01 FNCE 4070 Summer 2012 Introduction to Financial Markets by 4hRKVe0C


Lecture 1: Introduction to Financial

                 Professor Michael Palmer
                 Professor of Finance
                 University of Colorado at
                 Summer 2012
Where is this Financial Center?

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. World’s largest stock
exchange by market capitalization.
Federal Hall

       Site of Federal Hall built in 1700. Home to the
       first U.S. Congress, Supreme Court, and
       Executive Branch. George Washington’s
       inauguration took place here. U.S. Bill of Rights
       introduced in Federal Hall.
  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, Dawson’s Creek, and Supernatural)
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
       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
       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.
Ben Bernanke: The 14th Chairman of the
Federal Reserve Board
   Ben Bernanke replaced Alan Greenspan on February 1,
       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
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_query=ben+bernanke+every+b
    reath+you+take&aq=0 (link to Ben Bernanke Every Breath you Take
   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)
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).
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
         doesn’t it too provides us with important signals
         as to conditions in financial markets.
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.
Demand and Supply Model of Bank
Excess Reserves: Impact on Fed
Funds Rate         Fed selling government
Fed buying government       securities; reducing bank
securities; increasing      excess reserves
bank excess reserves
             S1 S2                      S2 S1
Funds                       Fed
Rate                        Funds
(%)                Demand   Rate              Demand

        Excess Reserves              Excess Reserves
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
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%).
Effective Federal Funds Rate
   Historical high (Daily data): April 10, 1980, 19.53%.
    Historical low: Dec 30, 2011 – January 2, 2012, 0.04%
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.
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?ticker=FEDL01:IND
   We can also evaluate the effective rate in
    relation to the target or range as indicators
    (signals) as to conditions in financial markets.

                                                                                                                                        in 2008

Effective Rate

Target Rate
                                                                            Target Fed Funds Rate Versus Effective Federal Funds Rate

                                                                                                                                        Assessing Financial Market Conditions
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
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.
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%)
Fed Funds Rate and Prime Rate
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)
Fed Funds Rate and Other Money
Market Rates
Fed Funds Rate and Capital
Market Rates
Fed Funds Rate and Equities
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)
U.S. Business Cycles, June 1854 –
June 2009 (NBER Data)
Cycle Dates               Average Recession   Average Expansion
                          (Months)            (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:         43 months
August 1929 – March
Longest Expansion:                            120 months
November 2001 –
December 2007
Recent U.S. Cycles
Federal Funds Rate and Business
Activity: Response of Federal Reserve
Equities and Business Cycles
Corporate Profits and Equities
Effective Federal Funds Rate and
Price Changes (Inflation)
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.
Relationship of Discount Rate (Primary
Credit Rate) to Fed Funds Rate
Cross Country Comparisons: 10-
Year Gov’t Rates, May 2012
Country           10-Year Gov’t      Country             10-Year Gov’t
                  Bonds (in local                        Bonds (in local
                  currency)                              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%
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
        country’s central bank (generally the more accommodative,
        the lower the interest rate)
       Relative differences in the market’s 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.
Inflation and Long Term Interest
Safe Haven Effect: U.S. Dollar and
U.S. 10-Year Bond Rates
EURO Exchange Rate (in   10-Year Bond Rate (1919-
USD)                     2012 average = 6.6%)
  Gov’t Rates: Spreads Over
  Benchmark Rates
Country    Latest   Spread     Spread    Country     Latest   Spread   Spread
           Yield    Versus     Versus                Yield    Versus   Versus T-
                    Bund       T-Bond                         Bund     Bond
United     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         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     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

What Do Spread Differences Tell
   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
Comparing Cross Country Interest
   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
       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
Central Bank Overnight Interest Rate
Targets, January 2008 and May 2012
Country           January May 2012 Country             January     May 2012
                  2008                                 2008
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%
Cross Country Comparisons:
Money Market Rates (3 Month
Government Rates) May 2012
Country          Interest Rate (in   Country     Interest Rate (in
                 local currency)                 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%
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?ticker=FEDL01:I
   For other key rates:
       http://www.bloomberg.com/markets/rates-bonds/key-
   For cross country comparisons on 10-Year
    Government bonds:
       http://www.tradingeconomics.com/bonds-list-by-country
Appendix 1

   Ben Bernanke’s 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
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.
Bernanke’s 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
   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
Appendix 2

   Changing Fed Chairs being introduced
   by the President
Changing Fed Chairs
Volcker to Greenspan,   Greenspan to Bernanke,
August 1987             February 2006

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