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Chapter 1 Financial Markets and Institutions Chapter 1 Financial Markets and Institutions Overview Introduction to financial markets Introduction

ction to financial institutions Review of terms

Student Notes

Financial Markets Channel through which financial assets are e changed! "rocess also known as funds intermediation! Surplus #nits suppliers of funds$ %ecause the& spend less than the& receive! 'ouseholds are the onl& net supplier of funds! (eficit #nits users of funds$ %ecause the& spend more than the& receive! 'ouseholds$ corporations$ and governments can all %e deficit units!

Financial Markets Mone& Markets markets that trade de%t instruments with maturities of up to one year! )reasur& %ills$ commercial paper$ federal funds$ negotia%le C(s$ repurchase agreements$ and %anker*s acceptances! Capital Markets markets that trade e+uit& and de%t instruments with maturities of more than one year! Stocks$ %onds$ and mortgages! "rimar& Markets markets in which corporations raise funds through new issues of securities$ such as stocks and %onds! Ma& %e first,time issues %& firms initiall& going pu%lic$ the sale of additional new shares of an alread& pu%licl& traded firm$ or first time de%t issuances! Secondar& Markets markets in which e isting securities are traded! Organi-ed . changes ph&sical meeting place and communication facilities are provided for mem%ers to conduct their transactions!

Chapter 1 Financial Markets and Institutions

Student Notes

Over,the,Counter /O)C0 markets no central location! Financial claims can %e traded %& phoning an O)C dealer or %& using a computer s&stem! .fficienc& Simpl& the idea that the market accuratel& prices the securities that are traded in them! Markets can %e weak$ semi,strong$ or strong form efficient! Regulation Most important regulator is the Securities and . change Commission /S.C0! 1lo%ali-ation Increased integration! It is %ecoming easier to ac+uire information a%out foreign companies and invest accordingl&!

Financial Institutions Institutions serve as intermediaries %ecause markets are not perfect! (epositor& Institutions receive deposits and make loans! Commercial 2anks most dominant depositor& institution! Savings Institutions take in deposits and provide mortgage loans! Credit #nions take in deposits and provide retail loans! Nondepositor& Financial Institutions do not accept deposits from consumers! Finance Companies Spans a variet& of fringe companies! Consumer finance companies 2usiness finance companies Sales finance companies Nondepositor& Financial Institutions /cont!0 Mutual Funds primar& investment tool of man& households! Securities Firms multiproduct firms that usuall& speciali-e in several market related activities! . amples include %rokerage houses$ underwriters$ investment %anks$ and market makers! Nondepositor& Financial Institutions /cont!0

Chapter 1 Financial Markets and Institutions

Student Notes

'edge Firms sells shares to upscale investors and are allowed to invest in risk& assets! 4argel& unregulated! Insurance Companies receive mone& from premiums and invest in financial securities! "ension Funds 1overnments and companies allow emplo&ees to invest mone& in securities! Competition #!S! %anks face increasing foreign competition! Consolidation 2anks continue to consolidate as regulations have rela ed! 1lo%al . pansion #!S! %anks$ insurance companies$ and securities firms have e panded into foreign countries in recent &ears!

5e& )rends 6ffecting 2anks Service "roliferation rapidl& e panding services! Rising Competition financial service firms entering other markets! 1overnment (eregulation fewer restrictions! )echnological Change 6)Ms$ "oint of Sale terminals$ online pa&ments$ etc! Consolidation and 1eographic . pansion roll,up of the industr& continues! Convergence the movement of financial institutions across product lines! 1lo%ali-ation largest %anks compete with each other internationall&!

Chapter 3 (etermination of Interest Rates Chapter 3 (etermination of Interest Rates Overview Introduction to interest rates Interest rate theories .conomic forces that affect rates

Student Notes

Interest Rates the price of %orrowing mone&! Relevance of Interest Rates (irect influence on the valuation of de%t securities! Indirect influence on nearl& all other financial instruments! ie! Stocks$ e change rates$ derivative securities!

4oana%le Funds )heor& rates are determined %& the interaction %etween suppl& and demand for funds! (emand8 Individuals and 'ouseholds 2usinesses 1overnments Foreign (emand 6ggregate (emand

Suppl&8 Individuals and 'ouseholds onl& net saver of funds 2usinesses 1overnments Foreigners

Chapter 3 (etermination of Interest Rates .+uili%rium Rate

Student Notes

Factors that Cause the Suppl& Curve to Shift :ealth as total wealth increases$ the suppl& curve shifts out! Risk as the risk decreases$ the suppl& curve shifts out! Near,)erm Spending Needs when participants have fewer spending needs$ the suppl& curve shifts out! Monetar& . pansion polic& o%;ects to allow e pansion$ the suppl& curve shifts out! .conomic Conditions as domestic economic conditions improve relative to other countries$ foreign inflows increase and the suppl& curve shifts out!

Factors that Cause the (emand Curve to Shift .conomic Conditions during periods of economic growth$ market participants %orrow more heavil&! )he increase in demand increases the interest rate!

.conomic Forces that 6ffect Interest Rates .conomic 1rowth demand increases with growth and rates rise! Inflation . pected inflation decreases suppl& and increases demand$ pushing rates higher! Fisher .ffect nominal rate < real rate = e pected inflation .conomic Forces that 6ffect Interest Rates Mone& Suppl& )he Fed can affect the suppl&$ and$ therefore the interest rates! 2udget (eficit 1overnment deficits increase demand for funds$ >crowding out? private demand$ driving rates higher! Foreign Flows #!S! rates are increasingl& more tied to the interest rates of other countries! #nified 1erman& .conomic e pansion drove rates up internationall&! @apan*s Recession :eak economic growth lowers rates internationall&! 6sian Crisis Funds fled to more sta%le markets$ driving rates down! A

Chapter 3 (etermination of Interest Rates

Student Notes

Summar& .conomic forces affect suppl& and demand of mone&!

Interest Rates Over )ime 1eneral (ecline we have seen a general decline in interest rates since the earl& 1BCDs! Eolatilit& Rates were particularl& volatile in the earl& CDs! Fed changed policies in the earl& CDs creating insta%ilit&! Fed regained control in the late CDs and have %een relativel& sta%le!

5e& Interest Rates Federal Reserve (iscount Rate )he rate the Fed charges %anks that %orrow from it! Federal Funds Rate the rate %anks charge when the& make short,term loans to each other! )reasur& 2ills short,term government securities! Commonl& used as a %enchmark >real? interest rate! "rime Rate a %ase rate that large$ mone& center %anks charge their %est customers! 4ondon Inter%ank Offer Rate /4I2OR0 the rate that .uropean %anks charge each other! Mortgage Rates reflect conditions in financial markets$ in general!

Forecasting Interest Rates .conomic Models estimating the statistical relationships %etween measures of the output of goods and services in the econom& and the level of interest rates! Flow,of,Funds 6ccounting shows the movement of savings through the econom& in a structured and comprehensive manner!

