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LectSlide4 - EC3070 FINANCIAL DERIVATIVES SPECULATION AND...

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EC3070 FINANCIAL DERIVATIVES SPECULATION AND CRISES Speculation Speculation entails running the risk of a loss in the expecta- tion of a high reward. Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, real estate, derivatives, or of any other financial instrument, in order to profit from fluctuations in its price. Leverage Financial leverage (or gearing) entails borrowing money to sup- plement existing funds for investment in such a way that the potential pos- itive or negative outcome is magnified. The degree of leverage is measured by the debt-to-equity ratio. Equity capital Equity capital is capital raised from the owners of a company. It differs from debt capital, which is money raised through the issuance of debentures and bonds etc. Ownership equity is the remaining interest in assets after all liabilities are paid. If valuations placed on assets do not exceed liabilities, then there is negative equity. 1
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EC3070 FINANCIAL DERIVATIVES The Leverage of the Banking System. The entire banking system is based on leverage. Commercial banks accept short-term deposits, on which they pay a modicum of interest, and they make long-term loans at higher rates of interest, thus deriving a profit. The money loaned by banks finds its way back to the banks as fresh deposits. The indefinite process of receiving desposits and of making loans results in the expansion of the money supply. Banks are highly leveraged, since their equity capital is a very small pro- portion on their total assets. Reserve Requirements The expansion of the money supply is limited only by the requirement for reserves of liquid assets, which is often a legal requirement. The essential reserves are notes and coins and money at call and short notice, lent to the national Treasury and to commercial borrowers. 2
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EC3070 FINANCIAL DERIVATIVES The Money Multiplier Let L be the total of the reserve assets of the banks, and let r be the reserve ratio, which is the proportion of reserves to liabilities, and define λ = 1 r . Then, the supply of money resulting from the process of depositing and lending will be M = L 1 λ = L (1 + λ + λ 2 + · · · ) = L r . Successive terms of the geometric expansion represent successive loans. The money multiplier is m = 1 /r . The Lender of Last Resort The process can go into reverse. In the 19th century, banking crises were caused by depositors demanding the return of their money. To give stability to the banking system, the central banks, e.g. the Bank of England the Federal Reserve Board, undertook to be lenders of last resort to the commercial banks.
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