Financial Markets and Institution PDF

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Week 1

01/14/2014

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Financial Institutions  

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Banks, Credit Unions, Pension Funds, Life Insurance. Consumers put $ in, FI gives interest back out

 Businesses put money in, receive interest back Financial Markets  Short Term: Money Market (Like Cash)  

Long Term: Stocks and Bonds Consumers buy and get money when selling (Dividends and capital

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gains or losses) Businesses buy and get money for their investments

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Expansion: Ups in business cycle

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Contraction: Downs in a business cycle

Week 1

01/14/2014

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Biggest 4 Banks  Wells Fargo, Chase, City Bank, Bank of America Interest is the Price difference between seller and buyer of money

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Real Rate: Compensation for not spending money at the moment Inflation Premium: Products go up in price over time

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Real Rate + Inflation Premium= Risk- Free Rate: Risk Free Rate(Treasury Bills) + Risk Premium=Required Rate of

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Return  Risk Premium: Risk in a security  Market Risk  

Default Risk Liquidity Risk

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 Interest Rate Risk Required Rate of return

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Why Interest Rates differ between securities

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Week 2

01/14/2014

 Wealth and Income Increases: Supply of loanable funds increases, demand of loanable funds stays the same  Risk Premium has decreased: Supply of loanable funds decreases, demand of loanable funds stays the same 

Near-Term Spending Needs: Supply of loanable funds decreases

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Monetary Expansion: Supply of loanable funds increases Economic Growth: Supply of loanable funds increases: demand of

loanable funds increases 

Utility derived from assets borrowed: decrease in supply funds

 :Increase in demand  Restricted covenant: Supply of loanable funds increases: Demand of loanable funds decreases  

Economic conditions: Supply of loanable funds increases: Foreign countries are buying debt: Supply of loanable funds goes up

 Inflation premium increases: Demand of loanable funds goes up: Supply goes down: interest rates go up   Market Segmentation Theory: There are Short, Medium and Long Term investors 

 Individual markets with individual supply and demand curves Expectations Theory: what the rates are supposed to be   

1 year = .05% 1 year (next year) = .075% 1 year (2 years from now) = 1.00

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1 year( 3 years from now) = 1.10 Current (next year) = (.05+.075)/2

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Current ( 2 years from now) = (.05+.075+1.0)/3 Liquidity Premium Theory: The longer you hold your money, the more premium you are going to add

(Simple Interest): FV = P * R* T (Compound Interest): FV = PV( 1+i)^n (Ex) P = 1000: R = .05: T = 4

Week 3

01/14/2014

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Coupon Rate determines payments

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A = Annuities = 50 P = Principal = 1000

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5% = coupon rate PVA = A ((1/(1+i)^n)-1)/i

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PV = P (1/(1+i)^n)

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Present Value of Cash Flows  

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P (1/(1+i)^n) + A ((1/(1+i)^n)-1)/ i i = market rate or yield to maturity

Liability Management  Bring in deposits at lowest rates Asset Management 

Reduce risk of assets by taking on low default risk by diversifying types o Net Interest Margin: (Interest Income – Interest Expense) / Assets

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Liquidity Management  Maintaining sufficient cash Capital Adequacy Management  

Ratio of debt to equity ratio and how best to acquire equity Return on Assets = Net Profit after Taxes / Assets o Net Profit After Taxes = Net Income applicable to U.S. Bancorp shareholders

 Return on Equity = Net Profit After Taxes / Equity  Equity Multiplier Amount you can pay today to make it 0     

P* (1/((1-(1/(1+i))/i)))

Week 4 

01/14/2014

Po = Principal( 1/ (1+i)^n) + Interest Payments 1-(( 1/ (1+i)^n)/i)

 Government Safety Net  Provision: Reflects those that are depositing money with banks   

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 Negative: Requires more capital so hurts investing. Restrictions on Bank Asset Holdings & Capital Requirements  Provision: More risky assets need to be lessened. 