Chapter 7 Structure of Interest Rates Chapter 7 Structure of Interest Rates Overview Factors 6ffecting Gields 6mong Securities )erm Structure #ses of the )erm Structure

Student Notes

Factors 6ffecting Gields 6mong Securities Inflation actual or e pected inflation! Real Interest Rates the interest rate that would e ist on a securit& if no inflation were e pected over the holding period of a securit&! Fisher .ffect the relationship among nominal interest rates$ real interest rates$ and e pected inflation! Nominal Rate = Real Rate + Expected Inflation 2ase Interest Rate )reasur& securities! Credit /(efault0 Risk the risk that a securit&*s issuer will default on that securit& %& missing an interest or principal pa&ment! 4i+uidit& )he risk that a securit& can %e sold at a fair market price in a short period of time! )a Status )a a%le securities must pa& a higher &ield than similar ta e empt securities! Municipal Securities Free of federal ta es and ma& %e free of state and local ta es! im < ic/t tf0 im< ic/t tf ts0 )erm to Maturit& )he length of time until the principal amount %orrowed %ecomes pa&a%le! Special "rovision call features$ converti%ilit& options$ and other provisions will influence the &ield of the securit&! H

Chapter 7 Structure of Interest Rates

Student Notes

6ctual Gield (ifferentials

)erm Structures of Interest Rates the relationship %etween &ield and term to maturit& on securities that differ onl& in length of time to maturit&I graphicall& appro imated %& the &ield curve! "ure . pectations )heor& the &ield curve reflects the market*s current e pectations of future short,term rates! 4i+uidit& "remium )heor& investors will hold long,term maturities onl& if the& are offered a premium to compensate for future uncertaint&! "referred 'a%itat )heor& the shape of the &ield curve is determined %& future interest rates and a risk premium$ to induce market participant to shift out of their preferred ha%itat! Segmented Markets )heor& the shape of the &ield curve is determined %& suppl& of and demand for securities within each maturit& sector! Research Results

#ses of the )erm Structure Forecast Interest Rates the& &ield curve can %e used to assess the general e pectations of investors and %orrowers a%out future interest rates! Forecast 2usiness C&cle provides information a%out the market e pectations of future %usiness activit&! Investment (ecisions investors can take advantage of different rates and ride the yield curve to make a profit! Financing (ecisions %& assessing the prevailing rates on securities for various maturities$ firms can estimate the rates to %e paid on %onds with different maturities! Impact of (e%t Management )reasur& decisions a%out de%t financing can impact the &ield curve! 'istorical Review #pward sloping!

Chapter 9 Functions of the Fed Chapter 9 Functions of the Fed Chapter O%;ectives 'istor& .sta%lished in 1B17 to control %ank panics! 13 largel& autonomous Federal Reserve %anks were esta%lished! "roviding the Mone& Suppl& prints and issues currenc&! Maintaining the Safet& of the Financial S&stem Facilitation of the "a&ments S&stem Conducting Monetar& "olic& Monitoring International Financial )ransactions . plain the #!S! Federal Reserve S&stem Introduce monetar& tools used %& the Fed Other monetar& polic& issues

Student Notes

Organi-ation Federal Reserve (istrict 2anks 13 %anks Mem%er 2anks 6ll chartered %anks must %e mem%ers! 2oard of 1overnors 5e& administrative %od& Regulate commercial %anks Control monetar& polic& Federal Open Market Committee /FOMC0 directs the open market actions of the Fed! 6dvisor& Committees 6dvises on consumer issues!

Monetar& "olic& )ools

Chapter 9 Functions of the Fed Open Market Operations %u&ing or selling of )reasur& securities!

Student Notes

"urchase of )reasuries Fed uses cash to %u& )reasuries$ usuall& from %anks! Sale of )reasuries Fed sells a portion of its )reasuries$ usuall& to %anks! )echnical Operations carried out through trading desk at New Gork Fed! o "olic& (irective o Straight /outright0 transactions o Repurchase 6greements o 6genc& Operations 6d;usting the (iscount Rate it is the rate a financial institution must pa& to %orrow reserve deposits from the Fed! 6d;usting the Reserve Re+uirement Ratio determines the amount of mone& that financial institutions must keep on hand!

Miscellaneous Fed .mphasis on Mone& Suppl& Monetar& Control 6ct of 1BCD /(I(MC60 1lo%al Monetar& "olic& Single .uropean "olic&

1D

Chapter A )he Fed and Monetar& "olic& Chapter A Fed and Monetar& "olic& Chapter O%;ectives Review 1oals of Fed and Monetar& "olic& Review Fed "olic& . plain the Impact of Monetar& "olic&

Student Notes

1oals of #!S! Monetar& "olic& "rice 4evel Sta%ilit& unsta%le price levels deter economic growth! Inflation the continuous rise in the average price level! #suall& caused %& an e ternal economic shock in the suppl& of a crucial material! :hen confronted with a suppl& shock$ the fed has two options8 Nonaccommodation 6ccommodation 'igh .mplo&ment /or low unemplo&ment0 %etween 9J and FJ is considered full capacit&! .conomic 1rowth increase in an econom&*s output of goods and services! Sta%ilit& in Foreign Currenc& . change Rates widel& fluctuating e change rates increases uncertaint& into the econom&!

)rade,offs and Conflicts 6mong "olicies Raise the rate of growth in the mone& suppl& %& providing more reserves! Reduce the rate of monetar& e pansion %& reducing the reserves in the %anking s&stem!

Recent Federal Reserve "olic& 1BHD 1BHB8 )argeting the Fed Funds Rate! 1BHB 1BC38 )argeting the %anking s&stem*s non%orrowed reserves! 1BC7 "resent8 2ack to the Fed Funds Rate!

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Chapter A )he Fed and Monetar& "olic& .conomic Indicators Monitored %& the Fed Indicators of .conomic 1rowth 1ross (omestic "roduct /1("0 Indicators of Inflation "roducer and Consumer "rice Indices Other Indicators Commodit& prices 4ags in Monetar& "olic&

Student Notes

Recognition 4ag the lag %etween the time a pro%lem arises and the time it is recogni-ed! Implementation 4ag the lag from the time a serious pro%lem is recogni-ed until the time the Fed implements a polic& to resolve it! Impact 4ag the lag until the polic& has its full impact on the econom&!

6ssessing the Impact of Monetar& "olic& Forecasting Mone& Suppl& Movements Improved Communication from the Fed! Market Reaction to Reported Mone& Suppl& 4evels! 6nticipating Reported Mone& Suppl& 4evels! Market Reaction to (iscount Rate 6d;ustments Integrating Monetar& and Fiscal "olicies 'istor& 1enerall&$ %oth the Fed and the government have %een concerned with maintaining economic growth and low unemplo&ment! Com%ining "olic& .ffects Moneti-ing the (e%t 6ction %& the Fed to counteract the effects of sales of )reasur& securities %& the )reasur&!

