TEXT AND REFERENCE MATERIAL &
FIVE
PARTS OF THE FINANCIAL SYSTEM
The Primary textbook for the course will be
“Money,
Banking and Financial Markets” by Stephan G. Cecchetti
International Edition, McGraw Hill Publishers, ISBN
0-07-111565-X”
Reference books will be
“The
Economics of Money, Banking and Financial Markets”, by Fredrick S. Mishkin
7th Edition
Addison Wesley Longman Publishers
“Principles
of Money, Banking and Financial Markets” by Lawrence S. Ritter, Willaim L. Silber and
Gregory F. Udell, Addison Wesley Longman Publishers
Course Contents
Money
and the Financial System
Money
and the Payments System
Financial
Instruments, Financial Markets, and Financial Institutions
Interest
rate, financial instruments and financial markets
Future
Value, Present Value and Interest Rates
Understanding
Risk
Bonds, Pricing and Determination of Interest Rates
The
Risk and Term Structure of Interest Rates
Stocks,
Stock Markets and Market Efficiency
Financial
Institutions
Economics
of Financial Intermediation
Depositary
Institutions: Banks and bank Management
Financial
Industry Structure
Regulating
the financial system
Central
Banks, Monetary Policy and Financial stability
Structure
of central banks
Balance
sheet and Money Supply process
Monetary
policy
Exchange
rate policy
Modern
Monetary Economics
Money
growth and Money Demand
Aggregate
demand
Business
Cycle
Output
and inflation in the short run
Money
and Banking in Islam
Monetary
and financial policy and structure for an Interest-free economy
Islamic
Banking in the contemporary world
Five Parts of the Financial System
Money
Financial
Instruments
Financial
Markets
Financial
Institutions
Central
Banks
1. Money
To
pay for purchases
To store wealth
Evolved
from gold and silver coins to paper money to today’s electronic funds transfers
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Traditional
Paycheck system vs. ATM Withdrawals and Mailed transactions vs. E-banking
2. Financial Instruments
To
transfer wealth from savers to borrowers
To
transfer risk to those best equipped to bear it.
Once
investing was an activity reserved for the wealthy
Costly
individual stock transactions through stockbrokers
Information
collection was not so easy
Now,
small investors have the opportunity to purchase shares in “mutual funds.”
3. Financial Markets
To
buy and sell financial instruments quickly and cheaply
Evolved
from coffeehouses to trading places (Stock exchanges) to electronic networks
Transactions
are much more cheaper now
Markets
offer a broader array of financial instruments than were available even 50
years ago
4. Financial Institutions
Provide
access to financial markets
Banks
evolved from Vaults and developed into deposits- and loans-agency
Today’s
banks are more like financial supermarkets offering a huge assortment of
financial
products and services for sale.
Access
to financial markets
Insurance
Home-
and car-loans
Consumer
credit
Investment
advice
5. Central Banks
Monitors
financial Institutions
Stabilizes
the Economy
Initiated
by Monarchs to finance the wars
The
govt. treasuries have evolved into the modern central bank
Control
the availability of money and credit in such a way as to ensure
Low
inflation,
High
growth, and
The
stability of the financial system
State
Bank of Pakistan
www.sbp.org.pk
Summary
Five Parts of the Financial System
Money
Financial
Instruments
Financial
Markets
Financial
Institutions
Central
Banks
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Lesson 2
FIVE CORE PRINCIPLES OF MONEY AND BANKING
1. Time has Value
Time
affects the value of financial instruments.
Interest
payments exist because of time properties of financial instruments
Example
At 6%
interest rate, 4 year loan of $10,000 for a car
Requires
48 monthly installments of $235 each
Total
repayment = $235 x 48 = $11,280
$11,280
> $10,000 (Total
repayment) (Amount of loan)
Reason:
you are compensating the lender for the time during which you use the funds
2. Risk Requires Compensation
In a
world of uncertainty, individuals will accept risk only if they are compensated
in some form.
The
world is filled with uncertainty; some possibilities are welcome and some are
not
To
deal effectively with risk we must consider the full range of possibilities:
Eliminate
some risks,
Reduce
others,
Pay
someone else to assume particularly onerous risks, and
Just
live with what’s left
Investors
must be paid to assume risk, and the higher the risk the higher the required
payment
Car
insurance is an example of paying for someone else to shoulder a risk you don’t
want to take.
Both parties to the transaction benefit
Drivers
are sure of compensation in the event of an accident
The
insurance companies make profit by pooling the insurance premiums and investing
them
Now
we can understand the valuation of a broad set of financial instruments
E.g.,
lenders charge higher rates if there is a chance the borrower will not repay.
3. Information is the basis for decisions
We
collect information before making decisions
The
more important the decision the more information we collect
The
collection and processing of information is the basis of foundation of the financial
system.
Some
transactions are arranged so that information is NOT needed
Stock
exchanges are organized to eliminate the need for costly information gathering
and thus
facilitate the exchange of securities
One
way or another, information is the key to the financial system
4. Markets set prices and allocate resources
Markets
are the core of the economic system; the place, physical or virtual,
Where
buyers and sellers meet
Where
firms go to issue stocks and bonds,
Where
individuals go to purchase assets
Financial
markets are essential to the economy,
Channeling
its resources
Minimizing
the cost of gathering information
Making
transactions
Well-developed
financial markets are a necessary precondition for healthy economic growth
The
role of setting prices and allocation of resources makes the markets vital
sources of
information
Markets
provide the basis for the allocation of capital by attaching prices to
different stocks or
bonds
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Financial
markets require rules to operate properly and authorities to police them
The
role of the govt. is to ensure investor protection
Investor
will only participate if they perceive the markets are fair
5. Stability improves welfare
To
reduce risk, the volatility must be reduced
Govt.
policymakers play pivotal role in reducing some risks
A
stable economy reduces risk and improves everyone's welfare.
By
stabilizing the economy as whole monetary policymakers eliminate risks that
individuals can’t
and so improve everyone’s welfare in the process.
