View
- Term
- Definition
- Both Sides
Study
- All (148)
Shortcut Show
Next
Prev
Flip
FIN 3303: FINAL EXAM
Purpose of Financial Futures: |
Stock Index Futures, Interest Rate (Bond) Futures, etc.
-Speculation
-Hedging
|
Interest Rate (Bond) Futures |
-Short Bond Futures if you think interest rates will rise in the future
-Go long Bond Futures if you think interest rates will decline in the futures
|
Stock Index Futures |
-Go long stock index futures if you think stock prices are going to rise in the future
-Shot stock index futures if you think stock prices are going to decline in the future
|
Hedging Interest Rate Futures (Short) |
-Use interest rate futures to create a short hedge. Short Bond Futures to protect your bond portfolio from losses due to rising interest rates.
|
Hedging Interest Rate Futures (Long) |
-Use interest rate futures to create a long hedge. If you are planning to invest in bonds and think interest rates are going to decline, go long bond futures.
|
Hedging Stock Index Futures |
Short Hedge
-Short stock index futures to offset expected declines in your stock portfolio from a declining stock market
|
Arbitrage with Stock Index Futures (Over-Priced) |
If the actual futures contract is over-priced relative to the underlying stock portfolio, an arbitrageur could sell (short) the over-priced stock index futures, and purchase the underlying stock index.
|
Arbitrage with Stock Index Futures (Under-Priced) |
If index futures are under-priced, the arbitrageur could buy the under-priced index futures contract and sell (short) the corresponding stock index portfolio.
|
Securities Firms as Arbitrageurs |
-Capitalize on discrepancies between prices of stock index futures and the underlying stock.
-If one owns the stock they receive dividends but no interest.
-If one owns the stock index futures, they receive interest but no dividends. Because they put down little margin and can pledge a bond against their purchase of the stock index future.
|
Market Risk |
Fluctuations in the value of the instrument as a result of market conditions
|
Basis Risk |
The risk that the position being hedged by the futures contract is not affected in the same way as the instrument underlying the futures contract
|
Liquidity Risk |
Refers to the potential price distortions due to the lack of liquidity
|
Credit Risk |
The risk that a loss will occur because a counterparty defaults on the contract
|
Prepayment Risk |
The risk from the possibility that the assets to be hedged may be prepaid earlier than the designated maturity
|
Operational Risk |
The risk of losses due to inadequate management or controls. (e.g. employees responsible for their futures positions do not fully understand how values of specific futures contract will respond to market conditions
|
T-Bill Futures Contracts |
Carry a $1million denomination and are priced in Basis Points where a Basis Point = .01%
-For example, a T-Bill futures contract priced at 95-75, or (95 and 75/100ths)% would have a price of $957,500
|
T-Bond Futures Contracts |
Carry a $100,000 denomination and are priced in 32nds
-For example, a T-Bond futures contract priced at 93-16, or (93 and 16/32nds)% would have a price of $93,500
|
Profit from T-Bill Futures:
-Quoted Price 93-50
-When Closed Out, Quoted Price 94-75
-Profit or loss per contract? |
-Purchase Price = $935,000
-Selling Price = $947,500
-Profit = $947,500 - $935,000 = $12,500
|
Profit from T-Bill Futures:
-Quoted Price 95-00
-Closed Out, Quoted Price 93-60
-Profit or loss per contract? |
-Purchase Price = $950,000
-Selling Price = $936,000
-Profit = $936,000 - $950,000 = -$14,000
|
Profit from T-Bill Futures:
-Sold Quoted 94-00
-Closed Out 93-20
-Profit or loss per contract? |
-Selling Price = $940,000
-Purchase Price = $932,000
-Profit = $940,000 - $932,000 = $8,000
|
Profit from T-Bill Futures:
-Sold 93-26
-Closed Out, 93-90
-Profit or loss per contract? |
-Selling Price = $932,600
-Purchase Price = $939,000
-Profit = $932,600 - $939,000 = -$6,400
|
Profit from T-Bond Futures:
-Purchased 91-00
-Close Out 90-10
-Profit or loss per contract? |
-Purchase Price = $91,000
-Selling Price = $90,312
-Profit = $90,312 - $91,000 = -$688
|
Profit from T-Bond Futures:
-Sold 92-10
-Closed Out 93-00
-Profit or loss per contract? |
-Purchase Price = $93,000
-Selling Price = $92,312
-Profit = $92,312 - $93,000 = -$688
|
Profit from Stock Index Futures:
-Sold 1690
-Closed Out 1720
-Profit or loss? |
-Purchase Price = $250 x 1720 = $430,000
-Selling Price = $250 x 1690 = $422,500
-Profit = $422,500 - $430,000 = -$7,500
|
Profit from Stock Index Futures:
-Buy September contract when index is 1400
-By September rises to 1750
-Value of S&P 500 futures contract is $250 times index
-Return? |
= [(1750 - 1400) / 1400]
= 25%
|
Interest Rate Swap |
One party exchanges one set of interest rate payments for a different set of interest rate payments
-typically involves exchanging a stream of fixed-rate interest payments for a stream of floating-rate interest payments
|
How Banks Generate Profit |
(1) They take in deposits (their liabilities), pay interest on these deposits (interest expenses).
