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659 Cards in this Set

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Central banks influence their country's rates
by buying and selling currencies. Especially if they perceive the market has become unstable.
foreign exhange intervention
buying and selling currencies
When the Fed uses US dollars to buy another currency
it increases the suppy of US dollars, decreases the supply of the foreign currency, and depreciates the dollar relative to the foreign currency
When the Fed uses another currency to buy US dollars
it decreases the supply of US dollars, increases the supply of the foreign currency and appreciates the dollar relative to the foreign currency
The current US policy on exchange intervention is...
to let exchange rates fluctuate freely
Recent challenges to other major central banks include (3)
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
3 basic type of financial intermediaries
1. Depository institutions
2. Brokerage houses
3. Insurance companies
Depository Institution
(banks, credit unions, savings & loans)
You loan your money and you get investment back with interest. Your return on investment can be accurately predicted.
Brokerage Houses
(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).
Insurance companies
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%
Money Markets
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.
Investor behavior in Money Markets
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
Money Market investors reduce opportunity costs because...
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
Default risk
the risk of late or non-payment of principal and/or interest
Money Market borrowers benefit from
low transaction costs and quick transfer of funds. Most individuals participate in money markets indirectly, through money market mutual funds and other financial institutions
Types of Money Market Instruments
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.
Treasury Bills (T-bills)
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
Formula for the discount yield of a T-bill
[(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.
Federal (fed) funds
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.
The fed funds rate
the one-day interest rate for borrowing fed fund.
Repurchase Agreements (repos)
- 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.
Reverse repurchase Agreements (reverse repo)
has 1 party buy securities from another and promises to sell them back on a given future date.
The formula for the yeild of a repurchase agreement
[(repurchase price - selling price) / selling price] x (360/days to maturity)
Both Fed funds and repurchase agreements are commonly used for
Overnight funding
Commercial paper
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.
The formula for the discount yield of commercial paper
[(face value - purchase price) / face value] x (360/days to maturity)
Negotialbe certificates of deposit (CDs)
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
Bankers' acceptances
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.
How to trade US treasury bills, the primary market
(1 of 2)
- 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.
Submitted bids are:
(2 of 2)
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.
How to trade US treasury bills: The secondary market
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.
Money Market Participants (6)
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
The US Treasury
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.
The Federal Reserve
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
Commercial banks
buy and sell almost all types of money market instruments, usually to meet reserve requirements and make better use of excess reserves
Primary Government security dealers
- 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
Money and security brokers
- act as intermediaries for gov't securities dealers, and
- link buyers and sellers in the fed funds and others secondary markets
Smaller brodkers and dealers
link smaller buyers and sellers in several secondary markets
Corporations
issue commercial paper and invest excess cash in money market securities
Other financail institutions
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
Euro Money Markets
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.
Eurodollar deposits
US dollar-denominated deposits in foreign bandks, no just European banks
London Interbank Offered Rate
(LIBOR)
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.
Euromarket securities
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.
Capital Markets
facilitate the trading of stocks, notes, bonds, mortgages, and other long-term debts instruments.
Bonds
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.
3 types of bonds
Treasury notes and bonds, municipal bonds and corporate bonds
Treasury notes (T-notes) and Treasury bonds (T-bonds)
FEATURES
-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.
STRIP - (Separate Trading of Registered Interest and Principal) Security
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
Treasury Inflation Protection Securities (TIPS) bond
in an inflation-indexed bond that provides returns ited to the inflation rate. Teh coupon rate on TIPS is determined by an auction process.
Treasury notes (T-notes) and Treasury bonds (T-bonds)
YIELDS
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.
Treasury notes (T-notes) and Treasury bonds (T-bonds)
TRADING
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.
Municipal Bonds
Issued by state and local gov't to fund tempoarary imbalances between expenditures and receipts and/or to finance long-term projects.
Municipal Bond
FEATURES
- 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.
General obligation bonds
General obligation bonds are backed by the issuer's full faith and credit and require taxpayer approval before they are issued.
Revenue bonds
-- 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.
Municipal Bonds
YIELDS
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)
Municipal Bonds
TRADING
Neew issues are sold publicly, through an investment bank that acts as security underwriter, or by private placement.
Public Trading
- 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
Firm Commitment Underwriting
the bank guarantees the issuer a bond price by buying the entire issue and then reselling all the bonds at higher prices
Best Efforts underwriting
the bank does not guarantee the issuer a price and places bonds with investors on a fee basis
Private Placement
- 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
Corporate bonds
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.
Bond Indenture
the contract that specifies the responsibilities and rights of the issuer and of the buyer.
Kinds of corporate bonds
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
Bearer Bond
has coupons attached to the bond, which the holder presents to the issuer for payment of interest with they come due
Registered Bond
mails coupon payments to the registered bond owner. Registered bonds have largely replaced bearer bonds because they are more secure (and more easily taxed)
Term bond
has the entire bond issue mature on the same date
Serial bond
part of an issue with several matuirty dates. Allow repayment over time and hence are better than term bonds for corporations with volatile incomes.
Mortgage bond
finances a specified project, which is pledged as collateral for th ebond. A mortgage bond is secured debt.
Equipment trust certificate
collateralized with tangible non-real estate property
Debenture
is an unsecured bond backed by the issuer's general credit.
Subordinated debenture
an unsecured bond that is junior to mortgage bonds and to regular debentures
Convertible bond
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
Stock Warrant
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.
Callable bond
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.
Call Provision
Lets the issuer force the bondholder to sell the bond back a given (call) price
Call premium
the difference between the call price and the face value.
Sinking Fund Provision
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.
Corporate bonds - how are they sold
The issuer sells corporate bonds through a public sale or private placement, just as with municipal bonds.
Corporate bonds have 2 secondary markets
The exchange market and the OTC over the counter market.
The OTC market is much more active than the exchange market.
Bond Ratings
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
Investment Grade Bonds
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
Junk bonds or higher yield bonds
Bonds below investment grade
Bond Market Participants
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.
Yield Spread
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.
