FNCE 4070FINANCIAL MARKETS AND INSTITUTIONS Professor Michael PalmerProfessor of FinanceUniversity of Colorado at BoulderSpring Semester 2011Lecture 1: Introduction to Financial Markets

Concepts and Current Issues

Beginning Quotes For Course“May you live in interesting times.”

Reputed to be an ancient Chinese proverb and curse

“The only certainty in financial markets is uncertainty”Credit Suisse, August 16, 2007 (Switzerland's second largest bank)

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.” George Soros (Hedge fund manager and philanthropist)

“Without the element of uncertainty, the greatest business triumph would be dull, routine, and eminently unsatisfying.” J. Paul Getty (American industrialist, founder of Getty Oil)

“I used to be scared of uncertainty; now I get a high out of it.” Jensen Ackles (Actor. TV; Smallville, Dawson’s Creek, and Supernatural)

Quiz: What is Your Understanding of Financial Markets? Who is the current chairman of the Federal Reserve? Who was the previous chairman of the Federal Reserve? What is the Federal Reserve responsible for? What is quantitative easing? Define the Federal Funds interest rate, the Discount

Rate, and the Prime Rate? What is the current level of the Federal Funds Rate? Is the Federal Funds Rate higher or lower than one year

ago? Which country currently has the highest (lowest) long and

highest (lowest) short term interest rate? United States, United Kingdom, Japan, Germany,

Australia, Canada, or Switzerland. When did the “international credit crisis” reach its peak? What is the offshore bond market?

Ben Bernanke: The 14th Chairman of the Federal Reserve Board Ben Bernanke replaced Alan Greenspan on February 1,

2006 Greenspan had served since August 1987.

Background: The Chairman of the Federal Reserve Board is named by the President and is confirmed by the U.S. Senate. They serve a term of four years, and can be reappointed.

The Federal Reserve is responsible for the conduct of monetary policy, which means: Setting interest rates and promoting money supply growth,

in pursuit of maximum employment, stable prices, and moderate long-term interest rates.

See Appendix 1 for some insights into Bernanke and Appendix 2 for previous Fed Chairs

Ben Bernanke in Song Columbia Business School's YouTube Video parody of Dean

Glenn Hubbard (Note: he is not the real Dean) singing about Ben Bernanke.

http://www.youtube.com/results?search_query=ben+bernanke+every+breath+you+take&aq=0 (link to Ben Bernanke Every Breath you Take video)

http://youtu.be/3u2qRXb4xCU (this may work).

As you watch and listen to this parody take note of the following terms: 1. Change of rate (i.e., interest rates) 2. Stagflate (aka, stagflation – a recession with inflation) 3. BPS (basis points, a measure of interest rates) 4. Yield curve flips (yield curve going from upwards sweeping to

downward sweeping as a signal of a future recession) 5. Interest rate policies (monetary policy used by central banks) 6. Models break (i.e., econometric models used to assess the impact of

monetary policy changes on the economy)

Federal Funds Rate This is the short term (generally overnight) interest rate in the U.S.

interbank market for lending/borrowing “excess” bank reserves. The rate at which one commercial bank will lend reserves to another

commercial bank. This is also regarded as a key (i.e., “benchmark”) short interest rate in

the United States because the Federal Reserve sets and announces its “target” federal funds rate.

Target achieved through open market operations Changes in this “target” rate (or lack of) indicate the stance (direction

and accommodation) of monetary policy. Other interest rates follow closely (especially short term rates).

Financial markets all over the world pay close attention to the Fed Funds Rate.

As well as other major central bank equivalent rates. We also need to follow the “effective” fed funds rate in relation to the

target. This is what the market is actually setting in the interbank market

and this rate tells us something more about Fed policy and conditions in financial markets.

How does the Fed Affect the Federal Funds Rate? As noted, through open market operations.

The buying and selling of government securities. Buying government securities increases bank

excess reserves. An increase in the supply of bank reserves (everything

else equal) will put downward pressure on the Federal funds rate.

Selling government securities reduces bank excess reserves. A decrease in the supply of bank reserves (everything

else equal) will put upward pressure on the Federal funds rate.

