Unit 1-3 Econ 351 Exam 1 Flashcards
consists of markets, individuals, institutions, and regulators (supervision)
Financial system
transfer funds from households, governments, and firms that have a surplus funds to those that have a shortage of funds
purpose of the Financial system
Types of financial assets
money, stocks, bonds, foreign exchange
anything people are willing to accept for goods and services and to pay debts: fiat …., legal tender, notes and coins issued by the fed/ commodity …, beads animal skin(pelts), cigarettes, gold, silver
money
issued by corporations: raise funds, give ownership rights (sometimes allows holders to vote), does not mature, held until sold, in some cases pays dividend
stocks(equities, shares)
issued by corporations or governments: purpose is to raise funds, debt security(company owes you), matures, interest paid on bonds(coupon payments), at maturity principal repaid
bonds
units of foreign currency facilitates international trade
foreign exchange(foreign currency)
loans that banks can sell: package mortgage and sell units(like bonds), securitization: borrower makes mortgage payments/investors receive cash flow
securitized loans (most common is mortgage-backed securities)
funds are transferred through…
financial markets, banks, and other financial intermediaries
funds are used to …
purchase financial assets and settle financial liabilities
anything of value owned by a person or firm
asset
a financial claim on someone else to pay you money
financial asset
process of converting loans and other financial assets that are not tradeable to securities
securitization
financial claim owed by a person or firm
financial liability
facilitates the buying and selling of stocks, bonds, and other securities
financial markets
how do firms obtain funds?
issuing debt or equity in financial markets
what are debt or equity instruments referred as?
securities
bonds, debentures, fixed maturity date, fixed periodic payment, principal returned at maturity
debt (securities)
ownership rights, voting rights if ordinary shares, dividends if preference shares, claim residuals if a company closes
equity (securities)
financial markets facilitate: reduction of time and cost associated with lending
operational efficiency
financial markets facilitate: funds are allocated in the most productive use
allocational efficiency
financial markets facilitate: market price reflects the value of security
informational efficiency
types of markets?
financial, primary, secondary, over-the-counter, exchanges
where new securities are issued
primary market
where new securities are being issued to initial buyers, proceeds are going to firms(stocks)/ government(bonds), IPO(initial public offering of shares), involves an investment bank that underwrites the offering
primary market
example of primary markets
JP Morgan, Wells Fargo, Citi Group, Bank of America
where previously issued securities are bought and sold
secondary market
where funds do not go to the firm, determines the market price of securities, involves brokers(work for investors) and dealers(holders of shares and equities on account)
secondary market
two types of secondary markets
exchange and over-the-counter markets
secondary market where assets are acquired at a central location (Newyork Stock Exchange(stocks), Chicago Board of Trade(commodities)), there is an open and closing time
Exchanges(Auction Markets)
secondary market that can be in different locations, primarily over the internet( no set operating period, sells bonds, foreign exchange, negotiable certificated deposits
Over the Counter
we can distinguish between markets based on the … … of securities
maturity date
trade short-term debt instruments, including debt securities (ex. bonds) less than 1 year, more widely traded and liquid(easy to convert to cash), primary players are usually banks
money market
trade long-term debt instruments, include debt securities greater than 1 year and equity(no maturity), often held by insurance companies and pension funds
capital market
buy and sell securities on behalf of customers, “go-between”, “middle man”
financial institutions(financial intermediaries)
type of financial intermediaries that accept deposits and make loans
depository institutions
examples of depository institutions
commercial banks, saving and loan associations, mutual savings banks, credit unions
non-despository institutions can be divided into … … … and … ….
