FIN 320 DePaul University Final Study Guide

long interest rate futures and short IRF positions: what are they and how do there values change with the price and yield of underlying assets

1. A short position in an interest rate futures contract represents a party that will: 2. Deliver (sell) an interest-bearing financial instrument to a buyer on some future date at a predetermined price. 3. Benefit if the price of underlying financial instrument decreases. 4. Benefit if the interest rate on the underlying financial instrument increases. 5. A long position in an interest rate futures contract represents a party that will: 6. Buy an interest-bearing financial instrument on some future date at a prearranged price. 7. Benefit if the price of the underlying financial instrument increases. 8. Benefit if the interest rate on the underlying financial instrument decreases.

what is purchasing power parity? (ppp)

1. A theory that supports the law of one price: the theory says that the price of one product should be the same across countries. So the exchange rates should adjust to reflect this 'one price' scenario.

what is the gap

1. An analysis of the difference between the dollar value of the banks variable rate assets and liabilities

if demand for dollars increase will dollar appreciate or depreciate

1. An increase in demand will cause the dollar to appreciate. A decrease in demand will cause the dollar to depreciate.

if supply ing FX market increase will dollar depreciate or appreciate?

1. An increase in supply will cause the dollar to depreciate. A decrease in supple will cause the dollar to appreciate.

how does an increase or decrease in risk adjusted assets affect a banks minimum capital requirements

1. An increase will increase the amount of capital a bank must hold and a decrease will decrease the amount

what will change the supply of dollars in the FX market

1. Anything that increases willingness of Americans to buy foreign goods or foreign assets. a. Increase in US wealth b. Increase in interest rates on foreign bonds relative to US bonds c. Increase in American preferences for foreign goods. d. Reduction in riskiness of foreign assets e. An expectation that money will lose value in future

what will change the demand curve fro dollars in FX market

1. Anything that increases willingness of foreigners to buy US goods/services or US assets. a. 1- increase in foreign wealth b. 2- increase in real interest rates on US bonds relative to foreign bonds c. 3- increase in foreign preferences for US goods d. 4- reduction in riskiness of US assets e. 5- an expectation that money will rise in value in future f. (There are reasons for increase demands for dollars) vi. If demand increases (curve shifts to right), will dollar depreciate

will Basel III increase or decrease the amount of tier 1 capital banks must hold? what will be the likely impact on the real economy in short and long run?

1. Basel III will increase the minimum amount of capital banks must hold. Large banks (Systematically Important Financial Institutions) will have to hold more capital than small banks. New Basel III standards have much higher minimum requirements for common equity Tier 1 capital as percentage of total assets. Banks will be required to have more capital in the form of common equity. All regulations have costs in the short-run to GDP but have a positive effect in the long-run.

OMO why does level of fed funds rate matter to economy?

1. Because the rate of the federal fund influences all other rates, the fed tells the market what rates should be.

interest rate paid on bank reserve balances held at the fed. how can fed use this as a tool in its exit strategy of Quantitative easing? how can a central bank use this tool to encourage banks to lend their excess reserves?

1. By raising the rate it pays on excess reserves, the Fed can raise the equilibrium Fed funds rate without reducing the supply of reserves. Basically, they are just increasing the amount of excess reserves bank are willing to hold at the Fed. This will decrease amount of bank lending and slow economic activity. In the meantime, the Fed can slowly unwind its balance sheet (ie sell securities). This is how the Fed plans to reduce its balance sheet once the economy reaches maximum employment and price stability. 2. The ECB set a negative rate for excess reserves balances. This means that banks pay interest to the ECB on their excess reserves balances. This should make banks more willing to lend and help the economy.

trade offs - can central banks always achieve all these goals at the same time

1. Can't achieve all these goals (six above) at once. However; these goals are really just two goals: price stability and maximum employment (dual mandate). If the Fed can attain these two goals, it will typically attain its other goals as well.

derivatives, definition and main purpose

1. Derivatives are an asset that derives its economic value from an underlying asset, such as a stock or a bond. Derivatives are used to transfer risk. Derivatives can be used to manage and reduce (hedge) risk. Can also be used to speculate, but main purpose is to transfer risk.

