FIN 384 Test 1

The smallest denomination of T-bills is

$100

Describe the market for banker's acceptances

- a banker's acceptance is a time draft drawn on and accepted by a commercial bank - most banker's acceptances arise in international trade - banker's acceptances typically trade in lots of $100,000 and $500,000 and mature in 30, 60, or 90 days. - the default risk on banker's acceptances is very low

noncompetitive bids

- all non-competitive bids accepted - specify quantity only - maximum 45,000,000 - mostly individuals and small businesses - accept the yield resulting from the auction the price to be paid by noncompetitive bidders is the weighted average price of accepted bids (NOT EQUALLY WEIGHTED)

risks faced by financial institutions

- credit risk - interest rate risk -liquidity risk - foreign exchange risk - political risk

Concurrent ways to classify Financial markets

- primary or secondary - public or private - exchanges or OTC - Spot, Futures, or Option - Foreign exchange - international or domestic - money or capital

Overview of the money market

- short-term debt market- most under 120 days - a few high quality borrowers - many diverse investors - informal market centered in New York City 0 standardized securities- one security is a close substitute for another - Good marketability- secondary market - large, wholesale open market transactions - many brokers and dealers are competitively involved in the money market - payments in immediately available funds - physical possession of securities is rare- centralized safekeeping

competitive bids

- specify price and quantity desired - minimum $10,000 and in multiples of $5,000 above $10,000 - mostly professionals- dealers and banks - no more than 35 percent of an issue is sold uner the competitive bidding process in order to ensure a competitive secondary market

US Government securities

- the fed holds two kinds 1. treasuries, debt securities issued by the US Treasury 2. Agencies, debt securities of other federally backed issuers the fed uses its securities holdings to conduct open market operations recently the fed has added larger holding of mortgage-backed securities

What are some problems with direct financing that make indirect financing a more attractive alternative?

-direct financing requires a more or less exact match - costly search and negotiation process, often complicated by information asymmetries concerning ultimate credit risk of the DSU - intermediaries transform direct claims sold by DUS and make them more attractive to SSUs

the 2007-2010 financial crisis that orginated inthe US subprime mortgagem market before spreading out to otehr sectors of the economy was a caused by a combination of factors:

1) deterioration of financial institutions' balance sheets 2) the housing bubble burst 3) abnormally low interest rates for an extended period of time 4) increase in uncertainty into economy 5) a banking crisis aset bubbles form when asset prices over inflate due to excess demand which is often caused by speculative motive. asset bubble are often drive by lower inters rates and credit booms, as was the case in the US housing bubble in the 2000s

Money market instrument characteristics

1) low defualt risk 2) short-term maturity 3) high marketability

As a discipline, finance can be classified into three areas

1) managerial finance, 2) investments 3) financial markets and institutions

What were the three most important factors that caused the 2008 financial crisis?

1. U.S. housing price bubble that burst. Asset price bubbles occur when demand is over inflated. US housing price bubble became possible due to the combination of low mortgage interest rates and lax lending standards. 2. When many mortgages made during the housing price run-up started defaulting, it caused deterioration in the balance sheets of financial institutions that held these mortgages or mortgage backed securities. 3. the bankruptcy of the investment bank Lehman brothers in September 2008. it signaled that the government was willing to allow large financial institutions to fail and caused major concerns about the U.S. financial services industry, bringing the financial system to the brink of the collapse

Describe the market for negotiable certificates of deposti (NCDs)

1. a bank deposit that can be traded in the secondary market before its maturity. 2. most are sold in denominations of $1 million and carry maturities of 1 to 4 months 3. negotiable- may be sold and traded before maturity. rate is negotiated between buyer and seller 4. issued at face value with coupon rate. interest computed on a 360-day year 5. primary market sales have denominations of at least $100,000. secondary market deals are for $1 million or more 6. interest rates on CDs are higher than on T-bills because they carry a higher credit risk and lower marketability 7. rates are lower for money center banks and are tiered upward for regional banks 8. purchase mainly by corporate businesses

the fed's capital accounts comprise 3 items

1. capital paid in: federal reserve bank stock held by member commercial banks 2. surplus: retained net earnings of the Federal Reserve System 3. Other Capital Accounts: unallocated Net earnings year-to-date

How has the power structure of the Fed change since 1913?

1. centralized 2.Fed banks have lost their authority to set monetary policy

Discuss the various participants of the money markets

1. commercial banks- use the money markets extensively, continuously adjusting their liquidity positions of the short-term nature of their liabilities 2. the federal reserve system controls the nation's money supply through open-market operations in which it buys and sells money market securities 3. the treasury department uses the money market to manage its liquidity given that tax receipts tend to be concentrated around scheduled tax payment dates, but government expenditures are spread more evenly across the year. 4. government security dealers are private financial institutions that make a market for treasury securities by standing ready to buy or sell from they inventory at quoted prices. their activities greatly enhance the liquidity of the market for treasury securities because of their willingness to buy or sell large amounts of securities 5. corporations use the money markets when inflow of cash collected from accounts receivable doesn't keep up with necessary can disbursements for payroll, tax obligations, and so on

Five basic risks that financial institutions face

1. credit risk (or default risk) is the possibility that a borrower may not pay as agreed. Financial institutions manage credit risk in 3 concurrent ways : 1. diversification among different borrowers representing different risks 2. credit analysis of each borrower to assess ability and willingness to pay 3. regular monitoring of each borrower while debt is outstanding 2. interest rate risk is the likelihood that interest rate fluctuations will change a security's price and reinvestment income 3. liquidity risk is the possibility that a financial institution may be unable to pay required cash outflows 4. foreign exchange risk is the possibility of loss on fluctuations in exchange rates 5. political risk is the possibility that government action will harm an institution's interest

What are the five services financial intermediaries perform as they transform claims?

1. denomination divisibility- DSUs prefer to borrow the full funding need all at once. SSUs tend to save small amount periodically. Intermediaries pool small savings into large investments 2. currency transformation- few ordinary SSUs will hold claims denominated in foreign currency. Intermediaries can buy claims denominated in one currency while issuing claims denominated in another 3. maturity felxibility- DSUs generally prefer longer-term financing. SSus generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both 4. liquidity- many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs 5. credit risk diversification- intermediaries can afford to spread risk by holding many different securities. the less correlated the securities are with each other, the more stable the pro folio's value

Four major types of financial intermediaries

1. depository institutions- take deposits and make loans. Ex) commercial banks are the largest most diversified, and most regulate intermediaries 2. thrift institutions- resemble commercial banks but concentrate more on real estate loans, especially residential mortgage loans; and are called savings associations or savings banks 3. credit unions resemble banks ro thrifts in the basic function but have 4 unique characteristics: - mutual ownership owned by depositors or members - common bond members must share some meaningful common association - not-for-profit and tax-exempt any surplus must be used to benefit members - restricted mostly to small consumer loans

Intermediaries enjoy three sources of comparative advantage:

1. economies of scale: large volumes of similar transactions 2. transaction cost control: finding and negotiating direct investments less expensively 3. risk management expertise: riding the "information gap" about DSUs' creditworthiness

basic components of the financial system

1. financial markets (markets for financial instruments, or financial claims or securities) 2. financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers

what are the major decisions in financial management

1. how much should the firm invest and what specific assets should the firm invest one? the answer is the firm's investment decisions or capital budgeting decisions. they are concerned with the use of funds- the buying holding or selling of all types of assets 2. how should the cash required for investment be raised? the answer is the firm's financing decisions. they are concerned with the acquisition of funds with which to make investments and finance day -to-day operaitons

What effects are decreases in reserve requirements likely to have on 1. housing investment 2. plant and equipment investment 3. intended inventory investment 4. government expenditures 5. consumption 6. exports 7. imports

1. increase 2. increase 3. increase 4. increase 5. increase 6. increase 7. decrease

What are the three characteristics of money market instruments

1. low default risk 2. short maturity 3. high marketability these characteristics protects the investor's principal and provide income. For the borrower, it is a constant source of relatively cheap funds, available with very low financing costs. Money market investors like these characteristics because they have very low risk tolerance due to their temporary nature of their cash surplus.

