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Finance Junior Core > 453 - Exam 1 > Flashcards

453 - Exam 1 Flashcards

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1
Q

BOOK CH. 1 fin. system and 6 parts

A

Fin system - like AIR to economy - need it to survive…but when fails to function, leads to huge crisis

6 parts of fin. system
1. Money - pay for purchases and store wealth

  1. FIN. instruments - to transfer resources/risks (securities - stocks, mortgage, insurance)
  2. Fin. mkts. - buy/sell quickly (NYSE)
    - -now electronic mkts. vs physical trading
  3. Fin. institutions - provide access to markets and info. (banks, securities firms, insurance comp.)
  4. Gov. regulatory agencies - ensure instruments/mkts/institutions ru properly and are reliable/safe
    - -Dodd-Frank Act - largest US regulatory change since 19302 - 2010 - update bank standards and consumer protection act
  5. central banks - monitor and stabilities economy (2 biggest are Fed reserve and Euro. central bank0
    - -open and transparent - job to control amt. of money to dec. inflation, inc. growth, provide stability
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2
Q

5 core principles of money and banking

A
  1. TIME HAS VALUE
    - -affects value of fin. transactions - interest pmts. (bc borrowed and has opp. cost to lender - rent to borrow)
  2. RISK REQUIRES COMPENSATION
    - -car insurance ex. - insurance comp. uses premiums from buyers to settle claims (stolen/accidents) and rest to invest - both benefit
  3. INFO IS THE BASIS FOR DECISIONS
    - -collection and processing of info. is foundation of system
  4. MARKETS DETERMINE PRICES AND ALLOCATE RESOURCES
    - -mkts. are core of Econ. system - buyers/sellers meet
    - -inc. developed mkt. = faster country grows
    - -mkts. are sources of info. - set prices that signal what is valuable
    - -inc. participation in mkts. by having them save and gov. regulated
  5. STABILITY IMPROVES WELFARE
    - -volatility inc. risk - some cannot be controlled - but other risks are stabilized by central banks
    - -stabilizing economy is primary function of central banks
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3
Q
  1. Money
A

Asset accepted as pmt. for goods/services

  1. means of pmt. (otherwise barter with commodities)
  2. unit of account - (used to quote prices and record debts…relative prices)
  3. store of value - not perishable (Stocks store value and can appreciate in value but money is the most LIQUID

market liquidity - ability to sell assets for money

funding liquidity - ability to borrow money to buy securities/make loans

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4
Q

pmts. system and commodity monies

A

pmts. system
- -arrangements that allow for change - efficient operation of Econ. depends on pmt. system
- -money @ heart of pmt. system - bc every transaction involves money at some point

commodity markets - has intrinsic value (silk, butter, potatoes)

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5
Q

fiat money

A

has value bc gov. says it does

  • -Sweden was 1st country in Euro. with paper currency - but King printed too much and ppl lost confidence in papers value and exchanged for copper metal they stood for - had issued too many and bank failed
  • -US was backed by gold - but people still fear gov. prints too much paper $, which throatiest its value and use
  • -gold standard is reliable store of value bc promise still has value in the future

AMERCA’S GOLD STANDARD ENDED AUG. 15 1971 (started 1879…slightly abandoned in 1933.- ended 1971)

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6
Q

electronic funds transfer

A

move funds directly from on account to another - most common is ACH (Automated clearinghouse transaction) - used for recurring pmts. (paychecks/utility bills)

  • -or stored value cards - “pre-paid credit cards” - like NYC subway pass
  • -E-money - transfer to issuer to e-money and they send to online stores
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7
Q

lack of liquidity

A

liquidity problem in 08-09

  • -banks had been relying on short-term borrowing to hold long term fin. instruments bc believed liquid assets would always be available
  • -2007, investors began to doubt securities value –> mkt. liquidity disappeared and banks had many losses - could not satisfy high demands
  • -liquidity is valuable and can disappear when most needed
  • -liquidity spiral
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8
Q

future of money and bitcoin

A
  1. means of pmt. –> soon req. no money at all to pay bc other methods
  2. unit of acct. - will still need to quote values and prices
  3. store of value –> start using other fin. instruments that have become more liquid - quick and cheap

