Term
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Definition
| A claim on the issuers future income or asset |
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Term
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Definition
| A debt security that promises to make payments periodically for a period of time |
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Term
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Definition
| The cost of borrowing or the price paint of rental of funds. |
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Term
| Interest Rates of US Government Long Term Bonds, Corporate Baa Bonds, and Three Month treasury Bills over course of US history |
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Definition
Over time, Corporate BAA Bonds have had higher interest rates than US government long term bonds, which have higher interest rates than three month treasury bills.
*Think of the graph from chapter 1, Corp BAA line always first, US govt Bond line always send, Three month treasury bill always third! |
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Term
| Stock Prices over time (using the Dow Jones Industrial Average) |
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Definition
| Stock prices have increased greatly over time! Up until 1980 they were about the same, and then they started to vastly increase every year! |
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Term
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Definition
| A share of ownership in a corporation |
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Term
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Definition
| Institutions that borrow funds from people who have saved and in turn make loans to others. |
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Term
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Definition
| AKA the Money Supply, defined as anything that is accepted as payment in exchange for goods and services |
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Term
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Definition
Banks are financial institutions/ intermediaries that accept deposits and make loans!
*It refers to commercial banks, savings and loan associations, mutual savings banks, and credit unions. |
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Term
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Definition
| The upward and downward movement of aggregate output produced in the economy. |
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Term
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Definition
| Periods of Declining aggregate output |
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Term
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Definition
| The total production of goods and services |
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Term
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Definition
| The average price of goods and services |
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Term
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Definition
| A continual increase in the price level |
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Term
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Definition
| The rate of change of the price level measured in percentage change per year |
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Term
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Definition
| The management of money and interest rates. It is conducted by the Federal Reserve |
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Term
| Federal Reserve (The Fed) |
|
Definition
| The central bank of the US that is responsible for monetary policy |
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Term
|
Definition
| Decisions about government spending and taxation |
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Term
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Definition
| The excess government expenditures over tax revenues during a period of time |
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Term
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Definition
| When government tax revenue exceeds government expenditures and debt. |
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Term
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Definition
| The measure of aggregate output |
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Term
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Definition
| Where moving of funds between countries to take place |
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Term
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Definition
| The price of one country's currency in terms of another |
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Term
|
Definition
The development of new financial products and services
*THIS CAN BE GOOD OR BAD |
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Term
| What are other financial intermediaries besides banks? |
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Definition
Insurance companies, finance companies, pension funds, mutual funds and investment companies
Think insurance invest finance and pension! or FIPI |
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Term
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Definition
| Major Disruptions in financial markets that are characterized by sharp declines in asset prices and failures of many financial and non financial firms |
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Term
| Aggregate Price Level and the Money Supply from 1950 to 2011 |
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Definition
For many years the aggregrate price level was above the money supply, until around 1985 they became the same, and after that the money supply soon outgrew and is now much larger than the price level!
*Think of the graph |
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Term
| Money and Interest Rate Relationship |
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Definition
| Interest rates are considered the "price of money" |
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Term
| The exchange rate over time |
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Definition
| The Exchange rate was very constant until 1985 when it spiked upward, and by 1990 fell back to the constant rate. It has stayed that way basically since |
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Term
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Definition
| This is another word for debt. Typically, an individual's asset is a banks liability (a guy having a bank check). An individual's liability is a banks asset (owing the bank a loan) |
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Term
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Definition
| Wealth, either financial or physical, that is employed to produce more wealth. (money to put into a business) |
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Term
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Definition
| The number of years that debt has until its expiration date |
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Term
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Definition
| When the debt maturity is less than 1 year |
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Term
|
Definition
| When the debt Maturity is over 10 years |
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Term
|
Definition
| When the debt maturity is between 1 and 10 years. AKA you have 1 to 10 years to pay the debt off |
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Term
|
Definition
| Claims to share income and assets of a corporation, such as a stock! |
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Term
|
Definition
| Periodic payments made by equities to their shareholders. It is their way of insuring that the share holders will remain, because equities don't have maturity dates |
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Term
|
Definition
This is where NEW securities are sold to their initial buyers. EX: it is when the first shares of a company are sold to individuals.
*INVESTMENT BANKS work in the primary market to sell you stock! |
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Term
|
Definition
The financial market where securities that have previously been issues (and are secondhand) can be resold. Such as buying a stock from another individual who bought it.
