Final Exam Econ 351 Flashcards
types of market efficiency: security prices reflect all historical information, can’t profit from looking at past trends (using technical analysis)
weak form
type of market efficiency: security prices reflect all publicly available information, doesn’t pay to over analyze annual reports looking for undervalued stocks(technical and fundamental analysis)
semi-strong form
type of market efficiency: security prices relfect all information-public and private, not true- it is possivle to earn above-average returns by trading on insider information, but that’s illegal(does not hold in reality)
strong form
changes in price of commodities such as crude oil, corn, etc
commodity risk
change in price of one currency in relation to another
foreign exchange risk
own or buy financial assets
long position
sell financial assets
short position
a financial transaction that eliminates or reduce risk (used as insurance against price change in the underlying asset)
Hedging
interest rate fluctuates due to fundamental factors, changes in monetary policy, expectations, etc, changes in interest rate impacts price of bonds
interest rate risk
prices of stocks can fluctuate, impacting rate of return on stocks(equity)
equity risk
place financial bets to profit from movements in asset prices(buy and sell derivatives to profit from price changes in the underlying asset)
speculating with financial derivatives
right to buy an asset
call options
right to sell an asset
put options
price agreed to in contract
strike price
date option exercised
expiration date or maturity
price paid to get the option
option premium
gives right to buy or sell asset (choose whether to exercise), at a specified date, at a specified/guaranteed price
options
which options are more flexible american or european(one can be exercised at any date up to maturity the other can only be exercised at maturity)
american
an investor who wants to bet that the price of the underlying asset will increase would buy a … option.
call
an investor who wants to bet that the price of the underlying asset will decrease would buy a … option.
put
intrinsic value(value of an option if exercised today) for a call option vs put option.
call: Spot-Strike
put: Strike-Spot
call vs put option (profit/loss)?
call: (spot-strike-premium)(# of options)
put: (strike-spot-premium)(# of options)
The rational expectations theory is applied to financial markets using what?
The Efficient Market Hypothesis
What is the key implication of the Efficient Market Hypothesis?
Stock prices are not predictable and follow a random walk(as likely to increase as to decrease)
What type of market is defined as one in which securities prices quickly and fully reflect all available information?
Efficient Market
The Efficient Market Hypothesis says a security’s price fully reflects all available information in an efficient mark therefore price only adjusts if … or … information becomes available.
new, unexpected
Arbitrage opportunity arises if the optimal forecast is … than the … …
greater than the equilibrium return(current price is different from optimal forecast)
Type of Market Efficiency: security prices reflect all historical information, meaning you … profit from looking at past trends (using … analysis)
weak
can’t
technical
- price movements assumed to be random, a past decline is no reason to think stock prices will go up or down in the future
Type of Market Efficiency: security prices reflect all publicly available information, meaning it does not pay to over analyze annual reports looking for undervalued stocks(… analysis)
Semi-strong
fundamental
- suggests that there are no under or over-valued stocks and rules out technical and fundamental analysis
Type of Market Efficiency: security prices reflect all information- public and private, this is … - it is possible to return above-average returns be trading on insider information, but that is …
strong form
untrue
illegal
- does not hold in reality, money managers and actively traded funds would not outperform the average market return
Implications of EMH for investing: better to “… and …”, based on EMH, cannot out-perform the market average return, costs associated with trading are reduced
buy, hold
Trading
Implications of EMH for investing: better to hold a diversified portfolio, index preferred to individual shares or actively managed mutual funds because they are as well off as each other, no manager of an actively managed fund has been able to … beat the returns on an index fund, the stock of a more profitable firm will not be a better investment than the stock of a less profitable firm.
