ECO test 2
Calculate a bank's change in profits if it has $45 million in rate-sensitive assets and $30 million in rate-sensitive liabilities, and interest rates fall by 1.5%
($45,000,000 - $30,000,000) x - 0.015 You would enter your response as -225000
What are the six macroeconomic goals that a central bank must consider in the conduct of monetary policy? Are these goals fully compatible in the short-run? Long-run? Why or why not?
-Price stability: We don't want prices fluctuating; In the short run, time inconsistency problem created high profit margins. Wages will adjust to prices. Overall, instability only exists in the short run -Full employment (Natural Rate) -Economic growth: Nothing above or below potential GDP. -Stability of financial markets -Interest-rate stability -Exchange rate stability: We want our currency to hold its value
What industry had the most influence on the rise of the New York Stock Exchange?
American Steel Monopoly
Understand the changes in bank liabilities and assets when cash deposits are made, or deposits of checks are made, using the T-account structure. What happens to reserves when deposits of checks or cash are made? When checks are written? When cash is withdrawn?
A T-account is a simplified balance sheet, with lines in the form of a T that lists only the changes that occur in balance sheet items starting from some initial balance sheet position. • Opening of a checking account leads to an increase in the bank's reserves equal to the increase in checkable deposits. • When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. • When deposits of checks and cash are made the excess reserve will be loan out
What is a "bubble" in the stock market; what causes bubbles? How can you recognize that a bubble might exist?
A bubble in the stock market is when someone pays more for a security than its actual value. Prices of assets rise well above their fundamental values, casts serious doubt on the stronger view that financial markets are efficient. If there is an environment in which a lot of investors are thinking that stock prices will rise in the future. The result is a positive feedback loop in which prices get too far out of line with fundamentals and there is a bubble.
What relationships do yield curves express? What are the macroeconomic interpretations of both the origin and slope of the curve
A yield curve is a plot of a yield of bonds with differing terms to maturity but the same risk liquidity and tax considerations. Two things can change in the curves: the origin that can move up or down and the slope that can become steeper or flatter. If the curve starts where X and Y intercept, there is a good economy
What are "reserves"? Why would a bank want to keep reserves as low as possible? Understand the terms required reserves, excess reserves, vault cash
All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves are these deposits plus currency that is physically held by banks, called vault cash because it is stored in bank vaults overnight. A bank wants to keep reserves as low as possible for two reasons. First, some reserves, called required reserves are held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves. This fraction is called the required reserve ratio. Also, banks hold additional reserves, called excess reserves, because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account
6. Why is it important for bankers to avoid "concentrations" of credit and diversify their loan portfolio?
Avoid "concentrations" of credit and diversifying its loan portfolio helps a bank mitigate risk. Bankers diversify their portfolio and spread their risk into different sectors so they are not putting all of their eggs in one basket.
Like bonds, stocks generate a stream of cash flows into the future. Why then, do we not use a similar process (discounting all future cash flows to the present) to calculate stock prices?
Because bonds have a precise, known cash flow, but for stocks we can only estimate future dividends and price. Bonds' cash flows are known, since the coupon rate and face value are known, and the annual interest payments are exact, and the same each period. Also, the face value is known, whereas a stock's future price cannot be known. Therefore, estimating a future growth rate for dividends will be more accurate than attempting to forecast the dollar amount of all future dividends.
Return on Assets: What does it tell us about management?
Because owners of a bank must know whether their bank is being managed well, they need good measures of bank profitability. A basic measure of bank profitability is the return on assets ROA. The ROA provides information on how efficiently a bank is being run, because it indicates how much profit is generated, on average, by each dollar of assets. ROA = net profit after taxes / assets
Discount Loans: What are these and what are they used for?
Borrowings from the Fed are called discount loans, also known as advances. Banks borrow reserves overnight in the federal funds market from other U.S. banks and financial institutions. Banks borrow funds overnight to have enough deposits at the Federal Reserve to meet the amount required by the Fed.
Multiple Deposit Creation: A Simple Model
Excess reserves increase; Bank loans out the excess reserves; Creates a checking account; Borrower makes purchases; The Money supply has increased
What are stocks' "cash flows"?