what is discount lending? is it usually a larges amount? when would it be large

1. Discount loans - gives the power to banks. Go to reserve bank for discount loans, are secured. They don't want to go there, will go to other banks. 2. Primary credit: goes to healthy banks that have adequate capital and good supervisory ratings (CAMEL). Main purpose is for short-term illiquidity, most are overnight. 3. Secondary credit: for banks with inadequate capital and bad supervisory rating. Long term loans. 4. With this question my guess is that the size of the amount is relatively small, might depend on what type of credit. If someone know, please change.

discount rate

1. Discount policy: setting terms and rates for discount lending

what is feds policy framework

1. Dual mandate maximum employment and stable prices. 2. (Stable prices means low inflation 2% not 0) 3. - Dual mandate: the practice in which elected officials serve in more than one elected or other public position simultaneously.

advantages and disadvantages of FDIC insurance

1. FDIC prevents bank runs and panics. FDIC has full faith and credit of US government. FDIC can ask for loan from government and treasury gas to give it to them. Banking industry is paying. It has increased leverage and moral hazard.

OMO How does fed add reserves to the banking system

1. Fed buying securities will increase reserves in banking system

what are Open market operations

1. Fed buys and sells securities, in order to influence amount of bank reserves and short-term interest rates. Fed sets a target for Federal Funds rate, rate at which banks make very short-term loans to each other. 2. - Fed buying and selling securities in order to influence amount of bank reserves and short term interest rates. 3. - Fed sets a target for Federal Funds rate; rate at which banks make very short term loans to each other.

Quantitative easing, hows it done? how will it effect size of fed balance sheet? how will it affect interest rates in economy? advantages and disadvantages

1. Fed is making open market purchases to put more reserves in the system than needed to reach target rate range (0-25bp) 1. It will increase the size of the balance sheet because they will be buying more securities which makes the banks put more reserves in the fed's balance sheet, increases both asset and liabilities side. 1. The Fed funds rate is basically zero, so additional reserves added to the system through QE is not going to have an impact on the equilibrium fed funds rate, but will affect other interest and the economy. One way QE will affect the economy is it increases demand for Treasury bonds (and/or MBS). The Fed becomes a big buyer of bonds. This should increase price and reduce yield. This will make longer-term interest rates lower, so interest rates for corporate borrowers decrease as well. So, if expected inflation is stable, QE should reduce real interest rates below what they otherwise would have been. Lower real interest rates will stimulate the economy 1. The QE increases reserves, monetary base, money supply, and the size of the Fed's balance sheet, lower interest rates and higher economic growth than if the Fed hadn't acted. 2. Disadvantages: a. Don't know it it will work as planned b. QE makes exit strategies more complicated c. Some think QE will lead to inflation down the road.

why is it important to have a lender of last resort?

1. Fed lends to solvent banks that are temporarily illiquid (need cash to meet depositors withdrawal demands)

OMO how does fed remove reserves from the banking system

1. Fed selling securities will decrease reserves in the banking system.

role of FOMC

1. Governing council 2. Sets monetary policy (i.e. controls amount of money and credit in system)

undervalued vs overvalued

1. If dollar price of foreign goods is less than (<) price of US goods, then foreign goods foreign currency is undervalued. 2. - If dollar price of foreign goods is great than (>) price of US goods, then foreign currency is overvalued.

What does the duration gap tell you about how movement in interest rates will affect bank capital?

1. If duration gap is positive, an increase in interest rate will decrease bank capital. Vice versa

What does the gap tell you about how movement in interest rates will affect bank profit?

1. If the gap is negative, banks profits decline with a rise in interest rates. If the gap is positive, banks profits increase with a rise in interest rates.

What are interest rate futures what kind of interest rate futures did we use in our example of hedging with futures?

