• Introduction and Overview

• Syllabus Review of Course Policies

• Functions of Financial Markets: What Do
Financial Markets Do, and How Do They Do
It?
• Where Do Companies Get Funds?
 The Supply of Capital
Physical Capital = Machines, Factories,
Office Bldgs.,
Infrastructure, etc.

Working Capital
 The Supply of Capital

Savings → Financial Capital → Physical +

Working Capital
 Functions of Financial Markets
 Provide ways to transfer economic resources
through time, across borders and among
economic sectors and industries.
 Provide essential information to facilitate and
coordinate decentralized decision-making
 Provide ways to manage risk
 Provide a means to clear and settle payments to
facilitate trade
 Provide a means for pooling of savings and
subdividing ownership shares
 Financing Alternatives
• What are a firm’s financing alternatives?

• What percentage of total capital raised is

represented by each alternative?
 Financing Alternatives
• Retained profits (plowback) 75%Internal
Funds

• Bank loans 15%

External
• Bonds 7.5%Funds
Securities
• Stocks 2.5%

Source: Professor’s Calculations based on Federal Reserve Flow

of Funds Data
• Financial Intermediation vs. Direct Finance
• Bank-Centered Systems vs. Market-Centered Systems
• Primary vs. Secondary Markets
• What Is Money vs. What Money Is
• Financial Intermediaries
• Banking: Some Facts and Figures
• The trend toward fewer and bigger banks
• How Do Banks Work?
• Basics of Accounting
• Bank Accounting
Intermediation vs. Direct Finance

Source: Mishkin and Eakins, Financial Markets and

Institutions, 6th ed., p. 18
Sources of External Finance
Intermediation vs. Direct Finance

Source: Mishkin and Eakins, Financial Markets and

Institutions, 6th ed., p. 18
 Finance Jargon:
Primary vs. Secondary Markets
• Primary markets – where securities are first sold
to the public, and where firms or governments
receive the bulk of the revenue from those sales.

• Secondary markets – where individual and

institutional investors trade securities among
themselves.

Issuers of securities receive none of the proceeds

from transactions in the secondary market.
Intermediation vs. Direct Finance

Source: Mishkin and Eakins, Financial Markets and

Institutions, 6th ed., p. 18
• Functions of Money

• Medium of Exchange
• Store of Value
• Unit of Account
 Liquidity

Savings
Cash Real Estate
Deposits

Liquid Illiquid

Chkg. Dep Time Stocks Fine Art

Deposits and
Bonds
 Measures of Money

• M1
• Currency and Traveler’s Checks
• Cash in the hands of the public
• Checking Deposits
• Held at commercial banks, S & Ls, Savings Banks, and
Credit Unions
• As of Sept. 5, 2019, M1 = $3.9 Trillion
 Liquidity

Savings
Cash Real Estate
Deposits
M1
Liquid Illiquid

Chkg. Dep Time Stocks Fine Art

Deposits and
Bonds
 Measures of Money
• M1
• Currency and Traveler’s Checks
• Cash in the hands of the public
• Checking Deposits
• Held at commercial banks, S & Ls, Savings Banks, and Credit
Unions
• As of Sept. 5, 2019, M1 = $3.9 Trillion
• M2
• M1
• Savings deposits
• Time deposits
• Money market mutual funds and other deposits
• As of Sept. 5, 2019, M2 = $14.9 Trillion
 Liquidity

Savings
Cash Real Estate
Deposits
M1 M2
Liquid Illiquid

Chkg. Dep Time Stocks Fine Art

Deposits and
Bonds
 Measures of Money

• What is not money?

• Checks
• Checks are not money, but checking deposits are
• Credit cards
• Credit cards merely allow you to take a short-term,
unsecured loan
Intermediation vs. Direct Finance

Source: Mishkin and Eakins, Financial Markets and

Institutions, 6th ed., p. 18
Types of Financial Intermediaries
 Principal Financial Intermediaries
and the Value of Their Assets
Value of Assets (Billions of $, End of Year); % of Total
Type of Intermediary 1980 1990 2000 2010
Depository Institutions (Banks)
Commercial Banks 1,482 37% 3,338 31% 6,709 25% 14,336 32%
Savings and Loan Associations 792 20% 1,323 12% 1,218 5% 1,244 3%
and Mutual Savings Banks
Credit Unions 68 2% 217 2% 441 2% 912 2%
Contractual Savings Institutions
Life Insurance Cos. 464 11% 1,351 12% 3,136 12% 5,176 12%
Fire and Casualty Insurance Cos. 182 4% 533 5% 858 3% 1,404 3%
Private Pension Funds 513 13% 1,629 15% 4,468 17% 6,112 14%
State and Local Govt. Pension Funds
196 5% 730 7% 2,293 9% 2,931 7%
Investment Intermediaries - - -
Finance Cos. 213 5% 596 6% 1,213 5% 1,590 4%
Mutual Funds 62 2% 608 6% 4,433 17% 7,935 18%
Money Market Mutual Funds 76 2% 493 5% 1,812 7% 2,755 6%
Totals 4,048 100% 10,820 100% 26,580 100% 44,396 100%
Source: Federal Reserve, Flow of Funds Accounts of the United
States, June 9, 2011 Release
 Depository Institutions

• Essential Activity: Take deposits and make

loans
• Commercial Banks
• Thrift Institutions
• Savings and Loan Associations (S & Ls)
• Savings Banks
• Credit Unions
• Money Market Mutual Funds
Number of Commercial Banks
in the U.S.
1984 – 2019
Jan., 1984
14,400

↓68%

Aug, 2019
4,605
My Favorite Bank
 Reasons for Bank Merger Activity
• Antiquated banking regulations in place until
the early 1990s led to too many banks—
overcapacity
• McFadden Act (1927)—prohibited branching
• Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994—abolished all
prohibitions on interstate banking
 Reasons for Bank Merger Activity
• Economies of scale
• Economies of scope
• Loan diversification
 Size Distribution of Insured Commercial
Banks and Savings Institutions in the U.S.
Second Quarter, 2019
Number Share Total Assets Share of
Assets of of Banks Assets
Banks (%) Held (%)
< $100 Million 1,230 23% $72.7 Billion .4%

$100 Million – 3,281 62% $1.1 Trillion 6%

$1
Billion
651 12% $1.7 Trillion 9.4%
$1-$10 Billion

$10 Billion – 132 3% $6.3 Trillion

34.4%
$250 Billion

> $250 Billion 9 .2% $9.1 Trillion 49.8%

Source:
[Link]
Total 5,303 100% $18.3 Trillion 100% nalytical/qbp/2019jun/qbp.p
df
 Ten Largest U.S. Banks,
March 31, 2019

Share of All
Bank Assets Commercial Domestic
Bank Assets Branches
(%)

1. J.P. Morgan Chase $2.3 T 14% 5,034

2. Bank of America $1.8 T 11% 4,339

3. Wells Fargo $1.7 T 10% 5,585

4. Citibank $1.4 T 9% 702

5. U S Bank $467 B 3% 3,048

Source: [Link]
 Ten Largest U.S. Banks,
March 31, 2019

Share of All
Bank Assets Commercial Domestic
Bank Assets Branches
(%)

6. PNC Bank $381 B 2% 2,416

7. Capital One $307 B 2% 537

8. TD Bank $301 B 2% 1,241

9. Bank of NY/Mellon $271 B 1% 2

10. State Street $225 B 1% 2

Source: [Link]
 Ten Largest Banks in the World
Jan. 1, 2019

Bank Country Assets

1. Industrial and Commercial

China $4.0 T
Bank of China

2. China Construction Bank China $3.4 T

3. Agricultural Bank of China China $3.3 T

4. Bank of China China $3.1 T

5. China Development Bank China $2.4 T

Source: [Link]
 Ten Largest Banks in the World
Jan. 1, 2019

Bank Country Assets

6. BNP Paribas France $2.3 T

7. JP Morgan Chase US $2.2 T

8. MUFG Bank Japan $2.0 T

9. Japan Post Bank Japan $1.9 T

[Link] Agricole France $1.9 T

Source: [Link]
 Depository Institutions

• Economic Functions
• Creating Liquidity
• Borrowing “short” and lending “long”
• Minimizing the Cost of Borrowing
• Minimizing the Cost of Monitoring Borrowers
• Pooling Risk
 Individual Balance Sheet

Assets (A) Liabilities (L)

Home $250,000 Mortgage $100,000

Car $ 25,000 Auto Loan $ 10,000

Stocks $100,000 Credit Card $ 5,000

Net Worth (NW)

(Assets – Liabilities)
$375,000 - $115,000
 Individual Balance Sheet

Assets (A) Liabilities (L)

Home $250,000 Mortgage $100,000

Car $ 25,000 Auto Loan $ 10,000

Stocks $100,000 Credit Card $ 5,000

Net Worth (NW)

$375,000 - $115,000
= $260,000
The Balance Sheet HAS TO
Balance

NW = A – L
 A = L + NW
 LHS = RHS
 Individual Balance Sheet

Assets (A) Liabilities (L)

Home $250,000 Mortgage $100,000

Car $ 25,000 Auto Loan $ 10,000

Stocks $100,000 Credit Card $ 5,000

$375,000 Net Worth (NW)

$260,000
$375,000
 Business Balance Sheet

Assets (A) Liabilities (L)

Office Bldg $10M Taxes Due $ 2M

Accounts Bank Loans $15M

Receivable $ 5M
Owner’s Equity
Inventory $ 3M
(= A – L)
Misc. $ 2M
$20 M - $17 M
= $3 M
Bank Balance Sheet

Assets (A) Liabilities (L)

Net Worth (NW)

(= Bank Capital)
(= A – L)
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves Deposits
Vault Cash Savings Deposits

Deposits with Checking Deposits

the Fed

Loans Bank Capital

Bonds (= A – L)
Other Assets
 The Balance Sheet HAS TO
Balance
Bank Capital = A – L
 A = L + Bank Capital
• How Do Banks Work?
• Basics of Accounting
• Bank Accounting
• Bank Accounting Exercises
• Measures of Bank Profitability
• Bank Leverage
• Where Does Money Come From? The Money
Multiplier Process
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves Deposits
Vault Cash Savings Deposits

Deposits with Checking Deposits

the Fed

Loans Bank Capital

Bonds (= A – L)
Other Assets
 The Balance Sheet HAS TO
Balance
Bank Capital = A – L
 A = L + Bank Capital
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves $2M Checking Deposits $2M

Loans $500K
Bank Capital
(= A – L)
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves $2M Checking Deposits $2M

Loans $500K
Bank Capital
$500K
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves $200K Checking Deposits $2M

Old Loans $500K

New Loans $1.8M Bank Capital
$500K
Changes in the Bank Balance Sheet
Someone deposits $500 cash

Assets (A) Liabilities (L)

Reserves +$500 Checking Deposits +$500

Loans
Bank Capital
Changes in the Bank Balance Sheet
Bank buys $1000 in bonds

Assets (A) Liabilities (L)

Reserves -$1000 Checking Deposits

Bonds +$1000
Bank Capital
Changes in the Bank Balance Sheet
Bank loans out $500 in cash

Assets (A) Liabilities (L)

Reserves -$500 Checking Deposits

Loans +$500
Bank Capital
Changes in the Bank Balance Sheet
Bank loans out $500 by crediting a
deposit account for the borrower
Assets (A) Liabilities (L)

Reserves −$500 Checking Deposits +$500

Checking Deposits −$500
Loans +$500
Bank Capital
Customer Makes a Loan Payment of
$1000: $800 interest + $200 principal

Assets (A) Liabilities (L)

Reserves +$1000

Loans −$200
Bank Capital

+$800
Changes in the Bank Balance Sheet
Bank is robbed of $500

Assets (A) Liabilities (L)

Reserves -$500

Bank Capital
-$500
 A $1M Loan Defaults

Assets (A) Liabilities (L)

Loans −$1M
Bank Capital
−$1M
Aggregate Bank Balance Sheets,
2007
Aggregate Bank Balance Sheets,
2013
 Measures of Bank Profitability
• Net Interest Spread
• Net Interest Income
• Net Interest Margin

• Return on Assets (ROA)

• Return on Equity (ROE)
 Fidelity Fiduciary Bank
Balance Sheet

Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)

Loans $ 150 B
(6% Interest)
Bank Capital
(= A – L)
$ 20 B
 Net Interest Spread
Net Interest Spread
• Difference between the rate which banks
earn on their assets and the rate which they
have to pay on their liabilities (for
example, the rate they pay on deposits)
• Does not account for the fact that the total
amount of interest earning assets and the
total amount of liabilities is different
 Fidelity Fiduciary Bank
Balance Sheet
Net Interest Spread = 6% − 2% = 4%
Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)

Loans $ 150 B
(6% Interest)
Bank Capital
(= A – L)
$ 20 B
 Net Interest Income
Net Interest Income
• Difference between total interest payments
received on a bank’s assets and the total
interest payments made on the bank’s
liabilities
• Net interest income
= (total interest received on
assets)
− (total interest payments on
liabilities)
 Fidelity Fiduciary Bank
Balance Sheet
Net Interest Income = 9B − 2.8B = 6.2B
Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)

Loans $ 150 B
(6% Interest)
Bank Capital
(= A – L)
$ 20 B
 Net Interest Margin

Net Interest Margin

Net interest income
Net interest margin =
Total interest earning assets
• Well-run banks have a high net interest
income and a high net interest margin.
• If a bank’s net interest margin is currently
improving, its profitability is likely to
improve in the future.
 Fidelity Fiduciary Bank
Balance Sheet
Net Interest Margin = 6.2B / $150B = 4.1%
Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)

Loans $ 150 B
(6% Interest)
Bank Capital
(= A – L)
$ 20 B
Bank Capital and Profitability
There are several other measures of bank
profitability.
1. Return on assets (ROA).
• ROA is the bank’s profit left after taxes
divided by the bank’s total assets.
Net profit after taxes
ROA 
Total bank assets
• It is a measure of how efficiently a particular
banks uses its assets.
• This is less important to bank owners than the
return on their own investment.
 Fidelity Fiduciary Bank
Balance Sheet
Net Interest Income = 9B − 2.8B = 6.2B
Other expenses = 2B Taxes = .3×4.2B = 1.26B
Net profit after taxes = 4.2B − 1.26B = 2.94B
Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)
ROA = 2.94B / 160B = 1.8%
Loans $ 150 B
(6% Interest) Bank Capital
(= A – L)
$ 20 B
 Bank Capital and Profitability
2. Return on equity (ROE)
The bank’s return to its owners is measured by
the ROE. This is the bank’s net profit after
taxes divided by the bank’s capital.
Net profit after taxes
ROE 
Bank capital
• ROA and ROE are related to leverage.
 Fidelity Fiduciary Bank
Balance Sheet

Net profit after taxes = 4.2B − 1.26B = 2.94B

Assets (A) Liabilities (L)

