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A market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party.
Role of Financial Markets..
- Financial marketstransfer funds from those who have excess funds to those who need funds
- 1.Surplus units: participants who receive more money than they spend, such as investors.
- 2.Deficit units: participants who spend more money than they receive, such as borrowers.
- 3.Securities: represent a claim on the issuers
Primary vs Secondary Markets
- Primary- Facilitate the issuance of new securities (buying it for the first time)
- Secondary- the trading of existing securities, which allows for a change in the ownership of the securities (buying it from a person that already owns it)
the degree to which securities can easily be liquidated (sold) without a loss of value
Money Market Securities
- a.Money markets facilitate the sale of short-term debt securities by deficit units to surplus units.
- b.Debt securities that have a maturity of one year or less.
Capital Market Securities
- facilitate the sale of long-term securities by deficit units to surplus units.
- a.Bonds - long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations.
- b.Mortgages - long-term debt obligations created to finance the purchase of real estate.
- c.Mortgage-backed securities - debt obligations representing claims on a package of mortgages.
- d.Stocks - represent partial ownership in the corporations that issued them.
- financial contracts whose values are derived from the values of underlying assetsa.
- Speculation - allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets.
- Risk management and hedging - financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities
- The Securities Act of 1933 was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.
- The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues.
- The Sarbanes-Oxley Act required that firms provide more complete and accurate financial information.
Role of Financial Institutions
- 1.Commercial Banksa.The most dominant type of depository institutionb.Transfer deposit funds to deficit units through loans or purchase of debt securities
- 2.Savings Institutionsa.Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banksb.Concentrate on residential mortgage loans
- 3.Credit Unionsa.Nonprofit organizationsb.Restrict business to CU members with a common bond
Role of Nondepository Institutions
- a.Finance companies - obtain funds by issuing securities and lend the funds to individuals and small businesses.
- b.Mutual funds - sell shares to surplus units and use the funds received to purchase a portfolio of securities.
- c.Securities firms - provide a wide variety of functions in financial markets. (Broker, Underwriter, Dealer, Advisory)
- d.Insurance companies - provide insurance policies that reduce the financial burden associated with death, illness, and damage to property. Charge premiums and invest in financial markets.
- e.Pension funds – manage funds until they are withdrawn for retirement
the spread of financialproblems, among financial institutions and across financial markets, that couldcause a collapse in the financial system.
Financial Reform Act of 2010
- a.Also referred to as Wall Street Reform Act or Consumer Protection Act
- b.Mortgage lenders must verify the income, job status, and credit history of mortgage applicants before approving mortgage applications.
The Loanable Funds Theory
suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds.
Demand Curves for Loanable Funds
Chapter 2, slide 11
- 1.largest supplier, but some supplied by government units.
- a.More supply at higher interest rates.
- b.Supply by buying securities
Aggregate Demand for funds
- DA = Dh + Db + Dg + Dm + Df
- Dh = household demand for loanable funds
- Db = business demand for loanable funds
- Dg = federal government demand for loanable funds
- Dm = municipal government demand for loanable funds
- Df = foreign demand for loanable funds
Aggregate Supply of funds
- SA = Sh + Sb + Sg + Sm + Sf
- Sh = household supply for loanable funds
- Sb = business supply for loanable funds
- Sg = federal government supply for loanable funds
- Sm = municipal government supply for loanable funds
- Sf = foreign supply for loanable funds
Factors That Affect Interest Rates
- 1.Impact of economic growth on interest rates: Puts upward pressure on interest rates by shifting demand for loanable funds outward.
- 2.Impact of inflation on interest rates: Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward.
- 3.Impact of Monetary Policy on Interest RatesWhen the Fed reduces (increases) the money supply, it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates.
- 4.Impact of the Budget Deficit on Interest RatesCrowding-out Effect: Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to “crowd out” the private demand for funds.
- 5.Impact of Foreign Flows of Funds on Interest RatesInterest rate for a certain currency is determined by the demand for funds in that currency and the supply of funds available in that currency.
- 1.securities with a higher degree of default risk offer higher yields.
- a.Rating Agencies - Rating agencies charge the issuers of debt securities a fee for assessing default risk. (Exhibit 3.1).
- b.Accuracy of Credit Ratings - The ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees.
