Module 3: Finance & Accounting (Lecture Slides 5-8) Flashcards
What is money?
Object that is portable, divisible, durable, and stable, and that serves as a medium of exchange, a store of value, and a measure of worth
What are the three functions of money?
- Medium of exchange
- Store of value
- Measure of worth
What problem does bartering pose?
The coincidence of wants. Bartering relies on both parties agreeing to the value of two objects based on want. Money is stable, durable and portable.
What led to money? (5)
Familial relationships → Tribal relationships → Debt or duty → Tally stick/beads or written records of debts → Precious metal money
Familial relationships and tribal relationships had a ___ economy rather than an ___ economy.
gift, exchange
There is little evidence for actual use of ___.
barter
During tally stick/beads or written records of debts times, records were sometimes denominated in…
cows or grain.
What is the concept of money supply?
How much “money” (however defined) is in circulation
What is M-1?
Measure of the money supply that includes only the most liquid (spendable) forms of money
What is currency/cash?
Government-issued paper money and metal coins
What is a check?
Demand deposit order instructing a bank to pay a given sum to a specified payee
What is a checking account or demand deposit?
Bank account funds, owned by the depositor, that may be withdrawn at any time by check or cash
What is M-2?
Measure of the money supply that includes all the components of M-1 plus the forms of money that can be easily converted into spendable forms
What is a time deposit?
Bank funds that have a fixed term of time to maturity and cannot be withdrawn earlier or transferred by check
What is a money market mutual fund?
Fund of short-term, low-risk financial securities purchased with the pooled assets of investor-owners
What is the reason to track money supply?
Excessive growth in the money supply can lead to inflation.
What damps down inflation?
However, if the economy is producing less than capacity (“slack” - the gap between the capital and labor that could be employed productively, but isn’t) this will tend to damp down inflation as prices for goods and services cannot rise while there is oversupply.
What are commercial banks?
A company that accepts deposits that it uses to make loans, earn profits, pay interest to depositors, and pay dividends to owners. They have a wide variety of services.
What are the three major types of savings institutions?
- Savings and Loan Associations (S&L) are investor owned and focused on mortgages.
- Mutual Savings Banks are depositor owned.
- Credit Unions are non-profit cooperatives that focus on services to the group.
What are 7 financial services provided by banks?
- Checking Accounts
- Deposit Accounts
- Certificates of Deposit
- Credit Cards
- Loans
- Mortgages
- Individual Retirement Account (IRA)
What is the prime rate?
Interest rate available to a bank’s most creditowrthy customers
What are the two “fun facts” about the prime rate?
- All time low was 1.5% in the mid-1930s to 1947 (aftermath of Great Depression)
- All time high was 20.5%, the last week in May 1981
Within parameters set by the Federal Reserve, United States banks have a role in increasing the money supply by…
lending out money that savers deposit.
What is a reserve requirement?
The percentage of any deposit that a bank must retain
What is significant about the remaining of any deposit in a bank?
The bank can lend that money.
The remaining of any deposit the bank can lend. This creates ___ ___.
new money
How does lending the remains of deposits make new money? (2)
See Figure 16.4.
- The original depositor’s checking balance counts in M-1
- The borrower’s cash in hand also counts within M-1
So essentially, the bank counts deposits and money to lend in their total supply, even though there is an overlap in money.
Figure 16.4 is an example of…
fractional reserve banking.
What is the alternative to fractional reserve banking?
Full reserve banking, where deposits can only be loaned out if they are over the time period of the loan.
What is a bank run? Walk me through such a scenario (3 steps).
When depositors lose faith in a bank or a financial institution’s ability to repay their money.
- They all run to the bank to try to get cash out of their accounts at the same time.
- The bank only has 10% reserve requirement immediately available.
- Bank fails and city panics.
Does full reserve banking have bank runs?
No, but it is more costly
What does the Federal Deposit Insurance Corporation (FDIC) do? What is its further relevance? (5)
- Preserves confidence by supervising banks and insuring deposits in banks and thrift institutions
- Commercial banks pay membership feeds to FDIC
- Guarantees the safety of all deposits (CDs, checking and savings) of every account owner up to the current maximum of $250,000 per bank
- Stocks and mutual funds are not insured
- Maintains the right to examine the activities and accounts for all member banks
What is a pension fund?
Nondeposit pool of funds managed to provide retirement income for its members
What is an insurance company?
Nondeposit institution that invests funds collected as premiums charged for insurance coverage
What are finance companies?
A company concerned primarily with providing money, as for short-term loans.
What is a broker-dealer?
A person or firm in the business of buying and selling securities
What is the Federal Reserve System?
Also known as the Fed, the Federal Reserve System is the central bank o the United States which acts as the government’s bank, serves member commercial banks, and controls the nation’s money supply
How many districts does the Federal Reserve have?
