Chapter 11 Solutions

What is meant by a multitiered market?

A multitiered market for CDs means that investors group issuing banks into different risk categories, with higher categories of banks being forced to issue the their CDs at significantly higher interest rates.

Liability Management:

A technique employed by bankers to exercise control over their balance sheets. By varying the daily interest rates they were willing to offer on CDs, Eurocurrency deposits, and other funds sources they could gain a measure of control over their liabilities. If more or less funds were needed to accommodate demand, they would lower or higher interest rates.

What is bankers acceptance:

A time draft drawn by a bank by an exporter or an importer to help pay for merchandise or to purchase foreign currencies. Its purpose is to shift default risk for the lender in a credit transaction from the borrower to the more creditworthy bank.

Eurodollar:

Deposits of U.S. dollars in banks located outside the U.S. U.S. banks cannot create Eurodollars in the U.S. because dollar deposits held inside the U.S., where the dollar is the official currency, cannot be Eurodollars by definition. If a U.S. deposit account holder decides to move the dollar deposit to a bank outside the U.S. the foreign bank hoods a claim to the original dollar deposit in the U.S. and will then be recorded on the foreign bank books as a Eurodollar deposit.

Disadvantaged sectors of the economy:

Disadvantaged sectors of the economy are those which appear to have an unusually difficult time raising funds in the money and capital markets. These include: agriculture, housing, small businesses and college students.

Process by which Eurocurrency deposits are created:

Eurocurrency (Eurodollars) deposits are created when a dollar deposit in a foreign bank is loaned to an individual or institution in a country outside the U.S.

Role of Eurodollars deposits in reserve management operations of U.S. banking firms:

Eurodollars are an alternative source of funds to meet reserve requirements. During period of credit crunches and rising interest rates, U.S. banks tapped the Eurodollar market heavily. Eurodollar loans have a higher rate of interest, there are fewer legal and regulatory restrictions on Eurodollar borrowing and because they are not insured, the assessment to cover FDIC deposit insurance is eliminated.

Can Eurocurrency deposits be destroyed? How can this happen?

Eurodollars can be destroyed when the loans that created the Eurodollars are repaid, or when deposits in foreign bank or bank branch are withdrawn and re-deposited in a bank in the country whose currency is used as the denomination unit for the deposit.

Why is the Eurocurrency market needed?

It rose from the worldwide need for funds denominated in relatively stable currencies. It is needed to finance transactions in nations where multinational companies are located.

Federal Agencies:

Legal a part of the government structure and their borrowing and lending activities are included in the federal budget. they are owned and operated by the Untied States government.

Principal lenders in the federal funds market:

Commercial banks with excess reserves. Since the reserves earn little or no come,most bankers try to lend out excess reserves.

Brokered CDs:

Consist of CDs sold through brokers or dealers in maximum $100,000 denominations to qualify for federal insurance.

Reserve computation period:

Legal reserve requirement for banks that is calculated on a daily average basis over a two-week period. (i.e. Tuesday through a Monday two weeks later.) The Fed Reserve calculates daily average level of transaction deposits help by each institution over this 2 week period and multiplies that average by the required reserve percent, 3 for smaller banks 10 for larger to determine the amount of legal reserves that must be help by each institution.

Credit Enhancements:

Letters of credit indemnity bonds, and other irrevocable payment guarantees. Issued by bank or other lending institutions who promise to repay the principal and/or interest on a customer's paper if the borrowing company fails to do so. This allows borrowing company to obtain a lower interest rate.

Commercial Paper:

Money market instrument consisting of short-term unsecured promissory notes issued by financially strong, well-known companies with high credit ratings.

Why do federal funds find the commercial bank with excess reserves a good place to lend money?

Most federal loans are overnight transactions or continuing contracts that have no specific mature and that can be terminated without advance notice by either party, so federal funds market is an easy and diskless way to invest excess reserves for sort periods and still earn some interest income.

When were CD's first offered in the money market?

Negotiable CD is one of the youngest of all U.S. money market instruments. It dates form 1961.

Principal Investors in commercial paper?

Non financial corporations, money market mutual funds, bank trust departments, small banks, pension funds, insurance companies and state and local governments. They regard paper as a low-risk outlet for their surplus funds (issues have caused money market funds to sharply cut back their purchases of low-quality paper).

