Money, Banking, and International Finance

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Money, Banking, and International Finance

Money, Banking, Banking, and International I nternational Finance Copyright © 2010 by Kenneth R. S!lcyk "ll right# re#er$ed Co$er de#ign by Kenneth R. S!lcyk

%dition 2, Febr!ary 201&

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Table of Contents

'"B(% )F C)*'%*'S.......................... ....................................... ......................... ......................... ..................................... ........................+ + R%F"C%......................... ...................................... ......................... ......................... .......................... .......................... ...................................................1. M)*% "*/ '% FI*"*CI"( SS'%M.......................................................10 Financial Market#...................... Market#................................... .......................... .......................... ......................... ..........................10 ..............10 Central Bank#....................... Bank#................................... ......................... .......................... .......................... ................................11 ...................11 Barter and F!nction# o Money........................ Money..................................... ......................................... ............................1+ 1+ For# o Money...................... Money.................................. ......................... .......................... .......................... .............................13 ................13 Bitcoin#....................... Bitcoin#................................... ......................... .......................... .......................... .........................................14 ............................14 Money S!pply /einition#......................... /einition#...................................... .......................... ...................................1......................1Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... ...................................21 ......................21 Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... .......................... ........................21 ...........21 2. )6%R6I%7 )F '% 8.S. FI*"*CI"( SS'%M.............................................2+ Financial Interediation.............. Interediation........................... .......................... .......................... ....................................2+ .......................2+ Financial In#tr!ent#.......................... In#tr!ent#...................................... ......................... .......................... ..............................29 .................29 'he 8nited State# Banking Sy#te....................... Sy#te.................................... .......................... ........................2: ...........2: 'he ;la## Steagall Banking "ct............................ "ct................................................................+ ....................................+0 0 Financial Inno$ation.......................... Inno$ation....................................... ......................... ...........................................+ ...............................+2 2 7eb#ite#........... 7eb#ite#........................ .......................... ......................... ......................... .......................... .......................................+& ..........................+& Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... ...................................+& ......................+& 'he Coon Financial In#tr!ent#........................... In#tr!ent#....................................... ......................... ...................+3 ......+3 Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... .......................... ........................+3 ...........+3 +. M8('I*"'I)*"( % *'%RRIS%S..................................................................+4 For# o B!#ine## )rganiation#........................ )rganiation#..............................................................+4 ......................................+4 Corporation#....................... Corporation#.................................... .......................... .......................... ......................... ......................... .....................+: ........+: Corporate Fra!d......................... Fra!d..................................... ......................... .......................... .......................................&1 ..........................&1 %
Kenneth R. S!lcyk F!nction# o International Bank#........................ Bank#.................................... .......................................&...........................&Becoing an International Bank......................... Bank...............................................................30 ......................................30 %!ency.......................... Fre>!ency....................................... ......................... ......................... ........................4: ...........4: "nn!itie# and Mortgage#...................... Mortgage#................................... .......................... ........................................:0 ...........................:0 Foreign In$e#tent#....................... In$e#tent#.................................... .......................... .......................... ......................... .....................:+ .........:+ Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... ...................................:3 ......................:3 Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... .......................... ........................:3 ...........:3 4. 6"(8"'I)* )F S')CKS "*/ B)*/S.........................................................:4 )$er$ie= o Bond#........................ Bond#..................................... ......................... ......................... ................................... ......................:4 :4 'he 6al!ation o Bond#....................... Bond#.................................... ......................................................:: .........................................:: ield ield to Mat!rity and Rate o Ret!rn........................................................Ret!rn........................................................-2 2 'he 6al!ation o Stock#........................ Stock#.................................... ......................... .........................................-& ............................-& Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... ...................................-: ......................-: Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... .......................... ........................-: ...........-: "'%S.......................... :. /%'%RMI*I*; '% M"RK%' I *'%R%S' R "'%S ...................................... ...............100 ...100

'he S!pply S!ppl y and /eand or Bond#....................... Bond#................................... ......................... ......................100 .........100 Intere#t Rate# and the B!#ine## Cycle..................................................... Cycle..................................................... 109 'he Fi#her %ect...................... %ect................................... .......................... .......................... ......................... .........................104 .............104 &

Money, Banking, and International Finance Bond rice# in an )pen %conoy.......... %cono y....................... ......................... .................................... ........................1010Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... ................................. ....................110 110 Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... ...................................111 ......................111 -. R ISK "*/ ISK "*/ '%RM S'R8C'8R% )F I *'%R%S' R "'%S "'%S...................................112 /ea!lt Ri#k and Bond rice#.........  rice#...................... .......................... ............................................112 ...............................112 (i>!idity and Bond rice#......................... rice#..................................... ......................... .......................... ......................11 .........11+ + Inoration Co#t# and Bond rice#............................ rice#....................................................... .............................11& ..11& 'a
120

" Bank?# Balance Sheet......................... Sheet...................................... ......................... .....................................120 .........................120 " Bank Fail!re......................... Fail!re...................................... .......................... .......................... ......................................12+ .........................12+ 'he Intere#t Rate Ri#k....................... Ri#k.................................... .......................... ......................... .............................124 .................124 Sec!ritiation and the 200: Financial Cri#i#...........................................12Key 'er#............ 'er#........................ ......................... .......................... .......................... .......................... .................................1+1 ....................1+1 Chapter 5!e#tion#....................... 5!e#tion#.................................... .......................... .......................... ...................................1+1 ......................1+1 11.............................................................. '% M)*% S8( R)C%SS

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'he Fed?# Balance Sheet...................... Sheet................................... .......................... .......................... ..........................1++ .............1++ M!ltiple /epo#it %
1&3

'he Fed?# Balance Sheet...................... Sheet................................... .......................... .......................... ..........................1&3 .............1&3 'he Check Clearing roce##....................... roce##.................................... .......................... ................................1& ...................1&4 4 Change# in the Monetary Ba#e............. Ba#e.......................... ...................................................1&......................................1&/oe# 8.S. 'rea#!ry "ect the Monetary Ba#e@...................................... Ba#[email protected] 130 " Central Bank Inter$ene# =ith it# C!rrency %
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Kenneth R. S!lcyk 'he Federal Re#er$e Sy#te?# Str!ct!re.................................................13: 'he %!ropean Central Bank.....................................................................190 I# the Federal Re#er$e Independent o the 8.S. ;o$ern[email protected] Key 'er#................................................................................................19& Chapter 5!e#tion#....................................................................................19& 1&.................................................................. M)*%'"R )(IC '))(S

199

)penAMarket )peration#.........................................................................199 Federal )pen Market Coittee.............................................................19: /i#co!nt olicy........................................................................................19Re#er$e Re>!ireent#.............................................................................142 Monetary olicy ;oal#............................................................................14& 'ie (ag# and 'arget#.............................................................................143 Key 'er#................................................................................................144 Chapter 5!e#tion#....................................................................................14: 13.............................................. '% I *'%R*"'I)*"( FI*"*CI"( SS'%M

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Balance o ayent#................................................................................1:0 'he %
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Foreign %
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Money, Banking, and International Finance Chapter 5!e#tion#....................................................................................221 1:............................... /%RI6"'I6% S%C8RI'I%S "*/ /%RI6"'I6% M"RK%'S

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For=ard and Spot 'ran#action#................................................................22+ F!t!re# and For=ard Contract#................................................................22& )ption# Contract......................................................................................224 Special /eri$ati$e#..................................................................................2+1 %$al!ating C!rrency S=ap#.....................................................................2+& Key 'er#................................................................................................2+3 Chapter 5!e#tion#....................................................................................2+9 1-............................................ 'R"*S"C'I)* "*/ %C)*)MIC %)S8R%S

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%
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Kenneth R. S!lcyk "n#=er# to Chapter 1& 5!e#tion#............................................................24"n#=er# to Chapter 13 5!e#tion#............................................................2:1 "n#=er# to Chapter 19 5!e#tion#............................................................2:2 "n#=er# to Chapter 14 5!e#tion#............................................................2:& "n#=er# to Chapter 1: 5!e#tion#............................................................2:3 "n#=er# to Chapter 1- 5!e#tion#............................................................2:4 "n#=er# to Chapter 20 5!e#tion#............................................................2:: R %F%R%*C%S..................................................................................................2-0

Preface

I ta!ght Money E Banking and International Finance #e$eral tie#, and I con$erted y lect!re note# into a te!ently, in#tr!ctor# can !#e thi# te
:


1. Money and the Financial System 'hi# chapter introd!ce# the inancial #y#te. St!dent# =ill learn the p!rpo#e o inancial arket# and it# relation#hip to inancial in#tit!tion#. Financial in#tit!tion# connect the #a$er# to the borro=er# thro!gh inancial interediation. "t the heart o e$ery inancial #y#te lie# a central bank. It control# a nation?# oney, and the oney #!pply i# a $ital coponent o the econoy. 8nort!nately, econoi#t# ha$e tro!ble in deining oney beca!#e people can con$ert any inancial in#tr!ent# into oney. 'h!#, central bank# !#e #e$eral deinition# to ea#!re the oney #!pply. F!rtherore, i an econoy did not !#e oney, then people =o!ld re#ort to an ineicient #y#te  barter. 8nort!nately, thi# #ociety =o!ld prod!ce a liited n!ber o good# and #er$ice#. *e$erthele##, oney o$ercoe# the inherent proble# =ith a barter #y#te and allo=# #pecialiation to occ!r at any le$el#.

Financial Markets Money and the inancial #y#te are intert=ined and cannot be #eparated. 'hey both inl!ence and aect the =hole econoy, #!ch a# the inlation rate, b!#ine## cycle#, and intere#t rate#. Con#e>!ently, con#!er#, in$e#tor#, #a$er#, and go$ernent oicial# =o!ld ake betterA inored deci#ion# i they !nder#tood ho= the inancial arket# and oney #!pply inl!ence the econoy. " financial market bring# b!yer# and #eller# ace to ace to b!y and #ell bond#, #tock#, and other inancial in#tr!ent#. B!yer# o inancial #ec!ritie# in$e#t their #a$ing#, =hile #eller# o inancial #ec!ritie# borro= !nd#. " inancial arket co!ld occ!py a phy#ical location like the *e= ork Stock %!ently, the bank co!ld lend thi# G100 to a borro=er. 'hen the borro=er pay# intere#t to the bank. In t!rn, the bank =o!ld pay intere#t to yo! or !#ing yo!r !nd#. Bank?# proit# relect the dierence bet=een the intere#t rate charged to the borro=er and the intere#t rate the bank pay# to yo! or yo!r #a$ing# acco!nt. 7hy =o!ld #oeone depo#it oney at a bank in#tead o directly b!ying #ec!ritie# thro!gh the inancial arket#@ " bank, being a inancial in#tit!tion, pro$ide# three beneit# to the depo#itor. Fir#t, a bank collect# information abo!t borro=er# and lend# to borro=er# =ith a lo= chance o dea!lting on their loan#. 'h!#, a bank?# #pecialty i# to rate it# borro=er#. Second, the bank red!ce# yo!r in$e#tent risk . Bank lend# to a $ariety o borro=er#, #!ch a# hoe ortgage#, b!#ine## loan#, and credit card#. I one b!#ine## bankr!pt# or #e$eral c!#toer# do not pay their credit card#, then the dea!lt doe# not inancially har the bank. Bank =o!ld earn intere#t incoe on it# other in$e#tent# that o#et the bad loan#. Finally, a bank depo#it ha# li>!idity. I people ha$e an eergency and need oney ro their bank depo#it#, they can ea#ily con$ert the bank depo#it into ca#h >!ickly. -

Kenneth R. S!lcyk %conoi#t# !#e li>!idity to deine oney. Liquidity i# people can ea#ily con$ert an a##et into ca#h =ith little tran#action co#t#. For e!idity, then li>!idity or# a #cale a# #ho=n in Fig!re 1. Ca#h i# the o#t li>!id a##et beca!#e a per#on already ha# oney and doe# not need to con$ert it to oney. S!b#e>!ently, a #a$ing# acco!nt i# alo#t a# good a# ca#h beca!#e c!#toer# can arri$e at a bank or "'M and con$ert their depo#it# into ca#h >!ickly =ith little tran#action co#t#. *e$erthele##, car# and ho!#e# are the lea#t li>!id a##et# beca!#e o=ner# re>!ire tie and highAtran#action co#t# to con$ert the#e a##et# into ca#h.

Figure 1. Ranking assets by liquidity

%conoi#t# deine the money or the money supply a# anything that people pay or good# and #er$ice# or repay debt#. In de$eloping co!ntrie#, people !#e ca#h a# oney. In co!ntrie# =ith #ophi#ticated inancial arket# like the 8nited State# and %!rope, the deinition o oney becoe# coplicated beca!#e oney incl!de# li>!id a##et#, #!ch a# ca#h, checking acco!nt#, and #a$ing# acco!nt#. eople can con$ert the#e a##et# into ca#h =ith little tran#action co#t#. Con#e>!ently, econoi#t# incl!de highly li>!id a##et# in the deinition# o oney. o=e$er, econoi#t# ne$er incl!de a##et# #!ch a# ho!#e# in the deinition o oney. 8nort!nately, hoeo=ner# need tie and ha$e highAtran#action co#t# to con$ert a ho!#e into ca#h. Many hoeo=ner# =ill not #ell their hoe# >!ickly by #elling it or a lo=er $al!e than the hoe?# arket $al!e.

Central Banks %$ery co!ntry !#e# oney. 'hereore, e$ery co!ntry ha# a go$ernent in#tit!tion that ea#!re# and inl!ence# the oney #!pply. 'hi# in#tit!tion i# the central bank . For e!ently, thi# =hole book e
Money, Banking, and International Finance Variable 1: Inflation i# a #!#tained ri#e in the a$erage price# or good# and #er$ice# o an econoy. 7hen a central bank increa#e# the oney #!pply, it can create inlation. For e!ickly, then the econoy e!ickly, then inlation can #trike an econoy =ith rapidly ri#ing price#. Variable 3: Interest rates relect the co#t o borro=ing oney. eople borro= oney to b!y car#, ho!#e#, appliance#, and cop!ter# =hile b!#ine##e# borro= to b!ild actorie# and to in$e#t in achine# and e>!ipent, e!ently the !neployent rate increa#e#, and the econoy enter# a rece##ion. 8nort!nately, i the oney #!pply gro=# too #lo=ly, or e$en contract#, it co!ld ca!#e the econoy to enter a rece##ion. %conoi#t# calc!late both the noinal ;/ and real ;/. ominal GDP incl!de# the ipact o inlation. For e
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Kenneth R. S!lcyk

Barter and Functions of Money I an econoy did not !#e oney, =hat =o!ld it look like@ 7itho!t oney, the b!yer# =o!ld e!ickly i they =ant to #a$e. Problem 3: rod!ct# and #er$ice# do not ha$e a coon ea#!reent or price#. For in#tance, i a #tore #tocked 1,000 prod!ct# and oney circ!lated =ith thi# econoy, #!b#e>!ently, thi# #tore =o!ld ha$e 1,000 price tag#. 'hen c!#toer# can copare prod!ct# ea#ily. 7ith barter and no oney, thi# #ae #tore =o!ld ha$e &--,300 price e!ation 1. 6ariable % indicate# the n!ber o price ratio# =hile n i# the n!ber o prod!ct# prod!ced in a barter #y#te. E =

n( n − 1) 2

=

1,000 ⋅ --2

= 499,500

1D

" price ratio #ho=# the ao!nt o one good that b!yer# and #eller# e!ently, a barter #ociety =o!ld prod!ce a liited n!ber o good# and #er$ice#. Money eliinate# any proble# =ith barter and ha# o!r !nction#. Fir#t !nction o oney i# a medium of e"c#an$e beca!#e people !#e oney to pay or good# and #er$ice# and repay debt#. Medi! o e
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Money, Banking, and International Finance the a!thor?# ca#e, he co!ld e!ently, in$e#tor# read the inancial #tateent# and ga!ge =hich copanie# are proitable. Finally, thi# !nction o oney eliinate# the a##i$e n!ber o price e!ire people to accept oney a# a ean# o payent to repay a debt or to pay ta!ireent i# H le$al tender . )n the other hand, bank check# are not legal tender, and people and b!#ine##e# can reect check# a# payent. Fo!rth and inal !nction o oney i# the standard of deferred payment . 'hi# !nction cobine# the Hedi! o e!ality, color, #o people kno= =hat they are getting. I a go$ernent i##!ed oney in dierent #ie# and color#, ho= =o!ld people deterine =hether bill# are legitiate or co!ntereit@ +. Durable' Money !#t be phy#ically #t!rdy, or it ight lo#e it# $al!e >!ickly a# it degrade# and all# apart. In #oe co!ntrie#, people do not accept torn, ripped, or aded oney.

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Kenneth R. S!lcyk &. aluable relative to its !ei$#t' eople can ea#ily carry large ao!nt# o oney aro!nd con$eniently and !#e it in tran#action#. 3. Divisible' !blic can break oney do=n into #aller !nit# to p!rcha#e ine!al# currency. F!rtherore, people becoe p#ychologically dependent on a c!rrency beca!#e they !#e a partic!lar c!rrency or a long tie. For e
Forms of Money eople #ince the da=n o ci$iliation created payent #y#te#. 'h!#, oney acilitate# b!#ine## tran#action#, and the payent #y#te becoe# the echani# to #ettle tran#action#. Fir#t and olde#t payent #y#te i# coodity oney. ommodity money i# go$ernent #elect# one coodity ro #ociety to becoe oney, #!ch a# gold or #il$er. I #ociety did not !#e gold or #il$er a# oney, then people #till !#e the coodity or other p!rpo#e#. eople !#e gold in e=elry, teeth illing#, electrical =ire#, or the pin# o a icroproce##or. Coodity oney co!ld be anything. For e!al# it# $al!e a# a edi! o e!al G1,000. 'h!#, thi# coin repre#ent# !llAbodied coodity oney beca!#e the coinN# inherent $al!e e>!al# the coinN# arket $al!e. ;o$ernent# di#co$ered a trick abo!t coodity oney. 7hat =o!ld happen i a go$ernent ade oneAo!nce gold coin# =ith a ace $al!e e>!aled to G2,000 =hile the coin contained G1,000 o gold@ S!b#e>!ently, a go$ernent had created G1,000 o!t o thin airP ;o$ernent can create $al!e by Hprinting oney, =hich =e call sei$niora$e+ and go$ernent co!ld recei$e #igniicant re$en!e by creating oney. ;o$ernent can deba#e it# c!rrency by relying on #eigniorage. For e
Money, Banking, and International Finance Second or o coodity oney i# representative full*bodied money. 'hi# oney ha# little inherent $al!e, #!ch a# paper bill#, b!t people can con$ert the oney into a $al!able coodity, #!ch a# gold and #il$er. For e!ently, people #top !#ing oney, and they re#ort to barter. 7e #ho= a 100Atrillion Qibab=e note in Fig!re +. " noble prie la!reate in econoic#, Milton Friedan, #tated, HInlation i# al=ay# and e$ery=here a onetary phenoenon.

Figure 3. "ne#$undred#trillion %imbab&e note

'hird payent #y#te, a c#eck+ i# credit oney tied to a per#on?# checking acco!nt. Bank#, credit !nion#, and other inancial in#tit!tion# oer checking acco!nt# to people and b!#ine##e#. 'hen people !#e check# a# a edi! o e!ently, check# ha$e three beneit#. Fir#t, people and b!#ine##e# do not carry ca#h. Second, the check pro$ide# proo o a b!#ine## tran#action. Finally, check# becoe con$enient in large tran#action#, #!ch a# b!ying a ho!#e or car. B!yer doe# not need to carry a #!itca#e o ca#h or thi# tran#action. o=e$er, check# create t=o proble#. Fir#t, the inancial in#tit!tion charge# ee# or !#ing check#, or the check =riter# ab!#e their acco!nt# and =rite ra!d!lent 13

Kenneth R. S!lcyk check# or ao!nt# that e!ently, the debit card red!ce# the !ncertainty the c!#toer# ha$e #!icient !nd# in their acco!nt or b!#ine## tran#action#. "ltho!gh any b!#ine##e# do not accept check#, they do accept debit card#. /ebit card# e
Bitcoins 'he internet created a ne= oney that e!e, encrypted n!ber that only a Bitcoin operator can decrypt. " per#on open# an acco!nt or =allet and can b!y Bitcoin# ro online $endor#. " per#on can #tore hi# Bitcoin# on hi# cop!ter or cellphone or !#e an online =allet. " per#on doe# not ha$e to re$eal hi# identity. 'hen he or #he #ettle# tran#action# by #ending the other party hi# Bitcoin inoration. "# a b!yer coplete# a tran#action, #ot=are encrypt# that per#on?# pri$ate key into the tran#action along =ith the Bitcoin n!ber. " pri$ate key i# like a per#on?# bank acco!nt n!ber. %n#!ring people do not #pend the #ae Bitcoin or !ltiple tran#action#, a iner coplete# the tran#action. " iner decrypt# the tran#action and record# it in a ledger. 'hen it reAi##!e# the Bitcoin to the #eller. " iner can earn tran#action ee# and recei$e# ne=ly created Bitcoin# by clearing tran#action#. Miner i# not the proper terinology. " iner !nction# a# a clearingho!#e. " clearin$#ouse can be a large bank that help# eber bank# tran#er oney bet=een the. 'hen eber bank# ha$e acco!nt# at the clearingho!#e. For e
Money, Banking, and International Finance Seller?# bank #end# inoration abo!t the check to the clearingho!#e and the clearingho!#e check# =ith yo!r bank. o!r bank check# yo!r balance en#!ring yo! ha$e eno!gh !nd# in the acco!nt to pay the check. )nce yo!r bank appro$e# the tran#action, the clearingho!#e red!ce# the acco!nt or yo!r bank by G300 and add# G300 to the acco!nt or the #eller?# bank. 'hen yo!r bank red!ce# yo!r acco!nt by G300 =hile the #eller?# bank add# G300 to hi# or her acco!nt, th!# clearing the tran#action. Bitcoin# ha$e o!r dra=back# that =o!ld pre$ent =ide #cale adoption. 1

eople =ho depo#it their #a$ing# into bank# ha$e depo#it in#!rance. I their bank ail#, the depo#it in#!rance g!arantee# the depo#itor# =ill not lo#e their oney. 'he Federal /epo#it In#!rance Corporation in#!re# bank depo#it# !p to G230,000 or 8.S. bank#. o=e$er, no go$ernent agency in#!re# Bitcoin or protect# people ro lo##e#.

9. acker# can break into online =allet# and #teal the Bitcoin#. Since all tran#action# are electronic, they can era#e hi#tory, and people ay not reco$er their #tolen Bitcoin#. 4. rice o Bitcoin l!ct!ate# greatly bet=een G:0 and G1,000, =hich =e #ho= in Fig!re &. For people to !#e and accept oney, people !#t kno= the oney?# $al!e. Soe in$e#tor# p!rcha#ed Bitcoin#, hoping to b!y at a lo= price and #ell or a high price. :. Fe= #eller# accept Bitcoin# a# payent.

So!rceJ httpJbitcoinchart#.cochart#

Figure !. '$e (itoin)s *alue

Bitcoin# pro$ide three beneit#. Fir#t, b!yer# and #eller# do not ha$e to re$eal their identitie# to each other. 'hey can reain #ecret. Second, people can !#e Bitcoin to la!nder or #!ggle c!rrency o!t#ide a co!ntry. " b!yer =o!ld p!rcha#e Bitcoin# in one co!ntry and =ithdra= the Bicoin# in another co!ntry, circ!$enting c!rrency control#. Finally, b!yer# and 14

Kenneth R. S!lcyk #eller# !#e Bitcoin# to #ettle tran#action# in the !ndergro!nd econoy that i# hidden =ithin the internet. 7e call thi# the deep internet =here o#t internet !#er# =o!ld ne$er #ee. 'he deep internet allo=# b!yer# and #eller# to co!nicate =ith each other =itho!t re$ealing their location or identitie#. Bitcoin i# e$ol$ing into the c!rrency o the black arket# on the internet. B!yer# and #eller# !#e Bitcoin like the n!bered S=i## bank acco!nt#. For e!ently, the tran#action reain# #ecret beca!#e no one ha# re$ealed hi# or her identitie#. 8.S. ederal go$ernent i# cracking do=n on the internet black arket and i# clo#ing do=n Bitcoin operator#. "gent# belie$e that i they can #h!t do=n the oney, they can eliinate the black arket# operating in the deep Internet or pre$ent the !nding o terrori#t#. For e!ire# all oney e
Money Supply Definitions %conoi#t# !#e t=o approache# in deining the oney #!pplyJ tran#action and li>!idity. I econoi#t# !#e the transaction approac#, they epha#ie the oney?# !nction a# a edi! o e!idity, and incl!de only li>!id a##et# in the oney #!pply beca!#e people can ea#ily #ell the#e a##et# at a !t!re tie at a kno=n price =ith ini! co#t#. 'hi# approach epha#ie# oney?# !nction a# a H#tore o $al!e, beca!#e i highly li>!id a##et# retain their $al!e, people can ea#ily !#e the a##et# to p!rcha#e good# and #er$ice# directly or indirectly. 7hy doe# thi# approach =ork@ 7hen the central bank boo#t# the oney #!pply, people =ill ad!#t their portolio# o a##et#, aecting con#!er #pending, national o!tp!t, incoe, and eployent. 'he Federal Re#er$e Sy#te deine# oney #!pply a# M1, M2, M+, and (. Many central bank# in the =orld ea#!re their oney #!pply #iilarly to 8nited State#. o=e$er, they dier =hich inancial in#tr!ent# they incl!de in their ea#!re#. %$ery co!ntry !#e# dierent inancial in#tr!ent# beca!#e co!ntrie# dier in their legal #y#te#, reg!lation# o inancial arket#, and c!#to#. 1:

Money, Banking, and International Finance %conoi#t# deine the .0 a# the narro=e#t deinition o oney #!pply beca!#e they !#e the tran#action approach to deterine =hich inancial in#tr!ent# to incl!de. M1 add# the ollo=ing three ite# togetherJ 

C!rrency held by the p!blic and in bank $a!lt#. It e


"ll or# o checking acco!nt#.



'ra$eler?# Check# that are held by people and not by the bank#.

%conoi#t# deine the .1 a# a broader deinition than M1 beca!#e they !#e the li>!idity approach to deine the oney #!pply. %conoi#t# add the ollo=ing together or M2J  

Incl!de e$erything in M1. Incl!de all #all denoination #a$ing# depo#it# and tie acco!nt# at all inancial in#tit!tion#. Sall denoination in the 8.S. ean# the bank acco!nt ha# a balance le## than a G100,000. %
%conoi#t# deine .2 broader than M2 and incl!de the ollo=ing ite# #!ed togetherJ 

Incl!de e$erything ro M2.



Incl!de large denoination #a$ing# and tie acco!nt#, and li>!id #ec!ritie# =ith longer in$e#tent tie# than the inancial in#tr!ent# incl!ded in M2. For e
%conoi#t# deine L or li>!idity a# the broade#t ea#!re o the oney #!pply and incl!de all li>!id a##et#. 'he Federal Re#er$e doe# control thi# ea#!re. ( #!# the ollo=ing ite# together. 

Incl!de e$erything ro M+.



Incl!de all #hortAter #ec!ritie#, #!ch a# 'rea#!ry Bill# i##!ed by the 8.S. Federal go$ernent. Reer to Chapter 2 or e
'he Fed #topped p!bli#hing the M+ deinition o the oney #!pply on March 2+, 2009. It #tated M+ doe# not pro$ide any !#e!l p!rpo#e, and the Fed doe# not !#e M+ in or!lating onetary policy. Soe international in$e#tor# belie$e the Fed #topped p!bli#hing M+ beca!#e #oe people ear a 8.S. dollar collap#e on the international arket# beca!#e the 8nited State# #!er# ro large trade deicit# and a a##i$e national go$ernent debt. 7e di#c!## the#e 1-

Kenneth R. S!lcyk i##!e# in Chapter 3D. 'he M+ deinition contain# the ao!nt o 8.S. dollar# held o!t#ide the 8nited State#. 7hich deinition o the oney #!pply i# the be#t@ Fo!r onetary aggregate# gro= at dierent rate#, at dierent tie#, and e$en in dierent direction#. Beore 1-:1, a #table relation#hip e
Key Terms inancial arket inancial in#tit!tion inoration ri#k li>!idity oney oney #!pply central bank Federal Re#er$e Sy#te Fed onetary policy inlation b!#ine## cycle ;ro## /oe#tic rod!ct ;/D intere#t rate# noinal ;/ real ;/ barter do!ble coincidence o =ant# edi! o e
#tore o $al!e p!rcha#ing po=er legal tender #tandard o deerred payent c!rrency coodity oney !llAbodied oney #eigniorage repre#entati$e !llAbodied oney iat oney hyperinlation check debit card a!toated teller achine# "'MD Bitcoin clearingho!#e tran#action approach li>!idity approach M1 M2 M+ (

Chapter Questions 1

Identiy the p!rpo#e o inancial arket# and inancial in#tit!tion#.

-. 7hich ad$antage# do inancial in#tit!tion# pro$ide =hen copared to the inancial arket#@

20

Money, Banking, and International Finance 10. 7hy i# li>!idity iportant in deining the oney #!pply or a co!ntry =ith #ophi#ticated inancial arket#@ 11. /eine onetary policy. 12. 7hich three $ariable# o the econoy can central bank# inl!ence@ 1+. lea#e deine the ollo=ing ter#J inlation, gro## doe#tic prod!ct, and intere#t rate#. 1&. Identiy the dierence bet=een real and noinal. 13. 7hich proble# doe# a barter econoy #!er ro@ 19. o= do the !nction# o oney o$ercoe the proble# a##ociated =ith barter@ 14. 7hat i# #eigniorage@ 1:. /i#ting!i#h bet=een the dierent payent #y#te#. 1-. /i#ting!i#h bet=een the tran#action approach and li>!idity approach o deining the oney #!pply. 20. Identiy the dierence# bet=een M1, M2, M+, and (. 21. !dge =hether credit card# #ho!ld be a or o oney.

2. Overview of the U.S. Financial System 'hi# chapter e!ently, the go$ernent pa##ed la=# that hea$ily reg!lated the banking #y#te, enlarging the n!ber o 8.S. bank# and #hrinking the bank#? a##et #ie. Moreo$er, the 8nited State# created t=o layer# o coercial 21

Kenneth R. S!lcyk bank#J national and #tate bank#. Se$eral go$ernent agencie# at the ederal andor #tate le$el reg!late the#e bank#. Con#e>!ently, bank# ha$e !#ed ingenio!# ethod# and inno$ation# to circ!$ent go$ernent#? reg!lation#.

Financial Intermediation " financial system tran#er# !nd# ro savers to borro!ers. Sa$er# and borro=er# can be anyone. Soe ho!#ehold#, b!#ine##e#, and go$ernent# are net #a$er# beca!#e they #pend le## than their incoe, and they becoe the #o!rce o loan# =hile other ho!#ehold#, b!#ine##e#, and go$ernent# are net borro=er#. 'hey #pend ore than their incoe#. For e!iring the to balance their b!dget#. 'hi# i#cal re#pon#ibility orce# any local and #tate go$ernent# in the 8nited State# to be net #a$er# =hile the 8.S. ederal go$ernent ha# been a net borro=er or the la#t 30 year#. 'ran#er o !nd# ro #a$er# to borro=er# i# $ital to an econoy. I the borro=er# in$e#t the !nd# by p!rcha#ing achine# and e>!ipent, the borro=er# can prod!ce ore good# and #er$ice#. 7hen b!#ine##e# prod!ce ore good# and #er$ice#, #!b#e>!ently, the econoy gro=#, and a gro=ing econoy create# ob# and ri#ing incoe#. "# con#!er# e!ently, the b!#ine## can in$e#t ne= achine# and e>!ipent, boo#ting it# prod!ction le$el, and creating econoic gro=th. Sa$er# link to the borro=er# thro!gh t=o ro!te#J inancial interediarie# and direct inance. Coon financial intermediaries incl!de bank#, !t!al !nd#, and in#!rance copanie#. For e
Money, Banking, and International Finance ipact on corporate policy. Finally, the #tockholder# earn a #hare o the proit#, =hich =e call dividends. Second inancial in#tr!ent i# a bond . " bond con#i#t# o a #tandardied loan to a corporation. " bond i# ancy paper gi$ing bondholder# legal right# =here the corporation proi#e# to repay a longAter loan pl!# intere#t to the bondholder#. I a corporation bankr!pt# and i# li>!idated, bondholder# ha$e a higher priority and clai on the corporation?# a##et#, =hile the coon #tockholder# coe la#t.

So!rceJ ===.old#tockre#earch.coa>.ht

Figure 1. +n example of a stok ertifiate

Bond# and #tock# ha$e t=o arket#J the priary arket and #econd arket. " corporation or go$ernent i##!e# brandAne= #ec!ritie# in the primary market by #elling the directly to #ec!rity dealer#. 'h!#, they #ell ne= #ec!ritie# in the priary arket, =hile in$e#tor# #ell and b!y e!idity o inancial in#tr!ent#. In$e#tor# can ea#ily #ell or b!y inancial #ec!ritie# on #econdary arket#. Moreo$er, =hen go$ernent or corporation# i##!e ne= #ec!ritie#, the price# ro the #econdary arket #et the price# or the ne= #ec!ritie# in the priary arket. 7hy =o!ld #a$er# depo#it their oney into bank#, in#tead o in$e#ting directly into the inancial arket#@ Financial interediarie# pro$ide three !nction#. Fir#t, yo!r bank acco!nt ha# liquidity. I an eergency ari#e#, yo! can ea#ily =ithdra= !nd# ro yo!r acco!nt. I yo! p!rcha#ed #tock and bond# ro the inancial arket#, yo! co!ld e
Kenneth R. S!lcyk hand, i yo! directly in$e#ted in a copany that bankr!pt#, then yo! co!ld lo#e all o yo!r in$e#tent. Sa$er# co!ld =ithdra= their oney o!t o the inancial interediarie# and in$e#t directly in the inancial arket#, #!ch a# b!ying 8.S. go$ernent #ec!ritie#. 7e call thi# proce##  financial disintermediation. Sa$er# ha$e t=o rea#on# to in$e#t directly in go$ernent. Fir#t, a go$ernent ay pay a higher intere#t rate than a bank. For e!ipent. Con#e>!ently, a large go$ernent debt co!ld ipact the inancial arket# and haper b!#ine## in$e#tent beca!#e a large go$ernent debt cro=d# o!t pri$ate in$e#tent. For e!antity today, b!t they e
Financial Instruments %$ery inancial in#tr!ent, e!id and alo#t a# good a# oney  hence the nae oney arket. Second category, the capital market , incl!de# longA ter #ec!ritie# =ith a at!rity greater than a year. Capital arket incl!de# coon #tock beca!#e #tock ha# no e
Money, Banking, and International Finance o! #ho!ld eorie the ollo=ing #ec!ritie# beca!#e =e contin!ally reer to the#e inancial in#tr!ent# thro!gho!t thi# book. For #t!dent# to !nder#tand the#e #ec!ritie#, reeber =ho i##!e# the #ec!rity, and =hether it i# a oney arket or capital arket #ec!rity. "ll the#e #ec!ritie# ha$e one p!rpo#e. )ne party o=e# another party oney pl!# intere#t e
34S4 -reasury bills or -*billsD are loan# to the 8.S. go$ernent. Mat!ritie# range ro 13 day# to one year. 'Abill# do not ha$e an intere#t rate #taped on the, and they #tart at G10,000. I an in$e#tor b!y# a 'Abill or G1-,000, and the 'Abill ha# a ace $al!e o G20,000 =ith a at!rity o #i< onth#. 'hen #i< onth# later, the go$ernent =ill pay G20,000. 'he G1,000 relect# the intere#t.



ommercial paper i# a loan to a =ellAkno=n bank or corporation or a #hortAtie period. Corporation# !#e coercial paper to rai#e !nd# =itho!t i##!ing ne= #tock# or bond#. Coercial paper i# a or o direct inance, and the loan ha# no collateral.



/anker5s &cceptances are !#ed in international trade. For e!id beca!#e holder# can #ell the on a #econdary arket.



e$otiable /ank ertificates of Deposit D#D are loan# to bank# that bank# #ell directly to depo#itor#. C/# ha$e a i!ently, C/# !#!ally pay a greater intere#t rate than a #a$ing# acco!nt.



Repurc#ase &$reements repo#D are #hortAter loan#. For e!ently, the bank paid intere#t on a checking acco!nt, altho!gh the 8.S. la= prohibited bank# to pay intere#t on checking acco!nt#.

23

Kenneth R. S!lcyk 

Federal Funds are o$ernight loan# bet=een bank#. For e


6urodollars are 8.S. dollar# that people depo#it in oreign coercial bank# o!t#ide the 8nited State# and in oreign branche# o 8.S. bank#. %!rodollar# are an iportant #o!rce o !nd# in the international arket. F!rtherore, the e!ro ha# becoe a pop!lar c!rrency or in$e#tor#, =ho ha$e bank acco!nt# denoinated in e!ro# that are located o!t#ide the %!roone. 'he %!roone copri#e# o the 14 co!ntrie# =ithin the %!ropean 8nion that !#e the e!ro a# it# c!rrency. I people and in$e#tor# ha$e e!ro denoinated acco!nt# o!t#ide the %!roone, then =e #till call it %!rodollar#.

Capital arket #ec!ritie# ha$e at!ritie# longer than a year, and =e li#t the coon one#J 

8.S. 'rea#!ry #ec!ritie# are loan# to the 8.S. go$ernent. 'he 8.S. go$ernent i##!e# -reasury otes or -*notes ro one to 10 year#, =hile -reasury /onds or -* bonds ha$e at!ritie# greater than 10 year#. 'he#e 'rea#!ry #ec!ritie# ha$e a #tated intere#t rate, and go$ernent !#!ally pay# intere#t e$ery #i< onth#.



State and local go$ernent# can i##!e bond#, called !nicipal bond#. 'he 8.S. ederal go$ernent enco!rage# in$e#tor# to b!y the#e bond# by e


7e incl!de #tock# and bond# that =e had deined earlier in thi# chapter.



.ort$a$e i# a loan on a ho!#e or property and the loan d!ration range# ro 13 to +0 year#. 8#!ally, the property becoe# the collateral. For in#tance, i a hoeo=ner lo#e# hi# ob and cannot repay the ortgage, then the bank take# po##e##ion o hi# ho!#e. 7e call thi# proce## oreclo#!re a# a bank take# the property and e$ict# the hoeo=ner#. " $ariety o #a$ing# in#tit!tion# and bank# grant# ortgage#, aking ortgage# the large#t debt arket.

29

Money, Banking, and International Finance 

Coercial bank loan# are bank# lending to b!#ine##e#. 'he#e loan# do not ha$e =ell de$eloped #econdary arket#.



;o$ernent agencie# can i##!e #ec!ritie#. For e!a#iA go$ernent agency and lend# to college #t!dent#. 'hen Sallie Mae pool# the #t!dent loan# into a !nd and i##!e# bond#, allo=ing in$e#tor# to b!y into the !nd. S!b#e>!ently, the in$e#tor# indirectly earn the intere#t ro the #t!dent#? onthly payent#. 'h!#, Sallie Mae increa#e# the li>!idity o #t!dent loan#.

Sallie Mae ay e!ently, high #chool grad!ate# ay #h!n college to a$oid acc!!lating debt, #parking a inancial cri#i# or the 8.S. college# and !ni$er#itie#. 'hen the college# and !ni$er#itie# co!ld contract #iilarly to the 8.S. ho!#ing arket ater 2004.

The United States Banking System 'he 8nited State# banking #y#te dier# ro other ind!#trialied co!ntrie#. For in#tance, the 8nited State# ha# ore bank# per capita, and the bank# po##e## e=er a##et# beca!#e the 8.S. go$ernent ipo#ed #trict reg!lation#. %arly in the 8nited State# hi#tory, the p!blic and go$ernent eared big bank#, #o #tate and ederal go$ernent# pa##ed reg!lation# that orced bank# to be #aller and enco!raged a large n!ber o bank# to or. 'he 8nited State#, !rtherore, ha# a dual bankin$ system. " bank choo#e# a charter ro a #tate go$ernent or ro the 8.S. ederal go$ernent. " charter i# a doc!ent that legally e#tabli#he# a corporation and allo=# a inancial in#tit!tion to participate in banking acti$itie#. " national bank recei$e# a charter ro the ederal go$ernent, =hile a state bank recei$e# a charter ro a #tate go$ernent. I a bank recei$e# a charter ro the ederal go$ernent, then three go$ernent agencie# can reg!late that bank, =hich areJ 

omptroller of t#e urrency, an oice in the 8.S. 'rea#!ry /epartent, reg!late# national bank#. 'hi# oice al#o grant# charter# on behal o the 8.S. ederal go$ernent, and it re>!ire# national bank# to be eber# o the Federal Re#er$e and Federal /epo#it In#!rance Corporation. "# o 2010, the 8nited State# had ro!ghly 1,300 national bank# and 30 oreign national bank#.



Federal Deposit Insurance orporation (FDI) in#!re# depo#it# at eber bank#. I thi# agency in#!re#, then it al#o reg!late#. "# o 200-, the F/IC had :,1-3 eber bank#.

24


Federal Reserve System (Fed) i# the central bank o the 8nited State# and the lender of t#e last resort . 7hen a bank enco!nter# inancial diic!ltie# and cannot recei$e a loan ro other inancial in#tit!tion#, then the bank can a#k the Fed or a loan. Moreo$er, the Fed reg!late# bank#.

" #tateAchartered bank co!ld ha$e e=er reg!lation#. " #tate go$ernent agency reg!late# it# #tate bank#, and any #tate# re>!ire their bank# to oin the Fed andor F/IC. 'hereore, a #tate bank co!ld ha$e one or ore reg!latory agencie# to deal =ith. 8.S. go$ernent ipo#ed another re#triction !pon the 8.S. banking ind!#try  the McFadden "ct. 'he .cFadden &ct prohibited a coercial bank ro opening a branch in another #tate. 'hi# la= p!t national and #tate bank# on e>!al ooting and helped o#ter copetition. o=e$er, thi# la= kept #all ineicient bank# in b!#ine##, ca!#ing the 8nited State# to ha$e the large#t n!ber o bank# in the =orld. 'he 8nited State# had 1&,214 bank# in 1-:9, =hich ell to -,&3- bank# by 2010. Soe #tate# ipo#ed ore re#triction# !pon their bank# than other #tate#. For e
Money, Banking, and International Finance aect# the inancial arket#. Con#e>!ently, central bank# need go$ernent reg!lation# to control onetary policy eecti$ely and help achie$e lo= inlation and lo= !neployent. Reason 3: 'he 8. S. go$ernent =ant# to proote eiciency in the inancial interediation proce##. Reason !: 'he 8.S. go$ernent =ant# to pro$ide lo=Aco#t inancing or hoeb!yer#. 'hi# de#ire led to the 8.S. o!#ing B!bble that occ!rred bet=een 1--4 and 2004. Reason ,: Financial arket# depend on acc!rate inoration. ;o$ernent# en#!re borro=er# pro$ide acc!rate inoration to in$e#tor#. In the 8nited State#, the Securities and 6"c#an$e ommission (S6) re>!ire# p!blicly traded copanie# i.e. a copany #ell# #tock to the p!blicD to di#clo#e inancial inoration ba#ed on acceptable acco!nting #tandard#. Reason -: 'he 8.S. go$ernent =ant# to protect con#!er#. Financial #y#te, #!ch a# a bank can be $ery coplicated. Many depo#itor# do not !nder#tand the inancial in#tr!ent#, and thereore, they are not able to ga!ge the #o!ndne## o the in#tit!tion or ake rational deci#ion#. In a copetiti$e arket like '6#, /6/#, cop!ter#, and cell phone#, the con#!er# can ea#ily e$al!ate and copare dierent prod!ct#.

The lass Steagall Banking !ct olitician# and the p!blic tho!ght coercial bank# #ho!ld not !nder=rite ne= #tock and bond# or corporation# beca!#e they belie$ed bank# =ere !nder=riting Hri#ky #ec!ritie#. F!rtherore, the bank# po##e## enoro!# po=er to create onopolie#. 'h!#, the 8nited State# go$ernent pa##ed the Glass*Stea$all /ankin$ &ct in 1-++. 'hi# la= di$ided the !nction# o in$e#tent banking and coercial banking. " coercial bank i# a #tandard bank =hile an in$e#tent banker arket# and #ell# brand ne= #tock# and bond#. In practice, the ;la##ASteagall Banking "ct in#!lated in$e#tent banking ro the copetition. Con#e>!ently, borro=er# co!ld pay ore or i##!ing ne= #ec!ritie# than they =o!ld pay i coercial bank# co!ld !nder=rite ne= #ec!ritie#. 'he 8nited State# go$ernent repealed piece# o the ;la##ASteagall "ct in 1--to allo= 8.S. in$e#tent bank# to copete internationally a# they o$ed into coercial banking and in#!rance. 'he ;la##ASteagall "ct al#o created the Federal /epo#it In#!rance Corporation F/ICD. 'he F/IC, a p!blic corporation, in#!re# the depo#it# o each depo#itor in coercial bank# !p to G230,000. For e
Kenneth R. S!lcyk depo#itor#. I F/IC doe# not recei$e eno!gh oney to pay all depo#itor# ro #elling the bank?# a##et, #!b#e>!ently, the F/IC pay# the dierence ro it# o=n !nd#. 'h!#, the F/IC rarely !#e# the ir#t ethod beca!#e the F/IC co!ld pay o!t illion# or billion# in clai#. Second, the F/IC p!rcha#e# and a##!e# control o the ailed bank. *e!id loan#, then the bank !#t #ell the#e loan# at a di#co!nt in order to rai#e ore re#er$e#. Selling the illi>!id loan# at a di#co!nt can ca!#e the bank to becoe in#ol$ent. Insolvent occ!r# a# a bankN# total liabilitie# e!ently, any bank on the $erge o ailing cannot ret!rn oney to it# depo#itor#. %$en a inancially healthy bank co!ld ail i people #pread r!or# the bank ha# inancial tro!ble#. 'hen the r!or trigger# a bank r!n. Bank r!n# can lead to contagion. onta$ion i# a bank r!n on one bank lead# to bank r!n# on other bank#. For e!ently, any depo#itor# do not get their oney back. 'hen the depo#itor# tell riend# and aily, and they begin >!e#tioning the health o their bank#. Many people cannot ga!ge the inancial health o bank#. Friend# and aily r!n to their bank# to =ithdra= !nd# ro their acco!nt#, triggering ore bank r!n#. "# the contagion #pread#, it ca!#e# a =a$e o #e$ere bank r!n# called financial panics. Financial panic# can p!#h the econoy into a #erio!# rece##ion. 'he F/IC charge# in#!rance prei!# ba#ed on the total ao!nt o depo#it# at the bank and the ri#k le$el the depo#itory in#tit!tion# po#e to the F/IC. Many bank# are e!ire# bank# to prepay their depo#it in#!rance or 2010, 2011, and 2012. 'he F/IC =ant# bank# to prepay G&3 billion in depo#it in#!rance ater it already do!bled the in#!rance prei!# or 200-.

Financial Inno"ation Financial arket# and in#tit!tion# contin!ally change and e$ol$e, and financial innovation can dri$e thi# change. I a ne= inancial in#tr!ent lo=er# ri#k, increa#e# li>!idity, or increa#e# inoration, then in$e#tor# are attracted to the ne= #ec!rity. For e
Money, Banking, and International Finance inancial inno$ation. " !t!al !nd pool# oney ro any people together into a !nd, and a !nd anager in$e#t# the !nd in a $ariety o #tock#. Con#e>!ently, thi# ethod lo=er# in$e#tor#? ri#k thro!gh di$er#iication o #tock#. For e!ently, the#e in#tit!tion# ingenio!#ly circ!$ented the#e reg!lation# by creating ne= inancial in#tr!ent# or ne= inancial in#tit!tion#. Fir#t ethod to circ!$ent banking reg!lation#, bank leader# and o=ner# de$eloped bank #oldin$ companies. " bank holding copany i# one corporation obtain# o=ner#hip or control o t=o or ore independent bank#. " bank holding copany can do three thing#. 

Bank holding copany can branch =ithin #tate# or acro## #tate line#. For e


Bank holding copanie# can b!y other nonAbank copanie# and enter other #phere# o econoic acti$ity, #!ch a# data proce##ing, in$e#tent ad$ice, and in#!rance. "llo=ing bank# to participate in noninancial acti$itie# i# called universal bankin$ .



Bank holding copany can rai#e nonAdepo#it !nd#. For e
Second inno$ation, nonbank bank+ allo=# bank# to circ!$ent ederal and #tate reg!lation#. (egal deinition o a bank i# an in#tit!tion that accept# depo#it# and ake# loan#. 7hat =o!ld happen i a bank #topped accepting depo#it#@ (egally, the bank i# no longer a bank and becoe# e!id oneyAarket a##et# anaged by in$e#tent copanie#. 'he MMMF i# identical to a !t!al !nd. In$e#tent copanie# #ell #hare# to the p!blic in #all denoination#, and the !nd anager# in$e#t in oney arket in#tr!ent#. Con#e>!ently, MMMF becae $ery #!cce##!l. MMMF gre= ro G+.+ billion in 1--4 into G1:9.- billion in 1-:1 and -3-.: billion by 2010. 'he MMMF# began h!rting the bank# inancially a# people #tarted =ithdra=ing oney ro their bank acco!nt# and in$e#ting the into MMMF#. MMMF# paid a higher intere#t rate, +1

Kenneth R. S!lcyk and they allo= checkA=riting pri$ilege#. "ccordingly, bank# began lo#ing c!#toer#, and they place pre##!re the reg!latory agencie# that, in t!rn, placed pre##!re on Congre## and the re#ident to change the la=#. Since 1-:2, bank# began oering money market deposit accounts (..D&D that are #iilar to a MMMF =ith only one dierence. 'he F/IC con#ider# a MM/" to be a bank acco!nt and th!#, it in#!re# the, =hile it doe# not in#!re MMMF#. Finally, MM/"# ha$e no re#er$e re>!ireent#, and they ha$e gro=n rapidly a# people #tarted to in$e#t in the. (a#t inno$ation, automated teller mac#ine (&-.)+ allo=ed bank# to circ!$ent reg!lation#. Modern cop!ter technology allo=# a bankN# c!#toer# to recei$e banking #er$ice# thro!gh cop!ter terinal# located at bank#, #tore#, and #hopping all#. C!#toer# can ake depo#it#, =ithdra=al#, and creditAcard tran#action#. 'echnically, "'M# are not bank branche#, and are not #!bected to branch banking re#triction#. 'hereore, "'M# are located #oe di#tance a=ay ro the ain bank. F!rtherore, any bank# created net=ork#, #o c!#toer# co!ld acce## their acco!nt# ro any place =ithin the 8nited State# and acro## the =orld. Moreo$er, bank# oer debit card#. For e!ire other bank#, red!cing the n!ber o bank# in the 8nited State#. Second, a# bank# erge, they becoe bigger a# their a##et# gro=. 8.S. bank# =ere approaching the #ie o apane#e and ;eran bank#, =hich traditionally =ere larger in a##et #ie. 'hen the 200: Financial Cri#i# #tr!ck the 8.S. econoy, ca!#ing any coercial and in$e#tent bank# to teeter on bankr!ptcy. 'he 8.S. ederal go$ernent cae to the re#c!e and p!rcha#ed #tock o any inancial corporation#. 'a!ently, the 8.S. go$ernent helped and appro$ed any bank erger#, incl!ding erger# bet=een coercial and in$e#tent bank#. Con#e>!ently, the 8.S. go$ernent bailed o!t the#e bank# beca!#e they =ere too big to ail. " =a$e o large bank ail!re# =o!ld iplode the =hole 8.S. inancial #y#te. 'h!#, the 8.S. bank# =ill becoe larger =ith partial go$ernent o=ner#hip or intererence depending on yo!r $ie=pointD. Many critic# o inancial dereg!lation deand the 8.S. go$ernent to reAenact the ;la## Steagall "ct that =o!ld #eparate coercial and in$e#tent banking acti$itie#. Many leader# aro!nd the =orld are debating =hether to pa## ne= la=# to #eparate coercial and in$e#tent banking in their co!ntrie# beca!#e the 200: Financial Cri#i# orced go$ernent# to #pend billion# in bailing o!t their large bank#.

#e$sites Coptroller o the C!rrency

httpJ===.occ.trea#.go$ +2

Money, Banking, and International Finance Federal /epo#it In#!rance Corporation

httpJ===.dic.go$

Federal oe (oan Bank Sy#te

httpJ===.hlbank#.co

Federal Re#er$e Sy#te

httpJ===.ederalre#er$e.go$

*ational Credit 8nion "dini#tration

httpJ===.nc!a.go$

Key Terms inancial #y#te #a$er# borro=er# inancial interediation inancial arket inancial #ec!rity direct inance e>!ity di$idend priary arket #econdary arket li>!idity inoration dea!lting ri#k di$er#iication inancial di#interediation ca#h arket #pot arket deri$ati$e arket principal intere#t at!rity oney arket

capital arket d!al banking #y#te national bank #tate bank Coptroller o the C!rrency Federal /epo#it In#!rance Corporation Federal Re#er$e Sy#te FedD lender o the la#t re#ort McFadden "ct !nit banking branch banking Sec!ritie# and %
The Common Financial Instruments coon #tock bond 8.S. 'rea#!ry bill 'AbillD coercial paper banker?# acceptance

'rea#!ry *ote 'AnoteD 'rea#!ry Bond 'AbondD generalAobligation bond re$en!e bond ortgage ++

Kenneth R. S!lcyk negotiable bank certiicate depo#it rep!rcha#e agreeent Federal F!nd# %!rodollar#

o

!t!al !nd oneyAarket MMMFD oney arket MM/"D

!t!al

!nd

depo#it

acco!nt

Chapter Questions 1

7hy =o!ld people depo#it their #a$ing# into inancial interediarie#, in#tead o directly in$e#ting in the inancial arket#@

22. /i#ting!i#h bet=een #tock# and bond#. 2+. /i#ting!i#h bet=een the priary and #econdary arket#. 2&. "pprai#e the iportance o the #econdary arket#. 23. /eine inancial di#interediation, and =hy it occ!r#@ 29. Identiy the oney arket in#tr!ent# and capital arket in#tr!ent#. 24. /i#ting!i#h bet=een a oney arket and capital arket. 2:. /o coon #tock# ha$e a at!rity date@ 2-. "pprai#e the dierence bet=een a #tate bank and a national bank. +0. 7hich go$ernent agencie# reg!late the coercial bank#@ +1. %
Money, Banking, and International Finance +-. /i#ting!i#h bet=een a oneyAarket !t!al !nd and a oneyAarket depo#it acco!nt.

3. Mltinational !nter"rises 'hi# chapter deine# and di#ting!i#he# the three b!#ine## or#J proprietor#hip#, partner#hip#, and corporation#. 'hen #t!dent# #t!dy the corporation# e
Forms of Business %rgani&ations ;oal o a b!#ine## i# to earn proit#. "lred . Sloan #tated, H;eneral Motor# i# not in the b!#ine## o aking a!toobile#. ;eneral Motor# i# in the b!#ine## o aking oney. "ll b!#ine## o=ner# #eek proit, and =e cla##iy the a# a #ole proprietor#hip, partner#hip, and corporation#. Sole proprietors#ip i# one per#on o=n# the b!#ine##. 'hat one per#on becoe# liable or all the b!#ine##?# debt#, and the b!#ine## i# di##ol$ed legally, =hen the o=ner die#. Sole proprietor# are the o#t n!ero!# b!#ine##e# in the 8nited State#, and they !#!ally o=n ar#, grocery #tore#, hotel#, and re#ta!rant#. " partners#ip i# a b!#ine## o=ned and anaged by t=o or ore people. artner#hip i# deined a# general or liited liability. 8nder a general partner#hip, all partner# becoe liable or the partner#hip?# debt# and obligation#. I one partner applie# or a bank loan, #teal# the oney, and lee# the co!ntry, the reaining partner# becoe liable or the bank loan. " liited liability partner#hip re#trict# liability and help# protect the partner#? a##et# that he or #he doe# not !#e directly in the b!#ine##. 'h!#, a partner can only lo#e a##et# in$e#ted in the partner#hip =hile hi# or her other a##et# are protected ro creditor#. )n the other hand, general partner#hip# do not ha$e thi# protection. I a general partner#hip bankr!pt#, then creditor# can go ater a partner#? a##et# #!ch a# the partner#? ho!#e, car, per#onal bank acco!nt#, and other a##et#. 8#!al partner#hip# are acco!nting and la= ir#. " corporation becoe# the la#t or, and the oc!# o thi# chapter. "ltho!gh corporation# copri#e appro
Kenneth R. S!lcyk a
Corporations Corporation# #tart a# pri$ate copanie# that tran#or into a corporation. 'hey ha$e an Initial Public 7ffer (IP7), the day the corporation begin# #elling #tock to the p!blic. 8#!ally, the corporation?# o!nder hold# large #hare# in the copany?# #tock and becoe# a illionaire or billionaire o$er night ro the arket $al!e o hi# or her #tock holding#. " c#arter i# a legal doc!ent ro go$ernent that create# the corporation. By la=, the corporation becoe# an independent legal entity =ith right# #iilar to a per#on. " #tate go$ernent appro$e# corporate charter# in the 8nited State#. For e!al# one $ote. Con#e>!ently, the aority #hareholder doinate# the board o director#, and thereore, control# the corporation. ) co!r#e, a aority #hareholder co!ld be another corporation. *e
Figure 1. '&o forms of orporate management

+9

Money, Banking, and International Finance Corporation# are large organiation# that can rai#e a #!b#tantial ao!nt o inancial capital. Con#e>!ently, a corporation ha# inancial re#o!rce# to enter oreign co!ntrie# and doinate international trade. F!rtherore, it create# #pecial departent# that eploy #peciali#t# in la=, ta
" corporation ha# liited liability. Stockholder# o=n the corporation, and they are not liable or a corporationN# debt. I a corporation ail#, #!b#e>!ently, the #tockholder# only lo#e their in$e#tent, the ao!nt o coon #tock that they had p!rcha#ed.



Stockholder# can ea#ily tran#er corporate o=ner#hip. Stocks are certiicate# that repre#ent o=ner#hip in a corporation, and #tockholder# can reely b!y or #ell #tock to other in$e#tor# thro!gh the #tock arket.



Corporation# ha$e contin!ity o lie. 'heoretically, a corporation co!ld li$e ore$er.