*Stock Brokers and Dealers work in secondary markets to sell you stock! |
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Term
|
Definition
| Firms that work in the primary market to assist in the initial sale of a security/ stock |
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Term
|
Definition
| Purchasing securities from a corporation and reselling them into the primary market. Investment banks UNDERWRITE stocks and put them into the primary market |
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Term
|
Definition
| People who match buyers and sellers of securities/ stocks |
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Term
| Do corporations gain funds when stocks are sold in the primary or secondary market? |
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Definition
| The PRIMARY MARKET. The secondary market involves an individual selling to another individual, so the original shareholder gets the funds, not the corporation |
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Term
|
Definition
| This is one of the ways to sell stocks in the secondary market! It is where buyers and sellers meet at a central location and conduct trades |
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Term
| Over the Counter Market (OTC) |
|
Definition
| This is one of the two ways in which stocks are sold in the secondary market. It is where a dealer has an inventory of securities/ stocks, and buyers and sellers can come "over the counter" to buy/ sell them. |
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Term
| Two ways to sell securities in the secondary market |
|
Definition
The Exchange Method (buyer meets seller)
The over the counter market (buyer goes to seller with large stock inventory) |
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Term
|
Definition
| A market where only short term debt instruments (those with a maturity less than one year) are traded |
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Term
|
Definition
| A Financial Market where only long term debt instruments (debt whose maturity is longer than 1 year) is traded |
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Term
|
Definition
A situation where the party issuing the debt instrument is unable to make the interest payments or pay off the amount when the interest matures.
*When the borrower of the asset/ money cannot pay it back! |
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Term
|
Definition
|
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Term
|
Definition
| The interest rate on overnight loans of deposits at the federal reserve. The interest rate on FED loans |
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Term
|
Definition
| Loans to households or firms to purchase housing, land, or other real structures, in which the house/ land itself serves as collateral for the loan |
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Term
| Mortgage-Backed Securities |
|
Definition
| Securities/ stocks that cheaply bundle and quantify the default risk of the underlying high risk mortgage. |
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Term
|
Definition
| Bonds sold in foreign country and denominated in that country's currency |
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Term
|
Definition
| Bonds that are denominated in a currency other than that of the country in which they are sold. EX US bond sold in England, but denominated in US currency still |
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Term
|
Definition
| This is what Financial Intermediaries (banks) do! It is the process of moving funds from lenders to borrowers |
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Term
|
Definition
| The time and money spent trying to exchange financial assets, goods, or services |
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Term
|
Definition
The reduction in transaction costs per dollar as the size of the transaction increases.
*banks utilize this to decrease transaction costs |
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Term
|
Definition
| Services financial intermediaries provide to their customers to make it easier for them to conduct transactions |
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Term
|
Definition
| The degree of uncertainty associated with the return of an asset |
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Term
|
Definition
| The process of creating and selling assets with low risks, then using those funds to purchase higher risk ones |
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Term
|
Definition
| This is another term for risk sharing. It is putting assets with high risk with those with lower ones, making them more likely to be purchased |
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Term
|
Definition
| Investing in a collection of assets, whose returns don't always move together. This makes the overall risk of the collection lower than the individual assets! |
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Term
|
Definition
| The unequal knowledge that each party to a transaction has about the other. One party knowing more about the other one than they do, and taking advantage of it |
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Term
|
Definition
| The problem created by asymmetric information that occurs before the transaction. It is when a bank lender picks to give someone a loan when they are much more riskier to pay it back than someone else. They incorrectly choose that person |
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Term
|
Definition
| This is a risk caused by asymmetric Information that occurs after the transaction. It is when the party who received the loan engages in behavior that is undesirable from the other parties point of view. They do behavior that is riskier than the lender thought they would behave in |
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Term
|
Definition
| The ability to use one resource and produce many different products and services |
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Term
|
Definition
| A manifestation of the moral hazard problem, particularly when a financial institution provides multiple services to risky clients. It is basically when too many people are given risky loans and use the money in ways that will hinder their ability to pay back those loans |
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Term
|
Definition
| Savings and loan associations, mutual savings banks, and credit unions. |
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Term
|
Definition
| Foreign currencies deposited in banks outside the US |
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Term
| Ways Financial Intermediaries Lower Transaction Costs |
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Definition
| They utilize economies of scale and liquidity services! |
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Term
| Ways Financial Intermediaries reduce risk exposure on investors |
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Definition
| Financial Intermediaries will reduce the risk to investors by using Risk Sharing/ Asset Transformation (selling a good stock and using the funds for a risky one) or diversification (bundling bad stocks with good ones) |
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Term
| 3 types of Financial Intermediaries |
|
Definition
1. Depository Institutions
2. Contractual Savings Institutions
3. Investment Intermediaries |
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Term
| Functions of Financial Intermediaries |
|
Definition
-Lower Transaction Costs
-Reduce the Exposure of Investors to Risk
-Deal with Asymmetric Information problems
-Help small savers and borrowers benefit from financial markets |
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Term
| Why Regulate the Financial System? |
|
Definition
-To increase the information available to investors
-To ensure the soundness of financial intermediaries |
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Term
| Why increase information available to investors when regulating the financial system? |
|
Definition
-Increasing investor information reduces adverse selection and moral hazard problems.
