In this post, I summarize key institutional details and historical episodes that come up consistently in seminars and job talks. For both empirical and theoretical research in finance, a solid understanding of these seems useful.

Monetary Policy & Fiscal Policy

  1. Conduct of Monetary Policy
    1. New Zealand is the first country to set an inflation target. The 2% target was somewhat ad hoc, but gradually other countries adopted this 2% target.
    2. Japan implemented the first quantitative easing to fight domestic deflation in the early 2000s. The Fed was next to follow in the aftermath of the subprime mortgage crisis.
    3. The ECB and the Fed have learned a great deal from each other. ECB now publishes meeting summaries analogous to the Fed’s minutes, while the Fed chair now holds a post-policy-meeting press conference, something the ECB has done from the start.
    4. In the past, the Fed influenced the federal funds rate through open market operations. When reserves were scarce, the Fed could influence the FFR with small changes in the supply of reserves by conducting open market operations that would shift the supply curve to the right (increasing reserves) or left (decreasing reserves).
    5. The Fed has now adopted a new strategy. With ample reserves in the banking system, the Fed now sets a target range for the FFR rather than setting a single target. It now also pays interest on both required reserves and excess reserves. Finally, an institute using the Overnight Reverse Repo Facility can deposit reserves at the Fed overnight and earn interest on the deposit, which essentially serves as a floor for the FFR.
    6. The FOMC meets eight times a year to formulate monetary policy (by law it must meet at least four times) and determine other Federal Reserve policies. Though all 19 members attend the meetings and take part in the discussion, at any given time only 12 of the FOMC have policy voting rights. All seven governors have a vote; the president of the New York Fed is a permanent voting member; and four of the remaining eleven Fed presidents vote for one year on a rotating basis.
  2. Communication of Monetary Policy
    1. FOMC meetings have been tape-recorded since the 1970s to prepare minutes. Initially, committee members believed that these tapes were erased afterward. In October 1993, following pressure from politicians, Alan Greenspan discovered and revealed that before being erased the tapes had, in fact, been transcribed and stored in archives all along. The Fed quickly agreed to publish all past transcripts and, a short time later, extended that policy to cover all future transcripts with a five-year lag.
  3. Government Debt
    1. Governments in good standing generally don’t repay debt because they refinance it. Unlike households who must eventually retire their debt, a government can in principle refinance its debt indefinitely.

Financial Stability

  1. Policies to Ensure Stability
    1. Bank capital $\neq$ bank reserves. Reserves are cash deposits at the central bank and vaulted currency. Therefore, the reserve requirement is about liquidity — it is designed to protect against runs. Capital is (essentially) assets minus liabilities of the bank. Therefore, capital requirements are about solvency — they are designed to absorb losses on loans and other investments. Reserves are accounted on the asset side of the balance sheet, while capital resides in the equity section of the balance sheet.

    2. Systematically Important Financial Institution (SIFI) refers to any financial institution that may pose a serious risk to the economy if it were to collapse.

    3. Stress tests are nothing fancy. You first figure out how much capital a bank has and then compute how much capital it would have left after going through adverse scenarios and paying out to shareholders. If the remaining amount is less than the required amount, then the bank fails the tests and cannot raise its dividend or do buybacks.

    4. Fannie Mae and Freddie Mac are two entities established by the government to boost the housing market. Fannie Mae stands for the Federal National Mortgage Association. Freddie Mac is the Federal Home Loan Mortgage Corporation. '

      The primary difference between Freddie Mac and Fannie Mae is where they source their mortgages from. Fannie Mae buys mortgages from larger, commercial banks, while Freddie Mac buys them from much smaller banks.


  1. Stock Market

    1. Payment for order flow is actually not that nefarious. It's the practice of wholesale market makers (like Citadel) paying brokers (typically retail brokers) for their clients' order flow. All three parties win because (1) market makers are able to trade profitably against client orders on average, (2) clients may benefit from reduced trading costs, and (3) retail brokers earn the spread between the two.
    2. You can still trade after the stock market closes. So the stock market doesn't really "close." Usually the bid-ask spreads are greater and liquidity lower. There is also potential adverse selection if you're a retail trader.
    3. Delisted companies to the OTC market. Liquidity in the OTC market is incredibly thin — 25% of OTC equities see no volume on 95% of trading days. Since there is no central exchange, a network of broker dealers execute trades bilaterally and post quotes on OTC link ATS.
  2. Treasury Market

    1. Form of Treasury securities, which are sold through auctions, depends on their maturity. Those with maturity of 1 year or less are T-bills, which bear no interest. Treasury also issues 2-, 3-, 5-, and 10-year notes on a regular cycle. Finally, Treasury also issues interest-bearing negotiable bonds with maturity at issue of 30-years.
  3. Corporate Bonds Market

    1. Insurance companies are major investors in corporate bond markets, but their share has been declining. The large groups that have been growing are mutual funds and the foreign sector.


                                                    Source: Ralph Koijen's Empirical Asset Pricing Notes
  4. Muni Bonds Market

    1. Income received from interest payments on munis is usually tax-exempt at the federal, state, and local level. Therefore, bonds are generally held by high-net-worth individuals who can benefit most from this exemption .The yields on municipal bonds are generally lower than a corporate bond with similar credit risk because investors require a lower return due to the tax-exemptions, and indeed the purpose of these exemptions is to give access to cheaper credit for municipal governments.