Stockholder# do not ha$e a mutual a$ency relations#ip, =here the #tockholder# cannot bind a corporation to contract#. Stockholder# ha$e no #ay in the daily operation o the corporation e$en tho!gh they o=n the corporation.

Corporation# ha$e t=o di#ad$antage#. Fir#t, go$ernent hea$ily reg!late# corporation#. Corporation# ile any report# =ith go$ernent beca!#e corporation# can e!ently, a corporation co!ld i##!e preerred #tock to e
umulative Preferred Stock  a corporation !#t pay pa#tAd!e di$idend# to c!!lati$e preerred #tockholder# beore it pay# di$idend# to coon #tockholder#. Stockholder# only recei$e di$idend#, =hen the board o director# declare# the.

+4


Protected Preferred Stock  a corporation !#t depo#it part o it# proit# into a !nd, and, th!#, the corporation can g!arantee di$idend payent# to preerred #tockholder#.



Redeemable Stock  a corporation ha# the right to rep!rcha#e the preerred #tock in the !t!re.



onvertible Stock  a #tockholder can con$ert preerred #tock into coon #tock on a #peciic date in the !t!re.

I##!ing o #tock allo=# corporation# to garner large ao!nt# o inancial capital. F!rtherore, a corporation can rai#e capital by i##!ing bond#. " bond i# a loan. o=e$er, a bond i# #tandardied, allo=ing in$e#tor# to b!y or #ell bond# on the inancial arket#. Moreo$er, a bondholder ha# t=o right#. Fir#t, a corporation pay# intere#t on the bond, regardle## o a corporation?# inancial po#ition. Second, a corporation pay# the ace $al!e o the bond on a #peciic date in the !t!re. I a corporation bankr!pt# or it i# di##ol$ed, #!b#e>!ently, the corporate debt# are paid ir#t that incl!de bond#, bank loan#, and ta!al# /L the #tock price i# , and t indicate# today?# tie. 7e calc!late yo!r di$idend yield a# 3 in %>!ation 1. D dividend yield = 100 ⋅ t P t

= 100 ⋅

G1 G20

= 3K 1D

In$e#tor# co!ld earn a capital $ain, =hich ean# they can #ell their #tock or a greater price than the ao!nt they paid or it. For e!ation 2. *otice the #!b#cript#L t repre#ent# today =hile tA1 repre#ent# la#t year. I the in$e#tent doe# not +:

Money, Banking, and International Finance e!al one year, then =e !#t ad!#t the capital gain. For in#tance, i yo!r in$e#tent la#ted or t=o year#, #!b#e>!ently, yo! =o!ld di$ide the capital gain by 2, con$erting it into an ann!al ret!rn. capital gain = 100 ⋅

P t − P t −1 P t −1

= 100 ⋅

G20 − G1: G1:

= 11.1K 2D

o!r ret!rn ro yo!r Facebook in$e#tent i# the di$idend yield pl!# the capital gain, or 19.1. Corporate anager# can inl!ence the di$idend yield that range# appro!ickly pl!et# d!ring a do=nt!rn in an econoy. For e!ently, in$e#tor# co!ld earn capital lo##e# i they #ell their #tock a# it all# in $al!e, or the corporation bankr!pt#. Corporation# can !#e #!b#idiarie# to a$oid reg!lation# or a$oid ta!ently, corporation# can #hit a##et# and liabilitie# aong #!b#idiarie# to decrea#e their o$erall ta< b!rden. "t thi# point, =e clariy #oe ta< terinology. -a" evasion i# a per#on or corporation o=e# a go$ernent or ta!ire# the to pay ta!ently, the Italian port# reported &0 decline# in yacht docking a# the yacht o=ner# a$oid Italy?# port#. 8nort!nately, the econoie# aro!nd the port# #!er ro e=er c!#toer#, =ho #hop and eat in the local co!nitie#, =hich co!ld !rther depre## ta< re$en!e#.

Corporate Fraud 'he %nron Corporation declared bankr!ptcy in 2001 and becae the !ni$er#al #ybol or corporate ra!d. %nron anager# created Special !rpo#e %ntitie# S%D =ith the #ole p!rpo#e to =ipe debt and liabilitie# ro %nron?# inancial #tateent#. " Special Purpose 6ntity con#i#t# o a copany or #!b#idiary o the corporation. " S% co!ld be a #hell copany, =here the copany doe# not phy#ically e
Kenneth R. S!lcyk 'he %nron anager# in$e#ted in any po=er plant# aro!nd the =orld, and #oe o it# in$e#tent# #o!red and ailed. 'hen, they created oAbalance #heet copanie#, and they #old it# bad in$e#tent# to it# S%#. "ter=ard#, their balance #heet appeared inancially #trong, and %nron applied or ore bank loan#, gaining ore ca#h. *e!ired CF)# and C%)# to #ign their copany?# inancial #tateent#. (a=?# goal =a# to increa#e tran#parency. -ransparency ean# o!t#ider# can look at an organiation, and kno= the r!le# and can acc!rately a##e## a irN# tr!e inance#. 8nort!nately, %nron =a# Ha black bo<, and only a e= in#ider# kne= %nron?# gen!ine inancial pict!re. )n the other hand, a nonA tran#parent go$ernent tend# to be corr!pt. For e!ently, the b!rea!crat# ha$e =ide di#cretion =hether to appro$e a b!#ine## licen#e or acti$ity, !eling corr!ption. 'he 8.S. econoy rebo!nded ro the #trong, o$erly optii#tic real e#tate arket. %$eryone orgot %nron?# i#deed# !ntil the 2004 ;reat Rece##ion, =hen the #cale o ra!d becae !ch larger. For e!ently, the bank co!ld grant lo=Aintere#t loan# to it# partner copanie#, and the Keiret#! !#!ally oc!#e# on longAter proit# and arket #hare#. F!rtherore, corporation# in So!th Korea, ;erany, and R!##ia al#o e#tabli#hed congloerate#, =hich are #iilar to a Keiret#!. &0

Money, Banking, and International Finance Soe go$ernent# becoe a #hareholder in a copany, =hich the orer co!ni#tic co!ntrie# oten !#e. ;o$ernent retain# control o$er the copany, and it attract# partner# =ho bring technology and eicient anageent practice#. 8nort!nately, go$ernent a# a #hareholder becoe# #!#ceptible to corr!ption beca!#e a go$ernent can !#e it# a!thority to protect the copany and i#olate it ro copetition. Soe corporation# #!er ro the principal*a$ent problem, =hen t=o related partie# ha$e dierent incenti$e#, creating conlict# and odd# =ith each other. For e!ently, they becoe both the agent and principal, and they ha$e one !nited intere#t A to earn proit#. 'h!#, the#e copanie# earned high ret!rn#, and anager# ha$e better $i#ion and o$er#ight o$er their corporation#.

'(panding into Foreign Countries " multinational corporation i# a copany incorporate# it#el in one co!ntry and operate# in one or ore oreign co!ntrie#. For e
Kenneth R. S!lcyk =o!ld ace narro= proit argin#. Soe e!ireent#. Fir#t, a go$ernent e#tabli#he# an open*market place that ean# a go$ernent allo=# ree arket# and allo=# the ree o$eent o capital, labor, and technology. 'h!#, a go$ernent rela!ire inancing. ence, a co!ntry !#t allo= the ree o$eent o oney, and corporation# are ree to i##!e ore #tock, bond#, or recei$e bank loan# =itho!t go$ernent intererence. Con#e>!ently, a ir ha# t=el$e rea#on# to relocate prod!ction to another co!ntry, rather than to e!ently, #oe go$ernent# oer incenti$e# to copanie# beca!#e they =ant to create ob# and red!ce !neployent and po$erty rate#. Reason 2: " copany gain# acce## to technology ro another co!ntry. For e!ently, a copany co!ld relocate to India to tap into their #killed =orkorce. Reason 3: "n enterpri#e that o$e# it# actorie# to a oreign co!ntry a!toatically a$oid# trade re#triction#, like tari# and iport >!ota#. ;o$ernent doe# not apply trade re#triction# to prod!ct# and #er$ice# prod!ced =ithin a co!ntry. Reason !: " copany relocate# it# an!act!ring acilitie# to red!ce tran#portation co#t#. For e!ently, #!gar prod!cer# locate the #!gar ill# clo#e to the #!garcane ield#. 'hen they e!ickly, =hile other arket# e!ently, the b!#ine## co!ld earn a ret!rn on it# in$e#tent#. Reason : " copany need# an iportant ra= aterial or prod!ction. For e
Money, Banking, and International Finance Reason /: B!#ine##e# and copanie# red!ce their prod!ction co#t#. Con#e>!ently, any 8.S. an!act!ring copanie# o$ed to China and Me!ently, o!t#o!rcing can lo=er a copany?# co#t, granting it a co#t ad$antage o$er it# copetitor#. Reason 1: " copany in$e#ting in a oreign arket today ay lead to !t!re in$e#tent#. For e!ipent, and labor bet=een dierent co!ntrie#. *e!ently, copanie# need e!ickly change d!e to l!ct!ation# in c!rrency e!ently, Kaakh#tan ade great #tride# to=ard# a arket econoy and attracted billion# in international in$e#tent beca!#e the co!ntry contain# $a#t petrole! and ineral =ealth. "ter the 200: Financial Cri#i#, the Kaakh go$ernent i# grad!ally re$i$ing the So$iet r!le#, practice#, and reg!lation#. 8nort!nately, the So$iet legal #y#te i# $ery b!rea!cratic, #lo=, and arbitrary, and #!er# ro corr!ption and political

&+

Kenneth R. S!lcyk a$oriti#. Moreo$er, the Kaakh go$ernent nationalied #e$eral oreignAo=ned copanie#, and international in$e#tent began pl!eting in 2012.

The )a* of Comparati"e !d"antage La! of omparative &dvanta$e or# the ba#i# o ree trade. /a$id Ricardo, a Briti#h political econoi#t, or!lated the la= in the 1- cent!ry. It #tate# t=o co!ntrie# can beneit ro trade by #pecialiing in the prod!ction o good# =here a co!ntry ha# a relati$ely cheaper co#t. 'h!#, go$ernent# that in#tit!ted ree trade bet=een the#el$e# help !el the rapid gro=th o globaliation and the ri#e o the !ltinational enterpri#e#. olitical leader# red!ced their tari# and trade barrier# to allo= oney, prod!ct#, and #er$ice# to cro## border#. Finally, the (a= o Coparati$e "d$antage #till =ork# or a large co!ntry that can prod!ce e$erything. %conoi#t# !#e a production possibilities curve (PP) to #ho= ho= t=o co!ntrie# beneit ro ree trade. " C repre#ent# graphically a co!ntry?# a!ipent, land, and entreprene!r#. 'he C ha# three a##!ption#J 

Both co!ntrie# prod!ce at !ll eployent, =hich ean# a co!ntry prod!ce# on the bo!ndary o the prod!ction po##ibilitie# c!r$e. 'h!#, #ociety eploy# it# entire labor orce, and entreprene!r# !#e all their achine#, e>!ipent, and land to prod!ce good# and #er$ice#.



'he C# are #traight line#. Con#e>!ently, an ind!#try e


'=o co!ntrie#, the 8nited State# and Me
7e begin the analy#i# =ith no trade bet=een Me
&&


Figure 2. '$e Prodution Possibilities ur*es for exio and t$e 4nited 5tates

7e #et each co!ntry?# prod!ction le$el at the halA=ay point. 'h!#, the 8nited State# prod!ce# 23 toatoe# and 30 car# =hile Me!ently, the total prod!ction or both co!ntrie# e>!al# 33 toatoe# and 93 car#. I Me!ently, the co!ntrie# #pecialie in prod!cing prod!ct# =here they ha$e lo= opport!nity co#t#. )pport!nity co#t relect# the #lope# o the C#. Slope or the 8nited State# e>!al# 0.3, =hich ean# the 8.S. !#t gi$e !p the prod!ction o one car to prod!ce 0.3 toatoe#. )n the other hand, Me!ently, the 8nited State# #pecialie# in car an!act!ring =hile Me!ently, the 8nited State# prod!ce# 100 car# and gro=# ero toatoe# =hile Me!al# +3 car# and 3 toatoe#. 8nort!nately, =e need ore trade theory to predict ho= the co!ntrie# =o!ld di$ide thi# e
Key Terms #ole proprietor#hip

di$idend yield &3

Kenneth R. S!lcyk partner#hip corporation #hareholder initial p!blic oer charter #tock !t!al agency relation#hip di$idend coon #tock preerred #tock C!!lati$e reerred Stock rotected reerred Stock Redeeable Stock Con$ertible Stock ta< e$a#ion ta< a$oidance ret!rn

capital gain #pecial p!rpo#e entity keiret#! principalAagent proble !ltinational corporation !ltinational enterpri#e econoic e
Chapter Questions 1

%
&0. Identiy the beneit# o incorporating a b!#ine##. &1. Board o director# o a corporation need# ore !nding to in$e#t in a ne= actory. o=e$er, they do not =ant to i##!e ore coon #tock beca!#e it =o!ld =eaken the aority #hareholder#N po#ition. Identiy the board?# option#. &2. Co!ld a corporation !#e a #!b#idiary to hide debt or anip!late it# inancial #tateent#@ &+. o! bo!ght #tock or a ne= internet copany or G23 per #hare la#t year and paid a G0.30 di$idend per #hare. 8nort!nately, the copany ace# bankr!ptcy, and yo! >!ickly #ell yo!r #hare# or G13. Calc!late yo!r rate o ret!rn or thi# in$e#tent. &&. /id the 8.S. ederal go$ernent i< corporate ra!d ater pa##ing the Sarbane#A)
Money, Banking, and International Finance &:. Co!ld a co!ntry prod!ce =ithin the interior o a prod!ction po##ibilitie# c!r$e@ &-. Identiy the beneit# or a b!#ine## to e
'obacco 1,000 300

Coee 300 1,000

lea#e dra= the t=o C# =ith the prod!ction #et at the halA=ay point. Identiy the gain o prod!ction i the t=o co!ntrie# engage in ree trade.

#. $nternational %an&s Globali%ation inl!ence# the inancial arket#. In the la#t &0 year#, #a$er# and borro=er# ha$e becoe linked thro!gh the international inancial arket#. For e
&4


Functions of International Banks International banks tran#cend the !nction# o a doe#tic bank beca!#e they link #a$er# and borro=er# acro## dierent co!ntrie#. Con#e>!ently, an international bank help# people and b!#ine##e# engage in international trade and inance. F!rtherore, an international bank help# =ith oreignAc!rrency e!idity o inancial arket#. (i>!idity i# the ea#e o con$erting a##et# to c!rrency. C!rrencie# and bank acco!nt# are the o#t li>!id, =hile ho!#e# and car# are the lea#t li>!id a##et#. Finally, international bank# #ti!late inancial inno$ation by creating ne= inancial in#tr!ent#. International bank# link #a$er# and borro=er# ro dierent co!ntrie# acro## the =orld, cro##ing international border#. International bank# are concentrated in inancial center# acro## the =orld, #!ch a# *e= ork City, 'okyo, and (ondon, and they operate 2& ho!r# e$ery day, #e$en day# a =eek. Con#e>!ently, a go$ernent in one co!ntry ha# proble# reg!lating it# bank?# acti$itie# in other co!ntrie#. For e!ently, #oe =ealthy people, b!#ine##en, and criinal# hide their oney in o#hore acco!nt# to e$ade ta
Becoming an International Bank Bank# in the 8nited State# !#e o!r ethod# to becoe an international bank, =hich areJ et$od 1: 'he 8.S. bank open# a bank branc# in a oreign co!ntry. 'he#e branche# accept depo#it# and ake loan#. 8.S. bank# open branche# in inancial center# aro!nd the =orld or place# =here 8.S. ir# and corporation# engage in b!#ine##. Bank branche# help the bank tran#er oney acro## nation#? border#. et$od 2: 'he 8.S. bank becoe# a #oldin$ company. 'he 8.S. bank b!y# and becoe# a aority #hareholder o a oreign bank. 'he Federal Re#er$e Sy#te re#trict# 8.S. bank# to in$e#t in oreign ir# that are Hclo#ely related to banking. &:

Money, Banking, and International Finance et$od 3: 'he 8.S. bank becoe# an 6d$e &ct orporation. 'he 8.S. bank e#tabli#he# a #!b#idiary. S!b#idiary can accept depo#it# ro both 8.S. re#ident# and oreigner# b!t can only grant loan# or international b!#ine## acti$ity. 'he#e international bank# a##i#t =ith international trade and oreignAc!rrency e!ently, the oreign bank branch !#t ollo= the 8.S. banking reg!lation#. et$od 3: " oreign bank enter# the 8.S. arket thro!gh a subsidiary 34S4 bank . Foreign bank b!y# 8.S. bank #tock, becoing the aority #hareholder. 'h!#, the oreign bank control# the 8.S. bank, con$erting it into a #!b#idiary. Many oreign bank# !#e #!b#idiarie# to enter the 8.S. banking arket beca!#e the 8.S. ha# an e
'(change +ate +isk "n e"c#an$e rate e>!al# the ratio o one c!rrency to another c!rrency. 7e !#!ally =rite an e!ation 1. For e!al# 1.3 e!ro#. G1 O 1.3 e!ro#

1D

For in#tance, yo! plan a trip to the 8nited State#, and =ant to con$ert 1,300 e!ro# into 8.S. dollar#. o= any 8.S. dollar# =o!ld yo! ha$e@ 7e !#e a trick =ith e!ation by one o the c!rrency !nit#. 7e #ho= the t=o ratio# in %>!ation 2J &-


$1 1.3 euros =1 1= 1.3 euros $1 or

2D

*o= !ltiply the ratio# by 1,300 e!ro#. 7e #ee the ir#t ratio i# correct in %>!ation + beca!#e one c!rrency !nit reain# ater the calc!lation. Ratio or %>!ation & i# =rong beca!#e the e!ro c!rrency !nit# becoe #>!ared. 1,300 euros

$1

1.3 euros

= $1,000

1.3 euros 2.23 ( euros ) = 1,300 euros $1 $1

+D 2

&D

%!ation 3, #!b#e>!ently, the 8.S. dollar b!y# ore e!ro#. 'h!#, the 8.S. dollar appreciated. I the 8.S. dollar appreciated, then the e!ro a!toatically depreciated. Con#e>!ently, appreciation ean# a c!rrency becoe# =orth ore in ter# o another c!rrency, =hile depreciation iplie# the other c!rrency all# in $al!e. Con#e>!ently, appreciation and depreciation are relati$e concept# applied to one e
3D

%!ation 9, #!b#e>!ently, the 8.S. dollar b!y# e=er e!ro#. 'h!#, the 8.S. dollar depreciated =hile the e!ro appreciated. G1 O 1 e!ro

9D

Financial analy#t# !#e the ter# #trong and =eak to reer to a c!rrency, =hich dier# ro appreciation and depreciation. For in#tance, a =eak 8.S. dollar iplie# =e copare the dollar to a Hba#ket o c!rrencie#. )$erall, the dollar ell in $al!e relati$e to the c!rrencie# in the ba#ket. Ba#ket o c!rrencie# incl!de# other ind!#trialied co!ntrie#, #!ch a# Britain, Canada, %!roone, and apan. Fl!ct!ating e
Money, Banking, and International Finance a b!#ine## in R!##ia or G1 illion. Many co!ntrie# enorce la=#, =here b!#ine## acti$ity !#t be denoinated in that co!ntry?# c!rrency. ence, the bank con$ert# the 8.S. dollar# into R!##ian r!ble# beca!#e b!#ine##e# !#e the r!ble in R!##ia. I the e!al# G1 or 23 r!ble#, =e cop!te the bank?# loan at 23 illion r!ble# in %>!ation 4. !an" oan = $1,000 ,000 ⋅

23 rubles $1

= 23 million rubles

4D

7hat =o!ld happen i the e!ently, the 8.S. dollar appreciated =hile the R!##ian r!ble depreciated. 7hen the R!##ian b!#ine## repay# it# 23 billionAr!ble loan, =e calc!late the bank recei$e# G0.3 illion in %>!ation :. 'hereore, the bank e
$1

30 rubles

= $300,000

:D

I the e!al 10 r!ble#, then the R!##ian r!ble appreciated =hile the 8.S. depreciated. 7e cop!te the R!##ian b!#ine## repay# a total o G2.3 illion dollar# in %>!ation -. Con#e>!ently, the international bank beneit# in thi# ca#e. !an" oan = 23 ,000 ,000 rubles ⋅

$1

10 rubles

= $2,300,000

-D

International Financial Securities International bank# created #e$eral inancial #ec!ritie# to hedge again#t oreign e!antity #peciied in the contract. /eri$ati$e contract protect# a bank, copany, or in$e#tor ro price l!ct!ation#, and they can b!y and #ell the contract# on the #econdary arket# beore the contract at!re#. For the e!antity o oreign c!rrencie# on a !t!re date =ith a i
Kenneth R. S!lcyk " deri$ati$e contract ha# any dierent or#. Fir#t or i# a or=ard contract. For e!antity, a i
Money, Banking, and International Finance %!rodollar# allo= bank# to circ!$ent la=# and reg!lation#. In the 8nited State#, bank# originally did not pay intere#t on checking acco!nt#. /!ring the 1-40#, depo#itor# =ithdre= their !nd# ro their checking acco!nt# a# intere#t rate# #oared. In Britain, bank# originally co!ld not grant loan# o!t#ide o Britain. *e$erthele##, %!rodollar# allo=ed the#e bank# to circ!$ent the#e la=#. 8.S. bank# co!ld borro= %!rodollar# ro Britain in#tead relying on doe#tic depo#it#. 'he 8.S. bank# paid arket intere#t rate# on the %!rodollar =hile Briti#h bank# co!ld lend o!t#ide o Britain by !#ing %!rodollar#. %!rodollar# =ere #o #!cce##!l that any go$ernent# repealed reg!lation#, and the 8.S. dollar #till doinate# the %!rodollar arket. %!rodollar# are not liited to only %!rope. /!ring the 1-40#, )rganiation o etrole! %!antity o %!rodollar#. %!rodollar# created t=o o#hoot#J 6uroloans and 6urobonds. Con#e>!ently, the principal and intere#t payent# or %!roloan# and %!robond# are denoinated in 8.S. dollar#. For e!ently, the b!#ine## cannot aord to con$ert a depreciating c!rrency into an appreciating one, and it dea!lt# on the %!roloan. Bank# can grant %!roloan# in billion# o dollar#. 'hereore, #e$eral international bank# cooperate to grant a #iable loan. 7e call thi# cooperation a loan syndication. Syndicate #pread# a large loan aong #e$eral bank#, and one bank anage# the loan and earn# a anageent ee. Mo#t international banking b!#ine## i# cond!cted thro!gh the 6uromarkets. 'he#e arket# reain !nreg!lated and incl!de all inancial arket# that are denoinated in 8.S. dollar# and are located o!t#ide o the 8nited State#. (a#t inancial in#tr!ent, a banker5s acceptance, acilitate# international trade. I a 8.S. #tore =ant# to iport coee ro Co#ta Rica, the e
Kenneth R. S!lcyk 7hen the e!ently, banker?# acceptance# lo=er tran#action co#t# and are li>!id a##et# beca!#e bank# and holder# can #ell or b!y the on #econdary arket#.

+egulatory %"ersight "ter 7orld 7ar II, the 8.S. dollar becae the international tran#action c!rrency. "n international transaction currency i# the preerred c!rrency !#ed in negotiating tran#action# in the international inancial arket#. For e!ently, t=el$e co!ntrie#, incl!ding the 8nited State# et in S=iterland to di#c!## capital re>!ireent#. 'hey naed the eeting ater the city, Ba#el. Ba#el coittee =anted to en#!re bank# had eno!gh capital to #!r$i$e a inancial cri#i# and a$oid a##i$e proit lo##e#. 8nort!nately, co!ntrie# ha$e diic!lty in ipleenting the Ba#el agreeent beca!#e e$ery co!ntry ha# di#tincti$e reg!lation# and dierent acco!nting #tandard#. *e$erthele##, the Ba#al agreeent #et coon capital #tandard# or bank# engaged in c!rrency #=ap#, inancial !t!re#, and option#. 'he 1-:0# debt cri#i# orced central bank# to eet and di#c!## their role# o being the lender# o la#t re#ort d!ring a banking cri#i#. Central bank# concl!ded they #ho!ld concentrate on the inancial #tability o their o=n doe#tic bank#. o=e$er, any bank# are linked internationally to other bank# abroad. Con#e>!ently, a banking cri#i# in one co!ntry can #pread and trigger a banking cri#i# in another. 'h!#, one central bank cannot contain a inancial cri#i#. (eader# o central bank# and go$ernent inance ini#trie# p!#h or coordination and re#triction# on depo#it in#!rance. For in#tance, depo#it in#!rance in the 8nited State# in#!re# !p to G230,000 or each per#on. )ther co!ntrie# do not ha$e genero!# depo#it in#!rance. C!rrently, 8.S. bank# pay ode#t prei!# only on doe#tic depo#it#. I the Federal /epo#it In#!rance Corporation F/ICD re>!ire# 8.S. bank# to pay depo#it in#!rance on all acco!nt#, incl!ding oreign acco!nt#, then their prei!# =o!ld increa#e. F!rtherore, go$ernent# ha$e t=o proble# coordinating international depo#it in#!rance. Fir#t, any reg!latory agencie# in other co!ntrie# lack the F/IC?# onitoring po=er. Second, only three co!ntrie# in %!rope, *etherland#, Spain, and 8nited Kingdo, ha$e la=# re>!iring the go$ernent to #tep in and !nd the depo#it in#!rance i the in#!rance prei!# cannot co$er all acco!nt# d!ring a bank ail!re. 'he 8nited State# and any co!ntrie# =ere dereg!lating, =hen the 200: Financial Cri#i# #tr!ck the =orld econoy. 'he 8nited State#, Ireland, Spain, and any co!ntrie# e!ently, #oe people #topped paying their ortgage#, haring the bank# inancially. Bank# #topped granting ne= ortgage#, and brand ne= ho!#ing con#tr!ction ha# halted. "ter=ard#, the ho!#ing price# began alling a# the bank# oreclo#e on ho!#e# that are lo#ing $al!e. 3&

Money, Banking, and International Finance 'he 8.S. go$ernent re#ponded >!ickly, !#ing the identical re#pon#e any other co!ntrie# had !#ed. 

'he 8.S. go$ernent p!rcha#ed preerred #tock in the large#t bank# in the 8nited State#, in!#ing the bank# =ith !nd#. 'he ir#t tie the 8.S. go$ernent #tarted o=ner#hip in a b!#ine## directly.



'he Federal Re#er$e bo!ght any o the to


'he Federal Re#er$e i# rapidly e


'he Federal Re#er$e becae the lender o the la#t re#ort or the de$eloped =orld. Central bank# ro Britain, %!ropean 8nion, and apan can borro= 8.S. dollar# ro the Federal Re#er$e thro!gh the 8.S. dollar li>!idity #=ap. " 34S4 dollar liquidity s!ap i# a central bank can borro= 8.S. c!rrency ro the Federal Re#er$e by gi$ing it# o=n c!rrency a# collateral. 'hen on the at!rity date, the central bank repay# it# loan in 8.S. dollar#, and the Fed ret!rn# the c!rrency. 'hi# i# #iilar to a or=ardAor=ard tran#action.



'he 8.S. go$ernent plan# to ipleent the Ba#el III re>!ireent# that increa#e bank#? capital re>!ireent# and orce bank# to boo#t their holding# o li>!id #ec!ritie#. /!ring the ho!#ing b!bble, any bank# increa#ed their le$erage ratio to !n#!#tainable le$el#. 8nort!nately, le$erage ha# #e$eral eaning# depending on it# conte!al# the ratio o debt a b!#ine## !#e# to ac>!ired a##et#. Many bank# acc!!lated debt to ac>!ire propertie# at the peak o the ho!#ing b!bble. )nce the b!bble delated, the property ell in $al!e, and the bank# co!ld not #ell it =itho!t enoro!# lo##e#. Bank# had high le$erage ratio# a# they acc!!lated debt or a##et# =ith alling arket $al!e#. I bank# hold ore capital or hold ore li>!id a##et#, then they =o!ld ha$e ore capital to deal =ith a inancial cri#i#.

%ect# o the 200: Financial Cri#i# #till plag!e the =orld?# econoy. "ltho!gh the ;reat Rece##ion had ended in 200-, any de$eloped co!ntrie# are on the $erge o entering a ne= rece##ion in 201&. Con#e>!ently, bank# tightened their lending #tandard# =hile ne= ho!#ing con#tr!ction reain# at a #tand#till. Many co!ntrie# incl!ding ;reat Britain, Ireland, Italy, ;reece, Spain, and the 8nited State# are alicted =ith an !neployent cri#i# beca!#e the !neployent rate reain# #t!bbornly high, and the !neployed cannot ind =ork. 'h!#, 33

Kenneth R. S!lcyk go$ernent reg!lation# and reg!latory dierence# aong co!ntrie# =ill diini#h beca!#e go$ernent# =ant to a$oid an econoic cri#i# like the 200: Financial Cri#i#.

Key Terms globaliation international bank o#hore arket bank branch holding copany %dge "ct corporation international banking acility IBFD agency oice oreign bank branch #!b#idiary 8.S. bank e
or=ard contract c!rrency #=ap or=ardAor=ard #=ap #pot again#t a or=ard %!rodollar# %!robond# %!roloan# loan #yndication %!roarket# banker?# acceptance international tran#action c!rrency to!idity #=ap le$erage

Chapter Questions 1

Identiy the beneit# o being an international bank.

32. %
Money, Banking, and International Finance 90. Identiy the p!rpo#e o a c!rrency #=ap. 91. %
'. Financial $nstittions Financial analy#t# and econoi#t# cla##iy the inancial arket# and in#tit!tion# into i$e categorie#J #ec!ritie# arket in#tit!tion#, in$e#tent# in#tit!tion#, contract!al #a$ing# in#tit!tion#, depo#itory in#tit!tion#, and go$ernent inancial in#tit!tion#. 'h!#, #t!dent# =ill #t!dy the proinent characteri#tic# o each category and !nder#tand ho= a inancial in#tit!tion ro one category dier# ro another category. 8nort!nately, the#e categorie# are not etched into #tone beca!#e a inancial copany co!ld be cla##iied !nder t=o or ore categorie#. Since the 1-:0#, the 8.S. ederal go$ernent #tarted dereg!lating the inancial arket# allo=ing the inancial in#tit!tion# to e!ently, inancial in#tit!tion# began copeting iercely a# inancial in#tit!tion# in one #ector #tarted copeting =ith in#tit!tion# in other #ector#. For in#tance, a copany co!ld e
Securities Market Institutions Sec!ritie# arket in#tit!tion# incl!de in$e#tent banker#, broker#, dealer#, and organied e!idity o the #econdary arket#. o=e$er, the#e in#tit!tion# are not inancial interediarie#, and they do not link the #a$er# to the borro=er#. In#tead, the #ec!ritie# arket in#tit!tion# help the #a$er# locate the borro=er#. roinent #ec!ritie# arket in#tit!tion i# the in$e#tent bank. "n investment bank help# corporation# i##!e ne= #tock and bond#, or it help# a local or #tate go$ernent i##!e# ne= bond#. F!rtherore, an in$e#tent bank co!ld help a corporation take o$er another. Con#e>!ently, the in$e#tent bank inl!ence# the priary arket hea$ily. In the 8nited State#, an in$e#tent bank i# not a reg!lar bank. It #er$e# a# a arketing agent or ne= #ec!ritie#. For e!ently, 34

Kenneth R. S!lcyk they #ell the on the #econdary arket# or organied e!ently, any go$ernent leader# acro## the =orld are debating to enact #iilar la=# to the ;la##ASeagall "ct. roce## o i##!ing ne= #tock i# called !nder=riting. 3nder!ritin$ lo=er# inoration co#t#. In$e#tent bank g!arantee# a #tock or bond price to the corporation. 'hen the in$e#tent bank #ell# the ne= #tock or bond or a higher price. ;reater price relect# the in$e#tent banker?# proit. F!rtherore, in$e#tent bank# ay =ork together, =hich =e call syndicates. )ne in$e#tent bank act# a# the anager and retain# part o the proit# =hile other in$e#tent bank# help #ell the ne= #ec!ritie#. 'he 8.S. go$ernent re>!ire# in$e#tent banker# to di#clo#e inoration to in$e#tor#, helping to pre$ent ri#k and ra!d. 8nort!nately, in$e#tent banker# ha$e acce## to inside information abo!t corporate erger#. 7hen a corporation take# o$er another corporation, the erger ca!#e# the copany?# #tock price to #oar. 'h!#, in$e#tent banker# can #ecretly b!y #tock or #hare inoration =ith riend# and aily =ho b!y# that partic!lar #tock. In#ider# can earn a #!b#tantial ao!nt o proit, and it i# illegal in the 8nited State#. 'he Sec!ritie# %!idity o #ec!ritie#. 7e deine or$ani%ed e"c#an$es a# either an e!ently, the #peciali#t atche# price# and >!antity o #tock or b!yer# and #eller#. Con#e>!ently, the broker and #peciali#t earn coi##ion ro each tran#action. )lde#t and large#t 8.S. corporation# are li#ted on the *e= ork Stock %!i$alent o *"S/"5, =hich the %!ropean# call %"S/"5. Many co!ntrie# reo$ed the barrier# to their inancial arket#, allo=ing international copanie# to #ell or b!y #tock in their co!ntrie#. For e
Money, Banking, and International Finance corporate #tock like ;% and IBM on the Frank!rt Stock %!ently, the inancial arket# are tr!ly global, and link #a$er# and in$e#tor# together acro## the =orld. Financial analy#t# copile arket indice# that ea#!re broad o$eent# in a inancial arket. Mo#t pop!lar and the olde#t #tock arket inde< !#ed today i# the Do! :ones Industrial &vera$es, other=i#e kno=n #iply a# the H/o= or Hthe ind!#trial#. 'he 7all Street o!rnal in$ented the /o= in 1::2, and it calc!late# the /o= by a =eighted a$erage o +0 repre#entati$e #tock# o *e= ork Stock %
City Sydney 'oronto ong Kong Shanghai (ondon ari# Frank!rt Milan 'okyo Me
*oteJ 'he "#terda Stock %
Market indice# pro$ide t=o beneit#. Fir#t, the arket indice# pro$ide a#t inoration. Financial analy#t# calc!late a arket inde< in #econd# and di#trib!te the inde< to in$e#tor# in#tantly. Second, pri$ate copanie# calc!late the arket indice#. 'h!#, go$ernent doe# not inl!ence the n!ber#. " #tock arket, occa#ionally, e
Kenneth R. S!lcyk Finally, a #tock arket cra#h in one arket can trigger another #tock arket cra#h, e$en a #tock arket located in a oreign co!ntry. Stock arket cra#h becae the prel!de to the ;reat /epre##ion. In 1-2-, the #tock arket cra#hed on )ctober 2&, )ctober 2:, and )ctober 2-. "ter=ard#, the !neployent rate peaked at 29 in the 8nited State#. Moreo$er, the *e= ork Stock %!ently, both the in$e#tent bank# and coercial bank# earned enoro!# lo##e# ro the ortgage arket a# hoeo=ner# #topped paying their ortgage#. Bank# re!#ed to lend to anyone, ca!#ing a credit cr!nch. " credit crunc# ean# inancial in#tit!tion# #top lending to the#el$e# and the p!blic, di#r!pting b!#ine## acti$itie#, #!ch a# con#tr!ction and an!act!ring. In$e#tent bank# becae in$ol$ed in ortgage# beca!#e they packaged ortgage# into ne= e
90


In"estment Institutions Investment institutions incl!de !t!al !nd# and inance copanie#. " mutual fund anager gro!p# together !nd# ro any in$e#tor# and in$e#t# the oney in a $ariety o #tock#. Con#e>!ently, a !t!al !nd di$er#iie# #tock#, and it lo=er# in$e#tor#? ri#k. For e!ently, yo! are g!aranteed not to lo#e yo! !nd# !p to the a
91

Kenneth R. S!lcyk or o direct inance and ha# no collateral. F!rtherore, inance copanie# lend to con#!er# or !rnit!re, appliance#, car#, hoeAipro$eent loan#, or they lend to #all b!#ine##e#. Soe corporation# created their o=n inance copanie# to help con#!er# b!y their prod!ct#. For e
Contractual Sa"ing ontractual savin$ institutions are in#!rance copanie# and pen#ion !nd#. Insurance companies pro$ide protection or people =ho b!y in#!rance policie#. In#!rance policy pre$ent# inancial hard#hip, #!ch a# a edical eergency, car accident, or the death o a aily eber. In#!rance copanie# are inancial interediarie# beca!#e they link the !nd# ro the policyholder# to the inancial arket#. olicyholder# ake periodical payent# to the in#!rance copany called premiums. In#!rance copany =ill in$e#t the prei!# in the inancial arket#. For the in#!rance copany to earn a proit, the ao!nt o intere#t earned in the inancial arket# pl!# the total ao!nt o prei!# !#t e!ently, the in#!rance copany charge# a higher prei! to a per#on =ho i# likely to ile a clai, =hich =e call a risk*based premium. Second, in#!rance copanie# !#e a deductible. 7hen a per#on ake# a clai, the per#on !#t pay the ir#t portion. For e
Money, Banking, and International Finance Fir#t type o in#!rance copany i# a life insurance company. 'he#e copanie# p!rcha#e longAter corporate bond# and coercial ortgage# beca!#e they can predict !t!re payent# =ith high acc!racy. F!rtherore, the in#!rance copanie# are organied in t=o =ay#J M!t!al copany or #tock copany. In#!rance policyholder# o=n a mutual company beca!#e the in#!rance policy !nction# a# corporate #tock, =hile a stock company i# a corporation that i##!e# #tock. 'h!#, the #hareholder# o=n the copany, =hile the in#!rance policyholder# do not. Stock copany i# ore coon beca!#e a #tock copany ha# ore !nding #o!rce#. 'hey recei$e !nding by #elling #tock to #hareholder#, and recei$e re$en!e by #elling in#!rance policie#. Mo#t policie# i##!ed are called term life policies. er#on b!ying the lie in#!rance !#t pay the prei! or the re#t o hi# lie. 'he#e policie# are pop!lar beca!#e the policyholder can borro= again#t the $al!e o the lie in#!rance policy, =hen he retire#. Borro=ing again#t in#!rance i# an ann!ity. "n annuity pay# a retired per#on a #peciic ao!nt o oney each year. Second type o in#!rance copany i# property and ca#!alty in#!rance copanie#. 'hey are organied a# either a #tock copany or !t!al copany, and they in#!re again#t thet, lood#, illne##, ire, earth>!ake#, and car accident#. 'he#e copanie# tend to p!rcha#e li>!id, #hortAter a##et# beca!#e the#e copanie# cannot acc!rately predict the ao!nt o !t!re clai#. In#!rance copanie# charge prei!# that corre#pond to the chance o the e$ent occ!rring. For e!ake in#!rance than a hoeo=ner in the Mid=e#t o the 8nited State# beca!#e Caliornia e!ake#. Pension funds are another contract!al #a$ing# in#tit!tion. Many people #a$e oney or retireent, and pen#ion !nd# becoe a $ital or o #a$ing. Soe eployer# #pon#or pen#ion !nd# a# a ob beneit, or =orker# can $ol!ntarily pay into per#onal retireent acco!nt#. 'hen the inancial copanie# anage the pen#ion !nd#, and they in$e#t pen#ion !nd# into the inancial arket#. en#ion !nd anager# can acc!rately predict =hen people =ill retire and !#!ally in$e#t in longAter #ec!ritie#, #!ch a# #tock#, bond#, and ortgage#. " per#on can only recei$e beneit# ro the pen#ion !nd ater the per#on becoe# $e#ted. ested ean# eployee# !#t =ork or their eployer or a tie period beore they can recei$e the beneit# ro the pen#ion plan. 'ie period $arie# or the pen#ion !nd#. For e!ire a per#on to be eployed by the city or 10 year# beore thi# per#on becoe# 100 $e#ted in the city?# pen#ion plan. %ployer# ha$e three rea#on# to oer pen#ion plan# to eployee#. Fir#t, the pen#ion !nd anager# can ore eiciently anage the !nd, lo=ering the pen#ion !nd#? tran#action co#t#. Second, the pen#ion !nd# ay oer beneit# #!ch a# lie ann!itie#. " lie ann!ity i# a =orker contrib!te# oney into the ann!ity !ntil he retire#. 'hen the =orker recei$e# reg!lar payent# e$ery year ro the ann!ity !ntil hi# death. (ie ann!itie# co!ld be e!e#t di#co!nt# ro pen#ion plan#. Finally, the go$ernent doe# not ta< the pen#ion !nd a# =orker# in$e#t !nd# into it, allo=ing the !nd to gro= a#ter. *e$erthele##, go$ernent !#!ally ipo#e# ta
Kenneth R. S!lcyk %ployer# ha$e t=o choice# or the o=ner#hip o a pen#ion plan. Fir#t, eployee# o=n the $al!e o the !nd# in the pen#ion plan, called a defined contribution plan. I the pen#ion !nd i# proitable, #!b#e>!ently, the retired eployee# =ill recei$e greater pen#ion incoe. I the pen#ion !nd i# not proitable, then the retired eployee# =ill recei$e a lo= pen#ion incoe. Copanie# that ha$e a deinedAcontrib!tion plan are likely to in$e#t the pen#ion !nd# into the copanie#? o=n #tock. 'hat =ay, eployee# ha$e an incenti$e to be ore prod!cti$e beca!#e the $al!e o their pen#ion plan depend# on their copany?# proitability. o=e$er, thi# pen#ion !nd becoe# dangero!# i thi# copany bankr!pt#. 'hen the eployee# o=n =orthle## #tock. )ne inao!# ca#e =a# the %nron collap#e in 2001. Soe eployee# =ere illionaire# !ntil their #tock portolio# collap#ed in $al!e o$ernight. Second, the o#t coon type o plan i# the defined*benefit plan. "n eployer proi#e# a =orker a #peciic ao!nt o beneit# that are ba#ed on the eployee?# earning# and year# o #er$ice to the copany. I thi# pen#ion !nd i# proitable, the copany pay# the proi#ed beneit# and retain# the reaining !nd# that are not paid to the retired eployee#. I the pen#ion !nd i# !nproitable, then the copany pay# the proi#ed beneit# o!t o it# o=n pocket. Federal and #tate go$ernent# reg!late the pen#ion !nd#. Reg!lation# re>!ire the anager# o the pen#ion !nd# to di#clo#e all in$e#tent#. 'hat =ay, eployee# kno= =hich #ec!ritie# the pen#ion !nd anager# ha$e in$e#ted in. Reg!lation# help pre$ent ra!d and i#anageent. 8nort!nately, a pen#ion !nd =ill bankr!pt, =hen the copany =here the eployee# =ork bankr!pt#. Con#e>!ently, Congre## created the en#ion Beneit ;!aranty Corporation that in#!re# pen#ion !nd beneit# !p to a liit i the copany cannot eet it# obligation#. Soe econoi#t# belie$e a pen#ion !nd di#a#ter =ill occ!r or #tate and local go$ernent retiree# ater 2012. Many #tate and local go$ernent# oered genero!# deinedAbeneit plan# to p!blic eployee#, and they ha$e not placed eno!gh oney a#ide to !nd the pen#ion plan#. " recent trend in pen#ion !nd# allo=# eployee# to anage their o=n pen#ion plan#, =hich are the &01kD plan#. 'he &01kD reer# to a #ection o la= in the Internal Re$en!e Ser$ice?# reg!lation#, and the beneit o thi# pen#ion plan i# the eployee can take hi# pen#ion plan =ith hi =hen he #=itche# eployer#. o=e$er, the &01kD ha# one ri#k. "o!nt o oney a per#on ha# acc!!lated at retireent depend# !pon ho= !ch oney he in$e#ted in the plan and ho= =ell the in$e#tent# ha$e done.

Depository Institutions Depository institutions accept depo#it# and ake loan#. 'h!#, they incl!de interediarie# that link the #a$er# to borro=er#. ommercial banks are the large#t and doinate the depo#itory in#tit!tion#. Many borro=er# #eek bank loan# or ortgage#, car loan#, or credit card#. Sa$er# ha$e three rea#on# to depo#it their #a$ing# in a bank than in$e#t directly into the inancial arket#. Fir#t, the bank depo#it# are li>!id. " depo#itor can >!ickly e!ently, coercial bank# are iportant or a co!nity beca!#e it# role o accepting depo#it# and granting loan#. 9&

Money, Banking, and International Finance Savin$s institutions are another depo#itory in#tit!tion. )riginally, the#e in#tit!tion# accepted depo#it# and granted lo=Aco#t ortgage# or hoeb!yer#. /!ring the early 1-:0#, any #a$ing# in#tit!tion# e!ently, yo! earn a lo##. 8nort!nately, thi# happened to the #a$ing in#tit!tion#. Intere#t rate# ro#e d!ring the 1-:0# a# the #a$ing# in#tit!tion# paid a greater intere#t rate to the depo#itor# than the ao!nt o the#e in#tit!tion# earned on the ortgage#. Mortgage# are !#!ally +0Ayear loan#, and #a$ing# in#tit!tion# =ere locked into lo= intere#t rate# ro the 1-90#. C!rrently, #a$ing# in#tit!tion# are #iilar to bank#, e!ently, the coercial bank# =ant credit !nion# on e>!al gro!nd# =ith coercial bank# beca!#e a credit !nion doe# not pay incoe ta
o"ernment Financial Institutions Federal, #tate, and local go$ernent# in the 8nited State# create $overnment financial institutions that lend !nd# to the p!blic. Fir#t, 'he 8.S. go$ernent !#e# direct inancing, =hen it create# a p!blic corporation that #ell# bond# and coercial paper to in$e#tor# in the inancial arket#. 'hen the p!blic copany !#e# the in$e#tor#? oney to lend to borro=er# directly. For e!ipent, or ortgage loan#. Second, the 8.S. go$ernent lend# oney to #t!dent# =ho p!r#!e a college ed!cation. For e!idity o the ortgage loan arket. For the #econd ethod, a go$ernent can lend to the p!blic thro!gh loan g!arantee#, =hich i# #iilar to in#!rance. For e!ently, the 8.S. /epartent o %d!cation repay# the loan to the bank, and then the 8.S. go$ernent !#e# it# a!thority to collect ro the #t!dent. Soe people >!e#tion a go$ernent?# role in inancing. 7hen a go$ernent directly lend#, the go$ernent #>!eee# the inancial in#tit!tion# o!t o the loan arket. F!rtherore, the ederal go$ernent loan g!arantee# increa#e the proble o oral haard. Financial in#tit!tion# 93

Kenneth R. S!lcyk recei$ing the loan g!arantee# ight not #creen borro=er# a# !ch, lending to borro=er# =ith a high dea!lt ri#k. For e!ently, the 8.S. go$ernent ight be liable or trillion# o dollar# in loan g!arantee# and bailo!t o p!blic corporation#. 7e e
'he 8.S. /epartent o %d!cation, SallieMae, and coercial bank# granted college #t!dent loan# that had #!rpa##ed G1 trillion in 2012. 8nort!nately, college grad!ate# contin!e to enter an aby#al ob arket in 201+. St!dentAloan dea!lt rate ho$er# aro!nd 2&. College #t!dent#, on a$erage, o=e appro


Fannie Mae and Freddie Mac hold ro!ghly G9 trillion in ortgage#, copri#ing hal the ortgage# in the 8nited State#. 'he 8.S. go$ernent had #eied the#e t=o in#tit!tion# in 200:, and it ha# #pent billion# o dollar# to bail the o!t. Bailo!t co#t =ill contin!e to #oar i the 8.S. econoy doe# not reco$er. 8nort!nately, the 8.S. go$ernent helped create thi# e## beca!#e it enco!raged Fannie Mae and Freddie Mac to grant ortgage# to lo=Aincoe ho!#ehold#, =ho becoe $!lnerable to do=nt!rn# in the econoy.

Key Terms in$e#tent bank !nder=riting #yndicate# in#ider inoration organied e
contract!al #a$ing in#tit!tion in#!rance copany prei! la= o large n!ber# ad$er#e #election oral haard ri#kAba#ed prei! ded!ctible lie in#!rance copany !t!al copany #tock copany ter lie policie# ann!ity pen#ion !nd $e#ted deinedAcontrib!tion plan deinedAbeneit plan depo#itory in#tit!tion 99

Money, Banking, and International Finance noAload !nd load !nd oneyAarket !t!al !nd oney arket depo#it acco!nt inance copany

coercial bank #a$ing# in#tit!tion credit !nion go$ernent inancial in#tit!tion

Chapter Questions 1.

7hich in#tit!tion# are deined a# #ec!ritie# arket in#tit!tion#@

2. lea#e e
(. Financial Statements and the )ale of Money 'hi# chapter pro$ide# an o$er$ie= o inancial #tateent# and the $al!e o oney. B!#ine## people and inancial analy#t# !#e and e!ity, and #tateent o ca#h lo=. Since all acco!ntant# record inancial #tateent# in a c!rrency, then they !#t di#co!nt !t!re payent# and receipt# o oney !#ing the pre#ent $al!e or!la. Con#e>!ently, #t!dent# =ill learn to !#e the pre#ent $al!e or!la to cop!te a $al!e today o !t!re =ithdra=al#, payent#, and in$e#tent#. F!rtherore, #t!dent# =ill learn to !#e the pre#ent $al!e or!la to calc!late the aortiation table or a ortgage, ann!ity payent#, $al!e o #a$ing# acco!nt#, and in$e#tent#. 'hen =e e

The Financial Statements "cco!ntant# !#e and create o!r inancial #tateent#. Incoe #tateent i# the ir#t and o#t iportant inancial #tateent beca!#e in$e#tor# !#t kno= =hether a b!#ine## ha# earned a proit or a lo##. 7e al#o call a proit the net incoe, and e$ery incoe #tateent ha# t=o ite#J 

Revenues are inlo=# o a##et# recei$ed in e


6"penses are o!tlo=# o a##et# beca!#e a b!#ine## pay# co#t# to operate a b!#ine##. " b!#ine## !#t pay =orker#? #alarie#, aterial#, ta
7e #ho= an e
*et Sale# /oe#tic %
303,10-,1:3 p &2+,3++,4-1 -2:,9&2,-49 p

Co#t# and )perating %
+91,144,++- p 21,-10,4:&9,:00,+-1 9:

Money, Banking, and International Finance 'otal co#t and operating e
&2-,:::,31-D p

%
14,924,903 p 3:0,92-,2-+D p

*et incoe

9&,2&4,2+1D p

So!rceJ %M% 2009D

'he Me!ently, %M% earned a 9&,293,2+1 pe#o lo## beca!#e it paid a large ao!nt o ta!aled G1 O 11 pe#o# in 2003. /alance S#eet i# the #econd inancial #tateent and #ho=# the inancial po#ition o a b!#ine## on a #peciic date. Balance #heet iteie# a b!#ine##?# a##et#, liabilitie#, and e>!ity. &ssets are econoic re#o!rce# o=ned by a b!#ine## =hile liabilities are debt# and inancial obligation# o the b!#ine##. Finally, equity e>!al# total a##et# in!# total liabilitie# that =e al#o call net a##et#. 7e e!ity in %>!ation 1. Moreo$er, creditor# =ant b!#ine##e# to ha$e a po#iti$e e>!ity. I a b!#ine## cannot repay it# debt#, the creditor# can legally orce the b!#ine## to #ell it# a##et# to repay debt#. 7e li#t #e$eral a##et# and liabilitie# in 'able 2. %>!ity O 'otal "##et#  'otal (iabilitie#

1D

" corporation di$ide# it# e>!ity into t=o capital acco!nt#J Contrib!ted Capital and Retained %arning#. ontributed apital i# the ao!nt o capital that a corporation #old. In other =ord#, the ao!nt o #tock that circ!late# bet=een in$e#tor# o!t#ide o the corporation. 'able + #ho=# #tockholder#? e>!ity or preerred #tock and coon #tock. 7e li#t the ao!nt# o a!thoried and o!t#tanding #hare# or both #tock type#. 7hen a corporation earn# proit#, it record# the proit# in the Retained 6arnin$s acco!nt. S!b#e>!ently, a corporation can !#e retained earning# to inance e
"##et# &ccounts Receivable  C!#toer# o=e oney to the b!#ine## or good# and #er$ice# #old on credit B!ilding# and (and %>!ipent Ca#h atent# and copyright#

(iabilitie# &ccounts Payable  B!#ine## o=e# oney to creditor# or good# and #er$ice# bo!ght on credit. Intere#t payable Salarie# o=ed to =orker# 'a
9-

Kenneth R. S!lcyk 'able 3. 5tok$olders) Equity

reerred #tock, 2,000 #hare# a!thoried, 1,000 #hare i##!ed and )!t#tanding Coon #tock, 12,000 #hare# a!thoried, 10,000 #hare# i##!ed and o!t#tanding 'otal capital contrib!ted by coon #tockholder# Retained earning# 'otal #tockholder#? e>!ity

G230,000 G+30,000 G900,000 G:0,000 G9:0,000

"cco!ntant# di$ide a copany?# a##et# into c!rrent and i!ipent =ith long lie #pan#. Store# 8S" ha# a #tore and oice e>!ipent $al!ed at G23,000 and G&,000 re#pecti$ely. "cco!ntant# #!btract the acc!!lated depreciation ro the e>!ipent beca!#e e>!ipent becoe# old and deteriorate#. /epreciation e>!al# G3,300 or the #tore e>!ipent and G1,300 or the oice e>!ipent. "cco!ntant# di$ide 'he Store# 8S" liabilitie# into c!rrent liabilitie# and longAter debt. C!rrent liabilitie# are debt# and obligation# that are le## than a year and incl!de acco!nt# payable, note# payable, and incoe ta!ity. Board o director# can pay di$idend# ro thi# acco!nt or inance an e!al the total liabilitie# pl!# #hareholder#? e>!ity, conoring to %>!ation 1. 'able !. + (alane 5$eet for 5tores 4.5.+.

C!rrent a##et#J Ca#h "cco!nt# recei$able# Merchandi#e in$entory repaid e!ipentJ Store e>!ipent (e## acc!!lated depreciation )ice e>!ipent (e## acc!!lated depreciation 'otal plant and e>!ipent

G:,000 10,000 20,000 1,000 G+-,000 G23,000 3,300 &,000 1,300 22,000 40

Money, Banking, and International Finance 'otal "##et#

G91,000

C!rrent liabilitie#J "cco!nt# payable Incoe ta
G+,300 1,000 G&,300

Stockholder#? %>!ity Coon #tock, G3 par $al!e, 10,000 #hare# a!thoried and o!t#tanding Retained earning# 'otal #tockholder#? e>!ity 'otal liabilitie# and #tockholder#? e>!ity

G30,000 9,300 39,300 G91,000

'he Stateent o Change# in the )=ner?# %>!ity i# the third inancial #tateent and #ho=# the change# in the o=ner?# e>!ity. For all b!#ine## organiation#, proit# or net incoe al=ay# increa#e# e>!ity beca!#e the organiation ha# ore re#o!rce# lo=ing into it. o=e$er, proprietor# and partner# co!ld in$e#t andor =ithdra= ro the b!#ine##. 'h!#, in$e#tent increa#e# the e>!ity, =hile =ithdra=al# red!ce it. For corporation#, the Stateent o Change# in the )=ner?# %>!ity i# called the Stateent o Retained %arning#. 7e #ho= an e!ity. Statement of as# Flo!s i# the la#t inancial #tateent and #ho=# the oney inlo=# and o!tlo=# o a b!#ine##. 'hi# #tateent i# iportant beca!#e a b!#ine## need# ade>!ate ca#h to operate #!ch a# paying =orker#, ta!it and lea$e the eployer. 'able ,. 5tatement of Retained Earnings for orporation 9;%

*et incoe "dd retained earning#, /eceber +1, 2010 'otal /ed!ct di$idend# declared Retained earning#, /eceber +1, 2011

G30,00 G10,000 G90,000 20,000 G&0,000 41

Kenneth R. S!lcyk 'able -. +ti*ities t$at +ffet a (usiness)s as$ Flo&

Ca#h Inlo=# )perating "cti$itie# C!#toer# pay or #ale# in ca#h C!#toer# pay acco!nt# recei$able# Merchandi#e in$entory decrea#e# "cco!nt# payable increa#e# In$e#ting "cti$itie# Recei$ed ca#h ro in$e#tent# Sold property or e>!ipent Financing "cti$itie# Copany i##!e# ore #tock Copany i##!e# bond#

Ca#h Flo=# ay #alarie# ay e
!rcha#ed #ec!ritie# !rcha#ed land Copany pay# di$idend# Copany retire# it# bond# or #tock#

7e #ho= a Stateent o Ca#h Flo=# in 'able 4. I ca#h enter# a b!#ine##, then the ca#h lo= i# po#iti$e. "# ca#h lea$e# a b!#ine##, #!b#e>!ently, the ca#h lo= i# negati$e. F!rtherore, the ca#h lo= #tateent ha# three #ection#J operating, in$e#ting, and inancing acti$itie#. For e!al total ca#h #ale# in!# erchandi#e ret!rn#. 'hen the b!#ine## in$e#ted in the b!#ine## by p!rcha#ing G20,000 in ne= e>!ipent or the in$e#tent acti$itie#. Finally, the b!#ine## i##!ed G30,000 in brand ne= #tock to e!ently, the b!#ine## ha# G110,000 in total ca#h at the end o the year. o! can calc!late thi# ao!nt by #tarting =ith the ca#h on hand at the beginning o the year and add the net ca#h lo= that the b!#ine## recei$ed d!ring the year.

'able . 5tatement of as$ Flo&s

Ca#h lo= ro operating acti$itie# Ca#h Recei$ed ro c!#toer# ayent# or ta!ipent p!rcha#e Ca#h lo=# ro inancing acti$itie# Ca#h recei$ed ro i##!ing #tock Ca#h paid or di$idend# *et increa#e in ca#h Ca#h balance at beginning 2010 Ca#h balance at end o 2010

G100,000 20,000D 20,000D 30,000 +0,000D G:0,000 G+0,000 G110,000

42


Single In"estment Financial analy#t# !#e the pre#ent $al!e or!la to price inancial #ec!ritie# or calc!late ortgage payent#. re#ent $al!e or!la place# a $al!e o !t!re ca#h lo=# in ter# o oney today. 'hereore, the pre#ent $al!e epha#ie# the pre#ent beca!#e people =ant their oney no= than =ait or a !t!re payent. Con#e>!ently, an intere#t rate re=ard# #a$er# or delaying payent. For e
"ter one year, yo! earn 0.03G100D O G3 in intere#t. o!r ending balance becoe# G103.00.



