ECO3223 Exam 3

3. What is "Bagehot's Dictum"?

"Bagehot's Dictum" states that during a financial crisis or panic, central banks should lend freely against quality assets as collateral and charge a penalty in the form of an interest rate to discourage excessive use of assets.

Trading U.S. Government Securities: How information on trading in Treasury securities is reported in the financial press, and what can be learned from it:

*Treasury Bills* - GSDs are important players in these markets (they manage portfolios of Treasury securities and make a market for Treasury bills by posting a bid rate and an asked rate) - The information on the final trade of the day will show us the: 1. maturity date 2. days to maturity 3. bid rate 4. asked rate (NOTE: bid rate is always higher than asked rate, ensuring a profit for the dealer if he could acquire the T-bill at the higher bid rate, or lower price, and sell it at the lower asked rate, or higher price) 5. "Chg" ---- represents the amount the asked rate changed relative to the previous trading's day close 6. Asked Yield ---- the investment rate/ yield to maturity that corresponds to the asked discount rate ---- Bid-ask spread for T-bills is the bid rate minus the ask rate (indicates the reward to the dealer for making the market) --------------- Table numbers for "On-the-Run" T-bill: 3-month ---- maturity date (Aug 3, 17), days to maturity (87), bid (0.863), asked (0.853), chg (-0.007), asked yield (0.866) 1-year ---- maturity date (Aug 26, 17), days to maturity (353), bid (1.095), asked (1.085), chg (0.015), asked yield (1.112) --------------- EXERCISE: Compute the asked yield for the 1-year T-bill using the remaining information in the table ---- there's 2 steps involved Step 1: Compute the price per $100 in par value for which the T-bill sold in the last trade of the day (use discount rate formula) DR (Asked) = (Par Value - Purchase Price) / Par Value x 360 / days to maturity ---- *purchase price is also market price of the T-bill* ---- 0.01085 = (100 - Market Price) / 100 x (360 / 353) ----> Market Price = *$98.936* Step 2: Use the investment rate formula to compute the asked yield IR (Asked Rate) = (Par Value - Purchase Price) / Purchase Price x 365 / days to maturity *plugging in the numbers we get* IR = (100 - 98.936) / 98.936 x 365 / 353 = 0.01112 or *1.112%* *Treasury Notes and Treasury Bonds* - GSDs also make the markets for the Treasury notes and Treasury bonds but the dealers are the ones that quote the Bid and Asked prices - Information on the final trade of the day will show us: 1. T-note/T-bond (length of note or bond) 2. maturity date 3. coupon ---- same as the coupon rate 4. bid rate 5. asked rate 6. chg 7. asked yield --------------- Table numbers for T-Note/T-Bond: 2-year ---- maturity date (Apr 30, 17), coupon (1.250), bid (99.8359), asked (99.8516), chg (-0.0313), asked yield (1.326) 3-year ---- maturity date (Apr 30, 20), coupon (1.375), bid (99.5097), asked (99.5234), chg (-0.0547), asked yield (1.539) 5-year ---- maturity date (Apr 30, 22), coupon (1.750), bid (99.1719), asked (99.1875), chg (-0.1172), asked yield (1.922) 7-year ---- maturity date (Apr 30, 24), coupon (2.000), bid (98.7969), asked (98.8125), chg (-0.1641), asked yield (2.184) 10-year ---- maturity date (Feb 15, 27), coupon (2.250), bid (98.9141), asked (98.9297), chg (-0.2031), asked yield (2.374) 30-year ---- maturity date (Feb 15, 47), coupon (3.000), bid (99.6641), asked (99.6953), chg (-0.5313), asked yield (3.016) --------------- EXERCISE: 1. Which of the T-notes and T-bonds are selling above, at, or below par at the close of trading? ---- can be solved in 2 ways: a. is the "asked price" > or = or < 100? b. is the "coupon rate" > or = or < the "asked yield"? Only if the coupon rate equals the asked yield is the bond selling at par. If the coupon rate > asked yield, its selling above par, and vice versa On this date: All of the on-the-run Treasury notes/ bonds were selling *below par* 2. If the securities had been issued at par initially, then have their yields fallen, remained unchanged, or risen since they were issued? a. Can be answered by comparing the asked price with 100 ---- if security is selling above par, the yield has fallen, if its selling below par then its risen b. If coupon rate is above the yield, then the yield has fallen and if it's below the yield then the yield to maturity has risen By the end of trading on this day: The yields on ALL of the notes/bonds have risen since the securities were initially issued

Composition of U.S. Treasury Debt

- *U.S. Government Debt Held by Public* $14,293 billion (72%) ---- of which, $13,928 billion is marketable & $365 billion is nonmarketable - *Intragovernmental Holdings* $5,552 billion (28%) ---- of which, $22 billion is marketable & $5,530 billion is nonmarketable ---- *Total U.S. Governmental Debt* $19,846 billion (100%) Breaking down marketable Treasurys, which total $13.9 trillion: - short-maturity *Treasury bills* (money market instruments with a year or less in maturity and are sold at a discount to their face value) comprise approximately 12% or $1.7 trillion - *Treasury notes* with maturities exceeding 1 year and up to/including 10 years represent about 2/3 of marketable Treasurys or $8.7 trillion - *Treasury bonds* having maturities of 10 years and up to/including 30 years comprise about 13% or $1.9 trillion - *Treasury Inflation Protection Securities* or *TIPS* are coupon securities with a special feature that is intended to provide their owners a means of avoiding losses due to inflation by systematically adjusting the coupon payments and the par value upwards for inflation measured by the CPI ---- there's currently $1.2 trillion in TIPS outstanding The Treasury Department chooses which maturity classes of securities to issue

Bank Assets

- Cash assets: are highly liquid and generally used to facilitate daily operations ---- they also reduce the risk assessment of the bank's portfolio holdings (helping the bank meet its capital requirements ---- stock of cash assets within the bank includes: vault cash or currency , deposits in accounts with other banks, and cash items in process of collection (checks drawn on other depository institutions that the bank has yet to clear) ---- banks must hold a minimum amount of the *legal reserves* of vault cash plus deposits at the Federal Reserve in relation to certain liabilities ---- the Fed sets these so-called *reserve requirements* - Bank credit: represents the total amount of credit that is created by the banking system ---- has several components including the most important income-generating assets owned by the bank ---- there's two major categories of bank credit: *investments in bank securities* and *loans and leases* *Interbank lending* represents funds that move between banks and are not part of bank credit ---- loans don't belong to bank credit sine these transactions reflect monies moving from one bank to another and never getting outside the banking system ---- the two important categories when banks are on the lending side of the transactions are referred to as: *federal funds sold* and *bank reverse repurchase agreements* Investments are typically made up of *fixed income securities* and include: Treasury securities, municipal bonds, and mortgage-backed securities (MBSs) *Commercial and Industrial (or C&I) loans* are the bread and butter assets of commercial banks in their loan portfolios ---- they're business loans, most of which have relatively short maturities of a year or less (represent one of the primary sources of credit for small businesses that are not able to access the capital markets by issuing stocks or bonds) Large corporations rely on commercial banks for *working capital loans* which are borrowings used to meet ongoing expenses, such as the firm's wage bill of payments made to its suppliers, when sales revenues fall short of those needs ---- interest rates are generally higher than the principal alternative (commercial paper) but firm's will usually maintain open lines of credit with commercial banks for a fee ---- since this line of credit is a requirement for these firms to be able to sell their commercial paper in the open market *Real estate loans* remain the most important interest-earning asset of commercial banks, representing nearly one-half of their total loan portfolio and nearly one-fourth of their total assets ---- One of the largest liabilities of households is *credit card debt* and banks are the principal issuers of credit cards Remaining assets of the bank are primarily comprised of their buildings, office equipment, etc.

The New York Fed's Special Roles

- Conducting *open market operations* - Maintaining surveillance of the financial markets (by closely monitoring activities of the major financial institutions) - Implementing the Treasury Department's decisions on intervention in the currency markets - Conducting Treasury auctions

Liabilities of Banks Operating in the U.S.

