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The four most common ways that the Fed affects interest
rates and the economy (and the order in which they are used)
- 1. Open market operations
- 2. Changing the discount rate
- 3. Changing the bank reserve requirement
- 4. Changing margin rates on stock transactions
- The Fed uses open market operations most often and
- margin rates least often.
Open market operations is buying and selling Treasury bills
and notes at the weekly and semi-monthly auctions,
Interest rates drop and bond prices rise.
Interest rates rise and bond prices decrease.
Overnight lending by banks decrease
The Fed buying and selling is always cleared through Fed
The reserve requirement is the amount of cash that banks
must keep on reserve.
– Changing the requirement has a multiplier effect on the
– This is often called “moral suasion,” basically “twisting the
arm” of banks to make them increase/decrease their reserves
without actually making it a rule.
• Moral suasion is never a correct test answer.
There are six main rates that are influenced by the Fed and Treasury securities:
– The Fed Funds rate is the quickest rate to move.
– The Discount Rate moves when changed by the Fed.
– The Prime Rate changes only after the discount rate changes.
– The Call Money Rate is close to the discount rate.
– The Overnight Repo Rate is close to the Fed Funds rate.
– The Passbook Savings rate is the slowest rate to move.
Federal Funds Rate
• Federal funds are the monies deposited by banks in the Federal Reserve Bank.
- – Broker/dealers and individuals also make deposits to the
- Federal Reserve Bank when buying Treasury bills, notes and
- – The money on deposit is considered Federal Funds.
- • When a bank needs more Federal Funds to meet the reserve
- requirement, the bank may borrow Fed funds from another
- – When one bank lends to another bank, it does so at the Federal Funds rate.
Federal Funds Rate (cont.)
• When a trade in securities is transacted between two broker/dealers
- or between the Fed and a bank, broker/dealer, or person buying
- treasury securities, the trade has to be “cleared.”
- – This means that the money has to be brought in by the purchaser, and
- the securities delivered by the seller.
- • When banks and broker/dealers do trades in U.S. Treasuries, they clear the trades through their Federal Funds Account.
- – Only Treasuries clear through the Fed in Federal Funds.
- • Trades of all other securities clear through Clearing House Funds.
- – This is the clearing of trades in stocks, corporate bonds, and municipal
- bonds through specific companies set up to clear the trades.
• The discount rate is the rate at which the Fed lends money to member banks.
- – If the Fed decides to loosen the money supply and drop rates, it “opens the discount window,” meaning it lends to non-member
- • This is the rate that everyone watches, and is usually the basis
- for all other rates.
- – As the Fed changes the discount rate, all other rates change.
- – Usually prior to changing the discount rate, the Fed starts by
- changing the Fed Funds rate.
• The prime rate is the base rate that banks charge business customers and other large borrowers.
- – Many people say it is the rate for a bank’s “best” customers, but
- the banks say it is for large loans.
- – This rate changes as the discount rate changes because the bank
- can borrow at the DISCOUNT rate and lend at the PRIME rate.
The call money rate is usually called the brokers’ loan
- – Broker/dealers borrow from banks at the call money rate to loan to customers when the customers buy stocks on margin.
- • This call money rate is based on the discount rate, and is
- always below the prime rate.
• The overnight repo rate is the rate that banks borrow from broker/dealers and other big lenders to meet their reserve
- requirement instead of borrowing at the Fed Funds rate.
- – If a bank can find a better yield in the overnight repo rate, it borrows there instead.
- – There is no risk in the overnight repo rate, because no securities exchange hands, the rate is only for one night, and
- the borrowing is only on paper.
- – The biggest player in the overnight repo rate is the Fed, with broker/dealers, corporations, and banks all getting into
- the market on a daily basis.
• The passbook savings rate is the least volatile of all the rates.
- • It is the rate that banks pay to savings accounts.
- • It only changes when the discount rate has changed and
- stayed changed for a long time.
- • It rarely moves up, but readily moves down.
Bond Prices & Interest Rates
• There are two comparisons in analyzing the economy and
- business influences that are tested:
- 1. The relationship of bond prices to interest rates.
- • This is known as the inverse relationship, or “teeter-totter” relationship, of bond prices to interest rates.
- • As interest rates go down, bond prices go up.
- • As interest rates go up, bond prices go down.
- 2. The comparison of U.S. goods and foreign goods as the dollar
- rises and falls.
Effects of Interest Rates &
Value of the Dollar
• The change in interest rates changes the demand for bonds.
- • Bonds that have already been issued have a set interest rate, and as the Fed changes interest rates, these bonds change
- prices due to the increased or decreased demand for them
- – As the Fed increases interest rates, these bonds decrease in demand and therefore, decrease in price
- – As the Fed decreases interest rates, these bonds increase in demand and therefore, increase in price
- – As the bonds change in price, their yields move toward the new
- interest rates.
- • Always remember, for the test, that bond prices move toward
- par faster than they do away from par.
Effects of Interest Rates &
Value of the Dollar (cont.)
• As the dollar is revalued, or goes up in comparison to foreign currencies, U.S. goods become more expensive.
- – When the dollar goes up, U.S. goods become less competitive (more expensive to purchase) and foreign goods become
- more competitive (less expensive).
- – Think about our goods with Mexico, when you have a problem with this.
The three theories are:
– Monetarist theory – belief that changing the money supply and interest rates are the best influences for a strong economy.
– Supply Side theory – belief that good fiscal policy, tax cuts, and less government spending are the best influences for a strong economy.
- – Keynesian theory – belief that government spending and tax
- increases are the best influence for a strong economy
Monetary Theories (cont.)
