Final Exam Review
Final Exam Review ECON 3303
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This 41 page Study Guide was uploaded by Ashlie Meckley on Friday December 11, 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 218 views.
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Date Created: 12/11/15
Final Test Review Money o Exchange for satisfaction or utility o Something people want for exchange o Importance 1. Affects business cycle (boom and bust in economy) 2. Inflation Continually rise in price level, purchasing power of money 3. Affects interest rate Cost of borrowing or price paid for rental funds Monetary Theory: ties change in money supply to change in price level and interest rate o Cash will NOT die due to privacy and underground community o ONLY Fort Worth and DC print money Banking o Finance transfer of capital o More important rule then direct financing Positive connection between money supply and price level Negative connection between money supply and interest rates Financial System o Network of markets to bring together savers and buyers 1. Creating financial instruments 2. Provides 3 key financial services Risk sharing Liquidity Information Important source of job and income Finance Connects Lenders and Barrowers Lender (savers, Barrower Direct Financing: From lender to have extra money) barrower through Financial Markets Indirect Financing: goes through financial Financial Intermediaries: intermediaries Banks: 2/3 of companies barrow money from banks Insurance Funding Companies o Financial Markets (Direct Financing): Promotes economic efficiency Efficient allocation of capital = increase production Directly improves well-being of consumers o Gives them time to purchase 1. Stocks: 2 or 3% company barrow from 2. Bonds (gov): o Debt security that promises to make payment periodically for specified period of time o 25% company barrow from 3. Foreign Exchange (FOREX): Converting one currency to another Determines Foreign Exchange Rate: o One currency in terms of another Overcoming Deficits o Increase Taxes ONLY CREDIABLE GOV o Issue Bonds ONLY CREDIABLE GOV Government buys bonds because they spend too much money o Printing money Bonds o Zero Bond: theory that interest rate can’t be below 0 o Yankee Bond :US bonds bought by foreigners o Domestic Bond: Local barrowers, local currency o International Bond: Local or foreign countries Foreign Bonds Eurobonds Terms for Bonds and Mortgages o Short Term: less than a year o Intermediate Term: 1 to 10 years o Long Term: More than 10 years Debt Equity Definition Constructional agreement Claims to share net income Ownership of firm No Yes Maturity Yes No Yield Interest Dividends Set rate Change with profit of firm Ex Bonds and mortgages Stocks Relative Advantage Get paid before equity Benefit directly from change in holders (when bankrupt) the firm profitability or asset value Residual Claimants: getting paid after (bonds get paid 1 then stocks) Primary Market o Deals with new issues of stocks or bonds which are sold to initial buyers o EX: investment banks underwrites securities before delling them to the public (IPO- Initial Public Offerings) Secondary Market o Secondhand sales of stock and bonds o EX: 1. Exchange Buyers and sellers (brokers ) meet in central location (New York Stock Exchange and Chicago Board of Trading) 2. Over the Counter Dealers @ different locations who have an inventory of securities and are ready to sell to anyone (Gov bonds, fed funds, foreign exchange) o Function 1. Easier to sell financial instruments to raise cash = increase Liquidity(easiness to turn assets into cash) 2. Determine price of security sold in primary market Money Market o SHORT TERM debt instruments are traded NO stocks Capital Market o LONG TERM debt and equity investment and traded Federal funds are overnight Depository Institutions o Commercial Banks o Saving and loans & neutral savings banks o Credit union Treasury Securities o Federal Reserve holds most treasury securities o Monthly interest for treasury securities in Fiscal 2014 was $ 35 Billion o China holds most internationally US Government Securities o Treasury Inflation Protected Securities (TIPS) 5, 10,20 years Paid interest semi-annually Protects against inflation Common Securties 11% Treasury Bonds: less then a year (4,13,52, 26 WEEKS), Min face value $10,000 36% T-Notes: earn & pay fixed rate every month of mautrity (2, 3, 4 ,10 yrs) $5,000 53% T-Bonds: Stopped in Oct 2001 resumed Feb 2006, earn interest every 6 months Money PPT Lecture Date: September 3 –September 10 Currency 1. Narrow concept of money 2. Cash Money 1. Any commodity or token that is (generally accepted) as a means of payment Recognized Usually able to be divided into small parts (coins and dollar bills) 3 Primary Function of Money 1. ***Medium of Exchange**** Object generally accepted in return for good or