12
What Federal Reserve district is California in?
12
What is the structure of the Fed? (5 parts)
- Board of Governors
- Reserve Banks
- Open Market Committee
- Member Banks
- Other Depository Institutions
What are the four functions of the Fed?
- The Government’s Bank
- The Bankers’ Bank
- Check Clearing
- Controlling the Money Supply
How does the Fed control the money supply?
- Reserve Equipment (to print money)
- Discount Rate/Federal Funds Rate (Key Rate)
- Open-Market Operations
What is fiscal policy?
How much the government spends vs. how much it raises in taxes
If the government spends more than it taxes, the fiscal policy is…
expansionary.
If the government taxes more than it spends, the fiscal policy is…
deflationary.
What is monetary policy?
How much money the government or central bank allows to be in circulation
If the money supply is increasing, the monetary policy is…
expansionary.
If the money supply is decreasing, the monetary policy is…
deflationary.
The Federal Reserve has a ___ mandate.
dual
What is in the Federal Reserve’s dual mandate?
- Achieve price stability (low or no inflation)
2. Maximize employment
What is a mandate?
A statement of what the Fed has to do, and a statement that it has the authority to act to achieve its aims. In this case, the mandate was given in 1977 by Congress.
Monetary policy manages the nation’s economic growth by managing ___ ___ and ___ ___.
money supply, interest rates
By controlling money supply and interest rates, the Fed influences…
the ability and willingness of banks throughout the country to loan money
The Federal Reserve manages ___ policy.
monetary
The Treasury manages ___ policy.
fiscal
What are the four things important to know about fiscal policy?
- Tax compared to spending
- Decided politically by Congress
- Managed by the Treasury
- Bond operations executed by the Bureau of the Fiscal Service
What are the three things important to know about monetary policy?
- Management of money supply and interest rates
- Managed by the Federal Reserve
- Operates under more of a political consensus
What is a reserve requirement?
Percentage of its deposits that a bank must hold in cash or on deposit with the Fed
What is a discount rate?
Interest rate at which member banks can borrow money from the Fed
What is the federal funds rate (key rate)?
Interest rate at which commercial banks lend reserves to each other, usually overnight
What are open-market operations?
The Fed’s sale and purchase of securities in the open market.
When the Fed buys securities, the money supply…
increases.
When the Fed sells securities, the money supply…
decreases.
Historically, the Fed’s open-market operations have been limited to…
treasury securities.
What are two emergency tools?
- Government Intervention
2. Quantitative Easing
Government intervention includes what three things?
- Assistance in Bank Reorganization
- Government Emergency Investment
- Assurances of Repayment
What is quantitative easing (QE)?
Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
How is the United States currently using QE?
Trick question! QE ended in October 2014.
What does Check 21 do?
Historically, check clearing was an important function of the Fed with 45 processing centers. However, in 2004 the Check Clearing for the 21st Century Act (Check 21) became law.
It allows a receiving bank to make an electronic image of a paper check and electronically send the image to the paying bank for instant payment instead of waiting days for the paper check to be physically transported back to the sender.
Now there is only one processing center and paper check volumes have decreased by 75%.
What is the Automated Clearing House (ACH) Network?
ACH is an electronic funds transfer system that provides interbank clearing of electronic payments for the nation’s financial institutions. The network allows businesses, government, and consumers to choose an electronic-over-paper alternative for payments.
ACH payments include 5 things. What are they?
- Internet-initiated debit and credit payments by businesses and consumers
- Direct deposit of payroll, Social Security benefits, and tax refunds
- Federal, state, and local tax payments
- e-checks
- Direct payment of consumer bills: mortgages, loans, utility bills, and insurance premiums
What is a point-of-sale (POS) terminal?
Electronic device programmed with electronic money that transfers funds from the customer’s bank accountt o pay for retail puchases
What is a smart card?
Plastic card with an embedded computer chip that can be programmed with electronic money or used as credit card. Commonly used in Europe and being adopted in the USA but Europe uses chip and PIN while USE uses chip and sign.
What is NFC based payment?
Secure payment using smartphone (e.g. ApplePay, Google Wallet)
What does NFC stand for?
near field communication
International trade links the countries of the world so that…
countries who have a comparative advantage in making a good make more of it.
Trade barriers limit ___.
trade
What are tariffs?
Extra taxes imposed only on imports
Since tariffs simply increase the price of an imported good, a producer can still compete if…
they have an extremely large advantage.
Tariffs are less undesirable than ___, or other trade restrictions that ___ imports.
embargoes, stop
What is the exchange rate?
The value of one currency compared to the value of another (e.g. $/Euro)
A high $/Euro exchange rate means…
U.S. tourists can buy accommodation and gifts cheaply abroad but discourages foreign tourists as their money does not go so far.
