FINANCIAL THEORIES

CHAPTER 2: AN OVERVIEW OF THE FINANCIAL SYSTEM

Money

Financial system
Financial market

Financial
instruments
Financial
Institutions

Financial agencies

Central bank

A. FLOWS OF FUNDS THROUGH THE FINANCIAL SYSTEM

B. DIRECT FINANCE vs. INDIRECT FINANCE

Direct finance Indirect finance

A financial institution (like: bank) takes the

Borrowers received funds directly from resources from the lenders in the form of
lenders. deposits  provide to borrowers in the form of
loans.

C. STRUCTURE OF FINANCIAL MARKETS

1. Debt and Equity markets
Issuing a Debt instrument A bond (trái phiếu)
A mortgage (khoản thế chấp)
Issuing Equities common stocks (cổ phiếu thường)
 2. Primary and Secondary markets (Thị trường sơ cấp và thị trường thứ cấp)

Primary market Secondary market

Where new issue of a security (bond, stock),

are sold to initial buyers (người mua ban đầu) Where securities that have been previously
by the corporation or government agency issued can be resold.
borrowing the funds.

 Investment banks underwrite (bảo lãnh) securities in primary markets.

 Brokers (môi giới) and dealers (đại lý) work in secondary markets.

3. Exchanges and Over-the-Counter (OTC) markets

Secondary markets can be organized in 2 ways:
Exchanges Over-the-Counter (OTC)

Where the buyers and sellers meet in 1 central Where the dealers at different locations to
location to conduct trade. trade.

4. Money and Capital markets

Money market Capital market

Where only short-term debt instrument (< 1 Where long-term debt instrument and equity
year) are traded. instrument are traded.

C. FINANCIAL MARKET INSTRUMENTS

1. Money market instruments
Because their short terms to maturity, the debt instruments traded in the money market undergo the
least price fluctuations (ít biến động giá nhất) and so are the least risky investments.

U.S Treasury bills: Tín phiếu kho bạc.

Negotiate bank certificates of deposit: Chứng nhận tiền gửi.
Commercial paper: Thương phiếu.
Repurchase agreements: Hợp đồng Repo.
Federal funds.

2. Capital market instruments

1. Where long-term debt instrument and equity instrument are traded.
2. Far wider price fluctuations (biến động giá hơn).
3. Fairly risky investments (khoản đầu tư khá rủi ro).
Stocks Agency securities
Mortgage and mortgage-backed securities State & local government bonds
Corporate bonds Consumer and bank commercial loans
Government securities
D. FUNCTION OF FINANCIAL INSTRUMENTS
1. Means of payment.
2. Store of value.
3. Transfer of risks.

E. FOREIGN BONDS AND EUROBONDS

Foreign bonds Eurobonds

Be sold in a foreign country and be dominated Be sold in a country and be dominated in

in that country’s currency. another country’s currency.

F. FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE

 Financial intermediations: the process of indirect financing using financial intermediaries.
1. Transaction cost
4. The time and money spent in carrying out financial transactions.
5. A major problem for people who have excess funds to lend.
6. Financial intermediaries can substantially reduce transaction costs:
 They have developed expertise in lowering them.
 Their large size allows them to take advantage of economies scale.
7. Financial intermediaries can provide customers with liquidity service, services that make it easier
for customers to conduct transactions.

2. Risk sharing

Asset transformation Diversification

Changes risk assets  safer assets. “You shouldn’t put all your eggs in one basket.”

G. TYPES OF FINANCIAL INTERMEDIARIES

Contractial
Depository Investment
savings
institutions intermediaries
institutions

Commercial Life insurance Finance

banks companies companies

Saving & loan Fire & casualty

association insurance Mutual funds
(S&Ls) companies

Pension funds &

Money market
Credit unions Government
mutual funds
retirement funds
 CHAPTER 3: WHAT IS MONEY?
A. MONEY
Anything that is generally accepted as payment for goods or services or in the repayment of debts.