Explain the economic functions of money markets

1. money markets are markets for liquidity. their securities are liquid, short-term, high quality debt securities issued by high quality borrowers and are used to store liquidity by investors around the world 2. provides a place for Federal Reserve transactions (open market transactions) 3. indicator of economic condition

Other characteristics of Federal funds

1. most liquid of all assets 2. originally a market for excess serves- now a source of investment (fed funds sold) and continued financing (fed funds purchased) 3. Small banks accumulate balances to sell the excess reserves to their correspondent banks which in turn consolidate for investment tin the fed funds market

Book entry securities

1. no physical securities: only record entries 2. book-entry record keeping only since 1976 3. most of marketable treasury debt is now in book entry form all transactions digital

What effects are decreased in the reserve requirement likely to have on: 1. bank reserves 2. federal funds rates 3. bank lending 4. treasury bill rates 5. the bank prime rate

1. none 2. reduce them 3. increase it 4. reduce them 5. reduce it

The six basic goals of US monetary policy, under the humphrey-Hawkins Full Employmetn and Balanced Growth Act of 1978

1. price stability 2. full employment 3. economic growth 4. interest rate stability 5. stability of the financial system 6. stability of the foreign exchange markets

the six goals of the US monetary policy under the employment act of 1946 and the full employment and balance growth act of 1978

1. price stability 2. full employment 3. economic growth 4. interest rate stability 5. stability of the financial system 6. stability of foreign exchange markets

Each federal reserve bank provides basic services in its district:

1. processing checks and electronic payments 2. issuing federal reserve notes 3. holding reserve deposits of banks and other deposit type institutions 4. monitoring regional economic conditions 5. advising the board of governors 6. helping make monetary policy

Describe the market for commercial paper

1. short-term promissory note issued by a large corporation to finance shot-term working capital needs 2. viewed as an open market alternative to bank borrowing and firms use the commercial paper market to achieve interest savings over otherwise similar bank loans 3. commercial paper maturities range from 1 to 270 days and is sold in denominations from $100,000 to $1 million 4. typically commercial paper is backed up by a line of credit from a commercial bank, which reduces the risk 5. only firms of good credit quality can issue commercial paper because it is unsecured- only a contingent promise from the bank 6. issued by high-quality borrowers 7. a wholesale money market instrument- no individual investors 8. sold at a discount from par-similar to t-bill discount yield 9. directly by a sales force of the borrowing firm or indirectly through dealers

Purposes of a central bank

1. suprevises a nation's money supply and payment stye 2. regulates financial institutions, especially depository institutions 3. is a lender of last resort when the financial system has liquidity problems 4. is the national government's fiscal agent

How did the bailout of 2008 change the Fed's balance sheet

1. the fed bought huge volumes of government securities to supply liquidity, drive interest rates downward, and alleviate general risk of panic 2. the fed made unprecedented purchases of mortgage-backed securities and commercial paper 3. the fed lent generously at the discount window 4. the fed paid interest on reserves causing the monetary base to exceed the money supply and bank reserves to rise to record levels

what were three important regulatory powers the the fed gained from the passage of the financial regulatory reform act of 2010

1. the power to intervene in the business activities of large nonbank firms to better control systemic risk across the economy. In extraordinary circumstances, it has the power to break up firms or require them to divest of certain assets 2. increased focus on strengthening firms considered "too big to fail" the fed may impose tougher capital, leverage, risk-taking, and other standards for such firms 3. focus on regulating larger financial firms: the fed no longer oversees small bank- holding companies and state-chartered banks and will only regulate large financial institutions, banks, and thrift holding companies with total assets in excess of $50 billion

Principles of finance

1. the time-value-of-money principle- money has a time value; a dollar today is worth more than a dollar received in the future 2. the principle of diversification the risk-return tradeoff

Other characteristics of the repo

1. this is a method used by banks to effectively pay market interest rate on deposits to corporate customers 2. the interest rate on repos is lower than the fed funds rate, since repos are backed by securities (usually T bill, t bonds or federal agency debt) 3. the repo is used as a source of funds (liability) by borrowers who sell securities with the agreement to buy them back as well as as a use of funds (asset) by investors with excess funds who buy the securities with the agreement to sell them back- reverse repo

How many federal reserve banks are there?

12 they remain operationally important but have lost their authority to set monetary policy- they are a minority (5 out of 12 votes) on the FOMC which sets US monetary policy

When does the Fed use a loose monetary policy and when does it use a tight monetary policy?

A loose monetary policy may be used to stimulate the economy, especially if inflation is not a concern. A tight monetary policy may be used to slow economic growth in order to reduce inflationary fears. In general, a stimulative monetary policy can increase economic growth and reduce unemployment, but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment

Describe the market for repurchase agreements.

A repurchase agreement consists of the sale of a short-term security usually as US treasury security with the condition that after a specified period of time, the original seller will buy the security back at a predetermined price (high price) in effect a repo is a short-term loan collateralized by a treasury security. repos are made for 1 day to 3 months or longer with a minimum denomination of one million dollars

Financial Balance Sheet

A= D (bond) + S (stock)

Accounting balance sheet

A= D + E

Why was the banking system so unstable prior to establishment of the fed in 1914

After termination of the second bank of the united states in 1836, the US was without a central bank until passage of the federal reservee act in late 1913. Thus ther was no overall control of the size or quality of the money supply. until the national banking and currency acts banks were largely unregulated and free not only to engage in unsound lending practices, but to issue banknotes- IOUS against themselves without restraint. over issue of the private currency prompted hoarding of gold and silver causing the money supply to be inelastic- unevenly distributed and not daily adjustable. frequent bank failures exacerbated downturns in the normal business cycle

What is likely to happen to the fed funds rate if the fed increases the reserve requirement?

An increase in reserve requirements on a given level of deposits will immediately convert more total reserves into required reserves or create a reserve deficiency if total reserves on hand are not adequate to comply. either way, the reallocation of resources to comply with the higher reserve requirement will pull loanable funds out of the system, pressuring the FFR upward.

How does controlling the monetary base influence the money supply?

As depository institutions lend or invest excess reserves, they increase M1 and finance spending in the real sector. By expanding or contracting the monetary base, the fed increases or decreases excess reserves, raising or lowering incentive to lend or invest to encourage or discouraging expansion in the real sector

Cash items in process of collection

CIPC minus DACI equals Float, a net extension of credit by the fed (money in transit- positive number means too much money out there) the fed plays a major role in check clearing clearing moves reserves around, but does not increase or diminish them

maturity flexibility

DSUs generally prefer longer-term financing. SSUs generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both.

denomination divisibility

DSUs prefer to borrow the full funding need all at once. SSUs tend to see small amount periodically. Intermediaries pool small savings into large investments.

Explain how the credit crisis affected the credit risk premium in the commercial paper market.

During the credit crisis, some institutional investors avoided commercial paper issued by financial institutions because of the financial problems they were experiencing. thus, the premium that some financial institutions had to pay when issuing commercial paper increased

True or False- the independence of the fed leaves it completely unaccountable for its actions

FALSE the fed is still subject to political pressure because congress can pass legislation limiting the fed's power.

True or False: Competitive bids in T-bill auctions require the bidder to specify only the quantity of bills desired

False

True or False: Currency is an asset of the Federal Reserve Banks

False

True or False: Financial intermediaries eliminate transactions and information costs

False

True or False: Many diverse institutions borrow the money markets, while relatively few invest.

False

True or False: Reserve requirements apply only to member banks in Federal Reserve System

False

True or False: There must be an equal number of DSUs and SSUs in a period.

False

True or False: Transaction deposits, such as DDAs, expand when the Fed sells securities.

False

True or False: Treasury bills are sold on a discount basis, with interest paid separately at maturity

False

Deferred availability cash items (DACIs)

Federal Reserve balance-sheet item representing the value of checks deposited at the Fed by depository institutions that have not yet been credited to the institution's accounts

How does the Deposit multiplier work?

IF the fed increases bank reserves via open market operations, the bank now has too many excess reserves that earn low interest so it seeks to loan the funds out. the lent funds are deposited in another bank. the second bank keeps some funds in the form of required reserves and lends the rest. the second loan is also redeposited at another bank and portion of those funds are lent again. At the limit a change in reserves increases deposits by the amount equal to the change in reserves x 1/reserve requirement. thus 10% reserve requirement ration leads to a multiplier of 10

Contractual Institutions

Insurance companies (life and casualty) private pension funds state and local government pension funds

Credit Risk Diversification

Intermediaries manage risk by evaluating and holding many different securities. SSUs on their own would have to leave "more eggs in one basket"

Explain how investors' preferences for commercial paper change during a recession.

Investors are less interest in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors

Why do large corporations typically make competitive bids rather then noncompetitive bids for Tbills

Large corporations make competitive bids because noncompetitive bidders are limited on the Size of noncompetitive bids

M2

M1 + savings deposits and money market deposit accounts + overnight repurchase agreements + eurodollars + noninstitutional or retail MMMFs + small time deposits (under $100,000)

What are some technical factors that affect the implementation of monetary policy?

Monetary policy does not transmit without interference the fed must constantly adjust for three technical factors 1. leaks 2. floats 3. treasury balance

which market (money or capital) would general motors use to finance a new vehicle assembly plant?

Money markets are markets for liquidity whether borrowed to finance current operations or lent to avoid holding idle cash in the short-termcapital markets are where real asset or capital goods are finance. GM would finance its new plant b issuing bonds or stock in the capital market GMAC the finance company subsidiary of GM would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds) GM would use the money market to store cash in money market securities, which are generally safe liquid and short term

Are the discount rate and the fed funds rate the same thing

NO are a fed sponsored mechanism for depository instituions to lend to each other the fed targets the influences the fed funds rate does not dictate it the fed funds rate is almost always lower than the discount rate

How does the Fed's monetary policy affect economic conditions?

The Fed's monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation and therefore affect the demand for loanable funds by influencing inflationary expectations

suppose you have the choice of investing in top-rated commercial paper or commercial paper that as a lower rating. How do you think the risk and return performances of the two investments differ?

