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

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. Where is this Financial Center?. NYSE.

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

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  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. World’s 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 Washington’s 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, Dawson’s 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_query=ben+bernanke+every+breath+you+take&aq=0 (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 doesn’t 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 buying government securities; increasing bank excess reserves Fed selling government securities; reducing bank excess reserves S2 S1 Fed Funds Rate Demand (%) Excess Reserves S1 S2 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?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.

  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)

  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 Gov’t Rates, May 2012 http://www.tradingeconomics.com/bonds-list-by-country

  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 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.

  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. Gov’t Rates: Spreads Over Benchmark Rates 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 http://www.fxstreet.com/fundamental/interest-rates-table

  44. Cross Country Comparisons: Money Market Rates (3 Month Government Rates) May 2012

  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?ticker=FEDL01:IND • For other key rates: • http://www.bloomberg.com/markets/rates-bonds/key-rates/ • For cross country comparisons on 10-Year Government bonds: • http://www.tradingeconomics.com/bonds-list-by-country

  46. 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 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. 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 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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