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  1. 1. Chapter 1 – Financial Markets and Institutions Student Notes1Chapter 1 – Financial Markets and InstitutionsOverviewIntroduction to financial marketsIntroduction to financial institutionsReview of termsFinancial MarketsChannel through which financial assets are exchanged. Process also known as fundsintermediation.Surplus Units – suppliers of funds, because they spend less than they receive. Householdsare the only net supplier of funds.Deficit Units – users of funds, because they spend more than they receive. Households,corporations, and governments can all be deficit units.Financial MarketsMoney Markets – markets that trade debt instruments with maturities of up to one year. Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements,and banker’s acceptances.Capital Markets – markets that trade equity and debt instruments with maturities of morethan one year. Stocks, bonds, and mortgages.Primary Markets – markets in which corporations raise funds through new issues ofsecurities, such as stocks and bonds. May be first-time issues by firms initially going public, the sale of additional new sharesof an already publicly traded firm, or first time debt issuances.Secondary Markets – markets in which existing securities are traded.Organized Exchanges – physical meeting place and communication facilities are provided formembers to conduct their transactions.Over-the-Counter (OTC) markets – no central location. Financial claims can be traded byphoning an OTC dealer or by using a computer system.
  2. 2. Chapter 1 – Financial Markets and Institutions Student Notes2Efficiency – Simply the idea that the market accurately prices the securities that are traded inthem. Markets can be weak, semi-strong, or strong form efficient.Regulation – Most important regulator is the Securities and Exchange Commission (SEC).Globalization – Increased integration. It is becoming easier to acquire information aboutforeign companies and invest accordingly.Financial InstitutionsInstitutions – serve as intermediaries because markets are not perfect.Depository Institutions – receive deposits and make loans. Commercial Banks – most dominant depository institution. Savings Institutions – take in deposits and provide mortgage loans. Credit Unions – take in deposits and provide retail loans.Nondepository Financial Institutions – do not accept deposits from consumers. Finance Companies – Spans a variety of fringe companies. Consumer finance companies Business finance companies Sales finance companiesNondepository Financial Institutions (cont.) Mutual Funds – primary investment tool of many households. Securities Firms – multiproduct firms that usually specialize in several market relatedactivities.Examples include brokerage houses, underwriters, investment banks, and market makers.Nondepository Financial Institutions (cont.) Hedge Firms – sells shares to upscale investors and are allowed to invest in risky assets.Largely unregulated. Insurance Companies – receive money from premiums and invest in financial securities.
  3. 3. Chapter 1 – Financial Markets and Institutions Student Notes3 Pension Funds – Governments and companies allow employees to invest money insecurities.Competition – U.S. banks face increasing foreign competition.Consolidation – Banks continue to consolidate as regulations have relaxed.Global Expansion – U.S. banks, insurance companies, and securities firms have expandedinto foreign countries in recent years.Key Trends Affecting BanksService Proliferation – rapidly expanding services.Rising Competition – financial service firms entering other markets.Government Deregulation – fewer restrictions.Technological Change – ATMs, Point of Sale terminals, online payments, etc.Consolidation and Geographic Expansion – roll-up of the industry continues.Convergence – the movement of financial institutions across product lines.Globalization – largest banks compete with each other internationally.
  4. 4. Chapter 2 – Determination of Interest Rates Student Notes4Chapter 2 – Determination of Interest RatesOverviewIntroduction to interest ratesInterest rate theoriesEconomic forces that affect ratesInterest Rates – the price of borrowing money.Relevance of Interest RatesDirect influence on the valuation of debt securities.Indirect influence on nearly all other financial instruments. ie. Stocks, exchange rates,derivative securities.Loanable Funds Theory – rates are determined by the interaction between supply and demand forfunds.Demand:Individuals and HouseholdsBusinessesGovernmentsForeign DemandAggregate DemandSupply:Individuals and Households – only net saver of fundsBusinessesGovernmentsForeignersEquilibrium Rate
  5. 5. Chapter 2 – Determination of Interest Rates Student Notes5Factors that Cause the Supply Curve to ShiftWealth – as total wealth increases, the supply curve shifts out.Risk – as the risk decreases, the supply curve shifts out.Near-Term Spending Needs – when participants have fewer spending needs, the supply curveshifts out.Monetary Expansion – policy objects to allow expansion, the supply curve shifts out.Economic Conditions – as domestic economic conditions improve relative to other countries,foreign inflows increase and the supply curve shifts out.Factors that Cause the Demand Curve to ShiftEconomic Conditions – during periods of economic growth, market participants borrow moreheavily. The increase in demand increases the interest rate.Economic Forces that Affect Interest RatesEconomic Growth – demand increases with growth and rates rise.Inflation – Expected inflation decreases supply and increases demand, pushing rates higher. Fisher Effect – nominal rate = real rate + expected inflationEconomic Forces that Affect Interest RatesMoney Supply – The Fed can affect the supply, and, therefore the interest rates.Budget Deficit – Government deficits increase demand for funds, “crowding out” privatedemand, driving rates higher.Foreign Flows – U.S. rates are increasingly more tied to the interest rates of other countries. Unified Germany – Economic expansion drove rates up internationally. Japan’s Recession – Weak economic growth lowers rates internationally. Asian Crisis – Funds fled to more stable markets, driving rates down.Summary – Economic forces affect supply and demand of money.Interest Rates Over Time
  6. 6. Chapter 2 – Determination of Interest Rates Student Notes6General Decline – we have seen a general decline in interest rates since the early 1980s.Volatility – Rates were particularly volatile in the early 80s. Fed changed policies in the early 80s creating instability. Fed regained control in the late 80s and have been relatively stable.Key Interest RatesFederal Reserve Discount Rate – The rate the Fed charges banks that borrow from it.Federal Funds Rate – the rate banks charge when they make short-term loans to each other.Treasury Bills – short-term government securities. Commonly used as a benchmark “real”interest rate.Prime Rate – a base rate that large, money center banks charge their best customers.London Interbank Offer Rate (LIBOR) – the rate that European banks charge each other.Mortgage Rates – reflect conditions in financial markets, in general.Forecasting Interest RatesEconomic Models – estimating the statistical relationships between measures of the output ofgoods and services in the economy and the level of interest rates.Flow-of-Funds Accounting – shows the movement of savings through the economy in astructured and comprehensive manner.
