Cpcu 560

Front 1

Central banks influence their country's rates

Back 1

by buying and selling currencies. Especially if they perceive the market has become unstable.

Front 2

foreign exhange intervention

Back 2

buying and selling currencies

Front 3

When the Fed uses US dollars to buy another currency

Back 3

it increases the suppy of US dollars, decreases the supply of the foreign currency, and depreciates the dollar relative to the foreign currency

Front 4

When the Fed uses another currency to buy US dollars

Back 4

it decreases the supply of US dollars, increases the supply of the foreign currency and appreciates the dollar relative to the foreign currency

Front 5

The current US policy on exchange intervention is...

Back 5

to let exchange rates fluctuate freely

Front 6

Recent challenges to other major central banks include (3)

Back 6

1. bank of Japan's failed attempts to stimulate the Japanese economy by targeting the o/s balance of current accounts (which threw the economy into a deflationary cycle)
2. European Central bank's efforts to set monetary policy to promote economic growth among all 12 European countries that use the euro
3. Bank of China's attempt to slow the overly rapid growth of the Chinese economy

Front 7

3 basic type of financial intermediaries

Back 7

1. Depository institutions
2. Brokerage houses
3. Insurance companies

Front 8

Depository Institution

Back 8

(banks, credit unions, savings & loans)
You loan your money and you get investment back with interest. Your return on investment can be accurately predicted.

Front 9

Brokerage Houses

Back 9

(Merrill Lynch)
You invest your money and get it back with interest (bonds), dividents (stocks), and capital gains or losses (options more than stocks more than bonds). Your return on investment can be accurately predicted (bonds) or fluctuate quite widely (stock, options).

Front 10

Insurance companies

Back 10

You pay your premium an in most cases don't get any back at all. Your return on investment can fluctuate incredibly.
Probably you'll get nothing back (if you had no losses) but you could be indemnified hundreds of dollars per dollar paid in premium; hence, your return on investment could exceed 10,000%

Front 11

Money Markets

Back 11

Facilitate the trading of short-term debt instruments, transferring money from those with short-term excess funds to those with short term needs for furnds.

Front 12

Investor behavior in Money Markets

Back 12

Investors typically invest in both money markts and capital markets to get the higher interest rates of long-term investments (from capital markets) and still preserve liquidity through money markets

Front 13

Money Market investors reduce opportunity costs because...

Back 13

money market instruments generate a higher rate of return than holding cash, coupled with
1. High liquidity
2. littel risk of loss of value
3. a low default risk

Front 14

Default risk

Back 14

the risk of late or non-payment of principal and/or interest

Front 15

Money Market borrowers benefit from

Back 15

low transaction costs and quick transfer of funds. Most individuals participate in money markets indirectly, through money market mutual funds and other financial institutions

Front 16

Types of Money Market Instruments

Back 16

All of the following are issued in large denominations and have low devalut risks and short maturities. Their liquidities vary according to the activity levels of their secondary markets: Treasury bill, Federal (fed) funds, Repurchase agreements (repos), Commercial papers, Negotiable certificates of deposits (CD's), Bankers acceptances.

Front 17

Treasury Bills (T-bills)

Back 17

short term obligations issued by the US treasury dept to cover budget deficits and to refi maturing debt.
- have littel default risk because they are issued by the US gov't
- have little liquidity risk because they're short term instruments with an active secondary market.
- t-bills are sold on a discount basis, and achieve their face value at maturity

Front 18

Formula for the discount yield of a T-bill

Back 18

[(face value - purchase price) / face value] X (360/days to maturity)

The discount yield is directly related to the discount from face value. As the discount rises so does the yield. The discount yield is indirectly related to the # of days to maturity. As the length of time to maturity lengthens, the yield falls.

Front 19

Federal (fed) funds

Back 19

short-term funds transferred between financial institutions, usually for one day.
Fed funds pay interest once at maturity. They are unsecured loans. Financial Institutions borrow fed funds to top up deficient reserves. Traders contact each other directly or through fed funds brokers.

Front 20

The fed funds rate

Back 20

the one-day interest rate for borrowing fed fund.

Front 21

Repurchase Agreements (repos)

Back 21

- 1 party sell securities to another and promise to buy them back at a specified price on a specified date.
- Traders contact each other directly or through brokers and dealers.
- less risky and have lower interst rates than fed funds
- are less liquid than fed funds, and tend to be used by non-banks.

Front 22

Reverse repurchase Agreements (reverse repo)

Back 22

has 1 party buy securities from another and promises to sell them back on a given future date.

Front 23

The formula for the yeild of a repurchase agreement

Back 23

[(repurchase price - selling price) / selling price] x (360/days to maturity)

Front 24

Both Fed funds and repurchase agreements are commonly used for

Back 24

Overnight funding

Front 25

Commercial paper

Back 25

unsecured, short-term promissory note issued to raise short-term cash, usually to finance working capital requirments.
-tends to displace bank loans because it offers lower interest rates.
- risky because it is unsecured debt with a weak secondary market
- The risk of default makes the credit rating of the issuing company an important consideration for the investor; but, the better the credit rating, the lower the interest rate.
- It is sold either directly, using the issuer's own sales force, or indirectly, through brokers and dealers. Dealers and brokers charge a fee for their work in return for a guarantee to sell the entire issue.

Front 26

The formula for the discount yield of commercial paper

Back 26

[(face value - purchase price) / face value] x (360/days to maturity)

Front 27

Negotialbe certificates of deposit (CDs)

Back 27

bank issued, fixed maturity, interest bearing, time deposits that specify their interst rates and maturity dates and are negotiable (can be sold).
- It is a bearer instrument.
- denominations range from $100,000 to $10 million.
- Money market mutual funds buy negotiable CDs and sell them to pools of individual investors.
- Issuing bankds post daily rates for CDs and sell them to investors
- sometimes a bank & an investor will negotiate the size, rate, and maturity of a CD.
- The secondary market for negotiable CDs is small and not very active
- Large banks can offer CDs at lower rates than smaller, less well-known banks

Front 28

Bankers' acceptances

Back 28

are time drafts payable to sellers of goods, with payment guaranteed by the banks.
- bankers' acceptances often finance import-export deals, when foreign exporters want to be sure they'll be paid for their goods. If the importer fails to pay for the goods, the exporter can hold the banker's acceptance until its maturity date or because it is negotiable, sell the acceptance at a discount to a buyer in the money market.
- Thus, banker's acceptance not only guarantee payments for imports-exports but also create a secondary market.
- Only large US banks are active in teh bankers' acceptances market.

Front 29

How to trade US treasury bills, the primary market
(1 of 2)

Back 29

- The Treasury sells new issues of T-bills through Treasury bill auctions. Every week the Treasury annonces the 13 week and 26 week T-bills it plans to sell.
- Interested buyers must get their bids in to a Federal Reserve Bank by 1 pm on the Monday following the announcement.
- The Treasury announces the allocations and the prices of its T-bills the next day, and delivers the bills by the following Thursday.

Front 30

Submitted bids are:
(2 of 2)

Back 30

Either:
Competitive: which specify the desired quantity and price of the T-bills
or
Noncompetitve: which specify the desired amount of T-bills and agree to pay the weighted-average price of winning competitive bids
- The highest competitve bidder gets the first allocation of T-bills
- The rest of the T-bills are distributed from highest to lowest bidders
- No one bidder may receive more than 35% of the total issue
- All bids that are awarded in full are called "winning bids"
- Non competitive bids are allocated T-bills before non-winning competitve bids are filled.

Front 31

How to trade US treasury bills: The secondary market

Back 31

The T-bill secondary market is the largest in the US. The largest dealers are the primary government securities dealers, consisting of about 30 financial institutions named by the Federal Reserve Bank of NY. Those dealers create the T-bill secondary market by buying and selling securities for themselves and for their customers.
- Another 500 smaller dealers trade directly in the secondary market. The secondary market is decentralized, with most trading being conducted by telephone or wire.

Front 32

Money Market Participants (6)

Back 32

1. The US treasury
2. The Federal Reserve
3. Commercial banks
4. Brokers and dealers:
a. Primary gov't security dealers
b. Money and Security brokers
c. Smaller brokers and dealers
5. Corporations
6. Other financial instituations
a. insurers
b. finance companies
c. money market mutual funds

Front 33

The US Treasury

Back 33

primarily a seller in money markets. The US Treasury issues T-bills to raise money for short -term expenditures while it waits for tax revenues.

Front 34

The Federal Reserve

Back 34

a major buyer and seller in money markets. The Fed:
- buys or sells T-bills to increase or decrease the money supply
- buys and sells repurchase agreements to stabilize interst rates and the money supply
- affects money market rates by targeting the fed funds rate
- affects the deman for and supply of fed funds and repurchase agreements through its operation of its discount window

Front 35

Commercial banks

Back 35

buy and sell almost all types of money market instruments, usually to meet reserve requirements and make better use of excess reserves

Front 36

Primary Government security dealers

Back 36

- market new issues of Treasury securities
- run the secondary market for T-bills
- help the Federal Reserve use repo markets to affect the supply of bank reserves

Front 37

Money and security brokers

Back 37

- act as intermediaries for gov't securities dealers, and
- link buyers and sellers in the fed funds and others secondary markets

Front 38

Smaller brodkers and dealers

Back 38

link smaller buyers and sellers in several secondary markets

Front 39

Corporations

Back 39

issue commercial paper and invest excess cash in money market securities

Front 40

Other financail institutions

Back 40

Insurers - which use money market instruments to maintain liquidity
Finance companies - which raise funds through money markets (primarily by using commercial paper)
Money Market mutual funds - which buy money market securities and sell shares of them to small investors

Front 41

Euro Money Markets

Back 41

Foreign investors are buying and selling more US money market secureities every year. hence foreign money markets are in a growht stage.
Becaue many interanational finance contracts call for payment in US dollars, both foreign and US gov't and businesses like to hold European deposits to facilitate spending.
Eurodollars trade in the Eurodollar market.

Front 42

Eurodollar deposits

Back 42

US dollar-denominated deposits in foreign bandks, no just European banks

Front 43

London Interbank Offered Rate
(LIBOR)

Back 43

London's largest banks operate an interbank Eurodollar market, which is used by banks aroudn the world as a source of overnight funding.
The rate in that market is called the LIBOR, which is generally higher than the fed funds rate due to the higher risk of foreign bank deposits.

Front 44

Euromarket securities

Back 44

1. Eurodollars CDs (US dollar-denominated CDs in foreign banks)
2. Euronotes (Short-term, dollar-denominated notes similar to commercial paper)
3. Eurocommercial paper (Eurosecurities issued by dealers of commercail paper w/out involving any bank)
The rate of return for the Eurodollar CDs was consistently higher than the return rate for the US bank CDs up until the 1990's when the 2 rates became virtually identical.

Front 45

Capital Markets

Back 45

facilitate the trading of stocks, notes, bonds, mortgages, and other long-term debts instruments.

Front 46

Bonds

Back 46

long term debt instruments issued by corporations and gov't units to raise funds for long-term operations.
The bond issuer promises to pay the face value of the bond upon maturity plus coupon interst. Bonds are issued and traded on bond markets.

Front 47

3 types of bonds

Back 47

Treasury notes and bonds, municipal bonds and corporate bonds

Front 48

Treasury notes (T-notes) and Treasury bonds (T-bonds)
FEATURES

Back 48

-backed by the US gov't and thus have no risk of defualt.
- pay low interest rates and are subject ot interest rate risk
- old notes and monds are not as liquid as new notes and bonds
- they pay coupon interst semiannually and are issued in minimum denominations of $1,000 T-note maturities range from 1 to 10 years, while T-bond maturities range from 10 to 30 years.

Front 49

STRIP - (Separate Trading of Registered Interest and Principal) Security

Back 49

is a Treasury security that separates the interst payments from each other and from the final principal payment. Each component of a STRIP is called a "Treasury zero-coupon bond" because the investor in an indvidual component receives only the interest payment attached to that component.
- sold through financial institutions and gov't securities brokers and dealers.
- investor use STRIPS to meet investment duration needs and to reduce interst rate risk.
- Investor can buy a STRIP that will pay a specific sum of money at a specified future date.
- Because STRIPS involve no intervening payments or reinvestment, they are not affected by interest rate changes.
- Most T-notes and T-bonds can be stripped
- Their interest payments are exempt from state and local income taxes

Front 50

Treasury Inflation Protection Securities (TIPS) bond

Back 50

in an inflation-indexed bond that provides returns ited to the inflation rate. Teh coupon rate on TIPS is determined by an auction process.

Front 51

Treasury notes (T-notes) and Treasury bonds (T-bonds)
YIELDS

Back 51

Ther present value of a T-bond or T-note equals the present value of its coupon payments plus the present value of its face value.
When an investor buys a T-note or T-bond between coupon payments, he must pay the seller accrued interest.
The bond price w/out accrued interest is called the clean price.
Teh bond price plus accrued interest is called dirty price or full price.

Front 52

Treasury notes (T-notes) and Treasury bonds (T-bonds)
TRADING

Back 52

The Treasury sells them through competitve and noncompetitve auctions.
Gov't securities dealers, businesses, and individuals submit bids through a Federal Reserve Bank until noon or one the day before the auction. Awards are announced the following day. Highest priority goes to the highest bid prices.
Most secondary trading is done through brokers and dealers.

Front 53

Municipal Bonds

Back 53

Issued by state and local gov't to fund tempoarary imbalances between expenditures and receipts and/or to finance long-term projects.

Front 54

Municipal Bond
FEATURES

Back 54

- repaid out of tax receipts. Their interest payments are exempt from federal income taxes and from most state adn local income taxes.
- Municipal bonds are issued in denominations of $5K and larger
- There is a secondary market but it is not as active as the Treasury secondary market.

Front 55

General obligation bonds

Back 55

General obligation bonds are backed by the issuer's full faith and credit and require taxpayer approval before they are issued.

Front 56

Revenue bonds

Back 56

-- A revenue bond finances a specific revenue generating project and is paid back from the cash flows from that project. They are riskier thand general obligation bonds because if the project fails the bonds are not repaid.

Front 57

Municipal Bonds
YIELDS

Back 57

To convert a municipal bond rate to a corporate (taxable) bond rate, divide the municipal bond rate by (1 - marginal income tax rate of the bondholder).
To convert a corporate bond rate to a municipal bond rate mulitply the corporate bond rate by (1 - marginal income tax rate of the bondholder)

Front 58

Municipal Bonds
TRADING

Back 58

Neew issues are sold publicly, through an investment bank that acts as security underwriter, or by private placement.