The commercial paper with the lower rating should have a higher rate of return and also a higher degree of default risk.

Who sets the federal funds rate? Why is the federal funds market more active on Wednesday?

The fed funds rate is not set directly by anyone but is determined by the market. The rate changes frequently in response to changing supply and demand conditions. The fed influences the federal funds rate by adjusting the money supply the federal funds market is active on Wednesday because depository institutions use the market to adjust their required reserve position on that day (it is the final day of the settlement period for required reserves)

What is likely to happen to the monetary base if the treasury department sends out social security checks payable from its account at the fed?

The monetary base will increase as the treasury checks clear the Fed providing increased bank reserves

How does the fed use the discount rate? Why does the fed not use the discount rate to conduct monetary policy?

Today changes in the discount rate signals policy intent. Raising the rate means the Fed wants a smaller money supply and higher rates. lowering the rate means the fed wants a larger money supply and lower rates. Loans at the window are still available but depository institutions have many funding choices and are wary of window scrutiny questions regulators might have about early or regular trips to the window.

Describe the market for Treasury bills

Treasury bills are the most important security used to finance short-term deficits and to refinance maturing government debt maturities of less than 1 year, highly marketable, and free of default risk because they are backed by the US government most active secondary market and can be bought and sold at low transaction cost

Who prints money?

Treasury not Federal Reserve

What is TARP? How much did it cost taxpayers? Why was TArp necessary and unpopular?

Troubled Asset Relief Program. The US Treasury acquired distressed assets from banks, especially mortgage-backed securities, and made capital injections into banks, at a total taxpayer cost of about $426 billion. This bailout of the financial system was arguably necessary to preserve flows of funds in the financial system and avert general financial panic, but is has not proven to be popular with the general public. To many ordinary people, it was government using their money to solve a problem many of them had nothing to do with causing.

True or False: All money market instruments are short-term debt

True

True or False: Federal Reserve regulations affect many nonbank institutions.

True

True or False: Households are the major source of funds to the financial system.

True

True or False: Money Market borrowers are small in number compared to money market lenders.

True

True or False: Private placements are the simplest form of direct finance.

True

True or False: Reserve Requirements are not useful for "fine tuning"

True

True or False: The Fed can influence the money supply by controlling the level of total bank reserves.

True

True or False: The Federal Open Market Committee basically establishes our nation's monetary policy.

True

True or False: The money market is a market where liquidity is bought and sold.

True

True or False: The purpose of the financial system is to bring savers and borrowers together.

True

True or False: a decrease in Federal Reserve float decrease member bank reserves.

True

True or False: a repurchase agreement is a secured loan.

True

True or False: the Fed can substantially control the level of total bank reserves

True

The asset of Federal Reserve banks associated with open market operations is

U.S. government securities

What defensive actions can th Fed take during periods of time when cash holding by the public increases? in other words, how does the fed offset these cash drains?

When the public cash holdings increase, decreasing bank reserves, the Fed would purchase Treasury securities via open market operations increasing reserves and offsetting the public' increased cash holdings

What are the US money markets?

a collection of markets where short-term marketable obligations with very little credit risk are bought and sold. The money markets are where businesses government units financial institutions and world investors store liquidity fund liquidity and adjust liquidity. They are also where the fed conducts its monetary policy

Federal Open Market Committee (FOMC)

a committee that consists of seven members of the Board of Governors of the Federal Reserve System plus five presidents of Federal Reserve banks and that determines the nation's monetary policy and financial institutions' reserve balances

Inflation is define as

a continuous rise in the average price level

Why are there different measures of money?

a desirable measure of money is one that can be precisely controlled by the Fed and has a creditable impact on economic variables. the Fed wants to know what definition of money has the greatest impact on interest rates, unemployment, and inflation.

banker's acceptance

a draft issued by a company, drawn on and accepted by a bank. the draft promises payment of a certain sum of money to its holder at some future date. in effect, the bank substitutes its credit standing for that of the issuing corporation.

use of draft to overcome the international trade problem

a draft or bill of exchange is an instrument drawn by the exporting firm on the buyer requesting the buyer to pay either upon presentation (sight draft) or within a certain time frame (time draft) in the case of a sight draft the exporter is to be paid once shipment has been made and the draft is presented to the buyer (through the exporter's bank) for payment. The shipping documents are forwarded to the buyer's bank, which will not release them to the buyer until the buyer makes the payment with a time draft, the buyer's bank releases the shipping documents against the buyer accepting the draft the risk to the exporter is that if the buyer fails to pay the draft on maturity, the bank is not obligated to honor payment, unless it has been accepted by the bank, thus creating a banker's acceptance

Fed funds market

a fed-spponsored system in which depository institutions lend and borrow excess reserves among themselves.

what are the difference between financial and real assets?

a financial asset (somebody owes, somebody owns) represents a financial claim on an asset that is usually documented by some form of legal representation such as a stock or bond. A real asset is an actual tangible item such as real estate, gold, antiques, jewels, etch.

letter of credit

a financial instrument issued by an importer's bank that obligates the bank to pay the exporter (or other designated beneficiary) a specified amount of money once certain conditions are fulfilled

Money market

a financial market in which financial claims with maturities of less than a year are sold. the most important money market is that for US treasury bills

elastic money supply

a flexible supply of currency that can accommodate changing public demand for cash

regulation Q

a historical federal reserve regulation that set a maximum interest rate that banks could pay on deposits. all interest rate ceilings on time and savings are phased out on april 1, 1986, by federal law

financial institutions

a large array of entry level finance jobs. banks, insurance companies, and regulator

money center bank

a large commercial bank located in a major financial center that directly transacts in the money market

call loans

a loan that either the borrower or the lender can terminate upon request

what is the function of a mutual fund? hows does a moeny market mutual fund differ from a stock or bond mutual fund?

a mutual fund sells shares to investors, pools the funds, and invests the funds in a portfolio of securities. a money market mutual fund invest in money market securities, whereas other mutual funds normally invest in stocks or bonds

structural unemployment

a portion of those who are unemployed are unemployed because ther is a mismatch between their skill levels and available job or there are jobs in one region fo the country but few in another region

how does a repo differ from a fed funds transaction? how do their rates compare?

a repo is basically a collateralized loan whereas fed funds are uncollateralized. the repo rate will typically be slightly below the equivalent maturity fed funds rate because the repos are collaterlized. repos are likely to be for longer maturity than fed funds although both may involve transfers of deposits held at the fed. fed funds loans can be arranged more quickly because no change of title of securities is involved

asymmetric information

a situation in which a party (for instance, a buyer) does not have the same information as the other (for instance, a seller)

toxic securities

a term for subprime mortgages during the 2008 financial crisis because of their toxic effect on a firm's capital and solvency

frictional unemployment

a term indicating that a portion of those who are unemployed are in transition between jobs

financial claim

a written promise to pay a specific sum of money (the principal) plus interest for the privilege of borrowing money over a period of time. Financial claims are issued by DSUs (liabilities) and purchased by SSUs

Which of the following securities is not a money market security? a) Ba-rated corporate bonds b) treasury bills c) certificates of deposit d) P2-rated commercial paper e) bankers acceptance

a) Ba-rated corporate bonds

A repurchase agreement calls for a) a firm to sell securities with the agreement to buy them back later at a higher price b) a firm to buy securities with the agreement to sell them back later at a lower price c) a firm to sell securities with the agreement to buy them back later at a lower price d) a firm to buy securities with the agreement to sell them back later at a higher price

a) a firm to sell securities with the agreement to buy them back later at a higher price

To increase the money supply immediately but just slightly, the Fed would most likely a) buy securities on the open market b) lower the discount rate c) lower reserve requirements d) any of the above would be suitable for this purpose

a) buy securities on the open market

If the money supply increases too rapidly a) inflationary expectations will rise b) bank lending will decrease c) government spending will decrease d) investment spending will fall

a) inflationary expectations will rise

Traditionally, commercial paper has been closely associated with all the following except a) monetary policy b) commercial banking c) consumer finance d) manufacturing

a) monetary policy

Who among the following does not have a permanent vote on the FOMC? a) president, Federal Reserve Bank of Los Angeles b) Chairman, Board of Governors c) Member of the Board of Governors d) President, Federal Reserve Bank of New York

a) president, Federal Reserve Bank of Los Angeles

explain how each of the following would use banker's acceptances a) exporting firms b) importing firms c) commercial banks d) investors

a) protect an exporter from the risk of nonpayment by the importer b) protect importing firms from the risk of paying for goods without ever receiving them c) enable banks to offer exporters and importers a service for which it charges a fee d) offer investors an investment instrument (when exporters sell the acceptance in the secondary market)

Which of the following money market instruments does not have a secondary market? a) repurchase agreements b) T-bills c) commercial paper d) banker's acceptances

a) repurchase agreements

Consumption spending should increase if a) reserve requirements decrease b) interest rates increase c) financial wealth decreases d) credit availability decreases

a) reserve requirements decrease

Money market instruments share all the following features except a) small denominations b) low default risk c) low price risk d) high liquidity

a) small denominations

The Fed's open market activities after the 2007-08 crisis involved all the following except a) stocks of troubled financial institutions b) commercial paper c) mortgage-backed securities d) U.S. Government securities

a) stocks of troubled financial institutions

liquidity

ability of an institution to hold sufficient amounts of cash and liquid assets to allow it to easily meet requests from its liability holders for cash payment

Asymmetric information problems occur in two forms

adverse selection and moral hazard

Explain the adverse selection problem. How can lenders reduce its effects?

adverse selection arises from asymmetric information and in the context of debt markets, refers to borrowers of poor credit quality applying for loans (perhaps because such borrowers nee the loans the most oil order to survive financially) the lender may reduce adverse selection by requiring loan applicants to supply detailed financial statements and other additional information, to use differential loan pricing for borrowers of different credit quality, or to reject loan applications if the risk appears too high. to process the information they collect, lenders often develop or acquire from third party credit scoring models that help determine borrowers' creditworthiness.

