Money and Financial Markets: PD Dr. M. Pasche Friedrich Schiller University Jena
Money and Financial Markets: PD Dr. M. Pasche Friedrich Schiller University Jena
Money and Financial Markets: PD Dr. M. Pasche Friedrich Schiller University Jena
PD Dr. M. Pasche
Friedrich Schiller University Jena
Creative Commons by 3.0 license 2014 (except for included graphics from other sources)
Work in progress! Bug Report to: markus@pasche.name
S.1
Outline:
1. Financial Markets
1.1 Overview over Financial Markets
1.2 Interest Rate Theory
1.3 Function and Measurement of Money
2. Theory of Financial Structure
2.1 Financial Intermediates
2.2 Portfolio Selection and the Management of Return, Risk and
Liquidity
2.3 Adverse Selection Problems
2.4 Moral Hazard Problems
3. The Money Supply Process
3.1 Creation of Central Bank Money (Money Base)
3.2 Multiple Deposit Creation and the Multiplier
3.3 Endogenous Money Supply
S.2
4. Theory of Money Demand
4.1 Keynesian Theory of Liquidity Preference
4.2 Portfolio Theory of Money Demand
4.3 Friedmans Neo Quantity Theory
5. Central Banking and Transmission of Policy
5.1 Goals of Monetary Policy
5.2 Transmission Mechanisms (Channels)
5.3 Targets, Strategies, and Rules
6. Monetary Macroeconomics
6.1 The Keynesian IS-LM-AD-AS Model
6.2 New Keynesian Macroeconomics
S.3
Basic Literature:
capital allocation:
transferring funds from saver/lender to investor/borrower
risk allocation:
risk sharing, diversication, asset transformation
transferring liquidity
The holder of an equity can sell the asset e.g. on the stock
exchange market.
S.12
1. Financial Markets
1.1 Overview over Financial Markets
1.1.1 Asset Market Classications
Advantages and disadvantages:
Debt: Regular payments are more or less certain (unless the debitor
stays solvent).
Equity: Residual payments are uncertain. Residual means that the
rm has to pay the debitors (and taxes) rst.
Debt: In case of insolvency the creditor has a prior claim on the
remaining assets.
Equity: Secondary claim on remaining assets in case of insolvency.
S.13
1. Financial Markets
1.1 Overview over Financial Markets
1.1.1 Asset Market Classications
Advantages and disadvantages: (cont.)
Debt: Holder do not prot from increasing protability and
increasing rm value since their payments are xed.
Equity: The holder prots directly by higher dividends and increased
value of their shares.
Debt: Holder has not the right to vote about management issues
and about the distribution of the net income of the rm.
Equity: Holder has these rights.
S.14
1. Financial Markets
1.1 Overview over Financial Markets
1.1.1 Asset Market Classications
b) Primary, Secondary and Derivative Markets
Primary Market:
Once an asset has been issued it can be traded at the current price.
The transactions are often performed by brokers instead of the asset
holders themselves.
Example: stock exchange, foreign exchange.
Derivative Markets:
Not the assets themselves are traded but other claims related to the
underlying assets, e.g. the right to buy a certain asset to a certain
price within a certain period.
Example: options, futures. S.15
1. Financial Markets
1.1 Overview over Financial Markets
1.1.1 Asset Market Classications
t=0
C
(1 + i )
t
with P
0
= bonds price in t, F = face value, C = coupon rate, n =
maturity date.
Expected return r when holding the bond for one period (before
maturity, without discounting):
r =
C + P
t+1
P
t
P
t
where P
t+1
is the expected bonds price in t + 1.
S.20
1. Financial Markets
1.1 Overview over Financial Markets
1.1.2 Bond Markets
If the interest rate is low and vice versa the bonds price is
high it is more attractive for governments, rms or institutions
to issue bonds to nance their activities. The supply curve
can be assumed to be downward sloped in i . Alternatively, in
the short run the bonds supply can be assumed to be
exogenously xed.