Front 59

Public Trading

Back 59

- Large issues can be sold nationally
- Small issues can be sold locally
- The UW invetment bank uses firm commitment underwriting,
- The bank can buy the bonds through competitive bidding or through direct negotiation with the issuer
- Some bonds are offered on a best efforts underwriting basis
- Publicly traded bonds must be registered with the SEC
- There is a thin secondary market

Front 60

Firm Commitment Underwriting

Back 60

the bank guarantees the issuer a bond price by buying the entire issue and then reselling all the bonds at higher prices

Front 61

Best Efforts underwriting

Back 61

the bank does not guarantee the issuer a price and places bonds with investors on a fee basis

Front 62

Private Placement

Back 62

- The municipality, sometimes with the help of an investment bank finds a large buyer or a group of buyers to buy the entire issue
- Private placements do not have to be registered with the SEC
- Issuers like private placements because they don't have to register the bonds
- Investors like private placements because they pay higher interest rates than publicly-traded municipal bonds
- There is a very thin secondary market

Front 63

Corporate bonds

Back 63

are long-term bonds issued by corporations. They come with bond indenture.
The bond indenture lowers the risk and therefore the interest rate, on the bond.
- A trustee, generally a bank trust department, is the bondholders' representative, overseeing the issuer's performance and initiating any legal action against the issuer.
- Corporate bond interest payments are raxable at federal, state, and local levels.

Front 64

Bond Indenture

Back 64

the contract that specifies the responsibilities and rights of the issuer and of the buyer.

Front 65

Kinds of corporate bonds

Back 65

Bearer Bond
Registered Bond
Term Bond
Serial bond
Mortgage bond
Equipment trust certificate
Debenture
Subordinaed debenture
Convertible bond
Stock warrant
Callable bond
Sinking fund provision

Front 66

Bearer Bond

Back 66

has coupons attached to the bond, which the holder presents to the issuer for payment of interest with they come due

Front 67

Registered Bond

Back 67

mails coupon payments to the registered bond owner. Registered bonds have largely replaced bearer bonds because they are more secure (and more easily taxed)

Front 68

Term bond

Back 68

has the entire bond issue mature on the same date

Front 69

Serial bond

Back 69

part of an issue with several matuirty dates. Allow repayment over time and hence are better than term bonds for corporations with volatile incomes.

Front 70

Mortgage bond

Back 70

finances a specified project, which is pledged as collateral for th ebond. A mortgage bond is secured debt.

Front 71

Equipment trust certificate

Back 71

collateralized with tangible non-real estate property

Front 72

Debenture

Back 72

is an unsecured bond backed by the issuer's general credit.

Front 73

Subordinated debenture

Back 73

an unsecured bond that is junior to mortgage bonds and to regular debentures

Front 74

Convertible bond

Back 74

may be exchanged for another security (usually common stock) of the issuing firm at the bondholder's discretion.
- Interest rates are lower than for nonconvertible bonds because the bondholder also receives an investment opportunity not available to other bondholders

Front 75

Stock Warrant

Back 75

lets the bondholder buy common stock at a specified price up to a specified date.
- The bondholder keeps the bond whether he buys stock or not.
- The bondholder may also sell the stock warrant and keep the underlying bond.

Front 76

Callable bond

Back 76

a bond with a call provision. The issuer calls the bond when the interest rate drops, so it can retire high interest rate bonds and issue new, low-interest bonds.

Front 77

Call Provision

Back 77

Lets the issuer force the bondholder to sell the bond back a given (call) price

Front 78

Call premium

Back 78

the difference between the call price and the face value.

Front 79

Sinking Fund Provision

Back 79

requires the issuer to retire a certain amount of the issue each year. The issuer makes periodic payments to the sinking fund, which the trustee uses to retire that year's bond.
- Investors like sinking fund provisions because they reduce default risk.

Front 80

Corporate bonds - how are they sold

Back 80

The issuer sells corporate bonds through a public sale or private placement, just as with municipal bonds.

Front 81

Corporate bonds have 2 secondary markets

Back 81

The exchange market and the OTC over the counter market.
The OTC market is much more active than the exchange market.

Front 82

Bond Ratings

Back 82

Bond rating agencies like Moody's and Standard and Poor's evaluate each bond's risk of default.
- Each bond receives a letter grade ranging from AAA to C or D (riskiest)
- The agencies evaluate the bond's likelihood of payment, the entire issue's nature and provisions and the protection in the fent of bankruptcy or reorganization

Front 83

Investment Grade Bonds

Back 83

Bonds rated Baa or higher by Moody's or BBB or higher by S&P.
Financial Institutions are prohibited by law from buying non-investment grade bonds

Front 84

Junk bonds or higher yield bonds

Back 84

Bonds below investment grade

Front 85

Bond Market Participants

Back 85

The major bond issuers are federal, state, and local gov't and corporations.
- Foreign investors, gov't units, financial institutions, and households buy most bonds.
- Investments by households are sometimes underestimated because household savings deposited in financial institutions often get invested in bonds.

Front 86

Yield Spread

Back 86

the difference between the highest and lowest interest rates offered by different types of bonds at the same time.
Yield spreads change as bonds' default risks, tax status, and marketability change.

Front 87

International Bond Markets

Back 87

A. Trade bonds that are underwritten by an dinternational syndicate.
B. Offer bonds simultaneously to investors in different countries
C. Issue bonds in more than one country
D . offer unregisterd bonds

Front 88

International Trade In Bonds -
CURRENCY

Back 88

Before 2004, most international bonds wer denominated in US dollars. The euro is now the most prevalent curreny for denominating international debt.

Front 89

International Trade in Bonds
TYPES OF BONDS

Back 89

Eurobonds
Foreign bonds
Brady bonds

Front 90

Eurobonds

Back 90

- Long term bonds sold outside the country of the currency in which they are denominated
- They are bearer bonds, traded in over-the-counter markets
- Because of the volatility of interest rates in the country of the chosen currency affects the overall cost of the bond, issuers choose currencies with stable interest rates.

Front 91

Foreign bonds

Back 91

long-term bonds issued by firms and gov't outside the issuer's home country
- Foreign bonds are denominated in the currency of the country of issue

Front 92

Brady Bonds

Back 92

- bonds backed by US T-bonds as collateral, that are swapped for o/s loans in developing countries.
- offer longer maturity and lower yeild than the underlying loan.
- let developing contures borros money from longer time periods, at lower interst rateds, and they provide creditor banks securities that can be traded, theus increasing the banks' liquidities.
- some have been converted to Sovereign bonds.

Front 93

Sovereign bonds

Back 93

Brady bonds w/out US T-bond collateral backing

Front 94

Common Stockholders have the rights to...

Back 94

1. Dividends
2. Residual Claims
3. Limited Liability
4. Voting

Front 95

Dividends

Back 95

Stockholders receive a share of the issuing firm's profits once the firm has paid its taxes and interest to bondholders.
- The firm's board of directors determines the amount of dividends, and may choose to reinvest all profits instead of paying any dividends at all.
- Stockholders are often satisfied with a company that reivests its profits because growing firms also have growing stock prices.
- Stockholders can sell their shares and pay capital gains taxes on their profits (gains) instead of paying (higher) income taxes on their dividends (earinings)

Front 96

Residual Claims

Back 96

Stockholders may claim the assets of a failed or dissolved form, after all debt and taxes are paid.

Front 97

Limited Liability

Back 97

Stockholders' losses are limted to the amounts of their original investments.

Front 98

Dual Class Firm

Back 98

has 2 classes of common stock o/s with different voting rights.
- Classes of stock with inferior voting rights often have higher dividend rights. A stockholder may cast his vote at the firm's annual meeting or by proxy.
Teh # of votes each stockholder has equals his number of shares mulitplied by the # of directors up for election, but the stockholder may use all of his votes to vote for one candidate.

Front 99

Cumulative Voting

Back 99

all diretors up for election are voted for at the same time. Allows minority stockholders the chance to elect at least soem of the board members.

Front 100

Straight Voting

Back 100

each director is boted on individually, with one share equaling one vote.

Front 101

Bondholders vs. Stockholders

Back 101

Bondholders do not own the firm that issues their bonds, but their claims to earnings and assets are superior to those of stockholders.

Front 102

Preferred Stockholders have the right to....

Back 102

1. Dividends
2. Residual claims
3. Limited liablity
4. Voting rights

Front 103

Preferred Stockholders dividends

Back 103

Preferred stockholders are paid before common stockholders

Front 104

Preferred Stockholders Residual claims

Back 104

Preferred stockholders are paid before commond stockholders

Front 105

Preferred Stockholders Limited liability

Back 105

Preferred stockholders' losses are limited to their original investments

Front 106

Preferred Stockholders
voting rights

Back 106

Preferred stockholders' generally do not have voting rights, unless prior cumulative preferred dividents have not been paid

Front 107

Corporate Stocks offer 2 types of returns

Back 107

Capital Gains - if the stock appreciates over time
Dividends - if declared by the board of directors

Front 108

Preferred Stock Dividends

Back 108

Are preset at a fixed rate

Front 109

Common Stock Dividends

Back 109

bary and are paid at the board's discreation

Front 110

Common Stock

Back 110

confers a fundamental, residual claim of ownership in a public corporation

Front 111

Preferred Stock

Back 111

is a hybrid of bonds and common stocks.
- Like bonds, prefered stocks pay fixed periodic payments.
- Like common stock, preferred stock represents ownership in teh issuing firm.
- Preferred stock is usually nonparticipating (the dividend is fixed, regardless of profits) and cummulative (prior missed dividends must be paid before current common stock dividends can be paid)

Front 112

Participating preferred stock

Back 112

may pay actual dividents that are greater tha promised dividends

Front 113

Noncumulative preferred stock

Back 113

does not pay missed dividends

Front 114

Preferred stock can bring disadvantages to corporations because

Back 114

- missed dividends scare new investors
- stockholders must be paid a rate of return that compensates them for the risk of missed dividends
- dividends are not tax-deductible expenditures, as are bond payments

Front 115

The return on a stock over hte past year (formula)

Back 115

[(current price - price on year ago) / (price one year ago)] + (last annual dividend / price one year ago)]

Front 116

Primary Market

Back 116

- facilitates the buying and selling of new issues of stocks
- Most primary market stock sales go through investment banks which sell securities using either firm commitment underwriting or best effort underwriting

Front 117

Firm commitment underwriting #2

Back 117

guarantees the issue's selling price
- the investement bank buys the entire issue for a guaranteed price (net proceeds) and sells the individual stocks to investors for a higher price (gross proceeds)

Front 118

The underwriter's spread

Back 118

equals the difference between gross proceeds and net proceeds.
- Investment bansk often introduce a new issue through a syndicate to spread the risk of selling stocks and to contact a wider pool of investors.
- The lead investment bank in syndicate is called the oriinating house.

Front 119

Syndicate

Back 119

a group of investment banks that distribute securities

Front 120

Initial public offering

Back 120

a firm's very first issue of stock

Front 121

Seasoned shares

Back 121

firms that already have shares trading in the secondary maket offer seasoned shares in the primary market

Front 122

Public sale

Back 122

offered to the general investing public

Front 123

private placement

Back 123

offered to a limited number of large investors

Front 124

Some states and corporate charers give stockholders preemptive right...

Back 124

which give stockholders the option (but not the obligation) to buy their proportional shares of any new issues before those new issues are offered for public sale or private placement

Front 125

Registration with SEC

Back 125

- All stocks sold publicly must be registered with the SEC.
- The registration statement focuses on full disclosure about the firm and its securities
- Since 1982 the SEC has allowed a fater and less expensive form of registration called a shelf registration, which lets the firm register mulitple issues of stock over 2 year period in 1 registration statement.

Front 126

Red Herring Prospectus

Back 126

While the firm registers its securities, it can also distribute a preliminary prospectus to prospective investors.

Front 127

Secondary stock market

Back 127

facilitates the trading of previoulsy issued stocks

Front 128

3 major secondary stock markets

Back 128

1. The NY stock exchange
2. The American Stock Exchange (AMEX)
3. The National Association of securities Delaers Automatied Quotation (NADAQ)
- The NYSE is the best known and one of hte most powerful stock market in the world, the NASDAQ is growing fast, the AMEX is small and getting smaller.

Front 129

NYSE trading process

Back 129

- All transactions occur at trading posts.
- Each stock has a specialist
- Individual investors cantact their borkers, who send buy and sell orders th their representatives at the NYSE.
- The representatives fulfill the orders by dealing with specialist or with other brokers
- The are also floor borkers
- Investors who use on-line trading bypass the broker and go directly to the floor broker who fulfills their buy and sell orders the same way a commission broker would

Front 130

Trading posts

Back 130

specific locations on the floor of the exchange

Front 131

Specialist

Back 131

an exchange member who arranges the market for that stock, maintains its liquidity and buys back stock as necessary to stabilize its price.

Front 132

Floor brokers

Back 132

work independently from large brokerage firms

Front 133

2 types of orders sent to floor and commission brokers

Back 133

Market order and limit orders

Front 134

Market Order

Back 134

asks the broker to transact at the best price available when the order reaches the post

Front 135

Limit Order

Back 135

asks the broker to transact at a specified price.
- Limit orders can be left with the stock's specialist who will execute the trade when the price is reached.

Front 136

Program Trading

Back 136

The simultaneous, computer-assisted bying and selling of a portfolio of atleast 15 different stocks valued at more than $1 million.

Front 137

P/E ratio

Back 137

which equals the company's closing price divided by its earnings per share over the previous year, inidicating the stock's relative profitability and value.

Front 138

Earning's per share calculations

Back 138

divide the firm's closing price by it's PE ratio

Front 139

A high PE ratio

Back 139

indicates high expections of growth in earnings

Front 140

A low PE ratio

Back 140

indicates the stock's earnings are not expecte to grow quickly

Front 141

The AMEX trading process

Back 141

lists stocks of smaller firms with national interest. The AMEX is organized like the NYSE.

Front 142

The NASDAQ

Back 142

The NASDAQ is the world's first electronic stock market. It currently has more firms listed thean the NYSE.
- It is a dealers market; Groups of dealers make the market for each stock.
- The original UW of a new issue can become a dealer of that stock in the NASDAQ.
- All NASDAQ trades are negotiated. Stocks go to the investor with the best price.

Front 143

Market Listing Requirements

Back 143

The NYSE has stringent listing requirements, but firms that list on the NYSE enjoy the benefits of improved marketability, publicity, and access to financial markets.
- The AMEX has less stringent listing requirements.
- Firms do not meet NYSE or AMEX requirements trade on the NASDAQ.

Front 144

Stock Market Indexes

Back 144

a composite value of a group of stocks traded on teh secondary market that indicates the overall market's performance and trend.

Front 145

Dow Jones Industrial Average

Back 145

composite of the stocks of 30 large companies, each with a history of successful growth.
- That list of 30 companies changes occassionally.
- Also publishes indexes for transportation companies, utility companies, and a composite in all of its indexes.

Front 146

The NYSE composite Index

Back 146

a composite of all common stocks listed on the NYSE with four sub-indexes for industrial, transportation, utility and financial companies

Front 147

The Standard and Poor's 500 Index

Back 147

a composite of 500 of the largest US corporations each listed on either of the NYSE or the NASDAQ, with sub-indexes for utility companies

Front 148

The NASDAQ composite index

Back 148

a composite of all industiral companies, banks, and insurers listed on the NASDAQ, with sub-indexes for industrial companies, banks, insurers, computer companies, and telecommunications companies.

