Chapter 1: Why Study Financial Markets and Institutions?

Key Roles of Financial Markets

• Efficient Capital Allocation: Helps allocate capital to firms with highest expected returns.

• Economic Growth: Well-functioning financial markets enable growth by directing funds to

productive investments.

• Channels Funds: From savers (lenders) to borrowers (firms/governments).

MCQ Clue: Why are financial markets important? → They enable efficient capital allocation.

Types of Financial Markets

• Debt Markets (Bond Markets): Short-term (money market), long-term (capital market).

• Equity Markets (Stock Markets): Ownership claims.

• Primary Market: New securities issued.

• Secondary Market: Resale of existing securities (e.g., NYSE, NASDAQ).

MCQ Clue: A market for trading existing securities → Secondary Market.

Function of Financial Intermediaries

• Banks, insurance companies, mutual funds, etc.

• Lower transaction costs, reduce risk through diversification, and help resolve asymmetric
information.

MCQ Clue: What reduces transaction costs and helps with diversification? → Financial
Intermediaries.

Importance of Interest Rates

• Affect consumer spending, business investment, inflation, and exchange rates.

• Serve as the "price" of borrowing funds.

MCQ Clue: Higher interest rates likely → Decrease in investment spending.

Money and Monetary Policy

 • Central Banks (e.g., Federal Reserve) control money supply and interest rates.

• Key tools: Open market operations, discount rate, reserve requirements.

MCQ Clue: What happens when the Fed increases the money supply? → Interest rates tend to
fall.

Internationalization of Financial Markets

• Rise in global financial institutions and international bond/stock markets.

• Eurobonds: Bonds denominated in a currency not native to the country where it is issued.

MCQ Clue: A bond issued in the UK in USD → Eurobond.

Key Terms to Remember

• Liquidity: Ease of converting to cash.

• Diversification: Risk reduction.

• Moral Hazard: Risk after a transaction.

• Adverse Selection: Risk before a transaction.

 Chapter 2: Overview of the Financial System

Function of Financial Markets

1. Channel funds from savers to borrowers.

2. Provide liquidity – assets can be quickly sold.

3. Price discovery – determine fair market prices.

4. Risk sharing – spread financial risk among investors.

5. Reduce transaction costs.

MCQ Clue: What is a primary function of financial markets? → Channeling funds from savers to
borrowers.

Types of Financial Markets

• Debt Market: Instruments with fixed payments (loans, bonds).

• Equity Market: Ownership (stocks).

• Primary Market: New issues (IPOs).

• Secondary Market: Existing securities traded.

• Exchanges: Centralized (e.g., NYSE).

• OTC (Over-the-counter): Decentralized.

MCQ Clue: Where do companies raise new capital? → Primary Market.

Money vs. Capital Markets

• Money Market: Short-term debt instruments (T-bills, CDs, commercial paper).

• Capital Market: Long-term instruments (stocks, bonds).

MCQ Clue: A 3-month Treasury bill trades in the → Money Market.

Globalization of Financial Markets

• Eurobond: Bond in foreign currency outside issuer’s country.

• Eurocurrency: Foreign currency held outside home market (e.g., Eurodollars).

 MCQ Clue: USD-denominated bond issued in Germany → Eurobond.

Financial Intermediaries

Main purpose: Overcome barriers to direct finance by:

• Reducing transaction costs (economies of scale).

• Providing liquidity services.

• Solving asymmetric information:

o Adverse selection: Problem before transaction.

o Moral hazard: Problem after transaction.

MCQ Clue: Which problem arises before lending occurs? → Adverse Selection.

Types of Financial Intermediaries

1. Depository Institutions: Commercial banks, savings banks, credit unions.

2. Contractual Savings Institutions: Insurance companies, pension funds.

3. Investment Intermediaries: Mutual funds, finance companies.

MCQ Clue: Which institution collects premiums and provides payouts? → Insurance companies
(contractual).

Financial Regulation Goals

1. Increase transparency to reduce info asymmetry.

2. Ensure soundness of financial institutions.

3. Protect consumers from fraud or abuse.

MCQ Clue: Why do governments regulate financial systems? → To protect the public and ensure
stability.

Key Terms to Remember

• Indirect finance: Funds flow through intermediaries.

• Direct finance: Borrowers and savers interact directly.

• Asymmetric information: Unequal knowledge between parties.

 • Economies of scope: Using information across multiple services

Chapter 3: What Do Interest Rates Mean and What Is Their Role in Valuation?

Present Value (PV) & Future Value (FV)

• Present Value Formula:

PV=CF(1+i)nPV = \frac{CF}{(1 + i)^n}PV=(1+i)nCF

Where CF = cash flow, i = interest rate, n = number of periods.

MCQ Clue: What does present value tell you? → Current worth of future cash flows.

Types of Credit Market Instruments

1. Simple Loan – Interest paid at maturity.

2. Fixed-Payment Loan – Same payment each period (e.g., mortgage).

3. Coupon Bond – Pays fixed coupon + face value at maturity.

4. Discount Bond (Zero-Coupon) – Bought at discount, pays face value.

MCQ Clue: Which instrument makes no interim payments? → Discount bond.

Yield to Maturity (YTM)

• YTM: The interest rate that equates a bond’s present value of payments to its price.

• Most accurate measure of interest return.

MCQ Clue: Which rate fully reflects the bond’s return if held to maturity? → YTM.

Current Yield vs. YTM

• Current Yield = Annual Coupon PaymentPrice\frac{\text{Annual Coupon

Payment}}{\text{Price}}PriceAnnual Coupon Payment

• Doesn’t account for capital gains/losses.

MCQ Clue: A bond with a 10% coupon selling below par has a → YTM > 10%.
Interest Rate vs. Return

• Return = YTM only if bond is held to maturity.

• Capital Gain = Price goes up → positive return.

• Capital Loss = Price drops → negative return.

MCQ Clue: If interest rates rise, bond prices ↓, causing → Capital loss.

Interest-Rate Risk

• Longer maturity → More price sensitivity.

• Reinvestment Risk: If interest rates fall, reinvested income earns less.

MCQ Clue: Which bond is more sensitive to rate changes? → Long-term bond.

Real vs. Nominal Interest Rates

• Nominal: Not adjusted for inflation.

• Real = Nominal − Expected inflation

MCQ Clue: If inflation = 3% and nominal rate = 6%, real rate = → 3%.

Duration

• Weighted average time to receive bond’s cash flows.

• Longer duration = higher interest-rate risk.

MCQ Clue: Purpose of duration? → Measure price sensitivity to rate changes.

Key Takeaways

• Higher rates → Lower bond prices.

• Duration ↑ → Interest rate sensitivity ↑.

• Choose short-term or floating-rate securities to reduce interest-rate risk.