-It also reduces insider trading. |
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Term
|
Definition
| This is the tendency for people with non-disclosed information to buy/sell stock (employees of a company buying/selling stock). This is illegal because it is using information that is not available to everyone. Regulating the financial system helps prevent this! |
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Term
| Why Ensure soundness of financial intermediaries when regulating the financial system? |
|
Definition
Ensuring soundness of the financial intermediaries helpsL
-restrictions of entry
-disclosing information to public
-Controls holding of risky assets
-Avoids bank runs, provides insurance to those who use a bank
-Limits on competition between intermediaries |
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Term
|
Definition
| The total collection of someone's property that has store of value. It is all resources owned by an individual |
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Term
|
Definition
| The flow of earnings someone makes from their job. It is how much someone makes over a course of time (4000 dollars a month) |
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Term
|
Definition
-Medium of Exchange
-Unit of Account
-Store of Value |
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Term
|
Definition
| This is one of the functions of money. It is how money acts as the "middle man" between transactions. It basically means money is used to pay for goods and services |
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Term
|
Definition
| This is one of the functions of money. It is how money can be used to measure the value of something! "that is worth 1.00 vs 1000 dollars" |
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Term
|
Definition
| This is a function of money. This function states how money can be used to represent someone's stored wealth. It is the idea that money can hold purchasing power over time, and only changes due to inflation! |
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Term
|
Definition
-Commodity Money
-Fiat Money
-Checks
-Electronic Payment
-E-money |
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Term
|
Definition
| This is a type of money. Valuable, easily standardized and divisible commodities (EX Cigarettes) |
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Term
|
Definition
| This is a type of money. It is Paper money decreed by government as legal tender |
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Term
|
Definition
| This is a type of money. It is an instruction to your bank to transfer money from your account |
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Term
|
Definition
| This is a type of money. This is like an online bill pay, it is paying via the internet |
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Term
|
Definition
| This is a type of Money. It is know as electronic money, and it is includes things like your debit card, e cash, etc |
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Term
| Are we headed for a cashless society? |
|
Definition
| With the conveinence of e-money, people aregue that we are headed to a cashless society. However this is not true, as there would be too high of security concerns. If people were able hack into a bank system, without cash as a backup, it would be a huge risk |
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Term
|
Definition
This is aggregate of the nations for liquid assets. It includes:
-Currency
-Travelers Checks
-Demand Deposits
-Other Check able Deposits |
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Term
|
Definition
M2 is the way the government measures the assets included in M1, plus other assets that are not as liquid. M2 includes:
-M1 (currency, travlers checks, liquid assets)
-small denomination time deposits
-savings deposits accounts
-Money market deposit accounts
-Money market mutual fund shares |
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Term
|
Definition
| The ease and speed something can be converted into a medium of exchange. How convenient something is to use it as money |
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Term
|
Definition
How much something is worth on that date, before any interest occurs
*This is why a dollar now is worth more than a dollar in 1 year, because in 1 year it will have incurred interest of:
1 x (1+i) !!! |
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|
Term
| Simple present value equation |
|
Definition
PV = CF/(1+i)^n
PV = present value of money
CF = Future cash flow
i = interest rate
n = number of years/ periods |
|
|
Term
| Four types of Credit Market Instruments |
|
Definition
-Simple Loan
-Fixed Payment Loan
-Coupon Bond
-Discount Bond |
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|
Term
|
Definition
This is one of the 4 credit market instruments. It is typically used as commercial and business loan.
This type of loan is simply where the borrower owes an amount of funds to the lender due at the maturity date (at the end of the loan), plus interest.
-make one payment after a certain time! |
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|
Term
| How to calculate a simple loan |
|
Definition
Just use the present value equation!