Government-sponsored agencies:

Not officially a part of the federal government's structure but are quasi-private institutions. Federally charted by privately owned. In some instances their stock is traded on major security exchanges. the borrowing and lending activities of government-sponsored agencies are not reflected in the federal government's budget.

Reserve Maintenance Period:

The bank's legal reserve must average the required amount over this two week period. For transaction deposits this period starts on a Thursday, 30 days after the transaction-deposit reserve computation period begins for the arrest U.S. banks and ends on a Wednesday two weeks later.

Levels of Vault Cash in the process of legal reserve position adjustment:

The federal funds allows money managers with shortages at the Fed to borrow (even overnight) to meet reserve requirements and allows money managers with excess reserves to lend money and earn a return on that money.

Why acceptances have been attractive to exporters and importers of good moving between countries:

The only credit risk the export faces is the risk the issuing bank will default on the acceptance when it matures. the risk in generally minimal, so this method is popular for importers and exporters.

Federal Funds:

The principal means of making payments in the money market. They are any monies available for immediate payment ("same-day money"). Federal funds are mainly despot balances of depository institutions held at regional Federal Reserve banks or larger correspondent banks.

What happens to the total volume of domestic bank reserves and deposits in the process of creating Eurocurrency deposits?

The total volume of dollar deposits and bank reserves remained unchanged. Eurodollar activity does not alter the total reserves of the banking system. Money itself usually does not leave the country where it originates; only the ownership of money is transferred across international boundaries.

How federal funds are transferred:

They are transferred from one depository institution to another by simple book-keeping entires requested by online computer, by wire, or by telephone after a purchase of securities is made or a loan is granted or repaid.

Advantages/Disadvantages of the bankers acceptance as an investment instrument:

They carry maturities ranging from 30 to 270 days (90most common) and are considered prime-quality instruments comparable to prime negotiable bank CDs, Treasury bills and prime commercial paper although trading volume is smaller. Acceptance is a high-quality investment and source of ready cash. Advantages include a competitive rate, brisk resale activity, and low default risk. Disadvantages: the odd-lot denominations in which acceptances are issued.

Why are commercial banks attracted to the federal funds market for the funds they require?

They use this as a way to adjust their legal reserve account at the Federal Reserve bank in their district. Federal funds are essential because credit can be obtained in a matter of minutes.

Is it likely that depository institutions will continue to develop and bring forward new types of CD's in the future?

Yes banks may be expected to continue to market innovative forms of CDs as they face the need to retain deposits or acquire additional deposits in the face of increasing competition from other financial institutions.

Principal borrowers active in federal funds market:

Commercial banks

Uses of Eurocurrency:

1. Finance the import and export of goods. 2. Supplement government tax revenues. 3. Provide working capital for the foreign operations of U.S. multinational corporations. 4. Provide liquid reserves for the largest U.S. banks.

Why it would not seem advisable to regulate the Eurodollar market:

1. The difficulty of instituting regulations worldwide. 2. Regulations would tend to inhibit the flow of this source of financing, limiting funds availability and therefore tending to increase rates on other funding sources. 3. The disruption of the international market that would occur would seem to offset the benefits that may affect a nation in a particular time. 4. There are other methods that may be used by a nation in times of need to regulate the Eurodollar market without disrupting the market worldwide.

Eurodollars arise from:

1. U.S. balance of trade deficits 2. U.S. tourism abroad 3. Dollar loans made by U.S. corporations and foreign-based firms.

Advantages accruing to a company large enough to the the commercial paper market for funds:

1.Interest rates on paper are lower than the interest rates on corporate loans extended by banks. 2. Interest rates on paper are more flexible than bank and finance company loan rates. 3. Paper market is faster than getting alone agreement among several parties.

Eurocurrency market:

A chain of international money markets, comparable to the U.S. money market, trading in the world's most convertible currency.

Principal disadvantages of commercial paper to an issuer

Alienating banks whose loans might be needed when a real emergency develops. Another problem for the issues lies in the fact that commercial paper cannot usually be paid off at the issuers discretion, but must remain outstanding until maturity. Following several commercial paper defaults, the SEC ruled that money funds must inform investors that their shares are not insured or guaranteed by the U.S. government.