1. Interest rate futures are financial futures with an interest-bearing financial instrument as the underlying asset (ex: treasury bond future)

changing composition of fed assets. how is it done? how will it affect size of fed balance sheet? advantages and disadvantages

1. It does so by buying or selling securities. One example is the Fed selling Treasuries and buying MBS. This increase in demand for MBS, boosts their price, and lowers their yield relative to Treasury bonds. Fed did this during 2007-2009 crisis to keep mortgage rates low. 2. nothing its unchanged 3. Advantages: reduction in longer-dated treasury rates, lowered financing costs and increased output. 4. Disadvantages: a. Has characteristics usually associated with fiscal policy, helps one part, has to pick "winners and losers". b. The Fed will eventually need to sell the asset → exit strategy. Securities are less liquid. Harder to sell large amounts of these securities without greatly affecting the price and yield.

duration analysis and what does it measure

1. It measures sensitivity of bank capital to changes in market interest rates. Duration is a measure of maturity. So, for example, the longer the duration of an asset or liability, the bigger change in price for any change in market interest rate.

expansionary Monetary policy vs tight MP

1. Lose, expansionary or accommodative monetary policy = Fed is increasing amount of reserves in system / lowering or keeping low target FF rate / maintaining a large balance sheet 2. Tight or contractionary monetary policy = Fed is decreasing the amount of reserves in the system / raising or keeping the target FF rate / reducing size of balance sheet.

how is ECB different from Fed

1. Many countries (19-currency is the Euro) 2. Different policy objective than Fed: ECB's primary objective is price stability defined as inflation, closest to but not less than 2%).

margin, what is it and why is it necessary

1. Margin is collateral, I.E. money put down by counter party to guarantee payment. Trades are market to market every day. If trade foes against them - say long treasury bond future in rising rate environment- the counterparty will have to put up more margin.

is duration gap of typical bank positive or negative

1. Most banks have a positive duration gap and a negative gap analysis because the main source of funds are short tem deposits and the main use of funds are longer term loans

is the gap of a typical bank positive

1. Negative because their liabilities, mainly deposits, are more likely to have rates than are their assets, mainly loans and securities.

is RR a good tool for monetary policy?

1. No, it is not easily predictable. It takes long time to implement.

ECB how is it similar to Fed

1. One currency 2. Executive board (Fed has Board of Governors) 3. National Central Banks (Fed has 12 Reserve Banks) 4. Governing Council (Fed has FOMC)

what does PPP tell you about how exchange rates move when countries have different inflation rates

1. PPP says that in the long run, exchange rates move to equalize purchasing power of different currencies.

goals of Monetary Policy

1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign exchange market stability

OMO what does fed do when equilibrium fed funds rate is above or below its target

1. Raise or decrease the amount of reserves, they change the supply

what is the most important determinant of exchange rates in the short run?

1. Real interest rate differentials between countries.

reserve requirement

1. Reserve requirement: 10% of the checkable account deposits set by the board

basel accords. What are risk adjusted assets? how do they relate to the riskiness of a banks assets? what assets have a zero risk weighting in the computation of risk adjusted assets?

1. Risk-adjusted (weighted) asset: In terms of the minimum amount of capital that is required within banks and other institutions, based on a percentage of the assets, weighted by risk. Link minimum required capital to the riskiness of assets held by the bank. The riskier the assets, the more capital requirement. Risk-adjusted assets are: 2. Cash and reserves 3. Bonds issued by industrialized countries (US Treasury bills) 4. Bonds issued by industrialized countries long-term 5. Residential mortgages 6. Consumer and corporate loans 7. Cash & reserves and bonds have a zero risk weighting.

Role of board of governors

1. Set reserve requirement 2. Sets discount rate (rate paid by banks on discounts loans) 3. Hold 7/12 seats on FOMC 4. Determine permissible activities of bank holding costs and approve bank merger applications 5. Supervise and regulate the 12 Reserve Banks 6. Analyze financial and economic conditions and publish statistical data 7. Along in Reserve Banks, regulate and supervise banks and SIFI's.

reserve requirement. effect of changes in reserve requirement on money and the availability of credit

1. Small changes have big effect on amount of money and credit. 2. Reserve requirement decrease → reserves in the system increase → multiplier effect increase 3. Reserve requirement increase → reserves in the system decrease → multiplier effect decrease

how can the fed create reserves or remove reserves to control the monetary base

1. The fed creates reserves by buying bonds of banks, and can decrease reserves by selling bonds to banks a. Reserves: deposits owned by banks held at Fed

if banks decide to hole more of their assets in the form of excess reserves, will it increase or decrease the multiplier effect?