PV (of a loan) = CF/(1+i)^n |
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Term
|
Definition
This is one of the 4 Credit Market Instruments. It is typically done with car payments and mortgages
This loan is when the borrower takes out the loan, and then pays off the loan to the lender by making periodic fixed payments for a number of years/
EX: pays the same thing once a month |
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|
Term
| How to calculate a Fixed Payment Loan |
|
Definition
LV = THE SUM OF (FP/(1+i)^n)
LV = loan value
FP = fixed payment
n = number of years
EX:
3 Years:
FP/(1+i) + FP/(1+i)^2 + FP/(1+i)^3 |
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|
Term
|
Definition
This is a type of credit Market Instrument. It is typically used as a government loan or corporation loan.
This type of bond is when the owner of that bond pays a fixed interest payment until the date of maturity, when at that point a specific amount is then repaid |
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|
Term
| How to Calculate a Coupon Bond |
|
Definition
Use a complex equation: PAge 73 in book though!
P = (THE SUM OF C/(1+i)^n )+ F/(1+i)^n
P = Price of coupon bond
C = Yearly Coupon payment
i = interest rate
n = Years to maturity
F = face value of the bond
EX:
2 Years:
P = C/(1+i) + C/(1+i)^2 + F/(1+i)^2 |
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|
Term
|
Definition
This is a type of Credit Market Instrument. It is typically used for savings bonds and US treasury bills.
This is a bond where it is bought at a price below its face value, and then its face value is repaid at the maturity date. There are no interest payments with a discount bond, you only pay the face value! |
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Term
|
Definition
| The interest rate that equates the present value of cash flow payments received from a debt instrument with its present value today |
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|
Term
|
Definition
A bond with no maturity date, that pays fixed payments forever!
It is written as:
P=C/i
P= price of consol/perpetuity
C= yearly interest payment
i = yield to maturity |
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Term
|
Definition
| The payments to the owner plus the change in value, expressed as a fraction of the purchase price |
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|
Term
| Yield to maturity equation |
|
Definition
i = C/P
C = yearly interest payment
P = price of consol/ perpetuity
yield to maturity is also the interest rate! |
|
|
Term
| The distinction between interest rate and returns |
|
Definition
This is also the relation between the return rate and the yield to maturity! It is written as:
R = i + g
where R is return
i is the yield to maturity/ the interest rate
g is the rate of capital gain
the rate of capital gain represents how much the price of the bond changed over a period of time!
IN OTHER WORDS:
If the price increased, returns > yield
If the price decreased, returns < yield
If the price constant, returns = yield! |
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|
Term
|
Definition
| This is the interest rate that does not adjust for inflation |
|
|
Term
|
Definition
| This is the interest rate that does adjust for inflation. It more accurately reflects the cost of borrowing. |
|
|
Term
|
Definition
This is how you relate the inflation rate with the interest rate!
n = i + (pi)
n = nominal interest rate
i = real interest rate
(pi) = expected inflation rate!
*When inflation is low, nominal is close to real interest rate!! |
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|
Term
| Determinants of Asset Demand |
|
Definition
-Wealth
-Expected Return
-Risk
-Liquidity |
|
|
Term
| Wealth as a Determinant of Asset Demand |
|
Definition
Wealth is the total revenue owned by the individual, including all assets.
*As wealth increases, QUANTITY DEMANDED of an asset increases |
|
|
Term
| Expected Return as a Determinant of Asset Demand |
|
Definition
Expected return is the return on the asst over the next period, relative to other assets
*as the expected return increases (relative to other assets), the QUANTITY DEMANDED increases |
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|
Term
| Risk as a Determinant of Asset Demand |
|
Definition
Risk is The degree of uncertainty associated with the return on the asset, relative to alternative assets
*As the risk increases (relative to another asset), the QUANTITY DEMANDED of that asset decreases |
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|
Term
| Liquidity as a Determinant of Demand |
|
Definition
Liquidity is the ease and speed which an asset can be turned into a medium of exchange (cash).
