Term
| function of financial markets |
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Definition
| channels funds from person or business without investment opportunities (lender-saver) to one who has them (borrower-spender) |
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Definition
1. households
2. business firms
3. government
4. foreigners |
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Definition
1.business firms
2. government
3. households
4. foreignser |
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Term
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Definition
| lenders are able to send money directly to borrowers through financial market |
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Term
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Definition
| lenders use financial intermediaries to get access to pool of borrowers |
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Term
| Primary vs. Secondary market |
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Definition
primary: investment bank underwriting the offer
secondary: usually involves brokers and dealers in which securities previously issued are bought and sold |
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Term
| even though companies don't get money, per se, from the secondary market, why is it still important |
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Definition
| it provides liquidity and establishes a price for the security |
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Term
| classification of scenodary market |
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Definition
1. Exchanges
2. Over-the-counter |
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Term
| what is the primary means of moving funds from lenders to borrowers? |
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Definition
| financial intermediation (indirect finance) |
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Term
| 3 types of financial intermediaries |
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Definition
1. depository institutions
2. contractual savings institutions
3. investment intermediaries |
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Term
| how do financial intermediaries make their money? |
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Definition
| they make their profits by reducing transaction costs with expertise and economies of scale |
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Term
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Definition
| when one party lacks crucial information about another, impacting decision making |
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Term
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Definition
| a banker may know less about a borrowers decision making than that borrower. |
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Term
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Definition
| hazard that one has incentives to engage in undesirable activities that make default more likely |
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Term
| How to cope with adverse selection and moral hazard? |
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Definition
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Term
| 2 things regulatory institutions do? |
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Definition
1. increase information to investors
2. ensure soundness of financial intermediaries |
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Term
| (4) gov poliies to protect the public and economy from financial collapse |
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Definition
1. disclosure requirements
2. restriction on assets and activities
3. capital requirements
4. government insurance of their liabilities |
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Term
| how do these apply to Lehman? |
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Definition
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Term
| until post-WW2, what type of martgages were most common |
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Definition
| short term balloon loans with maturities of 5 years or less |
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Term
| how did these balloons cause problems during recession |
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Definition
| lenders were not renewing loans because so many americans were out of work |
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Term
| 4 things that determine loan rate |
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Definition
1. market rates (general rates on bonds)
2. credit scores (default risk)
3. the term of loan (longer=higher rates)
4. discount points (decrease rates with more cash upfront) |
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Term
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Definition
| usually the real estate being purchased |
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Term
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Definition
| a portion of the purchase price paid by the owner |
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Term
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Definition
| Insurance against default by the borrower |
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Term
| Insured vs conventional mortgages |
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Definition
| when less than 20% down, insurance REQUIRED |
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Term
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Definition
- typically loans are sold immediately to the secondary market, but somebody need to collect the monthly paymnets.
- These are the loan servicers |
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Term
| Thrift institutions (S&L's) |
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Definition
| primary originator of loan in the US |
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Term
| 3 distinct elements in mortgage loans |
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Definition
1. loan originator
2. investor holds the loan
3. servicing agent handles paperwork |
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Term
| Securitization of mortgages (purpose?) |
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Definition
| By pooling mortgages, the minimized risk of default or prepayment and servicing through diversificaton. |
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Term
| Risk associated with Mortgage pass through securities |
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Definition
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Term
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Definition
| when mortgage rates fall, borrowers can restructure so that payments recieved would be lower than before. |
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Term
| How to manage prepayment risk? |
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Definition
| CMO's! (collaterized mortgage obligation) uses system of tranches to allocate prepayment risk |
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Term
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Definition
risky tranches = allocated the early prepayments
least risk tranches = nearly no prepayment risk |
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Term
| Benefits of securitizing the mortgage market? |
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Definition
1. reduces impact of local economic fluctuations
2. borrowers have access to national capital market
3. Investors get low risk long term investment without need to service the loan. |
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Term
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Definition
loans to borrowers with poor credit ratings or issues with collateral
* climbed to 17% by 2006 yikes! |
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Term
| what caused run up in housing prices (2000-2005) ? |
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Definition
1. Increase in sub prime loans created more demand for housing
2. real estate speculators |
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Term
| best known capital market securities? |
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Definition
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Term
| Primary issuers of securities |
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Definition
Federal and local gov: debt issuers
corporations: equity and debt issuers |
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Term
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Definition
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Term
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Definition
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Term
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Definition
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Term
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Definition
no default risk, and very low interest rates (risk free rate)
* although inflation risk still present |
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Term
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Definition
interest rate doe snot change throughout the term of the security.