Stabilizing
the economy is the primary function of central banks
A
stable economy grows faster than an unstable one
Financial System Promotes Economic Efficiency
The
Financial System makes it Easier to Trade
Facilitate
Payments - bank checking accounts
Channel
Funds from Savers to Borrowers
Enable
Risk Sharing - Classic examples are insurance and forward markets
1. Facilitate Payments
Cash
transactions (Trade “value for value”). Could hold a lot of cash on hand to pay
for things
Financial
intermediaries provide checking accounts, credit cards, debit cards, ATMs
Make
transactions easier.
2. Channel Funds from Savers to Borrowers
Lending
is a form of trade (Trade “value for a promise”)
Give
up purchasing power today in exchange for purchasing power in the future.
Savers:
have more funds than they currently need; would like to earn capital income
Borrowers:
need more funds than they currently have; willing and able to repay with
interest in the
future.
Why
is this important?
A) Allows those without funds to
exploit profitable investment opportunities.
Commercial
loans to growing businesses;
Venture
capital;
Student
loans (investment in human capital);
Investment
in physical capital and new products/processes to promote economic growth
B) Financial System allows the timing
of income and expenditures to be decoupled.
Household
earning potential starts low, grows rapidly until the mid 50s, and then declines
with age.
Financial
system allows households to borrow when young to prop up consumption (house
loans,
car loans), repay and then accumulate wealth during
middle age, then live off wealth during
retirement.
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Figure: Channel Funds from Savers to Borrowers
3. Enable Risk Sharing
The
world is an uncertain place. The financial system allows trade in risk. (Trade
“value for a
promise”)
Two
principal forms of trade in risk are insurance and forward contracts.
Suppose
everyone has a 1/1000 chance of dying by age 40 and one would need $1 million
to
replace lost income to provide for their family.
What
are your options to address this risk?
Summary
Five
Core Principles of Money and Banking
Time
has Value
Risk
Requires Compensation
Information
is the basis for decisions
Markets
set prices and allocate resources
Stability
improves welfare
Financial
System Promotes Economic Efficiency
Facilitate
Payments
Channel
Funds from Savers to Borrowers
Enable
Risk Sharing
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Consumption
Income
$
TimRetirement e
Begins
Dissavings Dissavings
Savings
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Lesson 3
MONEY & THE PAYMENT SYSTEM
Money
Characteristics
of Money
Liquidity
Payment
system
Commodity
vs. Fiat Money
Cheques
Other
forms of payments
Future
of Money
Money
Money
is an asset that is generally accepted as payment for goods and services or
repayment of
debt.
Not
the same as wealth or income
Money
is a component of wealth that is held in a readily- spend able form
Money
is made up of
Coin
and currency
Chequing
account balances
Other
assets that can be turned into cash or demand deposits nearly instantaneously,
without risk
or cost (liquid wealth)
Distinctions among Money, Wealth, and Income
While
money, income and wealth are all measured in some currency unit, they differ
significantly in
their meaning.
People
have money if they have large amounts of currency or big bank accounts at a
point in time.
(Stock variable)
Someone
earns income (not money) from work or investments over a period of time. (Flow
variable)
People
have wealth if they have assets that can be converted into more currency than
is necessary
to pay their debts at a point in time. (Stock variable)
Characteristics of Money
A
means of payment
A
unit of Account
A
Store of Value
A means of payment
The
primary use of money is as a means of payment.
Money
is accepted in economic exchanges.
Barter
is an alternative to using money but it doesn’t work very well.
Barter
requires a “double coincidence of wants,” meaning that in order for trade to
take place both
parties must want what the other has.
Money
finalizes payments so that buyers and sellers have no further claim on each
other.
As
economies have become more complex and physically dispersed the need for money
has grown.
Just
as the division of labor and specialization allow for efficient production,
money allows for
efficient exchange.
A unit of Account
We
measure value using rupees and paisas.
Money
is the unit of account that we use to quote prices and record debts.
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Money
can be referred to as a standard of value.
Using
money makes comparisons of value easy
Under
barter the general formula for n goods, we will have n (n - 1) / 2 prices
Two
goods 1 price
3
goods 3 prices
100
goods 4,950 prices
10,000
goods 50 million prices
A Store of Value
For
money to function as a means of payment it has to be a store of value too
because it must
retain its worth from day to day.
The
means of payment has to be durable and capable of transferring purchasing power
from one
day to the next.
Money
is not the only store of value; wealth can be held in a number of other forms.
Other
stores of value can be preferable to money because they pay interest or deliver
other services.
However,
we hold money because it is liquid, meaning that we can use it to make purchases.
Liquidity
is a measure of the ease with which an asset can be turned into a means of
payment
(namely money).
The
more costly an asset is to turn into money, the less liquid it is.
Constantly
transforming assets into money every time we wish to make a purchase would be
extremely costly; hence we hold money
Liquidity
Liquidity
is a measure of the ease an asset can be turned into a means of payment, namely
money
An
asset is liquid if it can be easily converted into money and illiquid if it is
costly to convert.
Cash
is perfectly liquid.
Stocks
and bonds are somewhat less liquid.
Land
is least liquid.
The Payments System
The
payment system is a web of arrangements that allows for the exchange of goods
and services,
as well as assets among different people
Money
is at the heart of payment system!
Types of Money
Commodity
Money – Things that have intrinsic value
Fiat
Money – Value comes from government decree (or fiat)
Commodity Money
The
first means of payment were things with intrinsic value like silk or salt.
Successful
commodity monies had the following characteristics
They
were usable in some form by most people;
They
could be made into standardized quantities;
They
were durable;
They
had high value relative to their weight and size so that they were easily
transportable; and
They
were divisible into small units so that they were easy to trade
For
most of human history, gold has been the most common commodity money
Fiat Money
Today
we use paper money that is fiat money, meaning that its value comes from
government
decree (or fiat).
A
note costs about 0.04% its worth to produce.
These
notes are accepted as payment for goods or in settlement of debts for two
reasons:
We
take them because we believe we can use them in the future.
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The
law says we must accept them; that is what the words “legal tender” printed on
the note
means.
As
long as the government stands behind its paper money, and doesn’t issue too
much of it, we will
use it. In the end, money is about trust.
Fiat or Commodity Money?
Does
money need to be backed by a commodity at all?
The
logical answer to this question is no.
