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Review Test 2

by: Ashlie Meckley

Review Test 2 ECON 3303

Ashlie Meckley

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Money and Banking
Chi-Young Choi
Study Guide
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This 17 page Study Guide was uploaded by Ashlie Meckley on Sunday November 1, 2015. The Study Guide belongs to ECON 3303 at University of Texas at Arlington taught by Chi-Young Choi in Summer 2015. Since its upload, it has received 35 views.


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Date Created: 11/01/15
Test 2 Review  Corporate bonds have higher default risk  After tax treasury pay less yield  Municipal Bond (Munis) pay less yield than treasury bond o tax free  Yields vary over o Liquidity & income tax  Bond Holding Risks o Default Risk  Issuer of bond unable or unwilling to make interest payments or pay off face value o Inflation Risk  chance that the cash flows from an investment won't be worth as much in the future o Interest Rate Risk  Risk that arises for bond owners from fluctuation interest rates  Risks o Measure of uncertainty about future payoffs of investments 1. Uncertainty 2. Qualified 3. Future Payoff 4. Relative to Benchmark 5. Time Horizon  US T-bonds o Default free  Risk premium o Spread between the interest rates in bonds with default risk and the interest rates on t-bonds  Default Risk and Credit Ratings o Stand and poor’s cut US to AA in August 2011  Cali rating changes a lot  Illinois lowest rating o Corresponds with credit score o Worse rating greater interest rate o Lower liquidly = lower yield o Long term bonds have higher yields o Junk bonds  Ranked below investment grades (non-investment grades  Maturity o Bonds with identical risk, liquidity and tax characteristics may have different interest rate because the time remaining to maturity is different o Treasury Bills (less than a year) o T-Notes ( 1 to 10 years) o T-Bonds (20 years) o Treasury Inflation-Protected Securities (TIPS) (semiannual)  Term Structure o Relationship between the length of time to maturity and the yield on bonds  Yield Curve o Plot of the yield on bonds with differing terms to maturity o Same risk, liquidity and tax considerations  Upward sloping  Long term rate > short term rate  Flat  Short term rate = long term rate  Inverted  Long term rate < short term rate  Shows recession  3 Facts of Yield Curve 1. Interest rates on bonds of different maturities tend to move together over time  Bonds are substitutes 2. When short term interest rates are low, yield curves are more likely to have an upward slope  Liquidity premium term case and by a low expected average in the second case 3. Yield curve almost always slope upward  Explained by a larger liquidity premium as the term to maturity lengthens  3 theories to explain facts of yield curve 1. Expectations Theory  Explains first two facts R = interest rate or annualized yield  Shows future interest rates R year purchasing year of bond n 1 1 1 maturity  R = R + R +…. R R = maturity 2015 2015 2016 2017 R = 1 year bond purchased in 2015 2015 N  Example 1: $ 1 million for 2 years 1. Buy one 2 year bond o Buy and hold strategy (BAH)  1,000,000 x (1 + R 2 )2 2015 2. Buy one 1 year bond today and another 1 year bond next year o Rollover Strategy  1,000,000 x (1 + R ) x (1 + R )1 2015 2016 3. Set 1 and 2 equal to each other and cancel 2 1 1 o R = (R + R ) / n 2015 2015 2016 o 2% = ( 1% + R 1 ) / 2 = 3% 2016  Example 2: 2115 2116 2117 2018 2019 1 year R 2015 R 2015 R 2015 2% 3 year R3 R3 R3 R3 R3 2015 2015 2015 2018 2018 3% 3% 3% 5 5 5 5 5 5 year R 2015 R 2015 R 2015 R 2015 R 2015 4% 4% 4% 4% 4%  R22016= ? 2  3% + 3% + 3% = 2% + 2 (R 2016 2  9% = 2% + 2 (R 2016)  R22016= 3.5% 2  R 2018= ? 