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Nominal exchange rate
The rate at which the currency of one contry trade for that of another, ie the price of of one currency in terms of another currency.
if the vlue of the dollar rises from 1 dollar per 100 yen to 1 dollar per 200 yen then the dollar has appreciated and the yen has depreciated
Real exchange rate
The rate at which the GOODS of one country trade for the goods of another coutnry
= Dollar price of a good / (euro price of good * nominal exchange rate)
Should equal 1
Foreign exchange market
OVer the counter market where curencies are traded... If you want to trade foreign stocks/bonds one must convert first.
*largest global financial markets
Trasactions of currencies immediately at the current exchange rate
of currencies at a specified future date
at an agreed upon rate
- A private trasaction
- Have credit risk.
Garenteed by clearing house standardized in terms of quality and settlement date
Exchange rate risk
the rist that a firm will suffer losses because of fluctuations in the future..
The forward rate reflects where the market expects the spot rate to be in the future.
*to hedge in a fall in the dallar you sell dollars in the forward market... A hedger uses the derviative market to reduce risk while a speculator uses the market to place a bet on the future value of a currency
What factors drive movements in exchange rates?
Law of one price
Theory of purchasing power parity
law of one price
the idea the identical produst should sell for the same price everywhere or in other words a given quatity of currency should be able to buy the same quantity of goods and services anywhere in the world.
Theory of Purchasing power parity
Name its limitations
States that exchange rate move to equalize the purchasing power of different currencies or in other words, nominal exchange rate should moe in such a way that the law of one price holds.
- PPP is limite because
- 1 not all products can be traded internationally
- 2 products are differentiated
- 3 gov impose barriers to trade
Domestic people want to get ouus of owning financial capital... drop in demand= less popular. Increase in supply=no one wants its anymore
Depriciation in currency
Giant pool of money
global savings appreciated the dollar in early 2000.. cause an increase in demand for us dollar. in 2008 fear came in the global crisis.. there was more demand for the US dollar because they thought the us was stronget than there own currency.. even in the depression
interest rate parity
The proposition that difference in interest rats on similar bonds in differ countries relect expected future changes in exchange rates.
Interest rate on domestic bond= interest rate on foreign bonds- expected appreciation of domestic currency
If inflation in rapidly increasing what happens to the curency
The financial system is designed to
Create long run capital accumulation
What are the 2 key categories of problems that impede the flow of financial capital?
- Transaction cost: the cost of makeing a trade
- -Financial intermediaries are able to reduve this through economies of scale-more products equal cheaper prices
Information costs the cost that a savor incurs to determine the creditworthiness of potential borrowers and to monitor how borrowers use the funds aquired.
one party to an economic transaction has better information than does the other party.
Adverselection.. Lemmons vs peaches (used cars)
How to over some adverse selection
a. The SEC
b. S&P and Moody's sell infor related to creditworthinesss. Athough may be believed to be under provided = Free rider problem
c.Collateral- assets borrower pledges to lender if he defauls on loan
d. Financial intermediation ; banks are good and producting information about firms.. Not subject to free-rider problem.. MOST LIKELY TO OVER COME ADVERSE SELECTION
The risk that people will take actions after they have entered into a trasaction that will make the other party worse off: in financial market the problem investors experience in varifying the borrower are using their funds as intended. This is also assymettric because the borrower knows more than the lender.. PONZI SCHEME
Pricipal agent problem
The agent or manager may not act in the pricipal or the owners bes interests.. and use money for personal benefits
How the system overcomes the Principal-agent problem
1. the SEC monitors
2. Incentive contacts: fixed price contracts
3.Restrictive covenents are used to limit the uses of funds that a borrower recieves
Three Key features of our financial system
1. Loans from financial intermediaries are the most important external source of funds for small to medium sized firms... Smaller firms cannot buy directly because costs are to high and cannot sell because of adverse selection
2.the stock market is a less important source of external funds to corporations than the bond market.- most trading involves existing shares and not knew ones.- corp have been recenly buying back more stock than they have been issueing
3.Debt contracts usually require collateral or restrictive covenants- goods purchased used as collateral.-corp bonds have collateral-savers recieve higher int rates while borrowers have lowerint rates.
Assymetric information in developing countries
- -poor system of property rights may prevent collateral
- -porr legal system make it difficult to enforce restrictive covenants
- -weak acct standards may reduce access to info
- -gov intervention throu credit programs and state owned banks are not efficient in allocation of financial capital
Balance sheet Liabilities
- Checkable deposits
- Nontransaction deposists-saving acct and CDs
- Borrowings (from other banks or fed)
- Bank capital
Balance sheet Assets
- Reserves (held at fed)
- Gov Securities (secondary reserves)
- -real estate
- Defined as the differnece between assets and liabilites
- Bank capital as a shcare of assets is an impt parameter
- Cap/assets ratio was at 12 % in 2010
JObs of bank manager
- 1. Capital adequacy managment
- 2.liquidity managment and asset managment
- 3. credit risk
- 4. interest rate risk
After tax profit / Assets
after tax profit / Capital
ROA * bank leverage
reflects the return the sharholders invesment
capital / assets
*managers want to hold a high ratio of assets to capital to maximize prfoits
* a high bank leverage is risky while is can amplify the affects of asset appreciation of ROE...
