1. FNCE 4070: FINANCIAL MARKETS AND INSTITUTIONS Lecture 1: Introduction to Financial Markets
Professor Michael Palmer
Professor of Finance
University of Colorado at Boulder
Spring Semester 2012

2. Where is this Financial Center?

3. Beginning Quotes For Course
“May you live in interesting times.”
Reputed to be an ancient Chinese proverb and curse
“The only certainty in financial markets is uncertainty”
Credit Suisse, August 16, 2007 (Switzerland's second largest bank)
“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.” George Soros (Hedge fund manager and philanthropist)
“Without the element of uncertainty, the greatest business triumph would be dull, routine, and eminently unsatisfying.” J. Paul Getty (American industrialist, founder of Getty Oil)
“I used to be scared of uncertainty; now I get a high out of it.” Jensen Ackles (Actor. TV; Smallville, Dawson’s Creek, and Supernatural)

4. Testing Your Understanding of Financial Markets?
Who is the current chairman of the Federal Reserve and who were the two previous chairs of the Federal Reserve?
What is the Federal Reserve responsible for?
Define the Federal Funds interest rate, the Discount Rate, and the Prime Rate?
What is the current level of the Federal Funds Rate and is the Federal Funds Rate higher or lower than one year ago?
Which country currently has the highest (lowest) interest rate?
United States, United Kingdom, Japan, Germany, Australia, Canada, or Switzerland.

5. Ben Bernanke: The 14th Chairman of the Federal Reserve Board
Ben Bernanke replaced Alan Greenspan on February 1, 2006
Greenspan had served since August 1987.
Background: The Chairman of the Federal Reserve Board is named by the President and is confirmed by the U.S. Senate.
They serve a term of four years, and can be reappointed.
The Federal Reserve is responsible for the conduct of monetary policy, which means:
Setting interest rates and promoting money supply growth, in pursuit of maximum employment, stable prices, and moderate long-term interest rates.
See Appendix 2 for some insights into Bernanke and Appendix 3 for previous Fed Chairs

6. Ben Bernanke in Song
Columbia Business School's YouTube Video parody of Dean Glenn Hubbard (Note: he is not the real Dean) singing about Ben Bernanke.
(link to Ben Bernanke Every Breath you Take video)
(this may work).
As you watch and listen to this parody take note of the following terms:
1. Change of rate (i.e., interest rates)
2. Stagflate (aka, stagflation – a recession with inflation)
3. BPS (basis points, a measure of interest rates)
4. Yield curve flips (yield curve going from upwards sweeping to downward sweeping as a signal of a future recession)
5. Interest rate policies (monetary policy used by central banks)
6. Models break (i.e., econometric models used to assess the impact of monetary policy changes on the economy)

7. Federal Funds Rate
The Fed Funds Rate is the short term (generally overnight) interest rate in the U.S. interbank market for lending/borrowing “excess” bank reserves.
Essentially, the interest rate at which one commercial bank will lend reserves to another commercial bank.
This is also regarded as a key (i.e., “benchmark”) short interest rate in the United States because the Federal Reserve sets this rate so as to implement monetary policy.
Since 1982, the Fed has announced a “target” for the federal funds rate.
Since 2008, the target has actually been a range (upper and lower limit).
For participants in financial markets, changes in this “target” rate (or lack of) indicate the stance (direction and accommodation) of monetary policy.

8. How does the Fed Affect the Federal Funds Rate?
Through open market operation:
The buying and selling of government securities.
Buying government securities increases bank excess reserves.
An increase in the supply of bank reserves (everything else equal) will put downward pressure on the Federal funds rate.
Selling government securities reduces bank excess reserves.
A decrease in the supply of bank reserves (everything else equal) will put upward pressure on the Federal funds rate.

9. Demand and Supply Model of Bank Excess Reserves
Fed selling government securities
Fed buying government securities
S1 S2
Fed
Funds
Rate
(%) Demand
Excess Reserves
S2 S1
Fed
Funds
Rate Demand
(%)
Excess Reserves

10. U.S. Federal Funds Target Rate: Sep 1982 (first used) to Dec 2008
Historical high: July 1974, 13%. Note: Fed targeted money supply from 1979 to 1993, but, in the 1980s, it started shifting policy towards fed funds; in 1995 it began announcing a specific fed funds target

11. U.S. Federal Funds Target Rate Range: Dec 2008 to the Present
Beginning in December 2008 the Federal Reserve announced a range for the Fed Funds Rate (currently 0.00% to 0.25%).