Cash flows are all the funds flowing into the firm. The dividends or the sales price of the stock or both
Factors that Determine the Money Supply
Changes in the nonborrowed monetary base MBn The money supply is positively related to the non -borrowed monetary base MBn Changes in borrowed reserves from the Fed The money supply is positively related to the level of borrowed reserves, BR, from the Fed Changes in the required reserves ratio The money supply is negatively related to the required reserve ratio. Changes in currency holdings The money supply is negatively related to currency holdings
Checkable Deposits: What is the main advantage/disadvantage to a bank of acquiring checkable deposits?
Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties. Checkable deposits are payable on demand. This means that the depositor can withdraw funds and the bank is obligated to pay, checkable deposits are a liability for the bank
6. What are the effect of expansionary and contractionary monetary policy upon stock prices?
Expansionary: the lowering of interest rates will cause the return on bonds (alternative asset to stocks) to decline and investors are likely to accept a lower required rate of return on an investment in equity (k) the resulting decline lead to a higher value of stocks. Also, lowering the interest rates is likely to stimulate the economy so the growth rate in dividends (g) is likely to be somewhat higher. Contractionary: decreases stock prices. Same thing but vice versa
What is the interpretation of a yield curve using the Expectations Theory?
Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high. When the yield curve is upward sloping, the theory suggests that short-term interest rates are expected to rise in the future. In this situation in which long-term rate is higher than short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can occur only if short-term interest rates are expected to rise. When the yield curve is inverted, the average of future short-term interest rates is expected to be lower than the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future.
Fed Funds Sold: What are these and what are they used for?
Fed Funds sold occur when banks sell (lend) excess reserves in the Fed Fund market so that another institution can meet the reserve requirement. A positive value indicates that the bank has spare (excess) liquidity and could lend money to other banks to borrow
What is meant by central bank "independence" from political pressure? What is the Fed's source of independence from political pressure in the U.S.?
Financial independence, do not have to ask congress for money. Political independence. Monetary policy does not have to accommodate fiscal policy. Fed reserve can choose to not expand the money supply regardless of gov't plans
Understand the accepted stock-valuation formula, and why holding period is not incorporated into the formula. Be able to calculate the price of a stock. From the resulting price you calculate, explain how k and g help interpret economic conditions as well as investors' beliefs.
Gordon Growth Model: P = D/(k-g) P: selling price D: the most recent dividend paid k: the required return on an investment in equity g: the expected constant growth rate in dividends K and g may differ from investor to investor because each may have different requirements for require returns and expected constant growth rates. The holding period is not incorporated on this formula because dividends are assumed to grow at a constant rate forever.
What is the theory of portfolio diversification, and who won the Nobel Prize for its origination?
Harry Markowitz The theory demonstrates that portfolio diversification can reduce investment risk
What were Charles Merrill's main contributions to bringing "Wall Street to Main Street"?
He believed that the average American who wanted to invest should be able to buy shares in the stock market. He educated the American public through mass-market media. Merrill Lynch published easy-to-read pamphlets on various investing topics as well as holding seminars open to anyone who wanted to learn how to invest.
What role does information play in determining stock prices?
If two investors have different information about a stock, they may price the stock differently. New information can cause changes in expectations about the level of future dividends or the risk of those dividends. Superior information about an asset can increase its value by reducing its risk
What is meant by goal and instrument independence? How do "hierarchical mandate" and "dual mandate" differ?
Instrument independence is the ability of the central bank to set monetary policy instruments. Also the Open market operations, OMO. They have to set the required reserves and the discount lending policy. Goal independence is the ability of the central bank to set the goals of monetary policy. Dual mandate is the price stability and full employment. Hierarchical mandate: 1. Price stability and then 2. Full employment
Suppose you receive a phone call from a friend who has a "hot tip" about a certain stock, that he learned through overhearing a conversation in a restaurant. You decide to buy as much of that stock now, as the price is going to rise in the future, when you could sell it later for a large profit. News Flash: This strategy is not likely to generate a large profit for you. Why not?
It is the Efficient Market Hypothesis that explains why investors are unlikely to profit from "hot tips". In efficient markets, most new information is reflected in current market prices within an approximate 12-hour period. Therefore, the current price already reflects the impact of the new manufacturing process efficiencies on the stock's price.
Know how to determine the risk of default on bonds; against what standard is this risk measured?
It is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
The idea of establishing a central bank in the U.S. was very unpopular throughout the 18th and 19th centuries. What finally persuaded Congress to pass the Federal Reserve Act of 1913?
