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96 Cards in this Set
- Front
- Back
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What is the primary purpose of financial markets?
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transfer funds from those who don't have a productive use for them, to those who do
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What type of market determines interest rates?
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bond markets
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What are the four key categories of borrowers/spenders and lenders/savers?
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households, business, government, foriegners
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What maturity of securities trade in money markets vs. capital markets?
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money market: short-term ( <1 yr.)
capital market: long-term ( >1 yr.) plus equities |
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foreign bonds
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sold in a foreign country and are denominated in that country's currency
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Eurobonds
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sold in a foreign country and are denominated in a currency other than that of the country in which they are sold
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Financial intermediaries act to reduce what two items?
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*transaction costs
*asymmetric information |
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Adverse selection
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*before transaction occurs
*potential borrowers most likely to produce unfavorable outcomes are ones most likely to see a loan |
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Moral hazard
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*after transaction occurs
*hazard that borrower has incentives to engage in undesirable activities making it more likely that he will not pay loan back |
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Value of a debt security depends on what 3 items?
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*Amount of cash flow it generates
*Timing of cash flows *Riskiness |
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Discount bond
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*aka: zero-coupon bond
*purchased at a price below face value *does not make interest payments |
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default risk
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risk that a loan customer may fail to repay a loan as promised
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interest rate risk
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possible reduction in returns that is associated with changes in interest rates
*partially offset by reinvestment risk |
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reinvestment risk
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interest-rate risk associated with the fact that the proceeds of short-term investments must be reinvested at a future interest rate that is uncertain
*partially offset by interest rate risk |
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inflation risk
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risk that interest rates will rise
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Which type of bond produces a more volatile return: short-term or long-term? Why?
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long-term bonds because they have higher interest rate risk
*there is no interest rate risk for and bond whose duration equals its holding period |
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When is there excess demand or excess supply in the market? What will happen to bond prices or interest
rates in order to restore market equilibrium? |
*excess demand: demand>supply ; P goes up, i goes down
*excess supply: supply>demand ; P goes down, i goes up |
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Do the following factors shift the demand curve for bonds? If so, which direction? Why?
a. Wealth b. Expected (nominal) interest rate c. Expected inflation rate d. Riskiness of bonds relative to other assets e. Liquidity of bonds relative to other assets |
Yes all of them, (pg 40-41)
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Do the following factors shift the supply curve for bonds? If so, which direction? Why?
a. Profitability of investments b. Expected inflation rate c. Government deficit |
Yes all of them, (pg 42-43)
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Analyzing changes in both demand and supply, what is the net effect of an increase in the expected inflation
rate? What do we call this “effect”? |
*Fisher Effect: when expected inflation rises, nominal interest rates also rise (nominal = real + inflation)
(pg 43-44) |
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During a recession, there is a decrease (leftward shift) in both bond supply and bond demand. What is the
impact on the equilibrium interest rate and price of bonds in the following situations?: a. The decrease in supply exceeds the decrease in demand b. The decrease in demand exceeds the decrease in supply |
a. P is higher, i is lower
b. P is lower, i is higher |
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During recessions observed over the period 1951-2010, have interest rates more commonly risen or fallen?
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fallen
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Remember that in equating the Bond Market Perspective and Loanable Funds Framework, supplying a bond
is equivalent to demanding a loan. Similarly, demanding a bond is equivalent to supplying a loan |
Remember that in equating the Bond Market Perspective and Loanable Funds Framework, supplying a bond
is equivalent to demanding a loan. Similarly, demanding a bond is equivalent to supplying a loan |
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Suppose an investor is trying to decide whether to invest in either corporate bonds or Treasury bonds.
a. When there is an increase in the default risk of corporate bonds, what happens to the demand for corporate bonds? What about the demand for Treasury bonds? Does this increase (widen) or decrease (narrow) the risk premium on corporate bonds? Hold supply constant in both markets. b. When there is a decrease in the liquidity of corporate bonds, what happens to the demand for corporate bonds? What about the demand for Treasury bonds? Does this increase (widen) or decrease (narrow) the risk premium on corporate bonds? Hold supply constant in both markets |
pg. 56
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Complete the following sentence: Investment-grade bonds correspond to a S&P bond rating of ____ and
above. Non-investment grade (aka “junk” bonds) correspond to a S&P bond rating of ____ and below. |
AAA-BBB, BB-D
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Why do municipal bonds tend to produce a lower yield than Treasuries?
