Lecture 1: Course Overview:

1) Role of the Financial System and an Overview of the Markets

a. Transfer Funds from those that have money to those that need money
b. Provide for Capital Formation
c. Services Provided: Risk sharing, liquidity, and information collection
d. Differentiate Money Markets and Capital Markets
e. Identify competition within the system
2) Valuation of Instruments
a. Fixed Income (Bonds and Loans)
b. Equity (Stock)
3) Interest Rate Determination and Financial Costs of Funds
a. How Interest Rates are Determined
b. Examine the effects of bond supply and demand
c. Factors influencing Premia and Term Structure
d. Discuss Types Risk and how its measured
e. Examine theories and evidence related to Term Structure
4) Market Structure and Factors influencing Financial Market Efficiency /Costs
a. Various theories: Rational Expectations, Efficient Markets Hypothesis
b. Evidence of Efficiency / Inefficiency; Implications for you (the investor)
c. Obstacles to Efficiency: Transaction Costs, Asymmetric Information,
Adverse Selection, Moral Hazard
d. Implications for Firm and Market Structure
e. Discuss market solutions
5) Examine Financial Institutions
a. Different types: e.g. Commercial Banks, Investment Banks, Funds, etc.
b. Their mechanical function
c. Their role in the Financial System e.g. reduce transaction costs
d. How they Make Money and Manage Risk

6) Origins of the Financial Industry

a. History of Crises
b. Regulation and Response to Crises
c. How these factors have influenced the Current Structure
d. The current regulatory structure US and Abroad

Really Important!

7) Derivatives and Risk Management

a. Provide an Overview of the Financial Derivatives Market
b. Study the theory behind financial options and derivatives
c. Review simple contracts: Forwards, Futures, Calls, and Puts
d. Discuss their use in Risk Management, and other Risk Management
Techniques
e. Discuss fundamental investment strategies using options
f. Provide Managerial Insight how to use these financial contracts and
discuss the risk involved

Financial System Overview:

1) What is the purpose of a financial system?
a. Connect Savers & Borrowers
b. Facilitate Capital Formationthe ability to raise needed funds
c. Financial System Transfers funds from savers (investors) to borrowers
d. Do this via two channels Financial Markets and Intermediaries

Financial Intermediaries:
Banks (loans)
Finance Co.s
Insurers
Lenders/Savers/Investors

Borrowers/Firms
Financial Markets:
Exchanges
OTC Market
Stocks, Bonds, Futures

2) Types Markets
a. Equity versus Debt
b. Primary versus Secondary
c. Money versus Capital (Short-term versus Long Term)
d. Cash versus Forward/Futures
3) Debt and Equity Markets, Key Instruments:
a. DebtFinancial Claims: Bonds
b. EquityOwnership: Stocks
4) Debt Markets
a. Bonds (effectively loansthat have been securitized)
b. Pays Interesta contractual cash-flow
c. Value dependent on interest paid and risk involved
d. Interest rate associated with level of risk
e. Contracts have fixed lives at which point principle is returned
5) Equity Markets (Stocks)
a. Shares represent Fractional Ownership
b. Pays Dividendsan uncertain cash-flow
c. Cash-flows are Residual to Expenses or Claims (Debt)
d. Infinitely lived

6) Definitions for Debt and Equity:

a. Principle (Debt)
b. Interest (Debt)
c. Default (Debtwhy? Why not equity?)
d. Dividends (Equity)
e. Capital Gains (Both)
7) Primary Markets:
a. Original Issues of Debt and Equity
b. Where the borrowers generate funds
c. Composed of Big PlayersInstitutions, Funds
d. Trades are in Large Blocks for Investment or Resale on Secondary Market
e. Firms trading in Primary Market make money two ways:
i. Buying and Holdinginvesting and speculation
ii. Spread or Premia from Resale to smaller investors on Secondary
Market
8) Secondary Market
a. RESALE of EXISTING SECURITY ISSUES
b. Trades conducted in Exchanges or Over-the-Counter
c. This is where you can buy stocks or bonds
d. Market Provides
i. Information (prices impound information)
ii. Liquidity (Standardized assets can be Liquidated easily)
iii. Risk Sharing (ability to diversify investments by purchasing a
portfolio)
e. This is the market where prices are determined and is the reason that our
financial system works.
f. Without it, you would have no way to dispose of financial assets
efficientlyyou could not sell your stocks or bonds.
9) Types of Secondary Markets:
a. AuctionExchange (Competitive bidding)
b. OTCyou take price as posted
c. In OTC markets, dealers maintain an inventory and are willing to sell at
their posted price. It remains competitive, because the dealers are aware
of other dealers prices.
10) Money versus Capital Markets
a. Short term debt instrumentshighly liquid/low risk
b. Longer term debt and equityused for Capital Projects
11) Cash Markets vs. Forwards and Futures
a. Cash PAY NOW (Current Settlement) Stock and Bond Markets
b. Futures and Forwards AGREE TO PAY LATER

