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71 Cards in this Set

  • Front
  • Back

What is a security? What are the 2 types of securities?

A security is a financial instrument used as a claim on the issuer's future income or assets; the 2 types of securities are bonds and stocks.

What is an interest rate?

An interest rate is the cost of borrowing funds.

What is the business cycle?

The business cycle consists of short-term fluctuations in growth and decline in GDP.

Financial intermediaries

Institutions that borrow funds from individuals and make loans to others.

What is the difference between monetary and fiscal policy?

Monetary policy - management of the money supply and interest rates (Fed)

Fiscal policy - gov. spending and taxation

Foreign exchange market

Where funds are converted from one currency to another

What is the quantity theory of money? (equation)

In the long run: MV = PY

Money supply x constant = price level x output

What is the aggregate price level? How is it measured?

Aggregate price level - refers to average prices in the economy. It is measured in 3 main ways: GDP deflator, PCE (personal consumption expenditures), and the CPI (consumer price index).

What would happen to consumer spending if stock prices overall were rising?

Aggregate consumer spending would be expected to rise.

How do financial firms promote economic efficiency?

They produce an efficient allocation of capital, which leads to increased production. Financial markets also directly improve the well-being of consumers by allowing them to time their purchases better.

Is everybody worse off when interest rates rise?

Borrowers - lose. They must pay higher interest on loans.

Savers - benefit. They get a higher rate back (e.g. savings account)

What are primary and secondary markets?

- Primary markets - new securities are issued.

- Secondary markets - used to buy and sell previously issued securities (e.g. stock exchanges). They provide liquidity and help determine prices in primary markets.

What do investment banks do in primary markets?

Investment banks underwrite (pledge to buy all remaining shares) securities in primary markets. This gives them the liability.

What do brokers and dealers do? In which market do they work?

Brokers - agents of investors who match buyers and sellers of securities.
Dealers- buy and sell securities at stated prices.
Both work in the secondary market.

What are money markets and capital markets?

Money markets - deal in short-term debt instruments; they are the least risky.

Capital markets - deal in longer term and equity instruments.

U.S. Treasury Bills

Issued by the U.S. government. Usually pay no interest rate but are sold at a price lower than what holder get at maturity. Has the lowest default rate because the government can simply print currency or raise taxes.

Negotiable Bank Certificates of Deposit

Sold by banks to depositors; pays annual interest and original purchase price at maturity.

Commercial paper

Issued by large banks and corporations.

Repurchase agreements

Very short term (less than 2 weeks) - Repos with treasury bills as collateral. Used by large corporations to loan out temporary funds to banks.

Federal funds

Overnight interbank loans of deposits at the Fed

Who are the major holders of stocks?

Major shareholders include individuals, pension funds, and insurance companies.

What are mortgages and who provides them?

Loans for the purchase of land, housing, etc. provided by banks.

What are mortgage-backed securities?

Mortgage-backed securities are bond-like debts whose interest and principals are paid to the holder.

What are corporate bonds? How do they work? Who are the major holders of corporate bonds?

Corporate bonds are issued by large corporations with strong credit ratings. Interest payments are made 2 times a year and pays off face value at maturity. Major holders of corporate bonds are life insurance companies, pension funds, and households.

Describe U.S. government securities:

U.S. gov. securities are issued by the U.S. Treasury to finance federal deficits. They are the most liquid, and are held by the Fed, banks, households, and foreigners.

What are U.S. government securities used for?

They are issued by government agencies such as Ginnie Mae, Farm federal credit bank, farm loans, etc.

Describe state and local government bonds:

Also called municipal bonds. They are issued by state and local governments to finance expenditures on schools, roads, etc. Interest payments on government bonds are income tax exempt. Commercial banks are the biggest buyers, along with wealthy individuals and insurance companies.

Consumer and bank commercial loans

Loans to consumers and businesses made primarily by banks.

What are the different types of mortgage rates?

- 30 year (most common)

- Jumbo rates (for prime customers)

- 5 year adjustable rate (ARM)

- 4 yr. new car loan rate

- 10 yr. treasury rate

Foreign bonds

Sold in a foreign country and denominated in that country's currency (e.g. British company sells bonds denominated in USD in the US)


A bond denominated in a currency other than that of the country in which it is sold.


Foreign currencies deposited in banks outside the home country.


U.S. dollars deposited in foreign banks.

What do world stock markets do?

They help finance the federal government; are gaining importance in the U.S. as well.

What are the functions of indirect financial intermediaries?

- Lower transaction costs

- Economies of scale

- Provide liquidity services

- Reduces exposure of investors to risk

- Allows for risk sharing

- Diversification

How do indirect financial intermediaries help economies and society as a whole (hint hint: adverse selection, moral hazards)

They help deal with asymmetric information problems in 2 ways:

- Adverse selection: gather info about borrowers to ensure that they are likely to pay back.