“bitcoin” - virtual currency schemes” - decentralized peer-to-peer network that allows for proof and transfer of ownership w/o needing a trusted 3rd party

  • -transactions recorded in block-chain tech.
  • -digital money - anonymous users
  • -but lacks all 3 uses of money –> unstable
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9
Q

inflation

A

peace at which prices are increasing over time - cause is printing too much money - makes money less valuable
-monetary aggregates - used to count amount of money in circulation - diff. bc some in hands, securities, loans and IOU

M1 AND M2 - Are a list of liquid assets defined by the fed

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10
Q

M1

A
  • -Coins and currency in circulation (not held by Fed, US treasury or bank vaults)
  • -demand deposits (amt. in checking accts.)
  • -traveler’s checks

Fed checks M1 balance daily

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11
Q

M2

A

Less liquid than M1

  • -includes all of M1
  • -savings deposits (deposits in savings accounts…can’t write checks)
  • -money market funds - (pools savings of Indiv. investors and invests together) (mutual fund shares)
  • -CDs (Certificates of deposits) - committed to stay in account for long time without removing…for higher interest rate
  • -other time deposits

m2 can withdraw and spend but it is more difficult than M1 - less liquid

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12
Q

inflation rate 2018 - CPI

A

watch CPI to catch inflation changes - calculate when Bureau of Labor Stats (BLS) surveys people to see what they bought

CPI = (cost of basket in current yr.) / (Cost of basket in base year) * all times 100

= (CPI 2018 - CPI 2017) / CPI in 2017
–% change in price = inflation

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13
Q

direct vs. indirect finance

A

direct finance - borrower sells a security directly to a lender

indirect finance - an institution (bank) stands btw lender and borrower
–ex. loan to buy car (car is asset and loan is liability) - but if borrow from parents = direct fin.

institutionalization - groenig trend where there is almost always an intermediary involved
–in indirect, asset holder has a claim on a fin. institution (bank or mutual fund), which has a claim on the borrower

role of fin. system is to facilitate production, employment and consumption

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14
Q

FIN. INSTRUMETS

A

written legal obligation (subject to gov. enforcement) of one party to transfer something of value (usually $) to another party
–party = person, comp. or gov

uses of fin. instruments

  • -means of pmt. and store of value - diff. than uses of money bc they ALLOW TRANSFER OF RISK
  • -means of pmt. bc sometimes give stock to employees as pmt.
  • -sometimes considered better store of value than money - better bc generates inc. in wealth (compensation for higher risk)
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15
Q

fin. instruments characteristics

A
  1. standardization (Terms, contracts) - auto insurance, mortgages
  2. communicate information - summarize essential details about issuer - eliminate expensive and time consuming process of finding info. on issuer
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16
Q

2 classes of fin. instruments

A
  1. underlying instruments - (primitive securities) - used by savers/lenders to transfer resources directly to investors/borrowers
    - -used to improve efficient allocation of resources in Econ.
    - -ex. - stocks and bonds - offer pmts. based on issuer status
  2. derivative instruments
    - -their value and payoffs are “Derived” from behavior of underlying instruments
    - -ex. - futures, options, swaps - primary use is to shift risk among investors
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17
Q

4 characteristics determine value of instruments

A
  1. SIZE of pmt. promised (> - more value)
  2. WHEN promised pmt. is to be Mae (sooner = INC. value…later = opp. cost)
  3. LIKELIHOOD that pmt. will be made - (inc. risk = dec. value)
  4. Circumstances under which pmt. is to be made ( increase need = inc. value)
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18
Q

Some fin. instruments

A

bank loans, bonds, home mortgages, stocks,

asset backed securities - shares in returns or pmts. arising from specific assets (like home mortgages, student loans, CC debt) - investor purchase shares in there rev. that comes from these underlying assets