Front 149

The Wilshire 5000 Index

Back 149

measure the performance of all US headquartered equity securities that are actively traded in an US based stock market and have available price data

Front 150

Stock Market Participants

Back 150

Households are the largest holders of corporate stock. They own more stock through direct holdings than they do through mutual funds. 50% of all stockholders are under 45. Teh major invsetors are between ages 45 and 64

Front 151

Stock prices reflect

Back 151

investors expectations of future profitabiity since stock prices increase with expected future dividends.
- Investors are willing to pay more for stocks that seem destined to rise, and so the prices of those stocks go up.
- Investors shy away from stocks that seem unsafe, and so those prices fall.

Front 152

Stock market and recession

Back 152

- The stock market does not accurately forecast recessions.
- Some but not all recessions have been preceded by a decline in stock market indexes. Some declines in indexes have not resuled in recessions at all.

Front 153

Market efficiency

Back 153

The speed with which a stock's price adjusts to interest rate changes or other significant changes that ought to affect the stock's value.

Front 154

3 Hypotheses of market efficiency

Back 154

-Weak form of market efficiency hypothesis
-Semi-strong form of market efficiency hypothesis
-Strong form of market efficiency hypothesis

Front 155

Weak form of market efficiency hypothesis

Back 155

Holds that current stock price reflects all historic public information about a company...that using past information about a company to predict its future stock price is useless.
- It is consistent with random walk hypothesis.
- Empirical evidence generally supports the weak form of market efficiency hypothesis: price changes are random and therefore are not predictable.

Front 156

Random walk hypothesis

Back 156

holds that historical stock prices can not be used to predict future stock prices

Front 157

Semi-strong form of market efficiency hypothesis

Back 157

Holds that public information about a company is immediately reflected in its stock price.
In other words, stock prices respond immediately to new public information about the company.
- Empirical evidence supports the semi-strong form of market efficiency hypothesis.

Front 158

Strong form of market efficinecy hypothesis

Back 158

holds that a stock's price reflects all public and all private information about the company... that even inside information can not help an investor make better stock choices.
- Because inside information is not available to investors, it's difficult to test this hypothesis.

Front 159

The Securitieis Act of 1993

Back 159

requires each SEC-listed compnay to register its stocks and to issue a prospectus with its new stock

Front 160

The Securities Exchange Act of 1934

Back 160

established the Securities and Exchange Commission as the main agency responsible for overseeing the secondary stock market.

Front 161

Regulation FD (fair disclosure) 2000

Back 161

outlaws selective disclosure of trading information

Front 162

Sarbanes-Oxley Act (2002)

Back 162

created an independent auditing board under the SEC, increased penalties for corporate malfeasance, and created recourse for wronged shareholders

Front 163

The Securities and Exchange Commissions (SEC)

Back 163

oversees the full and fair disclosure of information on securities issues to actual and potential investors. The SEC delelgates some of its responsibilities, including broker and dealer regulation, to the NYSE and NASDAQ

Front 164

The National Association of Securities Dealers (NASD)

Back 164

regulates brokers and dealers on the NASDAQ market

Front 165

How and Why to invest in international Stocks

Back 165

- US investors use foreign stocks to diversify their risks. While corporate stocks in a coutnry going through a recession may lose value, other corporate stocks in countries enjoying economic growth may increase in value.
- But, investment in foreign stocks aslo introduces information risk, foreign exchange risk and political risk

Front 166

American Depository Receipt (ADR)

Back 166

a certificate that represents ownership of a foreign stock. ADR's facilitate US investment in foreign stocks.

Front 167

Investors like ADRs because

Back 167

- They are traded in US exchanges in US dollars
- foreign companies that use ADRs must file financial statements with the SEC that are consistent witih GAAP (generally accepted accounting principles)

Front 168

US companies issue stock globally to....

Back 168

- reach larger markets and to enhance their interantional reputations.
- Foreign stock exchanges sometimes use different regulatory structures from the US.
- Investors need to be aware of those structures and the different investment risks they pose.

Front 169

Derivative Security

Back 169

a security with a payoff that is linked to another previously issued security.

Front 170

Mortgage backed security

Back 170

linked to an underlying mortgage

Front 171

Option

Back 171

is linked to the price of an underlying security and to a reference or strike price.

Front 172

Types of Derivative securities (3)

Back 172

1. Spot Contract
2. Forward Contract
3. Futures Contract

Front 173

Spot Contract

Back 173

an agreement between buyer and seller that includes the immediate exchange of assets and funds.
(example) A buyer agrees to buy a used car for $5K hands over the check immediately and receives the keys and title to the car right then and there.

Front 174

Forward Contract

Back 174

an agreement between byer and seller to exchange a nonstandardized asset for a certain amount of cash at a future date.
(example) A buyer agrees to buy a used car for $5K in 5 months, and the owner agrees to sell the car on that future date.
Forward contracts can involve exchange of a stated amoutn of currency at a stated interest rate.

Front 175

Futures contract

Back 175

an agreement between buyer and seller to exchange a standardized asset for cash at a future date.
-unlike forward contracts, future contracts exchange standardized assets, with standardized expiration dates, in centralized markets.
- Are marked to market daily, their prices being adjusted each day to reflect current futures market conditions.
- Buyers only have to post an initial margin in a margin account when they decide to trade.
- Buyers must maintain funds in their margin accounts at a stated level
- Defaults are rare because the exchange assumes the defaulting party's payment obligations.
- The terms are set by the exchange and subject to approval by the Commodity Futures Trading Commissions (CFTC)

Front 176

Marked to Market

Back 176

Prices being adjusted each day to reflect current future market conditions

Front 177

Initial margin

Back 177

A deposit that represents a portion of the value of a contract

Front 178

The maintenance margin

Back 178

byers must amintain funds in their margina ccounts at a stated level, usually 75% of the initial margin

Front 179

A futures contract holder may

Back 179

A. hold the contract until it expires
B. liquidate his position before the contract's expiration

Front 180

3 types of future contracts

Back 180

1. Interest rate futures
2. Currency futures
3. Equity stock index futures

Front 181

interst rate futures

Back 181

The underlying asset is the interst rate on a bond or short-term fixed-interest security

Front 182

Currency futures

Back 182

They underlying asset is the exchange rate of a currency

Front 183

Equity stock index futures

Back 183

The underlying asset is a major US or foreign stock market inex

Front 184

The buyer in a futures contract profits when....

Back 184

the value of the underlying asset increases before contract expriation

Front 185

The seller in a futures contract profits when....

Back 185

the value of the underlying asset decreases before contract expiration

Front 186

The Forward Contract Market

Back 186

- Forward contracts occur in the over-the-counter market
- Major participants are commercial banks, investment banks, and broker-dealers
- There is a small secondary market in forward contracts, which has increased the standardization of forward contracts.

Front 187

The Futures Contract Market

Back 187

- Uses an open outcry acution in which traders face each other and call out their offers to buy and sell
- Only members of the exchange can work on the floor of the exchange
- Public buyers and sellers place their orders through floor brokers, who trade with professional traders, who trade for their own accounts.

Front 188

Professional traders can be:

Back 188

1. position traders
2. day traders
3. scalpers

Front 189

Position Traders

Back 189

take their positions for more than a day, basing their trades on their expectations about the future direction of prices

Front 190

Day traders

Back 190

take their positions for a day and liquidate them by the day's end

Front 191

scalpers

Back 191

take positions for short durations, sometimes only minutes
- scalpers increase the liquidity of the market
- Futures holders take either long positions (looking to buy) or short positions (looking to sell)
- The exchanges clearinghouse guarantees all trades by bying all futures sales ans lessing all futures purchases

Front 192

An Option

Back 192

a contract that gives the holder the right but not hte obligation to buy or to sell an underlying asset at a specified price withing a specified time period.

Front 193

An American Option

Back 193

lets the holder buy or seel at any time before or on the expiration dated

Front 194

A European option

Back 194

lets the holder buy or sell only on the expiration date

Front 195

An option's intrinsic value

Back 195

equals the underlying asset's price minus the option's exercise price.

Front 196

An option's time value

Back 196

equals the option's price minus its intrinsic value.

Front 197

Intrinsic value and time value

Back 197

Before their exercise dates, options typically sell for more than thier intrinsic values because buyers and sellers know that the value of an option at expiration is almost always more than its intrinsic value. In other works buyers pay for the option's time value.

Front 198

The call option buyer faces...

Back 198

limited losses (the call premium) but unlimited gains, because the price of the underlying security could skyrocket.

Front 199

The call option writer faces...

Back 199

unlimited losses but limited gains: The seller profits when the buyer does not exercise the option, but his profits are limited to the call premium

Front 200

A Put Option

Back 200

gives the buyer the right to sell the underlying security to the option writer at a specified price (exercise or strike price) on a specified date.
- The buyer must gvie the option writer an up-front fee (put premium)

Front 201

A put option is in the money when...

Back 201

the price of the underlying security is below the exercise price

Front 202

A put option is out of the money when...

Back 202

the price of the underlying security is above the exercise price.
Buyers exercise put options when they are in the money.

Front 203

The put option buyer faces...

Back 203

limited losses (the put premium) but much larger gains.
- the best case scenario for buyers is for the price of the underlying asset to fall to zero. He can then sell the asset at the specified price and make a profit of the exercise price minus the put premium.

Front 204

The put option writer faces...

Back 204

large losses but limited gains (the put premium)

Front 205

The Options market:

Back 205

The first options market, the Chicago Boark of Options Eschange, was formed in 1973.
- options markets have grown rapidly since 1973
- The trading process is the same as for futures contracts
- Trades may be placed as market orders or as limited orders.

Front 206

The Black-Scholes pricing model for cal options considers five factors that affect option prices

Back 206

1. The spot price of the underlying asset
2. The exercise price on the option
3. The exercise date
4. The underlying asset's price volatility
5. The risk-free rate of interest

Front 207

Three Underlying Assets

Back 207

1. Stock option
2. Stock index option
3. Option on Futures contract

Front 208

Stock Option

Back 208

is based on the stock of a publicly traded company

Front 209

Stock index option

Back 209

is based on the value of a major stock market index.
- The dollar value of a stock index option equals the product of the index times a multiplier.

Front 210

Option on futures contract

Back 210

- is based on futures contract.
- The buyer of this option has the right to buy (or sell, if a put option) the underlying future contract before expiration.

Front 211

Regulation of futures and options markets

Back 211

- The Commodoties Futures Trading Commissions (CFTC) is the primary regulator of futures markets and thus is the main regulator of options on futures contracts.
- The SEC is the primary regulator of stock markets, and thus is the main regulator of stock options and stock index options.

Front 212

a SWAP

Back 212

is an agreement between 2 parites (called coutnerparties) to exchange an asset or a series of cash flows for a specified period of time.
- Counterparties typically swap interst rates, currencies, credit risks, commodoties, and/or equities.

Front 213

An Interest Rate Swap

Back 213

is an exchange of fixed-interest payments for floating-interest payments.
- The swap buyer agrees to make a number of fixed interest rate payments on specified dates to the swap seller who agrees to make a number of floating interest rate payments on specified dates to the swap buyer.
- both interest rates are based on a contractual amount called the notional principal.
- Swaps are typically long-term contracts
- Using future contracts to achieve the same effect would require the periodic creation of new contracts.
- the counterparties can arrange the swap directly or through a financial institution

Front 214

A currency swap

Back 214

is a hedge against exchange rate risk from mismatched currencies on assets and liabilitlies.
- a financial institiuationw ith most of its assets in 1 currency (US dollars) and large liabilities in an other currency (yen) runs the risk that the dollar will depreciate agains thte yen, making it more costly to pay it liabilities.
- If the FI finds another FI with the opposite problem (most assets in yen and large liabilities in US dollars) they can arrange a currency swap
- the 1st FI would issue notes in dollars and sel lthem to the 2nd FI.
- the 2nd FI woudl issue notes in yen and sell them otthe 1st FI.
- each FI would pay off its mismatched liabilites and assume new liabilities in a currency matching most of its assets.

Front 215

Swap markets

Back 215

- there are no standardized swap contracts.
- swap dealers find and match counterparties or take on side of a swap
- swap dealers usually guarantee swap payments over the life of the contract.

Front 216

Swap markets have little direct regulations but they are indirectly regulated by

Back 216

1. the international swaps and derivatives associations (ISDA)
2. the Board of Governors of the Federal Reserves
3. the FDIC

Front 217

Caps, Floors, and collars

Back 217

are derivative securities used to hedge interst rate risk

Front 218

A cap

Back 218

is a call option on interst rates, often with more than one exercise date. When the interst rate rises above the cap, the seller compenstates the buyers in return for an upfront premium.
- FI buy caps when they're exposed to losses if interest rates rise

Front 219

A floor

Back 219

is a put option on interest rates, often with more than one exercise date.
- When the interest rate falls below the floor, the seller compensates the buyer in return for an up-front premium.
- FI buy floors when they have fixed debt costs and variable returns on assets or when they are net long in bonds

Front 220

A collar

Back 220

is a compination of a cap and a floor.
- The FI usually buys a cap and sells a floor.
FI buys collars:
a. to finance cap and floor positions
b. if they're concerned about interest rate volatility

Front 221

ADD'L info
- global OTC trading far outweighs exchange trading, with US markets and currencies dominating global derivative securities markets.
European markets are a close second

Back 221

**add'l info only***

Front 222

Depository institution

Back 222

- a commercial bank, a saving institution, or a credit union.
- most funds come from customer deposits
- main assets are loans
- main liabilities are deposits
- the opposite is true of nonfinancial firms

Front 223

Commercial Bank

Back 223

a depository institution that has seveal types of nondeposit sources of funds (subordinated notes, debentures) and is regulated separately from, and offers a broader range of loans than, savings institutions and CU.

Front 224

Commercial Bank Assets

Back 224

- majority are loans, including business loans, commercial and residential real estate loans, individual loans and other loans
- The next most significant asset category is US gov't securities (in effect loans to the US gov't)
- Commercial banks compete with the commercial paper and bond markets for commercial loan customers.

Front 225

Commercial Banks risk insolvency......

Back 225

through their high exposure to loan default.

Front 226

Commercial Bank Liabilities

Back 226

- The two main sources of funds are deposits and borrowed funds. Banks are highly levaraged, holding littel equity, because most of their assets are funded by debt.

Front 227

The major segments of deposit funds:

Back 227

1. Transaccction accounts
2. Small nontransaction accounts
3. Negotiable certificates of deposits

Front 228

Transaction accounts

Back 228

include noninterest paying checking accounts (depand deposits) and interest paying chacking accounts (NOW, negotiable order of withdrawal, accounts)

Front 229

Small nontransaction accounts

Back 229

comprixe a large but shrinking section of deposit funds because banks are competing with money market mutual funds for those customers

Front 230

Negotiable certificates of deposits (CDs)

Back 230

are fixed maturity, interest-bearing deposits that can be traded in the secondary market

Front 231

Commercial bank's borrowed funds include....

Back 231

- purchases of federal funds, repurchase agreements, notes and bonds.
- A commercial banks's liabilities have a shorter maturity structure and are more liquid than its assets. That causes a matuirty mismatch that results in interest rate risk and liquidity risk.
- Regulators require banks to maintain a minimum level of equity capital. Banks stick close to that minimum because equity funding is more expensive than laibility funding (funds from depositors)

Front 232

Off balance sheet activities of commercial banks

Back 232

Because the competitiion for high quality loan applicants is intense, banks engage in off-balance-sheet activities to charge fees and to raise more capital

Front 233

An intem or activity is an off-balance-sheet (OBS) asset if

Back 233

the occurrence of a specified event moves the item onto the asset side of the balance sheet or converts it into realized revenue on the income statement.

Front 234

An item or activity is an OBS liability if

Back 234

the occurrence of a specified event moves the item onto the liability side of the balance sheet or converts it inot realized expense on the income statement.

Front 235

Off balance sheet activities allow the bank

Back 235

to raise funds while avoiding the need to raise reserves or to pay deposit insurance premiums because the the items do not appear on the balance sheet until the contigent event occurs.

Front 236

OBS increase banks

Back 236

insolvency exposures

Front 237

OBS decrease

Back 237

risk by reducing or hedging banks' intererst rate, credit, and foreign exchange risks.

Front 238

Major OBS activities include

Back 238

- transactions in derivatives, loan commitments, standby letters, letters of credit, when-issued securities, loans sold, trust services and correspondent banking.

Front 239

Derivatives

Back 239

futures, forwards, swaps and options

Front 240

Trust Services

Back 240

- hold and manager assets for individuals and corproations
- the 2 largest groups of clients are individuals and pension funds

Front 241

Correspondent Banking

Back 241

- provides banking services to banks that lack the staff to provide those services for themsleves.
- typical services include: check clearing and collection, foreign eschange trading, hedging services and participation in large loans and securities.
- the bank receiving the services pays for them through noninterest bearing deposits.

Front 242

How economies of scale and scope effect commercial banks:

Back 242

Regulatory deveopments in the past 20 years have led to the consolidation of the banking industry.
- in the 80s and 90s regulators began to let banks merge with other banks across state lines, which resulted in a great number of bank mergers

Front 243

The Reigle-Neal Act of 1994

Back 243

lets banks branch across state lines

Front 244

The Financial Services Modernization Act of 1999

Back 244

lets commercial banks merge with investment banks

Front 245

Banks merge to form larger banks to save money through

Back 245

1. Economies of Scale
2. Economies of scope

Front 246

Economies of scale

Back 246

- bank expansion reduces the average cost of producing services.
- Enhanced and improved technology lowers all banks' average costs, but larger banks can buy more and better technology and use it to provide services to more customers, maximizing the cost savings
- Large scale technological investments soemtimes don't create expected future revenues, causing banks to operate under condition of diseconomies of scale

Front 247

Diseconomies of scale

Back 247

the average costs of financial service production increase

Front 248

Economies of scope

Back 248

- combining financial services reduces the cost of producing each service separately.
- take the forms of reduced costs and increased volume
-

Front 249

Costs economies of scope

Back 249

occur when providing one financial sercie lowers the cost of providing other financail services

Front 250

The Financial Services Modernization Act

Back 250

lets a single finamcial institution provide banking, securities, and underwriting activities, creating cost economies of scope.

Front 251

Revenue economies of scope occur when

Back 251

a. a merger includes a FI in a growing market
b. a merger brings together 2 asset and liability portfolios that offset each other's risks
(which often occurs when the merging institutions are in different geographic areas) and/or
c. a merger expands an already successful FI inot a less competitive area

Front 252

Community Banks

Back 252

are small banks (under $1billion in assets) that specialize in retain and/or consumer banking.
- They finance their activities through depsits, fee, and interest.

Front 253

Regional or Superregional banks

Back 253

- are large banks (over $1billion in assets)
- finance their activities through purchased funds and capital markets as well as through depositis.

Front 254

Money center banks

Back 254

- are larger banks in major financial centers that rely heavily on borrowed funds.
- because large banks loan money to large corporations, their interest rate spread and net interest margin are lower than for small banks.
- large banks also pay more for salaries, buildings and supplies.

Front 255

Interest rate spread

Back 255

the average interest rate charged on loans minus the average interest paid on deposits

Front 256

net interest margin

Back 256

[(Interest income - interest expense) / earning assets]

Front 257

Noncurrent loans

Back 257

Loans 90 days or more past due and all loans not accruing interst

Front 258

Net charge-offs

Back 258

actual losses on loans ans leases

Front 259

Net Operating income

Back 259

income before taxes and extraordinary items

Front 260

13 technological innovations in the wholesale banking industry

Back 260

1. Controlled disbursement account
2. Account reconciliation
3. Lockbox service
4. Electronic lockbox
5. Funds concentration
6. Electronic funds transfer
7. Check deposit service
8. Electronic Initiaion of letter of credit
9. Treasury management software
10. Electronic data intercahnge
11. Business-to-business e-commerce
12. Electronic billing
13. Encryption technology

Front 261

Controlled disbursement

Back 261

informs the client in the morning of the total disbursements likely to be made from the client's account during that day

Front 262

Account reconciliation

Back 262

records which of the client's checks have been paid by the bank

Front 263

Lockbox services

Back 263

is a centralized collection service for corporate payments that reduces the delay in float and wries the details to the corporate client

Front 264

float

Back 264

the time it takes a check to clear

Front 265

Electronic lockbox

Back 265

is a lockbox service that collects online payments for public utilities and other corporate clients.

Front 266

Funds concentration

Back 266

redirects funds from several accounts at several banks to fewer accounts at one bank

Front 267

Electronic funds transfer

Back 267

makes overnight payments, automated payment of payroll and dividends, and automated transmission of payment instructions

Front 268

Check deposit services

Back 268

encodes, endorses, microfilms and handles customers' checks

Front 269

Electronic initiation of letter of credit

Back 269

lets customers request letters of credit via the bank's computer

Front 270

Treasury management software

Back 270

facilitates efficient management of muliple currency and security portfolios

Front 271

Electonic data interchange

Back 271

is email that lets businesses transfer and trasact invoices, purcahse orders, and shipping notices automatically, via their bank's computer

Front 272

Business-to-Business e-commerce

Back 272

automates information flow for buying and shipping goods and sevices among large and small businesses

Front 273

Electronic billing

Back 273

automates businesses' collection services

Front 274

Encryption technology

Back 274

verifies clients' identities

Front 275

6 technological innovations in the retail banking industry

Back 275

1. Automated teller machine
2. Point-of-sale debit card
3. Preauthorized debit/credit
4. Telephone payment
5. On-line banking
6. Smart Card

Front 276

Automated Teller Machine

Back 276

ATM
allows 24 hour world-wide access to checking accounts

Front 277

Point-of-sale debit card

Back 277

POS - pays for goods via an immediate transfer of funds

Front 278

Preauthorized debit/card

Back 278

deposits payroll checks and pays mortgage and utliity bills automatically

Front 279

Telephone payment

Back 279

uses voice or touch tone commands to transfer funds

Front 280

On-line banking

Back 280

lets customers conduct banking and investment activities via the internet

Front 281

smart card

Back 281

a card with a chip stoage device that "stores" money and disburses it on command.

Front 282

4 key commercial bank regulators

Back 282

1. The Federal Deposit Insurance Corporation (FDIC)
2. The Office of the Comptroller of the Currency (OCC)
3. The Federal Reserve System (FRS, the Fed)
4. State authorities

Front 283

The Federal Deposit Insurance Corporation

Back 283

FDIC - was est. in 1933 to insure commercial bank deposits
- levies insurance premiums, manages the insurance deposit fund and the S&L fund, conducts bank examinations, and acts as areceiver and liquidator when insured banks close.

Front 284

The Office of the Comptroller of the Currency

Back 284

OCC - was est. in 1863 to charter, examine, approve the bergers of, and close national banks.

Front 285

The dual banking system

Back 285

banks may be nationally chartered or state chartered, gives banks a choice of regulators.
- Most large banks apply for national charters, but some banks prefer the less-heavily-regulated state charters.

Front 286

The Federal Reserve System (FRS, the Fed)

Back 286

regulates all nationally chartered banks, all state chartered member banks, and those banks' holding companies

Front 287

holding companies

Back 287

parent companies that own controlling interests in their bank subsidiaries

Front 288

State authorities

Back 288

charter and regulate banks in their states

Front 289

6 advantages of international bank expansion

Back 289

1. risk diversification
2. Economies of scale
3. Innovation
4. Funds source
5. Customer relationships
6. Regulatory avoidance

Front 290

Risk Diversification

Back 290

International banks depend less on thier domestic economies

Front 291

Economies of Scale

Back 291

Expansion lowers a bank's average operating costs

Front 292

Innovation

Back 292

Selling new products internationally generates additional returns

Front 293

Funds source

Back 293

International banks can find the best and cheapest sources of funds

Front 294

Customer relationships

Back 294

International banks can better meet the needs of their multinational clients

Front 295

Regulatory avoidance

Back 295

International banks can pursue activities abroad that are regulated against domestically

Front 296

3 disadvantages of international expansion

Back 296

1. Information/monitoring costs
2. Nationalization/Expropriation
3. Fixed Costs

Front 297

Information/monitoring costs

Back 297

International banks must monitor their foreign investments closely. Information consts on those investments may be higher than they would be domestically.

Front 298

Nationalization/Expropriation

Back 298

Changing governments may lead to nationalization of a bank's foreign branches

Front 299

Fixed Costs

Back 299

It is expensive to establish a foreign branch

Front 300

6 types of banking regulations

Back 300

1. Safety and soundness regulations
2. Monetary policy regulation
3. Credit allocation regulation
4. Consumer protection regulation
5. Investor protection regulation
6. Entry and chartering regulation

Front 301

Safety and Soundness regulation

Back 301

Protects depositors and borrowers from commercial bank failures.
- The 1st layer of protection requires CB to diversify their assets
- The 2nd layer of protection sets minimum equiety requirements, because the equity holders are junior clmts to the CB's assets in the event of a bank failure
- The 3rd layer of protection requires guarantee funds to protect depositors against bank failures
- The 4th layer of protection is bank monitoring and surveillance by regulators.
Safety and soundness regulation imposes a regulatory burden on commercial bankds because each CB incurs costs while complying with regulations.
- The net regulatory burden equals the CB's private benefist minus the CBs private costs of regulation.

Front 302

Monetary policy regualtion

Back 302

uses minimum reserve requirements to control commercial bandks and implement monetary policy.
- If reserve requirements are higher than the CB would otherwise hold, those requirements increase the CB's regulatory burden by tying up money that could have been loaned.

Front 303

Credit Allocation regulation

Back 303

supports lending to socially important sectors, such as housing and farming. Commercial banks may be required to hold a minimum amount of assets in a particular sector and/or to stay below maximum interest rates, prices or fees to subsidize a partivular sector.
EX: The aualified thrift lender test requires each savings institution to hold at least 65% of its assets in residential mortgages to reain its thrift charter.

Front 304

Consumer Protection regulation

Back 304

prohibits unfair discrimination in lednign. CB's use a standard form to report to their chief regulators the reason for granting or dneying credit.
- The cost of comoplying with consumer protectiuon regulations is mainly the cost of producing information

Front 305

Investor protection regulation

Back 305

protects investors who use CBs to buy securities or to otherwise access securities markets.
- Specifically investor protection regulations protect investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibilities

Front 306

Entry and chartering regulation

Back 306

limits the number of CBs in each financial services sector. Regulations can keep competitiors outof protected sectors through high entry fees, entry restrictions and restrictions on activities that may be pursued under a charter.

Front 307

Regulatory history leading up to the financial services modernization act

Back 307

- Over the years US banks have been subject to many restirctions on their products and geographic activities.
- US CBs have always been heavily regulated, especially when compared tothe universal FIs of Germany, Switzerland, and the United Kingdom.
- Early regulation sough to separate commercial banking from investment banking

Front 308

Glass Steagall Act

Back 308

- separate commercial and investment banking
- went largely unchallenged until the early 60s when CBs began asking for and rec'g permission to UW municipal revenue bonds, commercial paper and morgage backed securities; act as discount brokers and advise on mutual funds.
- in 1987 the fed let CB holding companies establish separate section 20 affiliates
- 1997 the Fed and the OCC broadened the activities bank holding companies were allowed to pursue

Front 309

Financial Services Modernization Act

Back 309

in 1999, repealed the Glass Steagall Act barriers between commercial banking and investment banking.
- let banks pursue insurance activities and insurers to offer banking services through financial services holding companies

Front 310

Banks before 1999

Back 310

- banks were heavily restricted in their insurance activities
- National banks could only offer limited types of insurance, and could only act as agents in small towns (under 5K population)
- Bank holding companies and state chartered banks were also very restricted in their insurance activities
- most banks could offer annuities

Front 311

Fuctionally regulated

Back 311

Bank regulators regulate the banking activites and state insurance regulators regulate the insurance activities
- Financial services holding companies are functionally regulated

Front 312

Nonbank bank

Back 312

is a bank divested of either its commercial loans or its demand deposits.

Front 313

the Bank Holding Company Act of 1956

Back 313

restricts commercial firms' acquisition of banks.
- Commercial firms that acquire bank subsidiaries turn them into nonbank banks to meet the demands fo the Act while also entering into commercial banking activities
- The Financial Services Modernization Act of 1999 lets commercail banks owned by financial swervies holding companies take a controlling interest in nonfinancial enterprises, in some cases

Front 314

Intrastate banking

Back 314

- 100 years ago most banks were unit banks, with just one office.
- As banks began to grow and form branches some states restricted the number of intrastate branches a bank could have.
- By 1977 only 6 states still restricted intrastate branching

Front 315

The McFadden Act (1927, amended in 1933)

Back 315

- prevented any US banks from branching across state lines.
- banks established multibank holding companies (parent companies that own more than one banking subsidiary) to get around the act.

Front 316

The 1956 Douglas Amendment

Back 316

closed a few interstate-banking loopholes, but banks got around those by establishing one-bank holding companies (parent companies tha town one bank subsidiary and other nonbank subsidiaries) with nonbank subsidiaries in other states

Front 317

1970 Bank Holding Compnay Act Amendments

Back 317

closed the loophole

Front 318

The Riegle Neal Act (1994)

Back 318

allowed US and foreign banks to branch interstate, generally through acquisitions and mergers, making full interstate banking a reality in these US

Front 319

History of guarantee funds

Back 319

The FDIC was created in 1933 to regulate the US financial system. It worked well until the 1980's when bank failures began toincrease draining the FDIC fund

Front 320

The FDIC improvement Act (1991)

Back 320

restructured the bank insurance fund. The funds finances have improved since then and bank failures are down again.

Front 321

The Federal Savings and Loan Insurance Corporation (1934)

Back 321

was created to insure savings institutions' deposits. In the 80s and increase in S&L failures depleted the fund so much that the FSLIC adopted a policy of forbearance toward failing savings instituations because it couldn't afford to close them.