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because muni bonds are exempt from federal income taxes
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What are the basic assumption(s) and implication(s) of the following theories of the term structure?:
a. (Pure) Expectations Theory b. Market Segmentation Theory c. Liquidity Premium Theory See the middle of CN p. 61. Be able to recall which of the three theories of the term structure can explain which of these three questions. How do the Pure Expectations and Liquidity Premium theories compare in terms of the slope of their yield curves? |
pg 61-68
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Which theory of the term structure best explains the desire to “maturity match” assets
and liabilities? |
Not sure
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Under the Liquidity Premium Theory, we can use the yield curve to draw inferences about expected future
short-rates. In each of the following cases, are short-rates expected to (i) rise, (ii) not change much, (iii) fall moderately, or (iv) fall sharply? a. Steeply upward sloping yield curve b. Flat yield curve c. Slight upward sloping yield curve d. Slight downward sloping yield curve |
a. rise
b. fall moderately c. stay the same d. fall sharply |
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If given two exchange rates occurring at different points in time, be able to infer whether the currency
appreciated or depreciated and what this change in value implies in terms of the demand for domestic goods and foreign goods. |
(New - Old) / Old
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What is the law of one price?
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If two countries produce an identical good, and transportation and trade barriers are very low, the price of the good should be the same throughout the world no matter who produces it.
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What is the theory of purchasing power parity?
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PPP states that exchange rates between any two countries will adjust to reflect changes in the two countries.
*PPP is an application of the LOP to national price levels |
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We discussed four key factors that affect exchange rates in the long run. Know what these factors are and
how they affect exchange rates. |
*Relative Price Level*
-in the long run, rise in country's price level causes its currency to appreciate *Tariffs and Quotas (trade barriers)* -in the long run, increasing trade barriers causes a country's currency to appreciate *preferences for domestic vs. foreign goods* -in the long run, increased demand for domestic country's exports causes its currency to appreciate, while increased demand for imports causes the domestic currency to depreciate *productivity* -in the long run, as a country becomes more productive relative to other countries, its currency appreciates (pg 81-82) |
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Know the maturities of the three classes of Treasury securities that we studied.
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treasury bill: less than a year
treasury note: 1-10 years treasury bond: 10-30 years |
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Know the basic difference between general obligation bonds and revenue bonds (i.e., which type of bond is
backed by cash flows, and which is not?). |
*general obligation bonds: backed by "full faith and credit" of the issuer, not backed by specific assets
*revenue bonds: backed by the cash flow of a particular revenue-generating project |
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Be able to rank the following types of bonds by their priority claim in assets: secured bonds, debentures, and
subordinated debentures. Which bond(s) are backed by collateral? Which of these three theoretically carries the lowest interest rate? |
1. secured bonds: bonds with collateral attached, least risky and lowest interest rate
2. debentures: backed by general credit worthiness of the issuer 3. subordinated debentures: similar to debentures but have a lower priority claim |
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A credit default swap (CDS) involves a bond issuer, bondholder, and CDS seller. If a bond issuer defaults,
which of these three parties has assumed the responsibility of delivering on the bond? |
CDS seller, about 25 trillion $ in CDS outstanding right now
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Be familiar with the following bond definitions: coupon interest rate, market rate, yield to maturity, and
indenture. |
*coupon interest rate: stated annual interest rate on the bond, usually fixed for the life of the bond
*market rate: interest rate currently in effect in the market for securities of like risk and maturity, market rate is used to value bonds *yield to maturity: the yield an investor will earn if the bond is purchased at the current market price and held until maturity *indenture: |
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Be able to rank the following types of securities by their priority claim in assets: preferred stock, common
stock, and bonds. |
1. bonds
2. preferred stock 3. common stock |
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What is an exchange traded fund (ETF)? What is an advantage and disadvantage of ETFs?
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*ETF: recent innovation where a basket of securities is purchased and a stock is created based on the basket, it is then traded on the exchange
-advantage: certain valuation -disadvantage: requires a commission |
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What are the two main assumptions underlying the Gordon Growth Model?
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*dividends grow at a constant rate, forever
*growth rate is greater than required rate of return on equity |
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Know the number of stocks in the DJIA, S&P 500, and NASDAQ Composite, and know which of these is
price-weighted vs. market-value weighted. |
*DIJA: 30 industrial stocks, price-weighted
*S&P 500: 500 large-cap common stocks, market-weighted *NASDAQ Composite: over 3,000 stocks, market-weighted |
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In the context of IPOs, be familiar with the following definitions: underwriter, underpricing,
hot issue market, after-market, and selling stockholders. |
*underwriter: assist the company going public by pricing and marketing the initial offering of stock
*underpricing: when initial offering price is well below the closing price on the first day of trading *hot issue market: market where IPOs are in hot demand, substantial underpricing (large pops) are particularly prevalent in hot issue markets *after-market: begins on te first day of trading and usually ends several months or one year after the IPO *selling stockholders: existing stockholders with the ability to sell all or part of their stake in the company during an IPO |
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In the context of stocks, what is short selling?