12) Intermediaries (go-betweens) between Saver and Borrower

a. Commercial Banks, S&Ls, Credit Unions
b. Mutual Funds
c. Insurance Companies and Pension Funds
d. Finance Companies: e.g. Ford Motor Credit, GMAC
e. Other Financial Institutions THAT RAISE AND SUPPLY FUNDS
13) What do INTERMEDIARIES DO?
a. Pooling of funds for a loan portfolio Risk Sharing or Diversification
b. Pooling allows withdrawals Liquidity
c. Collect and Process information about Borrowers Info. Services
14) Institution Types: How they do it.
a. DepositoryCommercial Banks
b. Contractual SavingsInsurance Companies, Pension Funds
c. Investment IntermediaryMutual funds, Finance Companies
15) Other Institutions:
a. Investment Banks
b. Brokers/Dealers
c. Mutual Funds
d. Venture Capitalists
Can this cost you?

16) Key Issues:

a. Risk Sharing (Diversification of risk)
b. Liquidity (Ease of which these assets can be liquidated into cash)
c. Information (Credit of the borrower)
d. Asymmetric Information (What the Borrower knows and you dont)
e. EACH OF THESE INSTITUTIONS PROVIDES ONE OF THESE
FUNCTIONS.
17) Why do we Study the Institutions?
a. Components Make it Function and form a Complex Structure
b. Provides: Capital Raising, Risk-sharing, Information, and Liquidity
c. Financial Market composed of:
i. Central Bank (FED)establishes interest rates, controls the money
supply, and influences inflation
ii. Financial Intermediariesraise and lend funds
iii. Firms that create and trade financial securities (Investment Banks
and Brokerages)

Money Markets:
1) Short Term/Low Risk/Liquid
a. Investments have lives less than a year
b. Can be liquidated quickly (sold) at market value
c. Risk to Principle is Very Low
d. These are secure investments because they invest in Short-term securities
that are relatively insensitive to interest rates, and have low risk of default
e. Examples: T-bills, CDs, Repos
2) Purpose of the Money Markets
a. Facilitate Short-Term Loans/Investments
b. Permit temporary warehousing of funds
c. Provide Higher Returns than available from Demand Deposits at Banks
(Savings)this is because banks must set aside loss reserves
3) Characteristics
a. Large Denominations: $50-100 Million
b. Low Default Risk
c. Maturities of less than one year
4) Chief Instruments and Sources
a. T-bills:
i. Bullet payment in 3, 6, or 12 months
ii. Sold at Auction to highest bidder(s)
iii. Also sold via non-competitive bidding where US Treasury charges
weighted average of accepted bid prices
iv. Sold on secondary market on a discount basis (highly liquid)
v. Whats the Default Risk?
b. Certificates of Deposit (CDs)
i. Term securities (unlike savings accountsdemand deposits)
ii. Traded on secondary market in round lots of $1 Million
iii. Rates and Risk slightly higher than T-bills (Why?)
iv. Created to compete against T-bills
c. Repurchase Agreements (Repos)
i. Effectively a Secured Loan
ii. Bank/Firms sells a security to another Bank/Firm, and agrees to
Repurchase the security at a Predetermined date/price
iii. Also traded on the secondary market
d. Commercial Paper (CP)
i. Promissory Note maturing in less than 270 days
ii. Unsecured. Only sold by credit-worthy institutions
iii. Sold on secondary market on a discount basis like T-bills

e. Bankers Acceptances (Letters of Credit)

