Summary - Money and Banking midterm exam summary - Chapter 1 - 9 PDF

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Money and Banking midterm exam summary - Chapter 1 - 9...

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Money and Banking Midterm Exam Summary Chapter 1- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The bond and stock markets The structure of the financial system Business cycles, money supply, interest rates and inflation Fiscal and Monetary Policies Chapter 2- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The structure of the various financial markets The various financial market instruments The function of financial intermediaries Types of financial intermediaries Regulation in the financial system Chapter 3- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The definition, meaning, functions and forms of money M1 and M2 Chapter 4- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The concept of Present value and the simple calculation Types of credit market instruments Difference between real interest rates and returns Difference between real and nominal interest rates Chapter 5- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The determinants of asset demand The Bond market equilibrium and how shifts in demand &supply affect it Chapter 6- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text How risk, liquidity and income tax affects interest rates How term structure affects interest rates…The various theories Chapter 7- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text How is the price of common stock computed and set? One period valuation Theory of Rational Expectations and the implications Chapter 8- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The 8 basic facts about financial structure and the various reasons for each. Chapter 9- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text The various financial crisis and its stages both domestic and overseas Chapter 10- Review all highlighted definitions in the text Review all Tables, Figures and applications in the text Bank balance sheet part The various principles of bank management and their application

Chapter 1 Definitions: Financial markets- markets in which funds are transferred from people with an excess of available funds to those with a shortage Security- claim on the issuer’s future income Asset- financial claim or piece of property that is subject to ownership Bond- debt security that promises to make payments periodically for a specific period of time Interest rate- cost of borrowing, or the price paid for the rental of funds Common stock- represents a share of ownership in a corporation Financial intermediaries- borrow funds from people who saved and in turn make loans to others Financial crises- major disruption in financial markets characterized by sharp declines in asset prices and the failures of financial and non-financial firms Banks- financial institutions that accept deposits and make loans E-finance- ability to deliver financial services electronically Aggregate price level- average price of goods and services in an economy Inflation- continual increase in price level Inflation rate- rate of change of the price level Monetary policy- management of money and interest rates Central bank- responsible for the conduct of a nations monetary policy Federal Reserve System- United states central bank Fiscal policy- decisions about govt. spending and taxation Budget deficit- excess of govt. expenditures over tax revenues Budget surplus- tax revenues exceed govt. spending GDP- measure of aggregate output The Bond and Stock Markets

The Bond Market and Interest rates:  A bond is a debt security that promises to make payments periodically for a specific period of time.  The bond market is especially important to economic activity because it enables corporations and governments to borrow to finance their activities and because it is where interest rates are determined. The Stock Market:  Common stock represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation.  Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities  Stock market is the most widely followed financial market.  Stock market is also an important factor in business investment decisions because the price of shares affects the amounts of funds that can be raised by selling newly issued stock The Structure of the Financial System  The financial system is comprised of many different types of private sector financial institutions like banks, insurance companies, mutual funds, finance companies and investment banks (all regulated by the govt.)  Use of financial intermediaries to make loans Business cycles, Money supply, interest rates and inflation Business Cycles:  the upward and downward movement of aggregate output produced in the economy.  Ex. If output is rising, finding a good job will be easier, and vice versa Money Supply(money):  Anything that is generally accepted in payment for goods/services or in the repayment of debts Inflation:  A continual increase in the price level. A continuing increase in the money supply can be an important factor causing inflation. Interest rates:  The cost of borrowing, or the price paid for the rental of funds.  Interest rates have an impact on the overall health of the economy because they affect not only consumer’s willingness to spend or save, but also businesses investment decisions.

Chapter 2 Definitions: Liabilities- IOU or a debt for the individual or firm that buys them

Capital- wealth, either financial or physical, employed to produce more wealth Maturity- the number of years until the instruments expiration date Short term- maturity of less than a year Long term- maturity is 10 years or longer Intermediate term- between 1 and 10 years Equities- claims to share in the net income and the assets of a business Dividends- periodic payments made by equities Primary market- financial market in which new issues of a security (bond or stock) are sold to initial buys by corporations bowing the funds Secondary market- financial market in which securities that have previously been issued can be resold Brokers- agents of investors who match buyers with sellers of securities Dealers- link buyers and sellers by buying and selling securities at stated prices Liquid- quickness a financial instrument can be converted to cash Exchanges- buyers and sellers meet in one central location to conduct trades Over the counter market- dealers at different locations stand ready to buy and sell securities to anyone who comes to them and will accept their prices Money market- financial market where only short term debt instruments are traded Capital market- market where longer-term debt instruments and equity instruments are traded Default- the party issuing the debt instrument is unable to make interest payments or pay off the amount owed at maturity Currency- paper money or coins Federal funds rate- interest rate on federal funds loans Mortgages- loans to households or firms to purchase land, housing, or other real structures

