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Summary Macro-Finance (B-KUL-D0C15A) - Dewachter Hans
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Summary and exam questions of Macro-Finance by Dewachter Hans
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Macro-Finance summaryGrafieken da hij tekent in de les zijn examenvragen + dingen die hij op bord schrijft
Slides zijn te kennen voor dit vak + UOVT’s belangrijk voor examens
HOC1
Ik weet niet of het volgende te kennen is:
Example 1: need to save for pension to maintain standard of living
How much do i have to save at the age of retirement in order to have a specific consumption
type? = Wt zie p1 notities
Its just like NPV calculation
If you know future interest rates and you know how much P you get what is the optimal level?
The formula on the board is wrong à you have to discount it
First rule that you need to know:
#
(𝐶! − 𝑃" ) (1 + 𝑟) 1
𝑊= $ = [𝐶 − 𝑃][ (1 − )
(1 + 𝑟) " 𝑟 ( 1 + 𝑟 )#
"$%
Example 2= The Greek Job
Greek job = trick to play down and decrease the budget deficit in order to enter the EU
offered by Goldman Sachs. The trick is that you play around with forward contracts.
V* had to be repaid at time T (zie bord)
Two ways to hedge your debts:
- Play safe and go on the spot markets: now at time t you transfer enoug money to US
accounts, and invest in safe assets so that you reach V* at time T => V*/(1+r)
o In order t get V*/1+r => you have to convert in us dollars at spot exchange
rate S; [V*/1+R] x S à A1
- Enter in forward future contracts: i am going to buy US dollars at time t+1. I am going
to buy US dollars one period from now at a rate determined at time t. I am going to
need local currency ni gesnapt A2
Goldman proposed: instead of market pricing; we are not going to price in this but we are
going to set the forward rate in this contract much higher then the market rate
è Not a good idea: you can buy it at 100 in the market but with GS you buy it at 200 and
still the greek government signed that contract. Say okay we sign at 200 but at the
same time we sign, GS is going to pay a certain amount to the greek government à
how much? Bereken zelf?
è Why did they signed the contract?
Eurostat accounting rules: the amount GS pays at greek government can be booked
on the balance à it reduces the budget deficit because you get a certain amount of
GS. It comes in de debt level not in the budge and as a consequence, you got allot of
money of GS, you improve your budget deficit, you enter the EU. And the losses that
you had will be on the debt and not on the books. This is just again arbitrage pricing.
We have to found out what that amount is.
1
,Part 1: Money and the financial system
Lecture 1: The financial system: principles and relevance
The financial system: six parts
The financial system has six parts, each of which playing a crucial role in the financial system
and the economy:
• Money: means of exchange (as legal tender), unit of account and store of value
• Financial instruments: transfer of resources from savers to investors and transfer of
risk to risk absorbers, e.g derivatives, bonds, deposits, securitized assets, ....
• Financial markets: platform for buying/selling financial instruments efficiently (quickly
and cheaply) – e.g. stock and bond markets, derivative markets, insurance contracts..
• Financial institutions: proving large scale of financial services, including access to
financial markets and information collection - eg banks, insurance undertakings, stock
brokers
• Government regulatory agencies: supervising and regulating the financial system
in order to make it safe and reliable - eg microprudential and macroprudential
authorities (SSM, NCAs, NCBs,...)
• Central banks: monetary policy, monitor and stabilize the economy (and in some
case also directly) the financial system
While the form of these functions may change over time (e.g. as a result of technological
innovations) the underlying functions remain very stable.
Macro-Finance course: can we make some general statements about the financial system
that are both relevant and can stand the test of time?
This implies identifying and developing some of the core principles/fundamentals
underlying financial systems => a macro view on these principles will be developed in this
course
The financial system: five core principles
A number of core principles apply across financial instruments, markets and institutions and
form the basis of macro-financial analysis. Pricing is not about the price, but bout the return.
Pricing
Core principle 1: time has value and is rewarded in financial pricing through the (risk-free)
interest rate. Interest rates form the key determinant of pricing risk-free cash-flows or projects
Core principle 2: risk-taking requires compensation in the form of pecuniary payments. And
this compensation increases with the amount of risk taken and the market price of risk
2
,Return on investment (ri,t+1): the price level will follow automatically, it follows the market,
current prices are going to function as jump variables à it adjusts the order to fit the
equilibrium return equation.
Return can come in very different forms, coupons, divividens, … but typical caracteristics is
the quote capital gains and income streams that you might have.
The dividend yield/the return:
How do markets decide what its return should be?
o Time = time value (core principle 1)
o Risk = risk premium à 𝑟𝑝&,( (core principle 2)
o There is going to be a shock à 𝜀𝑖,𝑡+1 (core principle 3)
Summary:
Prices adjusts on the return à The return consists of capital gains and dividend yields à can
be decomposed in time value, risk premium and shock.
Two things are not known, the thing that is known is the expected return à 𝑟𝑓,𝑡 + 𝑟𝑝𝑜,𝑡
Information
Investors are going to decide on the basis on what they expect. The shock is never going to
be considered when making a decision. So, the question is what type of information is going
to be included in your decision making? Next to time and risk is information.
Core principle 3: Information is a key variable underlying financial decisions with the role of
information becoming more relevant as decisions increase in importance:
• Statistical information, economic information, information on counterparty, .....
• Note an interesting book by Daniel Kahneman on rational and intuitive decision
making “Thinking fast and slow”
How are you going to describe it? Behavioral or rational expectations …?
We are going to use statistical information to make a decision. But there is also an
important behavioral approach. But what we do in finance theory so far: we restrict
information to something rational and statistic. Uncertainty does not exist for us, we talk
about RISK.
The pricing equation is still empty, we do not know what what is.
3
, A number of core principles apply across financial instruments, markets and institutions and
form the basis of macro-financial analysis:
Financial markets
Core principle 4: financial markets “determine” financial prices and allocate resources
throughout the economy. Pricing is done on a market conform way, by the markets. By
pricing assets you need to make a difference between:
• Pricing fundamental assets (through supply and demand)
• Interest rate is determined by markets and markets determine the
fundamental assets based on supply VS demand.
• An example is stocks, real activity that runs risk, that gives you a return, it’s
not replicating any other financial underlying
• Supply = ?? and demand = expectation, prices, risk aversion, …
• Risk-free bonds: provides a yield curve of interest rate
• Market-wide prices of risk to determine the relevant price of non-
diversifiable (macro-financial) risks in investment projects
• This requires an equilibrium pricing (supply and demand)
• Derivative financial instruments priced using no-arbitrage on the basis of prices
of fundamental assets
• An example is the formula of forward contract (see first page smv) = risk
neutral pricing
• Information is aggregated into the price formation process and financial prices
become information variables!
• Proper market-functioning should be safeguarded by regulatory and supervisory
authorities
What is it that markets do when they price an asset? The margin on investors is going to
price the asset.
We are going to make this concrete by making risk premiums very specific. We write down a
ROI rt+1:
time value (we want to be rewarded because we don’t consume directly) + there is going to
be a risk premium + shock.
Expected return (rt + r.pi,t) is going to be decision variables for agents, it’s formed by one
way only: the risk premium which consist of 2 components:
- Price of risk
- Risk exposure or assessment of risk = statistical concept (≠ true risk) and is going to
be asset specific: 𝜎
o We will compute the structural part of the risk: 𝛽.
§ Every asset that I am going to price has an asset specific risk
exposure = 𝛽 = asset specific.
4
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