Unit 1 Exam

Financial Market

A market in which financial assets (securities) such as stocks and bonds can be purchased or sold

Surplus units

Participants who receive more money than they spend, such as investors

Deficit units

Participants who spend more money than \n they receive, such as borrowers

Securities

Represent a claim on the issuers

Debt securities

Debt (also called credit, or borrowed funds) incurred by the issuer.

Equity securities

(also called stocks) represent equity or ownership in the firm.

Accommodating Corporate Finance Needs

The financial markets serves as the mechanism whereby corporations (acting as deficit units) can obtain funds from investors (acting as surplus units).

Accommodating Investment Needs

Financial institutions serve as intermediaries to connect the investment management activity with the corporate finance activity.

Primary markets

Facilitate the issuance of new securities

Secondary markets

Facilitate the trading of existing securities, which allows for a change in the ownership of the securities

Liquidity

Degree to which securities can easily be liquidated (sold) without a loss of value.

Bonds

Long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations.

Mortgages

Long-term debt obligations created to finance the purchase of real estate.

Mortgage-backed securities

Debt obligations representing claims on a package of mortgages.

Stocks

Represent partial ownership in the corporations that issued them.

Speculation

Allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets.

Risk management

Financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities.

Securities Act of 1933

Intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.

Sarbanes-Oxley Act of 2002

Required that firms provide more complete and accurate financial information.

Financial markets vary across the world in terms of

• Degree of financial market development

• Volume of funds transferred from surplus to deficit units

Role of Foreign Exchange Market

International financial transactions normally require the exchange of currencies. The foreign exchange market facilitates this exchange

Role of depository institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities

Commercial Banks

• The most dominant type of depository institution

• Transfer deposit funds to deficit units through loans or purchase of debt securities

• Federal Funds Market - facilitates the flow of funds between depository institutions

Savings Institutions

• Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banks

• Concentrate on residential mortgage loans

Credit Unions

• Nonprofit organizations

• Restrict business to C U members with a common bond

Finance companies

obtain funds by issuing securities and lend the funds to individuals and small businesses

Mutual funds

Sell shares to surplus units and use the funds received to purchase a portfolio of securities

Securities firms

Provide a wide variety of functions in financial markets (Broker, Underwriter, Dealer, Advisory)

Insurance companies

Provide insurance policies that reduce the financial burden associated with death, illness, and damage to property. Charge premiums and invest in financial markets.

Pension funds

Manage funds until they are withdrawn for retirement

Emergency Economic Stabilization Act - October 2008

Intended to resolve the liquidity problems of financial institutions and to restore the confidence of the investors who invest in them

Federal Reserve Actions

Fed provided emergency loans to many securities firms that were not subject to its regulation

Dodd-Frank Wall Street Reform and Consumer Protection Act

Mortgage lenders must verify the income, job status, and credit history of mortgage applicants before approving mortgage applications

Rating Agencies

Investors can personally assess the creditworthiness of corporations that issue bonds, but they may prefer to rely on bond ratings provided by rating agencies. Rating agencies charge the issuers of debt securities a fee for assessing default risk

Credit Ratings and Risk Premiums over Time

Rating agencies can change bond ratings over time in response to changes in the issuing firm’s financial condition

Accuracy of Credit Ratings

The ratings issued by the agencies are opinions, not guarantees. Bonds that are assigned a low credit rating experience default more frequently than bonds assigned a high credit rating, which suggests that the rating can be a useful indicator of credit risk. However, credit rating agencies do not always detect firms’ financial problems

Oversight of Credit Rating Agencies

The Financial Reform Act of 2010 established an Office of Credit Ratings within the Securities and Exchange Commission in order to regulate credit rating agencies. Rating agencies must establish internal controls

Liquidity

The lower a security’s liquidity, the higher the \n yield preferred by an investor

Pure expectations theory

The term structure of interest rates is determined solely by expectations of interest rates

Impact of an Expected Increase in Interest Rates

Invest short-term to refinance at a higher rate

Borrow long-term to lock-in lower rate

Leads to an upward sloping yield curve

Impact of an Expected Decline in Interest Rates

Invest long-term to lock-in higher rate

Borrow short-term to refinance at a lower rate

Leads to a downward sloping yield curve.

Liquidity Premium Theory

The preference for the more liquid short-term securities places upward pressure on the slope of a yield curve. Liquidity may be a more critical factor to investors at some times than at others, and the liquidity premium will accordingly change over time.

Federal Advisory Council

Consists of one member from each Federal Reserve district who represents the banking industry. Meets with the Board of Governors in Washington, D.C., at least four times a year and makes recommendations about economic and banking issues.

Community Depository Institution Advisory Council (C D I A C, formerly called Thrift Institutions Advisory Council)

Consists of 12 members who represent savings banks, S&Ls, and credit unions. Meets with the Board of Governors twice a year.

Community Advisory Council

Consists of 15 members who offer diverse views on economic circumstances and the financial services needs of consumers and communities, with particular emphasis on low- and moderate-income populations. Meets with the Board of Governors twice a year

Federal Open Market Committee

Responsible for determining monetary policy with he goal of low unemployment/high economic growth and low stable inflation

GDP

Measures total value of goods and services produced during specific period

National Income

Total income earned by firms and individual employees during a specific period

Unemployment rate

Maintain a low unemployment rate in the US

Other Indexes

Industrial production index, a retail sales index, and a home sales index

Leading economic indicators

Predict future economy

Coincident economic indicators

Tend to reach their peaks and through at the same time as business cycles

Lagging Economic Indicators

Which tend to rise or fall a few months after business-cycle expansions and contractions

Producer and Consumer Price Indexes

Producer Price Index (PPI) represents prices at the wholesale level, and the Consumer Price Index (CPI) represents prices paid by consumers (retail level).

Other inflation indicators

Wage rates, oil prices, price of gold, economic growth

Demand Pull Inflation

Occurs when excessive spending pulls up prices

Fed’s Limited Ability to Control Long-Term Interest Rates

Since the Fed commonly buys and sells Treasury bills (with maturities of one year or less) when engaging in monetary policy, it might not be able to completely control long-term Treasury yields (and therefore other long-term interest rates).

Limited credit provided by banks

Even if the Fed increases the level of bank funds, banks may be unwilling to extend credit.

Low return on savings

Lower interest income translate to lower spending

Adverse effects on Inflation

Effect of increase in money supply growth may be disrupted due to an increase in inflationary expectations

Recognition lag

Delay between the time a problem arises and the time it is recognized

Strong economic conditions

High inflation low unemployment

Weak Economic conditions

Low inflation high unemployment

Advantages of inflation targeting

The Fed would no longer face a trade-off between controlling inflation and controlling unemployment.

The Fed would not have to consider responding to any fiscal policy actions.

The Fed’s role would be more transparent and would lead to less uncertainty in financial markets.

Disadvantages of inflation targeting

The Fed could lose credibility if the U.S. inflation rate deviated substantially from the Fed’s target inflation rate.

Could result in a much higher unemployment level.

Quantitative Easing

Purchased a specific dollar amount of a specific type of debt securities each month

Global Crowding Out

A government’s budget deficit can affect interest \n rates of various countries

Iliquid

Investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.

Money Market Securities

Sale of short term debt securities by deficit units to surplus units (maturity of one year or less, low risk, high liquid)

Capital Market Securities

Facilitate the sale of long-term securities by deficit units to surplus units

Derivative Securities

Financial contracts whose values are derived from the values of underlying assets

Securities Exchange Act of 1934

Extended disclosure requirements to secondary market issues

Additional Roles of Depository Institutions

• Offer liquid deposit accounts to surplus units \n • Provide loans of the size and maturity desired by deficit units \n • Accept the risk on loans provided \n • Have more expertise in evaluating creditworthiness \n • Diversify their loans among numerous deficit units

Role of activist shareholders

Help ensure that managers of publicly held corporations make appropriate decisions that are in the best interests of the shareholders

Global Consolidation of Financial Institutions

Many financial institutions have expanded internationally to \n capitalize on their expertise

Systemic Risk

Defined as the spread of financial problems among \n financial institutions and across financial markets that could cause a collapse in the financial system.

Loan-able Funds Theory

Market interest rate is determined by the factors \n that control supply of and demand for loan able \n funds.

Household Demand for Loan able Funds

Households demand loanable funds to \n finance housing expenditures as well as \n the purchase of automobiles and \n household items

Government Demand for Loanable Funds

Funds when planned expenditures are not covered by incoming revenues.

Interest Inelastic

Insensitive to interest rates

Impact of economic growth on interest rates

Puts upward pressure on interest rates by shifting demand \n for loanable funds outward

Impact of inflation on interest rates

Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward.

Impact of Monetary Policy on Interest Rates

When the Fed reduces (increases) the money supply, it \n reduces (increases) the supply of loanable funds, putting \n upward (downward) pressure on interest rates.

Impact of the Budget Deficit on Interest Rates

Crowding-out Effect: Given a certain amount of loanable \n funds supplied to the market, excessive government demand \n for funds tends to “crowd out” the private demand for funds

Impact of Foreign Flows of Funds on Interest Rates

Interest rate for a certain currency is determined by the \n demand for funds in that currency and the supply of funds \n available in that currency

Segmented Markets Theory

Investors choose securities with maturities that satisfy their forecast ed cash needs

Limitation of the Theory

Some borrowers and savers have the flexibility to choose \n among various maturities.

Implications: Preferred Habitat Theory

Although investors and borrowers may normally \n concentrate on a particular maturity market, certain events \n may cause them to wander from their “natural” or preferred \n market.

Forecasting Recessions

Some analysts believe that flat or inverted yield curves indicate a recession in the near future.

The Fed as it exists today has five major components

• Federal Reserve district banks \n • Member banks \n • Board of Governors \n • Federal Open Market Committee (F O M C) \n • Advisory committees

Consumer Financial Protection Bureau

Established as a result of the Financial Reform Act of 2010 and responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages

Decision Process

The F O M C meets eight times a year, sets targets \n for the money supply growth level and the interest rate level, and implements monetary policy.

Pre-meeting economic report (Beige book)

A consolidated report of \n regional economic conditions in each district

Economic presentations

Presentations include data and trends for wages, consumer prices, unemployment, G D P, business inventories, foreign exchange rates, interest rates, and financial market conditions.

F O M C decisions

Each member can offer recommendations regarding \n the federal funds rate target

F O M C Statement:

A a statement that summarizes their conclusion

Minutes of F O M C Meeting

Provided to the public and are also \n accessible on Federal Reserve websites.

Fed purchase of securities

To lower the federal funds rate, traders purchase Treasury securities from securities dealers. The dealers’ bank account balances increase, causing an increase in the supply of funds.

Fed sale of securities

To increase the federal funds rate, traders sell government securities to government securities dealers. As the dealers pay for the securities, their bank balances decrease, leading to a decrease in the supply of funds.

Dynamic

Reducing or increasing the federal funds rate, because they are intended to have a lasting impact on economic conditions.