*As liquidity increases, the QUANTITY DEMANDED of an asset also increases |
|
|
Term
|
Definition
| This means "with all other things equal" |
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|
Term
| Prices and Quantity Demanded for Bonds |
|
Definition
| When prices decrease (making interest rates increase), it causes the bond QUANTITY DEMANDED to increase. Bond demand and Prices are INVERSELY RELATED |
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|
Term
| Prices and Quantity Supplied for Bonds |
|
Definition
| When Prices decrease (making interest rates increase), it causes the QUANTITY supplied to also decrease. Bond Supply and price are POSITIVELY related |
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|
Term
| When does Bond Market Equilibrium Occur? |
|
Definition
| This occurs when the amount of people who are willing to buy equals the amount that are willing to sell! |
|
|
Term
| When Bond Demand Exceeds Bond Supply... |
|
Definition
| There is excess demand, causing the price to rise, and the interest rate to fall! This will re-establish equilibrium |
|
|
Term
| When Bond Supply Exceeds Bond Demand... |
|
Definition
| There is excess supply, causing there to be a decrease in price, and the interest rate will rise! This re-establishes equilibrium |
|
|
Term
| Determinants of Bond Demand |
|
Definition
-Wealth
-Expected Return
-Expected Inflation
-Risk
-Liquidity |
|
|
Term
| Wealth as a Determinant of Bond Demand |
|
Definition
| As wealth increases, the DEMAND for bonds increases, shifting the curve to the right |
|
|
Term
| Expected Return as a Determinant for Bond Demand |
|
Definition
| As expected returns increases, the DEMAND for bonds increases, shifting the curve to the right |
|
|
Term
| Expected Inflation as a Determinant for Bond Demand |
|
Definition
| As expected inflation increases, the DEMAND for bonds decreases, causing a shift to the left. INVERSELY Related |
|
|
Term
| Risk as a Determinant for Bond Demand |
|
Definition
| An increase in the risk causes a decrease in the DEMAND for bonds, causing a shift to the left. INVERSELY related |
|
|
Term
| Liquidity as a Determinant for Bond Demand |
|
Definition
| As liquidity increases, the DEMAND for bonds also increases, causing a shift to the right. POSITIVELY related |
|
|
Term
| Determinants of Bond Supply |
|
Definition
-Expected Profitability of Investments
-Expected Inflation
-Government Budget |
|
|
Term
| Expected Profitability of Investment as a Determinant of bond Supply |
|
Definition
| During an expansion, the profitability increases, and the SUPPLY increases. Shifts curve to the right |
|
|
Term
| Expected Inflation as a determinant of Bond Supply |
|
Definition
| An increase in inflation causes an increase in SUPPLY, shifts the curve to the right |
|
|
Term
| Government Budget as a Determinant of Bond Supply |
|
Definition
An increase in government budget DEFICIT increases the SUPPLY of bonds, shifts the curve to the right.
*government budget down = supply up! |
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|
Term
| Do bonds with the same Maturity have the same interest rate? |
|
Definition
NO!
There are other factors that go into a bond interest rate, they are:
-Default risk
-Liquidity
-Tax Considerations
All of those effect the bond interest rate as well! |
|
|
Term
| Default Risk on Bond Interest Rate |
|
Definition
| The higher the default risk, the higher the interest rate is! |
|
|
Term
|
Definition
| This is the probability the issuer of the bond is unable or unwilling to make the interest payments/ face off the face value. The Risk the lender will default! |
|
|
Term
|
Definition
The difference between the interest on a bond with default risk, and the interest rate on a bond with zero default risk (aka a treasury bond), when maturities are equal!
*Risk Premium is the difference in risk between a bond and a zero risk bond |
|
|
Term
| US Treasury bonds have ______ default Risk |
|
Definition
| Zero! US treasury bonds are considered default free |
|
|
Term
| Liquidity on the Bond Interest Rate |
|
Definition
| The higher the liquidity, the lower the bond interest rate |
|
|
Term
| Income Tax Considerations on Bond Interest Rate |
|
Definition
Bonds that are tax exempt have lower interest rates!
*this is because interest on federal municipal bonds are except from federal taxes! |
|
|
Term
| LOWER PRICES = ______ INTEREST RATE |
|
Definition
|
|
Term
| HIGHER PRICES = ______ INTEREST RATE |
|
Definition
|
|
Term
| Do Bonds with Identical risk, liqudity, and tax characteristics have the same interest rate? |
|
Definition
NO!
Don't forget about maturity, bonds can have different maturities, or "term structures" that effect the interest |
|
|
Term
| General Rule of Term Structure and Interest Rate |
|
Definition
| The longer you have to pay the greater the interest rate |
|
|
Term
|
Definition
| A plot of the interest rate on bonds! It assumes the risk, liquidity, and tax considerations are constant, while looking at the effect of maturity (term structure) |
|
|
Term
| Upward Sloping Yield Curve means... |
|
Definition
| This means that long term interest rates are above short term interest rates! |
|
|
Term
| Flat Yield Curve means... |
|
Definition
| Short term and long term interest rates are the same |
|
|
Term
| Inverted Yield Curve means... |
|
Definition
| This means long term interest rates are less than short term interest rates |
|
|
Term
| What must the Correct Theory of Term Structure on Interest Rates explain? |
|
Definition
Explain The 3 Facts!