If
the monetary system is stable and functions effectively, “backing” is
expensive, inconvenient, and
unnecessary.
Today,
money is only backed by confidence that government will responsibly limit the
quantity of
money to ensure that money in circulation will hold its
value.
Advantages of Fiat Money
Fewer
resources are used to produce money.
The
quantity of money in circulation can be determined by rational human judgment
rather than by
discovering further mineral deposits—like gold or
diamonds
Disadvantage
A
corrupt or pressured government might issue excessive amounts of money, thereby
unleashing
severe inflation.
Cheques
Cheques
are another way of paying for things, but
They
are not legal tender
They
are not even money.
Cheques
are instructions to the bank to take funds from your account and transfer those
funds to
the person or firm whose name is written in the “Pay to
the Order of” line.
When
you give someone a Cheque in exchange for a good or service, it is not a final
payment;
A
series of transactions must still take place that lead to the final payment
Following
are the steps in the process
1- You hand a paper cheque from your
bank to a merchant in exchange for some good
2- The merchant deposits the cheque
into merchant’s bank and merchant’s account is credited
3- The merchant’s bank sends the cheque
to the local central bank
4- The Central Bank
(a) Credits the merchant’s bank’s
reserve account
(b) Debits your bank’s reserve account
(This step involves money)
5- The Central Bank returns the cheque
to your bank
6- Your bank debits your Chequing
account by the amount of the cheque
The
whole process is time consuming and expensive;
Though
cheque volumes have begun to fall, paper Cheques are still with us because a
cancelled
cheque is legal proof of payment
Other Forms of Payments
Debit
Cards
Credit
Cards
Electronic
Funds transfers
Stored
Value Cards
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Lesson 4
OTHER FORMS OF PAYMENTS
Debit Card
The
money in your account is used for payments
Works
like a cheque and there is usually a fee for the transaction
Credit card
It is
a promise by a bank to lend the cardholder money with which to make purchases.
When
the card is used to buy merchandise the seller receives payment immediately
The
money that is used for payment does not belong to the buyer
Rather,
the bank makes the payment, creating a loan that the buyer must repay.
So,
they do not represent money; rather, they represent access to someone else’s
money
Electronic Funds Transfer
Move
funds directly from one account to another.
Banks
use these transfers to handle transactions among themselves
Individuals
may be familiar with such transfers through direct deposit of their paycheques
and the
payment of their utility bills, etc
E-money
Used
for purchases on the Internet.
You
open an account by transferring funds to the issuer of the e-money
When
shopping online, instruct the issuer to send your e-money to the merchant
It is
really a form of private money.
Stored-value card
Retail
businesses are experimenting with new forms of electronic payment
Prepaid
cellular cards, Internet scratch cards, calling cards etc
The Future of Money
The
time is rapidly approaching when safe and secure systems for payment will use
virtually no
money at all
We
will also likely see
Fewer
“varieties” of currency, (a sort of standardization of money) and
A
dramatic reduction in the number of units of account
Money
as a store of value is clearly on the way out as many financial instruments
have become
highly liquid.
Measuring Money
Different
Definitions of money based upon degree of liquidity. Federal Reserve System
defines
monetary aggregates.
Changes
in the amount of money in the economy are related to changes in interest rates,
economic
growth, and most important, inflation.
Inflation
is a sustained rise in the general price level
With
inflation you need more money to buy the same basket of goods because it costs
more.
Inflation
makes money less valuable
The
primary cause of inflation is the issuance of too much money
Because
money growth is related to inflation we need to be able to measure how much
money is
circulating
Money
as a means of payments
We
measure the quantity of money as the quantity of currency in circulation – an
unrealistically
limited measure, since there are other ways of payments
Alternatively,
broadly categorize financial assets and sort them by the degree of liquidity
Sort
them by the ease with which they can be converted into a means of payments
Arrange
them from most liquid to least liquid
Draw
a line and include everything on one side of the line in the measure of the
money
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Where
to draw the line?
In
reality, we draw line at different places and compute several measures of money
called the
monetary aggregates
M1,
M2, and M3
M1 is
the narrowest definition of money and includes only currency and various
deposit accounts
on which people can write Cheques.
Currency
in the hands of the public,
Traveler’s
Cheques,
Demand
deposits and
Other
chequeable deposits
M2
includes everything that is in M1 plus assets that cannot be used directly as a
means of payment
and are difficult to turn into currency quickly,
Small-denomination
time deposits,
Money
market deposit accounts,
Money
market mutual fund shares
M2 is
the most commonly quoted monetary aggregate since its movements are most
closely related
to interest rate and economic growth.
M3
adds to M2 other assets that are important to large institutions
Large-denomination
time deposits,
Institutional
money market mutual fund shares,
Repurchase
agreements and
Eurodollars
_ Symbol Assets included
C Currency
M1 C + demand deposits, travelers’ Cheques,
other chequeable deposits
M2 M1 + small time deposits, savings deposits,
money market mutual funds, money market deposit accounts
M3 M2 + large time deposits, repurchase agreements,
institutional money market
mutual fund balances
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Monetary Aggregates Figures in millions as of March 2005
1. Currency issued 711,997
2. Currency held by SBP 3,188
3. Currency in tills of Scheduled Banks
43,914
4. Currency in circulation (1 – 2 – 3)
664,895
5. Scheduled Banks demand deposits
93,272
6. Other Deposits with SBP 4,826
7. M1 (4+5+6) 1,602,423
8. Scheduled Banks Time Deposits
1,037,678
9. Resident Foreign Currency Deposits
172,074
10. Total Monetary Assets (M2) 2,812,175
11. M3 3,833,686
Source: State Bank of Pakistan
Table : The Monetary Aggregates
Monetary Aggregates Value as of August 2004 (U.S. $ billion)
M1= Currency in the hands of the
public
+ Traveler’s checks
+ Demand deposits
+ Other checkable deposits
Total M1
686.2
7.6
315.3
328.5
1,337.6
M2=M1
+ Small-denomination time deposits
+ Savings deposits including money market deposit
accounts
+ Retail money market mutual fund shares
Total M2
794.7
3415.3
735.5
6,283.1
M3=M2
+ Large-denomination time deposits
+ Institutional money market mutual fund shares
+ Repurchase agreements
+ Eurodollars
Total M3
1,036.3
1,104.7
516.6
344.5
9,285.2
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Figure:
Growth Rates in Monetary Aggregates
-5
0
5
10
15
20
25
30
35
40
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
M1
M2
M3
0
5
10
15
20
25
30
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
Years
%
Measures of Inflation
Fixed-weight
Index - CPI
Deflator
– GDP or Personal Consumption Expenditure Deflator
Consumer Price Index (CPI)
Measure
of the overall level of prices used to
Track
changes in the typical household’s cost of living
Allow
comparisons of dollar figures from different years
Survey
consumers to determine composition of the typical consumer’s “basket” of goods.
