Quiz 1

inflation (IP), real risk-free interest rate (RFR), default risk premium (DRP), liquidity risk (LRP), special provisions (SCP), term to maturity (MP)

determinants of interest rates for individual securities (6 things)

Board of Governors

Federal Reserve Banks operate under the general supervision of the __________________________.

1913

Federal Reserve was founded by Congress under the Federal Reserve Act in _______

Fedwire system, CHIPS

Federal reserve oversee _____________ and 47 large banks oversee international payments through __________.

transferring resources across time and space, pooling resources and sharing ownership, clearing and settling payments, managing risk, providing liquidity

Financial institutions mitigate transaction costs by ... (5 things)

expansionary policy

New York Fed purchases Treasury bills from primary dealer

contractionary policy

New York Fed sells Treasury bills to primary dealers

provide liquidity for investors, provide price for the security (true value)

Why are secondary markets important? (2 things)

inflation

________ arises when there is more money chasing the goods in the economy.

higher

_________ reserve ratios indirectly restrict lending

liability

currency is a ______ of the Fed: a promise to pay

t-bonds

debt obligations of the federal government with original maturities of one yr or more

federal agency debt

debt securities issued by some governmental agencies

corporate bonds

long-term debt issued by corporations typically paying semiannual coupons and returning the face value of the bond at maturity

disintermediation

many new technological innovations in the financial industry are displacing the role of financial intermediaries

transaction costs

matching borrowers and lenders, directly and/or indirectly

natural resources, physical capital, human capital, intellectual property, cultural captial

real assets (5 things)

FOMC

sets the target of the federal funds rate and corresponding reserve and discount rates

t-bills

short-term government securities issued at a discount from face value and returning the face amount at maturity

RP (repurchase agreement)

short-term sales of government securities with an agreement to repurchase the securities at a higher price

expectations hypothesis

theory that the shape of the yield curve is based upon investor expectations of future behavior of interest rates

liquidity preference theory

theory that the shape of the yield curve is based upon the difference in risk between short-term and long-term bonds

how people spend and save foreign demands changes such as ATMs, debit cards, etc

things that influence inflation that the Fed can't control

bank run

Happens when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent.

money, debt, equity, derivatives, combos

financial assets (5 things)

O/N RRP (overnight reserve repurchase agreement

market involves "a wide-range of market participants" who can lend to FED through reverse repos, not just banks, which increases the ability to influence interest rates

MBS and ABS (mortgage-backed securities and asset-backed securities)

ownership claim in a a pool of mortgages

institutional investors

paid to manage other people's money, trade large volumes of securities

1. Distributing currency 2. Oversees integrity of payments system, clearing deposits and interbank lending 3. Ensure the integrity of the financial system through monetary policy implementation 4. Lender of last resort

roles of a central bank (4 things)

taxes, treasury bills

two ways to raise money for government spending

bank panic

when many banks suffer runs at the same time

USA

Which country has the largest percentage of common stocks held by households?

fiat money

assets backing the money are treasury notes of the countried

adverse selection, moral hazard

asymmetric info leads to these two types of problems

individual investors

invest for personal financial goals (retirement, house)

annual percentage rate

APR, not a discount rate, measures amount of simple interest

no (they are an independent central bank)

Does the Federal Reserve's decisions have to be ratified by the President or Congress?

effective annual rate

EAR, a discount rate, measures actual amount of interest

sell, buy

FX, money market, fixed income, equity, derivatives - are on the _______ side of financial markets, endowments, pension funds, mutual funds, individual investors, insurance companies, banks, money managers - are on the ______ side of financial markets

d

How do corporations raise capital? a) stocks b) bonds c) bank loans d) all of the above

Institutions

Since 2005, who are the larger investors in stocks, households or institutions?

12

The Federal Reserve is divided into _____ Federal Reserve Disctricts

greater

The higher the duration measure, the ____________ the interest rate.

2

U.S., U.K., Euro, and Canada have explicit targets of around ____% inflation

1. project the demand for bank notes 2. oversee the payments system 3. administer monetary policy 4. ensuring financial stability 5. government's bank

What does "the Fed" do? (5 things)

maturity (term) in years

What is the Macaulay duration of a zero coupon bond?

bank loans (credit by intermediaries)

What is the dominant source of funding for corporations?

CD (certificate of deposit)

a bank time deposit where the bank pays interest and principal to the depositor only at the end of the fixed term

variable growth model

a dividend valuation approach that allows for a change in the dividend growth rate

derivatives

a financial contract or instrument that derives its value from the value of something else

bond indenture

a legal document issued to lenders that defines the key terms of the lending agreement including the coupon rate, the trustee, and covenants

bond

a legally binding contract between a borrower and a lender (AKA fixed-income securities)

duration

a measure of effective maturity and it is telling us the length of time in years that it will take a bond's cash flows to repay the investors the price they paid for the bond (a measure of the interest rate risk of a bond)

ACH (automated clearing house)

a nationwide network operated by private institutions that electronically process credit and debit transfers of funds.

CHIPS

a private sector electronic network operated by U.S. and foreign banks to facilitate correspondent services and international transactions

asymmetric information

a problem that arises in a transaction when one party had better information than the other party

CP (commercial paper)

a short-term unsecured debt issued by large corporations

permanent

a significant change in Fed Funds rate will likely lead to ________ open market operation

affirmative covenants

actions that the bond issuer promises to carry out

swaps

an agreement to exchange a series of cash flows at periodic settlement dates over a certain period of time

forward rate

an expected rate on a short-term security that is to be originated at some point in the future

bankers acceptances

an order to a bank by a customer to pay a sum of money at a future date

gold standard

assets backing the money are commodity

financial institutions

banks, savings and loans, savings banks, credit unions, insurance companies, pension funds

purchasing power risk

bond risk: the chance that bond yields will lag behind inflation rates

interest rate risk

bond risk: the chance that changes in interest rates will affect value

business/financial risk

bond risk: the chance the issuer of the bond will default

call risk

bond risk: the risk that a bond will be called before its scheduled maturity

liquidity risk

bond risk: the risk that the bond will be difficult to sell at a reasonable price

premium bond

bond that has a market value that is above par

discount bond

bond that has a market value that is below par

demander

business, supplier or demander of funds? typically net _________

OCC (Office of the Comptroller of the Currency)

charters national banks, which are members of the Federal Reserve System

futures and forwards

contracts between two parties to buy or sell an asset at a specified price on a future date

loanable funds theory

explains interest rates and interest rate movements, it views level of interest rates in financial markets as a result of the supply and demand for loanable funds

options, futures and forwards, swaps

financial instruments of derivative markets (3 things)

common stock, preferred stock

financial instruments of equity markets (2 things)

t-bonds, federal agency debt, munis, corporate bonds, MBS and ABS

financial instruments of the bond market (5 things)

t-bills, CD, CP, bankers acceptances, eurodollars, RP, Fed Funds

financial instruments of the money market (7 things)

Fed Funds (Federal Funds)

funds in the accounts of commercial banks at the Federal Reserve

demander

government, supplier or demander of funds? typically net __________

yield curve

illustrates the relationship between the yield to maturity and term to maturity (two main types are downward sloping and upward sloping)

negative covenants

impose restrictions on the bond issuer's activities

supplier

individuals, supplier or demander of funds? typically net _________

information asymmetry costs

monitoring the borrowers

MBS, ABS, CDO

mortgage backed securities _____ is backed by residential or commercial real estate ______ underlying loans are non-mortgage loans (e.g. car loans and credit loans) _______ collateralized loan obligations are backed by corporate loans

real interest rate

nominal interest rate - inflation (actual or expected)

moral hazard

occurs after the transaction (problem from asymmetric info)

adverse selection

occurs before the transaction (problem from asymmetric info)

bad behavior problem (moral hazard)

post-contractual bad behavior that is disadvantageous to the interests of the other party

munis (municipal bonds)

tax-exempt bonds issued by state and local goverments

seigniorage

the difference between the interest earned on the government securities and the cost of issuing and making notes and coins

nominal interest rate

the interest rate actually observed in financial markets

primary market

the market in which new issues of securities are sold to the public

secondary market

the market in which securities are traded after they have been issued

capital markets

the market where long-term securities such as stocks and bonds are bought and sold

money market

the market where short-term securities (usually debt) are bought and sold

option

the right to buy/sell an asset at a specified exercise price on or before a specified expiration date

transaction, information asymmetry

the two types of costs financial institutions mitigate

market segmentation theory

theory on shape of yield curve that suggests that the bond market consists of distinct segments (based on maturity) due to the preferences of investors and borrowers

1. changing reserve requirement 2. changing reserve money supply 3. changing the interest rates

three basic types of monetary policy tools used to influence inflation

maturity, coupon rate, initial yield

three factors affecting duration

clearing, settlement

two components of any payment system can happen together- like real-time gross settlement, Fedwire or with delay- like deferred net settlement, CHIPS

opportunity cost, adjustments for individual security characteristics (default risk, maturity, liquidity risk, payment terms)

two components of nominal interest rates

money (short term), capital (long term)

two financial markets