Portfolio allocation
consistently(due to arbitrage)
Implications of EMH for investing: these do not beat the markets(do not pay them)
Investment analysts (cannot earn abnormally high returns in the long term due to arbitrage)
Implications of EMH for investing: if you are ONE OF THE FIRST to get the information then above average returns are possible INITIALLY(once information becomes widely known, any … profit opportunities will be … due to arbitrage)
“Hot Tips”
unexpected
eliminated
Implications of EMH for investing: security prices will only adjust if … or … information is available that impacts the long-term profitability of the firm, sometimes stock price … when good news is announced
Stock Prices and Good News
declines
You hear in the news that Bank of America is going to expand its branch network. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing stock in Bank of America?
No
if you hear about the expansion on the news, it suggests information already available, not new information, so it is already reflected in the Stock price
Evidence Against EMH: use of trading strategies that can result in above-average returns, which should not be possible if EMH holds
Pricing Anomalies(the small-firm effect, January effect, Days of the Week effect)
Type of Pricing Anomaly: over the long run, investment in small firms has yielded a higher return than has investment in large firms (take advantage of price …) this is due to … risk, … liquidity, … information costs, … growth potential
Small-firm effect
mismatch
higher
low
high
larger
Type of Pricing Anomaly: during some years, rates of return on stocks have been abnormally high during January due to tax loss selling (investors sell … performing stocks at the end of the year and make a capital…(offset tax liability)
January effect
low, loss
Evidence Against EMH: some price changes are predictable using all available information
Mean Reversion and Momentum Investing
Stocks that have recently been earning high returns to experience low returns in the future (stocks revert to … price), suggest that you can earn abnormal profits by … stocks with high returns now and … stocks with low returns now
Mean Reversion
mean
selling
buying
Trading strategy based on the idea that there can be persistence in stock price movements, suggests to … when stock prices are rising and … when they are falling
Momentum Investing
buy
sell
Evidence Against EMH: strategy: selling stocks when they have fluctuated above their fundamental values and buying them when they are below their fundamental values
Excess Volatility
Evidence Against EMH: strategy: suggests that buying past losers while selling past winners (securities are overbought or oversold due to psychological reasons rather than fundamentals, stock prices overshoot)
Market overreaction
Evidence Against EMH: allows investors to earn above-normal returns until information becomes widely known
New information is not always immediately incorporated into stock prices
Empirical studies suggest that the stock market is:
… efficient in the weak form
… efficient in the semi-strong form
… efficient in the strong form
highly, reasonable, not
a financial security whose economic value depends on the value of an underlying asset
derivatives
stocks, bonds and foreign currency are which type of underlying asset
financial derivative
oil, wheat, and gold are which type of underlying asset
commodity derivative
involves taking an offsetting position to protect against risk
hedging risk
offset … position by taking a … position
long(own asset), short(agreement to sell asset at given price to protect against price decrease)
short(do not own asset), long(agreement to buy asset at given price to protect against price increase)
Hedging … flow of funds in the financial system and … investment and consumption impacting real GDP and economic growth
increases
increases
A financial institution has bought(or own) Treasury notes(long position) and plans to sell the security at some point in the future.
Risk:
Hedge:
interest rate risk(worried the YTM will change), increase in interest rate –> decrease in the price–> capital loss
short position–> contract to sell, at specified time in the future, at some guaranteed price
A financial institution has sold a security(short position) and needs to repurchase the security at some point in the future.
Risk:
Hedge:
equity risk if stocks/interest rate risk if bonds
long position–> contract to buy, at specified time, at guaranteed price
The manager at Tropicana is concerned that orange prices will rise in the future.
Risk:
Hedge:
commodity risk
long position –> contract to buy oranges, at a specified time, a guaranteed price
Why is speculating important?
the counterparty to hedging (hedgers transfer risk to speculators who are in pursuit of profit)
provides liquidity(increases the number of buyers and seller so market operates efficiently)
An investor thinks that Microsoft shares will decrease in the future(bearish) (currently do not own shares in Microsoft)
Action:
short position to sell Microsoft shares at a specified date at a guranteed price(if correct and price decreases–> buy shares in the spot market at a lower price and sell at contract price)
A US speculator thinks that the British pound will strengthen relative to the US dollar over the next 2 months(bullish)
Action:
take a long position(enter into a contract to buy pounds, at a specified date and guaranteed price)
if correct and the pound strengthens, sell at the current market price to make a profit
options contracts stipulate which three things?
strike price(exercised price), expiration date or maturity, option premium
The higher the strike price everything else being equal means what for the premiums on call vs put options?
call: lower premiums, strike price> spot (current market price) means it is cheaper to purchase at spot price in the market making call options less valuable
put: higher premiums, strike price> spot (current market price) means it is more valuable as higher selling price so premium on put option will be higher
What are the three determinants of the option premium?