What is a financial claim

aka security or financial instrument one's claim against another's wealth. to its holder, it is a financial asset to its issuer a liability. it may be debt or equity. DSUs issue claims in returns for funds; SSUs exchange funds for claims

Deposits of financial institutions

all US. depository institutions must keep reserves with the Fed Reserves pay low interest (since 2008) and are used to clear checks, wire transfers, and other payment items; control the rate of growth of the money supply; provide liquidity in the event of financial crisis total reserves equal required reserves plus excess reserves required reserves are minimum reserves required excess reserves are those exceeding required reserves excess reserves are available to lend or invest the fed's recent decision to pay interest on reserves has caused banks to hold historically high excess

dual banking system

all national banks must be members of the federal reserve system relatively few state banks choose to join gate federal reserve sytem

bond equivalent yield

allows an investor to compare more accurately a discount rate security like the T-bill to a coupon bearing security for the same maturity

systematic risk

also known a market risk or nondiversifiable risk. the risk that tends to affect the entire market in a similar fashion

Repurchase agreements

also known as a repo. A form of loan in which the borrower sells securities (usually government securities) and simultaneously contracts to repurchase the same securities, either on call or on a specified date, at a price that will produce a specified yield

reverse repurchase agreement

also known as a reverse repo. the reverse (lending) side of a repurchase agreement

M1 and M2

alternative definitions of the money supply as designated by the Fed

cash items in the process of collection (CIPC)

an account that is the value of checks drawn on other banks but not yet collected

inflation targeting

an economic policy wherein a central bank estimates and makes public a projected or target inflation rate, and then steer the actual rate of inflation in the economy toward the target rate through use of monetary policy tools

deficit spending unit (DSU)

an economic unit that has expenditures exceeding current income. A DSU sells financial claims on itself (liabilities) or sells equity to obtain needed funds

Surplus spending unit (SSU)

an economic unit whose income for the period exceeds expenditures. SSUs often purchase financial claims issued by deficit spending units

Market economy

an economy in which consumers have a free choice to buy or not buy whatever goods or services they want

How is money supply growth affected by an increase in the reserve requirement ratio?

an increase reduces the proportion of deposited funds that a financial institution can lend out. Consequently, it reduces the rate by which money can multiply

federal agency

an independent federal department or federally chartered corporation established by Congress and owned or underwritten by the US government

discount window

an operation of the federal reserve system whereby banks may borrow temporary reserves from the federal reserve system as an alternative to selling secondary reserves or borrowing federal funds to cover legal reserve deficiencies; the discount window is part of the mechanism for adjust short-term required reserve deficiencies

commercial paper

an unsecured short-term promissory not issued by a large credit worthy business or financial institution. Commercial paper has maturities ranging from a day to 270 days and is usually issued in denominations of $1 terms are negotiable. Dealer-placed commercial paper is sold through dealers with terms similar to those offers on banks' CDs

money market yields do not

assume compound interest

as of 1980, fed services are

available to any depository institution for a fee and reserve requirements apply to all US depository institution

A reverse repurchase agreement calls for a) a firm to sell securities with the agreement to buy them back in a short period at a higher price b) a firm to first buy securities with the agreement to sell them back in a short period at a higher price c) a firm to first sell securities with the agreement to buy them back in short period at a lower price d) a firm to first buy securities with the agreement to sell them back in a short period at a lower price

b) a firm to first buy securities with the agreement to buy them back in a short period at a higher price

The Fed Funds Rate does not a) relate closely to the conduct of monetary policy b) affect other interest rates c) measure the return on the most liquid of all financial assets d) measure the availability of excess reserves

b) affect other interest rates

The 12 Federal Reserve Banks are a) important and autonomous components of a "decentralized central bank" b) important components of the Fed, but no longer very autonomous c) all permanently voting members of the FOMC d) Neither important nor autonomous

b) important components of the Fed, but no longer very autonomous

An SSU's a) income and expenditures for the period are equal b) income for the period exceeds expenditures c) spending is entirely financed by credit cards d) expenditures for the period exceeds receipts

b) income for the period exceeds expenditures

a repurchase agreement is like a secured loan because a) it involves two parties b) it involves collateral, in this case the sale of a security under agreement to repurchase c) it is like the secured lending in that a mortgage is effected by the lender d) it is backed by a mortgage on a real property

b) it involves collateral in this case the sale of a security under agreement to repurchase

The Discount Window a) is the most common way for depository institutions to raise loanable funds b) relates to the Fed's "lender of last resort" function c) is a relatively recent innovation in the design of the Federal Reserve System d) is available only during emergencies

b) relates to the Fed's "lender of last resort" function

Which of the following is not a characteristic of money market instruments? a) short term to maturity b) small denominations c) low default risk d) high marketability e) all of the above are characteristics of money market securities

b) small denominations

Why is a bank line of credit necessary to back up an issue of commercial paper?

back up lines of credit would be used if the firm experiences financial difficulties or if credit market conditions become tight. Back up lines of credit are often required by investors to assure protection of the principal and liquidity of the investment

fiat money

backed by nothing but the issuer's faith and credit

Why are banks singled out for special attention in the financial system

banks are the dominant type of depository institutions. as such, they deal with consumers (depositors), and consumers' trust in the banking system is extremely important for the flow of funds and ultimately the well-being of the economy. Also, banks, like other depositories, are highly leverages (liabilities are often around 90% of total assets, with capital being the other 10%), which makes them much more vulnerable to credit and liquidity risks than other businesses.

What steps should bank management take to manage credit risk in the bank's loan portfolio?

banks manage credit risk of their loan portfolios by !) diversifying the portfolios across regions, industries, and types of loans 2) conducting a careful credit analysis of potential borrowers, and 3) continually monitoring the borrowers over the life of the loans or investment. banks develop and follow lending policies that set guidlelines for lending offiecer

wildcat banks

banks opened by dishonest bankers who intended to defraud the public by issuing banknotes far in excess of the reserves (gold or silver)

Common stock

basic ownership claim in a corporation, stockholders share in the distributed earnings and net worth of a corporation and selects its directors

Why can the fed no set the fed funds rate in the long run

because factors in the real sector ultimately determine credit demand. if the fed tried to sustain an for too low, M1 could grow too rapidly and real investment decisions could be distorted. Too high, and M1 might not keep up with the real sector. the economy could falter as real investment declined. the best the fed can ultimately do is try to promote stable price levels

Why was the federal reserve system set up with 12 regional federal reserve banks rather than one central bank, as in other countries?

because of traditional american hostility to a central bank and centralized authority, the system of 12 regional banks was et up to diffuse power along regional lines

why are financial markets important to the health of the economy?

because they channel funds from those who do not have a productive use for them to those who do, thereby resulting in higher economic efficiency.

keynesians

believe the key financial variable for changing economic activity is its interest rates. they discount or disregard direct money supply effects. Thus, real sector economic growth is stimulated by falling rates as economic activity costs less to finance or slowed by raying rates as economic activity costs more to finance. money supply changes reflect reactions to interest rates

monetarists

believe the key financial variable for changing economic activity is the money supply. they assume propensity to consume rises or drops as people perceive they have more o less money. thus the money supply can be used to influence aggregate demand and short term interest are merely indicate monetary policy 's effects

yankee bonds

bonds issued by foreign entities in the US

municipal bonds

bonds issued by state and local government bodies; they represent one of the largest fixed-income securities markets

as the fed manipulates the money supply and interest rates to promote its goals monetary policy transmits to the real sector via 3 channels

business investment in real assets consumer spending for durable goods and housing net exports

How do open market operations influence the Fed funds rate in the short run

buying pressures the FFR downward by increasing excess reserves. selling pressures the ffr upward by decreasing excess reserves

How does the fed influence the fed funds rate

by controlling overall availability of reserves; the fed funds rate is set by market forces and is a benchmark rate in the financial system- it normally represents the lowest possible cost of loanable funds

How does the fed control the money supply

by exclusively controlling the monetary base M1 focuses on money as a medium of exchange-demand deposits and currency. M2 expands the meaning of money to include its use as a short-term store of value. To the elements of M1 it adds savings deposits, money market deposit accounts, overnight repurchase agreements, eurodollars, non institutional money market mutual funds, and small time deposits.

