FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 1: Introduction to Financial Markets

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FNCE 4070 FINANCIAL MARKETS AND INSTITUTIONS
Lecture 1 Introduction to Financial Markets
Professor Michael Palmer Professor of
Finance University of Colorado at Boulder Spring
Semester 2012
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Where is this Financial Center?
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Beginning Quotes For Course

• May you live in interesting times.
• Reputed to be an ancient Chinese proverb and
  curse
• The only certainty in financial markets is
  uncertainty
• Credit Suisse, August 16, 2007 (Switzerland's
  second largest bank)
• Markets are constantly in a state of uncertainty
  and flux and money is made by discounting the
  obvious and betting on the unexpected. George
  Soros (Hedge fund manager and philanthropist)
• Without the element of uncertainty, the greatest
  business triumph would be dull, routine, and
  eminently unsatisfying. J. Paul Getty (American
  industrialist, founder of Getty Oil)
• I used to be scared of uncertainty now I get a
  high out of it. Jensen Ackles (Actor. TV
  Smallville, Dawsons Creek, and Supernatural)

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Testing Your Understanding of Financial Markets?

• Who is the current chairman of the Federal
  Reserve and who were the two previous chairs of
  the Federal Reserve?
• What is the Federal Reserve responsible for?
• Define the Federal Funds interest rate, the
  Discount Rate, and the Prime Rate?
• What is the current level of the Federal Funds
  Rate and is the Federal Funds Rate higher or
  lower than one year ago?
• Which country currently has the highest (lowest)
  interest rate?
• United States, United Kingdom, Japan, Germany,
  Australia, Canada, or Switzerland.

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Ben Bernanke The 14th Chairman of the Federal
Reserve Board

• Ben Bernanke replaced Alan Greenspan on February
  1, 2006
• Greenspan had served since August 1987.
• Background The Chairman of the Federal Reserve
  Board is named by the President and is confirmed
  by the U.S. Senate.
• They serve a term of four years, and can be
  reappointed.
• The Federal Reserve is responsible for the
  conduct of monetary policy, which means
• Setting interest rates and promoting money supply
  growth, in pursuit of maximum employment, stable
  prices, and moderate long-term interest rates.
• See Appendix 2 for some insights into Bernanke
  and Appendix 3 for previous Fed Chairs

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Ben Bernanke in Song

• Columbia Business School's YouTube Video parody
  of Dean Glenn Hubbard (Note he is not the real
  Dean) singing about Ben Bernanke.
• http//www.youtube.com/results?search_querybenbe
  rnankeeverybreathyoutakeaq0 (link to Ben
  Bernanke Every Breath you Take video)
• http//youtu.be/3u2qRXb4xCU (this may work).
• As you watch and listen to this parody take note
  of the following terms
• 1. Change of rate (i.e., interest rates)
• 2. Stagflate (aka, stagflation a recession
  with inflation)
• 3. BPS (basis points, a measure of interest
  rates)
• 4. Yield curve flips (yield curve going from
  upwards sweeping to downward sweeping as a signal
  of a future recession)
• 5. Interest rate policies (monetary policy used
  by central banks)
• 6. Models break (i.e., econometric models used
  to assess the impact of monetary policy changes
  on the economy)

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Federal Funds Rate

• The Fed Funds Rate is the short term (generally
  overnight) interest rate in the U.S. interbank
  market for lending/borrowing excess bank
  reserves.
• Essentially, the interest rate at which one
  commercial bank will lend reserves to another
  commercial bank.
• This is also regarded as a key (i.e.,
  benchmark) short interest rate in the United
  States because the Federal Reserve sets this rate
  so as to implement monetary policy.
• Since 1982, the Fed has announced a target for
  the federal funds rate.
• Since 2008, the target has actually been a range
  (upper and lower limit).
• For participants in financial markets, changes in
  this target rate (or lack of) indicate the
  stance (direction and accommodation) of monetary
  policy.

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How does the Fed Affect the Federal Funds Rate?

• Through open market operation
• The buying and selling of government securities.
• Buying government securities increases bank
  excess reserves.
• An increase in the supply of bank reserves
  (everything else equal) will put downward
  pressure on the Federal funds rate.
• Selling government securities reduces bank excess
  reserves.
• A decrease in the supply of bank reserves
  (everything else equal) will put upward pressure
  on the Federal funds rate.