It wanted to eliminate the printing of money by private banks (which led to extreme fluctuations in the price level and frequent bank panics) and to provide emergency liquidity to the banking system. The lack of a central bank, and regulations on which banks could print money had been problematic for hundreds of years. Private banks' printing money led to wild fluctuations in the price level, which in turn led to bank panics and bank failures which took their toll on the economy. Congress felt that with economic growth, stability in the banking industry was essential to avoid wild swings in the price level, and to provide credit as needed to the business community.
What was the intended role of the Federal Reserve when it was first chartered? Has its role remained the same, or has it expanded over time?
It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded
What was the intended role of the Bank of North America (first central bank in the U.S.)? Why was its charter revoked?
It was intended to act as a central bank for the U.S. Shares in the bank were sold to the public. It became the country's first initial offering . "BNA faced political controversy early on. Opponents argued it was an overreach of congressional power and a bastion for moneyed interests. Fears eased when bank directors chartered the bank in Pennsylvania giving BNA the unique distinction of holding two charters simultaneously. State politicians briefly revoked the charter in 1786"
Liquidity Management
Maintaining sufficient reserves to meet deposit outflow
7. Understand the two forecasting methods by which investors formulate their beliefs about future stock prices. The expression Xe = Xof represents which forecasting method?
Monetary economies theory of rational expectations: one part of this is the adaptive expectations, which suggest that changes in expectations will occur slowly over time as past data change. Example: if inflation had formerly been steady at a 5% rate, expectations of future inflation would be 5%, too. Then John Muth developed and alternative theory of expectations called rational expectations, which can be stated as follows: expectations will be identical to optimal forecasts (the best guess of the future) using all available information. Xe = Xof is the formal statement of the rationales expectations theory. The financial economies theory rational expectations in financial markets which concludes the same thing as the first one, but financial economist gave their theory their own name, calling it the "efficient market hypothesis"
The perceived risk of holding stock is (negatively/positively) related to stock price?
Negatively because as the required return is higher because of the risk I perceive, the price of the stock gets lower
Non-transaction deposits: What is the main advantage/disadvantage to a bank of acquiring these types of deposits?
Non-transaction deposits are the primary source of bank funds. Owners cannot write checks on non-transaction deposits, but the interest rate paid on these deposits are usually higher than those on checkable deposits
Fed Funds Purchased (Other Borrowings): What are these and what are they used for?
Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks)
Examine the model below. At which point on the graph will the economy be experiencing the "time inconsistency problem" following an unexpected increase in the money supply? (If you cannot view this graphic in your browser, a copy of it can be located in Module II in Canvas after the Study Guide.)
Point 2 Yes: Point 2 shows the short-run impact of expanding the money supply, which increases output, lowers unemployment and raises the price level. However in general, wages are not adjusted at the same time prices adjust, so workers are "left behind" during a period when their wages are not keeping up with inflation.
Operating Profit (Net Income): How is it calculated?
Revenue - cost (on the income statement)
Securities: What types are banks permitted to own?
Securities can be classified into three categories: U.S. government and agency securities, state and local government securities and other securities. Banks hold state and local securities because state and local governments are more likely to do business with banks that hold their securities
What is meant by "asset transformation"?
Selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics
Why did the Federal Reserve Act create the Federal Reserve System to be decentralized?
So that the federal reserve is not a part of the federal government. Congress believed that monetary policy should be conducted outside or independently from politics and would act as an independent agency of the federal government.
What four innovations greatly increased the efficiency of, and public knowledge about the stock market?
Telegraph, Pneumatic tubes, Computers, & Circuit breakers to prevent runaway trading
Overall, central banking was very unpopular throughout the 1700s and 1800s, and several attempts failed. What factors finally persuaded Congress to permanently establish a central bank in 1913?
The 1907 panic resulted in bank runs that wreaked havoc on the fragile banking system. It was established in 1913 in response to the nations recurring banking panics: its mission has since expanded into fostering a healthy economy
Discount loans, check clearing, and coin and currency services are provided to the banking system by
The District Banks
What is meant by the Fed's "Dual Mandate"?
