FNCE 4070: FINANCIAL MARKETS
AND INSTITUTIONS
Lecture 1: Introduction to Financial
Markets
Professor Michael Palmer
Professor of Finance
University of Colorado at
Boulder
Spring Semester 2012
Where is this Financial Center?
Beginning Quotes For Course
“May you live in interesting times.”
Reputed to be an ancient Chinese proverb and curse
“The only certainty in financial markets is uncertainty”
Credit Suisse, August 16, 2007 (Switzerland's second largest bank)
“Markets are constantly in a state of uncertainty and flux and money is made
by discounting the obvious and betting on the unexpected.”
George Soros (Hedge fund manager and philanthropist)
“Without the element of uncertainty, the greatest business triumph would be
dull, routine, and eminently unsatisfying.”
J. Paul Getty (American industrialist, founder of Getty Oil)
“I used to be scared of uncertainty; now I get a high out of it.”
Jensen Ackles (Actor. TV; Smallville, Dawson’s Creek, and Supernatural)
Testing Your Understanding of Financial
Markets?
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Who is the current chairman of the Federal Reserve and
who were the two previous chairs of the Federal
Reserve?
What is the Federal Reserve responsible for?
Define the Federal Funds interest rate, the Discount
Rate, and the Prime Rate?
What is the current level of the Federal Funds Rate and
is the Federal Funds Rate higher or lower than one year
ago?
Which country currently has the highest (lowest) interest
rate?
 United States, United Kingdom, Japan, Germany,
Australia, Canada, or Switzerland.
Ben Bernanke: The 14th Chairman of the
Federal Reserve Board
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Ben Bernanke replaced Alan Greenspan on February 1,
2006
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Background: The Chairman of the Federal Reserve
Board is named by the President and is confirmed by the
U.S. Senate.
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Greenspan had served since August 1987.
They serve a term of four years, and can be reappointed.
The Federal Reserve is responsible for the conduct of
monetary policy, which means:
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Setting interest rates and promoting money supply growth,
in pursuit of maximum employment, stable prices, and
moderate long-term interest rates.
See Appendix 2 for some insights into Bernanke and
Appendix 3 for previous Fed Chairs
Ben Bernanke in Song

Columbia Business School's YouTube Video parody of Dean
Glenn Hubbard (Note: he is not the real Dean) singing about Ben
Bernanke.
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http://www.youtube.com/results?search_query=ben+bernanke+every+breath+yo
u+take&aq=0 (link to Ben Bernanke Every Breath you Take video)
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http://youtu.be/3u2qRXb4xCU (this may work).
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As you watch and listen to this parody take note of the following
terms:
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1. Change of rate (i.e., interest rates)
2. Stagflate (aka, stagflation – a recession with inflation)
3. BPS (basis points, a measure of interest rates)
4. Yield curve flips (yield curve going from upwards sweeping to
downward sweeping as a signal of a future recession)
5. Interest rate policies (monetary policy used by central banks)
6. Models break (i.e., econometric models used to assess the impact of
monetary policy changes on the economy)
Federal Funds Rate
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The Fed Funds Rate is the short term (generally overnight)
interest rate in the U.S. interbank market for
lending/borrowing “excess” bank reserves.
 Essentially, the interest rate at which one commercial bank
will lend reserves to another commercial bank.
This is also regarded as a key (i.e., “benchmark”) short
interest rate in the United States because the Federal
Reserve sets this rate so as to implement monetary policy.
Since 1982, the Fed has announced a “target” for the federal
funds rate.
 Since 2008, the target has actually been a range (upper
and lower limit).
For participants in financial markets, changes in this “target”
rate (or lack of) indicate the stance (direction and
accommodation) of monetary policy.
How does the Fed Affect the
Federal Funds Rate?

Through open market operation:
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Buying government securities increases bank
excess reserves.
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The buying and selling of government securities.
An increase in the supply of bank reserves (everything
else equal) will put downward pressure on the Federal
funds rate.
Selling government securities reduces bank
excess reserves.

A decrease in the supply of bank reserves (everything
else equal) will put upward pressure on the Federal
funds rate.
Demand and Supply Model of
Bank Excess Reserves
Fed buying government
securities
Fed selling government
securities
S1 S2
Fed
Funds
Rate
(%)
Demand
Excess Reserves
S2 S1
Fed
Funds
Rate
(%)
Demand
Excess Reserves
U.S. Federal Funds Target Rate: Sep
1982 (first used) to Dec 2008
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Historical high: July 1974, 13%. Note: Fed targeted money supply
from 1979 to 1993, but, in the 1980s, it started shifting policy
towards fed funds; in 1995 it began announcing a specific fed funds
target
U.S. Federal Funds Target Rate
Range: Dec 2008 to the Present

Beginning in December 2008 the Federal Reserve announced a
range for the Fed Funds Rate (currently 0.00% to 0.25%).
Effective Federal Funds Rate