- c.Oversight of Credit Rating Agencies - The Financial Reform Act of 2010 established an Office of Credit Ratings within the Securities and Exchange Commission in order to regulate credit rating agencies. Rating agencies must establish internal controls.
Why Debt Securities Yields Vary..
Liquidity- The lower a security's liquidity, the higher the yield preferred by an investor
- Tax Status (Exhibit 3.2)
- a.Investors are more concerned with after-tax income.
- b.Taxable securities must offer a higher before-tax yield.
- Term to Maturity (Exhibit 3.3)
- a.Maturity dates will differ between debt securities.
- b.The term structure of interest rates defines the relationship between term to maturity and the annualized yield.
Pure Expectations Theory-
- Term structure reflected in the shape of the yield curve is determined solely by the expectations of interest rates.
- a.An expected increase in rates leads to an upward sloping yield curve (Exhibit 3.5)
- b.An expected decrease in rates leads to a downward sloping yield curve.
Liquidity Premium Theory-
Investorsprefer short-term liquid securities but will be willing to invest in long-termsecurities if compensated with a premium for lower liquidity.
Segmented Markets Theory-
- 3.Investors choose securities with maturities that satisfy their forecasted cash needs.
- Limitations of the theory: Some borrowers and savers have the flexibility to choose among various maturities
- Implications: Preferred Habitat Theory Although investors and borrowers may normally concentrate on a particular maturity market, certain events may cause them to wander from their “natural” or preferred market.
Forecasting Interest Rates
- a.The shape of the yield curve can be used to assess the general expectations of investors and borrowers about future interest rates.
- b.The curve’s shape should provide a reasonable indication (especially once the liquidity premium effect is accounted for) of the market’s expectations about future interest rates.
Some analysts believe that flat or iverted yield curves indicate a recession in the near future.
Investment and Financing Decisions
- Making Investment Decisions - If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term securities even though they have funds to invest for only a short period of time.
- Making Decisions about Financing - Firms can estimate the rates to be paid on bonds with different maturities. This may enable them to determine the maturity of the bonds they issue.
Five Major Components of the Fed:
- 1. Federal Reserve District Banks
- 2. Member Banks
- 3. Board of Governors
- 4. Federal Open Market Committee (FOMC)
- 5. Advisory Committees
Federal Reserve District Banks..
- a.12 Federal Reserve district banks. New York Fed is considered the most important.
- b.Commercial banks purchase stock in their Federal Reserve district bank to become members. The stock pays a maximum dividend of 6% annually.
- c.Each Fed district bank has 9 directors.
- d.Facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans (through the discount window) to depository institutions in need of funds.
- a.Commercial banks can elect to become member banks if they meet specific requirements of the Board of Governors
- b.All national banks are required to be members of the Fed.
Board of Governors
- a.The Federal Reserve Board is made up of seven members
- b.Each member is appointed by the President of the U.S. and serves a nonrenewable 14-year term.
- c.One of the seven board members is selected by the President to be the Federal Reserve Chairman for a 4-year renewable term.
- d.One of the seven board members is designated by the President to be the Vice Chairman for Supervision according to the Financial Reform Act of 2010.
Federal Open Market Committee (FOMC)
Made up of the seven members of the Board of Governors plus the presidents of five Fed district banks (the New York district bank plus 4 of the other 11 Fed district banks as determined on a rotating basis).
- a.Federal Advisory Council consists of one member from each Federal Reserve district who represents the banking industry. Meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.
- b.Consumer Advisory Council consists of 30 members who represent the financial institutions industry and its consumers.
- c.Thrift Institutions Advisory Council consists of 12 members who represent savings banks, S&Ls, and credit unions.
Open Market Operations - The FOMC meets eight times a year, sets targets for the money supply growth level and the interest rate level, and implements monetary policy.
- a.Pre-meeting economic report (Beige book) - a consolidated report of regional economic conditions in each district.
- b.Economic presentations - Presentations include data and trends for wages, consumer prices, unemployment, GDP, business inventories, foreign exchange rates, interest rates, and financial market conditions.
- c.FOMC decisions - each member can offer recommendations regarding the federal funds rate target.
- d.FOMC Statement - a statement that summarizes its conclusion.
- e.Minutes of FOMC Meeting - provided to the public and are also accessible on Federal Reserve websites.
