Final Exam Flashcards
(149 cards)
1
Q
Money markets are for which kind of assets?
A
Short-term (maturity of less than 1 year)
2
Q
The main reason for participating in the money market is…
A
Liquidity management
3
Q
Secondary trading in the money market is done via…
A
decentralized deal-broker networks
4
Q
Securities in the money market are standardized, which means that they are…
A
A very good substitute for one another
5
Q
Why are most money market securities easy to buy and sell in the secondary market?
A
They have very high liquidity
6
Q
Transactions in the money market are considered open-market transactions. This means that they are…
A
competitive and anonymous
7
Q
Liquidity is stored in the money market by
A
investing in securities
8
Q
Liquidity is bought in the money market by
A
Issuing securities
9
Q
Typically, securities in the money market have
A
- Low default risk
- Short maturity
- High liquidity
10
Q
How can the average household invest in the money market?
A
By purchasing shares of money market mutual funds (MMMFs)
11
Q
How are MMMFs different from other mutual funds?
A
They are more liquid and therefore less risky
12
Q
Discount instruments
A
Sold below par and only pay par value at maturity
13
Q
Add-on instruments
A
Sold at par and pay par value plus interest at maturity
14
Q
Treasury Bills
A
- Have maturities of up to 1 year
- Are free of default risk
- Are issued in the primary market through auctions conduced by the Treasury Department
15
Q
Stop-out rate
A
The lowest price at which treasury bills are sold
16
Q
Treasury auctions are uniform-pricing auctions meaning that…
A
all bidders pay the same price (receive the same yield) after the auction is decided
17
Q
The price of T-bills is expressed in terms of
A
discount yield
18
Q
Noncompetitive bids
A
submitted by individuals and small-scale investors
19
Q
Competitive bids
A
submitted by large investors such as large banks
20
Q
How are competitive bids accepted?
A
Bids with the lowest demanded yield are fulfilled first. Bids are accepted until supply is exhausted. The yield demanded by the last accepted bidder determines the stop-out rate
21
Q
Why does the discount yield formula underestimate the yield of a T-bill?
A
- It assumes a 360 day year
- Net returns are computed based on par, when usually an investor doesn’t pay par value
22
Q
Bond equivalent yield is always…
A
higher than discount yield
23
Q
The difference between the bid and ask price is
A
the dealer’s profit
24
Q
The main function of a federal agency is…
A
attract private capital to sectors of the economy where credit flows are insufficient
25
How are short-term federal agency securities different from T-bills
The yield is 1 to 20 basis points above similar treasury securities
26
What is the reason for this yield spread?
Most part due to liquidity reasons. The secondary market for federal agency securities is not as developed
27
Loans from the federal funds market are...
The most liquid of all financial assets
28
How do small and large banks differ when it comes to the Federal Funds market?
Smaller banks tend to be net lenders of fed funds while larger banks tend to be net borrowers of fed funds
29
Repos
Short-term interbank securities, usually overnight
30
How do repos differ from Fed Funds?
- Non-depository institutions can also access the repo market
- Repos are collateralized, usually by treasury securities
31
Repos do not have default risk. What kind of risk do they have
Their risks mostly lie in the value of collaterals
32
To compensate for collateral value risks, repos are typically issued with...
haircuts
33
Haircut
a discount on collateral value
34
How does yield for repos compare to the yield for fed funds?
Because repos are collateralized, their yield tends to be lower
35
Spikes of repo yields often indicate...
serious funding and liquidity issues for financial institutions
36
the higher the yield is...
the bigger the haircut
37
Commercial papers
unsecured corporate debt; a wholesale money market instrument
38
Because commercial papers are unsecured...
Only very trustworthy firms are able to issue them
39
How do individuals participate in the commercial papers market?
By investing in money market mutual funds (MMF)
40
Commercial papers are sold through direct financing, either by...
borrowing directly from firms (direct placements) or through dealers
41
Underwriting commission
Required when firms sell their commercial papers through dealers, typically a fixed proportion of the sale
42
Large financial firms typically choose which method of buying commercial papers?
Direct placements
43
Commercial papers are sold...
On a discount basis and carry no coupon
44
The commercial paper secondary market...
is very limited, because most investors hold their securities until they mature
45
Negotiable CDs
a time deposit issued by a bank to a firm in exchange for the firm's money
46
The main way that banks raise money from firms is
Negotiable CDs
47
NCDs cannot be withdrawn...
before the date of maturity
48
NCDs are...
tradable and transferable before maturity
49
Because NCDs are tradable and transferable...
A secondary market for them exists
50
NCDs are issued...
At face value and pay interest periodically
51
Why are NCD rates always above Treasury securities?