International Bond Markets
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
International Trade In Bonds -
CURRENCY
Before 2004, most international bonds wer denominated in US dollars. The euro is now the most prevalent curreny for denominating international debt.
International Trade in Bonds
TYPES OF BONDS
Eurobonds
Foreign bonds
Brady bonds
Eurobonds
- 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.
Foreign bonds
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
Brady Bonds
- 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.
Sovereign bonds
Brady bonds w/out US T-bond collateral backing
Common Stockholders have the rights to...
1. Dividends
2. Residual Claims
3. Limited Liability
4. Voting
Dividends
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)
Residual Claims
Stockholders may claim the assets of a failed or dissolved form, after all debt and taxes are paid.
Limited Liability
Stockholders' losses are limted to the amounts of their original investments.
Dual Class Firm
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.
Cumulative Voting
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.
Straight Voting
each director is boted on individually, with one share equaling one vote.
Bondholders vs. Stockholders
Bondholders do not own the firm that issues their bonds, but their claims to earnings and assets are superior to those of stockholders.
Preferred Stockholders have the right to....
1. Dividends
2. Residual claims
3. Limited liablity
4. Voting rights
Preferred Stockholders dividends
Preferred stockholders are paid before common stockholders
Preferred Stockholders Residual claims
Preferred stockholders are paid before commond stockholders
Preferred Stockholders Limited liability
Preferred stockholders' losses are limited to their original investments
Preferred Stockholders
voting rights
Preferred stockholders' generally do not have voting rights, unless prior cumulative preferred dividents have not been paid
Corporate Stocks offer 2 types of returns
Capital Gains - if the stock appreciates over time
Dividends - if declared by the board of directors
Preferred Stock Dividends
Are preset at a fixed rate
Common Stock Dividends
bary and are paid at the board's discreation
Common Stock
confers a fundamental, residual claim of ownership in a public corporation
Preferred Stock
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)
Participating preferred stock
may pay actual dividents that are greater tha promised dividends
Noncumulative preferred stock
does not pay missed dividends
Preferred stock can bring disadvantages to corporations because
- 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
The return on a stock over hte past year (formula)
[(current price - price on year ago) / (price one year ago)] + (last annual dividend / price one year ago)]
Primary Market
- 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
Firm commitment underwriting #2
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)
The underwriter's spread
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.
Syndicate
a group of investment banks that distribute securities
Initial public offering
a firm's very first issue of stock
Seasoned shares
firms that already have shares trading in the secondary maket offer seasoned shares in the primary market
Public sale
offered to the general investing public
private placement
offered to a limited number of large investors
Some states and corporate charers give stockholders preemptive right...
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
Registration with SEC
- 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.
Red Herring Prospectus
While the firm registers its securities, it can also distribute a preliminary prospectus to prospective investors.
Secondary stock market
facilitates the trading of previoulsy issued stocks
3 major secondary stock markets
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.
NYSE trading process
- 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
Trading posts
specific locations on the floor of the exchange
Specialist
an exchange member who arranges the market for that stock, maintains its liquidity and buys back stock as necessary to stabilize its price.
Floor brokers
work independently from large brokerage firms
2 types of orders sent to floor and commission brokers
Market order and limit orders
Market Order
asks the broker to transact at the best price available when the order reaches the post
Limit Order
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.
Program Trading
The simultaneous, computer-assisted bying and selling of a portfolio of atleast 15 different stocks valued at more than $1 million.
P/E ratio
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.
Earning's per share calculations
divide the firm's closing price by it's PE ratio
A high PE ratio
indicates high expections of growth in earnings
A low PE ratio
indicates the stock's earnings are not expecte to grow quickly
The AMEX trading process
lists stocks of smaller firms with national interest. The AMEX is organized like the NYSE.
The NASDAQ
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.
Market Listing Requirements
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.
Stock Market Indexes
a composite value of a group of stocks traded on teh secondary market that indicates the overall market's performance and trend.
Dow Jones Industrial Average
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.
The NYSE composite Index
a composite of all common stocks listed on the NYSE with four sub-indexes for industrial, transportation, utility and financial companies
The Standard and Poor's 500 Index
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
The NASDAQ composite index
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.
The Wilshire 5000 Index
measure the performance of all US headquartered equity securities that are actively traded in an US based stock market and have available price data
Stock Market Participants
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
Stock prices reflect
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.
Stock market and recession
- 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.
Market efficiency
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.
3 Hypotheses of market efficiency
-Weak form of market efficiency hypothesis
-Semi-strong form of market efficiency hypothesis
-Strong form of market efficiency hypothesis
Weak form of market efficiency hypothesis
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.
Random walk hypothesis
holds that historical stock prices can not be used to predict future stock prices
Semi-strong form of market efficiency hypothesis
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.
Strong form of market efficinecy hypothesis
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.
The Securitieis Act of 1993
requires each SEC-listed compnay to register its stocks and to issue a prospectus with its new stock
The Securities Exchange Act of 1934
established the Securities and Exchange Commission as the main agency responsible for overseeing the secondary stock market.
Regulation FD (fair disclosure) 2000
outlaws selective disclosure of trading information
Sarbanes-Oxley Act (2002)
created an independent auditing board under the SEC, increased penalties for corporate malfeasance, and created recourse for wronged shareholders
The Securities and Exchange Commissions (SEC)
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
The National Association of Securities Dealers (NASD)
regulates brokers and dealers on the NASDAQ market
How and Why to invest in international Stocks
- 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
American Depository Receipt (ADR)
a certificate that represents ownership of a foreign stock. ADR's facilitate US investment in foreign stocks.
Investors like ADRs because
- 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)
US companies issue stock globally to....
- 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.
Derivative Security
a security with a payoff that is linked to another previously issued security.
Mortgage backed security
linked to an underlying mortgage
Option
is linked to the price of an underlying security and to a reference or strike price.
Types of Derivative securities (3)
1. Spot Contract
2. Forward Contract
3. Futures Contract
Spot Contract
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.
Forward Contract
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.