(2) Make loans (their assets) from these deposits, and charge interest on these loans (interest revenues).
Net Interest Margin = (Interest Revenues - Interest Expenses) / Assets
|
Provisions of an interest rate swap include: |
-Notional Principal
-Fixed Interest Rate
-Formula and Type of Index used to determine floating rate
-Frequency of payments
-Lifetime of the swap
|
Notional Pricipal |
Reference value, to which the interest rates are applied to determine the interest payments to the respective participating parties
|
Example of Interest Rate Swap |
Party A will Exchange:
-11% fixed rate payments for...
Party B's (counter party):
-Floating payments at the prevailing one-year Treasury bill rate + 1%
-Based on $30 million of notional principal, at the end for each of the next seven years
|
Example Cont'd |
*Amounts owed are typically netted out so that only the net payment is made.
If firm A owes 11% of $30 million but is supposed to receive 10% of $30 million from firm B on a given payment date, it will send to firm B, a net payment of 1% of the $30 million, or $300,000
|
Where are Swaps Traded? |
Over-the-counter trading, rather than an organized exchange
-Less standardized
*Dodd-Frank financial reform bill wants to require more derivatives to be traded on exchange
|
Use of Swaps for Hedging |
Commercial banks in the United States, traditionally had more interest rate sensitive liabilities than assets, and were adversely affected by INCREASING interest rates
Conversely, some commercial banks in Europe had access to long term fixed-rate funding but used funds primarily to provide floating-rate loans (adversely affected by DECLINING interest rates)
|
Interest Rate Swap to reduce risk exposure |
U.S. Financial Institution could enter into a fixed rate for floating rate swap with European Commercial Bank.
-In the event of RISING interest rates, U.S. receives higher interest payments from the floating rate counterparty to the swap, which helps offset the rising cost of obtaining deposits.
-In the event of DECLINING interest rates, the European Bank (floating rate counterparty) may receive net payments from the fixed rate U.S. counterparty, which helps offset the lower interest payments received on its floating-rate loans.
|
When to Hedge? |
Interest rate swaps are primarily used by financial institutions that would be adversely affected by expected movement in interest rates
|
Use of Swaps for Speculating |
A firm may engage in a swap to benefit from its expectations that interest rates will rise, even if its other operations are not exposed to interest rate movements
|
Plain Vanilla |
Fixed-for-Floating swap
fixed-rate payments are periodically exchanged for floating-rate payments
|
Forward |
Exchange of interest payments that does not begin until a specified future point in time
|
Callable |
Swap Option or Swaption - provides the party making the fixed payments with the right to terminate the swap prior to its maturity
-Allows fixed rate payer to avoid exchanging future interest payments if it desires
-Disadvantage: The party given the right to terminate the swap pays a premium that is reflected in a high fixed interest rate. May also incur termination fee
|
Putable |
Swap Option - Provides the party making the floating-rate payments with a right to terminate the swap
-Pays premium and may also incur termination fee
|
Extendable |
Contains a feature that alows the fixed for floating party to extend the swap period
|
Zero-Coupon-for-Floating |
Fixed rate payer makes a single payment at the maturity date
Floating-rate payer makes periodic payments throughout the swap period
|
Rate-Capped |
Involves the exchange of fixed-rate payments for floating-rate payments that are capped
|
Equity |
Involves the exchange of interest payments for payments linked to the degree of change in a stock index
|
Basis Risk |
The interest rate of the index used for an interest rate swap will not necessarily perfectly track the movements of the floating-rate instruments of the parties involved in the swap
|
Credit Risk |
The risk that a firm involved in an interest rate swap will not meet its payment obligations
|
Concerns about a Swap Credit Crisis |
The willingness of large banks and securities firms to provide guarantees has increased the popularity of interest rate swaps, but has also increased concerns over the potential systemic risk these and other derivative instruments pose to our financial system
-e.g. if a large bank that has taken numerous swap positions and guaranteed many other swap positions, fails, there could be a chain reaction of defaults on swap payments and other financial obligations
