Lecture2_Fall18-2.pdf - Economics 1723 Capital Markets...

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Economics 1723: Capital Markets Lecture 2 Pedro Bordalo Ec1723 Pedro Bordalo (Ec1723) Lecture 2 1 / 44
Roadmap 1 Course topics 2 The money market 3 Measuring return 4 Leverage and short selling 5 Arbitrage in practice Pedro Bordalo (Ec1723) Lecture 2 2 / 44
Course topics Introduction Basic ideas of finance Implications of no-arbitrage Risk and risk aversion Risk and return Optimization: Mean-variance analysis Equilibrium: Capital Asset Pricing Model Arbitrage: The Arbitrage Pricing Theory and multifactor models Portfolio choice for long-term investors (later in the course) Pedro Bordalo (Ec1723) Lecture 2 3 / 44
Course topics Present value and efficient markets Market efficiency and random walk prices Equity valuation Term structure of interest rates Liquidity effects on prices Derivative Securities Forwards, futures, and swaps Options Risk management and crises Pedro Bordalo (Ec1723) Lecture 2 4 / 44
Key Questions What is buying on margin? What role did margins play during the recent crisis? What is short selling? When does a short seller make a profit? How can arbitrage fail in practice? Pedro Bordalo (Ec1723) Lecture 2 5 / 44
Roadmap 1 Course topics 2 The money market 3 Measuring return 4 Leverage and short selling 5 Arbitrage in practice Pedro Bordalo (Ec1723) Lecture 2 6 / 44
Financial instrument checklist Who issues or trades the instrument? What is the structure of future cash flows? What is the instrument’s tax treatment? How is the instrument issued and traded? Who typically holds the instrument? What are the risks to the holder? Pedro Bordalo (Ec1723) Lecture 2 7 / 44
Money market Money market instruments promise to pay: a fixed amount (of some currency), at some date within the next year. Typically very liquid (easy to trade), but in large denominations. So individuals do not usually hold these instruments directly. Issued by various entities of high credit quality (governments, banks, large corporations). Pedro Bordalo (Ec1723) Lecture 2 8 / 44
Examples of money market instruments Treasury bill – government debt obligation with maturity less than one year. Certificate of deposit – time deposit at a bank. Commercial paper – short-term debt (less than 270 days to avoid regulation) issued by a corporation. Bankers’ acceptance – a promise by a bank to pay a prespecified amount. Repurchase agreement (repo) – a loan using other securities (typically government securities) as collateral. Interbank loans – Fed funds, LIBOR. Eurodollars– deposits at foreign banks or bank branches. (Those things look boring, but they’re the medium of the 2008 crisis, and many crises) Pedro Bordalo (Ec1723) Lecture 2 9 / 44
Money market interest rates are currently very low Source: CNN Money, 08/24/18 Pedro Bordalo (Ec1723) Lecture 2 10 / 44
Money market interest rates also reflect some risk (typically low) and liquidity considerations Pedro Bordalo (Ec1723) Lecture 2 11 / 44
Roadmap 1 Course topics 2 The money market 3 Measuring return 4 Leverage and short selling 5 Arbitrage in practice Pedro Bordalo (Ec1723) Lecture 2 12 / 44
Measuring return Return is a measure of how well a security performs as an investment: Gross return = 1 + R t

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