FINC 381 Final

surplus units and their arrival

1. windfall 2. saving

what is the most powerful tool in money and capital markets?

-the federal reserve -stabilize the economy by conducting monetary policy and managing the money supply and interest rates

2012 regulatory act: fed gains

1. managing systematic risk 2. too big too fail problem 3. tougher regulations for large banks

conditions made for issuing bank notes

1. needed to be printed by the US mint to cut counterfeit 2. bank back the notes with holdings of US government bonds that slightly exceeded the value of each bank note issued, so the bank notes can be redeemed at face value even if the bank fails

services of investment banking

1. organization- preparing the security for sale 2. underwriting- helps form sell (assumes risk at a guaranteed price) 3. distribution- marketing of the sales of securities to institutional and individual investors

in order to be considered liquid an asset must have a high score in these characteristics....

1. stable price-purchasing power relatively stable 2. ready market 3. easily reversible- exit transaction should not be more burdensome than entry there will always be one asset that is better in each of these three cases and will be the mode of exchange

motives for holding money or "near-money" assets

1. transactional- bills, expenditures 2. precautionary- savings for rainy day, deductibles or copays on insurance 3. speculative- something we hope to cause to happen in the future (down payment on house)

investment branch

1. what is in it for me/ what is my likely return? 2. what could go wrong/ what are the risk inherent in this particular investment?

federal reserve primary goal today

economic stabilization through the management of the nation's money supply

funds can flow through the financing system...

either directly or indirectly

instruments

every instruments is not a security • ex. a promissory note • every security is an instrument

tougher regulations for large banks

fed only regulates larger financial institutions, banks, and thrift holding companies with assets greater than 50 billion

financial institutions

firms such as commercial banks, credit unions, insurance companies, pension funds mutual funds, and finance companies that provide services to consumers, businesses and government units they invest funds in financial assets such as business loans, stock, or bonds

investment banks

firms that specialize in helping businesses sell new debt or equity in the financial markets -once the security is sold a broker dealer service for securities that have already been issued

where does the money come from?

gather money from individuals and businesses that have more money than they need to fund those who need money now

cosmic intervention

if i borrow 1,000 today to pay back in a year and don't worry about purchasing power, can i borrow interest free? • yes and no • there is always opportunity cost to not having this 1000 for a year and this may not be the most productive thing to be done with the money

difference between Martindale's promissory note and a corporate bond

you can hand the bond away because of the readily available bond market -way more liquid

general obligation bonds

• "full faith and credit" (power to tax) of issuing political entity, there are no assets pledged in the event of default • -state and local debt • -issued to provide basic services to communities

NYSE is an example of an auction market

true

Hong Kong in relation to HF

• China is a communist place • Hong Kong is the capital and pro business • not a lot of rules about insider trading • British legal system is in place here

buys

• Credits new reserves to dealer's bank- • · Fed has a source of payment that we don't- they can create money • · Interest rates will be pushed downward- buying puts upward pressure on prices- yields decrease • · Quantities Easing

Speculative motive

• Holding money and saving for future fun

duration

• Holding period through which price risk and reinvestment risk are going to be in the best trade off of each other

under expectations theory, if people think interest rates will go down:

• Lenders want to dish out as many loans as they can if projected to fall, lock in high price, causes upward pressure on short-term rates and downward on long term- inverted

required reserved

• Slows down the rate at which money supply can grow • Keeps funds available in case of emergency • 10% • Every depository institution is subject to • After 2008, the Fed pays interest on excess reserves • If the banks are keeping more reserves, the monetary base is increasing faster than the money supply, which isn't good

3 functions of money

• Store of value • unit of account • Medium of exchange

market segmentation theory

• Supply and demand in each maturity segment of the market • says there will be breaks in the yield curve from one segment to the next- this is not true

efficient market hypothesis

• Theory of informational efficiency - the linkage between information and pricing- how quickly does information change the price • weak form, semi strong form, strong form

preferred habitat theory

• There are boundaries between maturity segments but there are not barriers like market segmentation state • Few legal obstacles of switching segments

investment companies charge a ____ free

management -percentage of overall investment

in 2008.....

many money center banks were forced to merge with investment banks to reduce the risk of failures that would destabilize the economy

easy money

meant is was easy for banks to issue banknotes when businesses wanted loans and low interest rates -wanted by western agricultural societies

pyramiding of reserves

meant that many banks could run short of reserves simultaneously

federal agency

• an independent federal department or federally chartered corporation established by congress and owned or underwrtitten by the US gov

limit order

• an order to buy or sell at a designated price or at any better price • -bid or offering of securities

market order

• an order to buy or sell at the best price available at the time the order reaches the exchange

if duration gap is ______, most of the price sensitivity is on the liability side -- one would hope for interest rates to rise bc liabilities will decrease more than assets and increase the net worth

negative

time is a _____ resource

nonrenewable

finance companies

obtain most funds from selling commercial paper to investors and DO NOT accept savings deposits

saving

• another way to arise a surplus • less fun • most educated people realize they need some sort of plan for the future • retirement is a major reason- older people are more picky investors • public sector has nice pensions • money you save and put aside has more value to you

crowding out

• as the fed govt soaks up available credit, it can push interest rates up for other borrowers

public markets

organized financial markets where securities registered with the SEC are bought and sold

if a duration gap is ______ this means assets are more price sensitive than liabilities (one would hope for a drop in interest rates, assets will increase more than liabilities in PV)

positive

durations can tell us which instruments will be more or less sensitive to _____ _____

price change

chile in relation to HF

• completely privatized social security and Medicare • way more solvent

credit risk

• default risk- accepting the possibility that the borrower will fail to make either interest or principal payments in the amount and time promised • managed by: diversification, careful credit analysis of borrower, and monitoring the borrower over the life of the loan to detect any changes in financial health

denomination problem

• deficit units need to raise large capital even amounts, surplus units need to raise capital in small, uneven amounts

investment funds

• money market mutual funds • mutual funds

if you work in the private sector where will most assets be?