Reserves $ 10 B Deposits $ 140 B

(0% Interest) (2% Interest)
ROE = 2.94B / 20B = 14.7%
Loans $ 150 B
(6% Interest) Bank Capital
(= A – L)
$ 20 B
Bank Capital and Profitability
• Prior to the financial crisis of 2007-2009,
the typical U.S. bank has a ROA of about
1.3%.
• For large banks, the ROE tends to be higher
than for small banks, suggesting greater
leverage, a riskier mix of assets, or the
existence of significant economies to scale
in banking.
• The poor performance during the crisis and
moderate returns after, suggests their high
returns were at least partly due to more leverage
or a riskier mix of assets.
 Bank Capital and Profitability
Bank Assets
• Leverage ratio  Bank Capital

• The extent of leverage can also be measured by the bank’s debt to

equity ratio: Bank Liabilities

Bank Capital

• The ratio of debt to equity in the U.S. banking system was about 8
to 1 in December, 2015.
• Although that is a substantial amount of leverage, it is nearly 25%
below the average commercial bank leverage ratio that prevailed
prior to the financial crisis of 2007-2009.
• Debt-to-equity ratio for nonfinancial business in the U.S. is less than
1 to 1.
• Household leverage is roughly 1/3 to 1.
• Leverage increases risk AND expected return.
Why is a High Leverage Ratio Attractive?
(High Leverage Case)

Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Bank Capital
Leverage Ratio =
(= A – L)
500/50 = 10
Debt to Equity Ratio
$50 Billion
= 450/50 = 9
Why is a High Leverage Ratio Attractive?
(Low Leverage Case)

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Bank Capital
Leverage Ratio =
(= A – L)
500/100 = 5
Debt to Equity Ratio
$100 Billion
= 400/100 = 4
 Party On!! High Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Liabilities Don’t
Value of Assets ↑ Change
By 10% Bank Capital
(= A – L)
New Asset Total:
$50 Billion
$550 Billion New Capital
Total: $100
 Party On!! High Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Liabilities Don’t
Value of Assets ↑ Change
By 10% Bank Capital
(= A – L)
New Asset Total:
New Capital
$550 Billion Total: $100
Owner’s Make 100% ReturnBillion
on Their Investment!!
 Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Bank Capital
Leverage Ratio =
(= A – L)
500/100 = 5
Debt to Equity Ratio
$100 Billion
= 400/100 = 4
 Party On!! Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Liabilities Don’t
Value of Assets ↑ Change
By 10% Bank Capital
(= A – L)
New Asset Total: $100 Billion
$550 Billion New Capital
Total:
 Party On!! Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Liabilities Don’t
Value of Assets ↑ Change
By 10% Bank Capital
(= A – L)
New Asset Total:
New Capital
$550 Billion Total:
Owner’s Make 50% Return on $150
Their Billion
Investment!!
 Why is a High Leverage Ratio
Dangerous?
High Leverage Case
Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Bank Capital
Leverage Ratio =
(= A – L)
500/50 = 10
Debt to Equity Ratio
$50 Billion
= 450/50 = 9
 Why is a High Leverage Ratio
Dangerous?
High Leverage Case
Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Liabilities Don’t
Value of Assets ↓ Change
By 10% Bank Capital
(= A – L)
New Asset Total: $50 Billion
$450 Billion New Capital
Total:
 Why is a High Leverage Ratio
Dangerous?
High Leverage Case
Assets (A) Liabilities (L)

$500 Billion $ 450 Billion

Liabilities Don’t
Value of Assets ↓ Change
By 10% Bank Capital
(= A – L)
New Asset Total: New Capital
$450 Billion Total:
$0
BANK IS INSOLVENT!!
 Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Bank Capital
Leverage Ratio =
(= A – L)
500/100 = 5
Debt to Equity Ratio
$100 Billion
= 400/100 = 4
 Bummer: Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Liabilities Don’t
Value of Assets ↓ Change
By 10% Bank Capital
(= A – L)
New Asset Total: $100 Billion
$450 Billion New Capital
Total:
 Bummer: Low Leverage Case

Assets (A) Liabilities (L)

$500 Billion $ 400 Billion

Liabilities Don’t
Value of Assets ↓ Change
By 10% Bank Capital
(= A – L)
New Asset Total: New Capital
$450 Billion Total:
$50
Owner’s Lose 50% Return on Their Investment!!
 Bank Capital and Profitability
• One of the explanations for the relatively high
degree of leverage in banking is the existence
of government guarantees like deposit
insurance.
• These government guarantees allow banks to
capture the benefits of risk taking without
subjecting depositors to potential losses.
 Bank Balance Sheet

Assets (A) Liabilities (L)

Reserves Deposits
Vault Cash Savings Deposits

Deposits with Checking Deposits

the Fed

Loans Bank Capital

Bonds (= A – L)
Other Assets
 The Balance Sheet HAS TO
Balance
Bank Capital = A – L
 A = L + Bank Capital
 Money Multiplier: Step 1
Somebody Deposits $10,000 in
Bank of America
Assets (A) Liabilities (L)

Reserves +$10K Checking Deposits +$10K

Bank Capital
Total New Deposits
$10,000 Original Deposit
 Money Multiplier: Step 1
Somebody Deposits $10,000 in
Bank of America
Assets (A) Liabilities (L)

Reserves +$10K Checking Deposits +$10K

- New Loans $9K

Bank Capital
 Money Multiplier: Step 1
Somebody Deposits $10,000 in
Bank of America
Assets (A) Liabilities (L)

Reserves +$10K Checking Deposits +$10K

-New Loans $ 9K

Bank Capital
Loans +$ 9K
 Money Multiplier: Step 1
Somebody Deposits $10,000 in
Bank of America
Final Changes in Balance Sheet

Assets (A) Liabilities (L)

Reserves +$1K Checking Deposits +$10K

Loans +$9K Bank Capital

 Money Multiplier
$9,000 loaned out by BOA ends up in
Cambridge Savings Bank
Assets (A) Liabilities (L)

Reserves +$9K Checking Deposits +$9K

Loans
Bank Capital
Total New Deposits
$10,000 Original Deposit in BOA
$ 9,000 Deposit in CSB
 Money Multiplier: Step 2
Final Balance Sheet of Cambridge
Savings Bank
Assets (A) Liabilities (L)

Reserves +$ 900 Checking Deposits +$9K

Loans +$ 8,100 Bank Capital

 Total New Deposits
$10,000 Original Deposit in BOA
$ 9,000 Deposit in CSB
$ 8,100 Deposit in Sovereign
Bank
$ 7,290 Deposit in Citibank
$ 6,561 Deposit in Capital One
Money Multiplier Process

Deposit → Loan
→ Deposit → Loan
→ Deposit → Loan
→ . . . . etc.
 Total Change in Deposits

1
 Total Deposits  Initial Deposit 
R
where R = the reserve requirement

If E = the percentage of their deposits banks

are holding as excess reserves……
1
 Total Deposits  Initial Deposit 
R+E
1
is called the "money multiplier"
R+E
 Total Change in the Money Supply
1
 Total Deposits  Initial Deposit 
R+E
1
is called the "money multiplier"
R+E

 Total Deposits
 Money Supply  
 Cash held by the public
 Two Fundamental Equations of
Money Creation

1
 Total Deposits  Initial Deposit 
R+E

 Total Deposits
 Money Supply  
 Cash held by the public
 Total Change in Deposits
Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 0%
1
 Total Deposits  Initial Deposit 
R+E
1
 $10,000 
.1+0
 $10,000 10
 $100,000
 Total Change in Deposits
Example:
and Money Supply
1
 Total Deposits  Initial Deposit 
R+E
 $100,000

 Total Deposits
 Money Supply  
 Cash held by the public
 $100,000   ($10,000)
 $90,000
Excess Reserves Before
and During the Crisis
 Total Change in Deposits
Example:
and Money Supply
What if E = 10%?
R still = 10%
1
Money multiplier 
R+E
1

.1+.1
1

.2
5
 Total Change in Deposits
Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 10%
1
 Total Deposits  Initial Deposit 
R+E
1
 $10,000 
.1+.1
 $10,000 5
 $50,000
 Total Change in Deposits
Example:
and Money Supply
1
 Total Deposits  Initial Deposit 
R+E
 $50,000

 Total Deposits
 Money Supply  
 Cash held by the public
 $50,000   ($10,000)
 $40,000
Reverse Money Multiplier Process

What happens if somebody withdraws

$10,000 from the bank?

Sets in motion the reverse money

multiplier process
Someone Withdraws $10,000 from
Bank of America

Assets (A) Liabilities (L)

Reserves −$10,000 Deposits −$10,000

Actual Reserves ↓ Required Reserves ↓
by $10,000 by $1,000

Bank is $9,000 Bank Capital

(= A – L)
short of reserves
 Reverse Money Multiplier Process

Four options when a bank is short of reserves:

1. Borrow the needed reserves from another
bank on the “Fed Funds” market
2. Borrow the needed reserves from the Fed at
the “discount window”
3. Reduce loans
4. Sell securities (bonds)
Eventually, some bank will need to do (3) or (4)
 Bank of America

Assets (A) Liabilities (L)

Reserves +$9,000

Loans −$9,000

Bank Capital
(= A – L)
 Citizen’s Bank

Assets (A) Liabilities (L)

Reserves −$9,000 Deposits −$9,000

Bank is $8,100
short of reserves
Bank Capital
(= A – L)
 Sovereign Bank

Assets (A) Liabilities (L)

Reserves −$8,100 Deposits −$8,100

Bank is $7,290
short of reserves
Bank Capital
(= A – L)
Reverse Money Multiplier Process

Withdrawal → Loan reduction

→ Withdrawal → Loan reduction
→ Withdrawal → Loan reduction
→ . . . . etc.
 Total Change in Deposits
Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 0%
1
 Total Deposits  Initial Deposit 
R+E
1
 $10,000 
.1+0
 $10,000 10
 $100,000
 Reverse Money Multiplier
Example:
Process
$10,000 Withdrawal
R = 10%
E = 0%
1
 Total Deposits  Initial Deposit 
R+E
1
 $10,000 
.1+0
 $10,000 10
 $100,000
 Reverse Money Multiplier
Example:
Process
1
 Total Deposits  Initial Deposit 
R+E
 $100,000

 Total Deposits
 Money Supply  
 Cash held by the public
  $100,000  $10,000
  $90,000
 The Federal Reserve System
• Open Market Operations
• Other Tools of the Fed
• Reserve Requirement
• Discount Rate
• Monetary Policy and Interest Rates
• Real vs. Nominal Interest Rates
• “Basis Points”
• The Economic Consequences of Fed Actions
• Unconventional Monetary Policy: Quantitative Easing
The Twelve Federal Reserve
Districts
Federal Reserve Building,
Washington
Boston Fed Building
Formal Structure of the Federal Reserve
System
 Federal Reserve Bank Functions:
General
• Clear checks
• Issue new currency and remove
damaged currency
• Evaluate bank mergers and expansions
• Lender to member banks
• Liaison between local community and the
Federal Reserve System
• Perform bank examinations
• Conduct monetary policy
 Informal Structure of the Federal
Reserve System
• Since its inception, the Federal Reserve System has
slowly acquired responsibility for promoting a stable
economy. This, in turn, has caused the Fed to evolve
into a more unified central bank.
• Legislation during the 1930’s granted the Fed
authority over open market operations and reserve
requirements.
• The Board of Governors have continued to gain some
control over the 12 district banks, through salaries and
review of policy.
Who Is This Man?
 Chairman of the
Federal Reserve System
• Spokesperson for the entire Federal
Reserve System
• Negotiates, as needed, with Congress and the President
of the United States
• Sets the agenda for FOMC meetings
• With these, the chairman has effective control over the
system, even though he doesn’t have legal authority to
exercise control over the system and its member
banks.
 Federal Reserve Bank Functions:
Monetary Policy
• Establish the “discount rate” at which member
banks may borrow from the Federal Reserve
Bank (subject to BOG review)
• Determine which bank receive loans
• Establish the reserve requirement
• Conduct open market operations
 Monetary Policy
• Expansionary Monetary Policy—actions
which increase the money supply

• Contractionary Monetary Policy—actions

which decrease the money supply
 Tools of the Fed
• Open Market Operations
• The Fed Buys or Sells T-Bonds
 An Open Market Operation
• The Fed buys a $100,000 T-Bond from a bond
dealer, and pays for it by electronic transfer of
$100,000 to the bond dealer’s checking account
 Fed Buys $100,000 Bond
Bond Trader’s Balance Sheet

Assets (A) Liabilities (L)

T-Bonds −100,000

Deposits +100,000
 An Open Market Operation
• The Fed buys a $100,000 T-Bond from a bond
dealer, and pays for it by electronic transfer of
$100,000 to the bond dealer’s checking account
• Consequently, the bond dealer’s bank’s balance
sheet shows a $100,000 increase in reserves
 Fed Buys $100,000 Bond
Bank’s Balance Sheet

Assets (A) Liabilities (L)

Reserves +100,000 Deposits +100,000

 Fed Buys $100,000 Bond
1
Δ Total = Initial Δ in Reserves 
Deposits (R + E)
1
= $100,000 
(.1 + 0)
1
= $100,000 
(.1)
= $100,000 × 10
= $1,000,000
 Fed Buys $100,000 Bond

Δ Total = $1,000,000
Deposits
Δ Money Supply = Δ Total Deposits
+ Δ Cash held by the public

= $1,000,000 + $0
= $1,000,000
Buying bonds is expansionary monetary policy
 An Open Market Operation
• The Fed sells a $100,000 T-Bond to a bond
dealer, and the bond dealer pays for the bond
by an electronic transfer of $100,000 from their
checking account
 Fed Sells $100,000 Bond
Bond Trader’s Balance Sheet

Assets (A) Liabilities (L)

T-Bonds +100,000

Deposits −100,000
 An Open Market Operation
• The Fed sells a $100,000 T-Bond to a bond
dealer, and the bond dealer pays for the bond
by an electronic transfer of $100,000 from their
checking account
• Consequently, the bond dealer’s bank’s balance
sheet shows a $100,000 decrease in reserves
 Fed Sells $100,000 Bond
Bank’s Balance Sheet

Assets (A) Liabilities (L)

Reserves −100,000 Deposits −100,000

 Fed Sells $100,000 Bond
1
Δ Total = Initial Δ in Reserves
Deposits (R + E)
1
= −$100,000 
(.1 + 0)
1
= −$100,000 
(.1)
= −$100,000 × 10

= −$1,000,000
 Fed Sells $100,000 Bond

Δ Total = $−1,000,000
Deposits
Δ Money Supply = Δ Total Deposits
+ Δ Cash held by the public

= −$1,000,000 + $0
= −$1,000,000
Selling bonds is contractionary monetary policy
Target Fed Funds Rate
in Recent Years
 Money Supply Curve

i M
S

Assumptions:
E constant for all
banks
No change in cash
held by the public

MS M
 Fed Buys Bonds

i M
S
MS′

MS MS′ M
 Fed Sells Bonds

i S
M ′ MS

MS ′ MS M
Money Demand Curve

MD

M
Equilibrium in the Money Market

i MS

i*

MD

M
M*
Equilibrium in the Money Market
What if the Fed buys bonds?

i MS

i1*

i2*
MD

M
M1 * M2 *
Equilibrium in the Money Market
What if the Fed sells bonds?

i MS

i2*

i1*

MD

M
M2 * M1 *
 Critical Dates:
FOMC Meetings
What: When the Fed’s Federal Open Market Committee meets
to decide on interest rates

When: 8 times per year

Roughly every six weeks
Special meetings may be called any time

Why Critical:
Changes in the federal funds rate decided at the
meetings trigger a chain of events that affect other
short-term interest rates, foreign exchange rates, long-
term interest rates, the amount of money and credit, and,
ultimately, a range of economic variables, including
employment, output, and prices of goods and services.
Target Fed Funds Rate
in Recent Years
Actual Fed Funds Rate
in Recent Years
 Hitting the Target:
Target and Actual Fed Funds Rate
in Recent Years
Target and Actual Fed Funds Rate
Since 1985
 Finance Jargon:
Basis Points (bps)
What is a “basis point”?

A basis point is 1/100 of a percentage point

Advantage:
Avoids the ambiguity between relative and absolute
discussions about rates.
For example, a "1% increase" in a 10% interest rate could
mean an increase from 10% to 10.1%, or from 10% to 11%.

10% to 10.1% = 10 basis points

10% to 11% = 100 basis points
 Real vs. Nominal Interest Rates
• Nominal interest rate = i
• Real interest rate =r
• Inflation rate =π
i=r+π
r = i – π
So, if i = 4%, π = 3%, then r = 1%
If forecasting, use πe, expected inflation:
i = r + πe
Bank wants r = 5%, and πe = 3%, sets i at 8%
 Tools of the Fed
• Open Market Operations
• The Fed Buys or Sells T-Bonds
• Changing the Reserve Requirement
 Total Change in Deposits
and Money Supply when R Changes
∆ Total Deposits = (Initial Deposit) × 1/(R + E)

1/(R + E) is the “money multiplier”

∆ Money Supply = ∆ Total Deposits

+ ∆ Cash Held by Public

R↓ → (R+E)↓ → 1/(R+E)↑ → ∆ Total Deposits ↑

→ ∆ Money Supply
↑
 Tools of the Fed
• Open Market Operations
• The Fed Buys or Sells T-Bonds
• Changing the Reserve Requirement
• Reserve Lending from the “Discount Window”
• Three Programs:
• Primary Credit
• Secondary Credit
• Seasonal Credit
• Role as “Lender of Last Resort”
• Main policy tool: The Discount Rate
“Lender of Last Resort” Role
Three “Discount Window” Programs
• Primary Credit Program
• Very short-term loans (usually overnight) to depository institutions
judged to be in generally sound financial condition
• Qualifying institutions pay the “Primary Credit” rate, ordinarily just
called the “Discount Rate”
• Secondary Credit Program
• Loans to depository institutions not eligible for “primary credit”
program
• Loans designed to meet short-term liquidity needs or to resolve “severe
financial difficulties”
• Qualifying institutions pay the “Secondary Credit” rate
• Seasonal Credit Program
• Loans to smaller depository institutions with seasonal funding needs—
e.g. banks in agricultural or resort communities
Five Interest Rates Since 1970
 Why Does the Fed Target i
Instead of M?

• i is easier to control than M

• i is more closely related to the economic
variables the Fed ultimately cares about, like
• Inflation
• Unemployment
Economic Consequences of Fed
Actions
Fed buys bonds  i↓
 Consumption ↑
Investment ↑
Net Exports ↑
 Aggregate Demand ↑
 National Income ↑
 Inflation ↑ (sooner or
later)
Economic Consequences of Fed
Actions
Fed sells bonds  i↑
 Consumption ↓
Investment ↓
Net Exports ↓
 Aggregate Demand ↓
 National Income ↓
 Inflation ↓ (sooner or
later)
 Tools of the Fed
• Open Market Operations
• The Fed Buys or Sells T-Bonds
• Changing the Reserve Requirement
• Reserve Lending from the “Discount Window”
______________________
New Fed Tools
Called collectively—”Quantitative Easing”
 Quantitative Easing
Conventional monetary policy
Central bank uses open market operations—buying and selling short-
term government bonds-- or loans from the discount window to bring
short-term interest rates (the Fed Funds rate in the U.S.) in line with a
target

Quantitative Easing
When short-term interest rates are already at or near zero, the central
bank buys other financial assets from financial institutions in order to
inject reserves into the system, lower interest rates on longer-term
financial instruments, and stimulate the economy.

In order to be effective, banks must be willing to lend their excess

reserves.
 Recent Quantitative Easing
Japan Early 2000s

Financial Crisis (2007 – 2009)

Eurozone
Britain
U.S.
QE 1 (Nov. 25, 2008 – March 31, 2010)
QE 2 (Nov. 3, 2010 – June 30, 2011)
QE 3 (Announced Sept. 13, 2012)
Recent Quantitative Easing
QE 1 (Nov. 25, 2008 – March 31, 2010)
Fed bought $1.2T in MBS
Fed bought $175B in bonds from Fannie Mae, Ginnie
Mae, and Freddie Mac
Impact: Lower mortgage interest rates
Impact of QE1 on Mortgage Rates
Recent Quantitative Easing
QE 1 (Nov. 25, 2008 – March 31, 2010)
Fed bought $1.2T in MBS
Fed bought $175B in bonds from Fannie Mae, Ginnie
Mae, and Freddie Mac
QE 2 (Nov. 3, 2010 – June 30, 2011)
Fed began the purchase of $600B of longer-term T-Bonds
Goal Keep longer-term interest rates, esp. mortgage rates,
low
Impact: Mortgage rates increased, despite the program
Impact of QE2 on Mortgage Rates
 QE in a Picture:
Fed Activity During the Crisis
QE 3 (Announced Sept. 13, 2012 – Oct. 2014)

Fed announced it would buy $40B/mo. in MBS

Increased buying to $85B/mo. in Dec. 2012

Publicly committed to keep interest rates low through 2015

ECB announced a similar program

Impact
Impact on Banks
Impact on Savers
 Time Value of Money

• Future Value (FV) and Present Value (PV)

• Examples
• Perpetuities
• Net Present Value (NPV)
• Examples
• Internal Rate of Return (IRR)
 Future Value of an Amount
Invested Today
Put $100 in a savings account today
Get an interest rate of 10%, credited at the end of
a year’s time
How much money will you have in one year?

$100 (Principal)
+ $ 10 (Interest)
$110 (Total account value in 1 yr.)
 Future Value of an Amount
Invested Today
$100 (Principal)
+ $ 10 (Interest)
$110 (Total account value in 1 yr.)

What is the formula for this?

Principal + (Principal × Interest rate) = Total value in 1 yr.
Principal × (1 + Interest rate) = Total value in 1 yr.
$100 × (1 + i) = Total value in 1 yr.
 Future Value of an Amount
Invested Today
Principal + (Principal × Interest rate) = Total value in 1 yr.
Principal × (1 + Interest rate) = Total value in 1 yr.
$100 × (1 + i) = Total value in 1 yr.

Principal can also be called

“Present Value”
or “Present Discounted Value”
 Time Value of Money Analysis
• Present Value (PV) or Present Discounted Value (PDV)
• Future Value (FV)

Basic Idea: Equivalence of cash flows received

at different times

PV → FV or FV → PV
Time Value of Money:
The Basic Equation

N
FV PV (1  i )
 FV Analysis
Value of $100 one year from today at i = 10%:

$100 (1 + .1) = $100(1.1) = $110

 FV Analysis
Value of $100 two years from today if invested
at i = 10%:
Value in 1 yr.

[$100 (1 + .1)](1 + .1)

= $100(1.1)2 = $121
 FV Analysis
Value of $100 N years from today if invested at
i = 10%:
N Terms

$100 (1 + .1)(1 + .1)∙ ∙ ∙ ∙ ∙ ∙ (1 + .1)

= $100(1.1)N
Time Value of Money:
The Basic Equation

PV → FV
N
FV PV (1  i )
 Time Value of Money:
The Basic Equation

PV → FV
FV → PV
FV
FV PV (1  i )  PV 
N
N
(1  i )
 PV Analysis
Value of $100 in one year at i = 10%:

$100 (1 + .1) = $100(1.1) = $110

so, $110 received one year from today is worth:

$110
$100 today
1.1
 PV Analysis
Value of $100 received one year from today at
i = 10%:
$100
$90.91
1.1

The Present Value (PV) or

Present Discounted Value (PDV)
of $100 received one year from now is
$90.91
 PV Analysis
Value of $100 two years from today if invested at
i = 10% = $100(1.1)2 = $121

PV of $121 received two years from today at

i = 10%: $121
2
$100
1.1
What is the PV of $100 received two years from today
at i = 10%?
 PV Analysis
PV of $100 received two years from today at
i = 10%:
$100
2
$82.64
1.1
 Example of a PV Calculation
Example: Find the present value of a $250
payment you expect to receive three
years from now, assuming an interest
rate of 6%

FV $250
PV  t
 3
(1  i ) (1  .06)
$209.90
 PV and N
PV of $100, discounted at 10%, payable in:

1 year $90.91
2 years $82.64
3 years $75.13
4 years $68.30
5 years $62.09
 PV and i
PV of $100 at different discount rates:
Payable in: 5% 10% 15%
1 year $95.24 $90.91 $86.96
2 years $90.70 $82.64 $75.61
3 years $86.38 $75.13 $65.75
4 years $82.27 $68.30 $57.18
5 years $78.35 $62.09 $49.72
 Formulas in General Form
The Future Value (FV) N years from now of the
present amount $PV invested at interest rate i is
given by:
N
FV PV (1  i )
The Present Value (PV) of $FV received N years
from today, discounted at interest rate i:

FV
PV  N
(1  i )
 Equivalence of Cash Flows

N FV
FV PV (1  i )  PV  N
(1  i )
It is i that establishes the equivalence
of cash flows received at different
times
 The Interpretation of i

i can be thought of as:

• Required rate of return: Minimum return an
investor must receive in order to accept an
investment
• Discount rate: To discount future cash flows
• Opportunity cost: Of current consumption
 Formulas in General Form
What if you are going to receive a stream of payments in the
future?
Example
You expect revenues of $50,000 per year for the next three years
from your small business….your discount rate is 7%.
What is the PV of that revenue stream?
The Present Value (PV) of $FV received N years from today,
discounted at interest rate i:

FV
PV of payment of FV in year N 
(1  i ) N
 Example: Calculating a PV
Yearly Revenues = $50,000 i = 7%
FV
PV of payment of FV in year N 
(1  i ) N
$50,000
PV of first year's revenues  1
$46,728.97
(1  .07)
$50,000
PV of second year's revenues  2
$43,671.94
(1  .07)
$50,000
PV of third year's revenues  3
$40,814.89
(1  .07)
PV of revenue stream $131, 215.80
 Formulas in General Form
The Present Value (PV) of a stream of payments for T years:

Pmt1 Pmt2 Pmt3 PmtT

PV  1
 2   
(1  i ) (1  i ) (1  i ) 3
(1  i )T
Pmt1 Pmt2
T 2 : PV  1

(1  i ) (1  i ) 2
Pmt1 Pmt2 Pmt3
T 3 : PV  1
 2

(1  i ) (1  i ) (1  i )3
Pmt1 Pmt2 Pmt3 Pmt4
T 4 : PV  1
 2
 
(1  i ) (1  i ) (1  i ) (1  i ) 4
3

Etc.
 PDV of Mass Lottery
Recent Estimated Jackpot
$136,000,000
Payable in:
• 1 immediate payment
+29 annual installments totaling $136M
or
• One lump sum of $80,000,000

Which one would you take?

 PDV of Mass Lottery

Let PON be the payout at the end of year N

Let the present be time 0
Assume the 30 payments are equal
Then the PV of 30 equal payments of $4,533,333
with the first payment now,
PO0 PO1 PO2 PO29
 PV  0
 1
 2
  29
(1  i ) (1  i ) (1  i ) (1  i )
 PDV of Mass Lottery
Recent Estimated Jackpot
$136,000,000
30 equal installments of $4,533,333
or
One lump sum of $80,000,000
4,533,333 4,533,333 4,533,333 4,533,333
PV  (1  i )0  (1  i )1  2
 
(1  i ) (1  i ) 29

PV = $80M assumes i = 4.2%

 Perpetuities

Perpetuity
A cash flow stream which never ends
Flow goes on forever
Pmt Pmt Pmt
PV   2
 3
 
(1  i) (1  i) (1  i)

Mathematically, this is called an infinite

geometric sum. . . . . . .
Yearly Pmt
PV 
i
 Uses of a Perpetuity

Perpetuity can be useful to calculate the PV of a cash

flow (e.g. a flow of profits) which one expects to go on
indefinitely.

Gives at least an approximation of the PV of the cash

flow

Can be helpful as a first calculation of the value of a

small business.
Example of Calculating the PV of a
Perpetuity
Curl Up and Dye Hair Salon is expecting an annual profit
of $50,000 to continue indefinitely. The opportunity
cost of their capital is 6%.
What is the current value of the business?
Yearly Profit
PV 
i
Expected yearly profit = $50,000 i = 6%

$50,000
PV  $833,333.33
.06
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows
 Net Present Value
Real Estate Developer

Can sell a small office building in one year for $1M

Costs (all payable at start of project):

$500,000 Construction
$350,000 Land
$ 50,000 Fees and admin. costs
$900,000 Total up front costs

Should the developer build the project?

 Net Present Value
Should the developer build the project?

The answer depends on NPV.

The developer must compare the PV of the $1 million he
expects to receive in a year with the costs he must incur
today.

Let’s say if he didn’t build the project, he would invest

his money in government bonds at 5%. 5% thus
becomes the discount rate he will use in his NPV
calculation.
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows
= $1M in 1 year – $900K now
$1M
 1 – $900K
(1  .05)
= $952,381 – $900,000
= $52,381
 Net Present Value

NPV Rule:

Undertake any project

with a positive NPV
 Net Present Value

What if the developer’s opportunity cost

goes up to 15%?
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows
= $1M in 1 year – $900K now
$1M
 1 – $900K
1.15

= $869,565 – $900,000
= −$30,435
 Net Present Value
Real Estate Developer
Instead of an office building, he could build a small
apartment complex
Takes one year to build

Expects to own it for 5 years, then sell it for $1.1M

Collects a total of $50,000 in rent at the end of each year
Costs are $900,000 up front for construction, and then
$20,000 each year for maintenance, taxes, etc.
His discount rate is 5%
Should the developer build the project?
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows

Construct a timeline of cash inflows and outflows

Cash Inflows (Project
finished) $50,000 $50,000 $50,000 $50,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows

Construct a timeline of cash inflows and outflows

Cash Inflows (Project $1,100,000
finished) $50,000 $50,000 $50,000 $50,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows

Construct a timeline of cash inflows and outflows

Cash Inflows (Project
finished) $50,000 $50,000 $50,000 $1,150,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows
 Net Present Value
NPV
= PV of Cash Inflows – PV of Cash Outflows
Cash Inflows (Project
finished) $50,000 $50,000 $50,000 $1,150,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows

$50, 000 $50, 000 $50, 000 $1,150, 000

NPV  2
 3
 4

1.05 1.05 1.05 1.055
 Net Present Value
NPV
= PV of Cash Inflows – PV of Cash Outflows
Cash Inflows (Project
finished) $50,000 $50,000 $50,000 $1,150,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows

$50, 000 $50, 000 $50, 000 $1,150, 000

NPV  2
 3
 4

1.05 1.05 1.05 1.055
$20, 000 $20, 000 $20, 000 $20, 000
− $900K  1.052  1.053  1.054  1.055
 Net Present Value
$50, 000 $50, 000 $50, 000 $1,150, 000
NPV  2
 3
 4
 5
1.05 1.05 1.05 1.05
$20, 000 $20, 000 $20, 000 $20, 000
− $900K  1.052  1.053  1.054  1.055

$1, 030, 734  $967,542

$63,192
 Net Present Value

What if the developer can do only one of

two projects:

The office building has NPV = $52,381

An apartment complex has NPV = $63,192
 Net Present Value
NPV Rule:

In case two mutually exclusive projects

have positive NPV, undertake the
project with the higher NPV
 Net Present Value

NPV
= PV of Cash Inflows – PV of Cash Outflows
Let CIt be the cash inflow at time t
COt be the cash outflow at time t
 CI 0 CI1 CI 2 CI N 
NPV  0
 1
 2
 N 
 (1  i ) (1  i ) (1  i ) (1  i ) 
 CO0 CO1 CO2 CON 
 0
 1
 2
 N 
 (1  i ) (1  i ) (1  i ) (1  i ) 
 Jargon: Internal Rate of Return
(IRR)
NPV
= PV of Cash Inflows – PV of Cash Outflows

Internal Rate of Return (IRR)

is the value of i that makes
PV of Cash Inflows = PV of Cash Outflows

i.e. that makes NPV = 0

 Jargon: Internal Rate of Return
(IRR)

NPV
= PV of Cash Inflows – PV of Cash Outflows

Cash Inflows (Project $1,100,000

finished) $50,000 $50,000 $50,000 $50,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows
 Jargon: Internal Rate of Return
(IRR)
Cash Inflows (Project $1,100,000
finished) $50,000 $50,000 $50,000 $50,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows

$50, 000 $50, 000 $50, 000 $1,150, 000

NPV  2
 3
 4

(1  i ) (1  i ) (1  i ) (1  i )5
$20, 000 $20, 000 $20, 000 $20, 000
− $900K  (1  i)2  (1  i)3  (1  i) 4  (1  i)5
What value of i makes NPV = 0?
NPV = 0 when i = 6.485%
 Jargon: Internal Rate of Return
(IRR)
Cash Inflows (Project $1,100,000
finished) $50,000 $50,000 $50,000 $50,000

$900,000 $20,000 $20,000 $20,000 $20,000

Cash Outflows

$50, 000 $50, 000 $50, 000 $1,150, 000

NPV  2
 3
 4

(1  i ) (1  i ) (1  i ) (1  i )5
$20, 000 $20, 000 $20, 000 $20, 000
− $900K  (1  i)2  (1  i)3  (1  i) 4  (1  i)5
What value of i makes NPV = 0?
NPV = 0 when i = 6.485% IRR = 6.485%

 Jargon: Internal Rate of Return
(IRR)
IRR Rule:

Undertake any project for which the

IRR is greater than the opportunity
cost of capital

In our example, the opportunity cost of

capital (the discount rate we used) was 5%
 Jargon: Internal Rate of Return
(IRR)
IRR Rule:
Undertake any project for which the IRR is
greater than the opportunity cost of capital

In our example, the opportunity cost of capital

(the discount rate we used) was 5%

The IRR = 6.485%

IRR > Opp cost of cap  Undertake project
 Midterm Exam Logistics
• PS 3 will be available starting tonight
(Wednesday, March 3) at 11 PM, Eastern
US time
• It is due next Tuesday, March 9 at 11:59 PM
• The midterm will be available starting at 8:10
PM (US Eastern time) on Wednesday,
March 10, until 8:10 PM (US Eastern time)
on Thursday, March 11
 Midterm Exam Logistics
• The midterm will be taken on Canvas
• You can start the exam any time in the 24-
hour window between 8:10 PM on March 10
and 8:10 PM on March 11.
• However, once you begin, you will have 60
minutes in which to complete the exam, and
the exam must be completed in one sitting.
• Hence, to get a full 60 minutes on the exam,
you would need to start it no later than 7:10
PM on March 10.
• The Bond Market
• Who Issues Bonds?
• Credit Risk vs. Interest Rate Risk
• Present Discounted Value (Review)
• Bond Pricing
• Components of a bond
• Role of the interest rate
• Pricing a bond with finite maturity
• Special kinds of bonds
 Who Issues Bonds?

• Corporations
• Governments
• U.S. Government
• Treasury Bills, Notes
and Bonds
• Agency Securities
• State and Local Governments
• Foreign Governments
 Investing in Bonds
• Bonds are the most popular alternative to stocks
for long-term investing.
• Even though the bonds of a corporation are less
risky than its equity, investors still have risk:
credit risk and interest rate risk
 Investing in Bonds
• The next slide shows the amount of bonds and
stock issued from 1983 to 2009.
• Note how much larger the market for new debt
is. Even in the late 1990s, which were boom
years for new equity issuances, new debt
issuances still outpaced equity by over 5:1.
Bonds and Stocks Issued
1983 - 2009
Corporate Bonds
 Corporate Bonds
• Typically have a face value of $1,000, although
some have a face value of $5,000 or $10,000
• Pay interest semi-annually
• Cannot be redeemed anytime the issuer wishes,
unless a specific clause states this (call option).
• Degree of risk varies with each bond, even
from the same issuer. As is always the case in
finance, the required interest rate varies with
level of risk.
 Corporate Bonds
• The next slide shows the interest rate on
various bonds from 1973–2009.
• The degree of risk ranges from low-risk (AAA)
to higher risk (BBB). Any bonds rated below
BBB are considered sub-investment grade debt.
Corporate Bonds Interest Rates
1973 – 2009
 Corporate Bonds: Characteristics of
Corporate Bonds
• Bearer Bonds
• Registered Bonds
• Replaced “bearer” bonds
• IRS can track interest income this way
• Restrictive Covenants
• Mitigates conflicts with shareholder interests
• May limit dividends, new debt, ratios, etc.
• Usually includes a cross-default clause
 Corporate Bonds: Characteristics of
Corporate Bonds
• Secured Bonds
• Mortgage bonds
• Equipment trust certificates
• Unsecured Bonds
• Debentures
• Subordinated debentures
• Variable-rate bonds
 Risks Relating to Bonds

• Credit Risk
Corporate Bonds: Debt Ratings
Corporate Bonds: Debt Ratings
Bond Ratings
 Most Recent Bond Ratings
AAA ExxonMobil, Johnson & Johnson,
Toyota
AA Wal-Mart, Citibank, Merck, Home
Depot
A McDonald’s, Sony, IBM, Disney
BBB Genzyme, Viacom, Comcast
BB General Motors, Ford, Sears
B [Link]
CCC Continental Airlines
D Delta Airlines
 High-Yield Corporate Bonds

• “Junk Bonds”
• Debt that is rated below BBB
• Often, trusts and insurance companies are not
permitted to invest in junk debt
• Michael Milken developed this market in the mid-
1980s, although he was subsequently convicted of
insider trading
 Financial Guarantees for Bonds
• Some debt issuers purchase financial
guarantees to lower the risk of their debt.
• The guarantee provides for timely payment of
interest and principal, and are usually backed
by large insurance companies.
 Financial Guarantees for Bonds
• As it turns out, not all guarantees actually make
sense!
• In 1995, JPMorgan created the credit default swap
(CDS), a type of insurance on bonds.
• In 2000, Congress removed CDSs from any
oversight.
• By 2008, the CDS market was over $62 trillion!
• 2008 losses on mortgages lead to huge payouts on
this insurance.
 Treasury Notes and Bonds
• The U.S. Treasury issues notes and bonds to
finance its operations.
• The following table summarizes the maturity
differences among the various Treasury
securities.
Treasury Securities
 Treasury Bond Interest Rates
• No credit risk since the government can simply
divert (or raise) taxes to pay off the debt
• The government can also simply increase the
money supply (create money) to service the debt
• Treasury securities have very low interest rates
• Risks involved in Treasury securities:
• Credit risk: None
• Interest rate risk:
• T-Bills: None (or very little)
• T-Notes: Some
• T-Bonds: Substantial
Treasury Bond Interest Rates:
Bills vs. Bonds
Treasury Bond Interest Rates
1973 – 2010
 Treasury Bonds: Agency Debt
• Although not technically Treasury securities,
agency bonds are issued by government-
sponsored entities, such as GNMA, FNMA, and
FHLMC.
• The debt has an “implicit” guarantee that the
U.S. government will not let the debt default.
This “guarantee” was clear during the 2008
bailout…
 The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• Both Fannie and Freddie managed their
political situation effectively, allowing them to
engage in risky activities, despite concerns
raised.
• By 2008, the two had purchased or guaranteed
over $5 trillion in mortgages or mortgage-
backed securities.
 The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• Part of this growth was driven by their
Congressional mission to support affordable
housing. They did this by purchasing subprime
and Alt-A mortgages.
• As these mortgages defaulted, large losses
mounted for both agencies. The final outcome
remains unknown.
 Municipal Bonds
• Issued by local, county, and
state governments
• Used to finance public interest projects
• Tax-free municipal interest rate  taxable
interest rate  (1  marginal tax rate)
 Municipal Bonds: Example
Suppose the rate on a corporate bond is 9% and
the rate on a municipal bond is 6.75%. Which
should you choose?
Answer: Find the marginal tax rate:
6.75%  9%  (1 – MTR), or MTR  25%
If you are in a marginal tax rate above 25%,
the municipal bond offers a higher after-tax
cash flow.
 Municipal Bonds: Example
Suppose the rate on a corporate bond is 9% and
the rate on a municipal bond is 6.75%. Which
should you choose? Your marginal tax rate is
28%.
OR Answer: Find the equivalent tax-free rate:
ETFR  9%  (1 – MTR)  9%  (1 – 0.28)
The ETFR  6.48%. If the actual muni-rate is
above this (it is), choose the muni.
 Municipal Bonds
• Two types
• General obligation bonds
• Revenue bonds
• NOT default-free (e.g., Orange County
California)
• Defaults in 1990 amounted to $1.4 billion in this
market
 Municipal Bonds
The next slide shows the volume of general
obligation bonds and general revenue bonds
issued from 1984 through 2009.
Note that general obligation bonds represent a
higher percentage in the latter part of the sample.
Municipal Bonds: Comparing Revenue
and General Obligation Bonds
1984 - 2009
 Risks Relating to Bonds

• Credit Risk

• Interest Rate Risk

 Time Value of Money:
The Basic Equation
PV → FV
N
FV PV (1  i )
FV → PV
FV
FV PV (1  i )  PV 
N
N
(1  i )
 PV Analysis
Value of $100 received one year from today at
i = 10%:
$100
$90.91
1.1

The Present Value (PV) or

Present Discounted Value (PDV)
of $100 received one year from now is
$90.91
 PV Analysis
PV of $100 received two years from today at
i = 10%:
$100
2
$82.64
1.1
 Example of a PV Calculation
Example: Find the present value of a $250
payment you expect to receive three
years from now, assuming an interest
rate of 6%

FV $250
PV  N
 3
(1  i ) (1  .06)
$209.90
 PV and N
PV of $100, discounted at 10%, payable in:

1 year $90.91
2 years $82.64
3 years $75.13
4 years $68.30
5 years $62.09
 PV and i
PV of $100 at different discount rates:
Payable in: 5% 10% 15%
1 year $95.24 $90.91 $86.96
2 years $90.70 $82.64 $75.61
3 years $86.38 $75.13 $65.75
4 years $82.27 $68.30 $57.18
5 years $78.35 $62.09 $49.72
 Formulas in General Form
The Future Value (FV) N years from now of the
present amount $PV invested at interest rate i is
given by:
N
FV PV (1  i )
The Present Value (PV) of $FV received N years
from today, discounted at interest rate i:

FV
PV  N
(1  i )
 Equivalence of Cash Flows

N FV
FV PV (1  i )  PV  N
(1  i )
It is i that establishes the equivalence
of cash flows received at different
times
Components of a Bond
F = Face value (also called par value)
c = Coupon rate
Components of a Bond
Face value

Coupon rate
Components of a Bond
F = Face value (also called par value)
c = Coupon rate
Fc = Coupon payment
T = Years to maturity

i = Interest rate (or discount rate, or

yield)
Components of a Bond
F = $100
c = 10%
Fc = $10
T = 3

i = 10%
 Payment Stream
End of Year
1 $10
2 $10
3 $10 + $100 (= F)
 Bond Pricing
Bond Price = PB
= PDV of payment stream
$10 $10 $10 $100
=  2
 3
 3
(1  .1) (1  .1) (1  .1) (1  .1)

= $100
 Bond Pricing
Scenario I: i Stays at 10%
Bond Price = PB
= PDV of remaining payment stream
= $10 $10 $100
 2
 2
(1  .1) (1  .1) (1  .1)

= $100

When i = c, PB = F
 Bond Pricing
Scenario II: i goes up to 12%
Bond Price = PB
= PDV of remaining payment stream
$10 $10 $100
=  
(1  .12) (1  .12) (1  .12)2
2

= $96.62

When i > c, PB < F

 Bond Pricing
Scenario III: i goes down to 8%
Bond Price = PB
= PDV of remaining payment stream
$10 $10 $100
=  
(1  .08) (1  .08) (1  .08)2
2

= $103.57

When i < c, PB > F

Summary of the Relationship Between
i, c, PB and F

When i > c, PB < F

When i = c, PB = F

When i < c, PB > F

 General Bond Pricing Formula

Fc Fc Fc Fc F
PB   2
 3
  T

(1  i) (1  i) (1  i) (1  i) (1  i)T
T
Fc F
 t
 T
t 1 (1  i) (1  i)
 Special Kinds of Bonds:
Zero Coupon Bonds
For a zero coupon bond, c = 0.

So, what would the bond pricing formula be?

