Thursday, May 28, 2015

Chapter 11 | Commercial Bank & Money Market

Definition

- There a lot of players in the scheme of money markets and require equal attention.
Commercial banks, corporations and credit agencies are the main ones. More
importance is given to the money market instruments that these organizations use or
implement.

Federal Funds

- Federal funds are the principal method of payment in the money market. Federal
funds are any monies available that can be used for immediate payment (same day
payment).

- They are known as such because originally, the funds that were at the Federal Bank
reserve were the most liquid form of money and would hence act as means of
payment. If banks needed a transfer of funds among them, they would just contact
the Feds and fund would be transferred from one banks reserve account to another.

- Nowadays, the scope of Federal Funds has enlarged. Almost all depository
institutions keep funds with large bank in cities, these deposits can also be
transferred immediately.

- Commercial Banks are the most significant borrower of Federal Funds.

Negotiable Certificates of Deposit

- A CD is an interest bearing receipt of fund left with a depository institution for a

certain amount of time.

- Banks and institutes issue a lot of CDs but true money CDs will be such that can be
sold over as many times as wanted before the maturity period.

- This was introduced by banks as people were starting to reduce their deposits and
option for investing in Treasury Bills.

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- As such, the interest rate of the CD is negotiated amongst the issuer and buyer. It
generally offers a higher rate than the market going rate.

- Savings Banks, Money market funds and credit unions are big consumers are CDs as
they are relatively low market risk with varied maturity and carry a decent return.
However, the CD isnt marketable in the secondary market and most buyers hold
them till maturity.

Eurocurrency

- In the current international money market, there is an increased demand to do

transactions in denominations of highly convertible currency like the dollar, euro and
yen. This market is termed as the Eurocurrency market.

- The onset of globalization could be cited as the primary reason for the birth of
Eurocurrency markets. As corporations and institutions grew, this came to be.

- Imagine a US firm expanding to Egypt. To set up the infrastructure in Egypt, they

would require an infusion of dollars. Using those dollars, they again need to get the
local currency because the construction will be done using the local currency.
Therefore, slowly banks have now started to accept deposits and transactions in
currency other than the host currency - mainly the stable ones like Dollar, Euro,
Pound.

- The market is large but there is no proper way to measure it. One of the main reason
is that Eurocurrency is always on the move. They are merely bookkeeping entries in
banks and not held as actually valued currency. They are used in imports and
exports, tax revenues, etc.

Bankers Acceptance

- This is a time draft that is drawn on a bank by an exporter or importer usually to help
pay for merchandise.

- The purpose of the draft is to shift the risk of default for the lend in the transaction
from the borrower to the credible and credit worthy bank.

- It can be best described by a very common scenario. A buyer of coffee in USA is

doing business with a seller of coffee in Brazil. Now before the shipment is done from
Brazil to USA, the supplier wanted payment of the coffee. However, the buyer wants
to actually get the coffee grains, market it, sell it and then pay for it using the
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proceeds. The supplier will be reluctant to sell the coffee on such a loan with a buyer
she might not have interacted before just based on faith.

- In this case, the buyer may negotiate with a bank and obtain the bankers
acceptance. This is done by discussing with the bank about a maturity date in which
the bank will make the payment so that the buyer can pay of the obligation before
that. The acceptance is basically a piece of paper that the bank is promised to pay
the amount to - no matter who hold the paper.

- Now, after obtaining the bankers acceptance, the buyer of coffee can sell this paper
to anyone in the secondary market at a discounted rate for cash. Using this cash, he
can pay the seller and receive the coffee. He can even sell the acceptance paper to
the seller directly if the seller is willing to exchange it for the goods. Hence, it is clear
that the person actually providing credit to the buyer is the person who finally gets to
hold the acceptance paper. However, the liability of making the payment mentioned in
the acceptance paper is of the Bank only.

- The Bank therefore bears the final risk as if the buyer of the paper does not make the
obligation payment, it has to be absorbed by the Bank.