1lo%al .ffects of Monetar& "olic&

13

Chapter A )he Fed and Monetar& "olic&

Student Notes

Impact of the (ollar a weak dollar increases e ports$ which stimulates econom& and ma& drive up inflation! )ransmission of Interest Rates Fed "olic& during the 6sian Crisis

17

Chapter H 2ond Markets Chapter F Mone& Markets (etail the participants and their roles! . plain different mone& market securities . amine valuations!

Student Notes

Mone& Markets Characteristics of the Mone& Market (e%t instruments that have a maturit& of 1 &ear or less! 'ighl& li+uid financial claims with negligi%le risk of loss! )ransaction si-e are ver& large /usuall& K1$DDD$DDD to K1D$DDD$DDD0 No formal organi-ation$ such as the NGS. for the e+uit& markets!

Mone& Market "articipants "articipants Commercial 2anks Most important class of %u&ers and sellers of mone& market instruments! Federal Reserve S&stem open,market operations! #!S! )reasur& finance the federal deficit! Corporations use to %alance their cash position! Mone& Market Mutual Funds purchase 1L7 of commercial paper! "ension funds the other institutions

Mone& Market Securities Securities )reasur& 2ills #!S! )reasur& (epartment issues various t&pes of de%t to finance the national de%t! )reasur& 2ill 6uction s&stematic$ regular procedure! o Competitive %ids

19

Chapter H 2ond Markets

Student Notes

o Noncompetitive %ids .stimating the Gield .stimating the discount Commercial "aper short,term$ unsecured promissor& note! Ratings Mood&*s and Standard M "oor*s "lacement with institutions o (irectl& placed paper o (ealer,placed paper Secondar& Market secondar& trading is limited! 2acking Commercial "aper not asset %acked! Slightl& higher return than )reasur& securities! Finance companies are fre+uent issuers! .stimating the Gield Negotia%le Certificates of (eposit /NC(s0 6 %ank time deposit that is negotia%le! "lacement corporate treasuries "remium often$ rate is a%ove ),%ill &ield Repurchase 6greements /Repos0 sale of a short,term securit& with the condition that the seller will %u& it %ack at a predetermined price! .stimating the Gield Federal Funds commercial %anks %orrow and lend e cess reserve %alances to each other! 2anker*s 6cceptances a %ank accepts the responsi%ilit& to repa& a loan to its holder! Facilitates international trade!

1A

Chapter H 2ond Markets Steps involved Mone& Market Securities Final Notes Institutional use Ealuation 4imited price movements Risk 1lo%ali-ation of Mone& Markets "erformance of Foreign Mone& Market Securities

Student Notes

1F

Chapter H 2ond Markets Chapter 7 Objectives )o identif& the different t&pes of )reasur& securities )o identif& the characteristics of municipal securities )o outline the t&pes of corporate de%t securities

Student Notes

Treasury Securities )reasur& 2ills )reasur& securities with a maturit& of less than one &ear! )hese are sold on a discount %asis! )reasur& Notes Securities with maturities %etween 3 and 1D &ears! )hese are coupon securities! )reasur& 2onds Securities with maturities greater than 1D &ears! )hese are coupon securities! )reasur& Inflation "rotection Securities /)I"S0 6 )reasur& coupon securit& /either note or %ond0 whose coupon rate is tied to the rate of inflation! "rimar& Market )reasuries are sold in fre+uent well,pu%lici-ed auctions!

Competitive %ids Noncompetitive %ids


Secondar& Market over,the,counter market where a group of dealers offer continuous %id and as prices on outstanding )reasuries! Stripped )reasur& Securities Separating all coupon and principal pa&ments into individual securities! For instance$ a 1D,&ear semiannual note would convert into 31 separate S)RI"S! Nuotations )he %id price and the ask price are +uoted per hundred of dollars of par value! Salomon 2rothers scandal Salomon took over a )reasur& %ond auction! 2rad& 2onds #!S! )reasur& department restructuring program for delin+uent 4(C de%t!

Federal Agency Securities Federal 6gencies generall&$ a private compan& that was originated %& the federal government!

1H

Chapter H 2ond Markets

Student Notes

)he Farm Credit S&stem 'ousing Credit 6gencies . port,Import 2ank Student 4oan Marketing 6ssociation /Sallie Mae0 Small 2usiness 6dministration /S260
Municipal Bonds State and local government bonds 1eneral o%ligation %onds provide %asic services! Revenue %onds used to finance a specific revenue,producing pro;ect!

Corporate Bonds Corporate 2onds de%t contracts re+uiring %orrowers to make periodic pa&ments of interest an to repa& principal at the maturit& date! Characteristics

Sinking,fund provision re+uires the %ond retire a specific dollar amount of %onds each
&ear!

"rotective Covenants 4imit dividends or additional de%t! Call "rovisions an option of the issuer to retire %onds %efore their maturit&! 2ond Collateral Mortgage %onds .+uipment )rust Certificates Collateral 2onds (e%entures

1C

Chapter H 2ond Markets

Student Notes

Oero, Coupon 2onds (o not pa& coupons! Earia%le,Rate 2onds Coupon is tied to an interest rate rather than fi ed! Converti%ilit& allows investors to e change the %ond for a stated num%er of shares of
the firm*s common stock! @unk 2onds Corporate %onds with high default risk!

Market Si-e 3AJ of outstanding corporate %onds are ;unk! Risk "remium Su%stantiall& higher interest rate! "erformance volatile! Contagion price shocks affect entire ;unk %ond market!
Restructuring through %onds

4everage 2u&outs investor group issues de%t to fund the purchase of a compan&! Capital Structure changes
Bond Markets .uro%ond Market a %ond issued in a countr& other than the currenc& it is denominate in!

1B

Chapter C 2ond Ealuation and Risk Chapter 8 Chapter Objectives Review the %ond valuation processI and Review %ond characteristics!

Student Notes

Bond Valuation Process 2ond a securit& that o%ligates the issuer to make specified pa&ments to the %ondholder! Characteristics

"ar Ealue face value of the %ond! Coupon specified num%er of dollars of interest paid each period! Coupon Rate )he annual coupon divided %& par value! Maturit& (ate when principal amount is due! Gield to Maturit& )he rate of return earned on a %ond if it is held to maturit&!
2ond Ealuation the present value of the cash flows! Changing %ond values over time New %onds are generall& priced to sell at par value! )he price of seasoned %onds often var& widel& from par value!

If the market interest rate e+uals the coupon rate$ a fi ed rate %ond will sell at its
par value!

Market interest rate rises a%ove coupon rate$ a fi ed rate %ond sells %elow
/discount0 its par value!

Market interest rate falls %elow coupon rate$ a fi ed rate %ond sell a%ove
/premium0 its par value!

)he price of the %ond approaches its par value as it approaches maturit&! Market interest rate falls %elow coupon rate$ a fi ed rate %ond sell a%ove
/premium0 its par value!

