STUDY GUIDE FOR THE FINAL EXAM: CHAPTERS 1-8, 11-18, 20, 21
Chapter 1:
- five components of the financial system;
- money (definition, what they do); financial instruments (what they do); financial
markets (what they do); financial institutions (what they do); central bank (what it
does);
- five core principles of money and banking (time has value, risk and
compensation, information as a basis for decision, markets and prices and
resources, stability and welfare);
Chapter 2:
- functions of money;
- liquidity level of an asset;
- the payment system;
- payments with: a) cash, b) check (how exactly the process of the payment works);
c) electronic payment;
- measuring money (M1, M2, and M3 monetary aggregates, their structure);
Chapter 3:
- indirect finance (the flow of funds);
- direct finance (the flow of funds);
- definition of a financial instrument;
- functions of financial instruments (means of payment, store of value, to transfer
risk);
- characteristics of financial instruments;
- primary instruments;
- derivatives;
- factors that affect the value of a financial instrument (size of the promised
payment, the time of the payment, risk level, conditions of payment);
- roles of financial markets;
- primary versus secondary financial markets;
- centralized exchange versus over-the-counter exchange;
- roles of financial institutions (reduce the transaction cost, reduce information inequality);
- major groups of financial institutions;
Chapter 4:
- future value (definition);
- present value (definition);
- the formula for the present value (the relationship between the present value and
the future value);
- compound interest rate (how to calculate);
- comparability between time units (“n”) and interest rates (annual, monthly, …);
- basis points (know how to convert basis points into percentages and percentages
into the basis points);
- properties of the present value;
- different names of the interest rate (as “discount rate”, “yield”);
- internal rate of return (formula, know how to calculate);
- coupon bond;
- zero-coupon bond;
- coupon rate (know how to calculate);
- the relationship between the price of the bond and its interest rate;
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Chapter 5:
- definition of risk;
- expected value (what is it, how to calculate);
- risk-free assets, risk-free rate of return;
- variance of the investment (what is it, how to calculate);
- standard deviation of the investment (what is it, how to calculate);
- risk-averse investor;
- risk-neutral investor;
- risk-loving investor;
- idiosyncratic risk (what is it, can it be reduced?);
- systematic risk (what is it, can it be reduced?);
- hedging (what is it, what does it do to the standard deviation of the investment?);
- diversifying (what is it, what does it do to the standard deviation of the
investment?);
Chapter 6:
- a bond as a financial instrument (definition);
- four types of bonds;
- the relationship between the number of investment periods and the prices of
bonds;
- the relationship between the price of the bond and its interest rate;
- the Yield to Maturity as the best measure of interest rate;
- properties of the YTM;
- current yield, its level of accuracy;
- the current yield and the YTM, their relationship;
- holding period return (know how to calculate); capital loss, capital gain;
- the supply of bonds (where does it come from);
- the demand of bonds (where does it come from);
- the equilibrium in the bond market;
- factors that shift the supply of bonds;
- factors that shift the demand of bonds;
- what happens to the equilibrium price of bonds of there is a shift of a curve, and
what we should expect to happen to the interest rate as a result of a change in the
price of bonds;
- sources of bond risk (default risk, inflation risk, interest-rate risk);
Chapter 7:
- default risk
- bonds rating; rating groups;
- risk structure of interest rates (bonds with default risk versus default-free bonds);
- default risk premium;
- yield on a risk bond (how to calculate);
- tax treatment of income generated from bond holdings (municipal bonds versus
treasury bonds);
- after-tax yield (what is it? how to calculate it);
- why interest rate on municipal bonds is lower than that of treasury bonds
assuming the same maturity time?
- term structure of interest rates;
- the yield curve (regular and inverted yield curves);
- the expectation hypothesis (assumptions; the formula for the yield of a longer
maturity bond; how to calculate);
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based on the expectation hypothesis: when will we have a regular yield curve and
what economic conditions the curve predicts? When will we have an inverted
yield curve and what economic conditions the curve predicts?
- the liquidity premium theory (the assumptions; the formula);
- know what a flat yield curve means with respect to liquidity theory;
- know what a U-shaped yield curve means with respect to the expectation theory;
- know what a ∩-shaped yield curve means with respect to the expectation theory;
- practical applications of the risk structure of the interest rates;
Chapter 8:
- the need for the stock market;
- what is a stock or a share of the stock?