- Deposits ($11.7 trillion, 72% of total assets) ---- core deposits: checkable deposits, savings accounts, and small CDs ($10.2 tril, 63%) ---- large negotiable CDs ($1.6 tirl, 9.9%) - Borrowings ($2 trillion, 12.3% of total assets) ---- federal funds, RPs, and discount window - Other liabilities ($0.8 trillion, 4.9% of total assets) TOTAL: $14.5 trillion and 89.5% of total assets

Commercial banks have four principal options from which to choose when raising funds quickly:

1. Large Negotiable CDs 2. Federal Funds 3. Arbitraging Bank Sources of Funds 4. Borrowing at the Federal Reserve's Discount Window

The Dual Policy Mandate

1. Price stability: objective has been given substance with an informal target of an underlying average inflation rate over what might be thought of as the medium run of 6 to 12 months of 2% - Rationale is that inflation in excess of 2% would induce too much volatility into prices, creating *inflation uncertainty* that would lead to significant economic inefficiencies ---- inflation below 2% runs the risk of plunging the economy into a state of *deflation* , or falling prices 2. Maximum sustainable employment: keeping the economy as close as possible to its *maximum sustainable level of employment* will coincide with *maximum sustainable economic growth*

Structure of the Dutch Auction of U.S. Treasury Securities

1. The Federal Reserve accepts sealed competitive bids on the announced offerings ---- bidders commit to purchasing a certain quantity of the new securities (by bidding a discount rate on T-bills or a price/$100 in par value for T-Notes/Bonds) 2. The Fed also receives *noncompetitive tenders* ---- investors agree to purchase a certain quantity of the new securities (at rates for T-bills or prices for T-Notes/Bonds determined by the auction) - many of the noncompetitive tenders are made online through treasury-direct.gov - An inexpensive way to invest for anyone interested in purchasing U.S. Treasurys (no brokerage fees to pay) 3. Once all bids are received, the Fed subtracts the noncompetitive tenders from the total amount of securities being auctioned 4. Competitive bids are then ordered ---- for T-bills the bid rates are ordered from low-to-high, and for T-Notes/Bonds the bid prices are ordered from high-to-low 5. Orders are then filled beginning with the highest bidder until the entire offering is exhausted 6. The highest discount rate for T-bills or the lowest price for T-Notes/Bonds that is accepted determines the auction rate for T-bills and the auction price for T-Notes/Bonds that ALL successful bidders receive ---- the price paid for these securities is referred to as the *stopout price* Auction results are published online

2. What is meant by a MMMF's NAV?

A MMMFs Net Asset Value (NAV) is the final value returned to the investors. The NAV is the full interest to investors minus the management fee. The MMMFs portfolios are composed on short-term money market assets that have no restrictions with respect to interest. This is the MMMFs advantage over depository institutions.

2. What can precipitate a bank run on a bank with a healthy asset portfolio?

A bank run occurs when there is a financial panic and the bank's depositors suddenly begin to withdraw all their deposits. Individuals can began to get nervous about their deposits when long-term liquid assets begin to be financed by short-term liquid liabilities. If a bank has a healthy asset portfolio then a bank run is quite rare. When individuals lose confidence in a financial institution a bank run can occur. If people believe that bad investments were made at their bank even with a bank with a healthy asset portfolio, people will stop depositing in that bank.

11. What are the principal attributes to the bank of its investment portfolio versus its loan portfolio?

A bank's investment portfolio is comprised of fixed income securities such as stock, mortgage backed securities (MBSs), mutual funds, money market funds, municipal bonds, and treasury securities. The main purpose of bank investment portfolios is to decrease risk through diversification to balance risk and liquidity. A bank's loan portfolio is more for their daily operation. Loan portfolio's largest category is in Commercial and Industrial Loans. They are short-term loans that can be beneficial to smaller banks because they cannot raise funds by issuing bonds, stock, or commercial paper. In addition, the bank's loan portfolio offers the ability for large companies to obtain working capital loans, which allows them to fund smaller expenses

Commercial Paper

A central asset in the portfolios of prime money funds ---- often referred to as *corporate IOU* - In their earliest form, these assets were uncollateralized short-term debt sold at a discount - Now, analogous T-bills, except they: 1. carry a higher risk of default 2. are much less liquid, generally traded in relatively "thin" markets (markets with a low volume of trading) - Has higher risk and lower liquidity than T-bills suggesting they carry a higher expected rate of return Other asset properties include: - Minimum investment of $1 million - Range in maturity from 30-270 days - Market is sensitive to risk so the volume of commercial paper falls dramatically during recessions - Since it's sold at discount, investor receives nothing until investment matures - Primary market is comprised of *direct paper* (sold by issuing firms directly to the investor) and *dealer paper* (issued by non-financial firms) - One of the largest buyers is the group of prime MMMFs, for whom commercial paper represents the riskiest asset and highest expected rate of return Used to deal with the additional risk of uncollateralized commercial paper: - Only blue-chip (firms with high credit ratings) can issue commercial paper - Even high quality firms must maintain a *backup line of credit* - *Covenants* in a bank's line of credit agreement include provisions for closing the line of credit if the firm's financials deteriorate too much - *Credit enhancements* are also offered by banks to some lesser quality firms where the bank essentially guarantees payment on maturing commercial paper (if the firm was unable to do so)

The Treasury Yield Curve

A plot of all the current interest rates or yields on Treasury securities versus their term to maturity If you obtained this information every day for 20 years and plot the Treasury yield curves, then averaged across all of those graphs, what would you expect the yield curve to look like? - The unbiased expectations hypothesis would show the slope of the yield curve reflecting the markets expectations of future short rates (when the short rate is expected to rise, the long rate is higher than the short rate and the slope of the yield curve is positive ---- when the short rates expected to fall, the long rate is below the short rate and the slope of the yield curve is negative) ---- However, logic suggests that the short rate is neither expected to rise not to fall on average - The *normal shape* of the yield curve is how it would appear on average, and the argument suggests that it would be flat *The Liquidity Premium* The predictions above don't totally match one's intuition. If we conducted the experiment described the normal shape of the yield curve, on average, should be upward sloping - What was missing from the first stated theory was the liquidity premium which biases long-term interest rates upward relative to short rates ---- when comparing short and long rates, consideration must be given to the perspectives of both the investors and the issuers of the assets - The magnitude of the liquidity premium tends to vary over the business cycle, reflecting interest rate risk (the uncertainty associated with future short-term interest rates and tends to increase when short rates become more volatile) The general formula identifying the term structure relationship between a one-period and an N-period asset that includes the liquidity premium appears as follows: ---------- (1 + R)^N = (1 + r1) (1 + Er2) (1 + Er3) ..... (1 + ErN) + liquidity premium ---------- The longer the maturity of the asset, the greater is the liquidity premium (tends to bias upward the slope of the yield curve) which tends to increase the interest rate on the longer term asset on average - A flat yield curve suggests that the short rates are expected to fall by just enough to offset the upward bias of the liquidity premium - When short rates are expected to rise in the future the yield curve is even more steeply sloping upward - A downward sloping yield curve, or *inverted yield curve* implies that the markets are expecting steep declines in short rates in the future

Banker's Acceptances

A short-term debt instrument where the issuer is a commercial bank rather than the federal government - Sold at a discount to face value and carries a maturity typically between 30-180 days - Once issued, it can be resold in the secondary market (therefore is *relatively liquid, low-risk, short-term debt instrument* that makes it an ideal investment for *MMMFs*) - Used by large firms for the payment of intermediate goods used in their production process, and are most frequently utilized in international trade involving import-export transactions

13. How and why did the manner in which the Federal Reserve's administration of the Discount Window change after 9/11? State the advantages of the changes.

After 9/11 it became more difficult for the FED to determine whether their member banks actually needed the FED as the lender of last resort. Before 9/11, the FED's Discount Window rate was just below the federal funds rate. The member banks had to argue their case as to why they needed lending from the FED. With the discount rate set above the fed funds rate, no bank could lend above that rate, since the borrowing bank could always borrow at the discount window from the Fed. Also, a large unexpected increase in demand for liquidity was automatically accommodated by the Fed, since they place no restriction on discount window borrowing. This helped reduce the cost of oversight of the discount window. These actions helped the FED discover the actual need for their funds and avoid wrong predictions that could increase the federal funds rate.

7. How do arbitrage opportunities in the markets for short-term funding sources cause interest rates in those markets to move together? Explain by way of example.

Arbitrage is an action that can be taken by financial institutions in order to use a difference in the price of the same or similar assets that exist in different markets. More specifically, they use arbitrage by finding and purchasing the funds with the lowest cost and then selling those funds in another market at a higher cost to make a profit. Banks require a fast source of funding in order to participate in arbitrage activities and often turn to short-term funding sources such as federal funds and repurchase agreements. Arbitrage opportunities for short-term funding sources make banks both lenders and borrowers. As a result interest rates in these markets would move together, because banks begin by choosing their funding with whichever source has the least cost.

10. What is meant by bank credit, and what is its composition?

Bank credit is another asset, which is the total credit that comprises the entire banking system. It is the total credit created by the banking system. It is composed of two parts. One is the investment in debt securities, which manages a bank's risk and liquidity levels. The second is the loans and leases such as Commercial and Industrial Loans, real estate loans, home equity loans, working capital loans, and student loans. This is the central core of the banks' assets

9. What are the primary reasons banks hold cash assets? What special features among cash assets do deposits at the Federal Reserve have?

Banks hold cash assets because they can be used for all day-to-day operations because of their liquidity. It also reduces the potential risk in banks' portfolios and maintains there given capital requirement determined by the FED. Therefore, deposits at the Federal Reserve are a critical aspect of a bank's capital requirements. They also allow banks to achieve daily transfers through Fedwire, the electronic transfer system.