Futures contract
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)
Marked to Market
Prices being adjusted each day to reflect current future market conditions
Initial margin
A deposit that represents a portion of the value of a contract
The maintenance margin
byers must amintain funds in their margina ccounts at a stated level, usually 75% of the initial margin
A futures contract holder may
A. hold the contract until it expires
B. liquidate his position before the contract's expiration
3 types of future contracts
1. Interest rate futures
2. Currency futures
3. Equity stock index futures
interst rate futures
The underlying asset is the interst rate on a bond or short-term fixed-interest security
Currency futures
They underlying asset is the exchange rate of a currency
Equity stock index futures
The underlying asset is a major US or foreign stock market inex
The buyer in a futures contract profits when....
the value of the underlying asset increases before contract expriation
The seller in a futures contract profits when....
the value of the underlying asset decreases before contract expiration
The Forward Contract Market
- 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.
The Futures Contract Market
- 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.
Professional traders can be:
1. position traders
2. day traders
3. scalpers
Position Traders
take their positions for more than a day, basing their trades on their expectations about the future direction of prices
Day traders
take their positions for a day and liquidate them by the day's end
scalpers
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
An Option
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.
An American Option
lets the holder buy or seel at any time before or on the expiration dated
A European option
lets the holder buy or sell only on the expiration date
An option's intrinsic value
equals the underlying asset's price minus the option's exercise price.
An option's time value
equals the option's price minus its intrinsic value.
Intrinsic value and time value
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.
The call option buyer faces...
limited losses (the call premium) but unlimited gains, because the price of the underlying security could skyrocket.
The call option writer faces...
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
A Put Option
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)
A put option is in the money when...
the price of the underlying security is below the exercise price
A put option is out of the money when...
the price of the underlying security is above the exercise price.
Buyers exercise put options when they are in the money.
The put option buyer faces...
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.
The put option writer faces...
large losses but limited gains (the put premium)
The Options market:
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.
The Black-Scholes pricing model for cal options considers five factors that affect option prices
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
Three Underlying Assets
1. Stock option
2. Stock index option
3. Option on Futures contract
Stock Option
is based on the stock of a publicly traded company
Stock index option
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.
Option on futures contract
- 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.
Regulation of futures and options markets
- 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.
a SWAP
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.
An Interest Rate Swap
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
A currency swap
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.
Swap markets
- 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.
Swap markets have little direct regulations but they are indirectly regulated by
1. the international swaps and derivatives associations (ISDA)
2. the Board of Governors of the Federal Reserves
3. the FDIC
Caps, Floors, and collars
are derivative securities used to hedge interst rate risk
A cap
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
A floor
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
A collar
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
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
**add'l info only***
Depository institution
- 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
Commercial Bank
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.
Commercial Bank Assets
- 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.
Commercial Banks risk insolvency......
through their high exposure to loan default.
Commercial Bank Liabilities
- 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.
The major segments of deposit funds:
1. Transaccction accounts
2. Small nontransaction accounts
3. Negotiable certificates of deposits
Transaction accounts
include noninterest paying checking accounts (depand deposits) and interest paying chacking accounts (NOW, negotiable order of withdrawal, accounts)
Small nontransaction accounts
comprixe a large but shrinking section of deposit funds because banks are competing with money market mutual funds for those customers
Negotiable certificates of deposits (CDs)
are fixed maturity, interest-bearing deposits that can be traded in the secondary market
Commercial bank's borrowed funds include....
- 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)
Off balance sheet activities of commercial banks
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
An intem or activity is an off-balance-sheet (OBS) asset if
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.
An item or activity is an OBS liability if
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.
Off balance sheet activities allow the bank
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.
OBS increase banks
insolvency exposures
OBS decrease
risk by reducing or hedging banks' intererst rate, credit, and foreign exchange risks.
Major OBS activities include
- transactions in derivatives, loan commitments, standby letters, letters of credit, when-issued securities, loans sold, trust services and correspondent banking.
Derivatives
futures, forwards, swaps and options
Trust Services
- hold and manager assets for individuals and corproations
- the 2 largest groups of clients are individuals and pension funds
Correspondent Banking
- 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.
How economies of scale and scope effect commercial banks:
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
The Reigle-Neal Act of 1994
lets banks branch across state lines
The Financial Services Modernization Act of 1999
lets commercial banks merge with investment banks
Banks merge to form larger banks to save money through
1. Economies of Scale
2. Economies of scope
Economies of scale
- 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
Diseconomies of scale
the average costs of financial service production increase
Economies of scope
- combining financial services reduces the cost of producing each service separately.
- take the forms of reduced costs and increased volume
-
Costs economies of scope
occur when providing one financial sercie lowers the cost of providing other financail services
The Financial Services Modernization Act
lets a single finamcial institution provide banking, securities, and underwriting activities, creating cost economies of scope.
Revenue economies of scope occur when
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
Community Banks
are small banks (under $1billion in assets) that specialize in retain and/or consumer banking.
- They finance their activities through depsits, fee, and interest.
Regional or Superregional banks
- are large banks (over $1billion in assets)
- finance their activities through purchased funds and capital markets as well as through depositis.
Money center banks
- 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.
Interest rate spread
the average interest rate charged on loans minus the average interest paid on deposits
net interest margin
[(Interest income - interest expense) / earning assets]
Noncurrent loans
Loans 90 days or more past due and all loans not accruing interst
Net charge-offs
actual losses on loans ans leases
Net Operating income
income before taxes and extraordinary items
13 technological innovations in the wholesale banking industry
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
Controlled disbursement
informs the client in the morning of the total disbursements likely to be made from the client's account during that day
Account reconciliation
records which of the client's checks have been paid by the bank
Lockbox services
is a centralized collection service for corporate payments that reduces the delay in float and wries the details to the corporate client
float
the time it takes a check to clear
Electronic lockbox
is a lockbox service that collects online payments for public utilities and other corporate clients.