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*writer is short the asset
*short-seller is short the stock, needs to purchase it at some point in time to "cover" their position |
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What are the two primary disadvantages of forward contracts?
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*lack of liquidity
*subject to default risk |
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Why might an individual choose to invest in a financial futures contract over a forward contract? We
discussed four reasons. |
*Liquidity: more liquid and sold in standardized markets
*Limited ability to corner the market *Protection against losses: marked to market daily *No delivery requirement |
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What is the fundamental difference between an American option and an European option?
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*American: may be exercised before they expire
*Euro: only exercisable at expiration |
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What is the fundamental difference between a hedger and a speculator?
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*hedger: option trader who has or will have a position in the asset
*speculator: option trader who has no position in the asset |
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Be able to rank the following bank assets from most liquid to least liquid: commercial loans, securities,
reserves, and physical capital |
1. Reserves
2. Securities 3. Commercial Loans 4. Physical Capiatal |
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What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?
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*benefit cushion: less likely to become insolvent in cases of larger loan losses
*cost: all else equal a lower ROE |
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Are profits affected when the bank records a Provision for Loan Losses? Assuming a sufficient balance in
the Allowance for Loan Losses account, are profits affected when the bank actually writes off a bad loan? |
pg 148-156
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Given a bank’s Balance Sheet, be able to identify whether the following accounts are Assets or Liabilities to the bank: Borrowings, Cash, Cash Items in the Process of Collection, Checkable Deposits, Deposits at Other Banks, Loans, Nontransaction Deposits, Reserves, and Securities.
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*Liabilities: Checkable deposits, Non-transaction deposits, Borrowings,
*Assets: Loans, Deposits at other banks, Cash items in the process of collection, Reserves, Securities |
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Which liability represents a bank’s lowest cost funds?
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Checkable deposits
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What is the primary source of bank liabilities? Of bank assets?
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*Liabilities: Non-Transaction Deposits (savings accounts, time deposits)
*Assets: Loans (business loans, car loans, mortgages) |
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Know the definitions of Discount Loans, Fed Funds, and Interbank Offshore Dollar Deposits.
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*Discount Loans: loans from the Fed
*Fed Funds: loans from banks to other banks (NOT FROM THE FED) *Interbank Offshore Dollar Deposits: deposits denominated in US dollars residing in foreign banks or foreign branches of US banks |
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Reserves pay only a nominal amount of interest (and sometimes none at all), so why do banks hold them?
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*to comply with the law, banks must hold a certain fraction of checkable deposits (i.e. 10%)
*to maintain liquidity and meet obligations when funds are withdrawn, banks hold excess reserves |
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A bank taking deposits and using the funds to make a mortgage loan is an example of what? Is this process
an important or unimportant role of the bank? |
*asset transformation
*important |
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Banks tend to borrow short and lend long. What is an example of borrowing short? Of lending long?
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*borrow short: checkable deposits
*lend long: mortgages |
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In managing its assets and liabilities, what are a bank’s four primary concerns?
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*Liquidity management
*Asset Management *Liability Management *Managing Capital Adequacy |
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What are the four ways in which a bank can replenish its reserves?
a. Which of these methods is most costly? b. What Balance Sheet accounts are affected in each method? c. Which of these methods are asset-side transactions (i.e., only involve increasing and decreasing asset accounts)? d. Which of these methods involve asset and liability accounts? |
*borrow funds from other banks in the federal funds market or to borrow from corporations
*sell some of its securities *acquire reserves by borrowing from the Fed *reduce loans and deposit the reduction with the Fed pg 142-143 |
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What are the objectives of a bank’s Asset Management?
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*diversify
*manage liquidity *buy securities with high return, low risk *get borrowers with low default risk, paying high interest rates |
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What is a subprime mortgage?
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type of mortgage geared for borrowers with higher risk of default, set up to have higher interest rates
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How does ROE change when there is an increase or decrease in a bank’s (1) net income, and/or (2) equity
capital? |
1. net income goes up, ROE goes up
2. equity capital goes up, ROE goes down |
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Off-balance sheet activities involve what?
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financial instruments and generating income from fees and loan sales
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What is a loan sale?
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involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank's balance sheet
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What are some examples in which banks can generate free income?
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*foreign exchange trades for customers
*servicing mortgage backed securities *guarantees of debt *backup lines of credit |
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What is a loan commitment?
