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FI 301: EXAM 1
Surplus Units
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participants who receive more money than they spend, such as investors
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Deficit Units
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participants who spend more money than they receive, such as borrowers
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Securities |
represent a claim on the issuers
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Debt Securities
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debt (also called credit, or borrowed funds) incurred by the issuer
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Equity Securities
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(also called stocks) represent equity or ownership in the firm
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Primary Markets
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facilitate the issuance of new securities
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Secondary Markets
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facilitate the trading of existing securities, which allows for a change in the ownership of the securities
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Money Market Securities
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Money markets facilitate the sale of short-term debt securities by deficit units to surplus units.
Debt securities that have a maturity of one year or less.
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Capital Market Securities
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facilitate the sale of long-term securities by deficit units to surplus units.
1) bonds
2) mortgages
3) mortgage-backed securities
4) stocks
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Bonds |
long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations.
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Mortgages
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long-term debt obligations created to finance the purchase of real estate.
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Mortgage-Backed Securities
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debt obligations representing claims on a package of mortgages.
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Stocks |
represent partial ownership in the corporations that issued them.
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Derivative Securities
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financial contracts whose values are derived from the values of underlying assets
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Efficient vs. Inefficient Markets
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Inefficient: market prices of common stocks and similar securities are not always accurately priced and tend to deviate from the true discounted value of their future cash flows.
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Securities Act of 1933
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was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.
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Securities Exchange Act of 1934
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extended the disclosure requirements to secondary market issues
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Required Rate of Return (RRR)
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The required rate of return is the rate that indicates the riskiness of an asset. Essentially, it reflects the riskiness of all future cash flows associated with the investment. To be willing to make the investment, it is the minimum return necessary for an investor to consider buying the asset
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Expected Rate of Return
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The expected rate is simply the rate an investor can expect to realize if the investment is made. The expected rate can also be thought of as the rate that would make the Net Present Value of the investment zero. The Net Present Value is zero when the rate of return is exactly in line with the level of risk associated with the investment. The higher the risk, the higher the return must be to compensate for the increased risk taken on by purchasing the asset
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Federal Funds Market
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facilitates the flow of funds between depository institutions
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Depository Institutions
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Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities.
-Offer liquid deposit accounts to surplus units
-Provide loans of the size and maturity desired by deficit units
-Accept the risk on loans provided
-Have more expertise in evaluating creditworthiness
-Diversify their loans among numerous deficit units
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Types of Depository Institutions
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-commercial banks
-savings institutions
-Credit Unions
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Commercial Banks
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The most dominant type of depository institution
Transfer deposit funds to deficit units through loans or purchase of debt securities
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Savings Institutions
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Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banks
Concentrate on residential mortgage loans
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Credit Unions
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Nonprofit organizations
Restrict business to CU members with a common bond
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-finance companies
-mutual funds
-securities firms
-insurance companies
-pension funds
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-finance companies
-mutual funds
-securities firms
-insurance companies
-pension funds
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Finance Companies
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obtain funds by issuing securities and lend the funds to individuals and small businesses.
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Mutual Funds
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sell shares to surplus units and use the funds received to purchase a portfolio of securities
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Securities Firms
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provide a wide variety of functions in financial markets. (Broker, Underwriter, Dealer, Advisory)
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Insurance Companies
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provide insurance policies that reduce the financial burden associated with death, illness, and damage to property. Charge premiums and invest in financial markets.
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Pension Funds
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manage funds until they are withdrawn for retirement
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Broker |
arranges transactions between a buyer and a seller for a commission when the deal is executed
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Dealer |
A person or firm in the business of buying and selling securities for their own account, whether through a broker or otherwise. A dealer is defined by the fact that it acts as principal in trading for its own account, as opposed to a broker who acts as an agent in executing orders on behalf of its clients
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Advisor
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The person or company responsible for making investments on behalf of, and/or providing advice to, investors
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Underwriter Roles
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A company or other entity that administers the public issuance and distribution of securities from a corporation or other issuing body
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Contributing Factors of the 2008 Financial Crisis
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A company or other entity that administers the public issuance and distribution of securities from a corporation or other issuing body
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Behavior Finance
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the application of psychology to make financial decisions
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Systemic Risk
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the spread of financial problems, among financial institutions and across financial markets, that could cause a collapse in the financial system
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Relationship Between Interest Rates and Quantity of Loanable Funds supplied/demanded
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ch. 2 slides 3-21
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Effect of increase/decrease in supply/demand on interest rates
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3-21
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Net Present Value (NPV)
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The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Formula: slide 6
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How the factors below impact supply/demand of loanable funds and interest rates
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-economic conditions
-budget deficit / taxes / gov’t spending
-inflationary expectations
-foreign borrowing/lending/interest rates
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Fisher Effect
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Slide 18
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Inelastic Demand
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An economic term used to describe the situation in which the supply and demand for a good or service are unaffected when the price of that good or service changes. Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.