contractual savings institutions and investment institutions
primary liabilities(sources of funds): customer deposits
primary assets(uses of funds): business & consumer loans, mortgages, US securities, municipal bonds
(about 4800)
commercial banks
primary liabilities(sources of funds): customer deposits
primary assets(uses of funds): mortgages
Savings and loan associations
primary liabilities(sources of funds): customer deposits
primary assets(uses of funds): mortgages
* owned by depositors, does not issue stock
Mutual savings banks
primary liabilities(sources of funds): customer deposits
primary assets(uses of funds): consumer loans (student loans)
*owned by depositors, based on membership in a particular group
Credit unions
a non-depository institution that acquires funds at periodic intervals on a contractual basis
contractual saving institutions
primary liabilities(sources of funds): premiums from policies
primary assets(uses of funds): corporate bonds, mortgages
life insurance companies
primary liabilities(sources of funds): premiums from policies
primary assets(uses of funds): corporate bonds, stocks, US securities
fire and casualty insurance companies
primary liabilities(sources of funds): employer and employee contributions
primary assets(uses of funds): corporate bonds, US securities, stocks
pension funds, government retirement funds
a non-depository institution that invests in securities & makes loans
Investment institutions
primary liabilities(sources of funds): commercial paper, stocks, bonds
primary assets(uses of funds): consumer and business loans
finance companies
primary liabilities(sources of funds): shares/ units
primary assets(uses of funds): stocks, bonds
mutual funds
primary liabilities(sources of funds): shares/ units
primary assets(uses of funds): money market instruments(short-term)
money market mutual funds
primary liabilities(sources of funds): partnership participation w/ a company
primary assets(uses of funds): stocks, bonds, loans, foreign currency, etc
hedge funds
financial institutions(intermediaries) are crucial because they:
reduce transaction costs, lower information costs, increase liquidity and lower price risks, provide payment services, allow for the transmission of monetary policy, provide credit allocation, provide maturity intermediation, provide intergenerational transfers or time intermediation, and provide denomination intermediation
financial institutions(intermediaries) are crucial because they deposit small funds and pool funds to make large loans
denomination intermediation
financial institutions(intermediaries) are crucial because they deposit funds today and make funds available to families in the future
intergenerational transfers or time intermediation
financial institutions(intermediaries) are crucial because they allow customers to deposit for a short term while they can lend for the long term
maturity intermediation
financial institutions(intermediaries) are crucial because they can access credit and make different categories of loans
credit allocation
financial institutions(intermediaries) are crucial because the fed relies on them to help control money supply
transmission of monetary policy
financial institutions(intermediaries) are crucial because they allow users to pay bills, set up standing order, and get salary
payment services
financial institutions(intermediaries) are crucial because they take savings short term and make long term loans, solves value inconsistency problem, create market for securities
increase liquidity and lower price risks
financial institutions(intermediaries) are crucial because they collect information on borrowers to forecast credit risk, better able to screen out bad credit from good ones
lower information costs
financial institutions(intermediaries) are crucial because of their large size which allows them to take advantage of economies of scale(Ex. one contract used for multiple loans
reduce transaction cost
funds flow from lenders to borrowers via two routes:
direct and indirect finance
flows of funds where borrowers borrow directly from lenders by selling them financial instruments
direct finance
securities that do not require financial intermediaries in the flow of funds
financial instruments
These are examples of?
IPO, a new bond from the US government, making a loan to a friend
direct finance
constraints of direct finance
transaction costs, diseconomies of scale, asymmetric information, moral hazard, adverse selection, time and value inconsistencies
a constraint of direct finance where time and money are needed to complete the transaction
transaction costs
a constraint of direct finance where an increasing number of transactions, due to a small scale of operation, makes transaction costs increase
diseconomies of scale
a constraint of direct finance where one party in the transaction has more information(usually the borrower who knows what they are doing with the loan and their willingness to repay)
asymmetric information
adverse selection and moral hazard are a consequence of … …
asymmetric information
a constraint of direct finance is that bad credit risks are more likely to seek out loans even with high interest rates(happens before entering transaction)
adverse selection
a constraint of direct finance is that a borrower takes on risky activity after receiving the loan (happens after entering transaction)
moral hazard
a constraint of direct finance is that savers want to lend for the short-term, borrowers want to borrow for the long-term, and it takes time to convert asset to money
time inconsistencies
a constraint of direct finance is that assets depreciate in value over loan period
value inconsistencies
flow of funds that involves a financial intermediary
indirect finance(financial intermediation)
these are examples of what type of flow of funds: deposit funds, in a savings account, purchase stocks in a secondary market
indirect finance(financial intermediation)
How does indirect finance smooth asymmetric information?