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Demand and Supply Model of Bank Excess Reserves

• Fed selling government securities

• Fed buying government securities

• S1 S2
• Fed
• Funds
• Rate
• () Demand
  
• Excess Reserves

• S2 S1
• Fed
• Funds
• Rate Demand
• ()
• Excess Reserves
  

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U.S. Federal Funds Target Rate Sep 1982 (first
used) to Dec 2008

• Historical high July 1974, 13. Note Fed
  targeted money supply from 1979 to 1993, but, in
  the 1980s, it started shifting policy towards fed
  funds in 1995 it began announcing a specific fed
  funds target

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U.S. Federal Funds Target Rate Range Dec 2008 to
the Present

• Beginning in December 2008 the Federal Reserve
  announced a range for the Fed Funds Rate
  (currently 0.00 to 0.25).

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Effective Federal Funds Rate

• (Note Fed targeted money supply from 1979 to
  1993 a specific fed funds target not announced
  until 1995)

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Relationship of Target to Effective Rate
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Relationship of Target to Effective Dec 2008 to
the Present

• Beginning in December 2008 the Federal Reserve
  announced a range for the Fed Funds Rate
  (currently 0.00 to 0.25).

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Relationship of Central Bank Interest Rates to
Economic Activity

• Important measures of economic activity
• Economic output (Business Activity).
• GDP (changes in real GDP)
• Price levels
• Inflation (Consumer and producer prices)

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U.S. Business Cycles
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Effective Federal Fuds Rate and Business Activity
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Effective Federal Funds Rate and Price Changes
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Monitoring the Effective Federal Funds Rate

• As noted, the effective federal funds rate
  follows the target (or range) and thus it would
  appear that we can monitor this rate as an
  indicator of the stance (and changes in the
  direction) of Fed policy.
• http//www.bloomberg.com/apps/quote?tickerFEDL01
  IND
• We can also evaluate the effective rate in
  relation to the target or range as indicators as
  to conditions in financial markets.

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Assessing Financial Market Conditions
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Effective Fed Funds Rate and Target Range, Dec
2008 to Present
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Central Bank Target Interest Rates Jan 2008, Dec
2008, Jan 2010, Jan 2011, Jan 2012

• United States 4.25, 0.25, 0.25, 0.25, 0.25,
  0.25
• Japan 0.50, 0.30, 0.10, 0.10, 0.10
• Switzerland 2.75, 0.50, 0.25, 0.25, 0.00
• United Kingdom 5.50, 2.00, 0.50, 0.50,
  0.50
• Euro-zone 4.00, 2.50, 1.00, 1.00, 1.00
• Canada 4.00,1.50, 0.25, 1.00, 1.00
• Australia 6.75, 4.25, 3.75, 4.75, 4.25
• China 7.20, 5.31, 5.31, 5.81, 6.56
• India 9.00, 6.50, 4.75, 6.25, 8.25
• Brazil 11.25, 13.75, 8.75, 10.75, 11.0
• Note For current rates and meeting dates see
  http//www.fxstreet.com/fundamental/interest-rates
  -table/

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Federal Reserve Discount Rate

• Federal Reserve Discount Rate Interest rate the
  Federal Reserve will charge member banks and
  other depository institutions to borrow short
  term (overnight) reserves.
• Administratively set by the Federal Reserve
• Currently .75 (January 2008 4.75) (Now Called
  Primary Credit Rate)
• This market is important as it represents a
  safety net for financial institutions.
• Also carries potentially important signals as to
  future fed policy directions.

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Prime Interest Rate

• Prime Rate Interest rate commercial banks will
  charge their best customers (i.e., high grade
  corporates) on loans to borrow short term funds.
• Tied to the Federal Funds Rate (with the Fed
  funds rate the casual rate).
• Prime rate is generally around 300 basis points
  higher than fed funds rate
• Currently 3.25. (January 2008 7.25)

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Prime Interest Rate, 1949 to the Present
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Why is the Fed Funds Rate So Important?

• Fed Funds rate is set by U.S. central bank and
  thus it carries important signals for the market.
• What the central bank thinks about the economy
  and the direction of the economy.
• These signals will affect how the market sets its
  interest rates.
• Bottom line Other money market rates are
  influenced by the direction and level of the Fed
  Funds Rate.

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Fed Funds Rate and Prime Interest Rate
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Fed Funds Rate and Short Term Government
Securities
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Fed Funds Rate and Short Term Money Market Rates
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Fed Funds Rate and Long Term Interest Rates
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Cross Country Comparisons Long Term Govt
Rates, January 2012
Country 10-Year Govt Bonds Country 10-Year Govt Bonds
United States 1.99 Italy 6.90
Switzerland 0.66 South Africa 7.91
Japan 0.99 India 8.60
Hong Kong 1.38 Egypt 8.29
Germany 1.92 Turkey 9.72
United Kingdom 2.04 Hungary 10.21
Canada 2.10 Brazil 11.26
France 3.33 Pakistan 14.23
China 3.52 Greece 36.62
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Short Term Interest Rates 1993 2010 Global
Comparisons
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Long Term Interest Rates 1993 2010 Global
Comparisons
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Useful Web Sites