Funds concentration
redirects funds from several accounts at several banks to fewer accounts at one bank
Electronic funds transfer
makes overnight payments, automated payment of payroll and dividends, and automated transmission of payment instructions
Check deposit services
encodes, endorses, microfilms and handles customers' checks
Electronic initiation of letter of credit
lets customers request letters of credit via the bank's computer
Treasury management software
facilitates efficient management of muliple currency and security portfolios
Electonic data interchange
is email that lets businesses transfer and trasact invoices, purcahse orders, and shipping notices automatically, via their bank's computer
Business-to-Business e-commerce
automates information flow for buying and shipping goods and sevices among large and small businesses
Electronic billing
automates businesses' collection services
Encryption technology
verifies clients' identities
6 technological innovations in the retail banking industry
1. Automated teller machine
2. Point-of-sale debit card
3. Preauthorized debit/credit
4. Telephone payment
5. On-line banking
6. Smart Card
Automated Teller Machine
ATM
allows 24 hour world-wide access to checking accounts
Point-of-sale debit card
POS - pays for goods via an immediate transfer of funds
Preauthorized debit/card
deposits payroll checks and pays mortgage and utliity bills automatically
Telephone payment
uses voice or touch tone commands to transfer funds
On-line banking
lets customers conduct banking and investment activities via the internet
smart card
a card with a chip stoage device that "stores" money and disburses it on command.
4 key commercial bank regulators
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
The Federal Deposit Insurance Corporation
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.
The Office of the Comptroller of the Currency
OCC - was est. in 1863 to charter, examine, approve the bergers of, and close national banks.
The dual banking system
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.
The Federal Reserve System (FRS, the Fed)
regulates all nationally chartered banks, all state chartered member banks, and those banks' holding companies
holding companies
parent companies that own controlling interests in their bank subsidiaries
State authorities
charter and regulate banks in their states
6 advantages of international bank expansion
1. risk diversification
2. Economies of scale
3. Innovation
4. Funds source
5. Customer relationships
6. Regulatory avoidance
Risk Diversification
International banks depend less on thier domestic economies
Economies of Scale
Expansion lowers a bank's average operating costs
Innovation
Selling new products internationally generates additional returns
Funds source
International banks can find the best and cheapest sources of funds
Customer relationships
International banks can better meet the needs of their multinational clients
Regulatory avoidance
International banks can pursue activities abroad that are regulated against domestically
3 disadvantages of international expansion
1. Information/monitoring costs
2. Nationalization/Expropriation
3. Fixed Costs
Information/monitoring costs
International banks must monitor their foreign investments closely. Information consts on those investments may be higher than they would be domestically.
Nationalization/Expropriation
Changing governments may lead to nationalization of a bank's foreign branches
Fixed Costs
It is expensive to establish a foreign branch
6 types of banking regulations
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
Safety and Soundness regulation
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.
Monetary policy regualtion
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.
Credit Allocation regulation
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.
Consumer Protection regulation
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
Investor protection regulation
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
Entry and chartering regulation
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.
Regulatory history leading up to the financial services modernization act
- 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
Glass Steagall Act
- 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
Financial Services Modernization Act
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
Banks before 1999
- 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
Fuctionally regulated
Bank regulators regulate the banking activites and state insurance regulators regulate the insurance activities
- Financial services holding companies are functionally regulated
Nonbank bank
is a bank divested of either its commercial loans or its demand deposits.
the Bank Holding Company Act of 1956
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
Intrastate banking
- 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
The McFadden Act (1927, amended in 1933)
- 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.
The 1956 Douglas Amendment
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
1970 Bank Holding Compnay Act Amendments
closed the loophole
The Riegle Neal Act (1994)
allowed US and foreign banks to branch interstate, generally through acquisitions and mergers, making full interstate banking a reality in these US
History of guarantee funds
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
The FDIC improvement Act (1991)
restructured the bank insurance fund. The funds finances have improved since then and bank failures are down again.
The Federal Savings and Loan Insurance Corporation (1934)
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.
The Financial INstitutions Reform, REcovery, and Enforcement Act (1989)
restructured the fund, renamed is SAIF and placed is under FDIC control
The 2001 FDIC proposal for Deposit Insurance Reform suggested
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
Deposit Insurance Premiums Ought to be Risk-based
to reduce the moral hazard of deposit insruance
- Penalizing FIs for investing in high-risk assets enourages them to reduce their risks.
Balance Sheet regulations:
Commercial Bank liquidity
regulators impose minimum liquid asset reserve requirements, which vary according to the type, scope and country of the commercial bank
Balance Sheet regulations:
Leverage
The FDICIA requires banks and thrifts to maintain minimum capital requirements relative to their assets.
2 different capital requirements:
Capital-to-asset ratio
Risk-based capital ratios
Capital-to-asset ratio
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)
The Capital-to-assets ratio is subject to 3 weaknesses
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
Risk based capital ratios
compenstae for the different credit risks of assets and off-balance sheet assets whose values are adjusted for approximate credit risk
1993 Basel Accord (aka Base I)
imposed risk based capital ratios on banks in major industrialized companies
Risk based capital ratios distinguish between
Tier I capital and Tier II capital
Tier I capital
the book value of the common equity + an amoutn of perpetual stock + minority equity interests held in subsidiaries - goodwill
Tier II capital
secondary captial resources, such as loan loss reserces upto 1.25% of risk-adjusted assets
Risk adjusted assets
are on-balance and off-balance sheet assets whose values are adjusted for approx credit risk
Total Risk based capital ratio
(Tier I capital + Tier II capital / risk adjusted assets)
Must not fall below 8%
Tier I capital ratio
(Tier I capital / risk adjusted assets)
Must not fall below 4%
If total risk based capital ratio falls below 8% or Tier I capital ratio falls below 4%
The bank is immediately subject to prompt corrective action by the FDICIA
New Basel Accord (Base II)
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
Off balance sheet regulations
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
Foreing versus domestic regulations
Product diversification
Teh Financial Services Modernization Act has made US banks' product diversification comparable to that allowed in most other major industrialized countries
Foreing versus domestic regulations
Global Expansion
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
The Foreign Bank Supervision Enhancement Act (1991)
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.
