Review outline for Final Exam Fin360
1. Overview of financial system (Chapter 1+2)
Chap 1
Chap 2
2. Interest rate and bond price, bond duration
Discount bond
When interest rates decrease, how might businesses and consumers change their
economic behavior? When interest rates decrease, consumers are willing to spend more
money on goods because they now receive fewer returns from their investments (for
example, interest payments on money in savings accounts fall)
Duration measures a bond's or fixed income portfolio's price sensitivity to interest rate
changes.
Macaulay duration estimates how many years it will take for an investor to be repaid the
bond’s price by its total cash flows.
Modified duration measures the price change in a bond given a 1% change in interest
rates.
A fixed income portfolio's duration is computed as the weighted average of individual
bond durations held in the portfolio.
In general, the higher the duration, the more a bond's price will drop as interest rates rise
(and the greater the interest rate risk). For example, if rates were to rise 1%, a bond or
bond fund with a five-year average duration would likely lose approximately 5% of its
value.
3. Structure of interest rate, yield curve
Stock valuation principle
Concepts of derivative securities (W3)
4. Stock valuation principle
5. Concepts of derivative securities
Web chapter 3
Chapter 9
Explain major sources and uses of fund by a bank
Principles in bank management: reserves, credit risk and interest rate risk
General Principles of Bank Management
- Liquidity management
- Asset management
- Liability management: your lender money invested in good things
- Capital Adequacy Management
- Credit Risk
- Interest-rate Risk: not risky, but high returns
Liquidity management and the role reserves
I want my 100 dollars back, but they only have 10 lefts, and the rest is put into loans.
4 options:
- Borrowing from other banks or corporations but they have to pay an interest rate
for that (The cost of this activity is the interest rate on these borrowings, such as the
federal funds rate)
- Selling securities: sell in secondary markets (The bank incurs some brokerage and other
transaction costs when it sells these securities. The U.S. government securities that are
classified as secondary reserves are very liquid, so the transaction costs of selling them
are quite modest. However, the other securities the bank holds are less liquid, and the
transaction costs can be appreciably higher.)
- Borrowing from the Fed: lower interest rate than borrowing from other banks
- Calling in or selling off loans: very desperate, scares of customers. (This process –
calling in loans is the bank’s costliest way of acquiring reserves when a deposit outflow
exists. The other is also very costly because other banks do not know how risky these
loans are and so may not be willing to buy the loans at their full value.)
A bank expects to attract most of its funds through short-term CDs and prefer to use most
of its funds to provide long-term loans.
A fixed-rate loan may be perceived as rate insensitive. Yet, if it is prepaid, the funds are
loaned out to someone else at the prevailing rate. Therefore, this type of loan can be
sensitive to interest rates. A bank could follow the strategy that the bank expects to attract
most of its funds through short-term CDs and would prefer to use most of its funds to
provide long-term loans and still reduce the interest rate risk by using the floating-rate
loans even with long-term maturities.
The floating rate is also known as variable or adjustable rate hence this strategy can be
used to manage the interest rate risk.
According to duration analysis, if interest rate falls, the market value of the long-term
loans will rise and increase further than the liabilities of short-term CDs, thus increase the
net worth of the bank and increases its profits.
Chapter on the Web 2
Operation of insurance companies and how asymmetric information affects the operation
of insurance companies; application: Insurance management
In the case of an insurance policy, moral hazard arises when the existence of
insurance encourages the insured party to take risks that increase the likelihood of
an insurance payout. For example, a person covered by burglary insurance might not
take as many precautions as possible to prevent a burglary because he or she knows the
insurance
company will pay for most of the losses if a theft occurs. Adverse selection holds that
the people most likely to receive large insurance payouts are the ones who will most
want to purchase insurance. For example, a person suffering from a terminal disease
would want to take out the biggest life and medical insurance policies possible, thereby
exposing the insurance company to potentially large losses. Both adverse selection and
moral hazard can result in large losses to insurance companies because they lead to
higher payouts on insurance claims.
All insurers face moral hazard and adverse selection problems, which explain the use of
insurance management tools, such as information collection and screening of potential
policyholders, risk-based premiums, restrictive provisions, prevention of fraud, insurance
cancellation provisions, deductibles, coinsurance, and limits on the amount of insurance.