 Bond Pricing For a Zero Coupon
Bond

Fc Fc Fc Fc F
PZCB   2
 3
  T

(1  i) (1  i) (1  i) (1  i) (1  i)T
F
0  0  0    0 
(1  i)T
F

(1  i)T
 Special Kinds of Bonds:
Bonds which never mature (Consols)
For a consol, T → ∞
Pricing formula becomes:
Fc Fc Fc
PC   2
 3

(1  i) (1  i) (1  i)

Fc
 t
t 1 (1  i)

Mathematically, this is just the sum of an

infinite geometric series, which turns out to be:
Fc
PC 
i
 Special Kinds of Bonds:
Bonds which never mature (Consols)
So the formula for pricing a consol is:

Fc
PC 
i
 Example of Consol Pricing
F = $10,000
c = 5%
i = 10%

Fc
PC 
i
$10,000 .05

.1
$5,000
Interest rate, discount rate and yield

When we know:

i, and solve for PB, i is called the interest,

or
discount rate

PB, and solve for i, i is called the yield, or

yield to maturity
 The Stock Market

• Introduction: Stocks vs. Bonds

• Long-run Returns vs. Short-run Volatility
• The Primary Market
• Finance Jargon: Shares Outstanding, Float, etc.
• Market Cap Categories
• The IPO Process
 Stocks vs. Bonds
Bonds Stocks
IOU Ownership share
Coupon payment Dividend
Are Dividends a Thing of the Past?
 Stocks vs. Bonds
Bonds Stocks
IOU Ownership share

Coupon payment Dividend

Position in Residual claimant

event of liquidation
Long-term Returns on Stocks vs.
Bonds
DJIA Over the Past Decade
NASDAQ Market Since 1980
 Finance Jargon:
Shares Outstanding, Float, etc.
• Authorized shares
• Largest number of shares a firm can issue
• Set in the articles of incorporation when the
company is formed
• Can only be changed by a vote of the shareholders
 Finance Jargon:
Shares Outstanding, Float, etc.
• Authorized shares
• Issued shares
• Unissued shares
 Finance Jargon:
Shares Outstanding, Float, etc.

Authorized shares = issued shares + unissued shares

 Finance Jargon:
Shares Outstanding, Float, etc.
• Authorized shares
• Issued shares
• Shares outstanding
• Treasury stock
• Unissued shares
 Finance Jargon:
Shares Outstanding, Float, etc.

Authorized shares = issued shares + unissued shares

Issued shares = shares outstanding + treasury stock

 Finance Jargon:
Shares Outstanding, Float, etc.
• Authorized shares
• Issued shares
• Shares outstanding
• Restricted shares (shares given to insiders as part of their
compensation; require special permission before being transacted)
• Treasury stock
• Unissued shares
 Finance Jargon:
Shares Outstanding, Float, etc.
• Authorized shares
• Issued shares
• Shares outstanding
• Restricted shares
• Float
• Treasury stock
• Unissued shares
 Finance Jargon:
Shares Outstanding, Float, etc.
Authorized shares
 Finance Jargon:
Shares Outstanding, Float, etc.
Unissued shares
Authorized shares

Issued shares

Treasury

Shares stock
outstanding
Restricted
shares

Float
 Finance Jargon:
Shares Outstanding, Float, etc.
An Example
• Authorized shares 1 Billion
• Issued shares 500 Million
• Shares outstanding 500 Million
• Restricted shares 100 Million
• Float 400 Million (IPO)
• Treasury stock
• Unissued shares 500 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares

Effect on the Float

400 Million
− 100 Million
300 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares
• Authorized shares 1 Billion
• Issued shares 500 Million
• Shares outstanding
• Restricted shares 100 Million
• Float 300 Million (IPO)
• Treasury stock
• Unissued shares 500 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares

Effect on Shares Outstanding

500 Million
− 100 Million
400 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares
• Authorized shares 1 Billion
• Issued shares 500 Million
• Shares outstanding 400 Million
• Restricted shares 100 Million
• Float 300 Million (IPO)
• Treasury stock
• Unissued shares 500 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares

Effect on Treasury Stock

+ 100 Million
100 Million
 Finance Jargon:
Shares Outstanding, Float, etc.
Firm Buys Back 100 Million Shares
• Authorized shares 1 Billion
• Issued shares 500 Million
• Shares outstanding 400 Million
• Restricted shares 100 Million
• Float 300 Million
(IPO)
• Treasury stock 100 Million
• Unissued shares 500 Million
 Finance Jargon:
Market Capitalization
Market capitalization (market “cap”)
= shares outstanding × price per share

Example:
1 Billion shares outstanding
Share price = $10
Market cap = $10 × 1 Billion
= $10 Billion
 Facebook Share Statistics

4.3 billion shares authorized

2.41 billion shares outstanding
100 million restricted shares
2.38 billion share float
Market cap (10/23/19) = 2.41 B × $185
= $446 Billion
 Finance Jargon:
Market Cap Categories
• Mega Cap > $200 Billion
• Slower growth—lower risk
• Wal-Mart, Microsoft, Exxon Mobil, GE
 Finance Jargon:
Market Cap Categories
• Mega Cap > $200 Billion
• Large Cap $10 Billion – $200 Billion
• Yahoo, IBM
 Finance Jargon:
Market Cap Categories
• Mega Cap
Blue Chips
• Large Cap
 Finance Jargon:
Market Cap Categories
• Mega Cap > $200 Billion
• Large Cap $10 Billion – $200 Billion
• Mid Cap $2 Billion – $10 Billion
• Growth stocks
• Wendy’s/Arby’s Group
 Finance Jargon:
Market Cap Categories
• Mega Cap > $200 Billion
• Large Cap $10 Billion – $200 Billion
• Mid Cap $2 Billion – $10 Billion
• Small Cap $300 Million – $2 Billion
• Relatively young companies
• Higher growth potential; higher risk
• Jet Blue, Chipotle Mexican Grill
 Finance Jargon:
Market Cap Categories
• Mega Cap > $200 Billion
• Large Cap $10 Billion – $200 Billion
• Mid Cap $2 Billion – $10 Billion
• Small Cap $300 Million – $2 Billion
• Micro Cap $50 Million – $300
Million
• Very small companies, with highly illiquid,
speculative shares
 The Initial Public Offering

• Initial Public Offering (IPO)

• First offering of stock to public
 Benefits vs. Costs of Going Public

• Benefits
• Increased access to capital markets
• Founders can “cash in”

• Costs
• Loss of control (Example: Jobs and Wozniak at
Apple)
• Exposure of sensitive information (SOX)
• Investor relations efforts
 The Initial Public Offering

• Initial Public Offering (IPO)

• First offering of stock to public
• Underwriting
• Role of the syndicate
Top Underwriters, 2014
How Do Firms Choose an Underwriter

• The contract
• The spread
• The “rep”
 Steps in an IPO: The Role of the
Lead Underwriter
• Valuing the company
• Determining the offering price of shares
• “Building the book” via road shows
• Filing the necessary paperwork
• Filing the prospectus
 Types of Underwriting Contracts

• Firm commitment contract: issuance to

distribution and sale
• Safest but most expensive for the issuer
• Underwriter’s profit is the “spread”
• Best efforts contract
• All-or-none contract
 Costs Involved in an IPO

• Legal and administrative costs

• Spread (or underwriting commission)
Spreads on Selected Recent Issues
Costs of Raising Capital
 Costs Involved in an IPO

• Legal and administrative costs

• Underwriting commission
• Underpricing
 The Stock Market (cont.)

• The Secondary Market

• Types of Exchanges
• ECNs
• The Globalization of Markets
• New Trading Strategies
• Algorithmic Trading
• High Frequency Trading
• Dark Pools
• Trading Jargon
 Different Types of Markets
• Direct search
• Buyers and sellers seek each other
• Brokered markets
• Brokers search out buyers and sellers
• Dealer markets
• Dealers have inventories of assets from which
they buy and sell
• Auction markets
• Traders converge at one place to trade
 Types of Exchanges
• Physical “Floor” Exchanges
• NYSE (now NYSE-Euronext)
New York Stock
Exchange (NYSE)
•Acquired by Intercontinental Exchange (ICE) in 2013
•2,800 companies listed
•“Open outcry” auction market, which is quickly evolving into an
electronic market
• “Hybrid market”—orders can be handled electronically, or by floor
brokers (as of January 24, 2007) 80%+ of trades now handled
electronically
• Diminished role of specialists
•$28T in total market capitalization
•Avg. daily volume (Sept., 2012): 3.2B shares
•Formerly: 1,366 “seats”, conferring the right to trade on the
exchange
•Now: NYSE sells 1-year licenses to trade on the exchange
•Lists the largest, most established companies: ExxonMobil,
General Electric, Wal-Mart, Disney
New York Stock
Exchange (NYSE)
• The largest U.S. stock exchange as measured by the
value of the stocks listed on the exchange
• Automatic electronic trading runs side-by-side with
traditional broker/specialist system
• SuperDot : Electronic order-routing system
• DirectPlus: Fully automated execution for small
orders
• Specialists: Handle large orders and maintain orderly
trading
 Types of Exchanges
• Physical “Floor” Exchanges
• NYSE (now NYSE-Euronext)
• Electronic Exchanges
• NASDAQ
• London Stock Exchange
NASDAQ

• Founded in 1971
• Electronic exchange
• Has always been “screen-based”
• 3,100 companies listed
• $8.5T in total market capitalization
• Avg. daily volume around 2B shares
• High tech and innovative firms: Microsoft, Intel,
Cisco, JetBlue
NASDAQ
• NASDAQ
• Originally, NASDAQ was primarily a dealer market
with a price quotation system
• Today, NASDAQ’s Market Center offers a
sophisticated electronic trading platform with
automatic trade execution
• Large orders may still be negotiated through
brokers and dealers
 Types of Exchanges
• Physical “Floor” Exchanges
• NYSE
• AMEX
• Electronic Exchanges
• NASDAQ
• London Stock Exchange
• Electronic Communication Networks (ECNs)
• A more automated, efficient kind of electronic
exchange
• No market makers
Open Outcry: The Platform for 200
Years
How Long Before It’s a Museum?
The New “Trading Floor”

Scenes from the NYSE Server

Farm in Mahwah, NJ
 ECNs
• ECNs
• Private computer networks that directly link buyers
with sellers for automated order execution over
multiple exchanges
• Compete in terms of the speed they can offer
• Latency: The time it takes to accept, process, and
deliver a trading order
• Major ECNs include Direct Edge, BATS, and
NYSE Arca
 ECNs
ECNs (electronic communication networks)
allow brokers and traders to trade without the
need of the middleman. They provide:
• Transparency: everyone can see
unfilled orders
• Cost reduction: smaller spreads
• Faster execution
• After-hours trading
 ECNs
However, ECNs are not without
their drawbacks:
• Don’t work as well with thinly-traded stocks
• Many ECNs competing for volume, which can be
confusing
• Major exchanges are fighting ECNs, with an
uncertain outcome
 Holdings of Corporate Equities
(Q2, 2012)

Together,
institutions account Percent of
for 47.3% of equity
holdings
Holdings
 Globalization of Stock Markets
• Widespread trend to form international and local
alliances and mergers
• NYSE acquired Archipelago (ECN), American Stock
Exchange, and merged with Euronext
• NASDAQ acquired Instinet/INET (ECN), Boston
Stock Exchange, and merged with OMX to form
NASDAQ OMX Group
• Chicago Mercantile Exchange acquired Chicago Board
of Trade and New York Mercantile Exchange
• Intercontinental Exchange Acquired NYSE in 2013
Ten Biggest Exchanges in the World May 2014, by Market Capitalization
(Billions of US Dollars)
Ten Biggest Exchanges in the World May 2014, by Market Capitalization
(Billions of US Dollars)
The Biggest Stock Markets in the World by
Domestic Market Capitalization
 Some World Exchanges: Asia
China
Shanghai Stock Exchange
Shenzhen Stock Exchange
+ 2 in Hong Kong
India
20 Separate Exchanges
Malaysia
2 Exchanges
Mongolia
Mongolian Stock Exchange
Vietnam
Ho Chi Minh Stock Exchange (est. 2000)
Hanoi Stock Exchange (est. 2005)
Afghanistan
Afghanistan Stock Exchange (scheduled to open soon)
Some World Exchanges: Africa and
Middle East
Botswana Stock Exchange
Cairo and Alexandria Stock Exchanges
Tehran Stock Exchange
Nigerian Stock Exchange
Khartoum Stock Exchange
Zimbabwe Stock Exchange
 Current Equity Market Issues
May 6, 2010 Dow down nearly 1,000 pts in
15 minutes
2:47 PM

Rebounds 700 pts in next half

hour

What’s the explanation for such incredible volatility?

 New Trading Strategies
• Algorithmic Trading
• The use of computer programs to make trading
decisions
• High-Frequency Trading
• Special class of algorithmic with very short order
execution time
• Dark Pools
• Trading venues that preserve anonymity, mainly
relevant in block trading
 Finance Jargon:
Algo Trading……High Frequency
Trading
Algo Trading
Algorithmic Trading
aka
Black box trading
Automated trading
Robo trading

Trading based on computer algorithms

The computer program specifies every aspect of the
trade: Price, quantity, timing
Computer usually initiates the trade
 Finance Jargon:
Algo Trading……High Frequency
Trading
High Frequency Trading

Computer programs used to generate trades within

fractions of a second
Algorithms designed to beat other firms’ algorithms
by milliseconds

Firms using HFT represent only about 2% of the

20,000 trading firms in the market, but are
responsible for 73% of share trading volume
 Finance Jargon:
Dark Pools
Dark Pools
Private trading networks that facilitate hidden or
anonymous trades between large institutional
investors
• Started in the 1980s with a small number of pools
associated with the major exchanges
• Expanded with trade-matching between clients of large
I-banks
• Increase in algorithmic trading made “parcelling” more
difficult
 Finance Jargon:
Dark Pools
Risks of Dark Pools
• Unfilled orders
• Information leakage
 Finance Jargon

• Selling Short
• Buying on Margin
• Limit Orders
• Stop-Loss Orders (“Stops”)
• Types of investment companies
• Mutual funds:
• Functions
• Investment styles and policies
• Investment costs
 Investment Companies
• Pool funds of individual investors and invest in
a wide range of securities or other assets
• Services provided:
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs
 The Growth of Mutual Funds
• There are five principal benefits of
mutual funds:
1. Liquidity intermediation: investors can quickly
convert investments into cash.
2. Denomination intermediation: investors can
participate in equity and debt offerings that,
individually, require more capital than they
possess.
3. Diversification: investors immediately realize the
benefits of diversification even for small
investments.
 The Growth of Mutual Funds
• There are five principal benefits of mutual
funds:
4. Cost advantages: the mutual fund can negotiate
lower transaction fees than would be available to
the individual investor.
5. Managerial expertise: many investors prefer to rely
on professional money managers to select their
investments.
 The Growth of Mutual Funds
• At the beginning of 2017, 57% of retirement
assets were held by mutual funds.
• 28% of the U.S. stock market and almost 44%
of all U.S. households hold stock via mutual
funds.
• Assets held by mutual funds have grown by
about 17% per year for the last 25 years,
reaching over $14 trillion.
 Net Asset Value
• Net Asset Value (NAV) is the value of each
share in the investment company