Why is commercial paper attractive to money market investors?

Because of its high quality (limited risk) and it is regarded as a substitute for T-bills, CDs ect. Commercial paper has limited marketability, but the low risk and small denominations (multiples of $1000) are attractive. Since its issued in maturities from 3 to 9 months, the investor can match the commercial paper maturity to his or her needs to help overcome the limited marketability.

Why were CD's developed?

CD's tended to increase the average cost and volatility of bank funds. However banks had no choice but to offer the new instrument or face the loss of billions of dollars in interest-sensitive deposits.

Prime CD:

CDs from the largest and mot financially sound banks. A holder of a regular type of CD is covered against loss by the Federal Deposit Insurance Corporation up to $100,000 if the issuing bank fails, however insurance is of limited value to a corporation holding million dollar or larger CD. Larger CD's do help discipline their banks from taking excessive risk by threatening to withdraw their funds if the banks with which they trade become too risky.

Factors that influence a banker's choice among negotiable CDs, Eurocurrency deposits, and federal funds as important sources of borrowed reserve banking institutions:

Cheapest funds source was borrowing in the federal funds market. The bank borrowing in money market must consider the level of current money market interest rates and expected interest rates and government regulations when choosing sources of funding.

Why has the federal funds market become so important to the United States' central bank?

Federal funds serve as the principal means of payment for securities and loans and are critical to the whole money market. The funds market is able to transmit the effects of Federal Reserve monetary policy quickly throughout the banking system because the Fed routinely sets target levels for the fed funds interest rate and raises or lowers these depending on whether the Fed wishes to slow down borrowing and spending the economy or speed it up. (Raise funds when there is inflation in price, and lower funds rate when inflation declines).

The variable, or floating-rate CDs:

Generally carry maturities out to five years with an interest rate adjusted every 30, 90 or 180 days. (known as a leg or roll period.

What factors influence the interest rate offered on CDs issued by depository institution?

Interest rates on CDs are computed as a yield to maturity on a 360-day basis. This is slightly higher than T-bills due to greater default risk, a thinner resale market, and the state and local tax exemption on earnings from Treasury Bills. The CD rates hover close to the average and current and future federal funds interest rates expected by investors to prevail over the life of the CD.

Negotiable CD:

Interest-bearing receipt for funds left with a depository institution set for a set period of time. True money market CDS are negotiable instruments that may be sold any number of times before reaching maturity and have a min denomination of $100,000.

Why do some investors find commercial paper unsatisfactory for their needs?

Investor groups regard commercial paper as a low-risk outlet for their surplus funds, although recent financial problems and few defaults among paper issuers have caused some investor groups, such as money market funds, to sharply cut back their purchases of lower-quality paper. Opportunities for resale in this market are limited

What changes has liability management brought to the depository institutions' industry?

It has had effects analysts thought from the start. The earnings of financial institutions have become more sensitive to fluctuations in interest rates and in periods of rapidly escalating market interest rates, profit margins have been often squeezed. Change in technology and growing use of risk-management tools could change adverse impact on earnings of bank in earnings of banks. Whatever the future holds, bankers have transformed the money market into a far larger and more dynamic institution than any other time in history.

Functions that dealers perform in the functioning of the commercial paper market.

Operate in 3 different ways: 1. May purchase the paper from the issuer at a discount plus commission and sell it at the highest price possible. 2. May act as an intermediary, agreeing to sell it at the best possible process less commission but not taking the risk involved in purchasing the paper. 3. May combine the two methods above. Dealer paper is issued mainly by non financial companies as well as by smaller bank holding companies and finance companies.

Asset-backed commercial papers:

Originates when loans or credit receivables are pooled into packages and paper is then issued as claims agains that pool. This and credit enhancements have aided the growth of the paper market by allowing access by lower-rates or smaller firms.

How is commercial paper rated?

Paper is rated through S&P, Moody's, Fitch Investor Service and other credit rating companies as prime, desirable or satisfactory, depending on credit standing of the issuer. (Generally ratings from two agencies are preferred by investors). Ratings are important because it is very difficult to market unrelated commercial paper. The rating depends heavily on the liquidity position and the amount of backup lines of credit held by the issuing company.

Nonprime CD:

Smaller banks or those viewed as less table issue