Cpcu 560

Front 1

Financial Institutions: entities that move funds from fund suppliers to fund users.

What are seven types of financial institutions?

Back 1

1) Insurance Companies
2) Mutual Funds
3) Pensions Funds
4) Commercial Banks: depositories with a wide range of loans for assets and deposits as liabilities
5) Finance companies: make loans
6) Investment Banks and Securities Groups: underwrite securities and create markets for trade.
7) Thrifts: similar to Commercial banks but with loans confined to a specific type.

Front 2

Four economic functions financial institutions provide to the entire financial system:

Back 2

1) Credit provision: major source of loans
2) Intergenerational money transfers or one time intermediation.
3) Transmission of monetary policy
4) Efficient payment services

Front 3

Financial institutions tolerate ten risks in providing economic functions benefiting fund suppliers, FIs, and the entire financial system.

Back 3

1) Country or sovereign risk
2) Off-balance-sheet risk
3) Liquidity risk
4) Interest rate risk
5) Credit Risk
6) Market Risk
7) Operational Risk
8) Technology risk
9) Insolvency risk
10) Foreign exchange risk

Front 4

1) Before the stock market crash in 1929, banks often provided a full range of financial services
2) In the 1930s, banks moved away from a full-service role.

Back 4

3) In the 1970s and 1980s, growth in new financial services industries (mutual funds) resulted in continued separation in providing financial services
4) Today, some are moving back toward full financial service, thanks to regulation changes.

Front 5

Financial Markets: structured financial avenues for the exchange of funds.

Two ways to distinguish between financial Markets:

Back 5

1) Primary vs Secondary Markets
2) Money vs Capital Markets

Front 6

Primary Markets: Where fund users raise funds with new issues such as stocks & bonds. They are usually arranged by other companies acting as intermediaries called investment banks.

Define:
1) Firm Commitment Underwriting
2) IPO

Back 6

1) An investment bank buys and entire issue of stocks or bonds for resell in pieces to individual investors
2) Exchanged on the primary market, first time issues from a corporation that allow public investors to buy the stock for the first time.

Front 7

Secondary Markets: financial instruments purchased on the Primary Market are repurchased and resold (traded) by other investors.

Three familiar secondary markets:

Back 7

1) AMEX
2) NYSE
3) NASDAQ, National Association of Securities Dealers Automated Quotation

Front 8

Advantage of the secondary market to issuers: acquire information demonstrating the amounts investors are willing to pay for issuers' financial instruments.

Four advantages of the secondary market to investors:

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1) Diversification
2) Information about the value of investments an investor holds.
3) Liquidity
4) Lower cost for trades

Front 9

Two important kinds of foreign exchange market trades:

Back 9

1) Spot Foreign Exchange Transations: immediate exchange of currency at present rates.
2) Forward foreign exchange transactions: exchange of currency at the rate that will exist on a specific date in the future.

Front 10

Five reasons for the growth in foreign financial Markets:

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1) Greater Access for US investors due to deregulation
2) Foreign investors hold US investments
3) Low cost foreign investment opportunities are offered
4) Information about foreign markets is more readily available.
5) Pool of savings increased in foreign countries.

Front 11

The Federal Reserve Bank: the central bank of the US that was founded by Congress in 1913 to provide a stable, flexible and safe monetary system.

Four Duties:

Back 11

1) Maintain the stability of the financial system
2) Supervise and regulate depository institutions
3) Conduct monetary policy
4) Provide payment and financial services to the US government, financial institutions, the public, and foreign institutions.

Front 12

Four services of the Federal Reserve to the US Government:

Back 12

1) Is the commercial bank of the US Treasury
2) Holds collateral of government agencies
3) Issues and redeems Treasury securities and savings bonds.
4) Makes periodic interest payments on these securities.

Front 13

Board of Governors of the Federal Reserve System (Federal Reserve Board): located in D.C. and consists of 7 members appointed by the US President and confirmed by the Senate to serve nonrenewable 14-year terms.

Three primary responsibilities of the Board:

Back 13

1) Formulating and conducting monetary Policy
2) Supervising and regulating banks
3) The chairperson of the Board acts as an adviser on economic policy to the US president and serves as the spokesperson of the Federal Reserve System.

Front 14

Currency in circulation is the largest liability of the Federal Reserve System.

Reserves: the amount of available cash at a commercial bank plus the depository institution's reserves in accounts at Federal Reserve Banks used to settle accounts of depository institutions when checks and fund transfers are cleared.

Two types of reserves:

Back 14

Required Reserves: reserves that banks are required to hold by the Federal Reserves

Excess Reserves: additional reserves beyond what is required

Front 15

Monetary base: the amount of currency in circulation plus reserves.

Assets of the Federal Reserve:

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1) Treasury Securities
2) Currency
3) Loans to domestic banks; represent only a small portion

Front 16

Monetary Tools
1) Reserve Requirements
2) Open Market Operations
3) Discount Rate

These have two main effects on the economy:

Back 16

Expansionary: Increase the money supply, lower interest rates, increase economic expansion.

Contractionary: Increase interest rates and slow economic growth.

Front 17

Six important components of the money supply:

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1) Monetary Base
2) M1
3) M2
4) M3
5) L
6) Debt

Front 18

Three monetary policy tools used by the Federal Reserve to control bank reserve levels:

Back 18

1) Reserve Requirements: minimum amount of reserve assets banks must hold by law.
2) Open Market Operations: when the Federal Reserve purchases or sells securities in the US Treasury securities market.
3) Discount Rate: the rate charged by Federal Reserve Banks on emergency loans to local banks.

Front 19

Define:
1) Adjustment Credit
2) Seasonal Credit
3) Extended Credit

Back 19

1) Adjustment Credit: discount window loan offered for short-term liquidity problems resulting from temporary deposit outflow.
2) Seasonal Credit: discount window loan that offsets seasonal liquidity problems.
3) Extended Credit: discount window loan offered to banks with serious liquidity issues that cannot be quickly resolved.

Front 20

US monetary policy has a major impact on foreign exchange rates; the current policy is to allow exchange rates to fluctuate.

Back 20

Foreign Exchange Intervention: a commitment between countries that concerns institutional intervention in the influence of exchange rates by buying and selling currencies, especially in the case of unstable markets.

Foreign exchange intervention allows central banks to control rapid appreciation or depreciation of a foreign currency, influencing economic factors.

Front 21

Money Market: financial market for trading debt securities with maturities of less than a year.

Six Characteristics:

Back 21

1) Immediate cash needs are addressed
2) Default risk is minimal
3) Sold in large denominations
4) Trade on a secondary market
5) Interest rate received is higher than transaction costs paid.
6) Return is greater than holding cash.

Front 22

Six participants in money markets:

Back 22

1) Commercial Banks
2) Corporations often raise funds through issuing commercial paper.
3) Money market dealers and brokers
4) US Treasury issues the most actively traded money market instruments: T-Bills
5) Federal Reserve
6) Financial institutions besides banks.

Front 23

Six types of money market securities:

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1) Negotiable CDs
2) Commercial paper
3) Repurchase agreement
4) Acceptances
5) Federal Funds
6) Treasury Bills

Front 24

Negotiable CDs: time deposit issued by a bank specifying a maturity date and interest rate.

Six Characteristics:

Back 24

1) Maturity ranges from 14 days to one year
2) one negotiable CD can be traded multiple times.
3) money market mutual funds often purchase these
4) Form of CDs was not negotiable until the 1960s
5) Approx 15 brokers trade these on a secondary market
6) Denominations are from $100K to $10M

Front 25

Define: Commercial Paper

Back 25

a short-term, unsecured promissory note issued by a corporation to obtain short-term cash

Front 26

Banker's Acceptances: time drafts in which payment to a seller of goods is guaranteed by a bank

8 Characteristics:

Back 26

1) Interest rates are low
2) Maturities range from 30 to 270 days
3) Denominations are based on the original transaction
4) Only the largest banks in the US actively participate in the banker's acceptance market.
5) Collateral is involved
6) Default risk is reduced due to the involvement of two banks vs. one
7) Actively traded in a secondary market
8) Discounted basis is used.

Front 27

Federal Funds: Short-term funds transferred between financial institutions for a period of up to 24 hours, usually overnight:

5 Steps to this transaction:

Back 27

1) A bank has surplus reserves kept at a FRB
2) Bank with the surplus contacts correspondent banks to ask if the banks need overnight reserves
3) Original bank sells the surplus to the bank offering the highest ROR for the fed funds.
4) Excess funds are transferred from the original bank's FRB to the correspondent bank's FRB
5) the following day, the funds plus interest are transferred back to the original bank

Front 28

T-Bills: federal government-issued short-term obligations.

Two reasons the government issues them:
1) Refinance the government's debts.
2) Cover deficits in the federal budget

Back 28

Four characteristics of T-Bills:
1) Maturities of T-bills are 91 days, 182 days or one year
2) Almost no default risk
3) Issued in $1,000 increments
4) Newly issued t_bills are generally sold in lots of $5 million for competitive bids

Front 29

Formula for the bond equivalent yield of a T-bill:

i = (face value - purchase price / purchase price) X 365 / number of days until maturity

Back 29

Formula for calculating the discount yield of a T-Bill:

i = (face value - purchase price / face value) X 360 / number of days until maturity

Front 30

Two ways money markets are growing internationally:

1) Foreign investors are selling and purchasing more US money market securities
2) Foreign money market securities are growing

Back 30

Three types of Euro Money Market Securities:
1) Eurodollar CDs
2) Euronotes
3) Eurocommercial Paper

Front 31

Bonds: Long-term debt obligations

- Bond issue proceeds are used to raise funds in support of the issuer's long-term operations such as projects involving capital expenditures.
- Bond issuers promise to pay investors a specific amount when the bond matures, along with coupon interest

Back 31

Bond markets are used by government units, corps, and individuals to transfer excess funds to gov. units and corps needing funding for long-term debt.
Three Classes of bond markets:
1) Municipal
2) Corporate
3) Treasury notes and bonds

Front 32

Suppliers and demanders of long-term funds are bought together in bond markets.

- The major suppliers of long-term funds are businesses, government units, foreign investors and households
- The major demanders of long-term funds are corps and locat, state and federal governments

Back 32

- Financial business firms such as insurance companies and banks held 20% of T-bonds and 62% of municipal bons and 57% of corporate bonds in 2001
- Households deposit funds in financial business firms and as a result are indirect investors in the bond market.

Front 33

During the period on 1980 to 1999, general changes in yields for 30-year T-bonds, high-grade corporate bonds and municipal bonds were highly correlated.
1) Changes in default risk, tax status and marketability can cause yield spreads among bonds to vary.
2) Changes in economic conditions can also cause yield spreads to vary over time, especially during slow economic growth periods when investors demand higher default risk premiums.

Back 33

Free online access is available to the St. Louis Federal Reserve Bank database of US economic and financial data, which provides the following five pieces of information:
1) US interest rates
2) Monetary business indicators
3) Balance of payments
4) Exchange rates
5) Regional economic data

Front 34

STRIPS (Separate Trading of Registered Interest and Principal Securities): Treasury securities in which periodic interest payments may be separated from each other and from the final principal payment.

Treasury zero-coupon bonds: single components of a STRIP in which investors receive only the single stripped payments for an investment.

Back 34

STRIPS are not issued directly to investors by the Treasury and may only be purchased through government securities brokers and dealers and financial institutions.

STRIPS are sold for a $K minimum face value in multiples of 1K and most T-bonds and T-notes are eligible to be STRIPS

Front 35

Municipal Bonds: securities issued by local governments to fund temporary budge imbalances or to finance long-term projects requiring capital expenditures.
1) Municipal bonds are repaid with revenues or taxes from a project
2) Interest payments are exempt from most income taxes.

Back 35

Investor s are willing to accept lower interest rates on municipal bonds compared to taxable bonds resulting in lower interest borrowing costs to governments.

Front 36

Best Efforts Underwriting: Securities issuance in which the underwriter does not guarantee the issuer a firm price and participates as a distribution or placing agent for a fee based on placement success; underwriters avoid setting the market price securities are offered at a price the municipality originally sets.

Back 36

1) A municipality or corp., with the aid of an investment bank, may seek to find a large institutional purchaser or group of purchasers for the private placement of a whole issue.
2) Interest rates paid to holders of privately placed bonds are higher than interest rates for publicly placed bond issues because a lack of information regarding privately placed bonds results in greater risk.