- holding stocks versus holding bonds: how comes first when it is time to receive
dividends; who gets what (% or a fixed $-payment);
- prices of stocks based on fundamentals;
- theory of efficient markets;
- inconsistencies with the theory of efficient markets (the small-firm effect; the
January effect; market over-reaction; mean reversion);
- strong form of market efficiency (is it supported by reality?);
- semi-strong form of market efficiency (is it supported by reality?);
- weak form of market efficiency (is it supported by realty?);
- adaptive expectations versus rational expectations;
Chapter 11:
- functions of financial institutions (pooling savings; safekeeping and accounting;
providing liquidity; risk sharing; information services);
- asymmetric information (the base for asymmetry);
- adverse selection (lemons problem);
- ways of reducing adverse selection (disclosure; collateral and net worth);
- moral hazard;
- ways of reducing moral hazard;
Chapter 12:
- total assets, total liabilities, bank net worth;
- banks’ balance sheet (the asset part: what are the assets; the liability part: what are
the liabilities);
- the basic operation of a bank;
- profitability of banks: return on equity; return on assets; equity multiplier;
- the trade-off between keeping bank’s capital low or high;
- total reserves; required reserves; excess reserves (how to calculate all three types
of reserves);
- liquidity risk (the result of an unexpected deposit outflow: the changes in a bank
T-account);
- ER as insurance against possible deposit outflows;
- credit risk;
- net interest income;
- interest rate risk (interest rate sensitive assets or liabilities versus fixed rate assets
or liabilities);
- gap analysis;
- off-balance sheep activities;
Chapters 13-14:
- the first and second U.S. central banks: their functions;
- dual banking system;
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banks’ panics at the end of nineteenth century (reasons for the panics);
the Federal Reserve Act of 1913;
competition between state and national banks;
the McFadden act (the need for it; the results);
the Glass-Steagall Act (1933);
the Banking Act (1935);
insurance companies (live insurance, term insurance, property and casualty
insurance companies);
- pension funds (defined-contribution and defined-benefit plans, fully funded
versus under-funded plans, vesting);
- mutual funds (open-end; closed-end funds);
- finance companies;
- government finance companies.
Chapter 15:
- central bank as the government’s bank (its functions);
- central banks is a banks’ bank (its functions);
- objectives for building a central bank;
- independence of the Fed;
- decision-making at the Fed;
- accountability;
Chapter 16:
- the structure of the Fed (the districts, the district main banks, the board of
governors, the chairman, voting on monetary issues);
- what does the Fed do as the government’s bank?
- what does the Fed do as the banks’ bank?
- what does the board of governors do?
- what does the FOMC do?
- the European Central Bank (its structure, differences between the ECB and the
Fed);
Chapter 17:
- participants of the money supply process;
- the Fed’s balance sheet (two major entries under “Assets” and “Liabilities”);
- why are Currency and Reserves called “monetary liabilities”?
- Monetary Base (definition, know how to calculate);
- High-powered money;
- open-market purchase of T-bills (the effect on reserves, on MB, changes in Taccounts for the Fed, the bank, the non-bank public);
- open-market sale of T-bills (the effect on reserves, on MB, changes in T-accounts
for the Fed, the bank);
- cash withdrawals by the public (the effect on the MB, reserves);
- discount loans (the Fed’s T-account, the bank’s T-account);
- instruments that the Fed uses to affect the MS;
- multiple deposit creation (for the entire banking system, know how to show it
through T-accounts of commercial banks: HW6);
- cash leakages (what are those, why are they important to note?);
- simple deposit multiplier (how to calculate it, how to use the SDM to find the
final effect of the multiple deposit creation on the MS);
- when the SDM works and when it does not (all the conditions);
- the link between the MB and the MS;
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know the formulas for m2 and m1 money multipliers (know how to calculate;
how to compare to the SDM, why m2 and m1 are so much different from the
SDM);
- derivation of the m2 and m1 money multipliers;
- who controls the small ratios (e, t, c, rd, rt);
- know how to do every question from HW6 and HW7;
Chapter 18:
- the three tools the Fed uses to affect the MS;
- the Federal Funds Rate (what is it?);
- the market for reserves (the demand and the supply of reserves);
- open market purchase or sale of T-bills and the market of reserves;
- discount lending the market for reserves;
- reserve requirements and the market for reserves;
- know how to do all the questions from HW8;
- ranking of the Fed’s tool (from the most favorite to the least favorite, know why);
- European central bank (its tools; how they work, differences with the Fed’ tools);
- how the Fed’ conducts its monetary policy (tools Î instruments Î intermediate
targets Î ultimate goals);
- what are the Fed’s tools, its instruments, what are the intermediate targets and
ultimate goals;
- how the Fed picks a monetary policy (chain of causation);
Chapter 20:
- the quantity theory of money (the equation of exchange);
- velocity;
- liquidity preference theory (transactions motive, precautionary motive,
speculative motive);
- Tobin’s demand for money (the two graphs);
- average cash holdings (how to calculate).
Chapter 21:
- potential GDP (what is it? why do we need it?)’
- expansionary and recessionary gaps;
- the equation of exchange in the growth rates, the growth rate of inflation through
growth rates of the money supply and potential GDP;
- Aggregate Demand and its components, the relationship between the inflation rate
and the AD;
- the AD in inflation-GDP space (graph, intuition behind);
- interest rates and the Fed’s actions on AD components;
KNOW HOW TO DO ALL THE QUESTIONS
FROM ALL THE HOME WORKS
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