  7. 7. Chapter 3 – Structure of Interest Rates Student Notes7Chapter 3 – Structure of Interest RatesOverviewFactors Affecting Yields Among SecuritiesTerm StructureUses of the Term StructureFactors Affecting Yields Among SecuritiesInflation – actual or expected inflation.Real Interest Rates – the interest rate that would exist on a security if no inflationwere expected over the holding period of a security. Fisher Effect – the relationship among nominal interest rates, real interest rates,and expected inflation.Nominal Rate = Real Rate + Expected InflationBase Interest Rate – Treasury securities.Credit (Default) Risk – the risk that a security’s issuer will default on that security bymissing an interest or principal payment.Liquidity – The risk that a security can be sold at a fair market price in a short periodof time.Tax Status – Taxable securities must pay a higher yield than similar tax exemptsecurities. Municipal Securities – Free of federal taxes and may be free of state and localtaxes.im = ic(t – tf)im= ic(t – tf – ts)Term to Maturity – The length of time until the principal amount borrowed becomespayable.Special Provision – call features, convertibility options, and other provisions willinfluence the yield of the security.
  8. 8. Chapter 3 – Structure of Interest Rates Student Notes8Actual Yield DifferentialsTerm Structures of Interest Rates – the relationship between yield and term to maturity onsecurities that differ only in length of time to maturity; graphically approximated by theyield curve.Pure Expectations Theory – the yield curve reflects the market’s current expectationsof future short-term rates.Liquidity Premium Theory – investors will hold long-term maturities only if they areoffered a premium to compensate for future uncertainty.Preferred Habitat Theory – the shape of the yield curve is determined by futureinterest rates and a risk premium, to induce market participant to shift out of theirpreferred habitat.Segmented Markets Theory – the shape of the yield curve is determined by supply ofand demand for securities within each maturity sector.Research ResultsUses of the Term StructureForecast Interest Rates – they yield curve can be used to assess the generalexpectations of investors and borrowers about future interest rates.Forecast Business Cycle – provides information about the market expectations offuture business activity.Investment Decisions – investors can take advantage of different rates and ride theyield curve to make a profit.Financing Decisions – by assessing the prevailing rates on securities for variousmaturities, firms can estimate the rates to be paid on bonds with different maturities.Impact of Debt Management – Treasury decisions about debt financing can impactthe yield curve.Historical Review – Upward sloping.
  9. 9. Chapter 4 – Functions of the Fed Student Notes9Chapter 4 – Functions of the FedChapter ObjectivesExplain the U.S. Federal Reserve SystemIntroduce monetary tools used by the FedOther monetary policy issuesHistoryEstablished in 1913 to control bank panics.12 largely autonomous Federal Reserve banks were established.Providing the Money Supply – prints and issues currency.Maintaining the Safety of the Financial SystemFacilitation of the Payments SystemConducting Monetary PolicyMonitoring International Financial TransactionsOrganizationFederal Reserve District Banks – 12 banksMember Banks – All chartered banks must be members.Board of Governors – Key administrative body Regulate commercial banks Control monetary policyFederal Open Market Committee (FOMC) – directs the open market actions of the Fed.Advisory Committees – Advises on consumer issues.Monetary Policy ToolsOpen Market Operations – buying or selling of Treasury securities.
  10. 10. Chapter 4 – Functions of the Fed Student Notes10 Purchase of Treasuries – Fed uses cash to buy Treasuries, usually from banks. Sale of Treasuries – Fed sells a portion of its Treasuries, usually to banks. Technical Operations – carried out through trading desk at New York Fed.o Policy Directiveo Straight (outright) transactionso Repurchase Agreementso Agency OperationsAdjusting the Discount Rate – it is the rate a financial institution must pay to borrow reservedeposits from the Fed.Adjusting the Reserve Requirement Ratio – determines the amount of money that financialinstitutions must keep on hand.MiscellaneousFed Emphasis on Money SupplyMonetary Control Act of 1980 (DIDMCA)Global Monetary Policy Single European Policy
  11. 11. Chapter 5 – The Fed and Monetary Policy Student Notes11Chapter 5 – Fed and Monetary PolicyChapter ObjectivesReview Goals of Fed and Monetary PolicyReview Fed PolicyExplain the Impact of Monetary PolicyGoals of U.S. Monetary PolicyPrice Level Stability – unstable price levels deter economic growth. Inflation – the continuous rise in the average price level. Usually caused by anexternal economic shock in the supply of a crucial material. When confrontedwith a supply shock, the fed has two options: Nonaccommodation AccommodationHigh Employment (or low unemployment) – between 4% and 6% is considered fullcapacity.Economic Growth – increase in an economy’s output of goods and services.Stability in Foreign Currency Exchange Rates – widely fluctuating exchange ratesincreases uncertainty into the economy.Trade-offs and Conflicts Among PoliciesRaise the rate of growth in the money supply by providing more reserves.Reduce the rate of monetary expansion by reducing the reserves in the bankingsystem.Recent Federal Reserve Policy1970 – 1979: Targeting the Fed Funds Rate.1979 – 1982: Targeting the banking system’s nonborrowed reserves.1983 – Present: Back to the Fed Funds Rate.Economic Indicators Monitored by the Fed
  12. 12. Chapter 5 – The Fed and Monetary Policy Student Notes12Indicators of Economic Growth – Gross Domestic Product (GDP)Indicators of Inflation Producer and Consumer Price Indices Other Indicators – Commodity pricesLags in Monetary PolicyRecognition Lag – the lag between the time a problem arises and the time it isrecognized.Implementation Lag – the lag from the time a serious problem is recognized until thetime the Fed implements a policy to resolve it.Impact Lag – the lag until the policy has its full impact on the economy.Assessing the Impact of Monetary PolicyForecasting Money Supply Movements Improved Communication from the Fed. Market Reaction to Reported Money Supply Levels. Anticipating Reported Money Supply Levels. Market Reaction to Discount Rate AdjustmentsIntegrating Monetary and Fiscal PoliciesHistory – Generally, both the Fed and the government have been concerned withmaintaining economic growth and low unemployment.Combining Policy EffectsMonetizing the Debt – Action by the Fed to counteract the effects of sales of Treasurysecurities by the Treasury.Global Effects of Monetary PolicyImpact of the Dollar – a weak dollar increases exports, which stimulates economy andmay drive up inflation.
