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FIN 408 > Exam 1 > Flashcards

Exam 1 Flashcards

1
Q

CH 1

6 Parts of the Financial System

A

1) money
2) financial instruments (stock, bonds)
3) financial markets (NASDAQ)
4) financial institutions (banks)
5) regulatory agencies (SEC)
6) central banks (fed reserve)

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2
Q

CH 1

5 Core Principles of Money and Borrowing

A

1) time has value
2) risk requires compensation
3) information is the basis for all decisions
4) markets determine prices and allocate resources
5) stability improves welfare

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3
Q

CH 2

3 Characteristics of Money

A

1) a means of payment (bartering requires a double coincidence of want)
2) a unit of account (standard value used to quote prices)
3) has a store of value (durable and capable of transferring purchasing power from one day to the next)

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4
Q

CH 2

2 Types of Liquidity

A

1) Market Liquidity - ability to sell assets for money

2) Funding Liquidity - the ability to borrow money to buy securities or make loans

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5
Q

CH 2

Income vs Wealth

A

Income - the flow of earnings over time

Wealth - value of (assets - liabilities)

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6
Q

CH 2

4 Methods of Payment

A

1) commodity - has intrinsic value (ie. wheat, gold)
2) fiat monies - value comes from government decree (dollar)
3) checks
4) electronic payments - credit cards, electronic funds transfers, etc.

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7
Q

CH 2

Measuring Money Quantity Changes

A
  • interest rates
  • economic growth
  • inflation rates
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8
Q

CH 2

Consumer Price Index

A

-percentage change in the cost of a basket of goods today compared to some base year

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9
Q

CH 3

Indirect vs. Direct Financing

A

Indirect - when an institution stands between a lender and a borrower
Direct - when borrowers sell securities directly to lenders in financial markets

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10
Q

CH 3

3 Functions of Financial Instruments and Securities

A
  1. a means of payment
  2. a store of value (bonds, loans, stocks)
  3. a transfer of risk (futures, options, contracts)
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11
Q

CH 3

Deleverage

A

When a firm experiences losses, they attempt to raise their net worth by getting rid of some of their liabilities

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12
Q

CH 3

Underlying vs. Derivative Instrument

A

Underlying Instrument - used by savers or lenders to transfer resources directly to investors or borrowers (ie. stocks, bonds), has value in itself

Derivative Instrument - value and payoff are derived from the behavior of the underlying instrument (ie. options, futures); primary use is to SHIFT RISK among investors

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13
Q

CH 3

4 Characteristics that Influence Financial Instruments’ Value

A
  1. Size of payment (large = more valuable)
  2. Timing of payment (the sooner the payment the better)
  3. Likelihood of payment (more likely that it will be made = more valuable)
  4. Conditions of which payment is made (if payments are made when needed it makes it more valuable
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14
Q

CH 3

3 Roles of Financial Markets

A
  1. market liquidity
  2. provide information
  3. risk sharing
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15
Q

CH 3

Debt Market

A
  • loans, mortgages and bonds are traded (Characterized by loan maturity)
  • repaid in < 1yr = money market
  • repaid in > 1yr = bond market
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16
Q

CH 3

3 Roles of Financial Institutions

A

Financial institutions are banks, insurance companies, securities firms, pension funds, etc.

  1. reduce transaction costs
  2. reduce information costs
  3. give savers ready access to their funds
17
Q

CH 3

Shadow Banks

A
  • provide services that compete w/ banks but do not accept deposits
  • ie. brokerages, hedgefunds
  • take on more risk than traditional banks and are less transparent (not required to disclose investments)
18
Q

CH 4

Future vs. Present Value

A

Future Value (FV) - the value at some future date of an investment made today

Present Value (PV) - the value today of a payment that is promised to be made in the future. A change in an IR has a greater impact on the PV of a payment made far in the future relative to one that has to be made soon. Higher IR = lower PV

19
Q

CH 4

Computing Percentage Change Per Year

A

Plug in PV, FV, and period of time, solve algebraically to find i

20
Q

CH 4

Coupon Bond

A

A promise to make a series of payments on specific future dates (coupon payments)

Coupon rate = annual interest rate that a borrower pays
Maturity date = the date on which payments stop and the loan is repaid

21
Q

CH 4

Valuing Coupon Bonds

A

value of PV of coupon bonds rises when:

  1. yearly coupon payment (c) rises
  2. interest rates fall *To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates
22
Q

CH 4

Nominal Interest Rates

A

-interest rates expressed in current dollars; the interest rate before taking inflation into account

23
Q

CH 4

Real Interest Rates

A

The rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation; this is un-observable thus it is estimated