2  4% + 4% + 4% + 4% +4% = 3% + 3% + 3% + (R 2018  20% = 9% + 2 (R 2 ) 2018  R22018= 5.5%  Bonds of different maturities are perfect substitutes  Yield of long-term bond of any particular maturity is equal to the (average geometric mean) of short term interest rates that people expect to occur over the life of the long-term bond 2. Segmented Markets  Explains fact three  Bonds of different maturities are not sustainable at all  Short term bond yield < long term bond yield  Price short term bond > Price long term bond  Interest rate for each bond with a different maturity is solely determined by the demand and supply that bond  Investors have performances for bonds of one maturity over another  Investors generally prefer bonds with shorter maturities that have less interest rate risk  Explains why yield curves usually slope up-ward 3. Liquidity Premium  Explains all three facts  Expectations theory + Premium (compensation for longer term bonds)  Preferred Habitat Theory o Prefer short-term bonds over long-term o Without premium people wouldn’t by long-term bonds  (R = R + R +…. R ) + Premium 2015 2015 2016 2017 n  Review Questions 1. Lowest yield to highest yield  Municipal bond  US Treasury bond  Corporate Aaa bonds  Baa bonds 2. Highest interest rate of long term bond?  Corporate baa bonds 3. Default Risk free (lowest risk)  US treasury bonds  Lowest interest rate (price increase, interest low decrease)  US treasury bills  Characteristic of Stock 1. Direct Finance 2. No maturity = capital market th 3. First appeared in the 16 century to finance the dangerous voyages for global exploration 4. Share are issued in small denominations 5. Share are transferable 6. Most stockholders no longer receive certificates 7. Pays dividends to the shareholders 8. Stockholders are residual claimants (gets paid after all else) 9. Composite indices are used to represent the overall movement of the stock prices  Rational Expectations 1. Make use of all available information 2. No unused information  Impossible to predict future movements = Efficient Market  No one can beat the market average  No use of investment advise  Investment “dashboard” o Picking stocks by throwing darts at a dart board  Random Wall Process o Impossible to predict o Stock same chance to go up as down  Ps= Price of stock  e= expected  D= dividends  I = interest rate e e  Ps= D + D …… (1 +i ) (1 +i ) e e  D and I = Fundamentals o Future Dividends (not fixed) o Future Interests Rate (not fixed)  Adaptive  Look at past to predict future  Stock Indices in the US 1. DJIA  Top 30  Originally 12  GE only one from beginning  AT &T replaced by apple 2. S & P 500 3. Russell 2000 4. Willshire 5000 5. NASDAQ 6. NYSE composite index  Fed in Stock Market 1. Stock Price Movements  Fluctuations in stock value  Volatile o show how stocks are valued  Valuation of stocks  Reflect the future net cash flows  Stocks are risky  Because residual claimants  Can change Money Supply (MS)  Money Supply increase  Interest rate Decrease  Economy Boost  Expansionary monetary is good news for stock market  Expectations plays essential role  High stock price next year means high stock price today  Fed Watcher 1. Look at Fed & what will be next move 2. Usually former employees   Rate of return on security 1. R = P (t+1) Pt+ C Pt 2. R = rate of return on security 3. P (1+t) price of the security at (t +1) 4. P t price of security at time t 5. C = cash payment  Efficient Market Hypothesis 1. React within ten minutes to an earnings announcements 2. Security’s price fully reflects all available information 3. In Favor  Perform well in the past does not mean they will do well in the future  If information is already public available then they won’t react to the market  Stock prices follow a random walk  Technical analysis cannot successfully predict changes in stock price 4. Against  Small-firm effect  January effect  Lower prices in December than January  Market Overreaction  Excessive Volatility  Mean reversion  Buy below profit or above mean line  New information is not always immediately incorporated in the stock market 5. Buy and hold strategy most sensible 6. Speculative Bubble  Influenced by factors other than fundamentals  Mispricing  Bubbles o Inflated asset prices that are not based on expected future profits o Occur because of investors buy stocks solely on the belief that they can sell them for a higher price in future  Dividend price ratio o Lower the ratio the more likely to be bubble  Dividends / price  PE Ratio o Price – earnings ratio o Higher the ratio the more likely to be a bubble o For each earning prices are higher by this #  More complicated statistical tools 8 basic facts of financial structure 1. Stocks are not the most important sources of external financing for business 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance is many times more important than direct finance 4. Financial Intermediaries are the most important source of external funds 5. The financial system is among the most heavily regulated