Describe and differentiate the operations of Finance companies, mutual fund, and
securities markets operations
Finance companies
Finance companies raise funds by issuing commercial paper and stocks and bonds and
then using the proceeds to make loans that are particularly suited to consumer and
business needs. Virtually unregulated in
comparison to commercial banks and thrift institutions, finance companies are able to
quickly tailor their loans to customer needs
securities markets operations
Investment bankers assist in the initial sales of securities in primary markets, whereas
securities
brokers and dealers assist in the trading of securities in the secondary markets, some of
which are organized
into exchanges. The SEC regulates the financial institutions in the securities markets and
ensures
that adequate information reaches prospective investors.
Mutual funds
Mutual funds sell shares and use the proceeds to buy securities. Open-end funds issue
shares that can be
redeemed at any time at a price tied to the asset value of the firm. Closed-end funds issue
nonredeemable
shares, which are traded like common stock. They are less popular than open-end funds
because their shares
are not as liquid. Money market mutual funds hold only short-term, high-quality
securities, allowing shares
to be redeemed at a fixed value using checks. Shares in these funds effectively function
as checkable deposits that earn market interest rates. All mutual funds are regulated by
the Securities and Exchange Commission
(SEC).
Chapter 14
Explain the function and organization for central bank (the Fed)
Function:
Central banks carry out a nation's monetary policy and control its money supply, often
mandated with maintaining low inflation and steady GDP growth.
On a macro basis, central banks influence interest rates and participate in open market
operations to control the cost of borrowing and lending throughout an economy.
Central banks also operate on a micro-scale, setting the commercial banks' reserve ratio
and acting as lender of last resort when necessary.
Organization
This initial diffusion of power resulted in the evolution of the Federal
Reserve System to include the following entities: the Federal Reserve Banks, the
Board of Governors of the Federal Reserve System, the Federal Open Market
Committee (FOMC), the Federal Advisory Council, and around 2,000 member
commercial banks.
Federal reserve Banks
Each of the twelve Federal Reserve districts defined by the Federal Reserve Act of 1913
has one main Federal Reserve Bank, which may have branches in other cities in the
district. Each of the Federal Reserve Banks is a quasi-public (part private, part
government)
institution owned by the private commercial banks in its district that are members of
the Federal Reserve System.
member Banks
All national banks (commercial banks chartered by the Office of the Comptroller of
the Currency) are required to be members of the Federal Reserve System. Commercial
banks chartered by the states are not required to be members, but they can choose to
join
Board of governors of the federal reserve system
At the head of the Federal Reserve System is the seven-member Board of Governors,
headquartered in Washington, DC. Each governor is appointed by the president of the
United States and confirmed by the Senate.
federal Open market committee (fOmc)
The FOMC usually meets eight times a year (about every six weeks) and makes decisions
regarding the conduct of open market operations and the setting of the policy
interest rate, the federal funds rate, which is the interest rate on overnight loans from
one bank to another. Indeed, the FOMC is often referred to as the “Fed” in the press
When the Fed pays for a government bond, it pumps money into the banking system.
However due to the reserve requirement, the entire money cannot be used by banks for
lending purposes. Hence the actual increase in money supply is equal to the money paid
for government bonds minus reserve requirement. This is equal to 120 m*(1-8%)= 110.4
million
Chapter 15
Explain meaning of items in the Fed’s balance sheet
4 items
Liabilities
The two liabilities on the balance sheet, currency in circulation and reserves, are often
referred to as the monetary liabilities of the Fed. They are an important part of the money
supply story, because increases in either or both will lead to an increase in the money
supply (everything else held constant). The sum of the Fed’s monetary liabilities
(currency in circulation and reserves) and the U.S. Treasury’s monetary liabilities
(Treasury currency in circulation, primarily coins) is called the monetary base (also
called high-powered money).
Assets
The two assets on the Fed’s balance sheet are important for two reasons. First, changes in
the asset items lead to changes in reserves and the monetary base, and consequently to
changes in the money supply. Second, because these assets (government securities and
Fed loans) earn higher interest rates than the liabilities (currency in circulation, which
pays no interest, and reserves), the Fed makes billions of dollars every year—its assets
earn income, and its liabilities cost practically nothing.