B. CURRENCY
One type of money, includes paper bills & coins.

C. WEALTH
Money Common stock Land Cars
Bond Art Furniture Houses

D. FUNCTION OF MONEY
1. Medium of exchange
 Barter economy: no money, where goods & services are exchanged directly for other goods &
services.
 Transaction costs are high (b/c of time spent to exchange goods & services).
 Money helps minimize the transaction costs  promote economy efficiency.
 Criteria:
Be easily standardized
Be widely accepted
Be divisible
Be easy to carry
Not deteriorate quickly (không xấu đi nhanh chóng)

2. Unit of account: be used to measured value in an economy.

3. Store of value
8. A repository of purchasing power available over the time.
9. Money is the most liquid asset.
E. EVOLUTION OF THE PAYMENTS SYSTEM
1. Commodity money (tiền hàng hóa)
10. Money made up of previous metals or another value commodity.
2. Fiat money (tiền định danh)
11. Example: paper currency.
12. Be degreed by governments as legal tender but not convertible into coins or precious metal.
13. Countries can change the currency they us at will.
3. Checks
14. An instruction from you to your bank to transfer money from your account to someone else’s
account when she deposits the check.
15. No need to carry around large amount of currency.
 4. Electronic payment
5. E-money
16. Money that exists only in electronic form.
17. 3 forms Debit card
Stored-value card  smart card
E-cash

F. MEASURING MONEY
 CHAPTER 4: THE MEANING OF INTEREST RATE
A. MEASURING INTEREST RATE
 Present value: is based on the commonsense notion that a dollar paid to you one year from now is
LESS than a dollar paid you today.
 Because: You can deposit a dollar today in a savings account that earns interest and have more
than a dollar in 1 year.

CF
 Formula: PV =
(1 + i)n

PV: present value; CF: cash flow in (n) years; n: number of years

B. FOUR TYPES OF CREDIT MARKET INSTRUMENT

1. A simple loan:
18. The lender provides the borrower with an amount of funds in (n) years.
19. At the maturity date: repaid Fund + Interest payment.
2. A fixed-payment loan:
20. The borrower must repay by making the same payment every period until the loan is completely
paid-off.
3. A coupon bond:
21. The bondholders are paid a fixed-interest payment every period until the maturity date (được trả
lãi định kỳ đến ngày đáo hạn).
4. A discount bond:
22. Is bought at a price < its face value.
23. Does NOT make any interest payments, just pay off the face value.

C. YIELD TO MATURITY (LỢI SUẤT ĐÁO HẠN)

 The INTEREST RATE that equates the present value of cash flow payments received from a debt
instrument with its value today.
 The measure that most accurately reflects the interest rate.

1. YTM on a Simple loan

The simple interest rate = the YTM

CF
PV =
(1 + i)n
2. YTM and the yearly payment on a Fixed-payment loan
The interest rate = the YTM

n FP
LV = ∑x=1[ ]
(1+i)x

LV: loan value/present value; FP: fixed yearly payment; n: number of years; i: interest rate = YTM

3. YTM and Bond price for a Coupon bond

n C F
P = ∑x=1[ ] +
(1+i)x (1+i)n

P: price of the coupon bond (giá thị trường)

C: yearly coupon payment
i: interest rate = YTM
F: face value (mệnh giá)
n: years to maturity date

 Notes:
Coupon bond price = Face value YTM = Coupon rate
Coupon bond price > Face value YTM < Coupon rate
Coupon bond price < Face value YTM > Coupon rate

 A perpetuity (consol):
24. A special case of Coupon bond
25. No maturity date
26. No repayment
27. Fixed coupon payments C forever
C
 YTM on a Perpetuity (Consol): PC =
ic

4. YTM on a Discount bond

CF
PV =
(1 + i)n
D. THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS
 Rate of return (tỷ suất hoàn vốn): How well a person does financially by holding a bond or any
other security over a particular time period is accurately measured by Rate of return.

 Rate of return = The amount of each payment to the owner + The change in the security’s value.