Intrinsic value(relative spot to strike price)
Term to Expiration( increased time to maturity–> greater possibility asset price will change, premium on option will be higher on both call and put options)
Volatility of prices of the underlying asset(bonds, stocks, oil, etc)( increased volatility–> higher demand for options, higher premium on both call and put options)
when are call options out of the money, at the money, and in the money?
spot<strike>strike</strike>
when are put options out of the money, at the money, and in the money?
spot>strike
spot=strike
spot<strike
When to exercise, allow to expire, and sell to close a call option?
spot>strike
spot<strike
any time
When to exercise, allow to expire, and sell to close a put option?
spot<strike>strike
at any time</strike>
What is the Taylor’s Rule formula?
Federal funds rate target= current inflation + equilibrium real federal funds rate + (0.5 x Inflation gap) + (0.5 x output gap)
How to calculate the inflation gap?
current-targeted inflation
How to calculate the output gap?
percentage deviation in Real GDP from potential GDP
(Ya-Yp)/Yp x 100
If the inflation rate is above the Fed’s target, the FOMC will raise target for the federal funds rate, The Fed should raise the nominal interest rate by more than the inflation rate so that the real interest rate increases
The Taylor Principle
Determines a target for the federal funds rate
Taylor rule for the Federal Funds Rate
What does the Fed use as its main policy instrument?
the federal funds rate
Assume that the equilibrium real federal funds rate is 2% and the target for inflation is 2%. Suppose that the inflation rate is 3.5% and real GDP is 0.5% above its potential. Determine the federal funds rate predicted by the Taylor rule.
6.5%
What provides the fed with feedback on whether they are on target to achieve its goals(closely linked to the goals of monetary policy?
Intermediate Targets
What are examples of intermediate targets
money aggregates(M1+M2), short-term interest rates
Operating and Intermediate Target Example: Which of the following would be considered the goal, intermediate, operating, tool, and feedback?
- If the Fed realizes that the monetary base is growing too slowly they can adjust OMOs
- To increase M2, the Fed needs to increase the monetary base by 3.5%
- The Fed wants to increase economic growth by 5%
- OMOs could be carried out to achieve growth in the monetary base
- The Fed feels this can be achieved by a 4% growth rate of M2
Goal: The Fed wants to increase economic growth by 5%
Intermediate: The Fed feels this can be achieved by a 4% growth rate of M2
Operating: To increase M2, the Fed needs to increase the monetary base by 3.5%
Tool: OMOs could be carried out to achieve growth in the monetary base
Feedback: If the Fed realizes that the monetary base is growing too slowly, they can adjust OMOs
The central bank can choose either … or … targeting as its intermediate target
monetary or inflation
Where the central bank sets a target for the annual growth rate of M1 or M2
Monetary Targeting
What is M1 referred to as and what does it encompass?
Narrow Money
currency, demand deposits, and saving deposits
What is M2 referred to as and what does it encompass?
Broad Money
M1, time deposits, money market funds
What are the advantages and disadvantages of monetary targeting?
advantages:
- Accountable(accountable for hitting the target)
- Immediate signal(M1+M2 data is released every two weeks/monthly)
disadvantages:
- Relies on a stable relationship between money and inflation(impacts the effectiveness of monetary policy)
What is the order that the central bank completes its goals?
tools–> operating(reserves, federal funds rate)–> intermediate(M1+M2, short-term rates)–> goals
When the central bank sets a target for the inflation rate for a period of time(average 2%)?
