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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 18
THE LIQUIDITY PREMIUM THEORY
Bonds
Liquidity Premium Theory
Stocks
Essential Characteristics
Process
Measuring Level of a Stock Market
Valuing Stocks
The Liquidity Premium Theory
Risk is the key to understanding the slope of the yield curve
The yield curve's upward slope is due to long-term bonds being riskier than short-term
bonds
Bondholders face both inflation and interest-rate. The longer the term the greater the
inflation and interest-rate risk
Inflation risk increases over time because investors, who care about the real return, must
forecast inflation over longer periods.
Interest-rate risk arises when an investor's horizon and the bond's maturity do not match. If
holders of long-term bonds need to sell them before maturity and interest rates have
increased, the bonds will lose value
Including risk in the model means that we can think of yield as having two parts:
Risk-free and
Risk premium
i1t + i1et +1 + i1et + 2 + .... + i1et + n -1
int = rp  n +
n
Pure expectations theory
Risk premium
Figure: Relationship between the Liquidity Premium and Expectations Theories
Liquidity Premium Theory Yield curve
Liquidity
premium
Expectations Theory Yield curve
(If short term interest rates are expected to remain
constant)
Time to maturity
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Money & Banking ­ MGT411
VU
Again, we arrive at the same three conclusions about the term structure of interest rates
Interest rates of different maturities tend to move together.
Yields on short-term bonds are more volatile than those on long-term bonds.
Long-term yields tend to be higher than short-term yields
Stocks: An Introduction
Stocks provide a key instrument for holding personal wealth as well as a way to diversify,
spreading and reducing the risks that we face
For companies, they are one of several ways to obtain financing.
Additionally,
Stocks and stock markets are one of the central links between the financial world and the real
economy.
Stock prices are fundamental to the functioning of a market-based economy
They indicate the value of the companies that issued the stocks and,
They allocate scarce investment resources
The firms deemed most valuable in the marketplace for stocks are the ones that will be able to
obtain financing for growth. When resources flow to their most valued uses, the economy
operates more efficiently
Most people see stock market as a place where fortunes are easily made or lost, and they recoil
at its unfathomable booms and busts.
Great American Depression (1929)
Post-September 11, 2001 scenario
Pakistan stock market on roller-coaster-ride (March 2005)
What happens in reality?
Stock prices tend to rise steadily and slowly, and
Collapse rarely when normal market mechanisms are out of alignment
For most people the experience of losing or gaining wealth suddenly is more memorable than
the experience of making it gradually.
By being preoccupied with the potential short-term losses associated with crashes, we lose sight
of the gains we could realize if we took a longer-term view
Essential Characteristics of Common Stock
Stocks, also known as common stock or equity, are shares in a firm's ownership
From their early days, stocks had two important characteristics that today are taken for granted:
The shares are issued in small denominations and
The shares are transferable
Until recently, stockowners received a certificate from the issuing company, but now it is a
computerized process where the shares are registered in the names of brokerage firms that hold
them on the owner's behalf
The ownership of common stock conveys a number of rights
A stockholder is entitled to participate in the shares of the enterprise, but this is a residual claim
i.e. meaning the leftovers after all other creditors have been paid.
Stockholders also have limited liability,
Even if a company fails, the maximum amount that the stockholder can lose is the initial
investment
Stockholders are entitled to vote at the firm's annual meeting including voting to elect (or
remove) the firm's board of directors
Following are some salient features of stock trading
1. An individual share represents only a small fraction of the value of the company that
issued it
2. A large number of shares are outstanding
3. Prices of individual shares are low, allowing individuals to make relatively small
investments
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Money & Banking ­ MGT411
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4. As residual claimants, stockholders receive the proceeds of a firm's activities only after
all other creditors have been paid
5. Because of limited liability, investor's losses cannot exceed the price they paid for the
stock; and
6. Shareholders can replace managers who are doing a bad job
Measuring the Level of the Stock Market
Stocks are one way in which we choose to hold our wealth, so when stock values rise we get
richer and when they fall we get poorer
These changes affect our consumption and saving patterns, causing general economic activity to
fluctuate
We need to understand the dynamics of the stock market, in order to
Manage our personal finances and
See the connections between stock values and economic conditions
Stock market indexes
Designed to give us a sense of the extent to which stock prices are going up or down
Tell us both how much the value of an average stock has changed, and how much total wealth
has gone up or down
Provide benchmarks for performance of money managers, comparing how they have done to the
market as a whole
Every major country in the world has a stock market, and each of these markets has an index
For the most part, these are value-weighted indices
To analyze the performance of these different markets it is useful to look at percentage changes,
but percentage change isn't everything
The Dow Jones Industrial Average
The Standard & Poor's 500 Index
NASDAQ Composite index
Financial Times Stock Exchange 100 Index
Hang Seng 100
Nikkei 225
KSE 100 Index
The KSE100
It contains a representative sample of common stock that trade on the Karachi Stock Exchange.
The KSE stocks that comprise the index have a total market value of around Rs. 1,197 Billion
compared to total market value of Rs. 1,365 Billion for over 679 stocks listed on the Karachi
Stock Exchange.
This means that the KSE100 Index represents 88 percent of the total market capitalization of the
Karachi Stock Exchange, as of February, 2004
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY