Lecture #1

BUSINESS CYCLES

There is more or less a pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth.

At cyclical peak- economic activity is high relative to trend.At cyclical trough ??

Over time what causes the trend line to change ?

More resources

Factors not fully employed all the time.

What is inflation ?

Why worry about inflation instead of unempmt.?

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Lecture #2

MARKETS

What are they ??

What makes a good market ??

Can we name some “bad” markets ??

FINANCIAL MARKETS & INSTITUTIONS

I. Financial markets exist to aid in the most efficient allocation of capital

II. Financial Institutions facilitate this allocation of capital.

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The players in the market are households, businesses and governments. How they play and what motivates them to play is critical to the well being of economies.

TYPES OF MARKETS

Primary – New fund raising

Secondary – Trading

There are specialized markets for fund raising and trading. The most important of these are:

Money Markets – Maturities < 1 yr.

Capital Markets – Maturities > 1 yr.

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Lecture #3

FLOW OF FUNDS

Who are the players?HouseholdsBusinessesGovernmentsRest of the World

All act at one point in time or another as borrowers and providers.Funds arrive directly or indirectly

What is the role of Financial Intermediaries ?

To lower transaction costsTo lower riskTo provide better market information

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Intermediaries also incur risks………

I/R risk

FX risk

Credit or default risk

What about Foreign Mkts & Intermediaries ?

Provide for borrowing or investing abroad

Important source of diversification

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Lecture #4

What is an interest rate ?

Compensation for lending or giving up one’s abilitiy to spend today.

Can be a measuring guideline governing corportate investing.

Why do we care about interest rates ?

They influence the allocation of capital.

They impact the economy and decision making.

How do we look at interest rates and time ?

Concept of Present ValuePresent value allows you to place a value on

future funds. What might $10 today be worth 10 years from now ?

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The Present Value calculation converts cash flows received in the future to a value assuming receipt today (the PRESENT ).

How much is $3000 received in two years worth today if the interest rate is 4% ?

How much is $2000 next year and $3000 the year after worth today if the interest rate is 5%?

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Where do you hear the concept of Present Value applied quite often ?

U.S. Savings Bonds

Winning the lottery

Back to our first example :PV of $3000 received in 2 years @ 4% =

If the i/r is 2%....is PV higher or lower ?

If the i/r is 6%.... is PV higher or lower ?

Why ????

Lecture #5

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WHAT DETERMINES THE LEVEL OF I/R AT ANY GIVEN POINT IN TIME ?

The supply and demand of loanable funds. Same concept as the supply and demand of goods and services you studied in Economics.

So there is a supply and demand curve here as well.

SUPPLYHouseholdsBusinessesGovernmentsForeign investors

DEMANDHouseholdsBusinessesGovernmentsForeign

What might the supply and demand curve look like ?

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What might cause the curves to shift ?

SUPPLY:I/RWealthRisk Near term spending needsMonetary ExpansionEconomic Conditions

DEMAND:Current utilityEconomic conditionsRestrictiveness of nonprice conditions.

Lecture #6What are the factors that can affect the i/r for an individual security ?

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Begin with the “real interest rate “

Direct correlation between inflation & i/r..

U.S. Treasuries become the benchmark..

What factors influence nominal i/r ?

Default risk

Liquidity risk

Covenants- puts/calls

Term to Maturity

Ubiased Expectations Theory

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Liquidity Premium Theory

Market Segmentation Theory

Lecture #7

What does the yield curve tell us ?

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What exactly are bonds ?

Debt instruments – Secured/Unsecured

Coupon or Zero

PV = Face Value = Par

PV> Face Value= Premium

PV < Face Value = Discount

These reflect the price of bonds. How does that relate to Yield….

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Price and yield are inversely related. Why ?

Duration – measure of the weighted average time to maturity. That is, it takes into account the timing of payments. Any received before maturity will result in a shorter duration that the maturity date…..

Higher interest rates shorten duration. Why ?

Lecture #8

THE FEDERAL RESERVE SYSTEM

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Objectives:

Moderate long-term i/r

Maintain high level of employment

Stable prices

Economic growth

It’s duties:

Conduct monetary policy

Supervise/regulate depository institutions

Maintain stability of financial system

Provide payments services for governmentsAlso check clearing & wire transfers

Independent of Executive BranchOversight by CongressChairman/Vice Chair appointed by President

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12 Regional Banks 7 Member Board of Governors

5 of Regional Bank Presidents + Board of Governors comprise the Federal Open Market Committee (FOMC)

The objectives shown above are their job….What is important is how they do it….

Lecture #9MONETARY POLICY

What is it and how does it affect us ?

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In essence it is an attempt to influence the amount of reserves that remain in the banking system….which in turn affects i/r and the availability of credit…which ultimately affects the levels of employment, output, and prices and inflation. In other words the money supply.

MONETARY POLICY TOOLS

Open Market OperationsDiscount RateReserve Requirements

The FOMC impacts the economy thru its practice of buying and selling government securities in the open market. In so doing they are either adding money (expanding) to the existing supply or taking it out (contracting).

Discount rate – Rate Fed. Charges bank to borrow from it….In reality is only used as a signal to the market as to which way the Fed wants to see rates go. The discount rate was

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lowered 11 time in 2001 in an attempt to stimulate the economy.

Bank reserves:Required – currently 10%Excess

How do these tools help expand the money supply ?

How do these tools help contract the money supply ?

Definitions of the money supply

Base

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M1

M2

The FED selects a target and uses Monetary Policy to get to that target.

Most popular targets:

Money Supply

Interest Rate

Lecture #10

MONEY MARKETS

Short term debt instruments < 1 year

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Active secondary market/ very liquid

Capital markets > 1 year

Characteristics of money market instruments:

Large – usually $1 mil. +

Low default risk

Maturity of 1 year or less

Corporates and governments usually sell money market instruments to meet short term needs.

TREASURY BILLS

Default risk free

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Benchmark for other securities pricing

Refinancing debt/govt. deficit/tax timing

Sold at auction weekly

Shortest maturity is 13 weeks.

Sold at a discount

Suppose you buy a 26 week T-bill for $9500 whose face value is $10,000. What is the discount yield ?

i = 10000-9500/10000 x 360/182 = 9.89%

FEDERAL FUNDS

Primarily overnight loans between banks.

One of the uses of their excess reserves.

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FED sets the lending rate.

For all practical purposes are just lending cash between two banks.

REPURCHASE AGREEMENTS (REPOS)

Actual sale of securities between two parties with agreement to repurchase at set date and price.

Is collaterized most often with govt. securities.

Normally 1-14 days but can go 90.

More secure than Fed Funds so has lower yield…often as much as 25 basis points.

Lecture #11

COMMERCIAL PAPER (CP)

An unsecured promissory note issued by corporations.

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Corporates with good credit can often borrow cheaper in the cp mkt. than from their banks. (see chart on page 135)…comparing cp rates to prime rate.

Normally held to maturity….up to 270 days.

Lower rated corporates can issue cp backed by LOC’s or bank lines of credit. Expensive by effective….better than issuing long term if improving credit.

Purchasers get internal approval on a credit and return again again.

Cp usually sold thru dealers like Goldman Sachs…agree to repurchase in event of default.

Rates are quoted on a discount basis NEGOTIABLE CD’s

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Bank issued promissory notes. Specific maturity and rate. Trade in secondary market at negotiated price.

Normal maturities are 14-360 days.

Unsecured issuance so yield is higher.

BANKERS ACCEPTANCES

A draft for payment backing a LOC issued against imported goods.Importer gets LOC guaranteeing payment to exporter. BA allows them to draw down money before delivery. Importer then reimburses the bank.There is a secondary market for BA’s.