NCDs are not insured by the FDIC, so rates depend on the default risks of the bank
52
Capital markets
Long-term asset markets (over 1 year)
53
Capital markets provide financing for:
- Homeownership
- Firms' long-term projects/assets
54
Why do capital market bonds have greater interest rate risk?
they have longer durations
55
Capital market bonds have greater...
liquidity risk, interest rate risk, and inflation risk
56
Real yield (formula)
Real yield = nominal yield - inflation rate
57
Treasury notes
- have a 1 to 10 year maturity
- carry coupons
58
Treasury bonds
- have an over 10 year maturity
- carry coupons
59
Treasury securities are...
default risk free
60
Treasury Inflation Protection Securities (TIPS)
notes and bonds issued by the Treasury Department that adjust cash flows according to inflation
61
So inflation and TIPS coupon payments are...
positively correlated
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Yields of TIPS bonds are in...
real terms
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Breakeven rate
the TIPS-implied future inflation rate
64
How are the actual inflation rate and the TIPS breakeven rate related?
If actual inflation is higher than the TIPS breakeven rate, the yield of TIPS will adjust down and vice-versa
65
Separate Trading of Registered Interest and Principal of Securities (STRIPS)
a STRIPS bond separates the principal payment and coupon payments into individual zero-coupon bonds
66
What are two advantages of STRIPS bonds?
1. They help investors mitigate higher interest rate risk associated with the longer maturities of T-notes and T-bonds
2. A duration-matching strategy is much easier to carry out (because the duration of a zero-coupon bond is equal to its maturity)
67
Why are STRIPS bonds typically priced above market value
Because they make risk management easier
68
Municipal bonds
issued by state and local governments
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Corporate bonds
issued by corporations to raise long-term funding
70
Financial guarantees
ensure payments of principal and interest in the event of default. traditionally sold by insurance companies
71
Credit Default Swap (CDS)
a type of tradable security that provides insurance against default risk by allowing an investor to swap their credit risk with that of another investor
72
Securitization
the process of pooling multiple financial assets to create a new "synthetic" security
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Benefits of securitization
- help investors diversify portfolios, reducing risk
- allows you to invest in a wide range of industries at once
- increases the liquidity of debt instruments
74
Securitizations transfer risk to...
investors
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Tranche
a segment created from a pool of securities that are divvied up by risk, time to maturity, or other characteristics in order to be marketable to different investors
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One popular practice of securitization is...
to slice the securities into tranches
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The junior tranche bears...
the most default risk
78
Expected cash flow for junior tranches is ___ than higher tranches
lower
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Promised payments are ____ for different tranches
the same
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Expected cash flow of a tranche (formula)
Expected cash flow=face value ∗(1−chance of default)
81
Why are mortgage loans always secure?
Because the real estate acts as collateral
82
When you take out a mortgage it means two things:
1. A lien is put on the property to be used as collateral for the loan
2. The loan's principal and interest payments are divided into monthly installments over a period of time
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Primary lien
mortgages with the highest/first repayment priority in the event of default
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Junior lien
mortgages that are subordinate to the primary lien, often used to finance part of the down payment on the primary lien
85
Purchase loans
mortgages to buy a home
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Refinancing loans
mortgages to refinance an existing mortgage on the same property
87
Home Equity Line of Credit (HELOC)
revolving loans secured by equity in the home that allows the homeowner to borrow up to the credit limit with flexibility to make principal and interest payments. No restrictions on use of funds
88
Reverse mortgage
provides a way for an elderly household to sell the home without losing the right to live in it. The household sells to a financial institution to provide the household with retirement cash flows
89
Fixed-rate mortgages (FRMs)
mortgages where the interest rate is fixed throughout the life of the debt
90
A longer mortgage means...
○ Lower monthly payment
○ Longer duration
○ More interest paid to the lender
91
Interest for each month is based on the remaining balance of the principal, therefore...
interest payment decreases as the balance goes down and a larger portion of the monthly payment goes towards the principal balance
92
Who carries the interest rate risk for an FRM?
the lender
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Adjustable Rate Mortgages (ARMs)
mortgages where the interest rate is tied to a market benchmark (such as the 10-year treasury rate) and changes with the benchmark rate over time
94
Who carries the interest rate risk for an ARM?
the borrower
95
Holding all other factors equal, the ARM interest rate when the mortgage is taken out is ____ than the FRM interest rate when the mortgage is taken out?
less
96
Locked-in period
the time when lenders cannot adjust interest rates
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Reset frequency
the frequency which the interest rate can be changed based on movements in the benchmark rate
98
Payment caps
limit the maximum amount the payment can go up in any year and over the life of a loan
99
Interest rate caps
limit the size of the increase in interest rate in any year over the loan's life
100
How do caps and adjustment limits protect borrowers?
By ensuring that lenders do not transfer all of the interest rate risk to borrowers
101
Why might ARMs be a better choice than FRMs?
