Chapter 3 - The Financial Information

Marketplace
This chapter focuses on the sources of financial information and the hypotheses concerning
information efficiency in the market.

I. Core Hypotheses
• Efficient Market Hypothesis (EMH): Contends that all available information is already
reflected in asset prices. This implies prices are "correct" and consistently earning excess
returns is impossible.

• Asymmetric Information Hypothesis (AIH): States that one party in a transaction

possesses superior information, leading to market inefficiencies such as:

o Adverse Selection: Problems caused by information imbalance before a

transaction occurs.

o Moral Hazard: Problems caused by information imbalance after a transaction

occurs.

II. Mathematical Calculation Formation & Explanation: Flow of Funds Accounts (FOFA)

FOFA is the system of "social accounting" used to track the movement of funds between
different economic sectors.

• Concept: FOFA aims to highlight interconnections between the financial sector and the
rest of the economy.

• Measurement: Data is typically presented in Billions of Dollars , tracking calculated

metrics like "Outstanding at Year-End" and "Total Net Borrowing and Lending".

• Formation (The Four-Step Accounting Construction):

o FOFA is built through a systematic four-step process:

1. Sectoring the Economy: Dividing the economy into distinct analysis

groups (e.g., Household, Government, Banking).

2. Building Sector Balance Sheets: Preparing statements of assets and

liabilities for each sector.

3. Preparing Sources and Uses of Funds Statements: Tracking where funds

originate (Sources) and where they are invested (Uses).
 4. Building a Flow of Funds Matrix: Combining all statements into a single,
balanced matrix for the whole economy.

Chapter 5 - Theories of Interest Rates

This chapter covers models that explain the determination of interest rates, focusing on the
Liquidity Preference Theory (LPT).

I. Core Theories

• Other foundational models discussed include the Classical Theory of Interest Rates and
the Loanable Funds Theory of Interest.

• The Liquidity Preference Theory (LPT), or Cash Balances Theory, states that the rate of
interest (r) is the price paid for parting with liquidity and is determined by the demand for
and supply of money.
II. LPT Motives

The Total Demand for Money (L) is the sum of three motives for holding cash:

1. Transaction Motive (L_t): Cash needed for routine transactions (depends on Income, Y).

2. Precautionary Motive (L_p): Cash held for emergencies (depends on Income, Y).

3. Speculative Motive (L_s): Cash held to speculate on future interest rate changes (depends
on the Rate of Interest, r).

III. Mathematical Calculation Formation & Explanation

1. Total Demand for Money Formation

o Formation:

L = L_1(Y) + L_2(r)
o Explanation: The total demand for money (L) is separated into two functions:
L_1(Y) represents the demand for money based on the combined Transaction and
Precautionary motives (a function of national Income (Y)), and L_2(r) represents
the demand based on the Speculative motive (a function of the Rate of Interest
$r)) [Implied by LPT structure noted in the file].

2. LPT Equilibrium Condition

o Formation (Money Market Equilibrium):

 M = L_1(Y) + L_2(r)

o Explanation: The equilibrium rate of interest (r) is determined at the point where
the fixed Money Supply (M) equals the total Demand for Money [Implied by the
LPT framework].

Chapter 10 – Money Market & Instruments

The Money Market is the market for highly liquid, short-term debt securities (maturities less than
or = 1 year, primarily used by participants to meet temporary cash shortages or surpluses (i.e.,
working capital needs).
I. Core Features and Risks

• Definition: Market for short-term borrowing/lending ($\leq 1$ year).

• Key Features: Very safe & liquid (low risk), huge/active market (stable prices), transacts
in big amounts (millions), mostly for large institutions.

• Key Risks: Credit risk, Interest rate risk, Liquidity risk, and Foreign exchange risk.

• Maturity Concepts: Original maturity (time from issue to redemption) vs. Actual maturity
(time remaining today).

• Important Participants: Corporations, Banks, Brokers/dealers, Central banks, Government

Treasury.

II. Instruments and Quantitative Formation

• Treasury Bills (T-bills): Short-term government securities, sold at a discount to face

value (no coupon).

▪ Explanation: Since there is no coupon, the investor's return comes from

the difference between the face value and the lower purchase price (the
Discount Amount).
• Repo (Repurchase Agreements): A dealer borrows money using securities as collateral
(very common overnight borrowing tool).
• Commercial Paper (CP): Short-term, unsecured note issued by corporations with good
credit (cheaper alternative to bank loans).

• Banker’s Acceptance (BA): Short-term draft guaranteed by a bank (used mostly

in international trade).
 • Eurocurrency Deposits: Deposits in a currency outside its home country (e.g.,
USD in London).

