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

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


1
FNCE 4070 FINANCIAL MARKETS AND INSTITUTIONS
Lecture 1 Introduction to Financial Markets
Professor Michael Palmer Professor of
Finance University of Colorado at Boulder Summer
2012
2
Where is this Financial Center?
3
NYSE
New York Stock Exchange Traced back to 1790
Trading in Federal Government Bonds issued to
finance the Revolutionary War. In 2007, merged
with Euronext (NYSE-Euronext). In 2008, acquired
the American Stock Exchange. About 2,800
companies, with a combined market capitalization
of about 18 trillion, are listed on the NYSE,
trading approximately 1.46 billion shares each
day. Worlds largest stock exchange by market
capitalization.
4
Federal Hall
Site of Federal Hall built in 1700. Home to the
first U.S. Congress, Supreme Court, and Executive
Branch. George Washingtons inauguration took
place here. U.S. Bill of Rights introduced in
Federal Hall.
5
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)
  • People should be more concerned with the return
    of their principal than the return on their
    principal.
  • Will Rogers (Popular American humorist, early
    20th century)
  • I used to be scared of uncertainty now I get a
    high out of it. Jensen Ackles (Actor. TV
    Smallville, Dawsons Creek, and Supernatural)

6
Your Understanding of Financial Markets?
  • What is a central bank (e.g., the Federal
    Reserve) responsible for?
  • What the difference between monetary and fiscal
    policy?
  • What do we mean by quantitative easing (QE)?
  • How does a central bank attempt to influence
    economic activity?
  • How can we measure economic activity?
  • Who is the current chairman of the Federal
    Reserve and who were the two previous chairs of
    the Federal Reserve?
  • Bank of England? European Central Bank?
  • What is the EU and what is the Euro-zone?
  • Which countries make up the G7 PIIGS BRICS
  • Which country, among the following currently has
    the highest (lowest) interest rate? United
    States, United Kingdom, Japan, Germany,
    Australia, or Switzerland.

7
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 (now defined as 2), and moderate
    long-term interest rates.
  • See Appendix 1 for some insights into Bernanke
    and Appendix 2 for previous Fed Chairs

8
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
    well).
  • As you watch and listen 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)

9
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.
  • What are excess reserves?
  • Essentially, the Federal Funds rate is the
    interest rate at which one commercial bank will
    lend excess reserves to another commercial bank.
  • The Federal Funds Rate is 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.
  • So we (financial market participants) get
    important signals from this rate (and changes in
    the rate).

10
Federal Funds Rate
  • Since 1982, the Fed has announced a target for
    the federal funds rate.
  • However beginning in December 2008 the target has
    actually been a range (upper and lower limit).
  • In addition to the Fed Funds target, another
    important overnight interbank rate is the
    effective federal funds rate.
  • This is the actual rate at which banks are
    lending excess reserves to one another.
  • It will generally parallel the target, but when
    it doesnt it too provides us with important
    signals as to conditions in financial markets.

11
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.

12
Demand and Supply Model of Bank Excess Reserves
Impact on Fed Funds Rate
  • Fed selling government securities reducing bank
    excess reserves
  • Fed buying government securities increasing bank
    excess reserves
  • S1 S2
  • Fed
  • Funds
  • Rate
  • () Demand
  • Excess Reserves
  • S2 S1
  • Fed
  • Funds
  • Rate Demand
  • ()
  • Excess Reserves

13
U.S. Federal Funds Target Rate Sep 1982 (first
used) to Dec 2008
  • Note Fed targeted money supply from 1979 to
    1993, but, in the 1982, it started shifting
    policy towards the fed funds rate in 1995 it
    formally announced a fed funds target

14
U.S. Federal Funds Target Rate Range Dec 2008 to
the Present
  • Beginning in December 2008 (Dec 16th) the Federal
    Reserve announced a range for the Fed Funds Rate
    (0.00 to 0.25).