- Bank Acceptance are very risk free as they are backed by credit worthy banks.
Commercial Paper

- They are short term, unsecured promissory notes issued usually by well known
companies that are financially strong and carry high ratings.

- These funds raised are usually used for current transactions - taking care of accounts
receivable and inventories.

- The papers are created by organizations and therefore are very customizable. The
investors can set the days to maturity as well as the amount of interest upon
discussion with the issuer.

- Big financial companies usually go for commercial paper as they have very high short
term requirement for money. Since these firms are very large, they directly issues the
paper as direct paper.

- Smaller companies opt for using dealers to take care of the issuance of the
commercial paper and these are therefore known as dealer paper.

Thursday, May 28, 2015

Chapter 12 | Central Bank and its Roles

Definition

- The Central Bank is an agency of the government and it aids the government in a lot
of public policy related matters such as the monitoring the operations of the financial
markets, controlling the growth of money supply and ensuring greater performance of
the economy.

- The Bank does not directly deal with the public but rather deals with banks acting as
the bankers bank in dealing out their policy making.

Roles

- The roles of the Central Bank can be primarily divided into four halves; controlling the
money supply, stabilizing the money and capital market, acting as lender of the last
resort and ensuring efficient payment mechanism.

- Controlling the money supply is nowadays heralded as the primary long term
objective of the Central Banks all over the world. Money is basically identified as
being a medium of exchange - therefore consisting of all currency, coins and
travellers cheque in the economy. Money is also termed as having very high liquidity
capability and therefore deposits have to be taken into account as well. All these
together make up the money supply and it has become increasingly important to
keep an eye on the growth of money supply. Close ties between growth of the
economy and growth of money supply has been found and as such, governments try
to control money supply to achieve certain economic growths. Another reason to
keep money supply in check is, without any regulatory ceiling, people will end up
creating unlimited money in the economy. The cost of printing a 1$ note and 100$ is
almost the same and therefore people would just print money. However, this might
lead to a situation of excess money fighting for scare goods - creating extreme
inflationary pressure. Ensuring this doesnt happen is the reason behind the stringent
approach to controlling money supply.

- Stabilizing the money and capital market is slowly becoming an increasingly part of
the Central Bank policies as capital markets become more evolved globally. Financial
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systems ensure money is shifted from those depositing to those who need to borrow
money for investment purposes. This system will only function efficiently if people
have the faith in the financial system and put in their deposits in the system. If the
financial systems have very fluctuating interest rates or have collapsed more than
they should in any given environment - then the public will lose faith and the entire
system will break down. Therefore, the Central Bank at times injects money into the
system if adequate funding is not found and they intervene if the market interest rates
are fluctuating at rates far distant from the expected rate they want for growth.

- Central Banks are term as the bankers bank and as such they act as lending
institutes to all the Commercial Banks in the given economy. Central Banks also
create the policies of the Commercial banks and the banks have to report to the
Central Bank about its performance and conformance to the policies.

- One of the last role of Central Bank is to ensure payments in the economy take place
without any hassle. They do that by ensuring there are no lags in cheques getting
cleared, adequate supply of coin and paper to pay and even transferring funds from
accounts. If the payment system is not working fluently and cheques are not being
cleared as an example - the entire economy will feel the burden of such a glitch and
can even come to a standstill hurting the nations economic growth.

Goals

- The goals of Central Bank can be divided into two main halves; ensuring the
maximum output and employment of the economy and promoting stable prices.

- Promoting stable prices has again turned out to become the more important of the
goals and kind of the primary goal of the Central Bank. They want to achieve this goal
to basically avoid inflation. Inflation implies reduction in economic growth,
misallocation of resources, misappropriation of funds as the borrowers get more
wealthy and rising interest rates. Central Banks in many nations have even gone to
this level to announce a level of inflation they would strive for in an year and try to
maintain.

- Just as inflation is a problem, Central Banks need to keep an eye on deflation as well.
Japan is a prime example of a nation hit with deflation where prices of goods kept on
going down, the lenders actually became more wealthy and it was more difficult to
find credit. Overall spending and growth in the economy went down which are areas
a Central Bank needs to keep an eye on.

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- One of the challenges of Central Bank in achieving its long term goals is that some of
the ways to achieve the goals end up creating conflict. That is, to method to achieve
Goal A can cause reduction in the achievements accounted for in Goal B. Higher
interest rates will slowly make the cost of credit high and reduce the want for people
to borrow. This leads to a much stabler price but at a cost of economic growth and
unemployment - since less money is being injected in the economy than before, the
growth slows and the lack of growth leads to no new demand for jobs.

Channels

- There are few channels through which a Central Bank can influence the condition of
the economy and the financial system; changes in the cost of borrowing for business
and consumer, change in the volume and growth of money supply, change in the
price of domestic currency to foreign currency, change in the expected future
conditions in the mind of the people and change in the value of the financial assets in
the economy right now.

Reserves

- All depository institutes in general need to keep a certain amount of their deposits as
reserves. This is known as legal reserves.

- Legal reserves accounts for the amount of deposit each institute keeps with the
Central Bank as well as the amount of currency and coin they hold in their vaults.

- Total Legal Reserve = Required Reserve + Excess Reserve

- Most deposit firms tend to have low to zero excess reserve as the total legal reserve
assets earns no asset income - it is basically idle cash. As a result, institutions try to
keep as little idle cash as possible.

Deposit Multiplier

- The dollar volume of deposits that the banking system can now create due to a 1
dollar excess legal reserve injected into the banking system is known as the deposit
multiplier.

- The deposit multiplier derivation is important to understand how exactly the multiplier
works. The Central Bank usually sets a Required Reserve ratio on the deposits a
bank receives.
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Required Reserves = RRR X Transaction Deposits

Banks at times hold excess reserves in their vault to act as a protective cushion if ever
the need arises. This excess reserve also depends on the growth of deposits and the
bank usually has a rate of excess reserve that they wish to hold.
Excess Reserves = EXR X Transaction Deposits.
Deposit Multiplier = 1/(RRR+EXR)
Now, it is clear that the reserves are dependent on transaction deposits. A bank may
want to hold a certain amount of money at hand as any amount higher than that will just
be sitting as idle cash. However, if suddenly a lot of deposits take place in that bank,
they will suddenly have a higher excess reserve than the amount they wish to hold!
Suppose this amount is 1 million dollar - the excess reserve in excess of the amount a
Bank actually wants to hold. Now, no Bank will want to have idle cash and therefore
lend this 1 million to earn interest. Now as soon as they extend loan, this loan may end
up as being a deposit in another Commercial Bank. As that Banks deposit increased
suddenly, there excess reserve amount will increase higher than the amount they wish
to hold. This new bank will again have to extend loan to others as their idle cash has
increased.
The entire process will continue like a domino effect until all of the excess 1 million is
absorbed by the banking industry. When this process ends, we can then figure out how
much new deposits and loan has been created in the process of absorbing excess
reserves using the Deposit Multiplier.
New deposits = Deposit Multiplier X injection of excess reserve
In this case, (1/RRR+EXD) * 1,000,000

Money Multiplier

- There is another thing that Central Bank likes to follow closely to get an update about
the situation of the economy. They look at the relationship of the money supply in the
economy that is related to the spending and income to the total reserve base
available to the depository institutions.

- Monetary Base = Legal Bank Reserves + Currency in the hands of the public

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- This total monetary base can be closely handled by the Central Bank using open
market operations. The relationships between the monetary base that can be
controller and the total money supply in the economy is the money multiplier.

- Money Multiplier X Monetary Base = Money Supply

Thursday, May 28, 2015

Chapter 13 | Tools of Central Bank

Definition

- To change the volume of reserves available to institutions for lending and to influence
the interest rates, the Central Bank has a few variety tools in their disposition; general
credit controls and selective credit controls.

- General Credit Controls are those which affect the economy and the entire financial
system. Tools of this operation are open market operations, discount rate and reserve
rates.

- Selective Credit Controls are those which affect a specific group of the banking and
financial institution. Moral suasion and margin requirements are two such policy.

Open Market Operations

- This is when the Central Bank directly gets involved in the buying and selling of
government and other securities. This is one of the most commonly used tool of the
Bank as it allows them to deal with short term problems.

- The use of this tool has to big impacts; interest rate and reserves.
- If the Central Bank decides to buy securities in the open market, it will lead to an
increased demand for securities in the market. This demand leads to higher prices
but lower yields. As yields have gone down, interest rates will fall as well. The reverse
happens if the Bank decides to sell securities.

- If the Central Bank decides to buy securities in the open market, they will have to buy
these already from the financial institutions that are out there. To pay the financial
institutions, they will just add cash to the reserve account they hold with the Central
Bank. This will directly lead to a rise of reserve for the financial institution - rise of
both the legal as well as excess reserve. They will use this new reserve to give out
more loads and lead to higher credit facilities in the economy. The reverse will
happen if CB decides to sell securities in the open market.

- The way the CB carries out this operation has three main parts; straight, repurchase
agreement and reverse RP.

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- Straight is when CB directly buys or sells securities creating a permanent change in

the securities outstanding in the financial market. RP is when the CB buys securities
from the sellers but agrees to sell back the securities at a given time, even at times as
short as a single day. This is at times done in times of credit crunch crisis. Reverse
RP is when CB sells securities in the open market with a deal of buying the securities
back after a certain time. This occurs when there is uncollected checks in the market
i.e. excess cash with the financial institutions.

- Goals of Open Market Operations is slightly different from a CB original goal - aiming
for economic employment, stable price level and a sustainable economy. A CB also
has to interact in the open market to ensure the current status quo of how things are.
This is the defensive approach of the CB. CB also uses the open market to achieve
its economic goals by adopting aggressive policies such as dynamic policies.

Discount Rate

- This is one of the oldest tool of the CB. Discount rate is the rate at which other
financial institutions takes loans from the CB during the discount period that it holds.

- The Federal Reserve provides loans to three type of categories; primary credit,
secondary credit and seasonal credit.

- Primary credit is for those institutions only that are strong and have higher
supervisory ratings with adequate capital. These loans can be used for any purpose.

- Secondary credit is for those who dont fall under the category of primary credit.
These cant be used to raise the asset of the institute - hedging it outside for higher
returns.

- Seasonal credit is for institutions like farm banks and to help them during their cyclical
tenure.

- There are atleast three changes with the discount rate change; cost effect,
substitution effect and announcement effect.

- If the discount rate rises, it becomes more costly to get credit from Central Bank.
Therefore, borrowing as a whole may reduce in the economy. The reverse is true if
the rate reduces.

- If the discount rate rises, institutes may now look for other avenues to get their credit
which are being offered at a lower rate. This in turn can make that avenue more
expensive as a rise in demand will lead to rise in prices.
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- Announcement effect is the idea that a change in discount rate is usually indicative of
a nations monetary policy. A tight policy of not offering credit can make the general
public stop borrowing in the economy and start to hold assets.

Reserve Requirement

- It used to be thought that the primary reason for reserve requirements was to ensure
the safety of the public and their deposits. However, it can now be seen that reserve
requirements can act as a strong tool to influence the state of the economy.

- A change in reserve requirement changes the deposit multiplier as well as the money
multiplier. A rise in reserve requirements actually reduces both the multipliers and
therefore the growth of money slows down.

- If the reserve requirement is now reduced, banks will now see that they currently
have more excess funds than before as the amount of legal fund required would
reduce. This new fund will be taken of to become new investments for the institute.

- Interest rates are also affected by change in reserve requirements. If the requirement
is increased, the institutes will now find they need to keep more reserves in bank than
before. If they do not have any cash at hand, they will have to aim to borrow from the
market which will make credit scare and more costly.

Moral Suasion

- This is basically arm twisting of the financial institutions by the Central Bank to ensure
they are following the general guidelines adopted by the Bank. If the CB is aiming for
tight credit policies, they will ensure by glaring over the financial institutes ensuring
they dont end up creating high credit in the economy.

