ECON 330 exam one

Debt contract A financial contract where the borrower promises to repay the principal plus interest. Examples: bonds (publicly traded) and loans (privately traded).

Equity contract A financial contract that represents an ownership claim in a firm. Examples: stocks/shares (publicly traded) and private equity (privately traded).

Present value (PV) The value today of a future cash flow. Formula: PV = CF / (1 + i)^n. A dollar today is worth more than a dollar in the future because today's dollar can earn interest.

Yield to maturity (YTM) The interest rate that equates the present value of all future cash flows from a debt instrument with its current price. It is the implicit interest rate on a bond.

Relationship between bond price and yield to maturity They are inversely related. When bond price goes up, YTM goes down. When bond price goes down, YTM goes up.

Coupon bond at par When a coupon bond is priced at its face value, the YTM equals the coupon rate.

Coupon bond at a discount When a coupon bond is priced below its face value, the YTM is greater than the coupon rate.

Coupon bond at a premium When a coupon bond is priced above its face value, the YTM is less than the coupon rate.

YTM formula for one-year discount bond i = (F - P) / P, where F = face value and P = current price.

Rate of return (RET) The total gain or loss on an asset over a holding period. Formula: RET = C/Pt + (Pt+1 - Pt)/Pt = current yield + rate of capital gain.

Condition for return to equal YTM The return equals the yield to maturity only if the holding period equals the time to maturity.

Effect of rising interest rates on long-term bonds A rise in interest rates causes a larger percentage price decline for bonds with more distant maturities.

Nominal interest rate The interest rate that makes no allowance for inflation.

Real interest rate The interest rate adjusted for expected changes in the price level (ex ante) or actual changes (ex post). It more accurately reflects the true cost of borrowing.

Fisher equation The equation linking nominal interest rates, real interest rates, and expected inflation: i = ir + π^e.

Determinants of asset demand Wealth, expected return, risk, and liquidity.

Effect of increased wealth on bond demand Increases bond demand (demand curve shifts right).

Effect of increased expected return on bond demand Increases bond demand (demand curve shifts right).

Effect of increased risk on bond demand Decreases bond demand (demand curve shifts left).

Effect of increased liquidity on bond demand Increases bond demand (demand curve shifts right).

Effect of increased expected inflation on bond demand Decreases bond demand (demand curve shifts left) because higher expected inflation lowers the expected return on bonds.

Effect of increased expected inflation on bond supply Increases bond supply (supply curve shifts right) because borrowers want to issue bonds at lower real borrowing costs.

Fisher Effect (combined effect of higher expected inflation) Bond demand decreases and bond supply increases. Bond prices fall and yields rise.

Effect of business cycle expansion on bond demand Increases bond demand (demand curve shifts right) due to higher wealth.

Effect of business cycle expansion on bond supply Increases bond supply (supply curve shifts right) due to higher expected profitability of investment opportunities.

Combined effect of business cycle expansion on bond prices and yields Ambiguous. Both demand and supply increase. Typically supply shifts more, leading to lower prices and higher yields.

Effect of government budget deficit on bond supply Increases bond supply (supply curve shifts right) because the government issues more bonds to finance the deficit.

One-period valuation model A model for valuing a stock held for one period. Formula: P0 = Div1/(1+ke) + P1/(1+ke), where ke is the required return on equity.

Generalized dividend valuation model The value of a stock today is the present value of all future dividend payments. Formula: P0 = Σ Dt / (1+ke)^t.

Gordon growth model A model for valuing a stock assuming dividends grow at a constant rate forever. Formula: P0 = D0(1+g)/(ke - g) = D1/(ke - g). Assumes g < ke.

Fed lowering rates effect on stock prices (channel 1) Lower interest rates reduce the return on bonds, causing investors to accept a lower required return on equity (ke). This lowers the denominator in the Gordon model, raising stock prices.

Fed lowering rates effect on stock prices (channel 2) Lower interest rates stimulate the economy, increasing the expected dividend growth rate (g). This lowers the denominator in the Gordon model, raising stock prices.

Adaptive expectations A theory where expectations are formed based on past experience and change slowly over time as new data becomes available.

Rational expectations A theory where expectations are identical to optimal forecasts using all available information. Predictions may still be inaccurate if some relevant information is unavailable.

Efficient market hypothesis (EMH) The application of rational expectations to financial markets. It states that a security's current price fully reflects all available information, and all unexploited profit opportunities are eliminated.