Basel I and Basel II

Basel I - The basic structure of capital requirements is first to assess the risk associated with each individual asset owned by the bank, and attach a risk-weight from 0 (no risk) to 1 (max risk) ---- the dollar volume of the assets are then multiplied by their *risk weights* and summed across all assets to create the *risk-adjusted asset base* - Banks are then required to maintain a minimum amount of bank capital as a percentage of the risk-adjusted asset base ---- this stresses the burden of risk that must be borne by stockholders Basel II - Essentially a refinement of the Basel I Accords to take into account many of the risk-management tools employed by the world's largest banks ---- it allowed those banks to perform their own risk assessment to recognize their unique risk management practices (although the risk assessment had to be made transparent to regulators)

9. Compare commercial paper with T-bills as investment instruments?

Both Commercial Paper and T-Bills are short-term investment instrument or debt obligation. They are short-term uncollateralized debt sold at a discount so that investors just receive returns when the investment reaches maturity. The Commercial Paper has a maturity that it between 30-270 days with a high very high risk. It can also be either "direct paper" or "dealer paper". The big difference between these two is that Commercial Paper has more risk and it is less liquid, which leads to a higher rate of return than the T-Bills.

Variable-Rate CDs or floating-rate CD

Carries an interest rate that is adjusted over time to market rates - Interest rate when it's first issued is generally set as a spread over a market rate (like a given T-bill rate or a market average of newly issued CDs) - To compute the interest earned on the CD ---- the length of the maturity of the CD is divided into periods of fixed length, such as one to three months (at the end of each period, the interest rate is reset - Maturity of these CDs is typically a little longer (18 months to 2 years) than traditional large CDs, which makes them attractive to MMMFs enabling them to maintain a market interest rate on those vesting maturing assets - The SEC allows the money funds to compute average maturity of their portfolio by treating the maturity of variable-rate CDs as the period over which the rate is reset

15. How would you characterize the significance of commercial banks in the housing (residential real estate) market?

Commercial banks are highly involved in the real estate market. They are significant in the real estate market because real estate investments comprise approximately one third of commercial bank investments. It also is a large portion of their interest earnings. Banks (and S&Ls) also originate the majority of mortgages, but securitize a large percentage of them.

Repurchase Agreements (Repos or RPs)

Comprised of two transactions that mimic a collateralized loan, where the collateral is usually a Treasury security, such as a 3 month T-bill - Maturity is typically *overnight* - Interest rate is known as the *RP* or *repo rate* and is the bank discount rate that's typically very low ---- reflecting the low risk involved in these assets and the very short maturities, implying high liquidity Example: A large bank that's in need of say, $1 billion quickly, in order to meet loan requests by its major corporate clients who want to draw a line of credit with the bank. - The bank possessed a T-bill with a market value worth $1 billion and could decide to enter into a repurchase agreement whereby it agrees to sell the T-bill today, and repurchase the same T-bill back tomorrow at a price that includes the sale price *plus* an interest payment (known as the *repurchase price*) - When commercial banks are on both sides of the transaction, the contract is referred to as a *bank RP* - These transactions take place over the double-entry bookkeeping and *electronic funds transfer (EFT)* system known as Fedwire ---- referred to as *delivery-versus-payment* of *DVP transactions* where the party possessing the T-bill is in control of the timing of the transactions If the borrowing bank does not repurchase the T-bill once the RP contract is fulfilled, the RP is labeled as *fails* ---- usually occurs due to technical reasons that caused the transaction to be unfulfilled - The chance of this happening could cause the short-term interest rate to rise and the market price of the T-bill to decline ---- making the lending bank incur some *interest rate risk* when making the loan ---- To protect the lending bank from this interest rate risk, the loan amount will reflect an amount based on a repurchase price that is less than the market value of the T-bill and that reduction is referred to as a *haircut* (this provides additional incentive for the borrowing bank to repurchase the T-bill when the RP matures to avoid what would otherwise effectively amount to selling the T-bill at a loss

4. What are core deposits in banks and how important are they for long-term sources of funding? How important are they for short-term sources of funding?

Core deposits are one of two categories of deposits, made up of checkable deposits/checking accounts, saving accounts and money market deposit accounts (MMDAs), and small certificates of deposit (CD's). Core deposits in banks comprise 63% of a commercial bank's total assets. They are very important in long-term funding because they create a stream of funds that grows over time. Core deposits are not important for short-term sources of funding since they grow over time. Banks are unable to grow funds quickly for short-term needs using core deposits.

The Origin of the Federal Reserve and its Mandate

Created by Congress with the passage of the *Federal Reserve Act of 1913* , the Federal Reserve holds the responsibilities and authority to act as both a principal regulator of the financial system and a chief architect of the nation's macroeconomic policy (increasing them significantly) It's current mandate encompasses the following: - It designs and implements monetary policy in accordance with the *dual policy mandate of price stability* (generally implying low and stable inflation, and *maximum sustainable employment* that fosters long-run economic growth - As the lender of last resort, it's empowered to supply funds to financial institutions that are under short-term economic stress (but are otherwise sound) - Along with the *FDIC* and the *Controller of the Currency* , the Fed is one of the principal regulators of the banking system - After the passage of the Dodd-Frank Act, it became the chief regulator of the "too-big-to-fail" firms that could represent a systematic threat to the financial system as a whole - Responsible for maintaining an efficient payments system ---- including the important role of Fedwire in facilitating huge volumes of large transactions on a daily basis

Movements of the Yield Curve

Curve can change along any of at least three different dimensions: level (or intercept), slope, and curvature - A change in the level/intercept means that interest rates all along the curve move roughly parallel ---- shifting the whole curve up or down ---- macroeconomic forces like increased inflation, a weak economy, or significant technological changes have the greatest impact on a yield curve's level - The slope changes when shorter-term interest rates rise or fall by greater amounts than longer-term interest rates ---- shifts in the Federal Reserve monetary policy are one of the major influences on the yield curve's slope ---- If long-term interest rates initially do not change, or change by a lesser amount than short-term rates (which is usually the case), then the average slope of the curve declines - The curvature of a yield curve may change when interest rates in the middle of the maturity spectrum are impacted ---- such as by a shift in economic conditions of moderate length ---- this development would tend to give the yield curve a greater or lesser "hump" along its midsection Financial markets get very nervous when an inverted yield curve appears because every recession since WWII has been preceded an inversion of the yield curve ---- The Fisher equation can explain why this phenomenon has been observed with such regularity - Since nominal interest rate is approximately equal to the sum of the real rate plus the expected rate of inflation ---- when the economy enters a recession: real rate falls as the demand for credit declines and inflation also falls as the demand for goods/services declines, thereby, reducing the markets expectation of inflation ---- with this expectation comes changes in the projections of future short-term interest rates and trading of Treasury securities ultimately producing an inversion of the yield curve associated with the anticipated sharp decline in short rates

Continuing Contratcs

Essentially RP contracts that are automatically renewed each day until one of the two parties decides to terminate the contract ---- RP rate is updated each day and interest accumulates on the contract until termination - Avoids transaction costs associated with the sale and resale of securities

Eurodollar and Yankee CDs

Eurodollar CDs - Large commercial banks with multinational operations can tap markets in locations where their branch offices are operating outside of the country ---- U.S. banks with branches in London or Tokyo can issue dollar-denominated CDs in foreign countries where those branches are domiciled (*eurodollar CDs*) ---- buyers are often large multinational corporations who are engaged in markets, such as oil, where transaction are primarily conducted in dollars Yankee CDs - Foreign banks also wish to service multinational corporations through operations of their branches in the United States ---- a significant portion of the funds they raise in deposit markets in the US is derived from large negotiable CDs referred to as *yankee CDs* ---- subject to regulations by the Federal Reserve

2. How do the measures of bank concentrations in the United States based on the number of banks per capita versus the total assets of the banking system held by the largest few banks tell a different story?

Even though we see the large number of banks per capita throughout the U.S., their consolidation has created this prominent bank concentration. Bank concentration in the U.S. can be measured by the number of commercial banks in the United States per capita. It can also be measured by the percentage of total assets held by the largest banks in the U.S. Chapter 9 in the textbook shows graphs on page 338-339. From these we can see that the number of commercial banks in the U.S. has declined over the past decade. At the same time, the total assets held by the largest 5 commercial banks have increased. The increase in the number of commercial banks in the U.S. implies an increase in the number of banks per capita. This suggests that we have low concentration of bank assets. However if we measure of total assets of the banking system held by the largest few banks, it suggests that bank concentration has grown tremendously over the years. The top 5 banks hold about 48% of the total U.S. commercial banking assets. Therefore the large number of banks per capita in the U.S. suggests low concentration of bank assets, yet we have a high concentration of total assets in the top 5 banks suggesting low concentration. We get conflicting stories. Examining the total assets in the top five banks, which suggests bank consolidation has increased, creates a more realistic picture of what is going on in the economy.

Liabilities of the Federal Reserve

Federal Reserve Notes (currency) - $1.556 trillion Reverse Repurchase Agreements - $446 billion Deposits - $2.471 trillion *deposits broken up into:* - Depository Institutions (reserves + term) - $2.165 trillion - US Treasury - $225 billion - Foreign Official - $5 billion - Other - $76 billion Other Net Liabilities & Capital - $48 billion Total Liabilities & Total Capital - $4.521 trillion The liabilities of the Federal Reserve represent its principal sources of funds

14. What is Fedwire and how is it used in federal funds transactions and RP transactions?

Fedwire is the Federal Reserve System for managing sales of treasury securities. It allows transfers of assets electronically between depository institutions. Transactions can be done quickly and at low cost and only require accounting changes through Fedwire. Therefore, Fedwire makes transferring ownership of federal funds and between different parties to RP quick and efficient.