• For current U.S. interest rate data see
• http//www.federalreserve.gov/releases/h15/update
• For Effective Fed Funds Rate see
• http//www.bloomberg.com/apps/quote?tickerFEDL01
  IND
• For other key rates
• http//www.bloomberg.com/markets/rates-bonds/key-r
  ates/
• For charting U.S. interest rate data and other
  U.S. data see
• http//research.stlouisfed.org/fred2/

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Appendix 1

• Hong Kong Background Notes

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Asia Pacific with Hong Kong
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Hong Kong as a Financial Center

• After being ceded by China to the British (as a
  result of the Opium Wars) under the Treaty of
  Nanking in 1842, the colony of Hong Kong rapidly
  became a regional center for financial and
  commercial services with China and South Asia.
  During the Korean War, the U.N. imposed an
  embargo on mainland China (for its support of
  North Korea) and as a result many industrialist
  moved from the mainland to Hong Kong and set up
  light industry export companies. During this
  period, Hong Kong grew as a shipping and textile
  export center.
• However, China's open-door policy in 1978 was the
  year that marked the new era of Hong Kong and its
  re-birth as a major economic and financial
  center. As manufacturing moved out of Hong Kong
  to mainland China, it was replaced by services,
  and Hong Kong GDP boomed as trade and investment
  links with China exploded. Global financial
  services also flourished because of Hong Kongs
  British-style legal system and the fact that
  English is spoken fluently both of which
  supported Hong Kongs financial networks with
  London, New York and other leading global cities.
  In additional, Hong Kong has had long existing
  stock market (since 1891).

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Hong Kong as a Financial Center

• Today Hong Kong is an important market for IPO
  (second only to New York last year) and funds
  management. Today Hong Kong is the worlds sixth
  largest foreign exchange trading center, with
  4.7 of the worlds total trades (or 238 billion
  per day). 71 of the largest 100 banks in the
  world have an operation in Hong Kong. Hong Kong
  is the world's 9th largest international banking
  center in terms of the volume of external
  transactions, and the second largest in Asia
  after Japan. The banking sector plays a vital
  role in establishing Hong Kong as a major loan
  syndication center in the region. The Hong Kong
  Stock Exchange is Asia's third largest stock
  exchange in terms of market capitalization behind
  the Tokyo Stock Exchange and the Shanghai Stock
  Exchange and fifth largest in the world. As of 31
  Dec 2010, the Hong Kong Stock Exchange had 1,413
  listed companies with a combined market
  capitalization of 2.7 trillion.
• Hong Kong was hit hard by the Asian Financial
  Crisis that struck the region in mid-1997, just
  at the time of the handover of the colony back to
  Chinese administrative control. The crisis
  prompted a collapse in share prices and the
  property market. However, unlike most Asian
  countries, Hong Kong (as well as mainland China)
  maintained their currencies exchange rates with
  the U.S. dollar rather than devaluing.

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Appendix 2

• Ben Bernankes View of the Role of Central Banks
• The following slides present a brief sketch of
  Bernanke and offer possible insights into his
  approach regarding the role of the U.S. central
  bank.

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Ben Bernanke

• Ben Bernanke was born on December 13, 1953, in
  Augusta, Georgia. He received a B.A. in economics
  in 1975 from Harvard University (summa cum laude)
  and a Ph.D. in economics in 1979 from the
  Massachusetts Institute of Technology.
• Before becoming a member of the Federal Reserve
  Board, Dr. Bernanke was the Howard Harrison and
  Gabrielle Snyder Beck Professor of Economics and
  Public Affairs and Chair of the Economics
  Department at Princeton University (1996-2002).
  Dr. Bernanke had served as a Professor of
  Economics and Public Affairs at Princeton since
  1985.

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Bernankes Views on Central Banking

• Bernanke, whose academic studies have focused on
  the Great Depression, has written that during
  that era the U.S. central bank allowed banks to
  fail, prices to fall and the money supply to
  contract, which contributed to the protracted
  slump.
• In essence, he blames the Fed for not acting in a
  proactive manner.
• In addition, Bernanke has been quoted as follows
  "We now know the lessons from that the
  Depression. "We are certainly going to make sure
  that the financial system remains in good
  functioning order.
• Conclusion It appears that Bernanke will follow
  a very aggressive proactive approach to monetary
  policy in the U.S.

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Appendix 3

• Changing Fed Chairs being introduced by the
  President

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Changing Fed Chairs

• Volcker to Greenspan, August 1987

• Greenspan to Bernanke, February 2006