|
Pricing Interest Rate Swaps |
a. Prevailing Market Interest Rates
b. Availability of Counterparties
c. Credit and Sovereign Risk
|
Factors Affecting the Performance of Interest Rate Swaps |
a. Indicators Monitored by Participants in the Swap Market
|
Interest Rate Caps |
Agreement that offers payments to the purchaser of the cap when a specified interest rate index exceeds a specified ceiling (cap) interest rate. Payments are based on the amount by which the interest rate exceeds the ceiling, multiplied by the notional principal specified in the agreement
|
Interest Rate Floors |
Agreement, which, for a fee, the purchaser of the agreement receive payments in periods when a specified interest rate index falls below a specified floor rate
|
Interest Rate Collar |
Purchase of an interest rate cap and simultaneous sale of an interest rate floor.
|
Currency Swap |
Agreement whereby currencies are exchanged at specified exchange rates and at specified intervals
|
Credit Default Swaps (CDS) |
Privately negotiated contract that protects investors against the risk of default on particular debt securities
-One party is the buyer who is willing to provide periodic (usually quarterly) payments to the other party.
-The seller receives payments from the buyer. Obligated to provide a payment to the buyer of the securities, specified in the swap agreement, default. Seller pays the par value of the securities in exchange for the securities.
-Alternatively, the securities may be auctioned off by the buyer and the seller must pay the buyer of the CDS the difference between the par value of the securities and the price at which they were sold.
|
Who Purchases CDS? |
Similar to financial insurance contract. The buyer of a CDS receives protection if the securities default.
-Financial institutions purchase CDS to protect their own investments in debt securities against default risk.
-The seller (similar to the insurer) of a CDS expects that the CDS is unlikely to default.
-If the seller's expectations come true, they will not have to pay the buyer (insured party) for claims (losses)
|
Maturity (CDS) |
Typically between 1 and 10 years, with most common being 5 years
|
Notional Value (CDS) |
Typically between $10 million and $20 million
|
Trading (CDS) |
Traded over-the-counter and were not backed by an organized exchange. (There is counterparty risk)
|
Secondary Market for CDS Contracts |
The counterparty can sell the CDS to another financial institution, subject to the approval of the other party on the contract
|
Dodd-Frank Financial Reform bill (2010) |
Endeavors to move derivatives trading (allowing exceptions) on to organized exchanges
|
Development of Credit Default Swaps |
-Created in 1990's to protect investors that purchased bonds against default risk
-Over time CDS were adapted to protect investors that purchased Mortgage-Backed Securities
-CDS market grew rapidly: $4 trillion in 2003, $25 trillion in 2006, $62 trillion (notional value) in 2008
|
Impact of Credit Crisis on CDS Market |
-Financial Institutions accumulated large holdings of MBS
-Housing market began to weaken in 2006, Financial Institutions purchased CDS contracts
-Lehman Brothers Bankruptcy - major participant in CDS market, which did not cover all of their CDS obligations after they filed for bankruptcy in September, 2008
-AIG's Financial Problems - insured $440 billion in debt securities (many of which were risky, sub-prime, MBS). As housing weakened, rumors circulated that AIG might not be able to cover all claims. To avoid a sysetmic collapse, Federal Reserve injected billions into AIG
|
Caspian Bank has negotiated a Plain Vanilla swap in which it will exchange fixed payments of 8% for floating payments equal to LIBOR plus 0.5% at the end of each of the next three years.
-1st year LIBOR is 8%
-2nd year 9%
-3rd year 7%
Total Net Payment if notional principal is $10million? |
Year 1 = 8% [Caspian pays 8% and receives 8.5% of $10,000,000] or receives .5% x $10,000,000 = $50,000
Year 2 = 9% [Caspian pays 8% and receives 9.5% of $10,000,000] or receives 1.5% x $10,000,000 = $150,000
Year 3 = 7% [Caspian pays 8% and receives 7.5% of $10,000,000] or pays .5% x $10,000,000 = $50,000
Net Payment Received = ($50,000 + $150,000 - $50,000) = $150,000
|
Thornton National Bank purchases a three-year interest rate cap for a fee of 2% of notional principal valued at $50 million, with an interest rate ceiling of 10% and LIBOR as the index representing the market interest rate.
