FI 301 Final Exam Study Guide
FI 301 Final Exam Study Guide FI 301
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This 9 page Study Guide was uploaded by Julie Knight on Sunday May 1, 2016. The Study Guide belongs to FI 301 at University of Alabama - Tuscaloosa taught by Sherwood Clements in Spring 2016. Since its upload, it has received 138 views. For similar materials see Financial Institutions in Business at University of Alabama - Tuscaloosa.
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FI 301 Final Exam Study Guide Chapter 25: Insurance and Pension Fund Operations Insurance- transfer risk to a company that can handle the risk o Avoid financial disaster o Types: car, health, house, life Payment= insurance premium Insurance companies invest your money Factor affecting premiums - Probability of loss, Size of loss, Competition, Expenses and profit margin Adverse Selection – those that need insurance are most likely to purchase it. (i.e. smokers, older people) Morale Hazard – careless or indifference to a loss because of the existence of insurance – i.e. speeding up to cross when the light turns orange Ownership o Life insurance- funeral costs, pay off debts (mortgage), protect your family o A stock owned company is owned by its shareholders o A mutual life insurance company is owned by its policy holders Whole life insurance o Protects insured until death o Set payment o Builds up cash value Term insurance o “betting” you are going to die o term o no cash value o less expensive than whole life Sources of funds o Annuity plan- pays you back money monthly over a definite time period Supplement their retirement Rollover their 401K into an annuity Uses of Funds o Government securities Risk free o Corporate bonds Long term bonds o Mortgages o Real estate (building) Rent them out Higher investment Property and casualty insurance o House, auto, etc. o Short term policy o Property and accidents o Insurer’s risk of loss is much greater Prices insurance- actuary Health care insurance o HMO- cheapest- restricted in doctors o PPO- more freedom to choose Pension Funds o Pension- saving structure for retirement Public- government (Social Security) Private- with company o Defined benefit plan Paid a portion of salary the rest of your life o Defined contribution plan You and company’s contributions and its investments = 401K Risk Management Benefits of risk management for a firm o 1)Reduces cost of risk. COR = total cost incurred by an org because of possibility of accidental loss and is comprised of: Losses not reimbursed by outside sources Insurance premiums or cost of noninsurance indemnity Cost of risk control to prevent or reduce loss Cost of administering RM activities o 2) Reduces deterrence effects Alleviates or reduces fears of potential losses Increases profit potential: more options Makes organization a safer investment: attracts capital Benefits of risk management for the economy o 1) Reduce waste of resources (benefit/cost) o 2) Improve allocation of productive resources Identifying loss exposures o Elements of loss exposures Financial value exposed Peril subject to Potential financial consequences o Types of loss exposures based on financial value exposed: Property Liability Personnel Net income Chapter 9: Mortgage Markets Mortgage- debt investment with house as collateral o Real estate loan o 1) mortgage rate o 2) maturity o 3) collateral o typical maturities- 15, 20, or 30 years any lender can originate mortgages secondary market- investments for sale o alternative investment- MBS everyone makes money off of interest quality for a mortgage o credit- FICO score o collateral- real estate (appraisal) o capacity- salary to cover payments o capital- down payment (20%) o conditions- verify employment prime (740-850) subprime (300-620) fixed rate mortgage o rate does not change o able to budget o interest rate risk o amortization schedule- principle/ interest adjustable rate mortgage (ARMs) o rate moves with the market o “teaser” rate o cap- limit to how much it can move annually and lifetime o hybrid- fixed that can convert to adjustable graduated payment (GPMs) o steps o 5 or 10 years o doctors (matches income) second mortgage o remodel or renovate shared appreciation o lower rate- share after sell balloon payment o business/commercial loans o short term GNMA (Ginnie Mae) o Government organization o Est. 1968 to guarantee timely payments by FNMA and FHMLC FNMA (Fannie Mae) o Est. after Great Depression o Buy government loans FHMLC (Freddie Mac) o Est. 1970 o Buy conventional loans from banks Chapter 17: Commercial Bank Operations Term for a checking account: demand deposit account; if you’re writing a check you’re writing a demand deposit o Conventional (regular) demand deposit: does not pay interest to you o Negotiable order of withdrawal (NOW) account: pays interest to you Electronic Transactions: E-check, direct deposit, transfer money between accounts online, open and close accounts, make payments on loans and bills, etc. Now account versus passbook savings account: now account can write checks on (both earn interest), savings account is less liquid with limited amount of transactions Another source of funds is time deposit—CD and NCD (more money than CD, about $100,000); you can’t touch it for a certain period of time Banks Sources of Funds o Federal Funds: banks borrow overnight mostly at a rate of 0-.25%, banks borrow here to make sure they have enough cash in the vault, and the rate matter because they use it to control the money supply (and base line for other interest rates); rate at which banks loan to other banks o