Comment on the Fed’s ability to control MB and banks’ reserves
Open market purchase
Because the monetary base equals currency plus reserves, an open market purchase
increases the monetary base by an amount equal to the amount of the purchase.
FED ability to control bank reserves
Banks loan funds to customers based on a fraction of the cash they have on hand. The
government makes one requirement of them in exchange for this ability: keep a certain
amount of deposits on hand to cover possible withdrawals. This amount is called the
reserve requirement, and it is the rate that banks must keep in reserve and are not allowed
to lend.
In the United States, the Federal Reserve Board sets the reserve requirements. The
Federal Reserve Board receives its authority to set reserve requirements from the Federal
Reserve Act. The Board establishes reserve requirements as a way to carry out monetary
policy on deposits and other liabilities of depository institutions.
The reserve requirement is another tool that the Fed has at its disposal to control liquidity
in the financial system. By reducing the reserve requirement, the Fed is executing an
expansionary monetary policy, and conversely, when it raises the requirement, it's
exercising a contractionary monetary policy. This latter action cuts liquidity and causes a
cool down in the economy.
Explain the simple and complete model of money supply process and determinants of
money supply
A single bank can make loans up to the amount of its excess reserves, thereby creating an
equal amount of deposits. The banking system can create a multiple expansion of
deposits, because as each bank makes a loan and creates deposits, the reserves find their
way to another bank, which uses them to make loans and create additional deposits. In
the simple model of multiple deposit creation, in which banks do not hold on to excess
reserves and the public holds no currency, the multiple increase in checkable deposits
(simple deposit multiplier) equals the reciprocal of the required reserve ratio.
The simple model of multiple deposit creation has serious deficiencies. Decisions by
depositors to increase their holdings of currency or by banks to hold excess reserves will
result in a smaller expansion of deposits than is predicted by the simple model. All three
players—the Fed, banks, and depositors—are important in the determination of the
money supply.
Determinants of money supply
The money supply is positively related to the nonborrowed monetary base MBn, which is
determined by open market operations, and the level of borrowed reserves (lending) from
the Fed, BR. The money supply is negatively related to the required reserve ratio, rr, and
excess reserves. The money supply is also negatively related to holdings of currency, but
only if excess reserves do not vary much when there is a shift between deposits and
currency. The model of the money supply process takes into account the behavior of all
three players in the money supply process: the Fed through open market operations and
setting of the required reserve ratio; banks through their decisions to borrow from the
Federal Reserve and hold excess reserves; and depositors through their decisions about
the holding of currency.
Chapter 16,17
Explain the goals of monetary policy: dual and hierarchical mandates
Describe the problem of time inconsistency and give real-life example for this problem
Explain the role of a nominal anchor in conducting monetary policy
Describe and differentiate tools of monetary policy and their advantage, disadvantage
Conventional monetary policy tools include open market operations, discount policy,
reserve requirements, and interest on reserves. Open market operations are the primary
tool used by the Fed to implement monetary policy in normal times to change interest
rates and monetary base, because they occur at the initiative of the Fed, are flexible, are
easily reversed, and can be implemented quickly. However, even if implemented quickly,
the macro effects of monetary policy generally occur after some time has passed. The
effects on an economy may take months or even years to materialize. Interest rates can
only be lowered nominally to 0%, which limits the bank's use of this policy tool when
interest rates are already low. Keeping rates very low for prolonged periods of time can
lead to a liquidity trap.
Discount policy has the advantage of enabling the Fed to perform its role of lender of last
resort, while raising interest rates on reserves to increase the federal funds rate eliminates
the need to conduct massive open market operations to reduce reserves when banks have
accumulated large amounts of excess reserves. Nevertheless, if a bank expects that the
Fed will provide it with discount loans if it gets into trouble, then it will be willing to take
on more risk, knowing that the Fed will come to the rescue if necessary. The Fed’s
lender-of-last-resort role has thus created a moral hazard problem similar to the one
created by deposit insurance: Banks take on more risk, thus exposing the deposit
insurance agency, and hence taxpayers, to greater losses.
when the zero-lower-bound problem occurs, central banks use nonconventional monetary
policy tools, which involve liquidity provision, asset purchases, and commitment to
future policy actions. Liquidity provision and asset purchases lead to an expansion of the
central bank balance sheet, which is referred to as quantitative easing. Expansion of the
central bank balance sheet by itself is unlikely to have a large impact on the economy, but
changing the composition of the balance sheet, which is accomplished by liquidity
provisions and asset purchases and is referred to as credit easing, can have a large impact
by improving the functioning of credit markets.