"ter t=o year#, yo! earn 0.03G103.00D O G3.23. o!r ending balance gro=# into G110.23.

7e can !#e intere#t copo!nding to cop!te the ending balance in %>!ation 2.

$ 100 ( 1 + 0.05 ) ( 1 + 0.05 ) =$ 100 ( 1 + 0.05 )

2

2D

= $ 110.25

I yo! let the oney earn intere#t ater ' year#, then yo! b!ild the #e>!ence in %>!ation +. In thi# ca#e, =e !ltiply the beginning balance by the intere#t repeatedly. Moreo$er, the one in#ide the parenthe#i# indicate# the principal a# G1 =hile the 0.03 relect# the intere#t.

$ 100 ( 1 + 0.05 ) ( 1 + 0.05 ) ⋯ ( 1 + 0.05 )=$ 100 ( 1 + 0.05 )

T

+D

For e
F!t!re 6al!e F6D in dollar# at 'ie '.



re#ent 6al!e 6D in dollar# at 'ie 0.



Intere#t rate iD i# the di#co!nt rate.



S!b#cript# relect the tie =ith the inal tie period being '.

7e =rite the or!la in %>!ation &.

FV 100 = PV 0 ( 1+ i )

T

= $ 100 (1 + 0.05 )

100

=$ 13,150.13

&D

o! =ant yo!r oney today beca!#e one h!ndred year# i# $ery ar a=ay. re#ent $al!e o G1+,130.1+ in one h!ndred year# i# =orth G100 to today beca!#e yo! can take that G100 today, 4+

Kenneth R. S!lcyk in$e#t it in a #a$ing# acco!nt at 3 intere#t, and let it gro= into G1+,130.1+. I yo! recei$e a payent in the !t!re, then =e cop!te the pre#ent $al!e in %>!ation 3.

PV 0=

FV T

(1 +i )

= T

$ 13,150.13

( 1+ 0.05 )

100

= $ 100

3D 7e !#e algebra to #ol$e or !nkno=n $ariable#. For e!ation 9, and the ini! intere#t rate e>!al# 10.99 ann!ally.

FV 0= PV T ( 1+ i )

T

$ 15,000= $ 10,000 (1 + i ) $ 15,000 4 =( 1 + i ) $ 10,000

√ 1.5=√ ( 1 + i ) 1.1066=1 + i i =0.1066 4

4

9D 4

4

7e ha$e an ea#y or!la to calc!late ho= long #oething do!ble# in #ie, kno=n a# the Rule of ;14 Intere#t rate, i, a# a percentage, and the tie indicate# the n!ber o year#. "ccordingly, the prod!ct o the intere#t rate and tie e>!al# 42 in %>!ation 4. i ∙ t = growth∙time=72

4D

For e

Multiple In"estments 7e can alter the analy#i#, #o people recei$e or pay !ltiple !t!re payent#. For in#tance, yo! depo#it G300 into the bank acco!nt e$ery year at 9 intere#t. 

"ter the ir#t year, yo! earn G300 W 0.09 O G+0 in intere#t. o!r balance gro=# into G300 X G+0 X G300 O G1,0+0 beca!#e yo! ha$e the initial G300, and then yo! depo#ited another G300 at the end o the year into yo!r acco!nt.



"ter the #econd year, yo! earn G1,0+0 W 0.09 O G91.:0 in intere#t. o!r balance gro=# into G1,0+0 X G91.:0 X G300 O G1,3-1.:0. o! added another G300 to yo!r acco!nt at the end o the year.



"ter the third year, yo! earn G1,3-1.:0 W 0.09 O G-3.30: in intere#t. o!r balance becoe# G1,3-1.:0 X G-3.30: X G300 O G2,1:4.+1. o! added the la#t G300, =hich did not earn intere#t.

7e calc!late the !t!re $al!e o yo!r bank depo#it# in %>!ation :. FV 3 =$ 500 ( 1 + 0.06 ) FV 3 =$ 2,187.31

3

+

$ 500 ( 1 + 0.06 )

2

+

$ 500 ( 1+ 0.06 )

1

+

$ 500 ( 1 +0.06 )

0

:D

(a#t ter in %>!ation : i# the inal depo#it. "ltho!gh yo! !ltiply thi# ter by an intere#t rate, the e!al# ero #etting the ter in#ide the parenthe#i# to a one. Con#e>!ently, the e!ation -.

PV 0=

$ 500

(1 + 0.06 )

+ 0

$ 500

( 1 + 0.06 )

+ 1

$ 500

( 1 +0.06 )

+ 2

$ 500

(1 + 0.06 )3

=$ 1,836.51

-D I yo! recei$ed G1,:+9.31 a# a l!p #! today, yo! co!ld in$e#t thi# oney into a #a$ing# acco!nt and earn G2,1:4.+1 in three year# at 9 intere#t. 7e con$erted a !ltiple #trea in$e#tent into a #ingle depo#it in$e#tent. re#ent $al!e or!la i# le
43

Kenneth R. S!lcyk ear 0 1 2 2 +

"cti$ity /epo#it /epo#it 7ithdra=al /epo#it 7ithdra=al

"o!nt G100 G+00 G30 G100 G43 'otal

Intere#t X Balance G1&:.13 G+:-.:: AG34 G11&.00 AG43 G320.0+

7ithdra=al or depo#it deterine# the #ign. " =ithdra=al i# negati$e, =hile a depo#it i# po#iti$e. F!rtherore, the intere#t pl!# balance col!n in 'able : incl!de# the intere#t rate that the depo#it =o!ld earn i held it !ntil the end o the third year. For e!al# G320.0+ at the end o ear +. 7e !#e the pre#ent $al!e or!la to calc!late today?# $al!e o the#e ca#h lo=#. o! =o!ld be indierent abo!t recei$ing a l!pA#! payent o G+31.01 today or G320.0+ in three year#. 7e calc!lated the pre#ent $al!e in %>!ation 10.

PV 0=

$ 100

(1 + 0.14 )

0

+

$ 300

( 1 + 0.14 )

1

+

$ 100 −$ 50

( 1 +0.14 )

2

+

−$ 75 3

( 1 + 0.14 )

= $ 351.01

10D I yo! in$e#ted G+31.01 today at 1& intere#t, then in + year#, yo! =o!ld ha$e G320.0&, the inal balance o yo!r bank acco!nt.

Compounding Fre,uency Financial analy#t# al=ay# deine an intere#t rate a# an ann!al ter, called the &nnual Percenta$e Rate (&PR). 'he "R coe ro the Federal Re#er$e?# reg!lation that help# pre$ent ra!d. For e!ently, thi# rate i# terrible. Borro=er took oney ro a loan #hark. For thi# book, =e deine all intere#t rate# in ann!al ter#, !nle## other=i#e #tated. Bank# and inance copanie# !#!ally calc!late intere#t payent# and depo#it# onthly. 'h!#, =e ad!#t the pre#ent $al!e or!la or dierent tie !nit#. I yo! reer to %>!ation 11, =e add a ne= $ariable, , the compoundin$ frequency =hile "R i# the intere#t rate in ann!al ter#. In the onthly ca#e,  e>!al# 12 beca!#e a year ha# 12 onth#.

49


(

APR FV T = PV 0 1 + m 11D

)

m ∙ T

For e!ently, =e calc!late yo!r #a$ing# gro= into G&-.24 in %>!ation 12J I yo!r bank copo!nded yo!r acco!nt ann!ally, then yo! =o!ld ha$e G&9.91.

(

APR FV T = PV 0 1 + m

)

m ∙ T

(

)

0.08 =$ 10 1+ 12

12 ∙ 20

=$ 49.27

12D

"ltho!gh the copo!nding re>!ency i# !#!ally 12 onth#, =e co!ld !#e #eiAann!ally t=o payent# per year, or  e>!al# 2D, or >!arterly o!r payent# per year, or  e>!al# &D. 7e can con$ert any copo!nding re>!ency into an "R e>!i$alent intere#t rate, called the effective annual rate (6FF). Fro the pre$io!# e!ation 1+. 'he %FF i# the #tandard copo!nding or!la reo$ing the year# and the pre#ent $al!e ter#.

EFF =

(

APR 1+ m

)

m

(

)

0.08 −1= 1+ 12

12

−1=0.083

1+D

I yo! depo#ited G10 in yo!r bank acco!nt or 20 year# that earn :.+ "R =ith no copo!nding or  e>!al# 1D, then yo!r #a$ing# =o!ld gro= into G&-.24, =hich i# the identical to an intere#t rate o : that i# copo!nded onthly. 7e calc!late thi# in %>!ation 1&.

(

APR FV T = PV 0 1 + m

)

m ∙ T

(

=$ 10 1+

0.083 1

)

1∙ 20

=$ 49.27

1&D

7e can adapt the pre#ent $al!e or!la or re>!ency copo!nding. For e
7e e


"ll tie #!b#cript# are onthly.

7e calc!lated a pre#ent $al!e o G212.09 in %>!ation 13.

44


PV 0=

$ 50

(

´ 1+ 0.0083 3

) ( 1

$ 100

+

´ 1+ 0.0083 3

) ( 6

$ 75

+

´ 1 + 0.0083 3

)

13

=$ 212.06

13D Copo!nding re>!ency ha# a #pecial ca#e. "#  approache# ininity  m → ∞ D, the cop copo! o!nd ndin ing g e>!a e>!ati tion on tran tran# #or or# # into into %> %>!a !ati tion on 19 19,, call called ed continuous continuous compoundin compoundin$ $ . Contin!o!# copo!nding ean# or e$ery raction o a #econdL yo!r balance earn# intere#t. "bbre$iation, li, reer# to the liit and deine# ho= the !nction beha$e# =hen  becoe# $ery large. 'h!#, the n!ber e i# a con#tant and e>!al# appro
(

APR FV T = lim PV 0 1 + m m→ ∞

)

T ∙m

APR ∙T

= PV 0 ∙ e

19D

For e!ation 14J %$ery raction o a #econd o$er 40 year#, yo! earn intere#t on yo!r acco!nt. )n the other hand, i yo!r bank !#e# onthly copo!nding, #!b#e>!ently, yo!r #a$ing# =o!ld gro= into G-,+4+.-0, yielding G13&.&1 le## than the #tandard copo!nding.

FV T = PV 0 ∙e

APR ∙T

= $ 50 ∙ e

0.075 ∙ 70

= $ 9,528.31

14D

Bank# and inancial in#tit!tion# rarely !#e contin!o!# copo!nding to calc!late arket $al! $al!e# e# o ina inanc ncia iall #ec! #ec!ri riti tie# e#.. Fina Financ ncia iall analy analy#t #t## and and athe athea ati tici cian an## !#e !#e conti contin! n!o! o!## copo!nding to #ipliy cople< calc!lation# o inancial or!la# and atheatical odel#.

!nnuities and Mortgages Mortgages Financial analy#t# !#e the pre#ent $al!e or!la to calc!late an ann!ity. "n annuity i# an in$e#tent or people =ho plan or retireent. "n ann!ity ha# t=o part#. "# people =ork, they ake periodic depo#it# into an ann!ity acco!nt. S!b#e>!ently, once they retire, they recei$e periodic payent# !ntil death. 7e deine ann!itie# a# an ordinary ann!ity or an ann!ity d!e. I a per#on pay# into an ann!ity at the end o period, then it i# an ordinary annuity. o=e$er, i a per#on pay# into an ann!ity ann!ity at the beginning beginning o the period, period, he or #he recei$e# recei$e# one e!ently, they only dier =hen payent i# applied to the ann!ity acco!nt and =hen payent# begin earning intere#t. For thi# chapter, =e #tick to ordinary ann!itie#. For e!ation 1:. 4:


FV 5 =$ 20,000 ( 1 +0.09 ) FV 5 =$ 20,000 [ 1.09 FV 5 =$ 119,694.21

4

4

3

+ $ 20,000 ( 1 + 0.09 ) + ⋯ + $ 20,000 ( 1+ 0.09 ) 3

2

1

+ 1.09 + 1.09 + 1.09 + 1.09

0

0

1:D

]

/o yo! notice anything #trange abo!t the e!ation 1: to the o!rth po=er beca!#e yo!r initial payent occ!rred at the end o period 1, and ha# earned o!r year# o intere#t. Finally, the la#t ter ha# a ero e!ation 1-, and c i# the periodic payent into an ann!ity. 8#ing the pre$io!# e!al# G11-,9-&.21.

[

FV T =C

( 1 + i )T −1 i

]

=$ 20,000

[

( 1 + 0.09 )5 −1 0.09

]

=$ 119,694.21

1-D 7e al#o ha$e the other #ide o an ordinary ann!ity. For e!al ann!al payent# o$er 10 year#. o= !ch do yo! recei$e ann!ally@ Reeber, yo! recei$e yo!r ir#t payent at the end o the ir#t period, =hich i# the beginning o the #econd period. 'hat G90,000 earn# intere#t or the ir#t period. 7e 7e cop!te an ann!al =ithdra=al payent o G4,+-4.&9 in %>!ation 20.

FV =

i∙PV −T

1 −( 1 + i )

=

0.04 ∙ $ 60,000 1 −( 1+ 0.04 )

−10

=$ 7,397.46

20D Financial Financial analy#t# !#e the pre#ent $al!e or!la to calc!late calc!late ortgage payent#, payent#, =hich i# $ital $ital to b!ildi b!ilding ng an aorti aortiati ation on table. table. "n amorti%atio amorti%ation n table iteie# e$ery payent or a ortgage loan and decopo#e# e$ery payent into intere#t and the ao!nt that red!ce# the principal. " ortgage i# a bank loan or a property, and the property becoe# the collateral. For F or in#tance, i a per#on ha# a ortgage or a ho!#e and dea!lt# on the loan, the bank can legally take po##e##ion o the ho!#e. 7e !#e the pre#ent $al!e or!la to b!ild an aortiation table. Matheatical notation or a ortgage i#J 

"ll !t!re ortgage payent# F6D are e>!al and are !#!ally onthly.



Intere#t rate iD i# loan rate and becoe# i


Bank loan i# ao!nt recorded or 6 0 beca!#e the bank loaned yo! oney at tie 0.

7e #ho= a ortgage a# a #trea o ca#h lo=# to the bank in %>!ation 21. 4-


PV 0=

FV 1

FV 2

(1 +i )

( 1+i )

+ 1

+ 2

FV 3

FV T

( 1+ i)

( 1 + i )T

+ ⋯+ 3

21D

"ll loan payent# are e>!al, #o =e #et F6 O F6 1 O F62 O F6+ O ... O F6 '. 'h!#, =e can actor the F6 ter# ro all intere#t ter# in %>!ation 22.

PV 0= FV

[(

1 1 +i )

1

+

1

( 1+ i )

2

1

+

( 1 +i )

3

+⋯ +

1

( 1 + i )T

]

22D

7e #ol$e #ol$e or F6, F6, =hich becoe# the loan payent, yielding %>!ation 2+.

FV =

PV 0

[(

1 1 +i )

1

+

1

( 1 +i )

2

+

1

(1 + i )

3

+ ⋯+

1

( 1 + i )T

]

2+D For e!ation 2&.

FV =

$ 60,000

[(

1 1 + 0.12 )

+ 1

1

( 1 + 0.12 )

+ 2

1

( 1 +0.12 )

+ ⋯+ 3

1

( 1 +0.12 )6

]

2&D

FV =$ 14,594 7e can !#e the ortgage loan inoration to b!ild an aortiation table. 7e #ho= an aortiation table in 'able -. For ear 0, yo! ha$e G90,000 o!t#tanding beca!#e yo! did not ake a payent yet. 'hen yo! ake yo!r ir#t payent in ear 1. o!r intere#t i# 12 !ltiplied by G90,000, e>!aling G4,200. I yo!r payent i# G1&,3-&, then G4,200 i# the intere#t =hile the reainder red!ce# the principal. 'h!#, yo! #!btract G4,+-& ro the loan balance. For ear ear 2, and beyond, yo! repeat the #e>!ence !ntil yo! pay the loan in !ll in ear ear 9. 'able 'able 0. +n +morti=ation +morti=atio n 'able

ear 0 ear 1 ear 2

ayent A G1&,3-& G1&,3-&

Intere#t A G4,200 G9,+1+

rincipal aid A G4,+-& G:,2:1 :0

(oan Balance G90,000 G32,909 G&&,+23

Money, Banking, and International Finance ear + ear & ear 3 ear 9

G1&,3-& G1&,3-& G1&,3-& G1&,3-&

G3,+1G&,209 G2,-3G1,39+

G-,243 G10,+:: G11,9+3 G1+,024

G+3,030 G2&,992 G1+,024 G0

"ll aortiation table# ha$e one eat!re. Fir#t payent ha# the highe#t intere#t =hile the lo=e#t principal applied to the loan balance. 'hen the intere#t ao!nt decline# o$er the lie o the loan !ntil it becoe# the #alle#t or the la#t payent. I a ortgage i# onthly, then yo! di$ide the intere#t rate by 12 and !ltiply the n!ber o year# by 12. For in#tance, a 20Ayear ortgage =ill ha$e 2&0 payent#, 12 W 20. "# yo! can #ee, %>!ati %>!ation on 2& =o!ld =o!ld ha$e ha$e 2&0 ter#. ter#. Con#e> Con#e>!en !ently tly,, athe atheati aticia cian# n# de$i#e de$i#ed d a or!l or!laa to calc!late a ortgage =ith any payent#. For e!ation 23. I yo! notice, %>!ation 23 i# the #ae or!la or an ann!ity payo!t =ith copo!nding re>!ency incl!ded. Intere#t rate, i, i# the "R intere#t rate di$ided by 12.

FV =

i∙PV −T ∙ m

1 −( 1 + i )

0.005 ∙ $ 150,000

=

1−( 1 + 0.005 )

−30 ∙ 12

=$ 899.33

23D "ortiation table can al#o handle balloon payent# and $ariable intere#t rate ortgage#. o=e$er, the#e topic# go beyond the te
Foreign In"estments 7e can !#e the net present value (P) to calc!late the onetary ret!rn to an in$e#tent in %>!ation 29. 'hi# e>!ation i# alo#t identical to the pre#ent $al!e or!la, e!al# ero, then thi# e>!ation red!ce# to the pre#ent $al!e or!la. 7ith the *6 or!la, =e co!ld in$e#t the ao!nt 6 0 today that generate# the !t!re ca#h lo=#, F6 i, that end# at 'ie '. Market intere#t rate i# i, and it a!toatically copare# o!t in$e#tent to the arket intere#t rate.

NPV =− PV 0 +

FV 1

FV 2

(1 +i )

( 1+i )

+ 1

+⋯ + 2

FV T

( 1+ i )T

29D

I =e calc calc!l !lat atee a po po#i #iti ti$e $e,, net net pre# pre#en entt $al! $al!e, e, then then o! o!rr in$e in$e#t #te ent nt i# pay paying ing o. o. Con#e>!ently, the in$e#tent i# increa#ing the in$e#tor?# =ealth beca!#e ore oney lo=# in :1

Kenneth R. S!lcyk than o!t. F!rtherore, in$e#tor# =o!ld !#e the net pre#ent $al!e or!la to e$al!ate #e$eral in$e#tent proect#. 'hen they #elect the proect =ith the highe#t *6, a# long a# the *6 i# po#iti$e. "n in$e#tor =o!ld ne$er choo#e a proect =ith a negati$e *6 beca!#e the proect?# ret!rn =o!ld be negati$e. )$er tie, ore oney lo=# o!t than in, creating a net lo##. For e!ation %>!a tion 24. 8nort!nately, yo! co!ld earn ore on the inancial #ec!ritie# than yo!r brother?# b!#ine## beca!#e the *6 i# negati$e.

NPV =−$ 10,000 +

$ 12,000

( 1 + 0.1 )

2

=− $ 82.64

24D

In$e#tor# can !#e the net pre#ent $al!e or!la in %>!ation 2: to calc!late the ret!rn o a oreign in$e#tent. 7e add a ne= $ariable, the e!i e>!i$a $ale lent nt o o!r o!r ho hoee c!rr c!rren ency cy.. 8nort!nately, the e
FV 1 E 1 FV 2 E2 FV T E T NPV =− PV 0 E0 + + + + ⋯ ( 1+ i )1 ( 1 + i )2 ( 1 +i )T 2:D For e!al# G1.30 per 1 e!ro. 'ie 1J %!al# G1.43 per 1 e!ro. 'ie 2J %!al# G2.00 per 1 e!ro. 'ie +J %!al# G2.10 per 1 e!ro. 7e calc!late the net pre#ent $al!e o yo!r in$e#tent o G12,+3:.24 in %>!ation 2-. 'he *6 i# po#iti$e, and the in$e#tent increa#e# yo!r =ealth. o=e$er, =e !#t oreca#t the e
:2


NPV =−20,000 € ∙ 1.50

$ + €

8,000 € ∙ 1.75

( 1 +0.05 )1

$ $ $ 8,000 € ∙ 2.00 8,000 € ∙ 2.10 € € € +

( 1 + 0.05 )2

+

( 1 + 0.05 )3

2-D NPV =−$ 30,000 + $ 13,333.33 + $ 14,512.47 + $ 14,512.47 = $ 12,358.27 7e contin!e o!r e!al# G1.30 per 1 e!ro. 'ie 1J %!al# G1.23 per 1 e!ro. 'ie 2J %!al# G1.00 per 1 e!ro. 'ie +J %!al# G0.30 per 1 e!ro. 7e calc!late the net pre#ent $al!e o AG-,49&.90 in %>!ation +0. )!r in$e#tent becae a di#a#ter beca!#e =e earned a negati$e ret!rn beca!#e the e!ro had depreciated.

NPV =−20,000 € ∙ 1.50

$ + €

8,000 € ∙ 1.25

( 1 +0.05 )

1

$ $ $ 8,000 € ∙ 1.00 8,000 € ∙ 0.50 € € € +

( 1 + 0.05 )

2

+

( 1 + 0.05 )3

+0D NPV =−$ 30,000 + $ 9,523.81 + $ 7,256.24 + $ 3,455.35=−$ 9,764.60

Key Terms re$en!e e!ity contrib!ted capital retained earning# acco!nt# recei$able acco!nt# payable c!rrent a##et# i
#tateent o ca#h lo=# R!le o 42 "nn!al ercentage Rate "RD copo!nding re>!ency eecti$e ann!al rate %FFD contin!o!# copo!nding ann!ity ordinary ann!ity ann!ity d!e aortiation table net pre#ent $al!e

:+


Chapter Questions 1

Cop!te the net incoe i a copany #old G30,000 o good# in ca#h, #old G90,000 o good# on acco!nt# recei$able, paid G100,000 in co#t# and operating e
2

Calc!late the retained earning# o a corporation at the end o the year i retained earning# =ere G20,000 at the beginning o the year, net incoe =a# G30,000, declared G90,000 in di$idend#, and #old G30,000 in additional #tock.

+

Cop!te a b!#ine##?# ca#h balance at the end o the year i the copany #tart# =ith a ca#h balance o G10,000, paid #alarie# o G40,000, recei$ed G100,000 in ca#h #ale# ro c!#toer# and G+0,000 or acco!nt# recei$able, and paid ta
&

o! =ill recei$e G1,000,000 in one h!ndred year# e!al# 3 "R@

3

o! depo#it G3,000 into a bank that earn# 10 "R. o= !ch =ill yo!r balance gro= in 30 year#@

9

o! depo#it G1,000 in a bank or t=o year#. 7hich intere#t rate in "R !#t yo! earn or yo!r ending balance to be G1,200@

4

o! depo#it yo!r #a$ing# into a oney arket that earn# + "R. o= any year# =o!ld it do!ble@

:

I the 8.S. econoy gro=# 3 per year, ho= any year# doe# the 8.S. econoy need to do!ble@

-

o! =ill recei$e a G1,000 each year or t=o year#. o!r ir#t payent #tart# in ear 0. Calc!late ca#h lo= $al!e to yo! today i the arket intere#t rate e>!al# 4 "R.

10 %$ery year, yo! #a$e G400. o= !ch =o!ld thi# oney gro= into ater + year# i the arket intere#t rate e>!al# + "R@ 11 Cop!te the pre#ent $al!e i a riend repay# a loan o$er + onth# =ith an ann!al intere#t rate o 12 and the onthly payent o G100. Fir#t payent begin# at the end o the ir#t onth. 12 I yo! depo#it G300 into a #a$ing# acco!nt that earn# 3 "R or +0 year#, calc!late the ending balance or the ollo=ing copo!nding re>!encie#J ann!al, onthly, and contin!o!#.

:&

Money, Banking, and International Finance 1+ I yo! are earning 19 "R on yo!r in$e#tent that i# copo!nded >!arterly, cop!te the eecti$e ann!al rate. 1& o! are #a$ing or retireent, and plan to in$e#t G2,000 e$ery year into an ordinary ann!ity that earn# 4 "R. Cop!te the $al!e o yo!r ann!ity in 20 year#. 13 o! ha$e #a$e an ordinary ann!ity =ith a balance o G30,000. Calc!late yo!r ann!al =ithdra=al payent# i the ann!ity earn# a 3 "R =hich yo! =ithdra= o$er 13 year#. 19 Cop!te the onthly payent or a G300,000 ortgage or +0 year# =ith a 4 "R. 14 o! re#ide in Malay#ia and ha$e an o$er#ea# bank acco!nt in %!rope. o! e
ayent# 0 1 2 +

%
&.00 r  Y &.23 r  Y &.30 r  Y 3.00 r  Y

Calc!late the net pre#ent $al!e o yo!r ca#h lo=# or a arket intere#t rate o &.

*. )alation of Stoc&s and %onds 'hi# chapter pro$ide# an o$er$ie= o #tock# and bond#, and the ethod# inancial analy#t# !#e to calc!late the arket price !#ing the pre#ent $al!e or!la. F!rtherore, corporation# i##!e a $ariety o bond# and #tock#, and !#e the to e!ently, in$e#tor# !#t kno= the dierence bet=een yield to at!rity and the rate o ret!rn. 'hi# chapter e
%"er"ie* of Bonds Corporation# oten borro= oney by i##!ing bond#. " bond i# #iilar to note# payable beca!#e they are =ritten proi#e# to pay intere#t and principal. 7e #ho= a pict!re o a bond in Fig!re 1. Face $al!e o thi# bond e>!al# G1,000, and thi# bond at!re# on Febr!ary 1, 2020. Con#e>!ently, =hoe$er hold# thi# bond =ill recei$e G1,000 on thi# date, and the bondholder al#o :3

Kenneth R. S!lcyk earn# G100  0.1 W G1,000D per year in intere#t. Mo#t bond# pay intere#t t=ice ann!ally or G30 e$ery #i< onth# or thi# e
Bond G1,000 10 Febr!ary 1, 2020 Figure 1. + piture of a bond

Bond#, ho=e$er, dier ro note# payable. " notes payable i# a loan ro a #ingle creditor #!ch a# a bank, =hile a bond i# a loan that corporation# i##!e in denoination# o G1,000, G2,000, etc. Finally, bond# are #tandardied, and th!#, in$e#tor# can p!rcha#e the. Moreo$er, in$e#tor# can b!y and #ell the#e bond# on the inancial arket# beore the bond# at!re. Bond# dier ro corporate #tock. " #hare o stock repre#ent# o=ner#hip in a corporation. For in#tance, i a #hareholder o=n# 1,000 #hare# o!t o 10,000, then he or #he o=n# 10 o the corporation?# e>!ity. Moreo$er, the #hareholder al#o recei$e# 10 o the corporation?# earning#, =hen the board o director# declare# di$idend#. )n the other hand, a bond repre#ent# a debt or a liability to the corporation. For e!ently, the #tockholder# lo#e part o control o the corporation. )n the other hand, the bondholder# do not #hare in the anageent or earning# o the corporation. "ltho!gh the corporation !#t pay the bond intere#t, =hether it earn# proit# or lo##e#, bond# red!ce net incoe, th!# lo=ering a corporation?# ta!ently, the corporation ha# t=o plan#. For lan ", the corporation i##!e# 200,000 ne= #hare# o the corporation?# #tock at G10 per #hare. For lan B, the :9

Money, Banking, and International Finance corporation i##!e# G2 illion o bond# =ith a 10 intere#t rate. ence, the intere#t e!al# G200,000 per year. %
lan " G1,000,000

%arning# beore bond intere#t and incoe ta
G1,000,000 &00,000D G900,000

lan " incoe per #hare 300,000 #hare#D lan B incoe per #hare +00,000 #hare#D

lan B G1,000,000 200,000D G:00,000 +20,000D G&:0,000

G1.20 G1.90

The -aluation of Bonds ;o$ernent# and corporation# i##!e a $ariety o bond# =ith dierent characteri#tic# and ca#h lo=#. Con#e>!ently, =e e
'rea#!ry Bill 8.S. ;o$ernent G10,000 "!g!#t 10, 201+ Figure 2. + piture of a 'reasury (ill

For e!ently, the ederal go$ernent =ill repay :4

Kenneth R. S!lcyk yo! G10,000 or thi# in#tr!ent on "!g!#t 10, 201+. 'he G300 dierence relect# the intere#t on thi# loan. In$e#tor# and analy#t# calc!late the yield to at!rity 'MD, the ret!rn to an in$e#tent. ield to at!rity relect# an in$e#tor?# proit ro a #ec!rity that i# #iilar to an intere#t rate. 7e #tate both intere#t rate# and yield to at!rity in ann!al percentage ter#. For o!r e!ation 1 i the bond?# ace $al!e e>!al# G10,000 =hile the arket $al!e i# G-,300 =ith a at!rity o one year. '( 1

P( 0 =

(1 & #% )

$-,300 =

$10 ,000

(1 & #% )

1 & #% =

$10 ,000 $-,300

#% = 0.0329

1D

I a di#co!nt bond ha# a at!rity le## than one year, then the tie #!b#cript reain# one year. o=e$er, =e ad!#t the yield to at!rity to ann!al ter#. For e!al 10.32. /i#co!nt bond# !#!ally ha$e a at!rity o one year or le##. o=e$er, =e can ad!#t the pre#ent $al!e or!la to calc!late bond# =ith longer at!ritie#. For e!ation 2. /id yo! notice the tie #!b#cript i# a three@ P( 0 =

'( +

(1 & #% ) +

$13,000 =

$20 ,000

(1 & #% ) +

(1 & #% ) + =

$20 ,000 $13,000

#% = + 1.+++++ + #% = 0.101

−1 2D

" coupon bond dier# ro a di#co!nt bond beca!#e it# intere#t rate i# #tated on the certiicate. /!ring the old day#, an in$e#tor =o!ld detach a co!pon ro the bond and ail it to ::

Money, Banking, and International Finance the corporation or go$ernent or an intere#t payent. 'hen the corporation or go$ernent =o!ld #end a check to the bondholder. 7e #ho= a co!pon bond in Fig!re + =ith dated co!pon# at the botto o the certiicate. 'rea#!ry *ote 8.S. ;o$ernent G20,000 10 "!g!#t 10, 2020

Figure 3. +n example of a oupon bond

'hi# co!pon bond i# a 8.S. 'rea#!ry note =ith a ace $al!e o G20,000, or 'Anote or #hort. Moreo$er, 8.S. go$ernent pay# 10 intere#t e$ery #i< onth#L con#e>!ently, the per#on =ho po##e##e# thi# in#tr!ent =o!ld clip o one co!pon and #end it to the 8.S. ederal go$ernent or payent. ence, the intere#t payent e>!al# 0.1 W G20,000 W 0.3 O G1,000 or e$ery #i< onth#. 7hen the 'Anote at!re# on "!g!#t 10, 2020, the bondholder recei$e# G20,000. Market intere#t rate rarely e>!al# the bond?# #tated intere#t rate. I the arket intere#t rate i# lo=er than the co!pon intere#t rate, then a corporation or go$ernent =o!ld ne$er #ell the bond or the ace $al!e beca!#e it =o!ld pay a higher intere#t rate than the arker. o=e$er, the go$ernent or corporation co!ld #ell the bond or a greater arket price, red!cing the in$e#tor?# ret!rn. igher arket price ean# the bond i##!er #old the bond or a premium. " corporation, or e!aling G:0 a year or G&0 e$ery #i< onth#. I the bond at!re# in t=o year#, then the pre#ent $al!e or!la ha# & period#. Market intere#t rate c!rrently i# & a year, or 2 or a payent period. I the arket intere#t rate drop# to &, the corporation =o!ld not #ell thi# bond at ace $al!e beca!#e the corporation =o!ld pay a higher intere#t rate than the arket. Con#e>!ently, the corporation can #ell thi# bond or a greater price, relecting the arket intere#t rate. 7e calc!late the bond arket price in %>!ation +, and it, P( 0, e>!al# G1,049.13. 'hereore, a corporation pay# & intere#t on bond# =ith an : intere#t co!pon rate. P( 0 =

$&0

(1& 0.02)

& 1

$&0

(1 & 0.02) 2

&

$&0

( 1& 0.02)

& +

P( 0 = $1,049.13

$&0 & $1,000

( 1 & 0.02) & +D

:-

Kenneth R. S!lcyk Market intere#t rate co!ld #=ing in the oppo#ite direction. Con#e>!ently, the corporation# and go$ernent# co!ld #ell bond# at a discount i the arket intere#t rate e!ation &, and the bond?# arket price, 6 0, e>!al# G-+0.40. Con#e>!ently, in$e#tor# =o!ld earn a 12 ret!rn on their : intere#t bond#. P( 0 =

$&0

(1& 0.09)

1

&

$&0

( 1& 0.09)

2

&

$&0

( 1& 0.09)

+

&

$&0 & $1,000

( 1& 0.09) &

P( 0 = $-+0.40

&D

" go$ernent or corporation co!ld i##!e a bond that ne$er at!re#, =hich =e call a consul or perpetuity. Con#e>!ently, the bond ha# no at!rity date, b!t the bondholder recei$e# intere#t payent# ore$er. " go$ernent or corporation rarely i##!e# the#e bond# beca!#e o#t people and go$ernent like end date# or loan#. o=e$er, thi# bond po##e##e# nice atheatical propertie#. " go$ernent, or e!al# :, then calc!late the arket price, 6 0, o thi# con#!l. Since all intere#t payent# are e>!al, #!b#e>!ently, all !t!re $al!e#, F6, are the #ae in the pre#ent $al!e or!la. 'h!#, the pre#ent $al!e becoe# an ininite #erie#, =hich red!ce# to F6 V i. Con#e>!ently, =e calc!late the arket price o thi# con#!l a# G923 in %>!ation 3. P( 0 = P( 0 =

'(

(1 & i ) $30 0.0:

&

'(

(1 & i ) 2

&

'(

(1 & i ) +

& =

'( i

= $923

3D

7e li#t #e$eral bond# =ith dierent characteri#tic# belo=J 

Re$istered /ondsJ Corporation regi#ter# the nae# and addre##e# o the bondholder#. Mo#t corporation# regi#ter bond# beca!#e the regi#tration protect# the in$e#tor# ro lo## or thet o the bond#.



/earer /ondsJ 7ho po##e##e# the#e bond# recei$e the intere#t payent. Co!pon bond# are !#!ally bearer bond#.

-0


Debenture /onds are !n#ec!red bond#. 'h!#, the corporation doe# not pledge a##et# or the bond i##!e#. " corporation !#t be inancially #trong to i##!e the#e bond# beca!#e the#e bond# rely on the corporation?# credit #tanding.



onvertible /onds' Bondholder# ha$e the right to e


.unicipal /ondsJ City and co!nty go$ernent# i##!e !nicipal bond# to inance local proect#. 'he#e bond# are pop!lar =ith in$e#tor# beca!#e the 8.S. go$ernent doe# not ta< their intere#t earning#. Con#e>!ently, !nicipal bond# !#!ally pay lo=er intere#t rate# than other bond#.

.ield to Maturity and +ate of +eturn In$e#tor# =ho p!rcha#ed a inancial #ec!rity kno= the ace $al!e, the at!rity date, n!ber o intere#t payent# per year, and the ao!nt o intere#t payent#. o=e$er, in$e#tor# do not kno= the di#co!nt rate. 'hey can #!b#tit!te the inoration into the pre#ent $al!e or!la and #ol$e or the di#co!nt rate. 'hen in$e#tor# can calc!late the di#co!nt rate or #e$eral dierent bond# and #elect the bond that ha# the highe#t di#co!nt rate. I in$e#tor# hold the bond !ntil at!rity, then =e call the discount rate the yield to at!rity. %conoi#t# con#ider yield to maturity the o#t acc!rate ea#!re o the intere#t rate# beca!#e the yield to at!rity allo=# in$e#tor# to copare dierent bond#. For e!ently, =e calc!late yo!r yield to at!rity o 1&.11 in %>!ation 9. o! can copare thi# yield to other in$e#tent# and choo#e the in$e#tent =ith the greate#t yield. $1,900 =

$&00

(1 & #% )

1

&

$&00

(1 & #% )

2

&

$&00 & $1,000

( 1 & #% ) +

#% = 0.1&11

9D

"# yo! can #ee, thi# calc!lation becoe# $ery coplicated. I yo! calc!late the di#co!nt rate an!ally, then yo! !#t calc!late the 6 0 by #electing $ario!# di#co!nt rate#, #!ch a# 0, 3, 10, and 20. *e!ation 4, and #elect the di#co!nt rate that ha# a pre#ent $al!e, 6 0 clo#e to G1,900. Matheatician# =rote progra# that can #ol$e or the di#co!nt rate. I yo! $i#it the a!thor?# =eb#ite, ===.kenA #!lcyk.co, he ha# a a$aScript progra that can #ol$e or the di#co!nt rate. P( 0 =

$&00

(1 & r )

1

&

$&00

( 1 & r )

2

&

$&00 & $1,000

( 1 & r ) +

4D -1

Kenneth R. S!lcyk ield to at!rity generate# t=o iportant r!le# on bond#, =hich areJ 

Market intere#t rate or yield to at!rityD and the arket price or pre#ent $al!eD o the #ec!ritie# are in$er#ely related. For e


I a bond ha# a #horter at!rity, #!b#e>!ently, it# price =ill l!ct!ate le## or a change in the arket intere#t rate. 7e #ho= thi# by an e
For e!ently, the intere#t rate change aected the 10Ayear bond ore than the oneAyear bond. 7e calc!lated the arket $al!e o the oneAyear bond in %>!ation : and the tenAyear bond in %>!ation -. "# thi# e
P( 0 =

$300 & $3,000

(1& 0.19) 1 $300

(1& 0.19 )

+ 1

= $&,4&1.+:

:D $300

(1& 0.19 ) 2

++

$300 & $3,000

(1& 0.19 ) 10

= $ +,330.0+

-D

o! can becoe con!#ed by the ter# !#ed thro!gho!t thi# book. 7e !#e yield to at!rity, di#co!nt rate, and intere#t rate interchangeably, and yo! can interpret the#e ter# to ean an intere#t rate. o=e$er, a rate o ret!rn dier# beca!#e in$e#tor# co!ld #ell their #ec!ritie# beore they at!red. 'h!#, the rate or ret!rn incl!de# the intere#t rate and capital gain# or lo##e#. " capital $ain i# an in$e#tor #ell# a inancial #ec!rity or greater price, =hile a capital loss i# an in$e#tor #ell# a inancial #ec!rity or a lo=er price. In$e#tor# do not =ant capital lo##e#, b!t they can occ!r. For in#tance, an in$e#tor !#t #ell an a##et =ho#e arket price ha# dropped beca!#e he or #he need# ca#h >!ickly. 'h!#, the pre#ent $al!e #till =ork# or capital gain# and lo##e#. Finally, i the in$e#tor hold# onto the #ec!rity onto the at!rity date, then the rate o ret!rn e>!al# the yield to at!rity. " bond, or e!ently, yo!r rate o ret!rn e>!al# the t=o year# o intere#t pl!# the capital gain o 1&.++. 7e calc!lated the capital gain in %>!ation 10, and r e>!al# the rate o ret!rn. 'he a!thor !#ed a cop!ter progra to #ol$e or r. -2

Money, Banking, and International Finance P( 0 =

'( 1

(1 & r )

$2,000 =

& 1

$100

(1 & r )

'( 2

(1 & r ) 2 &

$100 & $2,&00

(1 & r ) 2

r = 0.1&++

10D

" capital lo## i# #iilar. "# an ill!#tration, yo! bo!ght a inancial #ec!rity or G2,000 =ith a co!pon intere#t rate o 3 and held it or t=o year#. "ltho!gh yo! earned t=o year# o intere#t, thi# copany reported inancial tro!ble, and the bond price dropped to G1,000. 8nort!nately, =e calc!lated yo!r ret!rn ro the in$e#tent a# a h!ge lo## o A2+.+ in %>!ation 11. $2,000 =

$100

(1 & r )

&

$100 & $1,000

(1 & r ) 2

r = −0.2++

11D

The -aluation of Stocks 6al!e o a #tock e>!al# the pre#ent $al!e o an a##etN# !t!re ca#h lo=#. 'h!#, the pre#ent $al!e o all !t!re ca#h lo=# i# the a##et?# arket price in %>!ation 12. Market price o #tock per #hare e>!al#  0. Market price in the tie period 1 i#  1 =hile / 1 indicate# the di$idend#. Finally, the rate o ret!rn i# r, and the #!b#cript# indicate the tie period. P 0 =

D1

&

P 1

(1 & r ) (1& r )

12D

"n in$e#tor $al!e# hi# #tock,  0, at tie 0 that e>!al# the di#co!nted di$idend he recei$e# ne!ation 1+. 'h!#, =e o$ed the tie #!b#cript# ahead by one period. P 1 =

D2

&

P 2

(1& r ) (1& r )

1+D

7e obtain %>!ation 1& by #!b#tit!ting %>!ation 1+ into %>!ation 12. P 0 =

D1

&

D2

(1& r ) (1& r )

& 2

P 2

(1& r ) 2

1&D -+

Kenneth R. S!lcyk 'hen =e b!ild o!r #e>!ence by e!ation into %>!ation 1& or $ariable  2. 7e contin!e to e!ence in %>!ation 13. P 0 =

D1

(1& r )

D2

&

(1& r ) 2

&

D+

(1& r ) +

& 13D

D = D1 = D2 =  I the corporation pay# the #ae di$idend#, then , #!b#e>!ently, the arket price becoe# a perpet!ity, =here =e #ipliy a #tock?# $al!e to %>!ation 19. P 0 =

D r

19D

"# an ill!#tration, yo! p!rcha#e #tock a# a longAter in$e#tent. o!r ann!al rate o ret!rn i# 3, and yo! e!ently, yo! cop!te the arket $al!e o thi# #tock o G&0 per #hare in %>!ation 14. P 0 =

D r

=

$2

0.03

= $&0.00

14D

I yo! =ant to kno= the arket $al!e o thi# #tock or one year, then thi# becoe# a trick >!e#tion. Since yo! e!ently the arket price i# #till G&0.00. 'h!#, the in$e#tor doe# not e!ation 19 can incl!de a di$idend gro=th rate. I the di$idend gro=# at g percent per year, then =e !pdate the pre#ent $al!e or!la to incl!de a di$idend gro=th rate in %>!ation 1:. Con#e>!ently, =e can #ipliy thi# ininite #e>!ence into #oething #iilar to a perpet!ity. 2

+

D (1 & g ) D (1 & g ) D (1 & g ) D = P 0 = & & &  (1 & r ) r − g (1 & r ) 2 (1& r ) +

1:D

For in#tance, yo! p!rcha#e #tock a# a longAter in$e#tent. o!r rate o ret!rn e>!al# 10, and yo! e!ation 1-. P 0 =

D r − g

=

$2

0.10 − 0.03

= $&0.00

1-D

-&

Money, Banking, and International Finance 8#ing the #ae n!ber#, =hat =o!ld happen i di$idend# gro= at a #lo=er rate, #!ch a# 2 per year@ 7e calc!late a arket $al!e o G23 per #hare beca!#e the di$idend gro=# #lo=ly in %>!ation 20. P 0 =

D r − g

=

$2

0.10 − 0.02

= $23.00

20D

'=o orce# red!ce !t!re ca#h lo=#. Fir#t, a greater di#co!nt rate lo=er# the !t!re $al!e o ca#h lo=#. Second, a larger di$idend gro=th rate increa#e# the $al!e o !t!re ca#h lo=#, ca!#ing the di$idend# to gro= a#ter than the rate o ret!rn. *e$erthele##, the di$idend gro=th rate !#t becoe lo=er than the di#co!nt rate, or g Z r. )ther=i#e, the !t!re ca#h lo=# becoe ore $al!able o$er tie, aking the pre#ent $al!e negati$e. For e!ation 21. P 0 =

D r − g

=

$3

0.12 − 0.03

= $41.&+

21D

Market $al!e o #tock or the #econd period doe# not e>!al G41.&+ beca!#e the #tock price ha# gro=n 3 per year. In#tead, =e calc!late the arket $al!e o G43 in %>!ation 22.

P 1 = P 0 (1& g ) = $41.&+(1& 0.03) = $43.00

22D

8#ing %>!ation 1:, =e can #ol$e or dierent $ariable#, depending =hat =e kno=. For e!al# G100 per #hare =hile di$idend# are G+ per #hare that gro=# 3 per year. Cop!te the rate o ret!rn on thi# in$e#tent. 7e calc!late a rate o ret!rn o : per year in %>!ation 2+.

$100 =

$+

r − 0.03 r = 0.0:

2+D

Soe corporation#, e#pecially in highAtech ind!#trie#, pay lo= di$idend# in the beginning. S!b#e>!ently, the corporation gro=# rapidly o$er tie, and it begin# paying higher di$idend#. 7e can odiy the pre#ent $al!e or!la to handle thi# #it!ation. re#ent $al!e or!la ha# t=o coponent#J 

*onA#teady #tate  =e !#e the pre#ent $al!e to =rite o!t all ca#h lo=#, =hen the di$idend gro=th rate i# not con#tant. *onA#teady #tate occ!r# or a ne= corporation. -3


Steady #tate  the corporation begin# paying di$idend# o$er tie that increa#e at a con#tant rate. 'hi# occ!r# ater the corporation becoe# at!re. Con#e>!ently, =e calc!late the ca#h lo=# a# a perpet!ity.

"# an ill!#tration, =e #et the rate o ret!rn to 10. " corporation pay# a di$idend o G9 at tie 1. Corporation e
ear 1J /1 O G91X0.02D O G9.12



ear 2J /2 O G9.121X0.0&D O G9.+9&:



ear +J /+ O G9.+9&:1X0.09D O G9.4&99::

'hird year becoe# the perpet!ity beca!#e the corporation begin# increa#ing the di$idend at a con#tant rate. For thi# e!ation 2&. P 2 =

D+ r − g

=

$9.4&99::

0.10 − 0.09

= $19:.94

2&D

Finally, =e can calc!late the arket $al!e o the #tock #hare in the tie period 0 by di#co!nting the !t!re ca#h lo=# o the #tock in %>!ation 23. P 0 =

$9.12

&

$9.+9&:

(1& 0.1) (1& 0.1) 2

&

$19:.94

(1& 0.1) 2

$130.22 = 23D

" ne= #tart!p internet copany doe# not pay di$idend# or the ir#t three year#. In year &, the copany begin# paying a di$idend o G10 per #hare that gro=# 3 per year. I the rate o ret!rn i# :, then calc!late the arket $al!e o the #tock. 

Fir#t, =e #et the di$idend# to ero or the initial three year#, =hich ean# / 1 O /2 O /+ O 0



Second, =e #et the di$idend to G10, or the o!rth tie period, or / & O G10. *e!ation 29.

-9

Money, Banking, and International Finance P + =

D& r − g

=

$10 0.0: − 0.03

= $+++.++

29D

8nort!nately, %>!ation 29 yield# the arket $al!e o #tock or eriod +. I =e are in ear 0 or the ca#h lo=, then =e !#e the pre#ent $al!e or!la to calc!late the #tock price in 'ie 0 in %>!ation 24. Con#e>!ently, the arket $al!e o the #tock e>!al# G29&.91 per #hare. P 0 =

$+++.++

(1& 0.0:) +

= $29&.91 24D

Key Terms bond note# payable #tock di#co!nt bond co!pon bond prei! di#co!nt con#!l perpet!ity

regi#tered bond bearer bond debent!re bond con$ertible bond !nicipal bond di#co!nt rate yield to at!rity capital gain capital lo##

Chapter Questions 1

%
9&. Identiy the ad$antage# o i##!ing ore bond# in#tead o #tock. 93. " 'Abill ha# a ace $al!e o G20,000 =ith a yield to at!rity o +, and thi# bill at!re# in 240 day#. Calc!late the arket $al!e o thi# 'Abill. 99. I a con#!l pay# G100 o intere#t e$ery year and the arket intere#t rate e>!al# 9, cop!te the arket $al!e o thi# con#!l. 94. " bond ha# a ace $al!e o G2,000, an intere#t rate o 10,and pay# intere#t t=ice a year. I the yield to at!rity i# 3 and the bond at!re# in three year#, calc!late the arket $al!e o thi# bond.

-4

Kenneth R. S!lcyk 9:. " bond ha# a ace $al!e o G2,000, an intere#t rate o 10 and pay# intere#t t=ice a year. I the yield to at!rity i# 20 and the bond at!re# in three year#, cop!te the arket $al!e o thi# bond. 9-. %
+. ,eterminin- the Mar&et $nterest ates 7e e!antity, arket price, and arket intere#t rate. 'he#e #hit# allo= analy#t# and econoi#t# to predict change# in the intere#t rate# and bond price#. Moreo$er, =e !#e deand and #!pply !nction# to e!ently, the =orldN# intere#t rate either ca!#e# loanable !nd# to enter or lea$e a #all co!ntry.

The Supply and Demand for Bonds Intere#t rate# ha$e l!ct!ated #!b#tantially in the 8nited State# d!ring the #econd hal o the 20th cent!ry. For e!ently, pl!eted to belo= 9 in the idA1-:0# and 1--0#. C!rrently, 'Abill rate# ha$e allen belo= 1 ater the 200: Financial Cri#i#. -:

Money, Banking, and International Finance %$eryone clo#ely =atche# the intere#t rate#. 'hey deterine =hether con#!er# #ho!ld #a$e or b!y, =hether ailie# #ho!ld b!y a ho!#e or p!rcha#e bond#. F!rtherore, the intere#t rate# inl!ence b!#ine## deci#ion# to in$e#t in ne= e>!ipent or in$e#t their oney into inancial #ec!ritie#. Fro Chapter 2, yo! ha$e learned the aor inancial in#tr!ent#. "ll the#e in#tr!ent# repre#ent credit arket in#tr!ent#. "ll the#e in#tr!ent# are loan#, =here one party lend# !nd# to another party e!ently, the inter#ection o #!pply and deand !nction# in the bond arket deterine# the bond?# arket price and >!antity. Demand function relect# the relation#hip bet=een the >!antity deanded and the arket price o bond#, =hen =e hold all other econoic $ariable# con#tant. 7e #ho= a deand !nction in Fig!re 1. /eand !nction ha# a negati$e #lope beca!#e a# yo! o$e ro point " to point B, the price o bond# becoe# lo=er, #o in$e#tor# b!y ore bond# or a cheaper price. !#t iagine bond# are #iilar to a prod!ct. For e
Figure 1.
--

Kenneth R. S!lcyk Supply function #ho=# the relation#hip bet=een the >!antity #!pplied and the arket price, =hen =e hold all other econoic $ariable# con#tant. 7e dre= a #!pply !nction in Fig!re 2. S!pply !nction ha# a po#iti$e #lope beca!#e a# yo! o$e ro point " to point B, the price becoe# higher =hile the arket intere#t rate all#. Con#e>!ently, b!#ine##e# and ir# borro= ore !nd# beca!#e the intere#t rate# are cheaper. Reeber a bond?# intere#t rate o$e# in the oppo#ite direction o a bond?# price.

Figure 2. 5upply funtion for bonds

/eand and #!pply !nction# inter#ect at one point, the e>!ilibri!. 6quilibrium relect# a #tate o re#t. "# long a# the #!pply or deand !nction doe# not change, then the price and >!antity reain =here they are. 7e #ho= #!pply and deand !nction# in Fig!re +. "t thi# point, the >!antity deanded e>!al# the >!antity #!pplied or bond#. 'he 5[ and [ repre#ent e>!ilibri! >!antity and price. 8#ing the pre#ent $al!e or!la, =e can ded!ce =hat happen# to the arket intere#t rate. 7hat =o!ld happen to the bond arket i the bond?# price e!ilibri! price@ Con#e>!ently, the >!antity #!pplied i# greater than >!antity deanded, creating a surplus. B!#ine##e# and go$ernent #ell ore bond# beca!#e the price o bond# i# high, and intere#t rate# are lo=. o=e$er, the in$e#tor# do not b!y the#e bond# beca!#e the high price and lo= intere#t rate#. 'h!#, the bond?# price all# !ntil re#toring e>!ilibri! at [ again.

100


Figure 3. 5upply and demand for bonds

7hat =o!ld happen in the arket i the price o bond# =ere lo=er than the e>!ilibri! price@ 5!antity #!pplied becoe# le## than >!antity deanded, creating a s#orta$e. Bond price# are lo=, and intere#t rate# are high. Con#e>!ently, the in$e#tor# ha$e a large deand or bond# beca!#e the bond# ake a good in$e#tent. o=e$er, b!#ine##e# and go$ernent do not #ell bond# or a lo= price and high intere#t rate. 'h!#, the bond?# price !#t increa#e !ntil e>!ilibri! i# re#tored at [ again, decrea#ing the arket intere#t rate#. 'hereore, the arket al=ay# gra$itate# to e>!ilibri! and con#i#tently eliinate# #hortage# and #!rpl!#e# a# long a# a go$ernent doe# not interere in the arket. /eand !nction can #hit beca!#e a actor ha# changed. lea#e kno= the dierence bet=een a o$eent along a deand c!r$e and a deand !nction #hit. 7e #ho= a decrea#e in >!antity deanded in Fig!re &. In$e#tor# deand ore bond# a# =e o$e ro point " to point B. %conoi#t# call thi# a change in H quantity demanded4 In$e#tor# increa#e >!antity deanded beca!#e the price o bond# becae cheaper. Con#e>!ently, a actor ha# changed the #!pply !nction and not the deand !nction. I an o!t#ide actor aect# the deand !nction, then the deand !nction =o!ld #hit. %conoi#t# call a right=ard #hit an H increase in demand , =hile a #hit to the let i# a H decrease in demand4 7e #ho= deand !nction #hit# in Fig!re 3.

101


Figure !. + mo*ement along a demand funtion

Figure ,. + demand funtion s$ifts

7e li#ted #i< actor# to #ho= an increa#e in the deand !nction, #hiting it right=ard. 7e #ho= the increa#e in the deand !nction in Fig!re 9. 7hen the in$e#tor# increa#e their deand or bond#, the deand !nction #hit# right=ard beca!#e in$e#tor# b!y ore bond#. 'h!#, both the e>!ilibri! >!antity, 5[, and bond?# arket price, [, ri#e. 7hen =e di#co!nt the bond# !#ing the pre#ent $al!e or!la, the arket intere#t rate or the bond# all.

102


Figure -. + demand funtion inreases

(i#ting the #i< actor# that increa#e the deand !nctionJ 

"n increase in !ealt# increa#e# the bond?# deand !nction #hiting right=ard. " gro=ing econoy create# =ealth. 'h!#, the deand or bond# increa#e# too beca!#e in$e#tor# and the people ha$e ore =ealth and in$e#t ore in the bond arket.



" decrease in t#e e"pected returns on in$e#tent increa#e# the bond?# deand !nction #hiting right=ard. I in$e#tor# belie$e the intere#t rate# =ill becoe lo=er, then in$e#tor# =o!ld b!y ore bond# no=. For e!ently, the bond price# =o!ld increa#e. Con#e>!ently, yo! b!y bond# no= beca!#e yo! b!y bond# or a cheap price at a high intere#t rate and co!ld re#ell the bond# in the !t!re or a greater price a# arket intere#t rate all#.



" decrease in e"pected inflation increa#e# the bond?# deand !nction #hiting right=ard. Inlation erode# the p!rcha#ing po=er o ho!#ehold#, b!#ine##e#, and go$ernent#. Inlation al#o erode# the $al!e o in$e#tent#, #!ch a# #tock# and bond#. 'h!#, the in$e#tor# =o!ld b!y e=er bond# i they belie$e the inlation rate =ill ri#e in the !t!re, e#pecially longAter bond#. I in$e#tor# belie$e inlation =o!ld decrea#e in the !t!re, then in$e#tor# b!y ore bond# or in$e#tent.



" decrease in t#e risk o bond# increa#e# the bond?# deand !nction #hiting right=ard. In$e#tor# loan !nd# to borro=er#, =ho =ill not dea!lt on their loan#. In$e#tor# are !#!ally ri#k a$er#e. I in$e#tor# belie$e the bond arket becoe# ore #table and H#aer,\ then they b!y ore bond#.

10+




"n increase in t#e liquidity o the bond arket increa#e# the bond?# deand !nction #hiting right=ard. In$e#tor# are attracted to highly li>!id bond#. F!t!re i# !ncertain, and in$e#tor# can #ell an a##et a#t or little tran#action co#t. I the bond arket becoe# ore li>!id, #!ch a# 8.S. go$ernent #ec!ritie#, then in$e#tor# boo#t their deand or 8.S. go$ernent bond#. " decrease in information costs increa#e# the bond?# deand !nction #hiting right=ard. In$e#tor# contin!ally need inoration, #o they can e$al!ate their in$e#tent#. For e
lea#e note the deand !nction can #hit let=ard by the #ae #i< actor#. o! !#t re$er#e the logic or the #i< actor#. For e!ently, the bond price all# =hile the intere#t rate ri#e#. Fo!r actor# ca!#e the #!pply !nction to #hit. 7e li#ted the in a =ay that ca!#e# the #!pply !nction to increa#e and #hit right=ard in Fig!re 4. 7hen b!#ine##e# and go$ernent# i##!e ore bond#, the #!pply !nction #hit# right=ard, ca!#ing the e>!ilibri! >!antity 5[D to increa#e =hile the bond?# arket price [D all#. 7hen =e di#co!nt the bond?# price !#ing the pre#ent $al!e or!la, then the bondN# arket intere#t rate ri#e#.