13. In what way do firms rely on commercial banks? Does it vary between large versus small firms? Explain.

Firms rely on commercial banks for providing credit, managing deposits, loans, and issuing debt securities. Small firms typically rely on commercial banks for loans in order to obtain funds for large issues that come up. Whereas large firms typically issue into more securities such as stocks and bonds because they have more liquid assets.

2. An investor buys a U.S. Treasury bond whose current yield to maturity is 6 percent. The investor is subject to a 33 percent federal income tax rate on any new income received. His real after-tax return from this bond is 2 percent. What is the expected inflation rate in the financial marketplace over the life of the bond?

First step is to calculate the tax on the bond: This is calculated by multiplying the Yield to Maturity by the Federal Tax Income Rate: Tax on Bond = 6%*33% or = 0.06*0.33 = 0.0198 or *1.98%* Next, we calculate the nominal tax after inflation: This is calculated by using the formula for Nominal Tax: Nominal After Tax Return = YTM - Tax Nominal = 6% - 1.98% or = 0.06 - 0.198 = 0.0402 or *4.02%* Finally, we calculate the Expected Inflation Rate: This can be calculated using the formula: Nominal = Real + Inflation 4.02% = 2% + Inflation or 0.0402 = 0.02 + Inflation *Therefore,* Inflation = 0.0402 - 0.02 Inflation = 0.0202 or, Expected Inflation Rate = *2.02%*

6. An investor wishes to ride the yield curve to higher profits on an investment of $1,000. He observes in the market a zero-coupon T-note with one year left to maturity yielding 5 percent and another zero-coupon T-note yielding 7 percent with two years to maturity. What investment strategy should he pursue? Show how this investment strategy would be superior to a simple buy-and-hold strategy. Under what conditions will this strategy succeed? When will it fail?

First, we need to calculate the two different T-notes with his investment options. 1) Zero-Coupon T-note with one year left to maturity yielding 5 percent: Yield = $1,000*(1.05) = *$1,050* 2) Zero-Coupon T-note with two years left to maturity yielding 7 percent: Yield = $1,000*(1.07) = *$1,144.90* Based on this we can see that the second options with the two years left to maturity yields a higher return. In order for the first option with the one year left to maturity would have to gain $94.90 from interest ($1,144.90-$1,050=$94.90) in the second year and from this we know that the interest rate would have to be $94.90/$1,050= 9.04% in the second year. Therefore, the first option would be better if the liquid premium is no greater than 2% and the following year's yield is less than 9.04% and if the note can be sold with a higher yielding note arises. The first option could be worse than option two if the liquid premium is higher than 2% and the following year's yield is greater than 9.04% and the investor is not able to sell the bond then.

1. Mark wants a 3 percent real rate of return to invest in stock XYZ, and a 5 percent real rate of return to invest in stock ABC. Heidi believes that both stocks are less risky than Mark does and is willing to accept real rates of return of 2 percent on XYZ and 4 percent on ABC. Mark expects the inflation rate to be 3 percent, and Heidi expects the inflation rate to be 5 percent. If the current yield on both XYZ and ABC is 6 percent, then which of these situations would follow?

Mark would be willing to invest in XYZ, but not in ABC, while Heidi would not want to invest in either.

7. Repeat Problem 6, but where the market interest rates are: 7 percent for the oneyear, zero-coupon bond and a 5 percent for the two-year, zero-coupon bond.

First, we need to calculate the two different T-notes with his investment options. 1) Zero-Coupon T-note with one year left to maturity yielding 5 percent: Yield = $1,000*(1.07) = *$1,070* 2) Zero-Coupon T-note with two years left to maturity yielding 7 percent: Yield = $1,000*(1.052) = *$1,102.50* Based on this we can see that the second option with the two years left to maturity still yields a higher return. In order for the first option with the one year left to maturity would have to gain $32.50 from interest ($1,102.50-$1,070=$32.50) in the second year and from this we know that the interest rate would have to be $32.50/$1,070= 3.04% in the second year. Therefore, the first option would be better if the liquid premium is no greater than 2% and the following year's yield is less than 3.04% and if the note can be sold with a higher yielding note arises. The first option could be worse than option two if the liquid premium is higher than 2% and the following year's yield is greater than 3.04% and the investor is not able to sell the bond then.

Assets of the Federal Reserve

Gold Certificate - $11 billion Special Drawing Rights - $5 billion Foreign Currency - $21 billion Coin - $49 billion Reserve Bank Credit - $4.465 trillion *bank credit broken up into:* - US Treasurys - $2.465 trillion - Federal Agency - $8 billion - MBSs - $1.781 trillion - Loans - less than $1 billion - Other Net Assets - $180 billion Total Assets - $4.521 trillion Over time, as the Fed "normalizes" its policy stance following the steps it took to combat the Great Recession, it's expected that they'll remove the MBSs from the portfolio holdings and return to a more traditional portfolio ---- comprised primarily of US Treasurys

Unbiased Expectations Hypothesis

Helps us understand the relationship explained above ---- If an investor has available to him/her two investment opportunities involving assets that differ only by maturity (drawn from the same risk class), then the expected return of the two investments should be the same, provided: the same amount is invested and with the same time horizon for the investment ----- R = annualized rate of return or YTM r1 = interest rate the investor would receive in year 1 r = rate of return Er2 = expected interest rate in year 2 ----- IF R > r1 then, in the future r is expected to go up R = r1 then, in the future r is expected to not change R < r1 then, in the future r is expected to go down *and* IF R > r1 then, r1 < Er2 < Er3 < ..... ErN R = r1 then, r1 = Er2 = Er3 = ..... ErN R < r1 then, r1 > Er2 > Er3 > ..... ErN

14. What did the Federal Reserve do to combat the financial crisis that accompanied the Great Recession of 2007-2009? What problems have these actions of the Federal Reserve created for its current activities?

In response to the Great Depression the FED made it it's top priority to combat the financial crisis. They did so by taking measures to assure people that the U.S. banking system was strong. It also lowered short-term interest rates almost to zero. Additionally it bought a large amount of Mortgage Backed Securities in order to support the investors and financial institutions that owned assets connected to the housing market. The FED created multiple direct lending facilities as alternatives to help institutions and markets such as commercial banks, savings and loans, the commercial paper market, and money market mutual funds (MMMFs) that didn't have sufficient credit. However these policies have caused problems. The FED is now trying to mend issues through its "Exit Strategy." It takes on the problems related to short-term interest rates, consolidating their balance sheet, and bank reserve return rates.

The U.S. Treasury Market: Historical Background

Information is available to us from the non-partisan *Congressional Budget Office* or *CBO* who's responsible for advising Congress on the consequences of legislation that affects the levels of spending and revenues of the federal government - As the economy expands, government expenditures and revenues will also grow. The Federal gov hasn't grown much over the past 50 years, the size being projected to be roughly the same in 2017 as it was in 1968 and close to the 50-year average of 20.3% in terms of expenditures and 17.4% in terms of revenues - The difference between *federal expenditures* and *governments revenues* is the *federal deficit* and this deficit adds to the *federal debt* ---- when revenues exceed expenditures, the government is running a *government surplus* and the federal debt is shrinking (federal deficits are the norm for the U.S. economy) - Periods of economic recession or times of war tend to exacerbate federal deficits and we'll see the federal debt relative to the size of the economy rising ---- the peak in the debt-to-GDP ratio was during World War II, when the federal debt rose by 106$ of GDP (average since is 47% but is projected to be 77% by the end of 2017, the highest since 1950) - CBO projects rapid growth in debt in the future, with revenues falling further behind expenditures ---- principal factors: slowdown in growth of the labor force and an aging of the population, with the "baby boom" generation placing increasing pressure on social security and Medicare/Medicaid, along with a slower rate of productivity growth and continued increases in interest payments on the burgeoning debt - The so-called long-run *structural deficits* caused by legislation that systematically produces underfunding of federal expenditures has been the culprit of the pressure put on the federal budgets in recent years - The "tech-boom" in the late 90s did turn federal deficits to profits but deficits soon returned with two large tax cuts and the onset of the Great Recession - The GDP has subsided to historical levels in recent years because of the economic recovery and the initial slowdown in health care expenditures due to provisions in the *Affordable Care Act* but these gains are not expected to be lasting ---- The projected ballooning of debt is expected to occur absent a combination of slower growth in government spending and higher taxes and the CBO cautions that the following significant negative consequences are likely to result: 1. Federal spending on interest payments would increase substantially 2. The nation's capital stock will be smaller because of the reductions in federal savings in the economy over time 3. Lawmakers will have less flexibility to use tax and spending policies to respond to unexpected challanges 4. The likelihood of a fiscal crisis in the U.S will increase

11. Why do MMMFs find commercial paper so attractive to other money market assets?

MMMF's find commercial paper attractive because they the highest risk asset in their portfolio meaning they also have the highest expected rate of return.

3. How does a MMMF make money?

MMMFs make money through charging investors a management fee. Once the fee has been taken out, then the remaining income goes to the investors. The MMMFs tries to keep the NAV of $1 per share. Recall that the NAV is equal to the Money Market Interest Rate minus the management fee. Therefore for the MMMFs goal is for the Money Market Interest rate to be $1 higher than the management fee per share. The MMMFs make money from the management fees charge while keeping the NAV at $1 per share.