Explain how monetary policy tools can affect the Short-term interest rate in market for
bank’s reserves, draw figures for illustration
an open market purchase causes the federal funds rate to fall, whereas an open market
sale causes the federal funds rate to rise. the interest rate paid on reserves, ior, sets a
floor for the federal funds rate.
Strategies in conducting monetary policies: monetary targeting, inflation targeting,
interest rate/implicit nominal anchor
Monetary targeting (MT) is a simple rule for monetary policy according to which the
central bank manages monetary aggregates as operating and/or intermediate target to
influence the ultimate objective, price stability. Under MT, the inflation target is not
announced and the central bank intervention is concentrated only on the money market.
Typically, the central bank sets the interest rates to control monetary aggregates, which
are considered the main determinants of inflation in the long run. Thus, controlling
monetary aggregates would be equivalent to stabilising the inflation rate around the target
value.
Implicit nominal anchor
The Federal Reserve’s monetary policy has evolved over time. From the 1980s through
2006, the Federal Reserve set an implicit, not an explicit, nominal anchor. As with
inflation targeting, the central bank used many sources of information to determine the
best settings for monetary policy. The Fed’s forward-looking behavior and stress on price
stability helped discourage overly expansionary monetary policy, thereby ameliorating
the time-inconsistency problem.
Despite its demonstrated success, this monetary policy lacked transparency and was
inconsistent with democratic principles.
Current framework of monetary policy of FED
The Federal Reserve has a mandate from Congress to promote stable prices and
maximum sustainable employment. The Federal Open Market Committee’s (FOMC’s)
monetary policy framework spells out its strategy to achieve these goals over the medium
and longer run.
During 2019 and the first half of 2020, the Fed undertook a review of its monetary policy
strategy, tools and communications. Following that review, the Fed introduced a new
monetary policy framework in August 2020.
The FOMC made several key changes to its statement on longer-run goals and monetary
policy strategy, a few of which I will discuss here.3
Two of the main changes were related to the employment side of the Fed’s mandate. In
the updated statement, the FOMC stressed that the employment goal is broad-based and
inclusive, affecting all parts of the labor market and not just certain segments. The
updated statement also suggests that monetary policy decisions will aim to reduce
shortfalls—rather than deviations (as the prior statement said)—of employment from its
maximum sustainable level. With this second change, the FOMC is stressing that it will
react to high unemployment but not to particularly low unemployment unless inflation is
threatening the economy.
Another key change to the statement on longer-run goals is related to how the FOMC
aims to achieve the price stability goal. Under the new framework, the FOMC will focus
on hitting an inflation rate of 2% on average over time. To do so, the FOMC will aim for
inflation to run moderately higher than the 2% target for some time to make up for past
misses of inflation to the low side of the target. This new strategy is referred to as flexible
average inflation targeting, and it should help center longer-term inflation expectations at
2% and reinforce the inflation target.
Chapter 18
What is exchange rates and why are they important?
The price of one currency in terms of another is called the exchange rate. There are two
kinds of exchange rate transactions. The predominant ones, called spot transactions,
involve the immediate (two-day) exchange of bank deposits. Forward transactions
involve the exchange of bank deposits at some specified future date. The spot exchange
rate is the exchange rate for the spot transaction, and the forward exchange rate is the
exchange rate for the forward transaction. When a currency increases in value, it
experiences appreciation; when it falls in value and is worth fewer U.S. dollars, it
undergoes depreciation
Foreign exchange rates (the price of one country’s currency in terms of another’s) are
important because they affect the price of domestically produced goods sold abroad and
the cost of foreign goods bought domestically. When a country’s currency appreciates
(rises in value relative to other currencies), the country’s goods abroad become more
expensive, and foreign goods in that country become cheaper (holding domestic prices
constant in the two countries). Conversely, when a country’s currency depreciates, its
goods abroad become cheaper, and foreign goods in that country become more
expensive.