service Use of money Saves transportation costs, enhances production, promotes efficiency Without money we would use barter system (buyers want what sellers have, double coincidence of wants) Required Features for Exchange 1. Easily standardized 2. Widely accepted 3. Divisible 4. Doesn’t deteriorate quickly 5. Easy to carry o Yap 12ft diameter Value in lives killed trying to move it Worth thousands 2. Unit of Account Agreed upon measure for stating the price of a good or service Without money prices are needed # of prices per good n (n – 1) 2 In World Trade $ key currency in international trade o Most commonly traded Almost all commodity trade in $ International debts in $ Foreign countries saves $ for trade Seigniorage Difference between face value and cost to produce Ex: Value Cost $100 - $.123 = $99.877 Based taxes off Seigniorage Saddam Hussein tried to challenge US Seigniorage o $ would lose value 3. Store of Value Any commodity or token that can be held and exchanged later for goods and services Saves purchasing power Depends on price level Central bank goal keep value of money stable *****BONDS & STOCKS & CREDIT CARD NOT MONEY***** Evolution of money Commodity Money Goods had value Money with intrinsic value Ex salt and cigarettes Fiat Money Ordered by government Money not redeemable for any commodity No intrinsic value AKA $ Check NOT MONEY Electronic Payment E-money Debt Card, stored value card, e-cash Could risk Seigniorage Types of Money Commodity Money (see above section) Fiat Money (see above section) Token Money Money with positive Seigniorage Bank Notes Paper promising a specific amount of gold or silver to bearers who persuaded them to issuing banks for redemption Legal Tender Creditors must accept as payments of debts Medium of Exchange in Prison Cigarettes no longer allowed Mack Money Mackerel now in use Worth about $1 Currency in USA Federal Reserve Notes (paper money) + Coins (us treasury makes) $ Bills have letters A-L (12 letter for 12 Federal Reserve Banks) U.S. Treasury Secretary signature on $ bills Money Today Currency in Banks is NOT money Forms of Money Bank deposits Currency outside banks Credit Cards Create debt which you pay off Too little money in circulation makes exchange difficult Too much money in circulation creates inflation Monetary Aggregates Way to measure money in economy M1 Currency held by Nonbank public Travelers checks Checkable deposits Highly liquid (easily used for goods an services) M2 M1 Saving deposits Small time deposits (less then $100,000) Noninstutional Money Market Mutual Funds Certificate deposit M3 No longer in use M2 Large time deposits Institutional MMMF RP’s Eurodollar: dollar deposits outside US Profitability M1 < M2 < M3 Liquidity M1< M2< M3 Measuring money is crucial Predicting macroeconomic phenomena Should predict nominal & real out put Hyperinflation Fast changing value of money Inflation exceeds 50% / month That’s more than a $ a day When happens governments turn to foreign currency Because local currency does not store value of money Ex North Korea Zimbabwe Hyperinflation Price change for food just in the time you were eating Equivalent to $ was trillion of Zimbabwe $’s Hot Potato: spending money as soon as you get it before its value decreased Effect: shelves in markets were cleared out Cause: government tried to overcome deficit by printing more money Solution: Gov removed all local currency and replaced it with foreign currency Lost their Seigniorage Dollarization Other countries using US $ for currency Germany: Hit deficit and hyperinflation after WW1 Money was being used to make fires, wallpaper, and just trash on the ground Ch 4 Interest Rate Lecture Dates: September 15 -17 th Present Vale $1 today has a different value tomorrow $1 today is worth more than a $1 in the future o Amount invested today for future payment Future Value = Money x (1 + i) n n Present Value = Money / (1 + I) i = intrest rate n = number of years o Ex: suppose that you have $10,000 today and your bank pays 5% interest rate for your savings account, what will you have next year, two years from now, and three years from now? Next year 10,000 x (1+ .5) = $10,500 Two years 10,000 x (1+ .5) = $11,025 3 Three years 10,000 x (1+ .5) = $11,576 o Ex: Which of the following would you like to receive at 10% interest rate? 1 a) $75 one year from now = 75 / (1+.1) = 268.18 b) $85 two year from now = 85 / (1 +.1) = $70.25 c) $90 three year from now = 90 / (1 +.1) = $67.62 Borrowing and Lending o Borrowing cost on a loan a) Want interest lower b) More Productive(barrowers viewpoint) use of money o Lenders reward on the investment return a) Want interest higher b) Time Preference(lenders viewpoint) You want money now not later o Interest rate low a) Greater incentive to borrow b) Fewer incentive to lend Why are interest rates important? 