1. Explain when and why money market mutual funds came into existence in the United States.

Money Market Mutual Funds (MMMFs) were created in 1970s. These financial institutions formed out of the limited interest that commercial banks and saving institutions were allowed to pay to their patrons. Depository institutions were not legally allowed to pay interest on checking accounts. Also there were caps put on interest that could be paid on savings accounts of 5% for banks and 5-1/2% for S&Ls. This especially harmed households in the 1970s due to the high inflation. Households saw the value of their liquid assets dramatically decrease because the real returns were negative. Households were looking for an outlet to get higher returns in order to increase their savings. MMMFs were created to solve this problem by accepting deposit accounts that were not insured by the government and invest in a diverse portfolio that combated the growing inflation.

Treasury Bills (T-bills)

One of the principal assets in which virtually all MMMFs invest in - The Treasury Department is authorized by Congress to issue debt securities with maturities up to one year that have these characteristics: 1. They're currently insured in maturities of 4-week, 3-month, 6-month, and 1-year 2. All T-bills are sold at discount to face value (value paid to investors at maturity) 3. T-bills are backed by the taxing authority of the U.S. gov and are free from default risk 4. They're *paperless securities* whose ownership must be registered on the computers of the Federal Reserve ---- among the most liquid of all financial assets 5. Carry a low expected rate of return (low risk and high liquidity)

Open Market Operations and the System Portfolio

Over time, the economy grows and demand for liquidity rises, but not at a constant rate (there's swings up & down in the demand for liquidity on a daily basis) ---- to accommodate this increase, the Fed must expand its portfolio holdings of Treasurys through *open market operations* - The Fed attempts to conduct open market operations to keep short-term interest rates from swinging widely around its target The permanent holding of Treasurys follow a kind of step function (with large periodic outright purchases) - These daily swings in demand are met with temporary holdings of RPs

7. How has the change in retirement plans of firms and governments tended to support the MMMFs?

Pension funds (discussed previously) are the retirement plans of firms and governments. We have seen a switch in recent years where firms/governments have started to invest retirements plans into "defined contribution plans" verse the "defined benefits programs". The defined benefit plans guaranteed a certain amount in retirement funds based on the individuals' years of working for the company and the salary given over the last 3-4 years. On the other hand, defined contribution plans allow the company flexibility on how and where to invest employee's retirement. Employers also have the option to match the employee's retirement fund. The defined contribution plans allow individuals the option to let their employers invest their retirement funds in money markets. A large portion is invested in MMMFs because of their advantageous discussed in question 5.

Example of a Typical Open Market Operation

Purchases of Treasurys by the Fed are from *primary government security dealers* , whom we'll abbreviate GSDs (authorized to conduct transactions with the Federal Reserve - The Fed acquires Treasurys through one of two means: *outright purchases* comprising its "permanent holdings" , and *repurchase agreements* comprising its "temporary holdings" Example: The Federal Reserve purchases $1B in Treasury from a GSD. There are 3 parties to the transaction: the Federal Reserve, the GSD, and a bank GSD's assets: - $1B (Treasury Bond) + $1B (Bank Deposit) GSD's liabilities: N/A Commercial Bank's assets: + $1B (Deposits at Fed Res) Commercial Bank's liabilities: + $1B (Deposits of GSD) Federal Reserve assets: + $1B (Treasury Bond) Federal Reserve liabilities: + $1B (Deposits of Bank) - The GSD sees its portfolio holdings of Treasurys fall by $1B - The commercial bank (acting as the dealer's agent) notifies the Fed that it can take ownership of the Treasury in exchange for an increase in the commercial bank's deposit account at the Federal Reserve by the same amount ---- the commercial bank then credits the deposit account of the GSD by $1B ---- the net effect it that the dealer has exchanged one financial asset for another, while both the commercial bank and the Federal Reserve have seen their balance sheets expand RESULT: The amount of reserves in the banking system has risen by exactly $1B, which is how much the commercial bank's deposits at the Federal Reserve have increased

The Role of Government Securities Dealers

RP transactions are typically carried out by a *government securities dealer* or *GSD* who's job is to manage portfolios of Treasury securities and make markets for those assets in the same way that the NASDAQ are market makers for stocks - GSD's quote *bid and ask discount rates* for T-bills that they hold in their portfolios ---- they stand ready to buy selected T-bills at a price that guarantees the buyer a discount rate coinciding with the bid rate and they stand ready to sell the same T-bills from their portfolio at a price that guarantees the GSD a discount rate given by the ask rate - They prefer to act as brokers in the RP market by netting out their RP sales with their RP purchases ---- when they are unable to sell all of the RPs they've purchased, they usually seek out an alternative funding source (commercial banks, where the GSD takes out a *demand loan* which normally carries a higher rate than does the RP that they've issued ---- causing the GSD to lose money on the transaction)

Primary Market for U.S. Treasurys: How they're introduced into the market for the first place

Reasons that new issues of Treasurys are necessary: 1. As existing issues of Treasurys mature they need to be replaced with new issues ---- if the government wishes to maintain the existing level of U.S. government debt 2. Seasonal fluctuations take place in both the expenditures and the revenues of the federal government (typically more true of revenues than expenditures because of large swings in tax receipts occurring primarily in April) 3. Structural deficits (when there is a systematic shortfall in revenues relative expenditures) will have to be met with additional borrowing by the federal government ---- requiring new issues of Treasury securities During rare annual budget surpluses, the Treasury Department reduces its debt outstanding by: minimizing the amount of maturing debt that's replaced, or "rolled-over" and buying back outstanding debt by conducting *reverse auctions* (holders of selected U.S. Treasury securities can make offers to sell that debt back to the U.S. gov)

The Basel Accords

Since funds are able to move around the globe quickly and at low cost banks have had the opportunity to seek out countries where capital requirements are low, enabling them to increase the risk they take in selecting the assets in which to invest or increase the leverage they employ in funding those assets - To address this problem, nations from the major industrialized countries have attempted to coordinate their regulations by adopting standards for assessing a bank's *capital adequacy* ---- whether the bank has sufficient capital relative to its size and the risk represented by its asset holdings ---- these international meetings have taken place in Basel, Switzerland and have come to be called the *Basel Accords* The first meeting gave birth to *Basel I Accords* in 1988 - Since then, significant modifications to the agreements have been undertaken, producing the *Basel II Accords* and even more recently, in response to the word-wide financial crisis, the new *Basel III Accords* were put into place to strengthen the capital requirements on banks operating in all of the signatory countries

Treasury Auctions

Since the gov typically runs budget deficits, it's normal for new Treasury securities to be auctioned off each week in *single-price* or *Dutch auctions* - There's two parties involved in carrying out auctions: (a) The Treasury Department ---- decides on the amount of funds that need to be raised and on the composition of the Treasurys to be auctions, with consultation from Federal Reserve, and (b) The Federal Reserve Bank of New York ---- who conducts the auctions ---- goals of auctions are to ensure adequate participation to meet the government's borrowing needs at the lowest possible cost (interest rates), and avoid collusion by market participants who are purchasing the debt

5. What exactly is the "gold standard"?

The "gold standard" is a financial monetary system in which the value of the currency is fixed to gold. It was the relation between the U.S. Dollar and gold. When the U.S. was on the gold standard one would exchange dollars for gold.

3. How are the "too-big-to-fail" banks regulated differently than other commercial banks?

The "too-big-to-fail" banks are large banks that make up approximately 48% of the total assets in the U.S. banking system and if they were to fail, the entire economy would suffer. The government seeks to prevent the potential disastrous effects of their potential failure, which is why they are regulated much differently than commercial banks, as a result from Dodd-Frank. The "too-big-to-fail" banks are subject to stricter oversight and regulation such as having "funeral plans," which require the banks to create strategies on how to increased liquidity and avoid insolvency. These banks are also required to pass "stress tests" of their asset portfolio indicating that they could withstand a severe economic downturn.

1. Distinguish between the 3 central economic roles played by the central bank, and how it achieves those goals.

The 3 central economic roles played by the central bank are: Microeconomic Stability, Macroeconomic Stability, and Financial Stability. The central bank uses monetary policy, provision of liquidity, and financial regulation to accomplish their goals. Microeconomic stability involves insuring low and stable inflation. Macroeconomic stability involves stable growth in output and employment by using monetary policy to adjust the level of short-term interest rates to influence employment, inflation, production, and spending. Financial stability involves the prevention or mitigation of financial crises or panics by providing liquidity through shortterm loans to financial institutions or markets to help calm financial panics, serving as the "lender of last resort. The FED use financial regulation and supervision to help reduce in the level of financial crises and panics by providing assistance to the firms.

10. . How does the Federal Reserve define price stability? Explain the logic behind this definition.

