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Financial Markets and Institutions

by: Donato Heathcote

Financial Markets and Institutions FIN 310

Marketplace > Colorado State University > Finance, Real Estate & Law > FIN 310 > Financial Markets and Institutions
Donato Heathcote
GPA 3.59


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Class Notes
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This 8 page Class Notes was uploaded by Donato Heathcote on Tuesday September 22, 2015. The Class Notes belongs to FIN 310 at Colorado State University taught by Staff in Fall. Since its upload, it has received 39 views. For similar materials see /class/210344/fin-310-colorado-state-university in Finance, Real Estate & Law at Colorado State University.

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Date Created: 09/22/15
1 Risk a 57 Squot Sovereign riskrisk that repayments by foreign borrowers may be interrupted because of interference from foreign governments or other political entities 39 Country or sovereign risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments differs from credit risk of Fls domestic assets with domestic assets Fls usually have some recourse through bankruptcy courts ie Fls can recoup some of their losses when defaulted firms are liquidated or restructured iv foreign corporations may be unable to pay principal and interest even if they would desire to do so foreign governments may limit or prohibit debt repayment due to foreign lt currency shortages or adverse political events Country or sovereign risk cont Thus an Fl claimholder may have little or no recourse to local bankruptcy courts E s or to an international claims court viii Measuring sovereign risk includes analyzing ix the trade policy of the foreign government x the fiscal stance of the foreign government xi potential government intervention in the economy in the foreign government s monetary policy xiii capital flows and foreign investment xiv the foreign country s current and expected inflation rates xv the structure of the foreign country s financial system Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals or unexpected loan demand may require an Fl to liquidate assets in a very short period of time and at low prices 39 Daytoday withdrawals and loan demand are generally predictable Fls may hold liquid assets andor rely on purchased funds iquot Purchased funds include shortterm borrowings such as federal funds loans and brokered deposits iv Liquidity risk continued v Unusually large withdrawals by liability holders can create liquidity problems in these cases vi The cost of purchased andor borrowed funds rises for Fls vii The supply of purchased or borrowed funds declines viii Fls may be forced to sell less liquid assets at quotfiresalequot prices Credit riskis the risk that the promised cash flows from loans and securities held by Fls may not be paid in full i Fls that make loans or buy bonds backed by a small percentage of capital ii Thus banks thrifts and insurance companies can be significantly hurt by even minor amounts of loan losses PS NS iii Many financial claims issued by individuals or corporations have iv limited upside return v large downside risk with a low probability vi A key role of Fs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans vii Fs also charge interest rates commensurate with the riskiness of the borrower viii the effects of credit risk are evidenced by net chargeoffs ix the Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare bankruptcy x Fs can diversify away some individual firmspecific credit risk but not systematic credit risk xi firmspeci c credit risk is the risk of default for the borrowing firm associated with the specific types of project risk taken by that firm xii systematic credit risk is the risk of default associated with general economy wide or macroeconomic conditions affecting all borrowers d operational risk i Technology risk and operational risk are closely related ii Technology risk is the risk incurred by an H when its technological investments do not produce anticipated cost savings iii The major objectives of technological expansion are to allow the H to exploit potential economies of scale and scope by iv lowering operating costs v increasing profits vi capturing new markets vii Operational risk is the risk that existing technology or support systems may malfunction or break down viii The BIS defines operational risk as llthe risk of loss resulting from inadequate or failed internal processes people and systems or from external events e how they apply to financial institutions Calculate true cost of a loan a Stated rate vs compensating balance Non performing loan Given a H balance sheet be able to calculate net interest income given a certain change in interest rates using repricing gap model 2 questions on this Calculate all aspects of duration gap model given a Financial institution s balance sheet a Can use excel Difference between positive and negative repricing gaps GDS vs TDS loan criteria a Calculate both and determine loan qualification ofa potential borrower hmwm Pmch mm mm mm mm am wyumm m ms 7 c 11 ratm and 351 4a percentfurthe TDSratm s Reprmng gap vs duratmn gap mude wheh mezsunrg meresl rate Hsk 1 MN 11 HH MN mh 11 What 15 2 matunty baskeq and huw dues 1t heme m mterest rate sensmve assets 2 3 when 152 wash changed my 2 days accrumg mteresl b WhenScunsmerednunperfurm rg 14 Knuwthes cm cream 1 1 m er b czpzmty c cqutera Formulas 1 5 6 7 8 9 Accrued Interest a Accmedinterest 2 INT Actual number of days Since last coupon payment Actual number of days in coupon period Clean Price of a Bond dmNmMPVIEdmm a V MPVIFA m b Vb The present value of the bond c M The par value of the bond d INT Annual interest payments in dollars e N The number of years until the bond matures f m The number of times per year interest is paid g id interest rate used to discount cash ows on the bond Dirty Price of a Bond a Accrued Interest Clean Price b See ch6 quiz problem 1 After Tax Return a Corporate Taxable Bond i ia ib lt Municipal Tax Equivalent Rate of Return i ib ia lt ia AfterTax rate of return on a taxable corporate bond ib BeforeTax rate of return on a taxable bond t marginal total income tax rate of the bond See ch6 quiz problem 2 Rate of Return on a Bond Quoted Ask