Every
month, collect data on prices of all items in the basket; compute cost of
basket
CPI
in any month equals
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Figure:
Money Growth and Inflation
12
Cost of
basket in that month
100
Cost of
basket in base period
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Example:
The basket contains 20 pizzas and 10 compact discs.
Prices
Years Pizza CDs
2002 $10 $15
2003 $11 $15
2004 $12 $16
2005 $13 $15
From this table, we can calculate the inflation rate as:
Years Cost of Basket CPI Inflation rate
2002 $350 100.0 n.a.
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5%
GDP Deflator
The GDP deflator, also called the implicit price deflator
for GDP, measures the price of output relative to
its price in the base year. It reflects what’s happening
to the overall level of prices in the economy
GDP Deflator = (Nominal GDP / Real GDP) ×100
Years Nom. GDP Real GDP GDP Deflator Inflation Rate
2001 Rs46, 200 Rs46, 200 100.0 n.a.
2002 51,400 50,000 102.8 2.8%
2003 58,300 52,000 112.1 9.1%
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Lesson 5
FINANCIAL INTERMEDIARIES
Financial
Intermediaries
Financial
Instruments
Uses
Characteristics
Value
Examples
Financial Intermediaries
The informal
arrangements that were the mainstay of the financial system centuries ago have
since
given way to the formal financial instruments of the
modern world
Today,
the international financial system exists to facilitate the design, sale, and
exchange of a broad
set of contracts with a very specific set of
characteristics.
We
obtain the financial resources we need from this system in two ways:
Directly
from lenders and
Indirectly
from financial institutions called financial intermediaries.
Indirect Finance
A
financial institution (like a bank) borrows from the lender and then provides
funds to the
borrower.
If
someone borrows money to buy a car, the car becomes his or her asset and the
loan a liability.
Direct Finance
Borrowers
sell securities directly to lenders in the financial markets.
Governments
and corporations finance their activities this way
The
securities become assets to the lenders who buy them and liabilities to the
borrower who sells
them
Financial and Economic Development
Financial
development is inextricably linked to economic growth
o There aren’t any rich countries that
have very low levels of financial development.
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Figure: Financial and Economic Development
Financial Instruments
A
financial instrument is the written legal obligation of one party to transfer
something of value –
usually money – to another party at some future date,
under certain conditions, such as stocks,
loans, or insurance.
Written
legal obligation means that it is subject to government enforcement;
The
enforceability of the obligation is an important feature of a financial
instrument.
The
“party” referred to can be a person, company, or government
The
future date can be specified or can be when some event occurs
Financial
instruments generally specify a number of possible contingencies under which
one party
is required to make a payment to another
Stocks,
loans, and insurance are all examples of financial instruments
Uses of Financial Instruments
1. Means of Payment Purchase of Goods
or Services
2. Store of Value Transfer of
Purchasing Power into the future
3. Transfer of Risk Transfer of risk
from one person or company to another
Characteristics of Financial Instruments
Standardization
Standardized
agreements are used in order to overcome the potential costs of complexity
Because
of standardization, most of the financial instruments that we encounter on a
day-to-day
basis are very homogeneous
Communicate
Information
Summarize
certain essential information about the issuer
Designed
to handle the problem of “asymmetric information”,
Borrowers
have some information that they don’t disclose to lenders
Classes of Financial Instruments
Underlying
Instruments (Primary or Primitive Securities)
E.g.
Stocks and bonds
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Financial Development is
measured by the commonly
used ratio of broadly defined
money to GDP. Economic
development is measured by
the real GDP per capita.
0 50 100 150 200 250
5000
10000
15000
20000
Financial Market Development
25000
Per Capita Real GDP
Correlation=0.62
••
•
•••
•
•
•
•
•
••
•
•
•
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Derivative
Instruments
Value
and payoffs are “derived from” the behavior of the underlying instruments
Futures
and options
Value of Financial Instruments
Size
of the promised payment
People
will pay more for an instrument that obligates the issuer to pay the holder a
greater sum.
The
bigger the size of the promised payment, the more valuable the financial
instrument
When
the payment will be received
The
sooner the payment is made the more valuable is the promise to make it
The
likelihood the payment will be made (risk).
The
more likely it is that the payment will be made, the more valuable the
financial instrument
The
conditions under which the payment will be made
Payments
that are made when we need them most are more valuable than other payments
Value of Financial Instruments
1. Size Payments that are larger are more
valuable
2. Timing Payments that are made sooner
are more valuable
3. Likelihood Payments that are more
likely to be made are more valuable
4. Circumstances Payments that are made
when we need them most are more valuable
© Copyright Virtual University of Pakistan 16
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Lesson 6
FINANCIAL INSTRUMENTS & FINANCIAL MARKETS
Financial
Instruments
Examples
Financial
Markets
Roles
Structure
Financial
Institutions
Examples of Financial Instruments
Primarily Stores of Value
Bank
Loans
A
borrower obtains resources from a lender immediately in exchange for a promised
set of
payments in the future
Bonds
A
form of a loan, whereby in exchange for obtaining funds today a government or
corporation
promises to make payments in the future
Home
Mortgages
A
loan that is used to purchase real estate
The
real estate is collateral for the loan,
It is
a specific asset pledged by the borrower in order to protect the interests of
the lender in the
event of nonpayment.
If
payment is not made the lender can foreclose on the property.
Stocks
An
owner of a share owns a piece of the firm and is entitled to part of its
profits.