The FED defines price stability as an action in which it chooses a target inflation rate and a measure of inflation, and keeps inflation expectations low. The FED tries to keep an average inflation rate of 2%. Rates above 2% would cause higher price volatility and inflation uncertainty that could lead to economic inefficiency. A rate below less than 2% could cause deflation. The FED measures the price stability by looking at the Consumer Price Index (CPI) Price Deflator to examine Personal Consumption Expenditures (PCE), Core CPI, or Core PCE. These indicators examine inflation in the economy. The CPI and PCE are very volatile because of the short-run shock in things such as food and energy prices. This makes the Core CPI or Core PCE more reliable for the FED to use because they exclude food and energy while also having the same long-run trends as the CPI and PCE.

4. Why was the Federal Reserve System created?

The FED system was created after people began to have financial stability concerns resulting from multiple financial panics. There was also concern of economic stability such as deflation. It was a decided that a national lender of last resort needed to be established that had the resources to prevent bank runs on illiquid yet solvent banks. The economic stability concern of deflation came from the concern of loan recipients. Individuals with long-term loans had to pay back loans that had increasing real value because prices were decreasing.

15. What is meant by the FED's "Exit Strategy," and has it made any progress toward achieving its objectives of "policy normalization"?

The FED's "Exit Strategy" also referred to as "Policy Normalization" is the comprehensive plan of the FED to fix the damaged economy following the Great Recession of 2007. This strategy has four parts. First, the FED will increase the short rate up to a normal level through increasing the overnight federal funds rate goal. Second, it needs to reduce any excess reserves in the banking system in order to consolidate their balance sheet. Thirdly the FED will remove all Mortgage Backed Securities from their balance sheets. Fourthly, they need to lower the rate paid off on investor bank reserves below the federal funds rate goal. The FED are taking these steps while trying not to create too much inflation, uncertainty, volatility, or restricting credit. Overall the "Exit Strategy" is not progressing as much as the FED would hope. The short-term interest rates have still stayed around zero and their balance sheet has actually grown.

9. How does the Federal Open Market Committee differ from the Board of Governors in terms of their composition and responsibilities for policy decisions?

The Federal Open Market Committee (FOMC) is one of the two governing bodies of the FED. The FOMC is has 12 members. The members are comprised of one Chair that is the Chair of the Board of Governors, one is the Vice Chair that is the President of the Federal Reserve Bank of New York, the four Presidents of the District Banks serve in rotating terms among the non-New York District Banks, and an additional six member from the FOMC. The FOMC's responsibilities include setting a target for the federal funds rate and creating balance sheet adjustments through buying and selling of assets in the open market. The Board of Governors has seven members that are nominated by the U.S. President and confirmed by the Senate. Their members are comprised of the Chair, the Vice Chair, the Vice Chair for Supervision, and four additional governors. The Chair of the Board of Governors serves four-year terms with a maximum of a 14-year term. Dodd-Frank established the Vice Chair of Supervision to supervises the FED. The other four governors serve a one time 14-year term and are there to help the other three positions. The Board of Governors responsibilities for policy decisions include approving recommendations from the district banks pertaining to the discount rate; setting reserve requirements for depository institutions and the interest rate paid on member bank deposits, and approve federal charters for commercial banks.

Implementing Monetary Policy

The Federal Open Market Committee (FOMC) meets eight times a year at scheduled meetings and sets monetary policy for the upcoming inter-meeting period ---- decisions are implemented in large measure by the Federal Reserve Bank of New York - Six policy tools are available to the Fed: 1. *open market operations* , or the purchase and sale of securities in the open market 2. the *discount of prime credit rate* (interest charged by member banks in good standing for borrowing from the Fed at the Discount Window) 3. reserve requirements 4. *interest on revenues (IOR)* and *interest on excess reserves (IOER)* 5. *overnight reverse repurchase agreements* , or the temporary sale of securities from the Federal Reserve System's securities portfolio 6. *term deposit facility* , through which banks may place some of their deposits in a separate account, earning a higher interest rate than the IOER ---- effectively removing those reserves from the banking system for the duration of the contract - Of these tools, large excess reserve balances in the banking system have rendered reserve requirements (3) non-binding and therefore currently unavailable as an effective policy tool A critically important decision made at the FOMC meetings is the selection of a target for the *effective federal funds rate* , which represents an average of all overnight federal fund loans made each day At the conclusion of the meeting, the FOMC produces a *policy direction* that's sent to the Desk Manager of the New York Fed ---- providing him with guidance on how the policy decisions will be implemented - The Desk Manager has some discretion in carrying out the policy directive ---- he must decide: 1. how many securities to purchase or sell 2. what the maturity of the purchases or sales should be 3. when to make the purchases or sales 4. with whom the transactions are to be made

7. What were the policy mistakes of the Federal Reserve in response to the Great Depression of the 1930s?

The Federal Reserve made several policy mistakes in response to the Great Depression. First, from 1928-1929 the FED tightened monetary policy, which facilitated stock market speculation. This led to sharply drop in prices and large declines in output and employment. Second, in 1931 the FED used monetary policy tightening to try to stop the speculative attack. Third, in 1932 the FED didn't respond with any policy action even while the prices were decreasing and unemployment was increasing. Fourth, when the bank runs were occurring there was a contraction of bank lending, which created limited availability for credit for banks. Lastly, the FED created policy errors across the world through the gold standard while continuing to use the system.

12. Describe how the Federal Reserve was able to control the federal funds rate fairly closely prior to the Great Recession, and why this enables the Federal Reserve to have such good control over ALL short-term money market interest rates. Refer to changes in the Federal Reserve's balance sheet and how those changes are reflected on balance sheets of commercial banks.

The Federal Reserve was able to control the federal funds rate fairly closely prior to the Great Recession because it implement policy that was to directly achieve the federal funds rate goal. The Federal Reserve Board would get the information about the banks from their balance sheets. This information was used to predict the U.S. economy's total demand for bank reserves. The FOMC used Open Market Operations, which are buying/selling of Treasury Securities with payment made by increasing bank reserves. The Open Market Operations are used to determine the amount of bank reserves that is required to reach the goal federal funds rate. Additionally the FED controlled the federal funds rate by getting government securities through straight purchases or repurchase agreements. All these factors allow the FED to have such good control over ALL short-term money market interest rates. This is due to the fact that the federal funds rate is the average rate of overnight loans between the banks. Therefore changes in the rate are spread through short-term money market interest rates. When the FED buys Treasury Securities using bank reserves from government securities dealers, it alters their balance sheets. As the FED purchases more Treasury Securities its assets increase and well as its liabilities relative to the amount of money that it spends to buy those securities. The government securities dealers have sold their securities in exchange for bank deposits, which make their total assets to remain constant. Therefore the FED's member bank assets would go up relative to the amount of the FED's deposits to purchase the given securities from the government. At the same time their liabilities would also go up relative to the amount of deposits from the government securities dealers.

8. What are the principal objectives of the Federal Reserve's discount window? Answer this question in terms of the institutions that are borrowing the funds and the interest rates they must pay the Federal Reserve to have access to those funds.

The Federal Reserve's discount window is a short-term loan option through which banks can raise funds quickly. Loans are offered at a discount rate compared to commercial banks. Their rates are based on monetary policy. The discount window provides seasonal credit to rural banks in order to assist them in funding agriculture. Due to lower deposits than banks in urban areas, the rural banks often do not have enough funds to support businesses with seasonal demands. Secondly, the discount window provides liquidity to banks with abrupt loss of their liquidity. This is the FED's lender of last resort where the discount window allows these banks to borrow funds from the FED at interest rates that are less than the federal funds rate. Thirdly, the discount window allows "troubled banks" to borrow funds at lower cost. This rate is based on their secondary credit. The banks use this to insure that the met their FED regulations.

11. What is meant by the GDP Gap and how does it relate to the Natural Rate of Unemployment?

The GDP Gap is the gap between actual GDP and expected GDP if all resources in the economy were being used. The GDP Gap relates to the Natural Rate of Unemployment because if all available labor were being used then we would be at the Natural Rate of Unemployment. This would cause the expected rate of GDP would be equal to the potential GDP, which is used to calculate the GDP Gap.

1. What is unique about the structure of the U.S. banking system and how did this structure evolve?

The U.S. banking system is very unique because of its difference in the banking system's use of mutual funds and pension funds. The U.S. has to largest number of banks per capita in the entire world. The restrictive branching laws prior to 1980 actually caused there to be a greater number of banks. Banks could not offer services outside of designated regions, which led to a large number of small banks across the country. When the branching laws were relaxed, consolidation began to take place that reduced the number of banks, as the average size of the banks increased. Once the regulations were repealed in the 1980s, banks expand through multiple branches over a several regions of the country. In the past 30 years we have seen the number of different banks shrink due to bank consolidation.

6. What is the difference between an average cost and a marginal cost of deposit funds to commercial banks, and how does it play a role in choices that must be made for raising funds?

The average cost of deposit funds to commercial banks is the cost to the bank that must be repaid on all current and future deposits that are not certificates of deposit (CDs). The marginal cost of deposit funds to commercial banks is the additional cost to the bank of funding CDs. These are usually to large institutional investors that are willing to pay for the CDs at the higher rate than proposed by the bank. The increase in interest rate causes an increase cost to CDs deposit funds.

