financial markets and institutions

liquidity premium theory

explanation for a difference between two types of financial securities that have the same qualities except liquidity.

unconventional monetary policy tools

liquidity provision to banks or other financial institutions. asset purchase programs. negative IRs on excess reserves. forward guidance.

loss aversion

peoples tendency to prefer avoiding losses to acquiring equivalent gains. behavioral finance.

interest rate

percentage of principal that must be paid as interest to the lender on an annual basis.

functions of financial markets?

perform essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds. promotes economic efficiency by producing an efficient allocation of capital, which increases production, directly improve well-being of consumers b allowing them to time purchases better. well functioning financial markets are key factors in producing high economic growth.

check deposit

when a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves.

coupon bond and yield to maturity. do they equal each other? how are they related?

when coupon bond is priced at its face value, YTM equals coupon rate. price of coupon bond and YTM are negatively related. YTM is greater than the coupon rate when the bond price is below its face value.

if the interbank rate would exceed the discount rate, banks would....

would borrow from the central bank and supply an unlimited volume of these reserves to the interbank market

northern rock

UK bank unable to finance operations through interbank market. Depositors don't trust bank anymore. Bailed out by Bank of England. Bank run.- first movers advantage.

eurodollars

USD deposited in banks outside the US

business cycle and interest rates. do IR rise or fall during recession?

fall.

with excess supply of reserves, the federal funds rate falls/rises with excess demand for reserves, the federal funds rate falls/rises

falls. rises.

tier 1 capital ratio =

= common stock + retained earnings

banks expected loss on a loan (EL)=

= exposure at default x probability of default x loss given default. credit analysis typically predicts default within a specific period of time, 12 months is typical

financing requirement=

= financing gap + liquid assets.

tier 2 capital=

= less than tier 1. subordinated debentures. tier 2 cannot be larger than tier 1.

t or f: anyone can access securities markets to finance their activities.

false: only large, well established corporations

primary dealer credit facility

fed creates PDCF. investment banks can turn to FED for overnight funding. easing of liquidity problems at remaining investment banks.

t or d: maturity of a bond gives all needed info about price volatility.

false, coupon payments through time, and other cash flows before maturity, like amortization. exception: zero-coupon bonds

limits to the purchasing power theory:

many goods aren't tradable (services, not movable products, high transportation costs). tradable goods may be subject to tariffs and quotas. not all goods in the consumer basket are identical.

demand for securitization from institutions

many institutions demand or are required to hold a certain fraction of AAA rated securities (insurance companies, pension funds, mutual funds). typically no repo haircut on AAA rated assets.

dual mandate

two coequal objectives: price stability and employment.

a rise in interest rates is associated with an increase/decrease in bond prices, resulting in a capital gain/loss if time to maturity is longer than the holding period

fall, capital loss

Can a person with rational expectations expect the price of a share of Google to rise by 10% in the next month?

No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on Google stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person's expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.

yield curves and the markets expectations of future short-term interest rates according to the liquidity premium (preferred habitat) theory. 1)future short-term IRs expected to rise leads to what yield curve? 2)future short term IRs expected to stay same leads to what yield curve? 3)future short term IRs expected to stay same 4)future short term IRs expected to fall sharply

1)steeply rising yield curve 2)mildly upward sloping 3)flat 4)downward sloping

term structure of interest rates. theory of the term structure of IR must explain following facts: 1) IR on bonds of different maturities move together/apart over time. 2)when short term IR are low, yield curves are more/less likely to have which slope? and when they are high, yield curves more likely to have which slope? yield curves are almost always which slope?

1)together 2)more likely to have upward slop. when high, more likely to slope down and be inverted. 3)upward.

three theories explain term structure of IRs. show number 1 and 3 on graph.

1-expectations: straight yield line 3- liquiditiy premium/preferred habitat- upward sloping

"too big to fail"

Increased moral hazard problems for big financial institutions, whose failure would lead to major disruption > Regulators reluctant to let institution fail Government (implicitly) provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee. > Not only depositors, but also larger creditors have no incentive to monitor > Funding cost of banks do not reflect true risk

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a market bubble? Explain using the Gordon growth model.

A stock market bubble can occur if market participants either believe that dividends will have rapid growth or if they substantially lower the required return on their equity investments. > Both lower the denominator in the Gordon model and thereby cause stock prices to climb. By raising interest rates the central bank can cause the required rate of return on equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the expected growth rate of the economy and hence of dividends, thus keeping stock prices from climbing Challenge: Very difficult to identify bubble

what do you think are the main operational risks bank face today?

cyber risk and data security (threat from cyber attacks, data theft, losses, negative impact on reputation, actions from regulators). regulation (various new regulations following the financial crisis - fines due to non-compliance, restructuring of operations) outsourcing (FIs outsource activities - banks must ensure adequate controls and oversight (client data confidentiality or risk fines) other operational risks: geopolitical risk, conduct risk, organizational change, IT failure, anti money laundering, fraud, physical attack

maturity date. loan term

date the loan must be repaid. time elapsed from initiation to maturity date.

debt and equity markets

debt market: generally larger in total dollars due to greater number of participants. equity market: smaller bc only applicable participants are businesses

equity/debt markets are in general larger in total dollar than equity/debt markets, due to what?

debt markets > equity markets. due to greater number of participant classes (households, businesses, govt, foreigners) and size of individual participants ( businesses and govt)

example of types of security: nature of securities traded: form of organization: maturity of instruments: place where instruments issued:

debt markets, equity markets' primary/secondary markets exchanges/ OTC (secondary money market, capital markets domestic / international markets

a large part of the crisis was about what in the financial system

runs aka panics. Run before others run - first mover advantage > Incentive to be first to withdraw funds from troubled bank Runs on financial institutions > On commercial banks > Classic bank run by demand depositors > On investment banks > Clients (e.g. hedge funds) pull out funds from their prime brokers > Counterparties not rolling over short-term financing > On hedge funds > Prime broker requires higher margins > Redemptions by investors > On SIVs > Rollover stop by money market investors

first mover advantage

runs before other runs: incentive to be first to withdraw funds from troubled bank

credit score: at what point is it automatically approved and not approved

score>190 is auto approved. score <120 auto not approved.

adverse selection

screening before the transaction: try to avoid selecting the risky borrower by gathering info about them

securities previously issued are bought and sold. example. importance.

secondary market. ex: NYSE, AMEX, LSE, Borsa Italiana, Tokyo Stock Exchange, Euronext. importance: providing liquidity, setting prices. brokers match buyers and sellers. dealers link buyers and sellers by buying and selling securities at stated prices.

for US commercial banks, what are securities? loans? are these assets, liabilities, or capital? what are some liabilities?

securities:income earning assets. loans: primary source of profits. in europe, more interbank lending. different banks specialize in different types of loans. loans are an asset. liabilities: deposits, borrowings

three goals of asset management: four tools:

seek the highest possible returns on loans and securities. reduce risk. have adequate liquidity. find borrowers who will pay high IRs and have low possibility of defaulting. purchase securities with high returns and low risks. lower risk by diversifying. balance need for liquidity against increased returns from less liquid assets.

theory of rational expectations

expectations will be identical to optimal forecasts using all available info. Xe=Xof (expectation=optimal forecast). even though a rational expectation equals the optimal forecast using all available info, a prediction based on it may not always be perfectly accurate. people do not make the same mistake systematically. economic agents that don't act rationally will be pushed out of the market bc its costly.

three theories explain the three facts of term structure of interest rates: expectations theory, segmented markets theory, liquidity premium theory

expectations: explains first two facts but not third segmented: explains third but not first two liquidity premium: combines two theories to explain all three facts.

shifts in supply of bonds: expected profitability of investment opportunities. expected inflation. government budget.

expected profitability: in expansion, supply shift right. expected inflation: increased expected inflation shifts supply curve right. govt budget: increased budget deficits shift supply right.

t or f: recommendations from investment advisors can help us outperform the market.

false. these are called "hot tips". they are probably info already contained in the price of the stock. stock prices respond to announcements only when the info is new and unexpected. a "buy and hold" strategy is the most sensible strategy for the small investor.

define security and example

financial instrument. claim on issuers future income or assets. example: debt security (bond)

why do not all transactions directly in financial markets?

financial intermediaries better equipped to deal with asymmetric info problems (screening/monitoring), lower transaction costs (economies of scale), customization of specific needs, not available in markets, reduce the exposure of investors to risk (risk sharing / asset transformation , diversification)

institutions that borrow funds from people who have saved and in turn make loans to other people. example

financial intermediaries. example: banks. accept deposits and make loans.

what is a macro prudential policy?

financial stability of the system as a whole.

debt instruments have a finite/infinite life or maturity date

finite (short term is less than one year, long term is greater than or equal to one year)

Basel 1

focus: banking book (loans). cooke ratio: regulatory capital=8% x risk weighted assets (sum of assets). regulatory capital: core capital (common stock, RE), supplementary capital (long term debt, bonds)

eurocurrencies

foreign currencies deposited in banks outside the home country. eurodollars: USD deposited in banks outside the US

three types of mortgage backed securities (MBS)

from greatest to least risk and return: senior secured, mezzanine, unsecured (prime)

what makes up the value of a stock?

future cash flows (dividend payments and sales prices)

recession

global economic decline following financial crisis "great recession" unemployment rate in US reached 10% in october 2009.

goal of federal reserve

goal of max employment, stable prices, and moderate long term IRs

goal of SNB

goal of swiss national bank is to ensure price stability.

asset management: three goals and four tools

goals: seek highest possible returns on loans and securities. reduce risk. have adequate liquidity. tools: find borrowers who will pay high IRs and have low possibility of defaulting. purchase securities with high returns and low risk. lower risk by diversifying. balance need for liquidity against increased returns from less liquid assets.

on aggregate, the leverage built up within the shadow banking system increases/decreaes in good time and increases/deceraess in bad times

good times it increases. bad times it sharply decrease. Its (hidden) procyclicality amplifies the procyclicality of the traditional banking system

higher duration means greater/less bond price sensitivity to interest rate changes

greater

capital structure of banks

highly leveraged and have demand deposits as liabilities. public confidence matters. they have diffuse debt holders. they are large creditors. bank assets are opaque (bank risk taking can be unnoticed and fast changing). they are systematically important and benefit from the safety net (deposit insurance, LoLR, TBTF)

asset transformation and example: savings deposits provide the funds to make loans.

sell liability with one set of characteristics (liquidity, risk, size, return). buy assets with different set of characteristics. ex: entails maturity transformation. deposits can be withdrawn at short notice. loans are longer term. possible, bc normally not all depositors withdraw at the same time. banks hold reserves to allow for some deposit outflows.

remedy for these conflicts of interest

separate different functions (drawback: reduce economies of scale and scope) regulation (sarbanes oxley act, global legal settlement, rules of conduct of credit rating agencies.

Describe who issues each of the following money market instruments: e) interbank deposits

Interbank deposits are loans from one bank to another (mostly overnight) Unsecured OTC Used to balance liquidity needs to > allow for depositor withdrawals > trade with customers > satisfy reserve requirements Used to gauge conditions in financial markets > High interest rates in interbank market relative to treasury bills indicates market stress (high credit risk)

restrictions on competition

Justified as increased competition can also increase moral hazard incentives to take on more risk. Branching restrictions (eliminated in 1994) Glass-Steagall Act (repealed in 1999) > Rationale: avoid potential conflicts of interest > Commercial banks were prohibited from engaging in securities activities (investment banking & asset management) Disadvantages: Higher consumer charges (lack of competition) Decreased efficiency (no economies of scale and scope) Concentrated assets: banks can't diversify their income

money market funds september 2008

MMFs are important suppliers of liquidity for the banking system. reserve primary fund, one of the largest MMFs, breaks the buck (a share is worth less than $1 due to investments in lehmans commercial paper). investors don't consider MMFs as very low risk investments anymore causing a run of MMFs. (investors in MMFs always keep the right to redeem $1 per share. if assets of a MMF lose value to .95, but the fund promises to pay $1, there is an incentive to run).US treasury steps in and guarantees MMFs with $80 billion

gordon growth model

P0= D0(1+g)/(r-g) = D1 / r-g dividends are assumed to continue growing at a constant rate forever. the growth rate is assumed to be less than the required return on equity. used to determine intrinsic value of a stock based on a future series of dividends that grow at a constant rate in perpetuity.

one period stock valuation model: simple loan PV: coupon bond PV:

P0= Div1 / (1+Rr)^n + P1 / (1=Rr) (dividend + sales price) P0= CF / (1+i)^n = Coupon / (1+i)^n + F / (1+i)^n

one-period stock valuation model

P0=(Div1/(1+Ke)) + (P1 / (1+Ke)) Po=current price of the stock div1=div paid at end of year 1 Ke=required return on investment in equity P1=sale price of stock at end of first period

what is the YTM on a simple loan for 1 million that requires repayment of 2 million in five years time?

PV of 2 payment five years from now is 2/(1+i)^5 = 1 million. so, 1=2/(1+i)^5, so i=14.9%

present value and future value formulas

PV: FV/(1+i)^T FV: PV(1+i)^T

The household liquidity channel suggests that banks are more likely to lend to households when an easing of monetary policy drives house prices up

The household liquidity channel does not operate through the channel of bank lending, but is driven by household behavior If asset prices rise as a result of an easing of monetary policy, households financial asset holdings increase in value and the risk to fall into financial distress decreases As a result, households are more willing to consume durable goods and housing

The wealth channel of monetary policy suggests that - after a monetary policy easing - households will spend more on consumption because they can get cheaper consumer loans from banks.

