Risk return tradeoff-pplare generally risk averse Stock variable-ex. money-measured at a point in time Flow variable-ex.

income-measured over a period of time Commodity money-ex. Gold standard->must fix price of gold and outlaw buying and selling of gold for it to work Fiat money-currency that has legal guarantee for paying debts by the govnt->money needs to be relatively scarce to be valuable Credit money system-a monetary system in which the liabilities of private financial institutions serve as the primary medium of exchange Equation of Exchange: MV=PY %changeM+%changeV=%changeP+%changeY Vincrease->Mddecrease &V decrease->Mdincrease Quantity Theory of Money- if real GDP (y) in the long run is determined by y=AF(k,C) and if V is constant, then the price level is proportionate to the Ms Cambridge Version: k=1/V M=KPY Money=the proportion of ppls income they want to hold in the form of money=k=1/V (V decrease->1/Vincrease) Direct Finance-the flow of funds go from lenders to borrowers with no financial intermediaries Indirect Finance-lenders->financial intermediaries-> borrowers (reduces transaction costs and increases volume of exchange) Primary Markets-places of borrowing & lending Secondary Market-contains securities that have already been bought or sold once-places of liquidity-(NASDAQ) Money Market- securities with a term to maturity of less than one year (higher liquidity than capital -> lower return) Primary Market-securities with term to maturity over 1year Over the counter market-market that exists in the relationships of the traders (NASDAQ) Organized exchanges-physical market location (NYSE) Principle=face value-what the bond is worth at maturity Premium=Pbond> face value; Discount=Pbond< face value Coupon bond-fixed income stream-inverse relationship btwn bond prices and interest rates Pure Discount bond-income stream gets paid at maturity rather than at quarterly or yearly times like a coupon Collateral-the property one uses to ensure a loan, & which the lender takes possession of in the event of default Increase Securitization (greater diversification of securities)of retail loans b/c 1) increase liquidity 2) lower risk Municipal Bonds-interest paid on this bond is exempt from taxes interest rates tend to be lower on these bonds 2 Types: General obligation-interest paid out by states tax revenues-issued by govnt to finance general obligations Revenue- issued in connection with a particular project (bridge) interest paid out with the expected revenue from the project Convertibility-when a bond can be converted into stock under certain circumstances at the initiative of the lender Call feauture (provision)-money bonds are callable, meaning they can be repaid by the borrower before the maturity date whether the lenders like it or not Derivatives-securities that derive their value from the value of some other underlying asset: held by hedger&speculator Key Money Market Securities 1 T-bills-pure discount bonds 2 Negotiable Bank CDs-large denominational cds can be legally bought and sold in the secondary market if one wants to liquidate his cd 3 Commercial Paper-short-term debt thats issued to the biggest, most credit worthy companies 4 Repurchase Agreements negotiable 5 Fed Funds Rate-overnight loans for banks-market determined interest rate (not set by govnt) -buying & selling of bank reserves that are kept at the Fed -enables banks to maintain their reserve limits & make loans they otherwise wouldnt be able to 6 Eurodollars-$ deposits that are located outside US Time Preference When d increases->PV decreases -evaluation of things based on location in time rather space -most ppl exhibit some change of positive time preference with respect to most things which means the thing is more valuable in the present than in the future PV: what the future income stream is worth Ex. 60yrs old->good health=$100k PV of good health 40yrs hence=$100k/(1+d)tothe40 ->the higher the d (your personal rate of deposited time preference) is, the lower will be PV of good health Internal Rate of Return (iRR=1/P/E) iRRPushcart<iRRUSbond->bad deal to buy push cart for income stream Price to Earnings Ratio (P/E) -need a stocks P/E to find the better value

[A decrease in the highest marginal tax bracket affects the spread btwn municipal & regular bond yields- iT decrease>municipal bonds less desirable-> D for municipal bonds decreases->P of bonds decreases->iMincreases] [Yield to Maturityon a bond (i)=discount rate that equates the expected stream of payments back to bonds current P] [The returns from holding a bond can be considerably more or less than the interest rate on the bond if your holding period is different from the bonds term to maturity] [FV of $100 1yr hence at 10%?FV=100(1+i)=100(1.1)=$110 PV of $110 at 10% today? PV=110/(1+i)=$100] *Bond Prices & yields are negatively related*->when P of bond increases, the discount rate that equates the PV of its income stream to its P of bond goes down-> i decreases *when the i goes up, the PV of all income streams its being used to discount decreases->asset prices deceases *i increases->P of bond decreases->D for stock decreases-> P of stock decreases->DRE decreases->PRE decreases* Coupon Rate=Annual Coupon Payment/Face Value Coupon Yield=Coupon Rate/Price of bond PB > Face Value ->i < coupon rate [Suppose the coupon rate on a bond=10% & the bond is selling at a premium, PB> Face Value but CR=C/face value, will i > CR? i must be lower than the coupon rate] [Issued a bunch of 6% coupon rate bonds that mature in 30 yrs->6% of 2041 bonds are selling at a considerable premium in the secondary markets->angry b/c you could have borrowed at a lower interest rate] *P of bond above face value->coupon rate doesnt change but current yield decreases* Return on a bond=% rate of return you get on your investment (Return for 1yr=coupon/PBT) 2 Ways to Measure Risk 1 variation-how far from the average do expect return 2 value at risk-how much is lost if it all goes wrong Risk-Return Trade-off-in order to be willing to assume additional risk, investors require compensation ->combining risky securities into a portfolio will reduce risk as long as the returns move independently of one another Systematic risk-market risk Non-systematic risk-diversifiable risk Types of Bond Risk 1 inflation risk 2 interest rate risk-applies to situations where the holding period < term to maturity 3 default risk 4 reinvestment risk-applies to situations where the holding period > term to maturity *Holding period=term to maturity *Yield to maturity=current yield=coupon/PB [The term structure of interest rates shows the relationship btwn yields on bonds that differ only in terms of term to maturity->yield curve] Current Theory of Term Structure must explain or agree with 3 Facts:1 interest rates tend to move together 2 short term yields tend to be more volatile than long term yields 3 the yield curve is normally upward sloping Segmented Markets Approach -lenders prefer to lend short -borrowers prefer to borrow long Liquidity Premium Theory- as term to maturity increases -> compensation increases Upward Sloping Yield Curve- short term interest rates are expected to rise & theres liquidity preference Common stock entitles one to a pro-rated share in the issuing corp.s net earnings. If investors arent paid dividends the dividends are reinvested in company(increasing stock value), so in theory wealth is attained either way. Market capitalization-worth of company based off of what stocks are selling for. Ps(price of stock)=1+g/ d-g. (d=discount rate g=expected future growth rate). Rational expected value=optimal forecast of a variable. Theoretically, ppl take in all useful info thats available. Info and expected value doesnt have to be correct all the time though. X^e=X^OF. X^E=Xbar. Rational expectations forecast errors will on avg.=0, and therefore cant be predicted ahead of time. *Ppldo not make systematic mistakes in the economic part of life. Market participants neither systematically overestimate or underestimate the future value of a variable. R=Pt+1 Pt +C/ Pt. Pt+1=price @end of holding. R=rate of return on security from time t to t+1. C=coupon or div. payments. Summary.1. efficient capital mkts.are very efficient in reevaluating info. and prices. 2. On avg. the best you can do in financial mkts. is equilibrium returns. Derivatives-value is derived from some underlying asset. 3 main types of derivatives are futures, options, and swaps. *The [buyer] of a futures