- savers lend to trustworthy financial intermediary
- FI are able to differentiate bad credit risks
- FI are able to monitor loans
How does indirect finance reduce transaction risk?
FI reduces possibility of defaulting on a loan
How does indirect finance lower cost and increase volume of financial flows?
FI have large size benefits from economies of scale
How does indirect finance facilitate investment and economic activity?
FI increases the volume of loans and economic activity
What three key services does the financial system provide to savers and borrowers?
risk sharing, liquidity, information
allows savers to spread and transfer risk
risk sharing
aspects of risk-sharing includes:
asset transformation and diversification
aspect of risk-sharing where FI invest short term liabilities into long term assets, FI sell liabilities to customers(deposits, CD’s, money market investments), then convert small deposits into loans(assets)
asset transformation
aspect of risk sharing that allows savers to hold a variety of assets(savings, CD’s, stocks, and bonds) based on risk preference
diversification
ease of converting an asset into money
liquidity
service to savers and borrowers where savers are able to deposit for short term instruments purchase can be converted to money fast and easily dur to market created by FI
liquidity
service to savers and borrowers that provides facts about borrowers and returns on financial assets (access to this allows markets to operate efficiently)
information
financial regulation is important to:
increase the information available to investors
ensure the soundness of the financial system
who does the securities and exchange commission regulate?
financial markets
who does the federal deposit insurance corporation regulate?
insures deposits in banks
who does the office of the comptroller of the currency regulate?
federally chartered banks
who does the consumer financial protection bureau regulate?
protects consumers from fraud and deceptive practices in financial markets
who does the federal reserve system regulate?
the banking system
An interest rate represents:
“return” financial investment
cost of borrowing
These are examples of what in the macroeconomy: mortgage rates, savings rates, interest on car loan
interest rates
what do interest rates depend on?
rate of return expected
time preference
level of risk
expected inflation
interest rates affect consumers’ willingness to … or … and the businesses’ decisions …
consume or save
whether to invest in productive activity(use own funds or borrow funds to use)
Interest rates can viewed as:
compensation for inflation
compensation for default risk
compensation for the opportunity cost of waiting to spend your money
types of time preferences
short term horizon
long term horizon
riskiness of an asset relative to other assets (default, interest risk, reinvestment risk)
level risk
weighted average of all possible returns
rate of return expected
expected change in the price level
Fisher equation(links expected inflation to the nominal and real interest
expected inflation
Interest rates are a vital tool of monetary policy and can be used to control:
investment
inflation
unemployment
Interest rates are based on the principle of the … … of …
Time Value of Money
This sates that money held today is worth more than the value of the same sum of money in the future
Time Value of Money
amount of funds the lender provides to the borrower
loan principal
date a loan must be repaid
maturity date
amount (percentage) the borrower has to pay the lender to use the principal (Ex. Bond payment is called a coupon)
interest payment
length of time the security is held
holding period
how much a current sum of money is worth at some point in the future
future value
what is the future value formula?
FV= PV(1 + i)^t
interest calculated based on the principal and interest previously earned
compounding
how much a future sum of money is worth today(value of future sum discounted to … … at some interest rate)
present value
what is the present value formula?
PV = FV/(1+ i)^t
what changes in the future/present value formula happen when the time period is changed to semiannually and quarterly?
semiannually:
t= years x 2
i = i/2
quarterly:
t= years x 4
i = i/4
Suppose that a wealthy relative gives you $5000 to help provide for your newborn child’s university fees. You decide to invest this money at 10% p.a.(per annum) until your child is ready to begin their university studies. How much will be in the account 18 years from now?