  • -most common is mortgage-backed securities - bundle large # of mortgages together into a pool in which shares are then sold
  • -played huge role in fin. crisis bc securities were backed by subprime mortgages…loans to borrowers who are less likely to repay than borrowers of conventional mortgages - owners of securities rec. small share of the pmts. paid by homeowners when they pay their mortgage bills
  • -asset backed securities allow funds in one area to be produced uses elsewhere
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19
Q

fin. instruments used primarily to transfer risk

A
  1. insurance contracts
  2. futures contracts - agreement btw 2 parties to exchange a fixed quantity of a commodity (Wheat/corn) or an asset (bond) - specifies price
    - -derivative bc value based on price of another asset
  3. options - derivative instruments whose prices are based on value of some underlying asset
    - -give holder the RIGHT, not obligation, to buy or sell a fixed quantity of the underlying asset at a predetermined price on specified date or during period
  4. swaps - contracts to exchange 2 specific cash flows at certain times in the future
    - -interest rate swap ex. - exchange of pmts. based on a fixed rate of interest for pmts. based on rate of interest that fluctuates with the market
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20
Q

Fin. markets

A
  • -where instruments are bought and sold
  • -the Econ. central nervous system - efficiency
  • -react to info., allocate resources and determine prices
  1. roles
  2. offer savers and borrowers LIQUIDITY - imp!!
    - -also try to keep transactions costs low
  3. pool and comm. info. - summarizes as a PRICE
  4. allow risk sharing - bc can diversify when creating a portfolio

broker (finds us a counterpart), dealer (acts as the counterparty)

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21
Q

Dividing up fin. mkts.

  1. primary vs. secondary
A
  1. primary market - market where newly issued securities resold - mostly out of public eye (IB…small investors usually do not have access - from firm itself)

secondary market - mkt. where existing securities are traded
–prices we see on WSJ

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22
Q

Dividing up fin. mkts.

  1. Centralized exchanges vs. OTC vs. ECNSs
A
  1. Centralized exchanges
    - -2nd market where dealers meet in a central, physical location NYSE)

Over the counter markets - decentralized 2nd. markets where dealers sell and buy electronically (Nasdaq)

electronic comm. network (ECNS) - electronic system that brings buyers/sellers together to trade w/o using broker or dealer

(Tech. and globalization have transformed mkt. structure - HFTS (high freq. traders) - purchase and sell 1000s of stocks in seconds - goal to trad faster than comp.

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23
Q

Dividing up fin. mkts.

  1. D&E vs. derivatives mkt.
A
  1. D&E mkt. - market where fin. claims are bought and sold for immediate cash pmt.

derivatives mkt. - claims based on underlying asset are traded for pmt. at a later date

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24
Q

Dividing up fin. mkts.

  1. Money mats. vs. bond mkts.
A
  1. Money mkts.
    - -debt instruments that are repaid 1 year or less are traded here (T-bills)

bond markets
–1 year+ to maturity (treasury notes and treasury bonds)

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25
Q

characteristics of a well-run fin. mkt.

A
  1. designed to keep transaction costs low
  2. info communicated accurately and widely accessible (Affects prices)
    - -prices are LINK btw fin. market and real economy - to allocate resources
  3. protects investors
26
Q

Fin. institution

A

firms provide access to fin. markets (fin. intermediaries)

  • -banks, insurance comp., securities firms, pension funds
  • -help to lower costs, check credibility, connect buyers/sellers
  • -lower transaction costs by specializing in the issuance of standardized securities
  • -dec. info. costs of screening -help with info asymmetries problems
  • -issue short term liabilities to lenders while making long term loans to borrowers
27
Q

2 types of fin. institutions

A
  1. those that give BROKERAGE services - give households and corp. access to fin. markets and direct fin. (more DIRECT finance)
  2. TRANSFORM ASSETS
    - -take deposits/investments or issue insurance contracts - use income to make loans and purchase stocks, bonds and real estate
    - -(INDIRECT fin.)

look at flow chart on pg. 65 of book!!!

28
Q

depository vs. non depository institutions

A

depository institutions - take deposits and make loans
–commercial banks, savings banks, credit unions

non depository institutions - all kinds of diff. functions
–insurance - accepts premiums and inv. them in securities and real estate

–pension funds - inv. individual. and comp. contributions in stocks, bonds and real estate - to provide pmts. to retired workers (their liabilities)

–securities firm - brokers, IB, asset mgmt., PE/VC, hedge funds

–GSEs (gov. sponsored enterprises) - federal credit agencies that provide loans to farmers and home mortgages

29
Q

notes 1st day class

A

stock market is leading indicator of economy - sum of expected FCFs, which depend on economy

09-18 - reason for longest bull mkt. in history - trumps tax cuts, Fed lowering int. rates (his first WSJ ex.