sectors of the economy o Asymmetric problem 6. Only large well- established corporations have easy access to securities markets to finance their activities 7. Collateral is prevalent feature of deb contracts o Student loans have no collateral 8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on barrowers Two Main Problems in Financial Markets  Transaction Costs o Major Problems in Financial markets  Min face value  Brokerage commission – fee for stock trade  Legal fees o Financial intermediaries  Reduce transaction cost :  Economies of scale – more you produce cheaper selling in bulk o Ex:  Mutual funds  Class price decrease a increase of # of enrollment in class  Costco cheaper cause you buy in bulk  Expertise o Ex: MMMF provides liquidity  Problems with Asymmetric Information o Bottom of every financial crisis o Cannot be eliminated o Specialized in loan offices o Party’s having insufficient knowledge about the other party o Agency Theory  Analyses how asymmetric information problems affect economic behavior by interfering with the efficient functioning of financial markets  Adverse Selection Problem  Before transaction  Cannot tell good borrower from bad barrower  Lemons Problem: o George Akerlof o Lack of information can lead to poor function market o Ex: Car buyers do not know about the car as much as the seller does  Good Car (Peach) – willing to pay $10,000  Bad Car (Lemon)- willing to pay $4,000  Average of both is $ 7,000  Shouldn’t buy the $4,000 car for $7,000 and can’t buy the $10,000 for $7,000  No purchase  Car dealers a bankers of market o Ex: Banks and interest rates  Good investor – 3% interest rate  Bad investor – 15% interest rate  Average of both is 10%  Good investor is not happy with this  Bad investor is o If the quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality  Good quality items will not want to sell at average price  Buy won’t buy below average o Explains fact 2 and partially 1  Solutions: 1. Private Production & Sale information  Companies distinguish good from bad  Cant exclude free rider problem  Ex: Angies list 2. Government Regulation to increase information  Security & Exchange Commission (SEC)  Lessens adverse problem  Releasing negative info about firms can be politically difficult  Explains Fact 5 3. Financial Intermediation  Difficult obtaining information due to cost  Sort out good credit risk from bad ones  Can avoid free rider problem by primarily making private loans  can exclude information sharing  smaller role of securities in developing countries  EX: buying from a dealer rather random person, they have people who have evaluated car  Explain Facts 3,4, & 6 4. Collateral and net worth  Collateral – property promised to the lender if the borrower defaults  Net Worth (equity capital) – difference between a firms assets and its liabilities  Lenders more willing to make loans secured by collateral and high net worth  Explains Fact 7  Moral Hazard Problem  After transaction  Cannot monitor how good your money is used  Ex: People neglect to be careful with insurance  Principal-Agent Problem –  Separation of ownership and control of the firm  Managers pursue personal benefits and power rather than the probability of the firm  Ex: Enron Scandal  Solutions  Monitoring  Can’t prevent free rider problem and costly  Explain Fact 1  Government Regulation  Impose criminal penalties  Explains Fact 5  Financial Intermediation  Venture Capital Firm – pool the resources to help budding entrepreneurs start new business o Place their own people in the board of directors to monitor o Equity firm is marketable only to venture capital firm  prevents free-rider problem o Explain Fact 3  Debt Contracts o Less severe problem of moral hazard than equity o Explains Fact 1 o Not free from moral hazard problem o Barrowers have incentives to take on projects that are riskier than the lenders would like o Solution to Moral Hazard Prob  Net worth and Collateral – incentive compatible  Monitoring and Enforcement of Restrictive Covenants – provisions in contract to restrict  Financial Intermediation  Conflict of Interest  Moral hazard prob due to economies of scope –multiple product of production  multiple objectives and as results has conflict 1. reduces the quality of info in financial markets 2. increases asymmetric information problems 3. deteriorates the function of financial market in channeling funds into