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*type of backup line of credit
*for a fee, the bank agrees to provide a loan at the customer's request, up to a given dollar amount, over a specified period of time |
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What off-balance sheet activities are used to manage interest rate risk?
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*financial futures and options
*foreign exchange trading *interest rate swaps |
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In the context of bank failures, what is the contagion effect?
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the effect of one bank failing leading to the failure of others
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What are the two ways in which the FDIC handles bank failures? What do these methods entail? Which
method was used in the failure of Penn Square Bank? |
*payoff method: bank is permitted to fail, only 250,000 FOIC insurance survives
*purchase and assumption method: bank is folded into another banking organization, all deposits survive *pay off method |
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How does FDIC insurance create moral hazard incentives in banks?
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because of the lack of "market discipline" on the part of depositors
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How does FDIC insurance stimulate adverse selection in banks?
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those who can take advantage of insurance are most likely to find banks attractive
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What is the “too big to fail” doctrine? What implications does this doctrine impose on moral hazard in big
banks relative to small banks? |
*regulators are reluctant to let the largest banks fail because of the potential impact on the entire system
*increases moral hazard problem for big banks |
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Complete the following sentence: A bank’s two main capital requirements are a Leverage Ratio of more
than _____% and a level of equity capital that is at least _____% of a bank’s risk-weighted assets and offbalance sheet activities. |
5%, 8%
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What regulatory document specifies the risk-weights used to determine a bank’s risk-weighted assets?
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Basel Accord
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Following the establishment of these risk-weights, what did banks start doing? What is this called?
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regulatory arbitrage: for a given category, banks seek the riskiest assets
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Know that bank examiners assess bank characteristics using a CAMELS rating. Also know the six
categories assessed |
C apital adequacy
A sset quality M anagement E arnings L iquidity S ensitivity to market risk |
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What four areas do bank examiners assess that then feed into the Management component of the CAMELS
rating? |
*Quality of board and senior management oversight
*Adequacy of policies that limit risky activities *Quality of risk measurement and monitoring *Adequacy of internal controls that prevent fraud |
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What does the Community Reinvestment Act require that banks do?
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reduce discrimination in credit markets
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Created the Federal Reserve System
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Federal Reserve Act (1913)
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Created the FDIC
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Banking acts of 1933 and 1935
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Created the SEC and required that investors receive financial information on securities offered for public sale
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Securities Act of 1933 and 1934
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Re-capitalized the FDIC and put limits on the too-big-to-fail policy
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Federal Deposit Insurance Corporation Improvement Act of 1991
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Created the Public Company Accounting Oversight Board
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Sarbanes-Oxley Act of 2002
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Created the Consumer Financial Protection Bureau to regulate mortgages and other financial products
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Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
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What decade marked an enormous rise in the number of bank failures in U.S. history?
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1980s
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What is a systemic (as opposed to nonsystemic) financial firm?
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firms who pose risk to the overall financial system because their failure would cause widespread damage
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What are three ways in which a financial crisis can begin?
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(Stage 1, Initiation)
*mismanagement of financial liberalization *asset price booms and busts *a general increase in uncertainty caused by failures of major financial institutions |
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Generally speaking, what is the mindset of depositors? What does this lead them to do?
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(Stage 2, Banking Crisis)
*if banks are insolvent they'll panic leading them to withdraw all funds immediately |
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What is debt deflation?
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(Stage 3, Debt Deflation)
*when asset prices fall, but debt levels do not adjust, increasing debt burdens |
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In the 2007-2009 financial crisis, what agency problems existed in mortgage markets?
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*mortgage originators did not hold the actual mortgage, but sold the note in the secondary market
*mortgage originators earned fees from the volume of the loans produced, not the quality *in the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud |
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What does it mean for a bank to delever? Did this improve or worsen the 2007-2009 financial crisis?
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*sell off assets in an effort to pay off existing debt
*further depressed the struggling economy |
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Did the spread between Baa corporate bonds and U.S. Treasury bonds widen or narrow during the financial
crisis? What does this imply about the riskiness of corporate debt relative to Treasury debt? |
*widened
* |
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What does it mean to be “put into conservatorship”? In September 2008, what two enterprises were put into
conservatorship? Why? |
*Freddie Mac and Fannie Mae
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Bear Stearns was sold in March 2008. Who bought
the firm? What was the total purchase price (in millions of dollars)? What was Bear Stearns’ market value in January 2007? |
*JP Morgan
*$236 million *$20 billion |
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The biggest one-day drop in the U.S. stock market
since the terrorist attacks of September 11, 2001, occurred on September 15, 2008, in response to the failure of what firm? |
*Lehman Brothers
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