MONEY MARKET PARTICIPANTS

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Issuer Investor

T-bills Treasury Fed/Banks/Cor

Fed Funds Banks Banks

Repos Fed/Banks Fed/Banks/Cor

Cp Banks/Corps Corps/FI’s

Neg. CD Banks FI’s/Corps

BA’s Banks Banks/Corps

Where are there secondary markets ?

Where are yields the highest/lowest ?

Who are the important FI’s ?

Summary – Money markets are important to:

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The Fed – for controlling the money supply.

Banks – to meet reserve requirement and as a place to use excess reserves.

Broker-Dealers – Keep the market moving

Corporations - source of short term funding and as a place to invest short term cash.

Other FI’s – A place to maintain liquidity.

INTERNATIONAL MONEY MARKETS

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Foreigners are major investors in TreasuriesDiversification and default free

Keep deposits in foreign countries to facilitate exhange into $.

LIBOR is major lending rate.

Now major rate measurement for all types of loans, not just foreign.

Borrowing is usually quoted as a spread over LIBOR…might be 350, 30 or 3…depending on the risk associated with the borrower.

Lecture #12

THE BOND MARKET

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Bonds are capital market instruments with maturities of greater than one year.

Typically fixed income ….offering interest a set time periods and the return of principal at maturity. A bond with a coupon of 8% would normally pay interest every six months, 4% at a time.

Treasury notes >1<10 yearsTreasury bonds >10 <31 yearsThey comprise about 26% of total bond market securities.

Both pay semi-annual interest and are sold at auction..but are sold at par unlike T-bills.Treasury also issues inflation adjusted bonds called TIPS.

They also sell STRIPS where each coupon payment is sold separately.

The secondary market in Treasury issues is huge. If a bond is sold between coupon

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payments the seller must pay the buyer the accrued interest..or discount the price to account for it.

MUNICIPAL BONDS

Debt instruments issued by state and local governments. About 17% of all bonds o/s.Interest not taxed by feds or state investor lives in for bonds issued in that state.

Tax exemption lowers cost of bonds issuance for the governments because investors take a lower yield.

General obligation – backed by taxing powerRevenue bonds – backed by revenue of a project. General tax receipts cannot be used to pay off a revenue bond…thus is riskier. Industrial development bonds – normally for job creation.

How are municipal bonds sold ?

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Underwritten/best efforts/negotiated basisSecondary market very thin.

CORPORATE BONDS

Comprise about 57% of o/s bonds.Normally issued to fund long term obligations.Rating agency comments are critical to price.

Debentures – no collateralSubordinated debentures – junior in statusConvertible bonds – debt that converts to equity at some point in time if certain things occur.Callable bondsSinking funds

Moody’s/S & P / FitchWho are buyers of the various types of bonds?

Which bonds likely carry the highest and lowest yields ?

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INTERNATIONAL BOND MARKETS

Eurobonds – Sold outside the country of the currency in which they are issued. Could be dollar denominated bonds sold in Japan.

Foreign bonds – Bonds issued outside the home country but denominated in the host country currency…Samurai bonds are dollar denominated bonds issued by Japanese borrowers in the U.S.

Brady bonds – bonds substituted in a restructuring of a less developed country’s debt. Longer term and lower rates. Backed by the U.S. Treasury

Sovereign bonds – specific country issued . Lecture #13

MORTGAGES

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Loans to purchase real property such as a home, land or building.

75% of mortgages are for single family dwellings.

Characteristics of a mortgage:Size, term, i/r, collateral

Qualifications – fairly standard, income to value ratio (can you make the payments)Down payment – reduces default risk

Conventional vs. Insured.Maturity – 15/30 yr….. balloon payment

I/R – Fixed vs. ARMGreenspan ARM quotes.Amortization scheduleRefinancing depending upon rate cycle.

Originate with FI’s most of whom do not continue to carry them on their balance sheet.

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Sold off in secondary market thru securitization. Allows FI to enhance their liquidity and reduce i/r and credit risk.

What is securitization and how does it work?

Why securitize ?