Borrowing from the Federal Reserve Banks: rate is called discount rate because banks used to borrow at a discount window (a location banks used to go to so they could borrow money from the reserve); borrow from the Fed because you can’t get the money they want from the other banks o Eurodollar Borrowings: accept dollar denominated deposits (problem is conversion currencies) o Bonds Issued by the Bank: corporate bonds (last 10-30 years, do this for buildings/assets/equipment etc.) o Bank Capital: funds acquired by the issuance of stock or the retention of earnings (absorb operating losses) Uses of Funds by Banks o Assets (Cash—when banks get money through accounts they have to hold a certain amount of money. That amount of money has to be enough to meet the reserve requirement (now 10%) Banks hold money in their vaults or at the Fed o Lots of different types of loans Typical Business Loan: working capital loan, designed to support ongoing business operations (business loans) Term Loans: a loan for a certain amount of time, primarily to finance the purchase of fixed assets such as machinery and real estate Balloon Note—balloons after 2-7 years, big payments; pay for a certain amount of time and then its due Line of Credit: a loan that you can draw from when you want it, don’t have to take all of the money out at once Loan Participation: large loan where more than one bank participates; lowers risk because one bank doesn’t have to loan al the money Prime Rate: benchmark interest rate charged by banks, higher than other rates Banks make consumer loans—auto loans, education, short term loans o Interest is typically pretty high, generally higher than mortgage loans o Credit cards: like a line of credit, can borrow on credit card when you want o Installment loans: pay over time, link monthly to payments o Real Estate loans: a mortgage is a loan on real estate, typical maturities are 15,20, and 30 years (15 gives lower rate because less time to screw up) Commercial loans are short-term loans than residential mortgage loans Banks are in business to make loans—the characteristic that banks like to have are short-term, high interest loans o Investment in Securities, Loans, and Other Collateral Corporate and municipal bonds, treasury securities, mortgage-backed securities, federal funds sold, repurchase agreements, fixed assets Notice that stock is not on this list Off balance sheet activities where they don’t have to have cash on their balance sheet immediately: not loaning cash out right now o Loan Commitments: an obligation by a bank to provide a specified loan amount to a particular firm upon the firm’s request (loan you money later) o Standby letters of credit: backs a customer’s obligation to a third party (give you a credit letter, international trading) o Interest Rate Futures and Swap Contracts o Credit Default Swap Contracts: insurance product that pays the bank if the loan goes in default o Forward Contracts on Currencies: big customer that’s dealing international— fee to lock in currency rate Over time the number of banks have been decreasing because M&A, interstate banking, ad banks have become financial conglomerates o Banks holding companies generally own 10% or more of the bank and provide flexibility with short term debt, stock issuance, stock repurchase, and acquisitions Chapter 19: Bank Management Ultimate goal of banks is to maximize shareholders wealth o In order for them to do this they have to have inside and outside directors Outsider directors is the most effective because they have no bias Inside directors have a conflict of interest because thy are getting paid a commission so they might take on too much risk The loan committee is a group of people that approves large loans o A bank can align compensation with bank’s goals by paying some people salary and some people commission Important functions of bank directors: personnel decisions, compensation (salary vs. commission, bonuses), assessment and disclosure of the bank’s financial condition and performance to investors, mergers and acquisitions, capital structure of the bank Liquidity Risk: access to cash (do they have enough money in the vault to cover things) o Banks runs or making a lot of loans o Assessing liquidity: how much case do they have in their vault/at the Fed o Fixing liquidity: get more cash by securitization and investing in treasury Securitization: pulling their mortgages and selling them to Fannie Mae and Freddie Mac Interest Rate Risk: risk of interest rates rising quickly o Issue because may have to pay higher interest on savings/checking accounts/CD’s than what you would be receiving from long term loans Negative spread—net interest margin Net Interest Margin = Interest Revenues – Interest Expenses/Assets or banks profit margin/banks spread During rising interest rates, net interest margin will decrease o Assessing interest rate risk: GAP analysis, regression analysis, and duration Gap = ratesensitive assets – rate sensitive liabilities Gap Ratio = rate sensitive assets/rate sensitive liabilities (want to be positive and over 1) o Solve interest rate risk: make a floating rate (interest rate that moves with the market), maturity matching (try to match security of loans and their term) Hedge funds with derivatives: if interest rates are going to rise they’ll make them a derivative that will pay them if interest rates go down Credit Risk: risk of default (people don’t pay loans) o Assessing credit risk: FICO score (Fair Issue Corporation?), collateral To make sure they have enough collateral they get an appraisal (find the value of the collateral) Prime FICO score