Money and Banking Chapter 12 and 14

The credit derivative that, for a fee, gives the purchaser the right to receive profits that are tied either to the price of an underlying security or to an interest rate is called a

credit option.

In the 1950s the interest rate on three-month Treasury bills fluctuated between 1 percent and 3.5 percent; in the 1980s it fluctuated between ________ percent and ________ percent.

5; 15

Futures contracts are regularly traded on the

Chicago Board of Trade.

________ is the process of researching and developing profitable new products and services by financial institutions.

Financial engineering

The legislation that separated investment banking from commercial banking until its repeal in 1999 is known as the

Glass-Steagall Act.

Suppose that Wells Fargo Home Mortgage sells $10 million worth of mortgage payments to GMAC in exchange for $10 million in auto loan payments. This type of transaction is called a

credit swap.

Suppose Ford Motor Company issues a 5% bond with a stipulation that if a national index of SUV sales drops by 10%, then Ford can decrease the coupon rate to 3%. This security is called a

credit-linked note.

If a bank has more rate-sensitive assets than rate-sensitive liabilities

it reduces interest rate risk by swapping rate-sensitive income for fixed rate income.

Hedging by buying an option

limits losses.

A contract that requires the investor to buy securities on a future date is called a

long contract.

A person who agrees to buy an asset at a future date is going

long.

When the financial institution is hedging interest-rate risk on its overall portfolio, then the hedge is a

macro hedge.

Rising interest-rate risk

increased the demand for financial innovation.

Suppose you are currently in the long position of a long-term bond. In this case, to hedge against a capital loss, you would enter into a ________ contract to ________ a long-term bond in the future.

interest-rate forward; sell

Uncertainty about interest-rate movements and returns is called

interest-rate risk.

The U.S. banking system is considered to be a dual system because

it is regulated by both state and federal governments.

To say that the forward market lacks liquidity means that

it may be difficult to make the transaction.

A tool for managing interest-rate risk that requires exchange of payment streams is a

swap.

Hedging risk for a short position is accomplished by

taking a long position.

Hedging risk for a long position is accomplished by

taking a short position.

A firm that sells goods to foreign countries on a regular basis can avoid exchange-rate risk by

using a foreign exchange swap.

All other things held constant, premiums on options will increase when the

volatility of the underlying asset increases.

Prior to 1863, all commercial banks in the United States

were chartered by the banking commission of the state in which they operated.

When interest rates fall, a bank that perfectly hedges its portfolio of Treasury securities in the futures market

has no change in its income.

The modern commercial banking system began in America when the

Bank of North America was chartered in Philadelphia in 1782.

The most important source of the changes in supply conditions that stimulate financial innovation has been the

improvement in computer and telecommunications technology.

State banks that are not members of the Federal Reserve System are most likely to be examined by the

FDIC.

To eliminate the abuses of the state-chartered banks, the ________ created a new banking system of federally chartered banks, supervised by the ________.

National Bank Act of 1863; Office of the Comptroller of the Currency

The Second Bank of the United States was denied a new charter by

President Andrew Jackson.

Because of the abuses by state banks and the clear need for a central bank to help the federal government raise funds during the War of 1812, Congress created the

Second Bank of the United States in 1816.

Which of the following is not a financial derivative?

Stock

Which regulatory body charters national banks?

The Comptroller of the Currency

Which bank regulatory agency has the sole regulatory authority over bank holding companies?

The Federal Reserve System

Which of the following statements concerning bank regulation in the United States is true?

The Federal Reserve and the state banking authorities jointly have responsibility for the 900 state banks that are members of the Federal Reserve System.

A swap that involves the exchange of a set of payments in one currency for a set of payments in another currency is

a currency swap.

An instrument developed to help investors and institutions hedge interest-rate risk is

a financial derivative.

The agreement to provide a standardized commodity to a buyer on a specific date at a specific future price is

a futures contract.

Futures differ from forwards because they are

a standardized contract.

Although the National Bank Act of 1863 was designed to eliminate state-chartered banks by imposing a prohibitive tax on banknotes, these banks have been able to stay in business by

acquiring funds through deposits.

Both ________ and ________ were financial innovations that occurred because of interest rate volatility.

adjustable-rate mortgages; financial derivatives

An option that can be exercised at any time up to maturity is called

an American option.

An option that can only be exercised at maturity is called

an European option.

A swap that involves the exchange of one set of interest payments for another set of interest payments is called

an interest rate swap.

Elimination of riskless profit opportunities in the futures market is

arbitrage.

One advantage of using swaps to eliminate interest-rate risk is that swaps

are less costly than rearranging balance sheets.

The advantage of forward contracts over future contracts is that they

are more flexible

Currency circulated by banks that could be redeemed for gold was called

banknotes.

Before 1863,

banks acquired funds by issuing bank notes.

Adjustable rate mortgages

benefit homeowners when interest rates are falling.

If a bank manager wants to protect the bank against losses that would be incurred on its portfolio of treasury securities should interest rates rise, he could ________ options on financial futures.

buy put

A long contract requires that the investor

buy securities in the future.