Front 322

The Financial INstitutions Reform, REcovery, and Enforcement Act (1989)

Back 322

restructured the fund, renamed is SAIF and placed is under FDIC control

Front 323

The 2001 FDIC proposal for Deposit Insurance Reform suggested

Back 323

1. merginng the BIF and SAIF into a Deposit INsurance Fund
2. indexing deposit insurance coverae levels to inflation
3. replacing the minimum reserve ratio with a ratio ranging from 1.0 to 1.5 % AND
4. charging regular premiums for all risks

Front 324

Deposit Insurance Premiums Ought to be Risk-based

Back 324

to reduce the moral hazard of deposit insruance
- Penalizing FIs for investing in high-risk assets enourages them to reduce their risks.

Front 325

Balance Sheet regulations:
Commercial Bank liquidity

Back 325

regulators impose minimum liquid asset reserve requirements, which vary according to the type, scope and country of the commercial bank

Front 326

Balance Sheet regulations:
Leverage

Back 326

The FDICIA requires banks and thrifts to maintain minimum capital requirements relative to their assets.

Front 327

2 different capital requirements:

Back 327

Capital-to-asset ratio
Risk-based capital ratios

Front 328

Capital-to-asset ratio

Back 328

Equals the ratio of the book value of core capital divided by the book value of assets.
- A ratio of 5% or more indicates a well capitalized bank
- A ratio of 4% or less signals an undercapitalized bank
- A bank that is not well capitalized is subject to prompt corrective action (PCA)

Front 329

The Capital-to-assets ratio is subject to 3 weaknesses

Back 329

Market Value - The actual market value of assets may be well below the book value
Asset Rish - The book values of assets do not express do not express their different credit and interest rate risks
Off-balance-sheet activities - The capital-to-asset ratio does not consider the influence of off-balance-sheet activities

Front 330

Risk based capital ratios

Back 330

compenstae for the different credit risks of assets and off-balance sheet assets whose values are adjusted for approximate credit risk

Front 331

1993 Basel Accord (aka Base I)

Back 331

imposed risk based capital ratios on banks in major industrialized companies

Front 332

Risk based capital ratios distinguish between

Back 332

Tier I capital and Tier II capital

Front 333

Tier I capital

Back 333

the book value of the common equity + an amoutn of perpetual stock + minority equity interests held in subsidiaries - goodwill

Front 334

Tier II capital

Back 334

secondary captial resources, such as loan loss reserces upto 1.25% of risk-adjusted assets

Front 335

Risk adjusted assets

Back 335

are on-balance and off-balance sheet assets whose values are adjusted for approx credit risk

Front 336

Total Risk based capital ratio

Back 336

(Tier I capital + Tier II capital / risk adjusted assets)
Must not fall below 8%

Front 337

Tier I capital ratio

Back 337

(Tier I capital / risk adjusted assets)
Must not fall below 4%

Front 338

If total risk based capital ratio falls below 8% or Tier I capital ratio falls below 4%

Back 338

The bank is immediately subject to prompt corrective action by the FDICIA

Front 339

New Basel Accord (Base II)

Back 339

incorportates optional risk into capital requirements, empahsizes regulatory review to enforce minimum capital requirements and provides detailed requirements for the disclosure of capital structure, risk exposure and capital adequacy

Front 340

Off balance sheet regulations

Back 340

IN the 80s losses on loans to less developed and Eastern European contries, interest rate volatility, and decreasing interest rate margins encouraged banks to pursue off balance sheet activities to increase fee income and to avoid some regulatory costs and taxes.
- The Fed accordingly introduced a plan to track OBS activities in 1983, including reporting requirements

Front 341

Foreing versus domestic regulations
Product diversification

Back 341

Teh Financial Services Modernization Act has made US banks' product diversification comparable to that allowed in most other major industrialized countries

Front 342

Foreing versus domestic regulations
Global Expansion

Back 342

A. US banks into foreing countries - Federal Reserve Regulation K lets US banking offices in foreign countires engage in those countries' permitted practices, even if those activities would not be permitted in the US.
B. Foreign banks into the US - the International Banking Act (1978) requires national treatment of foreign banks in the US
- Foreing banks must have FDIC insurance to take retail deposits under $100,000 and can not pursue any activity not permitted to a federal bank

Front 343

The Foreign Bank Supervision Enhancement Act (1991)

Back 343

extends federal regulatory authority ofer foreign banks in the US
- The Federal Reserve has the authority to approve the bank's entry into the US, examine it, and close it if it violates US laws or engages in unsafe banking practices.

Front 344

The World Trade Organization

Back 344

works to allow foreign banks, insurers, adn securities firms to enter emergin market countries

Front 345

NAFTA

Back 345

lets US and Canandian banks expand into Mexico

Front 346

Thrift Institutions

Back 346

include savings associaitons, savings banks, and credit unions.

Front 347

Savings associaitons Assets

Back 347

are mainly residention mortgages

Front 348

Savings bank assets are mainly

Back 348

residential mortgages, but also include commercial loans and investment securities

Front 349

Credit Union Assets

Back 349

are mainly consumer loans

Front 350

A savings institution

Back 350

is either a savings association or a savings bank

Front 351

Savings Associations

Back 351

include Savings and Loan associations adn federally chartered savings banks that receive FDIC insurance unther the Savings Association Insurance Fund.
- Savings associations were traditionally mutual organizations, in which depositors were the legal owners and not stock was issued
- Now most savings associtaions are stock companies, allowing them to raise capital from outside investors

Front 352

in 2004 the largest asset categories for savings assocations were

Back 352

- mortgages 62%
- mortgage backed securities 14%
- Consumer loans 6%

Front 353

in 2004 the largest laiblity categories for savings assocations were

Back 353

- Deposits 60%
- borrowed funds 22%
- Federal funds and repos 5%

Front 354

Savings banks

Back 354

include state chartered savings banks that receive FDIC insurance under the Bank Insurance Fund
- concentrate their assets in mortgages and mortgage backed securities
- Ther 3rd larges asset catagory is bonds, corp stock and other securities
- rely more heavily on deposits for sources of funds than savings associations do adn have fewer borrowed funds.

Front 355

Reasons for the decline in the number of savings institutions

Back 355

- Savings associations specialized in long term mortgage loans backed by short term deposits, a practice that worked until the late 70s due to stable interest rates and the Fed's policy of smoothing interest rates.
- 70s to 80s the Fed changed its monetary policy targeting bank reserves to lower inflation
- Interest rates surged causing Negative net interest margins for savings associations.
- Savings associations found they had to offer higher interest rates to their depositors to avoiddisintermediation, but the Fed's Reugation Q Ceilings limited interest rates savings associations could legally pay on traditional savings accounts and retail time deposits.

Front 356

Net interest margins

Back 356

interest income - interest expense / earning assets

Front 357

disintermediation

Back 357

withdrawls of deposits to be reinvested into more lucrative money market mutual fund accounts

Front 358

Regulation Q Ceiling

Back 358

limited the interest rates savings associations could legally pay on traditional savings accounts and retail time deposits

Front 359

Depositiory Institution Deregulation and Monetary Control Act of 1980 and the Garn - ST. Germain Depository Institutions Act of 1982

Back 359

Let savings institutions offer negotiable order of withdrawal (NOW) and money market deposit accounts, adjustable rate mortgages and commercial loans to compete more effectively with mutual funds (which offer money market accounts)

Front 360

in the mid 1980s the collapse of the Texas and southwest real estate market and the nationwide recession caused....

Back 360

many mortgage defaults and the failure of many savings assocations.
- during that period, the FSLIC pursued a policy of regulator forbearance, allowing insolvent FIs to continue to operate

Front 361

Financial Institutions Reform, Recovery, and Enforcement Act (1989)

Back 361

replaced the FSLIC with the Savings Association Insurance Funds (SAIF), replaced the Federal Home loan Bandk Board with the Office of Thrift Supervision (OTS) as the main regulators of savings associations and creaed the REsolution Trust Corporation (RTC) to liquidate the most insolvent S&Ls

Front 362

Federal Deposit Insurance Corporation Improvement Act (FDICIA) (1991)

Back 362

introduced risk based deposit insurance premiums and methods for closing banks faster

Front 363

Organization Structure of Credit Unions

Back 363

- nonprofit, mutual, depository institutions owned by their depositors
- exist not to generate profits, but to satisfy their customers' depository and borrowing needs
- can be federally or state chartered
- do not serve the general public
- members share a common bond
- are tax-exempt which lets them offer higher reates on deposits and lower rates on loans
- less affected by rising interest rates in the 80s because most of their assets were in small consumer loans and were thsu well matched to their liabilities

Front 364

Corporate credit unions

Back 364

cooperatively owned by a group of member credit unions

Front 365

Largest asset categories (uses of funds) for credit unions (in 2004)

Back 365

1. consumer credit (33%)
2. home mortgages (32%)
3. US government securities (19%)

Front 366

Largest liability categories (uses of funds) for credit unions (in 2004

Back 366

1. small time deposits and savings deposits (66%)
2. checkable deposits (11%)
3. Large time deposits (9%)

Front 367

Thrift Insurance Regulators

Back 367

1. Office of Thrift Supervision
2. FDIC
3. National Credit Union Administration
4. State Regulators

Front 368

Office of Thrift Supervision

Back 368

Charters and examines all federal savings institutions and supervises the holding companies of savings institutions

Front 369

FDIC

Back 369

A. overseas SAIF, which provides insurance for savings associations
B. supervises, examines, and provides insurance for savings banks

Front 370

National Credit Union Administration (NCUA)

Back 370

regulates federally chartered credit unions

Front 371

State regulators

Back 371

regulate state-chartered thrift institutions

Front 372

Finance companies

Back 372

- make loans to individuals and businesses.
- Some loans are similar to commercail bank loans (commercial and auto loans) while others are specialized (high-risk loans).
- unlike banks, finance companies do not accept deposits
- Instead, finance companies rely on long-term and short-term debt for funding

Front 373

3 types of finance companies

Back 373

1. Sales finance institutions
2. Personal credit instituations
3. Business credit institutions

Front 374

Sales finance institutions

Back 374

make loans to customers of a specific retailer of manufacturer

Front 375

Personal credit institutions

Back 375

make loans to consumers

Front 376

Business credit institutions

Back 376

make loans to coprorations, usually through equiment leasing and factoring

Front 377

factoring

Back 377

buying accounts receivable at a discount and then collecting them

Front 378

Captive finance company

Back 378

finances the purchasing of products manufactured by its parent

Front 379

Finance company assets:
Real estate loans

Back 379

- Finance companies like to finance mortgages because the bad debt expense and admin costs of mortgages are lower than for any other finance compay loans.
- Finance companies either make direct loans to morgage customers or securitize morgage asets

Front 380

Finance company assets:
Consumer loans

Back 380

- major type of consumer loan is motor vehicle loans and leases.
- Finance companies that lend to high risk customers are called subprime lenders

Front 381

Finance company assets:
Business Loans

Back 381

- Finance companies making business loans have 4 advantages over commercial banks:
Finance companies
a. are less regulated
b. have specialized industry and product expertise
c. are willing to accept riskier customers
d. have lowe rover head costs

Front 382

Securitize mortgage assets

Back 382

- Mortgages packaged and used to back secondary market securities
- A real estate loan protfolio can contain first mortgages and home equity loans

Front 383

Loan Sharks

Back 383

are subprime lenders that lend to very high risk customers and charge very high interest rates

Front 384

2 major types of finance compay business loans are

Back 384

1. equipment loans
2. retail and wholesale motor vehilcle loans and lease

Front 385

Finance companies prefer leasing to lending because

Back 385

a. repossession of leased equipment is less complicated
b. the lack of down payment attracts more customers
c. the finance company claims equipment depreciation as a tax deduction

Front 386

Finance companies are lightly regulated becasue

Back 386

they do not accept deposits and thus do not come under the jurisdiction of bank and thrift regulators

Front 387

Finance companies signal their safety and solvency to their investors by

Back 387

- holding higher capital-to-assets ratios than banks
- providing default protection guarantees and letters of credit

Front 388

Foreign finance companies are often subsidiaries of foreign commercail banks thus...

Back 388

their financial heallth is closely tied to their parents' financial health

Front 389

In addition to life insurance, life insurers provide

Back 389

- annuity contracts
- persion plan management
- health and accident insurance with includes
a. medical expense insurance (covers increased expenses)
b. disability income insurance (covers decreased revenues)

Front 390

Adverse selection occurs

Back 390

when only those customers who think they need insurance want to buy it, making losses higher and more difficult to predict.
Life insurers protect against adverse selection by grouping insureds according to health and other characteristics adn using those smaller pools to calculate losses

Front 391

Ordinary Life

Back 391

- accounts for 59% of the life insurance policies in force in the US.
- ordinary policies are usually marketed individually

Front 392

5 basic Ordinary life contracts

Back 392

1. Term
2. Whole
3. Endowment
4. Variable
5. Universal

Front 393

Term Life

Back 393

- is called 'pure' life insurance because it has no savings element.
- the beneficiary received the payout if the insured dies while coverage is in effect

Front 394

Whole LIfe

Back 394

- pays its face value to the beneficiary upon the insures' death, if the owner has make the periodic premium payments.
- as long as the owner pays the premiums, the insurer is certain to make a payment
- Whole life is endowment life that matures at age 100

Front 395

Endowment life

Back 395

- is term life insurance with a savins element
- the beneficiary receives the face value if the insured dies before the endowment date.
- the insured receives the face value of the policy if he lives to the endowment date

Front 396

Variable life

Back 396

- invests fixed premium payments in mutual funds
- the policy's cash value increases adn decreases with the value of the mutual funds

Front 397

Universal life

Back 397

- lets the insured change both the premium amount and the contract maturity
- Variable universal life is a univeral life policy that invests premiums in mutual funds

Front 398

Group life

Back 398

- Accounts for 40% of the life insurance policies in force in the US
- Covers a large # of people under 1 policy, which produces cost economies:
a. mass admin of plans
b. lower evaluation costs for each participan
c. reduced selling and commision costs

Front 399

Credit life

Back 399

accounts for less than 6% of the life insurance policies in force.
- protects the lender against the borrowers death prior to debt repayment

Front 400

An annuity

Back 400

- liquidates a fund over a long period of time, producing a series of payouts.
- may be sold to individuals or groups, and may be fixed or variable
- payments may be immediate or deferred and may cease at death or continue to be paid to a beneficiary
- interest earned on annuitis is tax deferred
- tax deferred status of annuity contributions is not capped and not affect by the holder's income level

Front 401

Private Pension fund

Back 401

- sometimes bases on guaranteed investment contracts which guarantee the rate of interst over a given period and the annuity rates on beneficiaries contracts.
- in the early 2000s insurers manages 30% of all private pension plans

Front 402

Accient and health insurance

Back 402

- protects against the risks of ill health
- life insurers currently write over 50% of all health insurance premuims
- the growht of health maintenance organizations (HMO) has cut into life insurers accidnet and health insurance business

Front 403

Life Insurance Assets

Back 403

- life insurers are long-term investors because their liabilities are long term and because they must generate competitive returns on the savings elements of their products

Front 404

Life Insureres' 4 largest asset categories in 2004

Back 404

1. corporate securities 69.6%
2. government securities 11.8%
3. mortgages 6.7%
4. policy loans 2.6%

Front 405

Policy loans

Back 405

loans made to policyholders using thier policies as collateral

Front 406

The largest life insurer libility

Back 406

Policy Reserves, (48.2%)

Front 407

Policy Reserves

Back 407

- reflects expected payments on existing policies.
- based on actuarial assumptions reflecting the insurer's expected payouts for death benefits, maturing endowment policies and the surrener values of policies.