$27,799.58
You can afford to put $10,000 in a savings account that pays 6% interest compounded annually. How much will you have five years from now if you make no withdrawals? per annum and semiannually?
per annum: $13,382.26
semiannually: $13,439.16
What is the present value of $250 to be paid in two years if the interest rate is 15%?
$189.04
Suppose you are depositing an amount today in an account that earns 5% interest, compounded annually. If your goal is to have $5,000 in the account at the end of six years, how much must you deposit in the account today?
$3,731.08
What are the four basic types of credit market instruments?
simple loan, fixed payment loan, coupon bond, and discount bonds
credit market instrument where the principal and interest are paid at maturity?
Only one payment made at the end
principal= loan amount
interest depends on the amount borrowed
simple loan
credit market instrument where equal payments consisting of principal and interest are made each period (amortized loans)(ex. mortgages, car loans, student loans)
equal payment until maturity
fixed payment loan
What is the formula for a fixed-payment loan?
fixed payment = (principal + interest)/ t
fixed payment = total amount owed/ time period
a credit market instrument where a fixed interest payment is made each period and principal repaid at maturity
coupon bond
amount that will be repaid at maturity
usually $1000
face value(par value)(principal)
periodic interest payment received (usually annually or semi-annually)
coupon
coupon formula
coupon =(face value)(coupon rate)
fixed interest rate received on the bond, stipulated in the bond contract
coupon rate
annual interest earned on holding bond (profitability of a bond)
current yield
current yield formula
coupon/face value x 100 = coupon/price
length of time(loan period) before a bond expires
maturity
credit market instrument that is purchased at a price below face value, at maturity I receive face value(pays no coupon)(Ex. US treasure bills and US savings bonds)
discount bond(zero- coupon bond)
the return on a bond or other fixed-income security if held until the maturity date
Yield to Maturity (YTM)
for simple loans, the simple interest rate equals the yield to maturity what is the formula for YTM?
YTM = interest paid/ principal x100
If Susan borrows $1,500 from her sister and next year, she wants $1650 back from her, what is the YTM on this loan?
10%
You borrow $1 million from your friend today and promise to repay them $2.5 million in 2 years. What is the YTM on the loan?
0.581/ 58.1%
Formula for a discount bond
(price =present value)
Face Value-Price/ Price
What is the yield to maturity for a discount bond that is currently selling for $560 and will mature in 5 years with a face value of $1000?
0.123/ 12.3%
A discount bond pays a face value of $1500 in two years. If the current purchase price of this bond is $1200, calculate the YTM.
0.118/ 11.8%
Fixed payment loan formula?
LV = FP/(1+i) + FP/(1+i)^2 +FP/(1+i)^3 +FP/(1+i)^n
You borrow some money from a loan shark and promise to repay them in 3 equal payments of $300,000 per week. Suppose the loan shark requires a return of 40% per week, how much money have they lent you?
$476,676.38
Coupon Bond Formula(2)
P = C/(1+i) + C/(1+i)^2 + C/(1+i)^n + F/(1+i)^n
or
P =
calculate the present value of a $1000,10% coupon bond with five years to maturity if the yield to maturity is 6%?.
$1,168.49
max willing to pay today for 5 year, $100, 10% coupon bond given the YTM is 6%
what changes in the coupon bond formula is it is a semi-annual coupon bond?
coupon payments/2
number of years until maturity x 2
interest rate/2
What is the price of a bond that has a coupon rate of 4%, matures in 2 years, has a face value of $1,000 and whose yield to maturity is 5%(coupon payments are made semi-annually)
$981.19
max willing to pay given YTM is 5%
What is a special case of a coupon bond called where the bond has no maturity date(> 25 years) and no repayments of principal that make fixed coupon payments of $C forever?
Perpetuity of Consol bond
What is the perpetuity or consol bond formula?
Pc = C/ic
price
yearly payment
yield to maturity of the perpetuity
What is the yield to maturity on a bond that has a price of $3000 and pays $600 annually forever?