• mutual fund • investment industry provides workers savings for their own retirement with investment opportunities

investment company

• mutual fund (large, high volume) • exchange traded funds (ETF's) • closed end funds (oldest type) • hedge funds • private equity funds

sinking fund

• provision that requires the bond issuer provided funds to a trustee to return a specific dollar amount of bonds each year • -they MUSt retire a portion of the bond as promised in the bond indenture

broker example

• real estate agent • maintains a listing of houses that are for sale

industrial development bonds IDBs

• subclass of revenue bonds • -first issued to help local bus. after the Great depression • -assume no legal liability in event of default • -have low borrowing costs due to exempt of tax

public sale

• the bond issue is offered publicly in the open market to all interest buyers

loanable funds theory

• theory that states: • Credit is a commodity (supply and demand for it) • Cost of Credit is set by supply and demand- this is interest rates • Not every sector is equally elastic • Real Rate of Interest measures the opportunity cost of lending • Demand curve slopes downward because of diminishing marginal utility • Decrease in income tax would shift supply curve right and demand curve left

employee retirement income security act of 1974 ERISA

• this act directed pension fund managers to diversify their portfolios and encourage them to ,move more aggressively into real estate equities

hair cut

• this is due to the value of the collateral falling, repos are typically over collateralized thru a mechanism known as this

new regulatory powers of the fed

• thrust of new regulation is to provide the fed with authority to monitor when necessary and intervenes in the business affairs of large complex bank and nonbank holding companies that pose substantial risk to the economy

M1

• transactional measure of money supply • total of checking accounts, currency

moral hazard

◦ occurs after the transaction ◦ default risk is increased above agreed level

the federal reserve is NOT....

a government agency and IS free from presidential and congress power

mutual funds

a way for ordinary investors to access investments that they may not have time to research

aggressive stocks

beta greater than 1

defensive stocks

beta less than 1

going online and begging for money

crowdsourcing

insurance is a way of _____ our economic well-being in the future based on _____

enhancing risk

circuit breaking

falling to quickly

sales finance companies

finance the products sold by retail dealers

what connects money and capital markets

financial institutions connect the S-T and L-T markets

foreign exchange risk

fluctuation in exchange rates

business finance companies

focused on loans and leases to businesses

primary markets

for munis have a large number of relatively small bond issues- • -these bonds tend to be underwritten by small regional underwriters in the immediate ares of the issuing muni

direct financing

funds flow directly through the financial markets

indirect financing

funds flow through financial institutions in the financial intermediary market -they facilitate they trade between the DSU and SSU

how do consumers access financial markets?

gain access indirectly with transacting with financial intermediaries (commercial banks, mutual funds)

crowdsourcing

go online and beg for money, could get rid of financial intermediation in the future

US in relation to HF (heritage foundation)

have a higher income tax, but freedom of speech

economic units discussed in class

households, businesses, and governments

discount window borrowing

if interest rate is increased banks are inclined to borrow less at the discount window

bank panic

if the bank runs spread and cause failures of banks during a financial crisis

if the fed funds interest rate _____ the opportunity cost of holding excess reserves ____ and the quantity of reserves demanded _____

increases, increases, declines • banks borrow more money from the fed, increasing the amount of reserves in the system and the supply curve shifts upward

most common kind of financing relationship

indirect finance

fed funds rate

interbank ending rate representing the primary cost of short-term loanable funds • highly volatile • 1. measures return on the most liquid of all financial assets (reserves) • 2. closely related to monetary policy • 3. directly measures available reserves in the banking system, influencing decisions on making loans

bond prices and interest rates move ______

inversely

deposit balances are _____ to the depository institution

liabilities

difference between money and capital markets

liquidity

securities dealers

make markets • when a market is liquid and all participants can buy and sell at will

what happened in 1999?

money center banks gradually allowed to participate in investment banking activities

what happened in 2007?

money center banks were well established in the investment banking markets

_____ authority will always interfere with spending, saving, etc

politcal

feds role

protect consumers, deal with discrimination in the marketplace, and adjust to the changing structure of the financial system

financial system bailout

purchased distressed assets from financially impaired banks and other financial firms

OTC market

securities not listed on exchange, no central trading place

permits a corporation to register a quantity of securities with the SEC and sell them over time rather than all at once

shelf registration

consumer finance companies

specializing in installment loans to households

what did the eastern want?

stronger central bank with more power

what has helped lower adverse selection costs?

technology banks, this has helped achieve greater economies of scale

NASDAQ has _________ to help with circuit breakers

trading curbs -reduce average time of execution and gives the market time to slow down

CAPM is the most popular model of relation between systematic risk and expected return

true

NYSE has a specialists who acts as both a broker and dealer

true

dividend income is taxable

true

it takes longer for the RE to filter out changes than it does the stock market

true

projected stream of NOI is fundamental determinant of property's value

true

the OTC stock market is primarily a dealer market

true

the stock of most US corporations have a beta between .5 and 1.5

true

direct finance

used of funds (borrower) and provider (lender)

estonia in relation to HF

used to be part of the soviet union...

excess reserves

want to minimize because the Fed pays little or no interest on reserves • if they end up with excess they make more loans and buy more investments that pay an interest return

serial bond issue

what most muni bonds are • these contain a range of maturity dates rather than all of the bonds in the issue having the same maturity

bank runs

when everyone tries to convert their deposits into cash can pose a serious threat to economy

capital market

where capital goods are financed with stock or L-T debt instruments

fiat money

• "let be" in latin • money by decree says the govt • not backed by physical wealth

Rule 144A

• -adopted by the SEC, to liberalize the regulation of private placement market • -allows secondary trading of private securities by large institutional investors • -should lower corporations cost of capital

call provision

• -an option that grants the issuer the right to retire bonds before their maturity

registered bonds

• -bonds for which the owner is recorded and pmt due is mailed to the owner

bearer bonds

• -corporate bonds can be these • -coup are attached that the holder presents for pmt when they come due

dual class firms

• -firms recapitalized with two classes of stock having different voting rights • -by issuing stock with limited voting rights compared to existing shares the managers of a firm can raise equity capital while maintaining voting control of the firm

secondary market

• -for munis, is thin and primarily an over the counter market • -bid-ask spread is usually larger compared to corporate bonds bc these markets are relatively inactive

what are characteristics of money market instruments

• -low default risk • -low price risk • -high liquidity • -large denominations

what causes SHIFTS in a demand curve

• -variation in number of prospective tenants • -changes in operating expense levels • -yields available on other assets • -technology • -tastes

debentures

• -when no assets are pledged these bonds are secured only be the firms potential to generate cashflows • bond contracts that pledge assets in the event of default have lower yields than similar bonds that are unsecured

What three characteristics must an asset have to qualify as a liquid asset?