30
Q

Miracle of innovation

A

more growth in past 250 years than entire time before that - “GROW THE RESOURCES”

3 inputs to grow resources (Adam Smith)

  1. Natural resources
  2. labor capital
  3. financial capital
    - -role is to take natural resources, capture and harvest
    - - one of the best ways we can grow the resources is to BE EUCATED
  4. financial capital - traceable assets that can be moved around
31
Q

specialization exchange

A

story of his nephew getting the super obscure knee surgery

  • -huge factor in stirring innovation to grow resources in past 250 years
  • -do what you’re best at and trade for the rest
  • -CANNOT have specialization exchange w/o a good fin. system - need those 6 components

MIRACLE - stirred by SPECIALIZATION EXCHANGE -FOUNDATION is fin. system

32
Q

measuring the miracle

A

very difficult

  • -use real median household income to measure (adjusted for inflation, median bc skewed if use mean, and household bc consumer most things as a family)
  • -bad metric bc hasn’t inc. since 1999
  • -missing iNNOVATION - same household income but doesn’t show new products - also some new products are cheaper than it was then

so use GDP to measure
–if amt. of goods/services inc. means more jobs/wages - inc. standard of living

33
Q

GDP

A

market value of all FINAL goods and services produced in an economy during a period

Y = C + I + G + NX
--NX = net imports - net exports

current GDP
20T = 13.6T + 3.4T + 3.4T 0 .6T

GDP is measure of economic production more than consumer life
–almost always underestimated

34
Q

7 key points with GDP

A
  1. includes ALL market production - some non-market production (ex. wife cooking dinner and laundry - service not captured)
  2. valued at market prices
  3. measures production, not sales (GDP when produce, in 2018 but not when sold in 2019)
  4. includes only FINAL goods and exports
    - -process buying ingredients and making it into bread is FINAL and included - selling it to Was Mart not
  5. Three ways to measure
    - -production approach, income or value-added
  6. it captures output from a specific location (if produced in Mexico but sold in US = Mexico GDP)
  7. Gross measure
35
Q

GDP spiral web

A

If GDP decrease = recession (if GDP falls in 2 consecutive quarters)
–in 08/09 - GDP was approx. 15.6T

GDP falls - usually Consumption falls

  • -dec. corporate profits
  • -Fixed asset investments dec. as jobs and wages dec.
  • -demand dec.
  • -prices dec.
  • -inflation dec. (called deflation)
  • -interest rates dec.
  • -req. returns of bond holders (based on risk)
  • -based on purchasing power- inflation
  • -so if inflation is falling = less risky so int. rates decrease
  • -so currency dec.

interesting bc the symptoms of the recession will be the cure

FINAL STEP

  • -currency dec. - makes our products cheaper to other counties which will inc. our exports
  • -also of int. rates are low - inv. in fixed assets is cheaper so business will invest more which was inc. FAI which makes C increase
36
Q

miracle of free markets

A

it is self-healing

  • -but GD made us question (unemployment was 25%- in 2000 was 10%)
  • -but didn’t self heal in FD
  • -KEYNES said in DEEP recessions people and businesses hoard and save their $
  • -called savings parody - bc save and do not consumer or invest so actually hurts economy as a whole –> in hands of gov.
37
Q

Keynes ideas

A
  1. gov spending INC.
  2. taxes Dec. - puts $ in hands of people and corp. so their can inc. consumption and investments
  3. rates dec. - gov. force it to happen - by buying bonds - do it artificially…don’t wait for markets
  4. UNWIND - all 1st 2 steps again but opposite

RISKS
challenge – ppl do not want to unwind - do not vote in politicians who support this
–problem if overcompensate - too much gov. spending and taxes dec. - excessive
–amplify cycle
–the 1st 2 can lead to deficit spending = debt - can get huge amounts of national dent
–artificially dec. interest rates = artificial cost of capital - so companies start taking on negative NPV projects (According to market)

38
Q

Univ. of Michigan info.