The Dual Mandate means that the Fed must establish BOTH price stability and full-employment. Both goals are given equal weight. Congressional Mandate established that the Fed is to focus on BOTH price stability and full employment. Since wild swings in the price level have over time proven to be devastating to economic growth and stability, this is an important objective for the Fed. Likewise, full employment keeps the economy at long-run equilibrium and prevents swings in the business cycle, also an important objective. These two goals have been given equal weight because they are connected, and need to be achieved, but not one at the expense of the other.
What goal does the ECB consider the most important in its conduct of monetary policy, and why?
The ECB consider the most important the goal of price stability, which means that the goal for the euro system is more clearly specified than the fed
Does the Fed have precise control over expansion of the money supply? Why or why not?
The Fed does not have precise control over the money supply because the multiplier linking the monetary base and the money supply is not perfectly stable or predictable, especially in the short run. The money supply is ultimately controlled by the public, the banks, and the Fed. The public decides how much of the monetary base they will deposit in banks and how much they will hold as currency in the hands of the public. Banks decide the quantity of excess reserves they will hold. The Fed determines the monetary base and the required reserve ratio.
What factors led to the formation of the European Monetary Union and then the European Central Bank? (ECB)?
The Maastricht Treaty in 1999 created the European monetary system, the European central bank, and the euro
What role did the earliest central banks such as the Riksbank, Bank of England, Bank of France play in the economy?
The Swedish Riksbank was established in 1668 as a joint stock bank, it was chartered to lend the government funds and to act as a clearinghouse for commerce. In 1694 the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt. The Bank de France was established by Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the French Revolution, as well as to aid in government finance. These central banks issued private notes, which served as currency, and they often had a monopoly over such note issue. While these early central banks helped fund the government's debt, they were also private entities that engaged in banking activities. Because they held the deposits of other banks, they came to serve as banks for bankers, facilitating transactions between banks or providing other banking services. They became the repository for most banks in the banking system because of their large reserves and extensive networks of correspondent banks. These factors allowed them to become the lender of last resort in the face of a financial crisis. In other words, they became willing to provide emergency cash to their correspondents in times of financial distress
Liability Management
The acquisition of low-cost and "core" deposits to protect liquidity and increase profits
What is the name of the agreement that formalized the first U.S. stock exchange?
The buttonwood agreement
What is the effect on the monetary base of an Open Market Purchase? Open Market Sale?
The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase. The effect of an open market sale on the monetary base always decreases the monetary base by the amount of the purchase.
What is the Efficient Market Hypothesis, and what does it imply about the effectiveness of exploiting "hot tips" for certain stocks?
The efficient market hypothesis states that current security prices will fully reflect all available information, because in an efficient market, all vacant profit opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a financial market to be efficient does not require that all market participants be well informed. It indicates that hot tips and investment advisers' published recommendations cannot help an investor outperform the market
Loans: What types of loans to commercial banks make?
The largest categories of loans for commercial banks are commercial and industrial loans made to businesses and real estate loans. Commercial banks also make consumer loans and lend to each other
Which of the following (Expectations, Segmented Markets, and Liquidity Premium/Preferred Habitat theories) best explains why yield curves are generally upward-sloping?
The liquidity premium/preferred habitat theory combines the features of the other two theories so it is able to explain this fact. It views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. This theory allows us to infer the market's expectations about the movement of future short-term interest rates from the yield curve. If you take away my liquidity I charge you a premium
What is the monetary base? What is the money supply?
The monetary base is the sum of the Fed's monetary liabilities (currency in circulation and reserves) and the U.S. treasury's monetary liabilities (Treasury currency in circulation, primarily coins). Currency in circulation is the amount of currency in the hands of the public. Reserves consist of deposits at the Fed plus currency that is physically held by banks. Money supply is the entire stock of currency and other liquid instruments circulating in a country's economy as of a particular time. Also referred to as money stock, money supply includes safe assets, such as cash, coins, and balances held in checking and savings accounts that businesses and individuals can use to make payments or hold as short-term investments.
If the seller of bonds to the Fed keeps the proceeds in currency, what will be the effect on the monetary base? On reserves? On deposit expansion?
The monetary base will increase because there is an increase in the currency in circulation. However, it will not have any effect on reserves because they are not receiving that money to increase their reserves. As a result there is no deposit expansion because the seller is not depositing that money in the bank. It doesn't affect the money supply
Understand the components of the money multiplier, and how changes in the required reserve ratio, the excess reserves ratio, and the currency ratio will affect m, and the resulting expansion of the money supply. Be able to calculate m if given the variables.