Which of the following Fed actions directly increases total reserves int he banking system? a) lowering the discount rate b) lowering reserve requirements c) buying U.S. Government securities on the open market d) Selling U.S. Government securities on the open market

c) buying U.S. Government securities on the open market

After the 2007-08 crisis, the monetary base grew to record size because of all the following except a) heavy buying by the Fed on the open market b) interest on reserves c) lower reserve requirements d) increased borrowing at the Discount Window

c) lower reserve requirements

Federal Funds are typically a) treasury deposits b) Federal Reserve assets c) overnight interbank loans settled in immediately available funds d) commercial bank deposits at the Federal Reserve

c) overnight interbank loans settled in immediately available funds

a central bank

can issue liabilities and acquire assets at will- unique among financial institutions

leaks

cash drains between changes in the monetary base and changes in actual reserves. occur as the public chooses to hold cash outside banks making it unavailable to use as actual reserves. Because cash drains reduce actual reserves, the fed tries to anticipate when people are likely to widow cash. The fed then tries to expand the monetary base commensurately to maintain the desired level of reserves. when people put cash back in, the fed acts to decrease the monetary base back to the level consistent with monetary policy. open market operations are ideal for this kind of fine tuning keeping currency from circulating

The fed's assets

change as monetary policy changes 1. discount window loans to depository institutions are the Fed's smallest asset. The "discount rate" is the rate the fed charges on such loans 2. us government securities are the fed's largest asset 3. cash items in process of collection are cleared payment items from depository institutions for which funds have not yet been received

Member banks buy stock in the federal reserve bank for their district. They

collect dividends set by the fed but do not otherwise share profits elect 6 of the 9 federal reserve bank directors but have no other vote or say

Who owns the federal reserve banks?

commercial banks

Depository institutions

commercial banks thrifts (savings and loan associations; mutual savings banks) Credit unions

market failure

condition in the loan markets where banks decide not to make loans to businesses or consumers because reliable information is not available at a reasonable cost

how does fiscal policy compare to monetary policy

congress and president determine and th treasury department carries out fiscal policy in th US monetary policy on the other hand, boils down to the control of money supply; it is determined and carried out by central banks such as the Federal reserve system in the Us or the european central bank in the euro-zone

Financial systems need to be regulated for two reasons __________

consumer protection and stabilization of financial systems

political risk

country or sovereign risks that can result in financial claims of government, or of government policy, in a country

foreign exchange markets are where different nations' _____________

currencies are exchanged. Foreign exchange (forex) involves spot, futures, forward, and option markets

monetary base

currency in circulation plus financial institution reserve deposits at the federal reserve. the monetary base consists of all assets that can be used to satisfy legal reserve requirements. thus, if it grows, financial institution reserves (and financial institution deposits) usually grow, too

M1

currency, coin and travelers checks in circulation + demand checking deposits or checking accounts + NOW accounts and similar interest-on-checking accounts

How do reserve requirements influence the fed funds rate in the short run

cutting reserve requirements pulls the FFR downward by increasing excess reserves. raising reserve requirements pushes for upward by decreasing excess reserves. effect are direct, sustained, and too dramatic for fine tuning

how do discount rates influence the fed funds rate in the short run

cutting the discount rate pulls the FFR downward: the window becomes less costly relative to Fed Funds. Raising the discount rate pushes the FFR upward: fed funds become less costly, with institutions already reluctant to face "window scrutiny"

For what purposes do depository institutions keep deposits in the Federal Reserve Banks? a) for clearing checks b) to satisfy reserve requirements c) to earn interest d) a and b

d) a and b

The Fed supported the 2008 financial system bailout in all the following ways except a) expanding the monetary base b) lending at the "Discount Window" c) buying mortgage-backed securities d) acquiring failed financial institutions e) paying interest on reserves

d) acquiring failed financial institutions

The Fed supported the 2008 financial system bailout in all the following ways excetp a) expanding the monetary base b) lending at the "discount window" c) buying mortgage-backed securities d) acquiring failed financial institutions e) paying interest on reserves

d) acquiring failed financial institutions

Reserve requirements apply to a) national banks b) state banks c) Savings-and-loan associations d) all of the above

d) all of the above

Reserve requirements apply to a) national banks b) state banks c) savings-and-loan associations d) all of the above

d) all of the above

The monetary base excludes with Fed balance sheet items? a) U.S. Treasury securities b) "Agency" securities c) "DACI" d) all of the above

d) all of the above

Which of the following can be associated with original objectives of the Fed? a) coordinate an efficient payments mechanism b) provide an elastic money supply c) serves as a lender of last resort d) all of the above

d) all of the above

Which of the following can be associated with original objectives of the Fed? a) coordinate an efficient payments mechanism b) provide an elastic money supply c) serve as lender of last resort d) all of the above

d) all of the above

Which of the following yield calculations on a Treasury bill provides the best comparison yield for competing coupon-based securities of the same maturity? a) CD equivalent rate b) discount rate c) the prime rate d) bond equivalent rate

d) bond equivalent rate

Which of the following may be a liability of a non-financial business corporation? a) treasury securities b) Federal Funds c) agency securities d) commercial paper

d) commercial paper

An increase in excess reserves will cause a) planned inventory investment to fall b) the Fed Funds rate to rise c) foreign investors to buy more T-bills d) depository institutions to lend more freely

d) depository institutions to lend more freely

Federal Reserve float a) is the "lag time" required for monetary policy to take effect b) represents a net liability of the Fed c) is DACI minus CIPC d) represents a net extension of credit by the Fed, which increases bank reserves

d) represents a net extension of credit by the Fed, which increases bank reserves

FOMC

decides whether, when, and how much to buy or sell the FOMC deliberates 8 times a year about the economy the "green book" is a 2 year national economic forecast "beige books" are economic reports from the 12 districts the "blue book" offers 3 alternative monetary policy scenarios the FOMC issues policy directive to the Open Market desk at the Fed bank of new york the desk buys or sells specific dollar amounts of securities trades are executed by securities dealers on an approved list reserves flow into or out of special bank accounts kept by them

When a firm issuing commercial paper uses a backup line of credit, it

decreases the credit risk for investors

Immediately available funds

deposit liabilities of federal reserve banks, and liabilities of commercial banks that may be transferred or withdrawn during a business day

Sustained open market buying by the Fed will cause

depository institutions to lend more freely

money and capital markets represent

different intentions and time horizons

why are direct financial markets wholesale markets? how do consumers gain access to these important markets?

direct financial markets are dominated b institutions that want to avoid the costs of registering securities with the SEC and transact large amounts of securities between each other. only wealthy individuals called accredited investors (one must have high income and/or net worth to be consider dan accredited investor may participate in direct financial transaction such as private placements. small individual investors access financial markets indirectly through intermediaries such as commercial banks or mutual funds

Simplist way for funds to flow

direct financing to DSUs from SSUs

treasury bill (T-bill)

direct obligation of the federal government with initial maturities ranging from 3 months to 1 year. they are considered to have no default risk and are the most marketable of any security issued.

treasury bills are priced on a ___________ yeild

discount

The T-bill rate quoted by the Federal Reserve banks is the

discount rate

use of bill of lading to overcome the international trade problem

document issued by shipping firm to exporter acknowledging possession of stated goods also serves as a title for the merchandise allowing the importer to take possession of the goods

how does fiscal policy work when there is a recession?

during a recession, the government uses expansionary fiscal policy, which includes increasing government expenditures and/or decreasing tax collections. This fiscal policy alternative is intended to stimulate the economy by increasing aggregate expenditures and aggregate demand

describe two recent high profile ethical failures in finance how do ethical failures impact the financial services industry and the economy as a whole?

during the financial criss many large banks illegally manipulated a well-known interest rate called the LondonInterbank Offer Rate for their own profit. Many mortgage originators created loans they knew (or should have known) the borrower could not repay. these "front end" lenders knew they would quickly resell the mortgage and not bear the risk. this activity helped create the mortgage crisis and attendant "great recession" large scale ethical failures in the financial system cause huge economic losses and invite expensive additional regulation

Investors in the money markets are generally willing to take which of the following risks? a) default risk b) interest rate risk c) liquidity risk d) all of the above e) none of the above

e) none of the above

what impact have electronic markets had on markets overall?

electronic markets have made markets more efficient through lower cost transaction costs. markets are very sensitive to costs and high volume trader gravitate to the lowest cost systems as long as they provide equal speed of transactions with the equal bid ask spreads. electronic markets have also contributed to the liquidity in the market through high frequency trading and they have allowed algorithmic trading to flourish

The board of governors now has power to

enforce a uniform discount rate and appoint top officers of each federal reserve bank

The Fed's most important duty is to

establish he nation's monetary policy

International Trade Problem

exporters lack information about importer's credit rating and importers lack information about exporter's reliability

the financial system

facilitates the flow and allocation of funds throughout the economy

technical factors

factors outside the control of the fed that affect the monetary base

Describe the fed funds market

fed funds transactions are unsecured loans between banks for 1 to 7 days in denominations of $1 million or more. The most important role of the fed funds market is that it facilitates the implementation of monetary policy by the federal reserve when it conducts open-market operations just an oral promise to pay- count on trust

What item is on both sides of the industry balance sheet?

federal funds

other institutions

finance companies federal agencies

other types of intermediaries

finance companies make loans but do not take deposits - consumer finance companies make personal installment loans - business finance companies make loans and leases to businesses - sales finance companies finance retail purchases of products federal agencies can function as financial intermediaries - certain agencies channel low cost credit to targeted economic sectors by issuing "agency securities" Backed by the government and lending at sub-market rates to selected households or businesses - various agencies promote various socioeconomic interests

required reserves

financial institutions are required by law to maintain minimum reserves equal to a percentage of specified deposit liabilities. reserve requirements vary with the deposit size of the institution and the type of deposit they are held at federal reserve banks or as cash in financial institutions' values.