  13. 13. Chapter 5 – The Fed and Monetary Policy Student Notes13Transmission of Interest RatesFed Policy during the Asian Crisis
  14. 14. Chapter 7 – Bond Markets Student Notes14Chapter 6 Money MarketsDetail the participants and their roles.Explain different money market securitiesExamine valuations.Money MarketsCharacteristics of the Money MarketDebt instruments that have a maturity of 1 year or less.Highly liquid financial claims with negligible risk of loss.Transaction size are very large (usually $1,000,000 to $10,000,000)No formal organization, such as the NYSE for the equity markets.Money Market ParticipantsParticipantsCommercial Banks – Most important class of buyers and sellers of money marketinstruments.Federal Reserve System – open-market operations.U.S. Treasury – finance the federal deficit.Corporations – use to balance their cash position.Money Market Mutual Funds – purchase 1/3 of commercial paper.Pension funds the other institutionsMoney Market SecuritiesSecuritiesTreasury Bills – U.S. Treasury Department issues various types of debt to finance thenational debt. Treasury Bill Auction – systematic, regular procedure.o Competitive bidso Noncompetitive bids
  15. 15. Chapter 7 – Bond Markets Student Notes15 Estimating the Yield Estimating the discountCommercial Paper – short-term, unsecured promissory note. Ratings – Moody’s and Standard & Poor’s Placement – with institutionso Directly placed papero Dealer-placed paper Secondary Market – secondary trading is limited. Backing Commercial Paper – not asset backed. Slightly higher return than Treasury securities. Finance companies are frequent issuers. Estimating the YieldNegotiable Certificates of Deposit (NCDs) – A bank time deposit that is negotiable. Placement – corporate treasuries Premium – often, rate is above T-bill yieldRepurchase Agreements (Repos) – sale of a short-term security with the condition that theseller will buy it back at a predetermined price. Estimating the YieldFederal Funds – commercial banks borrow and lend excess reserve balances to each other.Banker’s Acceptances – a bank accepts the responsibility to repay a loan to its holder.Facilitates international trade. Steps involvedMoney Market SecuritiesFinal Notes
  16. 16. Chapter 7 – Bond Markets Student Notes16Institutional useValuationLimited price movementsRiskGlobalization of Money MarketsPerformance of Foreign Money Market Securities
  17. 17. Chapter 7 – Bond Markets Student Notes17Chapter 7 ObjectivesTo identify the different types of Treasury securitiesTo identify the characteristics of municipal securitiesTo outline the types of corporate debt securitiesTreasury SecuritiesTreasury Bills – Treasury securities with a maturity of less than one year. These are sold ona discount basis.Treasury Notes – Securities with maturities between 2 and 10 years. These are couponsecurities.Treasury Bonds – Securities with maturities greater than 10 years. These are couponsecurities.Treasury Inflation Protection Securities (TIPS) – A Treasury coupon security (either note orbond) whose coupon rate is tied to the rate of inflation.Primary Market – Treasuries are sold in frequent well-publicized auctions.¤ Competitive bids¤ Noncompetitive bidsSecondary Market – over-the-counter market where a group of dealers offer continuous bidand as prices on outstanding Treasuries.Stripped Treasury Securities – Separating all coupon and principal payments into individualsecurities. For instance, a 10-year semiannual note would convert into 21 separate STRIPS.Quotations – The bid price and the ask price are quoted per hundred of dollars of par value.Salomon Brothers scandal – Salomon took over a Treasury bond auction.Brady Bonds – U.S. Treasury department restructuring program for delinquent LDC debt.Federal Agency SecuritiesFederal Agencies – generally, a private company that was originated by the federalgovernment.
  18. 18. Chapter 7 – Bond Markets Student Notes18¤ The Farm Credit System¤ Housing Credit Agencies¤ Export-Import Bank¤ Student Loan Marketing Association (Sallie Mae)¤ Small Business Administration (SBA)Municipal BondsState and local government bondsGeneral obligation bonds – provide basic services.Revenue bonds – used to finance a specific revenue-producing project.Corporate BondsCorporate Bonds – debt contracts requiring borrowers to make periodic payments of interest anto repay principal at the maturity date.Characteristics¤ Sinking-fund provision – requires the bond retire a specific dollar amount of bonds eachyear.¤ Protective Covenants – Limit dividends or additional debt.¤ Call Provisions – an option of the issuer to retire bonds before their maturity.¤ Bond Collateral Mortgage bonds Equipment Trust Certificates Collateral Bonds Debentures¤ Zero- Coupon Bonds – Do not pay coupons.
  19. 19. Chapter 7 – Bond Markets Student Notes19¤ Variable-Rate Bonds – Coupon is tied to an interest rate rather than fixed.¤ Convertibility – allows investors to exchange the bond for a stated number of shares ofthe firm’s common stock.Junk Bonds – Corporate bonds with high default risk.¤ Market Size – 25% of outstanding corporate bonds are junk.¤ Risk Premium – Substantially higher interest rate.¤ Performance – volatile.¤ Contagion – price shocks affect entire junk bond market.Restructuring through bonds¤ Leverage Buyouts – investor group issues debt to fund the purchase of a company.¤ Capital Structure changesBond MarketsEurobond Market – a bond issued in a country other than the currency it is denominate in.
  20. 20. Chapter 8 – Bond Valuation and Risk Student Notes20Chapter 8 – Chapter ObjectivesReview the bond valuation process; andReview bond characteristics.Bond Valuation ProcessBond – a security that obligates the issuer to make specified payments to thebondholder.Characteristics¤ Par Value – face value of the bond.¤ Coupon – specified number of dollars of interest paid each period.¤ Coupon Rate – The annual coupon divided by par value.¤ Maturity – Date when principal amount is due.¤ Yield to Maturity – The rate of return earned on a bond if it is held to maturity.Bond Valuation – the present value of the cash flows.Changing bond values over time – New bonds are generally priced to sell at parvalue. The price of seasoned bonds often vary widely from par value.¤ If the market interest rate equals the coupon rate, a fixed rate bond will sell at itspar value.¤ Market interest rate rises above coupon rate, a fixed rate bond sells below(discount) its par value.¤ Market interest rate falls below coupon rate, a fixed rate bond sell above(premium) its par value.¤ The price of the bond approaches its par value as it approaches maturity.¤ Market interest rate falls below coupon rate, a fixed rate bond sell above(premium) its par value.¤ The price of the bond approaches its par value as it approaches maturity.
