Financial Markets and Institutions Final Exam Flashcards

Comprehensive flashcards covering the LUISS Financial Markets and Institutions course, including market mechanics, financial intermediaries, derivatives, and regulatory frameworks like Basel III and CAMELS.

How does the financial system facilitate the transfer of funds?

It channels funds from net savers (typically households) to net borrowers (firms and governments) through two channels: direct finance (markets) and indirect finance (intermediaries).

What are the four primary types of transformation performed by financial intermediaries (FIs)?

FIs perform maturity transformation, liquidity transformation, denomination intermediation, and risk transformation/diversification.

What is the 'net regulatory burden'?

It is the private cost of compliance minus the private benefit of being regulated. If this burden is too high, activity may shift to shadow banking.

Distinguish between microprudential and macroprudential policy.

Microprudential policy focuses on the soundness of individual banks in isolation, while macroprudential policy focuses on the soundness of the financial system as a whole by addressing systemic risk.

What are the three externalities that drive systemic risk?

1. Strategic complementarities (herding, too-big-to-fail incentives). 2. Fire sales (forced asset sales depressing prices). 3. Interconnectedness (contagion through counterparty exposure).

What is a Repurchase Agreement (Repo)?

A form of collateralized short-term borrowing where a bank or dealer sells a security with a promise to repurchase it at a higher price later.

What characterizes the 'semi-strong' form of the Efficient Market Hypothesis (EMH)?

Stock prices reflect all publicly available information, meaning fundamental analysis cannot be used to consistently beat the market.

Describe the six-step mechanism of securitization.

1. Origination of loans. 2. Pooling into a portfolio. 3. Transfer to a Special Purpose Vehicle (SPV). 4. Issuance of securities (MBS/ABS). 5. Tranching by risk level. 6. Distribution of cash flows to investors.

How do Mutual Funds and ETFs differ in their trading mechanisms?

Mutual Fund shares are bought or redeemed once a day at the end-of-day NAV, while ETF shares trade continuously on an exchange at real-time market prices.

What is the '2-and-20' fee structure commonly used by Hedge Funds?

It consists of a $2\%$ annual management fee and a $20\%$ performance fee based on profits.

Define 'Adverse Selection' and 'Moral Hazard' in the context of insurance.

Adverse Selection is an ex-ante problem where high-risk individuals are more likely to buy insurance. Moral Hazard is an ex-post problem where insured agents take less care because their losses are covered.

What is the functional difference between Defined Benefit (DB) and Defined Contribution (DC) pension plans?

In a DB plan, the employer promises a specific benefit at retirement and bears the investment risk. In a DC plan, the benefit depends on investment performance, and the employee bears the risk.

What was the primary purpose of the Glass–Steagall Act of 1933?

It established a rigid separation between commercial banking and investment banking to prevent conflicts of interest and protect deposits.

How does a clearing house eliminate counterparty risk in futures markets?

The clearing house acts as the central counterparty through novation, meaning every buyer and seller faces the clearing house rather than each other.

What is Basis Risk in hedging?

The residual risk that remains because the price of the hedging instrument does not move in perfect lockstep with the asset being protected. It is defined as $\text{Basis} = \text{Spot Price} - \text{Futures Price}$.

How do the payoffs of Futures and Options differ?

Futures have symmetric (linear) payoffs where both sides are obligated. Options have asymmetric (kinked) payoffs where the buyer has the right but not the obligation to trade.

What are the components of an Interest Rate Collar?

It is a combination of buying an interest rate cap and selling an interest rate floor (or vice versa) to bound funding costs within a specific range.

What formula is used to calculate a bank's Return on Equity (ROE)?

$ROE = ROA \times \text{Equity Multiplier}$, where $ROA = \frac{\text{Net Income}}{\text{Total Assets}}$.

List the six components of the CAMELS framework.

Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.

Under Basel III, what are the minimum risk-based capital requirements?

Banks must maintain a minimum $4.5\%$ CET1 ratio, a $6.0\%$ Tier 1 ratio, and an $8.0\%$ Total Capital ratio relative to Total Risk Exposure Amount (TREA).

What is the purpose of the Leverage Ratio in Basel III?

It acts as a non-risk-based backstop to ensure banks maintain a minimum of $3\%$ Tier 1 capital against their total exposure, preventing the gaming of risk weights.

What does 'Bail-in' mean in the context of bank resolution?

It is the process of writing down or converting eligible liabilities (equity, subordinated debt, etc.) into equity to absorb losses and recapitalize a failing bank without using taxpayer money.

What is the MREL requirement?

The Minimum Requirement for Own Funds and Eligible Liabilities, which ensures a bank has sufficient loss-absorbing capacity for a credible bail-in during resolution.

Compare the LCR and NSFR liquidity standards.

The Liquidity Coverage Ratio (LCR) ensures enough HQLA to survive a $30$-day stress scenario. The Net Stable Funding Ratio (NSFR) ensures long-term assets are funded by stable liabilities over a $1$-year horizon.

What type of assets qualify as Level 1 High-Quality Liquid Assets (HQLA)?

Cash, central bank reserves (if withdrawable), and sovereign/central bank issuances from the EU, which are subject to unlimited recognition.

What key risk led to the collapse of Silicon Valley Bank (SVB) in March 2023?

A massive maturity mismatch and interest-rate risk: deposits were invested in long-duration bonds which lost value as rates rose, leading to a digital bank run when those losses had to be crystallized.