-1st year LIBOR 9%
-2nd year 12%
-3rd year 13%
Total Net Payments including initial fee? |
Thornton pays (2% x $50,000,000) = $1,000,000 fee
Year 1 = 9%, Thornton receives nothing
Year 2 = 12% (Thornton receives 2% of $50,000,000) = $1,000,000
Year 3 = 13% (Thornton receives 3% of $50,000,000) = $1,500,000
Net Payment Received = (-$1,000,000 + $1,000,000 + $1,500,000) = $1,500,000
|
Orlando Bank entered into a three-year interest rate collar. (A collar involves purchasing an interest rate cap and, simultaneously, selling an interest rate floor.) The interest rate cap specifies a fee of 3% of notional principal valued at $50 million with an interest rate ceiling of 10%. The interest rate floor specifies a fee of 3% of notional principal valued at $50 million and an interest rate floor of 8%. The level of LIBOR over the next three years is:
Year 1= 6%
Year 2= 12%
Year 3= 11%
What is Orlando Bank's net profit (loss) from this strategy? |
= $500,000 profit. The fee paid by Orlando Bank to purchase the interest rate cap, (3% of $50 million = $1,500,000), is offset by the fee received by Orlando Bank for selling an interest rate floor, (3% of $50million = $1,500,000). In year 1, since LIBOR = 6% and is thus 2% below the interest rate floor of 8%, Orlando Bank pay's the buyer of the interest rate floor, (2% X $50,000,000) = $1,000,000. In year 2, since LIBOR = 12% and thus 2% above the interest rate cap of 10%, the seller of the interest rate cap pays Orlando Bank (2% X $50,000,000) = $1,000,000. In year 3, since LIBOR = 11% and thus 1% above the interest rate cap, the seller of the interest rate cap pays Orlando Bank (1% X $50,000,000) = $500,000. Hence, Orlando Bank's returns are:
-$1,500,000 from purchasing the interest rate cap.
+$1,500,000 from selling an interest rate floor.
-$1,000,000 in year 1(interest paid to the buyer of the interest rate floor)
+$1,000,000 in year 2 (interest received from the seller of the interest rate cap)
+$500,000 in year 3 (interest received from the seller of the interest rate cap)
$500,000 = Net Profit
|
Direct Exchange Rate |
Specifies the value of the currency in U.S. dollars.
-Mexican peso may have a value of $.10
-British pound may have a value of $2.00
-Euro $1.25
|
Indirect Exchange Rate |
Specifies the value of the currency as the number of that currency equal to a U.S. dollar
-98 Yen per dollar
-10 pesos per dollar
-.5 British pounds per dollar
|
Spot Rate |
Present exchange rate
|
Forward Rate |
Exchange rate at which a specified currency can be purchased or sold at a specified future point in time
|
Cross Exchange Rate |
Calculating the exchange rate between two non-dollar currencies
|
Formula - Cross Exchange Rates |
Value of 1 unit of Currency A in units of Currency B = Value of Currency A in $/Value of currency B in $
|
Bretton Woods Era |
1944 -1971, exchange rate at which one currency could be exchanged for another was maintained by governments within 1% of specified rate
-Fixed exchange rate regime, currencies pegged to the USD, which was based on the gold standard, with gold priced at $35/troy ounce
|
Smithsonian Agreement |
Approved December 1971, agreement allowed for the devaluation of the dollar and widened the boundaries from 1% to 2.25%
-Followed the August 15, 1971 unilateral suspension of the convertibility of dollar into gold (ENDING GOLD STANDARD)
-Reestablished an international system of fixed exchange rates
|
Freely Floating System |
March 1973, all boundaries were eliminated and ever since, the exchange rates of major currencies have been floating without Government imposed boundaries
-Exchange rates are market determined
|
Dirty Float |
System with no boundaries in which exchange rates are market determined but are still subject to government intervention
|
Pegged Exchange Rate Systems |
Some currencies may be pegged to another currency or a unit of account and maintained within specified boundaries
e.g. Since 1983, Hong Kong has tied its currency to the USD
|
Purchasing Power Parity (PPP) |
Addresses the relationship between two countries with regard to their respective inflation rates and exchange rates. Suggests that the exchange rate will, on average, change by a percentage that reflects the inflation differential between the two countries.