A

They do a test each month called the consumer sentiment survey

  • -productivity chases demand –> Hurricane Harvey actually inc. economic activity - bc cars destroyed…spurred investment in new cars
  • -war –> motivation and innovation –> WWII was an economic victory

recession timing –> look at GDP
–depends how you interpret it –> for sure recession was over by 2011…but technically GDP data shows it ended Q2 of 2009

39
Q

Fed reserve balance sheet

A

almost ALL assets funded by liabilities - liabilities are fed. reserve notes –> our bills/cash says “fed. reserve notes” - meaning the fed owes YOU

  • -used to be gold and silver, now just give you back the $50
  • -cash is liability on fed balance sheet

Fed’s L = currency and deposited from other banks

  • -2008 NS - Assets were 900B and inc. assets by 1.3T from 08-2011
  • -why? bc buy bonds and push $ out to lower interest rates
  • -put money into public by buying bonds
  • -int. rates are like the cost to use money –> so if added money to supply. supply up so price decreases bc less demand –so interest rates dec. which inc. C and I in GDP
40
Q

Fed. reserve MYSTERY

A

Inc. amt. of currency then eventually need BIG UNWIND - bring BS backdown to normal levels (bc if not leads to inflation)

MYSTERY - BS today has 4.2T in Assets —> just barely started union last year (should have HUGE inflation problem)
–if recession ended in 2011, then why did they keep pumping money?

was it over? GDP says it was?

  • -kept pumping $ bc even though GDP says it ended there are things that measure quality of life
  • -GDP does not factor unemployment - ability to put dinner on table - “disutility of the peasants”
  • -when discuss unemployment…when did recession end?
41
Q

unemployment and the recession

A

Fed started GREAT UNWIND at end of 2016

  • -bc were waiting for unemployment rate to dec. again
  • -Fed’s job is to INC. standard of living for people, not GDP (GDP is just a diagnostic)

UNEMPLOYMENT CIRCLE

  • –outer circle is “outside labor force” = students, retired, discouraged workers - it is “civilian non-institutional population (all ppl 16+ in US who are not inmates of institutions (prison) or not in military
  • -inner circle = labor force - INSIDE labor force have employed and smaller circle for unemployed

employed - work 15+ in family business, temporary absent, have job during survey week

unemployed - no employment, made effort to work and couldn’t find = out of work and looking

unemployment rate = (unemployed / labor force)

RATE DOES NOT INCLUDE STUDENTS, RETIRED, DISCOURAGED WORKERS (not looking) bc all not in the labor force

if look at graph of discouraged workers –>shows we just barely got out of GREAT recession
–shows can’t only look at just one macroeconomic variable

42
Q

Unemployment rate followup

A

21 T in national debt –> $300 B each year in interest expense

  • -know metric you are using and how it helps you understand bigger reality
  • -GDP not bad - in case study unemployment rate was a better indicator, but it left out discouraged workers

FRED - can compare unemployment and discouraged workers BUT don’t have good metric for underemployment

Fed balance sheet
2007 - $900B
2009 (Crisis) - 2.2T
2018 - 4.2T 
--(bc buying US treasury bonds and mortgage backed securities - so put more $ in economy - surplus - inflation which makes prices rise and int. rates fall - C&I inc. and GDP inc.

current national debt = 21.5T

–pump more $ to econ. STIMULATING LIQUIDITY son interest rates fall and C AND I in GDP rise

if fiscal house not in order and central bank keeps inc. balance sheet and pumping more $ –> can risk inflation

43
Q

4 major ways to measure inflation

A
  1. GDP deflator –> not important
  2. CPI - consumer price index
    - -measures price of basket of good and compares across location and time - “inflationary discontinuity to consumers”
    - -inflation on what you pay (ALL consumers, ALL items, ALL locations)
  3. PPI - producer price index
    - -prices sellers rec. not price consumer pays - similar but basket of goods to producers
    - -basket based on what seller gets
  4. PCEPI - personal consumption expenditures price index
    - -was labeled BEST indicator - most accurate metric
    - -similar to CPI but tries to estimate impact of SUBSTITUTION - captures that effect

