FIN350 Midterm exam

Net exports

- (Gross exports - gross imports) - Interest rates affect exchange rates, which affect imports and exports. This is based on the concept of Interest Rate Parity. Briefly, interest rate parity holds that foreign exchange rates and interest rates in different countries are linked in the following manner.

Duration

- can be used to measure bond price volatility - can also be used to immunize a bond portfolio from interest rate risk

Thrift insitituions

- savings and loan associations and mutual saving banks are commonly called this - obtain their funds by issuing checking accounts, savings accounts, and a variety of consumer time deposits - use these funds to purchase real estate consisting primarily of long term mortgages

Mutual funds

- sell equity shares to investors and use these funds to purchase stocks or bonds - the value of a share of this is not fixed

Interest

- the "rent" on borrowed money - penalizes the borrower for consuming before earning and rewards the lender for postponing consumption. Like any price, an interest rate is used to allocate scarce resources.

Brokers

-help bring buyers and sellers together by acting as "matchmakers" - they never actually own the security they trade so they are not subject to the risk of a change in price underlying the security

Secondary markets

-like used-car markets; this market provides liquidity for investors who own primary claims. - all subsequent transactions take place in this market - the NYSE is a well-known example for this market

Over-the-counter (OTC) market

-securities not listed on an exchange are bought and sold in this market - this differs from organized exchanges because the market has no central trading place

The 6 goals of U.S. monetary policy, established by the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978

1. Full Employment, 2. Economic Growth, 3. Stable Prices (stable price index), 4. Interest Rate Stability, 5. Stability of the Financial System, and 6. Stability of Foreign Exchange Markets.

3 major tools of monetary policy

1. Open market operations 2. Discount rate 3. Reserve requirements

Purposes of a Central Bank

1. Supervise nation's money supply and payments system 2. Regulate other financial institutions, especially depository institutions 3. "Lender of last resort" when financial system has liquidity problems 4. National government's "fiscal agent" (i.e. depository bank)

How changes in interest rates cause bond prices to change

1. There is an inverse relationship between bond prices and interest rates. 2. The value or price of a bond (or any fixed-income security) is the present value of the promised stream of cash flows discounted at the market rate of return, i.e., the required rate of return for this risk class in today's market. Fixed coupon rates establish the periodic cash flows; the price varies to provide the buyer a market rate of return.

Weaknesses in the 19th-Century Banking System

1. Unstable money supply— 2. No standard currency, mostly private banknotes 3. "Hard currency" (gold/silver) hoarded, unevenly distributed 4. No coordinated payments system 5. Banks were state-chartered and unregulated— 6. No deposit insurance or minimum capital requirements 7. No supervision of lending or accounting practices 8. Frequent bank failures 9. Disruptions of business credit from bank failures prolonged and intensified economic downturns 10. Exaggerated business cycle- "boom & bust"

M2

= M1 + savings deposits and money market deposit accounts + overnight repurchase agreements + Eurodollars + non-institutional or "retail" MMMFs + small time deposits (under $100,000)

M3

= M2 + institutional or "wholesale" money market mutual funds + large time deposits ($100,000 or over) + repurchase agreements + Eurodollars lasting more than 1 day

MZM

= M2 - small time deposits + institutional MMMFs

M1

= currency, coin and travelers checks in circulation + demand checking deposits or checking accounts + "NOW" accounts and similar interest-on-checking accounts

Maturity Flexibility

Borrowers generally prefer longer-term financing. Savers generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both.

Denomination Divisibility

Borrowers prefer to borrow the full funding need all at once. Savers tend to save small amounts periodically. Intermediaries pool small savings into large investments.

Open Market Operations (FFR)

Buying pressures the FFR downward by increasing the supply of excess reserves. Selling pressures the FFR upward by decreasing the supply of excess reserves. Reserve effects are direct, immediate, and dollar-for-dollar

Reserve Requirements (FFR)

Cutting reserve requirements pulls the FFR downward by increasing the supply of excess reserves. Raising reserve requirements pushes FFR upward by decreasing the supply of excess reserves. Reserve effects are direct, sustained, and too dramatic for "fine tuning"

Discount Rate (FFR)

Cutting the discount rate pulls the FFR downward: The Window becomes less costly relative to Fed Funds. Raising the discount rate pushes the FFR upward: Fed Funds become less costly, with institutions already reluctant to face "Window scrutiny". Reserve effects depend on whether and to what extent institutions actually go to the Window.

Currency Transformation

Intermediaries can buy claims denominated in one currency while issuing claims denominated in another. This would be difficult for most ordinary savers.

Credit Risk Diversification

Intermediaries manage risk by evaluating and holding many different securities. Savers on their own would have to leave "more eggs in one basket."

Liquidity

Many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of borrowers.

