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Year 2 Economics Term 1 > FE - Lecture 1 > Flashcards

FE - Lecture 1 Flashcards

1
Q

The 5 components of the financial system?

A
  • Participants
  • Securities
  • Markets
  • Trading Arrangements
  • Regulations
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2
Q

Participants in the financial system?

A

Firms maximize the sum of their current and future profits, i.e. maximize their long-term value
•Replacement investment: To replace obsolete equipment.

Households maximize the expected utility derived from their current and future consumption
Financial assets are a way to “smooth” consumption over time, taking into account:
•Uncertainty about the future (risk aversion)
•Preference for liquidity

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3
Q

How do firms fund investment?

A
  • Retained earnings
  • Bank loans
  • New equity
  • Bond issuing
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4
Q

3 Functions of FIs?

A

Maturity, transaction and risk transformation

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5
Q

What is maturity transformation?

A

Holding less liquid (long-term) assets issue more liquid (short-term) liabilities

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6
Q

What is Tranaction transformation?

A

Lower search costs
•Economies of scale
•Provision of standardized forms of securities

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7
Q

risk transformation?

A

Risky liabilities issued by the borrowers safe assets for primary lenders
•What does risky mean?
•Default/credit risk: Inability of borrower to repay loan and/or interest
•Equity risk: Failure of the investment made with loan
•Risk spreading (relative to default risk)
•Spreading a risky investment across a large number of lenders
•Risk pooling (relative to equity risk)
•Constructing portfolios of assets that exploit

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8
Q

2 types of FI’s?

A

Bank, non-bank

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9
Q

Bank FI’s?

A 
Retail banks
•Deal with households, small businesses
•What they do:
•Issue deposits
•Make loans

Investment banks
•Deal with institutional investors, large corporations, governments, etc
•What they do:
•Corporate finance (corporate loans, bond issues, initial flotation, M&As, etc.)
•Asset management (private banking= managing long-term equity and bond portfolios for private and institutional clients)
•Agency brokerage & market-making
•Proprietary trading (trading activity on bank’s own account to make profits)
•Equity banking (bank makes a direct investment in a company)
•International investment advice

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10
Q

7 Non-BFIs?

A

Finance houses, Building societies, pension funds, instance companies, collective investment schemes, specialist FIs and market makers.

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11
Q

Role of finance houses?

A

finance short term durable expenditure of members of the household sector: hire purchase agreements (type of leasing agreement where the buyer pays a monthly rate to use the good and becomes the owner of the good at the end of the period)

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12
Q

Role of building societies?

A

finance long term durable expenditure of members of the household sector (mortgages)

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13
Q

Role of collective investment schemes?

A

investment trusts, unit trusts, open-end investment companies (OEIC)
•Large and complex portfolios of financial assets
•Value of portfolio divided in units (unit trusts)/ shares(investment trusts/ OEIC)

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14
Q

role of specialist FIs

A

Arbitrageurs(perform fundamental analysis and check for deviations from fair price)
•Hedgersusing futures, options (derivatives securities) they minimize the risk of their positions, e.g.
•Share prices falling
•Debt obligations’ interest going up
•Adverse forexmovements
•Speculatorstake views on prices

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15
Q

Role of market-makers

A

do not act as agents between end-users but they buy and sell securities for their own account

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16
Q

What are securities?

A

a claim on some underlying asset (financial or physical)

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17
Q

Main ways securities are separated

A 
Issuer
Currency of denomination
Ownership and participation rights
Collateral
Maturity
Income Payments
Predictability of capital value
Degree of liquidity/ reversibility
Tax treatment 
Derivatives or not
Composite securities or not
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18
Q

Securities: maturity

A
  • Short-term (<1 year), long-term
  • Callables, puttables(redeemable at the option of the issuer/ holder)
  • Perpetuities (current and deposit accounts, perpetual bonds, preference shares, equity)
19
Q

Securities: income payments

A
  • Fixed or variable
  • Monthly, quarterly (certain deposit accounts), semi-annual (government and local authority bonds), annually (eurobonds, certificates of deposit), etc
  • No explicit payments: Sell at discount to their face value (Treasury bills, zero-coupon bonds, etc.)
20
Q

Securities: predictability of capital

A

•Deposits (value of principal=certain), bonds (at maturity, capital value=certain), shares ( capital value is never certain)

21
Q

Securities: issuer

A
  • Domestic, foreign governments: government bonds=gilts

* Domestic, foreign corporations: corporate bonds, stock

22
Q

Securities: Currency of denomination

A

Currency of denomination
•Domestic bonds (£ denominated, issued in the UK)
•Bulldog bonds (£ denominated, issued by a foreign issuer)
•Eurobonds (traded in the UK, but denominated in currencies other than £)

23
Q

Securities: Ownership and participation rights (both profit + decision making)

A
  • Common stock –ownership and participation
  • Preference stock –just ownership
  • Debt –none
24
Q

Securities: Collateral

A
  • Debentures: debt instrument for medium/ long term borrowing, securedagainst specific assets of the firm (UK)
  • Unsecured
25
Q

Securities: Degree of liquidity and degree of reversibility

A
  • Liquidity: time and/or cost of converting a security into cash
  • Reversibility: possibility to move cash-asset-cash, without high costs (bid-offer spread)
26
Q

Securities: Tax treatment

A
  • Income from securities (dividends, interests…) subject to income/corporation tax
  • Capital gains tax
27
Q

Securities: Are they derivatives?