CORE CPI/PPI - all less food and energy (very volatile products like gas and food not included)
–also bc food and energy prices get set in GLOBAL MARKETS –> leads to an indication of global inflation and we want to know about domestic

44
Q

recessions and inflation

A

all recessions are followed by a drop in inflation

  • -feds goal is 2% inflation
  • -fed has not started UNIWND bc inflation has not become huge problem yet – otherwise could start a recession
45
Q

KEY INDICATORS - Leading, coincident, lagging indicators

A

in ex. of GDP - this is what you want to know
–leading indicator moves 1st and GDP follows, coincident moves with GDP and lagging follows change in GDP – lagging is what we really care about (in GDP ex. I was the effects of GDP change on unemployment)

on FRED
leading - upcoming production
1. state level housing permits (bc structure, production –> impending GDP inc.)
2. unemployment insurance claim
–WHEN leading index dec. – previously has shown a recession is coming

coincident - move with GDP (unemployment rate, wages, salaries)

46
Q

America’s fiscal crisis

A

Forecast next 75years (Trustees report 2018)
–Currently $21.5T in national debt -

PV of projected unfunded liabilities - $13.2T social security, $37.7 medicare
–totals to about $50T in additional forecasted debt

  • -so really 21.5T + 50T = about $71 T in DEBT
  • -71T / 330,000,000 ppl - about $215,000 per person
  • -need to pay bc so much but also $263B in INTEREST on the debt
  • -in 2027 project $864B in interest on debt

2017 tax rev. = 3.316T
2017 expenses = 3.981 T (Spend more than take in)

47
Q

4 possible solutions for fiscal crisis in Am.

A
  1. raise taxes (but when raise they don’t dec. consumption)
  2. slash spending (spending most on 1. medicare/health, 2. social security, 3. defense, 4. welfare, 5. INTEREST
  3. rescues to repay - but who are you not going to pay?
  4. print money – inflation - monetize you debt
    - -which is what we have been doing since 2009 - buying US treasury bonds
48
Q

Fin. instruments class notes

A

store of wealth - 1. means of pmt. MOST IMP. TRANSFER RISK – which changes human behavior
–life insurance - transfer risk if he dies and needs to care for family

PUT options (transfers risk)

  • -gives the holder of the option the right NOT obligation to SELL underlying asset at the strike (Exercise) price at any point up to operation date
  • -ex. AAPL - spot price approx. $220 (current mkt. va)
  • -look on yahoo fin. –>most recent put option has strike price of $215 by date 12/20/18
  • -spot $220 - expect to drop to $200 - so buy put option at $7.35 then buy stock @ $200 if drops then sell for $215
  • -Also can transfer risk bc only lose about $12 - you have RIGHT to sell but someone else has OBLIGATION to buy - person who issued put option
49
Q

CDS final notes

A

Credit default swaps
–want to buy when disk of default Dec. and sell when risk of default inc. (bc price inc.)

buy/sell process creates huge mess - do not know who the counter party is - who the net seller is

in 2008, notional amt. invested in CDS was $60T (3x national debt)

  • -AIG was net seller with net exposure - bankrupt, 2008 losses of $100B on income stmt. - then ripple effect
  • -so GOV. came to bail out AIG

insurance for bonds - buyer (claim holder) and seller (insurer) – spreading risk among diff. buyers and sellers

  • -CDS were a way to mitigate risk for mortgage backed securities
  • -cash settlement vs. physical settlement
50
Q

history of money (Review)

A

in beg. had commodity money (intrinsic value - silk, salt)

  • -usable, easy to transport
  • -then paper money - instrumentals up until civil war was bank currency (Each bank had own currency and would redeem for value)
  • -then greenbacks 1862 in North (split in civil war) - gov. issued money
  • then fed. created 1912ish - Fed ran national bank
  • -in 70s became fiat currency - not backed by gold anymore
51
Q