e.g. If the U.S. has 3% inflation rate, while European inflation is 3%, and suddenly the U.S. inflation increases to 5%, then the Euro will appreciate against the USD by approximately 2%, reflecting increased demand by the U.S. for European goods and diminished demand by Europeans for U.S. goods
|
Differential Interest Rates |
-Increase in interest rates in one country relative to other countries, may attract foreign investors to the country with the higher interest rates, especially if these higher rates do not reflect an increase in inflationary expectations
-Such capital flows can put upward pressure on the exchange rate of the country with the higher interest rates
|
Central Bank Intervention |
Central banks do consider intervening in the currency markets to adjust their currency's value to influence economic conditions
|
Direct Intervention |
This occurs when a country's central bank, such as the Federal Reserve, sells some of its reserves for a different currency. They will purchase the currency they wish to appreciate and sell the currency they wish to depreciate
|
Indirect Intervention |
For example, the Federal Reserve can expand the U.S. money supply thus lowering interest rates (as long as this is not inflationary) which would discourage foreign investors from investing in the U.S. thus putting downward pressure on the USD
|
Foreign Exchange Controls |
Governments sometimes attempt to impose restrictions on the exchange of their currency in order to stabilize the exchange rate of their currency
One means is to place quotas on the amounts of local currency that can be exchanged for foreign currencies
|
Importance of Exchange Rate Movements |
Currency markets are the largest financial markets (trading >$5 trillion per day) in the world and are the most volatile
|
Market - Based Forecasting |
A process of formulating exchange rate forecasts from market indicators, which is based on either (1) the spot rate or (2) the forward rate
|
Spot Rate |
Represents the market's expectation of the spot rate in the near future
|
Forward Rate |
Functions as a forecast of the future spot rate, since speculators would place bets if there was a major discrepancy between the forward rate and expectations of the future spot rate
|
Forecasting Exchange Rate Volatiltiy |
(1) Measuring the volatility of historical exchange rate movements
(2) Use of a time series of volatility patterns from previous periods
(3) Derive the forecasted exchange rate volatility from the implied volatility of the currency' options and the use of the option-pricing model
|
Speculation in Foreign Exchange Markets |
Take positions in currencies to exploit exchange rate movements
Invest in currencies that they expect to appreciate and short those they expect to depreciate
Shorting involves borrowing the currencies, converting the borrowed funds into another currency and investing them
|
Currency Forward Contracts |
Customized (flexible) contracts negotiated through a commercial bank that permit the purchase or sale of an indicated amount of a given foreign currency at a specified exchange rate (the forward rate) on an indicated future date
|
Currency Futures Contracts |
Standardized contracts that specify an amount of a particular currency to be exchanged on an indicated date and at a specified exchange rate
|
Forward Premium |
A premium in the forward currency rate exists when the forward rate exceeds the spot rate
|
Forward Discount |
The forward rate exhibits a discount when the forward currency rate is below the spot rate
|
To Calculate Forward Premium or Discount |
p(premium) = [FR(forward rate) - S(spot rate)] / S x [360/n(days of forward rate)]
|
Currency Swaps |
An agreement that permits a given currency to be periodically exchanged for another at specified exchange rates
|
Currency Options (Calls and Puts) |
Use to speculate in the currency markets or hedge currency risk
Advantage of options over Forward and Futures contracts - provide right but not obligation to purchase
|
Conditional Currency Options |
Options which are structured wit ha conditional premium, such that the premium is predicated on the actual movements in the currency's value over the contract period
|
Location Arbitrage |
Process of capitalizing on price discrepancies between the spot exchange rate at two different locations (banks)
Purchasing the underpriced currency and simultaneously selling it where it is overpriced
|
Triangular Arbitrage |
When the quoted cross rate between two foreign currencies is not aligned with the two corresponding exchange rates, a discrepancy in exchange rate quotations exists
|
Triangular Arbitrage:
$1million and you are provided with the following exchange rates:
-EUR/USD = 0.8631
-EUR/GBP = 1.4600
-USD/GBP = 1.6939 |
-Sell dollars for euros: $1million x 0.8631 = 863,100 euro
-Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
-Sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars
$1,001,373 - $1,000,000 = $1,373
|
Interest Rate Parity |
p = [(1 + ih) / (1 + if)] - 1
where
p = forward premium of foreign currency
ih = home country interest rate
if = foreign interest rate
|
Interest Rate Parity Theory |
Any disparity in the interest rate of two countries is equalized or offset by the movement in their currency exchange rates
The premium or discount will approximate the differential in interest rates
|
Say the British pound (£) is quoted for $2.00.