Chapter 12: Central Banks

The Central Bank is the government agency managing the money supply, interest rates, and bank
system stability (the "Bankers’ bank" and lender of last resort).
I. Main Roles and Policy Types

• Main Roles: Control money supply, keep price stability (fight inflation), support
economic growth, and supervise the banking system.
• Monetary Policy Types:

o Expansionary: Lower rates, more money injected into the economy.

o Contractionary: Higher rates, money taken out of the economy to slow growth.

II. Key Tools and Mathematical Calculation Formations

1. Open Market Operations (OMO): Most commonly used tool.

o Buy securities = give banks money (Expansion).

o Sell securities = take money out (Contraction).

2. Reserve Requirement (RR):

o Higher RR = less money in economy (Contraction).

o Formation (Required Reserves):

Required Reserves = RR ratio*Deposits

o Formation (Excess Reserves):

Excess Reserves = Money banks can lend out = Total Reserves - Required Reserves

▪ Explanation: Banks create money based on these Excess Reserves.

3. Discount Rate: Interest rate central bank charges banks.

o Higher rate = banks borrow less = economy slows (Contraction).

4. Deposit Multiplier: Shows how the banking system creates money.

o Formation (Simple Deposit Multiplier, k):

k = 1/RR ratio
 ▪ Explanation: If the RR is low, banks can lend more, leading to a higher
multiplier and greater creation of new deposits.

5. Money Multiplier: Connects the monetary base to the M2 money supply.

o Formation (Relationship):

Money Supply (M_S) = Money Multiplier (m) *Monetary Base(M_B)

▪ Explanation: The money supply grows if the public holds less cash, banks
hold fewer excess reserves, or the Central Bank increases the monetary
base.

Chapter 14: The Commercial Banking Industry

Commercial banks provide deposits, loans, and modern financial services. The industry trend is
toward consolidation (fewer, but larger banks).

I. Bank Balance Sheet Structure

• Bank Assets (Uses of Funds): Loans (main income source), Securities, Cash reserves.

• Bank Liabilities (Sources of Funds): Deposits (main funding source), Borrowings (repo,
CDs, etc.).

• Loan Loss Allowance (LLA): Money set aside when loans might default.

• Money Creation by Banks: Banks create money when they make loans or buy securities,
based on their excess reserves.

II. Bank Performance Metrics and Calculation Formations

1. Capital Adequacy Ratio:

o Formation (Equity/Assets Ratio):

Capital Adequacy = Bank Equity/Total Assets

o Explanation: Measures the bank's cushion against unexpected losses (capital

adequacy).

2. Operating Efficiency Ratio (OER):

o Formation (Operating Efficiency):

Operating Efficiency = Operating Expenses/Operating Income

o Explanation: Measures cost management. A ratio below 60% is considered good.

 3. Non-Performing Assets (NPA): NPA ratio (Non-performing assets / Total Assets) is a
measure of Credit Risk.

Chapter 15 - International Financial Institutions

This chapter provides an overview of global and regional financial organizations and their
relative sizes.

I. Global Institutions

• The International Monetary Fund (IMF) and the World Bank (IBRD) are the twin
financial organizations known as the Bretton Woods Institutions, formed in 1944.

• The World Bank (IBRD) and IMF each have 186 member countries (as of the
presentation).

II. Regional Institutions & Mathematical Calculation Formations

1. Asian Infrastructure Investment Bank (AIIB)

o The AIIB is a multilateral development bank proposed by China with an

authorized capital of $100 billion.

o AIIB Capital relative to Asian Development Bank (ADB) Capital:

▪ Formation:

AIIB Capital = 2/3* ADB Capital

▪ Explanation: The AIIB’s $100$ billion capital is equivalent to two-thirds
of the capital of the Asian Development Bank.

o AIIB Capital relative to World Bank (WB) Capital:

▪ Formation:

AIIB Capital=approx.= ½* World Bank Capital

▪ Explanation: The AIIB’s $100$ billion capital is stated to be about half of

the capital of the World Bank.

2. European Bank for Reconstruction and Development (EBRD)

o The EBRD was created in 1990 to aid Eastern European countries in their
transition. It has 40 member countries in aggregate.
 o EBRD Shareholding Composition:

▪ Formation:

Western Europe Interest + Eastern Europe Interest + US Interest + Other Member Interest =
100%

▪ Calculation and Explanation: The major shareholding percentages are:

Western European countries (51%), Eastern European countries (13.5%),
and the United States (10%). The total interest of these groups is 74.5%,
with the remainder held by other members.

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