How can economies of scale help explain the existence of financial intermediaries?

financial intermediaries can take advantage of economies of scale and this lower transaction costs

primary market

financial market in which financial claims are first sold as new issues. all financial claims have a primary market

secondary market

financial market in which participants buy or sell previously issued financial claims

capital markets

financial markets in which financial claims with maturities greater than 1 year are traded. Capital markets channel savings into long-term productive investments

managerial finance

financial roles within a business or government

Direct financing

financing wherein DSUs issue financial claims on themselves and sell them for money directly to SSus the SSUs claim is against the DSU not a financial intermediary

Impact of monetary policy

first impacts the financial sector then the real sector perceives changes in costs or benefits of borrowing, spending, saving, or investing.

money in transition =

float

What are some of the potential conflicts between goals of monetary policy?

full employment and stable prices in the short run the conflict revolves around the perception that as employment increases so does inflation

Explain the problem information asymmetry presents to lenders

generally the borrower knows more than the lender 1. adverse selection- occurs before the transaction is completed nd the lender cannot tell the difference between high and low quality loans 2. Moral hazard- occurs after the loans is made. they occur because borrowers deploy funds into projects of higher risk than originally agreed upon. easiest way to reduce is to gather more information and to monitor the loan

international and domestic markets represent

global financial decisions

net exports

gross exports-gross imports interest rates affect exchange rates, which affect imports and exports. monetary policy thus usually affects net exports. the fed can waken or strengthen the dollar fo r reasons related or unrelated to export effects

Federal Reserve Bank of New York

has a permeant spot on the FOMC and is charged with executing open market operations for the Fed

Agency securities

have low default risk because they are either explicitly backed by the US government or because the market perceives a moral obligation fot he federal government to bk agency securities .

The principal SSUs in the economy are

households

why is the concept of a liquidy trap important inthe conduct of monetary policy

if money supply is expanded so much that any extra money would be hoarded (rathe than lent or invest) further injections of money have no effect on interest rate and the economy overall this state is known as a liquidity tap this is important when money supply is already high and interest rates low, such as after the crisis in the US. it means that the economy should be stimulated by other means

Federal funds

immediately available funds that can be lent on an overnight basis to financial institutions. Banks may lend their deposits at the Fed to other financial institutions by transferring them through federal funds market loans

Federal funds (fed funds)

immediately available funds that can be lent on an overnight basis to financial institutions. Banks may lend their deposits at the Fed to other financial institutions by transferring them through federal funds market loans

liquidity trap

in keynesian theory , an occurrence during major depressions when people already have so much money relative to their needs that any extra money is hoarded and will no longer drive down interest raes

Explain how the bankruptcy of lehman reduced the liquidity of the commercial paper market.

in september 2008, lehman brothers defaulted on its commercial paper, which temporarily scared many investors away from the commercial paper market . when you go out of business, none of your commercial papers will work

An increase in Federal Reserve float

increase bank reserve deposits in the Fed

The Federal Government eased regulation of "Fannie Mae" and "Freddie Mac" in order to

increase home ownership

Small investors are likely to invest in the money market _______ through_______

indirect; money market mutual funds

Intermediation, or ____________ financing, involves __________ financial claims linking SSU and DSU

indirect; two

financial intermediaries

institution that issues liabilities to SSUs and use the funds so obtained to acquire liabilities of DSUs

currency transformation

intermediaries can buy claims denominated in once currency while issuing claims denominated in another. This would be difficult for most ordinary SSUs.

How do financial intermediaries generate profits?

intermediaries pay SSUs less than they earn from DSUs. risks taken by the intermediary are rewarded by any remaining profit

inflation and unemployment are __________ related

inversely if unemployment is low, inflation is hight if unemployment is high, inflation is low

What is the role of the financial system?

it facilitates the flow of saving to investment via direct and indirect financing realationships formed in financial markets with the frequent help of financial institutions. Without it, financing relationships would arise only the preferences of SSUs and DUSs match as to amount maturity and risk. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize savings

Use of Letter of credit to over come the international trade problem

it is an instrument issued by a bank on behalf of the importer, promising payment on presentation of the appropriate shipping documents the bank substitutes its creditworthiness for the buyers' and will make payment when the exporter complies with the terms of the deal

Changes in treasury deposits

large payments into or out of Treasury balances at the Fed cause large shifts in depository institutions' reserves as the checks are deposited and collected. thus the Treasury trees to coordinate any large fluctuations in its deposits with the Fed

legal tender

lawful payment for any debt valued in US dollars

Explain how repurchase agreement transactions provide short-term investments to business

lender of money owns the security until the loan is paid back the corporate treasurer purchases government securities for the amount of the investment from a bank for a specified time period. The business would have idle cash deposit balance that it would transfer out to invest. the bank retains the funds by providing a repurchase transaction whereby it sells securities owned to the business and agrees to buy them back at a higher price, thus paying the money market rate for the business' funds. the purchase price and sale price are agreed upon at the time the deal is done. the interest paid the corporation is the difference between the purchase price and repurchase price of the collateralized securities.

natural rate of unemployment

level of unemployment that policy markers are willing to tolerate a sort of full employment unemployment rate

The Fed's _______ are the basis of the money supply

liabilities

US Treasury Deposits

liability of the Fed the federal government's checking accounts

mortgages

loans for which the borrower pledges real property as collateral to guarantee that the debt will be repaid

contractual savings institutions

long term savers and borrowers together life insurance companies insure against lost income at death liability insurance companies cover property against loss or damage sources and uses of funds resemble those of life insurers, but liability claims are not as predictable as death claims; so more assets are in short-term easily marketable investments pension funds help workers plan for retirement

corporate bonds

long-term financial claims issued by corporations against the firm's assets

Liquidity

many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs.

velocity of money

measures of the number of dollars of national income that are supported with each dollar of money in circulation. when velocity rises, more income can be generated with the same amount of money in circulation. the converse holds if velocity declines

The ____________ chiefly comprises the Fed's 2 largest permanent liabilities

monetary base 1. federal reserve notes in circulation 2. deposits of financial institutions

how can small investors participate in investments in negotiable certificates of deposits

money market funds can pool invested funds by individual investors and purchase NCDs. in this way, small investors can invest in NCDs

how do money and capital markets differ?

money markets are markets for short-term debt instruments (usually less than 4 months) and governments adjust their liquidity positions in the money markets. Capital markets are markets for long-term instruments such as bonds, stocks, and mortgages. capital market securities are issued to finance long-term capital investments

consumer spending for durable goods and housing

much consumer spending is on credit, so it tends to vary directly with credit conditions. falling interest rates tend to encourage spending; rising interest rates tend to discourage spending. consumers, however, don't necessarily make decision the way business do. thus, monetary policy should affect aggregate demand, but perhaps not as predictably as it affects business investment

Investment Funds

mutual funds money market mutual funds

How independent is the Fed in reality

no directly under congress' authority not answerable to the president the fed funds itself The fed is independent within not of the government, but if congress wants to get rid of it, that can be done easily

Are the monetary base and the money supply the same thing?

no! the monetary base comprises of federal reserve notes in circulation and deposits of financial institutions with the fed. the money supply reflects both monetary policy and private transactions

does the fed dictate federal funds rates?

no, owned by member bank

implementation lag

occurs when the fed recognizes a problem but does not implement a policy to solve the problem until later. then, even after the fed implements a policy, there will be an impact lag until the policy has its full impact on the economy.

broker

one who acts as an intermediary between buyers and sellers but does not take title to the securities traded

dealer

one who is in the security business acting as a principal rather than an agent. The dealer buys for his or her own account and sells to customers from his or her inventory

what is the fed's most useful technique for issuing liabilitilities and assets

open market operations- change the monetary base directly, immediately, and dollar-fori-dollar as the Fed credits new reserves to pay for open market purchases and retires existing reserves to collect for open market sales

public markets

organized financial markets where securities registered with the SEC are bought and sold

Financial institutions are classifiable by their

origins, purposes, and major characteristics

humphrey hawkin act

passed in 1978, this legislation specifies the primary objectives of monetary

Why does the Fed want the ability to pay interest on reserve accounts?