Margin Requirements

- This is a policy that is not regulated as much as the other policies but act as a
safeguard for the interest of the overall health of the financial institutions.

- Currently, common stock as well as preferred stock can be purchased at credit.

However, the investor has to atleast pay 50% of the stock price at market value
before making the credit arrangements - ensuring safety of the stock.

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Chapter 15 | Non Bank Thrift Institutions

Emergence of non bank thrift institutions

- Basically offered mortgage loans and saving options

- Now they have diversified to offer more solutions
- Both commercial banks and non bank organizations are slowly offering similar
products due to market convergence

Saving and Loan Associations

- Providing long term loans to households to enable them to buy apartment and pay
mortgages.

- Had a major up and down journey with it seeing a boom as well as fall in the US
economy.

Saving Banks

- Started out as a means for the low income earners to save and borrow money.
- Can be used to even deposit as low as $1 and start from there.
- The depositors are the owners of the bank by earning dividend from it.
- The US had passed laws for S&LA to become Saving banks and vice versa to help
ease banks consolidate and cut the cost of regulations.

- There is a increasingly blurred line between Commercial Banks, Saving Banks and
S&LA as they all fundamentally provide the option for individuals to deposit money.

Credit Union

- Cooperative and self help associations that are not profit based financial institutions.
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- They provide low loan interest rates and high deposit rates because their functional
costs are low and the organization structure is simple.

- Loans only handed out to association members and becoming members by common
bond.

- Has one of the lowest default rates of financial institutions.

- All the association members are the owners.
Money Market Funds

- Pooling of thousands of individuals money into low risk and high quality money
market instruments with small term maturities.

- Extremely popular because of being operating on a relatively risk free rate product
due to the government loopholes.

- Can at times back fire if the MMF focuses on slightly riskier instruments.
- Mainly focuses on Treasury bills and Bank CDs.
- The customers get cheque books which they can use to write and deposit checks in
their local bank accounts.

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Chapter 16 | Mutual Funds and other financial

institutions

Investment Company

- The place where thousands of individual investors investment is pooled together to

invest in a highly diversified portfolio of stocks, bonds and money market securities.

- This allows the individual to reduce their risk, diversify the portfolio, reduce cost,
avoid transaction cost and be able to hold high yielding stocks securities that couldnt
be purchased on his own.

- Held by individuals and families rather than corporations.

- Investment companies are majorly functioning with two goals; growth where the
invest in a portfolio filled with stocks or returns that have the potential to grow over
time and income where the current goal is on securities that will provide solid returns
as of this present moment.

- The structure of investment company is of two types; open end or mutual funds which
have open issuance of share of the company and close end where the amount of
share issued by the company is fixed which can be interchanged with the direct
meeting of seller and buyer.

- Mutual friends share price is calculated by the net asset value; difference of assets
with liabilities divided by the number of shares outstanding.

- Depending on the majority of security the investment company invests in, they are
named accordingly.

- Stock Funds are when they invest mainly on stocks that have a potential for higher
return in the upcoming future. The funds here does not put an emphasis on risk
diversification but rather aim for returns.

- Index Funds are when they invest on a portfolio of stocks that closely represent the
market. As such, the portfolios are usually very diversified and follow the likes of S&P
500. The portfolio will closely follow the market trends and therefore will be a less
risky investment.
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- Global Funds are when they invest on a global portfolio with stocks from international
stock exchanges added to the portfolio. The idea is that having a global stock
presence will help to further diversify risk but this can backfire due to certain volatility
of a few Asian and Oceanic stock exchanges.

- Vulture Funds are when investment are done on stocks that are performing extremely
poorly currently in the market. The hope is that if the company turns back, the stock
holders will be benefitted. Even if the assets of the company are liquidated, the stock
holder will have a claim on valuable assets of the company.

- Capitalization Funds are when companies are categorized as per their market
capitalization. Capitalization is just the value of the total number of shares
outstanding and its been seen that low cap and mid cap companies tend to be
slightly risker investment but pay off better returns.