Regulator: Federal Reserve, FDIC (Federal Depository Insurance Corporation)

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Positive: Banks have enough money to cover bad investments Negative: Harder for risky businesses to get loans, Banks make less

money Chartering & Bank Examination  Provision: Banks must choose a kind of charter(State or Federal) 

and examination Regulator: OCC or state regulators, Federal Reserve or FDIC

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Positive: Fewer New Entrants Negative: Fewer Entrants, Higher Costs for Consumers, Adequacy

of Examination Assessment of Risk Management  Provision: Banks and Financial Institutions are required to assess 

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Regulator: by FDIC Positive: More Willing to deposit cash

own risk Regulator: FFIEC, FSOC( under the Fed)

 Positive: Helps prevent future financial crisis  Negative: Reduces profits for banks, reduces bank freedom Disclosure Requirements  

Provision: Releasing Financial Statements Regulator: SEC, FDIC

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Positive: Stay away from insider trading Negative: Accrual Statements, Accounting records and financial

statements have GAAP and IFRS Consumer Protection  Provision: Prevent Banks from discriminating 

Regulator: Federal Reserve, Dodd-Frank Act

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Positive: Protects consumers

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Negative: Banks need more people to work at it, banks tell you everything so no excuses

Restriction on Competition  Provision: keep number of banks in area down   

Regulator: Anyone who charters you, State or Fed Positive: less competition for banks Negative: less choices for consumers, Prices go up

Week 6 

01/14/2014

Credit Unions 

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Who: Not-for Profit depository institutions mutually organized by their members (depositors). o Three tiers of credit unions: 

National level: U.S. Central Credit Union

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State or regional level: Corporate Credit Unions Local level: Credit Unions

What: o Small Consumer Loans o Mortgage Loans o Designed to serve members, not make profit  

Lower Fees Exclusive membership

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Where: Cannot serve general public o Can join same credit union in different branch

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When: Established in the early 1900’s as self-help organizations. o The first credit unions were organized in the North-east,

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initially in Massachusetts. Members paid an entrance fee and put up funds to purchase at least one deposit share. How: 62% are federally chartered and subject to the National Credit Union Administration (NCUA). If not then state & private depositors

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Savings & Loans/ Savings & Banks  Who: Accepting savings deposits and paying interest on those 

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deposits, gives out loans. What: Specialized in savings deposits/ credit card issuing/ Checking/ CD’s/ IRA’s etc… o Keep money saved for you and pay interest Where: Most located in Mid-Atlantic and industrial Northwest regions of U.S. o Originated in Europe for Local and Regional outreach o Subject to banks regulations

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When: Started in Europe in 18th and 19th century and provided easily accessible savings for all population o Older Banks: Most ceased to exist in 1980’s

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How: Federally Chartered

o Main Regulators : Office of Thrift Supervision (OTS), Federal 

Depository Insurance Corporation (FDIC) , State Regulators Finance Companies 

Who: Sales Institutions, Personal Credit Institutions, Business Credit Institutions, Captive Finance Companies

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What: Business and Consumer Loans, Mortgages o Non-Depository Organization

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Where: Non Limitations o Found in Strip Malls

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When: First Created during Great Depression

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How: Regulated by Federal Reserve, State Regulators, NCUA, (FSOC) Federal Services Oversight Council

Week 7 

01/14/2014

Financial Institutions  Banks o Assets: Deposits  Pay Low Interest Rates o Liabilities: Loans   

 Make High Interest Rates, Low Risk Interest Rate Risk Default Risk Asymmetric Information o Adverse Selection  People that want it most have the most need.  Happens before the transaction o Moral Hazard 

After the transaction

5 C’s of Credit  Capacity: o Do they have a job? o Businesses: Production 

Collateral o Did they put anything up for the Credit? o Businesses: Capital Structure

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Capital o Do they have any other capital around? o Businesses: Capital Structure

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Conditions o Are they employed in good environment? o Businesses: Production, Management, Marketing

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Character o Do they have good character?/ Good Credit Score? o Businesses: Management

EAR(Effective Annual Interest Rate):  

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Interest Rate / (1- Compensating Balance %) (Ex) 6.00% / 1-.20 = 7.5%

AnnualCreditReport.com Altman Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5  X1 = Net Working Capital/ Total Assets

o (Current Assets – Current Liabilities)/ Total Assets 

X2 = Retained Earnings / Total Assets

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X3 = EBIT/ Total Assets X4 = Market Value of Equity / Book Value of Long Term Debt X5 = Sales / Total Assets

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Z = 3.104 B) Because greater than 2.99 it is a low default risk

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C) o Sales: 500 to 450 o COGS: 360 to 360 o Gross: 140 to 90 o Interest: 62 to 62 o EBT: 78 to 28 o Taxes: 56 to 16 o (EAT)Net Income: 22 to 12 o Z score = 1.2(.0714) + 1.4(12/700) + 3.3(90/700) + 0.6(100/150) + 1.0(450/700) = 1.577 o

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Do 14. 