  21. 21. Chapter 8 – Bond Valuation and Risk Student Notes21Bond RiskAssessing the Riskiness of a BondInterest Rate Risk – risk of a decline in a bond’s price due to an increase in marketinterest rates.Reinvestment Rate Risk – The risk that a decline in interest rates will lead to a declinein income from a bond portfolio.Default Risk – The risk that the issuer will be late or unable to make a payment.¤ Mortgage bonds – backed by fixed assets.¤ Debentures – not secured by fixed assets but is a general obligation of the firm.¤ Subordinated Debentures – claim is lower than senior debt.Bond PriceBond Price MovementsRisk-Free Rate – General interest levels affect all bonds.¤ Inflationary Expectations¤ Economic Growth¤ Money Supply Growth¤ Budget DeficitDefault Risk Premium – Changing credit situations will affect bond prices.Bond Price SensitivityBond Price Elasticity – the sensitivity of bond prices to changes in the required rate ofreturn.¤ Coupon Rate – The lower a bond’s coupon rate, the greater the price sensitivity.¤ Maturity – Longer-term bonds have greater price sensitivity.Bond Pricing Theorems
  22. 22. Chapter 8 – Bond Valuation and Risk Student Notes22¤ Bond prices and market interest rates move in opposite directions.¤ When a bond’s coupon rate is greater (less) than the market’s required return, thebond’s market value will be greater (less) than its par value.¤ The price of longer-term bonds will change more than that of shorter-term bonds,for a given change in market rates.¤ The price of lower-coupon bonds will change more than that of higher-couponbonds, for a given change in market interest rates.Duration – bond price volatility varies directly with maturity and inversely withcoupon rate. Duration considers both coupon rate and maturity.¤ Portfolio – the weighted average of bond durations.¤ Using Duration to Reduce Interest Rate Risk Zero Coupon Approach Maturity-Matching Approach Duration-Matching ApproachBond Investment StrategiesBond Investing¤ Matching Strategy – Matching future cash outflows with coupon and principalpayments.¤ Laddered Strategy – Spreading an investment over several different maturityclasses.¤ Barbell Strategy – Investment is divided between short- and long-term bonds.¤ Interest Rate Strategy – Use forecasts to develop a bond investment strategy.International BondsReturn and Risk of International BondsForeign Interest Rates Differentials
  23. 23. Chapter 8 – Bond Valuation and Risk Student Notes23Credit Risk DifferentialsExchange Rate FluctuationsInternational Bond Diversification
  24. 24. Chapter 9 – Mortgage Markets Student Notes24Chapter 9 – Mortgage MarketsChapter overviewExamine unique nature of market.Review the evolution of the secondary markets.Examine the characteristics of different mortgages.Mortgage MarketsUnique Nature of the Mortgage Market¤ Secured by the pledge of real property.¤ Made for varying amounts and maturities.¤ Issuers are typically small, unknown entities.¤ Secondary market growing¤ Highly regulated and supported by the federal government.Residential Mortgage Characteristics¤ Standard Fixed-Rate Mortgages – lender takes a lien on real property in exchange forpayment. Conventional Mortgages – not insured by a federal government agency.» Private Mortgage Insurance (PMI) – insures against default for borrowers withless than a 20% down payment.» Historically, there has been no penalty for prepayment. However, this is notalways the case.Residential Mortgage Characteristics¤ Standard Fixed-Rate Mortgages – lender takes a lien on real property in exchange forpayment. Insured Mortgages – payment is guaranteed by a federal government agency.
  25. 25. Chapter 9 – Mortgage Markets Student Notes25 Federal Housing Authority (FHA) – allows a much smaller down payment andguarantees payment. Veterans Administration (VA) – insures mortgages of military veterans and does notrequire a down payment.Adjustable-Rate Mortgages (ARMs) – interest rate adjusts with the general level of rates.Interest rate risk is shifted to the borrower.Maturities – Traditional maturity is 30 years and 15 year mortgages have become morepopular. Others include 3, 5, or 7 year balloon mortgages.Creative MortgagesGraduated-Payment Mortgage – lower payments in the first few years and growing throughtime.Balloon Mortgage – a fixed-rate mortgage that expires at a predetermined time (3, 4, 5, or 7years). The unpaid balance is then due.Growing-Equity Mortgage – calls for rising payments over time resulting in a faster payoff.Second Mortgage – loans secured by liens on properties that are already mortgaged.Reverse Annuity Mortgage (RAM) – Provides regular monthly payments to the homeownerwith the home as collateral.Mortgage MarketSecondary Market – originators can sell mortgages in the secondary markets to both publicand private purchasers.Valuation – the present value if the future cash flows. Prices of existing mortgages arerelatively volatile due to their long term nature.Investment RiskInterest Rate Risk – the value of fixed rate mortgages decline as interest rates rise.Prepayment Risk – falling interest rates encourage refinancing.Credit Risk – the likelihood that a borrower will default on the loan.Mortgage-Backed Securities
  26. 26. Chapter 9 – Mortgage Markets Student Notes26Pass-Throughs – payments of principal and interest on pools of mortgages are passed throughto holders of securities in the pool.Government National Mortgage Association (GNMA Ginnie Mae) – pass throughs on a poolof federally insured mortgage loans.Federal National Mortgage Association (Fannie Mae) – issues a variety of pass-throughsecurities similar to Ginnie Mae’s.Publicly Issued Pass-Through Securities (PIP) – issued by private institutions.Federal Home Loan Mortgage Corporation (Freddie Mac) – assists lenders withsecuritization of conventional mortgages.¤ Participation Certificates (PCs) – different from Ginnie Mae’s in that: Contain conventional mortgages Not federally insured Various interest rates Much larger poolsCollateralized Mortgage Obligations – consists of a series of related debt obligations, calledtranches, which pay various borrowers with different priorities.Other Mortgage-Backed Securities¤ Mutual Funds – several mutual funds have been established to buy Ginnie Mae securities.¤ Fannie Mae or Freddie Mac debt – general obligation securities are basically secured bymortgages.¤ Mortgage-Backed Securities – Pass throughs
  27. 27. Chapter 11 – Stock Valuation and Risk Student Notes27Chapter 10 – Stock MarketsOverviewTypes and locations of tradingTrading mechanics and arrangementsPublic placementsMonitoring of firmsGlobalizationBackground on Common StockCommon Stock – represents basic ownership claim in a corporation.Owners expect capital gains and possibly dividends.Value – based on expected future cash flows.Trading LocationsOrganized Exchanges – consist of physical locations where buyers and sellers meet on atrading floor.¤ Auction System – trading mechanism placing competing buyers and sellers against eachother.Over-the-Counter (OTC) – dispersed traders linked via a computer system.¤ Negotiated System – individual buyers negotiate with individual sellers.Stock (Organized) Exchanges – consist of physical locations where buyers and sellers meeton a trading floor.¤ New York Stock Exchange (NYSE) – most popular stock exchange. Specialists – market makers in a stock. Commission brokers – execute orders for customers. Floor brokers – execute orders for other exchange members. Floor traders – trade solely for themselves.