1. Affects investments and consumption 2. Redistributes wealth between borrowers and lenders 3. Impacts prices of key financial assets such as stocks and bonds Investment purchase of new capital goods and additions to inventories o Internet Café Example a) How many computers should you buy? Revenue Cost (I Cost (I =7%) =8%) Computer $100 $70 $80 1 Computer $90 $70 $80 2 Computer $80 $70 $80 3 $70 $70 $80 Computer 4 1. Firms investment decreases when interest rate increases 2. Profit = revenue – cost Yield to Maturity Interest rate equates payments received from a debt instrument with its value today Most accurate measure of interest Rate Debt instruments Loans a) Simple Loans one payment b) Fixed Payment Loans same payment every period throughout the life of the loan More than one payment Fixed payment (1 + i)n Bonds a) Discount Bond (zero-coupon bond) Bought at a price below its face value which is repaid at the maturity date single payment price lower than face value means no interest Face Value Price paid b) Coupon Bond Multiple payments Consol (perpetuity) Perpetual bond with no maturity date and no payment of principal that makes fixed coupon payments of $C forever a) Price consol (P c 1 2 $c / (1 + i) + (1+i) …. b) Current Yield (I c $c/ P c Rate of Return Payments to the owner plus the change in value expressed as a fraction of the purchase price RET = C + P – P (1+t) t Pt Pt P = price of bond at time t P (t-1) price of bond at t+1 C = coupon payment C/P t current yield = i P(1+t) P t Pt= rate of capital gain = g rate of return = yield to maturity a) if the holding period equals the time to maturity interest rate rises bond price decreases capital loss if sold before the maturity rate of return < yield to maturity Real Interest Rate Interest rate that is adjusted for expected changes in the price level so that it reflects more accurately the true cost of borrowing or true reward of lending a) ex post real interest rate (r) i – (realized) inflation rate e b) ex ante real interest rate (r ) i – (expected) inflation rate Fisher Equation Real interest rate = Nominal IR – Expected inflation Federal Open Market Committee (FOMC) Believe change in interest rate may change a) Interest Rate increases Sensitive stock market Bad news o Bond price decrease People buy more bonds less stock Ch 5. Behavior of Interest Rate Lecture Dates: September 22 nd Market Equilibrium: Excess Demand: price will rise and interest rates will fall Excess Supply Excess Supply: price will fall and interest rates will rise Centeris Paribus all else remains the same Supply Curve Shift Factors ( - negative shift to the left, + shift Excess Demand to the right) Barrows are bond issuers + (shift right) = Increased expected investment opportunity + (shift right) = Increase inflation + (shift right) = Increased government deficit Demand Curve Shift Factors ( - negative shift to the left, + shift to the right) Savers are lenders + (shift right) = Increased income/ wealth - (shift left) = Increased expected returns (future inflation and futures interest rate) - (shift left) = Increased risk + (shift right) = Increased Liquidity Price of Bond reciprocal to interest rate Flight & Quality: risky assets get moved to safer investments Higher risk = higher interest rate Greek bond market gets risker then the demand for German bonds will increase German Greek Spread difference between two interest rates Expected inflation increases then Nominal interest increases Pro-Cyclical vs Counter-Cyclical Pro: Moves same direction as GDP Counter: Moves opposite direction as GDP Peak Peak Nominal Interest Rate is Pro-Cyclical Bond Price is Counter-Cyclical Business Cycle During Boom Contraction Trough Boom (expansion) Supply increases Demand Increases Interest Rate increase Price Decreases when supply shifts more than demand Operational Twist Fed sold $400 billion short term bonds = Supply increase o Sell = Supply Fed bought $400 billion long term bonds = Demand increase o Buy = Demand Short Term (t-bill) Market Long Term Market Price Price Decrease Increase Interest Interest Rate Rate Decreases Increase Theory into Practice (TIP) o Yield = interest rate Treasury Euro Dollar Spread (TED) o Peaks show problems Dump risky to gain safer assets Importance Bond Market is where interest rates are determined Income Effect: higher level of income shifts demand curve right Price- level effect: rise in price level shifts demand curve right 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 R = R + R +…. R 1 R maturi= 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) 2 2 1,000,000 x (1 + R ) 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 ) 2015 2016 3. Set 1 and 2 equal to each other and cancel 2 1 1 o R = (R + R ) / n 2015 2015 2016 1 o 2% = ( 1% + R ) / 2 = 3% 2016 Example 2: 2015 2016 2017 2018 2019 1 year R12015 R12015 R 12015 2% 3 year R32015 R32015 R 32015 R 2018 R32018 3% 3% 3% 5 year R 2015 R52015 R52015 R52015 R52015 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= ? 