An Investor borrows £1000 at 7% annual rate and converts it to $2000 and invests in the US at 11% interest for one year. The Investor simultaneously buys a forward contract to convert the $2220 received at the end of 1 year back into £1110.
The investor pays off the £1070 owed on borrowed funds, thus earning £40. |
Interest rate parity prevents this:
The forward rate, £ will rise by 3.74% against the US $ (£ = $2.0748) or the $2220 converts to £1070, thus negating the arbitrage opportunity.
Interest rate parity asserts that any disparity in the interest rates of two countries is equalized or offset by the movement in their currency exchange rates.
|
Value of 1 unit of Currency A in units of currency B = Value of Currency A in $/Value of currency B in $ |
p= [(FR- S)/S] X (360/n)
p = [(1 + ih)/(1+if)] - 1
|
Assume interest rate parity exists. If the spot rate on the British pound is $2 and the 1‑year British interest rate is 7 percent, and the 1‑year U.S. interest rate is 11 percent, what is the pound's forward discount or premium? |
p = [(1 + ih)/(1+if)] - 1
= [(1.11)/(1.07)] - 1
= (1.0374 - 1) = (.0374 X 100%)
= 3.74%
|
Assume the following information:
-Interest rate on borrowed euros is 5 percent annualized
-Interest rate on dollars loaned out is 6 percent annualized
-Spot rate for €0.83 per dollar (one € = $1.20)
-Expected spot rate in five days is €0.85 per dollar
-Alonso Bank can borrow €10 million
What is the euro profit to Alonso Bank over the five-day period from shorting euros and going long on dollars? |
Step 1: Borrow €10 million and convert to U.S.$ at (one € = $1.20), = $12,000,000.
Step 2: Invest the $12,000,000 at 6% annual rate for 5 days. (Assume a 360 day year convention to calculate daily rate to 4 decimal places.) 6%/360 = (.0167%/day) X 5 days = .0833%.
Step 3: After 5 days invested at 6% annual rate, the $12,000,000 grows to:
$12,000,000 X (1 + .000833) = $12,009,996
Step 4: Convert the $12,009,996 to € (euros) @ spot rate of €0.85/$,
$12,009,996 X (€0.85/$) = €10,208,497
Step 5: Pay back the borrowed €10 million plus interest of 5% annual rate for 5days. (Assume a 360 day year convention to calculate daily rate to 4 decimal places.) 5%/360 = .0139%/day X 5 days = .0694%. Hence, payback €10,000,000 (1 + .000694) = €10,006,940.
Step 6: Calculate profit = [ €10,208,497 - €10,006,940] = €201,557
|
If the spot rate of the British pound is $2, and the 180‑day forward rate is $2.05, what is the annualized premium or discount? |
p= [(FR- S)/S] X (360/n) =
[($2.05 - $2)/$2] X (360/180)
= 5% premium.
|
Assume that a British pound put option has a premium of $.03 per unit and an exercise price of $1.60. The present spot rate is $1.61. The expected future spot rate on the expiration date is $1.52. The option will be exercised on this date, if at all. What is the expected per unit net gain (or loss) resulting from purchasing the put option? |
( exercise price - future spot rate) - premium paid for the option
= ($1.60 - $1.52) - $.03 = $.05 gain.
|
In The Wall Street Journal, you observe that the British pound (£) is quoted for $1.65. The Australian dollar (A$) is quoted for $0.60. What is the value of the Australian dollar in British pounds? |
Value of 1 unit of Currency A in units of currency B = Value of Currency A in $/Value of currency B in $.
