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EC 404 > FINAL > Flashcards

FINAL Flashcards

1
Q

What is Yield to Maturity

A

The interest rate that makes the present value of all promised payments just equal to the price of the bond

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2
Q

Reasons why YTM might decrease Bond A started at 6% ON May 1 2016 and 8% on May 1 2010

A

A. market interest rates fell
B. the bond’s rating increased making it more desirable
C. some change in tax laws made bond A more attractive
D. The secondary market for bond A improved
E. the info on company A got better
F. bond A is a convertible bond and the price of the stock on this company rose
G. the yield curve us upward sloping so shorter maturities have lower yields

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3
Q

What does the acronym CAMELS stand for? How is it used in bank regulation?

A

C=capital: does the bank have sufficient capital
A=assets: what is the credit quality of the bank’s assets
M=management: is mngmt doing a good jon
E=earnings: is the bank profitable so that it can build up capital
L=liquidity: does the bank have sufficient liquidity to meet expected demands
S= sensitivity to market risk: how will the bank do if there is a downturn in the economy and the financial markets
Each bank is given a rating from 1(highest) to 5(lowest). Banks with lower CAMELS ratings are subject to more frequent exams and are often required to make improvements

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4
Q

What does FOMC stand for? Who is a member? What does FOMC do?

A

Stands for Federal Open Market Committee. Members: seven governors of the fed, the NY fed president and 4 other Fed Reserve Bank presidents
Decides on the course of monetary policy which currently means the interest rate target for the fed funds rate but also involved quantitative easing after the crisis of 2008

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5
Q

Defensive OMO and example that might trigger and what Fed would do

A

The FOMC sets a target for the federal funds rate at a level it thinks is best for the economy. Defensive open market operations are buying and selling U.S. bonds and bills to keep the funds rate close to or at the target. If the funds rate is above target, the Fed buys bonds, increases the monetary base and the supply of reserves and forces the funds rate down to the target. If the funds rate is below the target it sells bonds, lowers the monetary base and bank reserves, and pushes the funds rate up towards the target. Things that trigger defensive operations are the Treasury spending from its account which would require the Fed to sell bonds or the Treasury collecting taxes which would require the Fed to buy bonds. Changes in the currency ratio due to things like Y2K or holidays would also trigger defensive operations.

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6
Q

Dynamic OMO plus trigger and Fed transactions

A

Dynamic open market operations are buying or selling bonds to move the funds rate to a new target. If the FOMC raises the target the fed sells bonds. If the FOMC lowers the target the Fed buys bonds. Dynamic operations are usually triggered by changes in the economy that the Fed does not like such as an increase in inflation which would likely trigger a decision to raise the funds rate target by selling bonds or an increase in unemployment that might trigger a fall in the target accomplished by buying bonds.

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7
Q

Two Pension Fund types

A

Defined Benefit Plans

and Defined Contribution plans

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8
Q

Mutual Funds

A

Pool savings of many individuals and buy a portfolio of assets. Buyers then share in the income from the assets

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9
Q

Closed-Ended Funds

A

investment fund that sells a fixed amount of shares and invests the proceeds. Does not redeem shares. Price of shares on secondary market can deviate from NAV

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10
Q

Open-End Funds

A

Investment funds that will redeem shares at NAV and sell new shares

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11
Q

Load Funds

A

sell new shares at NAV+ sales fee up to 8.5% of NAV

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12
Q

No-Load funds

A

sell new shares at NAV

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13
Q

Exchange-traded funds (ETFs)

A

Initially, a sponsoring institution puts a portfolio of stocks that mimics a particular index into a fund that then issues shares. The shares are traded on stock exchanges like individual stocks. Now ETFs can be actively managed portfolios of stocks but have to inform investors of their portfolio.

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14
Q

Hedge Funds

A

Similar to Mutual funds but less regulated and limited to 100 participants. High Costs (managers take large cut of winnings)

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15
Q

Finance Companies

A

Traditionally offer loans to borrowers who were riskier than borrowers at depository institutions and charged higher interest rates

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16
Q

Investment Banks

A

help corporations raise funds through equity and bond financing
serve as brokers and dealers
advise on mergers/acquisitions
trade securities for their own accounts

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17
Q

Why Might banks fail?

