Financial markets and institutions

Lecturer: Dr Nguyen Kim Thu

Part 1: Introduction
Why study financial markets and institutions?

Overview of the financial system

Financial markets are markets in which funds are transferred from people who hav
e an excess of available funds to people who have a shortage
Greater economic ef
ficiency Direct effect on personal wealth, the behavior of businesses and consum
ers, and the overall performance of the economy

Debt markets and interest rates

A bond is a debt security that promises to make payments periodically for a spec
ified period of time.
Interest rate is the cost of borrowing or the price paid f
or the rental of funds. Interest rates affect the saving and investment decision
s, affect the profitability and value of financial institutions

The stock market

A stock is a security that represents a share of ownership in a corporation. It
is a claim on the earnings and assets of the corporation.

The foreign exchange market

The foreign exchange market is where the currency of one country is converted to
the currency of another country; and is where the foreign exchange rate (the pr
ice of one countrys currency in terms of anothers) is determined

Financial institutions
Financial institutions are what make financial markets work, enabling financial
markets to move funds from people who save to people who have productive investm
ent opportunities.

Central banks
Financial intermediaries: commercial banks, savings and loan assoc
iations, insurance companies, mutual funds

Overview of the financial system

Function of financial markets -Channeling funds from savers to investors
Structu
re of financial markets -Debt and equity markets -Primary and secondary markets
-Exchanges and the OTC markets -Money and capital markets

Structure of financial intermediaries -Stand between the lender and the borrower
and helps transfer funds from one to the other. -The indirect finance using fin
ancial intermediaries is far more important source of financing for corporations
than securities markets, since they reduce transaction costs for lenders.

Asymmetric information
One party does not know enough about the other party to make accurate decisions
e.g: the borrower who takes out a loan has better information about the investme
nt project than the lender does
Adverse selection -the problem created by asymme
tric information before the transaction occurs -occurs when the potential borrow
ers who are the most likely to produce an undesirable outcome are the ones who m
ost actively seek out a loan and are thus most likely to be selected. Therefore,
lenders may decide not to make any loans even though to good credit borrowers

Moral hazard: is the problem created by asymmetric information after the transac
tion occurs. -is the risk that the borrower might engage in activities that are
undesirable/risky -because moral hazard lowers the probability that the loan wil
l be repaid, lenders may decide not to make a loan

Financial intermediaries can deal with the asymmetric information problem. -bett
er equipped to screen out good from bad credits -expertise in monitoring the par
ties they lend to

Part 2: Fundamentals of interest rates

Measuring interest rates -A simple loan: pay at maturity date the principal plus
the interest -A fixed-payment loan: making the same payment every month, consis
ting of part of the principal and interest. -A coupon bond: pays the owner of th
e bond a fixed interest payment (coupon payment) every year until the maturity d
ate, and the face value (par value) is repaid at the maturity date -A discount b
ond: is bought at a price below its face value , and the face value is repaid at
the maturity date. How can you decide which of these instruments provides you w
ith more income?

Present value
The value today of a future payment (FV) received n years from now when the simp
le interest rate is i:
PV = FV/(1+i)n

Yield to maturity (YTM)

Yield to maturity is considered the most accurate measure of interest rates
It i
s the interest rate that equates the present value of payments received from a d
ebt instrument with its value today.

Simple loan: for simple loans, the simple interest rate equals YTM
Fixed-payment
loan: LV = FP/ (1+i) + FP/(1+i)2 + + FP/(1+i)n LV: loan value FP: fixed yearly p
ayment n: number of years until maturity

Coupon bond: P = C/(1+i) + C/(1+i)2 + + C/(1+i)n + F/(1+i)n P: Price of coupon bo

nd C: Yearly coupon payment F: Face value of the bond n: years to maturity date

Three interesting facts -When P = F, YTM = Coupon rate -P and YTM are negatively
related -YTM>Coupon rate when P<F

Perpetuity: is a perpetual bond with no maturity date, no repayment of principal

, makes fixed coupon payments of $C forever.
P = C/i P: Price of the perpetuity
C: Yearly payment So i = C/P or YTM = C/P

Discount bond: for any one-year discount bond, YTM is i = (F-P)/P F: face value
of the discount bond P: current price of the discount bond

Other measures of interest rates

YTM is the most accurate measure of interest rates and is what financial economi
sts mean when they use the term interest rate. However, because YTM is sometimes
difficult to calculate, people often use other, less accurate measures of inter
est rates, like the current yield and the yield on a discount basis

Current yield ic = C/P ic : current yield P: price of the coupon bond C: yearly
coupon payment -The current yield approximates the YTM better when the bond pric
e is nearer to the bonds par value and the maturity is longer. -A change in the c
urrent yield always signals a change in the same direction of the YTM

Yield on a discount basis idb = [(F-P)/F]* (360/Days to maturity) idb :

a discount basis F: face value of the discount bond P: purchase price of
scount bond -The yield on a discount basis always understates the YTM and
nderstatement becomes more severe the longer the maturity of the discount
-The yield on a discount bond always moves in the same direction with YTM

yield on
the di
this u
bond.

Real and nominal interest rates

i = ir + e or ir = i - e i: nominal interest rate ir: real interest rate e expec
ted inflation rate When real interest rate is low, there are greater incentives
to borrow and fewer incentives to lend

Interest rates and returns

The return on a bond held from time t to time t+1 can be written as R = (C + Pt+
1 Pt)/Pt R: return from holding the bond from time t to time t+1 Pt : price of b
ond at time t Pt+1: price of bond at time t+1 C: Coupon payment

R= C/Pt + (Pt+1-Pt)/Pt = current yield+rate of capital gain = ic + g

If time to maturity = holding period, then return = the initial YTM

When holding
period<terms to maturity, a rise in interest rates is associated with a fall in
bond prices, resulting in capital losses on bonds The more distant a bonds matur
ity, the greater the size of the price change associated with an interest-rate c
hange
Even though a bond has a substantial initial interest rate (high YTM), its
return can be negative if interest rate rises.