The money multiplier is: m= (1+c)/r+e+c c = currency ratio r = reserve requirement e = excess reserve ratio An increase in r will cause m to decrease, An increase in e will cause m to decrease, and An increase in c will cause m to decrease as well. Money supply is negatively related to the required reserves, excess reserves, and the currency in circulation.
Split the monetary base into two components MBn = MB - BR
The money supply is positively related to both the non-borrowed monetary base MB n and to the level of borrowed reserves, BR, from the Fed
Among major world central banks, which is the most independent?
The most independent central bank is the ECB (European central bank)
Know how to calculate tax-equivalent yield on a municipal bond.
The pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. This calculation can be used to compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher yield TEYm = Ym / (1- t)
Gap and Duration Analysis (Interest-Sensitive Assets & Liabilities - Be able to perform an analysis of changes in interest rates.)
The sensitivity of bank profits to changes in interest rates can be measured more directly using gap analysis that is the amount of rate-sensitive liabilities subtracted from the amount of rate-sensitive assets. By multiplying the gap times the change in the interest rate we can obtain the effect on bank profits. In Duration Analysis, the percentage change in the market value of a security is calculated by multiplying the negative percentage-point change in the interest rate by the duration in years, thus obtaining a good approximation of the sensitivity of a security's market value to a change in its interest rates (rate sensitive assets - rate sensitive liabilities) x change in interest rates = change in bank profit percentage change in the market value of a security = negative percentage-point change in the interest rate x duration in years • Maturity bucked approach: measures the gap for several maturity subintervals. • Standardized gap analysis: accounts for different degrees of rate sensitivity
Know how to identify the area of risk-premium on the supply/demand models for corporate bonds and U.S. Treasury securities
The spread between interest rates on bonds with default risk and default free bonds, both to the same maturity
The stock market crash of 1929: What were the two main contributing factors?
The use of credit, loaned money (which created a bubble) & Massive panicked trading
What are the main arguments for and against central bank independence? Does the evidence support independence?
There are several arguments against the Fed being independent: • Undemocracy • Fed is unaccountable • Would make it really difficult to coordinate fiscal and monetary policy
Why are shareholders referred to as "residual claimants"?
Those who hold stock in a corporation, own an interest in the corporation proportional to the percentage of outstanding shares they own. This ownership interest gives them a bundle of rights. The most important are the right to vote and to be the residual claimant of all funds flowing into the firm, known as cash flows, meaning that the stockholder receives whatever remains after all other claims against the firm's assets have been satisfied.
You are the Asset-Liability manager for a major bank holding company, and are considering purchases for the institution's bond portfolio. The company is in the 35% tax bracket. You are comparing between a U.S. Government Bond with a coupon rate of 8.25%, and a municipal Bond with a 6.50% coupon. You conclude that interest income would be maximized by purchasing the municipal bond; you are correct.
To calculate the comparable taxable-equivalent yields, the formula TEY=Cm /1-t, where TEY is taxable-equivalent yield, Cm is the coupon rate on the municipal bond, and t is the purchaser's tax rate. So: TEY = 6.50%/1-.35 TEY = 6.50%/ .65 TEY = 10%
Below is a diagram of the government bond yield curves for France, Germany, Italy, Spain, and the U.S. (see legend). For this question, assume that the "new normal" for the natural rate of interest is 2%. Among the nations depicted, which might be facing prices rising at levels that are not consistent with long-run macroeconomic equilibrium?
Under the Expectations Theory, short-term interest rates are expected to quickly reach, then exceed the natural rate of 2% only in the U.S. This indicates that the economy could be rapidly growing toward and beyond long-run equilibrium, putting undesirable pressure on inflation.
Calculate the price of a share of stock given the following information: Most recent dividend paid: $3.75 Expected dividend growth rate: 1.5% Investor's expected rate of return: 6.25%
Using the Gordon Growth Model: P = D(1+g) k - g P = $3.81 (1.015) ( .0625 - .015) P = $3.81 .048 P = $79.38
What determines the quantity of new loans a bank is able to make?
What determines the quantity of new loans a bank is able to make depends upon the required reserve ratio, and whether or not the bank feels there is going to be a rush of deposit outflows and thus hold more excess reserves instead of lending out.