12. How important is the banking system in providing credit to the housing market?

The banking system is critical in providing credit to the housing market. The bank's real estate loans make up about half of banks loan portfolio. Bank's real estate loans are equal to about a quarter of their overall assets. Banks provide home mortgages and home equity loans to support the housing market. They provide the main source of credit to households and they compete with credit unions. Banks have gained a large share of the credit market

10. Why is the maturity of commercial paper limited 270 days?

The limitation is due to the Securities and Exchange Commission's (SEC) rule that firms must file future commercial paper debt issues at a cost. Firms must issue commercial paper for 270 days or less in order to avoid absorbing the cost of this rule.

Bank Equity Capital

The difference between the value of the bank's assets and it's liabilities ---- represents the value of the banking firm or the *net worth* of the firm against which claims are held by the bank's stockholders - There's two broad components to bank equity capital: *capital paid in* (equals the amount of funds raised by the banks at the time of issuance of new shares of common and preferred stock) and the *surplus & undivided profits* (represents the cumulative bank's net income either held as retained earnings, or yet-to-be-declared as dividends or reinvestment in the bank's business ---- the so-called *undivided profits*) Bank capital is seen by regulators as a buffer to insulate depositors' funds from write-offs of bad assets by the bank

6. What are the 4 basic shortcomings of the gold standard that Ben Bernanke highlights?

The first basic shortcoming of the gold standard highlighted by Ben Bernanke is the effect on the money supply. The central bank had little ability to use monetary policy to stabilize the economy. Without monetary power the FED can to little to help adjust the economy. The second shortcoming was that there was a system of fixed exchange rates between the currencies on the gold standard. This was a problem because if there were to be shocks or changes in the money supply in a given country, the other countries that also use the gold standard will experience the same effects, negative or positive. The third basic shortcoming of the gold standard was the possibility for speculative attack. This is where central banks lower their gold reserves because of a decrease in confidence in the money supply. Banks would have to maintain a portion of the necessary amount of gold to back the money supply. The fourth basic shortcoming of the gold standard is that it creates stable inflation over long periods of time but creates inflation or deflation over shorter periods of time, because the amount of money in the economy would vary based on periodical gold strikes.

16. Describe in your own words the purpose of imposing capital requirements on banks, how they relate to the bank's balance sheet, and why there may be a need for an international standard such as those set by the Basel Accords.

The government imposes capital requirements on banks to insure that the bank executives take responsibility for investments losses. The bank capital determines the net value of the bank. A capital requirement is the required ratio of bank capital to their assets, which are dependent on risk of the bank's investments. The international standards set by Basel Accords help avoid the "race to the bottom". This is a concept where governments continually set lower capital requirements in order to attract international investments. With a set international standard it makes it so that all bank executives are responsible for all investment decisions. Capital requirements force more of the risk onto the owner's of the bank, i.e., the stockholders.

Large Negotiable Certificates of Deposit (CDs)

The group of regulated *depository institutions* comprised of *commercial banks, savings and loans (S&Ls), and credit unions* obtain the bulk of their funds in the money markets - Basically, MMMFs purchase liabilities of depository institutions to hold in a portfolio of money market assets that they're managing, and among these liabilities is the *large negotiable certificate of deposit (CD)* Properties (particularly attractive to money fund managers): 1. Minimum denomination of $100,000, however many have a minimum of $1 million (making them a market that small investors can only access through a mutual fund 2. Insured up to $250,000 and covered by the FDIC (mitigating risk) 3. Not sold at a discount to face value. Interest rate is computed on principal on a *CD basis* based on a 360-day year EX: To determine the total return (principal plus interest) on a 90-day, $1 million CD paying 3% on a CD basis, the formula is: ----------- Total Return = Amount Invested x [ 1 + (days to maturity/360) x CD rate ] *or* $1 million [ 1 + (90/360) 0.03 ] = *$1,075,000* To compute the *actual annualized rate of return* , rCD: = (Total Return - Amount Invested) / Amount Invested x (Days to maturity) / 365 *or* ($1,075,000 - $1 mil) / ($1 mil) x 90 / 365 = 0.03042 or *3.042%* ---------- 4. Payment to the holder of the CD is normally not made until the asset matures 5. Has a relatively high degree of liquidity (although many investors tend to buy and hold the assets until maturity, which is normally 1 year or less from date of purchase)

6. Who are the major suppliers of funds to the IO MMMFs? What advantage do these MMMFs have for those investors?

The major supplier of funds to IO (Institution-Only) MMMFs are large institutional investors with the most popular being pension funds. The Retail MMMFs are comprised of accounts that are $100,000 or less in money market assets are invest directly with the company. The IO MMMF only includes accounts that are greater that $100,000. The advantage that the IO MMMF has to offer to its investors is the ability to negotiate with companies the fees that will be charged for management because IO MMMFs work independently or through third parties rather than directly with the company.

8. Synchron Corporation borrowed long-term capital at an interest rate of 8.5 percent under the expectation that the annual inflation rate over the life of this borrowing was likely to be 5 percent. However, shortly after the loan contract was signed, the actual inflation rate climbed to 5.5 percent, where it is expected to remain until Synchrons loan reaches maturity. What is likely to happen to the market value per share of Synchrons common stock? Would its stock price be more affected or less affected than the price of its bonds? Explain your reasoning.

The market value of the common stock will most likely increase. This is due to the real cost of the loan to fund the investment has decreased which causes the profit from the investment to increase and a decrease in the risk of the investment. Additionally, all other prices are increasing so the value of their common stock should also increase. In this example, the price of the firm's bonds would be more affected than the price of its stocks. We see this from the Fisher Equation: Nominal Interest Rate = Real Interest Rate + Inflation Rate. The increased inflation would lead to prices falling. If the company thinks that the increased inflation will last over a long period, they increase their dividends in order to reduce the inflation change on the stock price. If the company chooses not to increase their dividends, the increase in inflation would causes losses for shareholders.

Basel III

The outcome of negotiations to address the problems that the financial crisis revealed about a number of aspects to banking activities that needed to be addressed - First step was to tighten up risk assessment of the assets ---- problems with the reliance of ratings agencies were addressed by banks now having to run *stress tests* of their portfolios to see how they would respond under various possible future scenarios reflecting differing economic and financial market conditions (specified by regulators) ---- these stress tests are then used to asses the overall level of risk inherent in the bank's asset portfolio, and whether the bank has sufficient reserves to absorb any losses it would incur under those severely adverse economic conditions - The resulting risk-adjusted asset base is used to define the capital requirements as before but the capital requirement ratios were significantly increased ---- with an even greater emphasis on equity capital - Banks were also now required to increase the liquidity of their asset portfolios and enhance the maturity match of their medium-term assets & liabilities ---- the latter requirement was to ensure that banks don't rely exclusively on short-term debt to fund long-term illiquid assets - Individual countries were free to set their own regulatory requirements, but provisions of Basel III were intended to be the minimum requirements for all signatory countries -------- Emphasis in the U.S. has been given to the stress tests on financial institutions deemed "too-big-to-fail" as required by the Dodd-Frank Act To date, these provisions have substantially improved the ability of the banks to whether the strain on their balance sheets resulting from severe economic conditions that may present themselves

5. Who are the principal lenders and who are the principal borrowers in the federal funds market? Explain why the markets are segmented in this way.

The principle lenders in the federal funds market include Government Sponsored Enterprises (GRE's), such as Fannie Mae and Freddie Mac. These groups' goal is to create more liquidity in the economy. They do this by buying mortgages from the commercial banks and holding or selling them as a group in Mortgage-Backed Securities (MBSs). They have become the principle lenders in the federal funds market because many times do not qualify for Interest on Excess Reserves (IOER). This is because their IOER often exceeds the overnight federal funds rate. The principle borrowers in the federal funds market are commercial banks that have deposits in the FED and qualify for IOER. They borrow funds from GSEs at the federal funds rate and then lend those to the FED at the higher IOER. The federal funds market is segmented like this so that banks can use arbitrage, by taking advantage of the differing prices from the IOER between them and the GSEs.

Bank Structure

The structure of the banking system in the United States is unique because it has, by far, the largest number of banks per capita of any country in the world ---- reason for this is the historically restrictive state regulations that prohibited banks from opening branches across state lines, and in many cases allowing individual banks to possess only one physical building - This structure has evolved beginning in the 1980's when these restrictions were gradually eliminated and the number of banks in the U.S. fell as well

8. What were the 2 principal successful policies adopted by Franklin Roosevelt that brought an end to the Great Depression?

The two principal successful policies adopted by President Franklin Roosevelt that brought an end to the Great Depression were deposit insurance and the abandonment of the gold standard. The deposit insurance was called the Federal Deposit Insurance Corporation (FDIC) and was used to stop bank runs. FDR also stopped using the gold standard so that U.S. money supply could expand.