- Upfront payments are smaller due to lower interest rates at origination
- The borrower might believe that rates are more likely to fall than rise over time
- The borrower plans to sell the home before the locked-in period expires,
102
Conventional loan
a mortgage loan not insured or guaranteed by a government agency
103
The two types of conventional loans
1. Conforming loans
2. Nonconforming loans
104
Conforming loans
satisfy the terms and conditions to be purchased by Fannie Mae and Freddie Mac
105
Two types of nonconforming loans
1. Jumbo
2. Subprime
106
Jumbo loans
typically high-quality loans where the loan amounts exceed the regulatory limits for conforming loans
107
Subprime loans
high-risk loans that do not meet Fannie and Freddie credit standards
108
Examples of nonconventional loans
- FHA loans - insured by the Federal Housing Administration for those with low income
- VA loans - for veterans; insured by the Department of Veterans Affairs
- USDA loans - for borrowers in eligible rural areas; insured by the Department of Agriculture
109
What are the three primary factors a mortgage lender considers when assessing a borrower's qualification?
1. Debt-to-income ratio (DTI)
2. Credit score
3. Down payment
110
In terms of mortgage qualification, a ___ debt-to-income ratio is better
lower
111
FICO scores below ___ are considered subprime and unlikely to qualify for a mortgage
620
112
Why is a larger down payment preferred?
A larger down payment creates more equity for the borrower and reduces the lender's risk
113
Why must you get mortgage insurance if your down payment is less than 20% of your home's value?
a down payment of less than 20% creates a substantial probability of negative equity and therefore more default risk
114
A mortgage with insurance requires ________ in addition to principal and interest in its monthly payment
insurance premiums
115
Insurance premiums are equal to
an increase in the interest rate of the mortgage
116
The primary risk in the mortgage segment of the capital market is
prepayment risk
117
Prepayment risk arises when...
the mortgage is paid quicker than the amortized schedule
118
Why are mortgages prepaid?
Excess payments will go towards the principal and reduce the borrower's interest expense
119
Mortgage securitization
the process of bundling mortgages into marketable securities called mortgage-backed securities (MBS)
120
What is the objective of mortgage securitization?
to create an active secondary market
121
Originate-to-distribute model
After the lender has made a conforming loan, they may sell (distribute) it to GSEs for securitization and recoup the initial investment
122
The equity market is also called...
the stock market
123
Shareholders' losses are limited to...
their original investment in the firm
124
Why is equity investment riskier than bond investment in the same firm
Priorities are given to creditors, so equity is last in line to receive payments in the event of a bankruptcy
125
Common stocks
- Lowest priority to bankruptcy claims
- No legal claims to dividends
- Voting rights
126
Preferred stocks
- Higher priority to bankruptcy claims than common stock
- Contractual rights to dividends
- No voting rights
127
Firms with missed dividend payments to preferred stock owners...
cannot pay any other dividends until it has repaid the missed dividends to preferred stock owners
128
Convertible stocks
Give owners the option to convert stocks to bonds
129
One benefit of convertible stocks is that...
They help hedge against the higher risk associated with stocks
130
Stock prices will increase when there is ____ growth potential for a firm
more
131
Two common listing venues are...
The NASDAQ and the NYSE
132
Trading venues
places where actual trades of stocks take place
133
Market orders
to buy or sell at the best available price, normally minimal waiting time
134
Limit orders
to buy or sell at a designated price, may involve significant waiting time
135
Stop orders
sell only if the market price drops to or below the stop price and buy if the market price increases to or above the stop price
136
Regulation National Market System (NMS)
a uniform regulatory framework adopted by the SEC in 2005 that requires all trading venues except for a few dark pools to disclose best bid/ask prices on their book in the system
137
One benefit of high frequency trading is that it
helps provide liquidity in the market because of their readiness to trade
138
Futures contract
an agreement to buy or sell a specific amount of underlying assets at a specific future date and a specific price
139
Long position
agrees to buy the underlying assets at a future date
140
Short position
agrees to sell the underlying assets at a future date
141
Settlement date
the pre-specified future date where short positions must deliver the underlying asset
142
Beta of a stock portfolio
reflects a portfolio's systemic risk relative to the whole market
143
If beta is greater than zero...
the portfolio's value is positively correlated with the market
144
If beta is less than zero...
the portfolio's value is negatively correlated with the market
145
If beta equals zero...
the portfolio's value is uncorrelated with the market
146
When beta is greater than 1...
the portfolio's value is more volatile than the market
147
When beta is less than 1...
the portfolio's value is less volatile than the market
148
How do we calculate the market-value weighted index?
1. Calculate the total market value a year from now (price * shares outstanding)+(price * shares outstanding)....
2. Calculate the total market value initially (price * shares outstanding)+(price * shares outstanding)....
3. Divide the total market value a year from now by the total market value initially
149
How do we calculate the price-weighted index?
1. Calculate the average price for your group of stocks one year from now
2. Calculate the average price for your stocks initially
3. Divide the average price for your stocks a year from now by the average price for your stocks initially
