Oral exam Flashcards
- Who are the major participants in money markets?
a. U.S. Treasury
b. Commercial Banks
c. Federal Reserve
d. Brokers and Dealers
e. Corporations
f. Other financial Institutions
- Why do most money market securities have large denominations?
a. The market has developed for institutional investors because institutional investors have large enough quantities of money to make it costly for them to not invest their excess funds. For most individual investors, the dollars lost by not keeping fully invested in interest-bearing assets is very minimal.
- How does a repo differ from a Fed Funds transaction?
a. A repo is basically a collateralized loan whereas Fed Funds are uncollateralized. The repo rate will typically be slightly below the equivalent maturity Fed Funds rate because the repos are collateralized.
- Given the functions of the money markets, why is it necessary for money market securities to have a maturity of one year?
a. Because these markets are designed to provide safe investments with little or no chance of principle loss. If you could lose principle you would be very unlikely to invest funds that are shortly needed. Low default risk implies that the promised cash flows will in all likelihood be paid in full and on time. The short maturity ensures that the value of these securities will be relatively insensitive to interest rate changes and, also, there is not much time for the issuer’s condition to change – this also limits the risk.
b. *note: money market securities need one year OR LESS
i. Short-term = increase
- What do bond rating agencies look at in setting a bond’s rating?
- *Profitability, liquidity, safety**
1. Profitability of operations
2. Competitive position in the industry
3. Overall financial strength
4. Ability to pay interest and principle in full and on time
5. Issuer’s liquidity and additional debt capacity
6. Specific collateral and other bond provisions such as protection provided to bondholders in the event of bankruptcy, takeover, etc.
- What is the difference between General Obligation and Revenue bonds?
Both are bonds issued by state or local municipalities. G.O.s are backed by the full revenue stream of the municipality (often called the General Fund). They typically require voter approval. Revenue bonds are backed by a specific project’s revenues, but not the general tax revenues of the municipality. Revenue bonds are thus riskier than G.O.s.
- How does each feature affect the bond’s required rate of return? Explain.
a) The call feature favors the bond issuer and unless the issue offers the investor a sufficiently higher rate of return, he would not want this feature.
b) The convertible feature allows the bondholder to convert to stock if they so choose. This sounds like a good deal but the quid pro quo is a reduced promised yield. This may be desirable if you believe the stock will increase sufficiently in price.
c) Warrants allow the bondholder to purchase stock at a fixed price, and unlike convertible bonds, the bondholder does not have to surrender the bond. Offering warrants allows the bondholder to offer a lower required rate of return. This may be desirable if you believe the stock will increase sufficiently in price.
d) Sinking funds help ensure that the bond issuer will be able to pay off the principle when due. If these are term bonds and the issuer sets aside money each year to ensure availability of funds when the principle is due, then the bondholders clearly benefit from this feature. Of course, this reduces the required promised yield. If the sinking fund requires retiring a certain percentage of the bonds each year, then the idea is not unambiguously better for bondholders. It may be that your bond is retired when rates have fallen and you must then reinvest at lower interest rates. used only to retire debt
e) The term debenture indicates that the bond has no specific collateral (other than the earnings and cash flows of the firm). The lack of security adds to bondholder risk and may imply a higher required rate of return than bonds with better collateral. ***non-secure bonds; higher risk due to no collateral backing
- The total sale proceeds from selling the stripped components of a Treasury security can sometimes be greater than the fair present value of the Treasury security. Why might this happen?
STRIPS are useful tools to minimize interest rate risk. Because they are zero coupon bonds, a strip held to maturity has no interest rate risk; the investor is certain of the nominal rate of return. Investors are apparently willing to pay a small premium to eliminate this uncertainty.
- What ratings comprise investment-grade bonds and what ratings are used for junk bonds? What are the primary differences between the two?
Investment-grade bonds are bonds rated AAA (Aaa) down to and including BBB- (Baa3) by S&P and Moody’s respectively. All lower ratings are considered speculative grade, or junk bonds. Investment-grade bonds have lower required returns than junk bonds although the credit spreads or default risk premiums (DRPs) vary inversely with economic performance. Investment-grade bonds are more marketable because many institutions are only allowed to hold either only a small amount of junk bonds or no junk bonds at all. Junk bonds carry significantly higher interest rates and are less marketable, but they are still used when a firm cannot obtain a higher rating and still wants to employ debt financing.
- “On the run” Treasury notes and bonds are newly issued securities and “off the run” Treasuries are securities that have been previously issued.
On-the-run Treasuries are the most recently issued U.S. Treasury bonds or notes of a particular maturity. “On-the-run” Treasuries are the opposite of “off-the-run” Treasuries, which refer to Treasury securities that have been issued before the most recent issue and are still outstanding.
- The ROA for financial institutions such as banks is typically quite low as compared to non-financial firms. Why? With such a low ROA, how can banks attract stockholders?
Microeconomics tells us that firms earn positive net present values by producing a good or service that not enough other firms can perfectly duplicate, at least not at the same cost. Because the major assets of a bank are pieces of paper (loans and securities), it is difficult for a bank to generate substantially positive NPVs and earn a large ROA. For instance, an ROA of 2% for a bank is outstanding. Trying to convince your stockholders that a 2% return on their investment is outstanding is however quite difficult! To get an acceptable ROE, (the rate of return to the shareholder) banks must resort to using a very high amount of leverage. The debt/asset ratio at a bank is usually over 90%.
- Most non-financial firms would never hold as much of their assets in safe liquid securities as banks do. Why do banks maintain such a high percentage of investment in securities?
To answer this we must look at the right-hand side of the balance sheet as well as the left side. A major portion of bank funds are raised through short-term deposits that people can choose to withdraw at short notice. Consequently, banks must plan for withdrawals and keep a significant portion of their assets in cash or near cash investments. Likewise, banks must have cash available for loan customers and to honor previous loan commitments. So even though much of the investment portfolio earns only low rates of interest, banks must maintain liquid reserves to meet loan demand and deposit withdrawals.
- What are the major sources of funds for banks? Provide a breakdown of all the major sources of funds at a bank and briefly describe the different types of deposits/non-deposit sources.
- Equity: Common stock, paid-in capital and retained earnings
- Deposits: The main source of funding
- Transaction accounts are composed of demand deposits (pay no interest) or NOW accounts (negotiable order of withdrawal or an interest-bearing checking account)
- Retail savings and time deposits ($100,000) are negotiable certificates of deposit that can be resold to other investors prior to maturity.
- Non-deposit liabilities include loans from other banks, repurchase agreements, and bonds.
- Why are banks different from other depository institutions?
Banks are the main conduit of monetary policy, they are also critical in operating the nation’s payments system. The banking industry constitutes the nation’s largest intermediary and is one of the major methods of allocating credit in the economy. Banks provide risk, liquidity, and maturity intermediation that encourages savers to make their money available to the system and thus encourages economic growth.
- Discuss the major differences between large banks and small banks. Which have had higher ROAs? Why?
Large banks tend to have:
- Lower equity (%)
- Easier access to capital markets, hence they often hold a lower percentage of liquid securities.
- More business loans, business borrowers often have greater bargaining power so profitability on these loans can be low.
- Lower interest rate spreads
- Higher salaries
- More non-interest income (and expense)
- More diversification
- More aggressive management
- The picture that emerges is that smaller banks tend to operate in less competitive markets and are more conservatively managed. In terms of profitability, large banks will tend to have lower ROAs but may often have higher ROEs when banks are performing well because they take more risks and have less equity.
- In periods of poorer bank performance, the more conservative tactics of smaller banks are likely to result in better ROA and ROE than large banks.