A

Due to bad loans or investments

Bank runs result in illiquidity (banker’s risk)

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18
Q

Provisions to prevent bank failures

A

A. restrictions on assets to make them less risky
B. the Fed acts as the “lender of last resort”
C. deposit insurance
D. restrict entry through chartering process
E. bank inspections

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19
Q

Bank Capital

A

the buffer that protects depositors and the FDIC when a bank suffers losses

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20
Q

Regulators for different types of Banks

A
  1. National Bank: Comptroller of the currency
  2. state member bank: The Fed
  3. State nonmember FDIC insured: FDIC
  4. State, non-FDIC insured: state banking office
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21
Q

FDIC response to bank Failure

A

A. close bank, pay off insured depositors, liquidate assets, and pay uninsured deposits some fraction of their deposits
B. merge failing bank with healthy bank, putting up cash to make deal attractive
C. assist or take over bank
FDIC chooses option least expensive to the FDIC

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22
Q

What are Bank-Holding Companies?

A

Originally formed to get around restrictions on branching

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23
Q

What is the stress test?

A

Regulatory test that try to assess how well a bank will weather severe economic changes

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24
Q

FED Board of Governors?

A

7 people appointed by the President and confirmed by the senate
Terms of 14 years
Chair serves 4 year renewable terms

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25
Q

Duties of FED Board of Governors

A

A. vote on requests for discount rate changes
B. change reserve requirements
C. regulate member banks and all bank holding companies
D. administer regulations on consumer finance
E. oversee regional Fed banks

26
Q

Regional Federal Reserve Banks

A

12

Operational arm of the Fed owned by member commercial banks

27
Q

Responsibilities of Regional FEDS

A 
supply currency and clear checks
serve as U.S. gov't bank
regulate banks
collect economic data
conduct economic research
request discount rate changes
administer discount "window"
administer required reserve regulations and hold deposits (reserves) for banks
28
Q

Independence of Fed Issues

A

Independence can be reduced or eliminated by Congress by rewriting Federal Reserve Act
possible conflict with fiscal policy

29
Q

Factors increasing currency ratio

A
  1. more currency circulating outside the U.S.
  2. increases in underground economy
  3. loss of confidence in safety of banks
  4. Low interest rate on checking accounts or high fees
30
Q

Factors Decrease Currency ratio

A
  1. increased use of ATMs, debit cards, and credit cards due perhaps to reduced fees
  2. higher interest on checkable deposits
31
Q

What are Capital restriction?

A

Banks must keep a certain proportion of their risky assets as capital

32
Q

Causes of Recent Recession

A

House Price Bubble
House prices levelled off in mid-2006 and began to fall
mortgage related losses caused problems for financial institutions
credit became difficult to get not only for mortgages but for other loans and spending started to fall

33
Q

5 New tools of Fed in repsonse to recent financial Crisis

A

A. tools to increase bank liquidity
B. tools to help primary dealers
C. tools to help Money Market mutual funds and commercial paper market
D. tools to help asset-backed securities marker
E. tools to help individual companies

34
Q

Intervention in the Foreign exchange market

A

central bank buying or selling currency in an attempt to change the exchange rate

35
Q

Unsterilized Intervention

A

allow monetary base to change

36
Q

sterilized intervention

A

offset effect on monetary base through OMO

37
Q

What is the Balance of Payments

A

A. Current account

B. Financial account

38
Q

Devaluations and Revaluations

A

Under fixed exchange rates, a country could raise or revalue its exchange rate by international agreement if it was agreed that the currency was undervalued and the country had persistent BOP surpluses.
More common were cases where a currency was over-valued (BOP deficits) and the country had to devalue its currency because it started to run out of international reserves

39
Q

Exchange rate regime effect on monetary/fiscal policy

A

Fixed Ex rates: Monetary policy less effective in affecting domestic spending. Fiscal policy more effective
Under Flex exchange rates: Increase in M causes downward pressure on Interest rates causing EX rate to fall and encouraging exports/ discouraging imports

40
Q

What is the yield curve

A

The yield curve is a plot of the yield to maturity against the term to maturity for bonds that are otherwise the same, that is have the same default risk and tax treatment. Typically U.S. government securities are used.

41
Q

What is Pure expectations theory?

A

. the pure expectations theory that assumes borrowers and lenders are risk neutral so that the expected return for any given maturity is the same across all securities. This implies that long term rates are the average of today’s short-term rate and the expected short-term rates in the future
This theory would explain the different yield curves as indicating that people expected short-term rates to rise more in the future in the U.S. than in Japan.