Mortgage market very cyclical. Govt. subsidies are key to role housing plays in the robustness of the economy. Home building may suffer as rates go up…

Lecture #14

STOCK MARKETS

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What is stock anyway ?Equity/ownership

How does one make a return from stock ownership ?

Common/Preferred

Dividends

Limited liability of ownership

IPO’s /Seasoned offerings

Primary vs. secondary markets.

SEC/Registration/Red Herring/Shelf registration

The Markets:NYSE/NASDAQ/AMEX

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How does trading occur on each market ?

Indices:DOW / S & P 500 / Wilshire 5000

What causes prices to change on the Market ?

Efficient market theory / Random walk

Lecture #15

FOREIGN EXCHANGE

Global trade requires that we exchange currencies.

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The foreign exchange rate is the ratio of one currency to another. How yen equal one dollar ?

Initially had fixed currency rates. And Gold !!

Eventually floating. Now the Euro !!

Can use spot or forward markets to make exchange rate more predictable.

What causes exchange rate differentials between countries ?

Economic flows between countries are measured by the balance of payments.Current Account:

Merchandise trade balanceService sectorUnilateral transfers

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Capital Account :Direct investmentPortfolio investment

Lecture #16

DERIVATIVES

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Financial instruments tailored to change where risk lies.

Swaps, caps, floors, etc. are examples of these.

Most deal with the i/r or credit markets.

Spot contracts - discussed in FX context. Is a given price today….a guarantee. When investing using spot contracts you are investing looking for appreciation.

Forwards are contracts to buy something at a given price in the future at a price determined today.Hedging future price change by locking in today.Example: Airlines buying fuel for their fleets.Locking in a mortgage rate could involve a forward contract.

Futures contracts are like forward buy are traded on a formal exchange. No default risk versus total with forwards. Futures are revalued every day. Futures are generally in 3 areas:

i/rcurrency

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index

Can hold contracts to maturity or trade….most liquidate before maturity.If hold to maturity you take possession of the underlying asset.

So in each of these markets you are betting on change.

Options are a contract giving you the right but not the obligation to buy or sell something within a specific period of time.

Call options give you the right to buy (call away from the seller)..a security at a predetermined price.This is the exercise or strike price.

Selling an option…you write a call option.

Put option…

You can buy stock options on many of the major companies in the world on the NYSE or NASD.Cheap way to invest..

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What happened to markets after 9-11 ?What would have happened to your options ?

You can purchase indices made up of the major stocks….Dow/ S & P 500, etc. You can use these to hedge (as a derivative) other stocks you own.

SWAPS – the most used derivative…great fun !!

Two parties agree to swap cash flows some time in the future based upon some underlying asset.

Terrific tool for companies to manage i/r risk, currency risk and credit risk.

Sold bond last year - $100 mil. 10yr – 7% coupon.Now I think rates are going to trend down. What can I do about it now ?

Nothing changes with the underlying assets…only the cash flows tied to them.

Currency swaps – evening out exposure

Swap markets –

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Counterparty risk

Caps (ceilings) – limit the upside exposure.

Floors – protect the bottom

Collars – give up a little to establish a range of risk.

.Lecture #17

COMMERCIAL BANKS

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Serve as principal channel for government monetary policy.

Loans are assets/Deposits are liabilities. How then do banks make a profit when their chief assets and liabilities are just pieces of paper ??

ASSETS:Loans – A promise to repay – Approx. 60% of

assets.Loans to whom ?

Business – 25% of totalRevolving lines of creditSeasonal (inventory)Floor plansFixed – collateralized

Real Estate – 46% of total

Commercial and residential Mortgages/equity lines of credit

Consumer credit – 16%

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International

Investments

Biggest problems:

DefaultFixed rate lendingMismatch of maturities

Keys to successful asset management:

Lend to good customersInvest in low risk securitiesDiversify

THERE IS A FINE LINE BETWEEN PROFITABILITY AND SAFETY.

LIABILITIES

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Why are deposits liabilities ?

