Financial management

Individuals and organizations with surplus funds invest their savings, enabling capital to flow efficiently in a well-functioning economy.

Businesses, individuals, and governments raise capital to fund needs, such as building power plants, buying homes, or constructing city infrastructure. [Page 6]

1. Direct transfer.

2. Through an investment bank.

3. Via a financial intermediary. [Page 8]

Investment banks underwrite securities by purchasing them from companies and reselling them to savers. This process is called a primary market transaction

They create new forms of capital, such as certificates of deposit, which are safer and more liquid than direct loans like mortgages. [Page 10]

By facilitating funds transfer between savers and borrowers, intermediaries like banks and mutual funds reduce transaction costs and risks

The level and efficiency of financial markets and institutions. In developed economies, a sophisticated financial system ensures efficient capital allocation.

Spot markets deal with immediate delivery of assets, while futures markets agree on asset delivery at a future date.

Money markets trade short-term, highly liquid debt securities, while capital markets focus on intermediate- and long-term debt and corporate stocks.

Primary markets involve raising new capital, whereas secondary markets trade already existing securities among investors.

Technological advances, deregulation, globalization, and increased complexity have made markets more efficient but also more challenging to navigate

It requires international cooperation, hindered by differing national banking structures, conglomerates obscuring market trends, and countries' reluctance to cede control of monetary policies.

Derivatives can hedge risks, like protecting wheat processors against rising costs, or for speculation, which increases risk exposure. [Page 23]

High-frequency trading, e-commerce payment platforms like PayPal, and innovations like Bitcoin have revolutionized financial operations and reduced costs. [Page 24]

A method for individuals or firms to bypass intermediaries and raise money directly from investors through platforms like Kickstarter and Indiegogo.

They design securities attractive to investors, buy them from corporations, and resell them to savers, functioning as underwriters. [Page 26]

Cooperative associations where members pool savings to loan to other members, typically at lower costs for auto, home improvement, and mortgage loans

They invest savings from corporate or government worker retirement plans in stocks, bonds, real estate, and mortgages, offering financial security for retirees. [Page 29]

Mutual funds pool money to buy diversified securities, while ETFs are traded like stocks and track specific indices or sectors. [Page 30]

Hedge funds are largely unregulated, require high minimum investments, and are aimed at institutions or wealthy individuals. [Page 33]

U.S. legislation aimed at increasing financial institution transparency, limiting excessive risk-taking, and creating consumer protection agencies. [Page 37]

The process of pooling loans (like mortgages) and converting them into securities for sale, which has transformed the banking industry. [Page 40]

The New York Stock Exchange (NYSE) and NASDAQ are the leading stock markets, with NYSE as a physical exchange and NASDAQ as an electronic dealer-based market. [Page 43]

ECNs enable faster, 24-hour trading, prompting exchanges like NYSE and NASDAQ to expand globally through acquisitions. [Page 48]

A decentralized market where dealers maintain inventories of infrequently traded stocks and trade them through brokers. [Page 51]

1. Secondary market: trading existing shares.

2. Primary market: issuance of new shares.

3. IPO market: private firms selling shares to the public for the first time. [Page 54]

They measure stock market performance, track industry trends, and serve as benchmarks for individual stock comparisons. [Page 66]

1. An auction method where investors bid for shares, and all winning bidders pay the same price.

2. Commonly used in bond markets.

3. The U.S. Treasury employs this method for its securities auctions.

It posits that stock prices reflect all publicly available information, making it difficult to consistently outperform the market. [Page 73]

Overconfidence, self-attribution bias, hindsight bias, and risk aversion influence investor behavior and market outcomes. [Page 79]

It is the tendency for individuals to credit their successes to their abilities while attributing failures to external factors like bad luck. [Page 80]

A cognitive bias where people with low ability at a task overestimate their ability. [Page 81]

Overconfident investors trade more frequently, and overconfident managers overestimate project profitability, potentially leading to poor outcomes. [Page 82]

In an efficient market, stock prices reflect all available information, so actively seeking bargains is less effective than investing in index funds. [Page 83]

1. 1955: 8.6 workers per retiree.

2. 2015: 2.8–3.4 workers per retiree.

3. Forecast for 2035: 2.2 workers per retiree. [Page 3]

A time line illustrates cash flows at specific times, including present value (PV), future value (FV), and interest rates. [Page 4]

A series of equal payments made at fixed intervals, such as monthly or annually. Ordinary annuities are paid at period ends, while annuities due are paid at period starts. [Page 27]

Calculate the present value of each option using a discount rate. For example, $15M today is better than $1M annually for 30 years at 6%.

Cash flows that are not equal, such as a bond with periodic payments plus a final lump sum. [Page 45]

1. APR: Annual Percentage Rate (stated rate).

2. EAR: Effective Annual Rate (actual rate considering compounding). [Page 55]

A 15% 14-day loan translates to a 391% APR and a 3,723.66% EAR. [Page 62]

A loan repaid in equal installments, like mortgages or car loans. Payments include principal and interest. [Page 70]

A shortcut to estimate doubling time for investments: 72/r, where r is the interest rate. [Page 74]

A bronze statue bought for $2,972,500 in 1998 sold for $4,039,500 five years later. Using the Rule of 72, the annual return was approximately 6.33%. [Page 75]

Interest is compounded an infinite number of times per year. The formula uses erte^{rt}ert, where rrr is the rate and ttt is time. [Page 78]

For short-term loans like payday loans, APRs and EARs can be extremely high. A 14-day loan at 15% translates to a 391% APR and 3,723.66% EAR. [Page 91]

Higher frequency (e.g., monthly or daily) results in a higher EAR than the nominal rate due to compounding effects. [Page 92]

To encourage business investment, repair the housing market, and support stock and bond markets, stimulating the overall economy. [Page 2]

The Fed purchased long-term financial assets, injecting funds into the economy to lower interest rates and stimulate growth. [Page 3]

Factors include the borrower's risk, loan collateral, use of funds, and the loan's duration. [Page 8]

Production opportunities, time preferences for consumption, risk, and inflation. [Page 11]

Borrowers compete for funds based on profitability, and investors supply capital based on the offered return. [Page 14]

Investors shift funds from riskier markets to safer ones, lowering rates in safe markets and raising rates in risky ones. [Page 17]

Short-term rates are more volatile, declining sharply during recessions, while long-term rates reflect expected inflation over decades. [Page 20]

The nominal interest rate minus the inflation rate, reflecting the actual return investors earn after inflation. [Page 24]

r=r*+IP+DRP+LP+MRP,

where each term represents a specific risk or premium. [Page 29]

r*=the real risk-free rate of interest

IP=premium for expected inflation

DRP=default risk premium

LP=liquidity (or marketability) premium

MRP=maturity risk premium.

Inflation expectations are built into the quoted rates, with higher inflation expectations leading to higher interest rates. [Page 37]

TIPS adjust their principal for inflation, ensuring the real return remains constant. [Page 45]

Expected inflation, maturity risk premiums, and bond risks. An upward slope typically indicates higher future inflation expectations. [Page 54]

The yield curve reflects market expectations for future interest rates, assuming no maturity risk premiums. [Page 66]

By controlling the money supply, the Fed can lower short-term rates through monetary easing or raise them through tightening. [Page 75]

Financing trade deficits often requires foreign investment, linking U.S. interest rates to global rates. [Page 80]