productive investment opportunities 4. Lowers economic efficiency  Why they arise 1. Underwriting research in investment banking  Bank is attempting to simultaneously serve two client groups  Spinning – allocates hot, but underpriced, IPO’s to other companies for future business 2. Auditing and Consulting in Accounting Firms  Maybe willing to skew judgment to win consulting business  Ex: Arthur Anderson & Enron  Remedies 1. Sarbanes-Oxley act of 2002  Public accounting return on investor protection act  Increase supervisory oversight to prevent conflict of interest  Made public company accounting oversight board  Increases SEC budget  No non-audit service to a client contemporaneously with an impermissible audit 2. Global Legal Settlement 2007  Investment banks have to serve the link between Review Questions True/ False Questions 1. Stocks are the most important sources of external financing for business. 2. Banks are the more important source of external funds than stock and bond markets together. 3. The financial system is among the most heavily regulated sectors of the economy. 4. Insured drivers are more careful in driving than uninsured drivers. 5. Loan documents are generally bulky to prevent asymmetric problem. Multiple Choice 1. Which of the following is the least important external funds for firms? a) Junk Bonds b) Loans c) Stocks d) Municipal Bonds 2. What is the primary source of external funds? a) Junk Bonds b) Loans c) Stocks d) Municipal Bonds 3. Which of the following is an accurate difference between Adverse Selection and Moral Hazard Problem? a) Moral hazard is an asymmetric problem while adverse selection is a transactional cost problem b) Adverse selection is an asymmetric problem while moral hazard is a transactional cost problem c) Moral hazard problem happens before a transaction and adverse selection happens after transactions. d) Adverse selection happens before a transaction and Moral hazard problem happens after transactions. 4. What is the best explanation for why the Lemons problem exist? a) Asymmetric information b) Transaction cost c) Not enough lemonade d) Stupid people 5. What is an example of market failure? a) Jane doesn’t buy a car because she doesn’t know the history of the car. b) James bargains with the guy about the car and finally buys it for less than it is worth. c) Jackie buys a car for more than it is worth. d) After Judy’s boyfriend concludes that the car is in good shape, she buys it from the owner. 6. Which of the following did we see in the Enron scandal? a) Adverse selection problem b) Moral Hazard problem c) Principle agent problem d) Lemons problem 7. Which of the following is not one of the 8 basic facts on financial structure? a) Interest rates on bonds of different maturities tend to move together over time b) Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations c) Indirect finance is many times more important than direct finance d) Financial intermediaries (in particular banks) are the most important source of external funds 8. The principle agent problem would not happen if a) Owners have complete information about the activities of the managers 9. Which of the following is true about adverse selection? a) More likely to obtain funds from banks and financial intermediaries rather than from securities market Fill in the Blank 1. Problem helps to explain why the private production and sale of information cannot eliminate . 2. Is the more you produce the cheaper it cost while has multiple products of production.  Banks (depository institutions) o Part of financial intermediaries o Take money from depositors and make loans to barrowers o Types  Commercial (common banks)  Saving & loans  Mutal Savings banks  Credit unions o Bold 3 are thrift institutions  Why Banking Matters? o Important source of firms financing o Supply more than $10 trillion in credit annually o Major employer of the economy o Provide services of checking and savings accounts  Bank Risks o Liquidity o Credit o Interest Rate  Sensitive liability or assets 1. Change with interest rate  Fixed rate  Gap Analysis – measure of sensitivity of bank profits to changes in inters rate  Gap –amount of rate sensitive liabilities – amount of rate sensitive assets  Bank profits = Gap X interest rate o Trading o Other risk  4 Primary Concerns o Assets management  Goals 1. Seek highest returns possible on loans and