Figure . + supply funtion inreases

Fo!r actor# #hit the #!pply !nctionJ

10&


" rise in e"pected profits increa#e# the bond?# #!pply !nction #hiting right=ard. " b!#ine## =o!ld borro= and boo#t it# debt to b!y a##et# like achine# and e>!ipent i the b!#ine## e!ipent d!ring a b!#ine## cycle beca!#e o proit e


" decrease in business ta"es increa#e# the bond?# #!pply !nction #hiting right=ard. I a go$ernent #!bect# a b!#ine## to high ta!ipent or e!ently, b!#ine##e# =o!ld in$e#t ore by !#ing bond#, increa#ing the bond?# #!pply o bond#, and the bond #!pply =o!ld #hit right=ard.



" rise in e"pected inflation increa#e# the bond?# #!pply !nction #hiting right=ard. Inlation erode# the $al!e o the dollar. Con#e>!ently, the $al!e o debt decrea#e# o$er tie. I b!#ine##e# and go$ernent belie$e inlation =o!ld ri#e, they borro= ore !nd# by i##!ing bond#. 'hen, they repay their loan# =ith Hcheaper dollar#.



" rise in $overnment borro!in$ increa#e# the bond?# #!pply !nction #hiting right=ard. 7hen go$ernent #pend# ore than =hat it collect# in ta
lea#e note the #!pply !nction can #hit let=ard by the #ae o!r actor#. o! !#t re$er#e the logic or the o!r actor#. For e!ently, the bond price ri#e# =hile the intere#t rate all#.

Interest +ates and the Business Cycle %pirical e$idence indicate# that arket intere#t rate# ri#e d!ring a b!#ine## cycle and all d!ring rece##ion#. /!ring a b!#ine## cycle, the ao!nt o good# and #er$ice# prod!ced in the econoy increa#e# beca!#e b!#ine##e# becoe optii#tic abo!t !t!re proit# and in$e#t in achine# and e>!ipent by i##!ing ore bond#. Con#e>!ently, the bondN# #!pply increa#e#. Moreo$er, i an econoy prod!ce# ore good# and #er$ice#, the econoy create# ore =ealth. In$e#tor# #a$e ore and in$e#t in the inancial arket#. 'h!#, the bondN# deand increa#e# and the deand !nction #hit# right=ard in Fig!re :. 7hen both the #!pply and deand !nction# #hit, =e kno= either the price or >!antity =hile the other $ariable becoe# indeterinate. In thi# ca#e, both !nction# increa#e, ca!#ing the >!antity o bond# to increa#e, b!t bond price# and intere#t rate# becoe !nkno=n. I yo! do 103

Kenneth R. S!lcyk not belie$e e, then e!ently, the arket price i# greater in the ir#t ca#e and lo=er in the #econd ca#e. 'hereore, change# in bond price# and intere#t rate# becoe abig!o!#. 8nort!nately, =e cannot pro$e intere#t rate# ri#e d!ring econoic e
Figure /. (ot$ supply and demand funtions inrease

The Fisher 'ffect 7e only di#c!##ed noinal intere#t rate#. 7e did not ad!#t the noinal intere#t rate# or inlation. 8nort!nately, inlation can ha$e a #igniicant inl!ence on the inancial arket#. In$e#tor# and #a$er# are concerned abo!t the real intere#t rate beca!#e the real intere#t rate relect# the tr!e co#t o borro=ing. 'he Fis#er 6ffect relate# noinal and real intere#t rate# and =e deine the notation a#J 

i i# the noinal intere#t rate.



r e>!al# the real intere#t rate.



πe i# the e
7e #ho= the Fi#her %ect %>!ation in %>!ation 1. It e>!al# a geoetric a$erage o the e
( i &1) = (1& r ) (1& ) e )

1D 109


For lo= inlation and lo= intere#t rate#, =e can !#e the appro
in %>!ation 2. 7e #et the cro## ter r π to ero beca!#e it becoe# a tiny n!ber. o=e$er, i the inlation rate or intere#t rate becoe# high, then the appro
( i & 1) = (1& r ) (1& ) e ) i + 1 = 1 + r π e i

+ r + π e

≈ r & ) e

2D

For e!ation +. r ≈ i − ) e

≈ 3−0=3

+D

7hat =o!ld happen i yo! belie$e inlation =ill increa#e to 3  πe O 3 D, and yo! grant a loan or one year at 3@ "t the end o year 1, yo! =o!ld ha$e 3 ore oney, b!t price#, !nort!nately, becae 3 greater too. Con#e>!ently, yo!r p!rcha#ing po=er =o!ld not change in real ter#. 7e calc!lated the real intere#t rate in %>!ation &. r ≈ i − ) e

≈ 3 − 3= 0

&D

Real intere#t rate, thereore, relect# the tr!e co#t o borro=ing and becoe# a better indicator o incenti$e# to lend and borro=. Many inancial analy#t# !#e noinal intere#t rate# beca!#e inlation i# lo= in the 8nited State#, a$eraging + per year or le##. 7e can !#e the bond arket to #ho= the Fi#her %ect. I the in$e#tor# and b!#ine##e# e!ently, the deand or bond# #hit# to=ard the let =hile the #!pply or bond# #hit# right=ard. 7e #ho= the ipact on the bond arket in Fig!re -. "ccordingly, the price o bond# decrea#e# and the intere#t rate# increa#e#. In thi# ca#e, the ao!nt o bond# 5[D in the arket i# abig!o!#. o! pro$e thi# by #hiting the deand and #!pply c!r$e eno!gh, #o the >!antity doe# not change. 'hen #hit either !nction a little ore and the e>!ilibri! >!antity change# direction. 'h!#, the greater inlationary e
Kenneth R. S!lcyk iD becoe greater. I the go$ernent =ant# lo= noinal intere#t rate#, then the p!blic and in$e#tor# !#t belie$e the inlation rate =ill be lo=.

Figure 0. 5upply and demand funtions explain t$e Fis$er Effet

Bond /rices in an %pen 'conomy In the pre$io!# #!pplyAdeand graph#, the bond =a# the good or the arket. o=e$er, =e co!ld #=itch the analy#i#, =here the oney e!ently, the bond and loanable !nd# arket# yield identical re#!lt# beca!#e =e e!ilibri! price in the loanable !nd# arket i# the intere#t rate =hile the e>!ilibri! >!antity i# the ao!nt o loanable !nd#. re$io!# #!pplyAdeand e!ently, the analy#i# !#e# the loanable !nd# approach. 5!antity repre#ent# the ao!nt o loanable !nd# =hile the price i# the real intere#t rate. 7e !#e the real intere#t rate beca!#e in$e#tor# are concerned abo!t their in$e#tent ret!rn ater acco!nting or inlation. 'h!#, =e ded!ct a co!ntry?# inlation rate ro the noinal intere#t rate, yielding the real intere#t rate. 10:

Money, Banking, and International Finance I a co!ntry =ere a clo#ed, #all econoy, the loanable !nd# arket =o!ld be at e>!ilibri!. /oe#tic in$e#tor# repre#ent the #!pply o loanable !nd# =hile b!#ine##e# and go$ernent# deand the. F!rtherore, =e a##!ed the co!ntry i# #all beca!#e the in$e#tor#, go$ernent, and b!#ine##e# cannot inl!ence the international intere#t rate. Con#e>!ently, the real intere#t rate e>!al# 3 in Fig!re 10 =hile the ao!nt o !nd# in the arket i# ([. I the =orld?# real intere#t rate =ere -, then the doe#tic in$e#tor# =o!ld in$e#t their !nd# in the international arket, earning a higher intere#t rate in Fig!re 10. o=e$er, b!#ine##e# and go$ernent# =o!ld not borro= !nd# at thi# intere#t rate beca!#e it i# too high. Con#e>!ently, the dierence bet=een >!antity #!pplied and >!antity deanded relect# the ao!nt o !nd# lea$ing the co!ntry at - real intere#t rate. I thi# co!ntry =ere a clo#ed econoy, #!b#e>!ently, the arket =o!ld ha$e a #!rpl!#, and arket orce# =o!ld lo=er the real intere#t rate to 3.

Figure 1. oanable funds in an open eonomy

I the =orld?# real intere#t rate =ere 1, then ir# and the go$ernent =o!ld borro= at the cheap rate# in Fig!re 10. o=e$er, the doe#tic in$e#tor# =o!ld not lend at that rate. Con#e>!ently, the dierence bet=een >!antity deanded and >!antity #!pply relect# the ao!nt o !nd# entering the co!ntry. I thi# co!ntry =ere clo#ed, then the loanable !nd# arket =o!ld ca!#e a #hortage, and arket orce# =o!ld increa#e the real intere#t rate. 7e a##!ed the co!ntry i# a small open economy beca!#e thi# co!ntry i# too little to inl!ence the =orld?# real intere#t rate. Many co!ntrie#, #!ch a# the *etherland# and Belgi! =o!ld all =ithin thi# category. o=e$er, a large co!ntry like the 8nited State#, ;erany, or apan =o!ld aect the =orld?# real intere#t rate.

10-


Key Terms bond arket deand !nction #!pply !nction e>!ilibri! #!rpl!# #hortage >!antity deanded

increa#e in deand decrea#e in deand Fi#her %ect loanable !nd# clo#ed econoy open econoy #all open econoy

Chapter Questions 1

7hich #i< actor# #hit the deand or bond# and in =hich direction@

4&. 7hich o!r actor# #hit the #!pply or bond# and in =hich direction@ 43. /ra= a bond arket =ith a #!pply and deand !nction. 7hat =o!ld happen in the arket i the 200: Financial Cri#i# ca!#e# =ealth to drop@ 49. /ra= a bond arket =ith a #!pply and deand !nction. 7hat =o!ld happen in the arket i a go$ernent ipo#e# higher ta!al# -0 =hile the inlation rate i# 100. lea#e calc!late the e!ation and the ipact o e!ilibri! intere#t rate o 4. 7hat =o!ld happen i the =orld?# intere#t rate i# -@ :+. /ra= a loanable !nd# arket =ith an e>!ilibri! intere#t rate o 4. 7hat =o!ld happen i the =orld?# intere#t rate i# 3@

110


/. is& and Term Strctre of $nterest ates B!#ine##e# and go$ernent# oer a $ariety o bond# that dier in dea!lt ri#k, li>!idity, inoration co#t#, and ta!ently, econoi#t# #t!dy the#e intere#t rate# ro the#e #ec!ritie# that they call the ter #tr!ct!re o intere#t rate#. 'hen econoi#t# can plot the ter #tr!ct!re, called the yield c!r$e. ield c!r$e !#!ally #lope# !p=ard and ean# the longAter 8.S. go$ernent #ec!ritie# pay a higher intere#t rate than the #hortAter one#. %conoi#t# !#e three theorie# to e
Default +isk and Bond /rices Default risk i# the po##ibility a borro=er =ill not repay the principal andor intere#t on a loan. For in#tance, the 8.S. go$ernent ha# little ri#k o dea!lt, and in$e#tor# call 8.S. #ec!ritie# default*risk*free instruments. 8.S. go$ernent can rai#e ta!ilibri! price and >!antity or both arket# in Fig!re 1, =hich ean# both arket# ha$e identical ri#k#. 8nort!nately, a corporation co!ld ha$e inancial tro!ble, #o in$e#tor# belie$e the corporation co!ld dea!lt. Soe in$e#tor# deand e=er corporate bond# and in$e#t ore in go$ernent bond#. 'h!#, the deand or corporate bond# all# =hile the deand or go$ernent bond# ri#e beca!#e the in$e#tor# con#ider the go$ernent bond# dea!ltAree. /id yo! notice the go$ernent bond# ha$e a higher bond price =hile corporate bond# ha$e a lo=er bond price@ 'h!#, the arket intere#t rate al=ay# o$e# in the oppo#ite direction o bond price# beca!#e o the pre#ent $al!e or!la. Con#e>!ently, corporation# pay greater intere#t rate# or their bond# =hile the 8.S. go$ernent pay# a lo=er intere#t rate. 'aking the dierence bet=een the go$ernent bond and corporate bond intere#t rate#, =e can calc!late the ri#k prei!. "# the dea!lt ri#k increa#e#, then the ri#k prei! increa#e# too. /!ring rece##ion#, =hen #oe b!#ine##e# bankr!pt, the dea!lt ri#k increa#e#, increa#ing the ri#k prei!. ence, the dierence bet=een go$ernent and corporate intere#t rate# =o!ld =iden.

111


Corporate Bond#

8.S. ;o$ernent Bond#

Figure 1. 8mpat of a risk premium on t$e bond markets

)i,uidity and Bond /rices (i>!idity ca!#e# bond price# and intere#t rate# to dier. For in#tance, 8.S. go$ernent #ec!ritie# are =idely traded and are the o#t li>!id. ence, in$e#tor# can b!y and #ell the. )n the other hand, corporate bond# are not a# li>!id and not a# =idely traded, #o in$e#tor# ha$e ore diic!ltie# in b!ying and #elling the. Con#e>!ently, =e !#e a #iilar analy#i# to dea!lt ri#k, =hich =e ha$e e!idity in both the go$ernent bond and corporate bond arket# in Fig!re 2. 'h!#, both bond arket# ha$e the identical e>!ilibri! bond price, [, and hence, the e!idity. 'hen the #econdary arket# e!idity or the#e #ec!ritie#. Con#e>!ently, the in$e#tor# are attracted to the go$ernent bond# beca!#e they are ore li>!id. /eand !nction increa#e# and #hit# right=ard or go$ernent bond#. o=e$er, in$e#tor# red!ce their p!rcha#e# o corporate bond# beca!#e they are le## li>!id, decrea#ing the deand !nction and #hiting it let=ard. 'h!#, the go$ernent bond price# ri#e, =hich red!ce# the intere#t rate or go$ernent bond#. )n the other hand, the corporate bond price# decrea#e, rai#ing the arket intere#t rate or corporate bond. 'aking the dierence bet=een the t=o intere#t rate#, =e ea#!re the degree o li>!idity. *e$erthele##, econoi#t# reer the dierence in intere#t rate# a# a ri#k prei!.

112


Corporate Bond#

8.S. ;o$ernent Sec!ritie#

Figure 2. 8mpat of liquidity on t$e bond markets

Information Costs and Bond /rices Inoration co#t# inl!ence the bond price# and intere#t rate#. I in$e#tor# need tie and oney to ac>!ire inoration on #ec!ritie#, then they pay a greater inoration co#t. 7e incl!de the#e co#t# in the bond?# arket price and intere#t rate, and they rai#e the co#t o borro=ing. For e!ently, the bond price# and intere#t rate# are identical. 7e depict the bond arket# in Fig!re +. 'he e>!ilibri! bond price# are identical or both arket# and e>!al [ and the intere#t rate# =o!ld be e>!al. In$e#tor# pay a greater co#t to ac>!ire inoration or the high inoration co#t bond#. 'h!#, in$e#tor# are attracted to the lo=Ainoration co#t bond#, boo#ting their deand or lo=A inoration co#t bond#, increa#ing the arket price and decrea#ing arket intere#t rate. ighA inoration co#t bond# are not a# attracti$e a# an in$e#tent, #o in$e#tor# b!y e=er bond#, red!cing bond price# and rai#ing intere#t rate#. 'hereore, lo=AinorationAco#t bond# pay a lo=er intere#t rate.

11+


igh Inoration Co#t#

(o= Inoration Co#t#

Figure 3. 8mpat of information osts on t$e bond markets

Ta(es and Bond /rices 'a!idity than !nicipal bond#, =herea# municipal bonds are the #tate and local go$ernent bond#. o=e$er, the intere#t rate# o !nicipal bond# are con#i#tently lo=er than 8.S. go$ernent bond# or the la#t 30 year# beca!#e in$e#tor# do not pay 8.S. ta!ently, yo! =o!ld earn a lo=er intere#t than 8.S. go$ernent #ec!ritie#. *e$erthele##, yo! pay no ta!idity. /eand and #!pply analy#i# #ho=# the ipact o ta!idity, and inoration co#t# are e>!i$alent or both arket#. Con#e>!ently, bond arket price# ha$e the #ae arket price, [ and pay identical intere#t rate#. 8.S. ;o$ernent ha# e
Term Structure of Interest +ates -erm structure of interest rates i# the intere#t rate# dier by at!rity i the #ec!ritie# ha$e identical ri#k, #ae li>!idity, #iilar inoration co#t#, and the #ae ta
Money, Banking, and International Finance the ter #tr!ct!re o intere#t rate# or 8.S. #ec!ritie# beca!#e the 8.S. go$ernent i##!e# a $ariety o #ec!ritie# =ith at!ritie# ranging ro 13 day# to +0 year#. *o other inance copany or b!#ine## i##!e# a =ide range o #ec!ritie# that dier by at!rity than the 8.S. go$ernent. 7e #ho= the intere#t rate# or 8.S. go$ernent #ec!ritie# in 'able 1 or three #peciic date#J !ly 2:, 1---, !ly +1, 2000, and !ly 14, 2009. ear 1--- =a# a good year or the 8.S. econoy a# it gre= a#t =ith a lo= !neployent rate. ield c!r$e or year# 2000 and 2009 predicted the rece##ion# in 2001 and 2004. 'a
M!nicipal Bond#

Figure !. 8mpat of taxes on t$e bond markets

'able 1. 'erm 5truture of 8nterest Rates for 4.5. >o*ernment 5eurities

Mat!rity 1 onth + onth 9 onth 1 year 2 year + year 3 year 4 year 10 year 20 year +0 year

42:1--*" &.41 &.43.0& 3.3& 3.33.40 3.-4 3.:1 9.+0 9.01

4+12000 *" 9.24 9.&2 9.04 9.+0 9.2& 9.19 9.19.0& 9.1+ 3.4-

4142009 &.-1 3.11 3.+0 3.2& 3.12 3.04 3.0& 3.0& 3.04 3.2+ 3.10

%conoi#t# plot 8.S. go$ernent #ec!ritie# by the arket intere#t rate# and at!rity, =hich they call a yield curve. ield c!r$e co!ld di#play a po#iti$e, negati$e, or lat #lope and ha# t=o 113

Kenneth R. S!lcyk characteri#tic#. Fir#t, the yield c!r$e !#!ally #lope# !p=ard beca!#e the longAter #ec!ritie# ha$e higher intere#t rate# than #hortAter #ec!ritie#. Con#e>!ently, 'Abond# =o!ld !#!ally ha$e a greater intere#t rate than 'Abill#. Second, intere#t rate# o$e together, #o the yield c!r$e norally #hit# !p=ard or do=n=ard a# the intere#t rate# change. %conoi#t# !#e three theorie# to e!ently, the yield c!r$e !#!ally #lope# !p=ard beca!#e people preer to hold #hortAter bond# rather than longAter bond#. 8nort!nately, thi# theory cannot e!idity, ri#k, inoration co#t#, and ta!ently, the intere#t rate on a longAter bond !#t e>!al the a$erage o #hortAter intere#t rate# that people e!al# -. o! e!al 10. I in$e#tor# e!ently, the yield c!r$e ha# a negati$e #lope. I in$e#tor# e!ently, the yield c!r$e #lope# !p=ard beca!#e the in$e#tor# add the ter prei! to long at!rity bond#. reerred habitat theory, !rtherore, e!al# the a$erage o the #hortAter intere#t rate# e!ently, the yield c!r$e =ill ha$e a negati$e #lope. o=e$er, in$e#tor# add a ter prei!, #o the yield c!r$e ha# a po#iti$e #lope beca!#e the ter prei! i# high eno!gh to cancel the eect o changing intere#t rate#. 119

Money, Banking, and International Finance %conoi#t# !#e the yield c!r$e to predict econoic acti$ity. 7hen a yield c!r$e i# do=n=ard #loping, #!ch a# a threeAonth 'Abill intere#t rate e!ently, the 8.S. econoy entered the ;reat Rece##ion in /eceber 2004, becoing the =or#t rece##ion #ince the 1-+0# ;reat /epre##ion a!brich and Millington 201&D. 8nort!nately, the =orld?# econoy #till eel# the lingering eect# o the ;reat Rece##ion in 201&. "ltho!gh any econoi#t# and analy#t !#e the yield c!r$e to oreca#t rece##ion#, the yield c!r$e i# not a perect predictor. It predicted t=o rece##ion# in 1-99 and 1--: that ne$er occ!rred a!brich and Millington 201&D. 7

6.5

6

5.5 7/28/1999

7/31/2000

7/17/2006

5

4.5

4

Figure ,. '$e ;ield ur*e for 4.5. go*ernment seurities for t$ree speifi dates

114


Key Terms dea!lt ri#k dea!ltAri#kAree in#tr!ent# dea!lt ri#k prei! bond rating !nicipal bond# ter #tr!ct!re o intere#t rate#

yield c!r$e #egented arket# theory e
Chapter Questions 1

I one bond arket ha# a high ri#k =hile the other i# lo= ri#k, then ho= doe# ri#k ipact the bond arket#@ lea#e !#e deand and #!pply analy#i# to an#=er thi# >!e#tion.

2

I one bond arket =ere highly li>!id =hile the other arket ha# lo= li>!idity, #!b#e>!ently, ho= =o!ld li>!idity ipact the bond arket#@ lea#e !#e deand and #!pply analy#i# to an#=er thi# >!e#tion.

+

I one arket ha# high inoration co#t# =hile the other doe# not, then ho= =o!ld inoration co#t aect the bond arket#@ lea#e !#e deand and #!pply analy#i# to an#=er thi# >!e#tion.

&

I a go$ernent ta!ently, ho= =o!ld ta!e#tion.

3

%
9

7hich three theorie# e
4

I yo! #a= a yield c!r$e =ith a negati$e #lope, =hich econoic phenoenon =o!ld yo! predict to occ!r in a year@

10.

The %an&in- %siness

7e #t!dy the b!#ine## o banking by e
Money, Banking, and International Finance ipact o intere#tArate ri#k !pon a bank?# balance #heet. 'hen =e di#c!## ho= bank# !#e #ec!ritiation to con$ert loan# into arketable #ec!ritie# and ho= thi# led to the 200: Financial Cri#i#. F!rtherore, #t!dent# !#t !nder#tand Chapter 10 to !nder#tand the ne
! Bank0s Balance Sheet Checking and #a$ing# acco!nt# are $ery pop!lar in the 8nited State#. 8.S. ho!#ehold# in$e#t nearly 1& o their =ealth in bank#. 'hey ake payent# by !#ing check# that tran#er oney ro one bank and to another bank. )ne rea#on behind the pop!larity o bank acco!nt# i# the federal deposit insurance. I a bank bankr!pt# and c!#toer# cannot =ithdra= ca#h ro their bank acco!nt#, then the ederal go$ernent =ill #tep in and pay the depo#itor# their acco!nt#. /epo#it in#!rance g!arantee# each c!#toer =ill not lo#e a a!ently, acco!nting tran#action# conor to the %>!ation 1. 'otal "##et# O 'otal (iabilitie# X Capital

1D

apital e>!al# total a##et# in!# total liabilitie#. Capital ha# any nae#, #!ch a# net e>!ity, net =orth, or net a##et#. I the b!#ine## i# a corporation, then =e call thi# capital  #tockholder#? e>!ity. Liabilities are the ir#t ite on a bank?# balance #heet. 'hey are the #o!rce o !nd# or a bank =ith the o#t iportant being depo#it acco!nt#. Reerring to 'able 1, people and b!#ine##e# held G:.1 trillion in depo#it#. 'hen checking acco!nt# becoe one the o#t iportant depo#it acco!nt#. For e!ently, checking acco!nt# becoe a liability to the bank beca!#e the bank o=e# yo! thi# oney. Moreo$er, checking acco!nt# earn the lo=e#t intere#t rate and are !#!ally the cheape#t #o!rce o !nd# or a bank. on*transaction deposits are the #econd liability. 'he#e depo#it# incl!de the $ario!# type# o #a$ing# acco!nt#. 'he#e acco!nt# earn intere#t and do not allo= checkA=riting pri$ilege#. Con#e>!ently, the#e depo#it# re>!ire e=er bank #er$ice# and earn higher intere#t rate# than checking acco!nt#. *onAtran#action depo#it# incl!deJ 

Savin$s account i# the o#t coon and pay# a higher intere#t than intere#t on checking acco!nt#. o=e$er, #a$ing# acco!nt# ha$e e=er #er$ice# than checking acco!nt#.

11-


Small*denomination time deposits "l#o called Certiicate# o /epo#itD ha$e at!ritie# ranging ro #e$eral onth# to o$er 3 year#. "ltho!gh they are le## li>!id than a #a$ing# acco!nt, they pay higher intere#t.



Lar$e*denomination time deposits are acco!nt# that e!id and an alternati$e to 'A bill#. "# 'able 1 #ho=#, in$e#tor# held G402.: billion in large tie depo#it# in /eceber 201+.

'able 1. ommerial (anks +ssets and iabilities on
"##et# in billion# o dollar# Sec!ritie# in bank credit

(iabilitie# in billion# o dollar# 2,313.0

/epo#it#

(oan# Coercial and ind!#trial loan#

1,++&.2

(arge tie depo#it#

Real e#tate loan#

+,&-:.2

)ther depo#it#

Con#!er loan#

1,133.:

"ll other loan# and lea#e# "llo=ance or loan and lea#e lo##e# Fed !nd# (oan# to coercial bank# Ca#h a##et# 'rading a##et# )ther a##et#

402.: :,11&.2

Borro=ing#

439.3

Borro=ing# ro 8.S. bank#

(01242)

:1.:

Borro=ing# ro other# 'rading liabilitie#

:.-

*et d!e to related oreign oice#

1,+4-.1

)ther liabilitie#

-4.1 :&0.+ 119.4 &0.3 +90.1

11-.1,090.0

Capital

'otal a##et# 11,4:9.2 'otal (iabilitie# pl!# capital So!rceJ Board o ;o$ernor# o the Federal Re#er$e Sy#te. Febr!ary 4, 201&. "##et# and (iabilitie# o Coercial Bank# in the 8nited State# 7eeklyD A .:. "$ailable at httpJ===.ederalre#er$e.go$relea#e#h:c!rrentdea!lt.ht acce## dateJ 02121&D.

1,31&.9 11,4:9.+

/orro!in$s becoe the la#t liability. " bank borro=# !nd# i the bank can lend the !nd# to a borro=er or a higher intere#t rate than the intere#t rate paid on the borro=ing#. Borro=ing# are not depo#it acco!nt#. Bank# can borro= ro the Federal Re#er$e or ro other bank#. 7e call a Federal Re#er$e loan a discount loans. 7e #ho= the bank#? borro=ing# in 'able 1. 8.S. bank# borro=ed G-4.1 billion ro 8.S. bank# and G:&0.+ billion ro other# nonbank#. )n the other #ide o a bank?# balance #heet, a bank ha# assets. Bank take# !nd# ro depo#itor# and loan# the#e !nd# to borro=er# =ho pay intere#t. 'h!#, bank# earn intere#t ro the loan# becoing a $ital #o!rce o incoe or the bank. Re#er$e# are the ir#t and o#t li>!id a##et. 'hey incl!de three ite#. Fir#t, a bank hold# vault cas#, =hich i# #iply ca#h the bank hold# in it# #ae. " bank ha# oney, #o a bank can pay depo#itor# ca#h =hen they coe to the bank to =ithdra= !nd#. "ccording to 'able 1, 8.S. bank# held G1.& trillion in /eceber 201+. Second, a bank hold# depo#it# at another bank beca!#e the#e depo#it# can aid in check clearing and in oreign e
120

Money, Banking, and International Finance central bank orce# bank# to hold a percentage o the bank?# checkable depo#it#, =hich are required reserves. 'he Federal Re#er$e =ant# to en#!re that bank# ha$e eno!gh re#er$e# to eet depo#itor#? =ithdra=al#. .arketable securities are the #econd a##et. Bank# hold 8.S. go$ernent #ec!ritie#, #!ch a# 'Abill#, 'Anote#, 'Abond#, and !nicipal bond#. Bank# can hold ortgageAbacked #ec!ritie#, =hich =e di#c!## !nder Sec!ritiationD. 'he#e #ec!ritie# are $ery li>!id that =e #oetie# call #econdary re#er$e#. I bank# need ca#h re#er$e# a#t, then the bank can #ell it# arketable #ec!ritie# >!ickly. 8.S. bank# held ro!ghly G2.3 trillion in /eceber 201+ a# #ho=n in 'able 1. Loans are the third a##et and the o#t iportant #o!rce o incoe. In /eceber 201+, loan# repre#ented ro!ghly 90 o total a##et#. 8nort!nately, loan# ha$e a greater probability o dea!lt than other a##et#, lo=er li>!idity, and ore inoration co#t#. o=e$er, bank# are copen#ated or thi# ri#k by earning higher intere#t rate#. (oan# earn higher intere#t rate# than arketable #ec!ritie#. "ccording to 'able 1, 8.S. bank# lent G1.+ trillion a# coercial and ind!#trial loan#, G+.3 trillion or real e#tate, and G1.2 trillion or con#!er loan#. FityAo!r percent o con#!er loan# copri#e credit card#. Federal funds market can be a bank a##et or a liability. %ach bank !#t hold re#er$e# in the or o $a!lt ca#h pl!# depo#it# at the Federal Re#er$e. 'he Federal Re#er$e #et# the percentage o re#er$e# a bank !#t hold beca!#e re#er$e# help en#!re bank# ha$e ca#h to eet depo#itor#? =ithdra=al#. Federal !nd# arket i# one bank =ith e!ently, Federal F!nd# becoe an a##et or the lending bank# and a liability to the borro=ing bank#. Reerring to 'able 1, bank# lent G:1.: billion to other bank# in the Federal F!nd# in /eceber 201+. Federal funds rate relect# the intere#t rate or thi# arket. 'able 1 contain# t=o ite# that are not #elAe!ipent, =hich totaled ro!ghly G1 trillion. BankN# net !ort# or capital becoe# the la#t ite on the bank?# balance #heet. Capital e>!al# total a##et# in!# total liabilitie#. "ll bank# organie the#el$e# into corporation#. " corporate bank?# capital i# the #tock #old to the in$e#tor# pl!# the bank?# proit. Creditor# con#ider capital iportant beca!#e it pro$ide# a inancial c!#hion or loan# and obligation#. I a copany bankr!pt# and cannot repay a loan, the creditor# ha$e the ir#t priority o the copany?# a##et#, =hile the #hareholder# ha$e the la#t priority. " po#iti$e capital en#!re# the bank can repay it# loan obligation#. " bankN# net =orth a$eraged ro!ghly 12.- in /eceber 201+. "ter the 200: Financial Cri#i#, bank# #tarted acc!!lating ore capital to deal =ith !t!re inancial cri#e#.

121


! Bank Failure " bank failure i# a bank de$elop# inancial proble# and ail#. 8nort!nately, the bank cannot ret!rn the depo#itor#? oney. " go$ernent ipo#e# reg!lation# to enco!rage bank# to hold a large ao!nt o re#er$e#, arketable #ec!ritie#, and e>!ity capital, red!cing a chance o bank ail!re. In thi# analy#i#, =e !#e 'Aacco!nt#. " -*account repre#ent# a #ipliied balance #heet li#ting only change# or a##et#, liabilitie#, and net =orth. For e
iabilities

XG100 Re#er$e#

XG100 Checking acco!nt

" central bank, or e!ire# coercial bank# to hold 10 o depo#it# in the or o $a!lt ca#h andor re#er$e# at the central bank. 'hereore, G10 o yo!r checking acco!nt becoe# re>!ired re#er$e# =hile the reaining becoe# e!ired re#er$e# X -0 %
iabilities


Bank earn# no intere#t on re#er$e#, #o the bank grant# a loan to a borro=er or G-0. (oan becoe# the bank?# #o!rce o incoe, and =e record the tran#action belo=J o!r Bank *ssets XG10 Re>!ired re#er$e# X -0 (oan#

iabilities


For the bank to earn a proit, the bank !#t earn a higher intere#t rate on the loan than the le$el o intere#t the bank pay# on yo!r checking acco!nt. I a borro=er dea!lt# and doe# not repay the loan, #!b#e>!ently, the bank !#t ret!rn yo!r G100, =hen yo! deand it. 'he bank =o!ld pay G-0 ro the bank?# net =orth and G10 ro re>!ired re#er$e#. Bank# ace another coplication, liquidity risk  the depo#itor# =ithdra= ore oney ro their acco!nt# than the ao!nt o ca#h held in a bank?# $a!lt. Con#e>!ently, bank# de$eloped a##et and liability anageent to pre$ent li>!idity ri#k. "##et anageent i# bank# lend to borro=er#, =ho =ill pay high intere#t rate# and are not likely to dea!lt on their loan#. 'hen, bank# p!rcha#e #ec!ritie# that ha$e high ret!rn#, are li>!id, and ha$e lo= dea!lt ri#k. I depo#itor# begin =ithdra=ing !nd#, the bank# can #ell the li>!id #ec!ritie# and pay the 122

Money, Banking, and International Finance depo#itor#? =ithdra=al#. (iability anageent i# bank# cannot orce c!#toer# to open checking and #a$ing# acco!nt#. 'h!#, bank# are liited in the#e !nding #o!rce#. o=e$er, bank# !#e inancial in#tr!ent#, #!ch a# certiicate# o depo#it#, %!rodollar#, ederal !nd# arket, and rep!rcha#e agreeent#. C!rrently, bank# ha$e e= re#triction# in rai#ing !nd#. Ill!#trating li>!idity ri#k or yo!r bank, =e #ho= yo!r bank?# balance #heet belo=. 'he Federal Re#er$e re>!ire# yo!r bank to hold 10 o depo#it# a# re>!ired re#er$e#. 'h!#, yo!r bank ha# eno!gh !nd# to eet depo#itor#? =ithdra=al#. o!r Bank *ssets Re>!ired re#er$e# %
iabilities

G10 illion 10 illion :0 illion 10 illion

/epo#it# Bank Capital

G100 illion 10 illion

/epo#itor# =ithdra= G10 illion that decrea#e# depo#it# by G10 illion. Bank pay# the !nd# ro e!aling G10 illion. Con#e>!ently, thi# bank ha# et =ithdra=al deand#. Both bank depo#it# and e!ired re#er$e# %
iabilities



G-0 illion 10 illion

/epo#itor# =ithdra= another G10 illion, and the bank pay# the =ithdra=al# ro re>!ired re#er$e#. Both depo#it# and re>!ired re#er$e# decrea#e by G10 illion, #ho=n in the 'Aacco!nt belo= o!r Bank *ssets Re>!ired re#er$e# %
iabilities



G:0 illion 10 illion

Bank !#t hold 10 o depo#it# a# re#er$e#, and the bank !#t ind G: illion or re>!ired re#er$e#. o!r bank ha# the ollo=ing option#J 

Bank co!ld #ell G: illion o #ec!ritie# to rai#e !nd#. 12+


Bank a#k# #e$eral borro=er# to repay G: illion in loan#. Moreo$er, the bank co!ld #ell loan# to other bank#.



Bank borro=# the !nd# ro the central bank or ro another coercial bank.

o!r bank borro=# the G: illion ro the Federal Re#er$e a# a loan. o!r bank anaged the li>!idity ri#k =ell. 7e #ho= yo!r bank?# balance #heet belo=J o!r Bank *ssets Re>!ired re#er$e# %
iabilities

G: illion 0 illion :0 illion 10 illion

/epo#it# Bank Capital Fed loan

G:0 illion 10 illion : illion

o= doe# a bank pre$ent a bank ail!re@ " bank hold# e!id #ec!ritie# to pre$ent a bank ail!re. In the ne!ired re#er$e# %
iabilities

G10 illion 0 illion -0 illion 10 illion



!blic circ!late# a r!or the bank pre#ident lo#t illion# in the deri$ati$e# arket and had di#appeared to the Bahaa#. Con#e>!ently, yo! and the other depo#itor# are araid yo!r bank =ill ail, #o yo! and the depo#itor# =ithdra= G20 illion ro yo!r bank. o!r bank #ell# G10 illion in #ec!ritie# and !#e# G10 illion in re>!ired re#er$e# to eet depo#itor#? =ithdra=al#, #ho=n in the 'Aacco!nt on the ne
o!r Bank *ssets

iabilities

12&

Money, Banking, and International Finance Re>!ired re#er$e# %
G0 illion 0 illion -0 illion 0 illion



*o= yo!r bank need# G: illion in re>!ired re#er$e#. I yo!r bank #old the loan#, the bank =o!ld #ell the loan# or a lo=er $al!e than the bank?# book $al!e. F!rtherore, the other bank# do not kno= yo!r bank?# borro=er#, #o the#e bank# =ill b!y the loan# or a raction o the loan?# $al!e, generating a #!b#tantial lo##. o!r bank co!ld a#k other bank# or a loan, b!t other bank# ay decline i they belie$e yo!r bank =ill ail. o!r bank co!ld a#k the Federal Re#er$e or a loan, b!t the Fed ay not grant the loan. o!r bank #ell# G&0 illion o loan#, b!t the other bank# =ill pay G23 illion or the. *o= yo!r bank becae in#ol$ent beca!#e total liabilitie# e!id #ec!ritie#. 7e di#play yo!r in#ol$ent bank?# balance #heet belo=. o!r Bank *ssets Re>!ired re#er$e# (oan#

iabilities




"# yo! can #ee ro the pre$io!# e
Bank# peror credit*risk analysis. Bank collect# inoration abo!t the borro=er#? eployent, incoe, and net =orth. Fro thi# inoration, the bank a##e##e# the borro=er#? ability to repay their loan#.



Bank pre$ent# ad$er#e #election by re>!iring collateral . Borro=er# pledge a##et# to the bank. I a borro=er dea!lt# on the loan, then the bank =ill #eie the a##et. For e

Bank iniie# ad$er#e #election by credit rationin$ . Bank# e#tabli#h a a


Bank# !#e re#tricti$e co$enant# to iniie ad$er#e #election. Bank# #peciy condition# or restrictive covenants in the loan agreeent that pre$ent the borro=er# engaging in certain acti$itie#. For e


Bank# ay a#k the borro=er to ha$e another relati$e ha$ing a good credit hi#tory coA #ign the loan. I the borro=er dea!lt#, then the bank can deand payent ro the borro=er or coA#igner.



Bank# iniie ad$er#e #election by o#tering a longAter relation#hip =ith the borro=er#. 7hen the bank# kno= their c!#toer# =ell, they can acc!rately a##e## the c!#toer#? ri#k o dea!lt.

The Interest +ate +isk Intere#t rate# becae $olatile d!ring the 1-:0#, orcing bank# to becoe ore concerned =ith intere#tArate ri#k. Bank# e
G20 illion

Intere#tArate #en#iti$e liabilitie#J illion  Certiicate# o depo#it

ShortAter #ec!ritie# 

Fi
iabilities G30

(ongAter #ec!ritie#

Money arket depo#it acco!nt#

G:0 illion Fi
G30

Sa$ing# acco!nt#

Intere#tArate #en#iti$e ite# are #hortAter #ec!ritie#, $ariable intere#tArate loan#, and #hortA ter depo#it#. 7hen the intere#t rate $arie#, the#e ite# change alo#t iediately. )n the 129

Money, Banking, and International Finance other hand, the i!al# a 3 intere#t increa#e, then the incoe ro intere#tArate #en#iti$e a##et# increa#e# by G1 illion 0.03 W G20 illion O G1 illionD. Moreo$er, the co#t o !nd# increa#e# by G2.3 illion 0.03 W G30 illion O G2.3 illionD. Con#e>!ently, the bank?# proit# decline by G1.3 illion G1 M A G2.3 M O AG1.3 illionD. 8nort!nately, change# in the intere#t rate# ipact a bank?# proit# #igniicantly. 'hree condition# occ!r a# the intere#t rate# l!ct!ateJ 

I the intere#tArate #en#iti$e liabilitie# exeed the intere#tArate #en#iti$e a##et#, then ri#ing intere#t rate# ca!#e bank#? proit# to pl!et, =hile alling intere#t rate# ca!#e bank#? proit# to increa#e.



I the intere#tArate #en#iti$e liabilitie# are less t$an intere#tArate #en#iti$e a##et#, #!b#e>!ently, increa#ing intere#t rate# ca!#e bank#? proit# to #oar, =hile declining intere#t rate# ca!#e bank#? proit# to pl!et.



I the intere#tArate #en#iti$e liabilitie# equal the intere#tArate #en#iti$e a##et#, then l!ct!ating intere#t rate# do not aect bank proit#.

For e!ently, he =o!ld boo#t intere#tArate #en#iti$e a##et# and decrea#e intere#tArate #en#iti$e liabilitie# by anip!lating balance #heet ite#. /!ring the la#t 20 year#, o!r actor# changed ho= a bank anage# it# balance #heet. Fir#t, the 8.S. ederal go$ernent dereg!lated the inancial arket#, granting bank# ore le!iring a##et# and liabilitie#. Second, inancial inno$ation created ne=, li>!id inancial in#tr!ent#, #!ch a# rep!rcha#e agreeent#, ederal !nd# arket, and #ec!ritiation. Bank# #ec!ritied their bank loan# and tran#ored the into li>!id #ec!ritie#. 'hird, the high $olatility o intere#t rate# d!ring the 1-:0# contrib!ted to the creation o ne= inancial in#tr!ent, #!ch a# the floatin$*rate debt . Soe bank# grant loan# to borro=er# =ith $ariable intere#t rate#. I the intere#t rate ri#e#, #!b#e>!ently, the bank# increa#e the intere#t rate on the loan#. For e
124


Securiti&ation and the 1223 Financial Crisis Securiti%ation i# #iilar to a !t!al !nd. 7e deine #ec!ritiation a# the proce## o tran#oring illi>!id inancial a##et# into arketable #ec!ritie#. Bank# and inancial in#tit!tion# package #iilar loan# together, #!ch a# ortgage#, place the into a !nd, and i##!e #ec!ritie# that are tied to the !nd?# a##et#. 'hen in$e#tor# b!y the #ec!ritie# to earn the ret!rn on the !nd?# a##et#. )n a$erage, the pool o !nd# ha# a predictable ca#h lo= a# people pay their loan#. 'hen in$e#tor# recei$e the#e payent# a# in$e#tent. Bank# !#ed #ec!ritiation beca!#e they !#e cop!ter# to #ipliy the record keeping proce##. Sec!ritiation i# ore cople< beca!#e a !nd co!ld i##!e dierent bond# called tranche#. " tranc#e i# a French ter eaning a portion or #lice. %ach tranche ha# a bond a##ociated =ith a ri#k le$el and a dierent credit rating. CreditArating agencie# co!ld rate #oe bond# a# """ that pay# the lo=e#t ret!rn to in$e#tor#, b!t in$e#tor# are ir#t in line i the !nd goe# b!#t. F!rtherore, the !nd i##!e# ri#ky bond#, called #pec!lati$e grade that pay a higher ret!rn, b!t in$e#tor# =o!ld lo#e their in$e#tent# i the !nd bankr!pt#. Bank# did not !#e #ec!ritiation on a large #cale beore the 1--0# beca!#e the bank# co!ld not price the dierent tranche# in the !nd !ntil a #tati#tician, /a$id (i, de$i#ed a ethod in 2000. (i?# ethod allo=# ea#y and >!ick pricing o the#e tranche#. Con#e>!ently, the banker# and inancier# applied #ec!ritiation to a $ariety o a##et#. 'hey #ec!ritied ortgage#, car loan#, third =orld debt, credit card#, and #t!dent loan#. Sec!ritiation o ortgage# ha# it# o=n naed, mort$a$e asset*back securities (&/S). 8nort!nately, the #ec!ritiation o ortgage# led to the 8.S. ho!#ing b!bble bet=een 2000 and 2004. %$en in 201+, bank# held G1.+ trillion in a##etAback #ec!ritie#. " proble o the 8.S. ho!#ing b!bble =a# the bank# rela!ireent#. Beore 2000, bank# =o!ld grant hoe loan# only to borro=er# =ith a #table =ork hi#tory and good credit hi#tory. F!rtherore, the borro=er# doc!ented their incoe# copletely. /!ring the ho!#ing b!bble, #e$eral large 8.S. bank# rela!ently, the bank# rela
12:

Money, Banking, and International Finance G100,000 hoe at 4 intere#t rate, a# a +0Ayear ortgage, then their onthly payent e>!al# G993 per onth. 'hi# payent doe# not incl!de property ta!ently, the in$e#tent bank# earned ee# ro the !nd?# #et!p and ro the !nd?# anageent. CreditArating agencie#, #!ch a# Standard E oor, and Moody?# con#pired =ith the in$e#tent bank#. Credit agencie# al=ay# rated C/)# =ith an """ credit rating, e$en tho!gh #oe C/)?# !nd# contained #!bprie ortgage#. CreditArating agencie# =ere either incopetent or perpet!ating ra!d. Many in$e#tor# and pen#ion !nd anager# only in$e#t in """ rated #ec!ritie#. 7itho!t the """ rating, the in$e#tent banker# co!ld not #ell the C/)#. For e!ire pen#ion !nd anager# to in$e#t in """ rated in$e#tent#. 'h!#, the 7all Street Banker# #old their C/)# to pen#ion !nd# or police, teacher#, and go$ernent =orker#. F!rtherore, the C/)# =ere not tran#parent, and any in$e#tor# did not !nder#tand ho= they =orked. 'he """ credit rating becae $ital or banker# to #ell the C/)#. " copany can !#e a collateralied debt obligation to enhance their inancial #tateent# artiicially. For e!ently, they becae in$e#tor# and p!rcha#ed the bond# to thi# C/) !nd, con$erting liabilitie# into a##et#. Financial analy#t# do not kno= ho= any copanie# !#ed C/)# to ipro$e their inancial #tateent#. 'he C/) arket ranged ro G0.3 trillion to G2 trillion in 2009. Mortgage a##etAbacked #ec!ritie# and collateralied debt obligation# attracted large #!# o oney to 8.S. ho!#ing arket, ca!#ing the rapid appreciation o ho!#ing price#. Coercial bank# kept lo=ering their lending #tandard# to grant ore people ortgage#. Real e#tate agent# in o!#ton repeated a oke  i yo! ha$e a heartbeat and paycheck #t!b in yo!r pocket, then a bank =o!ld grant yo! a ortgage loan. S!b#e>!ently, the 2004 ;reat Rece##ion #tr!ck the 8.S. econoy. 8neployent rate #oared to 10, and ho!#ehold#, e#pecially the #!bprie arket, began dea!lting on their ortgage# in record n!ber#. o!#ing con#tr!ction ind!#try had 12-

Kenneth R. S!lcyk collap#ed, =hen hoeo=ner# #topped b!ying ho!#e#. 'hen the 8.S. ho!#ing b!bble delated a# ho!#ing price# began pl!eting. S!rge in ortgage dea!lt# ca!#ed the in$e#tor# to >!e#tion "BS and C/)#, and they #topped in$e#ting in #ec!ritied debt. S!b#e>!ently, both the coercial and in$e#tent bank# becae #t!ck =ith billion# in !n#old C/)#. F!rtherore, the bank# and in$e#tor# o C/)# and "BS oreclo#ed on hoe# that are lo#ing $al!e. 8nort!nately, i the bank# acc!!late too any bad ortgage#, then they becoe in#ol$ent. Finally, the 200: Financial Cri#i# ca!#ed ear, panic, and paranoia to #=eep acro## the inancial =orld. Bank# and inancial in#tit!tion# had roen all credit and loan# o$ernight.

Key Terms ederal depo#it in#!rance balance #heet capital liabilitie# nonAtran#action depo#it #a$ing# acco!nt #allAdenoination tie depo#it largeAdenoination tie depo#it borro=ing# di#co!nt loan a##et# $a!lt ca#h re>!ired re#er$e# arketable #ec!ritie# loan# Federal !nd# arket Federal !nd# rate

net =orth bank ail!re 'Aacco!nt e!idity ri#k credit ri#k creditAri#k analy#i# collateral credit rationing re#tricti$e co$enant# intere#t rate ri#k loatingArate debt ad!#tableArate ortgage #ec!ritiation tranche ortgage a##etAback #ec!ritie# collateralied debt obligation#

Chapter Questions 1

Identiy a bank?# a##et#, liabilitie#, and capital.

2

%
+

%!idity ri#k.

&

o= doe# a bank becoe in#ol$ent@

3

Identiy ethod# bank# can red!ce ad$er#e #election.

9

o= did the 2004 o!#ing B!bble ca!#e bank# to becoe in#ol$ent@ 1+0

Money, Banking, and International Finance 4

Identiy ethod# a bank can protect it#el ro the intere#t rate ri#k.

:

%
-

/eine and e
10 Co!ld the Federal Re#er$e ha$e pre$ented the 200: Financial Cri#i#@

11.

The Money S""ly Process

7e e
The Fed0s Balance Sheet .onetary base e>!al# the c!rrency in circ!lation pl!# re#er$e# held by coercial bank#. urrency in circulation i# the Federal Re#er$e *ote# the p!blic i# holding, i.e. 8.S. oney, =hich doe# not incl!de vault cas# at the bank# beca!#e =e already co!nted the $a!lt ca#h a# bank re#er$e#. Moreo$er, the Fed can directly inl!ence the onetary ba#e, and in t!rn, the onetary ba#e inl!ence# the oney #!pply. Beore !nder#tanding ho= the oney #!pply proce## =ork#, =e introd!ce the Fed?# balance #heet. Con#e>!ently, the c!rrency in circ!lation and bank reserves are liabilitie# to the Federal Re#er$e. 8#ing a #iple e!al# G10. 'h!#, the G10 i# the required reserves. " bank co!ld hold ore than G10, =hich are e"cess reserves. Con#e>!ently, the bank hold# re#er$e# to eet depo#itor#? =ithdra=al#. o! co!ld ret!rn to yo!r bank and =ithdra= yo!r G100 depo#it. S!b#e>!ently, the bank ret!rn# yo!r oney ro it# re#er$e#. Bank either hold# G10 in it# $a!lt or depo#it# the G10 =ith the Fed. /id yo! notice bank re#er$e# are a##et# to the bank, b!t liabilitie# to the Fed@ )n the other hand, the p!blic holding oney i# an a##et, b!t oney i# a liability to the Fed. 'he Fed ha# t=o iportant a##et#J go$ernent #ec!ritie# and di#co!nt loan#. 7hen the Fed increa#e# it# a##et#, the onetary ba#e ri#e# 7hen the Fed decrea#e# it# a##et#, the onetary ba#e decline#. 'he Fed can change the onetary ba#e thro!gh openAarket operation#. "n 1+1

Kenneth R. S!lcyk open*market operation i# the Fed b!ying and #elling inancial #ec!ritie#. 8#!ally the Fed b!y# and #ell# 8.S. go$ernent #ec!ritie#. 7hen the Fed b!y# 8.S. go$ernent #ec!ritie#, =e call it an open*market purc#ase beca!#e the Fed?# a##et# increa#e, e
o!r Bank *ssets AG10,000 'Abill XG10,000 /epo#it at the Fed

iabilities

'he Fed *ssets XG10,000 'Abill

iabilities

XG10,000 Bank re#er$e#

'he Fed b!y# the 'Abill by !#ing a Fed check. 7hen the bank #end# the check to the Fed, the Fed increa#e# the re#er$e# at yo!r bank. " Fed check i# not backed by oney per #e. "# the Fed clear# it# o=n check, it add# n!ber# to a bank?# acco!nting book#. "ter=ard#, the bank?# re#er$e# increa#e and yo!r bank can lend to #oeone, #o the bank earn# intere#t. Con#e>!ently, the Fed?# a##et# increa#e =hile both the onetary ba#e and oney #!pply e!ently, yo! depo#it the Fed check at yo!r local bank, and yo!r net a##et# did not change. Bank?# re#er$e# increa#e by G10,000, a# =ell a# the deand depo#it. Finally, the Fed?# 'Aacco!nt becoe# identical to the la#t e
iabilities

o!r Bank *ssets XG10,000 Fed Re#er$e /epo#it

iabilities

XG10,000 /eand /epo#it 'he Fed

*ssets XG10,000 'Abill

iabilities

XG10,000 Bank re#er$e# 1+2

Money, Banking, and International Finance Money #!pply ha# ri#en beca!#e yo! traded the 'Abill or a deand depo#it. It ake# no dierence i the Fed p!rcha#ed 8.S. #ec!ritie# ro the p!blic or a bank. Con#e>!ently, the Fed?# a##et# increa#e, e!ently, the oppo#ite occ!r#. 'he Fed loan# are the #econd o#t iportant a##et. 'he Fed lend# to bank#, helping the bank# #!r$i$e li>!idity proble#. 'he Fed loan# are called discount loans. F!rtherore, =e call the intere#t rate the Fed charge# or the#e loan# the discount rate. 'he Fed doe# not !#e loan# to inl!ence the onetary ba#e. In#tead, the Fed relie# on openAarket operation# beca!#e the Fed ha# coplete control o$er ho= any #ec!ritie#, it b!y# and #ell#. 7ith di#co!nt loan#, the bank# deterine =hether they =ant to borro= ro the Fed. 'he Fed cannot orce a bank to accept a loan. o=e$er, i the Fed ake# ore di#co!nt loan#, #!b#e>!ently, the Fed?# a##et# increa#e, e
iabilities

XG1 illion

(oan ro Fed

XG1 illion

'he Fed *ssets (oan to in#tit!tion X G1 illion

iabilities

Bank re#er$e#

XG1 illion

Bank?# re#er$e# increa#ed by G1 illion, and the bank can grant ore loan#, e!ently, the Fed?# a##et# becoe #aller. F!rtherore, both the onetary ba#e and the oney #!pply decrea#e. 7e #ho= the tran#action belo= in the 'Aacco!nt#J 'he Bank *ssets Re#er$e# at Fed

iabilities

AG1 illion

(oan ro Fed

AG1 illion

'he Fed *ssets (oan to in#tit!tion AG1 illion

iabilities

Bank depo#it at Fed AG1 illion

Multiple Deposit '(pansion and Contraction Banking #y#te create# the oney #!pply thro!gh multiple deposit e"pansion. 'hi# ean# i the Fed increa#e# the onetary ba#e by G1, then the ao!nt o checkable depo#it# in the 1++

Kenneth R. S!lcyk banking #y#te =ill increa#e by ore than G1. Checkable depo#it# are a coponent o the M1 deinition o oney, con#e>!ently, the oney #!pply increa#e# by ore than G1. 7e #ho= the !ltiple depo#it e
o!r Bank *ssets Re>!ired Re#er$e# %
iabilities

G1,000 -,000

/epo#it#

G10,000

Money #!pply iediately e!ired re#er$e#. 'h!#, the bank hold# G1,000 o re#er$e# again#t yo!r acco!nt a# a depo#it at the Fed or a# $a!lt ca#h. o=e$er, the bank ha# G-,000 in e!ently, the bank loan# the o!t. For in#tance, yo!r bank grant# a G-,000 car loan to yo!r riend. 7e di#play the tran#action belo=J o!r Bank *ssets Re>!ired Re#er$e# %
(oan#

iabilities

G1,000 0

/epo#it#

G10,000

-,000

Bank #end# yo!r riend a check or G-,000. o!r riend take# thi# check to a car dealer#hip and b!y# a car. Car dealer depo#it# thi# check at hi# bank, and =e record thi# tran#action belo=J 'he Car /ealer?# Bank *ssets Re>!ired Re#er$e# %
(oan#

iabilities

G-00 :,100

/epo#it#

G-,000

0

/id yo! notice the change in the oney #!pply@ Money #!pply e!aling G-00. Reaining !nd#, G:,100, earn no intere#t. Con#e>!ently, the car dealer?# bank lend# thi# o!t. Car dealer?# bank grant# G:,100 b!#ine## loan. 7e record thi# tran#action belo=J 1+&


'he Car /ealer?# Bank *ssets Re>!ired Re#er$e# %
(oan#

iabilities

G-00 0

/epo#it#

G-,000

:,100

Sall b!#ine## contract# =ith a con#tr!ction copany to reno$ate hi# b!#ine##. Con#tr!ction copany recei$e# a check or G:,100 and depo#it# thi# check in it# bank. 7e record the tran#action belo=J Con#tr!ction Copany?# Bank *ssets Re>!ired Re#er$e# %
(oan#

iabilities

G:10 4,2-0

/epo#it#

G:,100

0

Con#tr!ction copany?# bank !#t hold 10 o thi# depo#it, e>!aling G:10. Reaining re#er$e#, G4,2-0, earn no intere#t, and con#e>!ently, thi# bank grant# a loan. /id yo! notice the change in the oney #!pply@ Money #!pply ha# e!ation 1. 'otal Re#er$e# O Re>!ired Re#er$e# X %
1D

In thi# ca#e, e!al ero beca!#e bank# earn no intere#t. Bank# grant loan# !#ing their e!ation calc!late# re>!ired re#er$e#. 7hen a bank accept# a ne= checking acco!nt, the bank !#t hold a percentage o the depo#it, =hich i# %>!ation 2. Re>!ired Re#er$e# O /epo#it# W Re>!ired Re#er$e Ratio r r D

2D

7e #!b#tit!te %>!ation 2 into %>!ation 1 and #et the e!al to ero, =hich yield# %>!ation +. 'otal Re#er$e# O /epo#it# W r r

+D

1+3

Kenneth R. S!lcyk /id yo! notice the oney #!pply change# =hen the Federal Re#er$e change# the bank re#er$e#@ 7e #ho= re#er$e change# in %>!ation & and depo#it change# in %>!ation 3. 'he ] #ybol ean# change, and =e take the dierence bet=een t=o adacent tie period#. Fir#t tie period i# t, =hile the !t!re tie period i# tX1. ^Re#er$e# O 'otal Re#er$e# tX1  'otal Re#er$e#t ^/epo#it# O /epo#it# tX1  /epo#it#t

&D 3D

I =e =rite %>!ation + or t=o adacent tie period#J t and tX1. %>!ation# becoe 'otal Re#er$e#tX1 O /epo#it#tX1 W r r and 'otal Re#er$e# t O /epo#it#t W r r. 'hen =e #!btract the e>!ation or the tie period tX1 ro the e>!ation or the tie period t, yielding %>!ation 9. ^Re#er$e# O ^/epo#it# W r r

9D

7e #ol$e %>!ation 9 or change in depo#it#, yielding the oney #!pply e>!ation in %>!ation 4. +/epo#it# = +Re#er$e#

×

1 r r

4D

I the Federal Re#er$e increa#e# the onetary ba#e by b!ying G10,000 o 'Abill#, #!b#e>!ently, the bank re#er$e# increa#e by G10,000. I the re>!ired re#er$e ratio e>!al# 10, then =e #!b#tit!te thi# into %>!ation 4. Con#e>!ently, checkable depo#it# =o!ld ri#e by G100,000. 7e call thi# or!la the simple deposit multiplier , =hich e>!al#  1 V r r D. Siple depo#it !ltiplier #ho=# the a!ired re#er$e# held by the banking #y#te. I the re>!ired re#er$e ratio e>!aled ero, then a oneAdollar increa#e in re#er$e# =o!ld e!al one. 'h!#, i the Fed increa#ed the onetary ba#e by G1 trillion, then it e
Money, Banking, and International Finance 'he Fed decrea#ed the onetary ba#e by #elling it# a##et#, contracting both bank re#er$e# and the oney #!pply. 7e call the Fed #elling #ec!ritie# the multiple deposit contraction. 'ran#action i# #iilar to !ltiple depo#it e!ently, the Fed can control the onetary ba#e ea#ily b!t ha# le## control o$er the oney #!pply. For in#tance, people can change their beha$ior that largely ipact# bank re#er$e#. For e
o!r Bank *ssets Re>!ired Re#er$e# %
iabilities

G1,000  200 0

(oan

/epo#it#

G10,000  200

-,000

Bank pay# yo!r G200 ro re>!ired re#er$e#. Bank doe# not ha$e any e!ently, yo!r depo#it becoe# G-,:00, and the bank !#t hold G-:0 in re>!ired re#er$e#. o=e$er, it only ha# G:00, #o the bank i# #hort G1:0. Bank call# in loan#, ca!#ing other bank# to lo#e depo#it#. 'h!#, the oney #!pply contract# by %>!ation :. +/epo#it# = +Re#er$e# ×

1 r r

= −$1:0 ×

1 0.10

= −$1,:00

:D

7e do not incl!de yo!r G200 beca!#e yo! con$erted G200 ro a checkable depo#it into c!rrency. Reeber the M1 deinition o oney, a# deined by %>!ation -. 7e #tart at the G1:0 beca!#e yo! #=itched the ir#t G200 ro a checkable depo#it into c!rrency, and !nort!nately, =e cannot co!nt the #ae oney t=ice. M1 O checkable depo#it# X c!rrency

-D

The Money Supply Multipliers eople, =ho hold ore c!rrency and e=er depo#it#, can ca!#e bank re#er$e# to all, contracting the oney #!pply. 'h!#, the p!blic deterine# the le$el c!rrency to hold relati$e to the bank depo#it#. %conoi#t# e
Kenneth R. S!lcyk the currency*deposit ratio C/D. Con#e>!ently, o!r actor# inl!ence thi# ratio o$er tie, =hich areJ 

igher =ealth ca!#e# the c!rrencyAdepo#it ratio to all. 7hen a co!ntry becoe# =ealthier, people ha$e greater incoe. 'h!#, people =o!ld depo#it their oney into bank# beca!#e holding large ao!nt# o c!rrency i# ri#ky.



igher intere#t rate# lo=er the c!rrencyAdepo#it ratio. Bank# pay intere#t rate# on depo#it# =hile c!rrency doe# not. 7hen intere#t rate# ri#e, people begin depo#iting oney into bank# to earn the greater intere#t rate.