42
Q

What is the liquidity preference theory

A

. liquidity preference theory that assumes that borrowers are income risk averse and lenders are wealth risk averse so that borrowers have to pay lenders a higher expected return the longer the maturity of the loan. This implies that the long-term rate is the average of the short rates plus a premium that increases with the length of the loan
This theory would explain the difference in yield curves as either indicating that people expected short-term rates to rise more in the future in the U.S. than in Japan or that U.S. lenders demand higher risk premiums than in Japan.

43
Q

Define Fed Funds

A

Federal funds or fed funds are loans between commercial banks in which one bank loans some of its deposits at the Federal Reserve to the other bank, typically overnight or for a short period. The interest rate on these loans is called the fed funds rate.

44
Q

Direct Vs. Indirect Finance

A

In direct finance there is one contract between the ultimate lender and the ultimate borrower. For example if I buy a bond issued by IBM. In indirect finance there are two contracts. One is between the ultimate lender and a financial intermediary and the other between the financial intermediary and the ultimate borrower. An example is when I deposit funds into my bank account (I lend to the bank) and the bank turns around and lends the funds, usually with other funds from deposits, to someone who wants a mortgage loan. Note that buying bonds or stocks through a broker is direct finance.

45
Q

If people are holding diversified portfolios they must be risk averse. True, false, or uncertain. Explain your reasoning.

A

True. Risk neutral investors would hold all their wealth in the asset with the highest expected return. Risk averse investors diversify in order to reduce the variance of returns for a given expected return and this will lead them to holding diversified portfolios.

46
Q

What is commercial paper?

A

Commercial paper is short-term, pure-discount debt of corporations, usually large corporations. The maturity is usually 30 days but always less than 270 days.

47
Q

Duration Gap Equation

A

DG=DA-(L/A)DL
DG=duration gap
DA=weighted average duration of assets(A)
DL= weighted average duration of Liabilities(L)

48
Q

Risk of positive duration gap

A

If DG>0, the value of assets will fall more than the value of liabilities when interest rates rise so the bank’s net worth falls if interest rates rise and rises if interest rates fall.

49
Q

Money market vs capital mrkt

A

<1 year in original maturity vs >1 year in maturity

50
Q

Covered Interest Rate Parity

A

1+i(us)=(1+i(f))(EX/F)

51
Q

What is a call option?

A

Call option – contract that gives the buyer the right but not the obligation to buy an asset for a given price (the strike or exercise price) for up to a specific date (American option) or on a specific date (European option).

52
Q

What is a put option?

A

Put option - contract that gives the buyer the right but not the obligation to sell an asset for a given price (the strike or exercise price) for up to a specific date (American option) or on a specific date (European option).

53
Q

What is PPP

A

Purchasing power parity states that the amount of goods a dollar can buy in the U.S. should equal the amount of goods that can be bought in a foreign country after exchanging the dollar for units of the foreign currency at the current spot rate.

54
Q

Adverse selection

A

Adverse selection is a problem of asymmetric information that occurs prior to the signing of contracts. The lender of funds or the insurer of risks has to be concerned that, when it specifies terms of the contract, it will attract only risky borrowers or high-risk insurance customers

55
Q

what is leverage

A

Leverage involves the fraction of your assets that are financed by equity versus debt. The leverage ratio is assets divided by equity (or capital) (A / C) with a high leverage ratio corresponding to a high level of leverage.

56
Q

What is solvency

A

the condition that the value of assets exceeds the value of liabilities

57
Q

Problems of a high leverage ratio

A

An institution that has a large leverage ratio incurs, all else equal, a higher risk of insolvency since a small amount of losses on the asset side would wipe out the equity of the firm.

58
Q
  1. What are the three main risks that a bank faces? Explain each risk briefly.
A

a. credit risk – the risk that loans or investments default
b. interest rate risk – the risk that interest rates change causing the bank’s income or equity to fall
c. liquidity or banker’s risk – the risk that the bank runs short of cash to pay back depositors who demand cash

59
Q

What is a bank’s Gap

A

Gap = $ amount of interest sensitive assets - $ amount of interest rate sensitive liabilities
The Gap measures how much the net interest income will vary with interest rates. If the Gap is > (

60
Q

Differences between credit unions and commercial banks

A

a. credit unions are mutual institutions and banks are stock institutions
b. credit unions do not pay corporate income taxes
c. credit union members (depositors or borrowers) should share a common bond

EC 404 (1 decks)

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