Inflation Targeting
Advantages of Inflation Targeting
- Transparent(simple, clear, readily understood by public, frequent communication)
- Accountable(public knows if the target is met)
- Flexible
- Consistent with Fed independence(requires central bank autonomy for effective implementation)
- Reduction of time-inconsistency problem
Disadvantages of Inflation Targeting
- Delayed Signal (inflation outcomes are revealed after a substantial lag)
- Rigidity (imposes a rigid rule and limits the ability of Fed to respond to unforeseen circumstances)
- Increased fluctuations (can lead to fluctuations in output if policy too tight when above target and to easy when below)
- Low economic growth (can lead to low growth and employment as focused on hitting target inflation)
focus on short-run goals of economic growth or full employment instead of price stability
time inconsistency problem
The Federal Reserve pursues a flexible form of … targeting consistent with its … …
inflation
Dual Mandate
A change in the federal funds rate impacts interest rates on:
short-term and long-term financial assets
Examples of short-term financial assets:
savings accounts, time deposits(CDs)
Examples of long-term financial assets:
mortgages, car loans, student loans
Combines the demand and supply for money and the focus is on determining the short-term nominal interest rates.
The Money Market (Bond Market)
The Money Supply Curve is … as controlled by the Fed using tools of monetary policy.(Uses tools–> impact reserves, impact MS)
vertical
Households and firms decide between holding money and other financial assets
The Demand for Money
What motives are there to hold money?
Transactions(buy goods and services)
Precautionary(held money as insurance against unexpected events “just in case”)
Speculative(hold money as part of an investment portfolio, money vs bonds vs stocks vs…)
The interest rate represents the opportunity cost of … …
holding money
An increase in the interest rate:
- … the opportunity cost of holding money
- money demand is …
- money demand is … sloping
increases
low
downward
What causes a movement along the demand for money curve?
changes in the interest rate
What causes the MD curve to shift?
Real GDP(y)
Prive Level(inflation)
Technology(money substitutes/alternatives)
- An increase in Real GDP–> … demand for money(shifts the curve …)(impacts demand for goods and services)
increase
right
- An increase in Price Level–> … demand for money(shifts the curve …)(impacts the quantity of money needed to purchase goods and services)
increases
right
- An increase in Money substitutes–> … demand for money(shifts the curve …)(impacts money substitutes: Apple Pay, Google Pay, Venmo, Credit Cards, etc)
decreases
left
Policy instruments that have a direct impact on the intermediate targets.
Operating targets
Operating targets are controlled using … and indicate the stance of monetary policy(… or …)
tools
tight or easy
Operating targets need to be …, …, and ….
measurable
controllable
predictable
Examples of operating targets
non-borrowed reserves + borrowed reserves(reserves aggregate)
federal funds rate
T-bill rate
Measurable- data available in short-time frame:
Reserve aggregate(data available after … …)(subject to revision)
Federal funds rate(available … …(nominal rather than real)
2 weeks
almost immediately
Controllable- able to exercise control over variables:
Monetary aggregate(… control)
Federal Funds rate(set … using tools)
imperfect
directly
Predictable- expected effect on goals(MOST IMPORTANT):
debatable whether the link of the operating targets is closer with the … … or … …
monetary aggregates
interest rate
The Fed can choose … reserve aggregates … the federal funds rate. Why?
either, OR
cannot be used together
to maintain the fed rate target, the fed will need to change the NBR using OMOs
Problems implementing monetary policy?