A high exchange rate means that U.S. firms and consumers can get a lot of imported goods for their dollars but means that U.S. exports look expensive to buyers in Europe.
What are the four major organizations and institutions in international finance?
- Federal Reserve (US)
- European Central Bank (“Euro zone”) - other important central banks are Bank of Japan and Bank of England
- World Bank President (by tradition, a US national)
- IMF President (by tradition, a European)
What is the World Bank?
A UN agency that provides a limited scope of financial services, such as funding improvements in underdeveloped countries
What is the International Monetary Fund (IMF)?
A UN agency consisting of about 150 nations that have combined resources to promote stable exchange rates, provide temporary short-term loans, and serve other purposes
What is the Risk-Return (Risk-Reward) Relationship?
The principle that safer investments tend to offer lower expected returns (rewards), whereas riskier investments tend to offer higher expected returns
Name types of investment from lowest to highest expected return and lowest to highest risk (same thing).
T-bills, T-bonds, Corporate Bonds, Common stock
What’s a bond?
- When you buy a bond, you are lending to the government or a company.
- The bond will pay a fixed amount per year. This looks like a good deal if interest rates are going lower, but a bad deal if rates are increasing.
- If bond prices rise, people see rates go lower and want to lock in the fixed payments. If bond prices fall, that is because investors see better deals elsewhere than fixing the payments, because interest rates are goin up.
Bonds are ___ ___ ___.
fixed income securities
When interest rates go up, bond prices go…
down.
T-Bonds trade in what kind of market?
a liquid market that shows an estimate of interest rates every day
What is a liquid market?
A market in which you can easily buy and sell
Liquid markets are very attractive to…
large investors. For example, the Chinese government is estimated to hold $1.2Tr of US Treasury Bills and Bonds.
The ___ is the dominant borrower in the world.
Treasury
Supply and demand for the Treasury’s bonds set the terms for…
borrowing by others, including consumers.
When you buy common stock, you are…
investing in the shareholders equity or ownership of a company.
The company’s total ownership is divided into small parts called ___.
shares
Shareholders make money out of stocks in what two ways?
- Try and sell the stock for more than they paid
- Get dividends while they hold the stock
What is a stock or market index?
A way of averaging the prices of a group of company stocks
The movements of individual stock prices are correlated in what way? What does this mean?
Highly. This means that most stocks tend to move up or down together (as they are all sensitive to the current and expected health of the economy).
A stock index is useful in summarizing what?
How the stock market is moving
What do stock indices do?
Indicate what has happened to stock prices on average
What are the four types of stock indices in the USA?
- Dow Jones Industrial Average (Dow 30)
- S&P500 (more broad based average of 500 large cap stocks)
- NASDAQ - tech weighted
- Russell 2000 tracks small cap stocks
What is personal financial planning? What does this include? (6)
The ability to plan your financial resources and liabilities to achieve your life goals. This includes:
- Secure a good place to live
- Have the family life you want
- Educational needs
- Accumulate capital for various purposes
- Use debt wisely
- Live a happy and productive life with limited stress
Most of all, you need to manage your…
human capital.
Why do you need to manage your human capital?
Your career is your fundamental source of value to fund your investments, and there is no “efficient market” for your services.
How can you maximize the value of your human capital? (5)
- Develop skills
- Networking
- Position yourself in growth industries and areas
- Learn from roles
- Negotiate better compensation
What are 4 themes in modern personal finance?
- Transfer of risk from employers to employees
- It may be a difficult time to invest
- Can’t trust brokers to work in your interest
- Many people are on the “sidelines”
What does the fiduciary rule do?
The Dept. of Labor’s definition of a fiduciary demands that retirement advisors act in the best interests of their clients and put their clients’ interests above their own.
The average 401k balance is…
$99,900. This equates to approx. $4000 a year retirement income.
In 2015, 40 million working age households (45%) had…
zero savings and the median was $2500.
What are the four new realities of retirement planning?
- Decreasing number of defined benefit pension schemes (pension depends on the number of years you work)
- Increasing proportion of defined contribution schemes (pension depends on amount you save)
- 50% of elderly marries couples and 71% of single older Americans depend on Social Security for more than half of their income - Independent Contractor model - little or no provision for pensions and benefits
What is the contribution or cost?
Sum of money paid in by employee and/or company during the working life of the employee
What is a pension?
Income paid to the retired employee after they have retired
What is a defined benefit (DB)?
The benefit is specified. Provides a known post retirement pension income, generally a percentage of final salary per year of employment with the organization.
Defined benefits are characteristic of…
local, state, and federal government employment (including emergency services) and the defense industry.
What is a defined contribution (DC)?
The benefit is uncertain. The money put in now (contribution) is known, but the plan does not guarantee any specific benefit or money/month pension. The employee’s contribution (plus usually an employer contribution such as an employer match) is invested to build a fund that employees can use to met retirement needs.