  28. 28. Chapter 11 – Stock Valuation and Risk Student Notes28Over-the-Counter (OTC) – dispersed traders linked via a computer system.¤ NASDAQ – a computer network linking thousands of market-making participants.¤ Other OTC Markets – subscriber markets where trading is via the telephone. OTC Bulletin Board (OTCBB) Pink SheetsAlternative Trading Systems – electronic communications networks or crossing networksthat link two parties for direct trading of stocks.Types of TransactionsLong Purchase – purchasing securities with the expectation that it will increase in value.Margin Trading – the use of borrowed funds to purchase securities. Purchased securities areused a collateral.¤ Initial Margin – minimum amount that must be provided by investor at time of purchase.¤ Maintenance Margin – minimum amount that an investor must maintain in the marginaccount.¤ Margin Call – notification of the need to add cash to a margin account.Short Selling – selling borrowed securities with the expectation that the price will fall.Trading MechanicsTypes of Orders – price and conditions of an order.¤ Market order – an order to buy or sell stock at the best price available when the order isplaced.¤ Limit order – an order to buy at or below a specified price. Or, sell at or above aspecified price. fill-or-kill order day order good-’till-canceled (GTC) order
  29. 29. Chapter 11 – Stock Valuation and Risk Student Notes29¤ Stop-loss order – an order to sell a stock when its price reaches or drops below aspecified level.Trading ArrangementsRetail Stock Trading – buying and selling of stocks by individuals.Institutional Trading – buying and selling by financial institutions such as mutual funds andpension funds.¤ Block Trades – trades of at least 10,000 shares or market value of $200,000 or greater.¤ Program Trades – buying and/or selling of a large number of different stockssimultaneously. Asset allocation trades Index arbitrageStock IndexesDow Jones Industrial Average – stock market average made up of 30 high-quality industrialstocks.Standard and Poor’s (S&P) – measures the current price of a group of stocks.New York Stock Exchange Composite – current price of the stocks listed on the NYSE.Other Indexes – AMEX, Nasdaq, Value Line, Wilshire 5000Preferred StockDebt/Equity hybrid – represents ownership in a company but pays a fixed dividend amount.Preferential treatment – preferred dividends are paid before common dividends can be paidand cumulate if they are not paid. Bankruptcy preference as well.Nonparticipating – usually no voting rights.Institutional tax advantages – other companies are able to deduct preferred dividendsreceived. Not attractive for individual investors.Public Placement of StockInitial Public Offerings (IPOs) – the first issuance of common stock by a firm to the public.
  30. 30. Chapter 11 – Stock Valuation and Risk Student Notes30¤ Venture Capital (VC) – firms that invest in private companies with the expectation oftaking them public.¤ Underwriters – an investment bank must be hired to take the company pubic.¤ Details – price range, number of shares, lockup period, and other details must beestablished and filed with the SEC.¤ Road Show – managers and underwriters travel to different cities to meet withinstitutional investors to sell the company.¤ Offering – the underwriter sets the price the number of shares and begins trading whenthe market opens. “Building the Book”¤ Initial Return – typically, the return on the first day is substantial. Flipping – process of selling soon after trading has begun.¤ Lockup Agreement – underwriter restricts managers, VCs, and other insiders from sellingtheir shares for at least six months.¤ Long-run Performance – generally poor.Secondary Stock Offerings – an initial offering of stock by a firm that has other stock alreadypublicly held.Shelf-Registration – a company must register stock offerings with the SEC. Once theregistration is complete, the company waits for favorable market conditions.Monitoring of FirmsShareholder Activism – shareholders take an active role in managing the company.¤ CALPERS¤ Socially conscious mutual fundsCorporate Monitoring¤ Acquisition – poorly run companies become targets.¤ Barriers Anti-takeover Amendments
  31. 31. Chapter 11 – Stock Valuation and Risk Student Notes31 Poison Pills Golden ParachutesSelf-Monitoring¤ Stock Repurchases – a firm purchases its own stock when it believes it is undervalued.¤ Leveraged Buyouts – use of debt financing to purchase the company.Globalization of Stock MarketsInternational Investment Performance – performance varies among countries and throughtime.Investing in foreign stocks¤ Indirect investment Purchase shares of U.S. based MNC Purchase international mutual fund¤ Direct investment Purchasing stocks on foreign exchanges Purchase stocks of foreign companies trading on U.S. exchanges. Purchasing American Depository Receipts (ADRs)
  32. 32. Chapter 11 – Stock Valuation and Risk Student Notes32Chapter 11 – Stock Valuation and RiskOverviewStock Valuation MethodsEstimating the Required Return and Growth RateOther Factors that Affect Stock PricesStock Performance MeasurementStock Market EfficiencyStock Valuation MethodsDiscounted Cash-Flow Valuation Techniques – the present value of some expected cashflows.Dependent on two estimated inputs:¤ Growth Rates¤ Discount RatesDividend Discount Model – value of stock is the present value of all future dividends.¤ Zero Growth Model – Dividends stay the same each year.¤ Infinite Constant Growth Model – Dividends grow at roughly the same percent each year.¤ Supernormal Growth Model – Dividends grow at higher rate for a period of time beforesettling into a constant growth.Present Value of Operating Cash Flows – Deriving the value of the total firm from operatingcash.Present Value of Free Cash Flows – Deriving the value using free cash.Relative Valuation Techniques – provides information about how the market is currentlyvaluing stock at several levels.¤ Contends that valuing firms is accomplished by a comparison to other firms.