Theory of Portfolio Choice

People prefer:

• Higher expected return

• Lower risk

• Greater liquidity

MCQ Clue: What increases demand for an asset? → Higher expected return or lower risk.

Determinants of Bond Demand

1. Wealth ↑ → Demand ↑

2. Expected returns ↑ → Demand ↑

3. Risk ↓ → Demand ↑

4. Liquidity ↑ → Demand ↑

5. Expected inflation ↓ → Real return ↑ → Demand ↑

MCQ Clue: What happens to bond demand if inflation is expected to fall? → It increases.

Determinants of Bond Supply

1. Profitability of investments ↑ → Supply ↑

2. Expected inflation ↑ → Supply ↑

3. Government budget deficits ↑ → Supply ↑

MCQ Clue: What increases the supply of bonds? → Greater expected inflation or bigger deficits.

Market Equilibrium (Bond Market)

• Demand > Supply → Price ↑ → Interest rate ↓

• Supply > Demand → Price ↓ → Interest rate ↑

MCQ Clue: What happens if bond demand increases? → Bond prices ↑, interest rates ↓.

Fisher Effect

• Nominal interest rate = Real interest rate + Expected inflation

MCQ Clue: If expected inflation increases, nominal rate must → Increase (Fisher Effect).
 Business Cycle Effects

• Expansion: Wealth ↑ → Demand ↑ and Supply ↑

• Recession: Wealth ↓ → Demand ↓ and Supply ↓

MCQ Clue: During expansion, what happens to interest rates? → They rise due to increased
demand and supply.

Key Relationships

Factor Impact on Interest Rates

Expected Inflation ↑ Rates ↑

Government Borrowing ↑ Rates ↑

Recession Rates ↓

Liquidity ↑ (of bonds) Rates ↓

Chapter 5: The Structure of Interest Rates

Key Concepts:

1. Interest Rates Overview:

o Interest rate: The cost of borrowing or the return on investment for holding money
over time.

o It’s determined by supply and demand for funds in the financial market.

2. Determinants of Interest Rates:

o Real Interest Rate: The return on investment after adjusting for inflation.

o Inflation Premium: Compensation for expected inflation.

o Risk Premium: Compensation for taking on risk.

o Liquidity Premium: Compensation for holding an asset that isn’t easily tradable.

o Maturity Premium: Compensation for holding longer-term securities, which have

more risk.
3. Yield Curve:

o A graphical representation of interest rates for bonds of different maturities but the
same credit quality.

o The shape of the yield curve can indicate economic expectations:

▪ Upward sloping: Indicates expectations of rising interest rates and inflation.

▪ Inverted: Indicates expectations of falling interest rates, often a signal of a

potential recession.

4. Term Structure of Interest Rates:

o Refers to the relationship between short-term and long-term interest rates.

o Influenced by factors like expectations of future inflation, changes in the economy,

and risk perception.

5. Factors Affecting Interest Rates:

o Monetary Policy: Central banks control short-term interest rates via tools like open
market operations, reserve requirements, and the discount rate.

o Fiscal Policy: Government borrowing can impact the supply of money in the
economy, which can influence interest rates.

o Economic Conditions: The level of demand for borrowing, the state of the
economy, and inflation expectations all influence interest rates.

6. Theories of the Term Structure:

o Expectations Theory: Interest rates on long-term bonds are determined by

expectations of future short-term rates.

o Liquidity Preference Theory: Investors require a premium for holding long-term

securities due to the added risk and uncertainty.

o Market Segmentation Theory: Different investors prefer bonds of certain

maturities, which influences the shape of the yield curve.

o Preferred Habitat Theory: Investors will deviate from their preferred maturity if they
are offered a higher yield.

7. Interest Rate Risk:

o The risk that changes in interest rates will affect the value of fixed-income
securities.

o Duration: A measure of the sensitivity of a bond’s price to changes in interest rates.

8. Risk and Return in Fixed-Income Markets:

o Higher interest rates tend to increase bond yields and lower bond prices.
 o The relationship between price and interest rates is inverse—when interest rates go
up, the price of bonds goes down.

Chapter 6: Risk and Return

1. Risk:

• Risk refers to the uncertainty about the future returns of an asset or investment. It is the
potential variability in the returns.

• There are two main types of risk:

o Systematic Risk (Market Risk):

▪ Affects the entire market or a broad segment of the market.

▪ Cannot be eliminated through diversification.

▪ Examples: Interest rate changes, economic recessions, political instability.

o Unsystematic Risk (Firm-Specific or Idiosyncratic Risk):

▪ Affects a specific company or industry.

▪ Can be reduced or eliminated through diversification.

▪ Examples: A company’s management changes, labor strikes, technological

issues.

2. Types of Risk and the Importance of Diversification:

• Diversification is the practice of holding a variety of investments in a portfolio to reduce

risk. By investing in a mix of assets that do not correlate perfectly, an investor can reduce
the overall risk of the portfolio.

o Portfolio Diversification reduces unsystematic risk, but systematic risk remains.

o The key principle of diversification is that the returns of different assets in the
portfolio will not always move in the same direction, thus smoothing out the overall
risk.

3. Expected Return:

• The expected return of an asset is the average return you anticipate receiving, considering
all possible outcomes and their probabilities.

• Formula for Expected Return:

E(R)=∑Pi×RiE(R) = \sum P_i \times R_i

Where:

o E(R)E(R) = Expected return,

 o PiP_i = Probability of outcome ii,

o RiR_i = Return in outcome ii.

• Example: If an asset has a 50% chance of returning 10% and a 50% chance of returning
20%, the expected return would be:

E(R)=(0.5×10%)+(0.5×20%)=15%E(R) = (0.5 \times 10\%) + (0.5 \times 20\%) = 15\%

4. Risk Premium:

• The Risk Premium is the additional return an investor expects for taking on the risk of an
asset, above the return on a risk-free asset (e.g., U.S. Treasury bills).

• Formula:

Risk Premium=E(R)−Rf\text{Risk Premium} = E(R) - R_f

Where:

o E(R)E(R) = Expected return of the risky asset,

o RfR_f = Risk-free rate (return on a risk-free asset like a government bond).

• Example: If the expected return on a stock is 12% and the risk-free rate is 4%, the risk
premium is 8%.

5. Portfolio Theory (Markowitz Model):

• Portfolio Return: The expected return of a portfolio is the weighted average of the expected
returns of the individual assets in the portfolio.

E(Rp)=∑wi×E(Ri)E(R_p) = \sum w_i \times E(R_i)

Where:

o E(Rp)E(R_p) = Expected return of the portfolio,

o wiw_i = Weight of asset ii in the portfolio,

o E(Ri)E(R_i) = Expected return of asset ii.