A typical pension available today is…
a defined contribution.
What are two examples of DC pension schemes?
401k, 403b
What’s the difference between DBs and DCs in terms of employee/company pay?
In DBs, the company pays in during working life of employee. In DCs, the employee and/or the company pays while working.
What’s the difference between DBs and DCs in terms of tax efficiency?
In DBs, companies deduct the cost as an expense. In DCs, contributions are tax deferred up to an annual limit.
What’s the difference between DBs and DCs in terms of pensions?
Pensions are always taxable income in DBs. In DCs, pension is usually taxable.
What’s the difference between DBs and DCs in terms of company/employee risk?
In a DB, the company takes the risk to provide pensions, while in DCs, employees take the risk by selecting investments.
What’s the difference between DBs and DCs in terms of liability/asset of employer/employee?
A DB is a liability of the employer. A DC is an asset to the employee.
What’s the difference between DBs and DCs in terms of pensions guaranteed?
In a DB, the pension is a guaranteed monthly income as long as the employer does not go broke. In a DC, the amount of pension depends on how much was contributed and the investment returns achieved.
What’s the difference between DBs and DCs in terms of portability?
A DB is less portable because it requires an actuarial analysis to determine value. A DC is more portable, because the account can be easily valued and transferred.
What is an individual retirement account (IRA)? (4)
- Designed to give the same tax efficiency as employer schemes to people who do not have an employer scheme
- However, limits of $5500 per year are too low to allow significant accumulation of capital
- Must be funded from earned income
- Also can rollover money in employer scheme into an IRA but beware of fees charged
Key Takeaway about DB Schemes
A DB scheme is attractive to employees and, if available, should figure in your job selection decision at graduation.
Three Points to Know about Cashing Out When Changing Employers
- Has negative investment consequences
- Has negative tax consequences of a 10% penalty plus income tax on the cash-out
- According to Fidelity, 35% do it anyway! :O
The earlier you retire, your pension has to last ___longer/shorter___ and there is ___less/more___ time for investments to grow.
longer, less
The earlier you start saving, the ___less/more___ time for investments to grow.
more
What is a portfolio?
Combined holdings of all the financial investments of any company or individual
What is diversification?
Purchase of several different kinds of investments rather than just one (see asset allocation) or purchase of several different securities within a category
Why is diversification important?
Rises in one stock due to good news can offset falls in another stock due to bad news.
Can all risk be eliminated?
Not all risk can be eliminated as there are still economy-wide ups and downs.
To obtain maximum returns, ___ must play a part.
stocks
Stocks’ average returns are ~_% per year greater than Treasury securities over the last 100 years.
5
Even though stocks’ average returns are higher, what is something to keep in mind?
Stocks’ volatility is much higher.
What is asset allocation?
Relative amount of funds invested in (or allocated to) each of several investment alternatives
What is optimal asset allocation?
Emphasized stocks early and bonds closer to retirement
What is the rule of thumb when investing?
Take you age and invest that percentage in bonds, the remaining in stocks.
Seek ___ fees and ___ portfolio periodically.
low, rebalance
Up to __% of “professionally managed” mutual funds underperform the market.
80
Where can lower investment management fees be found?
- In large, well-run, employer schemes
- By some high volume managers such as Vanguard
What is rebalancing?
Selling what you have “too much” of, buying what you have “too little” of, to keep your portfolio in line with your goals
When stocks rise, this increases their proportion of the portfolio, so you need to ___ stocks periodically to keep an age appropriate % of stocks vs. bonds. This takes some of the profits out of stocks and puts them into safer investments such as bonds or cash.
sell
It is difficult to detect a ___ without hindsight.
bubble
Great advice for investing that is difficult for the human animal?
Start small and steady with your investing, and do not get excited or get discouraged.
What are the characteristics of the brain’s two systems?
System 1: Fastthinking - IN CHARGE!
- Always on
- Quick reaction to immediate threats
- Loves patterns
System 2: Reasoning “self” - PASSENGER
- On call but slow reaction
- Huge energy consumption and attention if used
- Often invents reasons to System 1’s conclusions
What are visceral reactions? (2)
- Lack of concern for non-immediate threats
Ex. Spend now, save… never? - Once Invested
- deeply averse to losses
- comparatively little pleasure from gains
- tend to go with the crowd (bandwagon effect)
- buy high, sell low behavior of individual investors contributes to 4.7% return vs. 8.2% market return
What are two ways to minimize bias?
- Invest regularly - dollar cost averaging
2. Buy and hold through bad times and good
Can you end up with less money than what you invested?
Yup, if returns are low
What are Capsim’s uses of cash? (4)
- Retire stock
- Pay cash dividends
- Pay back current debt
- Retire long-term debt
What are Capsim’s sources of cash? (3)
- Issue stock
- Borrow current debt
- Issue long-term debt