Demand and Supply Model of Bank Excess ReservesFed buying government securities

S1 S2

Fed

Funds

Rate

Demand

Fed selling government securities

S2 S1

Fed

Funds

Rate Demand

U.S. Federal Funds Target Rate: Sep 1984 to Dec 2008Latest Cycle: Peak, June 2006: 5.25% - Sep 2007 (Historical High, July

1974: 13%).

U.S. Federal Funds Target Rate: Dec 2008 to the Present Beginning in December 2008 the Federal Reserve announced a

range for the Fed Funds Rate at 0.00% to 0.25%.

Effective Federal Funds Rate Since the Mid 1950s

Effective Federal Funds Rate Follows the

same pattern as the Fed funds target.

Can be viewed daily at:

http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND

Need to assess where it is in relation to the “target.”

Assessing Financial Market Conditions

Effective Fed Funds Rate and Target Range, Dec 2008 to Present

Central Bank Target Interest Rates January 2008, December 2008, January 2010 to January 2011 United States: 4.25%, 0.0/0.25%, 0.0/0.25%, 0.0/0.25% Japan: 0.50%, 0.30%, 0.10%, 0.10% Switzerland: 2.75%, 0.50%, 0.25%, 0.25% United Kingdom: 5.50%, 2.00%, 0.50%, 0.50% Euro-zone: 4.00%, 2.50%, 1.00%, 1.00% Canada: 4.00%,1.50%, 0.25%, 1.00% Australia: 6.75%, 4.25%, 3.75%, 4.75% China: 7.20%, 5.31%, 5.31%, 5.81% India: 9.00%, 6.50%, 4.75%, 6.25% Brazil: 11.25%, 13.75%, 8.75%, 10.75% For rates and meeting dates see: http://www.fxstreet.com/fundamental/interest-rates-table/

Federal Reserve Discount Rate Federal Reserve Discount Rate: Interest rate

the Federal Reserve will charge member banks and other depository institutions to borrow short term (overnight) reserves. Administratively set by the Federal Reserve Currently: .75% (January 2008: 4.75%) (Now

Called Primary Credit Rate) This market is important as it represents a

“safety” net for financial institutions. Also carries potentially important signals as

to future fed policy directions.

Discount Rate

Primary Credit Rate (i.e., Discount Rate)

Pro-Cyclical and Pro-Active Nature of Fed Interest Rate Changes

Bank of Canada: Pro-Cyclical and Pro-Active

ECB; Pro-Cyclical but More Reactive?

Reserve Bank of Australia: Target Rate on the Increase. What is the Explanation?

Prime Interest Rate Prime Rate: Interest rate commercial banks

will charge their best customers (i.e., high grade corporates) on loans to borrow short term funds. Tied to the Federal Funds Rate (with the Fed

funds rate the casual rate). Prime rate is generally around 300 basis points

higher than fed funds rate Currently: 3.25%. (January 2008: 7.25%)

Prime Interest Rate

Why is the Fed Funds Rate So Important? Fed Funds rate is set

by U.S. central bank and thus it carries important signals for the market. What the central bank

thinks about the economy and the direction of the economy.

These signals will affect how the market sets its interest rates.

Bottom line: Other money market rates are influenced by the direction and level of the Fed Funds Rate.

Fed Funds Rate and Short Term Government Securities

Fed Funds Rate and Short Term Money Market Rates

Fed Funds Rate and Long Term Interest Rates

Long Term Rates and Inflation

Basis Points Spread: Prime Rate Minus Fed Funds Rate Basis Points: A measure of:

(1) interest rate changes over time and

(2) differences in interest rates between two series of rates (or two different markets, i.e., countries).

1 Basis point = 0.01 percentage points. 100 basis points = 1.00

percentage points. Changes in spreads are

important because they indicate changes in financial market conditions.

Basis Point Spreads as a Measure of Changing Market Risk Basis point spreads

over “risk free” government rates is often used as an indicator of market risk and changes in market risk.