Ri#k co!ld rai#e the c!rrencyAdepo#it ratio. /!ring a inancial panic, people con$ert their depo#it# into c!rrency, haring the econoy. 7hen depo#itor# con$ert depo#it# into c!rrency, bank#? re#er$e# decrea#e, #hrinking the oney #!pply. 8nort!nately, a contracting oney #!pply co!ld trigger a rece##ion.



8ndergro!nd acti$itie# rai#e the c!rrencyAdepo#it ratio. eople participate in illegal acti$itie# do not =ant the go$ernent to kno= abo!t the, #o they deal e
7hat =o!ld happen i the Fed bo!ght a 'Abill ro yo! or G10,000@ S!b#e>!ently, yo! take the Fed check to a bank and a#k the bank to pay in ca#h. In thi# ca#e, the total bank re#er$e# =o!ld not change, b!t c!rrency in circ!lation and onetary ba#e ri#e by G10,000. %ect o an openAarket p!rcha#e on the onetary ba#e i# al=ay# the #ae, =hether the proceed# ro the #ale are in depo#it# or c!rrency. 7hen the Fed #ell# 8.S. go$ernent #ec!ritie#, it decrea#e# the onetary ba#e by the ao!nt o go$ernent #ec!ritie# it ha# #old. Con#e>!ently, the Fed ha# coplete control o$er the onetary ba#e. .oney multiplier e>!al# the ratio bet=een the oney #!pply and the onetary ba#e. 7e deine the notation a#J 

7e deine the oney #!pply M1D a# the c!rrency in circ!lation CD pl!# checkable depo#it# /D, =ritten a# M1 O C X /.



Monetary ba#e BD e>!al# bank#? re#er$e# RD pl!# c!rrency in circ!lation CD, =ritten a# B O C X R.



Money !ltiplier D e>!al# the ratio bet=een the oney #!pply M1D and the onetary ba#e BD or a# %1 = m × ! .

1+:

Money, Banking, and International Finance 7e !#e a cle$er #!b#tit!tion. Fir#t, =e #tart =ith the e>!ation M1 O M1 and on the rightA hand #ide, !ltiply and di$ide by the onetary ba#e, #ho=n a# %>!ation 10. 'he B?# =o!ld cancel, and M1 #till e>!al# M1.

 %1  × ! %1 =   ! 

10D

'hen =e #!b#tit!te M1 O C X / and B O C X R into the %>!ation 10 or the $ariable# =ithin the bracket#, yielding %>!ation 11.

 - & D  × !  - &  

%1 = 

11D

Money !ltiplier becoe# the ter =ithin the bracket#. 7e di$ide both the n!erator and denoinator in the raction by /, #ho=n in %>!ation 12.

 - & 1   × ! %1 =  D -   D & D 

12D

C!rrencyAdepo#it ratio e>!al# C  / =hile the re#er$e#Adepo#it ratio i# R  /. Both ratio# are i!al# G2&0 billionL checkable depo#it# e>!al G900 billion, and total bank re#er$e# e>!al G90 billion. 7e #!b#tit!te the#e n!ber# into the c!rrencyA depo#it ratio and total re#er$e#Adepo#it ratio in %>!ation# 1+ and 1&. - = G2&0 ! = 0.&0 D G900 !

1+D

 = G90 ! = 0.10 D G900b

1&D

7e #!b#tit!te the c!rrencyAdepo#it and re#er$eAdepo#it ratio# into the oney #!pply e>!ation, yielding %>!ation 13.

 0.& &1.0  × !  0.& & 0.1

%1 = 

%1 = 2.: B

13D 1+-

Kenneth R. S!lcyk Money !ltiplier e>!al# 2.:. "ltho!gh the oney !ltiplier relate# the total onetary ba#e to the oney #!pply, the oney !ltiplier al#o =ork# or change# in the onetary ba#e. For e!ently, the oney #!pply e!al one. 7e can pro$e thi# beca!#e R O /. 7e deri$e the oney #!pply !ltiplier or M2 #iilarly. 'he M2 deinition incl!de# tie depo#it#, denoted by '. 7e deine the M2 deinition a# M2 O C X / X '. Siilarly to the M1, =e #tart =ith %>!ation 19. Monetary ba#e BD =o!ld cancel, lea$ing M2 O M2.

 %2  × ! %2 =   ! 

19D

7e #!b#tit!te the M2 and onetary ba#e deinition# or the $ariable# in the bracket#, yielding %>!ation 14.

 - & D &   × !  - &  

%2 = 

14D

7e di$ide the n!erator and denoinator by /, yielding %>!ation 1:.

 - &  & 1 D  × ! %2 =  D  - D &  D 

1:D

7e add a ne= $ariable A the tie depo#it to the checkable depo#it ratio. !blic deterine# thi# ratio by depo#iting their !nd# bet=een tie depo#it#, checkable depo#it#, and c!rrency. For e!al# G2&0 billionL checkable depo#it# e>!al G900 billionL total bank re#er$e# e>!al G90 billion, and total tie depo#it# e>!al G:00 billion. S!b#e>!ently, =e calc!late the ratio# or c!rrencyAdepo#it, re#er$e#Adepo#it, and tieA checkableAdepo#it in %>!ation# 1-, 20, and 21. - = G2&0 ! = 0.&0 D G900 !

1-D 1&0

Money, Banking, and International Finance  = G90 ! = 0.10 D G900 !

20D

 = G:00 ! = 1.+++ D G900 !

21D

7e #!b#tit!te the#e ratio# into %>!ation 1:, yielding %>!ation 22.

 0.& &1.+++ &1.0  × !  0.& & 0.1 

%2 = 

%2 = 3.&4 !

22D

'he M2 oney !ltiplier e!ently, econoi#t# can ea#!re the #ophi#tication o a co!ntry?# inancial #y#te by coparing the oney deinition# and their oney !ltiplier#. I a co!ntry?# oney !ltiplier# are clo#e together, then thi# co!ntry #all, !nde$eloped inancial arket#. I the#e !ltiplier# di$erge greatly, #!b#e>!ently, thi# co!ntry po##e##e# #ophi#ticated inancial arket#. Fed ha# proble# ipleenting onetary policy i the oney !ltiplier# are !n#table. "ltho!gh the Fed can control the onetary ba#e preci#ely BD, it only inl!ence# the oney #!pply. 'he Fed #et# the re>!ired re#er$e ratio, b!t the p!blic deterine# the c!rrencyAdepo#it ratio, and the bank# decide the le$el o e
Key Terms onetary ba#e c!rrency in circ!lation $a!lt ca#h bank re#er$e# re>!ired re#er$e ratio re>!ired re#er$e# e
openAarket #ale di#co!nt loan di#co!nt rate !ltiple depo#it e
Chapter Questions 1

Identiy the a##et# and liabilitie# on the Fed?# balance #heet.

:&. /eine# the oney !ltiplier and identiy the partie# =ho inl!ence the oney !ltiplier. 1&1

Kenneth R. S!lcyk :3. Re>!ired re#er$e ratio e>!al# 3L the bank# hold ero e!ired re#er$e ratio e>!al# 20L the bank# hold ero e!ired re#er$e ratio e>!al# 10, and the bank# hold ero e!ired re#er$e ratio e>!al# 10, and the bank# hold ero e!al# G300 billionL checkable depo#it# e>!al G-00 billionL total bank re#er$e# are G400 billion, and total tie depo#it# e>!al G1,200 billion. Calc!late the M1 and M2 oney !ltiplier#.

12.

The Feds %alance Sheet

'hi# chapter e!ation that relate# change# in the Fed?# a##et# and liabilitie# to the onetary ba#e and oney #!pply. 'hen #t!dent# learn =hether a go$ernent i##!e# #ec!ritie# to co$er a b!dget deicit ipact# it# central bank?# balance #heet, onetary ba#e, and oney #!pply. Finally, a central bank can inter$ene in it# c!rrency e
The Fed0s Balance Sheet Siilar to any corporation or b!#ine##, the Federal Re#er$e ha# a balance #heet. 'he Fed?# a##et# are anything o $al!e the Fed o=n#. Moreo$er, the Fed ha# liabilitie#, =hich are 1&2

Money, Banking, and International Finance obligation# and debt the Fed o=e# to another party. "ter =e #!btract the Fed?# total a##et# ro total liabilitie#, the reainder becoe# the Fed?# net =orth. 'he Fed p!bli#he# it# balance #heet in the Federal Re#er$e B!lletin, and the p!blic ha# ree acce## to it. 'he Federal Re#er$e B!lletin i# a onthly p!blication o the Board o ;o$ernor# that incl!de# oney #!pply n!ber#, intere#t rate#, and other econoic data. %ach Federal Re#er$e?# a##et, liability, and net =orth are iteied in 'able 1 or Septeber 29, 2012J 'he =ord con#olidated ean# all a##et#, liabilitie#, and capital or all 12 Federal Re#er$e di#trict bank# are added together. -#e Fed5s &ssets' 

Securities are the large#t holding# o the Fed?# a##et#, and they con#i#t o 8.S. go$ernent #ec!ritie#J 'Abill#, 'Anote#, and 'Abond#. 7hen the Fed !#e# openAarket operation#, it b!y# and #ell# #ec!ritie#. 'he Federal Re#er$e held G1.4 trillion in #ec!ritie# in 2012.



.ort$a$e*/acked Securities' 'he Federal Re#er$e p!rcha#ed ortgage #ec!ritie# ro the coercial bank# and p!blic corporation# d!ring the 200: Financial Cri#i#. 'he#e ortgage# are bad loan#, =here the borro=er# dea!lted. 'he Fed p!rcha#ed G:+3 billion in ortgageAback #ec!ritie#, reo$ing the bad loan# ro the banking ind!#try.



Discount Loans are Federal Re#er$e loan# !nd# to bank#, helping the bank# o$ercoe #hortAter li>!idity proble#. 'he Fed control# the intere#t rate on the#e loan#, =hich inl!ence the ao!nt o loan# that bank# need. 7e call the intere#t rate the di#co!nt rate. 'he Fed loaned G1.4 billion to the coercial bank# in 2012.



Items in t#e Process of ollection (IP) are a##et# that ari#e ro the FedN# check clearing proce##, and it e>!aled G1+: illion in 2012. 7e #ho= the check clearing proce## in thi# chapter.

'able 1. Federal Reser*e?s onsolidated (alane 5$eet on 5eptember 2-@ 212 "##et# Sec!ritie# held o!tright MortgageAbacked #ec!ritie# (oan# Ite# in proce## o collection ;old certiicate# Special /ra=ing Right# Coin# Central bank li>!idity #=ap# Bank prei#e# )ther a##et#

G illion# 1,4+1,:0: :+&,-41,4+2 1+: 11,0+4 3,200 2,1:+ 1&,9-+ 2,+30 202,094

(iabilitie# and Capital Federal Re#er$e note# /epo#it# by depo#itory in#tit!tion# 8.S. 'rea#!ry depo#it# Foreign oicial depo#it# /eerred a$ailability ca#h ite# )ther liabilitie# Capital acco!nt#

1&+

G illion# 1,0:3,:0: 1,&4+,349 93,993 2&,220 44101,&21 3&,41:

Kenneth R. S!lcyk 'otal a##et# 2,:09,1:4 'otal liabilitie# and capital 2,:09,1:4 So!rceJ Federal Re#er$e. Septeber 24, 2012. Federal Re#er$e Stati#tical Relea#eAFactor# "ecting Re#er$e Balance#. "$ailable ro httpJ===.ederalre#er$e.go$relea#e#h&1c!rrenth&1.ht_h&1tab- acce##ed -2-2012D 

Gold ertificates are clai# to gold held by the 8.S. 'rea#!ry. 7hen the 8.S. 'rea#!ry b!y# gold, it #ell# the certiicate# to the Federal Re#er$e. In t!rn, the Fed credit# the 8.S. 'rea#!ry acco!nt at the Fed. 'he Fed held G11 billion in gold certiicate# in 2012.



Special Dra!in$ Ri$#ts (SDRs)' 'he International Monetary F!nd IMFD i##!e# Special /ra=ing Right# that are credit #ec!ritie#. 'he IMF allocate# S/R# to $ario!# co!ntrie# aro!nd the =orld, and the Fed hold# appro


oins' 'he 8.S. Mint de#ign# and prod!ce# all coin# or the 8nited State#. 'he 8.S. Mint i# a departent !nder the 8.S. 'rea#!ry. *orally, the Federal Re#er$e print# the 8.S. paper oney, a Fed?# liability. *e$erthele##, the Fed b!y# the coin# ro the 8.S. Mint, aking it an a##et. 'he Fed had G2.2 billion in coin# in 2012.



entral /ank Liquidity S!aps are Federal Re#er$e loan# ade to other co!ntry?# central bank# o de$eloped co!ntrie# 4 For e!idity #=ap# d!ring the 200: Financial Cri#i#. 'he Fed granted G1&.4 billion in central bank li>!idity #=ap# in 2012.



/ank premises are the b!ilding# and e>!ipent o=ned by the Federal Re#er$e, =hich =a# G2.& billion in 2012.



7t#er assets' 'he Fed o=n# other a##et#, incl!ding oreignAe
-#e Fed5s Liabilities and apital &ccounts' 

Federal Reserve notes are 8.S. paper oney that the Federal Re#er$e i##!e#. C!rrency o!t#tanding only incl!de# ca#h held in bank $a!lt# or ca#h circ!lating =ithin the econoy. In 2012, G1.1 trillion o 8.S. c!rrency circ!lated o!t#ide the Federal Re#er$e.

1&&


Deposits by depository institutions' Bank# hold re#er$e# in $a!lt ca#h and depo#it# at the Fed. /epo#it# are a##et# to the inancial in#tit!tion#, b!t liabilitie# to the Fed. 'he Federal Re#er$e held G1.3 trillion in bank depo#it# in 2012.



34S4 -reasury deposits' 'he 8.S. 'rea#!ry depo#it# it# oney into coercial bank# that it collect# ro ta< payent#, ee#, and 8.S. go$ernent #ec!ritie#. 7hen the 8.S. 'rea#!ry pay# e!ently, the 8.S. 'rea#!ry /epo#it# are an a##et to the 8.S. go$ernent, b!t a liability to the Federal Re#er$e. 'he 8.S. 'rea#!ry depo#ited G93.4 billion at the Fed.



Forei$n and ot#er deposits' 'he Fed hold# depo#it# ro oreign go$ernent#, IMF, 7orld Bank, 8nited *ation#, and 8.S. go$ernent agencie# #!ch a# F/IC. 'he Fed held G2&.2 billion in 2012.



Deferred &vailability as# Items (D&I) are liabilitie# that ari#e ro the Fed?# role in the checkAclearing proce##, =hich =a# G44- illion in 2012. 7e e


7t#er liabilities incl!de re$er#e rep!rcha#e agreeent# and di$idend# the Fed o=e# to the national coercial bank#. )ther liabilitie# =ere G101.& billion in 2012.



apital account e>!al# the Federal Re#er$e#N total a##et# in!# total liabilitie#. 'hi# category =a# #!b#tantial and e>!aled G3&.4 billion in 2012. 'he Federal Re#er$e i# a p!blic corporation and e$ery 8.S. coercial bank =ith a charter ro the 8.S. go$ernent !#t b!y #tock into it# Federal Re#er$e di#trict bank. S!b#e>!ently, the Fed pay# the coercial bank# 9 ann!al di$idend on their Fed #tock.

The Check Clearing /rocess 'he Fed ha# the a!thority to clear check#, and the check clearing proce## can ca!#e bank re#er$e# and the oney #!pply to l!ct!ate thro!gh the Federal Reserve float . 'he Federal Re#er$e loat i# the dierence bet=een cas# items in t#e process of collection (IP) and deferred availability cas# items (D&I), and it i# al=ay# po#iti$e. "# a loat increa#e#, it e!ently, it# bank #end# the check to the Fed beca!#e the Fed can clear the check bet=een yo!r bank and the cop!ter irN# bank. "ccordingly, the Fed credit# the cop!ter ir?# bank a G1,000 a##et, the /"CI. *e
Kenneth R. S!lcyk 'he Cop!ter Fir?# Bank *ssets XG1,000 /"CI

iabilities

XG1,000 /epo#it# 'he Federal Re#er$e

*ssets XG1,000 CIC

iabilities

XG1,000 /"CI

Cop!ter ir?# bank cannot to!ch the a##et, /"CI. 'he Fed ackno=ledge# the a##et and i# in the proce## o collecting oney or the cop!ter ir?# bank. "ter t=o day#, the Fed con$ert# the /"CI into bank re#er$e#. Con#e>!ently, the bank can lend the#e re#er$e#. 'he Federal Re#er$e *ssets

iabilities

G1,000 /"CI XG1,000 Re#er$e# or cop!ter ir?# bank 'he Cop!ter Fir?# Bank *ssets G1,000 /"CI XG1,000 Re#er$e# at the Fed

iabilities

I the Fed did not collect G1,000 ro yo!r bank =ith t=o day#, #!b#e>!ently, the Fed e!ation 1, and it e>!al# G1,000. Float O CIC  /"CI O G1,000 A 0 O G1,000

1D

'he Fed collect# the G1,000 ro yo!r bank. "ccordingly, the loat ret!rn# to ero, and yo!r checking acco!nt decrea#e# by G1,000. o!r check or G1,000 no longer e
iabilities

G1,000 Re#er$e# at yo!r bank o!r Bank 1&9

Money, Banking, and International Finance *ssets G1,000 Re#er$e# at the Fed

iabilities

G1,000 o!r checking acco!nt

8#!ally the loat change# predictably d!ring the idAonth beca!#e people pay their bill#. F!rtherore, the loat change# in /eceber beca!#e people =rite check# to b!y Chri#ta# pre#ent# or in "pril =hen people pay their ta!ently, an increa#e in the loat e!ently, bank# and central bank# clear check# and =ire tran#er# #iilarly.

Changes in the Monetary Base I the Fed?# balance #heet change#, #!b#e>!ently, both the onetary ba#e and oney #!pply change. "t ir#t, thi# proce## #ee# cople<, b!t econoi#t# !#e a trick. Fir#t, =e li#t the Fed?# total a##et# in %>!ation 2 and total liabilitie# in %>!ation +. 'otal "##et# O 8.S. go$. #ec!ritie# X di#co!nt loan# X gold certiicate# X S/R# X CIC

2D

'otal (iabilitie# O C!rrency o!t#tanding CD X depo#it# by depo#itory in#tit!tion# /D X 8.S. 'rea#!ry depo#it# X Foreign and other depo#it# X /"CI

+D

*e!ation + beca!#e the onetary ba#e e>!al# depo#it# held by depo#itory in#tit!tion# pl!# c!rrency in circ!lation, or B O / X C. "ter #!b#tit!ting the onetary ba#e into %>!ation +, =e yield %>!ation &. 'otal (iabilitie# O Monetary ba#e BD X 8.S. 'rea#!ry depo#it# X Foreign and other depo#it# X /"CI X Capital

&D

S!b#e>!ently, =e !#e the acco!nting identity a# deined by %>!ation 3 to relate the Fed?# a##et#, liabilitie#, and capital. 'otal "##et# O 'otal (iabilitie# X Capital

3D 1&4

Kenneth R. S!lcyk Finally, =e #!b#tit!te the total a##et# and total liabilitie# into the acco!nting identity, and =e #ol$e or the onetary ba#e, =hich becoe# %>!ation 9J Monetary ba#e BD O 8.S. go$. #ec!ritie# X di#co!nt loan# X gold certiicate# X S/R# X  CIC  /"CI D  8.S. 'rea#!ry depo#it#  Foreign and other depo#it#  Capital

9D

%>!ation 9 #ho=# ho= a change in the Fed?# balance #heet aect# the onetary ba#e. For in#tance, i the Fed p!rcha#e# an a##et, then the onetary ba#e increa#e# and e!ently, both the onetary ba#e and bank re#er$e# drop, and oney #!pply potentially #hrink#. Moreo$er, i the Fed ac>!ire# a liability in %>!ation 9, then the onetary ba#e, bank re#er$e#, and the oney #!pply all all. )n the other hand, i the Fed red!ce# a liability, #!b#e>!ently, both the onetary ba#e and bank re#er$e# ri#e, and the oney #!pply potentially increa#e#. Con#e>!ently, any thing# alter the Fed?# balance #heet. 8nort!nately, the Fed cannot control any ite# on it# balance #heet. For e
Does U4S4 Treasury !ffect the Monetary Base5 'he 8.S. ederal go$ernent ha# e
iabilities

G2,000 'a
*ssets G2,000 Re#er$e#

iabilities

G2,000 /epo#it# 1&:


'he Federal Re#er$e *ssets

iabilities

G2,000 Re#er$e# XG2,000 8.S. 'rea#!ry depo#it# 'he 8.S. 'rea#!ry /epartent *ssets G2,000 'a
iabilities

'he 8.S. 'rea#!ry, #!b#e>!ently, #pend# yo!r G2,000 to b!y ore paper or a go$ernent agency. " copany recei$e# G2,000 and depo#it# the !nd# into the copany?# bank acco!nt. "ltho!gh yo! paid higher ta
iabilities

o!r Bank *ssets G20,000 Re#er$e#

iabilities

G20,000 /epo#it#

'he Federal Re#er$e *ssets

iabilities

 G20,000 Re#er$e# XG20,000 8.S. 'rea#!ry depo#it# 'he 8.S. 'rea#!ry /epartent *ssets XG20,000 /epo#it# at the Fed

iabilities

X G20,000 8.S. 'Abill

1&-

Kenneth R. S!lcyk 'he 8.S. 'rea#!ry collect# yo!r G20,000 and b!y# #oething =ith it. 7hen the 'rea#!ry pay# or a prod!ct or #er$ice ro the p!blic, then the 8.S. go$ernent pay# G20,000 to a copany, and the copany depo#it# the G20,000 into it# bank acco!nt. Con#e>!ently, the 8.S. go$ernent ret!rn# G20,000 to the econoy, ca!#ing ero change# in bank re#er$e#. 'h!#, =hen the 8.S. 'rea#!ry i##!e# ne= #ec!ritie#, the ne= #ec!ritie# do not aect the onetary ba#e and oney #!pply. I the 8.S. 'rea#!ry #old go$ernent #ec!ritie# directly to the Fed, #!b#e>!ently, the Fed i# inancing b!dget deicit#, called moneti%in$ t#e debt . Media reer# thi# to printing oney. For e!ently, =e #ho= the ipact on the Fed?# and 8.S. 'rea#!ry 'Aacco!nt# belo=J 'he Federal Re#er$e *ssets XG100,000 'Abill#

iabilities

XG100,000 8.S. 'rea#!ry depo#it# 'he 8.S. 'rea#!ry /epartent

*ssets XG100,000 /epo#it# at the Fed

iabilities

X G100,000 'Abill#

'he Fed p!rcha#ing #ec!ritie# directly ro the 8.S. 'rea#!ry do not increa#e the onetary ba#e a# long a# the oney #it# into the acco!nt. o=e$er, once the 8.S. 'rea#!ry #pend# the oney in it# acco!nt, then the Fed?# a##et# increa#e, e!ired to b!y 8.S. go$ernent #ec!ritie# or help the 8.S. 'rea#!ry inance b!dget deicit#. 'he Fed and 8.S. 'rea#!ry are independent. o=e$er, the Fed can inance b!dget deicit# indirectly. For in#tance, i the Fed #tabilie# intere#t rate#, then the Fed co!ld onetie the debt indirectly. For e!ently, the Fed !#t b!y the 8.S. go$ernent #ec!ritie# to ret!rn the intere#t rate# to the #ae le$el. Central bank# are not independent ro their inance ini#trie# in de$eloping co!ntrie#. 8nort!nately, the inance ini#try orce# the central bank to inance b!dget deicit#. 7hen a central bank onetie# the debt, it increa#e# in the oney #!pply, creating inlation. Con#e>!ently, any de$eloping co!ntrie# #!er ro high inlation rate#.

! Central Bank Inter"enes *ith its Currency '(change +ate 'he 8nited State# inancial #y#te i# linked to the international inancial arket#. In$e#tor#, #a$er#, ho!#ehold#, b!#ine##e#, and go$ernent# in oreign co!ntrie# can inl!ence the inancial arket# in the 8nited State#, =hile the 8.S. inancial arket# #iilarly aect oreign inancial arket#. Con#e>!ently, go$ernent# inter$ene into the international arket# to aect their inancial arket#. 130

Money, Banking, and International Finance 'he Federal Re#er$e trie# to anage the $al!e o the 8.S. dollar in the international arket#. o=e$er, go$ernent# and central bank# ha$e diic!ltie# in inl!encing the e
7eak 8.S. /ollar ForeignAprod!ced good# are ore e
'he Fed belie$e# the dollar i# too =eak and #trengthen# the dollar. 'he Fed =ill #ell oreign c!rrencie# and b!y 8.S. dollar#. 'he Fed #ell# G10,000 in oreign c!rrency, and =e record the tran#action in the 'Aacco!nt belo=. 'he Federal Re#er$e *ssets G10,000 Foreign c!rrencie#

iabilities

G10,000 C!rrency in circ!lation

'hi# tran#action reo$ed G10,000 o 8.S. c!rrency o!t o the international arket beca!#e the Fed hold# the 8.S. dollar#. Con#e>!ently, the onetary ba#e decrea#e# by G10,000 =hile the oney #!pply contract#. 8nort!nately, the Fed?# international re#er$e# decline by G10,000. 'he Fed doe# not b!y 8.S. c!rrency. In#tead, the Fed co!ld accept a check or the oreignAc!rrency #ale#. 7hen the Fed ca#he# a check, the Fed decrea#e# the bank re#er$e# a# it reo$e# oney ro the banking #y#te. 7e record the tran#action belo=J 'he Federal Re#er$e *ssets G10,000 Foreign c!rrencie#

iabilities

G10,000 Bank re#er$e# 131


In thi# ca#e, the onetary ba#e #till decrea#e# by G10,000 =hile the oney #!pply contract#. It ake# no dierence =hether the Federal Re#er$e accept# a check or ca#h denoinated in 8.S. dollar#. Both tran#action# ipact the onetary ba#e the #ae. I the Federal Re#er$e belie$e# the 8.S. dollar i# too #trong, then the Fed can =eaken or depreciate the dollar by #elling 8.S. c!rrency and b!ying oreign c!rrencie#. For e
iabilities

XG+0,000 C!rrency in circ!lation

'he Federal Re#er$e?# a##et# increa#e by G+0,000, increa#ing the onetary ba#e by G+0,000 and e!ently, the change in the Fed?# a##et# and liabilitie# are ero, and =e record the tran#action in the 'Aacco!nt belo=. 'he Federal Re#er$e *ssets XG+0,000 Foreign c!rrencie# G+0,000 'Abill#

iabilities

XG+0,000 C!rrency in circ!lation G+0,000 C!rrency in circ!lation

Key Terms #ec!ritie# ortgageAbacked #ec!ritie# di#co!nt loan# Ite# in the roce## o Collection CICD gold certiicate# Special /ra=ing Right# S/R#D coin# Central Bank (i>!idity S=ap bank prei#e# Federal Re#er$e note#

8.S. 'rea#!ry depo#it# Foreign and other depo#it# /eerred "$ailability Ca#h Ite# /"CID capital acco!nt Federal Re#er$e loat onetiing the debt oreignAe
Money, Banking, and International Finance depo#it# by depo#itory in#tit!tion#

Chapter Questions 1

Identiy the Fed?# a##et#, liabilitie#, and capital.

-+. %
7hy do central bank# and go$ernent# inter$ene in the oreignAe
102. /i#ting!i#h bet=een a H=eak dollar and H#trong dollar. o= =o!ld a #trong 8.S. dollar aect the 8.S. econoy@ 10+.

/i#ting!i#h bet=een !n#terilied and #terilied oreignAe
13.

The Central %an&s of !ro"e and the United States

7e e!e region o the 8nited State#. Moreo$er, the Board o ;o$ernor# anage# the Fed, =hile the Federal )pen Market 13+

Kenneth R. S!lcyk Coittee handle# the p!rcha#e and #ale o the 8.S. go$ernent #ec!ritie# and other a##et#. Keeping it #traight, the Board o ;o$ernor# de$i#e# onetary policy, =hile the )pen Market Coittee p!t# onetary policy into action. 'hen =e #hit oc!# to the #tr!ct!re o the %!ropean Central Bank, =ho#e #tr!ct!re irror# the 8nited State#. 'he %
#hy the U4S4 o"ernment Created Federal +eser"e System 'he 8nited State# =a# a late coer to the =orld =hen it created it# central bank. 'he 8.S. go$ernent peranently e#tabli#hed a central bank in 1-1+ and naed it the Federal Reserve System. Congre##, go$ernent oicial#, and the p!blic did not =ant to create a po=er!l inancial in#tit!tion, #o the 8.S. go$ernent created the Federal Re#er$e Sy#te to ha$e any check# and balance#. Mo#t %!ropean co!ntrie# ored their central bank# in the 14, 1:, and 1- th cent!rie#. 'hey con$erted a large pri$ate bank into a central bank. For e!arter# or each Federal Re#er$e bank =ithin it# region. 'he Fed i# #pread acro## 12 bank# beca!#e each #ection o the co!ntry i# econoically dierent. For e!e region. )riginally, each Federal Re#er$e Bank pro$ided the ollo=ing !nction#J 

" Fed bank clear# check# or bank#.



" Fed bank reg!late# eber coercial bank#.



" Fed bank anage# the c!rrency by i##!ing ne= c!rrency and reo$ing old, =ornA o!t c!rrency.



" Fed bank pre$ent# inancial panic# by being a #o!rce o li>!idity or eergency loan# or bank# d!ring an econoic cri#i#. %ach Fed Bank had the po=er to #et the di#co!nt rate, or the intere#t rate on the loan.



" Fed bank collect# and p!bli#he# data or the p!blic. %ach Fed bank eploy# #ta o econoi#t#, re#earcher#, and h/#, =ho cond!ct re#earch or the p!blic intere#t.

13&


Figure 1. '$e ap of t$e Federal Reser*e (anks

'he re#ident and Congre## created the Federal Re#er$e Sy#te to pre$ent inancial panic#, #!ch a# the anic o 1-04. 'he *e= ork Stock %!ently, a Federal Re#er$e Bank i# a Hlender o the la#t re#ort. It pro$ide# eergency loan# to bank# and help# re#tore conidence in the banking #y#te. Moreo$er, the Fed loan# =ere originally di#co!nt loan#. For e
The Federal +eser"e System0s Structure 8ni>!e eat!re o a Federal Re#er$e Bank i# each bank i# a ederally chartered corporation. %ach bank ha# it# o=n #tockholder#, director#, and a pre#ident. F!rtherore, e$ery national coercial bank i# re>!ired to p!rcha#e #tock o the Federal Re#er$e Bank in it# di#trict, e>!aling to 9 o the coercial bank?# net e>!ity capitalD. *ational coercial bank# are bank# =ho#e charter coe# ro the 8.S. go$ernent. 'he#e national bank# are al#o called eber bank#, and they earn a i
Kenneth R. S!lcyk Governors+ =hich hold# the po=er at the Fed, appoint# the la#t three director#. In t!rn, the nine director# elect the pre#ident o the Fed di#trict bank. ) co!r#e, thi# i# not a ree election beca!#e the Board o ;o$ernor# !#t appro$e the bank pre#ident. Coercial bank# ha$e no control o$er their Fed di#trict bank#, altho!gh they pri$ately o=n the. " Fed bank doe# not operate like a corporation =here the #tockholder# can reely elect the board o director#, =ho $ote on the aor corporate policie#. Congre## created thi# odd #tr!ct!re beca!#e it did not =ant the Fed to be part o go$ernent or controlled by the bank#, b!t #oe=here bet=een the. *e$erthele##, the Fed i# a part o go$ernent or >!a#iA go$ernent. 7hen Congre## created the Fed in 1-1+, it di#per#ed the Fed?# po=er o$er the 12 Fed Bank#. )$er tie, the Board o ;o$ernor# con#olidated the central bank?# po=er. Board o ;o$ernor# i# the entity that control# the Federal Re#er$e Sy#te. It deterine# onetary policy, re#er$e re>!ireent#, and di#co!nt policy. Board con#i#t# o #e$en eber#, =ho #er$e a 1&Ayear ter. Mo#t board eber# =ill not ini#h their ter beca!#e they re#ign and =ork or the inancial ir# on 7all Street or i$e tie# their Fed #alary. " board eber earn# ro!ghly G130,000 per year. " 8.S. pre#ident =ith Senate appro$al appoint# the eber# and appoint# the chairper#on and $iceAchairper#on o the board. Chairper#on and $iceA chairper#on #er$e a o!rAyear ter. 'he Coptroller o the C!rrency and Secretary o the 'rea#!ry cannot be eber# o the board beca!#e the Federal Re#er$e !#t reain independent o the 8.S. ederal go$ernent. I the 8.S. go$ernent i# acc!!lating a a##i$e debt, and the 'rea#!ry cannot increa#e ta
139

Money, Banking, and International Finance #ec!ritie# directly ro the priary arket, then it =o!ld be b!ying directly ro the 8.S. 'rea#!ry. 'h!#, the Fed =o!ld not be independent ro 8.S. 'rea#!ry i it b!y# ne= #ec!ritie# in the priary arket. Chairper#on o the Board o ;o$ernor# i# al#o chairper#on o the F)MC. 'hi# per#on i# a po=er!l an beca!#e he or #he co!ld ad$i#e the re#ident, inor# Congre## o the Fed?# action#, and i# the #poke#per#on o the =hole Federal Re#er$e Sy#te. 7hen he or #he #peak#, e$eryone in the inancial =orld li#ten#. C!rrent chairper#on i# anet ellen, and any con#ider her the #econd o#t po=er per#on in the 8nited State# ater the 8.S. re#ident.

The 'uropean Central Bank 'he %!ropean 8nion %8D created a coon arket aong %!ropean co!ntrie#. Many co!ntrie# eliinated c!#to# bet=een %8 co!ntrie# a# they erected coon c!#to# to the o!t#ide =orld. 'h!#, capital, good#, labor, and #er$ice# can o$e any=here =ithin the %8 reely. F!rtherore, the %8 ha# ipro$ed eiciency in other area#. Many %8 co!ntrie# red!ced or eliinated their p!rity and labeling la=# that #topped iport# ro other %8 eber#. For e!ired all ;eran beer prod!cer# !#t ake beer ro only o!r ingredient#J barley, hop#, =ater, and yea#t. 'he %8 allo=# ne= co!ntrie# to oin, b!t they !#t o$ercoe any ob#tacle# or eber#hip. Both '!rkey and Croatia =ant to oin the %8, de#pite the 2012 %!ropean /ebt Cri#i#. %8 eber#hip re>!ire# a eber co!ntry be a deocracy, =here the citien# elect the go$ernent oicial#. F!rtherore, go$ernent# !#t re#pect h!an right# and ha$e a !nctioning arket econoy. "# o 2012, the %8 ha# 24 eber#. 'he %!ropean 8nion had created ne= in#tit!tion#, #!ch a# the %!ropean arliaent and %!ropean Co!rt o !#tice. 'he#e in#tit!tion# are not concentrated in one co!ntry b!t #pread acro## %8 eber#. Mo#t in#tit!tion# are located in Br!##el#, (!
Kenneth R. S!lcyk France #pecialie# in pharace!tical#, cheical#, and aero#pace. "# co!ntrie# =ithin the %!roone #pecialie, the prod!cer# e!ently, the one help# integrate %!ropean co!ntrie#, #p!rring econoic gro=th and !nlea#hing the copetiti$e arket orce#. )$er tie, the %!ropean# #ho!ld #ee their li$ing #tandard ri#e and their !neployent rate all. 'he 6uropean entral /ank (6/) anage# the e!ro and i# located in Frank!rt, ;erany. %CB =a# odeled ater the B!nde#bank, =hich =a# ;erany?# central bank. riary goal o the %CB i# to achie$e price #tability, keeping the e!ro #table =ith a lo= inlation rate. %!ro i# #!cce##!l =hile the %!roone ri$al# the 8nited State# in ter# o ;/. F!rtherore, the e!ro =a# appreciating again#t the 8.S. dollar a# it #tro$e to becoe the ne= international c!rrency beca!#e %!rope?# inancial arket# and international trade ri$al the 8.S. %!ro did =ell !ntil the 200: Financial Cri#i# #tr!ck the =orld?# econoy. %!ro began lo#ing gro!nd again#t the 8.S. dollar. S!b#e>!ently, #e$eral %8 eber co!ntrie#, #!ch a# ;reece, Ireland, ort!gal, and Spain =ere plag!ed =ith #e$ere b!dget proble# that led to the %!ropean /ebt Cri#i# in 2012. 7e di#c!## the cri#i# at the end o the chapter. Str!ct!re o the %!ropean Central Bank i# #iilar to the #tr!ct!re o the Federal Re#er$e Sy#te. 'he Governin$ ouncil decide# and or!late# onetary policy or the %!ropean Central Bank and i# #iilar to the Board o ;o$ernor# o the Federal Re#er$e Sy#te. 'he co!ncil i# copo#ed o the %!ently, the %!ropean Co!ncil cannot change the board eber# all at once. re#ident o the %!ently, Board o ;o$ernor# centralie# the po=er =ithin the Federal Re#er$e and control# it. "ll central bank# o the %!ropean 8nion b!y #tock into the %!ropean Central Bank, e$en co!ntrie# that are not eber# o the %!roone. 'h!#, the %8 central bank# o=n the %!ropean Central Bank. Siilarly, the national coercial bank# b!y the Federal Re#er$e#? #tock in it# di#trict =ithin the 8nited State#. "o!nt o #tock, a central bank b!y#, depend# on a co!ntry?# 13:

Money, Banking, and International Finance pop!lation and ;/. ;erany o=ned 1:.- o the %CB?# #tock in 2011 =hile France o=ned 1&.2, and ;reat Britain had 1&.3. 'he %CB ret!rn# :0 o it# proit# to the #tockholder#, =hich are the central bank# o eber co!ntrie#. 'he %!ropean Central Bank i# the o#t independent central bank in the =orld. *o %8 co!ntry or %8 in#tit!tion can hold it acco!ntable. %$en the %!ropean arliaent, the highe#t repre#entati$e body o the %8, cannot a!dit or dictate policy to the %CB. Moreo$er, the %CB doe# not recei$e !nding ro any %8 body or go$ernent, and the ter# are #taggered or the %!ently, the %CB concentrate# on price #tability, =hich they deine a# a 2 or le## inlation rate per year. )ther co!ntrie#, #!ch a# the 8nited State# can pre##!re the central bank to p!r#!e #e$eral goal#, #!ch a# lo=ering the !neployent rate or anip!lating intere#t and c!rrency e
Is the Federal +eser"e Independent of the U4S4 o"ernment5 '=o $ie=point# de#cribe =hether the Fed #er$e# the p!blic intere#t or act# in it# o=n #elA intere#t. Public interest vie! #tate# the Fed #er$e# the p!blic by ipleenting onetary policy that ca!#e# #table price#, lo= !neployent, and #trong econoic gro=th. Many econoi#t# arg!e the Fed doe# not #er$e the p!blic intere#t beca!#e it doe# not epha#ie price #tability and econoic gro=th. F!rtherore, any e!ently, the corporation =ill bankr!pt. roit# en#!re b!#ine##e# =ill prod!ce good# and #er$ice# that con#!er# =ant. )n the other hand, proit# do not g!ide the go$ernent agencie#, and no echani# keep# a go$ernent agency in check. %$ery year, go$ernent agencie# recei$e ore !nding, regardle## o the agencie#? perorance. )$er tie, b!rea!crat# becoe ore concerned =ith !nding, ob #ec!rity, and pre#tige, in#tead o ollo=ing it# original !nction. 'hi# e
Kenneth R. S!lcyk chairan =orrie# o$er hi# or her o=n #elAintere#t and protect# hi# riend#, #!ch a# the large coercial and in$e#tent bank#. 'he Fed i# independent o the 8.S. 'rea#!ry )ice, e$en tho!gh #oe re#ident# tried to inl!ence it. o=e$er, a go$ernent b!dget deicit co!ld lead to oney creation. I the Fed aintain# a con#tant intere#t rate, and the 8.S. go$ernent operate# a b!dget deicit, the 8.S. 'rea#!ry departent can inance the deicit by i##!ing 'Abill#. *e$erthele##, the 'Abill #!pply ri#e#, ca!#ing the arket price o 'Abill# to all. 'h!#, arket intere#t rate# ri#e. I the Fed aintain# a i!ently, a go$ernent b!dget deicit lead# to inlation i a central bank oc!#e# on the intere#t rate. Foreign co!ntrie# dier in their degree o independence bet=een go$ernent and their central bank#. For e!ently, a go$ernent =o!ld #!er ro a b!dget deicit that it# trea#!ry can inance by #elling go$ernent bond#. "# a go$ernent?# debt contin!ally gro=#, in$e#tor# =ill reach a point =hen they #top b!ying bond#. 8nort!nately, political leader# re!#e to c!t go$ernent progra# and #!b#idie# or rai#e ta!ently, the Federal Re#er$e =o!ld lo#e it# independence. 'he %!ropean 8nion e!ently, any %!ropean co!ntrie# had entered a rece##ion in 2012. 'he ;reek go$ernent cannot control it# b!dget deicit, and it orced bond# holder# to take a h!ge lo## on the ;reek bond# in 2010. Con#e>!ently, ;reece lo#t it# in$e#tor#, and it =ill likely lea$e the %!roone and reintrod!ce it# c!rrency, the dracha. 'he ;reek citien# and b!#ine##e# kno= the ;reek go$ernent =ill orce it# central bank to b!y it# bond#, ca!#ing the inlation rate to increa#e =hile the dracha depreciate# again#t the e!ro. !blic ha# #tarted bank r!n# on ;reek bank#, =ithdra=ing their e!ro# and creating ore inancial hard#hip or ;reece. 'hen ;reece?# inancial proble# trickled into Cypre## in 201+. 190

Money, Banking, and International Finance Cypre## i# an o#hore banking center that attracted #ieable depo#it# ro Briti#h and R!##ian#. o=e$er, Cypre## bank# #!ered h!ge lo##e# ro their ;reek bond#. 'he %8 re!#ed to bail Cypre## o!t and con$inced the Cypre## go$ernent to ta< all bank acco!nt# o$er G100,000. 'a< =o!ld ca!#e depo#itor# to =ithdra= their oney and lee the co!ntry, called capital light. 7e di#c!## capital light in Chapter 13.

Key Terms Federal Re#er$e Sy#te di#co!nt rate Board o ;o$ernor# 'he Federal )pen Market Coittee F)MCD directi$e %!roone

%!ropean Central Bank ;o$erning Co!ncil %
Chapter Questions 1

o= any di#trict bank# doe# the Federal Re#er$e ha$e@

10&. 7hy did Congre## and the re#ident create the Federal Re#er$e Sy#te =ith #e$eral independent bank branche#@ 103. lea#e de#cribe the #tr!ct!re o the Federal Re#er$e Sy#te@ For e
7hich actor# help the Fed be independent o the 8.S. ederal go$ernent@

10:. Identiy the !nction# o the Federal )pen Market Coittee, and =ho appoint# eber# to thi# board@ 10-.

%
110. Identiy the econoic con#e>!ence# i an %8 eber o the %!roone =ithdra=# ro the e!ro and reintrod!ce# it# c!rrency. 111. /i#ting!i#h bet=een the %
Identiy the beneit# and proble# or %8 co!ntrie# that are eber# o the %!roone. 191

Kenneth R. S!lcyk 11+.

/i#ting!i#h bet=een the p!blic intere#t $ie= and principalAagent $ie=.

11&. %
1#.

Monetary Policy Tools

'hi# chapter introd!ce# the Federal Re#er$e?# three #igniicant tool# or cond!cting onetary policyJ openAarket operation#, di#co!nt policy, and re#er$e re>!ireent#. F!rtherore, the Fed !#e# onetary policy to inl!ence the iportant acroeconoic $ariable# in #ociety incl!ding the ;/ gro=th rate and indirectly the !neployent rate, intere#t rate#, c!rrency e
%pen6Market %perations 'he Fed can !#e e!ireent# to ipleent a onetary policy. 7pen* .arket 7perations are the Fed?# p!rcha#e and #ale o 8.S. go$ernent #ec!ritie#, and it# o#t iportant tool. )penAarket operation# ha$e the #ae eect i the Fed p!rcha#ed any #hortA ter, li>!id #ec!ritie#. o=e$er, the Fed !#!ally b!y# and #ell# 8.S. go$ernent #ec!ritie#. 7e al#o di#c!## /i#co!nt olicy and Re#er$e Re>!ireent# in their #ection# in thi# chapter. 'he Fed, or e!antity or 'Abill# are [ and 5[. 'hen the Fed b!y# 'Abill#, creating a greater deand or 'Abill#, #hiting the deand !nction right=ard. 'he Fed pay# or the 'Abill# !#ing a HFed check. "ter the #eller depo#it# the check at hi# bank, then hi# or her bankN# re#er$e# increa#e, boo#ting the oney #!pply a# bank# grant loan# to borro=er#. Con#e>!ently, both the arket price and >!antity o 'A bill# ri#e#. 'hen the arket intere#t rate all# or 'Abill#, =hen =e calc!late it !#ing the pre#ent $al!e or!la. *oticing one thing, openAarket operation# aect the intere#t rate# beca!#e the 'Abill i# a #hortAter credit in#tr!ent. 7hen the Fed p!rcha#e# the 'Abill#, the 'AbillN# price ri#e# =hile the 'Abill intere#t rate all#. Con#e>!ently, the decrea#e in the #hortAter intere#t rate# #pread# to 192

Money, Banking, and International Finance other arket#, incl!ding the ederal !nd# rate, coercial paper, and banker?# acceptance#. 'hereore, #hortAter intere#t rate# on all #hortAter credit in#tr!ent# =ill ri#e and all together. Contractionary onetary policy =ork# #iilarly to e!antity or 'Abill# a# [ and 5[. 'he Fed #ell# 'Abill#, increa#ing the #!pply o 'Abill# and #hiting the #!pply c!r$e or 'Abill# right=ard. Con#e>!ently, the arket price o 'Abill# all# =hile the arket intere#t rate or 'Abill# ri#e# by !#ing the pre#ent $al!e or!la. F!rtherore, the #hortAter intere#t rate# or other credit in#tr!ent# ri#e. Finally, the bank#? re#er$e# all, and banker# grant e=er loan# that #hrink the oney #!pply. 'rea#!ry Bill Market

Figure 1. '$e Federal Reser*e inreases t$e money supply by pur$asing '#bills

'rea#!ry Bill Market

19+

Kenneth R. S!lcyk Figure 2. '$e Federal Reser*e dereases t$e money supply by selling '#bills

'he Fed can only control the gro=th rate o the oney #!pply or #hortAter intere#t rate#, b!t not both at the #ae tie. For e!ently, the Fed keep# b!ying 'Abill# !ntil the M1 oney #!pply e!al# 9, #!b#e>!ently, the Federal Re#er$e keep# b!ying 'Abill# !ntil the intere#t all# to &. *e$erthele##, a# the Fed contin!ally b!y# 'A bill#, both the bank#N re#er$e# and the oney #!pply e
Federal %pen Market Committee 'he Fed ored the Federal 7pen .arket ommittee (F7.) to ipleent onetary policy by b!ying or #elling a##et# like 8.S. go$ernent #ec!ritie#. 'he F)MC eet# eight tie# per year and i##!e# a $eneral directive that #tate# the obecti$e or the onetary aggregate# and intere#t rate#. F!rtherore, the Federal Re#er$e Bank o *e= ork i# re#pon#ible in carrying o!t the general directi$e. 'he Fed Bank o *e= ork deal# =ith abo!t &0 dealer# =ho #pecialie in 8.S. go$ernent #ec!ritie# i.e. #econdary arketD. 'he *e= ork Fed and dealer# are connected electronically. 7hen the Fed i# ready to b!y or #ell go$ernent #ec!ritie#, the Fed a#k the#e dealer# to bid. 'hen the Fed b!y# or #ell# to the dealer# =ith the be#t oer. 'he 7pen .arket -radin$ Desk i# the departent =ithin the *e= ork Fed Bank that b!y# and #ell# the go$ernent #ec!ritie#. 7hen the trading de#k at the Fed cond!ct# onetary action, the trading de#k can !#e dynaic or deen#i$e tran#action#. " dynamic transaction i# the Fed !#e# a tran#action to eet the onetary policy a# #peciied in the general directi$e. " defensive transaction i# the Fed !#e# openAarket operation# to o#et l!ct!ation# in bank re#er$e#. 'he Fed !#e# deen#i$e tran#action# ore than dynaic tran#action#. For e!ently, the oney #!pply decrea#e# aro!nd Chri#ta# and "pril. F!rtherore, nat!ral di#a#ter# and eployee#N #trike# can delay the deli$ery o the ail. " ail delay #lo=# the Fed?# check clearing proce##. 'h!#, the loat ri#e#, e
Money, Banking, and International Finance agreeent. 8#!ally, the dealer b!y# back the go$ernent #ec!rity =ithin 13 day#. Con#e>!ently, the R%) inect# teporary re#er$e# into the banking #y#te. For e!ickly. Many people #cr!tinie the Fed, and they read the FedN# directi$e# or it# openAarket trading de#k. o=e$er, the#e directi$e# are $ag!e and not preci#e, creating the principalAagent proble. I the directi$e# are $ag!e, then the o!tcoe doe# not atter. 'he Fed can dee any o!tcoe a# a #!cce##, aking the Fed !nacco!ntable or error#. Many central bank# acro## the =orld, incl!ding the %!ropean Central Bank !#e openA arket operation# #iilarly to the 8nited State#. "ltho!gh #oe co!ntrie# ha$e a #all arket or go$ernent #ec!ritie#, central bank# can b!y and #ell any a##et#.

Discount /olicy Fed?# #econd onetary policy tool i# the discount policy. 'he Fed can grant loan# to inancial in#tit!tion#. For e!ently, the bank #ell# a G10,000 'Abill to the Fed, and the Fed boo#t# bank?# re#er$e# by G-,000. 'he di#co!nt i# the dierence =hile the 'Abill becoe# the collateral o the loan. %$ent!ally, the bank repay# the Fed loan, and ater=ard#, the Fed ret!rn# the 'Abill or G10,000 to the bank. 'he G1,000 dierence relect# the intere#t rate the Fed charge# or the loan, called the discount rate. 'raditionally, the Fed only loaned to bank# that =ere eber# o the Federal Re#er$e Sy#te. C!rrently, any bank in the 8.S. can borro= ro the Fed, and the Fed ay not re>!ire collateral or the loan. %ach Fed di#trict bank pro$ide# loan#, kno=n a# the H discount !indo!. F!rtherore, the Fed co!ld !#e di#co!nt policy to inl!ence the oney #!pply and intere#t rate#. For e!ently, the bank# electronically tran#er the#e !nd# thro!gh the Fed=ire. /eand !nction con#tit!te# the bank#? deand or ederal !nd#. 'he#e bank# borro= !nd# to en#!re they hold eno!gh re#er$e# to eet depo#itor#? =ithdra=al# or #ati#y the Fed?# re#er$e 193

Kenneth R. S!lcyk re>!ireent#. /eand c!r$e i# do=n=ard #loping beca!#e bank# borro= ore !nd# i the intere#t rate decrea#e# i.e. the loan# are cheaperD. S!pply !nction repre#ent# the bank#? #!pply o ederal !nd# to the arket beca!#e the#e bank# hold e!ilibri! intere#t rate i[D and ao!nt o re#er$e# R[D. 'he Federal F!nd# Market

Figure 3. '$e Federal Reser*e uses t$e disount rate to inrease money supply

'he Fed co!ld !#e the di#co!nt rate or e!ently, the intere#t rate or ederal !nd# all and both the onetary ba#e and oney #!pply e!ilibri! re#er$e# are R[. For e!ently, the bank# ha$e e=er re#er$e# to lend, #hiting the #!pply or Federal F!nd# let=ard. Intere#t rate ri#e =hile both the onetary ba#e and oney #!pply #hrink. 'he Fed can grant ad!#tent, #ea#onal, or e!idity proble#. Seasonal credit i# a loan to help #all bank#, located in agric!lt!re area# or to!ri#t de#tination#. 'he#e area# e
Money, Banking, and International Finance large bank i# on the $erge o bankr!ptcy and ha# #e$ere li>!idity proble#. 'h!#, the Fed grant# a longAter loan to thi# bank, pre$enting a bank ail!re. 'he Fed along =ith F/IC co!ld e
Figure !. '$e Federal Reser*e uses t$e disount rate to derease money supply

Bank# can ab!#e the di#co!nt =indo=. For e
Kenneth R. S!lcyk Fed?# di#co!nt policy pro$ide# o!r beneit# to the banking #y#te. Fir#t, the Fed i# the Hlender o the la#t re#ort. I a bank ha# tro!ble =ith li>!idity or need# re#er$e#, and it cannot borro= ro other bank#, #!b#e>!ently, the Fed i# the la#t place to go to a#k or a loan. Second, the Fed create# the announcement effect , =hen the di#co!nt rate !ne
+eser"e +e,uirements Fed can !#e re#er$e re>!ireent# a# a onetary tool. Reserve requirements are the ratio o re#er$e# to depo#it# that bank# !#t hold to #ati#y depo#itor#? =ithdra=al#. Bank# #tore re#er$e# a# $a!lt ca#h or depo#it# at the Fed. 'he Fed ha# the po=er to #et re#er$e re>!ireent# or bank# =ithin the liit# #et by Congre##. 'he Fed rarely change# the re#er$e re>!ireent# beca!#e change# in the re#er$e re>!ireent# ha$e a #igniicant and di#r!pti$e ipact on the banking #y#te. 'able 1 #ho=# the c!rrent re#er$e re>!ireent# and the date the Fed la#t changed the. Con#e>!ently, the Fed ha# not changed re#er$e re>!ireent# #ince 1--0. 'able 1. '$e Federal Reser*e Required Reser*e Requirements

Bank liability Checking acco!nt# G0 to G10.+ illion 19:

Re>!ired Re#er$e Ratio D

%ecti$e date

0

1A0-A-0

Money, Banking, and International Finance More than G10.+ illion to G&&.& illion More than G&&.& illion *onper#onal tie depo#it#

+ 10

1A0-A-0 1A0-A-0

0

12A24A-0

'he Fed can !#e re#er$e re>!ireent# to alter the oney #!pply. I the Fed belie$e# bank# are holding too any e!ently, the Fed can increa#e the re#er$e re>!ireent ratio, #=itching #oe e!ired re#er$e#. Money !ltiplier 1 V r rD increa#e# i the Fed red!ce# the re#er$e re>!ireent, and $ice $er#a. For e!ired re#er$e ratio e>!al# 10, and the Fed b!y# a G10,000 'Abill !#ing a Fed check, #!b#e>!ently, the oney #!pply co!ld potentially e!ireent to 3, and it p!rcha#ed a G10,000 'Abill, then the oney #!pply can potentially increa#e to G200,000 or G10,000 V 0.03D. 'h!#, the Fed rarely change# the re#er$e re>!ireent# beca!#e thi# tool i# too po=er!l. Sall change# in the re#er$e re>!ireent co!ld ha$e an enoro!# ipact on the banking #y#te and the oney #!pply. %conoi#t# and policyaker# belie$e re#er$e re>!ireent# are not an eecti$e onetary policy tool beca!#e the ollo=ing rea#on#J 

Changing the re#er$e re>!ireent# i# too po=er!l beca!#e #all change# in re#er$e re>!ireent# ha$e a great ipact on the oney !ltiplier and the oney #!pply.



Re>!ired re#er$e# ipo#e a co#t to the bank# beca!#e they cannot lend the#e re#er$e# to borro=er#, and thereore, do not earn intere#t incoe on re>!ired re#er$e#. In#tead, the re#er$e# #it in a $a!lt a# ca#h or a# depo#it# at the Fed.