1. The more excess reserves banks hold, the lower the multiplier effect, and vice versa.

if the required reserves ratio decreases will it increase or decrease the multiplier effect? if required reserves ratio increases, will it increase or decrease multiplier effect

1. The multiplier effect is greater the lower the reserve requirement

are they secured or unsecured (discount lending)

1. They are secured ,but secondary credit offer less security

why does fed make discount loans

1. To help relieve liquidity strains for individual depository institution and for the banking system as a whole by providing a reliable backup source of funding

what is transparency and what are its benefits in relation to monetary policy

1. Transparency: letting public have more information on Fed's thinking operations 2. - Benefits: a. - Increases the effectiveness of monetary policy. Especially important when target fed funds rate close to 0. b. - Gives people/firms better info to make economic decisions c. - Politically smart d. - More accountability

why do big banks have higher minimum capital requirements than smaller banks? how can big banks reduce this capital surge?

1. Try to minimize the risks to the overall economy posed by large banks, they are systematically important financial institutions. The requirements makes for more capital, which means more security, banks won't go down as easy. Pursue them to be smaller

what time frame is long run?

10-20 years

what is feds long run inflation objective?

2%

fixed rate assets

Assets with interest rate that will not change anytime soon. Ex: Long maturity US Treasury bond, 5 year fixed-rate commercial and industrial loan, 30 year fixed-rate mortgage

variable rate assets

Assets with interest rates that can soon change. Ex: short-term government security (3 Mo Treasury bill), adjustable rate loans

OMO what is the fed funds market

Market where banks lend their excess reserves to other banks.

which is main policy tool for fed?

Open market operations

OMO secured or unsecured?

a. Bilateral agreements - unsecured b. Discount loans - secured

future contracts what is the price of a futures contract on settlement date

a. Futures contract are standardized contracts to buy or sell a specific amount of a commodity or financial asset on a specific future date at a predetermined price. Financial future contracts - agreements between a buyer and a seller to exchange a financial instrument for a predetermined price on a prearranged future date. A financial instrument is the underlying asset of a financial futures contract.

OMO taylor rule: When inflation is low and unemployment high (current output less than potential output), what would you expect level and direction of target fed funds rate to be? When inflation is high and unemployment low (current output higher than potential output), what would you expect level and direction of target fed funds rate to be?

a. If inflation is low and actual output < potential output the Fed will buy securities, they will want to reduce real interest rates to increase economic activity. Will set low and/or declining target rate. b. If inflation is high and actual output > potential output the Fed will want to increase real interest rates (sell securities) to slow economic activity. Will set higher + increasing target funds rate.

IRS what is exchanged in a interest rate swap

a. Interest-rate swaps are agreements between two counterparties to exchange periodic interest-rate payments over some future period, based on agreed amount of principal. This agreed amount of principal is called the notional principal because it is just used as the basis for the calculation.

OMO potential output?

a. Potential output: amount of output economy is capable of producing with resources being used

interest rate swaps notional principle

a. The agreed amount of principle that is used as the basis for the calculation. Not borrowed or exchanged.

FC settlement date/delivery date

b. The predetermined price is the futures price at the time you buy or sell the contract. The prearranged future date for the exchange is called the settlement date or the delivery date. The financial futures price moves with the market price of the underlying financial instrument. On the settlement date of the futures contract, the price of the futures contract must equal the price of the underlying asset. No payments are made initially between the buyers and sellers when the contract is agreed to. The seller - who has a short position - will deliver the financial asset on a specific future date at a predetermined price.

FC underlying assets

c. Profit (or loss) for a seller of futures = futures price at sale - spot price at settlement. Remember, spot price is current market price of the financial instrument. Short position (ie selling futures, short futures) is profitable if price of the underlying asset declines between the date futures sold and the settlement date.

