GLOBEMB Flashcards
What is the primary purpose of financial innovations?
Distributing money from those have a surplus of funds to those who need funds.
Channeling of funds from savers to borrowers
What are the differences between primary and secondary markets?
- Primary: financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds
- Secondary: financial market in which securities that have been previously issued can be resold
What are the two types of secondary markets?
- Exchanges such as NYSE
- OTC markets such as NASDAQ
What is the money market?
Financial market in which only short-term debt instruments (generally those with one year or less) are traded.
Less risky due to the shorter term.
What is the capital market?
The market in which longer-term debt instruments (+1 year) are traded.
More risky due to the longer term.
What are the four main money market interest rates?
- Prime rate: base interest rate on corporate bank loans
- Federal funds rate: interest rate charged on overnight loans in the federal funds market (cost for banks to borrow from other banks)
- Treasury bill rate: interest rate on treasury bills (tells something about general interest-rate movements)
- Libor rate: British Banker’s Association average of interbank rates for dollar deposits in the London market
What is U.S. Treasury bills?
Short-term debt instruments: 1, 3 or 6 months.
The most safe you can own.
What is a negotiable bank certificate of deposits?
CDs.
Debt instrument sold by a bank to depositors that pay annual interest of a given amount and at maturity pays back the original purchase price.
What is a commercial paper?
Short-term debt instrument issued by large banks and well-known corporations.
What is a repurchase agreement?
Short-term loans (usually with maturity in less than two weeks) for which Treasury Bills serve as collateral.
What are Federal funds?
Typically overnight loans between banks of their deposits at the Federal Reserve.
What are the four main capital market interest rates?
- Jumbo mortgage rate: interest rate on a 30-year fixed-rate residential mortgage for prime customers
- Five-year adjustable rate mortgage rate (ARM): first 5 years on a residential mortgage that adjust after 5 years (again for prime customers)
- New-car loan rate: interest rate on a 4-year fixed-rate car loan
- 10-year Treasury rate: interest rate on U.S. Treasury bonds maturing in 10 years
What are mortgage-backed securities?
Bond-like debt instruments backed by a bundle of individual mortgages (like CDOs)
What are corporate bonds?
Long-term bonds issued by corporations with strong credit ratings.
What is adverse selection?
The problem created by asymmetric information BEFORE the transaction occurs.
In financial markets, adverse selection occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out a loan and are thus most likely to be selected.
What is moral hazard?
The problem created by asymmetric information AFTER the transaction occurs.
It is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back.
What are the three main categories of financial intermediaries?
- Depository institutions
- Contractual savings institutions
- Investment intermediaries
What does depository institutions consist of?
- Depository institutions
- Commercial banks
- Thrift institutions
- savings and loan associations
- mutual savings banks
- credit unions
MAIN FOCUS IN THE COURSE
What does contractual savings institutions consist of?
- Life insurance companies
- Fire and casualty insurance companies (loss from theft, fire, accidents)
- Pension funds and government retirement funds
What does investment intermediaries consist of?
- Finance companies (fx. Ford Motor Credit Company. In general consumer finance)
- Mutual funds: pool funds by selling shares to many individuals and then invest those funds into stocks and bonds in a diversified portfolio
- Money market mutual funds: similar to mutual funds but also partly functions as depository institutions
- Hedge funds: a type of mutual funds with special characteristics
- Limited as limited partnerships with high minimum investments
- Subject to much weaker regulation
- Investment banks
- Helps corporations issue securities and then buys them from the corporation to sell them to the market.
- Also acts as deal makers and earn fees by helping corporations in M&A activities
What are the six types of regulations to ensure soundness of the financial intermediaries?
- Restrictions on entry
- Disclosure (reporting requirements)
- Restrictions on assets and activities (restricted from excessive risk-taking)
- Deposit insurance
- Limits on competition
- Restrictions on interest rates
What is a barter system?
A system where you lack a common value / currency ⇒ Money
What is money?
- Cash, commodities, gold, real estate etc.
- Anything that is acknowledged to be valuable ⇒ anything generally accepted as payment for goods or services or in the repayment of debts.
- Or a narrow class of assets with following properties:
- Medium of exchange
- Unit of account (nominal monetary unit = used to set prices/used to measure value)
- Store of value (can be saved, retrieved and used for exchange at a later time)
What is DCW?