15
Effective Federal Funds Rate
  • Historical high (Daily data) April 10, 1980,
    19.53. Historical low Dec 30, 2011 January
    2, 2012, 0.04

16
Relationship of Target to Effective Rate
  • Note An official fed funds target was first
    announced in1995, although minutes from the FOMC
    suggests the Fed was targeting this rate from
    1982 on.

17
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
    (signals) as to conditions in financial markets.

18
Assessing Financial Market Conditions in 2008
19
Assessing Financial Market Conditions with the
Fed Funds Range, Dec 2008 to the Present
  • Recall, beginning on December 16, 2008 the
    Federal Reserve announced a range for the Fed
    Funds Rate

20
Why is the Fed Funds Rate (Potentially) So
Important?
  • Fed Funds rate is set (or influenced) by U.S.
    central bank and thus it carries important
    signals for the market.
  • It tells us what the central bank thinks about
    the economy and the direction of the economy.
  • These signals, in turn, will affect how the
    market sets its interest rates.
  • Bottom line Other money market rates are
    probably influenced by the direction and level of
    the Fed Funds Rate.

21
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 (one
    year or less) funds.
  • By convention, the prime rate is tied to the
    Federal Funds Rate (with the Fed funds rate the
    casual rate).
  • Banks scale up from this cost of funds rate.
  • Prime rate is generally around 300 basis points
    higher than fed funds rate
  • Currently 3.25. (January 2008 7.25)

22
Fed Funds Rate and Prime Rate
23
Prime Interest Rate, 1955 - Present
  • Historical high (daily data) December 16, 1980
    January 1, 1981, 21.50. Historical low
    December 16, 2008 Present, 3.25 (matching
    August 1955)

24
Fed Funds Rate and Other Money Market Rates
25
Fed Funds Rate and Capital Market Rates
26
Fed Funds Rate and Equities
27
Measures of Economic Activity
  • Important measures of economic activity
  • Economic output (Business Activity).
  • GDP (changes in real GDP)
  • Business Cycles
  • Traditional recession definition 2 consecutive
    quarters decline in real GDP
  • Current definition incorporates more analysis.
  • Most recent U.S. cycle
  • Recession December 2007 - June 2009
  • Price levels
  • Inflation (Consumer and producer prices)

28
U.S. Business Cycles, June 1854 June 2009 (NBER
Data)
Cycle Dates Average Recession (Months) Average Expansion (Months)
1854 2009 (33 cycles) 16 months 42 months
1854- 1919 (16 cycles) 22 months 27 months
1919 1954 (6 cycles) 18 months 36 months
1945 2009 (11 cycles) 11 months 59 months
Great Depression August 1929 March 1933 43 months
Longest Expansion November 2001 December 2007 120 months
29
Recent U.S. Cycles
30
Federal Funds Rate and Business Activity
Response of Federal Reserve
31
Equities and Business Cycles
32
Corporate Profits and Equities
33
Effective Federal Funds Rate and Price Changes
(Inflation)
34
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)
  • Historically called the Discount Rate, now called
    the 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.
  • The relationship of this rate to the Federal
    Funds rate has changed since January 2003.

35
Relationship of Discount Rate (Primary Credit
Rate) to Fed Funds Rate
36
Cross Country Comparisons 10-Year Govt Rates,
May 2012
Country 10-Year Govt Bonds (in local currency) Country 10-Year Govt Bonds (in local currency)
United States 1.76 Italy 5.98
Switzerland 0.65 Spain 6.28
Japan 0.83 South Africa 7.78
Hong Kong 1.12 Ireland 8.21
Germany 1.46 India 8.52
Singapore 1.46 Turkey 9.31
Canada 1.92 Portugal 12.39
United Kingdom 1.94 Brazil 12.55
China 2.80 Pakistan 14.23
France 2.88 Greece 28.41
Australia 3.23
http//www.tradingeconomics.com/bonds-list-by-coun
try
37
Why the Differences in Rates?
  • Differences in cross country government bond
    interest rates reflect
  • Relative differences in economic growth (where
    countries are in their business cycles).
  • Relative differences in rates of inflation
    (generally the higher the rate of inflation, the
    higher the interest rate).
  • Relative differences in the accommodative
    stance of each countrys central bank (generally
    the more accommodative, the lower the interest
    rate)
  • Relative differences in the markets assessment
    about the risk associate with a sovereign
    borrower.
  • Impact of flight to safe havens as markets become
    risk adverse (movement into safer countries
    during regional and global uncertainty will drive
    down yields).
  • One quick way to observe and measure these
    differences is through spreads to major country
    bond rates.