• 1. Stable value • 2. Ready Market • 3. Ease of reversibility

steps in the investment decision process

• 1. estimate the stream of expected benefits • 2. adjust for timing differences among expected streams of benefits flowing from investment alternatives • 3. adjust for difference in perceived risk associated with the alternatives • 4. rank alternatives according to the relative desirability of perceived risk return combinations they embody

non-normal period in insurance companies

• 1918 the flu pandemic • lots of people died the agencies did not predict to die • had to liquidate assets to pay claims

cumulative and straight voting

• 2 procedures to electing directors

laddering

• 20% 0-1 yr. Investment and speculative grade • 20% 1-3 year Investment and speculative grade • 20% 3-5 year Investment and speculative grade • 20% 5-10 year Investment and speculative grade • 20% 10+ year Investment and speculative grade • Easy to implement and explain • Maturity Matching- matching maturities of liabilities with maturities of assets

Barbell

• 50% Short Maturities (45% investment grade, 5% speculative grade) • 50% Long Maturities (45% investment grade, 5% speculative grade- • Long Maturities hedge against reinvestment rate risk • Popular strategy with less sophisticated investors who need to be allocated into things that pay fixed income but don't have expertise

medium of exchange

• A method of exchange for goods & services

floating rates

• Adjustable rate mortgages • Interest rate risk on these assets are zero • Credit risk is an unsystematic risk- can be stopped through diversification

Semi Strong Form of EMH

• All relevant public information is fully reflected in the price seen

3 possible configurations of yield curve

• Ascending (normal)- • Inverted (descending)- • Indicator of Recession • Happens at most a year • Flat- rare- • Means investors are completely indifferent to maturity

financial claims

• DSUs write IOUs that the SSU is willing to accept • IOUs= financial claims, securities, or financial instruments • liabilities for the DSU (borrower) and assets for the SSU (lender)

sells

• Debits existing reserves from dealer's banks- • · Fed gets paid by debiting or taking reserve's from a dealer's bank (called draining) • · Monetary base decreases, yields increase, prices driven downward

reserve requirements

• Don't change very often because it shocks the system- only changes if it wanted to structurally change the financial system long term

T/F: Having a large amount of cash or cash equivalents is good from an investors pov.

• False, having lots of cash is bad because it's investors money just sitting there

investment banking

• Helps clients raise capital- once they identify the financing needs of the client, they underwrite- • Line up a group of investors and convince them that these securities are a good investment • Once there are enough investors, the Ibank will purchase the securities from the client and sell them to the investors, keeping the underwriting spread

Transactional motive

• Holding money to pay bills

discount rate

• Interest rate associated with discount window- Fed announces, usually higher than fed funds target to give people an incentive to borrow from Fed Funds • Banks can take loans at the discount window if other loans are hard to find- this is usually in a vibrant economy- • Fed is a lender of last resort • Window Scrutiny • the fed is not a regulator or dictator of interest rates, just the fed funds target rate

under expectations theory, if people think interest rates will rise:

• Lenders want to hold off loans till interest rates do rise, then lock in the high rates- this pressure short term rates downward and long term rates upward- ascending

maturity problem

• Lenders/investors bias toward short maturity (concerns about liquidity)

Active/ Differentiated stock selection

• Look at fundamentals, the characteristics of a company and assume that there is a link between the condition of a company and the value of a stock • Stock market can sometimes undervalue or overvalue a stock and this can be taken advantage of • Growth Investing- the idea that is possible to spot growth stocks that will increase in value

measures of the money supply

• M1= currency + checking deposits • M2=M1 + savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, non institutional money market mutual funds, and small time deposits ◦ role money please as a store of value

The only liquid asset and the raw material of finance

• Money

nonparticipating preferred stock

• PS dividend is fixed- it doesnt change regardless of how profitable the firm is • -can decide not to pay div to PSt w/out going into default

fed funds target rate

• Rate is lower than the discount window • Deal with other depository institutions that have excess funds • Open auction system • Fed likes this because monetary base doesn't change- it just rearranges- excess reserves are reallocated to their best use • When the Fed increases the signal rates (both fed funds and discount) it wants to tighten economic policy and decreases to ease- • Fed announces two rates at FOMC meetings

liquidity preference theory

• Rational investor confronting two investment choices will pick the more liquid • Ascending curve • Difference in rate of return between the two is the liquidity premium • Cannot explain downward sloping yield curves- • Something besides liquidity preference is happening- doesn't disprove liquidity preference though

money market mutual fund

• S-T securities with low default risk • sell from 1 million plus • restrict the amounts of withdrawals and the federal government does not insure the funds • carry default risk of individual securities that comprise the fund portfolio or trading loss the fund may incur