The World Trade Organization
works to allow foreign banks, insurers, adn securities firms to enter emergin market countries
NAFTA
lets US and Canandian banks expand into Mexico
Thrift Institutions
include savings associaitons, savings banks, and credit unions.
Savings associaitons Assets
are mainly residention mortgages
Savings bank assets are mainly
residential mortgages, but also include commercial loans and investment securities
Credit Union Assets
are mainly consumer loans
A savings institution
is either a savings association or a savings bank
Savings Associations
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
in 2004 the largest asset categories for savings assocations were
- mortgages 62%
- mortgage backed securities 14%
- Consumer loans 6%
in 2004 the largest laiblity categories for savings assocations were
- Deposits 60%
- borrowed funds 22%
- Federal funds and repos 5%
Savings banks
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.
Reasons for the decline in the number of savings institutions
- 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.
Net interest margins
interest income - interest expense / earning assets
disintermediation
withdrawls of deposits to be reinvested into more lucrative money market mutual fund accounts
Regulation Q Ceiling
limited the interest rates savings associations could legally pay on traditional savings accounts and retail time deposits
Depositiory Institution Deregulation and Monetary Control Act of 1980 and the Garn - ST. Germain Depository Institutions Act of 1982
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)
in the mid 1980s the collapse of the Texas and southwest real estate market and the nationwide recession caused....
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
Financial Institutions Reform, Recovery, and Enforcement Act (1989)
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
Federal Deposit Insurance Corporation Improvement Act (FDICIA) (1991)
introduced risk based deposit insurance premiums and methods for closing banks faster
Organization Structure of Credit Unions
- 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
Corporate credit unions
cooperatively owned by a group of member credit unions
Largest asset categories (uses of funds) for credit unions (in 2004)
1. consumer credit (33%)
2. home mortgages (32%)
3. US government securities (19%)
Largest liability categories (uses of funds) for credit unions (in 2004
1. small time deposits and savings deposits (66%)
2. checkable deposits (11%)
3. Large time deposits (9%)
Thrift Insurance Regulators
1. Office of Thrift Supervision
2. FDIC
3. National Credit Union Administration
4. State Regulators
Office of Thrift Supervision
Charters and examines all federal savings institutions and supervises the holding companies of savings institutions
FDIC
A. overseas SAIF, which provides insurance for savings associations
B. supervises, examines, and provides insurance for savings banks
National Credit Union Administration (NCUA)
regulates federally chartered credit unions
State regulators
regulate state-chartered thrift institutions
Finance companies
- 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
3 types of finance companies
1. Sales finance institutions
2. Personal credit instituations
3. Business credit institutions
Sales finance institutions
make loans to customers of a specific retailer of manufacturer
Personal credit institutions
make loans to consumers
Business credit institutions
make loans to coprorations, usually through equiment leasing and factoring
factoring
buying accounts receivable at a discount and then collecting them
Captive finance company
finances the purchasing of products manufactured by its parent
Finance company assets:
Real estate loans
- 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
Finance company assets:
Consumer loans
- major type of consumer loan is motor vehicle loans and leases.
- Finance companies that lend to high risk customers are called subprime lenders
Finance company assets:
Business Loans
- 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
Securitize mortgage assets
- Mortgages packaged and used to back secondary market securities
- A real estate loan protfolio can contain first mortgages and home equity loans
Loan Sharks
are subprime lenders that lend to very high risk customers and charge very high interest rates
2 major types of finance compay business loans are
1. equipment loans
2. retail and wholesale motor vehilcle loans and lease
Finance companies prefer leasing to lending because
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
Finance companies are lightly regulated becasue
they do not accept deposits and thus do not come under the jurisdiction of bank and thrift regulators
Finance companies signal their safety and solvency to their investors by
- holding higher capital-to-assets ratios than banks
- providing default protection guarantees and letters of credit
Foreign finance companies are often subsidiaries of foreign commercail banks thus...
their financial heallth is closely tied to their parents' financial health
In addition to life insurance, life insurers provide
- 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)
Adverse selection occurs
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
Ordinary Life
- accounts for 59% of the life insurance policies in force in the US.
- ordinary policies are usually marketed individually
5 basic Ordinary life contracts
1. Term
2. Whole
3. Endowment
4. Variable
5. Universal
Term Life
- 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
Whole LIfe
- 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
Endowment life
- 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
Variable life
- invests fixed premium payments in mutual funds
- the policy's cash value increases adn decreases with the value of the mutual funds
Universal life
- 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
Group life
- 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
Credit life
accounts for less than 6% of the life insurance policies in force.
- protects the lender against the borrowers death prior to debt repayment
An annuity
- 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
Private Pension fund
- 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
Accient and health insurance
- 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
Life Insurance Assets
- 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
Life Insureres' 4 largest asset categories in 2004
1. corporate securities 69.6%
2. government securities 11.8%
3. mortgages 6.7%
4. policy loans 2.6%
Policy loans
loans made to policyholders using thier policies as collateral
The largest life insurer libility
Policy Reserves, (48.2%)
Policy Reserves
- 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.
The 2nd largest life insurer liability
separate account busines (30.5%)
Separate account business
includes annuity programs in which each policy's payoff is linded to assets in which policy premiums are invested.
The 3rd largest life insureres liability
guaranteed investment contracts (7.5%)
Life Insurance Reguations:
The McCarran-Ferguson Act
(1945)
- 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.
State Insurance guaranted fund
requires annual contribuations from insureres which contributions are then used to compensate insureds in the even of life insurer failures
Unlike bank deposit insurance, insurance guarantee fund:
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
P&C insurance is dominated by it's top firms
The top 10 firms (about 1600) have 45% share of the market while the top 200 firms combined have 95% market share.
Net Premiums Written (NPW)
is the entire amount of premiums on insurance contracts written
The 5 larges P-C lines
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
The 2 priniciple liabilities of P-C insurers
1. loss reserves plus loss adjustment expenses
2. unearned premiums
Unearned premiums
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
Teh priniciple measuers of profitability for property-casualty inseres are related to 3 areas of P&C UW risk
1. Loss Risk
2. Expense risk
3. Investemnt yield or return risk
Loss Risk
the risk that losses will be hirhger than predicted.