!rpo#e o re#er$e re>!ireent# i# to ake depo#it# #ae and aintain a #table banking #y#te. o=e$er, i the aority o the depo#itor# cae to their bank to =ithdra= their depo#it#, then the bank =o!ld #till ail. 8nort!nately, the bank# hold e=er than 10 o the depo#it# a# $a!lt ca#h andor depo#it# at the Fed. 'h!#, re#er$e re>!ireent# =o!ld not pre$ent bank r!n# and doe# not #tabilie the banking #y#te. )nly depo#it in#!rance can help pre$ent bank r!n#.



Re#er$e re>!ireent ratio# are coponent# o the oney !ltiplier. 'h!#, the Fed !#t aintain a con#tant oney !ltiplier and re#er$e re>!ireent# in order or the Fed to control the oney #!pply. *o epirical e$idence indicate# re#er$e re>!ireent# ipro$e the #tability o the oney !ltiplier. Moreo$er, bank# =o!ld #till hold re#er$e# to eet depo#itor#? =ithdra=al# i a central bank did not ipo#e re#er$e re>!ireent#. 19-

Kenneth R. S!lcyk Milton Friedan, a *obel la!reate, #!gge#ted the central bank #ho!ld ipo#e a 100 re#er$e re>!ireent on bank#. "ccordingly, the bank# =o!ld hold all depo#it# either at the Fed andor $a!lt ca#h. Banking #y#te co!ld not create !ltiple depo#it e!ently, the Fed ha# coplete control o$er the oney #!pply =ith a 100 re#er$e re>!ireent. Bank# =o!ld hold all depo#it# a# re#er$e#, #o they co!ld eet depo#itor?# =ithdra=al#. Moreo$er, the 8.S. go$ernent co!ld eliinate ederal depo#it in#!rance and #!b#tantially red!ce bank reg!lation#. o=e$er, bank# co!ld not lend !nder thi# #y#te, ca!#ing the inancial interediation proce## to break do=n. Bank# link #a$er# to the in$e#tor#. 'h!#, the =hole econoy =o!ld need re#tr!ct!ring, and another inancial in#tit!tion =o!ld e$ol$e into #oething #iilar to a bank that =o!ld lend to b!#ine##e# and ho!#ehold#.

Monetary /olicy oals ;oal o onetary policy i# to increa#e the =ellAbeing o #ociety. %conoi#t# ea#!re =ellA being in ter# o the >!antity and >!ality o good# and #er$ice# that people con#!e. 'he Fed ha# #i< monetary policy $oals, =hich areJ Price stabilityJ rod!ct price# co!nicate inoration to ho!#ehold# and b!#ine##e#. o!#ehold# deterine ho= any good# to b!y =hile b!#ine##e# deterine ho= any good# to prod!ce. Inlation i# a contin!al increa#e in price# o good#, and #er$ice#, and it erode# the $al!e o oney. F!rtherore, a high inlation rate becoe# ore $ariable, th!#, creating !ncertainty or b!#ine##e#, con#!er#, and =orker#. 'he !ncertainty lead# to ad$er#e eect# on deci#ion# and hinder# econoic gro=th. I the inlation rate #oar#, then oney?# !nction# o a H#tore o $al!e and Hedi! o e!ipent becoe !nder!tilied. 7hen a #ociety doe# not !#e all it# re#o!rce#, an econoy?# ;/ gro=# at a #lo= rate or e$en decrea#e#. ;o$ernent cannot red!ce the !neployent rate to ero. In #oe ca#e#, !neployent occ!r# =hen =orker# >!it their ob# and look or ne= one#, or #t!dent# grad!ate and enter the labor arket. 'he Fed trie# to lo=er the !neployent rate to the nat!ral rate o !neployent. C!rrently, econoi#t# e#tiate the nat!ral rate o !neployent to be 9 or the 8nited State#. I the Fed #tri$e# or an !neployent rate belo= 9, then the Fed?# policy create# inlation. 6conomic $ro!t#J " gro=ing econoy ha# an increa#ing real ;/ beca!#e #ociety prod!ce# ore good# and #er$ice#. " high real ;/ gro=th rate lo=er# the !neployent rate =hile b!#ine##e# earn proit#. 'hen they rai#e their in$e#tent, prod!cing ore good# and #er$ice#. F!rtherore, #trong econoic gro=th ca!#e# increa#ing incoe# or b!#ine##e# and ho!#ehold#. 7hen b!#ine##e# and ho!#ehold# ha$e higher incoe#, the local, #tate, and ederal go$ernent# collect ore ta< re$en!e#. 'h!#, the Fed !#e# onetary policy to #p!r #trong econoic gro=th. Financial market and institution stabilityJ Financial panic#, bank r!n#, #tock arket cra#he#, or bankr!ptcie# o large inancial in#tit!tion# co!ld trigger a chain reaction that ca!#e# 140

Money, Banking, and International Finance other inancial in#tit!tion# to bankr!pt. 8nort!nately, a inancial panic di#r!pt# the link bet=een #a$er# and in$e#tor#. 'hen b!#ine##e# do not recei$e loan# they need to in$e#t =hile c!#toer# do not recei$e loan# to b!y hoe#, car#, and other a##et#. I the inancial arket# and in#tit!tion# break do=n, then the econoy can enter a #e$ere rece##ion, ca!#ing high !neployent and #lo= or negati$e ;/ gro=th rate#. Con#e>!ently, the Fed #tabilie# the inancial #y#te by being a Hlender o the la#t re#ort, pre$enting inancial panic#. Interest rate stabilityJ 'he Fed #tabilie# the intere#t rate# beca!#e l!ct!ating intere#t rate# create !ncertainty in the econoy, and b!#ine##e#, and ho!#ehold# e!ipent =hile con#!er# are !n#!re abo!t longAter in$e#tent#, #!ch a# b!ying a ho!#e or car. Intere#t rate #tability i# related to the #tability o the inancial arket#. (arge #=ing# in intere#t rate# can ca!#e #ieable capital gain# and lo##e# in the inancial arket#. Con#e>!ently, #oe in$e#tor# earn proit# =hile other# earn lo##e#. Forei$n*e"c#an$e market stabilityJ 'he Fed trie# to #tabilie the 8.S. dollar?# $al!e again#t the aor c!rrencie#, #!ch a# the apane#e yen and %!ropean e!ro. " #trong 8.S. dollar ca!#e# 8.S prod!ct# to becoe relati$ely ore e
Time )ags and Targets 'he Fed cannot inl!ence the onetary policy goal# directly. 'he Fed !#e# it# tool#, openA arket operation#, di#co!nt rate#, and re#er$e re>!ireent#, to inl!ence indirectly it# policy goal#. 8nort!nately, three tie lag# hinder onetary policy. Fir#t, the Federal Re#er$e or go$ernent need# data and inoration beore it can do anything, the information la$ . For in#tance, go$ernent calc!late# the !neployent rate onthly and e#tiate# ;/ data >!arterly. 'he go$ernent re>!ire# nine onth# to kno= =hether the econoy ha# entered a rece##ion beca!#e econoi#t# deine a rece##ion a# t=o con#ec!ti$e >!arter# o negati$e real ;/ gro=th. 'h!#, a go$ernent kno=# the econoy i# in a rece##ion by the end o the third >!arter. Second, the Federal Re#er$e or go$ernent !#t #t!dy the data, and then they de$i#e and appro$e a policy, the administrative la$ . Finally, a onetary policy doe# not ipact the econoy iediately. It take# tie =hen the Fed ipleent# a policy !ntil it #ho=# !p on the econoy, the impact la$ . 141

Kenneth R. S!lcyk 'ie lag# can apliy the b!#ine## cycle. For e!arterly ;/ data. 'he ;/ need# t=o con#ec!ti$e >!arter# o negati$e ;/ gro=th beore a rece##ion i# declared. 'h!#, the Fed !#t =ait nine onth# to deterine =hether the econoy ha# entered a rece##ion. I the adini#trati$e lag i# one onth =hile the ipact lag e>!al# #i< onth#, then the Fed?# policy take# hold ater one year and o!r onth# to inl!ence the econoy, or - X 1 X9. I the Fed co!nteracted thi# rece##ion, #!b#e>!ently, the Fed ake# the econoy ore !n#table. "ter the econoy ret!rn# to the !llAeployent le$el, the Fed?# policy kick# in, e!ireent, the Fed?# onetary policy ha# an iediate ipact on the ederal !nd# rate and nonAborro=ed re#er$e#. 7hen the Fed ipleent# onetary policy, #!ch a# a creating a greater ;/ gro=th rate, the Fed?# policy iediately aect# the operating target#, and, in t!rn, inl!ence the interediate target#, #!ch a# ;/ gro=th rate. "ccordingly, the Fed onitor# change# in the interediate and operating target#, deterining =hether onetary policy i# aecting the econoy correctly. 'he Fed !#e# three criteria to #elect an interediate target. Fir#t, the Fed !#t ea#ily ea#!re the interediate target in order to o$ercoe inoration lag#. Second, the Fed !#t ha$e control o$er the interediate target to o$ercoe the ipact lag. For e!ently, the bondN# price# increa#e, ca!#ing the intere#t rate# to drop. *e$erthele##, the bank re#er$e# e
Money, Banking, and International Finance oney #!pply, e!ently, the Fed !#t #ell 8.S. go$ernent #ec!ritie#. 'h!#, the price o the #ec!ritie# decrea#e#, increa#ing the intere#t rate#. o=e$er, bank re#er$e# all#, contracting the oney #!pply and =or#ening a rece##ion. Since the 1--0#, the Fed ha# epha#ied a lo= inlation goal, and thi# policy ha# been #!cce##!l. %!rope and apan al#o epha#ie price #tability and lo= inlation rate#. %conoi#t# #!gge#ted the Fed !#e other interediate target#, #!ch a# the ollo=ingJ 

ominal GDP' I an econoy prod!ce# ore good# and #er$ice#, then both real and noinal ;/ increa#e. I inlation ca!#e# higher price#, #!b#e>!ently, the greater price# increa#e noinal ;/, b!t ha$e no eect on real ;/. Soe econoi#t# belie$e the Fed cannot inl!ence real ;/, b!t it can aect the inlation rate, =hich in t!rn aect# the noinal ;/. I the Fed #elected noinal ;/ a# an interediate target, then the Fed =o!ld be oc!#ing on price #tability indirectly.



=ield urve' Soe econoi#t# #!gge#ted the Fed !#e the yield c!r$e a# an interediate target. "ltho!gh the Fed e


ommodity prices' Soe econoi#t# #!gge#ted the Fed oc!# on coodity price#. o=e$er, coodity price# do not acc!rately predict inlation =ell.



34S4 dollar e"c#an$e rate' %
Monetary policy can becoe ineecti$e in #oe ca#e#. For in#tance, apan entered a perpet!al rece##ion, #tarting in the 1--0#. B!#ine##e# and con#!er# becae $ery pe##ii#ticL =hen the apane#e central bank lo=ered the intere#t rate, b!t it had no ipact on the econoy. "ter the ho!#ing b!bble popped in 2004 in the 8nited State#, the Federal Re#er$e ha# p!r#!ed e!ently, #oe e!ickly =hile the central bank p!r#!e# other target# not related to price #tability. Finally, a 14+

Kenneth R. S!lcyk co!ntry =ith an independent central bank ro go$ernent co!ld e
Key Terms e
'er 'er "!ction Facility rogra anno!nceent eect re#er$e re>!ireent onetary policy goal price #tability high eployent econoic gro=th inancial arket and in#tit!tion #tability intere#t rate #tability oreignAe
Chapter Questions 1

7hat 7hat happen# happen# to bank re#er re#er$e# $e#,, intere# intere#tt rate#, rate#, bond bond price#, price#, and and the oney oney #!pply #!pply i the Fed Fed bo!ght 8.S. 'rea#!ry 'rea#!ry #ec!ritie#@

113. 113. 7hat 7hat happen# happen# to bank bank re#er re#er$e# $e#,, intere#t intere#t rate# rate#,, bond pric price#, e#, and and the oney oney #!ppl #!pply y i the Fed #old 8.S. 'rea#!ry #ec!ritie#@ 119. 119. %
/i#ting /i#ting!i# !i#h h bet=ee bet=een n R%)S R%)S and re$er re$er#e #e R%)S, R%)S, and and identi identiy y their their p!rpo# p!rpo#e. e.

11:. 11:.

/i#ting /i#ting!i# !i#h h bet=e bet=een en dyn dynai aicc and and deen deen#i$e #i$e tran#a tran#acti ction# on#..

11-. 11-.

%
120. 7hat 120. 7hat happen# happen# to the the #hortAte #hortAter r intere# intere#tt rate#, rate#, bank bank re#er$e re#er$e#, #, and the the oney oney #!pply #!pply i the Fed change# the di#co!nt rate@ 14&

Money, Banking, and International Finance 121.. 121

Identi Identiy y the the three three cred creditAl itAloan oan## that that the Fed can can grant grant to to bank#. bank#.

122.. 122

%
12+.. 12+

Identi Identiy y the the proble proble# # in in !#ing !#ing di#c di#co!n o!ntt policy policy a# a# a one onetary tary tool. tool.

12&.. 12&

7hy do do the inan inancia ciall analy# analy#t# t# and the the p!bli p!blicc #cr!tin #cr!tinie ie the the edera ederall !nd# !nd# arket arket@@

123.. 123

%!i re>!iree reent# nt# are are #!ch #!ch a po=er po=er!l !l onet onetary ary tool tool..

129.. 129

Identi Identiy y the co#t co#t## and benei beneit# t# by ipo# ipo#ing ing a 100 100 re#er$ re#er$ee re>!ire re>!ireent ent or or bank#. bank#.

124. 124.

Iden Identi tiy y the the Fed Fed?# ?# #i< #i< one oneta tary ry poli policy cy goa goal# l#..

12:.. 12:

7hat 7hat are the the tie tie lag#, lag#, and and =hy do do they ca!#e ca!#e probl proble# e# or or onet onetary ary polic policy@ y@

12-. 12 -.

%
1+0.. 1+0

/i#ting /i#ting!i# !i#h h bet=ee bet=een n an opera operatin ting g target target and and an inte intere redia diate te targe target. t.

1+1.. 1+1

Identi Identiy y the the crite criteria ria or #elect #electing ing intere interediat diatee targ target# et#..

1+2.. 1+2

%
1++.. 1++

7hich 7hich inter interedi ediate ate targ target# et# ha$e ha$e econo econoi#t i#t## #!gge# #!gge#ted ted the the Fed Fed !#e@ !#e@

1'.

The $nternational Financial System

;o$ernent# and central bank# oten inter$ene in the oreignAe
143


Balance of /ayments Balanc Balancee o payen payent# t# record# record# all tran#a tran#acti ction# on# bet=ee bet=een n the ho!# ho!#eho ehold# ld#,, b!# b!#ine ine##e ##e#, #, and go$ernent o one co!ntry to the re#t o the =orld. It i# a ca#h lo= #tateent and not a balance #heet. #heet. %cono %conoi#t i#t## !#e balanc balanceAo eAoApay Apayen ent# t# acco!nt acco!nt## to copar coparee the total total lo= lo= o on oney ey bet=een one co!ntry and the re#t o the =orld, =o rld, and econoi#t# al=ay# ea#!re it in a co!ntry?# co!ntr y?# c!rrency. 7e 7e #ho= the 2011 balance o payent# or the 8nited State# in 'able 'able 1. 'able 1. 4.5. (alane of Payments for 211

Category C!rrent "cco!nt 'otal %
"o!nt G illion#D

"o!nt G illion#D

2,:&4,-:: A+,1:0,:91 A1++,03+ A&93,-29 A&:+,93+ 1,000,--0 +-,010 A1,212 333,1+3 A:-,20: 1

So!rceJ B!rea! o %conoic "naly#i# "naly#i# 2012D

Balance o payent# !#e# the acco!nting do!ble entry #y#te, =here total debit# e>!al total credit#. " payent by 8.S. re#ident, b!#ine##, or go$ernent to another co!ntry repre#ent# a deicit ite or negati$e beca!#e oney i# lea$ing the 8nited State#. Se$eral e!al# total e!ently, ore oney lo=# o!t o the co!ntry than in a# the co!ntry b!y# ore prod!ct# and #er$ice# ro the =orld. F!rtherore, F!rtherore, the c!rrent acco!nt acco!nt incl!de# incl!de# the ite# or #hipping, #hipping, brokerage, brokerage, and in#!rance or the #hip# and airplane# that deli$er the cargo. 'hen econoi#t# add in$e#tent incoe to the 149

Money, Banking, and International Finance c!rren c!rrentt acco!nt acco!nt.. 7e !# !#tt be care! care!ll beca!# beca!#ee in$e#t in$e#te ent# nt# are inanc inancial ial tran#a tran#acti ction# on# that that econoi#t# record !nder the inancial acco!nt. o=e$er, econoi#t# record the incoe ro tho#e in$e#tent# !nder the c!rrent acco!nt. Finally, the c!rrent acco!nt incl!de# !nilateral tran#er# bet=een nation# #!ch a# oreign aid, pri$ate git#, and oney #ent to relati$e# li$ing in another co!ntry. For the 8nited State#, the c!rrent acco!nt balance e>!aled AG&93.- billion in 2011. C!rrent acco!nt i# negati$e beca!#e ore oney let the 8nited State# than entered, ca!#ing a c!rrent acco!nt acco!nt deici deicit. t. S!b#e>! S!b#e>!ent ently ly,, the 8nited 8nited State# State# inanc inance# e# thi# thi# deici deicitt by borro=i borro=ing ng ro oreigner#. C!rrent acco!nt deicit i# large beca!#e the 8nited State# iported ore good# than e!aled G333.1 billion in 2011, and it record# all tran#action# or #tock#, Financial account e>!aled bond#, and real e#tate bet=een the 8nited State# and the re#t o the =orld. I the inancial acco!nt acco!nt i# po#iti$e, po#iti$e, then ore oney lo=ed into the 8nited State# than let, called a inancial inancial inlo=. Con#e>!ently, the 8nited State# borro=# ro oreigner# beca!#e they in$e#ted ore a##et# in the 8nited State# than the ao!nt the 8.S. re#ident# bo!ght oreign a##et#. I the inancial acco!nt i# negati$e, then ore oney i# lo=ing o!t o the 8nited State# than lo=ing in, called a capital o!tlo=. 'h!#, a co!ntry i# lending to oreigner# beca!#e the $al!e o oreign a##et# bo!ght by re#ident# e!ation 1, =hich i# the c!rrent acco!nt pl!# the inancial acco!nt #ho!ld e>!al ero. Balance o ayent# B)D O c!rrent acco!nt X inancial acco!nt O 0

1D

7e !#e !#e %>!ation %>!ation 1 a# an e>!ilibri! e>!ilibri! e>!ation to predict predict change# change# in a co!ntry?# co!ntry?# e!al# ero, then that co!ntry?# e
Kenneth R. S!lcyk 8nited State#@ Con#e>!ently, balance o payent# becoe# negati$e, ca!#ing the 8.S. dollar to =eaken or to depreciate beca!#e the international arket# ha$e a #!rpl!# o 8.S. dollar#. S!b#e>!ently, a =eaker 8.S. dollar ca!#e# the c!rrent acco!nt to #hrink o$er tie a# iport# all =hile e!ilibri!. I the Federal Re#er$e doe# not =ant the dollar to =eaken, then it can b!y the#e 8.S. dollar# by !#ing oicial re#er$e a##et#. a##et#. 'he Federal Re#er$e can inance a balanceAoApayent deicit or red!ce 8.S. dollar# on the international arket by doing one or ore o the ollo=ingJ 

'he Fed co!ld #ell gold to b!y 8.S. dollar#.



'he Fed co!ld #ell oreign c!rrencie# and b!y 8.S. dollar#.



'he Fed co!ld borro= ro oreign central bank#.



'he Fed 'he Fed co!l co!ld d !#e !#e it# it# re#e re#er$e r$e## at the the Inte Interna rnati tiona onall Mo Mone neta tary ry F!nd F!nd or a#k a#k the the International Monetary F!nd or a loan.



'he Fed co!ld !#e Special Special /ra=ing /ra=ing Right# S/R#D. S/R#D. 7e di#c!## di#c!## the !rther !nder the %
%conoi#t# %conoi#t# record oicial re#er$e a##et# !nder the Financial Financial "cco!nt "cco!nt a# the 34S4 7fficial Reserve &ssets. In 2011, the oicial #ettleent# balance =a# a in!# G13.- billion, and =e already incl!ded thi# balance in the inancial acco!nt in 'able 'able 1. 'he Federal Re#er$e paid G13. billion by #elling a##et# to oreign co!ntrie#, =hich =e iteied in 'able 'able 2. %con %cono oi# i#t# t# add add a nonA nonAer ero o ao! ao!nt nt call called ed statistical discrepancy to orce the c!rrent acco!nt pl!# inancial acco!nt to e>!al ero. /i#crepancy ari#e# ro ea#!reent error#, and #oe people and b!#ine##e# do not report re$en!e ro illegal b!#ine##e#, e$ade ta
8.S. oicial re#er$e a##et#

;o ;old Special dra=ing right# Re#er$e po#ition in the International Monetary F!nd Foreign c!rrencie# 'otal

"o!nt G illionD 0 1,432 A1:,04&30 A13,:44

China China and the "#ian "#ian tiger# tiger# =eaken =eaken their their c!rren c!rrencie cie## beca!# beca!#ee they they boo boo#t #t their their e!ently, the#e co!ntrie# e
Money, Banking, and International Finance o!t. 'he go$ernent# can !#e thi# oney inlo= to p!rcha#e 8.S. go$ernent debt, real e#tate, and #tock# and bond# in 8.S. corporation#. 'h!#, the 8.S. debt and trade deicit# go together, and =e di#c!## the !nder the egeony #ection in thi# chapter. F!rtherore, the "#ian co!ntrie# can !#e thi# oney inlo= to b!y achine# and e>!ipent ro de$eloped co!ntrie#, boo#ting their in$e#tent e$en !rther.

The '(change +ate +egimes *ation# ipleent a regie or #y#te to #ettle international payent# ari#ing ro international trade and inance beca!#e nation# !#t !#e a #y#te to #ettle payent# bet=een the#el$e#. 'hi# #y#te i# the e"c#an$e rate re$ime. Fir#t and olde#t e!ently, the central bank agree# to con$ert their c!rrency to gold on deand. For e!ation# 2. 2,000 8.S. dollar# O 1 o!nce o gold

2D

200,000 apane#e yen O 1 o!nce o gold &,000 Briti#h po!nd# O 1 o!nce o gold I the 8.S. central bank =ant# a oney #!pply o G&0 illion, it !#t b!y and hold 20,000 o!nce# o gold, =hich i# G&0 illion V G2,000 per o!nce. For a central bank to boo#t the oney #!pply or grant eergency loan# to bank#, it !#t b!y and #tore ore gold. ;old #tandard orce# i!ently, one 8.S. dollar e>!al# 100 yen or 2 po!nd#. 7e calc!late the e!ation# +. Fir#t, =e #et all c!rrencie# e>!al to one o!nce o gold. 'hen =e di$ide by one c!rrency?# coeicient, yielding the e
=

200,000 yen 2,000

=

+D

&,000 pounds 2,000

$1 = 100 yen = 2 pounds " gold #tandard help# co!ntrie# aintain a ero balance o payent#. For e!ently, 8.S. dollar# are lo=ing o!t o the 8nited State# and into apan. )n 14-

Kenneth R. S!lcyk the other hand, apan acc!!late# 8.S. dollar#, and the apane#e central bank e!al# ero and gold #top# lo=ing o!t o the 8nited State#. %!ently, a gold #tandard a!toatically eliinate# trade deicit# and #!rpl!#e#. ;old #tandard ha# o!r beneit#J /enefit 0' igh inlation rate# =ere rare !nder the gold #tandard beca!#e central bank# had little control o$er the oney #!pply. I a central bank =ant# to increa#e the oney #!pply, then the central bank !#t b!y gold. For e!ently, a gold #tandard con#train# a central bank?# ability to e' ;old #tandard re#trict# coercial bank# and go$ernent. I bank# create too !ch credit, the credit e
I the 8nited State# enter# a rece##ion, the 8.S. con#!er# red!ce their deand or iport# or apane#e prod!ct#. I the 8.S. e
1:0


apan e!ently, the !neployed =orker# b!y e=er good# beca!#e they earn lo=er incoe# and delation ca!#e# apane#e prod!ct# to becoe cheaper. F!rtherore, contractionary onetary policy =o!ld rai#e intere#t rate# that red!ce in$e#tent. Falling in$e#tent =o!ld contract the econoy !rther.



"ll e
"ter 7orld 7ar II, && co!ntrie# ipleented a ne= international #y#te, the /retton ?oods System, =here the delegate# et at a $acation re#ort, Bretton 7ood#, in *e= ap#hire. 'he Bretton 7ood# Sy#te e#tabli#hed i!ently, the Bretton 7ood# Sy#te tran#ored the 8.S. dollar into the international re#er$e c!rrency 'he Bretton 7ood# #y#te =a# ore le!ently, co!ntrie# !#ed a #y#te re#ebling a gold #tandard, b!t a go$ernent can inter$ene =ith it# e!ently, the IMF i# #iilar to a central bank beca!#e a central bank can grant eergency loan# to it# bank# d!ring a inancial panic or cri#i#. 'h!#, the IMF #ho!ld #tabilie international payent# and proote international trade. Moreo$er, the IMF collect# and #tandardie# international econoic data. 'he IMF ha# 1:1 eber# and open# eber#hip to any independent nation#. I a co!ntry =ant# to oin the IMF, then thi# co!ntry contrib!te# capital ba#ed !pon a or!la. " co!ntry pay# oneAo!rth o the capital in gold and threeAo!rth# in that co!ntry?# o=n c!rrency. IMF rela!ireent, and co!ntrie# can pay !#ing #trong 1:1

Kenneth R. S!lcyk c!rrencie# #!ch a# e!ro#, po!nd# #terling, Special /ra=ing Right#, 8.S. dollar#, or yen#. Con#e>!ently, the IMF gain# inancial capital beca!#e the IMF po##e##e# gold and a pool o oreign c!rrencie# that it can lend to co!ntrie#. 'he IMF help# co!ntrie# that are e!ently, the IMF deine# the S/R a# a H!nit o acco!nt, =hich copri#e# one !nction o oney, and it e#tabli#he# e!ently, S/R certiicate# becoe a##et# to the Federal Re#er$e. "ltho!gh the co!ntrie# abandoned the Bretton 7ood# #y#te in 1-41, the 7orld Bank and IMF #till li$e. S!b#e>!ently, go$ernent# !#e a $ariety control#, ea#!re#, and #tandard# or their co!ntryN# c!rrency. ;o$ernent# #peciy the r!le# and liit# ho= people and b!#ine##e# can e
Money, Banking, and International Finance co!r#e, i in$e#tor# are pe##ii#tic abo!t a go$ernent?# ability to anage it# e!ently, in$e#tor# can o$er=hel a go$ernent, orcing it to de$al!e it# c!rrency. 'hen in$e#tor#? e!al three 8"% dirha# beore 200:. )nce the 200: Financial Cri#i# #tr!ck the =orld, 8"% de$al!ed it# c!rrency to one 8.S. dollar to +.94 dirha#. )ther co!ntrie# like Bahaa#, Barbado#, and ong Kong peg their c!rrencie# to the 8.S. dollar =hile Bo#nia and erego$ina and B!lgaria i< their c!rrency to the e!ro. 8nort!nately, a go$ernent !#t inter$ene in the c!rrency arket to aintain it# e!ently, black arket# or or their c!rrencie# beca!#e the black arket price relect# the tr!e arket $al!e. " go$ernent can !#e a pegged e!ently, dollariation allo=# a co!ntry to integrate it# econoy =ith 8nited State# or the %!roone by tying it# inlation rate to that co!ntry. /ollariation al#o reo$e# the e!ently, the#e co!ntrie# =o!ld aintain #table e
Financing Balance6of6/ayments Deficits and Surpluses %
Kenneth R. S!lcyk call a Hdeicit =ith tear# beca!#e a central bank or go$ernent !#t !#e it# re#o!rce# to inance it. )n the other hand, a balanceAoApayent# #!rpl!# allo=# a go$ernent or central bank to acc!!late oreign a##et#. Fi!ently, the deand or that co!ntry?# c!rrency =eaken# and depreciate#. For the go$ernent or central bank to aintain the i!ently, that co!ntry ha# a #hortage o c!rrency on the oreign e!ently, it# e
1:&


Figure 1. '$e A#ur*e Effet

Mo#t co!ntrie# !#e a anaged loat, =here a go$ernent or central bank $arie# the intere#t rate to inter$ene in the oreign e!ently, the central bank contract# the oney #!pply, boo#ting the intere#t rate. *e!al# ero again. " central bank or go$ernent can inance a balanceAoApayent# #!rpl!# ea#ily !nder a anaged loat #y#te. Central bank e!ently, the inancial acco!nt all# !ntil the balanceAoA payent# #!rpl!# approache# ero. " co!ntry can ha$e diic!ltie# inancing a balanceAoApayent# deicit or all e!ently, a go$ernent ight ipo#e oreignAe!ickly =ithdra= in$e#tent# ro a co!ntry. 'hey belie$e they =ill lo#e their in$e#tent# and they rapidly ca#h o!t, ca!#ing a a##i$e inancial acco!nt o!tlo=. " capital light i# #iilar to a bank r!n, =here all the depo#itor# appear at their bank to =ithdra= oney ro their acco!nt#, b!t capital light i# a bank r!n on a =hole nation. 8nort!nately, capital light ca!#e# proble# or a go$ernent beca!#e it co!ld depreciate a c!rrency rapidly. For e
Kenneth R. S!lcyk panicked and >!ickly =ithdre= their in$e#tent#, #parking a cri#i#. 'hen the cri#i# #parked a contagion. In$e#tor# >!e#tioned their in$e#tent# in other co!ntrie#, #preading the cri#i# to ong Kong, Indone#ia, (ao#, Malay#ia, So!th Korea, and the hilippine# a# a##i$e capital lo=# let the co!ntrie#. )ther co!ntrie# de$a#tated by capital light incl!ded Me
International in$e#tor# tran#er their ca#h o!t o the co!ntry $ia bank tran#er#. )nce the capital o!tlo= becoe# #e$ere, then go$ernent ay ipo#e capital control# on the bank# to liit o!tlo=#.



In$e#tor# co!ld #!ggle c!rrency o!t o the co!ntry. 'hen they depo#it it into bank# in their hoe co!ntry or to an o#hore acco!nt. " go$ernent can tighten #ec!rity at airport# and #eaport#, and c!#to# can #eie c!rrency i they catch any tra$eler =ho carrie# too !ch ca#h.



In$e#tor# co!ld con$ert their c!rrency to precio!# etal#, #!ch a# gold, #il$er, or platin!. 'hen they #!ggle the etal# o!t#ide o the co!ntry.



In$e#tor# co!ld !tilie oney la!ndering that !#e# any techni>!e# to #tr!ct!re ca#h depo#it# into the banking #y#te, hiding the in$e#tor#? acti$itie#. In$e#tor# co!ld !tilie al#e in$oice# i they deal =ith an iporter. For e
7egemony " nation can e
Money, Banking, and International Finance b!#ine##e#, and people operate !nder the international in#tit!tion#. Soe nation# po##e## #tr!ct!ral po=er to aect the international in#tit!tion# and change the r!le# in it# a$or. 'he 8nited State# po##e##e# both relational and #tr!ct!ral po=er#. It gained both po=er# ater 7orld 7ar II. 'he 8nited State# lead# co!ntrie# in technology, ha# the =orld?# large#t econoy, and po##e##e# a #trong ilitary. F!rtherore, the 8.S. ha# the #tr!ct!ral po=er to inl!ence the 7orld Bank and the International Monetary F!nd. ) co!r#e, the 8nited State# helped create the#e in#tit!tion# and becae a large inancial contrib!tor. " #e$emony e
Kenneth R. S!lcyk oreigner# #a$e their earning# in 8.S. dollar# =hile other# in$e#t in the 8.S. go$ernent?# debt. "gain, they are b!ying 8.S. 'rea#!ry Sec!ritie#, =hich are piece# o paper. For no=, the#e piece# o paper ha$e $al!e, b!t #oe >!e#tion =hether the 8.S. go$ernent can inance the d!al deicit# o$er a long tie period. I the 8.S. dollar collap#e# in $al!e, then oreigner# =ill po##e## =orthle## piece# o paper. Con#e>!ently, co!ntrie# that are not hegeonie# cannot acc!!late a large go$ernent debt by getting oreigner# to in$e#t in it. "# the 8nited State# gre= into a hegeony, it cannot ha$e a c!rrent acco!nt #!rpl!# beca!#e the #!rpl!# co!ld de$a#tate the =orld?# econoy. International b!#ine##e#, bank#, and go$ernent# !#e 8.S. dollar# to #ettle international payent#. I the 8.S. c!rrent acco!nt approached ero, then a li>!idity cri#i# =o!ld #trike the =orld beca!#e people, b!#ine##e#, and the go$ernent ha$e no ean# to #ettle international payent#. " hegeony?# trade deicit# becoe a oney #o!rce or the =orld?# econoy.

Key Terms c!rrent acco!nt inancial acco!nt balanceAoApayent# e>!ation 8.S. )icial Re#er$e "##et# #tati#tical di#crepancy e
ree loat clean loat anaged loat dirty loat pegged e
Chapter Questions 1

%
1+&. lea#e deine the ollo=ing ter#J c!rrent acco!nt, trade balance, inancial acco!nt, and oicial #ettleent balance. 1+3.

7hy doe# a #tati#tical di#crepancy occ!r in the balanceAoApayent# acco!nt#@

1+9.

lea#e deine and di#ting!i#h the three e
1+4.

Identiy the !nction# o the 7orld Bank. 1::

Money, Banking, and International Finance 1+:.

Identiy the !nction# o the IMF.

1+-. I a co!ntry ha# a i
%
1&1. I a co!ntry ha# a anaged loat e
1(.

The Forei-nCrrency !chan-e ate Mar&ets

Many co!ntrie# acro## the =orld !#e a le!ently, thi# chapter b!ild# !pon a arketN# c!rrency e
Foreign '(change +ates Forei$n*currency e"c#an$e market i# trader# e!ently, i$e partie# need oreign c!rrency. Fir#t, international bank# #pecialie in oreign c!rrencie#. 'hey tran#er billion# in oreign c!rrencie# =ith other bank#. Second, any per#on or b!#ine## engaged in international trade and coerce, e#pecially iport# and e
1:-

Kenneth R. S!lcyk e!al# +.0 Malay#ian ringgit# or G1 O + rD. o= !ch =o!ld a oneAliter o CocaACola co#t# in dollar# i CocaACola co#t# 1.3 r@ !#t !ltiply the ringgit price by the ratio G1  + rD in %>!ation 1, =hich e>!al# G0.30.

 $1  = $0.30   +.0rm 

1.3rm

1D

In$e#tor# and banker# can calc!late an e!al# 12.- pe#o# per G1, and the e!roA 8.S. dollar i# Y 0.44 per G1, #!b#e>!ently, =e calc!late the pe#oAe!ro e!ation 2 a# 19.: per Y. 7e !#e a trick  =e retain the c!rrency !nit#L th!#, the correct calc!lation ha# one o the c!rrency !nit# drop o!t, =hich i# 8.S. dollar# in thi# ca#e. G1  19.:p  12.- p    =     Y G 1 Y 0 . 44    

2D

8#ing another e!al# 2:2.9 Myanar kyat#, then =e !#e the 8.S. dollarA 1-0

Money, Banking, and International Finance e!ently, =e calc!late the 8.S. dollarAkyat e!ation + a# :&4.: kyat# per G1.

 2:2.9 k   + r  :&4.: k   =   G1  G1 1 rm   

+D

C!rrency e
G1.3&  1 `

Credit S!i##e

Y 1.9  1 `

/e!t#che Bank

G0.-4  1 Y

Fir#t, =e calc!late the cro## rate bet=een Citibank and Credit S!i##e in %>!ation &, =hich e>!al# G0.-923 per one e!ro. 'hen =e copare thi# e!aling G0.-4 per one e!ro. Since the e
 G1.3&   1`  G0.-923     Y 1.9   = Y 1 1 `    

&D

5tep 1: 'rader con$ert# the 8.S. dollar# to Briti#h po!nd# at Citibank, yielding 9&,-+3.09 `. 7e calc!late the re#!lt in %>!ation 3.

 1 `  = 9&,-+3.09 `   G1.3& 

G100,000

3D

5tep 2: 'rader con$ert# the Briti#h po!nd# into e!ro# at Credit S!i##e, yielding 10+,:-9.10 Y. 7e cop!te the ao!nt in %>!ation 9.

 Y1.9   9&,-+3.09 `   = 10+,:-9.10 Y 1 `  

9D

1-1

Kenneth R. S!lcyk 5tep 3: Finally, the trader con$ert# the e!ro# into 8.S. dollar# at /e!t#che bank. 'rader ha# G100,44-.22 and gain# a G44-.22 proit. 7e calc!lated the re#!lt# in %>!ation 4. "# the trader con$ert# oney ro one c!rrency to another, he #i!ltaneo!#ly create# deand and #!pplie# or c!rrencie#. )$er tie, the price dierence# bet=een e!ickly e
 G0.-4    = G100,44-.22 1 Y  

10+,:-9.10 Y 

4D

Demand and Supply for Foreign Currencies /eand !nction or a c!rrency originate# ro international trade bet=een Malay#ia and the 8nited State#. rice or Malay#ian ringgit# i# the e
1-2

Money, Banking, and International Finance 5!antity o ringgit#

Figure 1.
7e #ho= the e!ation# :. 7e =rite the c!rrency price ir#t =hile the #tandard e
or

G1 O +.0 r

oint BJ G0.23 per 1 ringgit

or

G1 O &.0 r

:D

S!pply !nction or ringgit# originate# ro the Malay#ian con#!er# =ho b!y 8.S. prod!ct#. 8.S. ir# #ell prod!ct# and #er$ice# to Malay#ian con#!er#, =hich are 8.S. e!ently, they ha$e a deand or dollar#, con$erting ringgit# to 8.S. dollar# #!pply ringgit# on the e!ently, the ringgit appreciated =hile the 8.S. dollar depreciated. rice o 8.S. good# becae cheaper =hile Malay#ian good# becoe ore e
5!antity o ringgit#

Figure 2. 5upply funtion for ringgits

1-+

Kenneth R. S!lcyk 7e #ho= the deand and #!pply !nction# or ringgit# in Fig!re +. 7e repre#ent the e>!ilibri! e!ilibri! >!antity a# 5[. "# an ill!#tration, "erican# increa#e their deand or ore Malay#ian prod!ct#, ceteri# parib!#. 'h!#, the deand !nction increa#e# and #hit# right=ard. rice o ringgit# increa#e#. Con#e>!ently, the 8.S. dollar depreciate# =hile the ringgit# appreciate#. 8.S. prod!ct# becoe cheaper to Malay#ian#. 8.S. e
5!antity o ringgit#

Figure 3.
%
Factors that Shift Demand and Supply Functions Many actor# inl!ence #!pply and deand !nction# or oreign e
Money, Banking, and International Finance Malay#ian ringgit e!antity are [ and 5[. I Malay#ia ha# a greater real intere#t rate than the 8nited State#, then 8.S. in$e#tor# increa#e their deand or ringgit#L they =ant to earn the greater intere#t rate. /eand or ringgit# ri#e# and #hit# right=ard. F!rtherore, Malay#ian citien# in$e#t ore =ithin their co!ntry, decrea#ing the #!pply o ringgit# on the international arket#. 7hen the #!pply and deand both #hit, either the arket >!antity or price becoe# indeterinate. In thi# ca#e, arket price increa#e# =hile arket >!antity becoe# indeterinate. Con#e>!ently, the 8.S. dollar depreciate# =hile the ringgit appreciate#. 7e can !#e a trick to deterine =hich $ariable becoe# indeterinate. Fir#t, #hit the deand !nction. 'hen dra= three #!pply !nction #hit#, =here the ir#t one #hit# a little, the #econd #hit# a little ore, and the third #hit# a lot. Con#e>!ently, one $ariable al=ay# o$e# in one direction =hile the other can increa#e and decrea#e, aking it indeterinate. Inlation rate# o co!ntrie# co!ld ipact the oreign e!antity are [ and 5[. igher inlation rate ca!#e# the price# o Me!ently, the 8.S. dollar appreciate# =hile the pe#o depreciate#. In thi# ca#e, the e>!ilibri! >!antity or 8.S. dollar# becoe# indeterinate. rice o ringgit# G per ringgit

5!antity o ringgit

Figure !. 8mpat of $ig$er interest rates on t$e ringgit ex$ange market

rice o 8.S. dollar

1-3

Kenneth R. S!lcyk e#o# per 8.S. dollar

5!antity o 8.S. dollar#

Figure ,. 8mpat of inflation on t$e 4.5. dollar ex$ange market

" central bank can increa#e or decrea#e the #!pply o it# c!rrency on the oreign e!antity. 'he Federal Re#er$e Sy#te, the 8.S. central bank, increa#e# the 8.S. dollar# on the international e!ently, the #!pply !nction increa#e#, #hiting right=ard, decrea#ing the arket price. 'h!#, the 8.S. dollar depreciate# =hile Malay#ian ringgit appreciate#. rice o 8.S. dollar Ringgit# per 8.S. dollar


Figure -. '$e Federal Reser*e inreases t$e supply of dollars on t$e ex$ange market

1-9

Money, Banking, and International Finance " central bank hold# oreign c!rrencie#. I a central bank =ant# to #trengthen it# c!rrency, it !#t b!y it# c!rrency !#ing a oreign c!rrency. Con#e>!ently, a central bank?# cache o oreign c!rrencie# =o!ld decrea#e. I a central bank =eaken# it# c!rrency, #!b#e>!ently, it b!y# oreign c!rrencie# !#ing it# o=n c!rrency. ence, a central bank acc!!late# ore oreign c!rrencie#. 'he key i# #carcity. I the e!ently, in$e#tor#, central bank#, and people $al!e it ore. I in$e#tor# belie$e a c!rrency =ill depreciate, then their belie# becoe #elA!lilling prophecie#. For e!ently, the in$e#tor# red!ce their deand or 8.S. dollar# and #hit the deand let=ard, decrea#ing the e

Figure . 8n*estors derease t$eir demand for 4.5. dollars

In the real =orld, any actor# inl!ence e!ota#. " tari i# a ta< on iport#, =hile a >!ota liit# the >!antity o iport#. Both trade barrier# red!ce a co!ntry?# iport#. F!rtherore, #oe co!ntrie# co!ld 1-4

Kenneth R. S!lcyk ipo#e #trict reg!lation#. %
Fi(ed '(change +ates Central bank# in #e$eral co!ntrie# e#tabli#hed a fi"ed e"c#an$e rate =ith a #trong c!rrency, #!ch a# the 8.S. dollar or e!ro. " i!ently, a central bank allo=# the arket to change the e!ire# a cache o c!rrency re#er$e#. 'he 8nited "rab %irate# 8"%D pegged it# c!rrency e!al# three dirha#. "# an ill!#tration, the international in$e#tor# red!ce their deand or the dirha#, decrea#ing the e!ently, the 8"% central bank !#t b!y dirha# ro the c!rrency e
rice o /irha# G# per dirhaD

5!antity o /irha#

Figure /. '$e urreny Ex$ange arket for
1-:

Money, Banking, and International Finance rice o /irha# G# per dirhaD

5!antity o /irha#

Figure 0. + entral bank inter*enes in t$e urreny market

'=o iportant ter# are a##ociated =ith a pegged e!ently, =e call it a devaluation. " co!ntry e!e#tion their in$e#tent# in other co!ntrie#, #preading the cri#i#. 'he Bank o International Settleent# and International Monetary F!nd IMFD bailed o!t Me
Kenneth R. S!lcyk S!b#e>!ently, the cri#i# becae a contagion, #preading to Indone#ia, Malay#ia, the hilippine#, and So!th Korea a# in$e#tor# >!e#tioned their in$e#tent in tho#e co!ntrie#. Cri#i# contin!ed to #pread !ntil it reached R!##ia and Brail. 8nort!nately, all the co!ntrie# e!ickly dea!lted. )nce their hoe c!rrency began depreciating, they co!ld not aord to repay their oreign debt. 'he IMF bailed o!t Indone#ia, So!th Korea, and 'hailand. "# part o loan condition#, the co!ntrie# ipo#ed a!#terity. &usterity i# the go$ernent !#t red!ce go$ernent #pending andor rai#e ta!ently, both co!ntrie# co!ld ipo#e a i
Key Terms oreignAc!rrency e
pegged e
Chapter Questions 1

8nited "rab %irate# !#e# the dirha a# it# c!rrency. o= !ch doe# a ep#i co#t# in dirha# i ep#i co#t# G0.43 =ith an e
1&&. lea#e calc!late the cro##Arate e
Money, Banking, and International Finance KM to e!ro#J KM 2  1 Y %!ro# to 8.S. dollar#J Y 0.41&  1G 1&3. " trader at Citibank ha# 300,000 Bo#nian con$ertible ark# KMD and ob#er$e# the ollo=ing e
Y 1 2 KM k!na 100  Y 1 k!naJ &9  1 KM

lea#e note the k!na i# the CroatiaN# c!rrency. lea#e calc!late the cro## rate to deterine i arbitrage e
201


1*.

$nternational Parity Conditions

S!pply and deand analy#i# allo=# in$e#tor# and econoi#t# to predict directional change# in a co!ntryN# e!antitati$e change#. Con#e>!ently, thi# chapter b!ild# on the #!pply and deand analy#i# and !#e# #e$eral theorie# to predict >!antitati$e change# in a co!ntryN# c!rrency e
! +andom #alk C!rrency arket e!ation 1. 6al!e o the #pot e!al# ye#terdayN# e!al# G1.+ per e!ro today, then =e e
s t =s t −1 + e t

1D

7e #ho= the onthly 8.S. dollarAe!ro e!e characteri#tic  the $ariable drit# in a partic!lar direction beore changing direction. I =e take a ir#t dierence o the e!al# the rando di#t!rbance, ill!#trated in %>!ation 2. " ir#t dierence i# =e take todayN# #pot e
s t −s t −1= et

2D

1 'he 8.S. dollarAe!ro e
−

Money, Banking, and International Finance "ltho!gh c!rrency e
Figure 1. '$e 4.5. dollar#per euro ex$ange rate

0.08

0.03

-0.02

-0.07

-0.12

Figure 2. First differene of t$e 4.5. dollar per euro ex$ange rate

20+


/urchasing /o*er /arity 8///9 Theory Purc#asin$ Po!er Parity (PPP) -#eory i# ba#ed on the (a= o )ne rice. ;ood# and prod!ct# denoinated in the #ae c!rrency #ho!ld ha$e the identical price bet=een arket# ater ad!#ting or tran#portation co#t#. I a price dierence e!ently, price# =o!ld con$erge to one price acro## all arket# a# trader# #hited #!pply ro the lo=Aprice arket to the highAprice arket. 'he high price# =o!ld all =hile the lo= price# =o!ld ri#e o$er tie. rice co!ld dier bet=een arket# beca!#e the price dierence relect# the tran#portation co#t# o #hipping the prod!ct ro one arket to another. *e$erthele##, the !rcha#ing o=er arity help# predict change# in e!al# G-0 per barrel in the 8nited State# and :30 pe#o# per barrel in Me!al# one 8.S. dollar e>!al# -.&&& Me!ently, the trader# co!ld b!y petrole! ro Me!ilibri! e
/oe#tic price le$el or hoe co!ntry e>!al#  d.



Foreign price le$el e>!al#   .



Spot e!al# S.

7e deine the ab#ol!te  e!ation +. / =

P . P d

+D

For e!al# G433.+ =hile the CI or S=iterland i# 1,2&1.2 ranc#. 'h!#, the ab#ol!te  predict# the e!ation &. 20&


/ =

P . P d

=

1,2412 .rancs $553

=

14 .rancs G1

&D

I the #pot e!ently, trader# !#e arbitrage. 'he CI in the 8nited State# in ranc# i# 1,034.&2 or G433.+ W 1.& ranc# per G1D, =hich i# #aller than the CI o S=iterland. 'h!#, trader# co!ld proit by p!rcha#ing a ba#ket o good# ro 8nited State# and #elling it to S=iterland. 'h!#, they potentially earn 1,2&1.20  1,034.&2 O 1:+.4: ranc# per ba#ket o good#. $4e Economist p!bli#he# the /i$ .ac Inde" , ba#ed on the !rcha#ing o=er arity. Mc/onald?# #ell# Big Mac# in o$er 12+ co!ntrie# aro!nd the =orld. 'he Big Mac re>!ire# any ingredient# like bee, b!n#, lett!ce, toatoe#, onion#, and it# #pecial #a!ce. F!rtherore, re#ta!rant# pay labor, retail #pace, and !tilitie# like =ater, electricity, and nat!ral ga#. Con#e>!ently, a Big MacN# price correlate# to the price# o it# inp!t#, and the inp!t# repre#ent a $ariety o #ector# in a co!ntry?# econoy. 'h!#, the price o a Big Mac relect# a co!ntry?#  that =e #ho= or 10 co!ntrie# in 'able 1. Finally, #oe analy#t# de#igned a Starb!ckN# Inde< #iilarly to the Big Mac Inde<. 'able 1. '$e Eonomist)s (ig a 8ndex for 2, Co!ntry

Big Mac rice Iplied  %
'he Big Mac price i# denoinated in 8.S. dollar#, and =e con$ert it to 8.S. dollar# !#ing the #pot e!ently, =e co!ld earn a proit by b!ying Big Mac# in Malay#ia or G2.++ and #elling the hab!rger# in the 8nited State# or G&.++. o=e$er, =e !#t pay tran#portation co#t# and =o!ld e!ickly #poil beore they reached their de#tination. 203

Kenneth R. S!lcyk 7e can calc!late the Big Mac ea#ily. For e!al# 1.41 ringgit# per 8.S. dollar. o=e$er, the #pot e!al# +.14 ringgit# per 8.S. dollar. Con#e>!ently, =e e#tiate in %>!ation 3 that the Malay#ian ringgit i# !nder$al!ed to the 8.S. dollar by appro
P %al aysi a − P  . / . P  ./ .

⋅100 =

$2.++ − $&.++ $&.++

100 O A&9K

3D

In general, the  tend# to hold in the long r!n, b!t not the #hort r!n beca!#e o the ollo=ing rea#on#J 

Co!ntrie# ipo#e trade re#triction#, #!ch a# tari# and >!ota#. Moreo$er, any go$ernent# ipo#e trade re#triction# on agric!lt!ral prod!ct#. Co!ntrie# !#e trade re#triction# to protect their ind!#trie# ro bacteria, $ir!#e#, in#ect#, or a daaging plant# or #pecie#. For e


 epha#ie# only price le$el# and e


 =ill not hold i go$ernent# deine dierent ba#ket# or their CI#. F!rtherore, #oe good# and #er$ice# are not tradable, #!ch a# hairc!t#, edical #er$ice#, and real e#tate. For e!ently, the b!#ine##e# pa## the greater co#t onto prod!ct#? price#.

'he Relative Purc#asin$ Po!er Parity -#eory i# change# in prod!ct#? price# bet=een co!ntrie# $ary the e
7e deine the change in the doe#tic e


Foreign co!ntry?# inlation rate bet=een no= and tie period ' i# π .

209


/oe#tic co!ntry?# inlation rate bet=een no= and ' i# πd.



S' and S0 are the doe#tic e
Change in the c!rrency e!ation, #ho=n in %>!ation 9. P . 1& ) . e=

/  − / 0 / 0

=

P d (1& ) d ) P .

−

P . P d

=

1& ) . 1& ) d

−1

P d

9D

7e !#e a linear appro!ation 4. e ≈ ) . − ) d

4D

For e!al# + =hile Me!ently, the relati$e  !#!ally hold# in the long r!n or co!ntrie# =ith large inlation rate dierence#. Co!ntrie# e!ation 9 and re=rite it a# %>!ation :. e=

1& ) . 1& ) d

−1 :D

'hen =e add a po#iti$e one to both #ide# o the e>!ation and then di$ide by e  1D to yield %>!ation -. 1=

1& ) .

(1& ) d )(1 + e)

-D 204

Kenneth R. S!lcyk 'hen =e replace the one =ith a k that repre#ent# the copetiti$e ratio. For e!ently, =e calc!lated the copetiti$ene## ratio or Malay#ia, =here k O 0.-:1 in %>!ation 10. Con#e>!ently, o!r calc!lation doe# not e>!al one, and the higher inlation rate and the depreciating c!rrency keep Malay#ian an!act!ring copetiti$e, boo#ting it# e
1& ) .

=

1 + .02

(1& ) d )(1 + e) (1 + .03)(1 − .01)

= 0.-:1 10D

R!le or the copetiti$ene## ratio i# a k greater than one indicate# a co!ntry?# e
Quantity Theory of Money 7e can !#e the 9uantity -#eory of .oney to e!ation 11, and =e deine e$ery ter a#J 

/eand or oney e>!al# M /.



7e denote the price le$el by .



" co!ntryN# real incoe i# , and econoi#t# ea#!re real incoe by a co!ntry?# real ;/. Moreo$er,  W  repre#ent# a co!ntry?# noinal ;/.



8ni>!e ter i# the $elocity o oney, 6.

D

11D

M ∙ V = P ∙Y

eopleN# deand or oney !#t e>!al the #!pply o oney. 7e denote the #!pply o oney by MS and #!b#tit!te it into the e>!ation. S!pply and deand or oney !#t e>!al each other beca!#e a central bank inect# oney into the econoy that the p!blic !#e#. !blic cannot !#e oney that the central bank doe# not #!pply. 'he intere#t rate en#!re# the #!pply and deand o oney e>!al each other. F!rtherore, =e #ol$e or the $elocity o oney, #ho=n in %>!ation 12. ( =

P ⋅ # % /

12D 20:


For e!al# G13 trillion or  W , and the oney #!pply i# G1 trillion, then the $elocity o oney e>!al# 13. Con#e>!ently, each 8.S. dollar i# circ!lated in the econoy 13 tie# d!ring the year. 7e can #!b#tit!te the 5!antity 'heory o Money into the !rcha#ing o=er arity %>!ation, yielding %>!ation 1+. rice le$el or the 8nited State# i# in the n!erator =hile the price le$el or the %!roone i# in the denoinator. 'h!#, the e!al# 8.S. dollar# per e!ro. / =

P / P euro

=

/ % / ( / # euro / % euro ( euro# /

1+D

%conoi#t# !tilie a atheatical trick to con$ert the ab#ol!te le$el# o %>!ation 1+ into percentage change, yielding %>!ation 1&. 7e #=itched the $ariable# to lo=er ca#e =ith a dot abo$e each one to indicate a percentage change or that $ariable. / /  / − m  euro ) + ( v/ − v euro ) + ( y  euro − y  / ) s = ( m

1&D

%conoi#t# can apply %>!ation 1& to any #it!ation#. For e!al eroD, #!b#e>!ently, the e!ro #ho!ld appreciate by 2 again#t the 8.S. dollar. Con#e>!ently, the higher real incoe and a #lo=er e
International Fisher 'ffect 'he Fis#er 6ffect relate# the noinal intere#t rate to the rate o inlation and real intere#t rate. 7e deine the ter# a# the ollo=ingJ   

Real intere#t rate e>!al# r. *oinal intere#t rate e>!al# i. %!al# π.

7e deine the Fi#her %ect by %>!ation 13J

i + 1=( 1 + r ) ( 1+ π )

13D 20-

Kenneth R. S!lcyk Many econoi#t# !#e algebra to red!ce the Fi#her %ect to %>!ation 19, =hich becoe# an appro
i =( 1 + r ) ( 1+ π )−1=1 + r + π + rπ −1 ≈ r + π

19D

"# long a# the e!al# 3, #!b#e>!ently, the real intere#t rate i# appro!ently, all price# in a #ociety ri#e by 10 =hile yo!r noinal in$e#tent only gre= by 3. 8nort!nately, a per#on acing thi# #cenario =o!ld lo#e nearly 3 o hi# or her p!rcha#ing po=er e$ery year. 'he International Fis#er 6ffect relate# the real intere#t rate to a noinal intere#t rate in a oreign co!ntry. 7e b!ild !pon the (a= o )ne rice or inancial tran#action#. For in#tance, international in$e#tor# #ho!ld earn coparable ret!rn# in oreign co!ntrie# a# copared to their hoe co!ntry ater =e ad!#t their ret!rn# to a c!rrencyN# e
/oe#tic noinal intere#t rate in "R i# i d, =hile r d repre#ent# the doe#tic rate o ret!rn o the in$e#tent in ' day#.



Foreign noinal intere#t in "R rate or an in$e#tent or ' day# i# i  .



ercent change in the e
7e deri$e the International Fi#her %ect =ith %>!ation 14. /oe#tic ret!rn i# the intere#t rate earned by a G1 in$e#tent in a oreign bank acco!nt ater ' day# o at!rity con$erted into the doe#tic co!ntry?# c!rrency. I the doe#tic c!rrency i# appreciating, a po#iti$e e, then thi# =eaken# the ret!rn on the oreign in$e#tent, aking r d #aller. )n the other hand, i the doe#tic c!rrency i# depreciating, a negati$e e, #!b#e>!ently, the ret!rn# to the oreign in$e#tent becoe greater. 'h!#, both the oreign intere#t rate and change o c!rrency e
 

(1 + r d )(1& e) = 1& i .

  +90  

14D

In$e#tor can in$e#t in hi# hoe co!ntry or ' day#. 7e calc!lated hi# ret!rn on hi# hoe bank depo#it in %>!ation 1:. 210

Money, Banking, and International Finance r d = id



+90

1:D

"n international in$e#tor i# indierent bet=een in$e#ting =ithin hi# hoe co!ntry or in$e#ting in a oreign co!ntry. Con#e>!ently, arbitrage dri$e# the rate o ret!rn# together. Fir#t, =e #ol$e %>!ation 14 or r d. 'hen =e #et %>!ation# 14 and 1: e>!al to each other beca!#e international arbitrage ca!#e# both in$e#tent ret!rn# to con$erge to the #ae rate, #ho=n in %>!ation 1-. r d = id



+90

 

= 1& i .