Precautionary motive

• Saving for a rainy day

forward transactions

• Set a price today, delivery will occur in the future • Allows parties to set expectations • Both parties take risk in doing this- • · They live with this because they get the certainty of being able to budget • Negotiated in large amounts, on an individual basis

expectations theory

• Yield curve reflects what investors expect will happen to interest rates • Doesn't take into account two curves • Ignores any type of economic friction (taxes transaction cost) • People adjust their supplying and demanding of credit based on their expectations of where interest rates are going

passive/efficient market hypothesis

• You can't consistently beat the market • Build a portfolio to capture the market over time • Dollar Cost Averaging

rights offering

• a company stockholders are given the right to purchase additional shares at a slightly below market price in proportion to their current ownership in the company

negotiated offering

• a contractual arrangement between the underwriter and the issuer whereby the investment banker obtains the exclusive right to originate, underwrite, and distribute the new bond issue

indenture

• a legal contract that states the rights, privileges and obligations of the bond issuer and the bondholder • -these are overseen by a trustee who is appointed as the bondholders rep

disintermediation

• a process where firms raise capital in the direct financial markets rathe than from financial intermediaries

competitive offering

• a public auction • -issuer advertises publicly for bids from underwriters and the bond issue is sold to the investment banker submitting the bid that results in teh lowest borrowing cost to the issuer

bankers acceptance

• a time draft (orders to pay a specified amount of money to the bearer on a given future date) drawn on and accepted by a commercial bank

higher level financial intermediary

• a transformation of claims- this kind is never done

liquidity

• ability to convert an asset into cash quickly WITHOUT LOSS OF VALUE • implies when a security is sold, its value is preserved

insurance and adverse selection and moral hazard

• adverse selection- smoking three packs a day (know before) • moral hazard- everything about me is fine when i buy the insurance, but then trigger a me that wasn't me when i bought it

cumulative voting

• all directors are elected at the same time and shareholders are granted a number of votes equal to the number of directors being elected times the number of share owned • -gives minority shareholders a voice • -they can distribute their votes across directos

what 3 concerns determine the relative value of all investment alternatives

• amount of benefits and the timing and certainty of their receipt

federal reserve district banks

• assist in each region in learning and processing check and certain electronic fund payments in their respective areas of the country • recent years the federal reserve board used its power to review discount rates to enforce uniformity • over time have relinquished powers to the board of governors ◦ can review and disapprove banks and discount rates ◦ board also appoints top officers and picks salary

the three budget positions

• balanced- income and expenditures equal • surplus- income>expenses (SSUs) ◦ households are primary SSU • deficit- income<expenses (DSU) ◦ group of businesses and government

federal funds

• bank deposits held with the federal reserve bank • banks with excess of required reserves may lend those excess reserves called fed funds to other banks ◦ used to recover deficit position or make loans • fed funds interest rate is the interbank lending rate

financial system is competitive....

• banks will pay at or near the highest interest rate you can earn on CD's of similar maturity and risk and businesses borrow at the lowest interest rate given their risk class • only projects with high-risk adjusted rates should be funded • banks and other lenders earn much of their profit from the spread between borrowing & lending rates

strategies for interest rate risk management

• barbell • laddering • zero • floating rates

eurobond

• bond denominated in a currency different from the currency of the country where it is issued

subordinated (junior) bonds

• bondholders claims to the companys assets rank behind senior debt

yankee bonds

• bonds issued by foreign entities in teh US • -denominated in US dollars and comply with SEC regulations

revenue bonds

• bonds sold to finance a specific revenue producing project; in the event of default only the revenue generated from the project backs these bonds • -ex: toll roads, bridges, water and sewage treatments, university dorms, parking facilities

convertible bonds

• bonds that can be converted into shares of CS at the discretion of the bondholder • -usually have lower yields • -contain a call provision

convertible bonds

• bonds that can be exchanged for shares of CS • -most are subordinated debentures (low rating claims, but claims rank above stockhodlers) • can convert bond to other securities

deficit unit

• borrower or debtor • operational risk taker • economic unit whose planned spending exceeds its internal resources, so they turn to outsider to provide funds

depository institution flow chart

• borrowers<----depository institution <----depositors ◦ borrowers transfer loans/balances to depositors ◦ depositors transfer funds to borrowers

equity

• bring in new shareholders • existing shareholders may have problem and want protection against dilution • morally and ethically obligated to offer preemption to existing shareholders • not contractual • demand a higher rate of return because of less certainty

difference between broker and dealer

• broker brings together the buyer and seller (matchmaker) • dealers stand by ready to buy and sell their inventory

dollar cost averaging

• budget a consistent sum of money at a consistent interval to go into portfolio- makes sense for small investors and retirement investors

insurance flow chart

• businesses and government<-----insurance company<---- policy holders ◦ b&G transfer securities to policy holders ◦ policy holders transfer funds to b&g

member banks

• buy stock in their regional Federal reserve banks and help elect each regional bank's board of directors ◦ stock pays the banks 6% dividends but does not carry any other traditional powers of ownership (voting)

convertible PS

• can be converted into CS at a predetermined ratio

cumulative PS

• cannot pay div to CStockholders until it pays div to PStockholders

dealer example

• car salesperson is a dealer • these cars belong to the dealership and they are responsible for property ownership relations

is independence important in the federal reserve?

• central bank can take short run policy actions that mat be politically unpopular but in the longer run benefit the economy's overall macroeconomic performance • research shows performance in controlling inflation is best in countries with the most independent banks

realities of monetary power

• chairman controls agenda and chairs the meetings of both the board of governors and the FOMC • leadership and intellectual skills to gain the respect of his colleagues