paying interest on reserves allows the fed to influence no only the supply of reserves (which it does by buying or selling securities via open market operations) but also the demand for reserves. increasing the interest rate on reserves provides banks with an incentive to keep more excess reserves with the Fed rather than to lend to other banks or customers. Decreasing this rate or eliminating interest on reserves altogether would encourage banks to keep less excess reserves and lend more, all else equal

Organized exchanges are

physically and relatively exclusive a physical trading floor and facilities are exclusively available to members of the exchange and for securities listed on the exchange

Too big to fail

policy adopted by federal regulator that the failure f certain financial institutions would have too much of an adverse effect on the economic and so those institutions will not be allowed to fail

Too Big to Fail

policy adopted by federal regulators that the failure of certain financial institutions would have too much of an adverse effect on the economy and so those institutions will not be allowed to fail. TBTF creates a serious moral hazard: depositors in large banks will only care whether such banks are TBTF, not whether they are taking too much risk

Direct finance works if

preferences of SSUs and DSUs match as to amount, maturity, and risk

business investment in real assets

present value of future cash flows depend significantly on interest rates, as do costs of financing real assets. monetary policy thus involves material incentive or disincentives for business investment

Over-the-counter market (OTC)

primarily a dealer market wehre securities not sold on one of the organized exchanges are traded

Types of financial markets

primary and secondary markets represent the stages of a financial claim's "life" 1. primary markets are where financial claims are "born"-originally issued 2. secondary markets are where financial claims "live"- are resold an repriced. Secondary markets offer liquidity. SSUs set their own holding periods

what are primary and secondary markets

primary markets are for sales of new securities. investment bankers are key institutions that hep issuers deisgn, price, and distribute new securities. secondary markets are for resale of existing financial instruments. brokers and dealers help bring together buyers and sellers in the secondary markets

adverse selection

problem of hidden information in general. For instance, the tendency of the most risky people to buy insurance or apply for loans

moral hazard

problems hidden actions. for instance, in the case of deposit insurance, insured individuals have less incentive to monitor the health of the deposit institutions and thus are more likely to incur a loss than when their deposit institution does not carry insurance

investment finance

products and services for the investing public with opportunities for analysts, brokers and traders

Recognition lag

represents the time when an economic problem arises until it is recognized by the fed. it occurs because the economic statistics that are monitored to detect problems are only reported periodically

Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper?

repurchase agreements with a similar maturity as commercial paper would likely have a slightly lower yield, since they are typically back by treasury securities

To assess the value of a firm, which side of the financial balance sheet is more effective?

right side value (firm)= value (debt) + value (equity)

option markets involve different

rights in underlying securities or commodities

The financial system brings

savers and borrowers together

explain how and why the secondary capital markets play an important role in our economy

secondary markets provide investors with liquid and the ability to re-balance their portfolios at any time. constant trading provides a base for selling atonal securities (primary issue) into the market and constant price discovery promotes continuing evaluation and feedback. Secondary markets also enable investors to choose their own holding periods

What are the functions of securities firms

securities firms provide a variety of functions (such as underrating and brokerage) that either enhances a borrower's ability to borrow funds or an investor's ability to invest funds

Asymmetric information

sellers or borrowers in financial transactions usually have more information than buyers or lenders expressed in two ways: adverse selection (before transaction) or moral hazard (after transaction) financial intermediaries are information producers

The primary responsibility of the Federal Open Market Committee (FOMC) is to

set monetary policy

The Federal open market committee

sets monetary policy under the board of governors has 12 members- 8 permanent 4 rotating the 7 governors are pemrnange members of the FOMC the president of the federal reserve bank of new york has a permanent seat because the new york fed operationally executes FOMC directive presidents of 4 other federal reserve banks rotating through 1 year terms the FOMC's actions substantially influence 2 major financial sector variables: the size of the money supply and the level of short-term interest rates

easy money

situations in which it is easy for banks to issue bank notes when businesses want loans (easy credit)

investment funds help

smal investors share the benefits of large investments mutual funds provide intermediated access to various capital markets money market mutual funds are close but uninsured substitutes for deposit accounts mummy buy money market instruments wholesale investors receive interest and limited check-writing privileges

characteristics of treasury bills

sold at discount from par maturities up to one year multiple denominations up to $41 million

"Margin requirements" determine the proportion of

stock value that can be used as loan collateral

pyramiding of reserves

system by which smaller country banks counted their deposits in large city banks s part of their reserves; when the country banks needed currency, they exchanged their reserves at larger banks for cash, thus depleting the larger banks' holdings. pyramiding of reserves often led to a liquid squeeze and financial panics

full employment

term implying that every person of working age who wishes to work can find employment

Do the 14-year nonrenewable terms of governors effectively insulate the board of governors from policital pressure?

the 14-year terms do not completely insulate the governors from political influence. the governors know that their bureaucratize power can be reined in by congressional legislation nd so must still curry favor with both congress and the president. Moreover, in order to gain additional power to regulate the financial system, the governors need the support of congress and the president to pass favorable legislation.

Federal Reserve notes held in bank vaults are the liability or obligation of

the Fed

The fed is the most independent of all US government agencies. What is the main difference between it and other government agencies?

the Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget

How does the Fed increase the money spply through open market oepration?

the Fed purchases securitie sin the secondary market

The most important participant in the money markets is usually

the Federal Reserve

what is likely to happen to the monetary base if the fed buys more government securities?

the Monetary base will reduce as the fed buys securities, increasing the bank reserve deposit account in the Fed

excess reserves

the amount arrived at when required reserves are subtracted from a bank's actual reserves

margin requirements

the amount of money people can borrow so they can buy stocks; this amount is restricted by federal reserve regulations G,T,U, and X in order to prevent excessive speculation in the stock market

What is the Beige book? Why is it important to the FOMC?

the beige book is consolidate report of regional economic conditions in each of the 12 districts. this book is sent to FOMC members before their meeting so that they are update on regional conditions before they decide on monetary policy

Why is a repo like a secured loan?

the borrower of the money sells a government security to the lender along with an agreement to repurchase it at a future time at a predetermined higher price that is based on the repo rate. thus the lender of the money owns the security until the money is paid back with interest, so the security serves as collateral for the loan,, sell low, buy back high = difference repo rate

what is the economic function of the capital markets?

the capital markets are where business firms obtain funds for long-term investment projects and where consumers finance the purchases of longterm assets, such as a real estate. Capital market securities have a long term-to-maturity and typically involve more risk than money market securities the most important capital market instruments are corporate stocks and bonds, treasury bonds, and residential mortgages

Why is the Fed chairman called the second most powerful person in the country?

the chairman sets the agendas and runs the meetings of the board of governors and FOMC, and thus can have a major effect on monetary policy as then public face and voice of the fed, the chairman can literally move financial markets with a few well-chosen words

inflation

the continuous rise in the average price level

marketability

the cost and quickness with which a financial claim can be resold. the greater the marketability of a financial security, the lower its interest rate

transaction costs

the costs involved in buying or selling securities

how does the bond equivalent yield differ from the discount yield

the discounted price is the denominator and 365 days is used as the annualizer . this causes the bond equivalent yield to always be greater than the discount yield

private placements

the distribution of equity securities in which the investment banker acts only as the company's agent and receives a commission for placing the securities with investors

panics

the events that occur when depositors lose confidence in banks in general and "run" many banks to redeem their deposits quickly

how does the fed use open market operations to reduce the money supply?

the fed can sell holdings of its existing treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions

float

the fed must engage in open market operations to offset the effect of float, the difference between cash items ain process of collection and deferred availability cash items. an increase in federal reserve float increases the monetary base positive= too much money out negative= not enough out

describe the fed's monetary policy response to the credit crisis?

the fed used a stimulative monetary policy during the credit crisis because economic conditions were very weak. specifically, the fed's policy resulted in lower interest rates in the US

What are the Fed's 3 major tools to conduct monetary policy?

the fed's most important duty is to establish the nation's monetary policy by changing reserve requirements,the discount rate, and its open market operations that affect the amount of reserves in the banking system and hence, the money supply

Does the federal reserve directly set the federal funds interest rate? How does the fed influence this rate?

the federal reserve can not directly set the federal funds rate of interest it can influence the interest rate by adding funds to or withdrawing reserves from the economy

foreign exchange risk

the fluctuation in the earnings or value of a financial institution that arises from fluctuations in exchange rates; responsible for gains or losses in the currency positions of financial institutions and changes in the U.S. dollar values of non-U.S. financial investments

stop (stop-out) rate

the highest accepted rate in treasury bill auctions

discount rate

the interest rate a financial institution must pay to borrow reserve deposits from its regional federal reserve bank

The main reason the Fed changes the monetary base is to affect

the level of output in the economy

what is fiscal policy

the main instruments of fiscal policy are government expenditures and the government' power to tax. fiscal policy is the use of government expenditures ad revenue collections to affect economic output over the business cycle

financial markets

the markets for buying and selling financial claim

The Fed's balance sheet

the mechanism through which the tools of monetary policy influence the money supply.