  33. 33. Chapter 11 – Stock Valuation and Risk Student Notes33¤ Provides information current valuation but it does not provide guidance on whethercurrent valuations are appropriate.Price to Earnings (P/E) Ratio – determine how many dollars one is willing to pay for a dollarof expected earnings.Price to Cash Flow (P/CF) Ratio – cash flow values are generally less prone to manipulationthan earnings.Price to Sales (P/S) Ratio – strong sales growth is a requirement for a growth company.Little chance of manipulation.Estimating the InputsRequired Rate of Return – will be the discount rate for most cash flow models.¤ Risk-Free Rate – the absolute minimum rate an investor should require.¤ Expected Inflation – if investors expect inflation, they should increase their requirednominal risk-free rate.¤ Risk Premium – the risk associated with a specific stock or portfolio of stocks.Growth Rates – estimates of the growth rate of cash flows, earnings, and dividends arerequired.¤ Estimating Growth from Fundamentals – dividend growth is determined by the growthrate of earnings and the payout ratio.¤ Estimating Growth based on History – time-series growth rates should provide a trendand the amount of variability.Factors that Affect Stock PricesEconomic Factors¤ Interest Rates – generally, an inverse relationship exists between stock prices and thelevel of interest rates.¤ Exchange Rates – currency strength affect market prices in many ways.Market-Related Factors¤ Anomalies – January effect, small firm effect, day of the week effect, etc.Firm-Specific Factors
  34. 34. Chapter 11 – Stock Valuation and Risk Student Notes34¤ Dividends – indication about the future of the company.¤ Secondary Offerings – dilution adversely affects stock price.¤ Repurchases – indication the firm is undervalued.Firm-Specific Factors¤ Earnings Surprises – changes may indicate future trends.¤ Acquisitions and Divestitures – Acquirers adversely affected, targets positively affected.¤ ExpectationsEvidence – stock prices are affected by factors other than fundamental factors.Indicators – Price movements are often used as an indicator.Stock RiskMeasures of Risk¤ Standard Deviation¤ Variation¤ BetaStock Performance MeasurementSharpe Index – measures the risk premium per unit of total risk, measured by the stock’sstandard deviation.Treynor Index – measures the risk premium of a stock per unit of nondiversifiable risk,measured by the beta.Stock Market EfficiencyForms of Efficiency¤ Weak-Form Efficient – past data on stock prices is of no use in predicting future prices.¤ Semistrong-Form Efficient – publicly available information is of no use in predictingfuture prices.
  35. 35. Chapter 11 – Stock Valuation and Risk Student Notes35¤ Strong-Form Efficient – no information, public or private, allows investors toconsistently beat the market.
  36. 36. Chapter 12 – Market Microstructure and Strategies Student Notes36Chapter 12 ObjectivesExamine methods of researching stocksExamine methods of trading stocksIntroduce alternatives (index funds) to investing in stocks.Stock Market InvestingResearch – there are numerous resources to use when researching stocks. Some include:¤ Valueline¤ Websites – Yahoo, Nasdaq, Morningstar, Bloomberg¤ Edgar Online – access to SEC filings at www.sec.govPlacing an Order – open an account with a broker. Full-service, discount, or online brokersare available.¤ Market Order – an order to buy or sell a stock at the best possible price.¤ Limit Order – an order that specifies the price to buy or sell the stock at.¤ Stop Loss Order – a conditional market order whereby the investor directs the sale of astock if it drops to a given price.¤ Stop Buy Order – a conditional market order if the stock rises above a given price.Margin Transactions – the investor pays for the stock with some ash and borrows theremaining through the broker, putting up the stock for collateral.¤ Initial Margin – 50 percent of the value of the stock.¤ Maintenance Margin – 25 percent of the value of the stock.¤ Margin Call – requirement to add more equity or sell the stock.Short Selling – the sale of stock that is not owned with the intent of purchasing it in thefuture at a lower price.¤ Specifically, you would borrow the stock from another investor, sell it in the market, andreplace it at a later date.
  37. 37. Chapter 12 – Market Microstructure and Strategies Student Notes37Investing in Stock Indexes – investor can select mutual funds the shadow a specific index oropt for exchange traded funds.¤ Exchange-Traded Funds (ETFs) – baskets of securities that are traded, like individualstocks, on an exchange. Can be bought and sold throughout the day. Very low expense ratio. However, commissions must be paid on trades.Trade ExecutionFloor Brokers – independent members of an exchange who act as brokers for other members.Specialists or Market-Makers –¤ Serve as brokers to match buy and sell orders.¤ Maintain limit order book.¤ Maintain fair and orderly market when necessary by buy and selling from their ownaccount.Electronic Communication Networks (ECNs) – displays customer orders electronically andprovide access to pricing information.¤ Rising in popularity.Program Trading – computerized trading that involves the buying or selling of a portfolio ofstocks.¤ Collars – NYSE applies program trading curbs when the Dow moves 160 points either upor down.¤ Circuit Breakers – NYSE halts trading if the market moves down by 10%.Regulation of Stock TradingSecurities and Exchange Commission (SEC) – created in 1934 to enforce newly enactedsecurities laws.¤ Division of Corporate Finance¤ Division of Market Regulation¤ Division of Investment Management
  38. 38. Chapter 12 – Market Microstructure and Strategies Student Notes38¤ Division of Enforcement
  39. 39. Chapter 13 – Financial Futures Markets Student Notes39Chapter 13 Financial Futures MarketsDetail the background on futuresIntroduce the trading and mechanismsExamine commodity and financial futuresBackground on FuturesFutures Contract – A commitment to deliver a certain amount of some specified itemat some specified date in the future.¤ Commodity Futures¤ Financial Futures¤ Options versus Futures – future contract involves an obligation from both parties.Option does not.¤ Forwards versus Futures – forward is tailored to meet the needs of the purchaser.Future is standardized.Trading FuturesParticipants – hedgers and speculators. Both are needed for the market to work.¤ Hedgers – enter into futures contract to protect a current position of loss of value.¤ Speculators – attempting to earn profits on price swings. Important in creatingliquidity.Trading Mechanics – futures are readily traded in the market.¤ Long position – purchasing a futures contract.¤ Short position – selling a futures contract.¤ Liquidating a position – entering into an opposite futures contract.Margin Trading – putting up only a fraction of the total price in cash. The marginusually ranges from 2 – 10% of the value of the contract.Commodities
  40. 40. Chapter 13 – Financial Futures Markets Student Notes40Basic Characteristics – four major segments include: grains and oilseeds, livestockand meat, food and fiber, and metal and petroleum.¤ Contract – every commodity has its own specifications regarding amounts andquality.¤ Price behavior – commodities react to economic, political, and internationalpressures.¤ Return on investment – only return comes from price movement. High returns arepossible due to the volatility of prices and the high leverage.Trading Commodities¤ Speculating – attempt to capitalize on the wide price swings.¤ Spreading – combining two or more different contracts into one position toachieve gains and limit losses.¤ Hedging – used by producers and processors to protect a position in a product orcommodity.Financial FuturesFinancial Futures Market – created in the early 1980s. Its level of trading has farsurpassed the level of trading in commodities.These are derivative securities because they derive their value from the assets thatunderlie them.¤ Currency Futures – futures contracts of foreign currencies.¤ Interest Rate Futures – futures contracts on debt securities.¤ Stock-Index Futures – futures contracts on broad based measures of stock marketperformance.¤ Trading Stock-Index Futures – predicting the future course of the stock market.¤ Hedging Other SecuritiesOptions on Futures – give the purchasers the right to buy or sell a single futurescontract.