Mortgage backed securities- bond-like instrument backed by a bundle of mortgages, whose interest and principal payments are collectively paid to the holders Foreign bonds- sold in a foreign country denominated in that country’s currency Transaction costs- time and money spent carrying out financial transactions Economies of scale- reduction in transaction costs per dollar of transactions as the size of transactions increase Liquidity services- services making it easier for customers to conduct transactions Risk- uncertainty about the returns an investor will earn on an assets Risk sharing- method of reducing risk where financial intermediaries create and selling assets people are comfortable with. Diversification- investing in a collection (portfolio) of assets whose returns do not always move together Asymmetric information- when one party doesn’t know enough about the other party to make accurate decisions Adverse selection- problem caused by asymmetric information before the transaction occurs. (ex. Bad credit risks) Moral hazard- problem caused by asymmetric information after the transaction occurs. It is the risk that the borrower might engage in activities that are undesirable from the lenders point of view. Conflicts of interest- moral hazard problem when a person or institution has multiple objectives and has conflict between those objectives Thrift institutions- savings and loan associations, mutual savings banks, and credit unions Underwrite- selling securities by purchasing them from the corporation at a pre-determined price and reselling them in the market Financial panic- asymmetric information can lead to widespread collapse of financial intermediaries

Structure of the various financial markets Debt and equity markets: two ways to obtain funds in the financial market

1) issue a debt instrument such as a bond or a mortgage. Pays the holder of the instrument a fixed amount at regular intervals until maturity when final payment is made 2) can also issue equities such as common stock, which are claims to share in the net income and the assets of a business. a. Equity holders are residual claimant. Businesses must pay debt holders before equity holders Primary and secondary markets: 1) investment banks underwrite securities in the primary market a. new issues of a security are sold to initial buyers by the corporation borrowing the funds 2) brokers and dealers work in the secondary market a. make it easier and quicker to sell financial instruments to raise cash b. they determine the price of the security that the issuing firm sells in the primary market. Exchanges and over-the-counter markets: 1) Exchanges-buyers and sellers of securities meet in one central location to conduct trades. 2) OTC markets- dealers at different locations who have an inventory of securities stand ready to buy and sell securities to anyone who comes to them and is willing to accept their prices Money and capital markets: 1) money markets- only short term debt instruments are traded a. more widely traded than longer term securities, so they tend to be more liquid 2) capital markets- longer term debt instruments are traded and equity instruments are traded. a. Often held by financial intermediaries which have little uncertainty about the amount of funds they will have available in the future Various financial market instruments Money market instruments 1) US Treasury bills: short-term debt instrument issued by the govt. They pay a set amount at maturity and have no interest payments but are sold at a discount. a. Most liquid of all money market instruments, most actively traded and are the safest b/c no possibility of default 2) CD’s: debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price a. Sold in the secondary market 3) Commercial paper: short term debt instruments issued by large banks and well-known corporations. 4) Repurchase agreements: short term loans for which treasury bills serve as collateral. 5) Federal funds: typically overnight loans between banks of their deposits at the Fed. Usually when banks don’t have enough deposits at the Fed Capital market instruments 1) Stocks: equity claims on the net income and assets of a corporation.

2) Mortgages and mortgage backed securities: mortgages are loans to households or firms to purchase more land or housing. a. Mortgage backed securities are a bond like debt instrument backed by a bundle of individual mortgages, interest and principal payments are collectively paid to the holders 3) Corporate bonds: long term bonds issued by corporations with strong credit ratings. Sends the holder and interest payment twice a year and pays off the face value when the bond matures. 4) US govt. securities: long term debt instruments issued by the US treasury to finance the deficits of the federal government 5) Govt. Agency Securities: long term bonds are issued by various govt. agencies to finance items like mortgages, farm loans, or power generating equipment. 6) State and local govt. bonds: Aka municipal bonds, long term debt instruments issued by state and local govt. to finance expenditures on schools, roads or other programs. 7) Consumer and bank commercial loans: loans to consumers and businesses are made principally by banks, but in case of consumer loans, by finance companies Financial Intermediation: financial intermediation allows “small” savers and borrowers to benefit from the existence of financial markets. They borrow funds from the lender-savers and then uses these funds to make loans to borrower-spenders Functions 1) lower transaction costs 2) reduce the exposure of investors to risk 3) deal with asymmetric information problems a. adverse selection-try to avoid selecting the risky borrower b. moral hazard- ensure borrower will not engage in activities that will prevent them from repaying the loan. Types 1) Depository institutions(banks):accept deposits from individuals and institutions and make loans. a. Commercial banks, mutual savings banks, savings and loan associations, credit unions 2) Contractual savings institutions: financial intermediaries that acquire funds at periodic intervals on a contractual basis. a. Insurance companies and pension funds 3) Investment intermediaries: includes finance companies, mutual funds and money market mutual funds a. Finance companies- raise funds by selling commercial paper and by issuing stocks and bonds b. Mutual funds- acquire funds by selling shares to many individuals and using proceeds to purchase diversified portfolios of stocks and bonds Regulation of the financial system 1) To increase the information available to investors: a. Reduce adverse selection and moral hazard problems b. Reduce insider trading