)he price of the %ond approaches its par value as it approaches maturit&!
3D

Chapter C 2ond Ealuation and Risk

Student Notes

Bond Risk Assessing the Riskiness o a Bond Interest Rate Risk risk of a decline in a %ond*s price due to an increase in market interest rates! Reinvestment Rate Risk )he risk that a decline in interest rates will lead to a decline in income from a %ond portfolio! (efault Risk )he risk that the issuer will %e late or una%le to make a pa&ment!

Mortgage %onds %acked %& fi ed assets! (e%entures not secured %& fi ed assets %ut is a general o%ligation of the firm! Su%ordinated (e%entures claim is lower than senior de%t!
Bond Price Bond Price Movements Risk,Free Rate 1eneral interest levels affect all %onds!

Inflationar& . pectations .conomic 1rowth Mone& Suppl& 1rowth 2udget (eficit


(efault Risk "remium Changing credit situations will affect %ond prices!

Bond Price Sensitivity 2ond "rice .lasticit& the sensitivit& of %ond prices to changes in the re+uired rate of return!

Coupon Rate )he lower a %ond*s coupon rate$ the greater the price sensitivit&! Maturit& 4onger,term %onds have greater price sensitivit&!

31

Chapter C 2ond Ealuation and Risk 2ond "ricing )heorems

Student Notes

2ond prices and market interest rates move in opposite directions! :hen a %ond*s coupon rate is greater /less0 than the market*s re+uired return$ the
%ond*s market value will %e greater /less0 than its par value!

)he price of longer,term %onds will change more than that of shorter,term %onds$
for a given change in market rates!

)he price of lower,coupon %onds will change more than that of higher,coupon
%onds$ for a given change in market interest rates! (uration %ond price volatilit& varies directl& with maturit& and inversel& with coupon rate! (uration considers %oth coupon rate and maturit&!

"ortfolio the weighted average of %ond durations! #sing (uration to Reduce Interest Rate Risk Oero Coupon 6pproach Maturit&,Matching 6pproach (uration,Matching 6pproach
Bond !nvestment Strategies 2ond Investing

Matching Strateg& Matching future cash outflows with coupon and principal
pa&ments!

4addered Strateg& Spreading an investment over several different maturit&


classes!

2ar%ell Strateg& Investment is divided %etween short, and long,term %onds! Interest Rate Strateg& #se forecasts to develop a %ond investment strateg&!
!nternational Bonds Return and Risk o !nternational Bonds

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Chapter C 2ond Ealuation and Risk

Student Notes

Foreign Interest Rates (ifferentials Credit Risk (ifferentials . change Rate Fluctuations International 2ond (iversification

37

Chapter B Mortgage Markets Chapter !ort"a"e !ar#ets

Student Notes

Chapter overvie" . amine uni+ue nature of market! Review the evolution of the secondar& markets! . amine the characteristics of different mortgages!

Mortgage Markets #ni+ue Nature of the Mortgage Market

Secured %& the pledge of real propert&! Made for var&ing amounts and maturities! Issuers are t&picall& small$ unknown entities! Secondar& market growing 'ighl& regulated and supported %& the federal government!
Residential Mortgage Characteristics

Standard Fi ed,Rate Mortgages lender takes a lien on real propert& in e change for
pa&ment!

Conventional Mortgages not insured %& a federal government agenc&!


"rivate Mortgage Insurance /"MI0 insures against default for %orrowers with less than a 3DJ down pa&ment! 'istoricall&$ there has %een no penalt& for prepa&ment! 'owever$ this is not alwa&s the case! Residential Mortgage Characteristics

Standard Fi ed,Rate Mortgages lender takes a lien on real propert& in e change for
pa&ment!

Insured Mortgages pa&ment is guaranteed %& a federal government agenc&!

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Chapter B Mortgage Markets

Student Notes

Federal 'ousing 6uthorit& /F'60 allows a much smaller down pa&ment and
guarantees pa&ment!

Eeterans 6dministration /E60 insures mortgages of militar& veterans and does not
re+uire a down pa&ment! 6d;usta%le,Rate Mortgages /6RMs0 interest rate ad;usts with the general level of rates! Interest rate risk is shifted to the %orrower! Maturities )raditional maturit& is 7D &ears and 1A &ear mortgages have %ecome more popular! Others include 7$ A$ or H &ear %alloon mortgages!

Creative Mortgages 1raduated,"a&ment Mortgage lower pa&ments in the first few &ears and growing through time! 2alloon Mortgage a fi ed,rate mortgage that e pires at a predetermined time /7$ 9$ A$ or H &ears0! )he unpaid %alance is then due! 1rowing,.+uit& Mortgage calls for rising pa&ments over time resulting in a faster pa&off! Second Mortgage loans secured %& liens on properties that are alread& mortgaged! Reverse 6nnuit& Mortgage /R6M0 "rovides regular monthl& pa&ments to the homeowner with the home as collateral!

Mortgage Market Secondar& Market originators can sell mortgages in the secondar& markets to %oth pu%lic and private purchasers! Ealuation the present value if the future cash flows! "rices of e isting mortgages are relativel& volatile due to their long term nature!

!nvestment Risk Interest Rate Risk the value of fi ed rate mortgages decline as interest rates rise! "repa&ment Risk falling interest rates encourage refinancing! Credit Risk the likelihood that a %orrower will default on the loan!

Mortgage#Backed Securities

3A

Chapter B Mortgage Markets

Student Notes

"ass,)hroughs pa&ments of principal and interest on pools of mortgages are passed through to holders of securities in the pool! 1overnment National Mortgage 6ssociation /1NM6 1innie Mae0 pass throughs on a pool of federally insured mortgage loans! Federal National Mortgage 6ssociation /Fannie Mae0 issues a variet& of pass,through securities similar to 1innie Mae*s! "u%licl& Issued "ass,)hrough Securities /"I"0 issued %& private institutions! Federal 'ome 4oan Mortgage Corporation /Freddie Mac0 assists lenders with securiti-ation of conventional mortgages!

"articipation Certificates /"Cs0 different from 1innie Mae*s in that8 Contain conventional mortgages Not federall& insured Earious interest rates Much larger pools
Collaterali-ed Mortgage O%ligations consists of a series of related de%t o%ligations$ called tranches$ which pa& various %orrowers with different priorities! Other Mortgage,2acked Securities

Mutual Funds several mutual funds have %een esta%lished to %u& 1innie Mae securities! Fannie Mae or Freddie Mac de%t general o%ligation securities are %asicall& secured %&
mortgages!

Mortgage,2acked Securities "ass throughs

3F

Chapter 11 Stock Ealuation and Risk Chapter $% &toc# !ar#ets Overview )&pes and locations of trading )rading mechanics and arrangements "u%lic placements Monitoring of firms 1lo%ali-ation

Student Notes

Background on Common Stock Common Stock represents %asic ownership claim in a corporation! Owners e pect capital gains and possi%l& dividends! Ealue %ased on e pected future cash flows!

Trading $ocations Organi-ed . changes consist of ph&sical locations where %u&ers and sellers meet on a trading floor!