Primarily to transfer risk
Insurance
Contracts
The
primary purpose is to assure that payments will be made under particular (and
often rare)
circumstances
Futures
Contracts
An
agreement to exchange a fixed quantity of a commodity, such as wheat or corn,
or an asset,
such as a bond, at a fixed price on a set future date
It is
a derivative instrument since its value is based on the price of some other
asset.
It is
used to transfer the risk of price fluctuations from one party to another
Options
Derivative
instruments whose prices are based on the value of some underlying asset;
They
give the holder the right (but not the obligation) to purchase a fixed quantity
of the
underlying asset at a predetermined price at any time
during a specified period.
Financial Markets
Financial
Markets are the places where financial instruments are bought and sold.
Enable
both firms and individuals to find financing for their activities.
Promote
economic efficiency by ensuring that resources are placed at the disposal of
those who can
put them to best use.
When
they fail to function properly, resources are no longer channeled to their best
possible use
and the society suffers at large
© Copyright Virtual University of Pakistan 17
Money & Banking – MGT411 VU
Role of Financial Markets
Liquidity Ensure that owners of financial instruments can
buy and sell them cheaply and easily
Information Pool and communicate information about the
issuer of a financial instrument
Risk Sharing Provide individuals with a place to buy and
sell risk, sharing them with individuals
Financial markets need to be designed in a way that keeps
transactions costs low
Structure of Financial Markets
Primary vs. Secondary Markets
In a
primary market a borrower obtains funds from a lender by selling newly issued
securities.
Most
companies use an investment bank, which will determine a price and then
purchase the
company’s securities in preparation for resale to
clients; this is called underwriting.
In
the secondary markets people can buy and sell existing securities
Centralized Exchanges vs. Over-the-counter Markets
In
the centralized exchange (e.g. Karachi Stock Exchange www.kse.com.pk ),
the trading is done
“on the floor”
Over-the-counter (or OTC)
OTC
market are electronic networks of dealers who trade with one another from
wherever they are
located
Debt and Equity vs. Derivative Markets
Equity
markets are the markets for stocks, which are usually traded in the countries
where the
companies are based.
Debt
instruments can be categorized as
Money
market (maturity of less than one year) or Bond markets (maturity of more than
one year)
Characteristics of a well-run financial market
Low
transaction costs.
Information
communicated must be accurate and widely available
If
not, the prices will not be correct
Prices
are the link between the financial markets and the real economy
Investors
must be protected.
A
lack of proper safeguards dampens people’s willingness to invest
© Copyright Virtual University of Pakistan 18
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Figure: Market size and investors protection
© Copyright Virtual University of Pakistan
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2.5
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Money & Banking – MGT411 VU
Lesson 7
FINANCIAL INSTITUTIONS
Financial
Institutions
Structure
of Financial Industry
Time
Value of Money
Financial Institutions
Financial
institutions are the firms that provide access to the financial markets;
They
sit between savers and borrowers and so are known as financial intermediaries.
Banks,
insurance companies, securities firms and pension funds
A
system without financial institutions would not work very well for three
reasons
Individual
transactions between saver-lenders and borrower-spenders would be extremely
expensive.
Lenders
need to evaluate the creditworthiness of borrowers and then monitor them, and
individuals are not equipped to do this.
Most
borrowers want to borrow long term, while lenders favor short-term loans
Role of Financial Institutions
Reduce
transactions cost by specializing in the issuance of standardized securities
Reduce
information costs of screening and monitoring borrowers.
Curb
information asymmetries, helping to ensure that resources flow into their most
productive
uses
Make
long-term loans but allow savers ready access to their funds.
Provide
savers with financial instruments (more liquid and less risky than the
individual stocks and
bonds) that savers would purchase directly in financial
markets
Figure: Flow of funds through Financial Institutions: Access to
Financial Markets
© Copyright Virtual University of Pakistan 20
Lenders/Savers
(Primarily Households)
Borrowers/Spenders
(Primarily Governments
and Firms)
Financial Institutions that
act as Brokers
Financial Institutions that
transform assets
Bonds & Stocks
Funds
Lenders/Savers
(Primarily Households)
Borrowers/Spenders
(Primarily Governments
and Firms)
Financial Institutions
that act as Brokers
Financial Institutions
that transform assets
Bonds & Stocks
Funds Funds
Bonds & Stocks
Loans, Bonds,
Stocks and Real
Estate
Funds
Deposits & Insurance
Policies
Funds
Indirect Finance
Money & Banking – MGT411 VU
The simplified Balance Sheet of a Financial Institution
Assets Liabilities
Bonds
Stocks
Loans
Real estate
Deposits
Insurance policies
The
structure of the financial industry
The structure of the financial industry:
Financial
institutions or intermediaries can be divided into two broad categories
Depository institutions -
take deposits and make loans.
(Commercial
banks, savings banks, and credit unions)
Nondepository institutions
Insurance
companies, securities firms, mutual fund companies, finance companies, and
pension
funds
Insurance companies
Accept
premiums, which they invest in securities and real estate in return for
promising
compensation to policyholders should certain events
occurs (like death, property losses, etc.)
Pension funds
Invest
individual and company contributions into stocks, bonds and real estate in
order to provide
payments to retired workers.
Securities firms
They
include brokers, investment banks, and mutual fund companies
Brokers
and investment banks issue stocks and bonds to corporate customers, trade them,
and
advise clients.
Mutual
fund companies pool the resources of individuals and companies and invest them
in
portfolios of bonds, stocks, and real estate.
Government Sponsored Enterprises:
Federal
credit agencies that provide loans directly for farmers and home mortgages, as
well as
guarantee programs that insure the loans made by private
lenders.
HBFC,
ZTBL, Khushhali bank, SME Bank
The
government also provides retirement income and medical care to the elderly (and
disabled)
through Social Security and Medicare.
Finance Companies:
Raise
funds directly in the financial markets in order to make loans to individuals
and firms.
The
monetary aggregates are made up of liabilities of commercial banks, so clearly
the financial
structure is tied to the availability of money and
credit.