0.2/20%
What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%?
$2000
the price of a coupon bond and the yield to maturity are … related?
negatively related
As YTm increases –> price decreases(discounting cash flow at a higher rate)
If the coupon bond is priced at its face value, the yield to maturity and the coupon rate are?
equal
If the YTM is greater than the coupon rate then the bond price is … its face value
below
price is less than face value (below par [at a discount])
if YTM is less than the coupon rate when then the price of the bond is … its face value
above (above par, at a premium)
Consider a bond with a 4% annual coupon and a face value of $1000. What is the current price of the bond if
Years to Maturity / Yield to Maturity
2 2%
2 4%
3 4%
5 2%
5 6%
$1038.83
$1000
$1000
$1094.27
$915.75
Given the same years to maturity: as YTM increases the price of the bond …
decreases
Given the same YTM: as years to maturity increases the price of the bond …
increases
measures how profitable an investment is
rate of return
what is rate of return is impacted by?
interest rate risk
default risk
a good approximation for the YTM of a bond(changes as price changes), annual return on a bond based on coupon and the price paid for the bond
current yield
current yield formula
coupon payment/ price
the difference between the selling price and the purchase price of a bond
capital gain/loss
capital gain/loss formula
selling price(Pt+1) - purchase price(Pt)/ Pt
rate of return =
current yield + rate of capital gain
rate of return formula
[C+ (Pt+1) - (Pt)]/ Pt
What would the rate of return be on a bond bought for $1800 and sold one year later for $1500? The bond has a face value of $2000 and a coupon rate of 8%
-0.078/ -7.8%
You have paid $950 for an 8% coupon bond with a face value of $1000 that matures in 5 years. You sell the bond one year later for $980. What would be the rate of return?
11.6%
prices and returns for long-term bonds are … …. than those for shorter-term bonds due to …-… …
more volatile
interest-rate risk
increase in the years to maturity causes:
decrease in the price of the bond
Pt+1 is less than Pt
capital loss
The longer the time to maturity:
the greater the price change, the lower the rate of return
when the principal is repaid?
term to maturity
how long I keep the bond?
holding period
what is true is the term to maturity and holding period are the same?
there is no interest rate risk
market interest rate or quoted interest rate does not account for inflation
nominal interest rate
interest rate adjusted for inflation
real interest rate
uses expected inflation
ex ante real interest rate
uses actual inflation
ex post real interest rate
What is the Fisher Equation?
Nominal = Real + Expected Inflation (ex ante)
or
Real = Nominal - Expected Inflation
low real interest rate means:
low incentive to save
prefer to spend than save
high real interest rate means:
high incentive to save
prefer to save than spend
Assume you just deposited $1000 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year.
a) what nominal rate would you require from the bank over the next year?
b) How much money will you have at the end of one year?
c) If you are saving to buy a stereo that currently sells for $1050, will you have enough to buy it?
d)Would the bank be better off if the actual inflation rate next year is 9% and the nominal rate on your account remained unchanged?
a) 8%
b) $1080
c) $1110, so no, because the price of the stereo increases due to expected inflation
d) actual inflation 9%, nominal interest 8%, the bank would be better off. Borrowers will gain while lenders will lose (expost real interest=nominal -actual)
The quantity demand for bonds is … related to the price level
negatively
bond demand depends on what 4 things? (shifters of bond demand)
wealth, expected return, risk, and liquidity
the total resources owned by the individual
all assets owned: money, art, gold, bonds, stocks, cars, homes
wealth
holding everything else constant, an increase in wealth … the quantity demanded of an asset (bonds at all prices)
raises
How the business cycle affects wealth:
- expansion(Boom)–> … wealth–> … quantity demanded of bonds
- contraction(recession) –> … wealth–> … quantity demanded of bonds
increases, increases(shift right)
decreases, decreases(shift left)
How does a consumer’s propensity to save affect wealth?