The increase in consumption according to the wealth channel is not trigger by cheaper consumer loans According to the wealth channel, households will consume more due to additional wealth Increasing wealth caused by the monetary policy easing rises life time resources of households In order to smoothen consumption household will consume a share of their increase in wealth

SBS instruments are typically what? asset securitization:

highly liquid and short term, just like bank deposits. this can create modern bank runs. enables maturity and liquidity transformations pool loans with similar characteristics together, and sell to off-balance sheet subsidiary like SPV or SIV. These subsidiaries create securities which are backed by cash flows of the loan portfolio. securities are sold to investors. SPV:special purpose vehicle: when assets mature, the subsidiary ends. limited maturity. SIV: structured investment vehicle: when assets mature, they are replaced with new assets. unlimited maturity.

domestic currency is currency used in ______ country of investor. domestic currency is / is not necessarily equal to base currency in quotation standards.

home country of investor. not necessarily.

what does interest rate duration tell us

how the price of a bond or fixed-income instrument changes as interest rates change %change in Price = -DUR x (change in I / 1+i)

Shortfalls of bank capital led to slower credit growth:

huge losses for banks from their holdings of securities backed by residential mortgages. losses reduced bank capital Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending. Recent regulation requieres banks to hold more capital (e.g., countercyclical capital buffers)

how does a rise in IR affect bank, according to repricing gap?

if a bank has more rate-sensitive liabilities than assets, the company will reduce bank profit.

the law of one price:

if identical goods are produced/sold in two countries the price of these goods should be the same in both countries. no arbitrage condition, otherwise goods would only be produced/sold in 1 country. this holds if transportation costs and trade barriers are low.

liquidity risk management

importnat to understand risk of different funding sources. liquidity risk across different funding sources is related. hold prudential level of liquid assets. resilient funding structure accounting for accessibility.

worsened conditions

in 2008 credit conditions further worsened dramatically.banks continue to incur heavy losses on loan portfolios. washington mutual seized by authorities and sold to JPM. wachovia sold to wells fargo. bailouts in europe. coordinated central bank actions. additional govt actions.

brokers vs dealers

in a secondary market. brokers match buyers and sellers. dealers link buyers and sellers by buying and selling securities at stated prices.

how do interest rates affect exchange rates?

increase in domestic interest rate leads to an appreciation of the domestic currency. but increase in nominal interest rate may not be ceteris parabus. if nominal rate increase is due to expected inflation, it will lead to expected future depreciation (PPP)

determinants of asset demand

increase in wealth, increase in expected return relative to other assets, decrease in risk relative to other assets, incraese in liquidity relative to other assets

security

a financial instrument. a claim on the issuers future income or assets.

hyman minskys theory of financial instability

a narrative approach- P is the market value of an asset, pi is its fundamental value. a bubble emerges when the market price departs form the fundamental value (p/pi is persistently too high). the life cycle of a financial crisis gets through seven phases. stages: displacement, boom, euphoria, profit-talking, panic, depressed value, recovery

nominal anchor

a nominal variable, such as the IR or the money supply, which ties down the price level to achieve price stability

the taylor rule

a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central banks, to changes in inflation, output, or other economic conditions. uses real IR and inflation gap. nominal IR should increase more than the increase in inflation. and nominal IR should decrease more than the decrease in inflation.

off balance sheet activities

actives that don't go on the balance sheet: loan sales (secondary loan participation) generation of fee income (guarantees, credit lines) creating SIVs (structured investment vehicles) which can potentially expose banks to risk, as it happened in the global financial crisis

Think of an example where you had to deal with the adverse selection problem

adverse selection: undesired results occur when buyers and sellers have access to different/imperfect/asymmetric information. Buying insurance, purchasing services at lowest cost asymmetric info

how do exchange rates affect inflation?

aggregate demand effects: exchange rate appreciation reduces next exports. exchange rate depreciation increases net exports. shift in aggregate demand impacts on inflation. exchange rate pass through effect:exchange rat appreciation implies lower prices of imports. exchange rate depreciation implies higher prices of imports. a countries monetary policy can't be conducted without taking international considerations into account.

factors that shift demand curve for bonds

increase in wealth, shift right increase in expected IR, shift left . due to lower expected return for long-term bonds. increase in expected inflation, shift left increase in riskiness of bonds relative to other asset, shift left increase in liquidity of bonds, shift right

the net value of cash flows to the swap buyer increases/decreases when credit risk increases

increases hedge against losses due to on balance sheet credit losses

LIBOR-OIS

indicator for stress in interbank market

Over the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of _____________ and more concerned with maintaining a ______________________ as a goal of economic policy.

inflation. stable price level

credit analysis: residential mortgages

info: capacity (debt service ratio), conditions (job security, local real estate market), character (repayment behavior), capital (downpayment), collateral (house value). aggregation: credit scoring (discriminant model) implications of the credit analysis (credit limit, acceptance/rejection, limited impact on pricing)

compounding interest for multiple periods

interest is reinvested to earn interest on interest at given interval

the risk incurred by FI when the maturities (duration) of their assets and liabilities are mismatched. three types:

interest rate risk. 1)refinancing risk (refinance at higher IRs)-risk to net interest income. 2_reinvestment risk ( reinvest funds at lower IRs) 3)market value risk (PV of assets and liabilities)

yield to maturity

interest rate that equates the PV of cash flow payments received from a debt instrument with its value today. this is the best value of the interest rate.

central banks target what in the interbank market?

interest rates

interest rates and expected inflation correlation

interest rates and expected inflation tend to comove

in the short run, exchange rates are largely influenced by what? in the long run, exchange rate developments are influenced by what?

international investment flows- interest parity condition suggests that exchange rates adapt to changes in domestic/foreign IRs an expected future exchange rates. international trade- purch power theory suggests that exchange rates adapt to domestic/foreign price levels, chagnes in preferences for traded goods and productivity changes.

big mac index

invented by the Economist.. are currencies at their correct level according to PPP? compares prices of big macs worldwide. most big macs are over or undervalued.

price and YTM are related how? YTM is greater than the coupon rate when bond price is above or below par value?

inverse below

liabilities. assets. which uses of funds and which is sources of funds? what is capital?

liabilities are sources, assets are uses of funds. capital is owners equity.

regulation to precent excessive risk taking

limit moral hazard incentives prevent banks from taking excessive risks (restrictions on asset holdings, capital requirements, licensing and examination, assessment of risk management, disclosure requirements, consumer protection). restrictions on asset holdings: promote diversification, prohibit holdings of certain risky securities (imposing max loan to value ratios for mortgages)

this identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario specified by supervisors.

liquidity coverage ratio LCR stock of high quality liquid assets/ net cash outflows over a 30 day time period >= 100%

relationship between liquidity premium (preferred habitat) and expectations theory on graph

liquidity premium IR will slowly increase as YTM increases. expectations theory yield curve is flat horizontal as YTM increases

conventional monetary policy aims to influence what? unconventional monetary policy aim to what?

aims to influence short term IRs in the interbank market (open market ops, discount lending, required reserves, and the IR on reserves are tools used to influence money market rates). aims to ease monetary conditions in times when markets are frozen and/or IRs have hit the zero bound (liquidity to financial intermediaries, asset purchases to ease conditions in specific credit markets, negative IRs on reserves)

perpetuity bond

aka consol coupon bond. a bond with no maturity date that does not repay principal but pays fixed coupon payments forever.

loan principal

amount of funds the lender provides to the borrower

efficient-market hypothesis (EMH)

an asset's prices fully reflects all available info. it is impossible to "beat the market" bc stock market efficiency causes existing share prices to always incorporate and reflect all relevant info. stocks always trade at their fair value, so it is impossible to outperform the overall market through expert stock selection when stocks cannot be purchased at an undervalue or inflated price

a _____ is the price of domestic assets in terms of foreign assets.

an exchange rate.

sterilized interventions. the effect of the foreign exchange intervention on money supply is offset by what?

an open market operation if foreign assets are sold, domestic assets are bought. if foreign assets are bought, domestic assets are sold. no change in the money supply and domestic interest rates.

most economists today believe that there are / are not arbitrage opportunities in financial markets. is this a strong or weak EMH?

are not. Weak EMH. the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset

unconventional monetary policy. the central bank wants to ease monetary conditions in a financial crisis where: the central banks needs to use instruments which don't target short term money market IRs...

asset and credit markets have frozen up. nominal short term IRs hit the zero-bound / lower bound. they can't lower short term IRs much further. even if they could, changes in short term rates may not be transmitted to credit markets, investment, and spending.

how securitization works:

asset originator to issuing agent (like a SPV), to capital market investors (senior tranches, mezzanine tranches, junior tranche) transfer of assets from originator to the issuing vehicle. SPV issues debt securities (Asset backed) to investors.

how is banking conducted? how do banks earn the highest profits?

asset transformation

the returns to domestic and foreign assets should be identical if....

assets are identical in terms of liquidity and return risk.there are no restrictions on international capital flows.

main risks involved in banking

liquidity risk credit risk interest rate risk

what are the major risks involved with banking?

liquidity risk, interest rate risk, credit risk, capital adequacy management

relative ease with which an asset can be converted into cash

liquidity.

GSIB

list of systematically important banks

primary source of profits for banks?

loans

required reserves depend on what?

bank deposits volume

what is the most common source of external funds for non financial businesses?

bank loans

plays major role in changeling funds to borrowers with productive investment opportunities. important for the economy to run smoothly and efficiently.

banks

required reserves depend on a banks what? excess reserves mitigate what risk?

banks deposit volume: and therefor on the banks intermediation activities. mitigate liquidity risk- the opportunity cost of holding excess reserves is the interest rate a bank could earn by lending these funds to other banks.

appreciation of base currency:

base currency rises in value relative to quoted currency. get more foreign currency for 1 EUR depreciation: opposite

liquidity management and role of reserves. borrowing: securities sale: federal reserve: reduce loans:

cost incurred is the IR paid on the borrowed funds. no problem, as long as interbank market is liquid and other banks are willing to lend. alternative source of immediate liquidity: sell securities. the cost of selling securities is the brokerage and other transaction costs. need market liquidity- in crisis it may be difficult or costly to sell. borrowing from the fed also incurs interest payments based on the discount rate (more expensive than interbank market). stigma: bad signal to the market. reduction of loans is the most costly way of acquiring reserves. calling in loans antagonizes customers. other banks may only agree to purchase loans at a substantial discount.

money markets and capital markets

money market: maturity of security traded is less than one year. short term debt. ex: bills, notes, commercial paper. more widely traded, meaning also more liquid. capital market: maturity of securities traded is one year or greater. example: long term bonds, equity

migration analysis

monitor changes in external or internal credit ratings of pools of loans (rating class, industry/geographical area) cut lending to segments which are experiencing stronger than average rating declines

moral hazard

monitoring after transaction. ensure borrower will not engage in activities that will prevent them to repay loan

principal-agent problem.

moral hazard in equity contracts. separation of ownership and control of the firm principal: stockholder is owner but has less info. agent: manager makes decisions and has more info. managers may pursue personal benefits and power rather than the profitability of the firm.

what is an exchange rate? when a countries currency appreciates, the countries goods become less/more expensive to foreigners and foreign good in that country become less/more expensive to domestic economic agents.

more expensive to foreigners. foreign goods are less expensive. this can have a large impact on economy.

how independent is the ECB?

most independent in the world. members of exec board have long terms-8 years. determines own budget. less goal independent. charter can't be changed by legislation. prohibited from granting loans to national public sector entities. international trend toward greater independence but skeptics remain.

5 C's

capacity: ability to repay. profitability, liquidity. conditions: market conditions and firm-specific conditions. real-estate market, job security. character:willingness to repay. repayment behavior. credit history. FICO score. capital: leverage to repay. downpayment. leverage of the firm. collateral: market value of pledge able collateral. house value or other pledged assets.

buyers of debt instruments are suppliers or owners to a firm?

capital suppliers.

liquid asset management. liability management.

cash reserve management (regulatory requirements). buffer reserve management (banks hold securities portfolios to manage liquidity risk and interest rate risk). trade off between return and liquidity. managing withdrawal risk and access to liquidity sources. recent phenomenon due to rise of money center banks. expansion of overnight loan markets and new financial instruments (such as negotiable CDs). checkable deposits have decreased in importance as source of bank funds.

lack of short selling is caused by what and may be explained by what?

causing over priced stocks. explained by loss aversion.

open market operations

central bank buys or sells securities to affect the quantity of reserves and monetary base

a coupon bond has a maturity of 5 years and a duration of 4. how does the price of the bond change, if interest rates decrease from 6% to 3%?

change in price / price = -DUR x change in i / (1+i) price changes by -4 x (0.03-0.06)/1.03=11.7%. the bond price increases by 11.7%

long urn exchange rate developments will reflect:

changes in relative price levels btwn two countries (inflation), productivity, preferences for domestic v foreign goods, changes in trade barriers

costs of too low inflation

changes in relative prices can't be implemented without cutting the nominal price of some goods. downward rigidity of some nominal prices (Wages). misallocation of labor.

menu costs

cost to a firm resulting from changing its prices. Cost to a firm resulting from changing its prices > Firms have to change their prices more often > Misallocation of resources because it becomes difficult to assess relative prices (Firms change prices at different frequencies and price rise can be due to change in relative price or simply due to inflation)

banking industry trends before the crisis

credit boom. low interest rate environment. transformation of the banking system (traditional banking model became less profitable, from "originate and hold" to originate and distribute". rise in securitization: after origination loans of similar characteristics are pools. pool of loans are sold to an off balance sheet subsidiary (SPV or SIV). these create securities which are backed by the cash flows of the loan portfolio. securities sold to investors. shortening of the funding maturity structure (increasing maturity mismatch between assets and liabilities. (SIVs finance long term assets like mortgages with short term paper (ABCP). investment banks increasingly fund their balance sheets with short term repurchase agreements (repos), requiring them to roll over a large part of their funding on a daily basis.

risk rating agency definition and their criticism

credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves (standard and poors, moodys, fitch) Credit rating agencies do not downgrade companies promptly enough > CRSs have too close relationships with company management and ownership > The lowering of a credit score by a CRA can create a vicious cycle and self-fulfilling prophecy > Oligopolies > Made huge errors of judgment in rating structured products; severe consequences for funding, e.g. under Basel II an AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation

who provides info on default risk?

credit-rating agencies (moodys, standard and poors, fitch)

comparison with previous crises

crisis similar to previous crisis also during the panic phase. panic phase with strong deleveraging dynamic with amplification and spillover effects. panics in the banking system including runs on financial institutions. crisis followed an ordinary pattern. but there are also some unique features... global scale, runs on shadow banking system rather than classic bank runs, role of rating agencies in conjunction with new types of securities (MBs, CDOS), coordinated central bank reactions including unconventional tools

current yield formula for bonds. when is the current yield a good approximation of the YTM?

current yield = coupon payment / current price. current yield will be good approximation to YTM whenever the bond price is very close to par or when maturity of the bond is long (more than 10 yrs). this is bc cash flows farther in the future have such small present discounted values that the value of a long term coupon bond is close to a perpetuity with a same coupon rate.

network of dealers ready to buy and sell securities. example

over the counter OTC. used to be significantly less transparent than exchanges. nowadays, very competitive, linked by computers and prices of difft dealers are readily available. ex: foreign exchange market, where funds are converted from one currency to another

weaknesses of the repricing model

overaggregation. cash flows from off balance sheet positions. run offs of deposits or loans with prepayment options. ignores market value effects.

debt securities and example. advantage and disadvantage

claim on a future cash flow of a person/firm. agreement to pay money at a given time. example: bond (debt security that promises to make payments periodically for a specified period of time) advantage: debt instrument is a contractual promise to pay with legal rights to enforce repayment. disadvantage: return/profit is fixed or limited

what is a prevalent feature of debt contracts for both households and businesses?

collateral

to what extent does the accuracy of credit ratings depend on the inclusion of financial and non financial factors?

combined use leads to a significantly more accurate default prediction than the single use of financial or nonfinacial factors alone.

provide transactional, savings, and money market accounts and accepts time deposits

commercial banks

provide transactional, savings, and money market accounts and accepts time deposits

commercial banks More specifically: Processing of payments and issuing bank drafts and bank checks. Accepting money on term deposit Lending money by overdraft, installment loan, or other means. Providing documentary and standby letter of credit, guarantees, and other forms of off balance sheet exposures. Safekeeping of documents and other items. Sales, distribution or brokerage of insurance, unit trusts and similar financial products. Cash management and treasury.

various types of financial institutions:

commercial banks, brokers/dealers, insurance companies, mutual funds. all interconnected

represents a share of ownership in a corporation. finite or infinite life/maturity date. advantage and disadvantage

common stock, a type of equity. buyers of common stock are owners of the firm. no finite life or maturity date. advantage: potential high income since return isn't fixed or limited disadvantage: debt payments must be made before equity payments can be made.

Tier 1 Capital Ratio

compares a banks equity capital to its total risk-weighted assets RWA. signifies how well a bank can withstand financial distress before it becomes insolvent (unable to pay debts owed). RWAs are all assets held by bank that are weighted by credit risk. comparison btwn banking firms core equity capital and its total RWAs. grads firms capital adequacy as well-capitalized, adequately capitalized, undercapitalized, or critically undercapitalized. to be well capitalized according to basel 3, firm must have tier 1 capital ratio of 6% or greater and must not pay any dividends that would affect its capital. central banks develop weighting scale for different asset classes (cash and govt securities have zero risk, vs mortgage loan which carries more risk). so cash would receive weighting of 0% when calculating its risk-weighted assets while mortgage loans would be assigned maybe 50% weighting.