© Copyright Virtual University of Pakistan 21
Money & Banking – MGT411 VU
Lesson 8
TIME VALUE OF MONEY
Time
Value of Money
Future
Value Concepts
Present
value
Application
in financial environment
Time Value of Money
Credit
is one of the critical mechanisms we have for allocating resources.
Even
the simplest financial transaction, like saving some of your paycheck each
month to buy a
car, would be impossible.
Corporations,
most of which survive from day to day by borrowing to finance their activities,
would not be able to function.
Yet
even so, most people still take a dim view of the fact that lenders charge
interest.
The
main reason for the enduring unpopularity of interest comes from the failure to
appreciate the
fact that lending has an opportunity cost.
Think
of it from the point of view of the lender.
Extending
a loan means giving up the alternatives. While lenders can eventually recoup
the sum
they lend, neither the time that the loan was outstanding
nor the opportunities missed during that
time can be gotten back.
So
interest isn't really "the breeding of money from money,'' as Aristotle
put it; it's more like a
rental fee that borrowers must pay lenders to compensate
them for lost opportunities.
It's
no surprise that in today's world, interest rates are of enormous importance to
virtually
everyone
Individuals,
businesses, and governments
They
link the present to the future, allowing us to compare payments made on
different dates.
Interest
rates also tell us the future reward for lending today, as well as the cost of
borrowing now
and repaying later.
To
make sound financial decisions, we must learn how to calculate and compare
different rates on
various financial instruments
Future Value
Future
Value is the value on some future date of an investment made today.
To
calculate future value we multiply the present value by the interest rate and
add that amount of
interest to the present value.
PV + Interest = FV
PV + PV*i = FV
$100 + $100(0.05) = $105
PV = Present Value
FV = Future Value
i = interest rate (as a percentage)
The
higher the interest rate (or the amount invested) the higher the future value.
Future Value in one year
FV = PV*(1+i)
© Copyright Virtual University of Pakistan 22
Money & Banking – MGT411 VU
Now
we need to figure out what happens when the time to repayment varies
When
we consider investments with interest payments made for more than one year we
need to
consider compound interest, or the fact that interest
will be paid on interest
Future Value in two years
$100+$100(0.05) +$100(0.05) + $5(0.05) =$110.25
Present Value of the Initial Investment + Interest on the
initial investment in the 1st Year + Interest on the
initial investment in the 2nd Year+ Interest on the
Interest from the 1stYear in the 2nd Year
= Future Value in Two Years
General Formula for compound interest – Future value of
an investment of PV in n years at interest rate i
(measured as a decimal, or 5% = .05)
FVn = PV*(1+i)
n
Table: Computing the Future Value of $100 at 5% annual interest
rate
Years into future Computation Future value
1 $100(0.5) $105.00
2 $100(0.5)2 $110.25
3 $100(0.5)3 $115.76
4 $100(0.5)4 $121.55
5 $100(0.5)5 $127.63
10 $100(0.5)10 $162.89
Note:
Both n and i must be measured in same time units—if i is
annual, then n must be in years, so future value of
$100 in 18 months at 5% is
FV = 100 *(1+.05)1.5
How
useful it is?
If
you put $1,000 per year into bank at 4% interest, how much would you have saved
after 40
years?
Taking
help of future value concept, the accumulated amount through the saving will be
$98,826 –
more than twice the $40,000 you invested
How
does it work?
The
first $1,000 is deposited for 40 years so its future value is
$1,000
x (1.04)40 =
4,801.02
The 2nd $1,000 is deposited for 39 years so
its future value is
$1,000
x (1.04)39 =
4,616.37
And
so on…..up to the $1,000 deposited in the 40th year
Adding
up all the future values gives you the amount of $98,826
Present Value
Present
Value (PV) is the value today (in the present) of a payment that is promised to
be made in
the future. OR
Present
Value is the amount that must be invested today in order to realize a specific
amount on a
given future date.
To
calculate present value we invert the future value calculation;
We
divide future value by one plus the interest rate (to find the present value of
a payment to be
made one year from now).
Solving
the Future Value Equation
© Copyright Virtual University of Pakistan 23
Money & Banking – MGT411 VU
FV = PV*(1+i)
Present
Value of an amount received in one year.
Example:
$100
received in one year, i=5%
PV=$100/
(1+.05) = $95.24
Note:
FV =
PV*(1+i) = $95.24*(1.05) = $100
For
payments to be made more than one year from now we divide future value by one
plus the
interest rate raised to the nth power where n is the number of years
Present
Value of $100 received n years in the future:
Example
Present Value of $100 received in 2 ½ years and an
interest rate of 8%.
PV = $100 / (1.08)2.5 = $82.50
Note:
FV =$82.50 * (1.08)2.5 = $100
© Copyright Virtual University of Pakistan 24
Money & Banking – MGT411 VU
Lesson 9
APPLICATION OF PRESENT VALUE CONCEPTS
Application
of Present Value Concept
Compound
Annual Rate
Interest
Rates vs. Discount Rate
Internal
Rate of Return
Bond
Pricing
Important Properties of Present Value
Present Value is higher:
The
higher the future value (FV) of the payment
The
shorter the time period until payment (n)
The
lower the interest rate (i)
The size of the payment (FVn)
Doubling
the future value of the payment (without changing time of the payment or
interest rate),
doubles the present value
At 5%
interest rate, $100 payment has a PV of $90.70
Doubling
it to $200, doubles the PV to $181.40
Increasing
or decreasing FVn by
any percentage will change PV by the same percentage in the same
direction
The time until the payment is made (n)
Continuing
with the previous example of $100 at 5%, we allow the time to go from 0 to 30
years.
This
process shows us that the PV payment is worth $100 if it is made immediately,
but gradually
declines to $23 for a payment made in 30 years
Figure: Present value of $100 at 5% interest rate
The rule of 72
For
reasonable rates of return, the time it takes to double the money, is given
approximately by
t = 72 / i%
If we
have an interest rate of 10%, the time it takes for investment to double is:
t = 72 / 10 = 7.2 years
This
rule is fairly applicable to discount rates in 5% to 20% range.
