Lecture#1
BUSINESS CYCLES
There is more or less a pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth.
At cyclical peak- economic activity is high relative to trend.At cyclical trough ??
Over time what causes the trend line to change ?
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More resources
Factors not fully employed allthe time.
What is inflation ?
Why worry about inflation instead of unempmt.?
Lecture #2
MARKETS
What are they ??
What makes a good market ??
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Can we name some “bad” markets ??
FINANCIAL MARKETS & INSTITUTIONS
I. Financial markets exist to aid in the most efficient allocation of capital
II. Financial Institutions facilitate this allocation of capital.
The players in the market are households, businesses and governments. How they play and
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what motivates them to play is critical to the well being of economies.
TYPES OF MARKETS
Primary – New fund raising
Secondary – Trading
There are specialized markets for fund raising and trading. The most important of these are:
Money Markets – Maturities < 1yr.
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Capital Markets – Maturities >1 yr.
Lecture
#3
FLOW OF FUNDS
Who are the players?HouseholdsBusinessesGovernmentsRest of the World
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All act at one point in time oranother as borrowers and providers.Funds arrive directly or indirectly
What is the role of Financial Intermediaries ?
To lower transaction costsTo lower riskTo provide better market
information
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Intermediaries also incur risks………
I/R risk
FX risk
Credit or default risk
What about Foreign Mkts & Intermediaries ?
Provide for borrowing or investing abroad
Important source of diversification
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Lecture #4
What is an interest rate ?
Compensation for lending or giving up one’s abilitiy to spend today.
Can be a measuring guideline governing corportate investing.
Why do we care about interest rates ?
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They influence the allocation of capital.
They impact the economy and decision
making.
How do we look at interest ratesand time ?
Concept of Present ValuePresent value allows you to
place a value on future funds. What might $10 today be worth 10years from now ?
The Present Value calculation converts cash flows received in
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the future to a value assuming receipt today (the PRESENT ).
How much is $3000 received in two years worth today if the interest rate is 4% ?
How much is $2000 next year and$3000 the year after worth today if the interest rate is 5%?
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Where do you hear the concept of Present Value applied quite often ?
U.S. Savings Bonds
Winning the lottery
Back to our first example :PV of $3000 received in 2
years @ 4% =
If the i/r is 2%....is PV higher or lower ?
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If the i/r is 6%.... is PV higher or lower ?
Why ????
Lecture #5
WHAT DETERMINES THE LEVEL OF I/R AT ANY GIVEN POINT IN TIME ?
The supply and demand of loanable funds. Same concept asthe supply and demand of goods
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and services you studied in Economics.
So there is a supply and demandcurve here as well.
SUPPLYHouseholdsBusinessesGovernmentsForeign investors
DEMANDHouseholdsBusinessesGovernmentsForeign
What might the supply and demand curve look like ?
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What might cause the curves to shift ?
SUPPLY:I/RWealthRisk Near term spending needsMonetary ExpansionEconomic Conditions
DEMAND:Current utilityEconomic conditionsRestrictiveness of nonprice
conditions.
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Lecture #6What are the factors that can affect the i/r for an individual security ?
Begin with the “real interest rate “
Direct correlation between inflation & i/r..
U.S. Treasuries become the benchmark..
What factors influence nominal i/r ?
Default risk15
Liquidity risk
Covenants- puts/calls
Term to Maturity
Ubiased Expectations Theory
Liquidity Premium Theory
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What exactly are bonds ?
Debt instruments – Secured/Unsecured
Coupon or Zero
PV = Face Value = Par
PV> Face Value= Premium
PV < Face Value = Discount18
These reflect the price of bonds. How does that relate to Yield….
Price and yield are inversely related. Why ?
Duration – measure of the weighted average time to maturity. That is, it takes
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into account the timing of payments. Any received before maturity will result in a shorter duration that the maturity date…..
Higher interest rates shorten duration. Why ?
Lecture #8
THE FEDERAL RESERVE SYSTEM
Objectives:
Moderate long-term i/r
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Maintain high level of employment
Stable prices
Economic growth
It’s duties:
Conduct monetary policy
Supervise/regulate depository institutions
Maintain stability of financial system
Provide payments services for governments
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Also check clearing & wire transfers
Independent of Executive BranchOversight by CongressChairman/Vice Chair appointed byPresident
12 Regional Banks 7 Member Board of Governors
5 of Regional Bank Presidents + Board of Governors comprise the Federal Open Market Committee (FOMC)
The objectives shown above are their job….What is important is how they doit….
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Lecture #9
MONETARY POLICY
What is it and how does it affect us ?
In essence it is an attempt to influence the amount of reservesthat remain in the banking system….which in turn affects i/r and the availability of credit…which ultimately affects the levels of employment,
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output, and prices and inflation. In other words the money supply.
MONETARY POLICY TOOLS
Open Market OperationsDiscount RateReserve Requirements
The FOMC impacts the economy thru its practice of buying and selling government securities inthe open market. In so doing they are either adding money (expanding) to the existing supply or taking it out (contracting).
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Discount rate – Rate Fed. Charges bank to borrow from it….In reality is only used as asignal to the market as to whichway the Fed wants to see rates go. The discount rate was lowered 11 time in 2001 in an attempt to stimulate the economy.
Bank reserves:Required – currently 10%Excess
How do these tools help expand the money supply ?
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How do these tools help contractthe money supply ?
Definitions of the money supply
Base
M1
M2
The FED selects a target and uses Monetary Policy to get to that target.
Most popular targets:
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Money Supply
Interest Rate
Lecture #10
MONEY MARKETS
Short term debt instruments < 1year
Active secondary market/ very liquid
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Capital markets > 1 year
Characteristics of money marketinstruments:
Large – usually $1 mil. +
Low default risk
Maturity of 1 year or less
Corporates and governments usually sell money market instruments to meet short term needs.
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TREASURY BILLS
Default risk free
Benchmark for other securitiespricing
Refinancing debt/govt. deficit/tax timing
Sold at auction weekly
Shortest maturity is 13 weeks.
Sold at a discount
Suppose you buy a 26 week T-bill for $9500 whose face valueis $10,000. What is the discount yield ?
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i = 10000-9500/10000 x 360/182 = 9.89%
FEDERAL FUNDS
Primarily overnight loans between banks.
One of the uses of their excessreserves.
FED sets the lending rate.
For all practical purposes are just lending cash between two banks.
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REPURCHASE AGREEMENTS (REPOS)
Actual sale of securities between two parties with agreement to repurchase at set date and price.
Is collaterized most often with govt. securities.
Normally 1-14 days but can go 90.
More secure than Fed Funds so has lower yield…often as much as 25 basis points.
Lecture #11
COMMERCIAL PAPER (CP)
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An unsecured promissory note issued by corporations.
Corporates with good credit can often borrow cheaper in thecp mkt. than from their banks. (see chart on page 135)…comparing cp rates to prime rate.
Normally held to maturity….up to 270 days.
Lower rated corporates can issue cp backed by LOC’s or bank lines of credit. Expensiveby effective….better than issuing long term if improving credit.
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Purchasers get internal approval on a credit and returnagain again.
Cp usually sold thru dealers like Goldman Sachs…agree to repurchase in event of default.
Rates are quoted on a discount basis NEGOTIABLE CD’s
Bank issued promissory notes. Specific maturity and rate. Trade in secondary market at negotiated price.
Normal maturities are 14-360 days.
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Unsecured issuance so yield is higher.
BANKERS ACCEPTANCES
A draft for payment backing a LOC issued against imported goods.Importer gets LOC guaranteeing payment to exporter. BA allows them to draw down money before delivery. Importer then reimburses the bank.There is a secondary market forBA’s.