(Note: Fed targeted money supply from 1979 to 1993; a
specific fed funds target not announced until 1995)
Relationship of Target to Effective
Rate
Relationship of Target to Effective:
Dec 2008 to the Present

Beginning in December 2008 the Federal Reserve announced a
range for the Fed Funds Rate (currently 0.00% to 0.25%).
Relationship of Central Bank Interest
Rates to Economic Activity

Important measures of economic activity:

Economic output (Business Activity).
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GDP (changes in real GDP)
Price levels
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Inflation (Consumer and producer prices)
U.S. Business Cycles
Effective Federal Fuds Rate and
Business Activity
Effective Federal Funds Rate and
Price Changes
Monitoring the Effective Federal
Funds Rate

As noted, the effective federal funds rate
follows the target (or range) and thus it would
appear that we can monitor this rate as an
indicator of the stance (and changes in the
direction) of Fed policy.
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http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND
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We can also evaluate the effective rate in
relation to the target or range as indicators as
to conditions in financial markets.
0
2008-01-02
2008-01-09
2008-01-16
2008-01-24
2008-01-31
2008-02-07
2008-02-14
2008-02-22
2008-02-29
2008-03-07
2008-03-14
2008-03-21
2008-03-28
2008-04-04
2008-04-11
2008-04-18
2008-04-25
2008-05-02
2008-05-09
2008-05-16
2008-05-23
2008-06-02
2008-06-09
2008-06-16
2008-06-23
2008-06-30
2008-07-08
2008-07-15
2008-07-22
2008-07-29
2008-08-05
2008-08-12
2008-08-19
2008-08-26
2008-09-03
2008-09-10
2008-09-17
2008-09-24
2008-10-01
2008-10-08
2008-10-16
2008-10-23
2008-10-30
2008-11-06
2008-11-14
2008-11-21
2008-12-01
2008-12-08
2008-12-15
2008-12-22
2008-12-30
Assessing Financial Market Conditions
Target Fed Funds Rate Versus Effective Federal Funds Rate
4.5
4
3.5
3
2.5
2
1.5
1
0.5
Effective Rate
Target Rate
Effective Fed Funds Rate and Target
Range, Dec 2008 to Present
Central Bank Target Interest Rates
Jan 2008, Dec 2008, Jan 2010, Jan 2011, Jan 2012
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United States: 4.25%, 0.25%, 0.25%, 0.25%, 0.25%, 0.25%
Japan: 0.50%, 0.30%, 0.10%, 0.10%, 0.10%
Switzerland: 2.75%, 0.50%, 0.25%, 0.25%, 0.00%
United Kingdom: 5.50%, 2.00%, 0.50%, 0.50%, 0.50%
Euro-zone: 4.00%, 2.50%, 1.00%, 1.00%, 1.00%
Canada: 4.00%,1.50%, 0.25%, 1.00%, 1.00%
Australia: 6.75%, 4.25%, 3.75%, 4.75%, 4.25%
China: 7.20%, 5.31%, 5.31%, 5.81%, 6.56%
India: 9.00%, 6.50%, 4.75%, 6.25%, 8.25%
Brazil: 11.25%, 13.75%, 8.75%, 10.75%, 11.0%
Note: For current rates and meeting dates see:
http://www.fxstreet.com/fundamental/interest-rates-table/
Federal Reserve Discount Rate
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Federal Reserve Discount Rate: Interest rate
the Federal Reserve will charge member
banks and other depository institutions to
borrow short term (overnight) reserves.
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Administratively set by the Federal Reserve
Currently: .75% (January 2008: 4.75%) (Now
Called Primary Credit Rate)
This market is important as it represents a
“safety” net for financial institutions.
Also carries potentially important signals as
to future fed policy directions.
Prime Interest Rate
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Prime Rate: Interest rate commercial banks
will charge their best customers (i.e., high
grade corporates) on loans to borrow short
term funds.
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Tied to the Federal Funds Rate (with the Fed
funds rate the casual rate).
Prime rate is generally around 300 basis points
higher than fed funds rate
Currently: 3.25%. (January 2008: 7.25%)
Prime Interest Rate, 1949 to the
Present
Why is the Fed Funds Rate So
Important?
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Fed Funds rate is set
by U.S. central bank
and thus it carries
important signals for
the market.
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What the central bank
thinks about the
economy and the
direction of the
economy.
These signals will
affect how the market
sets its interest rates.
Bottom line: Other
money market rates
are influenced by the
direction and level of
the Fed Funds Rate.
Fed Funds Rate and Prime Interest
Rate
Fed Funds Rate and Short Term
Government Securities
Fed Funds Rate and Short Term
Money Market Rates
Fed Funds Rate and Long Term
Interest Rates
Cross Country Comparisons: Long
Term Gov’t Rates, January 2012
Country
10-Year Gov’t
Bonds
Country
10-Year Gov’t
Bonds
United States
1.99%
Italy
6.90%
Switzerland
0.66%
South Africa
7.91%
Japan
0.99%
India
8.60%
Hong Kong
1.38%
Egypt
8.29%
Germany
1.92%
Turkey
9.72%
United Kingdom
2.04%
Hungary
10.21%
Canada
2.10%
Brazil
11.26%
France
3.33%
Pakistan
14.23%
China
3.52%
Greece
36.62%
Short Term Interest Rates: 1993 – 2010;
Global Comparisons
Long Term Interest Rates: 1993 – 2010;
Global Comparisons
Useful Web Sites
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For current U.S. interest rate data see:
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For Effective Fed Funds Rate see:
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http://www.bloomberg.com/apps/quote?ticker=FEDL0
1:IND
For other key rates:
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http://www.federalreserve.gov/releases/h15/update
http://www.bloomberg.com/markets/rates-bonds/keyrates/
For charting U.S. interest rate data and other
U.S. data see:

http://research.stlouisfed.org/fred2/
Appendix 1
Hong Kong: Background Notes
Asia Pacific with Hong Kong
Hong Kong as a Financial Center
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After being ceded by China to the British (as a result of the Opium Wars) under
the Treaty of Nanking in 1842, the colony of Hong Kong rapidly became a
regional center for financial and commercial services with China and South
Asia. During the Korean War, the U.N. imposed an embargo on mainland China
(for its support of North Korea) and as a result many “industrialist moved from
the mainland to Hong Kong and set up light industry export companies. During
this period, Hong Kong grew as a shipping and textile export center.
However, China's open-door policy in 1978 was the year that marked the new
era of Hong Kong and its re-birth as a major economic and financial center. As
manufacturing moved out of Hong Kong to mainland China, it was replaced by
services, and Hong Kong GDP boomed as trade and investment links with
China exploded. Global financial services also flourished because of Hong
Kong’s British-style legal system and the fact that English is spoken fluently
both of which supported Hong Kong’s financial networks with London, New
York and other leading global cities. In additional, Hong Kong has had long
existing stock market (since 1891).
Hong Kong as a Financial Center
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Today Hong Kong is an important market for IPO (second only to New York last
year) and funds management. Today Hong Kong is the world’s sixth largest
foreign exchange trading center, with 4.7% of the world’s total trades (or $238
billion per day). 71 of the largest 100 banks in the world have an operation in
Hong Kong. Hong Kong is the world's 9th largest international banking center in
terms of the volume of external transactions, and the second largest in Asia
after Japan. The banking sector plays a vital role in establishing Hong Kong as
a major loan syndication center in the region. The Hong Kong Stock Exchange
is Asia's third largest stock exchange in terms of market capitalization behind
the Tokyo Stock Exchange and the Shanghai Stock Exchange and fifth largest
in the world. As of 31 Dec 2010, the Hong Kong Stock Exchange had 1,413
listed companies with a combined market capitalization of $2.7 trillion.
Hong Kong was hit hard by the Asian Financial Crisis that struck the region in
mid-1997, just at the time of the handover of the colony back to Chinese
administrative control. The crisis prompted a collapse in share prices and the
property market. However, unlike most Asian countries, Hong Kong (as well as
mainland China) maintained their currencies’ exchange rates with the U.S.
dollar rather than devaluing.
Appendix 2
Ben Bernanke’s View of the Role of Central Banks:
The following slides present a brief sketch of
Bernanke and offer possible insights into his
approach regarding the role of the U.S. central
bank.
Ben Bernanke
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Ben Bernanke was born on December 13, 1953, in
Augusta, Georgia. He received a B.A. in economics
in 1975 from Harvard University (summa cum laude)
and a Ph.D. in economics in 1979 from the
Massachusetts Institute of Technology.
Before becoming a member of the Federal Reserve
Board, Dr. Bernanke was the Howard Harrison and
Gabrielle Snyder Beck Professor of Economics and
Public Affairs and Chair of the Economics
Department at Princeton University (1996-2002). Dr.
Bernanke had served as a Professor of Economics
and Public Affairs at Princeton since 1985.
Bernanke’s Views on Central Banking
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Bernanke, whose academic studies have focused on the
Great Depression, has written that during that era the U.S.
central bank allowed banks to fail, prices to fall and the
money supply to contract, which contributed to the
protracted slump.
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In essence, he blames the Fed for not acting in a proactive
manner.
In addition, Bernanke has been quoted as follows: "We now
know the lessons from that” [the Depression]. "We are
certainly going to make sure that the financial system
remains in good functioning order.“
Conclusion: It appears that Bernanke will follow a very
aggressive proactive approach to monetary policy in the
U.S.
Appendix 3
Changing Fed Chairs being introduced
by the President
Changing Fed Chairs
Volcker to Greenspan,
August 1987
Greenspan to Bernanke,
February 2006