- The Fed faces a trade-off between high economic growth and employment and low inflation
- The Fed faces timing difficulties in using monetary policy(Information/Impact lag)
- The Fed cannot impact goals of monetary policy directly
Problems implementing monetary policy: The Fed faces a trade-off between … … … and … and … …
- dual mandate: achieve low
unemployment + stable prices
- use … … as medium/long run goal (2% change in p.a.)
high economic growth
employment
low inflation
price stability
Problems implementing monetary policy: it takes time to recognize what is happening and takes time to gather data on GDP, inflation rates, and interest rates(implementing lag is low as the policy is implemented in minutes)
information lag
Problems implementing monetary policy: takes time for policy to impact macro-variables
- unemployment, output, inflation
impact lag
Problems implementing monetary policy: The Fed uses targets to help achieve macroeconomic goals because it has to go
… …–> … …–> … …–> …
policy tools, policy instruments, intermediate targets, goals
Examples of policy tools the Fed uses?
open market operations, discount policy, reserve requirements, interest rate on reserves, interest rate on overnight reserve repos
Examples of policy instruments the Fed uses?
reserves, federal funds rate
Examples of macroeconomic goals of the Fed?
output, inflation, unemployment rate
Effective federal funds rate, the mortgage interest rates and interest rates on corporate bonds move together overtime(the federal funds rate often increases and decreases … than other long term rates)
more
Target rate set by Fed?
Target Federal Funds Rate
Market federal funds rate(equilibrium in the market of reserves)
Effective Federal Funds rate
The Fed decreases its target for the federal funds rate:
- The fed uses … to get new federal funds rate
- Open Market …
- … supply of reserves(… portion)
- … federal funds rate
OMO’s
purchase
increase(vertical)
decrease
There is an increase in the interest rate paid on reserves(IOER<Iff):
- … IOER(but still … than Iff)
- … reserve demand(… portion)
- … impact on federal funds rate
increase (lower)
increase (horizontal)
no
There is an increase in the interest rate paid on reserves(IOER=Iff):
- … IOER(but still … than Iff)
- … reserve demand(… portion)
- … federal funds rate
increase(above Iff)
increase(horizontal)
increase
There is an increase in the required reserve ratio(Id>Iff):
-… required reserves
- … reserve demand(banks have to hold … reserves)(… portion)
- … federal funds rate
increase
increase
more(downward sloping)
increase
There is an increase in the required reserve ratio(Id=Iff):
-… required reserves
- … reserve demand(… portion)
- … federal funds rate
- … total and borrowed reserves
increase
increase(downward sloping)
unchanged
increase
There is an increase in the discount rate(borrowed reserves=0):
- Discount rate > federal funds rate
- … supply of reserves (… portion)
increase(horizontal)
There is an increase in the discount rate(borrowed reserves>0)(Discount rate=federal funds rate):
-… supply of reserves (… portion)
- … in the discount rate
- … federal funds rate
- … total and borrowed reserves
increase( horizontal)
increase
increase
decrease
What is the traditional assumption in the market for reserves?
Reserves are scarce(banks borrow from each other in federal funds market and after 2007-2009 banks hold larger quantities of excess reserves so little need to borrow)
The demand for reserves comes from … …
commercial banks
What is determined in the market for reserves?
the federal funds rate
Banks demand reserves to meet:
reserve requirement
short-term liquidity(insurance/protection)
changes in the … … and … … on … will impact the demand for reserves.
reserve requirement
interest rate on reserves(IOER)
The Demand for Reserves is … when the federal funds rate is above the interest on reserves(more attractive to … at federal funds rate than keep reserves at the Fed)
downward sloping
lend
The Demand for Reserves is … when the federal funds rate
falls below the interest on reserves(more attractive to … at lower federal funds rate and … reserves at the Fed & earn higher IOER)
horizontal
borrow, hold
The supply of reserves is made of?
borrowed and unborrowed reserves
The supply. of reserves comes from the …
Fed
The Fed provides borrowed(… …) and non-borrowed reserves(…)
discount loans
OMOs
The supply of reserves is influenced by the Feds decisions about … and the … …
OMO’s
discount rate
The Supply of Reserves is … at the non-borrowed reserves(NBR are … influenced by the Federal Funds rate, NBR based on Fed’s decisions about …)
vertical
not
OMO’s
The Supply of Reserves is … at the discount rate(if the federal funds rate is … than the discount rate–> it is … to borrow from the Fed, … from the Fed at lower discount rate/ … at higher federal funds rate, the discount rate is a … for the federal funds rate )
horizontal
greater
cheaper
borrow/lend
ceiling
What are the tools for zero lower bound on federal funds rate?