Return on Equity: To whom is this value particularly significant?
What the bank's owners (equity holders) care about most is how much the bank is earning on their equity investment. This information is provided by the other basic measure of bank profitability, the return on equity ROE: ROE = net profit after taxes / equity capital
When a bank gains deposits, it gains (fill in the blank); when it loses deposits it loses (fill in the blank).
When a bank gains new deposits, it gains new reserves. Reserves are deposits that banks deposit in their account at the Federal Reserve Bank that they are holding for customers. While banks are holding these deposits, they can lend them out to other customers to make a profit. So when customers withdraw deposits, the level of reserves the bank is holding will fall. "When a bank gains deposits, it gains reserves. When a bank loses deposits, it loses reserves."
Suppose the yield curve were perfectly flat. The interpretation would be that long-term interest rates and short-term interest rates are the same, and nothing is expected to change. Why, in reality would we almost never see a completely flat yield curve?
Yield curves almost always slope upward. This relates to the term structure of interest rates and Keynes' Liquidity Preference Theory. There is naturally more risk in lending/investing for a long period of time versus a short period of time. This is why long-term loans and investments will always carry a higher rate of interest, regardless of what the Expectations Theory tells us about the future of short-term interest rates. So, although a flat yield curve would indeed indicate that our expectations are that interest rates are not going to change in the future, we would rarely see that. Longer-term rates will most always be higher due to lenders'/investors' preference for liquidity.
describing the slopes of yield curves
a. an upward-sloping yield curve - long-term rates are above short-term rates. b. a steeply upward-sloping yield curve - it indicates that short-term interest rates are expected to rise in the future. There is a rapid change. c. a relatively flat yield curve. - short- and long-term rates are the same. It indicates that short-term rates are expected to fall moderately in the future. Slow change. d. an inverted yield curve. - long-term rates are below short-term rates. It indicates that a substantial decline in short-term rates is expected in the future.
One of the greatest challenges in managing Credit Risk is the problem of
asymmetric information. This answer is correct, because the biggest challenge to lenders is that the borrower has more information about credit risk than the lender. This can be overcome through careful screening of borrowers before the loan is made (the Adverse Selection Problem), and then using strategies like collateral and restrictive covenenants in the loan agreement to minimize the risk of default (the Moral Hazard Problem).
Interest-rate Risk Management
balancing interest-sensitivity on both sides of the balance sheet to minimize swings in profits when interest rates change
Given your calculation of the money multiplier m from the previous question, calculate the change in the money supply if the Fed engages in a $65 billion open market purchase of treasury securities.
change in MS = m x change in MB = 2.2 x 65,000,000,000 = 143,000,000,000
The monetary base consists of
currency, required reserves, and excess reserves
What are the five major bodies of the Federal Reserve "System"? What is (are)the primary role(s)
district banks, board of governors, federal open market committee
Refer to the previous question in which you calculated the price for a share of a certain company's stock: a. What would be the impact upon that price if monetary policy became more contractionary? b. What would be the impact upon that price if there was news of a major development in the efficiency of the company's manufacturing process? Assume that these events are separate and occur at different times. Choose the pair of answer combinations that correctly answer each portion of this question.
fall/rise If interest rates rise, the expected rate of return expressed by k will rise. Price will fall. Improvements in manufacturing efficiency should reduce cost and increase profit; g will rise. Price will rise.
Income tax considerations
interest payments on municipal bonds are exempt for federal income taxes. Tax-free status shifts demand for municipal bonds to the right and decreases demand for treasury bonds, municipal bonds end up with a higher price and lower interest rate than treasury bonds.
What generates interest income for the bank?
loans and bonds
Calculate the money multiplier m, given the following: c = .65 e = .002 r = .10
m = 1 +c r + e + c m = 1.65 .75 m = 2.20
Capital Adequacy Management
maintaining a sufficient cushion against loan losses while at the same time maximizing shareholders' returns on their investment capital
Credit Risk Management
minimizing the probability that borrowers will default on their loans
Choose the correct combination of answers below to answer the following: Changes in the money supply are (positively/negatively) related to each of the following: -an increase in the reserve requirement -an increase in the level of excess reserves -an increase in the holdings of currency
negatively, negatively, negatively
Default risk
probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value. U.S. treasury bonds are considered default free. Increase in default risk shifts demand curve for corporate bonds to the left and the demand for treasury bonds to the right. Raising price for treasury bonds and lowering price of corporate bonds will lower interest rate in treasury bonds and raise the interest rate on corporate bonds. A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.