• Calculation:

Market Value of Assets - Liabilities

Shares Outstanding
 Types of Investment Companies
• Unit Trusts
• Fixed portfolio of uniform assets
• Unmanaged
• Total assets have declined from $105 billion
in 1990 to $60 billion in 2012
 Types of Investment Companies
• Managed Investment Companies
• Open-End
• Fund issues new shares when investors buy in and
redeems shares when investors cash out
• Priced at Net Asset Value (NAV)
• Closed-End
• No change in shares outstanding; old investors cash
out by selling to new investors
• Priced at premium or discount to NAV
 Types of Investment Companies
• Other investment organizations
• Commingled funds
• REITs
• Hedge Funds
 Mutual Funds
• Money market
• Equity
• Sector
• Bond
• International
• Balanced and funds of funds
• Asset allocation and flexible
• Index
 Mutual Funds
Percentage of Total Net Assets, 2018
 U.S. Mutual Funds by
Investment Classification

368
Mutual Fund Structure:
the Organization
 Mutual Funds
• How Funds Are Sold
• Direct-marketed funds
• Sales-force distributed
• Revenue sharing on sales force distributed
• Potential conflicts of interest
• Financial supermarkets
 Costs of Investing in Mutual Funds
• Fee Structure:
1. Operating expenses
2. Front-end load
3. Back-end load
4. 12 b-1 charge
• Fees must be disclosed in the prospectus
• Share classes with different fee combinations
Fees for Various Classes
 Fees and Mutual Fund Returns
NAV1  NAV0  Income  Capital Gain
R
NAV0
• Example:
• Initial NAV = $20
• Income distributions of $.15
• Capital gain distributions of $.05
• Ending NAV = $20.10
$20.10  $20.00  $.15  $.05
R .015 or 1.5%
$20.00
 Impacts of Costs on
Investment Performance
 Taxation of Mutual Fund Income
• Pass-through status under the U.S. tax code
• Taxes are paid only by the investor
• Fund investors do not control the timing of the sales
of securities from the portfolio
• High portfolio turnover leads to tax inefficiency
• Average turnover = 60%
 Exchange Traded Funds
• Examples: “spiders,” “diamonds,” and “cubes”
• Potential advantages:
• Trade continuously like stocks
• Can be sold short or purchased on margin
• Lower costs
• Tax efficient
• Potential disadvantages:
• Prices can depart from NAV
• Must be purchased from a broker
Growth of U.S. ETFs over Time
 The Stock Market (cont.)
• Mutual Funds and Hedge Funds (cont.)
• Diversification
• Capital Asset Pricing Model (CAPM)
• Fundamental Analysis
• Technical Analysis
• Some technical indicators
• Efficient Markets Hypothesis (EMH)
• Logical basis
• Implications for investing
• Stock price as expected value
• Three forms of EMH
• Evidence supporting EMH
• Unfavorable Evidence on EMH
• Behavioral Finance
• Cognitive biases
• Behavioral biases
Investment Company Assets Under
Management, 2016 ($ Billion)
Mutual Fund Investment Performance

• Performance of actively managed funds:

• Below the return on the Wilshire index in 25 of the
41 years from 1971 to 2011
• Evidence for persistent superior performance (due
to skill and not just good luck) is weak, but
suggestive
• Bad performance is more likely to persist
Diversified Equity Funds versus Wilshire 5000
Index
 Consistency of
Investment Results
 Information on Mutual Funds
• Fund’s prospectus describes:
• Investment objectives
• Fund investment adviser and portfolio manager
• Fees and costs
• Statement of Additional Information (SAI)
• Fund’s annual report
 Information on Mutual Funds
• Morningstar ([Link])
• Yahoo ([Link]/funds)
• Investment Company Institute ([Link])
• Directory of Mutual Funds
 Hedge Funds vs. Mutual Funds

Hedge Fund Mutual Fund

• Transparency: Limited • Transparency:
Liability Partnerships Regulations require
with minimal disclosure public disclosure of
of strategy and portfolio strategy and portfolio
composition composition
• Investors: No more than • Investors: Number is
100 “sophisticated” and not limited
wealthy investors
 Hedge Funds vs. Mutual Funds

Hedge Fund Mutual Fund

• Investment Strategies: • Investment Strategies:
Very flexible, funds can Predictable, stable
act opportunistically strategies, stated in
and make a wide range prospectus
of investments • Limited use of shorting,
• Often use shorting, leverage, options
leverage, options
 Hedge Funds vs. Mutual Funds
Hedge Fund Mutual Fund
• Liquidity: Have lock-up • Liquidity: Investments
periods, require advance can be moved more
redemption notices easily into and out of a
• Compensation fund
structure: Management • Compensation
fee of 1-2% of assets structure: Fees are
and an incentive fee of usually a fixed
20% of profits percentage of assets,
typically 0.5% to 1.5%
 Hedge Fund Strategies
• Directional
• Bets that one sector or another will outperform
other sectors
• Non-directional
• Exploit temporary misalignments in relative
valuation across sectors
• Buy one type of security and sell another
• Strives to be market neutral
Hedge Fund Styles
 Hedge Fund Strategies
• Statistical Arbitrage
• Uses quantitative systems that seek out many
temporary and modest misalignments in prices and
involves trading in hundreds of securities a day
with short holding periods
• Pairs trading: Pair up similar companies whose
returns are highly correlated but one is priced more
aggressively
• Data mining to uncover systematic pricing patterns
Portfolio Risk (σ) as a Function of
the Number of Stocks in the
Portfolio
σ

Idiosyncratic Risk
Firm-Specific Risk
Unique Risk
Diversifiable Risk

Market Risk
Systematic Risk
Non-diversifiable Risk

n
The Benefits of Diversification
No. of
σP σP/σ1
stocks
(in %) (in %)
in portfolio
1 27.00 100%
2 17.00 63%
4 12.00 44%
6 10.33 38%
8 9.50 35%
10 9.00 33%
12 8.67 32%
14 8.43 31%
16 8.25 31%
18 8.11 30%
20 8.00 30%
25 7.80 29%
30 7.67 28%
35 7.57 28%
40 7.50 28%
45 7.44 28%
50 7.40 27%
75 7.27 27%
100 7.20 27%
200 7.10 26%
300 7.07 26%
400 7.05 26%
500 7.04 26%
1000 7.02 26%
Infinity 7.00 26%
 Diversification

But..........
It is not just the number of stocks in a portfolio
that matters…….
it is also the correlation between the stocks that
matters!
 How Do You Choose the Best
Portfolio of Stocks?
In an EMH world........
the only way an investor to achieve higher returns
is to take on higher risk!

Capital Asset Pricing Model (CAPM)

measures a stock’s risk as the correlation of a
stock’s return with the return of the overall market

Measure is called beta (β)

 Finance Jargon: Beta

• Beta (β) can be estimated with historical data

• Represents non-diversifiable risk, for which investors
must be compensated
• For the market as a whole, β = 1
• β >1 implies stock requires a return greater than the
market return, because the stock is riskier (has a higher
standard deviation) than the market
• β <1 implies stock requires a return lower than the
market return, because the stock is less risky (has a lower
standard deviation) than the market
 Beta for Some U.S. Stocks
(Computed from Trailing Data)
Stock Beta
American Airlines 3.85
Amazon 1.69
Google 1.15
Boeing .94
Starbucks .94
Microsoft .73
Colgate-Palmolive .72
 Fundamental CAPM Equation
Expected risk premium on stock = E(rS) – rF

Expected risk premium on market = E(rM) – rF

E(rS) – rF = β[E(rM) – rF]

E(rS) = rF + β[E(rM) – rF]
 Betas for Some U.S. Stocks
(Est. from data from 2001 – 2006)
Assume: rF = 5%
E(rM) – rF = 7%
E(rS) = rF + β[E(rM) – rF] = 5% + β × 7%
Stock Beta E(rS)
Amazon 2.20 20.4%
IBM 1.59 16.1%
Disney 1.26 13.8%
Microsoft 1.13 12.9%
Boeing 1.09 12.6%
Starbucks .69 9.8%
ExxonMobil .65 9.6%
Two Approaches to the Stock
Market

Fundamental Analysis
vs.
Technical Analysis
 Fundamental Analysis

Fundamental analysis analyzes the

economic and financial factors which are
thought to be the most important
influences of a stock’s value
• Aims to establish a stock’s “intrinsic
value” by looking at
• Macroeconomic data
• Industry data
• Firm-specific data
 Technical Analysis

Technical analysis attempts to exploit

recurring and predictable patterns in stock
prices
• Momentum (Trend-following)
• Moving-Average
• Contrarian
• Looking for signals of price reversals
• Looking for “overbought” and “oversold”
conditions
• Market Neutral
 Technical Analysis:
Chart Patterns
• Chart Patterns
• Support Levels
 Technical Analysis:
Chart Patterns
• Chart Patterns
• Resistance Levels
 Technical Analysis:
Chart Patterns
• Chart Patterns
• Double Top
 Technical Analysis:
Chart Patterns
• Chart Patterns
• Double Bottom
 Technical Analysis:
Chart Patterns
• Chart Patterns
• Head and Shoulders Top
 Technical Analysis:
Trends and Corrections
• Momentum and moving averages
• The moving average is the average level of prices
over a given interval of time, where the interval is
updated as time passes
• Bullish signal: Market price breaks through the
moving average line from below, it is time to buy
• Bearish signal: When prices fall below the moving
average, it is time to sell
Moving Average for INTC
 Technical Analysis:
Breadth
Often measured as
the spread
between the
number of stocks
that advance and
decline in price
 Technical Analysis:
Sentiment Indicators
• Trin Statistic
Volume declining
Number declining
Trin =
Volume advancing
Number advancing

• Ratios above 1.0 are bearish

 Technical Analysis:
Sentiment Indicators
• Confidence Index
• The ratio of the average yield on 10 top-rated
corporate bonds divided by the average yield on 10
intermediate-grade corporate bonds
• Higher values are bullish
 Technical Analysis:
Sentiment Indicators
• Put/Call Ratio
• Calls are the right to • A rising ratio may
buy signal investor
• A way to bet on pessimism and a coming
rising prices market decline
• Puts are the right to • Contrarian investors see
sell a rising ratio as a buying
• A way to bet on opportunity
falling prices
Efficient Markets Hypothesis (EMH)

Law of One Price  Arbitrage  EMH

EMH: Markets incorporate all available

information immediately into a security’s
price

The only time a security’s price changes is

when new information arrives
Efficient Markets Hypothesis (EMH)

EMH: Markets incorporate all available

information immediately into a security’s
price

 Stock prices follow a random walk

S&P 500 Index
S & P vs. A Coin Toss
Efficient Markets Hypothesis (EMH)

Law of One Price  Arbitrage  EMH

 Stock prices follow a random walk

 Best estimate of a stock’s future value

is it’s value today
This involves the concepts of present
discounted value and expected value
 Expected Value
• Expected Value (EV)
= Probability of Outcome 1 × Value of Outcome 1
+ Probability of Outcome 2 × Value of Outcome 2
+ Probability of Outcome 3 × Value of Outcome 3
+ .......
+ Probability of Outcome N × Value of Outcome N
 Expected Value
• Example
• Lottery with
• Outcome 1: Win $10,000 P(1) = .1
• Outcome 2: Win $0 P(2) = .9

EV = Probability of Outcome 1 × Value of Outcome 1

+ Probability of Outcome 2 × Value of Outcome 2
= (.1) × ($10,000) + (.9) × (0)
= $1,000
Efficient Markets Hypothesis (EMH)

In an EMH world…….a stock’s current

value will equal the present discounted
value (PDV) of the weighted average—
called the “expected value”—of future
possible prices, plus the PDV of any
expected dividends

The “weights” are the probabilities of

each of the possible future prices.
Stock Price as an Expected Value

Say there are 3 possible prices a stock can

be at on the first of next year:

12 18 24
Stock Price as an Expected Value

Say there are 3 possible prices a stock can be at

on the first of next year:

12 18 24

The probability of each price is 1/3

Expected dividend during year = $3
What will the stock sell for today?
Stock Price as an Expected Value

Say there are 3 possible prices a stock can

be at on the first of next month:
12 18 24
The probability of each price is 1/3
What will the stock sell for today?
It will sell for the PDV of its expected
value + PDV of the dividend:
EVPrice = 1/3(12) + 1/3(18) + 1/3(24) = 18
 Stock Price as an Expected Value

It will sell for the PDV of its expected

value + PDV of the dividend:
EV = 1/3(12) + 1/3(18) + 1/3(24) = 18
Assume that the required rate of return on
the stock is 12%.
This is the discount rate to use in calculating
the PDV of the EV and the dividend:
Stock Price as an Expected Value

Current price = PDV of EV + PDV of Dividend

18 3
= 
1.12 1.12

=18.75
 Three Forms of the Efficient
Markets Hypothesis (EMH)