The double coincidence of wants important in barter systems wherefore the transaction costs are much larger than in systems with money.
What is the definition of liquidity?
The relative ease and speed with which an asset can be converted into a medium of exchange
What is fiat money?
A currency established as money by the government regulation or law.
How has money evolutionized?
- Commodity money
- Fiat money
- Checks
- E-money
- Virtual money (bitcoins)
What is M0, M1, M2 and M3?
- M0: Notes and coins in circulation
- M1 = M0 + traveler’s checks + demand deposits + other checkable deposits (this is essentially money supply) ⇒ The most narrow form reported by central banks
- M2 = M1 + small denomination time deposits + saving deposits and money market deposit accounts + money market mutual funds shares
- M3 = M2 + large and long-term deposits
What is the monetary base?
M0 (notes and coins in circulation) + Bank reserves (high-powered, CB or narrow money)
What is the quantity theory of money?
Mt * Vt = Pt * Yt
M = money supply
V = velocity of money
P = price level
Y = real output/GDP
t = period of interest
Real output is constant. Hence velocity of money must be constant. Thus Mt = Pt ⇒ Increases in money supply increases the price level (inflation).
What are the main functions of CBs?
- Clearing payments
- Monetary policy and price stability
- Lending
- Bank regulation and supervision
What are the most important methods of business financing in prioritized order?
- Bank loans
- Non-bank loans
- Bonds
- Stocks
What is adverse selection?
When one party to a transaction has more information about the transaction than the other party.
What is moral hazard?
When one party cannot observe the behavior of the other party
When someone takes more risk because someone else bears the cost of those risks.
How does financial intermediaries help reduce transaction costs?
- Economies of scale
- Expertise (expert knowledge)
What are effective ways to solve adverse selection problems in financial transactions?
- Private production and sale of information
- Naturally this comes with a free-rider problem
- Government regulation to increase information / transparency
- Financial intermediation (acts like a car-dealer in the used car market)
- Expert in producing information
- Direct (warranty) or implicit (reputation) guarantee
- Collateral and Net worth
Explain this to yourself
Explain this to yourself
What are effective tools to solve the principal agent problem between managers (short-term) and stockholders (long-term)? / Moral hazard in equity contracts
- Production of information: monitoring (auditing)
- Government regulation to increase information
- Financial intermediation (helps avoid the free-rider problem)
- Debt contracts (the lender does not need to monitor the borrower unless the borrower does not meet its payments)
- Still some moral hazard as borrowers will try to maximize their profits (return - debt payment) and therefore takes risky investments
What are useful tools to help solve moral hazard in debt contracts?
- Net worth and collateral (incentive-compatible ⇒ aligns the incentive of borrower and lender)
- Monitoring and enforcement of restrictive covenants
- Covenants to discourage undesirable behavior
- Covenants to encourage desirable behavior
- Covenants to keep collateral valuable
- Covenants to provide information
- Financial intermediation
Why are debt contracts often very complicated legal documents?
Due to all the covenants put in place in order to avoid moral hazard.
How do banks (financial intermediation) help reduce asymmetric information?
- Screening borrowers
- Collateral and net worth
- Covenants and monitoring
- Interest rates and credit rationing
In what way can the institutional environment be poorly organized and thereby create financial repression?
- Poor system of property rights (unable to use collateral efficiently)
- Poor legal system (difficult for lenders to enforce restrictive covenants)
- Weak accounting standard (less access to information)
- Government intervention through directed credit programs and state owned banks (less incentive to proper channel funds to its most productive means)
What are the most important bank liabilities?
- Checkable deposits (once the biggest. Has shrunk over time)
- Nontransaction deposits (primary source - around 60 % typically)
- Savings accounts
- Time deposits (certificate of deposits = CDs)
- Large denomination time deposits (large CDs)
- Borrowings from the federal reserve/national banks (also called discount loans and advances)
- Bank capital (retained earnings and equity)
What are the most important bank assets?
- Reserves (around 10-15 % depending on reserve requirements)
- Cash items in process of collection
- Deposits at other banks
- Securities (around 20 %)
- Loans (around 50 %)
- Other assets (including buildings, electronic equipment etc.)
What are the opportunities a bank has to increase its reserves in case depositors withdraw too much money for the bank to live up to the reserve requirements?
- Borrow from another bank or corporation
- Borrow from the FED
- Sell of securities
- Reduce loans
How do you calculate ROA?