RAROC: One year income on a loan / loan or capital risk o Income = Interest = 5,000,000 * 10.28= 514,000 o Upfront Fees = 5,000,000 (.001) = 5000 o Service Fees = 5,000,000(.0005) = 2500 o Less cost of funds = (5000,000) o = 21,500 o basis point = 1/100 of 1% o 21,500 / (5,000,000(.03)(.90)) = .1593 = 15.93%

Week 7 

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01/14/2014

Feb 18, Bitcoin's Crisis Is Turning Point for Currency 

http://online.wsj.com/news/articles/SB10001424052702304899704 579388761205702496?mod=ITP_moneyandinvesting_0

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First, the current infrastructure—largely anonymous, anchored by unregulated overseas exchanges and vulnerable to manipulation by

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criminals—must be overhauled through the creation of U.S. exchanges overseen by financial watchdogs. Second, institutional money like pension funds will have to invest in

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bitcoin to curb its wild price volatility. Third, banks will have to view bitcoin as legitimate and enable

customers to exchange it for dollars and cents. Feb 19, Americans Ramp up Borrowing  http://online.wsj.com/news/articles/ SB10001424052702303945704579390924287626780 Feb 20, Fed Puts Rate Increase on Radar 

http://online.wsj.com/news/articles/ SB10001424052702304275304579393141610162738? mod=ITP_pageone_0

Week 8

01/14/2014

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Loans

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 Net Loans = Average Loans Deposits 

Core Deposits = (non-interest) + (Interest bearing) + (Time Deposits) o Non-interest = use % given o Interest-Bearing = use % given o Time Deposits = use % given

Financing Gap = Loans – Core Deposits Commerce Core Deposits  25% non int  40% savings 

 80% time deposits Ratio 

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Borrowed funds to Total Assets o (Short Term Borrowings + Long-term debt + Other Liabilities) / Total Assets Core Deposits to Total Assets o Look at Core Deposit Above/ Total Assets

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Loans to Deposits o Total Loans/ Total Deposits

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Commitments to Lend to Total Assets o

Week 8  

01/14/2014

3 year $30 million loan  

Interest Payments = $425 Current Market Rate: 8% or .08

Year

Cash Pmt.

P.V. Cash Pmt.

Weight

Weighted Maturity

1

4.25

4.25/ 1.08 = 3.9352

3.9352/34.7677 = .1132

.1132(1) = .1132

2

4.25

4.25/(1.08)^2 = 3.6437

3.6437/34.7677 = .1048

.1048(2) = .2096

3(int)

4.25

4.25/(1.08)^3

.0970(3) = .2910

30

= 3.3738 30/(1.08)^3 = 23.815

3.3738/34.7677 = .0970 23.815/34.7677 = .6850

3(principle )

.6850(3) = 2.0550

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Weight Total = 34.7677 Duration = Total Weighted Maturity = 2.6688 years  

1.5 Cash Payment = 2.85 years 3.12 = 2..73

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Portfolio Duration = 2.67(.3) + 2.85(.3) + 2.73(.4) = 2.748 GAP = Risk-Sensitive Assets – Risk Sensitive Liabilities

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Impact on bank income = GAP * Change in interest)  (Example)  RSA = 20 mil  

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RSL = 48 I = 4.00% - 4.8%

 Impact = (20-48) * (.048-.04) = -224,000 Duration Gap Analysis %Change Portfolio = -Duration * (Change in interest/(1+i))

Asset

Value

Duration

Liabilities

Value

Duratio n

Bonds

115 mil

9 years

Demand

690,000,00

1.0

Deposits

0

Savings Account

160,000,00

= 1+.6667 +2.7778

Consumer

245 mil

2 years

Loans Commercial

575 mil

.5

0

5 years

Loans Total Assets

1.035 bil

Duration of Assets

(115/103 5*9)+

(345/1035 *2) +

(575/1035 * 5)