Deposits represent aout 2/3 of total bank funding.Generally checking, savings and CD’s.

The remainder of funding comes from direct bond issuance, discount window and fed funds borrowings.

Liability characteristics:Shorter term and more liquid than assetsTransitory

Major problems:Maturity mismatchesI/R risk

BANK EQUITY

Regulators mandate a minimum level of equity(capital) to assets.. Today this number is about 9%. So banks are really highly levered.

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Capital is primarily common stock and retained earnings. It also includes reserves for losses.

Serves as a cushion against a drop in assets. What happens when liabilities exceed assets ?

Japan banking crisis

What happens in a recession to bank business ?

Banks frequently have lots of business off their balance sheets. Swaps, derivative contracts, some loan commitments, foreign exchange contracts, etc.Why would they do this ?

Commercial bank companies have been growing because of the change in the law allowing branching.This has brought on major merger/acquisition activity.

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More income coming from non-interest/fee based business.

Commercial banking – International

U.S. banks going abroad:Less regulationNew businessFollow their customers

Risks are higher – As are returnsCreditPoliticalCurrency

Banking around the World

Japan-China-EuroThe Regulators

Lecture #18THRIFTS

Historically small institutions serving specialized needs of local groups.

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Savings assoc. (formerly S & L’s)…population has declined by 75% over last 20 years. Now about 1200.

Traditionally made long term fixed rate mortgages to individuals funded by short term deposits.Problems of the 1970’s / Regulation Q

Disintermediation

Garn-St. Germain Act of 1982 / NOW-MMDA

Oil collapse / Regulators failed / New regulators

Assets: Mortgages and mortg. Backed sec. 73%Comm. Loans – 3%

What happens in an economic downturn ?

Thrift liabilities:

Over 60% is small deposits.Fed. Home Loan Bank borrowings = 22%Equity (capital) = 8.2 %

What happens in an economic downturn ?47

SAVINGS BANKS

Essentially S & L or Savings Assoc. in the NE.Less than 400 exist.Balance sheets similar to Savings Assoc. except that are more highly capitalized.

CREDIT UNIONS

Evolved from employer owned institutions.

Are now nonprofits owned by their depositors.Customers must have a common bond.Consumer loans make up 37% of assets with mortgages at 29%.Portfolio is more liquid and has lower default risk than that of banks and SA’s.

Credit Union Liabilities:

Member deposits = 89%Primarily savings, CD’s, and NOW accts.

Equity (capital) is in excess of 9%

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Should be able to offer better rates to customers and make a higher ROA because of tax status.

REGULATION OF THRIFTS;

Office of Thrift Supervision (part of Treasury)FDIC provides insuranceState assoc. are regulated by states.Natl. Credit Union Admin. Board charters and

Insures credit unions.

Will these institutions exist 10 years from now ?

Lecture #19

INSURANCE COMPANIES

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Life insurance – allows individual to protect themselves and their benefactors against the loss of income from death.

Insures pool risks – why /

What happens if they are wrong ?

Types of life insurance:Ordinary lifeTerm lifeWhole lifeEndowment lifeVariable lifeUniversal life

Group lifeCredit lifeAnnuities

GIC’s Accident and Health

What do the balance sheets of Insurers look like ?

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Premiums are assets – long livedInvestments ?

Policies are liabilities

Regulation is at state level. Business getting more competitive with brokerages, banks entering.

Property & Casualty:

FireHomeownersCommercialAuto Liability

Premiums are assets / claims are liabilitiesHow do these companies ever lose money ?

Lecture#20

SECURITIES FIRMS & INVESTMENT BANKING

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Securities firms…..

Investment banks…..

Activities:InvestingInvestment bankingMarket makingTradingCash managementM & A

Others:Research……the scandals…tying arrgmts.

SEC / Spitzer

Lecture #21

FINANCE COMPANIES

Lenders to consumers, businesses, mortgages.

How are they different from Banks ?