6uction S&stem trading mechanism placing competing %u&ers and sellers against each other!

Over,the,Counter /O)C0 dispersed traders linked via a computer s&stem!

Negotiated S&stem individual %u&ers negotiate with individual sellers!

Stock /Organi-ed0 . changes consist of ph&sical locations where %u&ers and sellers meet on a trading floor!

New Gork Stock . change /NGS.0 most popular stock e change! Specialists market makers in a stock! Commission %rokers e ecute orders for customers! Floor %rokers e ecute orders for other e change mem%ers!

3H

Chapter 11 Stock Ealuation and Risk Floor traders trade solel& for themselves!

Student Notes

Over,the,Counter /O)C0 dispersed traders linked via a computer s&stem!


N6S(6N a computer network linking thousands of market,making participants! Other O)C Markets su%scri%er markets where trading is via the telephone! O)C 2ulletin 2oard /O)C220 "ink Sheets

6lternative )rading S&stems electronic communications networks or crossing networks that link two parties for direct trading of stocks!

Types o Transactions 4ong "urchase purchasing securities with the e pectation that it will increase in value! Margin )rading the use of %orrowed funds to purchase securities! "urchased securities are used a collateral!

Initial Margin minimum amount that must %e provided %& investor at time of purchase! Maintenance Margin minimum amount that an investor must maintain in the margin account! Margin Call notification of the need to add cash to a margin account!

Short Selling selling %orrowed securities with the e pectation that the price will fall!

Trading Mechanics )&pes of Orders price and conditions of an order!

Market order an order to %u& or sell stock at the %est price availa%le when the order is placed! 4imit order an order to %u& at or %elow a specified price! Or$ sell at or a%ove a specified price! fill,or,kill order da& order

3C

Chapter 11 Stock Ealuation and Risk good,*till,canceled /1)C0 order

Student Notes

Stop,loss order an order to sell a stock when its price reaches or drops %elow a specified level!

Trading Arrangements Retail Stock )rading %u&ing and selling of stocks %& individuals! Institutional )rading %u&ing and selling %& financial institutions such as mutual funds and pension funds!

2lock )rades trades of at least 1D$DDD shares or market value of K3DD$DDD or greater! "rogram )rades %u&ing andLor selling of a large num%er of different stocks simultaneousl&! 6sset allocation trades Inde ar%itrage

Stock !nde%es (ow @ones Industrial 6verage stock market average made up of 7D high,+ualit& industrial stocks! Standard and "oor*s /SM"0 measures the current price of a group of stocks! New Gork Stock . change Composite current price of the stocks listed on the NGS.! Other Inde es 6M.P$ Nasda+$ Ealue 4ine$ :ilshire ADDD

Pre erred Stock (e%tL.+uit& h&%rid represents ownership in a compan& %ut pa&s a fi ed dividend amount! "referential treatment preferred dividends are paid %efore common dividends can %e paid and cumulate if the& are not paid! 2ankruptc& preference as well! Nonparticipating usuall& no voting rights! Institutional ta advantages other companies are a%le to deduct preferred dividends received! Not attractive for individual investors!

Public Placement o Stock 3B

Chapter 11 Stock Ealuation and Risk

Student Notes

Initial "u%lic Offerings /I"Os0 the first issuance of common stock %& a firm to the pu%lic!

Eenture Capital /EC0 firms that invest in private companies with the e pectation of taking them pu%lic! #nderwriters an investment %ank must %e hired to take the compan& pu%ic! (etails price range$ num%er of shares$ lockup period$ and other details must %e esta%lished and filed with the S.C! Road Show managers and underwriters travel to different cities to meet with institutional investors to sell the compan&! Offering the underwriter sets the price the num%er of shares and %egins trading when the market opens! >2uilding the 2ook?

Initial Return t&picall&$ the return on the first da& is su%stantial! Flipping process of selling soon after trading has %egun!

4ockup 6greement underwriter restricts managers$ ECs$ and other insiders from selling their shares for at least si months! 4ong,run "erformance generall& poor!

Secondar& Stock Offerings an initial offering of stock %& a firm that has other stock alread& pu%licl& held! Shelf,Registration a compan& must register stock offerings with the S.C! Once the registration is complete$ the compan& waits for favora%le market conditions!

Monitoring o Firms Shareholder 6ctivism shareholders take an active role in managing the compan&!

C64".RS Sociall& conscious mutual funds

Corporate Monitoring

6c+uisition poorl& run companies %ecome targets!

7D

Chapter 11 Stock Ealuation and Risk

Student Notes

2arriers 6nti,takeover 6mendments "oison "ills 1olden "arachutes

Self,Monitoring

Stock Repurchases a firm purchases its own stock when it %elieves it is undervalued! 4everaged 2u&outs use of de%t financing to purchase the compan&!

&lobali'ation o Stock Markets International Investment "erformance performance varies among countries and through time! Investing in foreign stocks

Indirect investment "urchase shares of #!S! %ased MNC "urchase international mutual fund

(irect investment "urchasing stocks on foreign e changes "urchase stocks of foreign companies trading on #!S! e changes! "urchasing 6merican (epositor& Receipts /6(Rs0

71

Chapter 11 Stock Ealuation and Risk Chapter $$ &toc# 'al(ation and Ris# (vervie" Stock Ealuation Methods .stimating the Re+uired Return and 1rowth Rate Other Factors that 6ffect Stock "rices Stock "erformance Measurement Stock Market .fficienc&

Student Notes

Stock Valuation Methods (iscounted Cash,Flow Ealuation )echni+ues the present value of some e pected cash flows! (ependent on two estimated inputs8

1rowth Rates (iscount Rates

(ividend (iscount Model value of stock is the present value of all future dividends!

Oero 1rowth Model (ividends sta& the same each &ear! Infinite Constant 1rowth Model (ividends grow at roughl& the same percent each &ear! Supernormal 1rowth Model (ividends grow at higher rate for a period of time %efore settling into a constant growth!

"resent Ealue of Operating Cash Flows (eriving the value of the total firm from operating cash! "resent Ealue of Free Cash Flows (eriving the value using free cash! Relative Ealuation )echni+ues provides information a%out how the market is currentl& valuing stock at several levels!

Contends that valuing firms is accomplished %& a comparison to other firms!

73

Chapter 11 Stock Ealuation and Risk

Student Notes

"rovides information current valuation %ut it does not provide guidance on whether current valuations are appropriate!

"rice to .arnings /"L.0 Ratio determine how man& dollars one is willing to pa& for a dollar of e pected earnings! "rice to Cash Flow /"LCF0 Ratio cash flow values are generall& less prone to manipulation than earnings! "rice to Sales /"LS0 Ratio strong sales growth is a re+uirement for a growth compan&! 4ittle chance of manipulation!

)stimating the !nputs Re+uired Rate of Return will %e the discount rate for most cash flow models!