Mangers may want to take on more risk than shareholders would prefer if rewarded base on ROE - moral hazard
A reserve shortfall can be remedied by?
- A) borrowing from another bank
- B)Borrowing from the fed
- C) Selling sequirities
- D) reducing loans
What are the few ways a manager can adrees Credit Risk?
- 1. Diversification
- 2. Credit risk anaylsis- the process that bank loan offer to screen loan applicants
- 3.Collateral or compensating balances
- 4. Speicalization in lending- when a bank focuses on specific industries that it knows very well
Analyzes the gap between the dollar value of a bank's variable rate asset and the dollar value of its variable rate liabilites... USUALLY NEGATIVE
(Variable rate asset-variable rate Liability)* interest rate= Profit
Analyzes how sensitive a banks capital is to changes in maret interest. Avg tim to maturity
The difference between the avg duration of a banks assets and the avg duration of the banks liabilities...
Positive duration gap
An increase in the market interest rates the duraction of assets more than the value of the liabilites
Off-balance sheet activities
- A) Standby letters of credi- a promise by a bank to lend funds to a seller of commercial paper at th time that the commercial paper matrues
- B) Loan Commitments- an agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time
- C) Loan sales a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to third party
- D) Trading activities- banks earn fees from trading in derivative markets
the Glass steagall act
In 1933 seperated the commercial and investment banking
Gramm-Leach Blilty act
Repealed the glass seagal act
Developement of financial holding companies
raise funds to invest in loans and securities
Financial intermederaries that raise funds by selling share to individuals and invest those funds ina portfolio of stcoks, bonds and mortgages and money market securities.
- -Reduce transaction costs.. provide risk share benefits... help gather infor
- -began in 1920s
close-ended mutual fund
A fixed number of nonredeemable shares issued, with the price of a share fluctuating with the market value of the asset. Share may sell at a discount or premium relative to the market value of the asset in the fund
Open-ended mutual fund
INvestors can redeem shares after the market close for a price tied to the value of the asset in the fund.
Exchange trade funds
like close ended funds, trade continually but prices track the value of the assetsin the fund more closeyly
*mutual funds that do not charge commission are called NO-Load Funds
Money Market mutual funds
Invest exclusively in short-term assets such as treasury bills, negotiable CDs and commercial paper.
- -allow savers to write checks against accts
- -popular with small savers as laternatives to commercial bank checking and savings accts because they typically pay a higher rate of interest
- -increase comp for commercial banks
Organized as partnerships of wealthy investors that make relatively high risk speculative investments
Nonbanke financial intermediaries that raise money through the sale of commercial paper and other secuties and use the fund to make small loans to housholds or firsm..
-lower degree of regulation
- 1. business
Contactual savings instituations
finfnacial intermediatires such as a pension fund or insurance sompany that revieces payments from individuals as reutl of a contrac then uses the funds to make investments
finfnacial intermediaries that inves t contributions of worker and firms in stocks bonds and mortgages to procide pension benefits during retirements...
private state and local gov. are the larges participands in the capital market
Finincail intermediatres that specialize in writing contracts to protect policy holders form the risk of financial loss associated with particual events
uses the law of large numbers to make predictisions
Risk pooling- quotes size of reserves needes
-acutatries compile probabilties...
Shadow banking system
financial institutions such as investment banks, hedge funds, and MMMF
most conserserned with systematic risk
assets are worth more than liabilities
when depositors who ahve lost confidence in a bank simultaneously withdraw enough funds to close the bank
when the closting of one bank spreads to run on other banks
How the government intervenes to prevent bank panics?
- a. FDIC
- b. Feds lender of last resort capacity
How the financial environ ment changed since the 2008 Crisis
- 1. Government as a safety net
- 2. Restrict competition
- 3.Capital requirements (CAMEL)
- Capital adequacey
- asset quality
- Sensitiviey on the market
lifted in the early 1980s place ceilings on the interest rates that banks could pay... to restict competition
How the FDIC regulates when undercapitalized
- 1. Submit capital resoration plan
- 2. restrict asset growth
- 3. seek regulatory approval for new ine of busines
- 4. closes bank
The wall street regorm and consumer protections act of 2010 DODD-FRAMK
-created the consumer financial proection bureau to procect consumers when investing
-Esablishes the Financial Stability oversight Council - identify systematic risk
- Ended TBTF
-Implented the Volcker rule- banned most proprietyary trading at commercial banks