 The return on a bond will NOT necessarily equal the YTM on that bond

 Formula:

R = return from holding the bond from time t to time t + 1

C = coupon payment
Pt = price of the bond at time t
Pt + 1 = price of the bond at time t + 1
ic = initial current yield
Pt+1−Pt
g= = rate of capital gain (lãi suất về vốn)
Pt

 Maturity and the volatility of bond returns: Interest-rate risk

28. Price and returns for long-term bonds are more volatile than those for short-term bonds.
29. Bonds with a maturity term that is as short as the holding period have no interest-rate risk.

E. THE DISTINCTION BETWEEN REAL AND NOMINAL INTEREST RATES

Fisher equation:
r = i - πe

r = real interest rate

i = nominal interest rate
πe = expected inflation rate
 CHAPTER 5: THE BEHAVIOR OF INTEREST RATES
A. DETERMINANTS OF ASSET DEMAND

B. SUPPLY AND DEMAND IN THE BOND MARKET

A particular value of the interest rate corresponds to each bond price.

 The quantity of bonds supplied > The quantity of bonds demanded  excess supply.
 The quantity of bonds supplied < The quantity of bonds demanded  excess demand.

C. CHANGES IN EQUILIBRIUM INTEREST RATES

1. Shifts in the Demand of bonds
2. Shifts in the Supply for bonds
  APPLICATION:
Change in the Interest rate due to a change in Expected Inflation
The Fisher effect

Change in the Interest rate due to a Business Cycle Expansion

Depending on whether the Supply curve shifts more than the Demand curve or vice versa, the new
equilibrium interest rate can either rise of fall.
a. The Demand curve shifts by a lesser amount than the Supply curve

b. The Demand curve shifts by a bigger amount than the Supply curve
D. SUPPLY AND DEMAND IN THE MARKET FOR MONEY: THE LIQUIDITY PREFERENCE
FRAMEWORK (MÔ HÌNH ƯA THÍCH TIỀN MẶT)
This framework determines the equilibrium interest rate in terms of the Supply and Demand for money
than the Supply and Demand for bonds.

Total wealth in the economy = Bs + Ms = Bd + Md

 People CANNOT purchase more assets than their available resources allow!

Change in equilibrium interest rates in the Liquidation Preference Framework

Response over Time to an Increase in Money Supply Growth
 CHAPTER 6: THE RISKS AND TERM STRUCTURE OF INTEREST RATE
A. RISK STRUCTURE OF INTEREST RATE (CẤU TRÚC RỦI RO CỦA LÃI SUẤT)
30. It explains the reasons for the different in interest rates between debt instruments of the same
maturity.
31. 3 components: Default risk, Liquidity, Income tax consideration.

1. Default risk (Rủi ro vỡ nợ)

 The possibility that a borrower will be unable or unwilling to pay interest or pay off the face value
when bond matures.
 Treasury bonds are default-free bonds.
 Risk premium (Phần bù rủi ro): The gap between interest rates on bonds with default risk and
interest rates on default-free bonds.

 Response to an increase in Default risk on Corporate bonds:

 A bond with default risk  risk premium > 0.

 Default risk increases  Risk premium increases.

2. Liquidity
 How quickly the bonds are traded.
 Treasury bonds are the MOST liquid of all long-term bonds.
 If the Corporate bonds become less liquid than the Treasury bonds:
 Demand for Corporate bonds falls.
 Demand for Treasury bonds rises.
 Price of Corporation bonds falls  Interest rate rises.
 Price of Treasury bonds rises  Interest rate falls.
 Liquidity premium.
 3. Income tax considerations
 Đối với những công cụ nợ miễn thuế thu nhập, lãi suất của nó sẽ thấp hơn lãi suất của công cụ nợ
chịu thuế thu nhập nhằm đảm bảo sự cân bằng về thu nhập sau thuế giữa chúng.
 Interest rates on Municipal (Trái phiếu đô thị) and Treasury bonds:

B. TERM STRUCTURE OF INTEREST RATES (CẤU TRÚC KỲ HẠN CỦA LÃI SUẤT)
32. Bonds with the same risk, liquidity, and tax characteristics may have different interest rates
because their times remaining to maturity are different.
33. 3 theories: Expectation theory, Segmented markets theory, Preferred habitat theories.
34. 3 theories have been put forward to explain the relationships among interest rates on bonds of
different maturities reflected in yield curve patterns.
35. Các hiện tượng thực tế:
a. Lãi suất trái phiếu có kỳ hạn khác nhau biến động cùng nhau theo thời gian.
b. Khi lãi suất ngắn hạn ở mức thấp, đường cong lãi suất có xu hướng dốc lên. Khi lãi suất ngắn hạn
ở mức cao, đường cong lãi suất có dạng dốc xuống và bị đảo ngược.
c. Lãi suất ngắn hạn > lãi suất dài hạn.
 Lý thuyết Dự tính giải thích được hiện tượng (a) và (b).
 Lý thuyết Thị trường phân cách giải thích được hiện tượng (c).
 Lý thuyết còn lại giải thích được cả 3 hiện tượng.

1. Expectation theory
a. Conclusion:
The interest rate on a long-term bond = The average of the short-term interest rates that people
expect to occur over the life of the long-term bond.

b. Example:
People expect that: short-term interest rates = 10% on average, coming 5 years
 The interest rate on bonds within 5 years to maturity (long term) = 10%.
 c. Explain why bonds with different maturities move together:
The bondholders DO NOT prior to hold bonds of any maturity, but care about the interest rates on
the bonds.
 They will hold the bond which provides higher interest rate.
 Bonds with different maturities are perfect substitutes (thay thế hoàn hảo cho nhau), then the
expected returns on those bonds must be equal.

d. Formula:

e. Explain why short-term bond yields affect the future yield curve
 Current short-term rates are low:
 Expected average short-term rates are high.
 Current long-term rates will higher than current short-term rates.
 The yield curve will have an upward slope.

 Current short-term rates are high:

 Expected average short-term rates are low.
 Current long-term rates will lower than current short-term rates.
 The yield curve will have a downward slope.
2. Segmented Markets theory (Lý thuyết Thị trường phân cách)
a. Definition:
36. Markets for different-maturity bonds are separate and segmented.
37. Determined by the bond’s supply and demand.
38. NOT affected by expected returns on other bonds with other maturities.

b. Key assumption:
39. Bonds with different maturities are NOT substitutes.
40. Expected return from holding a bond of 1 maturity has NO effect on the demand for a bond of
another maturity.

c. Explain why interest rates of the short-term bonds are lower than interest rates of the long-
term bonds:
41. Để hạn chế rủi ro, các nhà đầu tưu sẽ chỉ nắm giữ các trái phiếu có kỳ hạn thanh toán trùng với
kỳ hạn đầu tư của họ.
 Bonds with different maturities are NOT substitutes.
42. Các nhà đầu tư thường ưu tiên nắm giữ trái phiếu ngắn hạn hơn trái phiếu dài hạn.
 Interest rates of the short-term bonds are lower than interest rates of the long-term bonds.

3. Preferred Habitat theory (Lý thuyết môi trường ưu tiên)

a. Definition:
The interest rate of a long-term bond = an average of short-term interest rates expected + a
liquidity premium

