Finc 203

Derivative

Contract whose value comes from another asset.

Underlying asset

The asset the derivative is based on.

Hedging

Using derivatives to reduce risk.

Speculation

Using derivatives to try to profit from expected price movements.

Forward contract

Private, customised, over-the-counter contract with higher default risk.

Futures contract

Standardised, exchange-traded contract with margin and daily marking to market.

Clearing house

Organisation that stands between buyers and sellers in futures markets to reduce default risk.

Margin

Money deposited to cover possible futures losses.

Marking to market

Futures gains and losses are settled daily.

Swap

Contract where two parties exchange cash flows over time.

Interest rate swap

Swap where fixed interest payments are exchanged for floating interest payments.

Currency swap

Swap where cash flows are exchanged in different currencies.

Call option

Right, but not obligation, to buy an asset at the strike price.

Put option

Right, but not obligation, to sell an asset at the strike price.

Premium

The cost paid to buy an option.

Strike price

The agreed exercise price in an option contract.

Call buyer wants

The asset price to rise.

Put buyer wants

The asset price to fall.

Long call profit

Asset price minus strike price minus premium.

Long put profit

Strike price minus asset price minus premium.

Option buyer

Has the right to exercise the option.

Option seller

Has the obligation if the option is exercised.

Foreign exchange

The market where currencies are bought and sold.

Exchange rate

The price of one currency in terms of another.

Base currency

The first currency in an exchange rate quote.

Quote currency

The second currency in an exchange rate quote.

Direct quote

Domestic currency cost of one unit of foreign currency.

Indirect quote

Foreign currency received for one unit of domestic currency.

Bid price

The price at which the dealer buys the base currency.

Ask price

The price at which the dealer sells the base currency.

Buying currency from dealer

Use the ask price.

Selling currency to dealer

Use the bid price.

Bid-ask spread

The ask price minus the bid price.

Currency appreciation

A currency increases in value.

Currency depreciation

A currency decreases in value.

Percentage change

New value minus old value, divided by old value, multiplied by 100.

Cross rate multiply

Use when exchange rates connect directly through a shared currency.

Cross rate divide

Use when both exchange rates are quoted against the same currency.

Fixed exchange rate

A currency is held at a set value.

Floating exchange rate

A currency value is determined mainly by supply and demand.

Managed float

A currency mostly floats but the central bank may intervene.

Currency band

Exchange rate is allowed to move within a set range.

Bretton Woods

Fixed exchange rate system linked to the US dollar.

Nixon Shock

Ended US dollar convertibility into gold.

Current account

Records goods and services, primary income, and secondary income.

Financial account

Records investment flows, borrowing, lending, and asset ownership.

Central bank

Institution that manages monetary policy and financial stability.

RBNZ

Reserve Bank of New Zealand.

OCR

Official Cash Rate, the main conventional monetary policy tool.

Monetary policy

Central bank actions that influence interest rates, inflation, and economic activity.

Raise interest rates

Slows borrowing and spending and reduces inflation pressure.

Cut interest rates

Encourages borrowing and spending and supports the economy.

Conventional monetary policy

Normal OCR or cash rate changes.

Unconventional monetary policy

Policy tools used when normal interest rate changes are not enough.

Forward guidance

Central bank communication about the likely future path of monetary policy.

Delphic forward guidance

A forecast without a strong policy commitment.

Odyssean forward guidance

A stronger commitment to a future policy path.

LSAPs

Large-scale asset purchases where the central bank buys bonds or assets.

LSAP effect

Central bank buys bonds, bond prices rise, yields fall, long-term rates fall.

Portfolio balance effect

Investors move into other assets after central bank bond buying.

Policy signalling effect

Asset purchases signal that interest rates may stay low.

Term lending

Central bank lends longer-term funds to banks.

Negative interest rates

Deposits or reserves may earn below zero interest.

Foreign asset purchases

Central bank buys foreign assets to influence exchange rates or financial conditions.

Term Funding Facility

Reserve Bank of Australia Covid funding-for-lending tool.

Commercial bank

Financial institution that accepts deposits and makes loans.

Bank asset

Something the bank owns or is owed.

Bank liability

Something the bank owes.

Customer deposits

Bank liability.

Loans to customers

Bank asset.

Vault cash

Bank asset.

Central bank deposits

Bank asset.

Bank capital

Owners’ cushion, mainly shares and retained earnings.

Capital purpose

Absorbs losses and reduces insolvency risk.

Primary reserves

Vault cash and deposits at the central bank.

Primary reserves purpose

Meet withdrawals and immediate liquidity needs.

Secondary reserves

Liquid securities that can be sold for cash.

ROA

Return on assets, calculated as net income divided by assets.

ROE

Return on equity, calculated as net income divided by equity.

NIM

Net interest margin, calculated as net interest income divided by earning assets.

Bank trade-off

Banks balance liquidity, profitability, and safety.

Interest rate risk

Risk that interest rate changes affect bank income or value.

RSA

Rate-sensitive assets.

RSL

Rate-sensitive liabilities.

Positive gap

Rate-sensitive assets are greater than rate-sensitive liabilities.

Negative gap

Rate-sensitive liabilities are greater than rate-sensitive assets.

Rising rates and positive gap

Rising rates help banks with a positive gap.

Rising rates and negative gap

Rising rates hurt banks with a negative gap.

Duration

Sensitivity to interest rate changes.

Longer duration

More sensitive to interest rate changes.

VaR

Value at Risk, the maximum expected loss over a period at a chosen confidence level.

VaR weakness

Future losses may be worse than past data suggests.

Basel I

Simple credit-risk capital rules.

Basel II

Advanced credit, market, and operational risk models.

Basel III

Stronger bank capital and liquidity rules.

RWA

Risk-weighted assets.

Tier 1 capital

High-quality loss-absorbing bank capital.

CAMELS

Capital, Assets, Management, Earnings, Liquidity, Sensitivity.

Nonbank financial institution

Provides financial services but is not a registered bank.

Insurance company

Nonbank institution that pools risk and pays claims.