- decreases with the predictability of losses
4 characteristics that affect predictibility
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
Loss Ratio
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
Expense Risk
risk that expenses will be higher than predicted.
2 sources of expense risk
1. Loss adjustment expenses (LAEs)
2. commissions and other expenses
A typical P&C insurer expense ration ranges from 25% - 29%
combined ratio
measures overall underwriting profitability. If ratio exceeds 100 the insurer must rely on investment income for profitability
= loss ratio + expense ratio
Investment yield or return risk
the risk that investment yields will be lower than predicted
Operating ratio
measures overall profitability.
= combined ratio - investment yield
Most P&C insurers invest their premiums in ....
Treasury and corporate bonds, which provide reliable returns and a predictable stream of cash flow
P&C insurers are chartered and regulated at the state level.
Auto and WC lines are...
subject to rate regulation mativated by social welfare, which reduces insurer profitability in those lines
US insureres currently lead the world market in premiums written both in P&C and life...
Japan, Germany, and the United Kingdom are our most powerful competitors.
Services offered by securities firms and investment banks
- 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.
3 major typses of xecurities and investement firms
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
National full line banks that sever retail and corporate customers act as
a. Broker - dealers for retail customers (trading existing securities)
b. underwriters for corporations (issuing new securities)
Specialized and regional firms - 5 types
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
Securities firm and investment bank activities
1. investing
2. investment banking
3. Market making
4. Trading
5. Cash Management
6. Mergers and Acquisitions
7. Other services
Investing
Securities firms compete with commercial banks, life insurers, and pension funds to manage pools of assets
Investment banking
investment banks underwrite and distribute new securities issues.
Securities Underwriting
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.
A bank that offers best underwriting efforts
acts as a securities distributor without guaranteeing a price to the issuer
A bank that offers firm commitment underwriting
A. buys the securities at a guaranteed price and then
b. tries to sell them to the public at a higher price
Market Making
creates a secondary market in an asset.
Agency transactions and Principal transactions
Agnecy Transactions
are 2 way transactions for customers, such as buying stock from one customer and selling it to another
Principal transactions
are transcation for the investment bank's own account, such as buying stock and holding itin the expectation of a price increase
6 types of trading activities
1. Posting trading
2. Pure arbitrage
3. Risk arbitrage
4. Program trading
5. stock brokerage
6. Electronic brokerage
Position Trading
buys a large block of security in the expectation of a price increase
Pure arbitrage
buys an asset in one market and then immediately sells that asset in another market at a higher price
Risk arbitrage
buys securities in anticipation of some new information
Program trading
the simultaneous, computer-assisted buying and selling of a protfolio of atleast 15 different stocks valued at greater than $1 million
Stock Brokerage
trades securities on behalf of individuals
Electonic brokerage
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
Cash Management
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
Mergers and Acquisitions services
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
"Other Services"
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?
Industry balance sheet characteristics:
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
The Securities and Exchange Commission
Overseas securities firms' underwriting and trading activities and sets regulatory standards for th eentire industry
The New York Stock Exchange
Provides day-to-day regulation of trading practices
The National Association of Securities Dealers
provides day-to-day regulation of trading practices in the over-the -counter markets
The Securities Investor Protection Corporation
The guarantee fund that protects investors against losses up to $500,000 for securities firm failures
The purpose of a mutual fund
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
Mutual fund shareholder services (5)
1. Free exchange of investments
2. automatic investing
3. check writing privileges
4. automatic reinvestment of dividends
5. automatic withdrawls
Open-end Mutual funds
sells new shares to investors and redeems outstanding shares on demand at their fair market value
Money Market Mutual Funds invests in
securities with original maturitites of less than one year
Bond or Equity fund invests in....
securities (bonds or stocks) with original maturities of one year or more
Commercial banks participate in the mutual fund industry by...
buying existing mutual fund groups or managing mutual fund assets for fees
4 types of Mutual Funds
1. Equity Fund
2. Bond Fund
3. Hybrid Funds
4. Money Market Mutual Fund
Equity Fund
- contains common and, possibily, preferred stock
- tends to stress world equity, growth or income
Bond Fund
- contains fixed-income securities with matuirities of more than one year
- tend to stress high yields or strategic income
Hybrid fund
- contains stocks and bonds
- tends to stress asset allocation, balance, flexibility or mixed income
Money Market Mutual Fund
contains a mix of money market securities with original maturities of under one year.
- May be income tax taxable or tax exempt
Long term mutual funds
Equity, bond, and hybrid funds
Short term mutual funds
Money Market mutual funds
Mutual fund prospectus
states its objective and lists the securities that fund holds
3 elements of a mutual funds portfolio returns:
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
Net Asset Value (NAV) of a mutual fund
= the market value of a fund's assets/the # of outstanding shares
A closed end investment company
- 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
A real estated investement trust (REIT)
is a closed end investment company that invests in real estate company shares and/or large mortgages
Sales Load
the agent's one-time sales commision charge.
a load fund
has an up front sales or commission charge.
No load funds are more popular because
investors would reather pay less for funds than recieve the extra personal attention of a sales agent
Sales load can be "annualized"
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.
2 costs of investing in a mutual fund
1. Sales load
2. fund operating expenses
In the 90s and 2000s long term mutual funds did two things
1. increased their holdings in corporate equities
2. decreased their relative holdings in US and municipal securities
Mutual Fund Regulation
The Securities and Exchange commission
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
Mutual Fund Regulation
The National Association of Securities Dealers
supervises mutual fund share distributions
Mutual Fund Regulation
The investment Company Act
prevents conflicts of interest, fraud, and excessive fees for fund shares
Mutual Fund Regulation
The Insider Trading and Securities Fraud Enforcement Act
requires mutual funds to develop procedures for avoiding insider trading abuses
Mutual Fund Regulation
The Market Reform Act
let the SEC halt trading on exchanges and restirct program trading.