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MONEY MARKET PARTICIPANTS
Issuer Investor
T-bills TreasuryFed/Banks/Cor
Fed Funds Banks Banks
Repos Fed/BanksFed/Banks/Cor
Cp Banks/CorpsCorps/FI’s
Neg. CD Banks FI’s/Corps
BA’s BanksBanks/Corps
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Where are there secondary markets ?
Where are yields the highest/lowest ?
Who are the important FI’s ?
Summary – Money markets are important to:
The Fed – for controlling the money supply.
Banks – to meet reserve requirement and asa place to use excess reserves.
Broker-Dealers – Keep the market moving
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Corporations - source of short term fundingand as a place to invest short term cash.
Other FI’s – A place to maintain liquidity.
INTERNATIONAL MONEY MARKETS
Foreigners are major investors in Treasuries
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Diversification and default free
Keep deposits in foreign countries to facilitate exhangeinto $.
LIBOR is major lending rate.
Now major rate measurement for all types of loans, not just foreign.
Borrowing is usually quoted as a spread over LIBOR…might be 350, 30 or 3…depending on the risk associated with the borrower.
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Lecture #12
THE BOND MARKET
Bonds are capital market instruments with maturities of greater than one year.
Typically fixed income ….offering interest a set time periods and the return of principal at maturity. A bond with a coupon of 8% would normally pay interest every sixmonths, 4% at a time.
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Treasury notes >1<10 yearsTreasury bonds >10 <31 yearsThey comprise about 26% of total bond market securities.
Both pay semi-annual interest and are sold at auction..but are sold at par unlike T-bills.Treasury also issues inflation adjusted bonds called TIPS.
They also sell STRIPS where each coupon payment is sold separately.
The secondary market in Treasury issues is huge. If a bond is sold between coupon payments the seller must pay the buyer the accrued
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interest..or discount the priceto account for it.
MUNICIPAL BONDS
Debt instruments issued by state and local governments. About 17% of all bonds o/s.Interest not taxed by feds or state investor lives in for bonds issued in that state.
Tax exemption lowers cost of bonds issuance for the governments because investors take a lower yield.
General obligation – backed by taxing powerRevenue bonds – backed by revenue of a project. General
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tax receipts cannot be used to pay off a revenue bond…thus is riskier. Industrial development bonds – normally for job creation.
How are municipal bonds sold ?
Underwritten/best efforts/negotiated basisSecondary market very thin.
CORPORATE BONDS
Comprise about 57% of o/s bonds.Normally issued to fund long term obligations.
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Rating agency comments are critical to price.
Debentures – no collateralSubordinated debentures – junior in statusConvertible bonds – debt that converts to equity at some point in time if certain thingsoccur.Callable bondsSinking funds
Moody’s/S & P / Fitch
Who are buyers of the various types of bonds?
Which bonds likely carry the highest and lowest yields ?
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INTERNATIONAL BOND MARKETS
Eurobonds – Sold outside the country of the currency in which they are issued. Could bedollar denominated bonds sold in Japan.
Foreign bonds – Bonds issued outside the home country but denominated in the host countrycurrency…Samurai bonds are dollar denominated bonds issuedby Japanese borrowers in the U.S.
Brady bonds – bonds substitutedin a restructuring of a less developed country’s debt.
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Longer term and lower rates. Backed by the U.S. Treasury
Sovereign bonds – specific country issued .
Lecture #13
MORTGAGES
Loans to purchase real propertysuch as a home, land or building.
75% of mortgages are for singlefamily dwellings.
Characteristics of a mortgage:Size, term, i/r, collateral
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Qualifications – fairly standard, income to value ratio(can you make the payments)Down payment – reduces default risk
Conventional vs. Insured.Maturity – 15/30 yr….. balloon payment
I/R – Fixed vs. ARMGreenspan ARM quotes.Amortization scheduleRefinancing depending upon ratecycle.
Originate with FI’s most of whom do not continue to carry them on their balance sheet.
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Sold off in secondary market thru securitization. Allows FI to enhance their liquidity and reduce i/r and credit risk.
What is securitization and how does it work?