5 c's of credit

• character • capacity • capital • conditions • collateral

thrift institutions

• checking accounts, savings, and time deposits • savings and loan associations and mutual savings banks • largest providers of residential mortgage loans to consumers • maximum 250,000

the financial crisis and expanded powers

• collapse of mortgage market began in the subprime lending market and quickly led to the collapse of the speculative bubble in the housing market • defaults on home mortgages, falling house prices, and sharp unexpected increases in commodity prices such as oil and food led to the failure and collapse of large and prestigious financial institutions

deposit type institutions

• commercial banks • thrift institutions • credit unions • -most common, daily basis use -devoid of any risk of loss on principal -highly liquid

repurchase agreements

• consists of the sale of short term security with the condition that after a period of time the original seller buys it back at a predetermined price

private market

• contacts investors directly and negotiate a deal • advantage; SPEED at which funds can be raised at a low transaction cost • cannot be sold in public markets because they lack SEC regulation ◦ makes them less marketable

junk bonds

• corporate bonds with high default risk and low bond ratings • aka FALLEN ANGELS

financial guarantees

• cover the pmt of principal and interest to investors in debt securities in the event of a default • -insurance companies or commercial banks provide most of these

types of depository institutions

• credit unions • commercial banks • savings and loan associations

intermediation services

• denomination divisibility • currency transformation • maturity flexibility • credit risk diversification • liquidity

immediately available funds

• deposit liabilities of fed reserve banks and liabilities of commercial banks that may be transferred or withdrawn during a business day

liabilities and capital of the fed part 2

• depository institution reserves ◦ reserves consist of all deposits held at the Fed and cash that is physically in the vault ◦ historically not paid interest on reserves, but granted the authority to do so during periods of low interest rates when it had technical problems ◦ control the nation's money supply ◦ total reserves ▪ 1. required reserves- at specified fraction of total deposits ▪ 2. excess reserves- the greater the uncertainty in the economy the greater the management's desire to hold excess reserves ◦ treasury deposits ▪ acts as a bank for the treasury ▪ pays no interest on checking account ◦ deferred availability cash items ▪ value of checks deposited at the fed by depository institutions that have not yet been credited to the institution accounts ◦ capital ▪ primarily represents money paid in by banks that are members of the federal reserve system to purchase stock

too big to fail problem

• designed to reduce the possibility that tax payers will be placed imposition to bail out financial firms whose failures threaten the overall economy • economists believe that as companies grow they place a greater threat to their failure affecting the financial system

reserve requirement

• determine the amount of funds financial institutions must hold at the end in order to back their deposits • one of the controls to the nation's money supply

underwriters spread

• difference between the gross proceeds and the net proceeds, compensates the investment banker for the expenses and risks involved in the offering

the two kinds of financial relationships

• direct finance • indirect finance

treasury bills

• direct obligations from government with no default risk • 3 months- year

straight voting

• directors are elected one by one • -the max number of votes for each director = the number of shares owned

adjustable rate PS

• dividends are adjusted periodically in resposne to changing market interest rates

independence of the fed

• does not rely on congress for funding • makes most of earnings from large portfolio of government securities • lon 14 year terms of the governors insulates them from day to day pressures • independence is constrained- aware of political pressures and of secular changes in economic policy • independent within, not of the federal government

federal reserve bank of new york

• done primarily through open market operations- buying and selling of US treasury securities • conducts foreign exchange interventions on behalf on the Fed and the treasury department

full service broker

• ex. Meryl Lynch • give investment advice • trade on behalf of the client, client will check in every now and then to make sure they aren't broke • still around today, but it is more about E-trade

what is in it for me?

• expected return- learn about in statistics • required return- CAPM, bond yield + risk premium ◦ if you don't think you can make this much you probably shouldn't invest

the FOMC

• federal open market committee • consists of 7 members of the board of governors plus 5 presidents of federal reserve banks • the new york member is a permanent member because new york makes monetary policy on a day to day basis • this group actually determines monetary policy and directly effects the country's level of economic activity

transaction costs

• fees and commissions paid when buying or selling securities • higher when dealing with small businesses because the dollar amount is small

life insurance

• female and male in family are breadwinners and if you lose of of them you would like to replace their earning for a couple years • companies will typically have life insurance on their CEO

regulatory reform

• financial reform act 2010- most extensive reworking of financial regulations since the 1930's ◦ significant political compromise

businesses

• financial system sector: • Demand Loanable funds for Capital Projects- short term working capital • Supply loanable funds by Retaining Earnings and investing • Usually net deficit • Are Rate elastic- the most predictable sector- they are solely focused on profits and earnings- won't take out loans if not profitable

governments

• financial system sector: • Demand loanable funds for budget deficits • Supply loanable funds through budget surpluses • Usually Deity • Rate elasticity depends on other factors

board of governors

• financially and administratively independent from president and congress • congress established 14-year overlapping terms for federal reserve board members, with one 14-year term expiring every 2 years ◦ governors appointed by president, senate confirms ◦ chairman is also chosen by president among the existing governors

red adair

• first person to be successful at extinguishing oil well fires • "if you have to ask, you cant afford it" • proves that emergency situations will make companies pay more

political risk

• fluctuations due to US or foreign governments • managers must be prepared to act quickly when changes occur

methods of investment banking

• full commitment- investment banker commits to buying the whole offer • alternative method called best effort

what could go wrong?

• future is uncertain- "we know the past, but we can't change it. we can change the future, but we don't know it • class definition of risk • deviation to the upside is not thought to be risk • what the market gives it will also take away

futures and options markets

• futures: often called derivative securities- derive value from some underlying asset ◦ corporations use these contracts to reduce risk exposure caused by fluctuation in interest rates, etc. • options: call for one party to perform a specific act if called on to do so by the option buyer or owner

manager of SOMA (System Open Market Account)

• gets staff together and makes sure they understand the policy directive and form a trading strategy- • · Speak to the president of the New York fed and select group of securities dealers- make trades on Feds behalf

senior debt

• gives the bondholders first priority the firms assets (after secured claims are satisfied) in the event of default

financial markets

• goods are bought and sold • can be informal or formal • items sold include: bonds, stocks, futures contracts

normal period for insurance companies

• gross period premiums > gross period claims ◦ knowns as net underwriting income ◦ take this gross profit made to pay the overhead ◦ if there is leftover, invest it

Switzerland in relation to HF

• has compulsory military service • economic freedom does not mean freedom in every aspect

Canada in relation to HF

• has national healthcare • does not strike as an economically libertarian institution • don't appear to have a very active and intrusive government

