Quantitative Easing

Quantitative Easing (QE) is a monetary policy where central banks buy financial assets to boost the economy. It lowers interest rates, raises asset prices, and aids recovery. However, QE faces criticisms like inflating asset bubbles and doubts about its effectiveness. It’s a vital tool for central banks during economic crises.

Characteristics:

  • Asset Purchases: QE involves central banks purchasing a variety of financial assets, including government bonds, mortgage-backed securities, and corporate bonds.
  • Unconventional Monetary Policy: QE is considered unconventional because it goes beyond adjusting short-term interest rates, which are the typical tools of central banks.
  • Open Market Operations: Central banks conduct QE through open market operations, effectively creating new money to buy assets from the private sector.

Process:

  • Money Creation: When central banks purchase assets, they credit the accounts of the selling institutions with new money, increasing the money supply.
  • Lower Interest Rates: By buying large quantities of assets, central banks reduce the supply of those assets in the market, causing their prices to rise and their yields (interest rates) to fall.
  • Stimulating Borrowing and Spending: Lower interest rates encourage borrowing by consumers and businesses, leading to increased spending, investment, and economic activity.

Effects:

  • Asset Price Increases: QE often leads to rising prices of financial assets such as stocks and bonds due to increased demand.
  • Economic Stimulus: QE is used to stimulate economic growth, particularly during periods of recession or economic downturns.
  • Inflation Concerns: As QE increases the money supply, it can potentially lead to inflationary pressures in the economy.

Criticisms and Concerns:

  • Asset Bubbles: Critics argue that QE can inflate asset bubbles, causing overvaluation and instability in financial markets.
  • Income Inequality: Some believe that QE can exacerbate income inequality by benefiting asset owners while not necessarily benefiting those with lower incomes.
  • Effectiveness Debate: There is ongoing debate about the effectiveness of QE in achieving its intended economic goals, with varying opinions among economists and policymakers.

Use Cases:

  • Global Financial Crisis: QE was extensively used by central banks, including the U.S. Federal Reserve, to combat the 2008 financial crisis and subsequent economic recession.
  • COVID-19 Pandemic: Central banks implemented QE measures during the COVID-19 pandemic to stabilize financial markets and support economies hit by lockdowns and reduced economic activity.

Examples:

  • U.S. Federal Reserve: The Fed conducted multiple rounds of QE, including QE1, QE2, and QE3, to address economic challenges in the United States.
  • European Central Bank (ECB): The ECB implemented QE programs to combat economic issues in the eurozone, including the sovereign debt crisis.
  • Bank of Japan: Japan has a long history of using QE as a tool to combat deflation and stimulate economic growth.
  • Bank of England: The UK’s central bank has also employed QE measures to address economic challenges.

Key highlights of Quantitative Easing (QE):

  • Unconventional Monetary Policy: QE is an unconventional tool used by central banks to stimulate economic growth and manage financial crises.
  • Asset Purchases: Central banks buy a variety of financial assets, injecting new money into the economy.
  • Lower Interest Rates: QE lowers interest rates, encouraging borrowing, spending, and investment.
  • Economic Stimulus: It is used to combat economic downturns, such as recessions or financial crises.
  • Asset Price Increases: QE can lead to rising prices of financial assets like stocks and bonds.
  • Inflation Concerns: Critics worry that QE may contribute to inflationary pressures.
  • Debate on Effectiveness: There is ongoing debate about how effective QE is in achieving its economic objectives.
  • Examples: QE was used during the 2008 financial crisis and the COVID-19 pandemic by central banks worldwide.

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

profitability
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: HeuristicsBiases.

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