Front 37

T-Bonds and T-Notes: long-term debt obligations issued by the US Treasury to finance government expenditures and the national debt.

1) No default risk
2) Pays low interest
3) Not completely risk free

Back 37

Comparison of T-Bonds and T-Notes to T-Bills

- Both are fixed principal and inflation indexed paying semiannual coupon interest; T-bills are sold on a discount basis from the face value.

-T-notes have original maturities between one and 10 years and T-Bonds have original maturities between 10 and 30 years; T-bills have an original maturity of less than a year.

Front 38

Primary and Secondary market trading of T-Notes and T-Bonds: T-Bonds and T-Notes are sold by the Treasury through competitive and noncompetitive auctions.

1) Press releases are issued by Treasury one week before auction and include date of auction, amount to be sold and other details regarding securities.
2) Government securities dealers, individuals and business may submit bids through a FRB.

Back 38

3) Treasury auctions are discriminating, meaning different bidders pay different prices and priority is given to the highest bid prices.

Secondary market trading of these takes place directly through dealer and broker trading; FRB of NY reports average daily Tb/Tn trading in the hundreds of billions of dollars.

Front 39

Four characteristics of international bond markets:
1) Trade bonds underwritten by international syndicates
2) Offer bonds to investors in several countries at the same time.
3) Offer unregistered bonds
4) Issue bonds outside any single country's jurisdiction.

Back 39

International bond market grew rapidly between 1994 and 2001 with growth being driven by investor demand.

Front 40

Four classes of int'l bonds:

Back 40

1) Eurobonds
2) Foreign Bonds
3) Brady bonds
4) Sovereign bonds

Front 41

Define:
1) Primary Markets
2) Firm Commitment Underwriting

Back 41

Primary Market: financial markets where corporations raise funds with new issues

Firm Commitment Underwriting: an investment bank buys and entire new issue of stocks or bonds from a corporation for one price, then tries to sell the new issue in bits and pieces to individual investors at a profit.

Front 42

Seven steps in offering a new issue of stock to the public:

Back 42

1) Corporation decides to issue stock
2) Corp sends registration statement to the SEC
3) SEC requests more info or changes
4) Corp sends red herring prospectus to potential buyers
5) SEC approves and registers the issue
6) Corp sets final stock price and issues the official prospectus
7) Stock is offered to the public

Front 43

Three Main US Stock Exchanges:

Back 43

1) AMEX
2) NASDAQ
3) NYSE

Front 44

Holders of corporate common stock have three rights and privileges:

Back 44

1) Voting on certain issues with significant corp impact
2) Ownership rights in proportion to the amount of stock owned
3) Residual claims on corporate assets if the corporation fails

Front 45

Two types of corp stock:
1) Common
2) Preferred

Two Differences:

Back 45

1) All public corporations issue common stock but many do not issue preferred
2) Common stock dividends are uncertain and vary with time; preferred stock dividends are set at a fixed rate and are therefore certain.

Front 46

Common Stock: basic ownership stakes in public corporations

Five Characteristics:

Back 46

1) Voting Rights
2) Absentee, proxy, voting
3) Limited Liability
4) Optional Dividends
5) Residual claim

Front 47

Preferred Stock: securities with characteristics of common stock as well as bonds. Preferred stockholders have ownership interests and rights to periodic fixed dividend payments.
1) Preferred stockholders are paid before common stockholders but after bond owners and creditors
2) Preferred stockholders usually do not have voting rights; however, an exception may be granted if the corp does not make dividend payments as promised.

Back 47

- Preferred stock is usually cumulative and nonparticipating
- Preferred stock has two disadvantages
1) Dividend payments not made as promised decrease a corps ability to raise new capital.
2) Dividend payments must be made from after-tax profits.

Front 48

Participants in the stock market:
- Most people in the US own stock either directly or indirectly
- Households hold more corporate stock than any other group

Back 48

- Even though more than half of all stockholders are under 45 years old, this group owns only 23% of all outstanding stock.
- 34% of stockholders are professionally employed an 38% have earned a college degree
- The mean family income of all stockholders is $84K, and the mean value of all stockholders' investment portfolios is $148,000

Front 49

Investors are interested in international investments because diversification can decrease some risks. However, diversification cannot eliminate all risks.