Return on assets = net profit after taxes / assets
How do you calculate ROE?
Return on equity = net profit after taxes / equity capital
How do you calculate the equity multiplier EM?
Equity multiplier (EM) = Assets / equity capital
What is the relationship between ROA, ROE and EM?
ROE = ROA * EM
What are ways the bank uses to reduce the risk of lending? (credit risk management)
- Screening potential borrowers
- Specializing in lending to specific groups to make better assessments
- Monitoring and enforcing restrictive covenants
- Having long-term clients to gather as much information as possible
- Loan commitments (promising to loan x amount at x interest rate, tied to some market rate, to get long-term industrial clients)
- Collateral and compensating balances (requiring the borrower to keep some amount of money in the checking account)
If untrusted ⇒ Credit rationing ⇒ Refusing to lend money.
What is a gap analysis?
A comparison of the amount of rate-sensitive liabilities and assets of a bank.
If a bank has more rate-sensitive liabilities than assets, a rise in the interest rates will reduce bank profits, and a decline will raise bank profits.
What are off-balance-sheet activities in banking?
Ways to increase profits without being visible on the balance sheet such as:
- Loan sales
- Fee income
- Trading on the foreign exchange market, financial futures, options for debt instruments and interest-rate swaps (risky activities)
- Derivative trading
- Investment banking services
What are the 5 main types of risk banks have to cope with?
- Liquidity risk
- Interest-rate risk: fluctuations in rates ⇒ profit fluctuation
- Market risk: fluctuation in asset prices
- Economic risk: economic growth/circles
- Credit risk (loans won’t be paid back)
What is the traditional model of banking?
Originate to hold model.
How does a simplified version of modern banking look like?
Originate to distribute.
What is a CDS?
Credit Default Swap
A bilateral contract in which the buyer pays periodic fixed rate payments to the seller in exchange for protection/insurance against “credit events” related to some underlying asset.
Neither party needs actually to own the asset.
What are some of the rationales for government regulation in the financial industry?
- Its economic importance
- Asymmetric information, adverse selection and moral hazard (not taking into account in modern finance)
- Bank panics and the need for deposit insurance + LOLR
What are some drawbacks of government safety net to the financial industry?
- Moral hazard
- Adverse selection
- Too big to fail
⇒ Taking on too much risk
What are some of the most profound types of financial regulation?
- Restrictions on asset holdings (avoiding risky assets)
- Capital requirements (equity ratio + leverage ratio
- Prompt corrective action (intervention by the government when banks are classified as unstable ⇒ can be hard to spot)
- Financial supervision and risk management assessment (stress tests)
- Disclosure requirements (transparency and accounting practices)
- Consumer protection (to avoid more NINJA loans)
- Restrictions on competition (again against modern finance principles)
What is a dual banking system?
A system in which banks chartered by the federal government and banks chartered by the states operate side by side.
(U.S. system)
When was the FED founded?
1913
When was the Federal Deposit Insurance Scheme (FDIC) founded and why?
1933
After 9,000 bank failures from 1910-33.
What is shadow banking?
Lending and other financial activities conducted by unregulated institutions or under unregulated conditions (typically through the securities market).
Securitization is here completely essential for shadow banking’s existence.
What is securitization?
The process of bundlings small and otherwise illiquid financial assets into marketable capital market securities.
The fundamental building block of the shadow banking system.
What are some of the explanations behind the excessive financial innovation in the recent decades?
The environment has changed a lot and banks have seen
- A decline in cost advantages in acquiring funds (liabilities) as the restriction on paying interest on checkable deposits was removed
- A decline in income advantages on uses of funds (Assets)
- Securitization, junk bonds, the rise of the commercial paper market etc.
- Technology has in many cases removed banks’ role as middlemen
- Loss of profits from financial innovation and excessive competition
What are money market funds?
An open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper.
Higher yield than bank deposits but still very safe.
What is systemic risk?
The risk of collapse of the entire financial system/market.
Can potentially happen due to interconnectedness of banks.
How is the structure of the U.S. banking industry different from that of many other developed countries?
MANY small banks in the U.S.
30 % with less than $100 million in assets and another 60 % on top of that with $100-1000 million.
In most European countries, Canada, Japan etc, it is typically 5-10 banks that dominate the industry.
What is VaR?
Value at risk, which is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.
⇒ given current and expected asset prices “what is the worst that could realistically happen to my portfolio over one day, one week or one year?