• To keep the three theories straight, think the following:
- – Monetarist – money – the Fed affecting money
- – Supply – more supply of money if no taxes
- – Keynesian – the opposite of supply theory, so more taxes
Measures of the money supply:
- M1 = all currency in use plus interest bearing checking accounts
- – M2 = M1 plus small non-negotiable CDs
- – M3 = M2 plus large CDs
• Know M1 & M3
You need to know the order of the business cycle as it goes up and down, as well as the names for these movements:
- – The four names you need to know are:
- • Trough, expansion, peak, and recession
- • Expansion is now called recovery
• When given a question regarding the business cycle order:
- 1. Draw the picture
- 2. Label it
- 3. Pick the answer from those given
Business Cycle Downturns
The two main downturns in the business cycle for you to memorize are:
– Recession Two consecutive quarters of downward trends in the business cycle
– Depression Six consecutive quarters (18 months) of business downtrends
• There are 3 major indicators as determined by the US Department of Commerce:
- – Leading
- – Coincidental
- – Lagging
• There are 12 leading indicators listed by the Department of Commerce.
- – You must know 5 of them for your exam:
- • S&P 500 Index
- • Consumer Confidence Index (CCI)
- • Consumer Durable Goods
- • Housing Starts
- • Machine Tool Orders
Coincidental and Lagging
- • Coincidental Indicators
- – There are five indicators, but you only need to know one for the exam:
- • Industrial Production Index
- • Lagging Indicators
- – There are multiple indicators, but you only need to know one for the exam:
• Corporate Profits
- • On your exam, DO NOT EVER select CPI (consumer price index), GNP (gross national product) or GDP (gross domestic product) as answers to Economic Indicators.
- – These are always reported as information on the economy, but
- are not used as key indicators.
- • Another reported indicator you SHOULD NOT pick is employment.
- – Employment can be found in all three indicators, so employment is one indicator that you never pick as an answer.
Head & Shoulders Formations
Support & Resistance Levels
• There are many indicators and charts that investors watch
- to determine how, when and where to invest (next two slides).
- • Two of these are:
- – Head & shoulders formation, and inverted head & shoulders
- – Support & resistance levels
- • The others are discussed under Bull and Bear markets, and Market Indicators
Head & Shoulders Formation
Head and Shoulders Formation – shows a reversal of an up-trend
- The inverted head and shoulders formation signifies the reversal of
- a down trend
Support & Resistance Levels
• A support level is the price above which the stock stays during its up and down swings.
• A resistance level is the price below which a stock stays during its up and down swings.
Bull vs. Bear
- • There are numerous theories that investors use to decide
- when to invest, in what to invest, and what position to take.
- – If an investor is BULLISH, he thinks the market will go up, so he buys securities.
- – If an investor is BEARISH, he thinks the market will go down, so he sells what he owns, sells stocks short, and watches
- the trend lines.
• There are 2 types of stock analysts:
- – Technical analyst
- – Fundamental analyst
– Evaluates stock market trends and prices to determine when and what stocks to purchase
– Anything dealing with the stock market that influences the price of the security is considered a technical analysis
- – Uses:
- • Support and resistance levels
- • P/E ratios
- • Stock’s market price
- • Fundamental Analyst
- – Evaluates the company and industry to determine when and what stocks to purchase
- – Uses:
- • Earnings
- • Dividend payout
- • Management team
- • Competition
- – Anything dealing with the company and how the changes affect how the company competes in its industry
• How this industry is prospering in the overall economy
Dow, Efficient Market Theory
- • Some of the theories to which investors subscribe are:
- • The DOW Theory – The theory that the Dow Jones average (including all three indexes), is a prelude to the economy.
- • The EFFICIENT MARKET Theory – The theory that stock and bond prices instantaneously and fully reflect all
- available information.
- – This means that investors must act quickly on information or
- they will be left out.
- – This results in large swings in market prices of stocks and large
- swings in the indexes.
- – Investors must buy and hold so they don’t time the market
Odd Lot & Short Interest Theories
- • The ODD LOT Theory – The theory that when the small investor, the odd-lotter, is buying, the market is about to go
- down, and vice-versa.
- – The thought is that the small investor is always wrong.
- • The SHORT INTEREST Theory – The theory that believes the future of the market is based on the amount of trades that are short sales.
- – A large short interest is bullish in the long term, because all the short positions have to be covered.
- – A small short interest is bearish in the long term, because fewer short positions have to be covered.
Advance-Decline Line Theory
• The ADVANCE/DECLINE LINE Theory
uses a comparison (a ratio):
- # of advancing stocks /#of declining stocks
- – Regardless of how the market moves each day, investors should watch the advance/decline ratio and track the market line to determine what the market will do.
- • A number greater than 1 means a bullish market.
- • A number between 0 and 1 (fraction) means a bearish market.
- – This theory only uses the number of stocks that have advanced in a day to those that have gone down in price,
- and does not include those stocks that are unchanged.
- • You should be aware of some of the market indicators that are used – there are questions on the test that ask about or
- refer to them.
- – DOW JONES INDEX – An average of stocks found on the NYSE: 65 stocks, composed of 30 industrials, 20
- transportation, and 15 utilities
– Wilshire 5,000
– Broadest measure of the market with 6,000 different stocks found on the NYSE, AMEX, and Nasdaq
– S&P 100
– An average of 100 stocks of different exchanges and the OTC market, including Nasdaq
- – S&P 500 – Similar to the S&P 100, but broader based with 500
- stocks in the OTC market, including Nasdaq
- – NYSE Composite – Composed of all of the stocks on the NYSE and their average
• This information is very important as a building block for other modules.
- • There is a lot of information covered in this module and you are tested on all of it.
- • Get comfortable with these different theories and the effects of changes.
- • Closely review the Lessons to learn more detail.
- • Use the information from other modules to complement this