Big Mac Index

compares prices of Big Macs worldwide: burgers are undervalued and overvalued in some countries

signaling channel

consensus forecasts deviate strongly from actual real development.

gordon growth model 2 assumptions?

constant dividend growth. growth rate is smaller than required return.

gordon growth model key assumption? what happens when IRs increase and demand for the companies products decreases?

constant dividend growth. lower demand-> lower profits and lower dividends, so g decreases and P0 decreases. higher IRs> bonds more attractive, less demand for stocks, higher required return, Ke increases and P0 decreases

economies of scale

cost advantage that arises with increased output of a product.

yield curve. upward sloping, flat, inverted

plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations. upward sloping: long term rates are above short term rates. flat: short and long term rates are same. inverted: long term rates are below short term rates.

change in the supply of foreign vs domestic assets to the public. this may affect relative IRs.

portfolio balance effect

risk premium is always positive or negative?

positive- the probability of future negative events is larger than probability of positive events -> a positive risk premium must be paid

what is the current value of a share of stock?

price in the secondary market

goals of monetary policy

price stability. full employment, economic growth, stability of financial markets, IR stability, exchange rate stability

central banks have moved towards ______ as their main goal. however, central banks differ in their definition of __________________. this provides guidance on how a central bank should change the nominal interest rate in response to changes in inflation and real economic conditions.

price stability. relevant policy instruments, intermediate targets, monetary policy goals. the taylor rule.

what happens to prices of bonds when the interest rate changes

prices change. prices and returns for long term bonds change more than those for shorter term bonds. there is no interest-rate risk for any bond whose time to maturity matches the holding period

new security issues sold to initial buyers

primary market. increases the funds of the firm issuing them. not very well known to public as it is done through investment banks. investment banks underwrite securities: the IB guarantees a price for a corporations securities and then sells them to the public

goals of monetary policy: ECB

primary objective of European System of Central Banks is to maintain price stability. monetary policy: process by which the monetary authority of a country, like the central bank or currency board, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency

primary vs secondary market

primary: new security issues sold to initial borrowers. done through investment banks- they underwrite securities. IB guarantees a price for a corporations securities and then sells them to the public secondary: securities previously issued are bought and sold. NYSE. importance: provides liquidity and sets prices. brokers match buyers and sellers. dealers link buyers and sellers by buying and selling securities at stated prices.

open market operations

refers to buying and selling govt securities in the open market in order to expand/contract the amount of money in the banning system, facilitated by the fed reserve. selling and buying govt securities sets the money supply. to increase the money supply, it will buy securities.

defensive operations

repurchase agreement REPO with banks with eligible collateral. short term secured loan. auction system (price=money market interest rte is endogenous)

repo

repurchase agreement- repossess an item when a buyer defaults on payments. short term borrowing for dealers in govt securities.for the party selling the security, and agreeing to repurchase it in the future, it is a repo.

banks hold what type of reserves? the central bank supplies reserves through what two things?

required reserves and demand excess reserves. open market operations and lending to banks.

regulation of the financial system. how to ensure the soundness of financial intermediaries:

restrictions on entry (chartering process). disclosure of info. restrictions on assets and activities (control holding of risky assets) deposit insureance (Avoid bank runs)

types of liabilities

retail funding: demand deposits / checking accounts. savings accounts. term deposits. wholesale funding: medium term notes. wholesale certificates of deposits. commercial paper. unsecured interbank funds. secured interbank funds (repos). bonds.

if a bank has more rate-sensitive liabilities than assets, a rise in IRs will reduce/increase bank profits and a decline in IRs will reduce/increase bank profits.

rise-reduce. decline-raise

liquidity risk. liability side and asset side.

risk that a drain of liquidity will impose economic loss on the bank. liability side liquidity risk: withdrawal of customer deposit.s withdrawal of wholesale funds (lenders stop rolling over funding in interbank market). customer deposits play a crucial role. banks need to model the share of core deposits. stable source of funding and depends on contract type and customer structure. asset side: draw down of loan commitments. change in value of (liquid) assets. change in liquidity of status of assets.

repricing gap

risk-sensitive assets - risk-sensitive liabilities

how the market sets stock prices: who set the price?

set by the buyer willing to pay the highest price. buyer who can take best advantage of the asset. in valuation model: required return will be lower. the lower the discount rate, the higher the stock price an investor is willing to pay. superior info about an asset can increase its value by reducing its perceived risk. info is important for individuals to value each asset. when new info is released about a firm, expectations and prices change. market participants constantly receive info and revise their expectations, so stock prices change frequently.

why did "small" mortgage losses in the US cause a global financial crisis with significant effects on the real economy?

several hundred billion mortgage losses. loss of US stock market wealth was 8 trillion. amplifying mechanisms needed.

"Credit intermediation involving entities and activities outside the regular banking system are regulators concerned about this system?. does it have any risk?

shadow banking- increased importance of entities and activities structured outside the regular banking system that perform bank-like functions yes- size, systematic risk, regulatory arbitrage, interconnection, complexity, opaqueness, pro-cyclicality systematic risk- funds can be raised from suppliers (households, corporates, financial institutions) through short term or callable deposit like liabilities. these funds are then transformed into assets such as mortgages, loans, and other longer term or less liquid assets. typically includes build up of leverage.

major disruptions in financial markets that are characters by ______ in asset prices and the failures of many financial/nonfinancial firms

sharp declines in asset prices. financial crises,

response to an increase in the domestic interest rate shifts supply/demand left/right

shifts demand right, leading to a rise in the exchange rate.

response to an increase in the expected future exchange rate shifts demand/supply left/right

shifts demand right, leading to rise in current exchange rate

a purchase of dollars decreases the monetary base and the money supply, raising domestic interest rates and shifting sypply/demand curve left/right

shifts demand right. leading to a rise in the exchange rate.

lowering the discount rate shifts the supply/demand curve right/left. and does this raise or lower the federal funds rate?

shifts supply curve down (horizontal line). this doe snot lower the fed funds rate.

cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation, such as holding less cash, editing the menu card of an restaurant and having to make additional trips to the bank

shoe leather costs

preferred habitat theory says that investors are likely to prefer long/short term bonds over longer/shorter term bonds

short over long term. Investors have a preference for bonds of one maturity over another. They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return.

conventional monetary policy aims to influence what, using what?

short term IRs in interbank market, using open market operations, discount lending, required reserves, and IR on reserves

instruments in SBS shadow banking are typically what?

short term and highly liquid, but the risk profile investors is usually different (no deposit insurance, not explicit official sector backstop, not subject to the same prudential standards and supervision).

why should price stability be the primary long-run goal

short term deviations form price stability possible under dual mandate. but expansionary policy may have long term effects on inflation. (time inconsistency problem). central bankers favor hierarchical mandate.

today, most central banks define what as their policy target?

short term interest rates

interventions signal what central banks wants to happen to future exchange rate

signaling effect

four types of credit market instruments

simple loan, fixed payment loan, coupon bond, discount bond

four types of credit market instruments:

simple loan: lender provides funds to borrower that must be repaid at maturity along with addtnl interest pmts. ex: commercial loans to businesses. fixed payment loan: lender provides funds to borrower that must be repaid by making the same payment every period, consisting of part of the principle and interest. ex: consumer loans, mortgages. coupon bond: pays owner fixed interest payment (coupon) every year until maturity, when final amount aka FV is repaid. perpetuity coupon bonds: no maturity date. ex: corporate bonds discount bond: lender provides funds to borrower that must be repaid at maturity along with addtnl pmt for the interest.

foreign bonds

sold in a foreign country and denominated in that countries currency. ex: ABN AMARO sells bond in the US denominated in USD.

evidence of credit crunch

some savings banks are affected by subprime crisis directly through holdings in landesbanken with large exposure to subprime crisis. other savings banks are not affected. data set includes loan applications, internal credit ratings, and loans approved. test S and D effects for affected and non affected banks. affected banks accepted less loan applications. main results: affected banks reduce lending relative to non affective banks after 2007. demand for credits remains similar. this supports the hypothesis that the reduction in lending is due to suppy side. true for both consumer loans and mortgage loans.

off-balance sheet subsidiary with limited maturity

special purpose vehicles (SPV) bank sells loans to SPV (bank receives cash). SPV creates asset backed securities (ABS) -sells to investors, underlying assets belong to investors, all cash flows from loans are passed through to investors. SPV ceases to exist when underlying assets mature.

spot vs forward transactions in exchange markets

spot exchange transaction: immediate exchange of cash/bank deposits denominated in different currencies. forward exchange transaction: agreement to exchange bank deposits of different currencies at a specified future date. typically conducted to hedge exchange rate risk.

spot exchange transaction vs forward exchange transaction

spot: immediate exchange of cash / bank deposits denominated in different currencies. forward: agreement to exchange bank deposits of different currencies at a specified future date. typically conducted to hedge exchange rate risk.

default risk premium

spread btwn interest rates on bonds with default risk and the interest rates on same maturity treasury bonds.

three stages of financial crisis

stage 1: credit boom and bust: mismanagement of financial liberalization/innovation leading to asset price boom and bust. increase in uncertainty. deterioration in financial institutions balance sheets. adverse selection and moral hazard problems worsen. stage 2: banking crisis- economic activity declines, stage 3: debt deflation- unanticipated decline in price level.

big 3 risk rating agencies. criticism?

standard&poor. moody. fitch. criticism: they don't downgrade companies promomtly enough, too close relationships with company management and ownership. Lowering of a credit score creates a vicious cycle and self-fulfilling prophecy.

real effects of the financial crisis

stock market declined rapidly during crisis. (loss of US stock market wealth between october 2007-oct 2008 was 8 trillion. effects on real sector of the economy were global in nature. financial crisis led to widespread loss of confidence and concerns about solvency and liquidity to counter parties. reduction in demand for loans. banks started to hoard cash and stop lending. reduction in lending is mostly a supply effect.

off-balance sheet subsidiary with unlimited maturity

structured investment vehicles (SIV) Bank sells loans to SIV > bank receives cash SIV issues asset-backed bonds / commercial paper > sells bonds to investors > investors receive payments on bonds > underlying assets belong to SIV Maturing assets are replaced by others

impact of reduced loan supply- what effect did the reduced bank loan supply have on the activities of none-financial firms?

study in 39 countries asking about the cost and availability of credit and the effects on the firms decisions and actions. authors group firms in constrained and unconstrained and compare behavior during crisis. reduction in credit supply had significant impacts on credit-constrained firms.

liquidity spirals

sudden evaporation of liquidity through interaction of funding liquidity and market liquidity. funding liquidity: ease with which expert investors and arbitrageurs (dealers, hedge funds, investment banks) can obtain funding from financiers market liquidity: A market is liquid if a trader can sell an asset quickly, at low cost, without affecting the price > If market liquidity is low it is difficult to raise money by selling an asset (instead of borrowing against it)

an open market purchase shifts supply/demand curve right/left and this causes the federal funds rate to rise/fall.

supply curve right. causing fed funds rate to fall. but the fed funds rate can't fall below the interest rate paid on reserves.

an open market purchase shifts supply/demand curve left/right. this causes the federal funds rate to fall/rise.

supply right. fall. but federal funds rate cannot fall below the IR paid on reserves.

monetary targeting

target growth rate of money in the economy. used by a number of countries in the 1970s. advantages: monetary aggregates react quickly to monetary policy, immediate signal to the market about monetary policy stance, inflation expectations are updated quickly. disadvantage: unreliable relation between monetary aggregates and price stability.

how does the central bank achieve its goals?

tools of central bank (open market operations, discount policy, reserve requirements, interest on reserves, forward guidance) -> policy instruments (reserve aggregates, interest rates) -> intermediate targets (monetary aggregates, interest rates) -> goals (price stability, high employment, economic growth, financial market stability, IR stability, for exchange market stability)

bank balance sheet. total assets=

total liabilities + capital

sources of foreign exchange transactions: international trade. international investment.

trade: converting export revenues earned in foreign currency to domestic currency. buying foreign currency to pay for imports. investment: buying foreign currency to pay for foreign denominated assets. converting proceeds from sale of foreign assets to domestic currency in order to buy domestic assets.

strategy of the ECB

two pillar approach: organizing evaluating and cross-checking the info relevant for assessing the risks to price stability is based on two analytical perspectives, referred to as the two pillars: economic analysis and monetary analysis. they form the basis for the governing councils overall assessment of the risks to price stability and its monetary policy decisions.

examples direct finance

usually done by borrowers that sell securities and/or shares to raise money and circumvent the high interest rate of financial intermediary(banks

generalized dividend valuation model

value of stock today is PV of all future cash flows. P0= (D1/(1+Ke)^1) + (D2/(1+ke)^2) + .... + Dn / (1+Ke)^n) + Pn / (1+Ke)^n). the price of the stock is determined only by the PV of the future dividend stream. problem: we don't know future dividend stream with certainty (need to build expectations)

supply of non borrowed reserves: open market operations volume? changing the amount of reserves supplied affects what?

volume of open market ops is fixed by the central bank. affects IRs.

cost of unstable inflation

wealth and distribution: unexpected inflation compromises the storage function of money (hedging cost). inflation reallocates wealth from creditors to debtors (fixed rate mortgages, fixed income securities (bonds)). inflation redistributes wealth from households with financial assets to those with real assets (value of real assets (houses) increases relative to financial assets (cash).

determinants of asset demand: wealth, expected return, risk, liquidity. increase of these and their shifts in demand for bonds left or right?

wealth: total resources owned by the individual, including all assets.. ^wealth= shift in demand right expected return: return expected over the next period on one asset relative to alternative assets. higher expected IR in future lower expected return for long term bonds, so shifts left. risk: degree of uncertainty associated with the return on one asset relative to alternative assets. increase in riskiness causes shift left. liquidity: ease and speed with which an asset can be turned into cash relative to alternative assets. increase = demand shift right.

credit analysis varies strongly by loan type

what info is collected (assessing the "capacity" and "conditions" for a mortgage requires different info than for a business loan. how the info is aggregated (qualitative (Expert) models, quantitative (Credit scoring) models, hybrid models: quantitative and qualitative) implications of the analysis (Acceptance/rejection, pricing of loans, credit limit)

if mortgage rates rise fro 5% to 10% and the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

what matters for the decision is the real cost of financing the house. people are more likely to buy houses bc the real IR when purchasing a house has fallen from 3% (5-2) to 1% (10-9). the real cost of financing the house this us lower, even though nominal mortgage rates have risen.

wholesale deposits vs retail deposits

wholesale:Wholesale funding is a "catch-all" term, but mainly refers to: federal funds, foreign deposits and brokered deposits. Some also include borrowings in the public debt market retail: a sum of money held in a bank on behalf of an individual

rate sensitivity

will an asset or liability be repriced within a specific time frame? basic gap analysis (rate sensitive vs fixed rate) maturity bucket approach (specific time frames of days)

are the show banking system and regular banking system connected?

yes, highly interconnected. Banks > are frequently part of the shadow banking chain > provide (explicit or implicit) support to the shadow banking entities to enable maturity/liquidity transformation (and thus facilitating shadow banking activities) > invest in financial products issued by shadow banking entities alongside other suppliers of funds > and SBS are also often exposed to common concentrations of risks

if interest rates decline, would you rather be holding long-term or short-term bonds? which type of bond has the greater interest-rate risk?

you'd rather be holding long term bonds bc their price would increase more than the price of the short term bonds, giving them a higher return. longer-term bonds are most susceptible to higher price fluctuations than shorter-term bonds, and hence have greater interest-rate risk. note: interest rates of newly issued bonds fluctuate stronger for short term bonds compared with long term bonds.

what is the best strategy for a small investor?