© Copyright Virtual University of Pakistan 25
Money & Banking – MGT411 VU
The Interest rate (i)
Higher
interest rates are associated with lower present values, no matter what size or
timing of the
payment
At
any fixed interest rate, an increase in the time until a payment is made
reduces its present value
Table:
Present Value of a $100 payment
Payment
due in
Interest
rate 1 Year 5 Years 10 Years 20 Years
1%
$99.01 $95.15 $90.53 $81.95
2%
$3.77 $98.04 $90.57 $29.14
$82.03 $67.30
3%
4% $97.09 $86.26 32%
$74.41 $55.37
4%
$96.15 $82.19 $67.56 $45.64
5%
$95.24 $78.35 $61.39 $37.69
6%
$94.34 $74.73 $55.84 $31.18
7%
$93.46 $71.30 $50.83 $25.84
8%
$92.59 $68.06 $46.32 $21.45
9%
$91.74 $64.99 $42.24 $17.84
10%
$90.91 $62.09 $38.55 $14.86
11%
$90.09 $59.35 $35.22 $12.40
12%
$89.29 $56.74 $32.20 $10.37
13%
$88.50 $54.28 $29.46 $8.68
14%
$87.72 $51.94 $26.97 $7.28
15%
$86.96 $49.72 $24.72 $6.11
Figure: The relationship between Present value and Interest Rates
Compound Annual Rates
Comparing
changes over days, months, years and decades can be very difficult.
The
way to deal with such problems is to turn the monthly growth rate into
compound-annual rate.
An
investment whose value grows 0.5% per month goes from 100 at the beginning of
the month to
100.5 at the end of the month:
We can verify this as following
100 (100.5 - 100) = [(100.5/100) – 1] = 0.5%
100
What
if the investment’s value continued to grow at 0.5% per month for next 12
months?
© Copyright Virtual University of Pakistan 26
Money & Banking – MGT411 VU
We
cant simply multiply 0.5 by 12
Instead
we need to compute a 12 month compound rate
So
the future value of 100 at 0.5 %( 0.005) per month compounded for 12 months
will be:
FVn =
PV (1+i) n =
100(1.005)12 =
106.17
An
increase of 6.17% which is greater than 6%, had we multiplied 0.5% by 12
The
difference between the two answers grows as the interest rate grows
At 1%
monthly rate, 12 month compounded rate is12.68%
Another
use for compounding is to compute the percentage change per year when we know
how
much an investment has grown over a number of years
This
rate is called average annual rate
If an
investment has increased 20%, from 100 to 120 over 5 years
Is
average annual rate is simply dividing 20% by 5?
This
way we ignore compounding effect
Increase
in 2nd year
must be calculated as percentage of the investment worth at the end of 1st year
To
calculate the average annual rate, we revert to the same equation:
FVn =
PV (1+i) n
120 = 100(1 + i) 5
Solving for i
i = [(120/100)1/5 - 1] = 0.0371
5
consecutive annual increases of 3.71% will result in an overall increase of 20%
Interest Rate and Discount Rate
The
interest rate used in the present value calculation is often referred to as the
discount rate
because the calculation involves discounting or reducing
future payments to their equivalent value
today.
Another
term that is used for the interest rate is yield
Saving
behavior can be considered in terms of a personal discount rate;
People
with a low rate are more likely to save, while people with a high rate are more
likely to
borrow
We
all have a discount rate that describes the rate at which we need to be
compensated for
postponing consumption and saving our income
If
the market offers an interest rate higher than the individual’s personal
discount rate, we would
expect that person to save (and vice versa)
Higher
interest rates mean higher saving
Applying Present Value
To
use present value in practice we need to look at a sequence or stream of
payments whose
present values must be summed. Present value is additive.
To
see how this is applied we will look at internal rate of return and the
valuation of bonds
Internal Rate of Return
The
Internal Rate of Return is the interest rate that equates the present value of
an investment with
it cost.
It is
the interest rate at which the present value of the revenue stream equals the
cost of the
investment project.
In
the calculation we solve for the interest rate
A machine with a price of $1,000,000 that generates
$150,000/year for 10 years
© Copyright Virtual University of Pakistan 27
1 2 3 (1 )10
...... $150,000
(1 )
$150,000
(1 )
$150,000
(1 )
$1,000,000 $150,000
i i i + i
+ +
+
+
+
+
+
=
Money & Banking – MGT411 VU
Solving for i, i=.0814 or 8.14%
The
internal rate of return must be compared to a rate of interest that represents
the cost of funds
to make the investment.
These
funds could be obtained from retained earnings or borrowing. In either case
there is an
interest cost
An
investment will be profitable if its internal rate of return exceeds the cost
of borrowing
© Copyright Virtual University of Pakistan 28
Money & Banking – MGT411 VU
Lesson 10
BOND PRICING & RISK
Bond
Pricing
Real
Vs Nominal Interest Rates
Risk
Characteristics
Measurement
Bond Pricing
A
bond is a promise to make a series of payments on specific future date.
It is
a legal contract issued as part of an arrangement to borrow
The
most common type is a coupon bond, which makes annual payments called coupon
payments
The
percentage rate is called the coupon rate
The
bond also specifies a maturity date (n) and has a final payment (F), which is
the principal, face
value, or par value of the bond
The
price of a bond is the present value of its payments
To
value a bond we need to value the repayment of principal and the payments of
interest
Valuing the Principal Payment
A
straightforward application of present value where n represents the maturity of
the bond
Valuing
the Coupon Payments:
Requires
calculating the present value of the payments and then adding them; remember,
present
value is additive
Valuing
the Coupon Payments plus Principal
Means
combining the above
Payment stops at the maturity date. (n)
A payment is for the face value (F) or principle of the
bond
Coupon Bonds make annual payments called, Coupon Payments
(C), based upon an interest rate,
the coupon rate (ic), C=ic*F
A bond that has a $100 principle payment in n years. The
present
Value (PBP) of this is now:
BP n n i i
P F
(1 )
$100
(1 ) +
=
+
=
If
the bond has n coupon payments (C), where C= ic
* F, the Present Value (PCP)
of the coupon
payments
is:
CP n i
C
i
C
i
C
i
P C
(1 )
......