1) Interest rates on bonds with DIFFERENT maturities move together over time
2) When short term interest rates are low, yield curves are more likely to have an upward slope, but when short term is interest rates are high, the yield curve are more likely the slope down and be inverted!
3) Yield Curves almost always slope upward! |
|
|
Term
| Expectations Theory of Term Structure and Interest Rate |
|
Definition
This is the idea that the interest rate of a long term bond will equal an average of short term interest rates that people expect to occur over the life of a bond
-Therefore, buyers do not prefer one bond over another based on maturity, instead they choose it based on expected return!
*This explains why rates move together over time (consumers indifferent) and why yield curves shift up when short term rates are low (pick lower rate), but DOES NOT explain why yield curves slope upward |
|
|
Term
| Why does the expectations theory not explain properly interest rates and term structure? |
|
Definition
| The expectations theory, or the idea that consumers pick bonds with the same maturity indifferently and rather choose the one with the best returns, does NOT explain why yield curves typically slope upward (why in general long term rate > short term) |
|
|
Term
| Segmented Market Theory of Interest rates and Term Structure |
|
Definition
According to this theory, bonds of different maturities and NOT substitutes at all, opposite of the expectations theory. In this theory, the interest rate for each bond, with a different maturity, is determined by supply and demand. Consumers generally prefer shorter maturities, which explains why yield curves are generally upward sloping (long term > short term) AND why there is a change based on when short term rates are high or low and how that effects the yield curve.
*THIS DOES NOT EXPLAIN FACT 1, which is that interest rates move together over time. If they move together, how do consumers have different preferences based on maturity? |
|
|
Term
| Why does the Segmented Market Theory not explain properly interest rates and term structure? |
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Definition
It does not explain fact 1! Stating that consumers have preferences of maturity of bonds, stating that they prefer short term over long term, explains why the yield curve generally is upward sloping, and when short term rates are high, its likely to be downward (only time short > long).
BUT This does NOT explain why interest rates of bonds, both SHORT AND LONG TERM, move together over time. Consumer preference deteriorates over time? Lol not likely |
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Term
| Liquidity Premium Theory of Interest Rates and Term Structure |
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Definition
This theory states that the interest rate on a long term bond does equal the short term interest rates expected over the course of the long term, PLUS a liquidity premium that responds to supply and demand conditions of consumer preference!
Therefore, bonds of different maturities are Partial subsitutes (liquidity preference part is same, but maturity difference is not!) |
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Term
| Which theory DOES explain the relation between interest rates and term structures correctly |
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Definition
| The Liquidity Theory! It states that bonds of different maturities are PARTIAL substitutes. The different maturities will have the same liquidity premium, and therefore their consumer preferences will be the same, BUT their different maturities will lead to different interest rates |
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Term
| How to Calculate the Price of a Stock after 1 Period? |
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Definition
Use the One Period Valuation Model!
FORMULA:
Po = Div1/(1+k) + P1/(1+k)
Po = The current price of stock
Div1 = Dividend Paid After year 1
k = Required return on investment equity
P1 = The sale price of stock at the end of year 1 (period 1) |
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Term
| How does a stock sell for 50, when its current price is 53 and its projected to sell for 60 in a year? |
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Definition
| Because even though its technically worth 53, other investors are uncertain about the future, and predicting that gets complicated! Safer to sell it for 50 then run the risk! |
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Term
| The One Period Valuation Model |
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Definition
This is how you determine a stock price after one year/ period! The formula is:
FORMULA:
Po = Div1/(1+k) + P1/(1+k)
Po = The current price of stock
Div1 = Dividend Paid After year 1
k = Required return on investment equity
P1 = The sale price of stock at the end of year 1 (period 1) |
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Term
| Generalized Dividend Valuation Model |
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Definition
This is a way that people can calculate the price of a stock after multiple periods of time (AKA 2 Plus years). It is written a lot like the one period valuation model!
The formula is:
Po = D1/(1+k) + D2/(1+k)2 + D3/(1+k)3 + …….Dn/(1+k)n + Pn/(1+k)n
Po = current price of stock
D = dividend of that period/ year
k = required return
Pn = price of stock at the end of the final period
*NOTE: this model is not the best for predicting stock price, because it requires future stock prices and dividends, which is something that is hard to predict! |
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Term
| Problem with the Generalized Dividend Model |
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Definition
| The Generalized Dividend Model is used to measure the price of a stock after multiple periods. However, it requires using prices and dividends, which is something that is hard to predict! Therefore, when calculating stock price beyond 1 period, people use the Gordon Growth model instead |
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Term
| Calculating Price of a Stock After Multiple Periods |
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Definition
You should use the Gordon Growth Model! Under this model, we assume growth models are constant, so we can calculate the price of a stock without knowing future prices and dividends!