Explain determinants of exchange rates in long-run and short-run
Determinants of exchange rates in the long run
Law of one Price
The starting point for understanding how exchange rates are determined is a simple
idea called the law of one price: If two countries produce an identical good, and
transportation costs and trade barriers are very low, the price of the good should be the
same throughout the world, no matter which country produces it.
When certain conditions are taken into account, the law of one pricing stipulates that the
price of an identical item or commodity will be the same around the world, regardless of
location.
Relative prices, which are defined by the relative supply of money across countries and
the relative real demand for money across countries, govern the exchange rate in the long
run. resulting in a corresponding devaluation of the national currency (through PPP).
Exchange rates, like any other price in a local economy, are determined by supply and
demand – in this case, supply and demand for each currency. The following factors
influence a currency's supply in the foreign exchange market: Demand for that currency's
goods, services, and investments. If a factor increases the demand for domestic goods
relative to foreign goods, the domestic currency will appreciate; if a factor decreases the
relative demand for domestic goods, the domestic currency will depreciate.
Trade barriers, preferences for domestic versus foreign goods, productivity, inflation and
interest rate are among the many factors that influence exchange rates. The purchasing
power of a currency depreciates due to inflation. The demand for the currency will fall as
long as inflation is high.
The combination of supply and demand determines exchange rates, just as it does other
prices. The supply and demand for a currency are both equal at the equilibrium exchange
rate. Changes in the exchange rate occur when the supply or demand for a currency shift.
Determinants of exchange rates in the short run
In the short run, exchange rates are determined by changes in the relative expected return
on domestic assets, which cause the demand curve to shift. Any factor that changes the
relative expected return on domestic assets will lead to changes in the exchange rate.
Such factors include changes in the interest rates on domestic and foreign assets, as well
as changes in any of the factors that affect the long-run exchange rate and hence the
expected future exchange rate.
What is PPP and interest parity condition and applications of these theories.
PPP
One of the most prominent theories of how exchange rates are determined is the theory of
purchasing power parity (PPP). It states that exchange rates between any two currencies
will adjust to reflect changes in the price levels of the two countries. The theory of PPP is
simply an application of the law of one price to national price levels rather than to
individual prices. In reality, purchasing power parity is difficult to achieve, due to various
costs in trading and the inability to access markets for some individuals. The formula for
purchasing power parity is useful in that it can be applied to compare prices across
markets that trade in different currencies. As exchange rates can shift frequently, the
formula can be recalculated on a regular basis to identify mispricings across various
international markets.
interest parity condition
Interest rate parity (IRP) is a theory according to which the interest rate differential
between two countries is equal to the differential between the forward exchange rate and
the spot exchange rate.
interest parity condition is a commonly employed technique in making exchange rates
forecasts. Forecast under this condition are made by inputting the spot exchange rates and
the interest rates in the domestic and foreign countries respectively.
IRP is the fundamental equation that governs the relationship between interest rates and
currency exchange rates. The basic premise of IRP is that hedged returns from investing
in different currencies should be the same, regardless of their interest rates. IRP is the
concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and
sale of an asset to profit from a difference in the price). Investors cannot lock in the
current exchange rate in one currency for a lower price and then purchase another
currency from a country offering a higher interest rate.
Increasing domestic trade barriers (raising tariffs on foreign products) reduces demand
for foreign products (imports) relative to domestic products, which reduces the demand
for foreign currency, reduces the value of foreign currency, increases the value of
domestic currency.
The value of the indian rupee today will appreciate
The current exchange rate is 0.75 euro per dollar, but you believe the dollar will decline
to 0.67 euro per dollar. If a euro-denominated bond is yielding 2%, what return do you
expect in U.S dollars?
Calculation of the return you expect in US dollars:
Formula we will use here:
Forward rate = Spot rate x [(1+Return in Euro) / (1+Return in US)]
0.67 = 0.75 x [(1+0.02) / (1+ Return in US)]
(1+ Return in US) = 0.75 x 1.02 / 0.67
Return in US = 1.1418 - 1
Return in US = 0.1418 or 14.18%
So, the return you expect in US dollars is 14.18%
Type of questions: short question/problems and answer (as much details as possible
is better), give examples (with analysis and explanation), draw relevant figures (with
explanations)