1. Weak form: Past prices cannot help

you predict future prices

2. Semi-strong form: No publicly

available information can help you
predict future prices

3. Strong form: No public or private

information can help you predict future prices
 Evidence on Efficient
Market Hypothesis
• Favorable Evidence
1. Investment analysts and mutual funds don't beat
the market
2. Stock prices reflect publicly available info:
anticipated announcements don't affect stock price
3. Stock prices and exchange rates close to random walk
4. Technical analysis does not outperform market
 Evidence in Favor
of Market Efficiency
• Performance of Investment Analysts and Mutual
Funds should not be able to consistently beat the
market
─ The “Investment Dartboard” often beats investment
managers.
─ Mutual funds not only do not outperform the market on
average, but when they are separated into groups according
to whether they had the highest or lowest profits in a chosen
period, the mutual funds that did well in the first period do
not beat the market in the second period.
 Evidence in Favor
of Market Efficiency
• Performance of Investment Analysts and
Mutual Funds should not be able to
consistently beat the market
─ Investment strategies using inside information is the
only “proven method” to beat the market. In the
U.S., it is illegal to trade on such information, but
that is not true in all countries.
 Evidence in Favor
of Market Efficiency
• Do Stock Prices Reflect Publicly Available
Information as the EMH predicts they will?
─ Thus if information is already publicly available, a
positive announcement about a company will not,
on average, raise the price of its stock because this
information is already reflected in the stock price.
 Evidence in Favor
of Market Efficiency
• Do Stock Prices Reflect Publicly Available
Information as the EMH predicts they will?
─ Early empirical evidence confirms: favorable
earnings announcements or announcements of stock
splits (a division of a share of stock into multiple
shares, which is usually followed by higher
earnings) do not, on average, cause stock prices to
rise.
 Evidence in Favor
of Market Efficiency
• Random-Walk Behavior of Stock Prices that is,
future changes in stock prices should, for all
practical purposes, be unpredictable
─ If stock is predicted to rise, people will buy to equilibrium
level; if stock is predicted to fall, people will sell to
equilibrium level (both in concert with EMH)
─ Thus, if stock prices were predictable, thereby causing the
above behavior, price changes would be near zero, which
has not been the case historically
 Evidence on Efficient
Market Hypothesis
• Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. Excessive volatility
5. Mean reversion
6. New information is not always immediately incorporated into stock
prices
• Overview
─ Reasonable starting point but not whole story
 Evidence Against Market Efficiency
• The Small-Firm Effect is an anomaly. Many empirical
studies have shown that small firms have earned
abnormally high returns over long periods of time, even
when the greater risk for these firms has been considered.
─ The small-firm effect seems to have diminished in recent years but is
still a challenge to the theory of efficient markets
─ Various theories have been developed to explain the small-firm effect,
suggesting that it may be due to rebalancing of portfolios by institutional
investors, tax issues, low liquidity of small-firm stocks, large
information costs in evaluating small firms, or an inappropriate
measurement of risk for small-firm stocks
Evidence Against Market Efficiency
• The January Effect is the tendency of stock
prices to experience an abnormal positive
return in the month of January that is
predictable and, hence, inconsistent with
random-walk behavior
 Evidence Against Market Efficiency
• Investors have an incentive to sell stocks before the end of the
year in December because they can then take capital losses on
their tax return and reduce their tax liability. Then when the
new year starts in January, they can repurchase the stocks,
driving up their prices and producing abnormally high returns.
• Although this explanation seems sensible, it does not explain
why institutional investors such as private pension funds, which
are not subject to income taxes, do not take advantage of the
abnormal returns in January and buy stocks in December, thus
bidding up their price and eliminating the abnormal returns.
Evidence Against Market Efficiency
• Market Overreaction: recent research suggests that stock
prices may overreact to news announcements and that the
pricing errors are corrected only slowly
─ When corporations announce a major change in earnings, say, a large
decline, the stock price may overshoot, and after an initial large decline,
it may rise back to more normal levels over a period of several weeks.
─ This violates the EMH because an investor could earn abnormally high
returns, on average, by buying a stock immediately after a poor earnings
announcement and then selling it after a couple of weeks when it has
risen back to normal levels.
 Evidence Against Market Efficiency
• Excessive Volatility: the stock market appears to display
excessive volatility; that is, fluctuations in stock prices may be
much greater than is warranted by fluctuations in their
fundamental value.
─ Researchers have found that fluctuations in the S&P 500 stock index
could not be justified by the subsequent fluctuations in the dividends of
the stocks making up this index.
─ Other research finds that there are smaller fluctuations in stock prices
when stock markets are closed, which has produced a consensus that
stock market prices appear to be driven by factors other than
fundamentals.
Case: Any Efficient Markets Lessons from Black Monday of
1987 and the Tech Crash of 2000?

• Does any version of Efficient Markets Hypothesis (EMH) hold

in light of sudden or dramatic market declines?
• Strong version EMH?
• Weaker version EMH?
• A bubble is a situation in which the price of an asset differs
from its fundamental market value?
• Can bubbles be rational?
 Bubbles and Behavioral Economics
• Bubbles are easier to spot after they end
• Dot-com bubble
• Housing bubble
 Evidence Against Market Efficiency
• Mean Reversion: Some researchers have found that stocks
with low returns today tend to have high returns in the future,
and vice versa.
─ Hence stocks that have done poorly in the past are more likely to do well
in the future because mean reversion indicates that there will be a
predictable positive change in the future price, suggesting that stock
prices are not a random walk.
─ Newer data is less conclusive; nevertheless, mean reversion remains
controversial.
Evidence Against Market Efficiency
• New Information Is Not Always Immediately Incorporated
into Stock Prices
─ Although generally true, recent evidence suggests that, inconsistent with
the efficient market hypothesis, stock prices do not instantaneously
adjust to profit announcements.
─ Instead, on average stock prices continue to rise for some time after the
announcement of unexpectedly high profits, and they continue to fall
after surprisingly low profit announcements.
 THE PRACTICING MANAGER:
Implications for Investing
1. How valuable are published reports by
investment advisors?
2. Should you be skeptical of hot tips?
3. Do stock prices always rise when there is good
news?
4. Efficient Markets prescription for investor
 Implications for Investing
• How valuable are published reports by
investment advisors?
• Take them with a substantial grain of salt!
 Implications for Investing
1. Should you be skeptical of hot tips?
─ YES. The EMH indicates that you should be
skeptical of hot tips since, if the stock market is
efficient, it has already priced the hot tip stock so
that its expected return will equal the equilibrium
return.
─ Thus, the hot tip is not particularly valuable and
will not enable you to earn an abnormally high
return.
 Implications for Investing
2. Should you be skeptical of hot tips?
─ As soon as the information hits the street, the
unexploited profit opportunity it creates will be
quickly eliminated.
─ The stock’s price will already reflect the
information, and you should expect to realize only
the equilibrium return.
 Implications for Investing
3. Do stock prices always rise when there is
good news?
• NO. In an efficient market, stock prices will respond to
announcements only when the information being announced
is new and unexpected.
• So, if good news was expected (or as good as expected),
there will be no stock price response.
• And, if good news was unexpected (or not as good as
expected), there will be a stock price response.
 Implications for Investing
4. Efficient Markets prescription for investor
─ Investors should not try to outguess the market by
constantly buying and selling securities. This
process does nothing but incur commissions costs
on each trade.
 Implications for Investing
4. Efficient Markets prescription for investor
─ Instead, the investor should pursue a “buy and
hold” strategy—purchase stocks and hold them for
long periods of time. This will lead to the same
returns, on average, but the investor’s net profits
will be higher because fewer brokerage
commissions will have to be paid.
 Implications for Investing
4. Efficient Markets prescription for investor
─ It is frequently a sensible strategy for a small investor,
whose costs of managing a portfolio may be high relative to
its size, to buy into a mutual fund rather than individual
stocks. Because the EMH indicates that no mutual fund can
consistently outperform the market, an investor should not
buy into one that has high management fees or that pays
sales commissions to brokers but rather should purchase a
no-load (commission-free) mutual fund that has low
management fees.
 Behavioral Finance and Deviations
from Rationality

Two Broad Categories of Deviation:

(1) Cognitive biases

(2) Behavioral biases—acting on emotion

instead of rational analysis
• Introduction to Derivatives
• Options Mechanics
• Call Options
• Put Options
• Some Options Jargon
• Intrinsic and Time Value of an Option
• Hockey Stick Diagrams
• A Simple Option Pricing Model (OPM)
• Effect of Volatility on Option Value
• Leverage
 Derivatives

A derivative is an instrument whose value

depends on the values of other more basic
underlying variables
 Derivatives

• Derivatives play a key role in transferring risks in the

economy
• There are many underlying assets: stocks, currencies,
interest rates, commodities, debt instruments, electricity,
insurance payouts, the weather, etc.
• Many financial transactions have embedded derivatives
• The real options approach to assessing capital investment
decisions, which values the options embedded in
investments using derivatives theory, has become widely
accepted
 Main Kinds of Derivatives
• Forward Contracts
• Futures Contracts
• Options
• Swaps
Uses of Derivatives
• Hedging
• Speculation

• Hedging involves engaging in a

financial transaction that reduces or
eliminates risk.

• Speculation involves taking on risk in

the pursuit of profit in anticipation of a
favorable change in the price of an asset
 Finance Jargon

• Definitions
• long position: an asset which is purchased
or owned (now or in the future)
• short position: an asset which must be delivered to
a third party as a future date, or an asset which is
borrowed and sold, but must be replaced in the
future
 Options Contracts
• Definition: A call option is the right, but not
the obligation, to buy some asset in the future,
at a price that is agreed upon today, called the
strike price, or exercise price.
 Summary of Puts and Calls

Buy Sell
(Write)
Not obligated to buy Obligated to sell stock to
stock call buyer
Calls
Gains if stock goes Gains if stock stays below
above strike price strike price

Puts
 Options Contracts
• European Options—can be exercised only on
the expiration date
• American Options—can be exercised any time
up to the expiration date
• In the U.S. options expire on the 3 rd Friday of
the expiration month
• Standard option contract is for 100 shares of the
underlying stock
• Total cost of position
= Premium per share × 100 × No. of contracts
 Finance Jargon:
Long Call, Short Call
Long Call
“Buy to open” “Sell to close”

Short Call
(Often called “writing” a call)
“Sell to open” “Buy to close”
 Finance Jargon:
“In the money”
A call or put which has positive intrinsic
value is said to be “in the money”
A call or put which has zero intrinsic value
is said to be “out of the money”
A call or put for which K = current stock
price is said to be “at the money”
 Finance Jargon:
“Nearby Contract”
Nearby Contract—the option contract
currently trading that has the closest
expiration date
 Intrinsic Value of a Call
• Intrinsic value = Stock price – Strike price
or 0, whichever is greater

= max (S – K, 0)
 Intrinsic Value of a Call
• Intrinsic value = Stock price – Strike price
or 0, whichever is greater

• Facebook (FB) recently closed at 104

• Consider the nearby FB 100 call
• Intrinsic value = $104 – $100 = $4

• Consider the nearby FB 110 call

• Intrinsic value = ?
 Intrinsic Value of a Call
• Intrinsic value = Stock price – Strike price
or 0, whichever is greater

• Facebook (FB) recently closed at 104

• Consider the nearby FB 100 call
• Intrinsic value = $104 – $100 = $4

• Consider the nearby FB 110 call

• Intrinsic value = 0
 Time Value of a Call
• Intrinsic value = Stock price – Strike price

• Time value = Premium – Intrinsic value

 Intrinsic Value of a Call
• Intrinsic value = Stock price – Strike price
or 0, whichever is greater
• Facebook (FB) recently closed at 104
• Consider the nearby FB 100 call
• Intrinsic value = $104 – $100 = $4
• Premium = $6.20
• Time value = Premium – Intrinsic value
= $6.20 – $4.00 = $2.20
 Intrinsic Value of a Call
• Intrinsic value = Stock price – Strike price
or 0, whichever is greater
• Facebook (FB) recently closed at 104
• Consider the nearby FB 110 call
• Intrinsic value = $0
• Premium = $1.50
• Time value = Premium – Intrinsic value
= $1.50 – $0 = $1.50
 Hockey Stick Diagrams:
Intrinsic Value of a Long Call
Intrinsic Value

Max (S – K, 0)

K
0 Stock Price at Option
Out of the money In the money
Expiration
 Hockey Stick Diagrams:
Time and Intrinsic Value of a Long Call
Hockey Stick Diagrams: Profit/Loss
from Long Call
Profit

K K + Premium
Stock Price at Option
Option
Expiration
Premium

Loss
 Hockey Stick Diagram:
Long Nearby Google 720 Call
Premium = $20
Profit

$720 $740
Stock Price at Option
$20 Expiration

Loss
Hockey Stick Diagrams: Profit/Loss
from Short Call
Profit

Option
Premium
K + Premium
K Stock Price at Option
Expiration

Loss
 Hockey Stick Diagrams:
Short (Write) Nearby Google 720 Call
Premium = $20
Profit

$20
$740
$720 Stock Price at Option
Expiration

Loss
 Options Contracts
• Definition: A put option is the right, but not
the obligation, to sell some asset in the future,
at a price that is agreed upon today, called the
strike price, or exercise price.
 Summary of Puts and Calls

Buy Sell
(Write)
Not obligated to buy Obligated to sell stock to
stock call buyer
Calls
Gains if stock goes Gains if stock stays below
above strike price strike price

Not obligated to sell Obligated to buy stock

Puts stock from put buyer
Gains if the stock goes Gains if the stock stays
below strike price above strike price
 Finance Jargon:
Long Put, Short Put
Long Put
“Buy to open” “Sell to close”

Short Put
(Often called “writing” a put)
“Sell to open” “Buy to close”
 Intrinsic Value of a Put
• Intrinsic value = Strike price – Stock price
or 0, whichever is greater

= max (K – S, 0)
 Intrinsic Value of a Put
• Intrinsic value = Strike price – Stock price
or 0, whichever is greater

• Facebook (FB) recently closed at 104

• Consider the nearby FB 107 Put
• Intrinsic value = $107 – $104 = $3

• Consider the nearby FB 102 Put

• Intrinsic value = 0
 Time Value of a Put
• Intrinsic value = Strike price – Stock price

• Time value = Premium – Intrinsic value

 Intrinsic Value of a Put
• Intrinsic value = Strike price – Stock price
or 0, whichever is greater
• Facebook (FB) recently closed at 104
• Consider the nearby FB 107 Put
• Intrinsic value = $107 – $104 = $3
• Premium = $4.50
• Time value = Premium – Intrinsic value
= $4.50 – $3.00 = $1.50
 Intrinsic Value of a Put
• Intrinsic value = Strike price – Stock price
or 0, whichever is greater
• Facebook (FB) recently closed at 104
• Consider the nearby FB 100 Put
• Intrinsic value = $0
• Premium = $1.40
• Time value = Premium – Intrinsic value
= $1.40 – $0 = $1.40
 Hockey Stick Diagrams: Intrinsic
Value of a Long Put
Intrinsic
Value

K
Max (K – S, 0)

0 Stock Price at
In the money K Out of the moneyExpiration
Option
 Hockey Stick Diagrams:
Time and Intrinsic Value of a Long Put
 Hockey Stick Diagrams: Long Put

Profit

Max
Profit

K − Premium K
Stock Price at Option
Option
Expiration
Premium

Loss
 Hockey Stick Diagrams:
Long Nearby XYZ 540 Put
Premium = $5
Profit

$535

$535 $540
Stock Price at Option
$5 Expiration

Loss
 Hockey Stick Diagrams: Short Put

Profit

Option
Premium
K − Premium
K Stock Price at Option
Expiration

K − Premium
Loss
 Hockey Stick Diagrams:
Short Nearby XYZ Dec 540 Put
Premium = $5
Profit

$5

$535 $540 Stock Price at Option

Expiration

$535
Loss
 Hockey Stick Diagrams:
Long Nearby XYZ 540 Put
Premium = $5
Profit

$535

$535 $540
Stock Price at Option
$5 Expiration

Loss
 Hockey Stick Diagrams:
Short Nearby XYZ Dec 540 Put
Premium = $5
Profit

$5

$535 $540 Stock Price at Option

Expiration

$535
Loss
 XYZ Stock
Probabilities and Prices on 3rd Fri. of Next
Month
Probability 1/4 1/2 1/4

Price 360 420 480

EV of stock = ¼(360) + ½(420) + ¼(480)

= 90 + 210 + 120
= 420
 XYZ Stock
Probabilities and Prices on 3rd Fri. of Next
Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from
Call with
K=400