2.Role of the Fed’s Trading Desk- If a change in monetary policy is appropriate, the FOMC decision is forwarded to the Trading Desk (Open Market Desk) at the NY Fed through a policy directive.
- Control of M1 versus M2- The optimal form of money should (1) be controllable by the Fed and (2) have a predictable impact on economic variables when adjusted by the Fed.
- M1 includes currency held by the public and checking deposits (such as demand deposits, NOW accounts, and automatic transfer balances) at depository institutions.
- M2 includes everything in M1 as well as savings accounts and small time deposits, MMDAs, and some other items.
- M3 includes everything in M2 in addition to large time deposits and other items.
The Reserve Requirement
the proportion of bankdeposit accounts that must be held as required reserves or funds held inreserve. This has historically been set between 8 and 12 percent of transactionaccounts.
By reducing the reserve requirement, the Board increases the proportion of a bank’s deposits that can be lent out. The lower the reserve requirement, the greater the lending capacity of a depository institution.
The European Central Bank (ECB)-
- Based in Frankfurt, is responsible for setting monetary policy for all European countries that use the euro. The ECB’s monetary goals are price and currency stability.
- Impact of the Euro on Monetary Policy
- -Any changes in the money supply affect all European countries that use the euro.
- -Prevents participating countries from solving local economic problems using their own unique economic policies
GDP, National Income, Unemployment Rate, Other Indexes-
- GDP - measures the total value of goods and services produced during a specific period
- National Income - the total income earned by firms and individual employees during a specific period
- Unemployment rate - maintain a low of unemployment rate in the U.S.
- Other indexes - Industrial production index, a retail sales index, and a home sales index
Indexes of Economic Indicatiors include:
- Leading economic indicators which predict future economic activity.
- Coincident economic indicators which tend to reach their peaks and troughs at the same time as business cycles.
- Lagging economic indicators which tend to rise or fall a few months after business-cycle expansions and contractions.
Monitoring Indicators of Inflation
- a.Producer and consumer price indexes: Producer price index represents prices at the wholesale level, and the consumer price index represents prices paid by consumers (retail level).
- b.Other inflation indicators
- i.Wage rates are periodically reported in various regions.
- ii.Oil prices can signal future inflation because they affect the costs of some forms of production as well as transportation costs and the prices paid by consumers for gasoline.
- iii.The price of gold is closely monitored because gold prices tend to move in tandem with inflation.
- iv.In some cases, indicators of economic growth are also used to indicate inflation.
Lagged Effects of Monetary Policy:
- a.Recognition lag - lag between the time a problem arises and the time it is recognized
- b.Implementation lag - lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve that problem
- c.Impact lag – lag until the policy has its full impact on the econom
Inverse relationship between inflation and unemployment
- Strong economic conditions: high inflation, low unemployment
- Weak economic conditions: low inflation, high unemployment
Proposals to Focus on Inflation
- 1.Advantages of inflation targeting:
- The Fed would no longer face a trade-off between controlling inflation and controlling unemployment.
- The Fed would not have to consider responding to any fiscal policy actions.
- The Fed’s role would be more transparent and would lead to less uncertainty in financial markets.
- 2.Disadvantages of inflation targeting
- a.The Fed could lose credibility if the U.S. inflation rate deviated substantially from the Fed’s target inflation rate.
- b.Could result in a much higher unemployment level.
Global Monetary Policy
- 1.Impact of the dollar
- a.If the U.S. economic conditions are weak, a weak dollar can stimulate the economy by stimulating U.S. exports and discouraging U.S. imports.
- b.If U.S. economic conditions are weak, a strong dollar will not provide the stimulus needed to improve conditions. The Fed may need to implement a stimulative monetary policy.
- 2.Impact of global economic conditions
- a.Because economic conditions are integrated across countries, the Fed considers prevailing global economic conditions when conducting monetary policy.
- b.The Fed’s decision to lower U.S. interest rates during the 2008 credit crisis and stimulate the U.S. economy was partially driven by weak global economic conditions.
Transmission of Interest Rates
- Global interest rates will vary between countries.
- Countries with higher rates will attract investors from countries with lower rates.
- If investors leave due to U.S. falling rates, the Fed may believe it should act to prevent rates from falling lower.
- Given the international integration in money and capital markets, a government’s budget deficit can affect interest rates of various countries, referred to as global crowding out.