2) To ensure the soundness of financial intermediaries: a. Restrictions on entry b. Disclosure of information c. Restrictions on assets and activities (control holding of risky assets) d. Deposit insurance (avoid bank runs) e. Limits on competition i. Branching ii. Restrictions on interest rates Chapter 3 Definitions: Currency- paper money and coins Wealth- the total collection of pieces of property that serve as to store value Income- a flow of earnings per unit of time Medium of exchange- used to pay for goods and services Unit of account- used to measure value in the economy Store of value- a repository of purchasing power over time Liquidity- relative ease and speed with which an asset can be converted into a medium of exchange Hyperinflation- inflation rate exceeds 50% per month Electronic money- money that exists only in electronic form (debit cards) Monetary aggregates- measures of the money supply M1- most liquid assets: currency, checking account deposits and travelers checks M2- M1 plus assets that are not as liquid: small denomination time deposits, savings deposits and money market deposit accounts Money: anything that is generally accepted in payment for goods and services or in the repayment of debts. This includes currency (paper and coins), checking account deposits, and often savings deposits.

Functions Medium of exchange- money is used to purchase goods and services. Promotes economic efficiency by minimizing the time spent in exchanging goods and services Unit of account- used to measure value in the economy in terms of money

Store of value- used to save purchasing power from the time income is received until the time it is spent. Allows us the ability to wait to spend money Forms of money Commodity money- money made up of precious metals or another valuable commodity Fiat money- paper currency decreed by government as legal tender but not convertible into coins or precious metal Checks- instruction from you to your bank to transfer money from your account to someone else’s account when they deposit the check Electronic payment- banks made it possible to pay bills online E-money- money that exists only in electronic form. Debit cards enable consumers to purchase goods by electronically transferring funds directly from their bank account to a merchants account Chapter 4Definitions: -Cash Flows: Different debt instruments have very different streams of cash payments to the holder with very different timing. Cash payments to the holder of a security. -Coupon bond/face value- Pays the owners of the bond a fixed interest payment (coupon payment) every year until maturity date, when a specified final amount is repaid (Face value/par value) -Current Yield- An approximation of the yield to maturity that equals the yearly coupon payment divided by the price of a coupon bond -ex: P = C/i where: C = Yearly Payments = $100 P= Price of Perpetuity (Consol) = $2000 Thus; I = C/P = 100/2000; I = .05 or 5 % -Consol or Perpetuity- It is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever. -Coupon Rate- The dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond. -Discount Bond (Zero-Coupon Bond)- A bond bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments, it just pays off the face value. -Fixed-payment Loan (fully amortized loan)- The lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years.

-Indexed bond- Bonds whose interest and principal payments are adjusted for changes in the price level. -Interest-rate Risk- The possible reduction in returns associated with changes in interest rates. -Nominal interest rate- An interest rate that does not take into account inflation. -Present discount value- concept based on the commonsense notion that a dollar paid to you one year from now is less valuable than a dollar paid to you today. -Present value- The value of a dollar today verse in the future. -Rate of Capital Gain- The change in the bonds price relative to the initial purchases price. -Real interest rate- The rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. -Real Terms- in terms of real goods and services you can buy. -Return (Rate of Return)- How well a person does by holding a bond or any other security over a particular time period is accurately measured by the Return, or, in more precise terminology, the Rate of Return. -Simple Loan- Lender provides the borrower with an amount of funds (called the principal) that must be repaid to the lender at the maturity date, along with an additional payment for the interest. -Yield to Maturity- The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today. The concept of Present value and the simple calculation Present value: -PV =

FV (1 + i)^n

where FV = Future Value I = annual Interest Rate N = number of years Ex: FV= 133 i = .10 n=3 PV =

$133 (1+.10)^3

Future Value: -FV = PV(1 + i)^n ex: i = .10; PV = 100 FV in 1 year = 100(1+.10) = 110 FV in 2 years = 100(1 + .10)^2 = $121 ETC

Types of credit market instruments (Simple load, Fixed Payment Loan, Coupon Bond, Discount Bond) Simple loan- lend provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest.

Fixed Payment Loan (Fully amortized loan)- in which the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years. -Typically auto l...