quantitative easing
forward guidance
federal funds rate between 0-0.25%, lowering the rate would result in a negative rate which is not feasible
zero lower bound
buying long-term securities to stimulate the economy, interest rates on 10-year Treasury notes impact interest rates on corporate bonds and adjustable-rate mortgages(ARMS), impacts short and long term rates
quantitative easing
statements by the FOMC about how it will conduct monetary policy in the future:
- long-term rates influenced by expectations about short-terms
- to be effective, public must view the statement as credible
forward guidance
What are the new tools for monetary policy that focus on managing the federal funds rate?
Interest on bank reserve balance(IOER)
Overnight Reverse Purchase Agreement Facility(ON RRP)
Term Deposit Facility
Interest that the Fed pays on bank reserves(required and excess), 5.4% since 2023
- The Fed has … influence over banks’ reserve balance
provides a … bound on short-term interest rates
Interest on Bank Reserve Balance
greater
lower
An increase in the interest on bank reserve balance
- … holding of reserves
- … attracted to hold reserves
increase
more
IOER usually set … the federal funds rate
banks will not usually … at an interest rate lower than IOER
below
lend
REPO & Reverse REPO(Matched Sale-Purchase Agreement):
- the Fed can cahnge the interest rates on ….. to impact the target for the … … …
Overnight Reverse Purchase Agreement Facility(ON RRP)
federal funds rate
An increase on interest on ON RRP:
- … willingness of banks to lend at a lower rate
decreases
The Fed offers term deposits to banks in periodic auctions
Banks deposit reserves at the Fed for specific … and given …, usually higher IOER
Term Deposit Facility
periods
interest
The Term Deposit Facility allows the Fed to influence … …
reserve holdings
Shifts in the Money Supply are caused by:
OMO
discount rate
reserves
An in increase the money supply:
- … interest rate
- … quantity of money
decrease
increase
An increase in money demand:
- … interest rate
- … quantity of money
increase
unchanged
A discovery of gold that fuels inflation at the same time the central bank sells financial instruments to commercial banks:
- increase …
- … money demand
- … money supply
- … quantity of money
- … interest rate
price
increase
decrease
decrease
increase
A recession causes real GDP to fall at the same time the central bank increase the money supply:
- … money demand
- … interest rate
- … money supply
- … quantity of money
decrease
decrease
increase
increase
Change in short-term and long-term interest rates will impact …, …, and … …
consumption
investment
net exports
A decrease in the interest rate(through expansionary monetary policy):
- … cost of borrowing
- … return on savings
- … consumption & … savings
decrease
decrease
increase & decrease
A decrease in the interest rate(through expansionary monetary policy):
- … investment(machinery, equipment, factors, office space, etc)
- … residential investment (new homes/apts)
increase
increase
A decrease in the interest rate(relative to foreign interest):
-… demand for US financial assets & US dollar
-… of US dollar(US exchange rate falls)
-exports are …
-imports are …
-… net exports
decrease
depreciation
cheaper
expensive
increase
changes in the … … targets will affect aggregate demand, real GDP, employment and the price level
monetary policy
Functions of a Central Bank:
Banker to the …
Banker to … ….