What are the three main groups of commercial banks?
- Money-center banks located in financial centers: interbank borrowing as the main source of funding
- Regional and super regional banks: focusing on deposit taking and lending (bonds and borrowing are not important)
- Community banks: small banks, lending primarily to local consumers and small businesses
What are the two main types of thrift institutions?
- Savings and loan institutions (S&Ls)
- Accept saving deposits
- Make loans for home mortgages
- Credit unions
- Nonprofit banks owned by its depositor members
- Makes mortgage loans, auto loans, and personal loans to its members
What is the liquidity mismatch in banking?
- Short-term liabilities
- Long term assets
What is the DD model?
Diamond-Dybvig model ⇒ The idea of banks creating extra social welfare by distributing money from savers to borrowers.
What is the social banking created through banking?
The profit made by banks from distributing money from savers to borrowers.
- Savers = depositors are better off as they have a safe place to put their money AND can withdraw money any time
- Borrowers = get to borrow money (not possible or at least very hard to arrange by themselves)
- Bank: profits from the interest rate the borrower pays
What are the two kind of shocks a bank might be met by?
- Liquidity shock: more people than anticipated would like to withdraw their money
- Solvency shock: borrowers fail to payback their loans
Why are financial institutions and banking crisis special in comparison to other firms?
The wheels of the economy.
Connected to all industries ⇒ Can make a crisis for the entire economic system.
- Monetary channel: M/P
- Credit channel: credit crunch
- Demand channel: loss of savings ⇒ lower demand ⇒ higher unemployment
Contagion ⇒ Magnified by multiplier effect
What are basic regulations and interventions in the financial industry?
Interventions:
- LOLR
- Deposit insurance
- Suspension of payment & bank resolutions
Regulation
- Prudential regulations
- supervision
- capital adequacy
- reserve regulation
- Conduct of business
- transparency
- disclosure
- suitability
What were the two main reasons to why the FED was not established before 1913 following the disastrous bank run in 1907?
- A fear of centralized power
- Distrust of moneyed interests
How many regional banks does FED consist of and which are the largest?
12 Federal Reserve Districts.
- New York Fed (around 25 % of all assets)
- San Francisco
- Chicago
These three together have more than 50 % of all assets.
Who are FOMC?
The Federal Open Market Committee (FOMC)
Often wrongly referred to as FED by the media.
They are the ones setting the interest rate, the federal funds rate (overnight loan rate)
Consist of 7 governors appointed by US President.
They usually meet 8 times a year.
What does FED independence refer to?
Independence from economic, bureaucratic, and political powers.
- Instrument independence: ability to set monetary policy instruments
- Goal independence: ability to set goals of monetary policy
What are the arguments FOR FED independence?
- Political pressure leads to an inflationary bias to monetary policy ⇒ Short-term thinking governments
- Risk of a political business cycle in which politicians demand monetary expansions before elections to decrease interest rate and unemployment
What are the arguments AGAINST FED independence?
- Undemocratic to have a small group of elite professionals controlling something of utmost importance to the population and economy
- Historically, independent central banks have not used their freedom successfully
Which central bank is the most independent of the world’s CBs?
ECB
What are some other multi national central banks? (other than FED and ECB)
-
ECCB: The Eastern Caribbean Central Bank
- 8 members: 6 countries and 2 territories of the U.K.
- Small and vulnerable economies that unite to achieve economic development
-
Banque Centrale des Etats de L’Afrique de l’Quest: The Central Bank of Western Africa
- 8 West African nations
- Common currency = West African CFA franc
-
Banque des Etats de L’Afrique Centrale: The Central bank of Central Africa
- 6 nations
- Use the Central African CFA franc
How independent is the FED?
More independent than most agencies of the U.S. government, but it is still subject to political pressures because the legislation that structures the FED is written by Congress and can be changed at any time.
What does the theory of bureaucratic behavior imply?
That powerful institutions might attempt to increase their power and prestige = this should explain CBs actions, although CBs may also act in the public interest.
What is the general trend towards independence of Central banks around the world?
Independence is increasing.
What are the factors that determine bond demand?
- Wealth
- Risk (increased risk, demand curve shifts left)
- Expected returns
- Expected inflation (increased inflation expectations, demand curve shifts left)
- Liquidity (increased liquidity, demand curve shifts right)
What are the factors that determine bond supply?