(1 )1 (1 )2 (1 )3 +
+ +
+
+
+
+
+
=
© Copyright Virtual University of Pakistan 29
Money & Banking – MGT411 VU
Present Value of Coupon Bond (PCB) = Present value of Yearly Coupon
Payments (PCP)
+ Present Value of
the Principal Payment (PBP)
CB CP BP n n i
F
i
C
i
C
i
C
i
P P P C
(1 ) (1 )
......
(1 )1 (1 )2 (1 )3 +
+ ú
û
ù
êë
é
+
+ +
+
+
+
+
+
= + =
Note:
The
value of the coupon bond rises when the yearly coupon payments rise and when
the interest
rate falls
Lower
interest rates mean higher bond prices and vice versa.
The
value of a bond varies inversely with the interest rate used to discount the
promised payments
Real and Nominal Interest Rates
So
far we have been computing the present value using nominal interest rates (i),
or interest rates
expressed in current-dollar terms
But
inflation affects the purchasing power of a dollar, so we need to consider the
real interest rate
(r), which is the inflation-adjusted interest rate.
The
Fisher equation tells us that the nominal interest rate is equal to the real
interest rate plus the
expected rate of inflation
Fisher Equation:
i = r + e
Or
r = i - πe
Figure: Nominal Interest rates, Inflation, and real interest rates
© Copyright Virtual University of Pakistan
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Figure: Inflation and Nominal Interest Rates, April 2004
Risk
Every
day we make decisions that involve financial and economic risk.
How
much car insurance should we buy?
Should
we refinance the home loan now or a year from now?
Should
we save more for retirement, or spend the extra money on a new car?
Interestingly
enough, the tools we use today to measure and analyze risk were first developed
to
help players analyze games of chance.
For
thousands of years, people have played games based on a throw of the dice, but
they had little
understanding of how those games actually worked
Since
the invention of probability theory, we have come to realize that many everyday
events,
including those in economics, finance, and even weather
forecasting, are best thought of as
analogous to the flip of a coin or the throw of a die
Still,
while experts can make educated guesses about the future path of interest
rates, inflation, or
the stock market, their predictions are really only
that—guess.
And
while meteorologists are fairly good at forecasting the weather a day or two
ahead, economists,
financial advisors, and business gurus have dismal
records.
So
understanding the possibility of various occurrences should allow everyone to
make better
choices. While risk cannot be eliminated, it can often be
managed effectively.
Finally,
while most people view risk as a curse to be avoided whenever possible, risk
also creates
opportunities.
The
payoff from a winning bet on one hand of cards can often erase the losses on a
losing hand.
Thus
the importance of probability theory to the development of modern financial
markets is hard
to overemphasize.
People
require compensation for taking risks. Without the capacity to measure risk, we
could not
calculate a fair price for transferring risk from one
person to another, nor could we price stocks and
bonds, much less sell insurance.
The
market for options didn't exist until economists learned how to compute the
price of an option
using probability theory
We
need a definition of risk that focuses on the fact that the outcomes of
financial and economic
decisions are almost always unknown at the time the
decisions are made.
Risk
is a measure of uncertainty about the future payoff of an investment, measured
over some
time horizon and relative to a benchmark.
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Characteristics of risk
Risk
can be quantified.
Risk
arises from uncertainty about the future.
Risk
has to do with the future payoff to an investment, which is unknown.
Our
definition of risk refers to an investment or group of investments.
Risk
must be measured over some time horizon.
Risk
must be measured relative to some benchmark, not in isolation.
If
you want to know the risk associated with a specific investment strategy, the
most appropriate
benchmark would be the risk associated with other
investing strategies
Measuring Risk
Measuring Risk requires:
List
of all possible outcomes
Chance
of each one occurring
The
tossing of a coin
What
are possible outcomes?
What
is the chance of each one occurring?
Is
coin fair?
Probability
is a measure of likelihood that an even will occur
Its
value is between zero and one
The
closer probability is to zero, less likely it is that an event will occur.
No
chance of occurring if probability is exactly zero
The
closer probability is to one, more likely it is that an event will occur.
The
event will definitely occur if probability is exactly one
Probabilities
can also be expressed as frequencies
Table: A Simple Example: All Possible Outcomes of a Single Coin
Toss
Possibilities Probability Outcome
#1 1/2 Heads
#2 1/2 Tails
We
must include all possible outcomes when constructing such a table
The
sum of the probabilities of all the possible outcomes must be 1, since one of
the possible
outcomes must occur (we just don’t know which one)
To
calculate the expected value of an investment, multiply each possible payoff by
its probability
and then sum all the results. This is also known as the
mean.
Case 1
An Investment can rise or fall in value. Assume that an
asset purchased for $1000 is equally likely to fall to
$700 or rise to $1400
Table: Investing $1,000: Case 1
Possibilities Probability Payoff Payoff ×Probability
#1 1/2 $700 $350
#2 1/2 $1,400 $700
Expected Value = Sum of (Probability times Payoff) =
$1,050
© Copyright Virtual University of Pakistan 32
Money & Banking – MGT411 VU
Expected Value = ½ ($700) + ½ ($1400) = $1050
Case 2
The $1,000 investment might pay off
$100
(prob=.1) or
$2000
(prob=.1) or
$700
(prob=.4) or
$1400
(prob=.4)
Table: Investing $1,000: Case 2
Possibilities Probability Payoff Payoff ×Probability
#1 0.1 $100 $10
#2 0.4 $700 $280
#3 0.4 $1,400 $560
#4 0.1 $2,000 $200
Expected Value = Sum of (Probability times Payoff) = $1,050
Investment
payoffs are usually discussed in percentage returns instead of in dollar
amounts; this
allows investors to compute the gain or loss on the
investment regardless of its size
Though
both cases have the same expected return, $50 on a $1000 investment, or 5%, the
two
investments have different levels or risk.
A
wider payoff range indicates more risk.
© Copyright Virtual University of Pakistan 33
Money & Banking – MGT411 VU
Lesson 11
MEASURING RISK
Measuring
Risk
Variance
and Standard Deviation
Value
at Risk (VAR)
Risk
Aversion & Risk Premium
Measuring Risk
Most
of us have an intuitive sense for risk and its measurement;
The
wider the range of outcomes the greater the risk
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