International investments carry three specific risks:

Back 49

1) Information about foreign stocks is often incomplete and delayed.

2) Country or sovereign risk: risk that foreign entities will interfere with payments to foreign investors.

3) Exchange risk: risk that an Fi's foreign investments will be affected by foreign exchange rate swings.

Front 50

Market efficiency: the rate at which security prices adapt to interest rate changes, new information about corps and other factors affecting security values.

Three gauges of market efficiency:

Back 50

1) Weak Form: holds that current stock prices reflect all public information about a corporation to date and past prices do not indicate future stock prices.
2) Semistrong Form: holds that current stock prices reflect all new public, information about the corporation form the moment information becomes known.
3) Strong form market efficiency: Holds that current stock prices reflect all public and private information about the corporation, which means that even "inside" information does not indicate future stock prices.

Front 51

Finance companies: institutions designed to provide individual and business loans.

Finance companies fall into three major categories:

Back 51

1) Personal credit institutions
2) Business credit institutions
3) Sales finance institutions

Front 52

Finance companies have five advantages over commercial banks in offering business loans:

Back 52

1) Industry and product expertise as subsidiaries of corporate-sector holding companies
2) Willingness to accept risky borrowers
3) Overhead is lower than commercial banks
4) Regulations do not restrict products and services
5) Deposits are not accepted by finance companies, so bank-type regulators are not looking directly at finance companies.

Front 53

Thrift institutions: financial institutions performing residential mortgage services and household lending services in addition to services comparable to commercial banking.

Three categories of thrift institutions:

Back 53

1) Savings associations
2) Savings banks
3) Credit unions

Front 54

Credit unions lend only to members and as such are prohibited from serving the public at large.

The banking industry filed to suits to limit credit union growth in 1997:

Back 54

1) The American Bankers Association and four North Carolina banks challenged the AT&T Family Credit Union's acceptance of members from unrelated companies.
2) The American Bankders Association requested that the court prevent the federal government from letting occupation-based credit unions convert to community-based credit unions.

Front 55

Credit Union balance sheets.

Assets, as of 2001

-Credit unions had combined assets equaling $505.5 Billion with a growth rate of 162% from 1988 to 2001
- Credit union member loans equaled 65.3% of total assets.
- Investment securities equaled 23.5% of total assets

Back 55

Liabilities, as of 2001
- Regular share draft transaction accounts equaled 34.2% of all deposits.
- CDs equaled 27% of all deposits
- Share accounts equaled 12.4% of all deposits.

Front 56

Savings associations wer called savings and loan associations until the 1980s, when federally chartered savings banks appeared in the US having the same regulations and regulators as S&Ls; together, savings banks and S&Ls are referred to as savings associations.

A large number of savings associations failed between 1982 and 1992 and the industry's asset growth declined rapidly.

Back 56

Recent savings association industry trends:
- The savings association industry is facing fierce competition for mortgages from specialized mortgage brockers and commercial banks.

- Savings associations are exposed to significant liquidity, credit and interest rate risks from long-term mortgage lending.

Front 57

Savings association balance sheets.

Assets, as of December 2001.
- Mortgages and mortgage-backed securities mad e up 73% of total assets.
- Consumer loans made up 6.2% and commercial loans made up 2.71% of total assets
- Treasury securities and cash made up 7.15%
- Corp stocks and bonds made up 2.2%

Back 57

Liabilities, as of December 2001
- Small time and savings deposits made up 60%
- Borrowing from the 12 Federal Home Loan banks owned by savings associations was the second most important source of borrowed funds.
- The book value of net worth to total assets ratio equaled 8.21% for savings associations.

Front 58

Mutual organizations: savings associations in which liability holders are the legal owners; stock is not issued.

Mutual organizations are less risky than organizations issuing stock because no equity investment return is demanded and managers are able to focus on low-risk investments and organizational failure prevention.

Back 58

- Member deposits make up the savings association's equity and no stockholders exist.

- Many savings associations have moved form utual organizations to stock charters because the ownership of stock attracts higher levels of capital investment than can be achieved in mutual organizations.