Maturity and the volatility of bond returns: Interest rate risk

Prices and returns for long-term bonds are more volatile than those for shorterterm bonds
Interest rate risk is the riskiness of an assets return that results f
rom interest rate changes
Bonds with a maturity that is as short as the holding
period have no interest-rate risk, because return = YTM.

Reinvestment risk
Reinvestment risk occurs because the proceeds from the short-term bond need to b
e reinvested at a future interest rate that is uncertain.

The behavior of interest rates

Interest rates are negatively related to the price of bonds, so if we can explai
n why bond prices change, we can also explain why interest rates fluctuate.

Determinants of asset demand

An asset is a piece of property that is a store of value.
Whether to buy one ass
et rather another, consider -Wealth -Expected return -Risk -Liquidity

Wealth: more wealth means more resources to buy assets, so other things being co
nstant, an increase in wealth raises the quantity demanded of an asset
Expected
returns: an increase in an assets expected return relative to that of an alternat
ive asset, holding everything else unchanged, raises the quantity demanded of th
e asset

Risk: everything else constant, if an assets risk rises relative to that of alter
native assets, its quantity demanded will fall
Liquidity: The more liquid an ass
et is relative to alternative assets, the greater will be the quantity demanded.

Benefits of diversification
Diversification reduces the overall risk an investor faces, except in the extrem
e case where returns on securities move perfectly together
The less the returns
on two securities move together, the more benefit (risk reduction) there is from
diversification

Loanable funds framework:supply and demand for bonds

Loanable funds framework: Approach the analysis of interest-rate determination b
y studying the supply of and demand for bonds.

Factors that cause a shift in the demand curve for bonds -Wealth -Expected retur
ns on bonds relative to alternative assets -Risk of bonds relative to alternativ
e assets -Liquidity of bonds relative to alternative assets

Wealth: As wealth increases, bond demand curve shift to the right

Expected retur
ns: higher expected interest rates in the future decrease the demand for long-te
rm bonds and shift the demand curve to the left -If expected returns on stock in
crease, demand curve for bonds shift to the left -If expected inflation increase
s, expected returns on real assets (cars, houses) increase, and demand for bonds
fall

Risk: an increase in the riskiness of bonds causes the demand for bonds to fall
and the demand curve to shift to the left An increase in the riskiness of altern
ative assets causes the demand for bonds to rise and the demand curve to shift t
o the right.
Liquidity: increased liquidity of bonds results in an increased dem
and for bonds, and the demand curve shifts to the right. Increased liquidity of
alternative assets lowers the demand for bonds and shifts the demand curve to th
e left

Factors that cause a shift in the supply curve of bonds -Expected profitability
of investment opportunities: in a business cycle expansion, the supply of bonds
increases and the supply curve shifts to the right. -Expected inflation: when ex
pected inflation increases, the real cost of borrowing decreases, and the quanti
ty of bonds supplied increases

-Government activities: Higher government deficits increase the supply of bonds

and shift the supply curve to the right.

Changes in expected inflation: the Fisher effect

When expected inflation increases, demand curve for bonds shift to the left and
supply curve for bonds shift to the right, resulting in a fall in bond price and
a rise in interest rates

Business cycle expansion

As the economy expands, wealth increases, the demand for bond increases. Also, s
upply of bonds increases. Both demand curve and supply curve shift to the right.
Depending on whether the supply curve shifts more than the demand curve or vice
versa, the new equilibrium interest rate can either rise or fall
However, in re
ality, interest rate rises in business cycle expansion and falls in recession.

Liquidity preference framework: supply and demand for money

Liquidity preference framework: determines the equilibrium interest rate using t
he supply of and demand for money.

Assume there are two main categories of assets that people use to store their we
alth: money and bonds.
Quantity of bonds and money supplied must equal the quant
ity of bonds and money demanded:
Bs + Ms = Bd + Md
Bs Bd = Md - Ms

If the market for money is in equilibrium, the bond market is also in equilibriu
m The liquidity preference framework is equivalent to the loanable funds framewo
rk, which relates the money market with the bond market
The loanable funds frame
work is easier to use when analyzing the effects from changes in expected inflat
ion; and the liquidity preference framework provides a simpler analysis of the e
ffects from changes in income, the price level, and the supply of money.

Money includes currency and checking account deposits

Other things constant, int
erest rate and the quantity of money demanded are negatively related.
Quantity o
f money supplied is a vertical line Equilibrium interest rate at: Md = Ms

Shift in the demand for money

Income effect: a higher level of income causes the demand for money to increase
and the demand curve to shift to the right
Price-level effect: a rise in the pri
ce level causes the demand for money to increase and the demand curve to shift t
o the right.

Shift in the supply of money

An increase in the money supply will shift the supply curve for money to the rig
ht

Does a higher rate of growth of the money supply lower interest rates?
Liquidity effect: rising money supply leads to an immediate decline in the equil
ibrium interest rate.
Increasing money supply takes time to raise the price leve
l and income , which in turn raise interest rates. The expected-inflation effect
, which also raises interest rates, can be slow or fast, depending on whether pe
ople adjust their expectations of inflation slowly or quickly when the money gro
wth rate is increased
Three possibilities (p107)

The risk and term structure of interest rates

Risk structure of interest rates