Keynesian vs. austrian economics

A

◦ AUSTRIAN - Invisible hand that works in the market that works to allocate resources better than people can - principle that a hand can heal itself - they argue do nothing and allow economy to heal itself
• In a recession have lower yields/rates –> which leads to higher investments bc cheaper to invest
• In a recession do nothing - wait it out
◦ Keynesian - people are not going to spend money in a recession bc they are going to want to be thrifty…so gov. needs to increase spending and decrease taxes so people have more money in their pockets and can inc. consumption and investment –then big unwind after

52
Q

great unwind

A

Great unwind - inc. inflation and inc. taxes by adding things to its balance sheet - the great unwind is the process of the Gov. “shrinking their balance sheet” - announced TODAY the fed is increasing interest rates
• Inflation has been constant…and also the unemployment rate has not recovered until about 2016 (years after the end of the recession)

53
Q

put option basics

A

• The holder has a right to the strike price by an expiration date - right but not obligation to sell
• Put option mitigates your risk if the stock drops in value
◦ Ex. Pay $10 to buy option (so lose $10)…but if the price of apple’s stock decreases you only lose the $10, not the $220
◦ Do not HAVE to sell, not obligated, but you have the right to sell

54
Q

fin. instruments from his video

A

◦ IMP: Specialization and exchange
◦ Hard to specialize AND exchange without 6 components of financial system - what if lived on farm in early 1800s…little specialization and exchange…we did most of labor ourselves
◦ What if decided to specialize and grow corn - face many RISKS
• One risk: assets are perishable - most of wealth would be in form of corn –> but with money…can transform your perishable assets into more durable assets
• All of components of fin. System are IMP. But fin. Instruments allow us to transfer risk –> which allows us to change human behavior

55
Q

CDS

A

◦ Investor buys $1M in bonds - investor wants protection against default –> buys a CDS contract from Deutsche Bank
• Problem bc CDS are very NON STANDARD - Customized for specific transaction
• Ex. Notional amount is $1M - requires quarterly payments of 100 bps –> means annually pay 10% so 10,000 so pay $2,500 to the CDS seller every quarter
• Cash settlement if default - pay diff.
• If likelihood of default increases…the price of CDS (insurance policy) increases also!!! - incentive as the buyer to become a seller
• A certain buyer would think they were on contract with Deutsche bank…but really just another seller who was also a buyer –> turns out AIG became net seller and had entire burden to payback - had to payback all these investors who had thought they were protected
◦ Worst at its height in 2007 -IN NOTIONAL TERMS…meaning total value of all bonds that were protected by CDS contracts
• Notional amount of CDS market was over $60 TRILLION
• US GDP is over 19 trillion…so notional CDS mkt. was 3x GDP
• AND over 2x the total bond mkt. - there were more insurance contracts on bonds in $1 value than there were actually bonds being insured

56
Q

main problems with CDS and solutions

A

◦ Main problems with CDS market - causing this crisis
• Illiquidity - not standardized…all customized - no centralized exchanges
• Lack of transparency - bc same above reasons
• Counterparty risk
◦ SOLUTION TO 3 PROBLEMS: Is to have fin. Mkts. And fin. Institutions
• Help minimize the problems we saw in 2008 fin. Crisis in regards to CDS market

57
Q

CME and price risk

A

• Chicago mercantile exchange (CASE STUDY) - both a market and a fin. Institutions - serves both functions
• Price risk - look at airlines - problem arises bc asynchronous timing of revenue and expenses
◦ Rev. comes from selling seats, food - expenses come from airplane, labor, and one of the biggest is FUEL prices (fluctuate)
◦ Issue bc has to sell seats from 1 week to 6 months prior to flight…but doesn’t consume the jet fuel until it actually takes off…and does not pay for the jet fuel much in advance of that flight
◦ Rev. are locked in much in advance of the expenses being incurred - but in the amt. of time that airline locks in revenue…fuel prices can change significantly
• If prices rise sharply after rev. is locked in…then margin for each flight is squeezed and could incur losses!!
◦ Kellogg cereal - faces grain price risk - in trouble if grain prices rise…what if wheat prices rise? The problem is if Kellogg pass on those inc. in wheat prices to their customers?
• Depends on the price elasticity of demand - meaning if prices rise…what happens to demand?
▪ Cigarettes - very inelastic - so low price elasticity of demand…bc will buy no matter what price
▪ Other products have HIGH price elasticity of demand bc of SUBSTITUTION - if product has lots of substitutes…the demand will dec. bc can get same product elsewhere
▪ Lot of substitutes = HIGH price elasticity of demand
• If its high…cannot pass shocks of price changes of materials on to your customers