38
Inflation and Long Term Interest Rates
39
Safe Haven Effect U.S. Dollar and U.S. 10-Year
Bond Rates
  • EURO Exchange Rate (in USD)
  • 10-Year Bond Rate (1919-2012 average 6.6)

40
Govt Rates Spreads Over Benchmark Rates
Country Latest Yield Spread Versus Bund Spread Versus T-Bond Country Latest Yield Spread Versus Bund Spread Versus T-Bond
United States 1.75 0.30 ------- France 2.86 1.42 1.11
Germany 1.45 -------- -0.30 Australia 3.18 1.73 1.43
Switzerland 0.65 -0.80 -1.10 New Zealand 3.59 2.14 1.84
Japan 0.88 -0.57 -0.87 Italy 5.96 4.51 4.20
Denmark 1.33 -0.12 -0.43 Spain 6.28 4.83 4.53
United Kingdom 1.85 0.40 0.10 Portugal 12.39 10.94 10.64
Canada 1.90 0.45 0.15 Greece 28.90 27.45 27.15
http//markets.ft.com/RESEARCH/Markets/Government-
Bond-Spreads
41
What Do Spread Differences Tell Us?
  • Given that the spreads are relative to the two
    major default free sovereign borrowers (Germany
    and the U.S.), perhaps we can use these spreads
    as a market measure of risk of default (certainly
    the case of Italy, Spain, Portugal and Greece).
  • On the other hand, spreads may simply represent
    differences in inflation rates (Japan and U.K.),
    economic activity (Australia), or central bank
    accommodation (Switzerland).
  • Finally, differences between the Bund and T-Bill
    probably reflect differences in global market
    demand stemming from regional and global safe
    haven effects.

42
Comparing Cross Country Interest Rates
  • In comparing government bonds cross country, the
    2 most common comparison rates are either yields
    to maturity on 10-year U.S. Treasuries (T-Bonds)
    and 10-year German Treasuries (Bunds).
  • We assume both of these are default-free.
  • Thus we can compare other sovereigns to these
    (and to one another) to assess
  • Risk of default (credit risk).
  • Inflation risk.
  • Overall country risk (including political and
    exchange rate risk)
  • See http//markets.ft.com/markets/bonds.asp

43
Central Bank Overnight Interest Rate Targets,
January 2008 and May 2012
Country January 2008 May 2012 Country January 2008 May 2012
United States 4.25 0 0.25 India 9.00 8.00
Japan 0.50 0.10 Egypt 11.50 9.25
Switzerland 2.75 0.00 Brazil 13.75 9.00
Canada 4.00 1.00 Turkey 16.75 5.75
Euro-zone 4.00 1.00
United Kingdom 5.50 0.50
Australia 6.75 3.75
China 7.20 6.56
New Zealand 8.25 2.50
http//www.fxstreet.com/fundamental/interest-rates
-table
44
Cross Country Comparisons Money Market Rates (3
Month Government Rates) May 2012
Country Interest Rate (in local currency) Country Interest Rate (in local currency)
United States 0.07 Australia 3.28
Germany 0.06 Brazil 8.44
Japan 0.11 Greece 25.40
United Kingdom 0.26
Canada 1.00



45
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 cross country comparisons on 10-Year
    Government bonds
  • http//www.tradingeconomics.com/bonds-list-by-coun
    try

46
Appendix 1
  • 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.

47
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.

48
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.

49
Appendix 2
  • Changing Fed Chairs being introduced by the
    President

50
Changing Fed Chairs
  • Volcker to Greenspan, August 1987
  • Greenspan to Bernanke, February 2006
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