The formula is complicated, but its:
P0 = Do(1+g)/(k-g) = D1/(k-g)
Do = The most recent dividend
g = expected constant growth rate
k = required return on an investment in equity |
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Term
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Definition
Under this model, we assume growth models are constant, so we can calculate the price of a stock without knowing future prices and dividends!
The formula is complicated, but its:
P0 = Do(1+g)/(k-g) = D1/(k-g)
Do = The most recent dividend
g = expected constant growth rate
k = required return on an investment in equity |
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Term
| Gordon Growth Model Explaining the Financial Crisis of 2007 |
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Definition
-There was a downward revision in growth prospects (which decreased g)
-There was an increase in uncertainty (which required an increase in k)
-The lead to a "larger" denominator, and thus lower stock prices in 2007! |
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Term
| Theory of Rational Expectations |
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Definition
When explaining stock prices, it is reliant on people's expectations of the future. This explains how those theories are formed.
It is the idea that people's expectations are equal to the optimal forecasts in the future, given the information they have at hand!
AKA, people expect about the future will involve making the most realistic, best case scenario decision |
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Term
| 8 Basic Facts About Financial Structure |
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Definition
1. Stocks are NOT most important source of external finance
2. Issuing marketable debt and equity securities (stocks) is NOT the primary way in which business finance their operations
3. Indirect finance is MORE important that direct finance
4. Financial Intermediaries, particularly BANKS, are THE MOST imporant source of external funds
5. The financial system is among the most heavily regulated
6. Only large, well established corporations have easy access to securities
7. Collateral is a prevalent feature of debt contracts, in both household and business
8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers |
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Term
| What do basic facts of financial structure explain? |
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Definition
| The facts are explained with the importance of transaction costs, asymmetric information, adverse selection, and the moral hazard problem. All of those issues put power in the financial intermediaries, and that power to them calls for more government regulation and less power in stocks/securites |
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Term
| How do financial intermediaries, AKA banks, reduce transaction costs? |
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Definition
| They use Economies of scale (bundling funds together in large packages to reduce price), and expertise (utilizing latest technologies) |
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Term
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Definition
| This is one of the ways banks reduce Transaction Costs. By bundling funds together in large packages it reduces transaction costs. The cost of increasing the size of the transaction does not increase the cost of the transaction by much, so making large ones via economies of scale through banks reduces these costs! |
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Term
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Definition
| This is one of the ways banks reduce transaciton costs. Banks have expertise by utilizing the latest technologies and services, like using toll free numbers, which reduce TCs! They also can provide liquidity service, such as a bank/ATM card to reduce transaction costs |
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Term
| Tools to Help Solve Adverse Selection |
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Definition
1. Private Production/ Sale of Information (selling which firms are good/ bad)
2. Government Regulation to Increase Information
3. Financial Intermediation |
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Term
| Tools to help Moral Harzard for Equity |
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Definition
1. Monitoring/ Production of information (monitoring managers to make sure they behave accordingly)
2. Government Regulation
3. Financial Intermediation |
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Term
| Tools to Help Moral Hazard in Debt Contracts |
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Definition
1. Collateral and Net worth
2. Monitoring Enforcement of Covenants (Encouraging good behavior/ dis encouraging bad behavior)
3. Financial Intermediation |
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Term
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Definition
| This is when managers of a company behave for what benefits themselves, not what benefits the company/ stock holders. This is the moral Hazard problem for equity/ security contracts! |
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Term
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Definition
| This is when someone receives information that they did not pay for. For example, say you pay to find out who good firms are. You then invest in that firm, and someone then sees that and also invests. They get to invest in the good firm, but didnt have to pay for it |
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Term
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Definition
| Property promised to the lender if the borrower defaults. It is a way to protect from the adverse selection problem, because borrwers wont borrow if they cant pay and have to pay the collateral |
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Term
| What is a Financial Crisis? |
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Definition
| A financial crisis occurs when there is a large disruption to information flows in a financial market, with the result that financial frictions increase sharply, and financial markets stop functioning |
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Term
| Factors that Cause a Financial Crisis |
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Definition
-Deterioration in financial institutions
-Banking Crisis (Loss of Information production)
-Increase in Uncertainty
-Increase in interest rate
-Government Fiscal Imbalances |
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Term
| Stages of Events in Financial Crisis of Advanced Economies |
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Definition
1) Initiation of Crisis
2) Banking Crisis
3) Debt Deflation |
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Term
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Definition
This is the first stage financial crises in both types of economies. It is caused by either mismanagement of financial liberalization, or Severe fiscal imbalances, when the government is in need of funds!