58
Q

how to mitigate price risk

A

◦ So how to mitigate price risk?
1. Pay someone to take it from you (insurance)
▪ But easier to predict life expectancy in the case of life insurance
▪ But diff. to pay people to assume your price risk bc almost impossible to predict - no stats/models to predict when prices will go up/down - very few willing to take risk from you in form of pmt.
2. Swap it with someone for a different risk
▪ Ex. Kelloggs faces 2 possibilities with wheat prices - they either rise or fall
• Is there any entity out there that views wheat prices opposite? - happy when prices raise and sad when prices fall - it is the wheat farmers…Kelloggs should get in a partnership with wheat farmers
• Together can neutralize price risk - but how do they find each other??
• The reason why you NEED A MARKET

59
Q

CME pt. 2 - how it solves price risk problem

A

• CME (Chicago mercantile exchange) - is a market - brings together buyers and sellers
◦ Sells wheat futures contracts - an agreement to execute a transaction in the future at a price agreed upon today
◦ Agree to buy 5000 bushels of wheat and to sell 5000 bushels of wheat at a specific price (about $5.30 per bushel)
◦ Link arms to buy/sell wheat a year in advance
◦ CME - Place where all trading takes place for futures contracts
• But problem…bc what about COUNTERPARTY RISK? - farmer thinks he has entered in to a futures contract in April to sell wheat in Sept. - but the wheat prices drop significantly by Sept…the buyer pretends he never entered in to a contract
◦ CME clearing - serves as counterparty to every cleared transaction - becoming the buyer to each seller and seller to teach buyer - which limits credit risk by guaranteeing fin. Performance of both parties
◦ How does it do it?
1. Initial capital requirements - cannot be buyer/seller with CME unless put up initial investment
2. Maintenance margin requirements - keep a balance there that is adequate to them in showing you will meet your obligations
3. Collateral requirements
◦ CME becomes your trading partner in all transactions
◦ CME strictly monitors all parties trading on CME and req. adequate cash/assets at all times

60
Q

benefits of CME trading

A

◦ Benefits?
• Encourages trading - liquidity
• Saves time - no investigating counterparties
• Improves price efficiency - no counterparty risk discounts
• Allows them to jointly mitigate price risk!!! And ensures there is no counterparty risk

61
Q

fin. instituons getting “too big to fail”

A

• But…some fin. institutions can get “too big” - too big that if they fail our whole economy fails with it
◦ Too big to fail - meaning so big and so integral to our fin. System and economy that the collapse of that company would be catastrophic to our entire system
• Go big or go home (in capitalism there is always incentive to get big - so much competition that bigger comp. win)
◦ Economies of scale - can get cost savings of producing more and more of the good/service
◦ Economies of scope - sharing tech. and synergies across products and divisions
◦ Decreased competition - get so big that they cut out the competition - which gives more…
◦ Market and price power
• 1995 - allocation of all deposits across banks (pie chart) - Only 7% of deposits in giant banks (Was pretty evenly spread out)
◦ But in 2014 - 58% of deposits were in the giant 5 banks (BAML, WF, JPM, Citi, other)
• What do we do if they get too big?
◦ Nothing…let them die - or bail them out
◦ Or option: monitor, regulate, fracture
• But VERY costly - and may not even successfully prevent the companies from becoming too big to fail
▪ AT&T - spent a lot of money to stop it from growing…slowed it down for a time…then it came back stronger and bigger right after
◦ The Dodd Frank act of 2010 - preventing companies from becoming too big too fail

62
Q

Stephe Colbert - AT&T

A
  • Telecom industry - Cingular changing name to AT&T
    • History of AT&T taking over telecom industry - joking about how country has spent lots of money to stop AT&T from expanding…then said country has gone from AT&T dominated to AT&T dominated (with diff. logo)
    • No matter how many pieces you break AT&T into…it always comes back together

Finance Junior Core (14 decks)

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