- Profitability of investment (expected)
- Government budget (higher budget deficits, supply curve shifts right)
- Inflation expected (increased inflation expectation, supply curve shifts right)
Why do municipal (state and local government)
Bonds historically show lower interest rates than long term U.S treasury bonds?
Tax exemptions highly valuable to rich people who place their money in municipal bonds and keep them till bond maturity.
If selling and profiting from the bond sale, taxes must be paid, but no taxes on the interest earned while waiting for bond maturity.
What is a yield curve?
A curve of the yield on bonds with differing maturity periods but same risk, liquidity and tax conditions.
What is quantitative easing?
A monetary policy method used when a zero-interest rate level (liquidity trap) has been reached using normal expansionary monetary policy in which short-term bonds (and other assets) are bought to increase price and thereby decrease yield.
To decrease yield of also long term assets, quantitative easing is used. Here, the central bank creates more electronic money and buys long-term assets for the money, thereby decreasing the yield and “forcing” other investments and spending, while increasing money supply.
How does collateral help reduce the adverse selection problem in credit markets?
Lenders will be more willing to make loans when there is collateral that they can claim and sell if the borrower defaults.
Also incentivizes the borrower as the borrower’s liability indirectly increases.
Explain the principal-agent problem as it pertains to equity contracts
Stockholder own most of the equity while managers might own limited or no share of the company.
Managers = the agent will thus have less incentive to profit-maximize, which is why compensation structures are put in place, which though can create a new principal-agent problem in which the agent = managers only focus on short-term profits, while the owners = the principals want to maximize the value of the firm in the long run.
What crucial roles do financial intermediaries perform in an economy?
They match savers with borrowers and thereby channel savings toward investment
According to quantity theory of money, inflation and money supply move together one-to-one. Explain why that may not be true in reality.
Because of normal rigidities, i.e. prices do not adjust as quickly as they are expected to.
Furthermore, the assumption is that the velocity of money is constant. This assumption has been shown to be false.
Is velocity of money constant?
In the quantity theory of money = yes
In real life based on empiri = NO.
What factors characterize financial crisis?
- Sharp drop in asset prices
- Failures of financial institutions (credit decreases)
- High demand for liquidity and bank runs
- Interbank lending market can freeze
What is the typical political response to financial crisis?
- Fiscal stimulus (expansion)
- Monetary stimulus (expansion)
Crisis management:
- Bailing out or taking control of financial institutions
- Guaranteeing debts
Why don’t economist have a single, precise definition of money?
Because of the “moneyness” = liquidity of an asset is a matter of degree and interpretation
Which of the three function of money distinguishes money from other assets?
Unit of account ⇒ Making prices / nominal monetary unit
How has recent financial innovation affected the FED’s job of conducting monetary policy?
Has become difficult.
It is now harder for the FED to know what to consider money.
Which of the following is NOT included in the measure of M1?
- Currency
- NOW accounts
- Demand deposits
- Savings deposits
Savings deposits
How does M1 and M2 interact with each other. Do they move together?
No.
They do not move together so they cannot be used interchangeably by policymakers.
What is the name of the interest rate that equates the PV of payments received from a debt instrument?
YTM: Yield to maturity
If the expected path of one-year interest rates over the next 6 years is 4 %, 4 %, 5 %, 6 %, 7 %, 6 %, then the expectations theory predicts that today’s interest on the six-year bond is:
(4 + 4 + 5 + 6 + 7 + 6) / 6 = 5.333 %
According to expectations theory of the term structure, how does bonds with different maturities move over time?
They move together.
The idea of long-term bondholders demanding higher yields is not part of expectations theory but another theory.
Adverse selection is a problem associated with equity and debt contracts arising from:
The lender’s relative lack of information about the borrower’s potential returns and risks of his investment activities.
How could you avoid the principal-agent-problem from occurring at all?
If owners of the firm had complete information about the activities of the managers.
What is one of the primary reasons to why financial systems in developing and transition countries are underdeveloped?
The legal system may be poor making it difficult to enforce restrictive covenants.
What are some classical solutions to the moral hazard problem?
Monitoring and enforcement of restrictive covenants.
What does M0 consist of?
M0: Notes and coins in circulation
What does M1 consist of?
M1 = M0 + traveler’s checks + demand deposits + other checkable deposits (this is essentially money supply) ⇒ The most narrow form reported by central banks
What does M2 consist of?