A
  • Derivative: Delivers a security (underlying asset) at some future time
  • Financial futures, options, etc.
28
Q

Securities: Do they involve composite securities?

A
  • Composite security: Mixture of 2 or more securities

* Convertible bonds, swaps, etc.

29
Q

Types of markets for securities?

A

•Maturity of securities
–Money markets (<1 year) : Treasury bills, commercial bills, negotiable certificates of deposit
–Capital markets: bonds, shares
•Primary vssecondary market
–Primary: when security is first issued
•Initial Public Offering (IPO)
–Secondary: where existing securities are traded
•Exchange vs over-the-counter market
–Over-the-counter: off-exchange,trading directly between parties

30
Q

Definition of a market?

A

A system/place through which securities

are created and transferred

31
Q

9 Trading arrangements/ types of order?

A
  • Market order:best possible price
  • Buy Stop order:buy Xshares as soon as the price rises above P
  • Sell Stop order: sell X shares as soon as the price drops below P
  • Limit order:buy/sell at a specified price orbetter
  • Stop limit order:sell 104 stop, 100 limit= executed if share price falls bellow 104, but not lower than 100
  • Day order:order is cancelled if it is not executed on a particular day
  • Open order:remains in effect until it is either executed or cancelled
  • Fill-or-kill order: cancelled if it cannot be executed immediately
  • Round lot order:buy/ sell in the standard trading unit for a stock exchange (ex: 1000 shares LSE)
32
Q

Difference between a flat and effective rate?

A

Flat rate is the quoted level, e.g. 6% a year.
Effective rate = interest factor - 1.
If compounding takes place more than once a year, re > r.
re = (1+ r/m)^m - 1.

33
Q

An annuity?

A

A regular stream of payments. discounting back:

P = F(1+r)^-t

34
Q

Perpetuity?

A

An annuity that continues indefinitely.

35
Q

Characteristics of money market securities

A

•Maturity less than a year
•Quoted on
–Yield basis: % of interest
–Discount basis: sold at a discount from the face-value
•UK: 365-day year
•Settlement day: first business day following purchase
•London Interbank Market

36
Q

London interbank reference interest rates:

A

LIBID (London interbank bid rate)= rate at which one bank
bids for funds (accepts deposits from other banks)
“If you depositfunds in my bank for a week, I’ll giveyou an annual interest rate of 9%’’
•LIBOR (London interbank offered rate)= rate at which
one bank offers funds (lends to other banks)
“If you want to borrowfunds from my bank for a week, I’ll chargeyou an annual interest rate of 9.5%’’

37
Q

MMDs

A

Money market deposits:
• Issued for overnight, 1 week, or 1, 2, 3, 4, 5, 6, 9
and 12 months, fixed term
• Not negotiable: Cannot be liquidated before maturity
• Referenced to LIBID (ex: LIBID - x%)
• Fixed-rate
• Interest and capital repaid at maturity (no intermediate payments)
• Thus, simple interest

38
Q

CDs?

A

Negotiable Certificates of Deposit:
•Mostlyfixed-rate, but could be variable
•Referenced to LIBID
•Maturities mainlybetween 1-3 months
•Interest: computed as in the case of MMDs…
•…but if maturity > 1 year, interest paid annually
•Can be traded…so more liquid than MMDs

39
Q

Clean price?

A

of CD: Principal = P - accrued interest

40
Q

Name 5 other securities quoted on discount basis

A

•TreasuryBills:
– issued by the Government :3,6 months
•Bills of exchange
–similar to TBs but issued by companies against the sale of goods
• Banker’s acceptances
–Written promise by a borrower to a bank to repay borrowed funds
–tradable on asecondary market
-bank that first accepted is responsible in case of defaultt of future buyers
•Commercial paper
–promissory notes issued by large firms
–unsecured (nocollateral)
–firm must be listed with net assets > £50m
•These securities are sold at a discount to their par value (no interests)

41
Q

Expectations Hypothesis?

A

The Expectations Hypothesis says that long-term rates
describe the future path of short rates i.e. long-term
rates are determined by the expected future short-rates.
• Rising curve: Investors expect future short term rates to rise
• Falling curve: Investors expect future short term rates to fall
• Humped

42
Q

Liquidity preference theory?

A

Liquidity Preference Theory:As borrowers prefer to borrow for longer periods, while investors prefer to stay liquid, a liquidity premium is required by lenders to forgo liquidity. Premium increases with maturity

43
Q

Preferred habitat theory?

A

Preferred Habitat Theorysays that supply and demand conditions determine the slope of the yield curve. Banks demand short maturities, pension funds demand long maturities, no particular group demands medium

Year 2 Economics Term 1 (4 decks)

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