Yield on a Bond Cumulative Straight Line Earnings Per Share just by looking at a stock quote a Price PE V b c d e Knowledge Based A Sinking Fund Provision a A requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity Almost like a payment plan for bond issuers A fund held by a trustee that the issuer pays into to either call or buy bonds before their maturity or to simply accumulate the cash to pay the bond issue off at maturity before the time comes This reduces the probability of default at maturity and is attractive to bond holders so bonds with a sinking fund provision are less risky and have lower yields than comparable bonds with no sinking fund provision B Callable Bond Fquot a Allows the issuer to require the bond holder to sell the bond back to the issuer at a given call price usually set above the par value of the bond Callable bonds can be bought back by the issuer per a call provision at a price above the face value The difference between face value and call price is the call Fquot premium The call premium declines in value as maturity date approached because it saves the issuer less money Call options are executed when interest rates drop and issuers can borrow cheaper money Call provisions are unattractive to investors because the duration is controlled by the issuer so callable bonds have higher yields than comparable noncallable bonds C Required Rate of Return Based on Credit Quality a The better credit quality a company has the lower the required rate of return will be b Lower credit qualities require a higher rate of return which means they have a lower PV than a security of the same FV and a lower risldlower rate of return D Investment Grade Bonds vs Junk Bonds a Investment Grade Bonds i Bonds with a rating of BBB or higher ii Lower interest rate iii Lower Required Rate of Return b Junk Bonds or High Yield Bondsspeculative grade bonds i Bonds with a rating BB or lower ii Higher interest rates iii Higher Required Rate of Return E Municipal Bonds a Municipal bonds Munis i Securities issued by state and local governments 1 To fund imbalances between expenditures and receipts 2 To finance longterm capital outlays ii Attractive to household investors because interest is exempt from federal and most local income taxes b General Obligation GO Bonds i Backed by the full faith and credit of the issuing municipality c Revenue Bonds i Sold to finance specific revenue generating projects d Collateral i Taxexempt bonds are used as collateral for indebtedness F Stocks vs Bonds a Stocks Own part of a company i39 Have voting rights in the company iii Limited Liability iv Never expire v Quote 1 Ticker Price b Bonds i Lending money to somebody ii Get interest back on loan iii Expire after a certain amount of time 1 Quoted a Maturity Date Coupon Rate Bid Price Asked Price Change Asked Yield G Voting by Proxy a Allows stockholder to vote by absentee ballot by mail or online H Purchasing Power Parity a Is the theory explaining the change in foreign currency exchange rates as in ation rates in the countries change b iUS 1va RIRUS and is IPS RIRS c i interest rate d IP in ation rate e RIR real rate of interest f US the United States g S foreign contry h Assuming real rates of interest are equal across countries L iUS is 1va IPS j Finally the PPS theorem states that the change in the exchange rate between two countries currencies is proportional to the difference in the in ation rates in the countries k PUS IPS ASUSSSUSS l SW3 The spot exchange rate of US dollars per unit of foreign currency 1 Interest Rate Parity a The theory that the domestic interest rate should equal the foreign interest minus the expected appreciation of the domestic currency b 1439an 1S2X1iUKtXFl c I39m the interest rate on a US investment maturing at time t d I39m the interest rate on a UK investment maturing at time t e S Z spot exchange rate at time t f E forward exchange rate at time t J Going Long or Short on a Futures Contract a Long i When you think that the price of the Future is going to increase b Short i When you think that the price of the Future is going to decrease K Options a Put Option i An option that gives the purchaser the right but not the obligation to sell the underlying security to the Writer of the option at a speci ed exercise price on or up to a speci ed date b Call Option i An option that gives the purchaser the right but not the obligation to buy the underlying security from the Writer of the option at a speci ed exercise price on or up to a speci ed date L Strike Price The price at which a speci c derivative contract can be exercised b See Chapter 10 Slide 15 for Graph representation M Margin a Initial Margin i A deposit required on the futures trades to ensure that the terms of the contracts Will be met b Maintenance Margin i Is the margin a futures trader must maintain once a future position is taken 1 If losses occur such that margin account funds fall below the maintenance margin the customer is required to deposit additional funds in the margin account to keep the position open N Maximum Financial Exposure Payoff Payoff for pro t cal buyer C 0 39 Stock Price X at expiration C Payoff Payoff for call 10 S S writer my P quot19 1 bk Payoff PTO t Payo for put writer P 0 I Stock Price k at expiration P Payoff for put Payoff buyer loss I In a call option if the underlying asset s price rises the call optioin Writer has unlimited loss potential If stock price is greater than strike price the option buyer Will exercise the option Which forces the Writer to buy the stock at its high price and then sell it to the call buyer at strike Since stock could technically go up to an unlimited level losses are unbounded Calculate lossgain of call Writer Call premiumStock price strike price lossgain of call buyer stock pricestrike pricecall premium In put option the lower the price of the stock at expiration of the option the higher the pro t to the put option buyer If stock price is higher than strikeoption cost option expires unexercised When stock price fall below strike seller has large but not unlimited possible losses Writer Will have to buy stock at strike price Put buyer gainloss stock purchase priceput option cost strike price Put Writer gainloss put option premiumstrike price stock price


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