange rate, the relative expected
return on domestic (dollar) assets falls, the demand curve shifts to
the left. The dollar depreciates.

Changes in the demand for reserves will not affect the fed funds
rate - borrowed reserves will increase to match the demand
Open Market Operations
1. Dynamic: Change reserves and monetary base
2. Defensive: Offset factors affecting reserves, typically uses
repos
Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly

Open market operations are the dominant policy tool of the Fed since it
has complete control over the volume of transactions, these operations
are flexible and precise, easily reversed and can be quickly implemented
Inflation targeting involves:

1.
2.
3.
4.
5.

Announcing a medium-term inflation target


Commitment to monetary policy to achieve the target
Inclusion of many variables to make monetary policy decisions
Increasing transparency through public communication of objectives
Increasing accountability for missed targets

Advantages
Easily understood by the public
Helps avoid the time-inconsistency problem since public can
hold central bank accountable to a clear goal
Forces policymakers to communicate goals and discuss
progress regularly
Performance has been good!
Disadvantages
Signal of progress is delayed
Affects of policy may not be realized for several
quarters.
Policy tends to promote too much rigidity (inflexibility)
Limits policymakers ability to react to unforeseen
events
Usually flexible targeting is implemented, focusing
on several key variables and targets modified as
needed
Potential for increasing output fluctuations
May lead to a tight policy to check inflation at the
expense of output, although policymakers usually pay
attention to output
Usually accompanied by low economic growth
Probably true when getting inflation under control
However, economy rebounds
Basic gap analysis to measure the sensitivity of banks profits to changes
in interest rate
(rate sensitive assets - rate sensitive liabilities) x interest rates = change
in bank profit
Duration Analysis:
% change in market value of security - percentage point change in
interest rate x duration in years.
Net worth= Assets-liabilities
Explain the law of one price and the theory of purchasing power parity.
Why doesnt
purchasing power parity explain all exchange rate movements? What
factors determine
long-run exchange rates?
Answer: With no trade barriers and low transport costs, the law of one price states
that the price of traded goods should be the same in all countries. The purchasing
power parity theory extends the law of one price to total economies. PPP states
that exchange rates should adjust to reflect changes in the price levels between
two countries. PPP may fail to fully explain exchange rates because goods are not
identical, and price levels include traded and nontraded goods and services. Long-

run exchange rates are determined by domestic price levels relative to foreign
price levels, trade barriers, import and export demand, and productivity.
Explain and show graphically the effect of an increase in the expected
future exchange rate on
the equilibrium exchange rate, everything else held constant.
Answer: See figure below.

When the expected future exchange rate increases, the relative expected return
on the domestic assets increases. This will cause the demand for domestic assets
to increase and the current value of the exchange rate will appreciate.

Explain and show graphically the effect of an increase in the expected


inflation rate on the equilibrium exchange rate, everything else held
constant.
Answer: See figure below.
When

When the expected inflation rate increases, the relative expected return on
domestic assets is affected two ways. First, through the Fisher effect, the domestic
nominal interest rate will increase the expected return on domestic assets.
Second, through purchasing power parity, the future value of the domestic
exchange rate will decline which will decrease the expected return on domestic
assets. Since it is generally believed that the effect of the change in the expected
future value of the domestic exchange rate is larger than the Fisher effect, the net
effect is a lower expected return on domestic assets. This

will decrease the demand for domestic assets, which will cause the current value
of the
domestic exchange rate to depreciate.
Explain the Feds three tools of monetary policy and how each is used to
change the money
supply. Does each tool affect the monetary base or the money
multiplier?
Answer: The three tools are open market operations, the purchase and sale of
government securities; discount policy, controlling the price and quantity of
discount loans to banks; and reserve requirements, setting the percentage of
deposits that banks must hold in reserve. Open market operations and the
discount rate affect the monetary base, and reserve requirements affect the
money multiplier.
State whether the following statement is true or false AND explain why:
A decrease in the discount rate will always cause a decrease in the
Federal Reserve funds rate.
Answer: False. Since the discount rate is set above the federal funds rate, a
decrease in the discount rate will only cause a decrease in the federal funds rate if
the discount rate is decreased below the original federal funds rate level. If the
decrease in the discount rate is such that the new rate is still above the federal
funds rate, then the federal funds rate does not change, everything else held
constant.
Explain dynamic and defensive open market operations. What is the
purpose of each type?
Describe two situations when defensive open market operations are
used. How are defensive
open market operations typically conducted?
Answer: Dynamic OMOs are used to permanently change the monetary base and
money supply.
Defensive operations are used to offset temporary changes in the monetary base
and/or
money supply. Defensive operations are used to offset float, shifts in Treasury
balances
into or out of the Fed, and temporary changes in currency. Defensive purchases
are
typically conducted by using repurchase agreements, while reverse repos or
matched
sale-purchase transactions are used to conduct defensive open market sales.