Currency …
… and … of the country’s official foreign exchange reserves
Conduct … … for economic stabilization (and/ or growth)
government
commercial banks
issue
holder, manager
monetary policy
Goals of Monetary Policy:
- Price …
- … Employment
- Economic …
- … of Financial markets and institutions
- Interest-rate …
- Foreign exchange market …
stability
high
growth
stability
stability
stability
The Fed pursues a … …- Price stability and High employment
dual mandate
What are the old tools for monetary policy:
OMO
Discount policy
Reserve Requirements
Banks are required to hold a fraction of deposits as required reserves(as vault cash or at the Fed):
Advantages: Impacts … banks
Disadvantages: can create … for banks
cannot be used for … changes in MS
Reserve Requirements
ALL
uncertainty
small
Includes setting the discount rate and terms of discount lending
Discount Policy
increaserate banks pay to borrow from the Fed:
- increase discount rate
- … banks borrowing from the Fed
- … reserves
- … money supply
discount rate
decrease
decrease
decrease
rate banks pay to borrow from each other on overnight loans
federal funds rate
Discount loans:
available to healthy banks experiencing temporary liquidity problems
primary credit
Discount loans:
available to banks with inadequate capital or low supervisory ratings
secondary credit
Discount loans: used to satisfy seasonal requirements of smaller banks
seasonal credit
Since 2003, the discount rate is … than the target for the federal funds rate
higher
advantages of OMO’s:
flexibility
speed of implementation
control
Fed buys government securities (T-bills, bonds)(from public &/or from banks)
- … reserves in banks
- … money supply
Open market purchase
increase
increase
Fed sells government securities (T-bills, bonds)(to public &/or to banks)
- … reserves in banks
- … money supply
decrease
decrease
Type of OMO that changes the level of reserves and monetary base(permanent impact on level of reserves, outright purchases or sales, not self reserving)
Dynamic
Type of OMO to offset temporary fluctuations
- Repurchase Agreement: Fed … now with an agreement to re… to the buyer at a specified date(usually within 15 days)
- Reverse Repurchase Agreement: … now with agreement that the Fed will … back at a specified date
Defensive
buy, sell
sell, buy
Using the Discount Policy as a monetary policy disadvantages:
- can lead to …(announcement effect)
- fluctuations can … MS
- not as … as OMO’s because banks can choose whether or not to borrow
- serves as … … for banks
misinformation
destabilize
effective
moral hazard
The government regulates the financial system due to … …. which causes … …, and … …
asymmetric information
moral hazard
adverse selection
The government regulates financial markets for two main reasons:
-… the information available to investors
- to ensure the … of the financial system
increase
soundness
In the event of a bank failure the federal deposit insurance corporation gurantees deposits up to …( funded by banking industry and backed by the full faith and credit of the US government)
Deposit Insurance
$250,000
What method that the FDIC uses:
- … …: allows banks to … and … depositors
(guranteed 250,000 per account category, deposits in excess will typically get bank more than 0.90 cent on the dollar AFTER all debts are payed)
payoff method
fail
payoffs
What method that the FDIC uses:
- … & … … : reorganize bank through …(typically by finding a willing partner who assumes all of the failed bank’s liabilities so that no depositor or creditor loses any money, typically more … for FDIC because the guarantee… liabilities and deposits)
purchase and assumption method
merger
costly
ALL
Drawbacks of the Government Safety Net:
- Moral Hazard: depositors do not impose discipline on the marketplace
- financial institutions have an incentive to take on … risk
greater
Drawbacks of the Government Safety Net: policy under which the federal government does not allow large financial firms to fail, for fear of damaging the financial system
Too-Big-to-Fail Problem
Drawbacks of the Government Safety Net:
-… …: risk-lovers find banking attractive, depositors have little reason to monitor financial institutions
adverse selection
Drawbacks of the Government Safety Net: financial consolidation increased size of financial, larger and more complex financial organizations challenge regulations
financial consolidation and government safety nets
financial consolidation and government safety nets … the “too big to fail problem”(extending safety net to new activities increasing incentives for risk-taking in these areas)
increased
Types of Regulation: due to … …
- Consumer Protection Act of 1969
- The Equal Credit Opportunity Act of 1974(forbid discrimination by lenders based on race, gender, marital status, age, or national origin)