What is the economic function of the money markets?

the money markets are a collection of markets where commercial banks and businesses adjust their liquidity by borrowing or lending for short periods of time the fed conducts monetary policy int he money markets, and the treasury department uses the money markets to finance the day-to-day operations of the federal government. themes important money market securities are treasury bills, negotiable certificates of deposit, and commercial paper

investment banks

the most important participant in the direct credit market; firms that specialize in helping businesses and government sell their new security issues in the primary markets to finance capital expenditures

open market operations

the most useful and thus most important tool the fed ordinal buys and sell us government securities on the secondary market but after the 2008 crisis they also bought commercial paper and mortgage-backed securities on the open market open market trades directly change the level of reserves in the banking system the fed pays for purchase by crediting new reserves to the seller only the central bank can unilaterally create new money are new reserves are credeited, the monetary base grows the fed collects for a sale by taking existing reserves form the buyer as extisting reserves return to the fed, the money supply shrinks these dollar-for-dollar reserve effects make open market operations flexible and prices

what political realities might explain why the federal reserve act of 1913 placed two federal reserve banks in missouri?

the placement of two banks in the midwest farm belt might have been engineered to placate farmers, an important voting black in the early 12th century

credit risk (default risk)

the possibility that the borrower will not pay back all or part of the interest or principal as promised

Distinguish between the primary markets and the secondary markets for securities

the primary market is for securities being issued for the very first time and the issuer receives the funds paid for the security. the secondary market is for securities that have been issued previously but are being traded among investors

What is financial intermediation?

the process by which financial institutions mediate unmatched preferences of ultimate borrowers and ultimate lenders. Financial intermediaries buy financial claims with one set of characteristic from DSUs then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them more attractive to both DSUs and SSUs

indirect financing (financial intermediation)

the purchase of direct claims (IOUs) with one set of characteristics from DSUs and the transformation of them into indirect claims (IOUs) with a different set of characteristics individual equity in a pension plan, the concept of paying benefits in direct relation to contributions

open-market operations

the purchase or sale of government securities by the federal reserve. open market operations are used to increase or decrease bank reserve sand the monetary base. when the fed purchases securities, the monetary base expands

real gdp

the quantity of goods and services produced in the economy, as opposed to nominal GDP, which is the value (price times quantity) of goods and services produced in the economy

federal funds rate

the rate at which banks and other depository institutions lend excess reserves or other immediately available cash deposits to each other overnight; the rate is determined by negotiation between the private borrowers and lender of reserves

bid-to-cover ratio

the ratio of the dollar amount of tendered bids (competitive and noncompetitive) to the amount of accepted bids

why is the financial system so highly regulated?

the regulation is needed to protect consumers from abuses by unscrupulous financial firms and to ensure economic stability. people should have confidence in the financial system for it to function well, and well-functioning financial system is critical for ensuring the flow of funds and in turn economic growth

What is likely to happen to the monetary base if banks in general borrow less from the fed's fund discount windows and repay their past borrowings

the repayment of Fed borrowing will reduce the bank reserve component of the monetary basis

Explain the lesson to be learned about the repo market based on the experience of bear stearns.

the repo market funding requires collateral that is trusted by investors, and when economic conditions are weak, some securities may not serve as adequate collateral to obtain funding.

actual reserves

the reserve amount computed by a bank by summing its holdings of vault cash with its holding of reserve deposits at Federal Reserve banks over a 2-week reserve maintenance period

Disintermediation

the reverse of intermediation- not good- SSUs disintermediation when they perceive it will be more beneficial take funds out of intermediaries and invest directly; do not trust

liquidity risk

the risk that a financial institution will be unable to generate sufficient cash inflow to get required cash outflows

interest rate risk

the risk that changes in interest rates will cause an asset's price and realized yield to differ from the purchase price and initially anticipated yield

Lender of last resort

the role of the Fed as a lender to banks experiencing difficulties to prevent the banks from failing due to a lack of liquidity

price stability

the stability father average price of all goods and services in the economy

What is Finance?

the study and practice of making money-denominated decisions. Finance is a body of facts, principles, and theories relating to using and raising money by individuals, businesses, and governments

typical DSUs and SSUs

the typical houshold is a surplus spending unit while the typical business firm is a deficit spending unit. households are ultimately SSUs, but have deficit periods when a home or other "big ticket" items are purchased. Businesses usually invest more in real assets than they receive in current operating cash flow

fiscal policy

the use of government expenditures and tax collections to affect economic output over the business cycle. according to keynesian view, during recessions government should be proactive and use expansionary fiscal policy, which means increasing government expenditures and or decreasing taxes. in this line of though federal budget deficits are justified and even expected because they may help smooth out the business cycle

The money markets are called "open markets" because

they are impersonal and competitive

Why is the Board of Governors the most powerful policy group within the Fed?

they make up a majority of the FOMC which sets monetary policy (the feds most important power) handles financial system regulations, enacts the policies and procedures by which the federal reserve system is internally governed and appoints 3 of the 9 directors of each federal reserve bank

Board of governors of the fed

they run the fed the 7 governors are appointed by the president and confirmed by the senate- no two governors can be from the same federal reserve district; governors have 14-year terms of office expiring every 2 years (someone leaving every 2 years); governors' terms are nonrenewable one governor serves as chairman- the chairman has a 4-year term and may be reappointed.; when a new chairman is named, the old one traditionally leaves regardless of the time left in the underlying appointment as a governor

how have the asset compositions of thrift institutions differed from those of commercial banks?

thrift institutions have traditionally concentrated in mortgage lending, while commercial banks have concentrated in commercial lending

spot, futures, and forward markets involve different ________ of pricing and delivery

timing spot markets involves pricing for immediate delivery futures and forward markets involve pricing for a promise of future delivery

What were the four goals of the Federal Reserve Act of 1913?

to establish 1. a reliable mechanism for adjusting the money supply to the needs of the economy 2. a lender of last resort that could furnish liquidity to banks in times of financial crisis 3. an efficient payment system for clearing and collecting checks at face value 4. a more vigorous bank supervision system to reduce the risk of bank failures

Why was the Fed initially established?

to provide an elastic (money supply that increase and decreases as the economy grows or shrinks) money supply, be a lender of last resort, improve bank regulation and improve the performance of the nation's payment system. the fed could act as a lender of last resort to member banks needing extra liquidity. the fed could legally create circulate, and decirculate currency to keep the money supply elastic in relation to the economy. The fed provided free check clearing services to member banks and required that checks cleared through it clear at par, converting the payment system from a hindrance to a handmaiden of commerce. the fed included all national banks as member banks and required all member banks, state or national, to be examined regularly to ensure that they were sound and maintained adequate reserves

Purchasing T-bill via a computerized account without actually receiving the securities is achieved through a __________ account

treasury direct

True or False: all national banks must join the federal reserve system.

true

briefly describe the origin of the Federal reserve system

two attempts to establish a central bank in the 1800s had failed 1. bank of the unites states 2. second bank of the united states third attempt in 1913, the federal reserve act was passed and specified 12 districts across the united states, as well as a city in each district where a federal reserve district bank was to be established

Deferred availability cash items

uncleared payment items from depository institutions

negotiable certificate of deposit (NCDs)

unsecured liabilities of banks that can be resold before their maturity in a dealer-operated secondary market

over the counter markets are

virtual and relatively inclusive a decentralized information and trading network is available to any licensed dealer willing to buy access and obey the rules, the NASDAQ founded in 1971 is a famous OTC market the national association of securities dealers licenses dealers and polices their behavior

Auctioning New Treasury Bills

weekly sale by US Treasury of three and six month maturities; monthly or quarterly sale of longer-term bills T bills are soldthrough an auction process using both competitive and noncompetitive bids

What is mean by moral hazard? What problem does it present when a bank makes a loan?

when it comes to loans, moral hazard occurs if borrowers engage in activities that increase the probability of default. A firm that has taken a bank loan may take on very risky investment project which, if successful, would result in large profits, but which have high probabilities of failure. The reason for such behavior is that lenders do not share the upside with shareholders of the firm. To reduce moral hazard, the bank may impose some restrictions on the borrower stipulated in the loan contract and continually monitor the borrower

Why do the fed's open market operations have a different effect on money supply than transactions between two depository institutions?

when the fed engages in a purchase of treasury securities from a depository institution, money is transferred to the depository institution without any offset at another institution. However, a similar transaction between depository institutions would increase the account balance at one institution and decrease the account balance at the other institution

direct markets are

wholesale markets. transactions are large, typically $1 or more institutional arrangements are common 1. private placements are the simplest form of "direct finance" - a DSU sells a whole security issue to one investor or investor group; advantages include speed and low transaction costs 2. investment bankers often underwrite new issues of securities- buy entire issues from DSUs, then find SSUs to buy the securities at a higher price in order to profit from the difference- the underwriting spread 3. brokers help bring buyers and sellers of financial claims together. dealers "make markets" by carrying inventories of securities- dealer buy securitites at "bid price" and sell them at "ask price"; the resulting "bid-ask spread" represents a dealers gross profit