  41. 41. Chapter 13 – Financial Futures Markets Student Notes41Limits the loss exposure to the price of the option. Downside risk is limited.
  42. 42. Chapter 14 – Options Markets Student Notes42Chapter 14: Options MarketsChapter ObjectivesReview options and their applicationReview trading strategiesOptionsOption – a security that gives the holder the right to buy or sell a certain amount of anunderlying financial asset at a specified price.¤ Call – gives the purchaser the right to buy securities at a stated price for a specified timeperiod.¤ Put – gives the purchaser the right to sell securities at a stated price for a specified timeperiod.¤ Advantages Leverage Ability to earn profit on price declines Limited downside loss for purchasers¤ Disadvantages No ownership benefit Limited time frame ComplexStock Option Provisions¤ Strike (exercise) price – the state price at which you can buy a security with a call or sella security with a put.¤ Expiration date¤ Quotes - WSJOptions Pricing and Trading
  43. 43. Chapter 14 – Options Markets Student Notes43Profit Potential of Options¤ Call – limited loss to the premium and unlimited possible gains if the stock moves higher.¤ Put – limited loss to the premium and unlimited possible gains if the stock moves lower.Fundamental Value of OptionsValue – depends ultimately on the exercise price and the prevailing market price of theunderlying stock.¤ Call – (market price – strike price) x 100¤ Put – (strike price – market price) x 100¤ In-the-money Call – strike price < market price Put – strike price > market price¤ Out-of-the-money – no value Call – strike price > market price Put – strike price < market priceStock Option PremiumsFundamental value – the higher (lower) the market price for a call (put), the greater the value.Time premium – the longer the time to expiration, the greater the size of the premium.Price volatility premium – the more volatile the stock, the greater the premium.Trading StrategiesBuying for speculation – buy low and sell high.Hedging – purchasing an option to offset a current position in equities.Option Writing and Spreading¤ Writing Options – do so because they do not believe the price is going to move that far.
  44. 44. Chapter 14 – Options Markets Student Notes44 Naked Options – options written on a security not owned by the writer Covered Options – options written on a security owned by the writer.Options Spreading – combining two or more options with different strike prices and/orexpiration dates into a single transaction.Stock Index OptionsIndex Options – a put or call option written on a specific stock market index, such as theS&P 500.¤ Investment uses – Speculation – offer investors the opportunity to play the market with a small amountof money. Hedging – allows an investor to protect a current portfolio from downside risk.Other Types of OptionsInterest Rate Options – options written on fixed-income (debt) securities.Currency Options – options written on foreign currencies.LEAPS (Long-Term Equity AnticiPation Securities) – expiration dates that extend out as faras two years.
  45. 45. Chapter 15 – Interest Rate Derivative Markets Student Notes45Chapter 15: Interest Rate Derivative MarketsChapter ObjectivesReview swaps and their applicationReview Interest Rate Caps, Floors, and Collars.Swap BackgroundSwap – an agreement whereby two parties (called counterparties) agree to exchangeperiodic payments.Notional Amount (Principal) – the dollar amount of the payments exchanged is basedon some predetermined dollar principal.Types of SwapsInterest Rate Swap – the counterparties swap payments in the same currency based onan interest rate.¤ Plain Vanilla – one set of payments is fixed and the other is variable.¤ Coupon Swap – one party pays the other the fixed-coupon rate, and the other paysthe coupon rate on a floating-rate instrument.¤ Basis Swap – the parties exchange payments based upon floating-rate indexes, buteach coupon is determined by a different rate.¤ Application – useful ways of tailoring the interest rate risk desired. Reasons whya firm needs to alter their interest rate risk: Interest rate exposure has changed over time Two different firms have advantages in markets they prefer to not be in.Swap InterpretationEssentially, two parties enter into multiple forward contracts. Why do they exist?In many markets, forwards and futures do not extend out as far as that of a typicalswap.Swap is transactionally efficient – one contract to handle what it would have takenmultiple forward contracts to handle.
  46. 46. Chapter 15 – Interest Rate Derivative Markets Student Notes46Increased liquidityInterest Rate Caps, Floors, and CollarsInterest Rate Cap – a series of interest rate calls, designed to limit the cost of a loanwith multiple interest paymentsInterest Rate Floor – a series of interest rate puts, designed to protect the return on aloan with multiple interest payments.Interest Rate Collar – a combination of the purchase of an interest rate cap and thesale of an interest rate floor.
  47. 47. Chapter 16 – Foreign Exchange Derivative Markets Student Notes47Chapter 16: Foreign Exchange Derivative MarketsChapter ObjectivesGive background on foreign exchange marketsIntroduce foreign exchange derivative instrumentsForeign Exchange MarketsBackground¤ Foreign currency is simply another asset.¤ Exchange rate is the price at which the asset can be bought.¤ Volatility of exchange rates should be viewed as a source of risk.Spot Market – the market for immediate delivery of foreign currency.Forward Contract – a contract between a bank and a customer.¤ Exchange a specified amount.¤ Exchange on a specific date.¤ Exchange for a specified price.Futures Contract – agreement between two parties to exchange foreign currency.¤ Standardized amount¤ Traded on an exchange¤ Specified maturity dates¤ Speculators and hedgers participate¤ Contract interpretation¤ Closing a position – enter into an opposite position.¤ Credit risk – limited due to market restrictions.