Front 408

The 2nd largest life insurer liability

Back 408

separate account busines (30.5%)

Front 409

Separate account business

Back 409

includes annuity programs in which each policy's payoff is linded to assets in which policy premiums are invested.

Front 410

The 3rd largest life insureres liability

Back 410

guaranteed investment contracts (7.5%)

Front 411

Life Insurance Reguations:
The McCarran-Ferguson Act
(1945)

Back 411

- confirmed that state regulation of insurers is primary over federal reguation.
- unlike bansk, life insurers may only be chartered at the state level.
- State insurance commissions supervise and examine life insurers.

Front 412

State Insurance guaranted fund

Back 412

requires annual contribuations from insureres which contributions are then used to compensate insureds in the even of life insurer failures

Front 413

Unlike bank deposit insurance, insurance guarantee fund:

Back 413

1. are administered by the insurers themselves
2. are not permanent - insuerers pay into the fund only after an insurer has failed
3. do not standardize required contributions - contribution size varies from state to state depending partially on the # of failed insurers that year
4. do not provide immediate payment to insureds - because it takes time to collect the contributions

Front 414

P&C insurance is dominated by it's top firms

Back 414

The top 10 firms (about 1600) have 45% share of the market while the top 200 firms combined have 95% market share.

Front 415

Net Premiums Written (NPW)

Back 415

is the entire amount of premiums on insurance contracts written

Front 416

The 5 larges P-C lines

Back 416

1. Auto liability and PD
2. HO multiple peril
3. Commercial multiple peril
4. liability other than auto, HO, and commercial peril
5. Fire and allied lines

Front 417

The 2 priniciple liabilities of P-C insurers

Back 417

1. loss reserves plus loss adjustment expenses
2. unearned premiums

Front 418

Unearned premiums

Back 418

are reserves that equal the portion of premiums that has been paid before coverage has been provided.
- The PH surplus for PC insurers equaled 30.1% of total assets in 2004 and the PH surplus for life insurers equaled 5.8% of total assets in 2004

Front 419

Teh priniciple measuers of profitability for property-casualty inseres are related to 3 areas of P&C UW risk

Back 419

1. Loss Risk
2. Expense risk
3. Investemnt yield or return risk

Front 420

Loss Risk

Back 420

the risk that losses will be hirhger than predicted.
- decreases with the predictability of losses

Front 421

4 characteristics that affect predictibility

Back 421

1. Property v. Liability - PD are more predictible
2. Severity v. Frequency - low severity, high frequency lines are more predictable than high severity, low frequency
3. Long tail v. Short tail - short tail losses are more predictable than long tail losses. (a long tail loss has a long period between policy issuance and claim payment)
4. Product inflaction v. social inflation - social inflation is more difficult to predict (social inflation reflects juries willingnesses to increase damage awards father than the underlying rate of inflation

Front 422

Loss Ratio

Back 422

measures actual losses incurred ina policy line.
= the ratio of incurred losses to earned premium.
- A loss ratio of less than 100 means earned premiums covered incurred losses

Front 423

Expense Risk

Back 423

risk that expenses will be higher than predicted.

Front 424

2 sources of expense risk

Back 424

1. Loss adjustment expenses (LAEs)
2. commissions and other expenses
A typical P&C insurer expense ration ranges from 25% - 29%

Front 425

combined ratio

Back 425

measures overall underwriting profitability. If ratio exceeds 100 the insurer must rely on investment income for profitability
= loss ratio + expense ratio

Front 426

Investment yield or return risk

Back 426

the risk that investment yields will be lower than predicted

Front 427

Operating ratio

Back 427

measures overall profitability.
= combined ratio - investment yield

Front 428

Most P&C insurers invest their premiums in ....

Back 428

Treasury and corporate bonds, which provide reliable returns and a predictable stream of cash flow

Front 429

P&C insurers are chartered and regulated at the state level.
Auto and WC lines are...

Back 429

subject to rate regulation mativated by social welfare, which reduces insurer profitability in those lines

Front 430

US insureres currently lead the world market in premiums written both in P&C and life...

Back 430

Japan, Germany, and the United Kingdom are our most powerful competitors.

Front 431

Services offered by securities firms and investment banks

Back 431

- Securities firms offer securities services: They buy, sell and borker securities in secondary markets
-- Investment banks originate, underwrite and distribute new issues of securities. They also advise corporations on acquisitions, mergers, and restructuring.

Front 432

3 major typses of xecurities and investement firms

Back 432

1. National full-line banks that serve retain and corporate customers
2. National full line banks that specialize in corporate finance
3. Specialized and regional firms

Front 433

National full line banks that sever retail and corporate customers act as

Back 433

a. Broker - dealers for retail customers (trading existing securities)
b. underwriters for corporations (issuing new securities)

Front 434

Specialized and regional firms - 5 types

Back 434

1. specialized investment bank subsidiaries of commercial bank holding companies
2. Specialized discount brokers (who trade securities w/out offering investment advice or tips)
3. regional securities firms
4. specialized electronics trading securities firms
5. Venture capital firms

Front 435

Securities firm and investment bank activities

Back 435

1. investing
2. investment banking
3. Market making
4. Trading
5. Cash Management
6. Mergers and Acquisitions
7. Other services

Front 436

Investing

Back 436

Securities firms compete with commercial banks, life insurers, and pension funds to manage pools of assets

Front 437

Investment banking

Back 437

investment banks underwrite and distribute new securities issues.

Front 438

Securities Underwriting

Back 438

involves private and public placements.
- In private placement, the investment bank places the securities wiht one or a few large instituational investors
- In public placement the investement bank offers the securities to the public at large.

Front 439

A bank that offers best underwriting efforts

Back 439

acts as a securities distributor without guaranteeing a price to the issuer

Front 440

A bank that offers firm commitment underwriting

Back 440

A. buys the securities at a guaranteed price and then
b. tries to sell them to the public at a higher price

Front 441

Market Making

Back 441

creates a secondary market in an asset.
Agency transactions and Principal transactions

Front 442

Agnecy Transactions

Back 442

are 2 way transactions for customers, such as buying stock from one customer and selling it to another

Front 443

Principal transactions

Back 443

are transcation for the investment bank's own account, such as buying stock and holding itin the expectation of a price increase

Front 444

6 types of trading activities

Back 444

1. Posting trading
2. Pure arbitrage
3. Risk arbitrage
4. Program trading
5. stock brokerage
6. Electronic brokerage

Front 445

Position Trading

Back 445

buys a large block of security in the expectation of a price increase

Front 446

Pure arbitrage

Back 446

buys an asset in one market and then immediately sells that asset in another market at a higher price

Front 447

Risk arbitrage

Back 447

buys securities in anticipation of some new information

Front 448

Program trading

Back 448

the simultaneous, computer-assisted buying and selling of a protfolio of atleast 15 different stocks valued at greater than $1 million

Front 449

Stock Brokerage

Back 449

trades securities on behalf of individuals

Front 450

Electonic brokerage

Back 450

offers direct access to the market trading floor, bypassing the need for a stock broker.
- Electronic brokerage is stock brokerage's main source of competition

Front 451

Cash Management

Back 451

a cash managemeng account (CMA) lets a customer write checks against a mutual fund account, combining the advantages of money market investment and liquidity.
- Securities firms use CMAs to compete with depsitory instituations

Front 452

Mergers and Acquisitions services

Back 452

a. finding merger partners
b. assessing the value of target firms
c. recommednign merger agreement terms
d. udnerwriting new securities issued by the merged firms
e. helping target firms to avoid unwanted megers

Front 453

"Other Services"

Back 453

include custody, escrow, clearance, research, and advisory services.
- Research and advisory services can produce conflicts of interest when advisors charge clients for research they buy from another area of the firm or bank: should clients pay for research the firm has already acquired?

Front 454

Industry balance sheet characteristics:

Back 454

Assets concentrated in:
- Receivables from other broker-dealers
- securities bought under resell agreements
- Long positions in securities and commodities
Liabilities are concentrated in:
- securites sold under repurchase agreements
- payables to other broker-dealers
- short positions in securities and commodities
- payables to customers

Front 455

The Securities and Exchange Commission

Back 455

Overseas securities firms' underwriting and trading activities and sets regulatory standards for th eentire industry

Front 456

The New York Stock Exchange

Back 456

Provides day-to-day regulation of trading practices

Front 457

The National Association of Securities Dealers

Back 457

provides day-to-day regulation of trading practices in the over-the -counter markets

Front 458

The Securities Investor Protection Corporation

Back 458

The guarantee fund that protects investors against losses up to $500,000 for securities firm failures

Front 459

The purpose of a mutual fund

Back 459

A mutual fund is a finaincial intermediary that pools its investors' resoures and invests them in a diversified protfolio of assets.
- They let small investors:
1. Invest in financial services
2. diversify their risks
- They also reduce transaction costs adn commissions

Front 460

Mutual fund shareholder services (5)

Back 460

1. Free exchange of investments
2. automatic investing
3. check writing privileges
4. automatic reinvestment of dividends
5. automatic withdrawls

Front 461

Open-end Mutual funds

Back 461

sells new shares to investors and redeems outstanding shares on demand at their fair market value

Front 462

Money Market Mutual Funds invests in

Back 462

securities with original maturitites of less than one year

Front 463

Bond or Equity fund invests in....

Back 463

securities (bonds or stocks) with original maturities of one year or more

Front 464

Commercial banks participate in the mutual fund industry by...

Back 464

buying existing mutual fund groups or managing mutual fund assets for fees

Front 465

4 types of Mutual Funds

Back 465

1. Equity Fund
2. Bond Fund
3. Hybrid Funds
4. Money Market Mutual Fund

Front 466

Equity Fund

Back 466

- contains common and, possibily, preferred stock
- tends to stress world equity, growth or income

Front 467

Bond Fund

Back 467

- contains fixed-income securities with matuirities of more than one year
- tend to stress high yields or strategic income

Front 468

Hybrid fund

Back 468

- contains stocks and bonds
- tends to stress asset allocation, balance, flexibility or mixed income

Front 469

Money Market Mutual Fund

Back 469

contains a mix of money market securities with original maturities of under one year.
- May be income tax taxable or tax exempt

Front 470

Long term mutual funds

Back 470

Equity, bond, and hybrid funds

Front 471

Short term mutual funds

Back 471

Money Market mutual funds

Front 472

Mutual fund prospectus

Back 472

states its objective and lists the securities that fund holds

Front 473

3 elements of a mutual funds portfolio returns:

Back 473

1. Income - via interest and dividends
2. Capital gains - when the fund sells an asset for more than the original public offering
3. Capital appreciation - of the underlying values of existing assets

Front 474

Net Asset Value (NAV) of a mutual fund

Back 474

= the market value of a fund's assets/the # of outstanding shares

Front 475

A closed end investment company

Back 475

- has a fixed supply of outstanding shares in vested in other firms' securities and assets
- If shares are in high demand it can trade shares above NAV
- if shares are in low demand it might trade shares at below NAV

Front 476

A real estated investement trust (REIT)

Back 476

is a closed end investment company that invests in real estate company shares and/or large mortgages

Front 477

Sales Load

Back 477

the agent's one-time sales commision charge.

Front 478

a load fund

Back 478

has an up front sales or commission charge.

Front 479

No load funds are more popular because

Back 479

investors would reather pay less for funds than recieve the extra personal attention of a sales agent

Front 480

Sales load can be "annualized"

Back 480

spread over the life of the investment, to help calculate total mutual fund costs per year.
Simply divide the sales load % by the # of years the investor expects to hold the shares.

Front 481

2 costs of investing in a mutual fund

Back 481

1. Sales load
2. fund operating expenses

Front 482

In the 90s and 2000s long term mutual funds did two things

Back 482

1. increased their holdings in corporate equities
2. decreased their relative holdings in US and municipal securities

Front 483

Mutual Fund Regulation
The Securities and Exchange commission

Back 483

requires mutual funds to file registration statements and sets rules and regulatiosn for prospectuses.
- The buying and selling of mutual fund shares is subject to antifraud provisions

Front 484

Mutual Fund Regulation
The National Association of Securities Dealers

Back 484

supervises mutual fund share distributions

Front 485

Mutual Fund Regulation
The investment Company Act

Back 485

prevents conflicts of interest, fraud, and excessive fees for fund shares

Front 486

Mutual Fund Regulation
The Insider Trading and Securities Fraud Enforcement Act

Back 486

requires mutual funds to develop procedures for avoiding insider trading abuses

Front 487

Mutual Fund Regulation
The Market Reform Act

Back 487

let the SEC halt trading on exchanges and restirct program trading.

Front 488

Mutual Fund Regulation
The National Securities Margets Improvement Act

Back 488

exempts mutual fund sellers form oversight by state securities regulators

Front 489

Pension Funds

Back 489

offer their investors the advantages of retimtent planning and tax deferred savings.

Front 490

A private pension fund

Back 490

administered by a private corporation, such as a life insurer or mutual fund

Front 491

A pulbic pension fund

Back 491

is administered by a federal, state or local gov't

Front 492

A pension plan

Back 492

is the document that governs the operation of a pension fund

Front 493

An insured pension fund

Back 493

is administered by a life insurer.
- The pension plan funds of an insured pension fund are pooled and invested in the insurer's general assets.
- The insurer lists its pension fund-related assets as "pension fund reserves" as a liability on its balance sheet
- The insurer owns all of the fund's premium payments and assets

Front 494

A noninsured pension fund

Back 494

is administered by a FI orther than an insurer.
- the sponsoring business, participant, or union owns the pension fund's assets, which are listed as a separate pool of assets on the FI's balance sheet.
- the sponsor owns all the fund's premium payments and assets

Front 495

A defined benefit pension

Back 495

- Pays each employee a specific cash benefit upon retirement.
- The benefit formula is generally based on years of employment and salary during employment

Front 496

The flat benefit Formula

Back 496

- pays a flat amount for every year of employment
- employees who work longer get higher benefits

Front 497

The career average formula

Back 497

- bases benefits on the employee's average salary over the employee's entire employment period.

Front 498

The final pay formula

Back 498

- bases benefits on a % of the average salary earned during a specified # of years just prior to to retirement.
- usually provides the higest retirement benefits

Front 499

Fully funded plan

Back 499

has enough funds set aside to meet promised payments

Front 500

underfunded plan

Back 500

has too few funds set aside

Front 501

overfunded plan

Back 501

has more than enough funds set aside

Front 502

Defined Contribution Pension

Back 502

requires each employee to contribute a specified amount to the pension fund at regular intervals.

Front 503

Fixed income funds

Back 503

guarantee a minimum rate of return

Front 504

Variable income funds

Back 504

do not guarantee a minimum rate of return, but do fluctuate with the value of the underlying assets.