Why securitize ?
Mortgage market very cyclical. Govt. subsidies are key to rolehousing plays in the robustnessof the economy. Home building may suffer as rates go up…
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Lecture #14
STOCK MARKETS
What is stock anyway ?Equity/ownership
How does one make a return from stock ownership ?
Common/Preferred
Dividends
Limited liability of ownership
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IPO’s /Seasoned offerings
Primary vs. secondary markets.
SEC/Registration/Red Herring/Shelf registration
The Markets:NYSE/NASDAQ/AMEX
How does trading occur on each market ?
Indices:DOW / S & P 500 / Wilshire 5000
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What causes prices to change on theMarket ?
Efficient market theory / Random walk
Lecture #15
FOREIGN EXCHANGE
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Global trade requires that we exchange currencies.
The foreign exchange rate is the ratio of one currency to another. How yen equal one dollar ?
Initially had fixed currency rates.And Gold !!
Eventually floating. Now the Euro !!
Can use spot or forward markets to make exchange rate more predictable.
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What causes exchange rate differentials between countries ?
Economic flows between countries are measured by the balance of payments.Current Account:
Merchandise trade balanceService sectorUnilateral transfers
Capital Account :Direct investmentPortfolio investment
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Lecture #16
DERIVATIVES
Financial instruments tailored to change where risk lies.
Swaps, caps, floors, etc. are examples of these.
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Most deal with the i/r or credit markets.
Spot contracts - discussed in FX context. Is a given price today….a guarantee. When investing using spot contracts you are investing looking for appreciation.
Forwards are contracts to buy something at a given price in the future at a price determined today.Hedging future price change by locking in today.Example: Airlines buying fuel for their fleets.Locking in a mortgage rate could involve a forward contract.
Futures contracts are like forward buy are traded on a formal
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exchange. No default risk versus total with forwards. Futures are revalued every day. Futures are generally in 3 areas:
i/rcurrencyindex
Can hold contracts to maturity or trade….most liquidate before maturity.If hold to maturity you take possession of the underlying asset.
So in each of these markets you arebetting on change.
Options are a contract giving you the right but not the obligation tobuy or sell something within a specific period of time.
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Call options give you the right to buy (call away from the seller)..a security at a predetermined price.This is the exercise or strike price.
Selling an option…you write a call option.
Put option…
You can buy stock options on many of the major companies in the worldon the NYSE or NASD.Cheap way to invest..What happened to markets after 9-11?What would have happened to your options ?
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You can purchase indices made up ofthe major stocks….Dow/ S & P 500, etc. You can use these to hedge (asa derivative) other stocks you own.
SWAPS – the most used derivative…great fun !!
Two parties agree to swap cash flows some time in the future basedupon some underlying asset.
Terrific tool for companies to manage i/r risk, currency risk and credit risk.
Sold bond last year - $100 mil. 10yr – 7% coupon.
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Now I think rates are going to trend down. What can I do about it now ?
Nothing changes with the underlyingassets…only the cash flows tied to them.
Currency swaps – evening out exposure
Swap markets – Counterparty risk
Caps (ceilings) – limit the upside exposure.
Floors – protect the bottom
Collars – give up a little to establish a range of risk.
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Loans are assets/Deposits are liabilities. How then do banks makea profit when their chief assets and liabilities are just pieces of paper ??
ASSETS:Loans – A promise to repay –
Approx. 60% of assets.Loans to whom ?
Business – 25% of totalRevolving lines of creditSeasonal (inventory)Floor plansFixed – collateralized
Real Estate – 46% of total
Commercial and residential
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Mortgages/equity lines of credit
Consumer credit – 16%
International
Investments
Biggest problems:
DefaultFixed rate lendingMismatch of maturities
Keys to successful asset management:
Lend to good customersInvest in low risk securities
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Diversify
THERE IS A FINE LINE BETWEEN PROFITABILITY AND SAFETY.
LIABILITIESWhy are deposits liabilities ?