Mutual Fund Regulation
The National Securities Margets Improvement Act
exempts mutual fund sellers form oversight by state securities regulators
Pension Funds
offer their investors the advantages of retimtent planning and tax deferred savings.
A private pension fund
administered by a private corporation, such as a life insurer or mutual fund
A pulbic pension fund
is administered by a federal, state or local gov't
A pension plan
is the document that governs the operation of a pension fund
An insured pension fund
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
A noninsured pension fund
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
A defined benefit pension
- Pays each employee a specific cash benefit upon retirement.
- The benefit formula is generally based on years of employment and salary during employment
The flat benefit Formula
- pays a flat amount for every year of employment
- employees who work longer get higher benefits
The career average formula
- bases benefits on the employee's average salary over the employee's entire employment period.
The final pay formula
- 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
Fully funded plan
has enough funds set aside to meet promised payments
underfunded plan
has too few funds set aside
overfunded plan
has more than enough funds set aside
Defined Contribution Pension
requires each employee to contribute a specified amount to the pension fund at regular intervals.
Fixed income funds
guarantee a minimum rate of return
Variable income funds
do not guarantee a minimum rate of return, but do fluctuate with the value of the underlying assets.
401(K) or 403(B) palns
an employer sponsored plan that supplements a basic retirement plan.
The 4 general charactereistics of 401(K) and 403(b) plans
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.
Individual Retirement Account
(IRA)
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
3 advantages of IRAs
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.
a ROTH IRA taxes contributions in the year of each contribution, making withdrawals tax free if the withdrawer.....
1. is at least 59 1/2 years old
2. has invested the funds for at least 5 years
2 advantages of ROTH IRAs
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
Keogh Account
- a retirment account for a self-employed individual
- Contirubtions and accumulations are tax-deferred, and partiipants have some control asset allocation
Public Sector Pension
- 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
Public Sector Pensions become underfunded when...
- the # of current employees fall
- the # of retired employees rises and/or
- retired employees live longer than expected
2 types of federal gov't pensions
- Funds for federal gov't employees
- Social Security
Funds for federal governement employees
- 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
Social Security
- 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
Asset structure of private pensions
- 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
The Employee Retirment Income Security Act
- 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
ERISA requirements -
Underfunding
- 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
ERISA requirements -
Vesting
Pension plans must have minimum vesting requirement, and can not exceed a vesting period of 10 years.
ERISA requirements -
Fund Management
Pension fund manters must meet the prudent person rule: They must invest contributions with the same care as a prudent person in similar conditions
ERISA requirements -
Transferability
Emplyees may transfer pension credits from one fund to another when switching jobs.
ERISA requirements -
Insurance
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
Credit Risk of FI
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.
FIs reduce credit risk by
1. screening and monitoring their loan applicants
2. diversifying their credit related assets
Firm specific credit risks
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
Systematic Credit risk
is associated with general economic conditions that affect all borrowers worldwide.
- Asset diversification does not reduce systematice credit risk.
FI's Liquidity Rish
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
FI's liability holders can create liquidity risk
by losing confidence in the bank or by experiencing unexpected needs for cash
a run on a FI occurs
when all or many liability holders w/d their funds at the same time, often resulting in the bank's failure
FIs interest rate risk
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
3 types of interest rate risks
1. Refinance risk
2. reinvestment risk
3. present-value uncertainty
refinance risk
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
Reinvestment risk
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
Present-value risk
- 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
FIs Market risk
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
FIs Off Balance Sheet Risk
is the risk that activities related to contingent assets and liabilities will cause the FI to lose money
FIs off balance sheet activities
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
Foreign Exchange Risk
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
Country or Sovereign risk
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
Technology risk
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
operational risk
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
Insolvency risk
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.
What outside factors can affect FI's risks
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)
2 types of liquidity risk
1. Liability side liquidity risk
2. Asset side liquidity risk
Liability side liquidity risk
liability holders might w/d their financial claims (deposits) creating a need for cash
Demand deposits accounts
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
Core deposits
are rarely w/d providing a stable long term source of funds
The net deposit drain
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
Time deposit accounts
savings accounts
- they are less prone to w/d
Disintermediation
is the withdrawing funds from banks to then reinvest them elsewhere to earn higher interest rates
Asset side liquidity risk
holders of off balance sheet commitments might excercise those commitments converting them into assets that must then be balanced by add'l liabilities
Purchased liquidity
- 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
purchased liquidity - ADVANTAGES
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.
purchased liquidity -
DISADVANTAGES
are not covered by deposit insurance
- can be expensive because the buyer must pay the market interst rates for funds
Stored liquidity
cash raised through cash reserves adn the sale of assets
Stored liquidity -
ADVANTAGES
is less expensive than purchased liquidity
Stored liquidity -
DISADVANTAGES
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
5 measures of liquidity
1. Net liquidity statement
2. Maturity ladder
3. Peer group ratio comparisons
4. Liquidity index
5. Financing gap
Net Liquidity statement
lists sources and uses of liquidity, and thus provides a general measure of liquidity
Maturity ladder
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
Peer group ration comparisions
compare the banks dey rations to those of similar banks
high loans/deposits ratio and/or high borrowed funds/ total assets ration indicates...
heavy reliance on the short term money market
A high commitments-to-lend/ assets ratio indicates....
a need for high liquidity
Liquidity index
compares fire-sale asset prices and fair market prices to measure the potential loss from a sudden sale of assets at fire sale prices.