"buy and hold"

basic financial instruments:

debt securities

continuous compounding

interest is continuously compounding

rate of return

payments to the owner plus the change in value expressed as a fraction of the purchase price.

explain subprime mortgage crisis

2007: massive downgrades of mortgage-backed securities by rating agencies

curren assets=

=cash + AR + inventories

market liquidity

A market is liquid if a trader can sell an asset quickly, at low cost, without affecting the price > If market liquidity is low it is difficult to raise money by selling an asset (instead of borrowing against it)

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a market bubble? Explain using the Gordon growth model

A stock market bubble can occur if market participants either believe that dividends will have rapid growth or if they substantially lower the required return on their equity investments. > Both lower the denominator in the Gordon model and thereby cause stock prices to climb. By raising interest rates the central bank can cause the required rate of return on equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the expected growth rate of the economy and hence of dividends, thus keeping stock prices from climbing Challenge: Very difficult to identify bubble

what is asset securitization?

After origination loans of similar characteristics are pooled Pool of loans are sold to an off-balance sheet subsidiary Off-balance sheet subsidiary creates securities which are backed by the cash flows of the loan portfolio Securities are sold to investors

in the aftermath of the global economic crisis that started in 2008, US govt budget deficit increased dramatically, yet IRs on US treasury debt fell sharply and stayed low for quite some time. does this make sense?

All else equal, a larger deficit implies that interest rates should rise. The large federal deficits require the Treasury to issue more bonds; thus the supply of bonds increases. The supply curve shifts to the right and the equilibrium interest rate rises. The effects of the economic crisis lead to significantly lower wealth and income, which depressed Treasury bond demand, but also decreased corporate bond supply by even more because investment opportunities collapsed. > The larger leftward shift in the bond supply curve than the rightward shift in the bond demand curve would then result in a rise in bond prices and a fall in interest rates. In addition, due to the severity of the global crisis, U.S. Treasury debt became a safe haven investment, reducing relative risk and increasing liquidity for U.S. treasury debt. This significantly raised U.S. treasury bond demand, leading to higher bond prices and significantly lower yields. In other words, the decrease in investment opportunities and risk factors significantly offset the wealth effect on demand and the deficit effect on supply.

OTC derivative

Approximately 90% of derivatives contracts are transacted over-the-counter (OTC), i.e., transacted directly between two contracting parties without the interposing of an exchange or other intermediary According to BIS (2015), at the end of June 2015, the notional amount of the over-the-counter derivatives market was USD 533 trillion, i.e., around 7 times the world GDP! Exposes traders to counterparty risk Financial system more interconnected All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse."

reserves

Bank reserves are a commercial banks' holdings of deposits in accounts with a central bank (for instance the European Central Bank or the applicable branch bank of the Federal Reserve System, in the latter case including federal funds), plus currency that is physically held in the bank's vault ("vault cash")

basel 2 shortcomings

Basel II > Attempt to deal with many risks modern banks face Quite complex; lost much of the intuitive, common-sense appeal of Basel I Still silent about key issues, e.g., threshold and form of supervisory intervention > May not focus adequately on what regulators should do when banks do not comply with capital requirements Liquidity risk? Concerns that capital requirements under Basel II are likely to be procyclical

if bonds demanded > bonds supplied, there is excess of which, and price and IR will fall or rise?

Bd>Bs= excess demand. so price will rise and IR will fall

major modern banks- financial industry before the 90s vs now

Before the 90's, the financial industry was pretty regulated. Most regular banks were local businesses and prohibited from speculating with depositors' savings. Investment banks were relatively small private partnerships. In this traditional model, the partners put up the money and thus had the incentive to watch that money very carefully. Then, consolidation and investment banks went public, i.e., quoted at the main stock exchanges. Banks were then able to raise money from the public as new stockholders' capital. Separation between management and ownership: Managers are not the earlier partners anymore who stay in the bank for their entire life. ... and global!

macroprudential vs microprudential supervision

Before the global financial crisis, the regulatory authorities engaged in microprudential supervision, which is focused on the safety and soundness of individual financial institutions. The global financial crisis has made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate.

Describe who issues each of the following money market instruments: b) Certificates of deposit

Certificates of deposit (CDs) are issued (supplied) by banks and sold to depositors bank pays annual interest of given amount and at maturity pays back to the depositor the original purchase price plus the total annual interest earned. Often negotiable, meaning they can be traded, can be resold in a secondary market liquidity Covered by deposit insurance Fixed termtypically pays higher rate than savings accounts

financial supervision: chartering, examinations, disclosure requirements

Chartering (screening of proposals to open new fin. institutions) > Prevent adverse selection that risk-loving individuals want to create highly speculative businesses Examinations (scheduled and unscheduled) > Monitor capital requirements and restrictions on asset holding > Capital adequacy > Asset quality > Management > Earnings > Liquidity > Sensitivity to market risk Disclosure requirements > Requirements to adhere to standard accounting principles and to disclose wide range of information

consumer protection

Consumers may not have enough information to protect themselves (e.g., from bad borrowing decisions) Regulation to provide standardized and clear information (e.g., annual percentage rate and total charges for loans) Laws to protect customers from ill-advised investments

t or f: According to the bank lending channel an easing of monetary policy is more likely to affect investment by small firms than that of large corporates.

Correct. Small firms are more dependent on bank financing because they are not able to obtain market financing Hence, according to the bank lending channel they are more affected by an easing of monetary policy compared to larger firms

If banks have perfect access to capital market funding, then the bank lending channel should be weak

Correct. The bank-lending channel suggests that interest rate conditions affect the access of banks to loanable funds, especially to bank deposits. If banks have perfect access to capital market funding, they should be able to replace any decrease in customer deposits (on non-interest bearing or low interest bearing accounts) when interest rates rise.

cycles in regulation

Crisis leads to more regulation > Bankers, politicians, regulators strongly aware of potential risks/problems > Financial industry has less funds/power for lobbying Periods without crises > People forget about potential issues > Lobbying for relaxed regulation > "This-time-it's-different" mentality

relationship between ROA and ROE

expressed by the equity multiplier: amount of assets per dollar of equity capital. EM= assets / equity capital EM=leverage!

research question: did securitization diminish the incentives of banks to screen borrowers in the US mortgage market?

Data: > more than 1 mio. securitized sub-prime mortgages 2001-2006 > Loan amount, duration, Loan-to-Value ratio (LTV) > Credit score (FICO) of borrower, documentation Exploit the "rule of thumb" that loans with a FICO score of below 620 are less likely to be securitized → compare performance of loans just above 620 with those just below!

Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in the United States. Explain why this might create more problems than solutions in the financial system of a developing country.

Developed and developing countries have quite different financial systems. Usually not a good idea to "copy and paste" regulatory frameworks that ensure the soundness of a financial system from one country to the other Deposit insurance needs to be credible Incorporating a system of deposit insurance will likely result in an increase in deposits at financial intermediaries. > However, without proper regulations (i.e., prudential regulation and supervision) to limit the moral hazard problems associated with a system of deposit insurance, banks will probably accept more risks than they would otherwise do. This is obviously not a desired consequence. > The increase in moral hazard problems will probably offset the benefit derived from avoiding bank runs (the most immediate effect of a system of deposit insurance).

precautionary hoarding

Due to runs on shadow banking system > Off-balance sheet vehicles (SPVs/SIVs) likely to draw on credit lines from sponsoring banks > Banks' uncertainty about funding need and supply skyrocketed > Also: uncertainty about funding situation of other banks Precautionary hoarding of liquidity > Breakdown of unsecured interbank market > Higher haircuts in U.S. secured interbank market > Larger use of repos with safe collateral in Europe rather than unsecured loans

EUR/USD exchange rate: currency pair: EUR/USD appreciation of base currency: E^

E(USD/EUR)= #USD/1EUR first currency in pair is called base currency (EUR) second currency is called quote currency (USD) base currency rises in value relative to quoted currency. get more foreign currency for 1 EUR

is there more interbank lending in Europe or America?

Europe

assessment of risk management

Evaluating soundness of management processes for controlling risk Trading Activities Manual of 1994 for risk management rating based on: > Quality of oversight provided > Adequacy of policies and limits for all risky activities > Quality of the risk measurement and monitoring systems > Adequacy of internal controls Example: Interest-rate risk limits: > Internal policies and procedures > Internal management and monitoring

hedging credit risk with swaps

Exchange regular payments with another financial intermediary The net value of cash-flows to the swap buyer increases when credit risk increases > hedge against losses due to on-balance sheet credit losses Total return swap > outgoing payments by the swap buyer fall when credit risk increases Pure credit swap (Credit default swap) > incoming payments to swap buyer rise when credit event happens

pass-through mortgage backed securities in the US

FHA / GNMA (Ginnie Mae) / FHA > FHA provides credit risk insurance on 'standardized' mortgages > banks securitize FHA conform mortgages > GNMA sponsors (guarantees payment on) mortgage backed securities FNMA (Fannie Mae) > buys and securitizes mortgages > < 80% LTV, Loan limit > (Goverment supported SPV) FHLMC (Freddie Mac) > Fannie Mae for savings institutions

How does risk sharing benefit both financial intermediaries and private investors?

Financial intermediaries benefit by carrying risk at relatively low transaction costs. Since higher risk assets on average earn a higher return, financial intermediaries can earn a profit on a diversified portfolio of risky assets. Individual investors benefit by earning returns on a pooled collection of assets issued by financial intermediaries at lower risk. The financial intermediary lowers risk to individual investors through the pooling of assets Risk sharing benefits financial intermediaries because they are able to earn a spread between the returns they earn on risky assets and they returns they pay on the less-risky assets they sell. Investors benefit because they are able to invest in a better diversified portfolio then would otherwise be available.

stress-tests

Forward looking analysis > Stress tests assess the vulnerability of the financial system by examining its behavior under counterfactual conditions (scenarios) Important role in systemic risk monitoring > Codified in new regulation and international standards such as Basel III Regulators ask individual firms to estimate what would happen to them in a given scenario > Scenarios consist of various variables such as changes in GDP, stock prices, interest rates, etc. > Banks estimate what would happen to their balance sheet in each scenario. Success of stress-tests depends on the chosen scenarios Types of scenarios > Drawn from historical crisis periods (e.g. a stock price decline as on Black Monday, October 19, 1987) > Hypothesized based on expert opinion or statistical techniques Scenarios should be > Plausible > Severe > Suggestive of risk-reducing action Frequently: Tension between plausibility and severity > Outlandish scenarios have the most painful ramifications > Goal: choose severe, but plausible scenarios

Go to the St. Louis Federal Reserve FRED database and find data on the three-month treasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate (CPN3M), the 30-year treasury bond rate (GS30), the 30-year conventional mortgage rate (MORTGAGE30US), and the NBER recession indicators (USREC). a) b) c) d) In general, how do these interest rates behave during recessions and during expansionary periods? In general, how do the three-month rates compare to the 30-year rates? How do the treasury rates compare to the respective commercial paper and mortgage rates? For the most recent available month of data, take the average of each of the three-month rates and compare it to the average of the three-month rates from January 2000. How do the averages compare? For the most recent available month of data, take the average of each of the 30-year rates and compare it to the average of the 30-year rates from January 2000. How do the averages compare?

Generally speaking, the interest rates fall during recessions (shaded periods), and rise during expansionary periods. Term structure tends to be upward sloping>30-year rates > 3 month rates. Treasury rates lower than CP/mortgage rates>Risk premium is positive.

capital requirements

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions There are two forms: 1. Based on the leverage ratio (capital /total assets) > a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. 2. Risk-based capital requirements > Basel Accords > Amount of capital requirements depends on risk Prompt corrective actions necessary if capital too low. Capital (for each euro of risk hold at least X cents of capital) Beneficial for at least two reasons: 1. ex ante: bankers have less of an incentive to engage in "excessive" risk taking, so that actual risk taking is more in line with what is in the interest of all stakeholders (skin in the game effect) 2. ex post: banks have additional liquidity reserves, which mitigates insolvency and bank failure risk (buffer effect)

government-sponsored enterprises

Here we focus on GSEs that facilitated home ownership in the U.S., i.e., Fannie Mae and Freddie Mac > Private-sector companies, publicly traded, profit-making companies with implicit government backing and a public mission to support the mortgage market > Bought U.S. mortgages and securitized a large fraction in the form of MBS, financed by selling "agency debt" > Highly leveraged: owning and guaranteeing $5.3 trillion of mortgages with capital of less than 2%. • But you can include any institution that enjoys government support and guarantees • Risk mispricing

risk involved in global investment banking

High leverage > A small drop in asset value leads to a larger drop in capital Maturity imbalance > Long-term assets financed by short-term liabilities Liquidity imbalance > Illiquid assets financed by rolling-over short-term (liquid) funding Risk imbalance > Example: Duration mismatch between assets and liabilities Currency imbalance > Example: USD loans funded with EUR deposits

various new regulations following 2007-2009 financial crisis

Higher and stricter capital requirements Maximum leverage ratio Liquidity regulation Additional regulation for large, systemically important banks Living wills: orderly liquidation of failed banks Restrictions on trading activity Central clearing of derivatives Stronger consumer protection New agencies to strengthen supervision and oversight

invest banks _____ securities:

IB underwrites securities: they guarantee a price for a corps securities and then sells them to the public

adverse selection with... IPOs, issuing bonds, securities trading

IPOs: companies want to issue shares, investor do not know quality. same structure as market for used cars. issuing bonds: IR reflects probability of default (PD). manager know PD of firm, investors don't. same structure as market for used cars. securities trading: buyer values the security less than the seller: seller doesn't sell at P. buyer values the security more than seller: seller sells at P, but security might be worth less if sellers knows more.

expectations theory. ex: current rate of 1 year bond is 6%. you expect IR to be 8% next year. the the expected return buying 2 one year bonds averages what percentage? IR on a two-year bond must be ____% for you to be willing to purchase it.

IR on a long term bond will equal an average of the short term IR's that people expect to occur over the life of the long-term bond. buyers of bonds don't prefer bonds of one maturity over another, they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. bond holders consider bonds with different maturities to be perfect substitutes. 6+8/2=7%. 7%

changes in value of a security formula

IR risk: percent change in P = -DUR x (change in i / (1+i))

hedging IR risk

IR swaps: exhange interest payments. buying a swap turns variable rate liabilities into fixed rate liabilities to match fixed rate assets. increases duration of liabilities. example: savings banks, small commercial banks (variable rate liabilities: deposits, fixed rate assets (mortgages)

ETFs (passive investments in stock indices) have grown strongly in recent years. Explain how this growth may be related to the efficient market hypothesis?