Pension funds

• have steady and predictable streams of CF. these are ideal real estate investors

professional asset managers

• help passive investors, they acquire interests in real estate,or they acquire shares in corporation, partnerships, or trusts that hold extensive real property interests

heritage foundation

• huge (think tank size) • influences a lot of conservative politics in the world • countries: US, Hong Kong, Denmark, Iceland, Marceau's, Estonia, Chile, Canada, Switzerland, Australia, New Zealand, and Singapore

adjusting the discount rate

• if the fed decides to adjust the discount rate, profit maximizing banks may increase their borrowing from the fed to make loans ◦ banks borrow reserves when they borrow at the discount window---shifts the supply curve to the right

full faith and credit

• in the event of default, the bankruptcy court requires the city or local gov to raise taxes to pay coupon or principal pmts

open market operations

• increase reserves by purchasing treasury securities---supply curve shifts to the right which means market rate declines • if the fed sells treasury securities it will do the opposite

board's professional staff

• informational power • interact daily with the board of governors= situational briefings • indefineable, but significant influence on policy issues and in the decision making processes at the Fed

Singapore in relation to HF

• insider trading is elgal, security laws are a lot less here • receive English common law • don't have a lot of freedom outside of economics

elements of a financial system

• instruments • markets • institutions

contractual savings institutions

• insurance companies and pension funds

where should the money come from?

• internal financial resources- resources are finite • borrow (typically most popular) • equity

international and domestic markets

• international-important for the US are the Eurodollar (S-T market) and the Eurobond (L-T market) • closely lined to the US money and capital markets

pension funds

• invest money in corporate bonds and equity obligations • inflow is L-T and outflow is highly predictable • invest in higher yielding L-T securities

noncompetitive bid

• investor indicates the quantity of bills desired and agrees to accept the price based on the stop out discount rate of the auction

securitization

• involves setting up a trust that buys a large number of loans of similar types

mortgage backed bonds

• issued by city housing authorities based on mortgage pools generated under their jurisdiction • -interest on these are tax exempt • -congress has restricted these bonds

treasury notes and bonds

• issued by the US treasury an dare backing by the full faith and credit of the US gov • -free of default risk • -coupon issues (pay interest semiannually) • -maturity greater than 1 year • -notes: maturity 1-10 years • bonds more than 10 years

money center banks

• large commercial banks usually located in major financial centers who are major participants in money markets ◦ highly regulated by federal reserve ◦ have a large retail banking presence

negotiable certificates of deposit

• large denomination time deposits of the nation's larges commercial banks • may be sold in the secondary market before maturity • only sold by a handful of banks

if the money comes from borrowing...

• large firms--bond market • not so large- other financial institutions • its a natural cost allocator • contract so it is less costly because of legal remedies than equity • debt is better if they are credit worthy

mortgages

• largest segment in capital market in terms of amount outstanding • non active secondary market, unless a large amount is pooled together to create a mortgage-backed security

Strong form of EMH

• least reputable, has least empirical support- all relevant information, public and private, is fully reflected in the price we see

surplus unit

• lender, creditor, investor, saver • financial risk taker • economic unit whose internal resources exceed its planned spending

characteristicsof capital markets

• less marketable • default risks vary • maturities are 5-30 years

theories of what shapes the yield curve

• liquidity preference • expectations theory • market segmentation • preferred habitat

assets of the fed

• loans ◦ makes loans to other banks and depository institutions ◦ short period of time and the rate charged is the discount rate ◦ discount window- where banks borrow from the Fed to provide loans as a lender of last resort ▪ loans collateralized at less than their face value (discounted, hence name) • government securities ◦ buy and sell through open market operations ◦ when buying government securities pay for them by providing the bank with additional reserves • cash items in process of collection ◦ clearning but not yet obtained the funds ◦ fed clears many checks so this item in numerically large • float ◦ difference between the CIPC and DACI

New Zealand in relation to HF

• lots of economic freedom • gun laws and public speech code

what type of investments to insurance companies like

• love bonds, because predictable in the future • like preferred stock • common stock with dividend preference

casualty insurance companies

• major source of funds is premiums charged on insurance policies • provide no liquidity to holders • casualty companies have substantial holdings of equity securities and hold municipal bonds to reduce taxes

active investors

• make decisions- selecting on site management personnel, negotiating maintenance contracts, making rental rate decisions, approving leases- that directly affect operating results

passive investors

• make no operating decisions. they turn their wealth over to professional asset managers. • -their decisions have little direct impact on the outcome of real estate operations

feds role in check clearing

• make only net payments of net balances due among members in the association ◦ saves time because payments do not have to be made for each transaction individually • role in clearing checks drawn on depository institutions located in other market areas or different parts of the country ◦ deposits can be transferred easily from one institution to another by making an appropriate entry on the feds books • total level of reserves at the fed remains unchanged ◦ checks must be cleared between them, they do not disappear from the banking system, only from the account on which the check was drawn

Store of value

• making plans for money we havent spent

australia in relation to HF

• mind your own business kind of attitude • super anti-gun, very stringent rules on this

liabilities and capital of the fed

• monetary base- sum of currency in circulation + total reserves • open market operations- fed exercises control over monetary base through the purchase or sale of government securities in the open market • fed issues most of the currency in translation • federal reserve notes ◦ largest single liability ◦ lawful money-"legal tender for all debts, public and private"

adverse selection

• more sever for small firms • if reliable info is not available at a reasonable cost, banker may decide to not make any loans to businesses or consumers in a particular market (results in market failure)

underwritten offering

• most common distribution method in which the investment banker purchases the securities from the company for a guaranteed amount know as the net proceeds and then resells the securities to investors for a greater amount called the gross proceeds

residual claim

• most distinguishing feature of CS • -if firm goes bankrupt Common stockholders cannot be paid until after everyone else are paid first, they are entitled to whatever is left over

consumer protection regulation

• most focus on loan transactions • various laws protect against insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibility • does not protect any advice on the efficacy or soundness of investment

commercial banks

• most highly regulated • checking accounts, savings accounts, time deposits • maximum 250,000

open-market operations

• most important tool the fed has for controlling the money supply • FOMC is the focal point and at 8 meetings per year discuss the target growth rate • changes only to the money supply ◦ only institution that can expand or contract its liabilities at will ◦ sale of securities leads to a contraction in the money supply

