ch 1-5 - quiz 1 Flashcards
financial market
a market in which financial assets(securities: stocks/bonds) can be traded
surplus units
investors, participants who receive more money than they spend
deficit units
issuers, participants who spend more money than they earn
securities
represent a claim to the issure
debt securities
debt incurred by the issuer
equity securities
stocks, represent equity/ownership in the firm
primary markets
facilitate the trading of new securities
secondary markets
facilitate the trading of existing securities
liquidity
the degree to which securities can easily be liquidated(sold) without a loss of value
money markets
facilitate the sale of short-term debt securities by deficit units to surplus units
money market securities
debt securities that have a maturity of one year or less
capital markets
facilitate the sale of long-term securities from deficit units to surplus units
capital market securities
commonly issued to finance the purchase of financial assets
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
subprime mortgages
offered to some borrowers who do not have sufficient income to qualify for prime mortgages or make the down payment
mortgage-backed security
debt obligation representing claims on a package of mortgages
derivative securities
financial contracts whose values are derived from the values of underlying assets
how to value a security?
- measured as the present value of future cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows
- information can affect cash flows and price
efficient market
securities are rationally priced
behavioral finance
the application of psychology to financial decision making
asymmetric information
when a firm’s manager possesses knowledge that isn’t public
Sarbanes-Oxley Act of 2002
firms that have publicly issued stock have to have their financial statements audited by independent auditors
foreign exchange market
facilitates exchanges involving different currencies
how is the exchange rate determined?
market-determined price(exchange rate) changes in response to supply and demand
jobs of depository institutions
- accept deposits from surplus and provide credit to the deficit through loans and purchases of securities
- willing to accept the risk of default on loans they provide
federal funds market
facilitates the flow of funds between depository institutions
credit unions
- non profit enterprises
- restrict their business to members, who share a common bond
finance companies
obtain funds by issuing securities and then those funds to individuals and small businesses
mutual funds
sell shares to surplus units and use the funds to purchase a portfolio of securities
jobs of securities firms
- broker
- dealer
- underwriter
what does it mean for a securities firm to be a dealer?
making a market in specific security by maintaining an inventory of securities
underwriting
placing newly issued securities for corporations and government agencies involving the primary market
insurance companies role
- provide insurance policies
- charge fees(premiums) in exchange for the insurance
- invest funds from premiums until the funds are needed
loanable funds theory
- used to explain interest rate movements
- determined by factors controlling the supply and demand for loanable funds
demand for loanable funds
collective borrowing activities of households, businesses, and the gov
what is the relationship between the interest rate and the quantity of loanable funds?
inverse relationship
how does a lower interest rate impact the demand for loanable funds?
businesses and households demand a greater quantity of loanable funds at lower interest rates
what determines foreign demand for US funds?
demand for US funds is inversely related to US interest rates
relationship for aggregate demand for loanable funds
Demand for loanable funds is inversely related to interest rates
what is the largest supplier of loanable funds?
the household sector
what are the largest demanders for loanable funds?
businesses and governments
what is the relationship between the interest rate and the supply of loanable funds?
direct relationship
is supply or demand more elastic?
demand
equilibrium interest rate
the rate that equates the aggregate demand for funds with the aggregate supply of loanable funds
what are the five sectors that demand and supply loanable funds?
households, businesses, the federal government, municipal government, and foreign demand
is supply or demand higher when interest rates are extremely low?
demand is higher than supply
is supply or demand higher when interest rates are extremely high?
supply is higher than demand
what happens to interest rates when demand is greater than the supply of loanable funds?
interest rates should rise
what does economic growth do to interest rates?
puts upward pressure on interest rates
fisher effect
relationship between the nominal and real interest rates and expected inflation
the formula for nominal interest rates?
i = E(INF) + iR, where:
- i = nominal rate of interest
- E (INF) = expected inflation rate
- iR = real interest rate
real interest rate
the difference between the nominal interest rate and the expected inflation rate
how does the fed use monetary policy to affect interest rates?
Fed can affect the supply of loanable funds by increasing/decreasing the total amount of deposits held at commercial banks to other depository institutions
how does the federal budget deficit impact interest rates?