Front 505

401(K) or 403(B) palns

Back 505

an employer sponsored plan that supplements a basic retirement plan.

Front 506

The 4 general charactereistics of 401(K) and 403(b) plans

Back 506

1. Employers and employees contribute to the plan
2. Participants have some control over allocation of assets
3. Asset allocation affects the fund's risks and returns. Younger participants tend to invest in equities and older participants tend to invest in fixed income bonds funds and GIC funds.
4. Contributions and accumulations are tax-free utnil withdrawn.

Front 507

Individual Retirement Account
(IRA)

Back 507

is a self directed retirement fund.
- Individual may contribute up to $4K annually in '07
- contribution limits increased to $5K in 2008
- after 2008, the contribution limits will be indexed in $500 increments, adjusted to the cost of living.
- Most IRA contirubtions are invested in mutual funds

Front 508

3 advantages of IRAs

Back 508

1. Savings are tax deferred
2. Employees chaging jobs can transfer pension savings into IRAs to maintain tax-exempt status
3. Self-employed people may use IRAs in place of employee-sponsored pension funds.

Front 509

a ROTH IRA taxes contributions in the year of each contribution, making withdrawals tax free if the withdrawer.....

Back 509

1. is at least 59 1/2 years old
2. has invested the funds for at least 5 years

Front 510

2 advantages of ROTH IRAs

Back 510

1. There is no madatory withdrawal age (the mandatory w/d age for IRAs is 70 1/2)
2. Withdrawals are tax-free - since contirubtions were made with after-tax dollar

Front 511

Keogh Account

Back 511

- a retirment account for a self-employed individual
- Contirubtions and accumulations are tax-deferred, and partiipants have some control asset allocation

Front 512

Public Sector Pension

Back 512

- Available to federal, state, and local gov't employees
- administered by a gov't department
- Most are pay as you go, meaning that contributiosn from current employees pay current benefits to retired employees

Front 513

Public Sector Pensions become underfunded when...

Back 513

- the # of current employees fall
- the # of retired employees rises and/or
- retired employees live longer than expected

Front 514

2 types of federal gov't pensions

Back 514

- Funds for federal gov't employees
- Social Security

Front 515

Funds for federal governement employees

Back 515

- Civil service funds cover all federal employees who are not in the armed forces
- The military pension fund covers members of the armed forces
- The federal railroad pension system covers railroad employees

Front 516

Social Security

Back 516

- covers almost all other employees and self-employed persons in the US.
- it is underfunded and is expected to be bankrupt by 2042
- it may not remain solvent because contributions are invested in low risk, low return Treasury securities; the general population growth is slowing and the # of retired people is increasing as baby boomers retire andlife expectancies increase

Front 517

Asset structure of private pensions

Back 517

- over 64% of private pension fund contributions are invested in corporated equities or equity mutual fund shares.
- Defined benefit plans have more assets invested in gov't and corporate bonds than defined contribution plans because defined benefit plans rely on fixed-income securities to fund their fixed benefits

Front 518

The Employee Retirment Income Security Act

Back 518

- governs private pension pension funds, requiring employers to meet certain standards to qualify for tax-exampt status.
- Does not require employers to provide pension plans

Front 519

ERISA requirements -
Underfunding

Back 519

- sets guidelines for fudning and sets penalties for fund deficiencies. Contributions must meet all annual consts and expenses plus any unfunded historical liabilities over a 30 year period.
- any new underfudning must be funded over a 15 year period

Front 520

ERISA requirements -
Vesting

Back 520

Pension plans must have minimum vesting requirement, and can not exceed a vesting period of 10 years.

Front 521

ERISA requirements -
Fund Management

Back 521

Pension fund manters must meet the prudent person rule: They must invest contributions with the same care as a prudent person in similar conditions

Front 522

ERISA requirements -
Transferability

Back 522

Emplyees may transfer pension credits from one fund to another when switching jobs.

Front 523

ERISA requirements -
Insurance

Back 523

The Pension Benefit Guarantee Corporation - is an insurance fund for pension fund participants
- pays defined pension fund benefits if the fund can not
- has generally operate as a deficit since its inception in '74, and it has recently come under investigation for questionable practices and operations

Front 524

Credit Risk of FI

Back 524

the risk that contractually promised returns from the FI's loans and secrurities will not be paidn in full.
- When an borrower defaults on a loan or bond the FI
loses its interest income on the asset. (but may be able to recover at least some principal by claiming the borrowers assets through legal bankruptcy and insolvency proceedings)
- Credit card default rates are significantly higher than real estate loans default reates.

Front 525

FIs reduce credit risk by

Back 525

1. screening and monitoring their loan applicants
2. diversifying their credit related assets

Front 526

Firm specific credit risks

Back 526

is associated with a particular borrower and the risk of that borrow's project. FIs protect themselves against firm-specific credit risk by diversifying their assets

Front 527

Systematic Credit risk

Back 527

is associated with general economic conditions that affect all borrowers worldwide.
- Asset diversification does not reduce systematice credit risk.

Front 528

FI's Liquidity Rish

Back 528

is the risk that sudden w/d might force teh FI to liquidate assets quickly at low prices.
- they contribute to liquidity risks by limiting their cash holdings

Front 529

FI's liability holders can create liquidity risk

Back 529

by losing confidence in the bank or by experiencing unexpected needs for cash

Front 530

a run on a FI occurs

Back 530

when all or many liability holders w/d their funds at the same time, often resulting in the bank's failure

Front 531

FIs interest rate risk

Back 531

the risk that the FI mismatced assets and liabilities will produce and demand different rates of return.
- interest rates are affected by teh Feds monetary policy and by the increased level of financial market integration, which increases the swpeed of interest rate changes and transfers interest rate volatility among integrated countries

Front 532

3 types of interest rate risks

Back 532

1. Refinance risk
2. reinvestment risk
3. present-value uncertainty

Front 533

refinance risk

Back 533

a FI loses money when it holds assets with longer maturities than its liabilities' maturities, adn the interest rate INCREASES
- when the FI refi's its liabilities, the higher interes rate will cost the FI money

Front 534

Reinvestment risk

Back 534

a FI loses money when it holds assets with shorter maturities than its liabilities' maturities and the interest rate DECREASES
- when the FI reinvests in new assets the lower interest rate will cost the FI money

Front 535

Present-value risk

Back 535

- interest rate fluctuations change the present value of future cash flows associtiated with both assets and liabilities
- when the FI holds assets with longer maturities than its liabilities maturities an increas in interest rates reduces teh present values of the FIs assets by a larger amount than it does the present values of the FIs liabilities
- when and FI holds assets with shorter maturities than its liaiblities maturities a decrease in interest rates increases the present values of the FIs assets by a smaller amount than it does the present value of the FI's liabilities

Front 536

FIs Market risk

Back 536

the risk that changing interest rates, exchange rates, and other prices will affect the trading prices of assets and liabilites
- a FI that actively trades in securities faces the risk that trading prices will change downward unexpectedly costing the FI money

Front 537

FIs Off Balance Sheet Risk

Back 537

is the risk that activities related to contingent assets and liabilities will cause the FI to lose money

Front 538

FIs off balance sheet activities

Back 538

1. letter of credit (an insurer's or bank's guarantee to make some payment upon the occurrence of a future even -- usually the default of the buyer of the letter) entails that the issue will have to make the promised payment
2. loan commitments
3. mortgage services
4. positions in derivative securities

Front 539

Foreign Exchange Risk

Back 539

the risk that changing exchange rates will affect the value of foreign-denominated assets and liabilities
- A FI is exposed due to activities such as trading in foreign currencies, making foreign currency loans, buying foreign issued securities of issuing foreign currencies

Front 540

Country or Sovereign risk

Back 540

the risk that a foregn gov't will interfere with repayments by that country's foreign borrowers.
- Businesses that lend US dollar denominated money to foreign borrowers avoid currency risk but no soverign risk
- when foreign borrowers default on a loan due to governmental intereference, FIs usually have little recourse to local bankruptcy courts or international civil claims courts

Front 541

Technology risk

Back 541

the risk that technological investments will not produce their expected cost savings
- sometimes occurs through diseconomies of scale such as excess capacity, redundancies and bureaucratic inefficiencies that worsen as the FI grows
- impairs the FIs efficiency and ability to compete

Front 542

operational risk

Back 542

the risk that existing technological systems will break down
- a specialized form of technology risl
- the trend toward computer based and other electronic based systems since the mid 70s has increase the operation risk in the financial sector exponentially

Front 543

Insolvency risk

Back 543

the fisk that a FI might lack enough capital to offset a sudden decline in the value of its assets
- a FI become insolvent when its owners' equity approaches or equals zero
- regulators like FIs to have low leverage because low leverage increases their ability to withstand decline in asset values.

Front 544

What outside factors can affect FI's risks

Back 544

1. changes in taxation
2. changes in regulations
3. stock market crashes
4. major political events (wars, revolution)
5. crimes against the FIs
6. general macroeconomic changes (changes in inflation rate and/or the unemployment ratio)

Front 545

2 types of liquidity risk

Back 545

1. Liability side liquidity risk
2. Asset side liquidity risk

Front 546

Liability side liquidity risk

Back 546

liability holders might w/d their financial claims (deposits) creating a need for cash

Front 547

Demand deposits accounts

Back 547

are particulary prone to w/d which is why depository institutions have a high liquidity risk exposure.
- demand deposits are composed of core deposits and the net deposits drain

Front 548

Core deposits

Back 548

are rarely w/d providing a stable long term source of funds

Front 549

The net deposit drain

Back 549

is the amount by which deposit w/d exceed deposit additions.
- because there are always core deposits, a bank does not need to be prepared to convert all of its demand deposits into cash every day

Front 550

Time deposit accounts

Back 550

savings accounts
- they are less prone to w/d

Front 551

Disintermediation

Back 551

is the withdrawing funds from banks to then reinvest them elsewhere to earn higher interest rates

Front 552

Asset side liquidity risk

Back 552

holders of off balance sheet commitments might excercise those commitments converting them into assets that must then be balanced by add'l liabilities

Front 553

Purchased liquidity

Back 553

- cash raised through money market, either by borrowing funds from federal fund market or the repo agreement market or by issuing CDs, notes, or bonds

Front 554

purchased liquidity - ADVANTAGES

Back 554

only affects balance sheet liabilities, it doesn't affect the asset side of the balance sheet. Therefore, the business can maintain its current size while still raising cash.

Front 555

purchased liquidity -
DISADVANTAGES

Back 555

are not covered by deposit insurance
- can be expensive because the buyer must pay the market interst rates for funds

Front 556

Stored liquidity

Back 556

cash raised through cash reserves adn the sale of assets

Front 557

Stored liquidity -
ADVANTAGES

Back 557

is less expensive than purchased liquidity

Front 558

Stored liquidity -
DISADVANTAGES

Back 558

the cost of stored liquidity is the opportunity cost of not investing stored cash in interest bearing assets
- when used, it decreases the bank's assets

Front 559

5 measures of liquidity

Back 559

1. Net liquidity statement
2. Maturity ladder
3. Peer group ratio comparisons
4. Liquidity index
5. Financing gap

Front 560

Net Liquidity statement

Back 560

lists sources and uses of liquidity, and thus provides a general measure of liquidity

Front 561

Maturity ladder

Back 561

compares cash inflows and outflows on a daily basis and/or over a longer period to determine daily and cummulative net funding needs.
- a bank with a short term funding might use a 5 day maturity ladder
- a bank with less dependency on short term funding might measure liquidity over a longer period

Front 562

Peer group ration comparisions

Back 562

compare the banks dey rations to those of similar banks

Front 563

high loans/deposits ratio and/or high borrowed funds/ total assets ration indicates...

Back 563

heavy reliance on the short term money market

Front 564

A high commitments-to-lend/ assets ratio indicates....

Back 564

a need for high liquidity

Front 565

Liquidity index

Back 565

compares fire-sale asset prices and fair market prices to measure the potential loss from a sudden sale of assets at fire sale prices.

Front 566

financing gap

Back 566

equals average loans minus core deposits
- if the gap is positive, the bank must liquidated assets or borrow funds to bridge the gap

Front 567

The financing requirement equals

Back 567

the financing gap plus liquid assets
- the amount must borrow to finish bridging the financing gap once liquid assets have been exhausted
- widening financing gap indicates future liquidity problems, and may be caused by increase deposits w/d and/or increased exercise of loan commitments
- as a bank increases its money market loans in response to a widening financing gap, lenders get concerned about the bank's creditworthiness and respond with stricter credit limits and higher risk premium

Front 568

How banks manage liquidity

Back 568

Banks have 3 sources of cash:
1. the sale of liquid assets
2. borrowed funds
3. excess cash reserves
A banks maximum borrowed funds limit is an internal guideline based on the bank managers assessment of the credit limits the market is likely to impose on the bank

Front 569

Liquidity planning

Back 569

lets a bank set its borrowing priorities before liquidity problems arise, lowering the bank's cost of funds and minimizing its excess reserves

Front 570

4 components of liquidity plan

Back 570

1. managerial details and responsibilities
2. W/d patterns
3. w/d sizes and sources of funds
4. Internal borrowing limits

Front 571

Managerial details and responsibilities

Back 571

appoint managers responsible for interacting with regulatory agencies and disclosing information to the public, in the event of a liquidity crisis

Front 572

Withdrawal patterns

Back 572

identify which fund providers are loikely to w/d their funds in the event of a liquidity crisis
- map the likely pattern of w/d

Front 573

Withdrawal sizes and sources of funds

Back 573

- estimate the likely sizes of w/d over various time horizons (1 week, 1 month, 1 quarter, 1 year)
- identify the sources of funds for each time horizon

Front 574

Internal borrowing limits

Back 574

- decide how much each subsidiary and brank may borrow.
- determine acceptable risk premiums for market borrowing
- this section of the liquidity plan also contains the sequence in which assets may be liquidated

Front 575

A bank run

Back 575

is a sudden, unexpected w/d of deposits from a bank

Front 576

A bank run may be triggered

Back 576

1. concern about the bank's sovency
2. the failure of a related or nearby bank
3. sudden changes in investor preferences
- if a bank does not have deposit insurance, depositors who fear that bank may be in financial trouble will want to get to the bank fast and w/d their deposits before the bank runs out of cash

Front 577

A bank panic occurs

Back 577

when depositors lose their faith in the banking system as a whole, creating many simultaneous bank runs

Front 578

The banking system has 2 major liquidity risk insulation mechanisms

Back 578

1. deposit insurance
2. discount windows

Front 579

Deposit Insurance

Back 579

guarantees the repayment of deposits
- prevents bank runs by making depositors feel safe about their deposits even when banks are in financial trouble
- the level of deposit insurance coverage per depositor is capped at $100K per account, so each depositor can get more coverage by use of separate accounts and even separate banks

Front 580

Discount window

Back 580

provides short term loans to banks at the discount rate

Front 581

Life Insurers liquidity risk exposures:
The surrender value nof a life insurance policy

Back 581

is that portion of the poicy value the insurer must pay if the policyowner cashes in the policy before it matures

