Chapter 9 03 18 2014 Small investors prefer to put their savings in banks or mutual funds to avoid the problem of asymmetric information One party has more information than the other party o Typically in financial transactions the borrower has more info than the lender Crowd funding raising small amounts of money from large numbers of people Transactions costs costs of a trade or financial transaction Information costs costs savers incur to determine the creditworthiness of borrowers and monitor how they use the acquired funds Economies of scale the reduction in average cost that results from an increase in volume of a good or service produced Mutual funds have a portfolio of investments instead of having individual costs on each different investment o Financial intermediaries take advantage of economies of scale to reduce transaction costs Small to medium sized investors turn to financial intermediaries to avoid more costs 2 problems arise from asymmetric info adverse selection problem in distinguishing high risk form low risk borrowers moral hazard problem in verifying that borrowers are using funds as intended as interest rates rise the creditworthiness of potential borrowers deteriorates making adverse selection problem worse investors likely reduce the number of loans they are willing to give out rather than raise interest rates to meet supply and demand Credit Rationing the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate Happens in the bond market Reduce adverse selection by Making information available to the public Credit rationing Collateral Relationship banking ability of banks to assess credit risks on the basis of private information about borrowers Principle agent problem moral hazard problem of managers agents pursuing their own interests rather than those of shareholders principals incentive contracts are also used to decrease moral hazard in the stock market Reduce moral hazard in the bond market Restrictive Covenant a clause in a bond contract that places limits on the uses of funds that borrowers receive Venture Capital firms a firm that raises equity capital from investors to invest in startup firms Private Equity Firm firm that raises equity capital to acquire shares in other firms to reduce free rider and moral hazard problems Target young firms failing to maximize profits Take positions on board of directors and can monitor what they do Chapter 10 03 18 2014 Balance Sheet statement that shows an individual or firm s financial position on a particular day Assets uses of funds is on the left side loans Liabilities sources of funds bank capital on the right side deposits Bank capital difference between value of bank s assets and the value of its liabilities Borrowing by banks includes Short term loans in the federal funds market Loans from a bank s foreign branches Repurchase agreements banks sell securities such as Treasury Bills and agree to repurchase them Discount loans from the Fed Bank Assets Reserves most liquid includes vault cash and deposits they have with the Fed Claims on other banks cash items in the process of collection Securities marketable securities liquid assets banks trade in financial markets Loans largest category of bank assets illiquid relative to marketable securities which means higher interest rates Other assets include physical assets equipment buildings seized property T account accounting tool used to show changes in balance sheet items Net interest Margin difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt divided by total value of its earning assets Return on assets ROA ration of the value of after tax profits to the value of its assets ROA After tax Profit Bank Assets Return on Equity ROE ration of the value of after tax profit to value of its capital ROE After Tax Profit Bank Capital ROA and ROE are related in that ROE ROA x Bank assets Bank capital Leverage how much debt an investor assumes in making an investment Bank Leverage ratio of value of assets to value of capital The inverse is called bank leverage ratio o High leverage increases the degree of risk financial firms are exposed to by magnifying swings in profits as measure by ROE Liquidity Risk the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost Minimize this by holding fewer loans securities and more reserves Asset management and liquidity management Credit Risk risk that borrowers might default on their loans Reduce by o Diversification lend to different types of borrowers o Credit risk analysis process used by banks to screen loan applicants o Collateral assets pledged to the bank if borrower defaults o Credit Rationing restriction of credit by lenders result that borrowers cannot obtain all the funds they desire at the given interest rate o Monitoring and Restrictive Covenants o Long term business relationships Interest Rate Risk the effect of a change in market interest rates on a bank s profit or capital Higher interest rate lower PV of a bank s assets and liabilities Lower interest rate higher PV of a banks assets and liabilities Gap Analysis the difference gap between value of bank s variablerate assets and the value of its variable rate liabilities Used to measure interest rate risk Pg 297 Duration analysis an analysis of how sensitive a bank s capital is to changes in market interest rates Difference b w avg duration of assets and avg duration of liabilities Off balance sheet activities activities that don t affect bank s balance sheet because they don t change its assets or liabilities Standby Letter of credit promise by bank to lend funds if necessary to a seller of commercial paper at the time that the commercial paper matures Loan Commitment agreement by bank to provide a borrower with a stated amount of funds during a specified period of time Loan Sale financial contract in which a bank agrees to sell the expected future return from an underlying bank loan to a third party Chapter 11 03 18 2014 Investment Bank financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions Providing advice on new securities Underwriting new security issues o Underwriting investment bank guarantees to the issuing corp the price of a new security and then resells the security for profit o Syndicate group of