Comparing Risky Assets to (or close to) Risk Free Assets

Corporate Bond Rates: Aaa and Baa (See Appendix 3 for definitions)

U.S. Interest Rate Spreads Leading up to the 2008 Credit Crisis AAA Corporate – 10 Year

Government (1990 – 2007 spread = 123 basis points)

Baa – Aaa (1990-2007 spread = 83 basis points)

TED Spread TED Spread:

= 3-month U.S. dollar LIBOR rate minus 3-month T-Bill rate

A measure of credit risk over U.S. default free rate. Higher spreads suggest a lack of

confidence and greater risk aversion in the interbank market.

January 1990 to July 2007 the TED spread averaged 41 basis points.

On October 10, 2008, the spread reached 464 basis points (the highest since data collection began in 1971. Reflected a frozen interbank

market. Spread is currently 16.82

(1/06/2011). See:

http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND

Cross Country Comparisons: Short Term and Long Term Gov’t RatesShort term (3-Month) Japan 0.16% Switzerland 0.17% United States 0.21% United Kingdom 0.80% Canada 0.98% Germany 1.00% Australia 4.95% Source: The Economist,

January 8, 2011

Long Term (10-Year) Japan 1.16% Switzerland 1.61% Germany 2.94% Canada 3.39% United States 3.48% United Kingdom 3.66% Australia 5.52% Source: The Economist,

January 8, 2011

Short Term Interest Rates: 1993 – 2010; Global Comparisons

Long Term Interest Rates: 1993 – 2010; Global Comparisons

Useful Web Sites For current U.S. interest rate data see:

http://www.federalreserve.gov/releases/h15/update For Effective Fed Funds Rate see:

http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND

For TED spread see: http://www.bloomberg.com/apps/quote?ticker=.TEDSP

%3AIND For charting U.S. interest rate data and other

U.S. data see: http://research.stlouisfed.org/fred2/

Appendix 1

Ben Bernanke’s View of the Role of Central Banks:The following slides present a brief sketch of Bernanke and offer possible insights into his approach regarding the role of the U.S. central bank.

Ben Bernanke

Ben Bernanke was born on December 13, 1953, in Augusta, Georgia. He received a B.A. in economics in 1975 from Harvard University (summa cum laude) and a Ph.D. in economics in 1979 from the Massachusetts Institute of Technology.

Before becoming a member of the Federal Reserve Board, Dr. Bernanke was the Howard Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs and Chair of the Economics Department at Princeton University (1996-2002). Dr. Bernanke had served as a Professor of Economics and Public Affairs at Princeton since 1985.

Bernanke’s Views on Central Banking Bernanke, whose academic studies have focused on the

Great Depression, has written that during that era the U.S. central bank allowed banks to fail, prices to fall and the money supply to contract, which contributed to the protracted slump. In essence, he blames the Fed for not acting in a proactive

manner. In addition, Bernanke has been quoted as follows: "We

now know the lessons from that” [the Depression]. "We are certainly going to make sure that the financial system remains in good functioning order.“

Conclusion: It appears that Bernanke will follow a very aggressive proactive approach to monetary policy in the U.S.

Appendix 2

Changing Fed Chairs being introduced by the President

Changing Fed Chairs

Volcker to Greenspan, August 1987

Greenspan to Bernanke, February 2006

Appendix 3

Moody’s and Standard and Poors Corporate Bond Ratings: Investment Grade through Speculative Grade

Moody’s and S&P Bond RatingsInvestment Grade: Moody's Standard & Poors

Exceptional Aaa, Aaa1, Aaa2, Aaa3 AAA, AAA-, AA+

Excellent Aa, Aa1, Aa2, Aa3 AA, AA-, A+

Good A, A1, A2, A3 A, A-, BBB+

Adequate Baa, Baa1, Baa2, Baa3 BBB, BBB-, BB+

Speculative Grade:

Questionable Ba, Ba1, Ba2, Ba3 BB, BB-, B+

Poor B, B1, B2, B3 B, B-, CCC+

Very Poor Caa, Caa1, Caa2, Caa3 CCC, CCC-, CC+

Extremely Poor Ca, Ca1, Ca2, Ca3 CC,CC-, C+

Lowest C C