• Portfolio Risk: The risk of a portfolio is not simply the sum of the risks of the individual
assets. Instead, the portfolio's risk depends on how the returns of the assets correlate with
each other.

o Correlation between assets determines whether the assets will move in the same
or opposite directions. If two assets are negatively correlated, combining them can
reduce risk.

• Efficient Frontier: A graph that shows the optimal portfolios that offer the highest expected
return for a given level of risk or the lowest risk for a given level of expected return. Portfolios
that lie below the efficient frontier are suboptimal, as they either take on too much risk for
too little return or too little return for too much risk.
 • Diversification Effect: By adding assets with low or negative correlation, a portfolio can
reduce its total risk below the individual asset’s risk level.

6. Capital Asset Pricing Model (CAPM):

• The CAPM is a model that determines the expected return of an asset based on its risk
relative to the market.

• Formula for CAPM:

E(Ri)=Rf+βi×(E(Rm)−Rf)E(R_i) = R_f + \beta_i \times (E(R_m) - R_f)

Where:

o E(Ri)E(R_i) = Expected return of asset ii,

o RfR_f = Risk-free rate,

o βi\beta_i = Beta of asset ii,

o E(Rm)E(R_m) = Expected return of the market.

• Beta (β\beta): A measure of an asset’s sensitivity to the overall market movements.

o β>1\beta > 1: The asset is more volatile than the market.

o β=1\beta = 1: The asset moves in line with the market.

o β<1\beta < 1: The asset is less volatile than the market.

• Market Risk Premium: The difference between the expected return on the market and the
risk-free rate (E(Rm)−RfE(R_m) - R_f).

o Example: If the market return is expected to be 10% and the risk-free rate is 4%, the
market risk premium is 6%.

• Security Market Line (SML): The graphical representation of the CAPM equation. It shows
the relationship between the expected return and the beta of an asset.

o The SML is upward sloping, indicating that higher risk (higher beta) is associated
with higher expected returns.

7. Beta and Market Risk:

• Systematic Risk: Also known as market risk, this is the risk that affects the entire market. It
is measured by the asset's beta.

• Unsystematic Risk: Also called unique or specific risk, it is associated with individual
assets or companies. This risk can be diversified away in a portfolio.

• The beta coefficient measures the level of systematic risk of a security relative to the
market:

o β=1\beta = 1: The security’s returns are expected to move in line with the market.
 o β>1\beta > 1: The security is expected to be more volatile than the market.

o β<1\beta < 1: The security is expected to be less volatile than the market.

• Market Risk vs. Diversifiable Risk: Investors cannot eliminate market risk through
diversification, but they can eliminate diversifiable risk.

8. Risk-Return Tradeoff:

• The principle of risk-return tradeoff states that investors must be compensated with a
higher return for taking on additional risk.

• Higher expected returns are typically associated with higher risk. This is illustrated through
the efficient frontier and CAPM.

Chapter 7: Financial Markets and the Economy

1. The Role of Financial Markets in the Economy:

• Financial Markets are platforms where buyers and sellers trade financial assets like stocks,
bonds, and derivatives. They play a critical role in facilitating the flow of funds between
savers and borrowers, and thereby contribute to the functioning of the economy.

• The primary functions of financial markets include:

o Liquidity: Providing a space for investors to buy and sell assets quickly.

o Price Discovery: Helping to determine the prices of financial instruments through

the interaction of supply and demand.

o Efficient Allocation of Resources: Directing funds from individuals who have

excess capital (savers) to those who need it (borrowers) to fund productive
investments.

o Risk Sharing: Allowing investors to diversify their portfolios and spread risks by
investing in a variety of assets.

2. Types of Financial Markets:

Financial markets can be categorized based on the nature of the instruments traded, the maturity
of the instruments, or the level of organization.

• Capital Markets: Markets where long-term debt and equity securities are traded. They
include:

o Stock Markets (Equity Markets): Where shares of companies are bought and sold.

o Bond Markets: Where debt securities (e.g., government and corporate bonds) are
traded.
 • Money Markets: Markets for short-term debt instruments, typically with maturities of one
year or less (e.g., Treasury bills, commercial paper).

• Primary Markets: Markets where newly issued securities are sold to investors. Issuers raise
funds directly from investors.

o Example: An initial public offering (IPO).

• Secondary Markets: Markets where existing securities are bought and sold. Investors trade
securities among themselves.

o Example: The New York Stock Exchange (NYSE), NASDAQ.

• Derivatives Markets: Where financial instruments like futures, options, and swaps are
traded. These contracts derive their value from underlying assets like stocks or
commodities.

• Foreign Exchange Markets: Where currencies are traded, enabling international trade and
investment.

3. Market Participants:

Different groups of participants operate in financial markets, and each plays a specific role:

• Issuers: These are entities (governments, corporations) that issue securities to raise
capital.

o Example: Governments issuing bonds, companies issuing stocks.

• Investors: Individuals or institutions that buy securities to generate returns.

o Examples: Households, pension funds, mutual funds, hedge funds.

• Intermediaries: These include investment banks, brokers, and dealers who facilitate the
buying and selling of securities.

o Example: Investment banks that assist companies with issuing stocks and bonds.

• Regulators: Authorities like the Securities and Exchange Commission (SEC) that regulate
and oversee the operations of financial markets to ensure fairness, transparency, and
investor protection.

• Market Makers: Institutions or individuals that provide liquidity by being willing to buy or
sell a specific asset at any time.

4. The Impact of Financial Markets on the Economy:

Financial markets significantly influence economic performance through their role in:

• Economic Growth: By allocating capital to productive investments, financial markets

facilitate innovation, entrepreneurship, and infrastructure development.
 • Consumption and Investment: A well-functioning financial market provides consumers
and businesses with access to credit, allowing them to spend and invest more freely.

• Monetary Policy Transmission: Central banks, like the Federal Reserve in the U.S., use
financial markets to implement monetary policy. They control the money supply and
influence interest rates to stabilize the economy.

o Open Market Operations: The purchase or sale of government securities by the

central bank to influence short-term interest rates and control inflation.

5. The Relationship Between Financial Markets and the Business Cycle:

• Business Cycle: The natural rise and fall of economic activity over time, typically measured
by changes in GDP (Gross Domestic Product).

• Financial markets play a key role in the business cycle by affecting the availability of capital:

o During economic expansions, financial markets tend to be more liquid, interest

rates are lower, and capital is more accessible for businesses to expand.

o During economic contractions, market liquidity decreases, interest rates may rise,
and borrowing becomes more difficult, which can exacerbate economic
slowdowns.

6. Financial Intermediation:

• Financial Intermediaries are institutions that act as middlemen between savers and
borrowers, channeling funds from those who have them (savers) to those who need them
(borrowers).

o Examples: Banks, insurance companies, mutual funds, pension funds, investment

companies.

• They help in reducing information asymmetry between savers and borrowers, thus
facilitating investments and helping in risk diversification.

7. How Financial Markets Impact Interest Rates:

• Interest Rates in financial markets are determined by the supply and demand for funds.

o Supply of Funds: Savers and investors provide capital to the market.

o Demand for Funds: Borrowers (governments, corporations, households) seek

funds for investment or consumption.

• Central Banks: Central banks influence interest rates through monetary policy (e.g.,
changing the discount rate, using open market operations) to either stimulate or slow down
the economy.

• Inflation Expectations: Higher inflation expectations tend to push interest rates higher as
lenders demand more compensation for the eroding purchasing power of money.
8. The Role of Financial Markets in Managing Risks:

• Financial markets offer mechanisms for individuals and companies to manage risk through
various products:

o Hedging: Using derivatives (e.g., options, futures) to protect against adverse price
movements.

o Insurance: Transferring risk to insurance companies that absorb losses in exchange

for premiums.

o Diversification: Spreading investments across various assets to reduce exposure to

specific risks.

9. The Importance of Financial Market Regulation:

• Financial markets are highly regulated to ensure fairness, transparency, and stability.
Regulations prevent market manipulation, protect investors, and help maintain public
confidence.

o Key Regulatory Bodies:

▪ Securities and Exchange Commission (SEC): In the U.S., oversees the

securities industry to protect investors.

▪ Federal Reserve: Implements U.S. monetary policy and supervises financial

institutions.

▪ International Bodies: Such as the International Monetary Fund (IMF) and

Bank for International Settlements (BIS) that help regulate global financial
systems.

10. International Financial Markets:

• Globalization has made financial markets interconnected. Events in one country can have
a significant impact on markets around the world.

• Exchange Rates: Financial markets also facilitate the buying and selling of currencies in
foreign exchange markets. Exchange rates fluctuate based on supply and demand for
different currencies.

• Cross-Border Investment: Investors are able to diversify internationally by investing in

foreign assets, which adds complexity to global financial markets.

Key Points to Remember for MCQ-Style Questions:

• Financial Markets' Functions: Provide liquidity, price discovery, resource allocation, and
risk sharing.
 • Types of Markets: Capital markets (long-term), money markets (short-term), primary
markets (new issuance), secondary markets (trading of existing securities), derivatives
markets, and foreign exchange markets.

• Market Participants: Issuers, investors, intermediaries, regulators, market makers.

• Impact on Economy: Support economic growth, consumption, investment, and monetary

policy transmission.

• Financial Intermediaries: Reduce information asymmetry and provide risk diversification.

• Interest Rates: Influenced by supply and demand for funds, central bank policies, and
inflation expectations.

• Regulation: Ensures market fairness, transparency, and stability.

• International Markets: Globalization has interconnected markets and added complexity in

managing exchange rates and cross-border investments.

Chapter 8: Financial Institutions

1. Overview of Financial Institutions:

• Financial institutions are intermediaries in the financial system that facilitate the flow of
funds between savers and borrowers, and provide a variety of financial services.

• They include commercial banks, insurance companies, pension funds, mutual funds, and
investment banks, all of which play key roles in facilitating economic activities.

2. Types of Financial Institutions:

• Financial institutions are classified into two broad categories based on their role in the
financial system:

o Depository Institutions: These institutions accept deposits from the public and
provide loans.

o Non-depository Institutions: These institutions do not accept deposits but provide

financial services, such as insurance or investment management.

• Depository Institutions:

1. Commercial Banks: These are the primary depository institutions. They offer a wide range
of services, including accepting deposits, making loans, and offering payment services.

2. Savings and Loan Associations (S&Ls): These institutions focus primarily on accepting
savings deposits and providing home mortgages.

3. Credit Unions: Cooperative institutions that provide financial services to members,

typically offering lower interest rates and fees.
 • Non-depository Institutions:

1. Insurance Companies: Provide financial protection against risk in exchange for premiums.
They invest the funds received from premiums in various assets to generate returns.

2. Pension Funds: These institutions manage retirement savings for individuals, collecting
contributions during working years and paying out benefits in retirement.

3. Mutual Funds: Pool money from individual investors to create diversified portfolios of
stocks, bonds, and other assets.

4. Investment Banks: Assist companies in raising capital through the issuance of securities.
They also provide advisory services for mergers, acquisitions, and other corporate strategies.

5. Hedge Funds: Private investment funds that use more sophisticated strategies to generate
higher returns, often involving riskier assets.

3. The Role of Financial Institutions in the Economy:

Financial institutions contribute to the economy in several key ways:

• Intermediation: They act as intermediaries between savers and borrowers, helping to

channel funds from those with excess capital to those who need it for investment or
consumption.

• Risk Management: They offer products (e.g., insurance, derivatives) that help individuals
and businesses manage and mitigate risks.

• Payment System: Financial institutions provide the infrastructure for payments, enabling
individuals and businesses to settle debts and transfer funds efficiently.

• Market Liquidity: By providing lending and borrowing services, they ensure that financial
markets remain liquid and functional.

4. Commercial Banks:

• Functions: Commercial banks accept deposits, make loans, and offer various financial
services such as checking and savings accounts, mortgages, and personal loans.

• Primary Services:

o Accepting Deposits: Banks provide safe-keeping for funds, offering checking,

savings, and money market accounts.

o Lending: Banks extend loans to individuals, businesses, and governments for

purposes like home buying, business expansion, and infrastructure development.

o Payment Services: Banks provide mechanisms for transferring money (e.g., wire
transfers, payment cards, electronic transfers).

o Investment Services: Some commercial banks offer investment products like

mutual funds or wealth management services.
 • Profit Mechanism: Commercial banks earn a profit by borrowing at lower rates (accepting
deposits) and lending at higher rates (providing loans).

5. Insurance Companies:

• Functions: Insurance companies provide protection against risk in exchange for premiums.

o Life Insurance: Protects against the risk of death or disability, providing financial
security for dependents.

o Property and Casualty Insurance: Provides protection against loss of property

(e.g., home insurance) or liability (e.g., automobile insurance).

o Health Insurance: Provides coverage for medical expenses.

• Profit Mechanism: Insurance companies earn money by collecting premiums and investing
the funds in financial markets. The key is managing risk and ensuring that claims are lower
than the premiums collected.

6. Pension Funds:

• Functions: Pension funds manage retirement savings for individuals, ensuring that
contributions made during an individual's working years are invested and grow to provide
income during retirement.

• Types of Pension Funds:

o Defined Benefit Plans: The employer guarantees a specific retirement benefit

amount, often based on salary and years of service.

o Defined Contribution Plans: The employer and employee contribute to an

individual account, and the final benefit depends on the investment performance.

• Profit Mechanism: Pension funds generate returns by investing contributions in a

diversified portfolio of stocks, bonds, real estate, and other assets.

7. Mutual Funds:

• Functions: Mutual funds pool money from individual investors to create a diversified
portfolio of securities. They provide smaller investors with access to a range of assets and
professional management.

• Types of Mutual Funds:

o Equity Funds: Invest in stocks.

o Bond Funds: Invest in bonds.

o Money Market Funds: Invest in short-term debt securities.

o Balanced Funds: Invest in a mix of stocks and bonds to provide a balanced risk-
return profile.
 • Profit Mechanism: Mutual funds charge fees (management fees, transaction costs) and
earn returns from the underlying securities in the portfolio.

8. Investment Banks:

• Functions: Investment banks help corporations raise capital by issuing securities, provide
advisory services for mergers and acquisitions, and assist with corporate restructuring.

• Primary Services:

o Underwriting: Investment banks buy securities from issuers and sell them to
investors (primary market activities).

o Advisory Services: Investment banks advise companies on mergers, acquisitions,

and other corporate strategies.

o Trading and Market Making: Investment banks may also engage in proprietary
trading or act as market makers to provide liquidity in securities.

• Profit Mechanism: Investment banks earn fees for underwriting and advisory services, and
also generate profits through trading and investment activities.

9. Hedge Funds:

• Functions: Hedge funds are private, pooled investment funds that use a wide range of
strategies to generate high returns, often taking on more risk in the process.

• Investment Strategies:

o Leverage: Borrowing money to amplify returns.

o Short Selling: Betting against the value of assets.

o Derivatives: Using financial contracts like options and futures to hedge or

speculate.

• Profit Mechanism: Hedge funds charge management fees (typically 2% of assets) and
performance fees (often 20% of profits).

10. Regulatory Framework:

• Financial institutions are heavily regulated to ensure stability, protect consumers, and
maintain confidence in the financial system. Key regulatory bodies include:

o Federal Reserve: Regulates commercial banks and manages monetary policy.

o Securities and Exchange Commission (SEC): Regulates securities markets,

including investment banks and mutual funds.

o National Association of Insurance Commissioners (NAIC): Regulates the

insurance industry.
 o Pension Benefit Guaranty Corporation (PBGC): Oversees pension funds to protect
beneficiaries.

• Regulations focus on capital adequacy, consumer protection, and systemic risk to

ensure that institutions operate safely and maintain public trust.

Key Points to Remember for MCQ-Style Questions:

• Types of Financial Institutions: Depository (e.g., commercial banks, credit unions) and
non-depository (e.g., insurance companies, mutual funds, investment banks).

• Roles of Financial Institutions: Intermediating between savers and borrowers, managing

risk, providing payment systems, and enhancing market liquidity.

• Commercial Banks: Accept deposits, provide loans, and offer payment services.

• Insurance Companies: Provide risk protection through policies and invest premium funds.

• Pension Funds: Manage retirement savings and invest in a diversified portfolio.

• Mutual Funds: Pool money from investors to create diversified portfolios.

• Investment Banks: Help companies raise capital and provide advisory services.

• Hedge Funds: Use sophisticated strategies (e.g., leverage, derivatives) to generate high
returns.

• Regulation: Financial institutions are regulated to maintain stability, protect consumers,

and ensure a fair financial system.

Chapter 9: The Structure of Interest Rates

1. Understanding Interest Rates:

• Interest rates represent the cost of borrowing or the return on investment for saving or
lending money.

• Nominal Interest Rate: The stated interest rate on a loan or investment without adjusting
for inflation.

• Real Interest Rate: The interest rate adjusted for inflation, reflecting the true cost of
borrowing or the true return on an investment.

o Real Interest Rate = Nominal Interest Rate - Inflation Rate

2. The Term Structure of Interest Rates:

• Term Structure: Refers to the relationship between the interest rates on bonds of different
maturities but with similar risk.
 • Yield Curve: A graph that shows the relationship between the interest rates (or yields) on
bonds of different maturities.

o Typically, a normal yield curve is upward sloping, meaning long-term interest rates
are higher than short-term rates.

o An inverted yield curve occurs when short-term rates are higher than long-term
rates, which can be a signal of economic recession.

o A flat yield curve occurs when short-term and long-term interest rates are very
similar, often seen in uncertain economic times.

3. Theories Explaining the Yield Curve:

• Expectations Theory:

o Suggests that long-term interest rates are determined by the market’s expectations
of future short-term interest rates.

o If the market expects interest rates to rise in the future, long-term rates will be higher
than short-term rates.

o Conversely, if the market expects interest rates to fall in the future, the yield curve
may invert.

• Liquidity Preference Theory:

o Proposes that investors demand a premium (higher interest rates) for holding long-
term securities, which are more risk-prone due to uncertainty over a longer period.

o This theory assumes that investors prefer more liquid, short-term investments over
long-term ones due to the added risk of holding long-term securities.

o Therefore, the yield curve is typically upward sloping.

• Market Segmentation Theory:

o Argues that the market for bonds is segmented by maturity, and the supply and
demand for bonds of different maturities determine interest rates in each segment.

o Investors in one segment (e.g., short-term) may not be willing to invest in another
segment (e.g., long-term), which affects the shape of the yield curve.

• Preferred Habitat Theory:

o Combines elements of the liquidity preference and market segmentation theories. It

suggests that investors have a preference for bonds of certain maturities (their
"preferred habitat") but are willing to invest in other maturities if they are
compensated with a higher yield.

4. Determinants of Interest Rates:

The level of interest rates is determined by a variety of factors:

 • Inflation:

o Higher inflation expectations generally lead to higher interest rates. Lenders will
demand a higher return to compensate for the anticipated decrease in the
purchasing power of money.

• Risk:

o Credit Risk: The risk that the borrower will not repay the loan as agreed. Higher
credit risk typically leads to higher interest rates.

o Default Risk Premium: A premium added to the interest rate to compensate for the
possibility of a borrower defaulting on the loan.

• Time to Maturity:

o Longer-term loans usually have higher interest rates due to the increased
uncertainty over time.

• Demand for Money:

o When there is high demand for money (e.g., during periods of economic growth),
interest rates tend to rise.

o Conversely, when demand for money is low (e.g., during recessions), interest rates
tend to fall.

• Monetary Policy:

o Central banks, like the Federal Reserve or the European Central Bank, influence
interest rates through monetary policy tools such as setting the discount rate, open
market operations, and reserve requirements.

o Lower interest rates are typically used to stimulate economic activity during periods
of low growth or recession, while higher rates may be used to cool down an
overheated economy or control inflation.

5. The Structure of Interest Rates and Risk:

• Interest rates on debt securities vary depending on the risk associated with the issuer.

• Default Risk Premium: The additional yield required by investors to compensate for the
possibility of default by the issuer.

o Example: Government bonds typically have lower interest rates than corporate
bonds due to lower default risk.

• Maturity Risk Premium: The extra return investors demand for holding bonds with longer
maturities, which are more vulnerable to interest rate changes.

• Liquidity Risk Premium: The additional return required by investors for holding securities
that may be more difficult to trade or sell quickly.
6. The Role of the Federal Reserve in Determining Interest Rates:

• The Federal Reserve (Fed) and other central banks play a critical role in shaping the interest
rate environment through their monetary policy.

o Open Market Operations (OMO): The Fed buys or sells government securities in the
open market to adjust the money supply and influence short-term interest rates.

o Discount Rate: The interest rate at which commercial banks can borrow from the
Fed. A lower discount rate encourages borrowing and spending, while a higher rate
discourages borrowing and can help control inflation.

o Federal Funds Rate: The rate at which commercial banks lend reserves to each
other overnight. The Fed influences this rate as a tool to control inflation and
stabilize the economy.

7. Interest Rate Risk:

• Interest Rate Risk refers to the potential for investment losses due to changes in interest
rates.

o For Borrowers: Rising interest rates increase borrowing costs, making loans more
expensive and reducing consumer spending and business investments.

o For Investors: Changes in interest rates affect the prices of existing bonds. When
interest rates rise, the price of existing bonds falls, and vice versa.

• Duration: Duration is a measure of a bond’s sensitivity to changes in interest rates. The

longer the duration, the more sensitive the bond is to interest rate changes.

• Bond Price and Interest Rate Inversely Related: There is an inverse relationship between
bond prices and interest rates. When interest rates go up, bond prices go down, and when
interest rates go down, bond prices go up.

8. Theories and Models of the Term Structure:

• In addition to the theories already mentioned (Expectations, Liquidity Preference, Market

Segmentation, and Preferred Habitat), several other models attempt to explain the term
structure of interest rates:

o The Fisher Effect: This model suggests that the nominal interest rate is determined
by the real interest rate and expected inflation. It indicates that an increase in
expected inflation leads to an increase in nominal interest rates.

o The Pure Expectations Theory: This theory holds that the term structure of interest
rates is purely based on expectations of future interest rates, with no risk premium
attached to the maturity structure of interest rates.

9. Practical Applications of Interest Rates and the Yield Curve:

 • Investment Decisions: The shape of the yield curve provides important signals for
investors. A steep yield curve may indicate economic expansion, while an inverted yield
curve may signal a recession.

• Borrowing Decisions: Businesses and governments pay attention to interest rates when
planning to issue bonds or borrow money. A lower yield environment may encourage
borrowing for capital investment or expansion.

• Monetary Policy: Central banks use interest rate changes to influence economic growth,
inflation, and employment levels.

Key Points to Remember for MCQ-Style Questions:

• Interest Rates: The cost of borrowing or the return on investment, with real rates adjusted
for inflation.

• Term Structure: The relationship between interest rates on bonds of different maturities.

o Normal Yield Curve: Upward sloping (long-term rates > short-term rates).

o Inverted Yield Curve: Short-term rates > long-term rates, potentially signaling a
recession.

o Flat Yield Curve: Similar short-term and long-term rates, often during economic
uncertainty.

• Expectations Theory: Long-term rates are based on expectations of future short-term

rates.

• Liquidity Preference Theory: Investors demand a premium for longer-term investments.

• Market Segmentation Theory: Interest rates are determined by the supply and demand for
bonds of different maturities.

• Determinants of Interest Rates: Inflation, risk, time to maturity, demand for money, and
monetary policy.

• Federal Reserve's Role: Controls interest rates through tools like open market operations,
discount rate, and federal funds rate.

• Interest Rate Risk: The risk of loss from changes in interest rates, affecting both borrowers
and investors.

Chapter 10: The Risk and Return of Financial Assets

1. Introduction to Risk and Return:

• Risk and return are fundamental concepts in finance. Investors aim to maximize their
return while minimizing risk.
 • Return: The gain or loss on an investment over a period, typically expressed as a percentage
of the initial investment.

• Risk: The uncertainty about the return on an investment. Higher risk is usually associated
with the potential for higher returns.

2. Defining Risk and Return:

• Expected Return: The average return an investor expects to earn from an investment, often
based on historical data or forecasts.

o Formula for Expected Return:

E(R)=∑i=1nPi×RiE(R) = \sum_{i=1}^{n} P_i \times R_i

where:

▪ E(R)E(R) is the expected return,

▪ PiP_i is the probability of state ii,

▪ RiR_i is the return in state ii.

• Actual Return: The real return achieved on an investment, which may differ from the
expected return due to unforeseen circumstances or changes in market conditions.

• Risk (Volatility): The standard deviation or variance of the return distribution. It measures
the degree to which returns deviate from the expected return.

o Standard Deviation: A statistical measure of the dispersion of returns around the

expected return.

o A higher standard deviation indicates higher risk, as returns are more spread out
from the mean.

3. Types of Risk:

• Systematic Risk: Also known as market risk, this type of risk affects the entire market or
economy. It is unavoidable and cannot be mitigated through diversification. Examples
include changes in interest rates, inflation, and economic recessions.

• Unsystematic Risk: Also called firm-specific or idiosyncratic risk, this risk is specific to a
particular company or industry. It can be reduced or eliminated through diversification.
Examples include management changes, product recalls, or industry disruptions.

4. The Risk-Return Trade-Off:

• The risk-return trade-off suggests that higher returns are generally associated with higher
risk. Investors must decide on their preferred level of risk based on their risk tolerance,
investment horizon, and financial goals.

• Efficient Portfolio: A portfolio that offers the highest expected return for a given level of
risk, or the lowest risk for a given level of expected return.
 • Capital Market Line (CML): A line that represents the risk-return trade-off for efficient
portfolios in the context of a portfolio that includes both risky assets (stocks, bonds) and a
risk-free asset (e.g., government bonds).

o The CML shows the highest expected return for a given level of risk, or the lowest
risk for a given level of expected return, when combining risky assets and a risk-free
asset.

5. Portfolio Theory and Diversification:

• Portfolio Theory: Developed by Harry Markowitz, portfolio theory suggests that combining
different assets in a portfolio can reduce overall risk through diversification.

o Diversification involves spreading investments across different assets or asset

classes (e.g., stocks, bonds, real estate) to reduce exposure to any single
investment’s risk.

o Correlation: The degree to which asset returns move in relation to one another.
Assets with low or negative correlation provide better diversification benefits.

▪ Negative correlation between two assets means that when one asset's price
goes up, the other's goes down, reducing overall risk.

6. Measuring Portfolio Risk:

• Portfolio Return: The weighted average of the returns on the individual assets in the
portfolio.

o Formula for Portfolio Return:

Rp=w1R1+w2R2+⋯+wnRnR_p = w_1 R_1 + w_2 R_2 + \dots + w_n R_n

where:

▪ RpR_p is the portfolio return,

▪ w1,w2,…,wnw_1, w_2, \dots, w_n are the weights of each asset in the
portfolio,

▪ R1,R2,…,RnR_1, R_2, \dots, R_n are the returns of each asset.

• Portfolio Risk: The overall risk of a portfolio is not simply the weighted average of the
individual assets' risks. The correlation between asset returns plays a key role in
determining the total risk.

o Formula for Portfolio Risk (Standard Deviation):

σp=w12σ12+w22σ22+2w1w2Cov(R1,R2)\sigma_p = \sqrt{w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 +

2w_1w_2 \text{Cov}(R_1, R_2)}

where:

▪ σp\sigma_p is the portfolio standard deviation (risk),

 ▪ σ1,σ2\sigma_1, \sigma_2 are the standard deviations of individual assets,

▪ Cov(R1,R2)\text{Cov}(R_1, R_2) is the covariance between the returns of the

assets.

• Covariance: A measure of how two asset returns move together. If the covariance is
negative, the assets move in opposite directions, which is beneficial for diversification.

7. The Capital Asset Pricing Model (CAPM):

• The Capital Asset Pricing Model (CAPM) is a model that describes the relationship
between an asset's risk and its expected return.

• CAPM Formula:

E(Ri)=Rf+βi[E(Rm)−Rf]E(R_i) = R_f + \beta_i \left[ E(R_m) - R_f \right]

where:

o E(Ri)E(R_i) is the expected return of asset ii,

o RfR_f is the risk-free rate (e.g., the return on government bonds),

o βi\beta_i is the asset’s beta (a measure of the asset’s risk relative to the market),

o E(Rm)E(R_m) is the expected return of the market.

• Beta: A measure of an asset's volatility relative to the market. A beta greater than 1
indicates the asset is more volatile than the market, while a beta less than 1 indicates lower
volatility.

8. The Security Market Line (SML):

• The Security Market Line (SML) is a graphical representation of the CAPM, plotting the
relationship between an asset's expected return and its beta (systematic risk).

o The SML shows that assets with higher systematic risk (beta) should offer higher
expected returns to compensate investors for the increased risk.

o The slope of the SML represents the market risk premium, which is the additional
return expected from investing in the market as a whole rather than in risk-free
assets.

9. The Efficient Frontier:

• The efficient frontier is a curve that represents the set of portfolios that offer the highest
expected return for a given level of risk.

o Portfolios that lie below the efficient frontier are suboptimal, as they offer lower
returns for the same risk level or higher risk for the same return.

o Investors should aim to construct portfolios that lie on the efficient frontier.

10. The Risk-Return Trade-Off in Practice:

 • Investors must balance risk and return based on their personal risk tolerance, investment
horizon, and financial goals.

• In practice, investors often use a combination of assets (stocks, bonds, real estate, etc.) to
achieve the desired balance of risk and return.

• Understanding the diversification effect is critical, as it helps to reduce overall risk without
sacrificing too much return.

Key Points to Remember for MCQ-Style Questions:

• Risk and Return: Higher risk is usually associated with higher potential return, and lower
risk is associated with lower return.

• Expected Return: The average return expected from an asset, based on probabilities and
past performance.

• Systematic vs. Unsystematic Risk: Systematic risk affects the entire market, while
unsystematic risk is specific to individual assets.

• Diversification: The practice of combining assets to reduce overall risk by reducing

exposure to individual asset risks.

• Portfolio Risk: The risk of a portfolio is affected by the correlations between the assets in
the portfolio.

• Capital Asset Pricing Model (CAPM): Describes the relationship between expected return
and systematic risk (beta).

• Beta: A measure of an asset’s sensitivity to market risk.

• Security Market Line (SML): The graphical representation of CAPM, showing the
relationship between an asset’s expected return and its beta.

• Efficient Frontier: Represents the optimal portfolios that provide the highest return for a
given level of risk.
Slide contents:

Session 2: Introduction to Financial Markets

Benefits of Listing on the Stock Market

- Access to Capital: Companies raise funds by issuing shares for expansion or debt repayment.

- Liquidity: Publicly traded stocks allow easy buying and selling.

- Visibility and Prestige: Enhances credibility and attracts customers/partners.

- Employee Incentives: Stock options align employee interests with company performance.

- Market Valuation: Provides a market-determined value useful for mergers/acquisitions.

- Regulatory Oversight: Improves corporate governance and transparency.

Stock Market Indices

- Definition: Statistical measures tracking a group of stocks' performance.

- Purpose: Snapshot of market health; benchmark for individual stocks.

- Examples: Dow Jones, S&P 500, NASDAQ, KSE 100.

Types of Indices

1. Market Capitalization-Weighted: Reflects companies' market values (e.g., S&P 500, NASDAQ).

2. Price-Weighted: Based on stock prices (e.g., DJIA, Nikkei 225).

3. Equal-Weighted: All stocks have equal influence (e.g., S&P 500 Equal Weight).

4. Sector Indices: Track specific industries (e.g., NASDAQ-100 Tech, S&P Healthcare).

5. National Indices: Measure country-specific markets (e.g., CAC 40, DAX).

6. Global Indices: Cover multiple countries (e.g., MSCI World, FTSE All-World).

Stock Valuation Methods

- Dividend Discount Model (DDM): Values stocks based on expected dividends.

- Zero-growth formula: \( P = D/r \).

- Gordon Growth Model (GGM): For constant-growth dividends.

- Formula: \( P = D_0 \times (1 + g) / (r - g) \).

- CAPM: Links risk to expected return.

- Formula: \( E(R_i) = R_f + \beta_i (E(R_m) - R_f) \).

- P/E Ratio: Compares stock price to earnings per share (EPS).

- High P/E may indicate overvaluation or growth expectations.

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Session 3: Market Efficiency

Efficient Market Hypothesis (EMH)

- Weak-Form Efficiency: Prices reflect all past trading data; technical analysis ineffective.

- Semi-Strong Efficiency: Prices include all public information; fundamental analysis ineffective.

- Strong-Form Efficiency: Prices reflect all public and private information; insiders cannot profit.

Evidence For EMH

1. Analysts/mutual funds rarely outperform the market.

2. Stock prices adjust quickly to new public information (Event Study Analysis).

3. Prices follow a random walk; past prices don’t predict future prices.

4. Technical analysis lacks consistent predictive power.

Evidence Against EMH

1. Small-Firm Effect: Smaller firms outperform larger ones.

2. Neglected-Firm Effect: Lesser-known stocks outperform due to information inefficiencies.

3. January Effect: Abnormal returns in January due to tax-related selling.

4. Market Overreaction: Prices overreact to news and correct slowly.

5. Excessive Volatility: Prices fluctuate more than justified by fundamentals.

6. Post-Earnings Drift: Prices adjust slowly to earnings announcements.

Practical Implications

- Stock Tips: Skepticism advised; prices adjust rapidly to new information.