Deposits represent aout 2/3 of total bank funding.Generally checking, savings and CD’s.
The remainder of funding comes fromdirect bond issuance, discount window and fed funds borrowings.
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Liability characteristics:Shorter term and more liquid
than assetsTransitory
Major problems:Maturity mismatchesI/R risk
BANK EQUITY
Regulators mandate a minimum level of equity(capital) to assets.. Today this number is about 9%. So banks are really highly levered.
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Capital is primarily common stock and retained earnings. It also includes reserves for losses.
Serves as a cushion against a drop in assets. What happens when liabilities exceed assets ?
Japan banking crisis
What happens in a recession to bankbusiness ?
Banks frequently have lots of business off their balance sheets. Swaps, derivative contracts, some loan commitments, foreign exchange contracts, etc.Why would they do this ?
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Commercial bank companies have beengrowing because of the change in the law allowing branching.This has brought on major merger/acquisition activity.
More income coming from non-interest/fee based business.
Commercial banking – International
U.S. banks going abroad:Less regulationNew businessFollow their customers
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Risks are higher – As are returns
CreditPoliticalCurrency
Banking around the World
Japan-China-EuroThe Regulators
Lecture #18
THRIFTS
Historically small institutions serving specialized needs of local groups.
Savings assoc. (formerly S & L’s)…population has declined by 75% overlast 20 years. Now about 1200.
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Traditionally made long term fixed rate mortgages to individuals funded by short term deposits.Problems of the 1970’s / RegulationQ
Disintermediation
Garn-St. Germain Act of 1982 / NOW-MMDA
Oil collapse / Regulators failed / New regulators
Assets: Mortgages and mortg. Backedsec. 73%
Comm. Loans – 3%What happens in an economic downturn ?
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Thrift liabilities:Over 60% is small deposits.Fed. Home Loan Bank borrowings =
22%Equity (capital) = 8.2 %
What happens in an economic downturn ?
SAVINGS BANKS
Essentially S & L or Savings Assoc.in the NE.Less than 400 exist.Balance sheets similar to Savings Assoc. except that are more highly capitalized.
CREDIT UNIONS
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Evolved from employer owned institutions.
Are now nonprofits owned by their depositors.Customers must have a common bond.Consumer loans make up 37% of assets with mortgages at 29%.Portfolio is more liquid and has lower default risk than that of banks and SA’s.
Credit Union Liabilities:
Member deposits = 89%Primarily savings, CD’s, and
NOW accts.
Equity (capital) is in excess of 9%
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Should be able to offer better rates to customers and make a higher ROA because of tax status.
REGULATION OF THRIFTS;
Office of Thrift Supervision (part of Treasury)
FDIC provides insuranceState assoc. are regulated by
states.Natl. Credit Union Admin. Board
charters andInsures credit unions.
Will these institutions exist 10 years from now ?
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Lecture #19
INSURANCE COMPANIES
Life insurance – allows individual to protect themselves and their benefactors against the loss of income from death.
Insures pool risks – why /
What happens if they are wrong ?
Types of life insurance:Ordinary lifeTerm lifeWhole lifeEndowment life
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Variable lifeUniversal life
Group lifeCredit lifeAnnuities
GIC’s Accident and Health
What do the balance sheets of Insurers look like ?
Premiums are assets – long livedInvestments ?
Policies are liabilities
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Regulation is at state level. Business getting more competitive with brokerages, banks entering.
Property & Casualty:
FireHomeownersCommercialAuto Liability
Premiums are assets / claims are liabilitiesHow do these companies ever lose money ?
Lecture#20
SECURITIES FIRMS & INVESTMENT 73
BANKING
Securities firms…..
Investment banks…..
Activities:InvestingInvestment bankingMarket makingTradingCash managementM & A
Others:Research……the scandals…tying
arrgmts.
SEC / Spitzer
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Lecture #21
FINANCE COMPANIES
Lenders to consumers, businesses, mortgages.
How are they different from Banks ?