Value of Australian $ expressed in British pounds = ($0.60/$1.65) = £0.36 .
|
Fiat Money |
Money which a government declares shall be accepted as legal tender at its face value
Money without Intrinsic value
Only valuable because of government regulation or law
All national currencies are fiat currencies
|
Bank Market Structure |
a. Bank Participation in Financial Conglomerates
b. Impact of the Financial Service Modernization Act
1.) Benefits of the Act to Individuals and Firms
2.) Benefits of the Act to Financial Institutions
|
Most Common Source of Despoits |
a. Transactions Deposits, Electronic Transaction
b. Savings Deposits
c. Time Deposits
1.) Certificates of Deposit
2.) Negotiable Certificates of Deposit
d. Money Market Deposit Accounts
e. Federal Funds Purchased
f. Borrowing form the Federal Reserve Banks
g. Repurchase Agreements
h. Eurodollar Borrowing
i. Bonds Issued by the Bank
j. Bank Capital
|
Bank Capital |
Primary capital results from the bank issuing common stock, or preferred stock or is obtained from retained earnings
All other sources of funds for the bank, represent a future obligation to pay out funds in the future
With primary capital, the bank has no obligation to pay out funds in the future
|
Bank Capital as defined by Primary Capital |
Represents the equity of net worth of the bank
It is primary capital that must be sufficient to absorb operating losses in the event that expenses or losses exceed revenues, regardless of the reason for the losses
|
Secondary Capital |
Arises from issuing subordinated notes and bonds
Secondary Capital constitutes a liability to the bank and does not cushion against operating losses
|
Regulators 1981 |
1981, minimum primary capital requirement of 5.5% of total assets and a minimum total capital requirement of 6% of total assets
|
Regulators 1988 |
New risk-based capital requirements
Required level of capital for each Bank is dependent on its risk
Assets with low risk are assigned relatively low weights
Capital level is set as a percentage of the risk-weighted assets
Riskier banks are subject ot higher capital requirements
|
Most Common Uses of Funds by Banks |
1. Cash
2. Bank Loans
a. Types of Business Loans
b. Loan Participation
c. Loans Supporting Leveraged Buyouts
d. Collateral Requirements on Business Loans
e. Volume of Business Loans
f. Types of Consumer Loans
g. Real Esate Loans
3. Investment in Securities
4. Federal Funds Sold
5. Repurchase Agreements
6. Eurodollar Loans
7. Fixed Assets
|
Off-Balance Sheet Activities |
1. Loan Commitments
2. Standby Letter of Credit
3. Swap Contracts
4. Forward Contracts on currencies
|
International Banking |
Global Competition in Foreign Countries
Expansion by foreign Bank in the United States
|
Edge Act Corporations |
In additional to establishing full-service branches, since 1913 foreign banks have established Edge Act Corporations in the U.S to specialize in international banking and foreign financial transactions
|
Key Regulations Imposed on Commercial Banks |
1.) U.S. is dual banking system: it includes both federal and state regulators
|
Key Regulations Imposed on Commercial Banks |
2.) A charter is required to open a commercial bank in the U.S.
a. Comptroller of the Currency = federal bank
b. Department of Financial Institutions (CA) = a state
bank
|
Key Regulations Imposed on Commercial Banks |
3.) Regulatory Structure: Members of FDIC regulated by FDIC
a. Regulatory Overlap. State banks are also regulated
b. Regulation of Bank Ownership
i. Ownership by a bank holding co.