In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections, and took an ownership stake in the company. How would this have affected, if at all, the price, yield, and risk premium on AIG's corporate bonds, respectively?
rise/fall/fall
Asset Management
seeking the highest possible returns on loans and securities while simultaneneously making adequet provisions for liquidity
Liquidity
the relative facility with which an asset can be converted into cash. An increase in the money supply leads to lower interest rates. An increased liquidity of bonds results in demand curve shifting right. Lower liquidity of corporate bonds increases the risk premium between the interest rates of these 2 bonds because corporate bonds are less liquid than treasury bonds.
What is meant by the Fed's "Dual Mandate"?
v
Open Market Purchase: Summary
• The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits • The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase
Board of Governors
• Appointed for 14-year terms • Votes on conduct of open market operations • Fiscally independent • Sets reserve requirements • Controls the discount rate through "review and determination" process • Sets margin requirements • Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank's budget • Approves bank mergers and applications for new activities • Specifies the permissible activities of bank holding companies • Supervises the activities of foreign banks operating in the U.S. Chairman of the board of governors • Serves 4-year term • Advises the president on economic policy • Testifies in Congress • Speaks for the Federal Reserve System to the media • May represent the U.S. in negotiations with foreign governments on economic matters
Who are the four "Players" in the money supply process?
• Central bank (Federal Reserve System) • Banks (depository institutions; financial intermediaries) • Borrowers (individuals and institutions) • Depositors
district banks
• Clear checks • Issuing new currency (not the same thing as printing money. They take destroyed currency and replace it. • They make discount loans to member banks. Must be secured by U.S. Government securities. • Evaluate mergers, acquisitions, and new branches. • Act as liaison between business community and BOG • Examine bank holding companies and state-chartered member banks • Collect data on local business conditions • Conduct research for conduct of monetary policy
What are the six major challenges facing bank management? Be able to discuss how bankers approach these challenges (issues and solutions)
• Liquidity Management: Suppose bank's required reserves are 10%. If a bank has sufficient excess reserve a deposit outflow does not necessitate changes in other parts of its balance sheet. Reserves are a legal requirement and the shortfall must be eliminated. Excess reserves are insurance against the costs associated with deposit outflows. Cost suffered is the interest rate paid on the borrowed funds. The cost of selling securities is the brokerage and other transaction costs. Borrowing from the Fed also incurs interest payments based on the discount rate. Reduction of loans is the most costly way of acquiring reserves. Other banks may only agree to purchase loans at a substantial discount. • Asset Management: to maximize its profits a bank seeks the highest possible returns on loans and securities, reduce risk, and have adequate liquidity by holding liquid assets. Banks try to accomplish these three goals in four basic ways: 1. Find borrowers who will pay high interest rates and have low possibility of defaulting. 2. Purchase securities with high returns and low risk. 3. Lower risk by diversifying. 4. Balance need for liquidity against increased returns from less liquid assets. • Liability Management: 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. The acquisition of deposits at low cost in order to increase profits. • Capital Adequacy Management: Bank capital helps prevent bank failure. The amount of capital affects return for the owners (equity holders) of the bank. Meeting regulatory requirement. Benefits the owners of a bank by making their investment safe. It is costly to owners of a bank because the higher the bank capital, the lower the return on equity. The choice depends on the state of the economy and levels of confidence. • Credit Risk: minimizes the probability that borrowers will default • Interest-rate Risk: If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits
Federal open market committee
• Meets eight times a year • Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks • Chairman of the Board of Governors is also chair of FOMC • Issues directives to the trading desk at the Federal Reserve Bank of New York FOMC meeting • Report by the manager of system open market operations on foreign currency and domestic open market operations and other related issues • Presentation of Board's staff national economic forecast • Outline of different scenarios for monetary policy actions • Presentation on relevant Congressional actions • Public announcement about the outcome of the meeting
What generates interest expense for the bank?
• Sources of operating income other than interest income loans or investment • Off-balance sheet activities. • Servicing mortgage backed securities. • Creating structured investment vehicles, which can potentially expose bank to risk, as it happened in the global financial crisis