A higher federal government deficit increases the number of loanable funds demanded which increases interest rates
net demand for funds formula
ND = Da - Sa = (Dh + Db + Dg + Dm + Df) - (Sh + Sb + Sg + Sm + Sf)
how does credit(default) risk affect the structure of interest rates?
a higher degree of credit risk = credit risk premiums(higher yield above treasury bond yield)
how does liquidity affect the structure of interest rates?
securities that are less liquid must offer a higher yield to attract investors
how does tax status affect the structure of interest rates?
taxable securities must offer a higher before-tax yield than do tax-exempt securities
after-tax yield formula
Yat = Ybt (1 - T), where:
- Yat = after-tax yield
- Ybt = before-tax yield
- T = investors marginal tax rate
- Ybt = Yat / (1-T)
how does term to maturity affect the structure of interest rates?
generally the longer time to maturity the longer the interest rates are
the formula for modeling the yield to be offered on a debt security
Yn = Rf,n + CP + LP + TA, where:
- Yn = annualized yield of an n-year debt security
- Rf,n = annualized yield(return) pf an n-year treasury(risk-free) security with the same term to maturity as the debt security of concern
- CP = credit risk premium to compensate for credit risk
- LP = liquidity premium to compensate for less liquidity
- TA = adjustment due to the difference in tax status
pure expectation theory
the term structure of interest rates is determined solely by expectations of interest rates
what happens to supply and demand if interest rates are expected to increase?
- supply increases in short-term markets and decreases in long-term markets
- demand increases in long-term markets and decreases in short-term markets
what happens to supply and demand if interest rates are expected to decrease?
- supply increases in long-term markets and decreases in short-term markets
- demand increases in short-term markets and decreases in long-term markets
forward rate
commonly estimated and assumed to represent the market’s forecast of the future interest rate
liquidity premium theory
investors may prefer to own short-term securities because a shorter maturity represents greater liquidity
segmented markets theory
investors/borrowers choose securities with maturities that satisfy their forecasted cash needs
what are the implications of the segmented markets theory?
the preference for articular maturities can affect the prices and yields of securities with different maturities
federal reserve district banks and their operations
- commercial banks that have become members of the fed
- ops: clearing checks, replacing old currency, and providing loans to depository institutions in need of loans
member banks
commercial banks that can elect to become member banks if they meet specific requirements
board of governors(federal reserve board)
- 7 members appointed by the prez
- 14-year nonrenewable terms
- set margin and reserve requirements
FOMC
goals: achieve stable economic growth and price stability
- 7 board members + the presidents of 5 fed district banks
advisory committees
- federal advisory council
- community depository institutions advisory council
- community advisory council
federal advisory council
- an advisory committee
- one member from each federal reserve district
- meets with the board of governors at least 4 times a year and makes recommendations about economic and banking issues
Community depository institutions advisory council
- an advisory committee
- 12 members who represent savings banks, savings and loan associations, and credit unions
- Meets with the board of governors 2 times per year
Community advisory council
- an advisory committee
- 15 members
- Emphasis on low- and moderate-income populations
- Meets with the board of governors 2 times per year
consumer financial protection bureau
- an advisory committee
- responsible for regulating financial products and services
FOMC decision process
- meets 8 times per year
- actions are taken to implement monetary policy
- 2 weeks before the meeting members receive the beige book
beige book
a consolidated report of the regional economic conditions in each of the 12 districts
how the fed actually changes monetary policy
- the decision is forwarded to the trading desk(open market desk) at the NY fed reserve district bank
- managers instruct traders on the amount of T securities to buy/sell
when instructed to lower the federal funds rate…
- purchase T securities(mostly T bills) in 2nd market
- money is transferred from the fed to bank balances of dealers(increases supply)
- places downward pressure on the federal funds rate
When instructed to increase the federal funds rate…
- Sell government securities to dealers
- Money is transferred from dealers to the Fed(decreases supply)
- places upward pressure on the federal funds rate
Dynamic open market operations
reducing or increasing the federal funds rate
defensive market operations
intended to offset the impact of temporary conditions on the amount of funds in the banking system
M1
currency and checking deposits at depository institutions
M2
M1 + savings deposits, MMDAs(money market deposit accounts)
M3
M2 + large time deposits, money market mutual funds
reserve requirement ratio
the proportion of depository institution’s deposit accounts that must be held as reserves
what is the result of a reduction in the reserve requirement?
banks hold a smaller proportion of their new deposits as reserves→ make more loans
how does the fed implement quantitative easing?
- purchasing specific types of debt securities
- increase liquidity in specific markets for risky debt securities and reduce long-term interest rates
Composite index
combines various indexes to indicate economic growth across sectors
Leading economic indicators
used to predict future economic activity
Coincident economic indicators
tend to reach their peaks/troughs at the same time as business cycles
Lagging economic indicators
tend to rise or fall a few months after business cycle expansions and contractions
producer price index
reflects prices at the wholesale level
consumer price index
reflects prices paid by consumers
what is “core” inflation/
Excludes food/energy prices because they tend to be very volatile
Demand-pull inflation
occurs as a result of excessive demand(spending) that pulls up prices of products/services
why might stimulative monetary policy fail?
- fed’s limited ability to control long-term interest rates
- limited credit provided by banks
- Low returns on savings
- Adverse effects on inflation
- Lagged effects of monetary policy
credit crunch
if the fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some