- The Community Reinvestment Act(CRA) of 1977(prevent redlining a lenders refusal to lend in a particular area
Consumer protection
asymmetric information
Types of Regulation: improves … …
Restrictions on competition
Types of Regulation: improve the quality of … …
- Basel 2: disclosure of credit exposure, amount of reserves and capital
- Securities Act of 1933 and the Securities and Exchange Commission(SEC): Impose disclosure requirements on any corporation that issues publicly traded securities
Disclosure requirements
available information
Types of Regulation: focus on quality of oversight, adequacy of policies and limits for risky activities, quality of risk measurement and monitoring, quality of internal control to prevent employee fraud
Assessment of risk management
Types of Regulation: tight regulations exist to prevent … …
- examines the quality of the bank’s intended management, likely earnings of the bank, amount of the bank’s initial capital
- Chartered banks are required to file quarterly call reports and subject to examination at least once a year
- CAMEL rating: capital adequacy, asset quality, management, earnings, liquidity, sensitivity to market risk
Restrictions on Entry
adverse selection
Types of Regulation: Banks are classified into 5 categories based on their capital
- 3,4,5 restrictions placed on interest paid on deposits
- 4,5 banks are required to submit a plan to increase capital, restrict … …, require them to seek approval to open new branches or develop new liens of business
- 5 the FDIC will … … banks
Prompt corrective action
asset growth
close down
Types of Regulation: to minimize … …
- regulation limits the type and quantity of certain assets that can be held(restrict holdings of risk assets, promote diversification, limit the dollar amount of loans in particular categories or to individual borrowers
- banks are restricted from engaging in risky activities
Restrictions on asset holdings and activities
moral hazard
Types of Regulation: used to reduce … …
- regulate minimum amount of capital that banks are required to hold
- increase ability of bank to remain solvent
loss to owners of banks in the event of a bank failure
- Leverage Ratio: Total capital divided by total assets
- The Basel Accord: provides recommendations of risk-based capital requirements
- The higher a bank’s … … the … its leverage(Able to weather short-term losses)
Reacted to the Leverage Ratio and Basel Accord Stipulations using(*):
*off-balance sheet activities: generate income but do not show up on balance sheet
*special investment vehicles: formed by large banks to hold risky assets(mortgage-backed securities, etc) to reduce their capital requirement
Capital Requirements
moral hazard
Futures contracts standardized … of the asset to be delivered but do not specify …
- standardized … date available( cannot be chosen)
- buyers or sellers of futures contracts must put in an initial deposit, called a … …
- can be … again at any time up until the delivery date
quantity
price
settlement
margin requirement
traded
Consider a US speculator who in February thinks that the British pound will strengthen relative to the US dollar over the next 2 months. The specularo takes a long position in futures contracts on pounds worth 250,000 euros. The Aprical futures price is 1.4410 dollars per pound. Determine the profit or loss earned by the speculator.
a} The exchange rate turns out to be 1.5000 dollars per pound in April.
b) The exchange rate falls to 1.4000 dollars per pound in April
a) 14750
b) -10250
profit/loss formula call options
(spot-strike-option premium)* # of options
profit/loss formula put options
(strike-spot-option premium)* # of options
profit/ loss formula for a futures contract
(spot-delivery)* amount of underlying asset
Derivative where there is an obligation to deliver or receive a financial asset or commodity on a predetermined date for a sated price, traded on exchange markets
futures contracts
A treasurer of a US corporation knows that the corporation will pay 1 million euros in 6 months:
Risk: … … …
Hedge: corporation- … …
bank- … …
foreign exchange risk
long position
short position
Forward contracts stipulate:
- … to be delivered (usually a commodity(wheat, oil, gold) or financial asset)
- … of the asset to be delivered
- price to be paid(… price guaranteed in contract, … price at the current date(market price))
- … date when it must take place
asset
amount
delivery, spot
deliver(settlement)
Forward contracts are usually between two … … or between … … and one of its …
- two parties referred to as …
financial institutions, financial institutions, clients
counterparties
Agreement to engage in a financial transaction at a future date for a certain price
- Agreement to trade in the present
- buy asset(long-position)
- sell asset(short-position)
- traded in the over-the-counter market
Forward contracts