ii. Independently owned
|
Key Regulations Imposed on Commercial Banks |
4. Deregulation Act of 1980 (Depository Institutions Deregulation and Monetary Control Act (DIDMCA)
a. Eliminated interest-rate ceilings (formerly
regulation Q)
b. All banks could offer NOW accounts
c. More flexibility in lending
d. Fed would now charge for its services
|
Key Regulations Imposed on Commercial Banks |
5. Garn-St. Germain Act
a. Allowed more use of money market accounts
b. Lowered geographic boundaries to conduct
banking
|
Key Regulations Imposed on Commercial Banks |
6. Regulation of Operations
a. Bank Assets closely monitored
i. Highly leveraged transactions (HLTs)
ii. Bank's exposure to foreign debt
iii. Loan diversification
|
Securities Services - The Banking Act of 1933
(better known as Glass-Steagall Act) |
Separated banking and securities activities
Prompted by problems during 1929 when some banks sold some of their poor quality securities to their trust accounts established for individuals
Some banks also engaged in insider trading, based on confidential information provided by firms that had requested loans
|
Banking Act of 1933 or Glass-Steagall Act |
Prevented any firm that accepted deposits from underwriting stocks and bonds of corporations
Banks could underwrite general obligation bonds of states and municipalities or purchase or sell securities for their trust accounts
They could hold investment-grade corporate bonds within their asset portfolio
Bank was acting as a creditor and not as a shareholder
|
Banking Act of 1933 or Glass-Steagall Act |
Separation of securities activities from banking activities was intended to prevent potential conflicts of interest
For example, the belief was that if a bank was allowed to underwrite securities, it might advise its corporate customers to purchase these securities and could threaten to cut off future loans if the customers did not oblige
Might provide loans to customers with the understanding that a portion of the funds would be used to purchase securities underwritten by the bank
|
Financial Services Modernization Act of 1999 |
Banks suggested that any potential conflicts of interest could be prevented by regulators
Banks argued that if they could engage in securities activities, they might have easier access to marketing, technological and managerial resources and could reduce the prices of securities-related services to consumers
Banks could become financial supermarkets, providing securities activities as well as normal banking services. Added convenience to customers
Increased competition could force all firms providing securities activities to be more efficient
|
Financial Services Modernization Act of 1999 |
Also called Gramm-Leach-Bliley Act
Repealed the Glass-Steagall Act
|
Financial Services Modernization Act of 1999 |
Allows affiliations between banks, securities firms and insurance companies
Also allows bank holding companies to engage in any financial activity through their ownership of subsidiaries
Consequently, a single holding company can engage in traditional banking activities, securities trading, underwriting and insurance
Required that the holding company be well managed and have sufficient capital in order to expand its financial services
SEC regulates any securities products that are created, but, the bank subsidiaries that offer the securities products are regulated by bank regulators
c. Insurance Services
d. Off-Balance Sheet Transactions
e. The Accounting Process
f. Regulation of Interstate Expansion
|
McFadden Act of 1927 |
Prevented banks from establishing branches across state lines, regardless of their intrastate branching status
|
Financial Services Modernization Act of 1999 |
Regulation of Capital
Banks are required to maintain minimum amount of capital
|
Financial Services Modernization Act of 1999
- Basel Accord: |
Promoted uniform capital requirements between 12 countries
|
Financial Services Modernization Act of 1999
- Basel Accord II: |
1.) Revised Measures of Credit Risk
2.) Accounting for Operational Risk
3.) Public Disclosure of Risk Indicators
|
Financial Services Modernization Act of 1999 |
Use of the Value-at-Risk (VaR) Method to Determine Capital Requirements
|
Value-at-Risk (Var) Method to Determine Capital Requirements |
1.) Recognizes risk in market forces such as:
-Interest Rates
-Stock Prices
-Exchange Rates
|
Regulator apply CAMEL Ratings in their Audits |
1. Capital Adequacy
2. Asset Quality
3. Management
4. Earnings
5. Liquidity
|
Capital Adequacy |
Based on the capital ratio = capital / assets
When banks hold more capital, they can more easily absorb potential losses
The higher the ratio, the higher the capital adequacy rating
|
Asset Quality |
Indicated the bank's exposure to credit risk (i.e. loan quality)
Regulators use 5 C's to assess loan quality
1.) Capacity
2.) Collateral
3.) Condition
4.) Capital
5.) Character
|
Management |
a. Ratings based on management's
1.) administrative skills
2.) ability to comply with existing regulations
3.) ability to cope with a changing environment
b. Internal control system
|
Earnings |
Criteria ratio:
Return on Assets, ROA = (Earnings after Taxes) / Assets
Compare earnings with industry standards
|
Liquidity |
a. Ability to pay obligations
b. Banks often borrow by accessing
1.) the discount window (the Fed)
2.) federal funds market
|
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 |
To promote the financial stability of the United States by improving accountability and transparency in the financial system
To end "too big to fail", to protect the American taxpayer by ending bailouts
To protect consumers from abusive financial services practices, prevent another Financial Crisis and for other purposes
|
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 |
Passed as a response to the late-2000s recession, is the most sweeping change to financial regulation in the U.S. since the great depression
Must restore responsibility and accountability in our financial system to give Americans confidence that there is a system in place that works for and protects them
|
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 |
Consumer Protections with Authority and Independence:
Creates a new independent watchdog, housed at the Federal Reserve, with authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices
|
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 |
Ends Too Big to Fail Bailouts:
Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by:
Creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big;
Updating the Fed's authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses
|