 1 − 1  +90  (1& e) 

1-D

'hen =e #ol$e or e, yielding %>!ation 20. 1& i . e=

1& id



+90 

−1

+90

20D

I the intere#t rate# are lo=, then =e can !#e a linear appro!ation 21. e ≈ ( i . − id )



+90

21D

'he International Fi#her %ect let# analy#t# and econoi#t# #ol$e or e>!ilibri! e!ilibri! occ!r# =hen no capital lo=# ro one co!ntry to another. )nce in$e#tor# ha$e e!ently, the e!al# i  O 12. I an in$e#tent period i# -0 day#, #!b#e>!ently, =e !#e the International Fi#her %ect to predict the e!ation 22. e ≈ (i .

− id )



+90

≈ ( 0.12 − 0.0+)

-0 +90

≈ 0.0223

22D

Re#!lt #ee# co!nterint!iti$e beca!#e =e e!ently, that co!ntryN# 211

Kenneth R. S!lcyk c!rrency #ho!ld appreciate in the #hort r!n. o=e$er, a co!ntry =ith a greater intere#t rate =o!ld e!ation# 20 and 21 are longAr!n e>!ilibri! e>!ation#. For the #econd e!ently, the Me
Fidelity borro=ed !nd# ro the 8nited State# at i d O 3 and in$e#ted in Me!al# one year.



Fidelity con$erted 8.S. dollar# to Me
7e cop!te FidelityN# e!ation 2+.

 

r d =  1 & i .

 1 − 1 =  1 & 012 30  1 − 1 = 0.0    30  ( 1 & e ) 30  ( 1 + 005)  

2+D

Fidelity borro=ed !nd# ro a 8.S. bank at 3 that =e calc!lated in %>!ation 2&. r d = id

 30

= 005

30 30

= 0 .0 5

2&D

7e calc!late the e!ila /e$al!ation. Fidelity !#ed a #trategy called an uncovered position beca!#e Fidelity e
212


Interest +ate /arity Theorem In$e#tor# !#e Interest Rate Parity -#eorem to price or=ard contract#. " or=ard contract?# price originate# ro intere#t rate dierence bet=een co!ntrie#. Con#e>!ently, international in$e#tor# o$e inancial capital into co!ntrie# =ith higher intere#t rate#. 7e can e
/oe#tic noinal intere#t rate in "R e>!al# i d =hile the rate o ret!rn i# r d.



Foreign noinal intere#t rate in "R i# i =hile the oreign rate o ret!rn e>!al# r  .



C!rrency #pot e


For=ard contract i##!ed today at tie t or c!rrency deli$ery on a !t!re #peciic date on ' i# F.

International in$e#tor# !#e arbitrage to price a or=ard contract. "n in$e#tor in$e#t# G1 =ithin the 8nited State# or ' day# and earn# the doe#tic intere#t rate. 7e cop!te hi# or her rate o ret!rn in 8.S. dollar in %>!ation 23.

 

r d + 1 = 1 & id

  30  

23D

In$e#tor belie$e# Malay#ia oer# better in$e#tent opport!nitie# and in$e#t# in Malay#ia or ' day#, earning the oreign intere#t rate. Con#e>!ently, the in$e#tor e!al# 8.S. dollar# per Malay#ian ringgit, denoted by S. Rate o ret!rn o the Malay#ian in$e#tent yield# %>!ation 29 beca!#e the intere#t and principal are denoinated in ringgit#.

 1& i   ⋅ 1  .  +90   /

29D

"t tie t, the in$e#tor b!y# a 'Aday or=ard contract to e!ation 24.

 

r . + 1 = 1 & i .

 ⋅ '  30  / 

24D 21+


In$e#tor i# indierent bet=een in$e#ting in the 8nited State# and Malay#ia. Con#e>!ently, the in$e#tor# !#e arbitrage to in$e#t in 8nited State# and Malay#ia !ntil the rate# o ret!rn or both co!ntrie# con$erge to the #ae rate. 'h!#, =e can #et the t=o in$e#tent# e>!al to each other, yielding %>!ation 2:. r . + 1 = r d + 1

2:D

'       1& i .  = 1& id  +90   +90  /  Sol$ing or the or=ard contract yield# %>!ation 2-J

 1& i    d  +90  ' = /   1& i    .  +90  

2-D

7e can !#e an appro!ation in %>!ation +0.

 

' ≈ / 1& ( id − i . )

 +90  

+0D

7e can deri$e another e>!ation to #ol$e or the intere#t rate#, yielding %>!ation +1. ' − / /

≈ ( id − i . )

 30

+1D

For e!al# G0.++++ per ringgit, then =e price a #i!ality. I the intere#t rate# dier bet=een t=o co!ntrie#, the co!ntry =ith a higher noinal intere#t rate !#t greater inlation that =o!ld depreciate it# c!rrency. 'hereore, thi# analy#i# a##!e# a co!ntry =ith a higher intere#t rate po##e##e# a depreciating c!rrency. 7e can re$er#e o!r logic to yield an identical e>!ation to %>!ation 2-. "t tie t, =e borro= ro a oreign bank one !nit o a oreign c!rrency or ' day#. 7hen =e repay the bank loan on 'ie ', =e pay the oreign bank the ollo=ing !nit# o the oreign c!rrency in %>!ation +2. 21&


 1& i    .  +90  

+2D

"t tie t, =e e!ation ++J

 

/  1 & id

  30  

++D

"t tie t, =e b!y a 'Aday or=ard contract to e!ation +&. /     1 & id  '  30 

+&D

'hi# #trategy i# not proitable i at tie ', the ao!nt =e recei$e in oreign c!rrency i# le## or e>!al to than =e pay or the oreign c!rrency. 'h!#, arbitrage en#!re# =e #et the #o!rce o !nd# ro the oreign co!ntry e>!al to the !#e o the !nd# or the doe#tic co!ntry, yielding %>!ation +3. /        1 & id  =  1 & i .  '  30   30 

+3D

7e #ol$e or F to obtain %>!ation +9, =hich i# the #ae a# %>!ation 2-. Con#e>!ently, t=o dierent #cenario# yield the #ae e>!ation.

 1 & i    d  30   ' = /  1 & i    .  30  

+9D

"rbitrage ad!#tent proce## can be #lo=, and rate# o ret!rn# can dier bet=een co!ntrie#. 'h!#, international in$e#tor# can e
Kenneth R. S!lcyk or=ard contract e>!al# G0.0120 per yen. "ltho!gh the doe#tic co!ntry i# the 8nited State# or thi# in$e#tor, =e re$er#ed the e!ation +4. %!al# 2, =hich i# identical to the 8.S. intere#t rate.

 

r d = 1 & id

 −1 =  1 & 0.02 +90  − 1 = 0.02    30  30   

+4D

In$e#tor calc!late# the rate o ret!rn or hi# apane#e in$e#tent in %>!ation +:. "n in$e#tor =o!ld earn a negati$e ret!rn o 0.:. "ltho!gh apan ha# a greater intere#t rate, the depreciating yen =ipe# o!t any gain# ro the higher intere#t rate. ence, the in$e#tor #ho!ld in$e#t in the 8nited State =here hi# or her ret!rn i# greater. r .

+90  0.0120   '  = −1 = −0.00:  1 & i .  ⋅ −1 = 1 & 0.03  ⋅ 30 / 30 0 . 0124    

+:D

Key Terms rando =alk !rcha#ing o=er arity 'heory Con#!er rice Inde< Big Mac Inde< tran#portation co#t# Relati$e !rcha#ing o=er arity 'heory

5!antity 'heory o Money Fi#her %ect International Fi#her %ect !nco$ered po#ition co$ered po#ition Intere#t Rate arity 'heore

Chapter Questions 1

o! belie$e the Malay#ian ringgitA8.S. dollar e!al# + r per 8.S. dollar ye#terday, =hat i# yo!r be#t oreca#t or the e
132.

Identiy the proble# =ith the !rcha#ing o=er arity.

13+. 8#ing data ro 'able 1, ho= co!ld yo! earn the highe#t proit by tran#portation Big Mac bet=een co!ntrie# i it =ere theoretically po##ible@ 13&. "ccording to the Big Mac Inde<, e#tiate =hether the apane#e yen i# o$er$al!ed or !nder$al!ed relati$e to the 8.S. dollar@ 133.

/i#ting!i#h bet=een !rcha#ing o=er arity D and Relati$e . 219

Money, Banking, and International Finance 139. R!##ian ha# a 4 inlation rate =hile the 8nited State# ha# a +. 8#ing both the e!al# 3, and yo! plan to in$e#t or 1:0 day#@ 190. o! in$e#ted oney into a oreign co!ntry or t=o year#. Foreign intere#t rate e>!al# 19, and the e!al# i  O 3. I the #pot e
1+.

,erivative Secrities and ,erivative Mar&ets

7e e
For*ard and Spot Transactions Financial deri$ati$e# recei$ed bad p!blicity ro inao!# bankr!ptcie# d!ring the 1--0# and ro the 200: Financial Cri#i#. In 1--3, )range Co!nty, Caliornia, e
Kenneth R. S!lcyk ao!# ca#e =a# Baring# (C. Baring# =a# a (ondon in$e#tent ir that =a# o!nded in 149+. )ne trader, *ick (ee#on, lo#t ro!ghly G1.+ billion in the deri$ati$e# arket, bankr!pting Baring#. Finally, coercial and in$e#tent bank# created a $ariety o ne= #ec!ritie#, called Credit /ea!lt S=ap# C/SD that played a role in the 200: Financial Cri#i#. C/S i# #iilar to in#!rance or in$e#tor#. 'he 200: Financial Cri#i# created hard#hip on any inancial ir# and in$e#tent bank#. 'he#e in#tit!tion# g!aranteed payent on pool# o ortgage# that bankr!pted. 'h!#, the#e ir# paid billion# o dollar# in payo!t# to honor the#e C/S contract#. 7e di#c!## C/S contract# in thi# chapter. /eri$ati$e# are a contract, a piece o paper. Farer# and erchant# in$ented deri$ati$e# in the Middle "ge# to protect the#el$e# ro price l!ct!ation#. B!yer# and #eller# agree to a price today, b!t they e!ently, the bread copany enter# into contract# =ith =heat arer#, =here the bread copany and arer# negotiate a price o =heat today. o=e$er, the bread copany =ill pay the arer# or the =heat =hen the arer# har$e#t the =heat #i< onth# ro no=. Contract protect# both the bread copany and arer# ro price l!ct!ation#. rice o deri$ati$e# recei$e# or \deri$e#\ their $al!e ro the !nderlying a##et#. "##et# co!ld be cooditie# #!ch a# coee, corn, petrole!, pork bellie#, and =heat, or inancial a##et# #!ch a# #tock#, bond#, c!rrencie#, %!rodollar#, and other inancial in#tr!ent#. Derivatives are contract#, and b!yer# and #eller# e!ick proit# and are gabler#. "# yo! g!e##ed, a #pec!lator can gain or lo#e a##i$e ao!nt# o oney ro the deri$ati$e# arket. Spec!lator# are $ital to the arket beca!#e their pre#ence increa#e# the li>!idity o the #ec!ritie#. In$e#tor# !#e #ed$in$ to b!y and #ell #ec!ritie# to red!ce ri#k or !#e longAter in$e#tent #trategie#. edger protect# hi#el in three =ay# by !#ing deri$ati$e#. Fir#t, he lock# in a !t!re price today, protecting hi#el ro price l!ct!ation#. Second, deri$ati$e# are li>!id a##et#. I an in$e#tor need# oney no=, he ea#ily can #ell hi# !t!re# contract in a deri$ati$e# arket. Finally, in$e#tor# b!y and #ell deri$ati$e on organied e
Money, Banking, and International Finance ase 2: edger co!ld red!ce the intere#tArate ri#k. I a banker kno=# he or #he =ill grant a loan on a #peciic date in the !t!re, #!b#e>!ently, he or #he can b!y a deri$ati$e that lock# in the !t!re intere#t rate. Intere#t rate becoe# the price on the inancial deri$ati$e. 'h!#, the banker borro=# at a lo= intere#t rate and lend# at a high intere#t rate. ase 3: edger co!ld red!ce the e
Futures and For*ard Contracts Fir#t cla## o deri$ati$e# i# futures and for!ard contracts. 'hey #peciy #ie, at!rity date, and price. Sie indicate# the n!ber o !nit# in each contract, =hile the at!rity date i# the day the partie# coplete the tran#action. Finally, the !t!re# price i# the #elling price o the a##et on the at!rity date. o=e$er, !t!re# dier ro or=ard#. " or=ard contract i# tailor ade that bank# or dealer# i##!e. I##!er?# rep!tation and collateral g!arantee the contract. )n the other hand, a !t!re# contract i# #tandardied. Mat!rity, #ie, and collateral are the #ae or all contract#. Standardied contract# allo= in$e#tor# to b!y and #ell !t!re# contract# on organied e!al the #pot price. " b!yer ne$er p!rcha#e# a !t!re# contract i the arket price o the !t!re# contract e
Kenneth R. S!lcyk higher. F!rtherore, a #eller =o!ld ne$er #ell a !t!re# contract, =hen the arket price o the !t!re# contract i# lo=er than the #pot price. For in#tance, i the #pot petrole! arket price =ere G-0 per barrel today, then no one =o!ld #ell a deri$ati$e# contract that at!re# today or a price belo= G-0. B!yer# and #eller# do not kno= each other =hen they b!y or #ell a !t!re# contract thro!gh an e!ently, a b!yer or #eller depo#it# oney =ith a broker to co$er po##ible lo##e# ro a !t!re# contract. "# the #pot arket price change# or a coodity daily, either the b!yer or #eller =ill lo#e oney i the e!al# G-0 per barrel today@ Seller 10 ⋅ 10 ,000 ⋅ ( $-0 − $43) = $130,000 depo#it# =ith hi# broker. I thi# contract at!red today, then a b!yer =o!ld p!rcha#e thi# oil or G43 and #ell it or G-0, earning a large proit o G13 per barrel. I a #pec!lator bo!ght 10 petrole! contract#, he or #he co!ld earn G130,000 i the deri$ati$e# contract# at!red today. 7ho pay# the argin i the petrole! price all# to G90 per barrel@ B!yer depo#it# 10 ⋅ 10 ,000 ⋅ ( $43 − $90 ) = $130 ,000 =ith hi# broker. I thi# contract at!red today, then the #eller =o!ld b!y oil on the #pot arket or G90 per barrel and #ell it to the b!yer or G43, earning a large proit o G13 per barrel. I a #pec!lator bo!ght 10 contract#, #!b#e>!ently, he or #he =o!ld earn a G130,000 lo## i the contract# at!red today. 'h!#, #pec!lator# co!ld earn enoro!# proit# or e!ently, the bank ha# g!aranteed a !nding #o!rce ne
Money, Banking, and International Finance protect# the bank ro intere#tArate ri#k beca!#e the bank Hlocked into a !nding #o!rce at 10 that en#!re# a proit o 2. F!t!re# and or=ard contract# can red!ce e!ently, %<!ation 1 and the !t!re# contract in %>!ation 2. +,000 ,000 rm

Spot arketJ +,000,000 rm

F!t!re# arketJ

$1

& rm $1

+ rm

= $430,000

1D = $1,000,000

2D

%<!ation + and the !t!re# tran#action in %>!ation &. +,000 ,000 rm

Spot arketJ +,000 ,000 rm

F!t!re# arketJ

$1

2 rm $1

+ rm

= $1,300,000

+D = $1,000,000

&D

221

Kenneth R. S!lcyk %<
%ptions Contract 7ptions contract repre#ent# the #econd cla## o deri$ati$e#. )ption# contract dier# ro a !t!re# contract beca!#e the option holder ha# the choice to b!y or #ell an a##et. For e!al# G40 per barrel, yo! do not e
I the #pot arket price ri#e#, #!b#e>!ently, the optionN# prei! or a %!ropean call option increa#e# =hile the prei! decrea#e# or the p!t option. Reeber, the option holder# =o!ld e


I the #trike price increa#e#, then the optionN# prei! or a %!ropean call option decrea#e# =hile the prei! increa#e# or a p!t option. In$e#tor =o!ld not e

I a coodityN# price i# highly $olatile, #!b#e>!ently, the coodityN# price l!ct!ate# greatly, and an option holder i# likely to e!ently, the option i##!er charge# a greater option prei! or both call# and p!t#. For e


"n option =ith a longer tie at!rity ha# a greater option prei!. For e


Intere#t rate# aect option# !#t like bond# and #tock. " higher intere#t rate red!ce# the pre#ent $al!e o the option, increa#ing the $al!e o the call option and decrea#ing the $al!e o the p!t option.

Example 1J Strike price or petrole! i# G:0 per barrel, and the %!ropeanN# option prei! e>!al# G0.1 per barrel =ith an option #ie o 10,000 barrel#. " copany b!y# 10 call option# =ith a total >!antity o petrole! o 100,000 barrel#. 'h!#, the copany pay# $0.1 ⋅ 10 ,000 ⋅ 10 = $10 ,000 or the prei!.

'=o #cenario# occ!r =ith an option# contractJ 5enario 1: I the #pot arket price e!ation 3J

profit =( spot prie− stri!e prie ) ∙"#%tit& − premi#m profit =( $ 90− $ 80 ) ∙ 100,000− $ 10,000=¿ G--0,000

3D

5enario 2: I #pot arket price all# belo= G:0 per barrel, #!b#e>!ently, the copany doe# not e!al# G0.04 per ton. %ach option contract #peciie# a >!antity o 10,000 ton#. " arer b!y# i$e p!t option#, in#!ring 30,000 ton# o corn. Con#e>!ently, the arer pay# G0.04 W 10,000 W 3 O G+,300 in prei!#. " arer =ill e
22+

Kenneth R. S!lcyk 5enario 2: I #pot arket price all# belo= the G&0 per ton #trike price, #!b#e>!ently, the arer e!ently, =e calc!late the arer earn# G4&9,300 in proit in %>!ation 9.

profit =( stri!e prie− spot prie ) ∙"#%tit& − premi#m profit =( $ 40 −$ 25 ) ∙ 50,000− $ 3,500 =¿ G4&9,300

9D

C!rrency option# are #iilar to coodity option#, b!t the #trike price i# an e!al# G0.01 per ringgit, and the contract #ie i# 100,000 ringgit#. In$e#tor need# 90 contract# and pay# G90,000 or the prei!, calc!lated in %>!ation 4. premium =

$0.01 ringgit

⋅ 9 million ringgits = $90 ,000 4D

In$e#tor ace# t=o #cenario# on the e!aled G0.& 8S  ringgit, #!b#e>!ently, the ringgit appreciated =hile the 8.S. dollar depreciated. In$e#tor need# G1.: illion 0.+ W 9 illionD to p!rcha#e the #i< illion ringgit# !#ing the call option, or he or #he pay# G2.& illion 0.& W 9 illionD i the in$e#tor b!y# the ringgit# on the #pot arket. 7e calc!lated a #pec!latorN# proit o G3-&,000 in %>!ation :. Spec!lator can b!y at the e
profit =( spot prie−e'erise prie ) ∙"#%tit& − premi#m $ 0.4 $ 0.3 − profit = ∙ 6,000,000 ri%ggits −$ 6,000= $ 594,000 ri%ggit ri%ggit

(

:D

)

5enario 2: I the e!al# G0.2 8S  ringgit, #!b#e>!ently, the ringgit depreciated =hile the 8.S. dollar appreciated. In$e#tor pay# G1.2

22&

Money, Banking, and International Finance illion or the #i< illion ringgit 0.2 W 9 illionD, or he or #he co!ld e!al# the prei!. Example !J "n in$e#tor ha# 8.S. dollar# and =ant# to #ell 300 tho!#and e!ro# !#ing a %!ropean p!t option. Strike price i# G0.: 8S  e!ro. rei! e>!al# G0.02 8S per e!ro =hile the contract #ie i# 23,000 e!ro#. In$e#tor need# 20 contract# and pay# G20,000 or the prei!, calc!lated in %>!ation -. In$e#tor need# 20 contract#. premium =

$0.02

Y

⋅ 300 ,000 Y = $10 ,000

-D

In$e#tor ob#er$e# t=o #cenario# on the e!ently, the in$e#tor# #ell 300,000 e!ro# or G&30,000 on the #pot arket. In$e#tor# co!ld #ell tho#e #ae e!ro# or G&00,000 i they had e!aling the optionN# prei!. 5enario 2: I the e!ently, the in$e#tor #ell# the 300,000 e!ro# or G&00,000 by e!ation 10.

profit =( e'erise prie− spot prie ) ∙ "#%t it&− premi#m $ 0.8 $ 0.7 profit = − ∙ 500,000 € − $ 10,000 =$ 40,000 € €

(

10D

)

/id yo! notice #oething #trange abo!t the call and p!t option#@ In$e#tor# e!ation# : and 10.

Special Deri"ati"es Se$eral inancial in#tit!tion# oer !t!re# and option# that are ba#ed on a arket inde<, #!ch a# the /o= one# Ind!#trial "$erage and SE 300. For e
Kenneth R. S!lcyk arket inde< and #ettle acco!nt# in ca#h. Since no cooditie# are e!al n!ber o call and p!t option# =ith identical at!ritie# or the *ikkei #tock inde<. ence, the in$e#tor# rarely e!ake #tr!ck Kobe, apan, and both the #tock price# and *ikkei a$erage ell rapidly on the 'okyo #tock e!ently, the #tock price# contin!ed pl!eting, re#!lting in a G1.& billion lo## or Baring#. 8nort!nately, Baring# =a# orced to #ettle =ith option holder# =ho bet the *ikkei a$erage =o!ld all. 'he Chicago Board o )ption# %!al# 20, #!b#e>!ently, the in$e#tor# e
229


Figure 1. '$e Volatility 8ndex BV89C bet&een 100 and 212

In#!rance copanie# and in$e#tent bank# created redit Default S!aps (DS). 'hi# inancial in#tr!ent i# #iilar to in#!rance. Soe in$e#tor# =o!ld like to p!rcha#e #pec!lati$e grade i.e. ri#kyD bond# beca!#e the#e bond# pay greater intere#t rate# than #ae in$e#tent#. o=e$er, i the b!#ine## bankr!pt#, then the#e bond# becoe =orthle## and the in$e#tor# lo#e their in$e#tent. 'h!#, C/S# =ere born. In$e#tor# co!ld b!y both ri#ky bond# and C/S contract#. F!rtherore, in$e#tor# =o!ld pay prei!# on C/S# a# i they =ere paying or in#!rance to the in$e#tent bank# or in#!rance copanie#. I a copany did bankr!pt and it# ri#ky bond# collap#ed in $al!e, #!b#e>!ently, the in$e#tent bank or in#!rance copany =o!ld pay the in$e#tor# their lo## #peciied !nder the C/S contract. I the copany =ith the ri#ky bond# did not bankr!pt, then the in$e#tent bank kept the prei! payent# a# proit#. S!b#e>!ently, in$e#tor# can b!y and #ell credit dea!lt #=ap# on the deri$ati$e# arket. C/S# ha$e t=o #e$ere dra=back#. Fir#t, C/S contract# are not tran#parent. Many in$e#tor# did not !nder#tand ho= to !#e C/S e!ently, the in$e#tent bank# =o!ld collect C/S prei!# a# p!re proit. /!ring good tie#, """ rated copanie# ha$e a ero dea!lt rate =hile #pec!lati$e grade bond# ha$e a dea!lt rating le## than &. o=e$er, d!ring the 2001 Rece##ion, """ rated copanie# #till had clo#e to a ero dea!lt rate =hile the dea!lt rate #oared to 10 or #pec!lati$e in$e#tent#. "# bankr!ptcie# clib, copanie# can acc!!late #taggering lo##e# d!ring a do=nt!rn in the econoy. In$e#tor# trade C/S# contract# in the deri$ati$e# arket#. "nyone can b!y the, e$en i the in$e#tor# do not o=n the ri#ky bond# that are #peciied !nder the C/S contract. 'hereore, 224

Kenneth R. S!lcyk #pec!lator# can enter the arket and gable on o!tcoe#. For e!ently, the gabler# lo#e their bet, the C/S prei!#. Iagine the oney people co!ld earn i they had in#ide inoration abo!t a copany?# inance#. Soe in$e#tor# bet the ho!#ing arket =o!ld collap#e and bo!ght C/S contract# on ri#ky ortgage pool#. In$e#tor# bo!ght C/S contract# on ortgage a##etAbacked #ec!ritie# beca!#e they predicted the collap#e o the ho!#ing b!bble in 2004 and p!rcha#ed C/S contract# a# a bet. "# the ortgage a##etAback !nd# bankr!pted, the holder# o C/S contract# re>!e#ted their payo!t#. I yo! are e!ick & coi##ion on the deal. 'h!#, !ltiple C/S contract# in#!re the #ae debt. 8nort!nately, the C/S contract# depend on one iportant a##!ption. I##!ing copanie# can indeed pay o!t the C/S contract# i the copanie# ail. 'he C/S arket in the 8nited State# >!ickly gre= into G&4 trillion arket by !ne 200:, co$ering a debt o ro!ghly G+& trillion. !tting thi# n!ber into per#pecti$e, the #ie o the 8.S. econoy =a# ro!ghly G1& trillion in ;ro## /oe#tic rod!ct ;/D in 2012. Con#e>!ently, the potential lo##e# i the in$e#tent bank# and in#!rance copanie# !#t pay o!t all C/S contract# =o!ld e!ickly acc!!lated billion# in lo##e# a# in$e#tor# re>!e#ted the payo!t# ro the C/S contract#. "I;?# lo##e# e!ity into the copany. F!rtherore, it proi#ed "I; o!r bailo!t loan# =orth a total o G19+ billion. 8nort!nately, "I; =orked =ith #e$eral in$e#tent bank# like ;oldan Sach# and (ehan Brother#, =hich al#o e
Money, Banking, and International Finance go$ernent =o!ld not help it, the inancial arket# pl!eted in Septeber 200:. F!rtherore, the credit arket# roe a# all inancial in#tit!tion# #top granting loan#. Ro!ghly +30 bank# and in$e#tor# =o!ld lo#e their C/S in#!rance beca!#e (ehan Brother# i##!ed appro!idating it# a##et#. (ehan Brother# =a# the greate#t ca#!alty o the 200: Financial Cri#i# and the large#t bankr!ptcy in 8.S. hi#tory. Barclay#, the #econdAlarge#t bank in %ngland, bo!ght (ehan Brother?# 8.S. core a##et# or G1.+ billion, incl!ding (ehan Brother?# #ky#craper in Manhattan. %
'"aluating Currency S*aps " currency s!ap i# a periodic e
Fre>!ency o the payent# bet=een t=o partie#.



/!ration o the #=ap.



" ethod to calc!late the #=ap payent# or leg#. )ne leg i# a i
7e deine #=ap# in o!r =ay#, and they dier in ho= the payent# o leg# are inde
re#ent $al!e o di#co!nted ca#h lo=# ro the oreign c!rrency ca#h lo=# i# 6oreign .



C!rrent #pot e


re#ent $al!e o di#co!nted ca#h lo=# ro the doe#tic c!rrency ca#h lo=# i# 6doe#tic. 22-

Kenneth R. S!lcyk 7e calc!late the #=ap $al!e in %>!ation 11.

(wp V)#e= PV foreig% ∙ ( 0− PV *omesti

11D

For e!al# S t O G1.23 per e!ro. C!rrent di#co!nt rate# are 3 "R or the 8nited State# and 9 "R in %!rope. 7e cop!te the pre#ent $al!e o ca#h lo=# or the %!ropean #=ap in %>!ation 12.

PV foreig% =

5.25 mi))io% € 210 mi))io% € + 5.25 mi))io% € + =208.0 mi))io% € 2 1 + 0.03 ( 1 + 0.03 )

12D

7e cop!te the $al!e o ca#h lo=# or the 8.S. #=ap in %>!ation 1+.

PV *omesti=

$ 4 mi))io% $ 200 mi))io% + $ 4 mi))io% 1 + 0.025

+

2

( 1 +0.025 )

= $ 198.1 mi))io%

1+D

7e cop!ted the #=apN# pre#ent $al!e in %>!ation 1&.

(wp V)#e= PV foreig% ∙ ( 0− PV *omesti $ 1.25 (wp V)#e=208.0 mi))io% € ∙ −$ 198.1 mi))io% = $ 61.9 mi))io% 1 €

1&D

I Copany Q li>!idate# the #=ap, the copany !#t recei$e G91.- illion to #ell the #=ap. Copany Q beneited beca!#e the copany i# e!ently, the pre#ent $al!e o the #=ap ri#e#. Moreo$er, i the oreign intere#t rate ri#e#, then the pre#ent $al!e o the #=ap !#t all. )ppo#ite i# tr!e or the i##!er o the #=ap.

2+0


Key Terms #pot tran#action or=ard tran#action deri$ati$e deri$ati$e arket deri$ati$e #ec!rity hedging #pec!lation !t!re# or=ard contract long po#ition #hort po#ition argin acco!nt option# contract

call option p!t option e
Chapter Questions 1

/i#ting!i#h bet=een #pot and or=ard tran#action#.

192.

7here do deri$ati$e# get their $al!e@

19+.

/i#ting!i#h bet=een hedging and #pec!lation.

19&.

/i#ting!i#h bet=een long and #hort po#ition#.

193.

/eine a argin acco!nt.

199. " copany b!y# 10 contract# or petrole! that #peciie# a price o G43 per barrel. %ach contract #peciie# 1,000 barrel#. 7ho pay# and ho= !ch into the argin acco!nt i the price o petrole! #hoot# !p to G130 per barrel@ 194. "n in$e#tor b!y# a c!rrency !t!re# contract or G1 O 1.3 e!ro# ro a bank or 130,000 e!ro#. 7ho pay# and ho= !ch into a argin acco!nt i the e
/i#ting!i#h bet=een a !t!re# and option# contract.

19-.

/i#ting!i#h bet=een a call option and a p!t option.

140.

7hich actor# deterine the $al!e o an option?# prei!@

2+1

Kenneth R. S!lcyk 141. o! are holding 10 call option# or petrole! =ith a #trike price o G43 per barrel. )ption prei! e>!al# G0.3 per barrel, and each contract #peciied a >!antity o 1,000 barrel#. Cop!te the prei!, and =hether yo! =ill e!al# G3 per b!#helL the option prei! i# G0.01 per b!#hel, and each contract #peciied a >!antity o 100 b!#hel#. Calc!late the arer?# prei!, and =hether he =ill e!al# G9 per b!#hel@ 14+. Can yo! identiy any proble# or a inance copany to i##!e deri$ati$e# that are not ba#ed on a coodity, b!t on a #tock arket inde<@ 14&.

7hat are Credit /ea!lt S=ap# C/SD@

143. Co!ld the Federal Re#er$e or 8.S. go$ernent ha$e pre$ented the 200: Financial Cri#i#@ 149. Copany Q enter# into a 3Ayear #=ap agreeent =ith a dealer, and o!r year# ha$e pa##ed. ayent# are #eiAann!al, and t=o payent# are let. S=apN# ace $al!e# are G100 illion and 110 illion e!ro# =ith a co!pon intere#t o + or 8.S. dollar# and & or the e!ro#. C!rrent di#co!nt rate# are 3 "R or the 8.S. and 9 "R in %!rope =hile the c!rrent #pot e
1/.

Transaction and !conomic !"osres

"# a b!#ine## in$e#t# or operate# in a oreign co!ntry, a changing e!ently, thi# chapter deine# the type# o e
'(posure Types Fir# are #!bected to c!rrency ri#k, called e"posure. %
Money, Banking, and International Finance -ransaction e"posure coe# ro the ri#k o tran#action# denoinated in dierent c!rrencie#. Con#e>!ently, a change in an e!ently, it# ca#h lo=# =ill =or#en. 8nort!nately, it# re$en!e# are in 8.S. dollar# that are lo#ing $al!e =hile it# co#t# are in ranc# that are #trengthening in $al!e. Keeping the #traight, econoic e!al ao!nt. 'hen acco!ntant# con$ert balance #heet ite# into ranc#. " depreciating 8.S. dollar ca!#e# the $al!e o loan# to decrea#e beca!#e it# liabilitie# are decrea#ing. o=e$er, the $al!e o c!rrent a##et# i# decrea#ing ro the dollar in$entorie#. *e$erthele##, d!e to S=i## acco!nting r!le#, acco!ntant# !#e dierent e!ently, acco!ntant# generate acco!nting gain# or lo##e# by !#ing the $ario!# e
Measuring and /rotecting against Transaction '(posure 7e can identiy and ea#!re tran#action e
Kenneth R. S!lcyk day#, gi$ing a predictable ca#h lo=. I todayN# #pot e!al G1, then =e calc!lated the proit, 1.&3 illion ranc# by !#ing %>!ation 1. pro.it =

145 .ranc $1

( $2,500 ,000 − $1,500 ,000) = 1,450 ,000 .rancs 1D

o=e$er, the tran#action occ!r# in +0 day#, and the #pot e!ently, S=i## Cr!i#e# proit# in ranc# =ill l!ct!ate along =ith the e!ipent to a Briti#h copany or + illion po!nd# d!e in -0 day# a# an acco!nt# recei$able. "ltho!gh 'rident #old the e>!ipent, it !#t =ait -0 day# or it# re$en!e, and anything co!ld happen =ithin -0 day#. "n analy#t at 'rident $ie=# o!r #trategie# to red!ce any lo##e# ro thi# international tran#action. Strategie# areJ 1

Spot e!al# G1.492 per 1 po!nd, and the copany =ill !#e the #pot e
144. 'rident Copany can !#e a deri$ati$e# contract. 'rident can b!y a -0Aday or=ard contract =ith an e!ation 2. *e$erthele##, 'rident ha# an e!ently, 'rident =ill gain ore 8.S. dollar#. )n the other hand, i the Briti#h po!nd# depreciate, then 'rident recei$e# e=er 8.S. dollar#.

mo#%t ( $ )=3 mi))io% po#%*s

(

$ 1.760 1 po#%*

)

=$ 5.28 mi))io%

2+&

2D


5trategy 2: 'rident enter# a or=ard contract. " or=ard contract i# better than a c!rrency !t!re# beca!#e the or=ard contract# are tailor ade or ao!nt# and do not re>!ire a argin call. Con#e>!ently, 'rident doe# not ha$e any e!ation +. For=ard contract i# better than the !t!re #pot e
mo#%t ( $ )=3 mi))io% po#%*s

(

$ 1.785 1 po#%*

)

=$ 5.355 mi))io%

+D

5trategy 3: 'rident b!y# the p!t option. It pay# a prei!, G4:,430, calc!lated in %>!ation & and in#!red it# tran#action or an e!ation 3. 'rident =ill only e!ently, 'rident #ell# it# po!nd# in the #pot e
premi#m( $ )=3 mi))io% po#%*s ( 0.015 ) mo#%t ( $ )=3 mi))io% po#%*s

(

(

$ 1.750 1 po#%*

)

&D

=$ 5.25 mi))io%

3D

$ 1.750 1 po#%*

)

= $ 78,750

5trategy !: 'rident co!ld borro= ro a Briti#h bank. 'hi# #trategy i# ore in$ol$ed and entail# no e!ation 9. "ccordingly, the Briti#h bank charge# 1& intere#t and 'rident =ill o=e the bank + illion po!nd# in -0 day#. Con#e>!ently, =e !#e the pre#ent $al!e or!la to calc!late the pre#ent $al!e that gro=# into the ao!nt the Briti#h copany =ill pay in -0 day#.

f#%*s ¿ +orrow ( , )=

f#t#re -)#e 3 mi))io% po#%*s = = 2.899 mi))io% po#%*s T 90 9D 1+ i 1+ 0.14 360

360

'hen 'rident iediately tran#er# the bank loan in 8.S. dollar# today !#ing the #pot e!ently, 'rident recei$e# G3.104 illion today. )nce the Briti#h copany pay# it# acco!nt# recei$able, #!b#e>!ently, 'rident repay# the Briti#h bank loan. 'hi# tran#action dier# ro the ir#t three #trategie# beca!#e 'rident recei$e# !nd# today or an acco!nt# recei$able that the Briti#h copany pay# in -0 day#. "ltho!gh Strategy & yield# the lo=e#t 2+3

Kenneth R. S!lcyk ao!nt, 'rident recei$e# oney today that it co!ld in$e#t and earn intere#t =hile 'rident =o!ld =ait -0 day# !ntil recei$ing oney or the ir#t three #trategie#.

mo#%t ( $ )=2.899 mi))io% po#%*s

(

$ 1.762 1 po#%*

)

=$ 5.107 mi))io%

4D

" copany co!ld !#e $ario!# #trategie# to red!ce the e
Caterpillar co!ld !#e the #pot e
1:0. Caterpillar co!ld enter a 1:0Aday or=ard contract =ith the e!ently, Caterpillar =o!ld pay ore 8.S. dollar# to #ati#y thi# obligation. I the #pot e!ation :.

mo#%t ( $ )=6,030 mi))io% wo%s

(

$1 1,200 wo%s

)

= $ 5.025 mi))io%

:D

5trategy 2: Caterpillar co!ld !#e a or=ard contract to lock in a !t!re e!ently, thi# #trategy ha# no e!ation -. Clearly, Strategy 2 i# better than Strategy 1 beca!#e Caterpillar kno=# the e
mo#%t ( $ )=6,030 mi))io% wo%s

(

$1 1,260 wo%s

)

= $ 4.786 mi))io%

-D

5trategy 3: Caterpillar co!ld b!y a call option to b!y =on# at a i!ation 10. 'hen Caterpillar =ill e
2+9

Money, Banking, and International Finance relati$e to the 8.S. dollar. Caterpillar =o!ld pay G3.023 illion at o#t, cop!ted in %>!ation 11. "ltho!gh thi# Strategy i# =or#e than Strategy 2, Caterpillar =o!ld !#e thi# #trategy i it belie$ed the Korean =on =o!ld depreciate, =hich red!ce# CaterpillarN# obligation. 'hen, i the Korean =on appreciate#, Caterpillar =ill e
premi#m( $ )=6,030 mi))io%wo%s ( 0.03 ) mo#%t ( $ )=6,030 mi))io% wo%s

(

(

$1 1,200 wo%s

$1 1,200 wo%s

)

=$ 150,750

)

= $ 5.025 mi))io%

10D 11D

5trategy !: Caterpillar co!ld tran#er !nd# today into So!th Korea !#ing the #pot e!ation 12. Con#e>!ently, Caterpillar !#e# todayN# c!rrency e!ation 1+. 'hi# #trategy yield# the lo=e#t co#t# to pay that acco!nt# payable beca!#e Caterpillar depo#it# !nd# in a Korean bank. In theory, it co!ld depo#it the#e !nd# in a 8.S. bank to earn intere#t or #i< onth#, and then !#e# the other #trategie#.

f#%*s ¿ *eposit =

f#t#re -)#e 6,030 mi))io%wo%s = =5,583.3 mi))io% wo%s T 180 1 +i 1 + 0.16 360

mo#%t ( $ )=5,583.3 mi))io%wo%s

12D

360

(

$1 1,200 wo%s

)

= $ 4.65 mi))io%

1+D

In another e!ipent or 12.3 illion yen to a apane#e ir. "cco!nt# recei$able i# d!e in +0 day#. "n analy#t at Seattle Scientiic ob#er$e# the o!r #trategie#J 1

Seattle Scientiic !#e# today?# #pot e
1:+.

Seattle Scientiic b!y# a +0Aday or=ard =ith a i
1:&.

Seattle Scientiic !#e# a -0Aday or=ard rate =ith an e
1:3.

'he apane#e ir pay# ca#h today i Seattle Scientiic =o!ld grant a &.3 di#co!nt.

2+4

Kenneth R. S!lcyk 5trategy 1: Seattle Scientiic doe# nothing and !#e# the #pot e!ation 1&. I the yen depreciate# relati$e to the 8.S. dollar, #!b#e>!ently, Seattle Scientiic =o!ld recei$e e=er 8.S. dollar#.

mo#%t ( $ )=12.5 mi))io% &e%

(

$1 111.40 &e%

)

=$ 112,208.26

1&D

5trategy 2: Seattle Scientiic !#e# a +0Aday or=ard contract and lock# in the !t!re e!ation 13.

mo#%t ( $ )=12.5 mi))io% &e%

(

$1 111.00 &e%

)

=$ 112,612.61

13D

5trategy 3: Seattle Scientiic !#e# a -0Aday or=ard contract. "gain, thi# #trategy ha# no e!ation 19. "ltho!gh thi# #trategy #ee# odd, Seattle Scientiic =o!ld depo#it the oney in a apane#e bank or an e
mo#%t ( $ )=12.5 mi))io% &e%

(

$1 110.40 &e%

)

= $ 113,224.64

19D

5trategy !: Seattle Scientiic granted the &.3 di#co!nt and recei$e# it# !nd# today. 'hi# #trategy ha# no e!ently, Seattle Scientiic recei$e# G104,13:.:-, calc!lated in %>!ation 14. 'hi# #trategy yield# the #alle#t ao!nt or the acco!nt# recei$able. *e$erthele##, Seattle Scientiic recei$e# it# !nd# today. *e
mo#%t ( $ )=12.5 mi))io% &e% ( 0.955 )

(

$1 111.40 &e%

2+:

)

=$ 107,158.89

14D

Money, Banking, and International Finance For the la#t e!etal# in #i< onth#, creating an acco!nt# payable. Farah ean# =ant# to red!ce it# e
Spot e!al# 4.0 >!etal# per G1. "naly#t belie$e# the ;!atealan Central Bank =ill de$al!e the >!etal to :.0 >!etal# per G1. o=e$er, the analy#t belie$e# a #all chance that the >!etal co!ld #trengthen to 9.& >!etal# per G1.

1:9. Farah ean# co!ld enter a 1:0Aday or=ard contract =ith an e!etal#  G1. 1:4. Farah ean# iediately tran#er the !nd# to ;!ateala and earn the intere#t rate 1& "R or 1:0 day#. 1::. Farah ean# co!ld in$e#t in the 8nited State# and earn 9 "R or 1:0 day# and then !#e a or=ard contract to tran#er !nd# to ;!ateala. 5trategy 1: Farah ean# co!ld !#e the #pot e!etal doe# depreciate, then Farah ean# =o!ld pay G1,030,000, calc!lated in %>!ation 1:. o=e$er, i the >!etal appreciate#, #!b#e>!ently, Farah ean# =o!ld pay o!t G1,+12,300, cop!ted in %>!ation 1-.

( (

) )

$1 8.0 "#et.)s $1 mo#%t ( $ )=8.4 mi))io%"#et.)s 6.4 "#et.)s mo#%t ( $ )=8.4 mi))io%"#et.)s

= $ 1,050,000

1:D

= $ 1,312,500

1-D

5trategy 2: Farah ean# !#e# a 1:0Aday or=ard contract to hedge again#t the e!ation 20.

mo#%t ( $ )=8.4 mi))io%"#et.)s

(

$1 7.1 "#et.)s

)

= $ 1,183,098.59

20D

5trategy 3: Farah ean# co!ld in$e#t oney in ;!ateala today and earn intere#t or #i< onth#. 'hen the copany !#e# the !nd# to pay it# acco!nt# payable. "ltho!gh thi# #trategy doe# not ha$e an e!etal# in #i< onth#. 7e calc!lated 4.:3 illion >!etal# in %>!ation 21.

2+-


f#%*s ¿ *eposit =

f#t#re f#t#re -)#e 8.4 mi))io%"#et.)s = =7.85 mi))io%"#et.)s T 180 1 +i 1+ 0.14 360

21D

360

'hen Farah ean# tran#er G1.121 illion today to ;!ateala !#ing the #pot e!ation 22. 8nort!nately, thi# good #trategy ha# a dierent tie horion than the pre$io!# t=o #trategie#. I Farah ean# ha# G1.121 illion il lion in it# acco!nt#, #!b#e>!ently, it co!ld earn intere#t by depo#iting it in a 8.S. inancial in#tit!tion and then !#e Strategie# 1 or 2.

mo#%t ( $ )=7.850 mi))io%"#et.)s

(

$1 7.0 "#et.)s

)

= $ 1.121 mi))io%

22D

5trategy 5trate gy !: 'hi# #trategy addre##e# the tie horion and ha# no e!ently, !#e# a or=ard contract to tran#er oney to ;!ateala in #i< onth#. Farah ean# need G1,1:+,0-:.3in #i< onth# or the or=ard contract, cop!ted in %>!ation 20. 'hen =orking back=ard#, the cop copany any ! !#t #t in$e in$e#t #t G1,1 G1,1&: &:,9 ,9++-.& .&1 1 in the the 8.S. 8.S. to earn earn the the 9 inte intere re#t #t or #i< #i< o onth nth#, #, calc!lated in %>!ation 2+. Con#e>!ently, Farah ean# =o!ld earn intere#t in the 8nited State# or #i< onth# and !#e a or=ard contract to tran#er !nd# to ;!ateala to pay o it# obligation.

f#%*s ¿ *eposit =

f#t#re f#t#re -)#e $ 1,183,098.59 = = $ 1,148,639.41 T 180 1 +i 1 + 0.06 360

2+D

360

"n international copany co!ld hedge nat!rally and protect it# c!rrent contract!al contract# in a oreign co!ntry by !#ing dierent #trategie#. Fir#t, a copany ha# both acco!nt# recei$able# and acco!nt# acco!nt# payabl payablee in the #ae #ae oreig oreign n co!ntry co!ntry.. I they they are ro!ghly ro!ghly e>!al =ith =ith #iila #iilar r at!ritie#, then the copany !#e# the proceed# ro the acco!nt# recei$able to pay it# acco!nt# payable =ith no e!ire payent in it# hoe c!rrency. For e!ire all payent# are ade in 8.S. dollar# =hile copanie# in the %!roone =o!ld re>!ire payent# in e!ro#. 'h!#, the copanie# orce the e!ire payent in Special /ra=ing Right# beca!#e the International Monetary F!nd #et# the $al!e o the S/R# to e>!al a c!rrency ba#ket o Briti#h po!nd#, e!ro#, 8.S. dollar#, and apane#e yen.

Measuring and /rotecting against 'conomic '(posure "naly#t# ha$e diic!ltie# ea#!ring econoic e
Money, Banking, and International Finance the c!rrency e!eeing proit#. "n analy#t ea#!re# the econoic e!ation, #ho=n in %>!ation 2&. 8#ing a #iple e!ation ea#!re# the a##ociation bet=een the a##et?# price and the e!al# l# ero ero =ith =ith a con# con#ta tant nt $ari $arian ance ce =hil =hilee α an and β are the e#tia e#tiated ted parae paraeter# ter#.. ε, e>!a Con#e>!ently, thi# e>!ation e#tiate# a #traight line bet=een  and S =ith an intercept o α and a #lop #lopee o β. 7e reer reer the parae paraeter ter β a# the the Fore" /eta or 6"posure oefficient , and it indicate# the e
2&D

7e can e#tiate the regre##ion e>!ation ea#ily, and =e calc!late β by !#ing %>!ation 23. Co$ariance ea#!re# the $ariation o the a##et?# price to the e!ently, t=o actor# inl!ence βJ the l!ct!ation# in the e
0 =

o-ri%e ( P 2 ( ) -ri%e ( ( )

23D

o!, o!, or e
State 1

robability 1+

Rent YD 1,:00 Y

%
Rent D G1,:00

Kenneth R. S!lcyk 2 +

1+ 1+

2,000 Y 2,200 Y

G1.23  1 Y G1.30  1 Y

G2,300 G+,+00

7e calc!late :00 or β in thi# ca#e. " po#iti$e β indicate# yo!r ca#h rent $arie# =ith the e!al# the #pot rate, #o =e neither gain nor lo#e anything. Finally, i State + occ!r#, the e!ro appreciated again#t the 8.S. dollar, #o =e lo#e G200 on the or=ard contract. Since S ince each #tate i# likely to occ!r, =e, on a$erage, break e$en by b!ying the or=ard contract. 7e contin!e =ith the #ae e!ally likely. "ltho!gh yo!r rent l!ct!ate# greatly, greatl y, the e!al the #ae n!ber, n!ber, G2,300, and β e>!al# A1,999.99@ " negati$e β indicate# the e!ently, yo! cannot !#e a or=ard contract in thi# ca#e beca!#e yo! do not ha$e econoic e
State 1 2 + 'otal

is t$e orret Dedge for ase 1

For=ard rice G1.23  1 Y G1.23  1 Y G1.23  1 Y

%
ield 1.231.00DW:00 YO G200 1.231.23DW:00 YO G0 1.231.30DW:00 YO AG200 G0

'able 3. Renting out your ondo for ase 2

State 1 2 +

robability 1+ 1+ 1+

Rent YD 2,300 Y 2,000 Y 1,999.94 Y

2&2

%
Rent D G2,300 G2,300 G2,300

Money, Banking, and International Finance 7e, inally, e!al# 0 in thi# ca#e beca!#e the rent in e!ro# doe# not $ary. Con#e>!ently, yo! co!ld hedge again#t the e
State 1 2 +

robability 1+ 1+ 1+

Rent YD 2,000 Y 2,000 Y 2,000 Y

%
Rent D G2.000 G2,300 G+,000

Condoini! e!e# to red!ce it# econoic e!ality car#, tr!ck#, and otorcycle# in actorie#, located in Brail, Canada, China, India, Indone#ia, apan, aki#tan, 'hailand, 8nited State#, and other co!ntrie#. I the apane#e yen appreciate# relati$e to the other c!rrencie# and rai#e# ondaN# prod!ction co#t#, #!b#e>!ently, onda can #hit it# prod!ction to it# other acilitie#, #cattered acro## the =orld. 'e$nique 2: " copany o!t#o!rce# it# prod!ction or !#e# lo=Aco#t labor. For in#tance, any hotel# and re#ta!rant# operate in e Con#e>!en !ently tly,, hotel# hotel# and re#ta! re#ta!ran rant#, t#, locate located d in co!ntri co!ntrie# e# =ith =ith an appreciating c!rrency rely on iigrant# or e$en !ndoc!ented =orker# to red!ce both it# co#t# and price#. In another e!ently, it 'e$nique !: " copany contin!ally in$e#t# in re#earch oer# inno$ati$e prod!ct# that con#!er# =ant. For in#tance, "pple Inc. #et the #tandard or highA>!ality #art phone# and tablet cop!ter#. "ltho!gh "pple #ell# it# prod!ct# in a co!ntry =ith a depreciating c!rrency, it po##e##e# #oe onopoly po=er to rai#e it# prod!ct#N price# =itho!t red!cing it# #ale#. 'e$nique ,: " copany can !#e deri$ati$e# and hedge again#t e
Kenneth R. S!lcyk e!ro !ntil 200:. Con#e>!ently, the depreciating 8.S. dollar red!ced it# 8.S. #ale# =hile it# co#t# ro#e. 'h!#, the or#che inancial anager# hedged or #horted again#t the 8.S. dollar, and #oe inancial analy#t# e#tiated 30 o or#cheN# proit# cae ro it# hedging acti$itie#.

Key Terms %
ta< e
Chapter Questions 1

/ei /eine ne the the o! o!rr type type## o o e

1:-. 1:-. o! are are e!al# G1.23 per e!ro. Moreo$er, yo! e
o!r o!r copany !#e# the #pot e!al# G0.G0 .-  1 C/.



o!r copany enter# a threeAonth or=ard rate that i


Copany plan# to borro= again#t the acco!nt# recei$able in Canada, and the threeA onth loan rate in Canada i# 3 "R.



Copany =o!ld pay iediately i yo!r copany granted a + di#co!nt rate.

1-2. o!r copany 1-2. copany =ill =ill p!rch p!rcha#e a#e toat toatoe# oe# ro ro Me

o!r copany decide# to !#e the #pot e!al# G1  11 pe#o#.



o!r copany enter# a or=ard contract that i


o!r copany in$e#t# in Me


1-+.

o!r copany b!y# a thirtyAday call option or pe#o#. Strike price e>!al# G1  1+ pe#o# =hile the prei! i# 1.3

lea#e deine the Fore< Beta and identiy the #o!rce# o $ariation.

1-&. o!r copany an!act!re# and #ell# backpack# acro## the =orld. Identiy t=o ethod# to red!ce econoic e
20.