Behavioral finance explanation for stock market bubbles Bubbles may be explained by overconfidence and social contagion.

Bank assets (uses of funds) Reserves, cash, securities, loans (largest asset), and other assets (physical capital like buildings and equipment).

Bank liabilities (sources of funds) Deposits (largest liability, around 70%), borrowings, and bank capital.

Bank capital (equity capital) The bank's net worth. It acts as a cushion against bankruptcy. If loans are not repaid, bank capital shrinks.

Reserve requirement The regulation requiring banks to hold a minimum fraction of deposits as reserves. Formula: reserves / deposits ≥ required reserve ratio (typically 10%).

Required reserves The minimum amount of reserves a bank must hold. Formula: required reserves = reserve requirement ratio × checkable deposits.

Excess reserves Reserves held above the required amount. Formula: excess reserves = total reserves − required reserves.

Effect of a cash deposit on bank balance sheet Vault cash (reserves) and checkable deposits both increase by the same amount.

Effect of a deposit outflow on bank balance sheet Reserves and checkable deposits both decrease by the same amount.

Most costly way for a bank to meet a reserve shortfall Reducing loans. This antagonizes customers and loans may only be sold at a substantial discount.

Cheaper ways for a bank to meet a reserve shortfall Borrowing (from other banks or the Fed) or selling securities.

Asset management goals (3 goals) Seek highest returns on loans and securities, reduce risk, and have adequate liquidity.

Liability management The management of a bank's sources of funds. A more recent phenomenon made possible by overnight loan markets and negotiable CDs.

Return on assets (ROA) Net profit after taxes per dollar of assets. Formula: ROA = net profit after taxes / assets.

Return on equity (ROE) Net profit after taxes per dollar of equity capital. Formula: ROE = net profit after taxes / equity capital.

Equity multiplier (EM) The amount of assets per dollar of equity capital. Formula: EM = assets / equity capital. Also known as leverage.

Relationship between ROA, ROE, and EM ROE = ROA × EM. A bank can increase ROE by having a higher equity multiplier (less capital), but this increases risk.

Trade-off of high bank capital High capital provides a larger cushion against bankruptcy (safer) but lowers ROE for a given ROA.

Trade-off of low bank capital Low capital increases ROE for a given ROA (more profitable for owners) but provides less cushion against bankruptcy (riskier).

Managing credit risk: screening The process of gathering information to identify borrowers who are likely to repay.

Managing credit risk: monitoring and restrictive covenants Monitoring involves checking on borrowers after a loan is made. Restrictive covenants are provisions in loan contracts that restrict borrower behavior.

Managing credit risk: tools Screening, specialization in lending, monitoring, restrictive covenants, long-term customer relationships, loan commitments, collateral, compensating balances, and credit rationing.

Gap analysis A tool for measuring interest rate risk. Formula: Δ bank profit = (rate sensitive assets − rate sensitive liabilities) × Δ interest rates.

Effect of rising interest rates on a bank with more rate-sensitive liabilities than assets Bank profits decrease because liabilities reprice upward faster than assets.

Stage one of a typical financial crisis (initiation) Triggered by a credit boom and bust, asset-price boom and bust, or an increase in uncertainty. Lenders become overexcited, then suffer losses, and become reluctant to lend.

Stage two of a typical financial crisis (banking crisis) Deteriorating balance sheets and uncertainty lead to bank runs. Banks sell assets at fire-sale prices, leading to a contraction in lending.

Stage three of a typical financial crisis (debt deflation) A fall in the price level (deflation) increases the real value of fixed nominal debt, reducing net worth and worsening the economic downturn.

This time is different syndrome The belief during a boom that countries and creditors have learned from past mistakes, leading to excessive risk-taking and underestimation of crisis risk.

Causes of the Great Depression (1929) Stock market crash, bank panics, continuing decline in stock prices, and debt deflation.

Causes of the 2007-2009 Global Financial Crisis Financial innovations (subprime mortgages, MBS, CDOs), housing price bubble, agency problems from originate-to-distribute model, housing price bubble burst, write-downs, high-profile firm failures, stock market crash.

Debate over the cause of the housing price bubble (2007-2009) Taylor argued low Fed interest rates caused low mortgage rates fueling the bubble. Bernanke argued new mortgage products, relaxed lending standards, and capital inflows were the culprits.

Why the 2020 pandemic did not become a full financial crisis Aggressive Federal Reserve intervention and U.S. government fiscal policies helped shore up businesses and financial markets.