S.22
1. Financial Markets
1.1 Overview over Financial Markets
1.1.2 Bond Markets
B
B
D
B
D
B
S
B
S
B
price
interest
rate
S.23
1. Financial Markets
1.1 Overview over Financial Markets
1.1.3 Loan Markets
Types of loans:
Simple loan: borrowed amount L is paid back plus interest
payment IP at the maturity date n. The interest rate i then solves:
L =
L + IP
(1 + i )
n
Fixed-payment loan: borrowed amount is paid back including
interest in xed payments FP (amortisation plus interest) per
period until maturity date. The interest rate i then solves
L =
n
t=1
FP
(1 + i )
t
S.24
1. Financial Markets
1.1 Overview over Financial Markets
1.1.3 Loan Markets
Problems:
(r ) > 0, u
(r ) < 0.
Risk premium:
Given a return of a risk-free asset A. Which risk premium RP on
the return will be neccessary so that the utility of the uncertain
asset B equals the utility of the risk-free asset A?
A
=
A
,
B
=
B
+, E[] = 0, V[] > 0
E[u(
A
)] = E[u(
B
)]
A
+ RP =
B
S.37
1. Financial Markets
1.2 Interest Rate Theory
1.2.2 Risk Structure of Interest Rates
r
u(r )
RP
B
E[u(
A
)] = E[u(
B
)]
A
S.38
1. Financial Markets
1.2 Interest Rate Theory
1.2.2 Risk Structure of Interest Rates
The interest rates of more risky bonds are higher than of low
risk bonds e.g. corporate bonds are more risky than US
government bonds, bonds of AAA-rated rms are less risky
than of BBB-rated rms etc..
S.39
1. Financial Markets
1.2 Interest Rate Theory
1.2.1 Behavior of Interest Rates
interest
rate
B
S
interest
rate
treasury bonds corporate bonds
B
S
B
D
1
B
D
2
B
D
1
B
D
2
spread
increasing risk of corporate bonds
S.40
1. Financial Markets
1.2 Interest Rate Theory
1.2.1 Behavior of Interest Rates
source: Mishkin (2010)
S.41
1. Financial Markets
1.2 Interest Rate Theory
1.2.1 Behavior of Interest Rates
source: German Council of Economic Experts
S.42
1. Financial Markets
1.2 Interest Rate Theory
1.2.2 Risk Structure of Interest Rates
Interest rate dierentials can furthemore be explained by
Flat yield curve: same interest rate in short and long run
Explains the rst two stylized facts but not the third one.
S.47
1. Financial Markets
1.2 Interest Rate Theory
1.2.3 Term Structure of Interest Rates
Example: Amount L is invested for two periods.
Question: Buying one long-term contract or two subsequent
short-term contracts?
R
long
= L (1 + i
0,2
)
2
R
short
= L (1 + i
0,1
)(1 + i
1,1
)
where i
j ,k
is the interest rate at time j for a k-period contract.
In an arbitrage-free market we have R
long
= R
short
which implies
i
0,2
=
(1 + i
0,1
)(1 + i
1,1
) 1
where i
1,1
is the expected interest rate. The current long-term
interest rate is the geometric mean of the current and the expected
short-term interest rate in the future.
S.48
1. Financial Markets
1.2 Interest Rate Theory
1.2.3 Term Structure of Interest Rates
If expectations are not systematically false, there should be a
correlation between the slope of yield curves and the business
cycle: before a cyclical downturn the yield curve will become at or
inverted. Before an economic recovery the slope of the yield curve
will rise.
Empirical Literature:
Bernhard, H., Gerlach, S. (1998), Does the Term Structure Predict
Recessions? The International Evidence. International Journal of
Finance and Economics Vol. 3(3), 195-215.
S.49
1. Financial Markets
1.2 Interest Rate Theory
1.2.3 Term Structure of Interest Rates
Segmented Markets Theory:
Medium of Exchange
Unit of Account
Store of Value
S.53
1. Financial Markets
1.3 Function and Measurement of Money
1.3.1 Functions
Medium of Exchange: