Financial Markets and Institutions

Units

1. 1

   An overview of the financial system

   4 lessons

   1. Functions of the financial systemTrace how funds flow from savers to borrowers directly through markets and indirectly through intermediaries, and show with numbers why this channeling raises economic welfare and how pooling shares risk.
   2. Types of financial marketsClassify financial markets by the claim traded (debt or equity), by whether the security is new or already issued (primary or secondary), by how trading is organized (exchange or over the counter), and by maturity (money or capital).
   3. Financial intermediariesExplain with numbers how intermediaries cut transaction costs and share risk, how a bank balance sheet transforms assets and absorbs losses, and sort the main types: depository institutions, insurers, pension funds, mutual funds and finance companies.
   4. Asymmetric informationDistinguish adverse selection from moral hazard and explain how screening, net worth, collateral, monitoring and regulation can reduce information problems in lending.
2. 2

   Money and interest rates

   4 lessons

   1. Money and the monetary aggregatesDefine money by its three functions, explain why money replaces barter, trace how payment forms have changed, and compute M1 and M2 from their components.
   2. Measuring interest ratesCompute the yield to maturity of a simple loan, a fixed-payment loan, a coupon bond, a discount bond and a perpetuity, and show that a bond's price and its yield move in opposite directions.
   3. Real interest rates and returnsSeparate the yield to maturity from the rate of return on holding a bond for a year, compute the return from the coupon and the capital gain, and convert nominal rates to real rates with the Fisher equation.
   4. Supply and demand for bondsFind the equilibrium bond price and interest rate from the demand and supply of bonds, predict how wealth, expected inflation and other factors shift each curve, and use liquidity preference to see how the supply of money sets the interest rate.
3. 3

   The risk and term structure of interest rates

   4 lessons

   1. The risk structure of interest ratesExplains default risk premiums, credit ratings, liquidity and the tax exemption of municipal bonds, using a chart of corporate, Treasury and municipal yields.
   2. Yield curvesDraws upward, flat and inverted yield curves and states the three facts a theory must explain: comovement, slope with short rates, and usually upward slope.
   3. Expectations and liquidity premium theoriesComputes long rates as averages of expected short rates, adds a term premium under the liquidity premium theory, and contrasts segmented markets theory.
   4. The yield curve as a forecasterInfers expected future short rates from the yield curve and explains why inverted curves have preceded recessions.
4. 4

   Central banks and monetary policy

   4 lessons

   1. The Federal Reserve SystemDescribes the Fed's Board of Governors, regional banks and FOMC, central bank independence, and comparisons with the ECB and other central banks.
   2. The money supply processExplains the monetary base, reserves, the simple and full money multiplier m = (1 + c)/(r + e + c), and T account changes from open market purchases.
   3. Tools of monetary policyExplains open market operations, discount lending, reserve requirements, interest on reserves, the federal funds market diagram and quantitative easing.
   4. Monetary policy strategyExplains price stability goals, the dual mandate, inflation targeting, the Taylor rule with a worked calculation, and the zero lower bound.
5. 5

   Banking and the management of financial institutions

   4 lessons

   1. The bank balance sheetBuilds a bank balance sheet of reserves, securities, loans, deposits, borrowings and bank capital, with T accounts for deposit and loan flows.
   2. Liquidity, asset and capital managementExplains liquidity, asset, liability and capital adequacy management, the tradeoff between ROA and ROE via the equity multiplier, and credit risk management.
   3. Interest rate risk and gap analysisMeasures a bank's interest rate risk with income gap analysis and duration gap analysis, with numerical examples of rising rates.
   4. Insurance, pension and investment firmsExplains insurance companies, pension funds, mutual funds, hedge funds, private equity and investment banks, and how their risks differ from banks.
6. 6

   Financial regulation

   4 lessons

   1. Deposit insurance and the safety netExplains bank runs, deposit insurance, lender of last resort, too big to fail and the moral hazard the safety net creates.
   2. Capital requirements and BaselExplains leverage ratios, risk-weighted assets and the Basel I, II and III accords, including capital buffers and liquidity coverage ratios.
   3. Regulatory history and reformsTraces regulation from Glass-Steagall and Regulation Q through the savings and loan crisis and Gramm-Leach-Bliley to Dodd-Frank and the Volcker rule.
   4. Shadow bankingExplains money market funds, repos, securitization vehicles and other shadow banks, maturity transformation outside banks, and regulatory arbitrage.
7. 7

   Money and bond markets

   4 lessons

   1. Money market instrumentsExplains Treasury bills with discount yield calculations, federal funds, repurchase agreements, commercial paper and negotiable CDs.
   2. Treasury, municipal and corporate bondsCompares Treasury notes and bonds, TIPS, municipal general obligation and revenue bonds, and corporate bonds with covenants and ratings.
   3. Mortgage markets and securitizationExplains mortgage types, Fannie Mae and Freddie Mac, mortgage-backed securities, pass-throughs and CDOs, drawn as a securitization flow diagram.
   4. Bond market trading and pricingExplains Treasury auctions, primary dealers, bond pricing conventions and how the bond market sets benchmark rates for the economy.
8. 8

   Stock and foreign exchange markets

   4 lessons

   1. Stock marketsExplains exchanges and electronic markets, market makers, indexes, IPOs and the role of investment banks, and stock valuation with the Gordon model.
   2. The foreign exchange marketExplains spot and forward exchange rates, appreciation and depreciation, and how a currency's value affects export and import prices.
   3. Exchange rates in the long runExplains the law of one price and purchasing power parity, and how relative prices, tariffs, preferences and productivity move exchange rates.
   4. Interest parity and short-run exchange ratesDerives interest parity, i_D = i_F - expected appreciation, and uses it to show how interest rate changes move exchange rates in the short run.
9. 9

   Derivatives markets

   4 lessons

   1. Forward and futures marketsExplains forward and futures contracts, standardization, margin and marking to market, and how a bank hedges interest rate risk with Treasury futures.
   2. Options marketsExplains calls and puts, premiums, payoff diagrams, and how financial institutions use options to hedge.
   3. Swaps and credit derivativesExplains interest rate and currency swaps with cash flows, credit default swaps, and their role in hedging and in the AIG failure.
   4. Risks of derivativesExplains counterparty risk, leverage, notional versus market value, central clearing after Dodd-Frank, and episodes such as Barings and Long-Term Capital Management.
10. 10

    Financial crises

    4 lessons

    1. Dynamics of financial crisesDiagrams Mishkin's three stages: initiation (credit boom and bust, asset bubble, uncertainty), banking crisis, and debt deflation, linked by asymmetric information.
    2. The Great DepressionExplains the 1929 crash, bank panics of 1930 to 1933, Friedman and Schwartz on Fed failure, debt deflation and the regulatory response.
    3. The global financial crisis of 2007 to 2009Traces subprime mortgages, securitization, the housing bust, Lehman Brothers, the run on shadow banks and the Fed and Treasury response (TARP, QE).
    4. Emerging market and euro crisesExplains crises in Mexico 1994, East Asia 1997, Argentina 2001 and the European sovereign debt crisis, including currency mismatch and sudden stops.