securities 2. Reduce risks 3. Adequate provisions for liquidity by holding liquid assets  Achieved by 1. Barrowers who pay high returns BUT unlikely to default 2. Purchasing securities with high returns and low risk 3. Lowering risk by diversifying 4. Managing the liquidity of assets to satisfy reserve requirements o Liabilities management  Optimal mix between deposits and barrowing  Before 1960 no need for liquidity management  Now 1. Money center to increase flexibility in liquidity (NY, Chicago, San Fran) o Develop overnight loan markets and ne financial instruments o Aggressive in acquiring funds 2. Banks increase proportion of their assets held in loans to earn higher income o Liquidity management o Capital management  Purpose 1. Helps prevent bank failure 2. Affects returns for the owners 3. Required by regulations  Banks maintain banks capital to lessen chance of insolvency 1. At 0 is okay below 0 is insolvent  Increase Capital 1. Issue new stocks 2. Reduce banks dividends 3. Trouble Asset Relief Program o Federal gov purchases assets and equity from troubled banks  Insolvency Problem o FDIC takes over bank o Sells assets or gives to another stable bank  License o National Banks (1/3)  Get license from OCC (Office of Currency and Control) o State Banks (2/3)  Get license from State government  Indirect Financing o Depository institutions o Commercial savings institutions o Investment intermediaries  SIFI (Systemically Important Financial Intermediaries) o Metlife o AIG o Prudential financial o GE capital  Thrift Institutions o Savings & loans association (S&L) o (Mutual) Savings Banks o Credit Union  Commercial Banks o Firm that is licensed by the Office of Comptroller of the Currency in the US Treasury  Can accept deposits and make loans o Less than 5,500 Commercial Banks (still a lot compared to other countries) o 14,000 Commercial Banks in 1980’s o Role  dominant role in monetary system  channeling funds from lenders (households AKA us) to borrowers (Firms and Government) o Goal – maximize profit  Positive spread Banks charge higher interest rates which they borrowed from depositors  Source of Funds : deposits & borrowings  Use of Funds: 1. Loans 2. Government Securities 3. Keep some cash in vault for JIC (reserves) o Cash in vault o FED o Balance Sheet  Total Assets = Total Liabilities + Capital (net worth)  Net Worth  Value of the owners equity on the bank (residual claim)  Cushion against a drop in the value of its assets  Assets < Liabilities  Net Worth < 0  Banks become insolvent  Liabilities (source of funds)  Deposits 1. Transaction Deposits (CD)  Demand Deposits  Other checkable deposits (NOW, MMDA’s) 2. Non-transaction Deposit: primary source (55%)  Saving deposits  Time deposits  Ex: CD (Certificate of Deposits)  Borrowings 1. Discount Loans (the FED) 2. Federal Funds Market (other banks) 3. From Parent Companies  Assets (use of funds)  Reserves  Vault cash  Deposits from FED  Required vs. Excess Reserve  Required held by banks required by FED regulation  Reserve Ratio = required reserve Deposit  Excess reserves that exceed those need to meet the required ratio o Total reserve – required reserve  Securities  No stocks, debt instruments only  U.S. gov’t securities as second reserve  Loans  Primary source of banks’ profits  Less liquid and higher risks  Other physical building, computer ect. assets *Comerica Incorporated largest bank in DFW (State Bank)* Assets Liabilities Loans Deposits Securities Barrowing Reserve Capital (Equity) ASSETS MUST = LIABLITIES  Liquidity Problem 1. Federal Funds Market 2. Sell Securities 3. Borrow from FED 4. Call in Loans  ROA (return on asset)  Net profit after tax Assets  Smaller for larger banks (better risk management)  ROE (return on equity)  Net profit after tax Equity  Higher for larger banks (economy of scale)  EM (equity multiplier)  Assets Equity  Higher in large banks  Stock holders want high  ** ROE = ROA X EM**  Capital Adequacy Management (Safety)  Good for owners of bank  Money is safe  Costly to owners  Higher bank capital = lower return on equity  Trade off  Depends on economy and levels of confidence  Off balance sheet activities  Affect bank profit but not on B/S  Financial Derivatives  Financial instruments value depends on the value of some other financial instruments  Original purpose to transfer risks  Trading


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