4% + 4% + 4% + 4% +4% = 3% + 3% + 3% + (R 22018 2 20% = 9% + 2 (R 2018 R2 = 5.5% 2018 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 n 1 1 1 (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 P = Price of stock s e= expected D= dividends I = interest rate P = De + D e …… s e e 2 (1 +i ) (1 +i ) 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 Characteristics of Banking Industry 1. Large # of Banks Commercial: 5,445 S & L: 1,300 Mutual Savings Banks: 400 Credit Union: 8,900 Large # of banks due to lack of competition is due to regulations meant to restrict concentration of monetary power Distrust from public Inefficient banks have not succeeded 2. Dual Banking Industry National bank – chartered form the federal government OCC (Office of Comptroller of Currency) State bank – chartered by the state gov Until 1863 – no national currency only banknotes issued by state banks National banks account for 1/3 of banks 3. 4 different regulatory agency’s to supervise banks To deal with asymmetric information problems OCC – 1,850 national banks FED – BHC (bank holding companies), some State banks, ALL National banks State Banking Authorities – state banks FDIC – state banks Caused “regulatory shopping” problem in sub-prime crisis History of US Banking st 1782 - 1 Commercial Bank – Philadelphia 1863 – Dual Banking Born – National bank and state bank 1913 – Central Bank Birth- due to bank problems Delayed due to: Anti-federalist o Jefferson and Jackson o Did not want central bank Federalist o Hamilton o Wanted central bank Innovation as response of firms to changing environments: Changes in environment Demand – volatility of interest rate Increase in interest rate risk Responses o ARM (Adjustable Rate Mortgages) – flexible interest rates keeps profits high when rates rise Lower initial interest rates make attractive to home buyers o Financial Derivatives – ability to hedge interest rate risk Payoffs are linked to previously issued securities ***Supply – rapid advance in computer technology Responses: 1. Improved information of technology Lower the cost of processing financial transactions Easier for investors to acquire information Generate many new financial products and services 2. Bank credit and debit card 3. Electronic Banking Atm, Homebanking, ABM (automated business machine), Virtual banking (Not PayPal) Consequences: o Junk Bonds – easier to acquire financial information Corp with lower cred ratings banks lost business o Commercial Paper Market (CP) o Securitization –transform illiquid financial assets into marketable capital market securities Ex: MBS (mortgage backed securities) o Disintermediation Avoidance of Regulations o Financial industry is more heavily regulated Lead financial innovations by banks 1. Reserve requirements act as a tax on deposits 2. Restrictions on interest paid on deposits Non-interest bearing checkable deposits and regulation Q o Led to disintermediation Deposit Rate Ceilings – max interest rate paid to depositors (6% in 1970’s) Change in financial regulations and deregulations JP Morgan Chase # 1 bank in US Great lakes Bank of America # 2 bank in US East coast Decline of Traditional Banking Due to increased competition in both lending (assets) and deposit-taking activities (liabilities) Inside banking industry Changes in regulations on restricting bank branching Outside banking industry Financial innovations and some regulations changes Source of funds for barrowers, market share decrease Share of total financial intermediary assets decrease No decline in overall profitability thanks to an increase in income from off-balance-sheet activities and provision of derivative instruments Increased exposure to risk Assets Liabilities Decline in income advantages on Decline in cost advantages in uses of funds acquiring funds Junk Bonds MMF CP Market (And regulation) Securitization Deposits decrease Loan decrease Banks Responses o Expand new and riskier areas of lending Commercial real estate loans Leverages buyouts Corporate takeovers o Pursue new and more profitable (off balance) sheet activities Non-interest income Concerns about risk Increased risk taking Regulations protect barrowers & lenders not banks Key Legislations o 1927 McFadden Act – outlawed interstate branching Can’t cross borders to run branches National Banks to conform to the branching regulations Transaction restrictions Unit Banking - no branch Limited Branching – narrow geographic area Statewide Branching – within a state border Responses 1. BHC open several different banks in different states 2. Nonbank banks: not subject to regulation, only loans or only deposits 3. ATM (Automatic Teller Machine) function as a bank 1994 Reigle-Neal Act – repealed the McFadden Ac
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