If investors believe in EFH, it is optimal to passively invest in market index rather than pick stocks Only very few mutual funds outperform the market and a significant share actually underperforms after cost better to invest in market using ETFs Potential issue: > If everybody just invests in market will markets become less efficient? > Stock picking investors help to eliminate over/underpricing

assuming the expectations theory is correct for term structure, calculate the IRs in the term structure for maturities of 1 to 5 years, and plot the resulting yield curves for the following paths of 1 year interest rates over the next 5 years a) 5%,6%,7,6,5 b)5,4,3,4,5 how would your yield curves change if people preferred shorter term bonds over longer term bonds?

If people preferred shorter-term bonds over longer-term bonds , the upward- and then downward-sloping yield curve in (a) would tend to be even more upward sloping because long-term bonds would then have a positive risk premium. The downward- and then upward-sloping yield curve in (b) also would tend to be more upward sloping because of the positive risk premium for long-term bonds

What could GBI do to immunize the bank against interest rate risk?

Immunization requires the bank to have a leverage adjusted duration gap of 0 > GBI could reduce the duration of its assets to 0.5 (=0.55 x 200/220) by using more fed funds and floating rate loans > Or GBI could use a combination of reducing asset duration and increasing liability duration in such a manner that DGAP is 0.

agency theory example.

analyses how asymmetric info problems affect economic behavior. conflicts btwn people with different interest in the same assets. ex: shareholders and managers of companies.

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

Investors in financial instruments who engage in information collection face a free-rider problem > Other investors may be able to benefit from their information without paying for it. > Individual investors therefore have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. > Able to reap all the benefits from the information they collect, their information collection activities will be more profitable. > Greater incentive to invest in information collection

If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation?

It can raise $1 million of capital by issuing new stock. 2. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. 3. It can deleverage, i.e., decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements

basel 3

Key issues in need of reform after financial crisis Too high leverage No liquidity framework Poor risk management Interconnectedness Too big to fail Too low quality and quantity of capital Tougher conditions for capital and asset classification > Tier 1 capital >= 6% × risk weighted assets Leverage ratio > Tier 1 capital / bank's assets (on and off BS) >= 3% Liquidity buffers > Liquidity Coverage Ratio (LCR): > Require banks to have sufficient high-quality assets to withstand 30-day stressed funding scenario specified by supervisors > Net Stable Funding Ratio (NSFR) > Longer-term structural ratio designed to address liquidity mismatches > Incentivize banks to use stable funding Mitigate procyclicality of Basel II / reduce systemic risk > Capital Conservation Buffer (CCB) > GSIB (global systemically important banks) charge Systemically important banks need special regulation > Indicators of systemic importance: cross-countries activity, size, interconnectedness, complexity > 28 global systemically important banks (BIS) > Additional elements: recovery and resolution plans, higher capital requirements, more intense supervision Domestic systemically important banks Bail-in capital

financial consolidation and govt safety net

Larger and more complex financial organizations challenge regulation: > Increased "too big to fail" problem > Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the global financial crisis Example: banks suffering losses due guarantees provided for SIVs

trade off between safety and returns to equity holders:

More capital benefits the owners of a bank by making their investment safe More capital is costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy and levels of confidence Banks are required to hold capital

coupon bond and example

pays the owner a fixed-interest payment (coupon) every year until maturity, when the final amount (par/face value) is repaid/ example: corporate bonds

Can you think of any financial innovation in the past ten years that has affected you personally? Has it made you better off or worse off? Why?

Online/mobile banking; PayPal; ETFs; Bitcoins; Robo-advisors. generally, financial innovations since 1960s generally viewed as more positive than negative (ATMs, credit cards, money market funds, ETFs, TIPS)

issues with altman discriminant model?

Only discriminates between 'good' and 'bad' borrowers Relative importance of firm characteristics for predicting default may vary over time > weights are unlikely to be stable over time Ignores 'soft' information on credit relationship, business outlook, industry outlook Back-testing the model is difficult > data on corporate loan performance

gordon growth model

P0= D0(1+g)/(Ke-g) = D1/(Ke-g) D0=most recent dividend paid g=expected constant growth rate in dividends Ke=required return on an investment in equity dividends are assumed to continue growing at a constant rate forever. the growth rate is assumed to be less than the required return on equity. used to determine intrinsic value of a stock based on a future series of dividends that grow at a constant rate in perpetuity.

expected return equation

Re= (Pe(t+1) - Pt +C) / Pt. at the beginning of the period, we know Pt and C. P(t+1) is unknown and we must form an expectation of it. expectations of future prices are equal to optimal forecasts using all currently available info, so Pe(t+1) = Pof(t+1) -> Re = Rof. supply and demand analysis states Re will equal the equilibrium return R*. so Rof=R*

challenges to regulation

Regulators continually face new challenges in a dynamically changing financial system Devil is in the details: Regulatory policy can have large consequences Cost of regulation: > Implementation/monitoring cost > Influence and lobbying cost (social waste) > Market distortions (Any intervention will create it's own inefficiency/externality) > Too little risk taking Regulator itself is an interested party and exposed to political pressures (example: risk weights)

Describe who issues each of the following money market instruments: d)Repurchase agreement (repo)

Repos are a form of collateralized loan issued primarily by banks. Mostly very short-term (less than 1 month maturity) Lenders are other banks or institutional investors such as money market funds Collateral: an asset that the lender receives as security if the borrower does not pay back the loan

excess. reserves. Suppose a bank's required reserves are 10%. If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet shortfall:

Reserves are a legal requirement and the shortfall must be eliminated, e.g., by borrowing in the interbank market Excess reserves are insurance against the costs associated with deposit outflows.

central bank and interbank market

central bank has open market ops, required reserves, discount loan rate and interest on reserves. the market between banks is called interbank market.

mmf in europe and US

Securitization issuance was smaller in volume in the euro area than in the United States before the crisis (around 5% and 12% of GDP respectively) and remains less developed Assets under management by MMFs amounted to €1.83 trillion and €1.1 trillion in the United States and in the euro area respectively by the second quarter of 2011

What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the zero lower bound?

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional monetary policy would be ineffective Main advantage of quantitative easing is that purchases of intermediate and longer term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion

who are the players involved in the monetary system? types of monetary policy?

central banks, banks, and depositors

the most important players in financial markets

central banks- affect IRs, amount of credit, and money supply. direct impact on financial markets and the overall economy.

interest rate stay same or changes over time?

change

The bank you own has the following balance sheet: assets: reserves (75 million) and loans (525 million). liabilities: deposits (500 million) and bank capital (100 million) If the bank suffers a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, what actions should you take?

The $50 million deposit outflow means that reserves fall by $50 million to $25 million. Since required reserves are $45 million (10% of the $450 million of deposits), your bank needs to acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off $20 million of loans, borrowing $20 million in discount loans from the Fed, borrowing $20 million from other banks or corporations, selling $20 million of securities, or some combination of all of these

SBS avoidance of existing regulations

The SBS is "bank-like" without being subject to the same regulatory constraints as banks that have access to an official liquidity backstop and deposit insurance • The SBS operates without internalizing the true cost of its risks and thus gains a funding advantage relative to banks where regulation aims to achieve such an internalization mispricing of risk

Suppose you are the manager of a bank whose $100 billion of assets have an average duration of four years and whose $90 billion of liabilities have an average duration of six years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points. What actions could you take to reduce the bank's interest-rate risk?

The assets fall in value by $8 million (= $100 million × -2% × 4 years) Liabilities fall in value by $10.8 million (= $90 million × -2% × 6 years) Because the liabilities fall in value more than the assets do, the net worth of the bank rises by $2.8 million. The interest-rate risk can be reduced by shortening the maturity of the liabilities to a duration of four years or lengthening the maturity of the assets to a duration of six years. Alternatively, you could engage in an interest-rate swap, in which you swap the interest earned on your assets with the interest on another bank's assets that have a duration of six years.

lender of last resort. capital adequacy. liquidity requirements branching restrictions. activity restrictions

The banking industry faces much more: > Lender-of-last-resort (LLS): a countries central bank that offers loans to banks that are experiencing difficulty depository insurance and other types of guarantees > Capital adequacy: banks need to hold capital to support their activity > Liquidity requirements: banks need to hold enough liquid assets and have sufficient stable funding > Traditionally (typically in the US, by now largely abolished): > Branching restrictions: where can banks locate their branches? > Activity restrictions: what types of activities are permissible banking activities? e.g., are commercial banks allowed to engage in securities underwriting and insurance?

interpret this yield curve: . -- . --- .----------- . . .----------------------

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future • The steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. • Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

Suppose you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of rate-sensitive assets, $25 million of fixed-rate liabilities, and $20 million of rate-sensitive liabilities. Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by 5 percentage points. What actions could you take to reduce the bank's interest-rate risk?

The gap is $10 million ($30 million of rate-sensitive assets minus $20 million of ratesensitive liabilities) The change in bank profits from the interest rate rise is $0.5 million (5% × $10 million) The interest-rate risk can be reduced by increasing rate-sensitive liabilities to $30 million or by reducing rate-sensitive assets to $20 million. Alternatively, you could engage in an interest-rate swap in which you swap the interest on $10 million of rate-sensitive assets for the interest on another bank's $10 million of fixed-rate assets

after origination a bank sells a loan to another bank or investor.

secondary loan market (individual loan, part of a syndicated loan, pool of loans)

shortcomings of 1988 approach

The risk classes are crude, inviting for exploitation (e.g. mortgages require half of the capital of business loans) Risk classes do not properly reflect actual credit risk exposure Does not reward diversification within portfolios > No recognition of the covariance of returns that affect diversification and portfolio risk It assumes that banking risk is the same across countries and time Capital ratios are expressed in book-value and they fail to adjust for changes in market values

If the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis predict will happen to the price of the stock when the $4 loss is announced?

The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise. The unexpected component $5-$4 = +$1 is what matters for stock prices

over the counter securities are part of what market?

secondary market

what is the potential change in net interest income in a time period

change in R is the average IR change affecting assets and liabilities. change in NII = RSA x (change in R - RSL ) x change in R = CGAP x change in R

immunization

change in equity is 0. requires bank to close the leveraged duration gap.

Capital Tiers

Tier 1 "core" capital: describes core capital adequacy of bank. RE+CS+PS includes equity capital and disclosed reserves. tier 1 is money the bank has stored to keep it functioning through all the risky transactions it performs (like trading, investing, lending). core capital includes disposed reserves (Aka retained earnings) and common stock. Tier 2 "supplementary capital": includes hybrid capital instruments, loan-loss and revaluation reserves as well as undisclosed reserves. this capital is supplementary funding (not as reliable as first tier) tier 2 is less secure than tier 1. also less reliable bc its more difficult to accurately calculate and composed of assets that are more difficult to liquidate. long term debt is tier 2. tier 2 capital must be less than or equal to tier 1. Tier 3 Capital: tertiary capital held by banks to meet part of their market risks, includes greater variety of debt than tier 1 and 2 capitals. tier 3 capital is used to support market risk, commodities risk, and foreign currency risk.

interest rate

cost of borrowing or the price paid for the rental of funds

Describe who issues each of the following money market instruments: a) Treasury bills

Treasury bills are short-term debt instruments issued by the (United States) government to cover immediate spending obligations, i.e. finance deficit spending. Issued for terms of 4, 13, 26, and 52 weeks Most liquid money market security > Very actively traded Very safe security Held by banks, households, corporations, other intermediaries In NL: Dutch State Treasury Agency issues Dutch Treasury Certificates

bailouts in europe

UBS gets a bailout. british gov helps scotland bank. french govt helps their banks. dutch govt bails out ING

what spillover into interbank market event happened in september 2007?

UK bank northern rock unable to finance its operations through interbank market. depositors don't trust the bank anymore and doubt that their money is safe. bailed out by bank of england. bank run: depositors withdrew their savings as quickly as possible.

Describe who issues each of the following money market instruments: c) Commercial paper

Unsecured short-term debt instrument Corporations and large banks issue commercial paper as a method of short- term funding in debt markets Only the largest and most creditworthy corporations Interest rate reflects issuer's level of risk

the "market" for reserves takes place between whom?

between banks. short term interbank lending (secured or unsecured) the price for interbank funds is determined by the interaction between banks. central banks sets conditions under which banks interact in the market for reserves (and thus influences interest rate)

eurobond

bond denominated in a currency other than that of the country in which it is sold. ex: ABN AMARO sells bond in the Netherlands, denominated in USD.

When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American-made or foreign-made jeans? Are U.S. companies that manufacture jeans happier when the dollar is strong or when it is weak? What about an American company that is in the business of importing jeans into the United States?

When the dollar increases in value, foreign goods become less expensive relative to American goods More likely to buy Italian-made jeans than American-made jeans. The resulting drop in demand for American-made jeans because of the strong dollar hurts American jeans manufacturers. On the other hand, the American company that imports jeans into the United States now finds that the demand for its product has risen, so it is better off when the dollar is strong.

if the interest paid by the central bank on reserves exceeds the interbank rate, banks would demand what?

an unlimited volume of reserves in the interbank market

valuation model

compares firms value to that of its competitors to determine firms financial worth

bond

debt security that promises to make payments periodically for a specified period of time

herding

large numbers of people acting in same way at same time. behavioral finance.

ROE=

profits/earnings = ROA*EM

response to an increase in the foreign interest rate shifts suppply/demand left/right.

shifts demand left, leading to a fall in the exchange rate.

covered interest rate parity:

two investment strategies. return of the two strategies should be the same (arbitrage relation). covered interest parity (CIP) condition. violations to CIP: CIP frequently assumed to always hold. nevertheless, deviations may aries and frequently have since global financial crises. potential explanations: limits to arbitrage trading and strong hedging demand affect forward rates.

leverage=

=equity multiplier = assets / equity capital

return on assets=

=net profit after taxes / assets net profit after taxes per dollar of assets

return on equity=

=net profit after taxes / equity capital. net profit after taxes per dollar of equity capital ROE= ROA x EM

EBIT=

=revenues + COGS

net liquidity position=

=sources of liquidity - uses of liquidity. sources: total cash type assets, max borrowed funds limit, excess cash reserves. uses: funds borrowed, federal reserve borrowing. measures currently available liquidity to then bank. can be computed at different maturities.

physical floor or electronic limit order book where agents meet

exchanges (NYSE, AMEX, CBOT, NYMEX, Euronext

leverage=

=total assets/equity capital the ratio of a companies loan capital (debt) to the value of its ordinary shares (equity)

theories that explain facts about the yield curve

expectations theory, segmented markets, liquidity premium

insured banks have... less/more capital less/more reserves rely less/more on deposits

less capital. less reserves. rely more on deposits

repricing gap formula GAPi= cumulative repricing gap formula CGAP=

=volume of risk sensitive assets - volume of risk sensitive liabilities. =volume of risk sensitive assets - volume of risk sensitive libalilites

4 examples of agents pursuing personal benefits/power

1) effort: managers work until their marginal cost of working is equal to their marginal gain (and not the cost and gain of the principle) 2) empire building: managers may increase the size of the company to gain prestige rather than increase share holder value 3) fringe benefits: manager may use company funds to pay for expenses (corporate jets) that are payed for by the owners, but may not be necessary. 4) short-termism: if managers pay is tied to stock prices, manager may have an incentive to positively affect stock prices in the short-term at the cost of long-term profits. key issue: managers (Agents) know more about their activities than owners (principals)

three stages of financial crisis:

1) initiation. credit boom and bust. increase in uncertainty. asset prices are declined. 2)banking crisis: economic activity is declined. 3)debt deflation:declined price level and economic activity.