Risk,Free Rate the a%solute minimum rate an investor should re+uire! . pected Inflation if investors e pect inflation$ the& should increase their re+uired nominal risk,free rate! Risk "remium the risk associated with a specific stock or portfolio of stocks!

1rowth Rates estimates of the growth rate of cash flows$ earnings$ and dividends are re+uired!

.stimating 1rowth from Fundamentals dividend growth is determined %& the growth rate of earnings and the pa&out ratio! .stimating 1rowth %ased on 'istor& time,series growth rates should provide a trend and the amount of varia%ilit&!

Factors that A ect Stock Prices .conomic Factors

Interest Rates generall&$ an inverse relationship e ists %etween stock prices and the level of interest rates! . change Rates currenc& strength affect market prices in man& wa&s!

Market,Related Factors

6nomalies @anuar& effect$ small firm effect$ da& of the week effect$ etc!

77

Chapter 11 Stock Ealuation and Risk Firm,Specific Factors


Student Notes

(ividends indication a%out the future of the compan&! Secondar& Offerings dilution adversel& affects stock price! Repurchases indication the firm is undervalued!

Firm,Specific Factors

.arnings Surprises changes ma& indicate future trends! 6c+uisitions and (ivestitures 6c+uirers adversel& affected$ targets positivel& affected! . pectations

.vidence stock prices are affected %& factors other than fundamental factors! Indicators "rice movements are often used as an indicator!

Stock Risk Measures of Risk


Standard (eviation Eariation 2eta

Stock Per ormance Measurement Sharpe Inde measures the risk premium per unit of total risk$ measured %& the stock*s standard deviation! )re&nor Inde measures the risk premium of a stock per unit of nondiversifia%le risk$ measured %& the %eta!

Stock Market ) iciency Forms of .fficienc&

:eak,Form .fficient past data on stock prices is of no use in predicting future prices!

79

Chapter 11 Stock Ealuation and Risk

Student Notes

Semistrong,Form .fficient pu%licl& availa%le information is of no use in predicting future prices! Strong,Form .fficient no information$ pu%lic or private$ allows investors to consistentl& %eat the market!

7A

Chapter 13 Market Microstructure and Strategies Chapter $) Objectives . amine methods of researching stocks . amine methods of trading stocks Introduce alternatives /inde funds0 to investing in stocks!

Student Notes

Stock Market !nvesting Research there are numerous resources to use when researching stocks! Some include8

Ealueline :e%sites Gahoo$ Nasda+$ Morningstar$ 2loom%erg .dgar Online access to S.C filings at www!sec!gov

"lacing an Order open an account with a %roker! Full,service$ discount$ or online %rokers are availa%le!

Market Order an order to %u& or sell a stock at the %est possi%le price! 4imit Order an order that specifies the price to %u& or sell the stock at! Stop 4oss Order a conditional market order where%& the investor directs the sale of a stock if it drops to a given price! Stop 2u& Order a conditional market order if the stock rises a%ove a given price!

Margin )ransactions the investor pa&s for the stock with some ash and %orrows the remaining through the %roker$ putting up the stock for collateral!

Initial Margin AD percent of the value of the stock! Maintenance Margin 3A percent of the value of the stock! Margin Call re+uirement to add more e+uit& or sell the stock!

Short Selling the sale of stock that is not owned with the intent of purchasing it in the future at a lower price!

Specificall&$ &ou would %orrow the stock from another investor$ sell it in the market$ and replace it at a later date!

7F

Chapter 13 Market Microstructure and Strategies

Student Notes

Investing in Stock Inde es investor can select mutual funds the shadow a specific inde or opt for e change traded funds!

. change,)raded Funds /.)Fs0 %askets of securities that are traded$ like individual stocks$ on an e change! Can %e %ought and sold throughout the da&! Eer& low e pense ratio! 'owever$ commissions must %e paid on trades!

Trade )%ecution Floor 2rokers independent mem%ers of an e change who act as %rokers for other mem%ers! Specialists or Market,Makers

Serve as %rokers to match %u& and sell orders! Maintain limit order %ook! Maintain fair and orderl& market when necessar& %& %u& and selling from their own account!

.lectronic Communication Networks /.CNs0 displa&s customer orders electronicall& and provide access to pricing information!

Rising in popularit&!

"rogram )rading computeri-ed trading that involves the %u&ing or selling of a portfolio of stocks!

Collars NGS. applies program trading cur%s when the (ow moves 1FD points either up or down! Circuit 2reakers NGS. halts trading if the market moves down %& 1DJ!

Regulation o Stock Trading Securities and . change Commission /S.C0 created in 1B79 to enforce newl& enacted securities laws!

(ivision of Corporate Finance (ivision of Market Regulation

7H

Chapter 13 Market Microstructure and Strategies


Student Notes

(ivision of Investment Management (ivision of .nforcement

7C

Chapter 17 Financial Futures Markets Chapter $* +inancial +(t(res !ar#ets (etail the %ackground on futures Introduce the trading and mechanisms . amine commodit& and financial futures

Student Notes

Background on Futures Futures Contract 6 commitment to deliver a certain amount of some specified item at some specified date in the future!

Commodit& Futures Financial Futures Options versus Futures future contract involves an o%ligation from %oth parties!
Option does not!

Forwards versus Futures forward is tailored to meet the needs of the purchaser!
Future is standardi-ed! Trading Futures "articipants hedgers and speculators! 2oth are needed for the market to work!

'edgers enter into futures contract to protect a current position of loss of value! Speculators attempting to earn profits on price swings! Important in creating
li+uidit&! )rading Mechanics futures are readil& traded in the market!

4ong position purchasing a futures contract! Short position selling a futures contract! 4i+uidating a position entering into an opposite futures contract!
Margin )rading putting up onl& a fraction of the total price in cash! )he margin usuall& ranges from 3 1DJ of the value of the contract!

Commodities 7B

Chapter 17 Financial Futures Markets

Student Notes

2asic Characteristics four ma;or segments include8 grains and oilseeds$ livestock and meat$ food and fi%er$ and metal and petroleum!

Contract ever& commodit& has its own specifications regarding amounts and
+ualit&!

"rice %ehavior commodities react to economic$ political$ and international


pressures!

Return on investment onl& return comes from price movement! 'igh returns are
possi%le due to the volatilit& of prices and the high leverage! )rading Commodities

Speculating attempt to capitali-e on the wide price swings! Spreading com%ining two or more different contracts into one position to
achieve gains and limit losses!

'edging used %& producers and processors to protect a position in a product or


commodit&! Financial Futures Financial Futures Market created in the earl& 1BCDs! Its level of trading has far surpassed the level of trading in commodities! )hese are derivative securities %ecause the& derive their value from the assets that underlie them!

Currenc& Futures futures contracts of foreign currencies! Interest Rate Futures futures contracts on de%t securities! Stock,Inde Futures futures contracts on %road %ased measures of stock market
performance!