i. Bank guarantees the payment of a firm
ii. Charges firm a fee for the guarantee
iii. Widely used in International Trade and is traded in the secondary
markets
f. EurodollarOffshore Markets
i. Dollar denominated loans/deposits overseas
ii. Available in deposits and CDs
iii. Has become a reference rate more widely used then the Treasuries
http://www.marketprices.ft.com/markets/currencies/international

g. Fed Funds Rate

i. Loan rate between banks
ii. Overnight borrowing to cover Reserve Shortfalls (Not traded)
5) Money Market Participants
a. Treasury issuing T-bills
b. FED buying and selling bills (FED is the banker for the federal
government)
c. Commercial Banks, Firms, Securities Firms, Finance Co.s, Insurance
Co.s, Pension funds, etc.
6) Money Market Mutual Funds
a. Established to give Small Investors access to the Money Markets
b. Aggregates Deposits from Investors to purchase large block securities
c. Makes profits on spreadno fees charged for investing
d. Looks like a Demand Deposit, requires a Minimum Investment

Capital Markets:
1) Longer Term Financing/Greater Returns/Greater Risk
a. Purpose is to provide Long-term capital financing to Governments and
Corporations
b. Reduces risk to those firms of having to roll-over short term debt at higher
rates
c. Riskier to Investors because of greater default and interest rate risk
d. Provided via Bonds, Stocks, and Mortgages
2) Market Participants
a. Federal, State, and Local Governments (Debt)
b. Corporations (Debt and Equity)
c. Property Owners (Mortgages)participation is indirect, mortgages
securitized by various providers
3) Markets
a. PrimarySale of Initial Public Offerings (IPOs) to major finance firms
(mutual funds, insurance companies, pension funds, etc.)
b. Secondarywhere most trading occurs: Exchanges and OTC
4) Exchanges
a. National: NYSE, American, Foreign (DAX, Nikkei) etc.
b. Regional: Pacific, Philadelphia
c. Have listing requirements; most stringent is NYSE, can list on multiple
exchanges
5) Over the Counter Markets (OTC)
a. Nasdaq (Nation Association of Securities Dealers Automated Quotation
System)
b. Other regional markets
Instruments:
6) Bonds
a. Securitized Debt (effectively a loan from the issuer)
b. Always pays interest, however, interest may be accumulated until the bond
matures
c. Coupon Bonds pay interest each year (usually semi-annually)
d. Face Value is the principle amount paid on maturity
7) Federal Bonds
a. T-bonds
i. Semi-annual interest payments
ii. Quoted as a percentage of $100 face value
iii. Credit is Federal Government

b. Strips
i. Principle and Interest payments sold separately
ii. Principle Only (PO)
iii. Interest Only (IO)
c. Agency Bonds
i. GNMA, FNMA, SLMA
ii. Used to supply funds for home loans and student loans
iii. Sell at a premium to treasuries (higher interest rate), why?
8) Municipal Bonds
a. State and Local Bonds
b. General ObligationClaim on revenues to general fund
c. Revenue Bondswhole slew of types, basically these have some revenue
stream pledged as collateral. Examples:
i. Sewer Bondsclaims on sewer system revenues
ii. Golf Course Bondsclaim on revenues from Municipal Golf
Courses
iii. Assessment Districtsclaim on the assessments from a specific
district
iv. Lease Obligationclaim on the revenue stream from municipal
lease, uses leased property as collateral
d. Bonds may be rated or non-rated (why wouldnt you want a bond rated?)
9) Corporate Bonds
a. Usually, $1000 denominations, paying interest semi-annually
b. Bearer Bondsrarely issued, bearer has right to payments
c. Registered Bondsregistered in owners name
d. Callable Bondsmay be called in by issuer after some date
e. Convertiblescan be converted to stock by purchaser if the stock price
reaches a threshold level (after some date)
f. Can be Unsecured or Secured with Property (collateralized)
g. Investment grade or Junk (speculative)
10) Equities
a. Common Stockfractional ownership of a firm with voting rights
b. Preferred Stock
i. Fixed Dividend paid prior to payment of normal dividends
ii. No voting rights
iii. Claim residual to that of bond-holders
c. Valuation should reflect the present value of expected future cash-flows,
also known as dividendsthis valuation method is known as the Dividend
Discount Model
d. American Depository Receipts (ADRs)
i. Provides claim on foreign stocks not traded on US exchanges
ii. Traded like stocks on US exchanges