Political4 Contry4 and 5lobal S"ecific is&s

Political risk originate# ro go$ernent beca!#e a go$ernent can ipo#e it# a!thority o$er an enterpri#eN# operation# =ithin a border or e$en o!t#ide it# border#. )nce an international copany or in$e#tor e#tabli#he# a b!#ine## =ithin a oreign co!ntry, the ho#t go$ernent enorce# it# o=n la=#, r!le#, reg!lation#, and ta
/olitical: Country: and lo$al Specific +isks olitical ri#k coe# in any or#. For in#tance, firm specific risk , al#o called icro ri#k, i# a oreign b!#ine## and the ho#t go$ernent enco!nter# a conlict. /ierent ir# e!ire# billion# o 2&3

Kenneth R. S!lcyk 8.S. dollar# or in$e#tent. Moreo$er, the oicial# in a oreign go$ernent =ill kno= abo!t the electronic# copany =ell, b!t the re#ta!rant chain ay not appear on the go$ernent?# radar. F!rtherore, a ir ha# a c!rrency e!ently, /!bai 7orld #old it# intere#t in the port# to an "erican copany, "I;. " go$ernent and oreign copany co!ld cla#h o$er local intere#t# $er#!# a oreign copanyN# #elAintere#t#. Con#e>!ently, a go$ernent retain# control o$er it# deen#e ind!#trie# and re#trict# o=ner#hip o prod!ction or ilitary e>!ipent and #!pplie#. I a go$ernent relied on a oreign co!ntry or ilitary #!pplie#, then that oreign co!ntry co!ld =ithhold e!ently, a go$ernent hinder# oreign in$e#tent or re#trict# oreign enterpri#e# ro operating =ithin it# border# a# a go$ernent protect# it# o=n ind!#trie# and copanie#. " go$ernent ight ipo#e tari# on it# iport#. " tari boo#t# the prod!ct?# arket price =hile it red!ce# it# iport#. In #oe ca#e#, go$ernent# in de$eloping co!ntrie# ipo#e high tari# beca!#e the go$ernent# need the ta< re$en!e. ;o$ernent# in de$eloping co!ntrie# !#!ally ha$e ta< e$a#ion proble#, b!t they retain tight control# o$er their air and #eaport#. 'h!#, they can collect tari re$en!e a# prod!ct# o$e thro!gh the port#. Soe oreign copanie# ight in$e#t =ithin a co!ntry to circ!$ent the trade barrier#. " co!ntry co!ld oin a trade bloc =ith other co!ntrie#, oring a ree trade one. "ccordingly, eber# o a trade bloc allo= ree trade bet=een eber# =hile nonAeber# ace trade protection. ence, a oreign copany in$e#t# =ithin a co!ntry to not only circ!$ent a trade barrier, b!t al#o gain ore acce## to con#!er# =ho li$e =ithin the trade bloc. For e
Money, Banking, and International Finance %8 go$ernent erect# a #ingle c!#to# to the nonA%8 eber#. Con#e>!ently, oreign copanie# ha$e an incenti$e to in$e#t in#ide the trade bloc gaining ore con#!er#. " go$ernent can ipo#e any condition# on oreign copanie#, =hich areJ ondition 1: " go$ernent orce# oreign ir# to !#e local copanie#, p!rcha#e local re#o!rce# and #!pplie#, and hire local labor. F!rtherore, a go$ernent co!ld re#trict or liit the n!ber o e!ently, a go$ernent bargain# or control by threatening to #h!t do=n operation#. For e!ota# on it# eber#. rod!ction >!ota# red!ce the petrole! #!pplie#, boo#ting petrole! price# and proit#. ondition !: " go$ernent re>!ire# the oreign copanie# to or oint $ent!re# =ith the go$ernent or #tateAo=ned ir#. 7e#tern ir# bring in$e#tent, technology, and eicient anageent practice# =hile the go$ernent retain# control o$er the b!#ine## acti$itie#. oint $ent!re i# coon in national deen#e, agric!lt!re, banking, or the ineral# ind!#trie#, and go$ernent# in po#tASo$iet #tate#, apan, Me!ickly change. For e!ently, the go$ernent# change their po#ition# d!ring it# #ociali#tic pha#e a# they begin p!ni#hing b!#ine##e#. Moreo$er, political leader# =ith a #trong nationali#tic leaning ay $ie= oreign in$e#tent !na$orably. $arateristi 2: International in$e#tor# and b!#ine## people can collect inoration abo!t a oreign co!ntryN# political leader# or a co!ntryN# econoic en$ironent. olitical leader# =ho belie$e in ree arket# and liited go$ernent are likely to pa## a$orable go$ernent la=# and reg!lation# to oreign in$e#tent. Soe organiation# #!ch a# the eritage Fo!ndation collect #tati#tic# on co!ntrie# and attept to ea#!re the le$el o econoic reedo. Con#e>!ently, econoic reedo corre#pond# directly to b!#ine## reedo and the le$el o intererence by go$ernent. $arateristi 3: Soe co!ntrie# are copo#ed o ractio!# and contentio!# ethnic gro!p# or plag!ed =ith religio!# anatici#. 'he#e co!ntrie# are poor choice# or international 2&4

Kenneth R. S!lcyk in$e#tent. For e!ently, the prote#tor# and rioter# co!ld daage the oreign in$e#tor#N a##et#. In e
Money, Banking, and International Finance thoro!ghly beore in$e#ting beca!#e in$e#tor# co!ld e!ently, other agencie# ay deand bribe# and kickback#, once they di#co$er a copany had paid bribe#. 5uggestion 3: Co!rt #y#te# are !#!ally =eak in corr!pt co!ntrie#, and the !dge# co!ld be !#t a# corr!pt a# the b!rea!crat# and politician#. %$en i a b!#ine##an and corr!pt politician or a $erbal contract, !dge# ight not enorce the contract# beca!#e corr!ption i# illegal. 'h!#, the b!#ine##an ha# no legal reco!r#e i the corr!pt politician# change the ter# o the contract. 5uggestion !: " copany or in$e#tor co!ld e!ently, they #ho!ld !#e a local ad$i#or to handle the go$ernent oicial# and or riend# and connection# at high place#. M!ltinational enterpri#e# can !#e eight #trategie# to iniie political and co!ntry ri#k, =hich areJ 5trategy 1: " !ltinational copany can !#e frontin$ loans to red!ce it# tran#er ri#k. For e!ire# loan# =itho!t increa#ing it# e>!ity. Siply, a ir borro=# hea$ily =ithin the oreign co!ntry. I a ir e!ently, the ir co!ld dea!lt on it# loan# and obligation#. /ea!lt co!ld #park a backla#h again#t the go$ernent, and thi# #trategy i# eecti$e i a go$ernent #eie# or nationalie# an ind!#try. 'h!#, the ir lea$e# the co!ntry and #top# paying it# loan#. 5trategy 3: " ir artiicially create# e
Kenneth R. S!lcyk 5trategy !: Soe ir# ha$e bargaining po=er =ith go$ernent, called special dispensation. 'h!#, a ir co!ld con$ince a go$ernent to tran#er !nd# o!t#ide the co!ntry or to deand e!ently, the b!#ine## prod!ce# good# in acilitie# #pread acro## co!ntrie#. "ltho!gh thi# ethod increa#e# the tran#portation co#t#, a copany red!ce# it# ri#k. I the b!#ine## lo#e# it# actory in one oreign co!ntry, then the b!#ine## only lo#e# a piece o the b!#ine##. For e!ickly. "ltho!gh #oe co!ntrie# do not enorce intellect!al property right#, co!ntrie# #!ch a# the %!rope 8nion and the 8nited State# are orcing co!ntrie# to coply =ith intellect!al property right# and are cracking do=n on piracy and $iolation#. 5trategy /: " go$ernent co!ld ipo#e capital and e
230

Money, Banking, and International Finance go$ernent. *e$erthele##, terrori#t# are not the only global proble#. 6iolent riot# and prote#t# er!pted in ;reece, Spain, and the Middle %a#t in 2011 a# prote#tor# and rioter# de#troyed property and a##et# o !ltinational enterpri#e#. !#t in tie in$entory #y#te that any b!#ine##e# ha$e adopted or# another global ri#k. B!#ine##e# hold lo= in$entorie# beca!#e they pay co#t# to #tore part# and prod!ct#. Con#e>!ently, b!#ine##e# prod!ce part# !#t in tie a# they are needed. 8nort!nately, !#t in tie in$entory #y#te# are #!#ceptible to #!pply di#r!ption# i part# coe ro any co!ntrie# aro!nd the =orld. For e!ake had #tr!ck apan in 2011, apane#e #teel and a!to part# copanie# #h!t do=n, di#r!pting the part# #!pply or the apane#e copanie#. Man!act!ring plant# acro## the =orld #h!t do=n beca!#e they co!ld not get the nece##ary part# ro apan. rote#t# ca!#e another global ri#k. For e!ently, corporation# clai they do ore than earn proit#L they beneit the co!nitie# =here they operate. 'hey clai they ipro$e the #ocial, en$ironental, and econoic condition# that #!rro!nd the b!#ine##. For e
Measuring Country +isk Fir# in$e#ting in oreign arket# are e!ently, the $al!e o oreign in$e#tent and oreign a##et# co!ld pl!et in $al!e a# international in$e#tor# and b!#ine##e# lee the co!ntry. "ter the people had elected !go Cha$e a# pre#ident in 6ene!ela, hi# go$ernent began nationaliing ind!#trie#, ca!#ing an e
Kenneth R. S!lcyk International in$e#tor#, b!ying oreign bond#, can e!ently, the intere#t rate i# copri#ed o the ri#kAree intere#t rate and ri#k prei!. Risk* free interest rate relect# the arket intere#t rate =ith a ero dea!lt rate. For in#tance, the in$e#tor# con#ider 8.S. go$ernent #ec!ritie# to be ri#k ree beca!#e the 8.S. go$ernent ha# ne$er dea!lted on it# debt, or at lea#t not yet. o=e$er, any in$e#tor# are becoing alared ater the 8.S. go$ernent debt #!rpa##ed G14 trillion d!ring 201+. In$e#tor# belie$e the 8.S. go$ernent debt i# ri#kAree beca!#e the 8.S. go$ernent can increa#e ta!ently, the borro=er pay# a greater intere#t rate, copen#ating the in$e#tor or lending to a ri#ky borro=er. " credit ri#k i# a borro=er doe# not repay the principal andor intere#t o a loan. Con#e>!ently, creditArating agencie# ea#!re a borro=er?# ri#k. For in#tance, MoodyN# and Standard E oorN# a##ign the ri#k le$el or corporate and go$ernentN# bond# =ith a letter grade. 'h!#, a higher grade iplie# a #aller dea!lt ri#k, and con#e>!ently, the bondholder# =o!ld earn a lo=er intere#t rate. "naly#t# and econoi#t# ea#!re a co!ntry?# ri#k #iilarly, applying the #ae credit rating r!le#. In$e#tor# earn #aller intere#t rate# or proect# and in$e#tent# in a oreign co!ntry =ith a higher letter credit grade. Con#e>!ently, a proectN# rate o ret!rn i# the co!ntryN# ri#k pl!# the rate o ret!rn to a coparable 8.S. 'rea#!ry #ec!rity. " coparable inancial #ec!rity ha# an identical at!rity. 'h!#, a co!ntryN# ri#k inl!ence# the intere#t rate on the debt i##!ed by that co!ntryN# go$ernent. For e!al the ret!rn o a coparable 8.S. go$ernent #ec!rity pl!# a ri#k prei!. F!rtherore, a creditArating agency rated the Me!al# a #pread o 1&0 basis points (bps). Spread becoe# the ri#k prei!, and the 1&0 ba#i# point# e>!al 1.&0, or 1&0 V 100. I a coparable 8.S. go$ernent bond ha# a & intere#t rate, #!b#e>!ently, the yield or a coparable Me!ently, the in$e#tor# =ant an additional re=ard or =aiting or 232

Money, Banking, and International Finance the longer tie. Financial analy#t# and in$e#tor# con#ider a co!ntry?# rating o BBB or better to be Hin$e#tent grade, =hile they rate a BB or lo=er a# H!nk. 8#!al #pread o !nk debt range# ro &00 to 900 ba#i# point# o$er oneAyear 8.S 'rea#!ry bill#. Range co!ld be e!ently, a co!ntryN# ri#k dier# ro a c!rrency e!alitati$e and >!antitati$e approache# to ea#!re co!ntry ri#k. 5!alitati$e incl!de# a co!ntry?# data and e!antitati$e approach incl!de# a co!ntry?# data, and analy#t# cop!te a #core ro data. 5!antitati$e approach Happear# being ore obecti$e beca!#e analy#t# calc!late it ro data. 'able 1. + ountry)s Rating and 5pread o*er 4.5. 'reasuries )$erall ;rade %
Rating

Spread ba#i# point#D

"$erage ba#i# point#D

""" "" "

10 A40 30  100 :0  1+0

30 40 100

BBB BB B

110  220 1-0  +00 240  &10

190 2&0 +30

CCC CC C In /ea!lt

+90  &-0 &30  400 "bo$e 400

&30 340 :00

Risk Ratin$ .et#od , a >!antitati$e approach, i!alitati$e and >!antitati$e ea#!re#. 8#ing thi# ethod, =e cop!te a =eighted a$erage o grade# or o!r a#pect# o a co!ntry. "n analy#t grade# each actor ro ero to 100. " high #core indicate# a lo= co!ntry ri#k =hile a lo= #core iplie# high ri#k. Fo!r actor# areJ 

6conomic Indicators (6I) are ea#y to obtain and indicate a co!ntry?# inancial condition. %conoic Indicator# incl!de ;/ per capita, ;/ gro=th rate, inlation, and intere#t rate#. In$e#tor# are likely to in$e#t in a co!ntry =ith a #trong ;/ gro=th rate, lo= inlation rate, and #table intere#t rate#.

23+


Debt .ana$ement (D.) indicate# a co!ntry?# ability to repay a debt and incl!de# oney gro=th, trade balance, oreign and doe#tic debt, and a go$ernent?# b!dget deicit. " co!ntry rapidly acc!!lating debt or e


Political Factors (PF) are grade# o political #tability. " high grade indicate# a politically #table co!ntry, =hile a lo= grade indicate# co!p#, $iolent prote#t#, and e$en a re$ol!tion. 'hi# grade incl!de# e!antitati$e ea#!re# or political #tability. o=e$er, i the ea#!re =ere good, a oreca#t co!ld be =rong beca!#e an election or re$ol!tion bring# ne= leader# into po=er =ho radically change the r!le#, reg!lation#, and econoy.



Structural Factors (SF) are #ocioeconoic condition#, #!ch a# ed!cation le$el, healthcare, and po$erty rate.

7e calc!late a co!ntryN# #core, 6, by !#ing %>!ation 1. 6ariable, = i, indicate# a =eight =hile the #core i# one o the actor# li#ted abo$e. " =eight i# po#iti$e and range# bet=een ero and one. For e!ally, then e$ery =eight i# #et to 0.23, and a co!ntryN# #core e>!al# the a$erage o it# o!r actor#. F!rtherore, the =eight# !#t #! to one, =hich =e #ho= in %>!ation 2. "ter an analy#t calc!late# a co!ntryN# #core, the #core al=ay# range# bet=een ero and 100 beca!#e the =eight# #! to one. Finally, an analy#t co!ld ad!#t the =eight# to relect hi# or her preerence#. For in#tance, #oe analy#t# $ie= debt anageent a# an e
6 = 71 /core( E8 ) & 72 /core( D% ) & 73 /core( P' ) & 74 /core( /' )

1D

71 & 72 & 73 & 74 = 1

2D

" co!ntry?# #core lie# bet=een 0 and 100. I a co!ntry po##e##e# a lo= #core, then analy#t# and econoi#t# =o!ld add a large ri#k prei! to the ri#kAree intere#t rate. 'h!#, a co!ntry?# ba#i# point# bp#D are greater or lo=er #core#. Moreo$er, in$e#tor# co!ld ad!#t the =eight# and grade# to relect dierent tie horion#. 'hereore, the dierent =eight# yield di#tincti$e ri#k oreca#t# or #hort ter, edi! ter, and longAter in$e#tent. For e!ently, thi# ethod i# an art rather than a #cience. 23&


International Credit +ating !gencies International credit*ratin$ a$encies do not oc!# on ri#k or partic!lar copanie# b!t a##e## in$e#tent ri#k a##ociated =ith co!ntrie#. Ri#k relect# the o$erall danger to international in$e#tor# in in$e#ting in a partic!lar co!ntry beca!#e e$ery co!ntry ha# a $ariety o in#tit!tion#, la=#, and c!#to#. For e
Co!ntry "!#tralia, "!#tria, Canada, /enark, Finland, France, ;erany, ;ibraltar, ;!ern#ey, I#le ) Man, er#ey, (!
'ier II

Barbado#, Belgi!, Ber!da, Briti#h 6irgin I#land#, Cayan I#land#, Chile, ong Kong, Ireland, Italy, apan, (iechten#tein, Maca!, *e= Qealand, Slo$enia, So!th Korea, Spain, and 'ai=an

'ier III

"ng!illa, Bahaa#, Bahrain, Brail, China, Cypr!#, I#rael, K!=ait, Malay#ia, Malta, Me
'ier I6

"ntig!a and Barb!da, "rgentina, Br!nei, Colobia, Co#ta Rica, %l Sal$ador, India, Indone#ia, ordan, Kaakh#tan, Ma!riti!#, Morocco, anaa, er!, hilippine#, R!##ia, '!ni#ia, and '!rkey

"lgeria, Belar!#, Boli$ia, Bo#nia and erego$ina, /oinican Rep!blic, %c!ador, 'ier 6 %gypt, ;hana, ;!ateala, ond!ra#, aaica, Kenya, (ebanon, (ibya, *icarag!a, *igeria, aki#tan, Syria, 8kraine, 6ene!ela, and 6ietna So!rceJ ".M. Be#t. 2012. "$ailable ro httpJ===+.abe#t.corating#crcri#k.a#p< acce##ed on 10192012D

Coace, FranceN# e
Kenneth R. S!lcyk copanie# that deal =ith oreign copanie#. I a oreign b!#ine## dea!lt# on a payent to the in#!red copany, then Coace =o!ld pay the in#!rance clai. 8nort!nately, a oreign copany co!ld #!er inancial tro!ble# ro bankr!ptcy, $iolent prote#t#, re$ol!tion, or an international =ar. Con#e>!ently, copanie# pay greater in#!rance prei!# or in#!ring b!#ine## tran#action# =ith oreign copanie# located in highAri#k co!ntrie#. Finally, Coace copile# a #iilar ranking #cale or co!ntrie#? b!#ine## cliate.

Key Terms political ri#k ir #peciic ri#k trade bloc co!ntry ri#k tran#er ri#k 'ran#parency International ronting loan# le$erage

#pecial di#pen#ation global #peciic ri#k ri#kAree intere#t ri#k prei! ba#i# point# bp#D Ri#k Rating Method international creditArating agencie#

'able 3. ofae)s 5e*en#'ier Rating of ountries for 212 Co!ntry Rating /einition o Rating "!#tralia, Canada, ong Kong, apan, (!
239

C

" $ery !n#teady political and econoic en$ironent co!ld deteriorate an already

Money, Banking, and International Finance Cypr!#, /ibo!ti, %c!ador, %gypt, %thiopia, ;eorgia, ;reece, ;!ateala, ond!ra#, aaica, Kenya, (ebanon, Macedonia, Madaga#car, Ma!ritania, Mongolia, Montenegro, Moabi>!e, *icarag!a, *iger, arag!ay, Sao 'oe and rincipe, Serbia, Sierra (eone, Sri (anka, 'iorA(e#te, 'ogo, 8ganda, 6ene!ela, 6iet *a, and Qabia

bad payent record.

"ghani#tan, Belar!#, Bo#nia and erego$ina, B!r!ndi, / ighAri#k proile o a co!ntryN# econoic Cabodia, Central "rican Rep!blic, Chad, Congo, C!ba, and political en$ironent =ill !rther %>!atorial ;!inea, %ritrea, ;!inea, aiti, Iran, Ira>, I$ory =or#en !rther a generally $ery bad Coa#t, Kyrgy#tan, (ao, (iberia, (ibya, Mala=i, Mali, payent record. Moldo$a, Myanar, *epal, *igeria, aki#tan, R=anda, S!dan, Syria, 'aiki#tan, '!rkeni#tan, 8kraine, 8beki#tan, een, and Qibab=e So!rceJ Coace. 2012. Rating 'able. "$ailable ro httpJ===.coace.coCoaceortalC)Men%*page#hoeri#k#hoeco!ntryri#k#ratingtable@ geoareaAco!ntryOEcratingOEbratingO acce##ed on 10192012D

Chapter Questions 1

o= co!ld a ir protect it# b!#ine## in a oreign co!ntry by !#ing acility location, intellect!al property right#, and le$erage@

1-3.

7hich ind!#trie# doe# a go$ernent !#!ally protect@

1-9.

o= doe# a ir !#e e
1-4.

/eine #pecial di#pen#ation.

1-:. o! had p!rcha#ed bond# ro a co!ntry =ith a CCC credit rating. Calc!late the e
/i#ting!i#h bet=een >!alitati$e and >!antitie# ea#!re# or ea#!ring a co!ntry?# ri#k@

201.

o= =o!ld yo! rate ong Kong !#ing ".M. Be#t and Coace@

202.

o= =o!ld yo! rate the 8kraine !#ing ".M. Be#t and Coace@

6nswers to Cha"ter 7estions 234


!ns*ers to Chapter ; Questions 1

!rpo#e o inancial arket# and inancial in#tit!tion# i# to connect the #a$er# to the borro=er#. 7ealthy co!ntrie# ha$e de$eloped inancial arket#. I the #a$er# hide their oney !nder the attre##, then they reo$e thi# oney ro the econoy. 'hen bank# cannot inect the #a$ing# into an econoy by lending to ho!#ehold# and b!#ine##e#.

20+. Financial in#tit!tion# acc!!late and analye inoration abo!t borro=er# and their ability to repay loan#, =hich lo=er the lending ri#k to a $ariety o borro=er#, and increa#e# li>!idity. Sa$er# can ea#ily con$ert their depo#it# into ca#h. 20&. Many a##et# are technically not oney, b!t the p!blic can ea#ily con$ert the into oney. 'h!#, #oe a##et# are good a# oney. 203. " central bank !#e# the oney #!pply to aect it# econoy. ;oal i# to keep an econoy gro=ing at a #!#tainable rate =ith a lo= !neployent rate and lo= inlation rate. 209.

'hree $ariable# are inlation, ;/, and intere#t rate#.

204. Inlation i# contin!al increa#e# in the a$erage price#L ;/ ea#!re# the total ao!nt o prod!ction o all good# and #er$ice# =ithin the econoy. Finally, intere#t rate# relect the borro=er?# co#t, b!t a beneit to the #a$er. 20:. Real ean# econoi#t# reo$ed the ipact o inlation ro the $ariable =hile noinal ean# inlation #till inl!ence# a $ariable. 20-. Barter i# ineicient beca!#e it doe# not allo= people to #pecialie in the prod!ction o good# and #er$ice#. F!rtherore, it re>!ire# a large n!ber o e
Money, Banking, and International Finance 21+. 'ran#action approach oc!# on any a##et# that are !#ed a# oney in a tran#action, =hile the li>!idity approach deine# any li>!id a##et# a# oney. eople can con$ert #oe a##et# to oney ea#ily, #o they are alo#t oney. 21&. M2 dier# ro M1 by the #all denoination tie depo#it# and #a$ing# acco!nt#. /ierence# bet=een (, M+, M2, and M1 indicate the #ie o a co!ntry?# inancial #y#te. (arge dierence# iply a co!ntry ha# ore de$eloped inancial arket#. 213. Credit card# are loan# ro a bank or inance copany. ) co!r#e, any people !#e credit card# a# oney, !rther coplicating the oney deinition e$en ore.

!ns*ers to Chapter 1 Questions 1

Bank depo#it# are li>!id. Bank# di$er#iy their loan# a# a =ay to red!ce the ri#k. Finally, bank# collect inoration abo!t borro=er#, #o bank# kno= =ho to lend, red!cing the dea!lt ri#k.

219.

Stock# are o=ner#hip o a corporation, =hile bond# are a loan to a corporation.

214. riary arket i# or ne=ly i##!ed #tock# and bond#, =hile the #econdary arket# allo= in$e#tor# to b!y or #ell their e!idity. 'h!#, in$e#tor# can #ell their #ec!ritie# ea#ily i they do not =ant to hold the anyore. 21-. Financial di#interediation i# depo#itor# =ithdra= their depo#it# ro inancial in#tit!tion# and in$e#t directly into the inancial arket# beca!#e the inancial arket# oer a better ret!rn andor red!ce ri#k#. 220. Money arket in#tr!ent# incl!deJ 8.S. 'rea#!ry bill# 'Abill#D, coercial paper, banker?# acceptance#, negotiable bank certiicate# o depo#it C/#D, rep!rcha#e agreeent#, Federal F!nd#, and %!rodollar#. Capital arket in#tr!ent# are 'rea#!ry note# 'Anote#D, 'rea#!ry bond# 'Abond#D, generalAobligation bond#, re$en!e bond#, and ortgage#. 221. Money arket i# or #ec!ritie# =ith a at!rity le## than one year, =hile the capital arket incl!de# #ec!ritie# =ith at!ritie# o$er one year. 222.

Stock ha# no at!rity date beca!#e a corporation can theoretically li$e ore$er.

22+. " #tate bank ha# a charter ro a #tate go$ernent, =hile a ederal bank ha# a charter ro the 8.S. ederal go$ernent.

23-

Kenneth R. S!lcyk 22&. 'he Coptroller o the C!rrency, F/IC, and the Fed reg!late the national bank#. " #tate bank co!ld be reg!lated by one or ore reg!latory agencie#, depending !pon the #tate =here the bank i# located. 223. 'he 8.S. go$ernent =ant# a #table inancial #y#te that protect# banking c!#toer#, enco!rage# hoeo=ner#hip, proote# eiciency in the interediation proce##, and control# the oney #!pply. 229.

'he F/IC in#!re# bank depo#it# !p to G230,000 per per#on and not by the acco!nt.

224. 'he F/IC li>!idate# a bank?# a##et# and re!nd# the depo#it# to the depo#itor#, or the F/IC ind# another bank to erge =ith the ailed bank. 'hen the F/IC =ill grant lo=A intere#t loan# or b!y the bad loan# to ake a bank erger ore attracti$e. 22:. " bank r!n i# depo#itor# #ho= !p at their bank at once and deand their depo#it# back. " contagion i# one bank r!n lead# to other bank r!n#, e$en or inancially healthy bank#. " inancial panic i# a =a$e o bank ail!re# that p!#h a #ociety into a #e$ere rece##ion. 22-. Co!ntrie# repealed la=# that allo= international b!#ine##e# to operate =ithin their border#. F!rtherore, gro=ing incoe# allo= people and b!#ine##e# to in$e#t ore !nd# into international arket#. Finally, corporation# and bank# are global a# their acti$itie# #pread acro## border#. 2+0. " go$ernent =ant# a #table inancial #y#te and inancial in#tit!tion# to di#clo#e acc!rate inoration. Reg!lation# help a central bank e!ire# #tock in another bank, allo=ing it to cro## a #tate line. Second, bank can i##!e coercial paper on it#el and tran#er !nd# bet=een #!b#idiarie#. Finally, bank# co!ld ac>!ire nonbank# and enter other #phere# o acti$ity. 2+2. " nonbank bank #top# one !nction like accepting depo#it# or granting loan#, th!# it i# no longer a bank. F!rtherore, "!toated 'eller Machine# allo= c!#toer# to bank at #oe di#tance ro the bank, e$en in oreign co!ntrie#. 2++. Bank# oer MM/" =hile inancial copanie# oer MMMF. 'h!#, the MM/" i# co$ered by depo#it in#!rance.

!ns*ers to Chapter < Questions 1

)ne per#on, the o=ner, i# liited in the le$el o capital he or #he can rai#e. o=e$er, corporation# can i##!e #tock# and bond# and rai#e illion# or billion# o dollar#. artner#hip# co!ld rai#e #oe capital beca!#e t=o or ore partner# pool their !nd# together. 290

Money, Banking, and International Finance 2+&. Corporation# can rai#e a #!b#tantial ao!nt o capital, ha$e liited liability, ea#ily tran#er o=ner#hip, contin!ity o lie, and ree ro the !t!al agency relation#hip. 2+3. Corporation co!ld i##!e preerred #tock or corporate bond# beca!#e it doe# not dil!te the #hare# o the coon #tockholder#. 2+9. " coon ra!d i# a #!b#idiary hide# a corporation?# debt and e
8nort!nately, thi# =a# a bad in$e#tent. o!r rate o ret!rn i#J return = 100 ⋅

G0.3

+ 100 ⋅

G13 − G23

= −+:K G23 G23 2+:. I yo! had read the chapter care!lly, the 8.S. e
Kenneth R. S!lcyk 2&3. Bo#nia =o!ld prod!ce 300 !nit# o tobacco, and 230 !nit# o coee. Colobia gro=# 230 !nit# o tobacco and 300 !nit# o coee. 'h!#, total coee and tobacco prod!ction are 430 !nit# each. I they engage in trade, Bo#nia prod!ce# 1,000 !nit# o tobacco =hile Colobia prod!ce# 1,000 !nit# o coee. Con#e>!ently, both co!ntrie# gain 230 !nit# in prod!ction or both cooditie# ater trade.

!ns*ers to Chapter = Questions 1

Bank# can #tr!ct!re their b!#ine## to circ!$ent reg!lation# or lo=er ta
2&9. "n o#hore arket i# bank# are located in co!ntrie# =ith la< reg!lation#, lo= ta!ire# an e!antity today, and they e
Money, Banking, and International Finance 233. "n e
!ns*ers to Chapter > Questions 1

Broker#, in$e#tent banker#, and organied e
2

'he /o= one# "$erage i# an a$erage o the top, bl!eAchip #tock# on the *e= ork Stock %
+

" #tock arket cra#h occ!r# =hen #tock price# reach a peak and >!ickly pl!et. eople and in$e#tor# hold #tock a# =ealth. I #tock price# all too, then peopleN# =ealth di#appear#. F!rtherore, #oe in$e#tor# borro=ed to b!y #tock, and they cannot repay the loan#. 'h!#, a #tock arket cra#h co!ld lead to a inancial cri#i#.

&

M!t!al !nd# and inance copanie#. For e
3

"d$er#e #election i# a per#on kno=# he dri$e# reckle##ly and b!y# in#!rance to protect hi# car. Moral haard i# a dri$er becoe ore carele##, like lea$ing hi# key# in the car.

9

In#!rance copanie# and pen#ion !nd#. For e
4

Coercial bank#, #a$ing# in#tit!tion#, and credit !nion#.

:

Coon 8.S. go$ernent in#tit!tion# reerred in thi# book are Federal /epo#it In#!rance Corporation, Fannie Mae, Freddie Mac, and Sallie Mae.

29+

Kenneth R. S!lcyk -

College b!bble i# not likely to aect France. )nce French #t!dent# grad!ate or drop o!t, and they cannot ind eployent, #!b#e>!ently, they ha$e no debt# to repay. 'he French #t!dent# only lo#e the $al!e o their tie at the !ni$er#ity.

!ns*ers to Chapter ? Questions 1

*et incoe i# G30,000 X G90,000 A G100,000 A G+0,000 A G+0,000, =hich e>!al# AG30,000.

23:. Retained earning# are G20,000 XG30,000 A G90,000 O G10,000. /o not incl!de the #ale# o #tock beca!#e #tock tran#action# are recorded !nder the coon #tock acco!nt. 23-. Ca#h balance e>!al# G10,000 A G40,000 XG100,000 A G10,000 O G+0,000. /o not incl!de the acco!nt# recei$able beca!#e the#e are credit #ale# and the b!#ine## did not collect ca#h. P( 0 =

P( 

(1 & i )



=

G1,000,000

(1 + 0.03) 100

290.

7e calc!lated

291.

7e calc!lated P(  = P(  (1 & i )



= G4,90&.&-

= G3,000(1 + 0.1) 30 = G3:9,-3&.29

292. S!b#tit!te =hich $ariable# yo! kno= into the e>!ation, and then !#e algebra to #ol$e or the intere#t rate, i, e>!aling -.3&.

FV 2= PV 0 ( 1 + i )

T

$ 1,200= $ 1,000 (1 + i ) i =0.0954

2

29+.

8#ing the R!le o 42, yo!r bank acco!nt do!ble# in 2& year#, or 42 V +.

29&.

8#ing the R!le o 42, the 8.S. econoy do!ble# in 1&.& year#, or 42 V 3. P( 0 =

293.

7e calc!lated

$1,000

(1& 0.04 )

0

&

$1,000

(1& 0.04)

1

&

$1,000

(1& 0.04 )

2

= $2,:0:.02

299. 7e calc!lated G2-2:.3& belo=. 5!e#tion =a# not clear beca!#e =e do not kno= =hen the depo#it =a# ade. Con#e>!ently, =e #ho=ed depo#it# being ade at the beginning o the period. +

2

'( 3 = $400(1& 0.0+) & $400(1& 0.0+) & $400(1& 0.0+) '( 3 = $1,&9&.42 294.

7e calc!lated the pre#ent $al!e o 29&

1

Money, Banking, and International Finance P( 0 =

29:.

$100

(1& 0.01) 1

&

$100

(1& 0.01) 2

$100

( 1& 0.01) +

= $2-&.10

7e calc!late the gro=th in the #a$ing# acco!nt or each copo!nding re>!ency.

'( +0 = G300(1 + 0.03)

(

'( +0 = G300 1 + 0.03 '( +0

29-.

&

= G2,190.-4

+0

12⋅+0

) 12

= G2,2++.:4

= G300 ⋅ e0.03⋅+0 = G2,2&0.:&

7e calc!late the eecti$e ann!al intere#t rate o 12.33 belo=.

(

E'' = 1 + 0.12

) &

&

− 1 = 0.1233

240. 8#ing the or!la or an ordinary ann!ity, =e calc!late the ann!ity $al!e o G:1,--0.-: belo=J

 (1 + 0.04) 20 − 1 = G:1,--0.-: '(  = G2,000  0.04   241. 8#ing the or!la or an ordinary ann!ity, =e calc!late yo!r ann!al payent# a# G&,:14.11 belo=J P =

242.

1 − (1 + 0.03)

−13

= G&,:14.11

7e calc!late onthly ortgage payent o G+,+29.31 belo=J

P =

24+.

0.03 ⋅ G30,000

0.003:++ ⋅ G300,000 1 − (1 + 0.003:++)

−+0⋅12

= G+,+29.31

7e calc!late the net pre#ent $al!e o &+,129.3& r belo=J

(

rm NPV =−2,000 € 4.00 € NPV =43,126.54 rm

)

(

3,000 € 4.25 +

)

rm €

( 1+ 0.04 )1 293

(

4,000 € 4.50 +

)

rm €

( 1 + 0.04 )2

(

5,000 € 5.00 +

( 1 + 0.04 )3

rm €

)


!ns*ers to Chapter @ Questions 1

Both a note# payable and corporate bond are loan# to the corporation. o=e$er, a bond i# #tandardied and allo=# in$e#tor# to b!y and #ell the in the #econdary arket#, =hile a bank !#!ally grant# a note# payable.

24&. Bond# are a liability that co!ld lo=er a corporationN# ta< b!rden. F!rtherore, the bondholder# do not $ote at a corporation?# #tockholder# eeting and th!#, do not copete =ith the #tockholder# o$er control o a corporation. Con#e>!ently, #tockholder# co!ld earn a higher di$idend i a corporation !#e# bond# to e
7e ad!#ted the calc!lation already or the ann!al yield to at!rity o the di#co!nt bond, '( 1 $20 ,000 P( 0 = = = $ 1- ,33-.-0 ⋅ ⋅ r  0 . 0+ 240 1& 1& +90 +90 =hich i#J

(

249.

) (

7e calc!latedJ

P( 0 =

P( 0 =

244.

7e calc!latedJ P( 0 =

24:.

7e calc!latedJ

'( i

)

$100 = $1,999.94 0.09

=

$100

(1 & 0.023) $100

(1 & 0.1)

&

&

$100

(1 & 0.023) 2

$100

(1 & 0.1)

2

&&

& &

$2,100

( 1 & 0.023) 9

$2,100

( 1 & 0.1) 9

$2,243.&1 =

= $1,39&.&4

24-. Money arket #ec!ritie# ha$e at!ritie# le## than a year. 'h!#, =hen the intere#t rate change#, the oney arket #ec!ritie# #=ing le## in arket $al!e a# copared to the capital arket #ec!ritie#. 2:0. 7hen the intere#t rate decrea#e#, #!b#e>!ently, the $al!e o bond# becoe# greater. 'h!#, yo! #ho!ld b!y bond# no= and re#ell the or a higher price =hen the intere#t rate decrea#e#. o=e$er, i yo! are =rong, then yo! lo#e oney, or yo! co!ld be holding onto the bond# or a =hile. G&,300 =

2:1. o! #et !p the e>!ation a# 'M, e>!aling +.34.

2:2.

7e cop!ted

P 0 =

D r − g

=

G3,000

(1 & #% ) + . 'hen yo! !#e algebra to #ol$e or the

$1

0.0& − 0.0+

= $100.00

. 299

Money, Banking, and International Finance 2:+.

Fir#t, yo! #et /1 O /2 O 0. Second, yo! calc!late the #tock price a# D+ $1 P 2 = = = $20.00 r − g 0.10 − 0.03 . o=e$er, thi# i# or ear +. 'hen yo! di#co!nt the ca#h $20.00 $19.3+ P 0 = = 2 ( ) 1 0.10 & lo= back to ear 0, yielding


Si< actor# are =ealth, e!idity, and inoration co#t#.

2:&. Fo!r actor# are e!antity decrea#e. F!rtherore, the bond intere#t rate #ho!ld ri#e. 2:9. S!pply or bond# decrea#e# and #hit# let=ard. 'h!#, the bond price increa#e# =hile >!antity decrea#e#. F!rtherore, the bond intere#t rate #ho!ld all. 2:4. /eand or bond# increa#e# and #hit# right=ard. 'h!#, both the bond price and >!antity ri#e. F!rtherore, the bond intere#t rate #ho!ld decrea#e. 2::. /!ring a b!#ine## cycle, both #!pply and deand or bond# increa#e and #hit right=ard. /!ring a rece##ion, both the #!pply and deand or bond# decrea#e and #hit let=ard. 5!antity i# deterinate =hile bond price#, and th!# bond intere#t rate# are indeterinate. 2:-. Real intere#t rate i# A3 =hile the appro
( 0.-0 &1) = (1& r )( 1& 1.00)

r = −3K

0.-0 ≈ r & 1.00

r = −10K

2-0. I in$e#tor#, b!#ine##e#, and go$ernent e
Kenneth R. S!lcyk 2-2. 7orldN# intere#t rate i# higher. 'h!#, in$e#tor# =o!ld loan their #!rpl!# !nd# abroad to earn the greater intere#t rate. 2-+. 7orldN# intere#t rate i# lo=er. 'h!#, b!#ine##e# and the go$ernent =o!ld borro= the cheaper !nd# ro oreign in$e#tor#.

!ns*ers to Chapter A Questions 1

In$e#tor# are !#!ally ri#k a$er#e. 'h!#, in$e#tor# increa#e their deand or the lo=Ari#k bond# and decrea#e their deand or the highAri#k one#. Con#e>!ently, bond price# increa#e or the lo=erAri#k bond# b!t decrea#e or the higherAri#k bond#. F!rtherore, the intere#t rate# are lo=er or the lo=Ari#k bond# and higher or the highAri#k bond#.

2

In$e#tor# preer to hold li>!id #ec!ritie#. 'h!#, in$e#tor# increa#e their deand or the highly li>!id bond# and decrea#e their deand or the lo= li>!id one#. Con#e>!ently, bond price# increa#e or the li>!id bond# b!t decrea#e or the nonAli>!id bond#. Moreo$er, the intere#t rate# are lo=er or the li>!id bond# and higher or the nonAli>!id bond#.

+

In$e#tor# preer to in$e#t in #ec!ritie# that entail lo= inoration co#t#. 'h!#, in$e#tor# increa#e their deand or the lo= inoration co#t bond# and decrea#e their deand or the high inoration co#t one#. Con#e>!ently, bond price# increa#e or the bond# =ith lo= inoration co#t# b!t increa#e or the high inoration co#t bond#. F!rtherore, the intere#t rate# are lo=er or the bond# =ith lo= inoration co#t# and higher or the other bond#.

&

In$e#tor# preer to in$e#t in #ec!ritie# that ha$e lo=er ta!ently, bond price# increa#e or the ta
3

'er #tr!ct!re o the intere#t rate# i# an entity oer# a large $ariety o #ec!ritie# =ith dierent intere#t rate#. 'h!#, the #ec!ritie# ha$e the #ae ri#k, li>!idity, inoration co#t#, and ta
9

'hree theorie# are #egented arket# theory, e
Money, Banking, and International Finance 4

7hen a yield c!r$e ha# a negati$e #lope, the in$e#tor# are pe##ii#tic abo!t the !t!re, and the econoy !#!ally enter# a rece##ion a year later.

!ns*ers to Chapter ;2 Questions 1

(iabilitie# are deand depo#it#, #a$ing# acco!nt#, #all and largeAdenoination tie depo#it#, borro=ing#, di#co!nt loan#, and ederal !nd# i the bank borro=ed !nd#D. "##et# incl!de $a!lt ca#h, depo#it# at other bank#, depo#it# at the Federal Re#er$e, loan#, and bank?# phy#ical a##et# like it# b!ilding# and cop!ter#. Capital relect# a bank?# net =orth.

2-&. " bank?# net =orth e>!al# bank?# total a##et# in!# total liabilitie#. In$e#tor# =ant a po#iti$e net =orth beca!#e the #tockholder# recei$e a##et# i the bank i# li>!idated. 2-3. (i>!idity ri#k i# the ri#k that depo#itor# #ho= !p at the bank and =ithdra= too !ch at one tie. Con#e>!ently, the bank# !#t !#e good anageent to eet depo#itor#N =ithdra=al#. 2-9.

Soething #e$ere happen# to a bank that ca!#e# total liabilitie# to e
2-4. Bank# !#e credit ri#k analy#i#, collateral, credit rationing, and re#tricti$e co$enant# to red!ce ad$er#e #election. F!rtherore, bank# co!ld o#ter a longAter relation#hip =ith their c!#toer#. 2-:. o!#ing b!bble popped, ca!#ing ho!#ing price# to pl!et. I a bank oreclo#e# on a hoe that i# lo#ing $al!e, then too any oreclo#!re# ca!#e total liabilitie# to e!ently, it iediately ipact# the#e a##et# and liabilitie#. Bank# can de$elop #trategie#, =hether a bank anager belie$e# intere#t rate# =ill ri#e or all. +00. Floating rate debt i# loan# =ith a $ariable intere#t rate. I the intere#t rate increa#e#, then borro=er# !#t pay ore intere#t on their payent#. +01. Sec!ritiation i# the b!ndling o illi>!id a##et# like ortgage# into a !nd. 'hen thi# !nd allo=# in$e#tor# to in$e#t in it. " !nd oer# dierent tranche# =ith dierent credit rating# and rate# o ret!rn. +02. 'hi# i# really a to!gh >!e#tion. I bank# retained their rigid lending #tandard# and the creditArating agencie# acc!rately rated the C/)# and "BS, then the ho!#ing b!bble =o!ld #till or b!t at a #lo=er rate. 'he ;reat Rece##ion =o!ld #till ha$e occ!rred, b!t the eect# =o!ld not ha$e been a# har!l and #e$ere. 29-


!ns*ers to Chapter ;; Questions 1

'he FedN# a##et# are the di#co!nt loan# and holding# o 8.S. go$ernent #ec!ritie# =hile it# liabilitie# are bank re#er$e# and c!rrency in circ!lation.

+0+. Money !ltiplier #ho=# ho= the oney #!pply change#, =hen the onetary ba#e change#. Con#e>!ently, the p!blic, bank#, and the Fed all inl!ence the oney !ltiplier. +0&.

7e calc!latedJ +/epo#it# = +Re#er$e# ×

+03.

1 1 = $30 ,000 × = $1 million r r 0.03

7e calc!latedJ +/epo#it# = +Re#er$e# ×

1 r r

= −$10 ,000 ×

1 = −$30,000 0.20

+09. 7e calc!lated thi# belo=. /o not incl!de the ir#t G1,000 beca!#e the per#on con$erted a G1,000 o c!rrency into a bank depo#it. +/epo#it# = +Re#er$e# ×

1 1 = $-00 × = $-,000 r r 0.1

+04. 7e calc!lated thi# belo=. /o not incl!de the ir#t G3,000 beca!#e the per#on =ithdre= G3,000 ro hi# checking acco!nt and con$erted it into ca#h. +/epo#it# = +Re#er$e#

× 1 = −$&,300 × r r

1 = −$&3,000 0.1

+0:. C!rrencyAtoAdepo#it ratio repre#ent# the portion o oney held by the p!blic a# c!rrency. "n increa#e in =ealth, higher intere#t rate#, lo=er ri#k ro bank ail!re#, and an increa#e in illegal acti$itie# =ill decrea#e thi# ratio. +0-. 'hi# occ!rred d!ring the 200: Financial Cri#i#. 'he Federal Re#er$e granted G2 trillion in loan#. o=e$er, the bank# held onto thi# oney and did not increa#e loan#. 'h!#, the !ltiple depo#it creation cea#ed to =ork. !rpo#e o the bailo!t =a# to get the 8.S. banking #y#te to #tart lending again. +10. Bank# and the p!blic can th=art a FedN# action by changing their beha$ior. Bank# can hold e
7e calc!lated both the M1 and M2 oney !ltiplier# belo=J

240


 - + 1   0.33 3 + 1  = m2 =  D = 1.994  -  + 0 . 33 3 0 . 44 4  D + D       - +  + 1  0.333 + 1.++ + + 1 D = m2 =  D = 2.194 -   D + D   0.333 + 0.444  !ns*ers to Chapter ;1 Questions 1

'he Fed?# a##et# incl!de #ec!ritie#, di#co!nt loan#, Ite# in the roce## o Collection CICD, ;old Certiicate#, Special /ra=ing Right# S/R#D, coin#, b!ilding#, and oreignA c!rrency re#er$e#. 'he Fed?# liabilitie# are c!rrency o!t#tanding, depo#it# by depo#itory in#tit!tion#, 8.S. 'rea#!ry depo#it#, oreign and other depo#it#, /eerred "$ailability Ca#h Ite# /"CID, Federal Re#er$e loat. 'he Fed?# net =orth e>!al# total a##et# in!# total liabilitie#.

+12. ;o thro!gh the 'Aacco!nt tran#action# or the checking =riting proce## by changing the ao!nt o the check. +1+. Float change# in /eceber and "pril. eople b!y Chri#ta# pre#ent# in /eceber and pay their ta
" ri#e in the loat increa#e# both the onetary ba#e and oney #!pply.

+13. 'he 'rea#!ry /epo#it increa#e# the FedN# liabilitie#, #hrinking both the onetary ba#e and oney #!pply. +19. I the bank# red!ce the ao!nt o di#co!nt loan#, then the FedN# a##et# all, decrea#ing both the onetary ba#e and oney #!pply. +14. 'he Fed cannot control the 8.S. 'rea#!ry depo#it#, the loat CIC A /"CID, gold certiicate#, S/R#, and oreign go$ernent depo#it#. +1:. 'he 8.S. 'rea#!ry doe# not inl!ence the onetary ba#e or oney #!pply by changing ta
241

Kenneth R. S!lcyk +20. /e$eloped co!ntrie# like the 8nited State# and %!rope =ant #trong c!rrencie#. It attract# oreign in$e#tor#. China and the "#ian tiger# aintain =eak c!rrencie#, boo#ting their e!ently, the 8.S. c!#toer# b!y ore iport# =hile the 8.S. e!ently, the 8.S. trade deicit =or#en#. +22. "# the Federal Re#er$e b!y# or #ell# oreign c!rrencie#, the FedN# a##et# and liabilitie# change. 'h!#, the onetary ba#e and oney #!pply change#. 8n#terilied tran#action# do not o#et the change in the oney #!pply =hen the Fed inter$ene# in the oreign e
!ns*ers to Chapter ;< Questions 1

'he Federal Re#er$e ha# 12 Federal Re#er$e bank#.

+2+. %ach region o the co!ntry i# econoically dierent. 'h!#, each Federal Re#er$e Bank tailor# it# #er$ice# or each !ni>!e region. F!rtherore, the po=er o a central bank i# di#per#ed aong the 12 Fed bank#. +2&. 'he Federal Re#er$e Sy#te ha# 12 Fed bank#. %$ery national bank !#t p!rcha#e #tock in it# regional Fed bank and can $ote or three director# ro the banking. F!rtherore, the Board o ;o$ernor# can choo#e three director# and appro$e# the choice o the FedN# bank pre#ident. Finally, b!#ine##e# can elect the la#t three director#. +23. 'he Board o ;o$ernor# anage# the Federal Re#er$e Sy#te. 'he Board ha# #e$en eber# =ho the 8.S. re#ident appoint# =ith Senate appro$al. +29. 'he Fed rai#e# it# o=n !nding independent o the 8.S. go$ernent. Moreo$er, the eber# o the Board o ;o$ernor# ha$e #taggered ter#, #o one re#ident cannot change the entire board at once. Finally, the 8.S. go$ernent cannot copletely a!dit the Fed. +24. 'he Federal )pen Market Coittee p!t# onetary policy into action. 'hey deterine openAarket operation#, =hile the Board o ;o$ernor# control# the F)MC. +2:. Chairan ad$i#e# the re#ident and inor# Congre## on FedN# action#. Finally, the inancial analy#t# pay clo#e attention to the chairan?# policie# and #peeche#. +2-. Con#e>!ence# co!ld be di#a#tro!# beca!#e the co!ntry re$er#e# the gain# or a #ingle c!rrency. For e
Money, Banking, and International Finance go$ernent cannot balance it# b!dget, and in$e#tor# do not =ant to in$e#t in ;reek bond#. !blic belie$e# i the ;reek go$ernent reintrod!ce# the dracha, then the go$ernent =ill de$al!e a# it create# oney to co$er b!dget deicit#. Con#e>!ently, the ;reek citien# #tarted a r!n on the bank# to =ithdra= their #a$ing# in e!ro# beore the ;reek go$ernent con$ert# c!rrency to dracha#. ++0. 'he %
Co!ntrie# =ith independent central bank# !#!ally ha$e $ery lo= inlation rate#.

!ns*ers to Chapter ;= Questions 1

'he Fed create# a higher deand in the bond arket. 'h!#, the bondN# arket price ri#e# =hile the intere#t rate all#. 'he Fed inected re#er$e# into the banking #y#te, e
++&. 'he Fed increa#e# the #!pply in the bond arket. 'h!#, the bondN# price all# =hile the intere#t rate ri#e#. 'he Fed reo$ed re#er$e# ro the banking #y#te, contracting the oney #!pply. ++3. I the Fed increa#e# the oney #!pply by +, it !#t b!y eno!gh 8.S. 'rea#!ry #ec!ritie# to achie$e thi# goal. o=e$er, the Fed b!ying the #ec!ritie# ro the bond arket decrea#e# the intere#t rate. I the Fed concentrated on the intere#t rate, it !#t b!y or #ell bond# to achie$e the target intere#t rate. *e$erthele##, the b!ying or #elling o bond# change# the bank re#er$e#, and hence, the oney #!pply. ++9. " R%) i# a rep!rcha#e agreeent. 'he Fed teporarily b!y# a 8.S. go$ernent #ec!rity, and the #eller =ill b!y it back on a #peciic date in the !t!re. " re#er$e R%) i# the Fed #ell# a 8.S. go$ernent #ec!rity and agree# to rep!rcha#e it on a partic!lar date in the !t!re. R%)S inect re#er$e# into the banking #y#te =hile re$er#e R%)# reo$e re#er$e# teporarily.

24+

Kenneth R. S!lcyk ++4. " deen#i$e tran#action o#et# !ne!antity o #ec!ritie# it can b!y or #ell. 'h!#, it can change the oney #!pply by a little or a lot, ea#y to correct i#take#, and ipleent onetary policy >!ickly. ++-. I the Fed decrea#e# the di#co!nt rate, then the Fed enco!rage# bank# to borro= ore ro the Fed. " lo=er di#co!nt rate i# e!ently, it ipleent# contractionary onetary policy. +&0.

'he Fed co!ld grant ad!#tent credit, #ea#onal credit, or e
+&1. 'he Fed co!ld a!dit the bank ore, co!ld ipo#e ine# on the bank, or #top lending to a bank. +&2. 'he Federal Re#er$e cannot orce bank# to accept loan#. 'he Fed co!ld lo=er the di#co!nt rate, b!t bank# ight not increa#e their borro=ing# ro the Fed. +&+. 7hen the Fed cond!ct# onetary policy, the policy aect# the ederal !nd# rate ir#t. I the ederal !nd# rate ri#e#, then the Fed ay be p!r#!ing contractionary onetary policy. I the ederal !nd# rate drop#, #!b#e>!ently, the Fed ay be !#ing e!ireent# change# the oney !ltiplier#. 'h!#, e$en a #all change in the re#er$e re>!ireent co!ld ha$e a large ipact on the oney #!pply. +&3. )ne beneit i# the go$ernent co!ld eliinate depo#it in#!rance. Bank# =o!ld hold all depo#it#. F!rtherore, the oney !ltiplier# =ill be one, and the Fed ha# e!ickly, creating inlation. +&:. "ltho!gh the Fed ha# #i< goal#, it cannot control the. o=e$er, the Fed !#e# target# beca!#e it ha# better control o$er the and in t!rn, the target# inl!ence the goal#. 24&

Money, Banking, and International Finance +&-. Monetary policy ha# an iediate ipact on operating target# like the ederal !nd# rate# and nonAborro=ed re#er$e#. )$er tie, onetary policy inl!ence# the interediate target#. )perating and interediate target# dier by Fed control and tie lag#. +30. 'he Fed !#t acc!rately ea#!re the target# and e
!ns*ers to Chapter ;> Questions 1

!rpo#e o the balanceAoAtrade acco!nt# i# to acco!nt or oney lo=# bet=een one co!ntry and the re#t o the =orld. %conoi#t# cla##iy oney lo=# into categorie# that allo= the to analye pattern# in the ca#h lo=#.

+3+. C!rrent acco!nt incl!de# e
Kenneth R. S!lcyk I the co!ntry re!#e# to !#e re#er$e# or de$al!e it# c!rrency, then black arket# =o!ld or or it# c!rrency. +3-. I a co!ntry de$al!e# it c!rrency, #!b#e>!ently, the ipact doe# not iediately red!ce a trade deicit. " co!ntry?# iport# contin!e ri#ing =hile it# e!ently, the central bank increa#e# the oney #!pply and red!ce# the intere#t rate. International in$e#tor# #lo= do=n their in$e#tent# in the co!ntry that red!ce# the inancial acco!nt. +91. Capital light i# #iilar to a bank r!n on a oreign co!ntry. International in$e#tor# ca!#e a a##i$e o!tlo= o capital a# they ca#h in their in$e#tent#. " capital light co!ld lead to the collap#e o a co!ntry?# c!rrency. In$e#tor# !#e o!r ethod# to tran#er oney o!t o the co!ntryJ bank tran#er#, oney la!ndering, al#e in$oicing or iport# and e
!ns*ers to Chapter ;? Questions 1

'he ep#i co#t# 2.23 dirha#.

+9+. 2

 2 k   Y 0.41&      = 1.&2: "m G1  Y 1   G1  7e calc!latedJ 

7e calc!lated the cro## e!ently, arbitrage i# po##ible.

 2 k   Y 1  1 "m    =   "una100  "una 30 Y 1     5tep 1: 'rader con$ert# the con$ertible arket# into e!ro#, calc!lated belo=J

 1 Y    = 230,000 Y "m 2  

300,000 "m

249

Money, Banking, and International Finance 5tep 2: 'rader con$ert# the e!ro# into Croatian k!na#, #ho=n belo=J

 k!na100  ,   = 23,000,000 k!na# Y 1  

230,000 Y 

5tep 3: 'rader con$ert# the k!na# back into Bo#nian con$ertible ark#, calc!lated belo=. Con#e>!ently, the trader earn# &+,&4:.29 k in proit#.

 1 k  = 3&+,&4:.29 k  k!na# &9  

23,000,000 k!na# 

+9&. S!pply or 8.S. dollar# coe# ro people holding 8.S. dollar#, and they trade tho#e dollar# or another c!rrency. " deand or c!rrency in one arket a!toatically create# a #!pply o c!rrency in another arket a# people e!ently, the pe#o depreciate# =hile the 8.S. dollar appreciate#, ca!#ing Me!ently, the 8.S. dollar depreciate# =hile the arket >!antity o 8.S. dollar# becoe# abig!o!#. +9:. (o=er deand or the 8bek #o ca!#e# the #o to depreciate again#t the 8.S. dollar. 'he 8bek central !#t red!ce it# #o on the c!rrency e!ently, i the apane#e go$ernent dea!lted on it# debt, the cri#i# =o!ld o#t likely reain in#ide o apan.

244


!ns*ers to Chapter ;@ Questions 1

Be#t oreca#t or a rando =alk i# the pre$io!# periodN# $al!e, + r per 8.S. dollar.

+40. Fir#t, co!ntrie# erected trade re#triction# and barrier# that pre$ent the ree lo= o good# entering or lea$ing a co!ntry. Second,  doe# not incl!de tran#portation and tran#action co#t#. 'hird, #oe #er$ice# are not internationally traded, #!ch a# hairc!t# and real e#tate. Finally, co!ntrie# deine their ba#ket o good# dierently. +41.

B!y the Big Mac# ro R!##ia or G2.2- and #hip the to 6ene!ela or G4.-2.

+42.

'he apane#e yen i# !nder$al!ed appro
 P !ig %ac =

P :aoan − P  / 

⋅ 100 =

$409 − $&.+3

100 = 0055 P $ 3 &.+  /  +4+. 'he  only incl!de# the ab#ol!te price le$el#, =hile the relati$e  allo=# dierent price le$el# bet=een co!ntrie# beca!#e the inlation rate# ca!#e the e
+43.

1 & ) . 1 & ) d

−1=

1 & 0.04 1 & 0.0+

− 1= 0.0+-

7e calc!lated the 8.S. copetiti$e ratio belo=J " =

1 & ) .

=

1 + .02

( 1 & ) d )(1 + e ) (1 + .0+)(1 + .02)

= 0.-41

+49. 7e a##!e the change in the $elocity o oney i# ero beca!#e the proble did not reer to the. I the ringgit i# deined at the hoe c!rrency, the ringgit #ho!ld appreciate appro
+44.

oe c!rrency #ho!ld depreciate appro
e ., ≈ ( i . − id )

+4:.

+ ( v/ − v %alay ) + ( y %alay − y / ) = 0.02 − 0.03 + 0.04 − 0.0+ = 0.01



≈ ( 005 − 010 )

24:


 

r d =  1 & i .

 ( 1 & e) − 1 =  1 & 01 20  ( 1 & 004) − 1 = 032;    30  30   . 

+4-. 7e !#ed the appro
 1 & ( 00 − 005 ) 1;0  ≈ 00 <  $1  $1 30 

!ns*ers to Chapter ;3 Questions 1

Spot tran#action# occ!r =hen a b!yer and #eller agree to an e
+:0.

/eri$ati$e# obtain their $al!e ro the a##et that i# #peciied in the contract.

+:1. In$e#tor# !#e hedging to protect the#el$e# ro !t!re $olatile price#. Spec!lator#, on the other hand, b!y and #ell #ec!ritie# to earn >!ick proit#. "# yo! g!e##ed, #pec!lator# can earn large proit# or a##i$e lo##e# ro the deri$ati$e# arket. +:2. )nce an in$e#tor b!y# a !t!re# contract, the b!yer i# obligated to b!y the a##et at the #peciied price i.e. long po#itionD, =hile the #eller i# obligated to #ell the a##et at the #peciied price i.e. #hort po#itionD. +:+. "##etN# price =ill l!ct!ate daily on the #pot arket. I the dierence bet=een the a##et price and contract price e
) ⋅ ⋅( − +:&. I##!er depo#it# 10 1 ,000 $130 $43 = $430,000 =ith the e
+:3.

$1

1 euro

= $130,000

6al!e o the contract on the #pot arket e>!al# . 6al!e o $1 = G100,000 130,000 euros 1.3 euro the !t!re# contract i# . In$e#tor pay# only G100,000 by !#ing the contract, in#tead o G130,000. 'h!#, the i##!er depo#it# oney into the argin acco!nt.

24-

Kenneth R. S!lcyk +:9. F!t!re# i# a contract. Both the b!yer and #eller are obligated to carry thro!gh =ith the tran#action. 7ith the option# contract, the holder choo#e# to e!al#J $0.3 ⋅ 1 ,000 ⋅ 10 = $3,000 . o! co!ld e!ently, yo! =o!ld b!y the oil ro the #pot arket. +-0. rei! e>!al#J $0.01 ⋅ 100 ⋅ 100 = $100 . Farer co!ld #ell hi# corn or G9 per b!#hel on the #pot arket, or e!al# G0.9:2 per e!ro. re#ent $al!e# o the ca#h lo=# areJ

PV foreig% =

2.2 mi))io% € 110 mi))io%€ + 2.2 mi))io% € + =107.9 mi))io% € 1 + 0.03 ( 1 +0.03 )2

PV *omesti=

$ 1.5 mi))io% $ 100 mi))io%+ $ 1.5 mi))io% 1 + 0.025

+

( 1 +0.025 )2

7e calc!late the S=apN# pre#ent $al!e a#J 2:0

= $ 98.1 mi))io%


(wp V)#e= PV foreig% ∙ ( 0− PV *omesti $ 1.2 (wp V)#e=107.9 mi))io% € ∙ −$ 98.1 mi))io% = $ 31.4 mi))io% 1 € !ns*ers to Chapter ;A Questions 1

'ran#action e
+-3. 'hi# i# not a good #it!ation beca!#e yo! earn re$en!e ro #ale# in pe#o# =hile yo! pay co#t# in dollar#. 'h!#, the tran#action e
o! calc!lated yo!r gain ro thi# tran#action belo=J

profit = $ 1 mi))io%

(

1 €

$ 1.25

)

−500,000 € =300,000 €

" l!ct!ating e
(

)

+-4. Fir#t, the copany ha# an e

'hird, the copany need# &-3,&3:.+0 pe#o# to depo#it today, and it =o!ld tran#er G&3,0&1.99 today !#ing the #pot e!al# 349.-2 =hile the copany i# g!aranteed a ini! o G+:,&91.3&. +--. 'he Fore< Beta ea#!re# the econoic e!ation. It ha# t=o #o!rce# o $ariationJ Fl!ct!ation# in the e!al acco!nt# payable and acco!nt# recei$able. 'hen it !#e# acco!nt# recei$able# to o#et it# acco!nt# payable. Second, copany can #hit it# prod!ction to lo=Aco#t co!ntrie#, e#pecially in co!ntrie# that =eaken it# c!rrency.


" ir only in$e#t# and operate# a #all portion o it# prod!ction in a oreign co!ntry. I a ir ha# a conlict =ith the go$ernent, then only that portion o the prod!ction acility i# in eopardy. F!rtherore, i a copany contin!ally !pdate# it# technology, #!b#e>!ently, it co!ld !#e intellect!al property right# to protect it# technology. In theory, the ir co!ld deny the go$ernent to !#e it# technology. Finally, a ir co!ld !#e le$erage, =here it hea$ily borro=# ro bank# =ithin the oreign co!ntry. I the ir ha# a conlict =ith the go$ernent, it can e
&01. " go$ernent protect# it# agric!lt!ral, deen#eilitary, energy, and co!nication ind!#trie#. 'he#e ind!#trie# are critical or a odern, !nctioning #ociety, and a #!pply di#r!ption co!ld ca!#e a #e$ere cri#i# =ithin the co!ntry. &02. " ir cannot tran#er it# proit# o!t#ide a co!ntry beca!#e the co!ntry ipo#ed capital control#. 'h!#, a ir co!ld b!y a local prod!ct and e
Money, Banking, and International Finance a$erage o the o!r actor#. "ltho!gh thi# ethod appear# to be obecti$e, the =eight# and ea#!re# o #oe actor# are #!becti$e. &09. 5!alitati$e ea#!re# rely on e
ong Kong i# politically #table, and ".M. Be#t rated it 'ier II =hile Coace rated it "1.

&0:. 8kraine i# a orer rep!blic o the So$iet 8nion that ipleented little arket reor#. ".M. Be#t rated the 8kraine a# a 'ier 6 =hile Coace rated it a /.

eferences

".M. Be#t. 2012. "$ailable ro httpJ===+.abe#t.corating#crcri#k.a#p< acce##ed on 10192012D "!#tralian Sec!ritie# %
2:+

Money, Banking, and International Finance

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