The Term Structure of Interest Rates

The underlying relationship between the interest rates or yields on various Treasury securities ---- essentially a mathematical relationship between the rates of return (or interest rates) on assets that differ only by their term to maturity - Since investors are investing in assets that are free of default risk they have choices to make regarding what maturities they wish for their investments

Money Market Mutual Funds (MMMFs)

Their role is to accept deposits (which aren't federally insured), aggregate those funds, and invest in a portfolio of short-term money market assets which were not subject to the interest rate ceilings that existed at the time on deposits in banks and S&Ls - A fee is extracted for managing the investment portfolio and the remaining interest income is passed to investors - The value of assets under management is known as the MMMFs *net asset value* of *NAV* ---- A NAV of $1.00 per share is typically maintained and MMMFs rarely lose money. A combination of low short-term money market interest rates and bad investments could cause the value of the fund's NAV to fall below $1.00, in which case, it is said to be *breaking the buck* MMMFs are regulated by the SEC, who ensure that investors' funds are properly managed to avoid the scenario of a "broken buck" The flight of funds from the depository institutions into MMMFs that occurred during the 1970s is referred to as *disintermediation* and was creating a major threat to the viability of those institutions ---- In the 80s Congress passed two major pieces of banking legislation to address this problem by *leveling the regulatory playing field* across depository institutions CHARACTERISTICS of MMMFs: 1. Assets are very liquid 2. Investors earn a market rate of return from portfolio (minus the money funds fees) and achieve *diversification* by investing in a range of money market assets 3. Markets are opened up to small investors 4. Large institutional investors reach their desired balance between risk and return 5. Shifted pension plans of firms and government from *defined benefits programs* (guarantee a monthly retirement payment based on the number of years of service and the average salary over the past 3-4 years) to *defined contribution plans* (employer invests the retirement money on behalf of the employee, who directs how those funds are to be invested) Retail money market mutual funds hold more than $700 billion with accounts below $100,000 but the larger accounts, in excess of $100,000 are collected into *institution-only* or *IO MMMFs* , which have more than $1.8 trillion dollars in them

5. Explain the advantages to households that retail MMMFs offer as a savings asset.

There are several advantages that MMMFs offer. First is their high liquidity. The MMMFs can be easily and quickly bought/sold. Second is the diverse investment within the MMMFs. The portfolios are invested across various money market assets, which lower the risk in their investments. Thirdly they offer a higher return verses the limited commercial banks' checking and savings and loans rate. The MMMF earn back a market rate of interest, which is much higher than the commercial bank rate. Fourthly MMMFs help small investors because it allows them to partake in investments that have million dollar investment requirements. Because MMMF allows for investors to pull resources in the portfolios, it encourages invests from all ranges. Lastly, The MMMFs have become advantageous to areas such as pension funds due to its lower level of risk and higher return on investments.

"On-the-Run" Treasurys

There are several securities of each maturity category being traded in the marketplace at any given time. The financial markets however, focus more intently on the most recently issued security from each maturity class, known as the *on-the-run Treasurys* - These securities comprise only about 10% of all marketable Treasury securities but represent approximately 50% of the trading in Treasurys that takes place throughout the day ---- as a consequence of being the most actively traded, they therefore tend to have the highest liquidity and the lowest rates of return of all securities in their maturity class - There's 2 on-the-run Treasury rates that are exceptionally important: 1. The 3-month T-bill rate is a key short-term interest rate in the economy in which other short rates (like credit card rates) are tied 2. The yield on the 10-year T-note is similarly a key long-term interest rate, with mortgage rates very closely tied to this yield ---- an increase in the yield on the 10-year T-note will generally lead to a rise in the 30-year mortgage rate

8. What are the principal characteristics of U.S. Treasury bills as investment vehicles?

U.S. Treasury bills are short term U.S. government debt dispensed by the U.S. Treasury Department. They are a form of a money market instrument. The T-Bills can be one of four possible maturities (1 month, 3 month, 6 month, and 1 year). They are the most liquid financial assets and are sold at discount to the face value paid to investors when the T-Bill reaches its maturity. They can be traded very easily because they are exchanged electronically. These T-Bills are registered through the FED and set the standard for other assets that have high liquidity and low short term risk interest rates.

Computing the amount of the loan that a bank may receive when issuing an overnight RP against the $1 billion T-bill, when the lending bank demands an RP rate on its investment of 2% and is instituting a haircut that is 1% of the market rate of the T-bill

We can use the discount rate formula to determine how much money the bank can raise by issuing this RP (only change is that the par/face value is replaced by the repurchase price, reflecting the haircut): ---------- RP Rate = (Repurchase Price - Loan Amount) / Repurchase Price x 360 / 1 day to maturity *where* Repurchase price = Face value of the T-bill x (1 - %Haircut) *plugging in the numbers* 0.02 = $1 bil (1 - 0.01) - Loan Amount / $1 bil (1 - 0.01) x 360 = *$989,945,000* (Loan Amount) ---------- NOW, we can compute the interest income that the lending back should receive on this loan: ---------- Interest Income = Repurchase Price - Loan Amount *so* $1 billion - $989,945,000 = *$55,000* ---------- The annualized rate of return can be found by answering the question: What would the lending bank receive if it were able to roll-over the original investment in this overnight loan for 365 days and receive the same daily return? ---- In this case, the total return would be 365 x $55,000, or $20,075,000. The annualized rate of return on the investment can be computed as: ---------- Annualized Rate of Return = Total Return per Year / Loan Amount x 100% *or* $20,075,000 / $989,945,000 x 100% = *2.028%* ----------

4. What is meant by "breaking the buck," and why is it so important?

When the MMMF's NAV drops below $1 per share it is called "Breaking the Buck". This could occur due to a combination of low interest rates from short-term money market assets and bad investments. This is important because when the NAV follows below $1, it represents a loss on short-term money market assets that make up any specific MMMF. When the NAV is "breaking the buck", investors receive lower dividends. MMMF are viewed as virtually risk-free so it is important when the NAV drops below the "buck" because it could be a signal that the economic is in trouble. One of the purposes of The Securities and Exchange Commission is to avoid their NAVs "breaking the buck".

Using TIPS to Approximate Market Expectations of Inflation

When traders have the option to buy a standard coupon bond or a TIPS of the same maturity, they will price those investments differently based on their expectations of future inflation ---- easiest to compute by comparing their "asked yields" - Asked yield for the standard coupon bond is the nominal interest rate, while the asked yield on the TIPS is real, or inflation adjusted, interest rate Use the Fisher equation ---- nominal/ market rate of interest (R) is approximately equal to the real interest rate (r) plus the expected rate of inflation (Epi) - The asked yield for standard coupon is equal to (R) and the asked yield on the TIPS is equal to (r) *so* Expected inflation rate (Epi) in 2017 = Asked yield on std coupon bond (R) - Asked yield on TIPS (r) = *example number 1.995%* ---------- If the bonds were issued at par, their yields would have been equal to the coupon rate. Therefore, the difference on their coupon rates should yield an estimate of expected inflation at that time *so* Expected inflation rate (Epi) in 2007 = Coupon rate on std coupon bond - Coupon rate on TIPS = *example number 2.125%* Using the *example numbers* from above (1.995% and 2.125%), the calculations indicate that long-run inflation expectations fell slightly between 2007 & 2017 ---- 1.995% - 2.125% = *-0.130%*

11. An investor, with a 2-year investment horizon for a $1,000 investment has the options of: (a) buying a 2-year T-note and holding it until it matures, or (b) purchasing a oneyear T-Bill and "rolling-it-over" in a second one-year T-Bill when the first T-Bill matures. If the current T-note is currently yielding 4 percent and the current T-Bill rate is also 4 percent, then:

a) The investor would expect to receive a total return at the end of 2 years of $1,081.60 if he purchased the T-note, and this would exceed the expected total return if he adopted the investment strategy (b). (since the short-rate is expected to fall in the second period with a flat yield curve) b) The investor would expect to receive a total return at the end of 2 years of $1,080.00 if he purchased the T-note, and this would exceed the expected total return if he adopted the investment strategy (b). c) The investor would expect to receive a total return at the end of 2 years of $1,081.60 on his investment regardless of the investment strategy he adopted. d) The investor would expect to receive a total return at the end of 2 years of $1,080.00 on his investment regardless of the investment strategy he adopted.

9. Which of the following are TRUE?

a) There has never been a recession since World War II that was not preceded by an inverted yield curve. *TRUE* b) An inversion of the yield curve can occur if the markets anticipate a strong recession coming up since it raises expected inflation due to a weak consumer economy and also increases real interest rates due to weak loan demand. *FALSE*

5. Indicate which is true. The unbiased expectations hypothesis of the term structure of interest rates: a) Applies only to assets that have the same maturity b) Applies only to assets that have the same default risk. c) Ignores maturity of assets. d) Ignores the market risk of assets.

b) Applies only to assets that have the same default risk.

3. Indicate which applies. The liquidity premium: a) Is negative only during an economic recession. b) Is the result of greater interest rate volatility for longer-term assets. c) Biases the slope of the yield curve downward. d) Causes long rates to always exceed short rates.

b) Is the result of greater interest rate volatility for longer-term assets.

10. According to the Expectations Hypothesis of the yield curve that INCLUDES the liquidity premium, a flat yield curve is consistent with market expecting: a) Long rates to fall. b) Short rates to fall. c) Short rates to rise. d) Short rates to neither rise not fall.

b) Short rates to fall.

4. Suppose that the actual U.S. Treasury yield curve is approximately flat. This yield curve would suggest that the markets are expecting: a) Short rates to remain essentially unchanged in the future. b) Long rates to increase in the future. c) Long rates to increase in the future. d) Short rates to fall in the future.

d) Short rates to fall in the future.