Duration of Liabilities

690/2290 *1

1600/2290 * .5

= .3103 +.2493

= .6506

=4.445

 Example change in portfolio (assets) = -444 * ((.048-.4)/(1+.04)) = 3.42%  Example change in portfolio (liab) = .6506 *((.048 -.04)/ 1.04) = -.5%   

Change in net word = change in assets- change in liabilities =1.035 bil *(-.0342) – (2.290 bil *-.005) = -35.397 mil – (-11.45 mil)  =-23.947 mil

week 10

01/14/2014

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Who:  Investment & Security Firms

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Nature of Involvement ( what)?  Middle-man

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Which instruments utilized?  Mutual Funds, Closed Ended Funds, UIT, Treasury Bonds, Commercial Paper, Federal funds Repurchase agreements,

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Negotiable Cd’s, Banker’s Acceptances How Price? 

Make money off difference between bid/ ask price

 Selling Price: 973,750 Face Value: 1,000,000 Discount yield: ((1,000,000– 973,750) / 1,000,000) * (360/65) = 14.538 % Bond equivalent yield: ((1,000,000– 973,750) / 973,750) * (365/65) Equiv. Annual Yield: ((1+((.15138) / (365/65))) ^ (365/65) – 1 = 16.11 % Selling Price: 9,875 Face Value: 10,000 Discount yield: (10,000 – 9,875)/(10,000) * (360/68) = 6.618% Bond Equivalent Yield: (10,000-9,875)/(9,875) * (365/68) = 6.794% Equivalent Annual Yield = (1+((.06794)/(365/68))) ^(365/68) – 1 = 6.984% September 30,2010, July 7,2010  84 days between Asked Value % = .155 Price of ask= 10000 – [.00155 * (84/360) * 10,000] = 9996.383 Price of Bid = 10000 – [.00160 * (84/360) * 10,000] = 9996.267 October 28,2010 ; July 7, 2010 Price of Bid = 10000 – [.00158 * (112/360) * 10,000] = 9995.084

Week 12 

01/14/2014

Common & Preferred Stock  

Ownership interest in a public company Returns o Dividends plus Change in Price per share Price change could be either Capital Gain or Loss

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 Total Return

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 Dividends + Capital Gain/ Loss Total Return %

 Total Return/ Original Price  Dividend Yield + Capital Gains Yield. Constant Dividend Growth Model 

 Po = (Do *(1+g))/ (Re-g) Stock Market Indexes 

Major Indexes o Dow Jones o NYSE o Standard and Poor’s (S & P) o NASDAQ o Wilshire o Russell

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Price-weighted vs. Value-weighted o Price-weighted = Total all stock prices on index and divide by # of companies represented o Value-Weighted = Sum of market price * # of shares outstanding divided by # of companies represented

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 Bigger companies can pull the weight Market Efficiency 

Efficient Market Hypothesis o Criteria 

Prices adjust rapidly to new information

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Continuous market- new trades are close to price of previous trade

Able to absorb large amounts of money without destabilizing prices o Degrees of efficiency 

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Weak Form Efficient

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 Current Prices are based off of historical prices Semi-strong Form Efficient 

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All publically released information instantly affects the market

Strong Form Efficient  All information public and private affect the market

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History  Congress- during the peak year of the Depression- Passed the Securities Act of 1933 o Designed to restore investor confidence o Providing investors and the markets with   

More reliable information Clear rules of honest dealing

Main Purposes o Public companies must tell the truth

Week 13 

01/14/2014

Bank of America  

Depository Institution Financial Holding Company o Primary Services: 

Loans  Mortgage  

Car Business Loans

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ETF Trades Estate Planning  Life Insurance 

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Retirement Funds

Week 14 

01/14/2014

 A long-term loan secured by real estate Mortgages were used in the 1880’s, but massive defaults in the

agricultural recession of 1890 made long-term mortgages difficult to attain  Until post-WWII, most mortgage loans were short-term balloon loans with maturities of give years or less.  Term: longer-term mortgages have higher rates  Discount points: a lower rates negotiated for cash upfront.  

How do we get here How do we keep it from happening again

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What do we do about bonus’

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