12. Effective Federal Funds Rate
(Note: Fed targeted money supply from 1979 to 1993; a specific fed funds target not announced until 1995)

13. Relationship of Target to Effective Rate

14. Relationship of Target to Effective: Dec 2008 to the Present
Beginning in December 2008 the Federal Reserve announced a range for the Fed Funds Rate (currently 0.00% to 0.25%).

15. Relationship of Central Bank Interest Rates to Economic Activity
Important measures of economic activity:
Economic output (Business Activity).
GDP (changes in real GDP)
Price levels
Inflation (Consumer and producer prices)

16. U.S. Business Cycles

17. Effective Federal Fuds Rate and Business Activity

18. Effective Federal Funds Rate and Price Changes

19. Monitoring the Effective Federal Funds Rate
As noted, the effective federal funds rate follows the target (or range) and thus it would appear that we can monitor this rate as an indicator of the stance (and changes in the direction) of Fed policy.
We can also evaluate the effective rate in relation to the target or range as indicators as to conditions in financial markets.

20. Assessing Financial Market Conditions

21. Effective Fed Funds Rate and Target Range, Dec 2008 to Present

22. Central Bank Target Interest Rates Jan 2008, Dec 2008, Jan 2010, Jan 2011, Jan 2012
United States: 4.25%, 0.25%, 0.25%, 0.25%, 0.25%, 0.25%
Japan: 0.50%, 0.30%, 0.10%, 0.10%, 0.10%
Switzerland: 2.75%, 0.50%, 0.25%, 0.25%, 0.00%
United Kingdom: 5.50%, 2.00%, 0.50%, 0.50%, 0.50%
Euro-zone: 4.00%, 2.50%, 1.00%, 1.00%, 1.00%
Canada: 4.00%,1.50%, 0.25%, 1.00%, 1.00%
Australia: 6.75%, 4.25%, 3.75%, 4.75%, 4.25%
China: 7.20%, 5.31%, 5.31%, 5.81%, 6.56%
India: 9.00%, 6.50%, 4.75%, 6.25%, 8.25%
Brazil: %, 13.75%, 8.75%, 10.75%, 11.0%
Note: For current rates and meeting dates see:

23. Federal Reserve Discount Rate
Federal Reserve Discount Rate: Interest rate the Federal Reserve will charge member banks and other depository institutions to borrow short term (overnight) reserves.
Administratively set by the Federal Reserve
Currently: .75% (January 2008: 4.75%) (Now Called Primary Credit Rate)
This market is important as it represents a “safety” net for financial institutions.
Also carries potentially important signals as to future fed policy directions.

24. Prime Interest Rate
Prime Rate: Interest rate commercial banks will charge their best customers (i.e., high grade corporates) on loans to borrow short term funds.
Tied to the Federal Funds Rate (with the Fed funds rate the casual rate).
Prime rate is generally around 300 basis points higher than fed funds rate
Currently: 3.25%. (January 2008: 7.25%)

25. Prime Interest Rate, 1949 to the Present

26. Why is the Fed Funds Rate So Important?
Fed Funds rate is set by U.S. central bank and thus it carries important signals for the market.
What the central bank thinks about the economy and the direction of the economy.
These signals will affect how the market sets its interest rates.
Bottom line: Other money market rates are influenced by the direction and level of the Fed Funds Rate.

