FIN 341 Exam 1

Flow of funds

Savings-Investment, bringing Savers & borrowers together via markets & institutions

Primary Market

Mechanism for issuing & Selling new Securities, funds going to the firm

Secondary Market

Market for sales of Securities; process of re-selling existing securities

Financial Intermediaries

Financial institutions between Suppliers & users of funds

Households (individuals)

Influence economy through wealth, income, saving, interest; transfer funds

Businesses (firms)

Invest in real assets; use funds from income, government & household investments; compensate households by means of dividends or capital gains

Government as a participant in the financial system

Fiscal policy & monetary policy, subsidies, regulation

Surplus Spending Unit (suppliers)

Entities with excess funds available to lend or invest

Deficit Spending Units (users)

Entities that need to borrow funds

Direct transfer

Direct exchange of funds for financial claims between users and suppliers

Indirect transfers

Intermediary acquires funds from saver by issuing new financial claims on itself, lends these to borrower

Securities

Claims against someone else's money at a future date

IPO

Initial Public Offering; new equity issues by firms

IEO vs SEO

Initial public Offering: first time a private company sells shares of its stock the the public

Seasoned Equity Offering; sale of additional stock to the public by firms

Public Market

Organized, securities registered with SEC and bought & sold to individual & institutional investors (highly regulated)

Private Market

Direct transactions between 2 parties (little regulation)

Money market

Short-term, high liquidity debt securities (short maturing)

money markets vs Capital markets

money market: market for short term highly liquid debt securities, less than a year

capital market: market for Intermediate or long-term debt & corporate stocks (1–10+ yrs)

Treasury bills

Short-term obligations issued by government

Commercial papers

Short-term, unsecured promissory notes issued by a company to raise short-term cash

Federal funds

Short-term funds transferred between financial institutions, usually 1 day

Common stock

Fundamental ownership claim in public corporation

Corporate bonds

Long-term debt obligations issued by corporations

Treasury bonds

Long-term debt obligations issued by the treasury

Municipal bonds

Long-term debt obligations of a local/state government

Mortgage

Loans to individuals or businesses to purchase a home, land or other real property

Adverse Selection

Occurs BEFORE transaction takes place (companies in high-risk categories are more likely to borrow money)

Moral hazard

Occurs AFTER transaction takes place (bailouts reduce penalty to firms; firms take more risks)

Depository Institutions

Collect from depositors, lend to borrowers; convenient payment system, most common

Contractual Savings Institutions

Acquire funds under long-term contracts & invest the funds in capital markets e.g life insurance (collect funds at regular intervals based on long-term contracts)

Investment funds

Sell shares to investors, use these to purchase direct financial claims (common stock, bonds)

Finance Companies

Make loans to consumers and small businesses; don't take deposits, raise funds in commercial paper market / from shareholders

Nominal Interest Rate

Stated/quoted rate on loan (not adjusted for inflation); reflects real rate & expected inflation rate

Real Interest Rate

Effects of inflation have been factored in; occurs at equilibrium between desired level of borrowing & desired level of lending

Demand factors impacting real Interest rate

Breakthrough tech, lower income tax rate -> increase level of borrowing -> shifts demand curve right -> increases real IR

Supply factors

decrease real interest rate, people want to spend less, need to encourage spending, decrease in income tax, increase in money supply increase in savings. increase in loanable funds lenders must decrease interest rate to attract borrowers

Loanable funds theory

Supply of all loanable funds = all source available to invest in financial claims; demand for loanable funds = all uses of funds raised by issuing financial claims

Equilibrium Interest Rates

If competitive forces operate in financial sector, level of supply & demand will bring rates to equilibrium (temporary/dynamic)

Inflation

Increase in general price level of goods in an economy

Disinflation

Decrease in general rate of inflation

Deflation

Decrease in general price level of goods and services

Fisher Effect Equation

(1 + i) = (1 + r)(1 + Expected Inflation) or approximately i ≈ r + Expected Inflation

Realized Return

Actual rate of return to the lender at the end of the contract; reflects impact of inflation on past investments

Negative Nominal IR

Nominal IR < 0; used by central banks & regulators unusually when there's strong signs of deflation (you pay someone to take your money)

negative realized real interest rate

If nominal IR < actual inflation rate, Realized Real IR will be negative

Expected Real IR

Result from government intervention in the financial market or investors' sole concern for their wealth

Origin of the Fed

Bank panic of 1907 shifted debate; Fed Reserve Act 1913 established the Fed as central bank

Core Functions of the Fed

1. Conduct nation's monetary policy; 2. Serve as lender of last resort; 3. Provide safe & efficient payment/settlement system; 4. Supervise & regulate depository institutions

Structure of the Fed

12 Federal Reserve Banks, several thousand member commercial banks, Board of Governors, Federal Open Market Committee (FOMC)

Managing Systemic Risks

Power to intervene in business activities; FSOC makes recommendations to Fed to improve standards for capital, leverage, risk management

what does the independence of the fed mean and why is it important

Independent central bank can take short-run policy actions that may be politically unpopular, but benefit long-run macroeconomic performance

Federal Reserve Assets

US Government Securities, Loans at discount window, Cash items in process of collection (CIPC)

Federal Reserve Liabilities

Federal Reserve notes in circulation, Depository Institution Reserves, Treasury Deposits, Deferred Availability Cash Items (DACI)

Float

Float = CIPC - DACI

Open Market Operations (OMO)

Federal Open market commitee Change money supply by buying/selling securities on open secondary market

Discount Rate

Interest rate charged to commercial banks borrowing from the Fed

Reserve Requirements

Depository institutions must reserve a set percentage of certain deposits

Interest Rate on Reserves

Interest payments on reserve balances held at the Fed

Required Reserves vs. Excess Reserves

Required = minimum funds a bank must hold by regulation; Excess = additional funds beyond required

Time Value of Money (TVM)

A dollar today is worth more than a dollar tomorrow

Par Bond / Discount / Premium

Par: YTM = Coupon Rate; Discount: YTM > Coupon Rate (sells below par); Premium: YTM < Coupon Rate (sells above par)

Zero Coupon Bonds

Bonds without periodic coupon payments, issued at a discount

Yield to Maturity (YTM)

Annual expected rate of return earned if bond is held to maturity

Price Risk vs. Reinvestment Risk vs default risk

Price Risk: market price decreases when IR rises; Reinvestment Risk: future cash flows reinvested at lower IR

default risk: risk that the issuer may not be able to make payments

Macaulay Duration

Weighted average duration of all cash flows; measures bond price sensitivity to interest rate changes

Bond Volatility Rules

Longer maturity = greater volatility; lower coupon rate = greater volatility; lower starting IR = greater volatility

Money Base

total amount of money created by central bank

4 major types of financial intermediaries

depository institutions

contractual savings institutions

investment funds

other types: financial companies and federal agencies

Finance Company

make loans to consumers, small businesses, don’t take deposits, raise funds in commercial paper market and from shareholders

Why is the fed considered a hybrid public-private institution

Run by board of governors for national monetary goals, owned by thousands of member commercial banks (private) that buy stocks in 12 regional reserve banks