3 solutions to help solve principal-agent problem

1) monitoring (costly state verification): audit firm, check what manager is doing. free rider problem- if monitoring is paid for by some stockholders. 2) govt regulation to increase info. standard accounting principles, laws against hiding and stealing profits. doesn't fully solve problem (detection is difficult) 3) financial intermediation: indirect financing reduces free-rider problem.ex: venture capital firms. pool funds to invest in new businesses. receive equity and usually become part of the board of directors to closely monitor firms activities. 4) debt contract rather than equity: monitoring is too expensive to conduct on ongoing basis. debt holders have lower monitoring cost: only check activities when company is in bad shape and there is a risk that debt cannot be repaid. explains why debt more important than equity.

tools to help solve moral hazard in debt contracts (2 solutions)

1) net worth and collateral. borrower has skin in the game. incentive compatible. 2)monitoring and enforcement of restrictive covenants: discourage undesirable behavior, keep collateral valuable, provide info. covenants needs to be monitored (free rider problem) bank loans rather than marketable debts (bonds)

life cycle phases of financial crisis

1)displacement: catalyst of crisis can be new tech or financial innovation that leads to expectations of increases profits and economic growth. 2) boom: usually characterized by low volatility, abundant market liquidity, credit expansion, cheap funding, increase in investment. asset prices rise, exceeding actual improvements. 3)euphoria: investors trade overvalued asset in frenzy. prices increase explosively. investors are suspicious of bubble, but confident they can sell their asset to a greater fool at a higher price in future. high trading volume and increasing volatility. 4)profit taking: sophisticated investors convinced the market is in a bubble. start taking their profits, worried bubble will burst. theres enough demand from dumber investors. prices start to fall rapidly. 5) panic: investors dump asset. prices spiral down. since run up was financed with credit (leverage), then a deleveraging dynamic kicks in. causes amplification and spillover effects. high selling volume and high price volatility. 6) depressed values: contagion and spillover effects depress asset prices. market prices are below fundamental values. lending standards tighten, creditors are more risk-averse.markets are illiquid (assets traded infrequently with low volume, high transaction costs) 7)recovery: sophisticated investors more convinced asset is a good deal. price is below its fundamental value. they find opportunities to fund arbitrage strategies. arbitrageurs provide liquidity to markets and prices increases again.

1.Stocks are / are not the most important sources of external financing for businesses. 2. Issuing marketable debt and equity securities is /is not the primary way in which businesses finance their operations. 3. Indirect finance is many times more important than direct finance 4. Financial intermediaries, particularly banks, are / are not the most important source of external funds used to finance businesses. 5. The financial system is / is not among the most heavily regulated sectors of the economy. 6. Only what have easy access to securities markets to finance their activities. 7. what is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are / are not extremely complicated legal documents that place substantial restrictive covenants on borrowers.

1. are not 2.is not 3.is 4.are 5. is 6. large, well-established corporations 7. collateral 8.are

cash reserve requirements in USA

10% of net transaction accounts must be held in cash. transaction accounts (demand deposits) minus net interbank position.

capital requirements: from Basel 1 to Basel 3

1988 Basel I accord: • designed by regulators and central banks all over the globe under the coordination of the Bank of International Settlements in Basel, Switzerland - harmonized requirements • minimum capital requirements that must be met by commercial banks to guard against credit risk • focus on loan book and book value of assets 1996 amendment: • market risk (i.e., risk stemming from changes in market prices, e.g., interest rates, equities, FX, commodities...) • focus on trading book (i.e., banks' proprietary trading positions in financial instruments) 2004 Basel II accord • 3 pillars: minimum requirements, supervisory review, transparency • Standardised and Internal ratings based Now Basel III • Liquidity risk • Trading book: counterparty credit risk

responds to a business cycle expansion. (bonds)

1: business cycle expansion shifts bond supply curve rightward. 2: shifts bond demand curve rightward, but less than supply curve. 3: price of bonds falls and equilibrium IR rises. whether IR rises or falls depends on which curve shifts more.

response to an increase in default risk on corporate bonds

1: increase in default risk shifts demand for corporate bonds left. 2: and shifts demand for treasury bonds right. 3: which raises price of treasury bonds and lowers price of corporate bonds, therefore lowers IR on treasury bonds and raises rate on corporate bonds. thereby increasing spread btwn IR IR on corporate and treasury bonds.

troubled asset relief program

2008-2009. US congress passed TARP after political quarrels. purchases of troubled mortgage assets. forced recapitalization of banks. central banks engaged in unprecedented interventions. coordinated reduction in IRs. swap agreements btwn central banks to provide liquidity in other currencies. addtnl govt actions: regulators ban short selling in financial institutions in many countries. european govts guarantee all savings deposits to calm markets and avoid bank runs. in US, FDIC bank deposit insurance increased from 100k to 250k.

AIG

2008. only one day after bankruptcy of lehman brothers, AIG, a large international insurance company, faced a serious liquidity shortage. AIG was very active in the credit derivative business: enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging the exposure. rating agencies warned of potential downgrades to AIGs credit rating, which would increase collateral requirements. stock price fell by more than 90%. through derivative business AIG was very interconnected with the whole financial system. bailout: FED lends billions in exchange for 80% equity stake of AIG.

lehman brothers

2008: barely survived in march 2008 and heavily relied on PDCF. did not issue new equity to strength capital base. stock price declined, worries continued. CEO blames short sellers. funding problems: another urn on short term debt, brokerage, derivatives, counter parties. talks about investment from kore development bank fail. stock plunged. fidelity reduced its tri-party repo lending to lehman a lot. JPM as repo clearing bank demands more collateral. emergency meeting at the FED NY over weekend- CEOs of all major banks present. deals with barclays and BOA didnt materialize bc they didnt want to take over lehman without govt guarantees. FED and govt officially decide not to offer guarantee. spetember 2008: lehman declared bankruptcy. same weekend: merrill lynch is sold to BOA.

derivative contracts are transacted how?

90% OTC. ex: transacted directly btwn two contracting parties without interposing of an exchange or intermediary.

EUR/USD exchange rate=

=#USD / 1 EUR first currency (euro) in currency pair is called base currency. second currency is called quote currency (USD)

current liabilities=

=AP + accruals + NP

financing gap=

=average volume of loans - average deposits.

domestic currency: USD quotation standard: EUR/USD domestic currency appreciates=

=base currency (EUR) depreciates

when bond is priced at FV, YTM=

=coupon rate

working capital=

=current assets - current liabilities

EBA stress test 2014

Credibility? • Differences to 2011 stress test • Asset quality review (AQR) conducted beforehand • Focused on a wider range of risks, including credit risk, market risk, sovereign risk, securitization and cost of funding. Examples: • Market risk shock applied to all fair value accounted positions • Market and credit risk shock applied on counterparty exposure • Credit concentration risk shocked in trading book • Pass rates: 8% in baseline and 5.5% Common Equity Tier 1 capital in adverse scenario compared with just 5% in adverse scenario in 2011. Results of the 2014 stress test: • Aggregate capital shortfall for the 123 banks participating is €24.6 billion • 24 banks failed the test • 10 of them have taken measures to bolster their balance sheets in the meantime • Italian banks most affected: The worst affected was Banca Monte dei Paschi di Siena, which had a capital shortfall of €2.1bn (£1.65bn, $2.6bn) What hasn't been changed (and is frequently criticized) > Capital measure based on risk-weighted assets > Potentially better to use leverage ratios, i.e., use unweighted total assets in denominator > Before and during the 2007-09 crisis, risk-based capital measures were indicating that the largest US and EU banks were well-capitalized; by contrast, leverage ratios were indicating that these banks had thin capital cushions > Total capital shortfall of €24.6bn is tiny when compared with the €22tn of assets held by the banks included in the process > Tests did not include the vast litigation costs still facing the banks

Why might banks be reluctant to issue new equity to strengthen its capital base during financial crises?

During crises, investors typically require a high return to be incentivized to buy new shares > Costly Issuing new shares comes at the cost of existing shareholders > During crises they have already had negative return and issuing more equity would dilute their holdings Reaction to crises: force banks to have increase capital once it becomes low > Contingent convertible (Coco) bonds > The idea is to have some debt in the capital structure of banks that converts into equity when a bank faces financial distress

In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit on insured losses to bank depositors from $100,000 per account to $250,000 per account. How would this help stabilize the financial system?

During the financial panic, regulators were concerned that depositors worried their banks would fail, and that depositors (especially with accounts over $100,000) would pull money from banks, leaving cash-starved banks with even less cash to satisfy customer demands and day-to-day operations. This could create a contagious bank panic in which otherwise healthy banks would fail. Raising the insurance limit would reassure depositors that their money was safe in banks and prevent a bank panic, helping to stabilize the financial system. Similar measures, e.g., in Germany Important: Deposit insurance needs to be credible

Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?

How could an investor profit from overpriced stocks: > Sell the stock short Behavioral finance suggests that market participants are less likely to engage in short sales, because people are more averse to downside risk than upside risk > Short sellers can incur nearly unlimited losses > Little short selling occurs in practice. > Short selling is sometimes seen as taboo, since it is viewed as profiting off the losses of others.

in the current environment with interest basically at zero, would you rather hold high or low duration bonds?

IRs unlikely to decrease even further. if IRs go up, prices of previously issued bonds decline. the larger the duration, the stronger the drop in value. thus, if you expect IRs to rise, you would prefer low duration over high duration bonds.

bear sterns

March 2008 > Proprietary trading, brokerage and derivatives dealer funded with 30:1 leverage and mostly short-term debt > BS experienced severe trouble as a result of its poor equity base relative to its leverage and huge exposure of its assets to the housing market > BS strongly relied on short term funding: liability side indicates that BS was rolling over more than $75 billion of repo contracts on mortgage-backed securities each day > Rumors about deteriorated liquidity, rating downgrade, ... > FED announcement of Term Securities Lending facility interpreted as sign that an investment bank is in trouble (BS is smallest & weakest) > Repo lenders, hedge fund customers, and derivatives counterparties became increasingly reluctant to do business with BS. BS was unable to secure funding on the repo market- within a few days they busted. March 16, 2008 > JP Morgan Chase agrees to buy BS with Federal Reserve Assistance for $10 per share (BS traded at more than $150 less than a year before) > FED agreed to purchase $30 billion of BS assets to get them off BS's books through a new entity called Maiden Lane LLC (JPM contributes $1 billion) FED creates Primary Dealer Credit Facility (PDCF) > Investment banks can turn to FED for overnight funding > Easing of liquidity problems at remaining investment banks

EBA stress test and example of stress-test failure.

Stress test exercises have been conducted by regulators in recent years Example: European Banking Authority (EBA) EU-wide stress test in 2011 > Objective: Assess the resilience of a large sample of banks in the EU against an adverse but plausible scenario > Scenario > Deterioration from the baseline forecast in the main macroeconomic variables such as GDP, unemployment and house prices > The scenario includes a sovereign stress, with some losses to sovereign and bank exposures > Changes in interest rates and sovereign spreads also affect the cost of funding for banks in stress > Results > EBA's 2011 stress test exercise shows that 8 out of 90 banks fall below the Tier 1 capital threshold of 5% over a two-year time horizon, with an overall shortfall of EUR2.5bn. > In addition, 16 banks display a Tier 1 capital ratio between 5% and 6%. as of 2011 dexia is very healthy. but in 2011 they suffered the biggest loss in history. only after 6 month after stress test, dexia went bust.

during 2008, the difference in yield (the yield spread) between three month AA rated financial commercial paper and three month AA rated non financial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in october 2008. what explains this sudden increase?

The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system, and doubt about the soundness of even the most healthy banks and financial companies. Spread could be due to illiquidity and/or credit risk > Sharp decrease in demand for financial commercial paper relative to the seemingly safer nonfinancial commercial paper. > Spike in the yield spread between the two could also reflect greater risk of financial company investments that is not (yet) mirrored in ratings. Bond spreads are used as indicator for riskiness of bonds (as they may react quicker to news than ratings)

A significant number of European banks held large amounts of assets as mortgage- backed securities* derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

The international trade of mortgage-backed securities is generally beneficial European banks that held the mortgages could earn a return on those holdings, while providing needed capital to U.S. financial markets to support borrowing for new home construction and other productive uses In this sense, both European banks and U.S. borrowers should have benefitted. However, with the sharp decline in the U.S. housing market, default rates on mortgages rose sharply, and the value of the mortgage-backed securities held by European banks fell sharply. Even though the financial crisis began primarily in the United States as a housing downturn, it significantly affected European markets; Europe would have been much less affected without such internationalization of financial markets.

interpret the yield curve ; ; ; --- ; ---- --- ; --- --- ;-- ;---------------------------------

The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. • The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the preferred habitat theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates are expected to fall far into the future. • Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on

what are the two main sources of cash flows for an equity investor? How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. Which security would you predict to be more volatile?

Two cash flows from stock: > periodic dividends > future sales price. Both cash flows from stock difficult to estimate > Dividends are frequently changed when a firm's earnings either rise or fall > Future sales price depends on the dividends that will be paid at some date even further in the future Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. > Established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy Stock prices tend to be more volatile, because their cash flows change more

what are the two main sources of cash flows for an equity investor? how reliably can these cash flows be estimated? compare the problem of estimating stock cash flows to the problem of estimating bond cash flows. which security would you predict to be more volatile?

Two cash flows from stock: > periodic dividends > future sales price. Both cash flows from stock difficult to estimate > Dividends are frequently changed when a firm's earnings either rise or fall > Future sales price depends on the dividends that will be paid at some date even further in the future Bond cash flows also consist of two parts, periodic interest payments and a final maturity payment. > Established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy Stock prices tend to be more volatile, because their cash flows change more

Short-term interbank interest rates (e.g., the federal funds rate in the United States) never decrease below the interest rate paid on reserves." Is this statement true, false, or uncertain? Explain your answer

Uncertain In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate on reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower rate However, in practice, the fed funds rate can (and has) been below the interest rate paid on reserves. This is because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds market and provide a significant amount of funding to the market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest rate on reserves may not be arbitraged away.