Consumer spending for durable goods & housing

Much consumer spending is on credit, so it tends to vary directly with credit conditions. Falling interest rates tend to encourage spending; rising interest rates tend to discourage spending. Consumers, however, don't necessarily make decisions the way businesses do. Often, the decision by consumers is based on the monthly payment required to purchase the durable good. Thus, monetary policy should affect aggregate demand, but perhaps not as predictably as it affects business investment.

Business investment in real assets

Present values of future cash flows depend significantly on interest rates, as do costs of financing real assets. Monetary policy thus involves material incentives or disincentives for business investment. Recall that capital budgeting employs NPV or IRR calculations.

Open Market Operations (monetary base)

This is the Fed's most useful technique for its conduct of monetary policy. It consists of the buying and selling of U.S. Government securities on the open market. These transactions change the monetary base directly, immediately, and dollar-for-dollar as the Fed credits new reserves to pay for open market purchases and reduces existing reserves to collect for open market sales

Reserve Requirements

This is the level of required reserves that must be maintained at the Fed by all banks

Discount Rate

This is the rate the Fed charges banks for borrowing from the Fed

Explain the function of financial intermediaries as indirect conduits for these flows

When SSUs and DSUs do not have common preferences, financial intermediaries can transform the claims of each by issuing their own liabilities and creating their own assets, e.g. issue demand deposits and make loans. This eliminates the problem of unmatched preferences and is known as financial intermediation

Federal funds rate (FFR)

a "benchmark" rate in the financial system—it normally represents the lowest possible cost of loanable funds. The Fed substantially influences the FFR in the short-term by controlling the overall availability of reserves.

The Fed Funds Market

a Fed-sponsored system in which depository institutions lend and borrow excess reserves among themselves. The interest rate on these transactions—the Fed Funds Rate—is set by market forces as they bargain with each other

Future market

a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future

Money market mutual funds

a mutual fund that invests in money market securities, which are short-term securities with low default risk

The demand for loanable funds comprises of

a. Consumer credit purchases. b. Business investment. c. Government budget deficits

The supply of loanable funds comprises of

a. Consumer savings. b. Business savings (depreciation, amortization, and retained earnings). c. Government budget surpluses. d. Central bank action.

Excess reserves appear

as the Fed buys securities on the open market, lends at the Discount Window, or cuts reserve requirements. As depository institutions lend or invest excess reserves, new loans or investments increase M1 and finance purchases in the real sector

Role of the financial system

brings savers and borrowers together. By providing a stable and efficient environment for the flow of funds from SSUs to DSUs economic activity is maximized.

The key players in the money market are

commercial banks, the Federal Reserve System, Treasury Department, securities dealers and brokers, and CFO's of non-financial corporations.

Depository institutions

commercial banks, thrifts, credit unions

Monetary base

comprises Federal Reserve Notes in circulation and deposits of financial institutions with the Fed. Each progressively more inclusive measure of the money supply includes elements substantially influenced by monetary policy but ultimately determined by private transactions:

A bond yield compensates for at least 3 risks

default risk, price risk, and reinvestment rate risk

To meet reserve requirements

depository institutions must deal in monetary base assets by either depositing adequate reserves with the Fed or holding adequate quantities of Federal Reserve Notes in their vaults. Either way, they earn little interest. The more they hold above requirements, the more they want to avoid lower interest income

"Real" rate of interest

determined by the real output of the economy. It is determined at equilibrium between the demand for financing for productive real assets and the supply of savings. By definition it is "the minimum rate of return necessary to offset the positive time preference for consumption in the absence of any transactional risk or expected change in purchasing power".

Deficit budget

expenditures for the period exceed revenues; these economic units need to borrow money and are called deficit spending units (DSU's)

Primary markets

financial claims are initially sold by DSU's in this market. An example of this is IBM corporation raising external funds through the sale of new stock or bonds

Direct financing

funds flow directly through financial markets

Indirect financing

funds flow indirectly through financial institutions in the financial intermediation market

Derivative market

he financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives.

Investment bank

helps companies raise money through the capital market

Balanced budget

income and expenditures are equal

Surplus budget

income for the period exceeds expenses; these economic units have money to lend and are called surplus spending units (SSU's)

Open market operations

involve the buying and selling of government securities through the trading desk at the FRB of New York. When the Fed buys securities it pays for them by depositing the funds into the selling bank/dealer's reserve account. When the Fed sells it takes the funds out of the buying bank/dealer's reserve account. This provides immediate and direct impact on the level of bank reserves which is quickly reflected in changes in interest rates. Open market operations are flexible and can be adjusted as needed.