EV of stock = 420
 XYZ Stock
Probabilities and Prices on 3rd Fri. of Next
Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from 0 20 80
Call with
K=400
EV of stock = 420
EV of call = ¼(0) + ½(20) + ¼(80)
= 0 + 10 + 20
= 30
 Volatility and an Option’s Price
• What is the effect of volatility on an call’s price
(premium)?
 XYZ Stock
Probabilities and Prices on 3rd Fri. of Next
Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from 0 20 80
Call with
K=400
EV of stock = 420
EV of call = ¼(0) + ½(20) + ¼(80)
= 0 + 10 + 20
= 30
 XYZ Stock
Probabilities and Prices on 3rd Fri. of Next
Month
Probability 1/4 1/2 1/4

Price 320 420 520

Gain from 0 20 120

Call with
K=400
EV of stock = 420
EV of call = ¼(0) + ½(20) + ¼(120)
= 0 + 10 + 30
= 40
 XYZ Stock
Probabilities and Prices on 3rd Fri.
of Next Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from
Put with
K=400

EV of stock = 420
 XYZ Stock
Probabilities and Prices on 3rd Fri.
of Next Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from 40 0 0
Put with
K=400

EV of stock = 420
EV of put = ¼(40) + ½(0) + ¼(0)
= 10
 Volatility and an Option’s Price
• What is the effect of volatility on a put’s price
(premium)?
 XYZ Stock
Probabilities and Prices on 3rd Fri.
of Next Month
Probability 1/4 1/2 1/4

Price 360 420 480

Gain from 40 0 0
Put with
K=400

EV of stock = 420
EV of put = ¼(40) + ½(0) + ¼(0)
= 10
 XYZ Stock
Probabilities and Prices on 3rd Fri.
of Next Month
Probability 1/4 1/2 1/4

Price 320 420 520

Gain from 80 0 0
Put with
K=400
EV of stock = 420
EV of put = ¼(80) + ½(0) + ¼(0)
= 20
 Leverage on XYZ Calls
XYZ stock was recently selling for $544/share:
Cost to buy 100 shares = $544 × 100 = $54,400

The nearby XYZ $550 call is selling for $6

Cost to buy 1 contract (options on 100 shares)
= $6 × 100 = $600

$54, 400
Leverage = 91:1
$600
 Scenario I: Dinner at L’Espalier
Assume XYZ goes up to
$600/share by contract expiration
Own 100 shares of the stock: Sell for $60,000
 Profit = $60,000 – $54,400 = $5,600
$5,600
 Return on investment = $54, 400 = 10.3%

Own 1 contract of the $550 call:

When stock = $600, call with K = $550 has intrinsic value
of $600 – $550 = $50/share…..sell 1 contract for $5,000

 Profit = $5,000 – $600 = $4,400

$4, 400
 Return on investment = = 733%
$600
 Scenario II: Big Mac at Mickey D’s
Assume XYZ goes down to $500/share
by mid-December
Own 100 shares of the stock: Sell for $50,000
 Profit = $50,000 – $54,400 = −$4,400
 $4, 400
 Return on investment = $54, 400 = −8%

Own 1 contract of the 550 call:

When stock=$500, intrinsic value of call with K=550 is ?
 Scenario II: Big Mac at Mickey D’s
Assume XYZ goes down to $500/share
by option expiration
Own 100 shares of the stock: Sell for $50,000
 Profit = $50,000 – $54,400 = −$4,400
 $4, 400
 Return on investment = $54, 400 = −8%

Own 1 contract of the 550 call:

When stock = $500, call with K = 550
has intrinsic value of $0….option expires worthless
 Loss = $0 – $600 = −$600
 $600
 Return on investment = = −100%
$600
• Calls and Puts (Review)
• Hockey Stick Diagrams
• Option Strategies
• Bull Spreads
• Bear Spreads
• Straddles
• Strangles
 Rob’s notes
• I have left Bruce’s review slides in here
because his goal is for you to see how profit
and loss from options strategies results from
profit and loss of individual options.
• Understanding those connections will help you
truly understand option strategies.
 Time Value of a Call
• For a call

• Intrinsic value = Stock price – Strike price

• Time value = Premium – Intrinsic value

 Options Contracts
• Definition: A put option is the right, but not
the obligation, to sell some asset in the future,
at a price that is agreed upon today, called the
strike price, or exercise price.
 Summary of Puts and Calls

Buy Sell
(Write)
Not obligated to buy Obligated to sell stock to
stock call buyer
Calls
Gains if stock goes Gains if stock stays below
above strike price strike price

Not obligated to sell Obligated to buy stock

Puts stock from put buyer
Gains if the stock goes Gains if the stock stays
below strike price above strike price
 Intrinsic Value of a Put
• For a put

• Intrinsic value = Strike price – Stock price

or 0, whichever is greater
 Time Value of a Put
• For a put

• Intrinsic value = Strike price – Stock price

• Time value = Premium – Intrinsic value

 Hockey Stick Diagrams: Long Call

Profit

K K + Premium
Stock Price at Option
Option
Expiration
Premium

Loss
 Hockey Stick Diagram:
Long Nearby Google 600 Call
Premium = $15
Profit

$600 $615
Stock Price at Option
$15 Expiration

Loss
 Hockey Stick Diagrams: Short Call

Profit

Option
Premium
K + Premium
K Stock Price at Option
Expiration

Loss
 Hockey Stick Diagrams:
Short (Write) Nearby Google 600 Call
Premium = $15
Profit

$15
$615
$600 Stock Price at Option
Expiration

Loss
 Hockey Stick Diagrams: Long Put

Profit

Max
Profit

K − Premium K
Stock Price at Option
Option
Expiration
Premium

Loss
 Hockey Stick Diagrams:
Long Nearby Google 600 Put
Premium = $15
Profit

$585

$585 $600
Stock Price at Option
$15 Expiration

Loss
 Hockey Stick Diagrams: Short Put

Profit

Option
Premium
K − Premium
K Stock Price at Option
Expiration

K − Premium
Loss
 Hockey Stick Diagrams:
Short Nearby Google Dec 675 Put
Premium = $15
Profit

$15
$660
$675 Stock Price at Option
Expiration

$660
Loss
 Bull Spread
Spread—Trade two of the same kind of option (calls or
puts) with different strike prices

Bull Spread—Buy and sell two calls with different strike

prices

• Buy call with lower K; Sell call with higher K

• Bought by an investor who thinks the stock price will go up
• Reduces the cost of a long position
 Bull Spread
Let’s say Google stock is currently selling for $600/share,
and you think Google stock is going up. You could:
• Buy a nearby Google call contract with K=600
Assume the premium = $10
Total cost of 1 contract: $10 × 100 = $1,000
• Put on a bull spread
Buy the nearby Google 600 call @ $10
Sell the nearby Google 610 call @ $5
Total cost of spread: $10 × 100 = $1,000
− $ 5 × 100 = $ 500
$ 500
 Profit and Loss from Bull Spread
Buy the nearby Google 600 call @ $10
Sell the nearby Google 610 call @ $5
Stock Price at Option Expiration
0 600 605 610 615 620 630
Long GOOG 600 call @ 10 −10 −10 −5 0 +5 +10 +20
Short GOOG 610 call @ 5 +5 +5 +5 +5 0 −5 −15
Net Profit/Loss from
Position
−5 −5 0 +5 +5 +5 +5

Max gain when stock price  $610

Max loss when stock price  $600
Breakeven when stock price = $605
 Hockey Stick Diagrams:
Bull Spread Using Calls
Max gain when stock price  $610
Profit Max loss when stock price  $600
Breakeven when stock price = $605

600 605 610

Stock Price at Option
Expiration

−5

Loss
 Bear Spread
Let’s say Google stock is currently selling for $600/share,
and you think Google stock is going down. You could:
• Buy a nearby Google put contract with K=600
Assume the premium = $10
Total cost of 1 contract: $10 × 100 = $1,000
• Put on a bear spread
Buy the nearby Google 610 call @ $5
Sell the nearby Google 600 call @ $10
Total revenue of spread: $10 × 100 = $1,000
− $ 5 × 100 = $ 500
$ 500
 Profit and Loss from Bear Spread
Buy the nearby Google 610 call @ $5
Sell the nearby Google 600 call @ $10
Stock Price at Option Expiration
0 600 605 610 615 620 630
Short GOOG 600 call @ 10 +10 +10 +5 0 −5 −10 −20
Long GOOG 610 call @ 5 −5 −5 −5 −5 0 +5 +15
Net Profit/Loss from
Position
+5 +5 0 −5 −5 −5 −5

Max gain when stock price  $600

Max loss when stock price  $610
Breakeven when stock price = $605
 Hockey Stick Diagrams:
Bear Spread Using Calls
Max gain when stock price  $600
Profit Max loss when stock price  $610
Breakeven when stock price = $605

+5

600 605 610

Stock Price at Option
Expiration

Loss
 Hockey Stick Diagrams: Long Call

Profit

K K + Premium
Stock Price at Option
Option
Expiration
Premium

Loss
 Hockey Stick Diagrams: Long Put

Profit

Max
Profit

K − Premium K
Stock Price at Option
Option
Expiration
Premium

Loss
 Long Straddle

Profit

K − Call & Put K + Call & Put

Premiums K Premiums
Stock Price at
Call + Put
Option Expiration
Premiums

Loss
 Long Straddle on Google

Profit

$565 $600 $635

Stock Price at
$35 Option Expiration

Loss
 Hockey Stick Diagrams: Short Call

Profit

Option
Premium
K + Premium
K Stock Price at Option
Expiration

Loss
 Hockey Stick Diagrams: Short Put

Profit

Option
Premium
K − Premium
K Stock Price at Option
Expiration

Loss
 Short Straddle

Profit

Call + Put
K – Call & Put K + Call & Put
Premiums
Premiums Premiums
K Stock Price at
Option Expiration

Loss
 Short Straddle on Google

Profit

$35
$565 $635
$600 Stock Price at
Option Expiration

$565
Loss
 Long Strangle

Profit
Put K − Call &
Put Premiums

Put K − Call & Call K + Call &

Put Premiums Put K Call K Put Premiums
Stock Price at
Call + Put
Option Expiration
Premiums

Loss
• Futures Contracts
• How Futures Markets Evolved
• Options vs. Futures
• Futures Market Mechanics
• Leverage
• Stock Index Futures
• “Trillion Dollar Bet”
 Options vs. Futures
Options Futures
 Options vs. Futures
Options Futures
Exchange of a right
 Options vs. Futures
Options Futures
Exchange of a right Exchange of
promises
 Options vs. Futures
Options Futures
Exchange of a right Exchange of
promises
Only seller obligated
(to buy or sell stock)
 Options vs. Futures
Options Futures
Exchange of a right Exchange of
promises
Only seller obligated Both parties
obligated
(to buy or sell stock)
 Options vs. Futures
Options Futures
Exchange of a right Exchange of promises
Only seller obligated Both parties obligated
(to buy or sell stock)
Buyer pays for option
at time of purchase
 Options vs. Futures
Options Futures
Exchange of a right Exchange of promises
Only seller obligated Both parties obligated
(to buy or sell stock)
Buyer pays for option Both parties put up
at time of purchase “margin”
 Options vs. Futures
Options Futures
Exchange of a right Exchange of promises
Only seller obligated Both parties obligated
(to buy or sell stock)
Buyer pays for option Both parties put up
at time of purchase “margin”
Standardized contract Standardized contract
terms terms
 The Array of Futures Contracts
[Link]
 Futures Contracts Mechanics
An Example
• Nearby contract on wheat on the CBOT
• 1 contract is standardized to 5,000 bushels
• Contract buyer is obligated to take delivery of
5,000 bushels of wheat by the time the contract
expires, or must sell their futures contract before it
expires
• Contract seller is obligated to deliver 5,000 bushels
of wheat by the time the contract expires, or must
buy an offsetting futures contract before their
contract expires
 Futures Contracts Mechanics
An Example
• Nearby contract on wheat on the CBOT
• 1 contract is standardized to 5,000 bushels
• Say the nearby contract is selling for 500 (cents per
bushel, i.e. $5.00/bu.)
• Value of contract = 5,000 bu. × $5/bu. = $25,000
• But …… the buyer and seller don’t have to come up
with $25,000 to enter into the trade
• They only have to put up good faith money, called
“margin,” (performance bond) equal to a fraction of the
contract’s value
• For example, the margin on a wheat contract might only
be $2,500, 10% of the value of the contract
 Futures Contracts Mechanics
• Nearby contract on wheat
• $5/bu. Say it goes up to $7/bu. by contract
expiration
• 1 contract = 5,000 bushels
• I make $2/bu. × 5,000 bushels = $10,000
on a $2,500 investment!
 Futures Contracts Mechanics
• Nearby contract on wheat
• $5/bu. Say it goes down to $3/bu. by contract
expiration
• 1 contract = 5,000 bushels
• I lose $2/bu. × 5,000 bushels = $10,000
on a $2,500 investment!
 Futures Contract Example
Soybeans (CBOT) Nearby contract
1 contract = 5,000 bu.

Price = 993 cents per bu. ($9.93 per bu.)

Value of 1 contract = 5,000 bu. ×
$9.93/bu.
= $49,650
Initial margin = $2,090
$49,650
Leverage = 24 :1
$2,090
 Futures Contract Example
Soybeans (CBOT) Nearby contract
1 contract = 5,000 bu.
Price = 993 cents per bu. ($9.93 per bu.)
Value of 1 contract = 5,000 bu. × $9.93/bu.
= $49,650
Initial margin = $2,090
Maintenance margin = $1,900

So…..if the value of the contract goes down just $190

a trader would need to deposit $190 in their account to
restore it to $2,090. This would happen if the price
went
down just $.04/bu to $9.89!!
Mechanics of Stock Index Futures
I sell 1 nearby S&P contract @ 2600

I have obligated myself to pay

$250 × S & P Index
when the contract expires

Whoever bought my contract has obligated themselves

to pay me $250 × 2600 = $650,000
when the contract expires

I think the index is going to go down; whoever bought

my contract thinks the index is going to go up
 Scenario I: Market Goes Down
S & P Index = 2,500
at contract expiration
Seller: Owes buyer $250 × Index value when contract
expires
Buyer: Owes seller $250 × 2600 = $650,000 when
contract expires

Buyer owes seller $250 × 2,600 = $650,000

Seller owes buyer $250 × 2,500 = $625,000
Buyer pays seller $ 25,000
Buyer Loses $25,000 on the trade
Seller Makes $25,000 on the trade
 Scenario II: Market Goes Up
S & P Index = 2700
at contract expiration
Seller: Owes buyer $250 × Index value at contract
expiration
Buyer: Owes seller $250 × 2600 = $650,000 at contract
expiration

Seller owes buyer $250 × 2,700 = $675,000

Buyer owes seller $250 × 2,600 = $650,000
Seller pays buyer $ 25,000
Seller Loses $25,000 on the trade
Buyer Makes $25,000 on the trade