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1. Sales Finance Institutions

2. Personal Credit

3. Business Credit

Asset makeup / Liabilities

Subprime ???

How do they fund their business ?

How much equity capital do they employ ?

Why do they even exist ?

Lecture #22

MUTUAL FUNDS & HEDGE FUNDS

Financial instruments that pool funds.

Various funds have different objectives:Growth, international, bond, etc.

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Prospectuses

How do you make money in a mutual fund ?

How do mutual fund companies make money ?

401-k growth

Regulation

Lecture #23

PENSION FUNDS

Savings plans through which participants accumulate tax deferred savings for retirement.

Defined benefit plan

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Defined contribution plan

Private plans:401-kIRAKeogh

Public plansState & localFederal

Lecture #24

REGULATION OF DEPOSITORY INSTITUTIONS

Crucial – Confidence in FI’s key for domestic andInternational business.

Safety & Soundness

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Monetary PolicyCredit AllocationConsumer ProtectionInvestor ProtectionEntry & Chartering

Reg. of Product & Geographic ExpansionPrior to crashGlass – StegallSection 20Glass – Stegall repeal

Geog. Expansion-Unit/restricted branching/interstate branching

FDICFSLIC

Why did problems of the 1980’s arise ? Balance Sheet Regulations:

Focus on leverageCapital to assets ratios become triggers:

>5% all the way to <2%

On balance sheet versus including off balance sheet

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What is history of foreign banks ?

Social Security problems / solutions

Lecture #25

FINANCIAL INSTITUTION RISKS

Credit – Bad investments/ Bad loansFirm specific riskSystemic risk

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Liquidity – High withdrawals/ “run”

Interest Rate – Mismatching

Market – Trading

Off Balance Sheet - draw downs/derivatives

FX –

Sovereign –

Technology – Operational

Insolvency

Lecture #26

MANAGING CREDIT RISK

Have had bouts of bad credit …..1980’s – thrifts/real estate1990’s – junk bonds/credit cards

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2000 – telecom’s/tech/sovereign debt

What is the best way for a FI to lessen its risk of extending bad credit ?

Real estate lending:Ability to payCollateral

Ability to pay:How long have you lived somewhere /JobCredit historyOther obligations

Calculate ratios Credit scoring also used. Compares your situation to others like you. If you look like those who have defaulted then assumption is you will also.

Collateral : Perfect security interest/lienDefault and they foreclose.

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Non-mortgage consumer loans just based on ability to pay.

Small business lending looks at cash flow of the business.

Mid-market focuses more on the business itself….cash flow/customer book/cyclicalityIn the end, how predictable is the cash flow /

Credit analysis of the smaller firms is critical.The 5 C’s….

Character/Capacity/Collateral/Conditions/CapitalHaircutsRatios

Large borrowers:Tougher sell for the FI. More options.Information is better.

Once you have decided to make the loan how do you decide what to charge for it ? In other words, how do you make money at this game ?

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RAROC

How much is a relationship worth ?

Lecture# 27

MANAGING LIQUIDITY RISK

I WANT MY MONEY NOW !!!

Can purchase liquidity or use stored liquidity.

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Runs and panics

FDIC

Fed Discount Window

Life Insurance Co. liquidity risk

Property and Casulty liquidity risk

Mutual Funds liquidity risk

Lecture #28

INTEREST RATE & INSOLVENCY RISK

Measuring the Risk…..

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Rate Sensitive Assets and Liabilities

The Repricing Gap

The Duration Model

What is Capital and how is it Valued ??

Lecture #29

MANAGING DERIVATIVE RISKS

Review Contracts:Spot / Forwards / Futures

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Hedging with Contracts

Accounting Rules / Bank Regulations

Options / Swaps

Lecture #30

LOAN SALES AND SECURITIZATION

What are Loan Sales ? Why did they come to be ?

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Participations / Assignments

What is the Market ? Who are the Players ?What drives the Market ?

How is Loan Securitization different from Loan Sales ?

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