1. Sales Finance Institutions
2. Personal Credit
3. Business Credit
Asset makeup / Liabilities
Subprime ???
How do they fund their business ?
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How much equity capital do they employ ?
Why do they even exist ?
Lecture #22
MUTUAL FUNDS & HEDGE FUNDS
Financial instruments that pool funds.
Various funds have different objectives:
Growth, international, bond, etc.
Prospectuses
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How do you make money in a mutual fund ?
How do mutual fund companies make money ?
401-k growth
Regulation
Lecture #23
PENSION FUNDS
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Savings plans through which participants accumulate tax deferred savings for retirement.
Defined benefit planDefined contribution plan
Private plans:401-kIRAKeogh
Public plansState & localFederal
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Lecture #24
REGULATION OF DEPOSITORY INSTITUTIONS
Crucial – Confidence in FI’s key fordomestic and
International business.
Safety & SoundnessMonetary PolicyCredit AllocationConsumer ProtectionInvestor ProtectionEntry & Chartering
Reg. of Product & Geographic Expansion
Prior to crash79
Glass – StegallSection 20Glass – Stegall repeal
Geog. Expansion-Unit/restricted
branching/interstate branching
FDICFSLIC
Why did problems of the 1980’s arise? Balance Sheet Regulations:
Focus on leverageCapital to assets ratios become triggers:
>5% all the way to <2%
On balance sheet versus including off balance sheet
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What is history of foreign banks ?
Social Security problems / solutions
Lecture #25
FINANCIAL INSTITUTION RISKS81
Credit – Bad investments/ Bad loansFirm specific riskSystemic risk
Liquidity – High withdrawals/ “run”
Interest Rate – Mismatching
Market – Trading
Off Balance Sheet - draw downs/derivatives
FX –
Sovereign –
Technology – Operational
Insolvency82
Lecture #26
MANAGING CREDIT RISK
Have had bouts of bad credit …..1980’s – thrifts/real estate1990’s – junk bonds/credit cards2000 – telecom’s/tech/sovereign
debt
What is the best way for a FI to lessen its risk of extending bad credit ?
Real estate lending:Ability to payCollateral
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Ability to pay:How long have you lived
somewhere /JobCredit historyOther obligations
Calculate ratios
Credit scoring also used. Compares your situation to others like you. If you look like those who have defaulted then assumption is you will also.
Collateral : Perfect security interest/lienDefault and they foreclose.
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Non-mortgage consumer loans just based on ability to pay.
Small business lending looks at cash flow of the business.
Mid-market focuses more on the business itself….cash flow/customerbook/cyclicalityIn the end, how predictable is the cash flow /
Credit analysis of the smaller firms is critical.The 5 C’s….
Character/Capacity/Collateral/Conditions/CapitalHaircutsRatios
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Large borrowers:Tougher sell for the FI. More
options.Information is better.
Once you have decided to make the loan how do you decide what to charge for it ? In other words, howdo you make money at this game ?
RAROC
How much is a relationship worth ?
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Lecture# 27
MANAGING LIQUIDITY RISK
I WANT MY MONEY NOW !!!
Can purchase liquidity or use stored liquidity.
Runs and panics
FDIC
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Fed Discount Window
Life Insurance Co. liquidity risk
Property and Casulty liquidity risk
Mutual Funds liquidity risk
Lecture #28
INTEREST RATE & INSOLVENCY RISK
Measuring the Risk…..
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Rate Sensitive Assets and Liabilities
The Repricing Gap
The Duration Model
What is Capital and how is it Valued ??
Lecture #29
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MANAGING DERIVATIVE RISKS
Review Contracts:Spot / Forwards / Futures
Hedging with Contracts
Accounting Rules / Bank Regulations
Options / Swaps
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Lecture #30
LOAN SALES AND SECURITIZATION
What are Loan Sales ? Why did they come to be ?
Participations / Assignments
What is the Market ? Who are the Players ?What drives the Market ?
How is Loan Securitization different from Loan Sales ?
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