Parties who have bought a futures contract and thereby agreed to ________ (take delivery of) the bonds are said to have taken a ________ position.

buy; long

If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign exchange-rate risk by ________ foreign exchange futures ________.

buying; long

An option allowing the holder to buy an asset in the future is a

call option.

An option that gives the owner the right to buy a financial instrument at the exercise price within a specified period of time is a

call option.

An advantage of using swaps to hedge interest-rate risk is that swaps

can be written for long horizons.

The government institution that has responsibility for the amount of money and credit supplied in the economy as a whole is the

central bank.

The main advantage of using options on futures contracts rather than the futures contracts themselves is that interest-rate risk is

controlled while preserving the possibility of gains.

If one party pays a fixed fee on a regular basis in return for a contingent payment that is triggered by a downgrading of a firm's credit rating, that is called a

credit default swap.

The regulatory system that has evolved in the United States whereby banks are regulated at the state level, the national level, or both, is known as a

dual banking system.

The Glass-Steagall Act, before its repeal in 1999, prohibited commercial banks from

engaging in underwriting and dealing of corporate securities.

All other things held constant, premiums on call options will increase when the

exercise price falls.

If you bought a long contract on financial futures you hope that interest rates

fall.

If you sold a short futures contract you will hope that bond prices

fall.

Today the United States has a dual banking system in which banks supervised by the ________ and by the ________ operate side by side.

federal government; states

Financial instruments whose payoffs are linked to previously issued securities are called

financial derivatives.

With the creation of the Federal Deposit Insurance Corporation,

member banks of the Federal Reserve System were required to purchase FDIC insurance for their depositors, while non-member commercial banks could choose to buy deposit insurance.

When a financial institution hedges the interest-rate risk for a specific asset, the hedge is called a

micro hedge.

The Federal Reserve Act of 1913 required that

national banks join the Federal Reserve System.

The Federal Reserve Act required all ________ banks to become members of the Federal Reserve System, while ________ banks could choose to become members of the system.

national; state

The seller of an option has the

obligation to buy or sell the underlying asset.

A call option gives the seller the

obligation to sell the underlying security.

The seller of an option has the ________ to buy or sell the underlying asset while the purchaser of an option has the ________ to buy or sell the asset.

obligation; right

Forward contracts are of limited usefulness to financial institutions because

of default risk.

The number of futures contracts outstanding is called

open interest.

Options are contracts that give the purchasers the

option to buy or sell an underlying asset.

If Second National Bank has more rate-sensitive liabilities then rate-sensitive assets, it can reduce interest rate risk with a swap that requires Second National to

pay fixed rate while receiving floating rate.

The amount paid for an option is the

premium.

The payoffs for financial derivatives are linked to

previously issued securities.

On the expiration date of a futures contract, the price of the contract converges to the

price of the underlying asset.

Financial innovations occur because of financial institutions search for

profits.

If Second National Bank has more rate-sensitive assets than rate-sensitive liabilities, it can reduce interest-rate risk with a swap that requires Second National to

receive fixed rate while paying floating rate.

By hedging a portfolio, a bank manager

reduces interest-rate risk.

A call option gives the owner the

right to buy the underlying security.

If you bought a long futures contract you hope that bond prices

rise.

If you sold a short contract on financial futures you hope interest rates

rise.

A short contract requires that the investor

sell securities in the future.

If a firm is due to be paid in euros in two months, to hedge against exchange-rate risk the firm should ________ foreign exchange futures ________.

sell; short

Parties who have sold a futures contract and thereby agreed to ________ (deliver) the bonds are said to have taken a ________ position.

sell; short

A contract that requires the investor to sell securities on a future date is called a

short contract.

The price specified on an option at which the holder can buy or sell the underlying asset is called the

strike price.

A financial contract that obligates one party to exchange a set of payments it owns for another set of payments owned by another party is called a

swap.

The belief that bank failures were regularly caused by fraud or the lack of sufficient bank capital explains, in part, the passage of

the National Bank Act of 1863.

Probably the most significant factor explaining the drastic drop in the number of bank failures since the Great Depression has been

the creation of the FDIC.

Assume you are holding Treasury securities and have sold futures to hedge against interest-rate risk. If interest rates rise

the decrease in the value of the securities equals the increase in the value of the futures contracts.

The most significant change in the economic environment that changed the demand for financial products in recent years has been

the dramatic increase in the volatility of interest rates.

Assume you are holding Treasury securities and have sold futures to hedge against interest-rate risk. If interest rates fall

the increase in the value of the securities equals the decrease in the value of the futures contracts.

With the creation of the Federal Deposit Insurance Corporation, member banks of the Federal Reserve System ________ to purchase FDIC insurance for their depositors, while non-member commercial banks ________ to buy deposit insurance.

were required, could choose

A major controversy involving the banking industry in its early years was

whether the federal government or the states should charter banks.

State banking authorities have sole jurisdiction over state banks

without FDIC insurance.