)rading Stock,Inde Futures predicting the future course of the stock market! 'edging Other Securities
Options on Futures give the purchasers the right to %u& or sell a single futures contract! 9D

Chapter 17 Financial Futures Markets

Student Notes

4imits the loss e posure to the price of the option! (ownside risk is limited!

91

Chapter 19 Options Markets Chapter $,- Options !ar#ets Chapter (b*ectives Review options and their application Review trading strategies

Student Notes

(ptions Option a securit& that gives the holder the right to %u& or sell a certain amount of an underl&ing financial asset at a specified price!

Call gives the purchaser the right to %u& securities at a stated price for a specified time
period!

"ut gives the purchaser the right to sell securities at a stated price for a specified time
period!

6dvantages
4everage 6%ilit& to earn profit on price declines 4imited downside loss for purchasers

(isadvantages
No ownership %enefit 4imited time frame Comple

Stock Option "rovisions

Strike /e ercise0 price the state price at which &ou can %u& a securit& with a call or sell
a securit& with a put!

. piration date Nuotes , :S@

93

Chapter 19 Options Markets (ptions Pricing and Trading "rofit "otential of Options

Student Notes

Call limited loss to the premium and unlimited possi%le gains if the stock moves higher! "ut limited loss to the premium and unlimited possi%le gains if the stock moves lower!
Fundamental Value o (ptions Ealue depends ultimatel& on the e ercise price and the prevailing market price of the underl&ing stock!

Call /market price strike price0 1DD "ut /strike price market price0 1DD In,the,mone&
Call strike price Q market price "ut strike price R market price

Out,of,the,mone& no value
Call strike price R market price "ut strike price Q market price

Stock (ption Premiums Fundamental value the higher /lower0 the market price for a call /put0$ the greater the value! )ime premium the longer the time to e piration$ the greater the si-e of the premium! "rice volatilit& premium the more volatile the stock$ the greater the premium!

Trading Strategies 2u&ing for speculation %u& low and sell high! 'edging purchasing an option to offset a current position in e+uities! Option :riting and Spreading 97

Chapter 19 Options Markets

Student Notes

:riting Options do so %ecause the& do not %elieve the price is going to move that far!
Naked Options options written on a securit& not owned %& the writer Covered Options options written on a securit& owned %& the writer!

Options Spreading com%ining two or more options with different strike prices andLor e piration dates into a single transaction!

Stock !nde% (ptions Inde Options a put or call option written on a specific stock market inde $ such as the SM" ADD!

Investment uses
Speculation offer investors the opportunit& to pla& the market with a small amount of mone&! 'edging allows an investor to protect a current portfolio from downside risk!

(ther Types o (ptions Interest Rate Options options written on fi ed,income /de%t0 securities! Currenc& Options options written on foreign currencies! 4.6"S /4ong,)erm .+uit& 6ntici"ation Securities0 e piration dates that e tend out as far as two &ears!

99

Chapter 1A Interest Rate (erivative Markets Chapter $.- Interest Rate /erivative !ar#ets Chapter (b*ectives Review swaps and their application Review Interest Rate Caps$ Floors$ and Collars!

Student Notes

S"ap Background Swap an agreement where%& two parties /called counterparties0 agree to e change periodic pa&ments! Notional 6mount /"rincipal0 the dollar amount of the pa&ments e changed is %ased on some predetermined dollar principal!

Types o S"aps Interest Rate Swap the counterparties swap pa&ments in the same currenc& %ased on an interest rate!

"lain Eanilla one set of pa&ments is fi ed and the other is varia%le! Coupon Swap one part& pa&s the other the fi ed,coupon rate$ and the other pa&s
the coupon rate on a floating,rate instrument!

2asis Swap the parties e change pa&ments %ased upon floating,rate inde es$ %ut
each coupon is determined %& a different rate!

6pplication useful wa&s of tailoring the interest rate risk desired! Reasons wh&
a firm needs to alter their interest rate risk8 Interest rate e posure has changed over time )wo different firms have advantages in markets the& prefer to not %e in!

S"ap !nterpretation .ssentiall&$ two parties enter into multiple forward contracts! :h& do the& e istS In man& markets$ forwards and futures do not e tend out as far as that of a t&pical swap! Swap is transactionall& efficient one contract to handle what it would have taken multiple forward contracts to handle! 9A

Chapter 1A Interest Rate (erivative Markets

Student Notes

Increased li+uidit&

!nterest Rate Caps+ Floors+ and Collars Interest Rate Cap a series of interest rate calls$ designed to limit the cost of a loan with multiple interest pa&ments Interest Rate Floor a series of interest rate puts$ designed to protect the return on a loan with multiple interest pa&ments! Interest Rate Collar a com%ination of the purchase of an interest rate cap and the sale of an interest rate floor!

9F

Chapter 1F Foreign . change (erivative Markets Chapter $0- +orei"n Exchan"e /erivative !ar#ets Chapter (b*ectives 1ive %ackground on foreign e change markets Introduce foreign e change derivative instruments

Student Notes

Foreign )%change Markets 2ackground

Foreign currenc& is simpl& another asset! . change rate is the price at which the asset can %e %ought! Eolatilit& of e change rates should %e viewed as a source of risk!
Spot Market the market for immediate deliver& of foreign currenc&! Forward Contract a contract %etween a %ank and a customer!

. change a specified amount! . change on a specific date! . change for a specified price!
Futures Contract agreement %etween two parties to e change foreign currenc&!

Standardi-ed amount )raded on an e change Specified maturit& dates Speculators and hedgers participate Contract interpretation Closing a position enter into an opposite position! Credit risk limited due to market restrictions!
9H

Chapter 1F Foreign . change (erivative Markets

Student Notes

Currenc& option purchaser receives the right to %u& or sell a currenc& at a later date at an agreed price!

No o%ligation for the purchaser! Call right to %u& a currenc& at the strike price on or %efore the e piration date! "ut right to sell a currenc& at the strike price on or %efore the e piration date!
Currenc& swap an agreement %etween two parties to trade pa&ments in different currencies!

9C

Chapter 1H Commercial 2ank Operations Chapter $7 Commercial 1an# Operations 4ook at %ank regulations (etermine sources and uses of funds 4ook at off,%alance,sheet activities

Student Notes

Financial Conglomerates Financial Services Moderni-ation 6ct allows %anks to offer a wide variet& of products$ including insurance and underwriting services! (iversified Services are there %enefits to customersS (iversified Services are there %enefits to %anksS

Bank Sources o Funds (emand (eposits checking accounts Savings (eposits important source for small %anks! )ime (eposits have a maturit& date

Certificates of (eposit /C(s0 fi ed interest rate and maturit& date Negotia%le Certificates of (eposit /;um%o C(s0 denominations of K1DD$DDD or
greater! Mone& Market (eposit 6ccounts pa&s an interest rate! Federal Funds "urchased %orrowing from another %ank*s reserves! Federal Reserve %orrowing %orrowing funds from the district Federal Reserve %ank! Repurchase 6greements /R"s0 %anks sells securities and simultaneousl& contracts to repurchase the same securities! .urodollar 2orrowings short,term deposits at foreign %anks! 2onds large commercial %anks ma& issue %onds! Capital e+uit& ownership of a %ank! 9B

Chapter 1H Commercial 2ank Operations

Student Notes

Bank ,ses o Funds Cash vault cash$ Fed reserves$ %alances at other %anks$ collections! 2ank 4oans primar& %usiness activit& of a commercial %ank!