Treasury inflation protection securities TIPS

• note maturities of 5 and 10 years • bond maturities of 20 and 30 years • ADJUST FOR INFLATION • -coup rate is determined by via the auction process • -principal amounts are affected by change in interest rates (Ex: CPI-U)

Weak form of EMH

• o all past price movements are fully reflected in the price that we see today- • § Nothing that can be gained by analyzing the price history of a stock- technical analysis is pointless

comparing the monetary tools

• open market operations ◦ can be done easily (day to day) ◦ easily reversed without an announcement effect ◦ to increase MS- purchase securities ◦ to decrease MS- sell securities • adjust the discount rate ◦ effect MS only if banks are willing to respond ◦ borrowing at discount window is short term ◦ increase MS- board of governors lowers discount rate ◦ decrease MS- board of governors increases discount rate • adjust bank reserve requirements ◦ not used as a tool of monetary policy because difficult to make small adjustments ◦ increase MS- board of governors lowers the reserve ratio to cause a higher money multiplier ◦ decrease MS- board of governors raises the reserve ration to cause a lower money multiplier

what are money markets transactions called

• open market transactions • -bc of impersonal and competitive nature

insurance companies

• operate on a mass of historical data on which you can spot patters

2008 example for investment companies

• panic overwhelmed safety devices that were built • E-mail and texting spread the news faster

M2

• precautionary and speculative money (savings accts, money mkt accts, etc)

Fixed Income Financial Asset

• preferred stock, mortgage-backed securities, bonds • the longer the maturity, the more opportunity there is for int rates to change

primary market v secondary market

• primary= financial claims are initially sold by DSU • secondary= let people exchange previously issued financial claims for cash at will

proxy

• process by which shareholders vote by absentee ballot

lower level financial intermediary

• provides a set of services, moves on and is done • ex. sellers<---broker<----buyers ◦ funds from buyers to sellers ◦ securities from sellers to buyers

duration matching (instead of maturity matching)

• provides for future payment needs without taking on more interest rate risk than needed

no cosmic intervention

• purchasing power will fluctuate- there will be inflation ◦ systematic risk- can hedge against it but can't get rid of • credit and default risk are associated ◦ unsystematic risk (firm specific)- can be partly managed by diversification

federal agencies

• purpose: reduce the cost of funds and increase the availability of funds to targeted sectors of the economy • sell debt instruments in the direct credit markets at or near the government borrowing rate, then lend the funds to economic participants in the sectors they serve

regulatory powers of the fed

• regulation Q- maximum interest rate that banks can pay to depositors ◦ came under the Banking Act of 1933 and phased to by DIDMCA of 1980 • can write regulations mandating that financial institutions meet the requirements of Equal Credit Opportunity Act, the Fair Credit Billing Act and many other consumer protection anti discrimination acts

common stock

• represent an ownership claim on a firm's assets (equity security) • holds gains and losses the company incurs- have claim on assets in event of bankruptcy • most transactions occur in secondary market

corporate bonds

• returns are fixed • 5-30 year maturity • secondary market is not as active for equity securities

interest rate risk

• risk of fluctuation • applicable to bonds and balance sheets

life-insurance companies

• risk protection along with some savings • invest in higher yielding L-T assets like corporate bonds and stock • regulated by the states they operate in and are less strict

circuit breakers

• rules require halts to all trading if the DJIA falls by a certain percentage within certain times

thin

• secondary market trades of corporate bonds are relatively infrequent

households

• sector in financial system: • Demand loanable funds for big ticket items like houses • Supply loanable funds by saving and investing • Usually net surplus • Partly rate elastic- respond in different ways to changes in the cost of credit- house mortgages are rate elastic, credit card and education debt are not

mutual funds

• sell equity shares to investors and use funds to purchase stocks or bonds • small investors access to reduced investment risk from diversification • value of share is not fixed

commercial paper

• short team promisory note historically issued by large corporations to fiannce short term working capital needs • -basic reason for this is to achieve interest rate sabings as an alternative to bank borrowing

credit unions

• small, nonprofit, cooperative, consumer-organized institutions owned entirely by member-consumers • maximum 250,000 • exemption of federal income tax due to cooperation • savings and checking accounts

municipal bonds

• state and local bonds • -encompass all issues of state gov and their political subdivisions • -this market is one of the largest fixed income securities market

Denmark in relation to HF

• stereotype Scandinavian countries with 90% income tax • have economic freedom

households as an economic unit

• supply all the labor • demand/consume all the output of the economy ◦ may not be all directly, but indirectly happens too • where most SURPLUS units are • preparing to retire at some time

windfall

• surplus unit arriving where they shouldn't • ex. wreck a car that think isn't worth much and end up getting a lot more money than you think you would after looked at

characteristics of depository institutions

• take everybody's money and pool it together to give out as loans • interest rates that you charge on loans should be larger than the interest rates you make people pay on deposits • indirect sense make a loan to an entire group of people who you don't know (covered by FDIC)

private placement

• the bonds are sold privately to limited number of investors • unregistered securities • -emerged as a distinct method of issuing securities bc of the securities and exchange act of 1934 (required publicly sold securities to be registered with the SEC) • for equity securities, the investment banker acts only as the companies agent and receives a commission for placing the securities with investors

general obligation

• the creditworthiness of these bonds depends on the income levels of the households and the finical strength of the businesses within the municipality's tax base. What are these bonds called

credit spreads

• the difference between yields of debt instruments with different default risk • -lower rating= high yield • -high rating= lower yields • the space from the yield curve of risky security and treasury curve

marketability

• the ease at which a security can be sold and converted into cash • lower cost= greater marketability

fractional reserve banking

• the idea that not everyone will want to withdraw their funds at the same time- if too much paper money got in circulation, their positions in the reserves would become depleted

reverse repurchase agreement

• the purchase of short term securities with the promise to sell the securities back to the original seller at a predetermined price at a given date in teh future