*this all leads to increases in the interest rate, uncertainty, and therefore the ADVERSE SELECTION problem! |
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Term
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Definition
| This is the second step in the financial crisis for advanced economies. It occurs when a banks net worth becomes negative! Due to the rise in the adverse selection problem from stage 1, banks fear of failing, especially when their net balance is negative. They then lower their prices to compete, but this puts other banks in worse shape in a contagion effect! When enough of this occurs, it leads to Debt Deflation (step 3) |
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Term
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Definition
| This is the 3rd stage of the advanced economies financial crisis. It occurs from bank crisis of too many banks failing, due to too high of a spike of the adverse selection problem. This all leads to Debt Deflation, or a sudden decrease in the price level. This causes more and more adverse selection with the lowered price level, and loans continually getting put in the wrong hands, until we reach a crisis |
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Term
| Stages of Financial Crisis in Emerging Markets (international) |
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Definition
1) Initiation of Crisis
2) Currency Crisis
3) Full Fledged Crisis |
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Term
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Definition
| This is the 2nd stage of a financial crisis in an emerging/ international market. It is caused by all the banks going to a negative net worth due to the increasing adverse selection from stage 1. This makes investors sell the currency of that country and buy currency of other countries, making that currency worthless! |
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Term
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Definition
| This is the 3rd and final stage of a financial crisis from an emerging/ international country. It occurs when the debt burden of holding their own currency and net worth of banks worses, leading to inflation and reduces in cash flow. This causes more banks to fail, and the higher inflation causes individuals of the country less likely to pay off their debt. Their currency crisis reaches a point where it becomes almost worthless to banks and individuals |
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Term
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Definition
The total collection of a banks liabilities and assets (their collection of net worth).
It includes their liabilities, which are
-checkable deposits
-Nontransaction deposits
-Borrowings
-Bank Capital
And their assets
-reserves
-cash items in process of collection
-deposits
-securities
-loans
-other assets |
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Term
| Liabilities on a Bank Balance Sheet |
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Definition
-checkable deposits
-Nontransaction deposits
-Borrowings
-Bank Capital |
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Term
| Assets on a Bank Balance Sheet |
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Definition
-reserves
-cash items in process of collection
-deposits
-securities
-loans
-other assets |
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Term
| General Principles of Bank Management |
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Definition
-Liquidity Management
-Asset Management
-Liability Management
-Capital Adequacy Management
-Credit Risk
-Interest-rate Risk |
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Term
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Definition
This is a principal of Bank Management. It is a bank overseeing how liquid the assets they provide are. They do this by:
1) Borrowing (increases liquidity)
2) Securities Sale (selling stock)
3) Federal Reserve (borrowing from Fed incurs interest payments)
4) Reducing loans |
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Term
| 3 Goals of Asset Management |
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Definition
1. Seek highest possible returns on loans and securities
2. Reduce risk
3. Have adequate liquidity in assets |
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Term
| 4 Tools of Asset Management |
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Definition
1. Finding borrowers who will pay high interest, they have low default possibility
2. Purchase securities with high returns and low risk
3. Lower risk by diversifying
4. Balance need for liquidity against increased returns from less liquid assets (aka balance liquidity and returns!) |
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Term
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Definition
| This is one of the general principles of bank management. It is managing loan markets, new financial instruments. It is also managing check able deposits, but those liabilities have decreased in importance |
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Term
| Capital Adequacy Management |
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Definition
| This is one of the general principles of bank management. It is managing a banks captial, which includes making sure there is enough so that the bank does not fail, enough return to the owners of the bank, and meeting regulation requirements |
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Term
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Definition
| This is one of the general principles of bank management. It is monitoring the credit of the bank, and it is done so by screening and monitoring. By monitoring managers and enforcing covenants, placing collateral, and ensuring the bank is behaving the way the shareholders want it to |
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Term
| The need for Deposit Insurance |
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Definition
| The need for deposit insurance is to protect against bank panics! Financial regulation such as deposit insurance helps oversee the financial intermediaries that dictate the financial system |
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Term
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Definition
| The FDIC was created in 1934 to help with bank panics, they short circuit bank failure and stop contagion effects |
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