b. Key assumption:
43. Các nhà đầu tư ưu tiên nắm giữ các trái phiếu có kỳ hạn thanh toán trùng với kỳ hạn đầu tư của
họ.
44. Vẫn quan tâm tới các trái phiếu ở những kỳ hạn khác nếu lãi suất của chúng hấp dẫn.
 Trái phiếu ở những kỳ hạn khác nhau có thể thay thế cho nhau.
45. Các nhà đầu tư ưa thích nắm giữ các trái phiếu ngắn hạn  Trái phiếu dài hạn sẽ phải có mức lãi
suất cao hơn để thu hút nhà đầu tư.
 Lãi suất trái phiếu dài hạn > lãi suất trái phiếu ngắn hạn (vì có 1 mức bù kỳ hạn tương
đối).
46. Lãi suất ngắn hạn trong tương lai được dự đoán tăng lên  Lãi suất dài hạn hiện tại sẽ tăng lên.
 Lãi suất các trái phiếu có kỳ hạn khác nhau sẽ dịch chuyện cùng nhau theo thời gian.
 CHAPTER 7: THE STOCK MARKET
A. COMPUTING THE PRICE OF COMMON STOCK
 Common stock: the principle medium through which corporations raise equity capital.
 Stockholders: who hold stock in a corporation.
 Bundle of rights (quyền lợi):
 Voting
 Being a residual claimant (người thụ hưởng cuối cùng)
 May receiving dividends
 Limited liability (chịu trách nhiệm hữu hạn)

B. THE ONE-PERIOD VALUATION MODEL (MÔ HÌNH ĐỊNH GIÁ 1 THỜI KỲ)

C. THE GENERALIZED DIVIDEND VALUATION MODEL

Or

D. THE GORDON GROWTH MODEL

 Requiring:
1. Dividends are assumed to continue growing at a constant forever.
2. The growth rate is assumed to be LESS than the required return on equity (k e).

E. HOW THE MARKET SET THE STOCK PRICES

47. The interaction among traders is what actually sets prices on a day-to-day basis. The trader who
values the security the most will be willing to pay the most.
 48. As new information is released, investors will revise their estimates of the true value of the
security and will either to buy or sell it, depending on how the market price compares with their
estimated valuation.
49. Small changes in estimated growth rates or requir returns  price changes a lot  markets are
often volatile.

F. THE THEORY OF RATIONAL EXPECTATIONS (LÝ THUYẾT KỲ VỌNG HỢP LÝ)

1. Rational expectations: Expectations will be identical to optimal forecasts (the best guess of the
future) using all available information.

2. The forcast has to be correct on average: The forcast does NOT have to be perfectly accurate to
be rational – it needs only the best posible forecast given available information.

3. Two reasons make an expectation may fail to be rational:

(a) People might be aware of all available information but find it takes too much effort to make their
expectation to the best guess posible.
(b) People might be unaware of some available relevant information, so their best guess of the future
will not be accurate.

4. Adaptive expectations (Kỳ vọng thích ứng):

50. Expectations of inflation are viewed as being an average of past information rate.
51. Expectations formation indicate, that changes in expectations occur slowly over time as past data
change.

5. Rationable behind the theory:

Accurate expectations are desirable  people have a strong incentive to try to make expectations –
optimal forecasts by using all available information.

6. Implications of the theory:

(a) If there is a change in the way a variable moves, the way in which expectations of this variable are
formed will change as well.
(b) The forecast errors of expectations will, on average, be ZERO and CANNOT be predicted ahead of
time.

G. THE EFFICTION MARTKET HYPOTHESIS (GIẢ THUYẾT THỊ TRƯỜNG HIỆU QUẢ): RATIONAL
EXPECTATIONS IN FINANCIAL MARKETS
1. Definition: An application of rational expectation to the pricing of stocks and other securities.

2. Assumption: Prices of securities in financial markets fully reflect all availale information.
 3. Equation:

(The expected return on the security = The optimal forecast of the return)

(The expected return on a security = The equilibrium return, where the quantity of security demanded =
quantity supplied)

4. Rationable behind the hypothesis:

a. The concept of arbitrage (Kinh doanh chênh lệch giá): mua cổ phiếu ở 1 thị trường và đồng
thời bán nó ở một thị trường khác có giá cao hơn.

 When Rof > R*  you buy more stocks  Pt increase

 lowering Rof until Rof = R*
 When Rof < R*  you sell more stocks  Pt decrease
 rising Rof until Rof = R*

b. Unexpected profit opportunities (Cơ hội lợi nhuận chưa được khai thác):
In an efficient market, all unexploited profit opportunities will be eliminated (loại bỏ).

c. Note: Note everyone in a financial market must be well informed about a security or have rational
expectations for its price to be driven to point at which the efficient market condition holds.