A bank has the following balance sheet (in $millions). assets: cash (9), loans (95), securities (26). total: 130. liabilities and equity: deposits (75), borrowed funds (40), equity (15). total: 130. The bank's securities portfolio includes $16 million in T-bills and $10 million in GNMA securities. The bank has a $20 million line of credit to borrow in the repo market and $5 million in excess cash reserves (above reserve requirements) with the Fed. The bank currently has borrowed $22 million in the interbank market and $18 million from the Fed discount window to meet seasonal demands. a) What is the bank's total available liquidity (sources of liquidity)?What is the bank's current total use of liquidity? c) What is the net liquidity of the bank? d) Calculate the financing gap. e) What is the financing requirement? f) The bank expects a net deposit drain of $20 million. Show the bank's balance sheet if (i) the bank borrows in the interbank market to offset this expected drain (ii) the bank uses its holdings of liquid securities to meet the expected drain

What is the bank's total available liquidity (sources of liquidity)? The bank's available resources for liquidity purposes are $16m + $10m + $5m +$20m +$18 + $22 = $91m. b) What is the bank's current total use of liquidity? The bank's current use of liquidity is $22m + $18m = $40m. c) What is the net liquidity of the bank? The bank's net liquidity is $91 million - $40 million = $51m d) Calculate the financing gap. Financing gap = average loans - average deposits = $95 million - $75 million = $20m. e) What is the financing requirement? Financing requirement = financing gap + liquid assets = $20 million + $35 million = $55m. Solutions to Additional Questions Vrije Universiteit Amsterdam 28 Financial Markets and Institutions Jan Wrampelmeyer f) The bank expects a net deposit drain of $20 million. Show the bank's balance sheet if (i) the bank borrows in the interbank market to offset this expected drain (ii) the bank uses its holdings of liquid securities to meet the expected drain Solutions to Additional Questions Assets Liabilities and Equity Cash 9 Deposits 55 Loans 95 Borrowed funds 60 Securities 26 Equity 15 Total 130 Total 130 Assets Liabilities and Equity Cash 5 Deposits 55 Loans 95 Borrowed funds 40 Securities 10 Equity 15 Total 110 Total 110

what helps mitigate liquidity risk?

excess reserves

the basel accords

basel 1-1988. minimum capital requirements that must be met by commercial banks to guard against risk. the capital adequacy risk (risk that a financial institution will be hurt by an unexpected loss), categorized assets of financial institutions into five categories. sets minimum capital requirements of 8% or less with goal of minimizing credit risk. focus on banking book (loans). uses cooke ratio: regulatory capital must be >= 8%*RWAs shortcomings: doesn't reward diversification within portfolio. capital ratios are in book value- fail to adjust for changes in market values. basel 2 2004: focuses on 3 pillars: 1)min capital requirements, 2)supervisory review of institutions capital adequacy and internal assessment process, encourages better risk management. 3)transparency and market discipline: effective use of disclosure as lever to strengthen market discipline and encourage sound banking practices including supervisory review. bank monitoring, high disclosure standards. shortcomings: no form of supervisory intervention, no focus on liquidity risk, requirements are pro cyclical. basel 3: included liquidity ratios and stress tests.continuation of 3 pillars, along with addtnl requirements/safeguards, including requiring banks to have minimum amount of common equity and minimum liquidity ration. addtnl requirements for banks that are "too big to fail". to be classified as well-capitalized, firm must have tier 1 capital ratio of 6% or greater. Liquidity regulation (LCR-require banks to have sufficient high quality assets to withstand 30 day stressed funding scenario, NSFR-longer term structural ratio designed to address liquidity mismatches.), stricter capital requirements, capital surcharge for SIFIs, countercyclical capital buffers focuses on liquidity risk. GSIB:systematically important banks need special regulation.

basel 2

basel 2 reform: address shortcomings of capital adequacy regulation. introduced 3 pillars: 1)minimum capital requirement: link capital requirements to a broader range of risk. more accurate and complicated. 2)supervisory review of capital adequacy: ensure that bank have adequate capital to support all risk. better risk management. supervisors evaluate how well banks are assessing their capital needs. 3) market discipline: monitoring banks by pro investors and financial analysts as complement of bank supervision. high disclosure standards.

doubts about EMH have led to emergence of this new field. definition. how does it explain financial data (using what 3 things?)

behavioral finance: study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. it helps explain why and how markets might be inefficient. it explains financial data using loss aversion, herding, and overconfidence.

contractual vs behavioral maturity. core deposits vs noncore deposits.

behavioral maturity:? core deposits: primary deposits. made by individuals. they are retail, liquid deposits. noncore:

segmented markets theory

bonds of different maturities are not subsituttues. the interest rate for each bond with a different maturity is determined by the demand for and supply of that bond. investors have preferences for bonds of one maturity over anything (to match maturity with desired holding period). if investors generally prefer bonds with shorter maturities that have less IR risk, then this explains why yield curves usually slope upward. theory can't explain facts 1 and 2 bc markets are completely segmented

direct finance

borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrowers future income or assets. no use of a financial intermediary. borrower issuing securities directly on the market.

indirect finance

borrowers borrow indirectly from lenders via financial intermediaries by issuing financial instruments which are claims on the borrowers future income or assets

borrowers/lenders have incentives to take on project that are riskier than the borrowers/lenders would like. example for excess risk taking incentive: Company borrows €1m from investors at r=0% to invest in one of two investment projects Project 1: > Receive 2 with probability 0.5 profit in good state 1 > Receive 1 with probability 0.5 profit in bad state 0 > Expected profit for company: €0.5m > Investors get repaid in both states Project 2: > Receive 3 with probability 0.5 profit in good state 2 > Receive 0 with probability 0.5 profit in bad state 0 (bankruptcy) > Expected profit for company : €1m > Investors do only get paid in good state (and lose everything in bad state)

borrowers. lenders. Managers of company have incentive to take excess risk, which may prevent the company from paying back the loan.

purchasing power parity vs interest parity

both based on no-arbitrge conditions in international trade and investment. international investment flows are typically much faster than international trade flows. interest parity is likely to explain exchange rates better in the short term. PPP provides a long-run anchor.

economies of scale:

bundling investors funds to reduce average costs.

how can the bursting of an asset-price bubble in a stock market help trigger a financial crisis?

bursting of bubble makes borrowers less credit-worthy and causes a contraction in lending and spending. asset-price bubble bursts->asset prices realign with funametal economic values->decline in net worth. businesses have less skin in the game and so have incentives to take on more risk at the lender's expense, increasing the moral hazard problem. lower net worth means there is less collateral and so adverse selection increases. the asset price bust can also lead to a deterioration in financial institution balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

interventions in the foreign exchange market:

buying and selling of foreign assets by the central bank. a central banks sale of foreign assets leads to a decline in its international reserves and the monetary base. a central banks purchase of foreign assets leads to an increase in its international reserves and the monetary base.

exchange rates are determined by what?

by flows in international trade and international investment.

FICO score

calculated from a lot of different credit date in your credit report. this data can be grouped into 5 categories. the percentages in the chart reflect how important each of the categories is to determining your FICO score (payment history, amounts owed, length of credit history, new credit, typed of credit used)

financial innovation and decline of traditional banking- cost advantages of acquiring funds? income advantages on uses of funds? banks responses:

decline due to globalization, competition, and financial innovation. Decline in cost advantages in acquiring funds (liabilities) Rising inflation (in 70s) led to rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance Decline in income advantages on uses of funds (assets) Information technology has decreased need for banks to finance short-term credit needs or to issue loans Information technology has lowered transaction costs for other financial institutions, increasing competition Rise of alternatives to loans (junk bonds, commercial paper) Lower net interest margin Banks' Responses Expand into new and riskier areas of lending > Commercial real estate loans > Corporate takeovers and leveraged buyouts Pursue off-balance-sheet activities > Non-interest income > Concerns about risk Profitability sustained (until 2008)

credit risk. how to manage it? example?

default credit risk. manage exposure in 3 ways: 1)reduce (regulation) 2)manage(diversify portfolio) 3)hedge(buy credit insurance) also manage through long term customer relationships, loan commitments, collateral, credit rationing. model: altman discriminant model. uses z scores. only discriminates good and bad borrowers. no in between, and difficult to back test the model.

bonds with the same maturity have different interest rates due to what 3 things:

default risk, liquidity, tax considerations

default risk and credit analysis

default risk: risk that a borrower is unable or unwilling to fulfill the terms promised under the loan contract (late payments and non payments of promised cash flows) objective of credit analysis is to estimate the probability that the borrower will not repay (at origination, during life time of a loan)

increasing the reserve requirement causes supply/demand curve to shift left/right. causing what to happen to federal funds rate?

demand shifts right. fed funds rate rises.

government safety net. bank panics and need for what?

deposit insurance avoid bank failures and contagion effects. overcome reluctance to put funds in the banking system. other form of govt safety net: lending from central bank to troubled institutions (lender of last resort). bailouts (troubled institutions receive capital injections). moral hazard: depositors do not impose discipline of marketplace. financial instutitons have an incentive to take on greater risk. adverse selection: depositors have little reason to monitor financial institutions. risk lovers find financial industry attractive. manager: heads I win, tails the taxpayer loses.

banks are largely funded by what?

deposits

banks are largely funded by what? commercial banks vs community banks/savings banks / credit unions

deposits. commercial: broad variety of financial services and client base, typically shareholder owned. community banks: narrow range of financial services and specific client base, often mutual or state ownership.

altman discriminant model

developed for publicly traded manufacturing firms in the US. output of a credit-strenth test that gauges a publicly traded manufacturing companies likelihood of bankruptcy. altman z score is based on five financial ratios calculated from data found on companies annual 10K report. high default risk: Z<1.81 (don't lend to these firms) above 2.99: low default risk

what is bank capital?

difference between banks assets and liabilities. represents net worth of bank (its value to investors). it is the margin to which creditors are covered if bank liquidates its assets assets include cash, govt securities, and interest earning loans (mortgages and interbank loans) liabilities include loan-loss reserves and debt.

haircut

difference between market value of an asset used as a loan collateral and the amount of the loan. amount of haircut reflects lender's perceived risk of loss from the asset falling in value or being sold in a fire sale.

why reduct credit exposure? why remove credit risk from balance sheet? why hedge?

diversification, but fear of adverse selection and moral hazard. basis risk if hedging instrument only partially correlated with underlying loans. sale might be difficult due to relationship with borrower, implicit commitments not to sell.

uncovered interest parity condition=

domestic interest rate = =foreign interest rate minus expected appreciation of the domestic currency. limits to interest parity: exchange rate volatility, risk aversion. liquidity, transaction costs.

risk premiums on corporate bonds are usually anti cyclical; that is, they decease during business cycle expansions and increase during recessions. why?

during business booms, fewer corps go bankrupt and there is less default risk on corp bonds, which lowers their risk premium. conversely, during recessions default risk on corp bonds increases and their risk premium increases. the risk premium on corporate bonds is thus anti cyclical, rising during recessions and falling during booms

unconventional monetary policy aims to do what?

ease monetary conditions in times when markets are frozen and/or IRs have hit the zero bound. through use of liquidity in financial intermediaries, asset purchases, negative IRs on reserves

funding liquidity

ease with which expert investors and arbitrageurs (dealers, hedge funds, investment banks) can obtain funding from financiers

residual claim on the assets of a firm. example:

equity ex: common stock

financial intermediaries

established to source both loanable funds and loan opportunities. an institution, such as a bank, building society, or unit-trust company, that holds funds from lenders in order to make loans to borrowers.

prominent conflict of interest problems in financial markets (4). what are their services? simultaneously serve to which client groups?

investment banking. (investment research and underwriting). security issuing firms and security buying investors. accounting firms. (audit, consulting). acctg firms may skew judgment during audit to win consulting business. credit rating agencies. issuers pay rating agencies to have securities rates (investors fear that ratings are biased (better ratings) to gain more business. many securities that lost value during financial crisis were designed to just barely receive top rating. mortgage origination. mortgage originator frequently sells mortgages. less incentive to adequately check credit quality.

Assist individuals, corporations and governments in raising capital- how

investment banks- by underwriting and/or acting as the client's agent in the issuance of securities. Assist companies involved in mergers and acquisitions (M&A). Market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities on behalf of its customers or on its own (i.e. proprietary trading).

are international investment or trade flows faster? exchange rates are determined by what?

investment flows flows in international trade and investment

banking industry trends before the crisis cont.

investors (via MMFs for example): demand safe alternatives to insured deposits, want to be able to withdraw funds at short notice. supply of ABS and demand for alternative to insured deposits led to strong growth of shadow banking system. developments led to complexity, cheap credit, and fall in lending standards.

preferred habitat theory

investors have a preference for bonds of one maturity over another. they will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return. investors are likely to prefer short-term bonds over long-term bonds.

why was there a decline of traditional banking?

it costs more to attain funds (liabilities) due to rising inflation and IRs. you don't profit as much from using funds (assets) due to IT lowering trisection costs for other institutions (increased competition) Due to this, banks expand into new and riskier areas of lending, pursuing off balance sheet activities (SBS). SBS enables maturity and liquidity transformation

costs of high inflation

it creates uncertainty and leads to lower economic growth. high inflation compromises the three functions of money (medium of exchange, storage, unit of account). menu costs: cost to a firm resulting from changing its prices. firms have to change their prices more often. misallocation of resources bc it becomes difficult to assess relative prices. shoe leather costs (households and firms hold less money and need to go to the bank more often)/ increases distortionary effects of taxes (ex: tax on nominal capital gains; gain may be much smaller in real terms)

market fundamentals. weak or strong EMH?

items that have a direct impact on future income streams of the securities. some financial economists believe all prices are always correct and reflect market fundamental, and so financial markets are efficient (strong EMH)

the subprime mortgage crisis

january-july 2007- increase in subprime mortgage defaults. compared with other loan types, subprime adjustable-rate loans were substantially higher. massive downgrades of mortgage-backed securities by rating agencies. uncertainty about rating reliability and valuation of structured products (ABCP market dries up, SIVs unable to roll over ABCP funding). banks have to provide liquidity to SIVs. spillover into interbank markets- indication for elevated counterpart risk and illiquidity in the money market. central banks step in: provide liquidity and lower IRs.

what are equity markets smaller than debt markets?

largely due to fact that the only applicable participants are businesses. true even in markets such as US, which have the worlds largest stock market

secondary credit facility?

lender of last resort-lending to bansk with severe liquidity problems. different from primary credit facility (lending facility for healthy banks)

simple loan. example

lender provides funds to borrower that must be repaid at maturity alone with additional payment for the interest. interest rate = yield to maturity. example: commercial loans to businesses

discount bond and example

lender provides funds to borrower that must be repaid at maturity along with additional payments for the interest. ex: UK treasury bills

fixed payment loan. example

lender provides funds to borrower that must be repaid by making the same payment every period, consisting of part of the principle and interest. example: consumer loans, mortgages

shadow banking

lending and other financial activities conducted by unregulated institutions or under unregulated conditions

discount lending. primary credit facility

lending facility for healthy banks. rate set for primary credit facility influences interbank rate. collateralized with securities. should be distinguished from secondary credit facility / lender of last resort : lending to banks with severe liquidity problems. a penalty rate follows.

how does securitization imply a decomposition of lending?. rationale for securitization: limits of securitization:

lending process goes to origination, servicing, funding, and risk processing. risk management (credit risk, IR risk and liquidity risk), focus on brokerage activities (origination, credit assessment, servicing, lower capital requirements). private info: originator knows more about the underlying assets than investors. moral hazard: originator may put less effort into credit assessment and monitoring. solutions: standardization, originator holds junior tranche of ABS, performance contingent servicing contracts)

liquidity provision in the US: provide liquidity to banks and nonbank intermediaries. term auction credit facility (TAF): primary dealer credit facility: asset backed commercial paper money market mutual fund liquidity facility (AMLF):

lending to banks through competitive auctions. repo loans to primary dealers, through direct lending to investment banks. lend to investment banks so that they can buy ABCP from mutual funds.

libor-ois and alternative method

london interbank offer rate. rate at which banks indicate they are willing to lend to other banks for a specified term of the loan. the term overnight indexed swap (OIS) rate is rate on a derivative contract on the overnight rate. LIBOR-OIS spread > Commonly used indicator for stress in the interbank market > Spread between interest rates for transactions with different risks > LIBOR (London Interbank Offered Rate): Estimation of average interest rate that large banks need to pay to borrow from other banks in unsecured interbank market Rate for unsecured loans that involve counterparty risk > OIS (overnight index swap): Swap rate only interest payments are exchanged at end of contract less credit risk than LIBOR > Higher LIBOR-OIS spread means higher counterparty risk and illiquidity in the unsecured money market Alternative measure: TED spread > Difference between the three-month USD LIBOR and the three-month T-bill interest rate

managing credit risk

long term customer relationships, loan commitments, collateral and compensating balances, credit rationing

the lack of short selling (causing over-priced stocks) may be explained by what? the large trading volume may be explained by what? stock market bubbles may be explained by what?