FC what happens if price of futures contract if price of underlying assets goes up or down

d. Profit (or loss) for buyer of futures = spot price at settlement date - futures price at purchase. Long position (ie buying futures, long futures) is profitable if price of the underlying asset increases between the date futures sold and the settlement date.

why do we need regulation to set minimum amount of bank capital

do we need regulation to set minimum amount of bank capital? i. ROE = net profits after tax / ban capital ii. An increase in the bank capital will lower the banks return to shareholders (ROE). So banks have an economic incentive to skimp on capital

OMO what is lent or borrowed in FFM

excess reserves

secondary credit for troubled banks? is is second higher or lower

higher

primary credit for healthier banks. is primary discount rate higher or lowed than fed funds rate

higher, target funds rate 0-25 basis points. primary Discount rate: 75bp

definition of bank capital, whats its purpose

i. Bank capital= bank assets - bank liabilities

definition of solvency, insolvency, liquidity and illiquidity

i. Bank is solvent if bank capital (net worth) is > 0 ii. Insolvency is when a banks assets do not cover its liabilities iii. A bank is liquid if cash has what it nes to pay those who want to withdraw fund iv. A bank is illiquid if it doesn't have cash that it needs to pay those who want to withdraw funds (illiquidity is when a bank does not have enough reserves to meet depositors withdrawals)

excess reserves

i. Banks are required to hold amounts of 10% of checkable deposits are reserves with the Fed. Whatever amount is over 10% is called excess reserves

why are some banks to big to fail? why is the a problem? is moral hazard a problem for small or for big banks?

i. Because failure of bank would cause a financial crisis (systematic risk) ii. Moral hazard is a bigger problem for big banks

bank supervisions: camel ratings

i. Capital adequacy ii. Asset quality iii. Management iv. Earnings v. Liquidity vi. Sensitivity to risk

what doesn't a central bank do?

i. Control securities market ii. Control government budget

monetary base

i. Currency in circulation and reserves in banking system ii. Fed controls monetary base by buying and selling securities (open market operations)

fixed vs flexible exchange rates?

i. Flexible exchange rate- determined by supply and demand ii. Fixed exchange rate- the government or central bank ties the official exchange rate to another country's currency (or price of gold). Same a currency pegging..

marginal interest rate risk and why is it important banks manage it

i. Interest rate risk is the effect of a change in market interest rates on a bank's profits and capital. This risk is caused by a mismatch of maturity of bank assets and bank liabilities. Failure to identify and qualify interest rate risk exposure could lead to insolvency, losses in excess of bank capital. Id banks couldn't hedge some of these risks they would be able to make fewer loans. The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship.

forward guidance

i. Involves the Fed making commitments today for future policy target. We learned in the term structure of interest rate that long-term bond yields depend on expectations of future short-term rates. So if Fed states that future short-term rates will remain low, it will lower today's long-term interest rates. If expected inflation is stable, that this will have a one-to-one effect on real interest rates. Lower long-term real interest rates will increase economic activity.

primary reason countries create their own central banks?

i. Is to ensure control over its currency

two reasons for government regulations on banks

i. It helps to avoid financial crisis. A financial crisis is a significant disruption in flow of funds from savers to borrowers. Financial crisis is a very costly thing to the economy ii. Consumer Protection, FDIC insurance

thrift crisis of 1980's what happened and what did regulators do wrong

i. Late 1970s US had very high inflation and the Fed raised interest rates to slow economy and reduce inflation. ii. January 1980 yield on 3-month Treasury bills was 6.49%. Treasury bill rates peaked at 16.3% in May 1981. Went back to single digits in 1982. iii. Thrift (savings association=savings loan) has to pay more to issue deposits, profits went down, negative gap. iv. What regulators did wrong: 1. 1- Capital Forbearance - didn't insist thrifts raise more capital. Actually reduced thrifts capital requirements. 2. 2- Gave thrifts new investment powers. Let them buy corporate bonds, make consumer loans and construction loans. 3. 3- Raised FDIC max insured limit from $40,000 to $100,000. Moral hazard went up. v. Thrifts got bigger- brought in lots of deposits and made riskier loans. Most of these thrifts were in Southwest. Real estate bubble burst in SW. vi. Prices for real estate were way higher than fundamental value. vii. Value of thrift went down because of defaults on loans, many thrifts failed. Cost taxpayers $200 billion.