managing systematic risk

• the risk of failure of the entire financial system resulting from the interdependencies among financial institutions ◦ shared jointly with financial stability oversight council ◦ fed to take appropriate action before large fries threaten the stability of the economy

markets

• time comes when we become interested in economies of scale • when they work well perform two favors.... ◦ let everyone chose their own holding periods ◦ give us a price that most people are willing to accept • if they have a lot of participants less objective pricing mechanism...turns us into price takers

what is the most important ecomonic function of the money market

• to provide an efficient means for economic units to adjust their liquidity positions

bank run

• too many people have deposited money and want there money all physically back at the same time ◦ today not so much a thing ◦ there is a well established regulatory system to protect depository institutions from this ◦ if there is a loss of faith in the banking system can create safety issues

market capitalization

• total value of all the outstanding stock, number shares outstanding times price per share

foreign exchange markets

• traded for spot or forward delivery over the counter at large commercial or investment banks • spot market= currency sold for immediate cash • forward market= dealers agree to deliver these financial claims at a fixed price and future date

3 motives for holding money?

• transactional motive • precautionary motive • speculative motive

Separate Trading of Registered interest and principal of Securities STRIPS

• treasury security that has been separated into its components • -each interest payment and the principal pmt become a separate zero coupon security

liquidity risk

• unable to generate cash inflow to meet required cash outflow • if unable to meet S-T obligations because of inadequate liquidity, the firm will fail even though the firm may be profitable over the long run

initial public offerings IPOs

• unseasoned offering • -when it is the first time the company has offered a particular type of security to the public, meaning the security is not currently trading in the secondary market

commercial paper

• unsecured promissory note of a large business • maturity of a few days to 120 days • no secondary market

municipal bonds

• used to finance capital expenditures for schools, highways, airports • coupon income is exempt from federal income taxes ◦ so individuals in highest income bracket invest in these • limited secondary market, thus not considered a liquid investment

ex. schwab

• want speed of execution- guarantee by them also being dealers as well • creates a little bit of an ethical problem to trade in a way that benefits firms rather than ones benefit clients • regulated by FINRA

insurance is regulated at the ____ level

◦ state ▪ be prepared to follow the rules of the state accordingly ▪ a lot depends on safety and soundness

economic units include

1. household 2. businesses 3. governments 4. foreign investors

types of finance companies

1. consumer finance companies 2. business finance companies 3. sales finance companies

Federal Reserve Act of 1913

1. establish a monetary authority that would expand and contract the nations money supply according to the needs of the economy 2. lender of last resort- could furnish additional funds to banks in times of financial crisis 3. an efficient payment system for clearing and collecting checks at par value through the country

an investor can enter more than one competitive bid, but the total of the bids cannot exceed ___ percent of the t-bills offered in the auction

35 percent

Federal Reserve Act of 1913 part 2

4. a more vigorous bank supervision system to reduce risk of bank failures • elastic money supply- issue a new type of banknote called Federal Reserve Note

current structure of the Fed

7 member board of governors, 12 regional federal reserve banks, member banks, and a series of advisory committees

Zero

Can complicate bookkeeping and tax returns • Relies on zero coupon bonds- • Can be mixed and matched with barbell or ladder • Not paying interest but still accruing it • Part is accounted for as interest and part is capital gain • A way to speculate on interest rate movements

what act separated commercial and investment banking?

Glass Stegall Act of 1933

indirect finacne

User <-- 3rd party <-- provider • they transfer funds to them • they lend it out to people you don't know • much more manageable when a third party is involved

loan balances are ____ to the depository institution

assets

paying interest on reserves

• wanted authority to pay interest on the reserves balances it held at the fed to better implement monetary policies • fed does not control the fed funds rate, it influences it by affecting the supply and demand resorts in the open market • interest payments provide an incentive to banks to put more reserves on deposit at the Fed and lend less of their reserves to other banks in the interbank market • trading desk has two options when it wants to raise the fed funds rate ◦ 1. reduce the supply of reserves by selling treasury securities in the open market ◦ 2. it can influence the demand for reserves by raising the rate it pays on excess reserves--- encouraging banks to put more reserves on deposit at the Fed and to lend less of their reserves to other banks

1987 example for investment companies

• went down a little more than 10% in one day • not many cell phones at this time • E-mail is not a thing

stop-out rate

• what is the highest accepted rate known as

primary market

• what market does a company issue equity in

term bonds

• what most corporate bonds are? • -all fo the bonds taht comprise a particular issue mature on a single date

real estate

• what represents 6.3 % of total pension funds' assets

shelf registration

• whats an important method of selling both equity and debt securities ?

$5,000

• whats the minimum denomination typically for municipal bonds

1. reinvest the profits in the company (RE) for benefit of shareholders 2. or pay money to shareholders directly (dividends)

• when a company makes money or has positive earnings it can do one of two things..

asymmetric information

• when buyers and sellers do not have access to the same information • more of a problem for small businesses because information is not as readily available

adjusting the reserve requirement

• when the fed decides to increase the reserve requirement, the required reserves held by banks increase and so does the quantity of reserves demanded---shifting the demand curve to the right ◦ increases the fed funds rate

seasoned offering

• when the firm already has similar securities trading in the secondary market

moral hazard

• when you get taken advantage of after money has changed hands

money markets

• where depository institutions and other businesses adjust their liquidity positions by borrowing or investing for short periods of time • are a place to borrow liquidity shortly, or park liquidity when you need it back in the near future • Safe and low rate of return • Security with original maturity of one year or less

governments as an economic unit

• where most DEFICIT units are • demand/need for financing • certain public goods we want, but don't want private sector to produce ◦ ex. defense, education ◦ argument on wether healthcare is a public good

businesses as an economic unit

• where most DEFICIT units are • if a business is successful it should have more growth/improvement opportunities that it can pay for with its own funds

samurai bonds

• yen denominated bonds issued by forgein companies in Japan • -interest rates in Japan are low bc they are the worlds most prolific savers