Commercial banks

largest and most diversified intermediaries on the basis of of range of assets held and liabilities issued

Capital market

long-term debt plus equity

Finance companies

make loans to consumers and small businesses. Unlike commercial banks, they do not accept savings deposits from consumers. Balance of funds come from sale of equity capital and long-term financing

Dealers

make markets for securities by carrying an inventory of securities from which they stand ready to either buy or sell at quoted prices

Informational efficiency

measures the extent to which prices quickly reflect relevant information.

Life insurance companies

obtain funds by selling insurance policies that protect against loss of income from premature death or retirement

Pension funds

obtain their funds from employer and employee contributions during the employees working years and provide monthly payments upon retirement. Purpose is to help workers plan for their retirement years

Federal agencies

primary purposes are to reduce cost of funds and increase availability of funds to target sectors of the economy . These agencies do this by selling debt instruments called agency securities in direct credit markets at or near the government borrowing rate

Organized security exchanges

provide a physical meeting place and communication facilities for members to conduct their transactions under a specific set of rules and regulation

Spot market

public financial market in which financial instruments or commodities are traded for immediate delivery

Price risk

refers to the inverse relationship between bond prices and interest rates

Reinvestment rate risk

refers to the need to reinvest coupon income at the same interest rate as the yield-to-maturity in order to actually earn the yield-to-maturity

The term-structure of interest rates

refers to the relationship between the term, or maturity, of an interest bearing instrument and the interest rate. This structure is most often seen in the form of a yield curve. The Expectations theory, the Liquidity Premium theory, and the Market Segmentation or Preferred Habitat theory attempt to explain the shape of the yield curve.

Casualty insurance companies

sell protection against loss of property from fire, theft, accident, negligence, and other causes that can be actuarially predicted.

Federal Open Market Committee (FOMC)

sets U.S. monetary policy and is the most powerful policy group in the Fed. It is composed of the Board of Governors (and especially the Chairman), the President of the NY Fed and four of the remaining 11 Regional Bank Presidents. The 12 Federal Reserve Banks were once largely autonomous in their respective regional districts. Today they remain operationally important but have essentially lost their authority to set monetary policy.

Money market

short-term debt

Credit unions

small, nonprofit, cooperative, consumer-organized institutions owned entirely by their member-customers

The Loanable Funds Theory

states that interest rates, in the near term, depend on the supply of, and the demand for, loanable funds

By expanding or contracting the monetary base

the Fed increases or decreases excess reserves, thus raising or lowering incentive to lend or invest, thus encouraging or discouraging expansion in the real sector.

By exclusively controlling the monetary base

the Fed substantially controls the money supply

Marketability

the ability to resell a security as needed

A default risk premium

the difference between the yield on a default-free U.S. Treasury security and the yield on a risky category of bonds. Default risk premiums vary over the business cycle and bond ratings are a measure of default risk

Allocational efficiency

the extent to which funds find their highest productive uses

Operational efficiency

the extent to which transactions costs are minimized, is based on sufficient competition among financial institutions

Foreign exchange risk

the fluctuation in the earnings or value of a financial institution that arise from fluctuations in exchange rates. These fluctuations can cause gains or losses in the currency positions of financial institutions

Political risk

the fluctuation in value of a financial institutions resulting from the actions of the U.S. or foreign governments. Risk concerns are much more dramatic in international investments and loans

The implied forward interest rate

the interest rate that makes an investor indifferent between buying a longer-term security and buying a shorter-term security and then reinvesting the proceeds of the shorter-term security, upon its maturity, for the balance of the longer-term period or horizon. The implied forward rate is the rate at which the shorter-term security must be reinvested, upon maturity, to equal the same return as simply buying the longer-term security to begin with

Foreign Exchange market

the market in which foreign currencies are bough and sold and is the worlds largest market by daily trading volume with trading over $5 trillion per day

Financial Intermediaries

the middle men, facilitating transactions between SSU's and DSU's

Interest rate

the price of "renting" or borrowing another's purchasing power; thus credit or borrowed money carries a price like any other commodity

If expectations underestimate actual inflation

the realized rate of return will not compensate the lender adequately for lost purchasing power and the borrower will receive an unintended transfer of wealth

Interest rate risk

the risk of fluctuations in a security's price or reinvestment income caused by changes in market interest rates

Liquidity risk

the risk that a financial institution will be unable to generate a sufficient cash inflow to meet required cash outflows

The economic role of the money market

to provide an efficient means for economic units (i.e. businesses, governments, and households) to adjust their liquidity positions.

Credit risk

when a financial institution makes a loan or invests in a bond or other debt security, the institution bears this type of risk because it is accepting the possibility that the borrower will fail to make either interest or principal payments in the amount and at the time promised

A tax-free bond

will have a lower pre-tax yield than will a fully taxable bond (like a corporate bond).

Direct finance

works if preferences of savers and borrowers match as to amount, maturity, and risk, etc.