quantity theory of money. what does it tell u about the main determinant of inflation in long run

i. M (Amount of money) x V (Velocity, number of times money turn over) = P (price) x Y (output) ii. Velocity is determined by payment mechanism. iii. → % Change of M + % Change of V (Can be ruled out) = % change of P + % Change of Y (potential) iv. → % Change of M = % Change of P (Inflation) + % Change of Y (Often zero or very low) v. → % Change of M = % change of P (Inflation) vi. In the long-run, inflation is determined by the rate of growth of the money supply (% change of M)

what does a central bank do as a bankers bank?

i. Manages and settle payments ii. Oversee bank for safety and soundness (regulate banks)

what does a central bank do as a governments bank?

i. Manages finances of government ii. Controls availability of money and credit in the economy through monetary policy

micro-prudential versus macro-prudential regulations. define systematic risk

i. Micro prudential regulation: limits risk within a particular financial institution. ii. - Macro prudential regulation: limits systematic risks, i.e. risks of blow up economy, financial crisis. iii. - Systematic risk: The risk inherent to the entire market or an entire market segment-affects the overall market not just a particular stock or industry.

two ways for FDIC to resolve a bank failure and implications for deposits over the FDIC-insured limit

i. Pay off method- FDIC closes banks and pays off deposits up to FDIC max ii. Purchase and assumption method- find a bank willing to take over failed banks 1. Acquiring has to be paid by FDIC to buy failing bank deposits just more to acquiring bank, even people with > FDIC insured limit are safe1. FDIC prevents bank runs and panics. FDIC has full faith and credit of US government. FDIC can ask for loan from government and treasury gas to give it to them. Banking industry is paying. It has increased leverage and moral hazard.

what is the Volker rule and why is it necessary? what are the short run costs and long term benefits of the rule?

i. Seeks to prevent banks from making speculative bets with shareholder money that could put themselves -- and taxpayers -- at risk. ii. Short run Costs 1. Restrictions on proprietary trading by commercial banks 2. A bank can't keep any merchandise on its shelves. It needs to match a buyer and seller; the bank is simply the middleman. iii. Long term Benefits 1. Institutional efficiency and better, more economical service to customers. 2. Prevent banks from taking outsize bets and putting taxpayers at risk.

is the feds monetary policy highly accommodative or contractionary

i. The economy is highly accommodative, meaning that the economy's balance sheet is big, so there are a lot of reserves in the system.

gap analysis and what does it measure

i. The process through which a company compares its actual performance to its expected performance to determine whether it is meeting expectations and using its resources effectively. 1. Gap analysis looks at the gap between cash flows from assets and cash flows from liabilities. It tells us how a change in interest rates will affect bank profits. 2. Gap analysis is a simple IRR measurement method that conveys the difference between rate sensitive assets and rate sensitive liabilities over a given period of time.

why do banks get the most regulation

i. They are our only way of accessing payment systems ii. Banks are prone to runs and panics (people withdraw money with scared) iii. Government provides FDIC insurance iv. Banks are fragile

how will these new rules affect JP morgan and the banking industry as a whole?

i. This is going to pressure bank earnings well into the future ii. One part of the bill would push much of the buying and selling of derivatives onto clearinghouses, forcing banks to put up collateral against each trade. iii. Banks would be required to hold more capital in reserve to cover potential trading losses iv. The bank would also have to be more careful about separating its money from the money it manages for clients in its private equity and hedge fund units, because of a rule to limit the amount banks can invest in such funds

variable rate liabilities

liabilities are deposits and borrowings that are short-term or pay variable rates. Ex: Checking deposits, money market deposit accounts, 3 months CDs

fixed rate liabilities

liabilities would be: Long-term bonds issued by the bank, long maturity Certificate of Deposits

OMO how does fed pick target fed funds rate? (taylor rule)

potential output

Yield to maturity

the interest rate at which the PV of a bonds payments equal its price

OMO what is term of loan in FFM

very short, overnight

MP using unconventional methods, when does fed use there policy tools

when fed funds rate is already at Zero

can fed control size of its balance sheet

yes