- Moral hazard: can sign a contract with restrictive covenants (e.g. sign a contract stating you will not use the money for a risky hedge fund, gambling, etc.)

What are commercial banks?

Commercial banks are the largest type of financial intermediary with the most diversified portfolios.

What do savings/loan associations and mutual savings banks do?

They make mortgage loans.

What are credit unions?

Credit unions are small co-operative lenders who usually lend to particular groups (union members, firm employees, etc.)

Life insurance

Offers payments in case of death

Fire and casualty insurance

Insures against fire, theft, accidents, etc. (These firms need more liquid assets than life insurance companies)

What do finance companies do?

Finance companies give short-term loans to consumers and sometimes provide funds to buy a particular product.

What do mutual funds do? What about money market mutual funds?

They sell shares and use the proceeds to purchase a diversified portfolio.

Money market mutual funds are similar but provide more liquidity.

What are hedge funds?

A type of mutual fund with a minimum investment of $100k or more (usually more)

What is money?

Money is anything that is generally accepted as payment for goods or services.

How is money different from "wealth" and "income"?

- Wealth is the total collection of property that serves to store value (e.g. house, bonds, stocks)

- Income is a flow of earnings per a unit of time.

What are the 3 functions of money?

Money serves as a:

- medium of exchange

- unit of account

- store of value

What are the criteria for a medium of exchange?

A medium of exchange must be:

- easily standardized

- widely accepted

- divisible

- easy to carry

- not deteriorate quickly

What is commodity money?

Commodity money refers to money in its past uses (gold, silver, cigarettes). It is easily standardized, has intrinsic value, but is hard to transport.

What is fiat money?

Fiat money is paper money declared by a government as legal tender.

What is e-cash?

With e-cash, an individual can hold a specialized account with a bank which allows cash to be stored in a computer.

Why is bitcoin unlikely to replace cash in the future?

Bitcoin performs less well as a unit of account and as a store of value.

What is included in M1?

- Currency

- Traveler's checks

- Demand deposits

- Other checkable deposits

What is included in M2?

- Everything in M1

- Small denomination time deposits

- Saving deposits + money market deposit accounts

- Money market mutual funds

Define present value and how it works:

A dollar paid to you one year from now is less valuable than a dollar paid to you today

In terms of simple present value, how is present value calculated?

Present value = (future cash flow)/(1=i)^n

What are the four types of credit market instruments?

- Simple loan

- Fixed payment loan

- Coupon bond

- Discount bond

What is a yield to maturity?

The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today. For simple loans, the simple interest rate equals the yield to maturity.

How does a fixed payment loan work? How is the loan value calculated?

The same cash flow payment is given every period throughout the life of the loan.

Loan value = (fixed yearly payment)/(1+i) + (FYP)/(1+i)^2 + (FYP)/(1+i)^3 and so on

How is the loan value of a coupon bond calculated?

Same strategy as fixed payment loan:
Price of coupon bond = (C)/(1+i) + (C)/(1+i)^2...and so on
C = yearly coupon payment

Describe discount bonds

The yield to maturity equals the increase in price over the year divided by the initial price. As with a coupon bond, the yield to maturity is negatively related to the current bond price.

What is rate of return?

Rate of return = the payments to the owner + the change in value

Expressed as a fraction of the purchase price

What is the difference between nominal and real interest rates?

A nominal interest rate does not account for inflation.

A real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing.

Ex ante real interest rates are adjusted for expected changes in the price level, and ex post real interest rates are adjusted for actual changes in the price level.

What are the determinants of asset demand?

- Wealth

- Expected return

- Risk

- Liquidity

Describe the theory of portfolio choice:

Ceterus paribus,

1) The Qd of an asset is positively related to wealth, expected return, and liquidity.

2) The Qd of an asset is NEGATIVELY related to the risk of returns.

Describe supply and demand in the bond market:

At lower prices (higher interest rates), the quantity demand of bonds is higher. Conjointly, at lower prices, the quantity supplied of bonds is lower.

Describe the income effect and price-level effect in terms of shifts in the demand for money (the liquidity preference framework):

A higher level of income causes the demand for money at each interest rate to increase, and the demand curve to shift to the right. A rise in the price level causes the demand to shift to the right as well.

Bonds with the same maturity can have different rates due to:

- Default risk
- Liquidity
- Tax considerations (higher taxes are usually compensated with a higher interest rate)

What is a default risk? Which bonds are considered default-free?

Default risk is the probability that the issuer of a bond is unable/unwilling to make interest payments or pay off the face value. U.S. Treasury bonds are considered default-free.

What is a yield curve?

A yield curve is a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations.

What are the 3 facts (explained by the theory of term structure of interest rates) of interest rates?

1) Interest rates on bonds of different maturities move together over time.

2) When short-term interest rates are low, yield curves are more likely to have an upward slope.

3) Yield curves almost always slope upward.