contract (the long) has the right and obligation to buy the underlying asset at the pre-agreed upon price at the expiration of the futures contract. The [seller] of a futures contract (the short), has the right and obligation to sell the underlying asset at the pre-agreed upon price at the expiration of the futures contract. When theres an increase in the futures price the long wins. When theres a decrease in the futures price the short wins. *Options: The issuer of options has obligations. The buyer of options has rights. Two main options are call and put options. The issuer of a [call] option has the obligation to sell underlying asset at a pre-agreed upon price(strike price). The buyer has the right to buy at the strike. The buyer wins when the assets price increases above the strike price. The issuer of a [put] option has the obligation to buy the asset at the strike price. The buyer of the put option has the right to sell the underlying asset at the strike price. The buyer of a put option wins when the assets price decreases below the strike price. Options entail rights, so the value can never be negative, Put option, the intrinsic value=0. Put option is in the money. *Interest rate swaps: the variable rate payer is the fixed rate receiver. The fixed rate payer is the variable rate receiver. Hedging w/ interest rate swaps: Risk: rising interest rates will increase your cost of funds, your payments will be adversely affected by a change in i. therefore, youwanna be the fixed rate payer and variable rate receiver. Risk: Falling interest rates, where asset sides would be disproportionately affected by change in i .youwanna be variable rate payer and fixed receiver. Current exchange rate- e=F/$1 real exchange rate =F/$1 x Pd/Pf PPP suggest: Pdedomestic money depreciates. Pfe domestic money appreciates. When i D d$e. When i Fs $ e. Suppose the FedMsi D(d$ or s $) either way, e (dollar depreciates) but if dQan s $ results from domestic residents buying more foreign securitiesQ*. e$dollar appreciates and euro depreciates. Security brokers=intermediate btw. Buyers and sellers, but dont trade on their own account. Security dealers=trade on their own account. Bid-buying price.Ask-selling price. Less competition and liquidity leads to greater bid-ask price. Operating banks have 4 managing positions: 1. Liquidity management-dont want too much or too little cash. 2. Asset management-min. risk and max. return. 3. Liability management-actively competing for deposits.4. Capital management-want minimum amt. of capital w/o risking bank failure. ROE=net earnings/assets x assets/capital=ROA x 1/capital/asset. 1/capital/asset=equity multiplier. When capital EM. The lower is bank capital the more likely theyll assume risk. Gov./regulators goal is to hold enough capital to avoid bankruptcy. demand for cashsell assets(liquidation)Pa capitaleventually capital=0 & then close doors. *Banks risk: Liquidity risk: problem=banks running out of cash. When bnk. Is faced w/ this they can 1. Sell securities 2. Fail to renew loans 3. Borrow from FED at the discount rate or by borrowing in the FED fund mkt. 4. Attract deposits. Credit risk= risk that a banks loan portfolio will go bad. Bnks. can min. risk by diversifying their loans to diff. sector and regions. Interest rate risk= how banks profit will change based off of interest rate. GAP analysis-measures proportion of liabilities and assets that are interest rate sensitive. *GAP analysis=% of assets that are sensitive to interest minus % of liabilities that are sensitive to the interest rate. Banks w/ negative GAP means liabilities are more sensitive when interest rates increase. Banks create new money every time they make new loans. Real bills doctrine-increase in Ms need not be inflationary if they give loan to ppl. Who intend to use it for productive reasons(not for useless reasons). Fed has to serve as last resort of making loans to banks. M=(1 +CU/D)/ RR/D + ER/D + CU/D x MB. RR=reserve requirement CU/D=publics currency deposit ratio. ER/D=excess reserve ratio. MB=bank reserves +currency in the hands of the public. ER/Dmoney multiplier CU/D money multiplier RR/Dmoney

multiplier.iER/D MMM. i CU/D MMM