2usiness 4oans usuall& secured %& an asset!


2ridge 4oan cash for a specific transaction! Seasonal 4oan term financing to handle the fluctuations of the %usiness c&cle! 4ong,)erm 6sset 4oan loan for a specific asset!

4oan "articipations a group of %anks cooperate to underwrite large loans! Consumer 4oans %ank loans to individuals! Real .state 4oans mortgage loans!
Investment in Securities primaril& consists of #!S! government %onds$ municipal securities$ and %onds issued %& #!S! government agencies! Fed Funds Sold lending of e cess %ank reserves to other commercial %anks! Reverse Repurchase 6greements counterpart& to a repurchase agreement! .urodollar 4oans short,term loans denominated in dollars and made outside the #!S! Fi ed 6ssets the %ank!

( #Balance Sheet Activities 4oan Commitments promise %& a %ank to lend mone& according to the terms outlined in the commitment! Stand%& 4etters of Credit %ank promise to pa& a third part& in the event that the %ank*s customer fails to pa&! (erivative Securities interest rate and currenc& forwards$ futures$ options$ and swaps! AD

Chapter 1H Commercial 2ank Operations

Student Notes

A1

Chapter 1B 2ank Management Chapter $ 1an# !ana"ement Chapter (b*ectives . amine the goals of %ank management . amine how to measure and manage risk Review %ank mismanagement

Student Notes

&oals o Bank Management Ma imi-e shareholder wealth Managing 4i+uidit& asset and lia%ilit& management 6sset Management deposits$ investments$ loan repa&ments$ and asset sales! 4ia%ilit& Management certain t&pes of %ank lia%ilities are ver& sensitive to interest rate changes! Securiti-ation grouping like assets and selling the securities to investors!

Managing !nterest Rate Risk Methods of 6ssessing Interest Rate Risk 1ap 6nal&sis the rate sensitivit& of %ank earnings as measured %& the gap %etween the maturit& of assets and lia%ilities! (uration Measurement measuring the gap %etween the durations! Regression 6nal&sis how performance has historicall& %een influenced %& interest rate movements! Methods of Reducing Interest Rate Risk Maturit& Matching matched funding of loans! Floating,Rate 4oans loans that ad;ust to current interest rates! Interest Rate Futures Contracts take offsetting position in futures markets! Interest Rate Swaps e change periodic cash flows %ased on specified interest rates! A3

Chapter 1B 2ank Management

Student Notes

Interest Rate Caps %u& calls on interest rate movements! Managing Credit Risk )radeoff %etween Credit Risk and Return the lower the risk$ the lower the e pected return! Measuring Credit Risk credit anal&sis and collateral! (iversif&ing Credit Risk avoid concentrating assets among a single firm or firms in the same industr&!

(ther !ssues Measuring Market Risk Ealue,at,Risk /E6R0 method to determine possi%le losses! 2ank Capital Management maintain ade+uate amounts of capital! "rovides a financial cushion Maintains pu%lic confidence "rovides protection to depositors Source of funds for growth Restructuring shifted revenues awa& from interest margins to fee income 6c+uisitions growth +uickl& achieved through ac+uisitions! Bank Mismanagement "enn S+uare 2ank loans concentrated with energ& companies! Continental Illinois 2ank small core deposit %ase so it relied on %orrowed funds! 2ank of New .ngland concentrated loans on commercial real estate! Implications risk is greatl& increased with lack of diversit& and aggressive loan strategies!

A7

Chapter 3D 2ank "erformance Chapter )% 1an# 2erformance Chapter (b*ectives . amine the factors that affect cash flows!! Review the factors that affect the re+uired rate of return! . amine performance evaluation!

Student Notes

Factors that A ect Cash Flo"s .conomic 1rowth strong economic growth increases e pected future cash flows! Risk,Free Interest Rate interest rates are inversel& related to the value of a %ank! Industr& Conditions regulations have a large impact on the industr&! Management 6%ilities skilled management increases cash flows!

Factors that A ect the Re-uired Return Risk,Free Rate inversel& related to value! Risk "remium also inversel& related to value! .conomic conditions has a large impact!

Per ormance )valuation Interest Income has %een declining in recent &ears! Is still comparativel& large for small %anks! Interest . pense interest paid on deposits and other %orrowed funds! Net Interest Income difference %etween interest income and interest e pense! Noninterest Income fees charged for services! Noninterest . pense e penses not related to the pa&ment of interest on deposits!

Bank Per ormance )valuation Return on 6ssets /RO60 Net IncomeL)otal 6ssets tells how much profit is generated with a given amount of assets!

A9

Chapter 3D 2ank "erformance

Student Notes

Return on .+uit& /RO.0 Net IncomeL)otal .+uit& the amount of profits in relation to the capital contri%ution to the firm!

AA

Chapter 31 International 2anking Chapter )$ International 1an#in" &lobal Bank Regulations #niform 1lo%al Regulations

Student Notes

#niform Regulations for 2anks Operating in the #!S! foreign %anks su%;ect to same regulations as #!S! %anks! #niform Regulations across .urope one set of rules for %anks operating in .urope! #niform Capital 6de+uac& 1uidelines 9J capital to assets ratio! &lobal Bank Competitions Competitions in Foreign Countries more competition in other companies! Competition in the #!S! man& foreign %anks have esta%lished %ranches in the #!S! Impact of the .uro increased competition for financial services across .urope!

Risks o Multinational Banks Credit Risk more difficult to o%tain credit information a%road! . change Rate Risk currenc& value and e change controls! Countr& Risk closel& tied to political developments in a countr&! Settlement Risk risk that it ma& not receive mone& due to default and have little recourse! Interest Rate Risk forecasting %ecomes more difficult with the level of international involvement! Com%ining all )&pes of Risk asset management %ecomes ver& comple !

!nternational .ebt Crisis 4atin and South 6merica man& countries defaulted in the earl& 1BCDs! Reducing 2ank . posure to 4(C (e%t Selling 4(C 4oans AF

Chapter 31 International 2anking

Student Notes

(e%t,.+uit& Swaps 2oosting 4oan 4oss Reserves 2rad& "lan voluntar& de%t,relief measures allowing %anks various e it instruments! 2rad& 2onds an e it %ond that e changed de%t for lower principal and interest amounts! Country Risk Assessment .conomic Indicators evaluates the countr&*s economic environment! (e%t Management measures the fiscal polic& of the countr&! "olitical Factors risk of une pected change in the political environment! Structural Factors evaluation of the natural resources of the countr&! Overall Rating each varia%le generates a rating which is then weighted to created an average score!

AH

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