M2 = M1 + small denomination time deposits + saving deposits and money market deposit accounts + money market mutual funds shares
What does M3 consist of?
M3 = M2 + large and long-term deposits
What is a checking account?
A checking account is a deposit account held at a financial institution that allows withdrawals and deposits. Also called demand accounts or transactional accounts, checking accounts are very liquid.
Is a checking or savings account most liquid?
The checking account is most liquid.
A savings account is also very liquid but often has a limit to the amount of deposits and withdrawals that can be made in a period.
What is indirect finance?
Indirect Finance : Borrowing money from a bank. The bank lends out depositors money to borrowers at a profit.
What is direct finance?
Direct Finance : Borrowing money from friends; borrowing money directly from investors by selling stocks or bonds
What is a bank run?
A bank run occurs when a large number of customers of a bank or another financial institution withdraw their deposits simultaneously due to concerns about the bank’s solvency.
What are the typical causes of bank runs?
- Individual liquidity shock
- Bad loans (missing repayments making the bank insolvent)
- Bank losses (negative profits)
Which of the following is included in M2 but NOT in M1?
- NOW accounts
- Demand deposits
- Currency
- Money market mutual fund shares (retail)
Money market mutual fund shares (retail)
What does bank reserves consist of?
- Vault cash
- Deposits at the FED
What is vault cash?
Cash kept on hand in a depository institution’s vault to meet day-to-day business needs, such as cashing checks for customers; can be counted as a portion of the institution’s required reserves.
What is liquidity transformation?
A type of transformation that involves the use of short-term debts like deposits to finance long-term investments like loans.
In other words, it is an intermediation process used by banks and similar intermediaries to mitigate the so called “run problem” or “liquidity run”.
Why is it important to have a well-functioning financial system?
- To channel savings toward productive investments
- To help the economy to grow
What are the main differences between stocks and bonds?
Stockholders are owners, bondholders are creditors
Bond returns are fixed, stock returns are volatile
Bondholders have first claims on the company’s asset; stockholders can vote on policies
What are traditional banks (deposit-taking)
- Commercial banks
- Credit unions
- Thrifts (savings and loan)
What are nonbank financial institutions?
- Investment banks, underwriters, brokerages
- Hedge funds, mutual funds, pension funds
- Money market funds
- Insurance companies
What is the difference between channeling through financial institutions and channeling through financial markets?
The difference between indirect and direct finance.
What does the financial system more specifically do? (not just matching savers and borrowers)
- Liquidity provision
- Demandable deposits
- Credit lines
- Funding complex/illiquid positions
- Screening: solving for asymmetric information problem (moral hazard, adverse selection)
- Increase pledgeable income
- Risk sharing/diversification
What is money?
Anything that is generally accepted as payment for goods or services or in the repayment of debts.
What is DCW?
Double coincidence of wants
Why do we use M1?
- It is closely related to the monetary base via the money creation process
- Conceptually the best measure of money supply when money is considered as the medium of exchange
- Also FED’s primary measure and other central banks (especially before 1980s)
What are the main functions of central banks?
- Clearing payments
- Monetary policy
- Lending
- Bank regulation
How can adverse selection occur in the securities market?
As firms that sell securities (stocks and bonds) know more about the risks and returns than buyers.
How can moral hazard take place in the bond market?
When firms pose high risk of default by misusing funds / increasing risk.
They are misallocating funds toward riskier projects.
What is a covenant?
A provision in a loan contract that restricts the actions of the borrower.
What are corporations main source of funding?
Bank loans.
Thus indirect finance often many times more important than direct finance.
How can financial institutions work around the risk of fluctuations in asset prices?
Derivatives
How can financial institutions work around the risk of economic downturns?
- International diversification
- Credit rationing
How can financial institutions work around the risk of liquidity issues?
Federal funds borrowing when withdrawals are higher or close to liquid assets (reserves)
How can financial institutions work around default risk of borrowers? (that they won’t be paid back)
- Screening
- Collateral
- Covenants
How can financial institutions work around the interest-rate risk? (fluctuations in rates)
- Floating-rate loans
- Loan sales
- Derivatives
What are the main criteria for LOLR?
- Must be solvent banks
- Must have good collateral
- Must pay high rates and repay quickly
What is the definition of YTM?
It is the interest rate that equates the PV of cash flow payments received from a debt instrument with its value today.