27. Fed Funds Rate and Prime Interest Rate

28. Fed Funds Rate and Short Term Government Securities

29. Fed Funds Rate and Short Term Money Market Rates

30. Fed Funds Rate and Long Term Interest Rates

31. Cross Country Comparisons: Long Term Gov’t Rates, January 2012
10-Year Gov’t Bonds
United States
1.99%
Italy
6.90%
Switzerland
0.66%
South Africa
7.91%
Japan
0.99%
India
8.60%
Hong Kong
1.38%
Egypt
8.29%
Germany
1.92%
Turkey
9.72%
United Kingdom
2.04%
Hungary
10.21%
Canada
2.10%
Brazil
11.26%
France
3.33%
Pakistan
14.23%
China
3.52%
Greece
36.62%

32. Short Term Interest Rates: 1993 – 2010; Global Comparisons

33. Long Term Interest Rates: 1993 – 2010; Global Comparisons

34. Useful Web Sites For current U.S. interest rate data see:
For Effective Fed Funds Rate see:
For other key rates:
For charting U.S. interest rate data and other U.S. data see:

35. Hong Kong: Background Notes
Appendix 1
Hong Kong: Background Notes

36. Asia Pacific with Hong Kong

37. Hong Kong as a Financial Center
After being ceded by China to the British (as a result of the Opium Wars) under the Treaty of Nanking in 1842, the colony of Hong Kong rapidly became a regional center for financial and commercial services with China and South Asia. During the Korean War, the U.N. imposed an embargo on mainland China (for its support of North Korea) and as a result many “industrialist moved from the mainland to Hong Kong and set up light industry export companies. During this period, Hong Kong grew as a shipping and textile export center.
However, China's open-door policy in 1978 was the year that marked the new era of Hong Kong and its re-birth as a major economic and financial center. As manufacturing moved out of Hong Kong to mainland China, it was replaced by services, and Hong Kong GDP boomed as trade and investment links with China exploded. Global financial services also flourished because of Hong Kong’s British-style legal system and the fact that English is spoken fluently both of which supported Hong Kong’s financial networks with London, New York and other leading global cities. In additional, Hong Kong has had long existing stock market (since 1891).

38. Hong Kong as a Financial Center
Today Hong Kong is an important market for IPO (second only to New York last year) and funds management. Today Hong Kong is the world’s sixth largest foreign exchange trading center, with 4.7% of the world’s total trades (or $238 billion per day). 71 of the largest 100 banks in the world have an operation in Hong Kong. Hong Kong is the world's 9th largest international banking center in terms of the volume of external transactions, and the second largest in Asia after Japan. The banking sector plays a vital role in establishing Hong Kong as a major loan syndication center in the region. The Hong Kong Stock Exchange is Asia's third largest stock exchange in terms of market capitalization behind the Tokyo Stock Exchange and the Shanghai Stock Exchange and fifth largest in the world. As of 31 Dec 2010, the Hong Kong Stock Exchange had 1,413 listed companies with a combined market capitalization of $2.7 trillion.
Hong Kong was hit hard by the Asian Financial Crisis that struck the region in mid-1997, just at the time of the handover of the colony back to Chinese administrative control. The crisis prompted a collapse in share prices and the property market. However, unlike most Asian countries, Hong Kong (as well as mainland China) maintained their currencies’ exchange rates with the U.S. dollar rather than devaluing.

39. Appendix 2 Ben Bernanke’s View of the Role of Central Banks:
The following slides present a brief sketch of Bernanke and offer possible insights into his approach regarding the role of the U.S. central bank.

40. Ben Bernanke
Ben Bernanke was born on December 13, 1953, in Augusta, Georgia. He received a B.A. in economics in 1975 from Harvard University (summa cum laude) and a Ph.D. in economics in 1979 from the Massachusetts Institute of Technology.
Before becoming a member of the Federal Reserve Board, Dr. Bernanke was the Howard Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs and Chair of the Economics Department at Princeton University ( ). Dr. Bernanke had served as a Professor of Economics and Public Affairs at Princeton since 1985.

41. Bernanke’s Views on Central Banking
Bernanke, whose academic studies have focused on the Great Depression, has written that during that era the U.S. central bank allowed banks to fail, prices to fall and the money supply to contract, which contributed to the protracted slump.
In essence, he blames the Fed for not acting in a proactive manner.
In addition, Bernanke has been quoted as follows: "We now know the lessons from that” [the Depression]. "We are certainly going to make sure that the financial system remains in good functioning order.“
Conclusion: It appears that Bernanke will follow a very aggressive proactive approach to monetary policy in the U.S.

42. Changing Fed Chairs being introduced by the President
Appendix 3
Changing Fed Chairs being introduced by the President

43. Changing Fed Chairs Volcker to Greenspan, August 1987
Greenspan to Bernanke, February 2006