Economics of Financial Markets Unit 2 Flashcards
Name the Determinants of Asset Demand:
Wealth: the total resources owned by the individual, including all assets
Expected Return: the return expected over the next period on one asset relative to alternative assets
Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets
Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets
Explain the Theory of Portfolio Choice:
Holding all other factors constant:
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
Liquidity Premium Theory
we prefer to be as liquid as possible so if an asset is less liquid there will be a higher premium; best reason for why yield curve slopes upward
Gordon Growth Model
P= D(1+g) / (k-g)
D= most recent dividend paid g= the expected constant growth rate in dividends k= interest rate needed
Tax Equivalent Yield Formula
TEY= Cm/(1-t)
Cm= coupon rate on municipal bond t= tax bracket
LOOK AT HW SUPPLEMENT
LOOK AT FORMULAS THAT ARE IMPORTANT.
Factors that will shift the Supply Curve for bonds? (and in which direction with an increase/decrease).
a. Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right (to gear up for production)
b. Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right
c. Government budget: increased budget deficits shift the supply curve to the right
factors that determine and shift the demand for money;
- Income Effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
- Price-Level Effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
factors that determine and shift the supply for money
Changes in the Money Supply: When the money supply increases (everything else remaining equal), interest rates will decline
What is the Fisher Effect?
ir=in -iie
- Inflation has an effect on the real interest rate
- When expected inflation rises, interest rates will rise.
Liquidity management
maintaining sufficient reserves to protect against deposit outflows
Asset management
seeking the highest possible returns on loans and securities, while simultaneously making adequate provision for liquidity
Liability management
the acquisition of deposits at low cost in order to increase profits
Capital adequacy management
meeting the regulatory requirement, protecting against loan losses, while at the same time maximizing returns to shareholders
Credit risk management
minimizing the probability that borrowers will default
Interest-rate risk management
reducing the bank’s exposure to dramatic swings in profitability with fluctuations in interest rates.
Board of Governors
responsible for the overall operation of the Federal Reserve System and the general direction of monetary policy.
Federal Open Market Committee
makes decisions regarding the conduct of open market operations and the federal funds rate
District banks
make discount loans and provide operational support to member banks
Member banks
are required to maintain reserves and have the ability to borrow through the discount window
Federal Advisory Council
provides information to District banks as to regional economic and business conditions in their districts
Keynes liquidity preference framework.
determines the equilibrium interest rate in terms of the supply of and demand for money.
Bs + Ms = Bd + Md
Bonds with the same maturity have different interest rates due to:
o Default risk: probability that bond will not be repaid at maturity
o Liquidity: how easily the bond is convertible to cash (some bonds are easier/more difficult to sell)
o Tax considerations: interest rate on municipal bonds are tax-free
against what standard is this risk for bonds measured?
bond Ratings by Moody’s Standard and Poor’s, and Fitch
-Ba1 and below is quite risky
What can a slowly upward sloping starting from the bottom yield curve can tell you?
it can tell you the following: Current short-term int. rates are Low Monetary Policy is Expansionary Output is currently below potential Unemployment is above NR Inflation is low
What two ways in which investors formulate their beliefs about future stock prices.
Adaptive expectations: expectations are formed from past experience only
rational information: expectations will be identical to optimal forecasts using all available information
What are Liabilities?
Source of funds, o Checkable deposits o Nontransaction deposits o Borrowings o Bank Capital
What are Assets?
Use of funds o Reserves(*vault cash), loans, securities, deposits at other banks.
Efficient Market Hypothesys
will tell you hot tips never work, •In an efficient market, a security’s price fully reflects all available information
portfolio diversification
1950 marcuwitz and won a nobel price
Asset transformation:
- Take liabilities and turn it into income
- the process of creating a new asset (loan) from liabilities (deposits) with different characteristics by converting small denomination, immediately available and relatively risk free bank deposits into loans- new relatively risky, large denomination asset- that are repaid following a set …
Calculate Return on Assets
ROA=Net income(after tax)/Total Assets
Calculate Return on Equity
ROE=Net income(after tax)/Total Equity
the net profit after taxes per dollar of equity (bank) capital:
Calculate GAP and Duration
change in profits = (rate-sensitive assets - rate-sensitive liabilities) x change in interest rates
Calculate Capital Ratio:
Book says formula is: Total equity capital/ Total Assets
Regulatory Level = 10% of Total Assets =
Total Assets x .10