financing gap
equals average loans minus core deposits
- if the gap is positive, the bank must liquidated assets or borrow funds to bridge the gap
The financing requirement equals
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
How banks manage liquidity
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
Liquidity planning
lets a bank set its borrowing priorities before liquidity problems arise, lowering the bank's cost of funds and minimizing its excess reserves
4 components of liquidity plan
1. managerial details and responsibilities
2. W/d patterns
3. w/d sizes and sources of funds
4. Internal borrowing limits
Managerial details and responsibilities
appoint managers responsible for interacting with regulatory agencies and disclosing information to the public, in the event of a liquidity crisis
Withdrawal patterns
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
Withdrawal sizes and sources of funds
- 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
Internal borrowing limits
- 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
A bank run
is a sudden, unexpected w/d of deposits from a bank
A bank run may be triggered
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
A bank panic occurs
when depositors lose their faith in the banking system as a whole, creating many simultaneous bank runs
The banking system has 2 major liquidity risk insulation mechanisms
1. deposit insurance
2. discount windows
Deposit Insurance
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
Discount window
provides short term loans to banks at the discount rate
Life Insurers liquidity risk exposures:
The surrender value nof a life insurance policy
is that portion of the poicy value the insurer must pay if the policyowner cashes in the policy before it matures
In order of preference, life insurers raise cash to pay surrender values by ....(4)
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
P&C insurers liquidity risk
CLAIMS
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
PC insurers liquidity risk
CANCELLATIONS
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
State Guarantee funds differ from deposit insurance in 4 ways
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
Mutual Funds' Liquidity Risk Exposures
- 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
Bank run vs. Mutual fund run
- 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
Roles of FIs in financial markets
- 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
Without FIs
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
3 disadvantages to direct invesment
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
FIs reduce monitoring costs
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.
FIs transform assets
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
FIs reduce transaction costs
Conduct transactions more efficiently than individual investors by using "economies of scale"
(cost reduction from increased efficiency)
FIs act as maturity intermediaries
- 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
FIs act as denomination intermediaries
- 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.
FIs transmit monetary policy
The size of the money supply is determined largely by band and/or thrift deposits
The federal reserve uses it control over depository institutions to:
- Control the money supply and thus control the rate of inflation
Money Supply
the measure of the money stock in a nation
FIs allocate credit
- 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
FIs can act as time intermediaries
Pension and life insurance funds let savers trasnfer wealth from their youth to their old age, or from ongeneration ot the next
FIs provide payment services
Depository institutions provide check clearing and wire transfer services to speed up the payment process amoung buyers and sellers
FIs do these 9 things through indirect transfer
- 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
The Securities and Exchange commission (SEC)
regulates financial markets by:
1. emphasizing full and fair disclosure of information
2. monitoring markets for evidence of insider trader
Foreign Exchange Markets
- Financial markets in other countires, denominated in currencies other than US dollars
- risk depreciation of that foreign currency relative to the dollar
Primary Market
- Trades newly issued securities
- Corporations can rais money by selling newly issued stocks to investors
Investment Banks
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
Initial Public Offering (IPO)
A corporations first public issue of financial instruments
Secondary Market
- 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
Derivative securities
securities whose payoffs are linked to other previously issued securities
Secondary markets benefit both buyers and sellers by
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
The Money Market
- 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
The capital market
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
10 riskes face by FIs
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
Credit risks
the risk that promised cash flows from loans and securities held by FIs will not be paid in full
Foregin exchange risk
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
Country or sovereign risk
the risk that repayments from foreign borrowers will be interrupted due to interference from foreign government
Interest rate risk
occurs when the baturities of the FIs assets and liabilites are mismatches
Market Risk
the risk that changes in interest rates, exchange rates and other prices will result in trading losses
off balance sheet risk
the risk that the FI will lose money due to activities related to contigent assets and liabilities
Liquidity risk
the risk that a surge in liabilitiy withdrawals will force the FI to liquidate assets a low prices
Technology risk
the risk that technological investments won't produce the expected savings
Operational risk
the risk that existing technology or support systems will break down
Insolvency risk
the risk that the FI won't have enough capital to offset a sudden decline in the value of its assets
5 factors that have caused the globalization of financial markets
- 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
Eurodollar bonds
- 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
The federal reserve
- 12 Federal Reserve Banks
- Each located in one of 12 Federal Reserve districts
- 7 member board of governors (located in DC)
Most income of Federal Reserve Bands come from...
- Interset on government securities
- interest on bank reserves
- fees fro services provided to member banks
4 major functions of the federal reserve
1. Conduct monetary policy
2. supervise and regulate depository institutions
3. stabilize the financial system
4. Provide financial services
Federal Reserve conducts monetary policy
- the FRB presidents serve on the Federal Open Market Committee
- set and change the discount rate
Discount rate
the interest rate on "lender of last resort" loan made by Federal Reserve Banks to depository institutions
The Federal Reserve Banks supervise and regulate depository institutions
- examing banks, issue warnings to bansk about unsafe practices and approve applications for expanded activities
The Federal Reserve stabilizes the financial system
through monetary policy and through supervisory and regulatory activities
Federal reserve banks provide financial services
- 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
2 wire transfer services operate by the Federal reserve
The Fedwire adn automated Clearinghouse
The Federal Reserve Board
- 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
Federal Open Committee
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
The Federal Open Market Committee sets guidelines regarding....
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.
The major assets of the Fed's balance sheet
- Teasury securities, treasury currecny gold and foreign exchange
- The fed owns substantial treasury because its open market operations involve buying and selling treasury securities
Majory liabilities on the Fed's balance sheet
1. Currency in circulation
2. Reserves
Money base or Monetary base
Teh sum of currency in circulation and reserves
Money Supply Definitions
M1
- 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
Money Supply Definitions
M2
M1 PLUS deposits and small denomination time deposits and balances in reatil money market mutual funds
Money Supply Definitions
M3
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
Reserves
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)
excess reserves
- earn no interest, banks trade excess reserves among themselves at the fed funds rate
Fed funds rate
benchmark interest rate used to guide monetary policy
By changing the fed funds rate or required reserve, the fed can....
1. reduce inflation, encourage low unemployment
and/or
2. control economic growth
Open Market Operations
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
When the Fed buys securities
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
The increase in money supply equals
(1/reserve requirement)(open market purchases)
When the Fed sells securities
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
Repurchase Agreements
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
Discount Rate
- 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
Reserve Ratio
- 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.
The Change in bank deposits equals
(1/reserve requirement) (Cahnge in reserve created by new reserve requirement change)
3 types of discount window loans
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.
Expansionary Activities
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
Contractionary Activities
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
The Fed can't target both interest rates and the money supply simultaneoulsy because...
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