Front 582

In order of preference, life insurers raise cash to pay surrender values by ....(4)

Back 582

1. selling more policies to generate more premium income
2. relying on returns from current assets
3. selling liquid assets
4. selling assets at fire-sale prices

Front 583

P&C insurers liquidity risk
CLAIMS

Back 583

insurers pay claims as they arise and are settled.
- because claims are impossible to predict perfectly and because payments, once settled, must be paid promptly, PC insurers hold lots of short term liquid assets
- disasters that create many claims can deplete a PC insurers liquidity

Front 584

PC insurers liquidity risk
CANCELLATIONS

Back 584

policy cancellations and nonrenewals reduce the PC insurer's premium income, possible creating a liquidity crisis.
- This theoretical risk (many, many cancellations within a few days) rarely arises in practice

Front 585

State Guarantee funds differ from deposit insurance in 4 ways

Back 585

1. state funds are run and administered by insurers themselves
2. Insurers pay into the fund only when another insurer has failed (except NY)
3. The size of required contirbutions varies from state to state
4. there is a delay between recognizing the need to pay PH and actually paying them

Front 586

Mutual Funds' Liquidity Risk Exposures

Back 586

- Open end fund must be ready to buy back shares from investors
- investors can create a run on a mutual fund similar to a bank run
- potential mutual fund insolvency is less of an incetnive to sell shares than falling asset values, because in the event of a mutual fund's failure, investors share asset losses equally

Front 587

Bank run vs. Mutual fund run

Back 587

- a bank run based on percieved financial trouble the last depositors in line get nothing
- a mutual fund run, the last investors in line get the same amount of cash per share as all other investors.
- on the other hand, if asset values are falling the longer the mutual fund investors wait to sell their shares, the more money they will lose

Front 588

Roles of FIs in financial markets

Back 588

- channel funds from those with surplus funds to those that need funds
- allow indirect transfer of funds in which buyers and sellers deal with an intermediary instead of with each other

Front 589

Without FIs

Back 589

Buyers and sellers would engage in direct transfer of funds in with corporations sell:
1. equities (common & preferred stocks)
2. debt (commercial paers and bonds)
directly to investors

Front 590

3 disadvantages to direct invesment

Back 590

1. Monitoring costs - invoestors must constantly monitor the use of their funds
2. Liquidity costs - loss of liquidity upon invesment, especially long term projects
3. Price risk - investors take the risk that an asset's sale price will be lower than its purchase price

Front 591

FIs reduce monitoring costs

Back 591

as delegated monitors, FIs monitor the use of all their investors funds by the ultimate user of those funds for far less money that it would take all investors to monitor their own investments seperately.

Front 592

FIs transform assets

Back 592

By buying corporations securities and issuing them as secondary securities that can be bought and sold quickly, financial institutions increase liquidity and decrease the price risk of those assets, making them more attractive to investors
- FIs reduce their own investment risks & pass those reductions along to investors, through diversification

Front 593

FIs reduce transaction costs

Back 593

Conduct transactions more efficiently than individual investors by using "economies of scale"
(cost reduction from increased efficiency)

Front 594

FIs act as maturity intermediaries

Back 594

- FIs can purposely mismatch matuirities to offer both buyers and sellers the maturities they want
- a typical mismatch has the FI funding a longterm mortgage loan w/funds from a short term savings and checking deposits
- The FI essentially assumers the interst rate risk that small investors can't handle

Front 595

FIs act as denomination intermediaries

Back 595

- FIs can by assets sold in very large denominations and sell shares of those assets to small investors who otherwise wouldn't be able to afford the minimum investment
- EX: a FI can buy a negotiated CD @ the minimum sale of $100K and then sell shares of the DC to small investors through a mutual funds.

Front 596

FIs transmit monetary policy

Back 596

The size of the money supply is determined largely by band and/or thrift deposits

Front 597

The federal reserve uses it control over depository institutions to:

Back 597

- Control the money supply and thus control the rate of inflation

Front 598

Money Supply

Back 598

the measure of the money stock in a nation

Front 599

FIs allocate credit

Back 599

- FIS can extend credit to those sectors of the economy in need of financing
- Policymakers decide which secotrs need financing and then encourage FIs to extend credit

Front 600

FIs can act as time intermediaries

Back 600

Pension and life insurance funds let savers trasnfer wealth from their youth to their old age, or from ongeneration ot the next

Front 601

FIs provide payment services

Back 601

Depository institutions provide check clearing and wire transfer services to speed up the payment process amoung buyers and sellers

Front 602

FIs do these 9 things through indirect transfer

Back 602

- reduce monitoring costs
- transform assets
- reduce transation consts
- act as matuirty intermediaries
- act as denomination intermeidiaries
- transmit monetary policy
- Allocate credit
- act as time intermediaries
- provide payemnt services

Front 603

The Securities and Exchange commission (SEC)

Back 603

regulates financial markets by:
1. emphasizing full and fair disclosure of information
2. monitoring markets for evidence of insider trader

Front 604

Foreign Exchange Markets

Back 604

- Financial markets in other countires, denominated in currencies other than US dollars
- risk depreciation of that foreign currency relative to the dollar

Front 605

Primary Market

Back 605

- Trades newly issued securities
- Corporations can rais money by selling newly issued stocks to investors

Front 606

Investment Banks

Back 606

Arrange primary market transactions by buying a corporation's entire new issue at a set price and then selling that new issue to investors at a slightly higher price

Front 607

Initial Public Offering (IPO)

Back 607

A corporations first public issue of financial instruments

Front 608

Secondary Market

Back 608

- Trades previously issued securities. The original issuer of the security is not involved in the trade
- Trade in stocks, bonds, financial instruments backed by mortgages and other assets, foreign exchange and derivative securities

Front 609

Derivative securities

Back 609

securities whose payoffs are linked to other previously issued securities

Front 610

Secondary markets benefit both buyers and sellers by

Back 610

Providing information on the current value of its previously issued securities, which in turn reflects the corporations current value and influencing the likely selling price of any new issue

Front 611

The Money Market

Back 611

- trades money market instruments which are debt securities with maturities of less than one year
- Price fluctuatiosn in the money market are small
- US money markets are called (OTC) over the counter markets because they don't operate in a specific location but do trade via phone, wire transfer, and computer

Front 612

The capital market

Back 612

trades capital market instruments which are debt and equities instruments with maturities of more than one year (or no maturity at all)
- Price fluctuatiosn are larger than with money market instruments

Front 613

10 riskes face by FIs

Back 613

1. credit rsk
2. Foreign exchange risk
3. country or soverieng risk
4. interest rate risk
5. market risk
6. off balance sheet risk
7. liquidity risk
8. Technology risk
9. Operational risk
10. Insolvency risk

Front 614

Credit risks

Back 614

the risk that promised cash flows from loans and securities held by FIs will not be paid in full

Front 615

Foregin exchange risk

Back 615

the risk that fluctating exchange rates will adversly affect the values of assets and liabilities located abroad if the dollar depreciates or the foreign currency appreciates

Front 616

Country or sovereign risk

Back 616

the risk that repayments from foreign borrowers will be interrupted due to interference from foreign government

Front 617

Interest rate risk

Back 617

occurs when the baturities of the FIs assets and liabilites are mismatches

Front 618

Market Risk

Back 618

the risk that changes in interest rates, exchange rates and other prices will result in trading losses

Front 619

off balance sheet risk

Back 619

the risk that the FI will lose money due to activities related to contigent assets and liabilities

Front 620

Liquidity risk

Back 620

the risk that a surge in liabilitiy withdrawals will force the FI to liquidate assets a low prices

Front 621

Technology risk

Back 621

the risk that technological investments won't produce the expected savings

Front 622

Operational risk

Back 622

the risk that existing technology or support systems will break down

Front 623

Insolvency risk

Back 623

the risk that the FI won't have enough capital to offset a sudden decline in the value of its assets

Front 624

5 factors that have caused the globalization of financial markets

Back 624

- Foreign countries have more $ to invest in other countries
- international investors have been very interest in buying inot US and private pension as the value of public pension in Europe has decreased
- The internet and other technological advances have made interational investmenst easier to research
- FI encouragement of foreign investments
- deregulation in many foreign countries

Front 625

Eurodollar bonds

Back 625

- dollar denominated bonds issued in Europe
- They are not regulated by the SEC
- They account for over 80% of new issues in the international bond market

Front 626

The federal reserve

Back 626

- 12 Federal Reserve Banks
- Each located in one of 12 Federal Reserve districts
- 7 member board of governors (located in DC)

Front 627

Most income of Federal Reserve Bands come from...

Back 627

- Interset on government securities
- interest on bank reserves
- fees fro services provided to member banks

Front 628

4 major functions of the federal reserve

Back 628

1. Conduct monetary policy
2. supervise and regulate depository institutions
3. stabilize the financial system
4. Provide financial services

Front 629

Federal Reserve conducts monetary policy

Back 629

- the FRB presidents serve on the Federal Open Market Committee
- set and change the discount rate

Front 630

Discount rate

Back 630

the interest rate on "lender of last resort" loan made by Federal Reserve Banks to depository institutions

Front 631

The Federal Reserve Banks supervise and regulate depository institutions

Back 631

- examing banks, issue warnings to bansk about unsafe practices and approve applications for expanded activities

Front 632

The Federal Reserve stabilizes the financial system

Back 632

through monetary policy and through supervisory and regulatory activities

Front 633

Federal reserve banks provide financial services

Back 633

- operate as commercail banks for the US treasury
- hold gov't agencies collateral on funds NOT protected by deposit insurance
- operate the US savings bond scheme
- issue, sell, and service Treasury and other gov't securities
- collect, replace, and distribute currency
- operate the central check clearing system for US banks
- operate 2 wire transfer services
- gather and analyze economic datea and developments in the banking system

Front 634

2 wire transfer services operate by the Federal reserve

Back 634

The Fedwire adn automated Clearinghouse

Front 635

The Federal Reserve Board

Back 635

- formulates and conducts monetary policy
- supervises and regulates state chartered member banks, bank holding companies, and Edge Act and agreement corporations
- Member are appointed by the president and confirmed by the senate.
- The chairman advises the president on economic policy

Front 636

Federal Open Committee

Back 636

The major monetary policymaking body of the Federal Reserve Ssytem.
- Consists of:
- the 7 members of the Federal reserve board
- President of the Federal Reserve bank of NY
- the presidents of 4 other FRB's on a rotating basis

Front 637

The Federal Open Market Committee sets guidelines regarding....

Back 637

open market regulations (purchase and sales of US gov't and federal agency securities by the Fed) in accordance with FOMC policies to promote full employment of economic growith, price stability, and a sustainable pattern of international trade.
- it also guides the Feds activities in foreign exchange markets and monitors the discount rate.

Front 638

The major assets of the Fed's balance sheet

Back 638

- Teasury securities, treasury currecny gold and foreign exchange
- The fed owns substantial treasury because its open market operations involve buying and selling treasury securities

Front 639

Majory liabilities on the Fed's balance sheet

Back 639

1. Currency in circulation
2. Reserves

Front 640

Money base or Monetary base

Back 640

Teh sum of currency in circulation and reserves

Front 641

Money Supply Definitions
M1

Back 641

- Currency outside the US treasury, Fed REserve bansk and vaults of depository institutions PLUS travelers checks of nonbank issuers PLUS demand depositis at all commercial banks PLUS other checkable deposits

Front 642

Money Supply Definitions
M2

Back 642

M1 PLUS deposits and small denomination time deposits and balances in reatil money market mutual funds

Front 643

Money Supply Definitions
M3

Back 643

M2 plus large denominatin time deposits, balances in institutional money funds, RP liabilities issued by all depository institutions and eurodollars held by US residents at foregn branches of US banks and all banking offices in the UK and Canada

Front 644

Reserves

Back 644

INclude depository institution reserve balances at the Fed and vault cash
- Depository institution reserve balances include:
- required reserves (reserve bansk must hold)
- excess reserves (reserve banks choose to hold)

Front 645

excess reserves

Back 645

- earn no interest, banks trade excess reserves among themselves at the fed funds rate

Front 646

Fed funds rate

Back 646

benchmark interest rate used to guide monetary policy

Front 647

By changing the fed funds rate or required reserve, the fed can....

Back 647

1. reduce inflation, encourage low unemployment
and/or
2. control economic growth

Front 648

Open Market Operations

Back 648

The FOMC issues policy directives to the Federal reserve board trading desk.
- The trading desk then tells tratders how many US treasury securities to buy or sell to reach the money supply target

Front 649

When the Fed buys securities

Back 649

It increases the selling banks' reserve deposity accounts, which increases banks' abilities to make new loans and to create new depositis, thereby increasing our nations money supply

Front 650

The increase in money supply equals

Back 650

(1/reserve requirement)(open market purchases)

Front 651

When the Fed sells securities

Back 651

It decreases the buying banks reserve deposit accountes, which reducses the banks abilities to loan money and to creat new deposits, decreasing the money supply

Front 652

Repurchase Agreements

Back 652

The trading desk can temporarliy affect the moeny supply by issuing repurchase agreements.
- let banks sell securities but require them to buy the same securities back in a day or two

Front 653

Discount Rate

Back 653

- Fed raises rate to signal its desire to see higher interest rates and less borrowing in general
- Fed lowers rate to encourage lower interest rates adn more borrowing
- Rarely used as monetary policy tool. Because its hard to predict how a change will affect bank kiscount window borrowing and financial markets overall

Front 654

Reserve Ratio

Back 654

- The Fed changes the reserve ratio to increase or decrease reserve requirements
- Increasing the reserve rations increases the amoutns of reserves bands must hold and thus decreases the banks' ability to loan. That in turn decreases our nations money supply
- The Fed changes the reserve ratio much less often tha it chagnes the discount rate.

Front 655

The Change in bank deposits equals

Back 655

(1/reserve requirement) (Cahnge in reserve created by new reserve requirement change)

Front 656

3 types of discount window loans

Back 656

Primary Credit - very short term loan to generally sound FI. Maybe used for any purpose
Secondary Credit - very short term loan offered to FIs that don't qulaify for primary credit. May not be used to add to borrowers assets
Seasonal Credit - loan used to solve a seasonal liquidity problem. Offered to banks that can demonstrate a historical seasonal pattern to their bussiness.

Front 657

Expansionary Activities

Back 657

Fed activities that increase (or expand) the money supply
1. increase money supply
2. decrease interest rates
3. increase prices of securities
4. encourage borrowing and spending
5. decrease the foreign exchange value of the dollar
6. increase US exports
7. increase production
8. increase inflation

Front 658

Contractionary Activities

Back 658

Fed activities that decrease or contract money supply:
1. decrease the money supply
2. increase interest rates
3. lower the price of securities
4. discourage borrwoing and spending
5. increas teh foreign exchange value of the dollar
6. decrease US exports
7. decrease production
8. decrease inflation

Front 659

The Fed can't target both interest rates and the money supply simultaneoulsy because...

Back 659

tareting the money supply leads to volatile - and thus hard to target - interest rates and targeting interest rates leads to volatile changes in the money supply
- So the Fed must target one adn let the other variable fluctuate freely