- Life Cycle Funds are when investment of an investors money is done initially majorly
on stocks (around 80-85%) and then as the investor approaches retirement to shift
the funds to bonds to ensure a more secured return at that time.

- Hedge funds are highly exclusive group of fund managers where investors are only
allowed based on accreditation and higher risks are taken to garner even higher
returns. The word hedge implies that the portfolio is highly diversified and guarantees
a relatively stable return on any investment made in the company.

Pension Funds

- Pension Funds where set up to ensure a source of financial revenue when the
primary source of income of the investors stopped. The investors could set aside a
certain amount of money right now for future income. The money is invested in
portfolios consisting of stocks and bonds with the idea of generating revenue to
increase the size of the portfolio. Thats how income of this time can still ensure a
solid income in the future.

- Pension Funds are mainly two types; defined benefits and defined contribution plan.
- Defined benefit plans are when a fixed amount of money per month after retirement is
set by the plan. These plans are slowly being shoved away as the investor may at
times not receive the defined benefit if they were terminated from work or retired at a
time than set as per plan.

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- Defined contribution plans are when a fixed amount of money has to be contributed
by the investor and the final value upon retirement will depend on the performance of
those contributions in the securities.

- These are a safer plan because the contributions are the money of the investor and
therefore they are fully entitled to it no matter the time of job tenure.

Life Insurance Companies

- Life Insurance Companies allow the investors a hedge against the financial risk of
unexpected death, disability, ill health or retirement.

- The policyholders will receive risk protection in return for a premium that is high
enough to cover the cost of potential benefit claims, operational cost and a profit
margin.
Function

Type of Insurance
Whole life

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Covers entire lifetime

Premium can be borrowed by policy holder

Term life

Certain number of years so that the beneficiaries get the

amount if the death occurs in that time.

Endowment policy

Benefits payable at a future fixed date or payable to the

beneficiaries if death occurs early.

Group life

Master insurance policy for a group of people usually of

the same organization

Industrial life

Small denomination policy where payments are

collected regularly by agents

Universal life

Premium amount and timing that can be changed and

includes a saving account with flexible rate of return

Variable life

Benefits vary based on the value of the assets behind

the pledged contract

Adjustable

Can alter policies term, period of coverage or face value

Credit

Policy to pay off loan in case holder dies or becomes

disabled

Health

Coverage of medical bills and cost of hospitalization

Fixed

Pools of saving built up over time and expected to pay

out a future stream of income

Variable annuities

Based on assets which might appreciate over time and

income depends on the valuation of the assets.

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Finance Companies

- They are like the department store for buying credit of both business and consumers.
- They grant credit to business and consumers for a wide variety of purpose such as
asset purchase, car purchase, household machinery, etc.

- Depending on the specialization of the company they are divided into three parts;
Consumer Finance, Sales Finance and Commercial Finance.

- Consumer Finance companies extend credit to households to purchase items such

as cars, home equity loans and to cover medical expenses. These loans are deemed
to be more risky than other finance company loads due to higher rate of default. As
such, they are priced higher.

- Sales Finance companies are basically captive company. They are tied but dealers
and firms by buying installments from these institutions. Basically, the finance
company will have a few set installment policies that they would accept and they give
these terms to the dealers, often in blank installment papers. The dealer would just fill
the installment paper and then sell the installment to the sales finance company.

- Commercial Finance companies extend credit to businesses in times of credit need of

the business firm. They often provide direct cash loans to the accounts receivable of
the company and also offers lease financing to these business entities.

Investment Banks

- There is a fundamentally difference between investment banks and commercial

banks; investment banks do not offer any deposit facility.

- Investment Banks raise funds for and provide guidance to governments and
corporations. The principal function of investment banks is to market large scale new
issuance of bonds, stocks issued by the government or corporations.

- They are basically the wholesaler of new issuance of large volume securities.
-

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Venture Capital Firms

- Venture capital firms tried to bring in private investors and other sources to pool in
money and invest in rapidly emerging companies.

- They often fund the development of new technology or innovative products like
computer products or medicine hoping to earn high returns if the product is a
success.

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