- Increase in propensity to save–> … hold of assets, … wealth, … quantity demanded of bonds at all prices
increase, increase, increase(shift right)
weighted average of all possible returns
expected return
Hold everything else constant, an increase in an asset’s expected return relative to that of an alternative asset … the quantity demanded of an asset.
raises(shift right)
What are expected returns on bonds influenced by?
future interest rates, the expected inflation, and the expected return on other assets
A change in the current prices and current interest rate … … shift the demand curve.
do not
decrease in the future nominal interest rate –> … future price of bond(Pt+1), … expected return, … quantity demanded of bonds at all prices
increase, increase(capitol gain), increase(shift right)
increase in expected inflation–> … in real interest rate, … real expected return on asset, … quantity demanded bond at all
decrease, decrease, decrease (shift left)
increase expected return on bonds relative to other assets–> … quantity demanded of bonds at all prices
increase (shift right)
degree of uncertainty associated with the return on one asset relative to alternative assets
risk
Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, it quantity demanded will …
fall(shift left)
ease and speed with which an asset can be turned into cash relative to alternative assets
liquidity
increase in relative risk of their assets and risk of bonds remained unchanged or changed by less than other assets–> … quantity demanded of bonds at all prices
increase(shift right)
Holding everything else constant, the more liquid an asset is relative to alternative assets, the … … it is, and the … will be the quantity demanded.
more desirable
greater(shift right)
An increase in the relative liquidity of other assets –> … in quantity demanded of bonds
decrease(shift left)
the quantity supply of bonds is … related to the price level
positively
firms (large) and government: increase the price of bonds –> … quantity supplied
increase
What does bond supply depend on?(shifters)
expected profitability of investment opportunites
business taxes
expected inflation
government budget deficits
increase in the profitability of firms investment –> … quantity supplied bonds at all prices
impacted by business cycle Boom –> … profitability –> … quantity suppled at all prices
increase, increase, increase (shift right)
increase business taxes –> … firm profitability, … investment, … quantity supplied at all prices
decrease, decrease, decrease (shift left)
increase expected inflation –> … real interest –> … real cost of borrowing, … quantity supplied at all prices
decrease, decrease, increase (shift right)
increase government budget deficit –> … issue of bonds, … quantity supplied bonds at all prices
increase, increase(shift right)
if bond supply > bond demand(price above p): bond prices will … (interest …) to return to P(i*)
fall, rise
Bond Supply and Demand Example: Business cycle expansion and interest rate:
increase wealth –> bond demand shifts … –> price …(interest rate …)
… investment opportunities(firms) –> … profitability, … bond supply(shift …), … price(… interest rates)
right, increases, decreases
increase, increase, increase, right, decrease, increase
Fisher Effect and Real Interest Rate Example:
increase expected inflation –> … nominal interest rates, … price of bonds, capitol …, … expected return, bond demand shifts … , price …(interest rates …)
… real interest rate, … real cost of borrowing, bond supply shifts …, price …, interest rates …
increase, decrease, loss, decrease, , left, decrease, increase
decrease, decrease, right, falls, rises
The federal government runs a series of budget surpluses:
Bond supply shifts … –> price …, interest rates …, bond demand is …
left, rises, falls, unaffected
Investors believe that the level of risk in the stock market has declined:
Bond demand shifts … –> … risk in stock relative, … demand for bonds
left, increase, decrease
Wealth in the economy increases at the same time that Congress raises the corporate income tax:
increases in wealth–> bond demand shifts …, price …( interest rates …)
Increase corporate income tax–> … firms profitability, … in investment, bond supply shifts …, price …(interest …)
right, rises, falls
decrease, decrease, left, rise, falls
The demand curve and supply curve for one-year discount bonds with a face value of $1000 are represented by the following equations:
bond demand: Price = -0.6Q+1140
bond supply: Price = Q + 700
a) What is the expected equilibrium price and quantity of bonds in the market?
b) What is the expected interest rate in this market?
Q= 275, P=$975
YTM= 2.56%