24
Q

CH 5

Risk

A

Measure of uncertainty about future payoffs to an investment, assessed over some time horizon, and relative to a benchmark

25
Q

CH 5

Probability Theory Steps

A

1) list all possible outcomes

2) figure out the chance of each outcome occurring

26
Q

CH 5

Steps to Calculate Variance/SQRT

A

Variance = The average of the squared deviations of possible outcomes from their expected value, weighted by their probabilities

**STDEV = sqrt of variance

1) compute expected return
2) subtract E(r) from each possible payoff and square the result to get rid of any negatives
3) multiply each result by its probability
4) add up the results

27
Q

CH 5

Value at Risk

A

Worst possible loss over a specific horizon at a given probability
-used to assess whether a fixed or variable rate mortgage is better, ie.

28
Q

CH 5

Sources/Types of Risk

A

Idiosyncratic (Unique) Risk - risk affecting a small # of people but no on else; can be risk that is bad for one sector of the economy but good for another; can hedge risk with diversification

Systematic (Market) Risk - risk that affects everyone and cannot be diversified away

29
Q

CH 5

How to Spread Risk

A

Find investments whose payoffs are unrelated (uncorrelated)

1) look at the possibilities, probabilities, and associated payoffs on different investments
2) the more independent sources of risk that are held in a portfolio means that there is a lower overall risk and the standard deviation becomes negligible

30
Q

CH 6

4 Basic Types of Bonds

A

1) zero coupon bonds - a promised single payment at a future date with no coupon payments; ie. a Treasury Bill
2) fixed payment loans - sequence of fixed payments such as car loans, mortgages, etc. value of = sum of PV of payments
- amortized loans: borrower pays part of the principal along w/ interest for the life of the loan
3) coupon bonds - have periodic interest payments and a principal repayment at maturity (US treasury bonds, most corporate bonds, etc.)
4) consol or perpetuities - have periodic interest payments forever, the principal is never repaid

31
Q

CH 6

What happens to YTM based on the bond price?

A

If:
Bond Price = Face Value (FV) of the bond, YTM = coupon rate
Bond Price > FV of the bond, YTM < than coupon rate
Bond Price < FV of the bond, YTM > than coupon rate

as bond price goes up, YTM goes down!

32
Q

CH 6

Current Yield

A

A measure of the proceeds a bond holder receives for making a loan

  • the measure of the part of the return gained from buying the bond that arises solely from the coupon payments
  • if:
  • BP is < than its FV the coupon rate will be < than the CY which is < than YTM
  • BP is = to its FV then Coupon Rate = CY = YTM
  • BP is > than its FV then Coupon Rate
33
Q

CH 6

Holding Period Return

A
  • the return from holding a bond and selling it before maturity
  • it may differ from YTM
34
Q

CH 6

Yield Curve Changes

A

Moving Along the Curve = change in quantity supplied or demanded

Shift in the Curve = change in the supply or demand

35
Q

CH 6

Factors that Shift Bond Supply

A

1) changes in government borrowing
- an increase in gov borrowing needs an increase in the quantity of bonds outstanding -> shifts supply curve right
2) changes in general business conditions
- as business conditions improve -> it shifts the supply curve to the right
3) changes in inflation
- expected inflation rises -> cost of borrowing falls -> supply curve shifts right

AND VICE VERSA

36
Q

CH 6

Factors that Shift Bond Demand

A

1) wealth
- an increase in wealth shifts the demand of bonds to the right
2) expected inflation
- declining inflation means promised payments have higher value, so demand curve shifts right
3) expected returns and expected interest rates
- if the expected return on bonds rises relative to the return on alternative investments, shift right
- if IR are expected to fall, prices are expected to rise, demand curve shifts right
4) risk relative to alternatives
- if a bond becomes less risky relative to alternative investments, then it will lead a right shift
5) liquidity relative to alternatives
- b/c investors like liquidity, the more liquid bonds are, the higher the demand, it’ll shift right then

37
Q

CH 6

Why are bonds risky?

A
  • default risk
  • inflation risk
  • interest rate risk (a rise in interest rates before its sold could mean a capital loss is incurred)
38
Q

CH 6

Securitization

A

The process by which financial institutions pull various assets that generate a stream of payments and transforms them into a bond that gives the bond holder claim to those payments

39
Q

CH 6

Inflation Risk Indexed Bonds

A
  • government promises to pay a fixed interest rate plus the change in CPI
  • 2 types:
    1) series 1 savings bond
    2) treasury inflation protected securities (TIPS)

greater inflation risk –> larger compensation needed for the bond

FIN 408 (2 decks)

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