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Elastic Demand
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A situation in which the supply and demand for a good or service can vary significantly due to the price. The elasticity of a good or service can vary according to the amount of close substitutes, its relative cost and the amount of time that has elapsed since the price change occurred.
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Crowding out
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Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to “crowd out” the private demand for funds.
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credit rating
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rating of the risk involved in lending money to a specific person or business
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The yields on debt securities are affected:
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Credit (default) risk
Liquidity
Tax status
Term to maturity
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Credit (default) Risk
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Investors must consider the creditworthiness of the security issuer.
All else being equal, securities with a higher degree of default risk must offer higher yields.
Especially relevant for longer term securities.
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Liquidity |
The lower a security’s liquidity, the higher the yield preferred by an investor.
Debt securities with a short-term maturity or an active secondary market have greater liquidity.
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Relationship between before- and after-tax yields
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Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax yield.
slide 9 and slide 10
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Term structure of interest rates
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Maturity dates will differ between debt securities.
The term structure of interest rates defines the relationship between term to maturity and the annualized yield.
slide 12
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Pure Expectations Theory
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Term structure reflected in the shape of the yield curve is determined solely by the expectations of interest rates
Impact of an Expected Increase in Rates leads to an upward sloping yield curve (Exhibit 3.5)
Impact of an expected Decline in Rates leads to a downward sloping yield curve.
slide 19 and 20
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Liquidity Premium Theory
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Investors prefer short-term liquid securities but will be willing to invest in long-term securities if compensated with a premium for lower liquidity. (Exhibit 3.6)
slides 21 and 22
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Segmented Markets Theory
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Investors choose securities with maturities that satisfy their forecasted cash needs.
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Preferred Habit Theory
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Although investors and borrowers may normally concentrate on a particular maturity market, certain events may cause them to wander from their “natural” or preferred market.
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Factors that affect slope of yield curve
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slides 24-31
*know how to calculate forward yields
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Federal Reserve System components
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Board of Governors
12 Federal Reserve District Reserve Banks
Depository Institutions
Federal Open Market Committee
Ch. 4 slide 11 (exhibit 4.2)
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The federal funds rate is the rate that?
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Banks Charge for overnight use of excess reserves held at the federal reserve banks
Closely watched because it indicates when banks are strapped for funds(high) or when banks' credit needs are low(low)
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Primary Credit Lending Rate
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The Fed’s rate on short-term loans to depository institutions.
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Relationship between Fed and Money Supply
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When the fed buys bonds, the money supply is increased.
When the fed sells bonds, the money supply is decreased.
slides 13-23
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Federal Reserve Goals
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Stable Prices: Low Inflation rates
Economic growth: Growth in real GDP
High Employment
Stability of financial markets and institutions
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Effects of Reserve Requirement
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The Reserve Requirement is the proportion of bank deposit accounts that must be held as required reserves or funds held in reserve. This has historically been set between 8 and 12 percent of transaction accounts.
By reducing the reserve requirement, the Board increases the proportion of a bank’s deposits that can be lent out. The lower the reserve requirement, the greater the lending capacity of a depository institution.
Impact of Reserve Requirements on Money Growth: Leakages occur when households hold cash or banks hold excess reserves. In these cases, the money does not multiply as expected. (Exhibit 4.5)
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expansionary monetary policy
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increase in money supply
decrease value of money you can buy less with each dollar
increase in inflation, prices go up
**in recession the government increases the money supply, in order to shorten the duration and severity of recession
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stimulative policy
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give out money to increase consumption to increase GDP to improve economy.
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Loose Monetary Policy
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- Goal is to increase money supply (NOW)
- lower short term interest rates, AD shrifts to the right, and GDP goes up
- lowers discount rates
-buys government bonds
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contractionarymonetary policy
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-stop inflation or when financial stabilization is over
- decrease in bank reserves leads to decrease in monetary base which leads to decrease in money supply and increase in interest rates
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tight monetary policy
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fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy
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Monetary policy and the Dynamic Aggregate Demand Curve
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-when faced with very high inflation, central bankers will focus almost exclusively on controlling money growth
-must examine the connection between short-term interest rates and policymakers' inflation output targets
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Why and how is defensive monetary policy used?
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people's preference for holding money may change (for example in the holiday season), an •Increased demand for money will shift thedemand curve rightward causing interest rate to go up and that is not good forthe economy [Equilibrium GDP will fall]
- So Fed will increase( or decrease) the money supply to counteract
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Fed and the Credit Crisis
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slide 24 and 25
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European Union Issues
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The European Central Bank (ECB), based in Frankfurt, is responsible for setting monetary policy for all European countries that use the euro. The ECB’s monetary goals are price and currency stability.
Impact of the Euro on Monetary Policy
Any changes in the money supply affect all European countries that use the euro.
Prevents participating countries from solving local economic problems using their own unique economic policies.
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Global Crowding out
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Given the international integration in money and capital markets, a government’s budget deficit can affect interest rates of various countries
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