- at maturity, securities are redeemed at greater of inflation adjusted or par amount |
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Term
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Definition
- when a bonds coupons and principal payments are stripped and sold as separate zero-coupon bonds
- investor recieves pmt ONE time (when it matures) |
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Term
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Definition
| bonds issued by local, county, and state governments for the purpose of financing public interest projects. |
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Term
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Definition
= taxable interest rate x (1 - marginal tax rate)
* when solving for MTR, if its above 25%, the municipal offers higher after tax cash flow |
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Term
| Two types of Municipal bonds |
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Definition
1. general obligation bonds
2. revenue bonds |
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Term
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Definition
| do not have specific assets pledged as security or a specific source of revenue allocated to their repayment |
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Term
| revenue bonds (more common) |
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Definition
| backed by the cash flow of a particular revenue-generating project (ex: toll bridge project) |
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Term
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Definition
- face value of $1000
- cannot be redeemed anytime unless callable
- interest rate varies or company health |
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Term
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Definition
- low risk (AAA) have low interest rates
- high risk (BBB) will have high interest rate
- spread widens during recession (people looking for safety) |
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Term
| what bonds replaced conventional "bearer" bonds |
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Definition
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Term
| Managers are more interested in protecting stockholders than bondholders. (moral hazard) What is used to mitigate this? |
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Definition
| Restrictive covenants: limit amount of dividends paid and additional debt issued. |
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Term
| Why do callable bonds have higher yield than non-callable bonds? |
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Definition
- because call provision put a limit on the amount of money a bondholder can earn from the appreciation of a bonds price (rates falling)
- it gives the firm more flexibility |
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Term
| Would a convertible have higher or lower yield than anon-convertible? |
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Definition
| for firms, the yield is higher to issue convertible bonds because borrowers will accept a lower interest rate in return for more flexibility |
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Term
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Definition
- bonds with collateral attached (buildings, equipment etc)
- less risky
- lower interest rate |
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Term
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Definition
- backed only by the creditworthiness of the issuer
- debentures (lower priority than secured)
- subordinate debentures (lower priority than debentures) |
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Term
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Definition
- market deveolped by michael milken
- 10% of corpo market
- debt rated below BBB |
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Term
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Definition
Credit rating of the insurer is substituted for the credit rating of the issuer
- reduction in risk lowers interest rate demanded by bond holders |
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Term
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Definition
provides credit against default
- speculators could legally bet on whether a firm or security would fail in the future. |
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Term
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Definition
- usually sold in large denominations ($1,000,000 or more)
- low default risk
- mature in one year or less |
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Term
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Definition
| when interest rate rose, depositors moved their money from banks to money market to earn a higher interest rate. |
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Term
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Definition
provides a place to warehous surplus funds for short periods of time.
- ex: if they feel market conditions arent right or expect interest rate to rise |
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Term
| Why do corporations and US gov us money markets? |
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Definition
- becasue cash inflows and outflows are not always synchronized.
- money markets solve these cash timing problems |
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Term
| Discounting (treasury bills) |
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Definition
- most money market securities dont pay interest, instead the investor pays less for the security than it will be worth when it matures.
- Increase in price provides a return. |
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Term
| competitive bidding on treasuries |
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Definition
| treasury accepts bid offering the highest price. |
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Term
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Definition
| treasury automatically accepts noncompetitive bids at the highest competitive bid price. |
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Term
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Definition
| - the effective rate that financial institutions use to trade amongst eachother. |
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Term
| how federal reserve can affect fed funds rate? |
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Definition
- buying/selling securities
- raising interest rates paid on reserves |
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Term
| how buying securities affects fed fund rate |
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Definition
| - government buys securities -> investors selling these securities to the gov will deposit money in bank accounts -> deposits increase supply of reserves and lower interest rates |
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Term
| how selling securities affects fed fund rate? |
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Definition
| - gov sells securities -> investors buy them -> drains bank deposits and decreases bank reserves -> this increases the fed funds rate |
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Term
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Definition
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Term
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Definition
| can be withdrawn at any time |
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Term
| Negotiable CD "bearer instrument" |
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Definition
| whoever holds the instrument at maturity recieves the principle and interest |
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Term
| why are rates paid on cD' similar to that on other money market instruments |
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Definition
because risk is relatively low.
Large banks are able to offer lower rates because people believe the gov would never let one of the largest banks fail |
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Term
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Definition
| unsecured promissory notes, issued by corporations, that are usually backed by a line of credit from a bank. |
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Term
| why do money market instruments appear to move so closely together? lockstep |
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Definition
- low risk and short term
- deep markets (priced competitively)
- they are close substitutes, thus market supply/demand would correct any departures. |
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Term
| Asset-backed-commercial paper |
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Definition
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Term
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Definition
| discount rate = (F-P)/P X 360/N |
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Term
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Definition
| investment rate = (F-P)/F X 365/N |
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Definition
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Definition
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Term
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Definition
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Term
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Definition
| = reserve requirement ratio |
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Definition
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Definition
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Definition
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Definition
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Term
| PMT for discount equation |
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Definition
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