loss aversion. investor overconfidence. overconfidence, herding, and social contagion.

what kind of inflation is the primary goal of monetary policy for all central banks?

low and stable inflation

the more distant a bond's maturity, the higher/lower the rate of return that occurs as result of increase in IR

lower

the more distant a bond's maturity, the lower/higher the rate of return that occurs as a result of an increase in the interest rate

lower

at lower prices, interest rates are lower/higher, and the quantity demanded of bonds is lower/higher. what type of relationship is this? same question with supply instead of demand:

lower P = higher IR = Qd of bonds is higher. inverse relationship. demand is downward sloping. lower P = higher IR = Qs of bonds is lower. positive relationship. supply curve is upward sloping.

what happens to price of bonds when interest rates increase and demand for companies products decrease?

lower demand: lower profits and lower dividends. so g decreases leading to decrease in P0. higher IRs: bonds more attractive. less demand for stocks. higher required return. so R increases leading to decrease in P0

why not do all transactions directly in financial markets?

lower transaction costs (time and money spent in carrying out financial transactions). economies of scale. liquidity services (banks provide depositors with checking accounts that enable them to pay their bills easily). depositors can earn interest on checking/saving accounts and yet still convert them into goods/services whenever necessary. customization of specific needs not available in markets. reduce exposure of investors to risk. risk sharing- FIs create/sell assets with small risk (deposits to consumers) to buy/issue assets with greater risk (loans). this process is referred to as asset transformation. diversification financial intermediaries better equipped to deal with asymmetric info problems (adverse selection and moral hazard). asymmetric info and agency theory (one party has more info than another)

at lower prices, quantity supplied of bonds is higher or lower

lower- a positive relationship. supply curve is upward sloping.

increase in expected rate of inflation- how does this shift demand for bonds

lowers expected real return for bonds, causing shift left

assets and liabilties

make up equity. assets: deposits, cash liabilities: reserves

money markets: maturity of securities traded. made of what? examples. how popular?

maturity of securities traded is less than one year. short-term debt. ex: bills, notes, commercial paper. more widely traded -> more liquid. participants use market to earn interest on surplus funds that are available temporarily.

capital markets. maturity of securities? examples

maturity of securities traded is one year of greater. ex: long term bonds, equity

barras, scaillet, and wermers 2010 - empirical evidence

measure performance of mutual funds controlling for the role of luck. find that only .6% are skilled

repricing model

measures the risk to the net interest income of a financial institutions. changes in interest rate levels and spreads. earnings effects arising from IR changes are the key source of risk to future earnings for most depository institutions.

duration model

measures the risk to the net worth of a financial institution arising from changes to the level and term structure of interest rates. IR changes affect the PV of all future cash flows from assets and liabilities. the current economic value of an institution is given by the difference between the PV of assets and liabilities.

short term deposit like funding in the SBS can create what?

modern bank runs- a withdrawal of run-able deposit like instruments such as short-dates ABCP, short term repos and money fund investments could undermine the wider financial system

three main strategies for central banks to achieve goal of long term price stability

monetary targeting, inflation targeting, implicit nominal anchor

a financial intermediary that manages funds on behalf of investors who wish to invest in low risk securities while being able to withdraw funds at short notice.

money market funds main task is to maintain the value of the principal of its assets. alternative to savings accounts. typically investment in short term securities like treasuries, commercial papers, and CDs. normally, they earn a slightly higher return than bank deposits. provide financing to shadow banks via repos or ABCP.

what are the main components and function of financial system?

to transfer resources from savers/lenders to consumers/borrowers

why would a government choose to issue a perpetuity, which requires payments forever, instead of a terminal loan, such as a fixed-payment loan, discount bond, or coupon bond? example: assuming a 5% IR over 10 years, on a $1000 loan..

near-term costs to maintaining a given size loan are much smaller for a perpetuity than for a similar fixed payment loan, discount, or coupon bond. ex: a perpetuity costs 50 per year (over 500 in payments over 10 years). for a fixed payment loan, this would be 129.5 per year (or 1295 in payments over same 10 year period). for a discount loan, this loan would require a lump sum payment of 1628.89 in 10 years. for a coupon bond, assuming same 50 coupon payment as perpetuity implies a 1000 face value. thus, for the coupon bond, the total payments at the end of 10 years will be 1500.

measures amount of longer-term, stable sources of funding employed by an institution relative to the liquidity profiles of the assets funded and potential for contingent calls on funding liquidity arising from off-balance sheet commitments and obligations.

net stable funding ratio available amount of stable funding / required amt stable funding > 100%

OTC

network of dealers ready to buy and sell securities. very competitive. ex: foreign exchange market.

compounding simple interest

no interest on interest

why liquidity matters in normal times: however, abnormal deposit drains may occur due to:

no major unexpected deposit outflows. no major unexpected exercise of loan commitments. wholesale markets available to borrow funds. solvency concerns. failure of related institutions (contagion). sudden changes in investor preferences regarding holding of nonbank financial assets.

do investment banks take deposits?

no- From 1933 (Glass-Steagall Act) until 1999 (Gramm-Leach- Bliley Act), the United States maintained a separation between investment banking and commercial banks. • Other industrialized countries, including G8 countries, have historically not maintained such a separation

are stocks the most important sources of external financing for businesses? is issuing marketable debt and equity securities the primary way in which businesses finance their operations?

no- financial intermediaries, particularly banks, are most important external funding source used to finance businesses. and no

should central banks be independent?

no: principal agent problem is bad with politicians. undemocratic. pro independence: political pressure would impart an inflationary bias to monetary policy. political business cycle. could be used to facilitate financing of large govt budget deficits. too important to leave to politicians- the principal agent problem is worse for politicians. independent central bank can pursue policies that are politically unpopular yet in the public interest. against independence: undemocratic, unaccountable, difficult to coordinate fiscal and monetary policy, has not used its independence successful

nominal vs real interest rates (two types of real interest rates. which is better indicator of the incentives to borrow and lend?

nominal: makes no allowance for inflation real: adjusted for changes in price level so it more accurately reflects the cost of borrowing ex ante real: adjusted for expected changes in the price level ex post real: adjusted for actual changes in price level. real IR better indicator.

regulation in banking

nonfinancial industries face many types of regulation (antitrust, workplace security, trade restrictions, consumer protection). banking industry faces much more: lender of last resort (LLS), capital adequacy, liquidity requirements, branching restrictions, activity restrictions

example of deposit withdrawals

northern rock in 2007.

chart analysis

not based on theory. chartists look for patterns in stock prices to estimate whether stock prices are over or undervalued.

objective of credit analysis vs portfolio risk management

objective of credit analysis is to evaluate the default risk on an individual loan (decision on whether to lend or not, credit limit, pricing terms of the loan) objective of credit portfolio management is to manage the aggregate exposure of the banks net worth to default risk (concentration/diversification of the loan portfolio, goes beyond credit analysis to asses the interrelations between default risk across loans)

central banks can influence the interbank rate in the market for reserves with 4 tools:

open market operations, interest rates charged on discount loans, interest rate paid/charged on excess reserves, required reserves

defined by risk of losses as a consequence from failure of internal processes, people, systems or from external events > Includes all legal risks as well as fines from supervision authorities or settlements > Excludes strategic or reputational risks

operational risk (theft, fraud, unauthorized trading, client data confidentiality, regulatory reporting)

when a countrys currency appreciates, it makes its goods abroad more or less expensive and foreign goods in its own currency more or less cheap?

our goods abroad are expensive and foreign goods are cheaper

total return swap. pur credit swap

outgoing payments by the swap buyer fall when credit risk increases. aka credit default swap: incoming payments to swap buyer rise when credit event happens.

dynamic market operations

outright sale/purchase of short term securities like T-bills. OTC with primary dealers. auction system (price=short term yield is endogenous)

how to help solve adverse selection problems

private production and sale of info. example: rating agencies (S&P, moodys, fitch): collect info and sell to clients. less likely that seller knows more than buyer of a security. free-rider problem: investor A buys info from rating agency and then buys stock Z. Investor B knows that A bought info and observes that A buys Z. B uses this to deduce that info about Z was positive and also buys Z. govt regulation to increase info. disclosure requirements: companies need to disclose relevant info immediately. (ex: Volkswagen denies investor claims of slow emissions disclosure) intermediaries (used car dealers- reputation and guarantees) financial intermediation reduces asymmetric info collateral- lender receives collateral that covers losses in case the borrower defaults. mitigates effect of asymmetric info. its a prevalent feature of debt contracts for both households and businesses. equity capital (net worth) can perform similar role. debt holders have seniority in case of default. firms with a lot of equity have more resources and thus receive loans more easily. generally, more info is available on large firms.

pro and con of having high excess reserves:

pro: deposit outflows can be easily satisfied. con: expensive (opportunity cost)

pro EMH and contra EMH

pro: only very few investors consistently outperform the market. same is true for investment funds. chartists do not beat the market on average. contra: speculative bubbles? NASDAQ stocks in the 1990s, subprime bubble 2007. however, bubbles can be rational -> can be profitable to buy if you believe you can sell at an even higher price later. excess volatility: stocks are more volatile than realized dividends.

default risk

probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the value. US treasury bonds are considered default free (govt can raise taxes)

asset transformation

process of risk sharing, where FIs create/sell assets with small risk (deposits to consumers) to buy/issue assets with greater risk (loans). in a sense, risky assets are turned into safer assets for investors.

define interest rate

proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding.

interset on excess reserves

provides a floor to the interbank rate- as conventional monetary policy tool it helps the central bank keep IRs within their target range. hardly used as an active policy tool in normal times. but IRs on reserves can be an effective tool of monetary policy when nominal rates hit the zero bound. central bank can implement negative IRs. and IRs on reserves can be an important tool of monetary policy when exiting a financial crisis. increasing IRs on reserves allows CB to raise IRs despite a huge excess reserve volume.

what are the disadvantages of using loans to financial institutions to prevent bank panics?

providing loans to financial institution creates a moral hazard problem. if firms know that they will have access to federal loans, they are more likely to take on risk, knowing that the fed will bail them out if a panic should occur. as a result, banks that deserve to go out of business bc of poor management may survive bc of fed liquidity provision to prevent panics. this might lead to an inefficient banking system with many poorly run banks.

three main reasons for imposition of required reserves?

prudential(wise), monetary control, liquidity management

three main reasons for the imposition of required reserves:

prudential, monetary control, liquidity management

inflation targeting

public announcement of medium term numerical target for inflation. institutional commitment to price stability as the primary, long run goal of monetary policy and a commitment to achieve the inflation goal. info-inclusive approach in which many variables are used in making decisions. increased transparency of the strategy. increased accountability of the central bank. advantages: doesn't rely on one variable to achieve target. easily understood. reduces potential of falling in time-inconsistency trap. stresses transparency and accountability. disadvantages: delayed signaling (monetary aggregates react immediately, whereas inflation reacts with a delay to monetary policy). too much rigidity. potential for increases output fluctuations. low economic growth during disinflation.

Theory discussing long term exchange rates:

purchasing power parity. exchange rates will reflect changes in price levels in two countries

hierarchal mandate

put goal of price stability first. as long as its achieved, other goals can be pursued.

credit easing

quantitative: focus of policy is quantity of reserves. composition of assets on central bank balance sheet is incidental. credit: conceputally different. central banks aim at shifting the composition of the balance sheet from risk free (treasury) to risky assets (MBS). supports markets for risky securities. FED policies consistent with both CE and QE.

efficient market hypothesis

rational expectations in financial markets. eugene fama nobel laureate 2013. current price of a security reflects all available info. there are no arbitrage opportunities. investors who outperform the market, either took a higher risk or were lucky.

the rate at which domestic goods can be exchanged for foreign goods

real exchange rate. price of domestic goods relative to foreign goods denominated in domestic currency. purchasing power theory suggests that the real exchange rate is 1.

regulation of the financial system. how to increase the info available to investors:

reduce adverse selection and moral hazard problems. reduce insider trading.

why are financial intermediaries important?

reduce exposure to risk (risk sharing, asset transformation, diversification). lower transaction costs (economies of scale, developing expertise). reduce asymmetric info (adverse selection and moral hazard)

credit risk management: three tactics

reduce exposure: selection, screening and monitoring, enforcement manage exposure: diversification hedge exposure: credit insurance / guarantees, credit default swaps

deleveraging

reducing the level of one's debt by rapidly selling one's assets.

what provides guidance on how a central bank should change the nominal IR in response to changes in inflation and real economic conditions?

taylor rule

duration

tells us how price of bond or fixed-income instrument changes as IR change. %change in Price = -DUR x (change in i / (1+i))

purchasing power theory

the exchange rate between two currencies will adjust to reflect changes in the general price levels in the two countries

implicit nominal anchor

the federal reserve conducts monetary policy without using an explicit nominal anchor such as inflation target. there is no explicit nominal anchor in the form of an overriding concern for the fed. forward looking behavior and periodic "preemptive strikes". the goal is to prevent inflation from getting started. advantages: uses many sources of info. demonstrated success. forward looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby ameliorating the time inconsistency problem disadvantages: lack of accountability. inconsistent with democratic principles. lack of transparency; strong dependence on the preferences, skills, and trustworthiness of the individuals in charge of the central bank.

discount rate

the minimum interest rate set by the US fed reserve for lending to other banks

unsterilized interventions and the exchange rate. foreign asset sales/purcahses lead to a change in ...... sale of foreign assets= increase/decrease in intl reserves ... purchase of foreign assets=

the money supply and domestic interest rates. sale = decrease in international reserves. domestic interest rate rises and exchange rate appreciates. purhcase: increase in intl reserves. domestic interest rate falls and the exchange rate depreciates.

credit risk analysis and the 5 Cs

the probability that the borrower will repay depends on ability and willingness to repay: capacity ( assessment of ability to repay), conditions (assessment of market / client specific conditions), character(assessment of willingness to repay), capital (assessment of leverage), collateral (Assessment of market value of pledgeable collateral)

credit risk two types

the risk that promised cash flows from loans and fixed income securities may not be paid in full. loan level risk: risk that a particular borrower will partially default. portfolio level risk: risk that a share of the due payments on a loan portfolio will not be repaid

advantage of financial intermediaries?

they allow small savers and borrowers to benefit from the existence of financial markets

what are buyers of debt instruments to the firm?

they are suppliers of capital, not owners of the firm

if a bank has a shortfall under their legal reserve requirement, what do they do?

they can borrow from the interbank market, sell securities, borrow from Fed (but this is a bad signal to the market), reduce loans (costly)

a customer defualts on loan: loss of $5 million.

this means the customer didnt pay back their loan to the bank. so the banks loan asset decreases by 5 million and dank capital decreases by 5 million. if its a high capital bank, then this is okay because they still have a positive number of bank capital. but if its a low capital bank, then the loss of 5 might bring them to the negatives.

why might bonds with identical risk, liquidity, and tax characteristics have different interest rates?

time remaining to maturity is different

capital adequacy management: three functions of capital?

to fund activities of the financial intermediary absorb unanticipated losses in order to prevent insolvency (bank failure) protect uninsured creditors, deposit insurance fund, and taxpayers, in the case of insolvency. the amount of capital affects return for the owners (equity holders) of the bank

central banks engage in international financial transactions to influence what?

to influence exchange rates