is 740 or above Subprime FICO score is 620 or below o Solve credit risk: diversify loans, don’t make bad loans (loan only to good credit), securitization (sell loans so you don’t have to worry about defaults on long term mortgage) Market Risk: risk that the whole market collapses or does poorly o Assessing market risk: VAR (value at risk) o Solve market risk: stop investing and making loans (which they can’t do); we all have market risk Currency/Exchange Rate Risk: international transactions, avoid by not doing it, but if they avoid it might be less diversified Risk Assess Solve Liquidity Cash in Vault Securitization Minimum Balance Checking Invest In Treasuries Interest Rates GAP Analyses Maturity Matching Duration Hedge with Derivatives Regression Analysis Floating Rate Loan Interest Rate Futures contracts, swaps, and caps Credit FICO (Fair Issac Diversify Loans Corporation) Score Securitization Collateral = Appraisal Make Less Loans Proper Interest Rate Market Value-At-Risk (VAR) Quit Investing Quit Lending VAR: calculation showing the maximum loss on an investment over a given time period with a certain degree of confidence; 5% change of 5 return that day; see how much they would lose if market failed Regression: statistical analysis of interest rate risk o R = a + Bi + E; Bi = I/R FI 301 Final Exam Review (In Class) Chapter 25 Insurance- transfer risk to someone else o Don’t have to pay for losses Life insurance o Insurance for when you die o Funeral costs, pay off debts, take care of family, education o Term- set time limit (5 or 10 years) Pay less for more coverage o Whole Life- same payments for life Builds up cash value Property and Casualty Insurance o Cars, house, disabilities o Harder for actuaries to price o Shorter term policies o Insurance companies lose more money on them than life insurance Health Insurance o Sickness o Most common: HMO (Health Maintenance Organization) Invests in corporate bonds- longer term investments o Policy is long term so they invest in long term o Same as pension funds Annuity- investment that helps with retirement o Roll over 401k to an annuity Pension plan- saving structure for retirement o 1) Defined benefit plan (educators) portion of your salary for life causes companies to go broke (employees are living longer) o 2) Defined contribution plan 401K- pay money into it and money is invested get however much you get from the investments (budget the money) benefits of RM (2 questions) identifying loss exposures (step 1) what are the loss exposures Chapter 9 Mortgages Mortgage- long term loan with real estate o real estate is the collateral o 15, 20, and 30 years o pay more in interest at first then principle o amortization schedule- principle and interest on mortgage Fixed interest rate mortgage Adjustable rate mortgage (hard to budget) o Moves with the market Could go up or down o Also called variable rate and floating rate Residential mortgage o Sell them to Fannie mae and Freddie Mac Securitization Commercial mortgage Insured mortgage o Government guaranteed- insured against default Conventional mortgage 5 C’s o Credit FICO score (fair Isaac corporation) (300-850) Prime (740+) subprime (620-) o Collateral Real estate o Capital Down payment (20%) o Capacity Salary (can you make the payments) o Conditions Employment Secondary market- where Fannie mae sells investments to investors Primary- where the bank loans you the money Crisis- FM and FM- buying a lot of subprime loans which went into default o Could not handle the defaults o Underwater- owe more than your house is worth o Short sale- sell for less than what the mortgage is worth Chapter 17 Demand deposit account- checking account Savings account- earn interest Time deposit = CD Banks get money by borrowing it o Federal funds rate Borrow from other banks o Discount rate Borrow from the Fed o Borrow by issuing bonds – they need real estate to run their bank in branches Banks use money o Make loans Term loan- borrow money up front for a specific time Line of credit- limit, but you can borrow when you need it over time Balloon note- pay a little at a time then all of it at the end o 5-year note o Worried about interest rates Banks cannot invest in stocks o Too volatile Banks issue credit cards o Higher interest returns Off balance sheet- loan commitment (commit to loaning later) o Cash is not being loaned at the time o Invest later Chapter 19 Ultimate goal of the bank o Make money for their shareholders So they take risk! Liquidity risk o If they can run out of cash (vault) o How much cash they have in the vault o How they fix it Securitization- selling residential mortgages to FM and FM Minimum balance checking- have to keep a minimum amount of money in account Credit risk o Risk of default o FICO score and collateral (appraisal- value of the real estate) o How to fix it Diversify loans- loan in different sectors (Auto and Healthcare) and location Make less loans (only good) During the financial crisis in 2009 Securitization Market risk o Risk of the market falling or economy falling o VAR (value at risk) o How to fix it Quit lending and investing Exchange rate risk o Loaning overseas o Changing of currencies (volatile) Interest rate risk o Risk of rising interest rates o Prepayment risk- fear of falling interest rates o Assess risk Gap- math*** Duration- how long it takes for loans to get paid off Regression- statistical measure o How they fix it Floating rate loans- changes with the interest rate (Fixed rates are bad) Maturity matching- match maturities (investments vs. loans) (loan vs. CD)
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