5. Random-walk behavior of stock prices:

 Random-walk: The movement of a variable whose future values CANNOT be predicted.
 Stock prices should approximately follow a random-walk.

H. PRACTICAL GUILD TO INVESTING IN THE STOCK MARKET

1. The Efficient market hyphothesis states that hot tips and investment advisors’ published
recommendation CANNOT help an investor outperform the market.
2. Empirical envidence (bằng chứng thực nghiệm) generally supports these implications of the Efficient
market hypothesis in the stock market.
 CHAPTER 18: THE FOREIGN EXCHANGE MARKET
A. FOREIGN EXCHANGE MARKET
1. Foreign exchange market: Where the trading of currencies and bank deposits denominated in
particular currencies takes place.

2. Foreign exchange rates: The price of 1 currency in terms of another.

 2 kinds of exchange rate transaction:
Spot transaction (giao dịch giao ngay): 2-day exchange.
Forward transaction (giao dịch có kỳ hạn): exchange at some specified future date.

 Example: Jan 1, 1999: 1 euro = 1.15 dollar  1 euro = 1.17 dollar

The euro is slightly

A currency increases in value Appreciation (định giá cao)
appreciated (against dollar).

The dollar is slightly

A currency decreases in value Depreciation (định giá thấp)
depreciated (against euro).

3. Why are Exchange rates important?

Because they affect the relative prices of domestic and foreign goods.

A country’s currency appreciates A country’s curreny depreciates

 The country’s goods abroad are  The country’s goods abroad are
more expensive. cheaper.
Impacts
 The foreign goods in that country  The foreign goods in that country
are cheaper. are more expensive.

Import more Export more

Results
Export less Import less

4. Two types of quoting (2 cách niêm yết giá):

Direct quotation Indirect quotation

Definition 1 foreign currency = ? domestic currency 1 domestic currency = ? foreign currency

Amount of Domestic currency Amount of Foreign currency 1

Formula = Direct quotation
Amount of Foreign currency Amount of Domestic currency

Example 1 USD = 23,809 VND 1 VND = 0.000042 USD

B. EXCHANGE RATES IN THE LONG-RUN
THEORY OF PURCHASING POWER PARITY (PPP)
(THUYẾT SỨC MUA TƯƠNG ĐƯƠNG)
1. Statement: The exchange rate between any 2 countries’ currencies is such that a basket of goods
and services, wherever it is produced, costs the same in both countries.
 PPP predicts that in the long-run, the real exchange rate is always equal to 1.0, so that the
purchasing power of this currency is the same as that of other currencies.
 2 types of PPP: Absolute PPP and Relative PPP.
Absolute PPP không tính thêm vấn đề lạm phát, còn Relative PPP thì có. Relative PPP bổ sung
cho Absolute PPP.

2. Formula:
P1 (Price of the basket in country 1)
S (Real exchange rate) =
P2 (Price of the basket in country 2)

3. Note:
𝐏 𝐝𝐨𝐦𝐞𝐬𝐭𝐢𝐜
𝐏 𝐟𝐨𝐫𝐞𝐢𝐠𝐧
 = 1  ngang giá sức mua
 < 1  nội tệ được định giá cao
 > 1  nội tệ bị định giá thấp

4. Factors that affect Exchange rate in the long-run:

C. EXCHANGE RATE IN THE SHORT-RUN

 EA > E*:
 The quantity of Rupee assets supplied > The quantity demanded.
 Excess supply (thặng dư lượng cung).
 More people want to sell Rupee than want to buy them.
 The value of Rupee will fall until it reaches the equilibrium rate of E*.

 EC < E*:
 The quantity of Rupee assets demanded > The quantity supplied.
 Excess demand (thặng dư lượng cầu).
 More people want to buy Rupee than want to sell them.
 The value of Rupee will rise until it reaches the equilibrium rate of E*.

D. EXPLAINING CHANGES IN EXCHANGE RATE