- Fundamental Analysis: Useful but should be combined with technical analysis.

- Investment Horizon: Long-term investing (value investing) is more reliable than short-term.

- Trading Frequency: Avoid excessive trading due to high transaction costs.

- Mutual Funds: Choose low-fee, no-load funds for cost efficiency.

Behavioral Finance

- Challenges EMH by highlighting irrational behaviors (e.g., herd behavior, bubbles/crashes).

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Session 4: Interest Rates and Valuation

Interest Rates

- Definition: Cost of borrowing, expressed as a percentage of principal.

- Types: Fixed vs. variable rates; central bank rates influence economy-wide borrowing costs.

- Economic Impact: High rates slow growth; low rates stimulate borrowing/investment.

- Inflation Control: Central banks adjust rates to manage inflation.

Present Value (PV)

- Concept: Future cash flows are discounted to reflect their current worth.

- Formula: \( PV = \frac{\text{Future Cash Flow}}{(1 + i)^n} \).

- Application: Evaluates debt instruments based on cash flow timing/amount.

Yield to Maturity (YTM)

- Definition: Interest rate equating bond price to present value of future payments.

- Example: For a bond priced at $900 with a $1,000 face value, YTM = 11.11%.
- Price-Yield Relationship: Inverse; bond prices fall as YTM rises.

Real vs. Nominal Interest Rates

- Real Rate: Adjusted for inflation (\( i_r = i - \pi^e \)).

- Implications: Negative real rates discourage lending (e.g., Japan’s negative T-bill rates).

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Key Takeaways

- Stock Markets: Provide capital, liquidity, and valuation benefits.

- Indices: Serve as benchmarks; vary by weighting methodology and scope.

- Valuation: Models like DDM, CAPM, and P/E ratios guide investment decisions.

- Market Efficiency: Prices reflect information to varying degrees; anomalies exist.

- Interest Rates: Central to economic stability; real rates account for inflation.

- Behavioral Finance: Explains deviations from rational market behavior.

Session 5: Risk, Term Structure, and Money Markets

I. Risk Structure of Interest Rates

Definition: Relationship among interest rates for bonds of similar maturity but different risk levels.

Key Risk Factors:

1. Default Risk:

- Risk that issuer fails to make payments.

- Default-free bonds: U.S. Treasuries (backed by taxation/money printing).

- Risk premium: Additional yield demanded for risky bonds (e.g., corporate bonds).

2. Liquidity Risk:
 - Ease of converting bonds to cash without loss.

- Government bonds are highly liquid; corporate bonds less so.

3. Information Costs:

- Higher costs (e.g., for unknown issuers) increase yields.

- Treasuries have minimal information costs.

4. Tax Considerations:

- Tax-exempt bonds (e.g., municipals) offer lower pre-tax yields.

Credit Ratings (Moody’s/S&P):

- High-grade (Aaa/AAA): Microsoft, J&J (low default risk).

- Speculative (B/D): Netflix, Sears (high default risk).

Lower ratings → Higher yields.

Market Behavior:

- Recessions: Risk premiums spike for low-rated bonds.

- Crises: "Flight to quality" to government bonds widens spreads.

---

II. Term Structure of Interest Rates

Definition: Relationship among interest rates for bonds of different maturities but similar risk.

Yield Curve:

- Normal: Upward-sloping (long-term yields > short-term).

- Inverted: Downward-sloping (predicts recessions).

- Flat: Neutral expectations.

Theories:

1. Liquidity Premium Theory:

- Long-term yields = Expected future rates + Liquidity premium.

- Investors demand extra yield for holding longer-term bonds due to:

- Interest rate risk.

- Inflation uncertainty.

2. Expectations Theory:

- Yield curve reflects market expectations of future rates.

Economic Indicators:

- Steep curve: Expectation of rising inflation/growth.

- Inverted curve: Predicts economic slowdown (e.g., U.S. 2008 crisis).

Example: Pakistan’s Yield Curve (2024-2025):

- March 2024: Upward-sloping (3M: 16.7%, 10Y: 14.23%).

- March 2025: Flattened (3M: 12.05%, 10Y: 11.41%), signaling potential rate cuts.

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III. Money Markets

Definition: Short-term (<1 year) borrowing/lending markets.

Key Instruments:

1. Treasury Bills (T-Bills):

- Risk-free, issued at discount (e.g., U.S. T-Bills).

2. Commercial Paper:

- Unsecured corporate debt (higher credit risk).

3. Certificates of Deposit (CDs):

 - Bank-issued time deposits.

4. Federal Funds:

- Overnight interbank loans; rate set by central banks.

Roles:

- Liquidity management: Banks adjust reserves.

- Monetary policy: Central banks influence rates (e.g., Fed Funds Rate).

- Benchmarking: Short-term rates guide pricing of other financial products.

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Session 6: Foreign Exchange (FX) Markets

I. Exchange Rate Basics

Spot vs. Forward Rates:

- Spot: Immediate exchange at current rate.

- Forward: Future exchange at agreed rate (hedges FX risk).

Determinants (Long Run):

1. Purchasing Power Parity (PPP):

- Exchange rates adjust to equalize price levels (e.g., Big Mac Index).

- Limitations: Non-traded goods, trade barriers.

2. Key Factors:

- Price levels ↑ → Currency depreciates.

- Productivity ↑ → Currency appreciates.

- Trade barriers ↑ → Currency appreciates.

Determinants (Short Run):

- Interest rates:
 - Higher domestic rates → Currency appreciates (if real rates rise).

- Higher inflation expectations → Currency depreciates.

- Speculative flows: Carry trades exploit interest differentials.

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II. Exchange Rate Regimes

1. Fixed: Pegged to another currency (e.g., Saudi Riyal to USD).

2. Floating: Market-determined (e.g., USD, EUR).

3. Managed Float: Central bank intervenes occasionally (e.g., PKR).

Carry Trade Example:

- Borrow in JPY (low rate), invest in AUD (high rate).

- Risks: Exchange rate volatility (AUD/JPY swings).

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III. Practical Applications

- Inverted Yield Curve: Predicts recessions (investors flee to long-term bonds).

- PPP Deviations: Explain currency misalignments (e.g., Argentine peso).

- Central Bank Policies: Rate hikes can attract capital flows, appreciating currency.

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Key Takeaways

- Risk vs. Return: Higher default/liquidity risks demand higher yields.

- Yield Curve: Shape signals economic expectations.

- FX Markets: Rates driven by PPP, interest differentials, and speculation.

- Policy Impact: Central banks influence short-term rates and FX values.