  48. 48. Chapter 16 – Foreign Exchange Derivative Markets Student Notes48Currency option – purchaser receives the right to buy or sell a currency at a later dateat an agreed price.¤ No obligation for the purchaser.¤ Call – right to buy a currency at the strike price on or before the expiration date.¤ Put – right to sell a currency at the strike price on or before the expiration date.Currency swap – an agreement between two parties to trade payments in differentcurrencies.
  49. 49. Chapter 17 – Commercial Bank Operations Student Notes49Chapter 17 Commercial Bank OperationsLook at bank regulationsDetermine sources and uses of fundsLook at off-balance-sheet activitiesFinancial ConglomeratesFinancial Services Modernization Act – allows banks to offer a wide variety ofproducts, including insurance and underwriting services.Diversified Services – are there benefits to customers?Diversified Services – are there benefits to banks?Bank Sources of FundsDemand Deposits – checking accountsSavings Deposits – important source for small banks.Time Deposits – have a maturity date¤ Certificates of Deposit (CDs) – fixed interest rate and maturity date¤ Negotiable Certificates of Deposit (jumbo CDs) – denominations of $100,000 orgreater.Money Market Deposit Accounts – pays an interest rate.Federal Funds Purchased – borrowing from another bank’s reserves.Federal Reserve borrowing – borrowing funds from the district Federal Reserve bank.Repurchase Agreements (RPs) – banks sells securities and simultaneously contractsto repurchase the same securities.Eurodollar Borrowings – short-term deposits at foreign banks.Bonds – large commercial banks may issue bonds.Capital – equity ownership of a bank.
  50. 50. Chapter 17 – Commercial Bank Operations Student Notes50Bank Uses of FundsCash – vault cash, Fed reserves, balances at other banks, collections.Bank Loans – primary business activity of a commercial bank.¤ Business Loans – usually secured by an asset. Bridge Loan – cash for a specific transaction. Seasonal Loan – term financing to handle the fluctuations of the businesscycle. Long-Term Asset Loan – loan for a specific asset.¤ Loan Participations – a group of banks cooperate to underwrite large loans.¤ Consumer Loans – bank loans to individuals.¤ Real Estate Loans – mortgage loans.Investment in Securities – primarily consists of U.S. government bonds, municipalsecurities, and bonds issued by U.S. government agencies.Fed Funds Sold – lending of excess bank reserves to other commercial banks.Reverse Repurchase Agreements – counterparty to a repurchase agreement.Eurodollar Loans – short-term loans denominated in dollars and made outside theU.S.Fixed Assets – the bank.Off-Balance Sheet ActivitiesLoan Commitments – promise by a bank to lend money according to the termsoutlined in the commitment.Standby Letters of Credit – bank promise to pay a third party in the event that thebank’s customer fails to pay.Derivative Securities – interest rate and currency forwards, futures, options, andswaps.
  51. 51. Chapter 19 – Bank Management Student Notes51Chapter 19 – Bank ManagementChapter ObjectivesExamine the goals of bank managementExamine how to measure and manage riskReview bank mismanagementGoals of Bank ManagementMaximize shareholder wealthManaging Liquidity – asset and liability managementAsset Management – deposits, investments, loan repayments, and asset sales.Liability Management – certain types of bank liabilities are very sensitive to interestrate changes.Securitization – grouping like assets and selling the securities to investors.Managing Interest Rate RiskMethods of Assessing Interest Rate Risk Gap Analysis – the rate sensitivity of bank earnings as measured by the gapbetween the maturity of assets and liabilities. Duration Measurement – measuring the gap between the durations. Regression Analysis – how performance has historically been influenced byinterest rate movements.Methods of Reducing Interest Rate Risk Maturity Matching – matched funding of loans. Floating-Rate Loans – loans that adjust to current interest rates. Interest Rate Futures Contracts – take offsetting position in futures markets. Interest Rate Swaps – exchange periodic cash flows based on specified interestrates.
  52. 52. Chapter 19 – Bank Management Student Notes52 Interest Rate Caps – buy calls on interest rate movements.Managing Credit RiskTradeoff between Credit Risk and Return – the lower the risk, the lower the expectedreturn.Measuring Credit Risk – credit analysis and collateral.Diversifying Credit Risk – avoid concentrating assets among a single firm or firms inthe same industry.Other IssuesMeasuring Market Risk – Value-at-Risk (VAR) method to determine possible losses.Bank Capital Management – maintain adequate amounts of capital. Provides a financial cushion Maintains public confidence Provides protection to depositors Source of funds for growthRestructuring – shifted revenues away from interest margins to fee income Acquisitions – growth quickly achieved through acquisitions.Bank MismanagementPenn Square Bank – loans concentrated with energy companies.Continental Illinois Bank – small core deposit base so it relied on borrowed funds.Bank of New England – concentrated loans on commercial real estate.Implications – risk is greatly increased with lack of diversity and aggressive loanstrategies.
  53. 53. Chapter 20 – Bank Performance Student Notes53Chapter 20 – Bank PerformanceChapter ObjectivesExamine the factors that affect cash flows..Review the factors that affect the required rate of return.Examine performance evaluation.Factors that Affect Cash FlowsEconomic Growth – strong economic growth increases expected future cash flows.Risk-Free Interest Rate – interest rates are inversely related to the value of a bank.Industry Conditions – regulations have a large impact on the industry.Management Abilities – skilled management increases cash flows.Factors that Affect the Required ReturnRisk-Free Rate – inversely related to value.Risk Premium – also inversely related to value. Economic conditions has a largeimpact.Performance EvaluationInterest Income – has been declining in recent years. Is still comparatively large forsmall banks.Interest Expense – interest paid on deposits and other borrowed funds.Net Interest Income – difference between interest income and interest expense.Noninterest Income – fees charged for services.Noninterest Expense – expenses not related to the payment of interest on deposits.Bank Performance EvaluationReturn on Assets (ROA) – Net Income/Total Assets – tells how much profit isgenerated with a given amount of assets.
  54. 54. Chapter 20 – Bank Performance Student Notes54Return on Equity (ROE) – Net Income/Total Equity – the amount of profits inrelation to the capital contribution to the firm.
  55. 55. Chapter 21 – International Banking Student Notes55Chapter 21 International BankingGlobal Bank RegulationsUniform Global Regulations Uniform Regulations for Banks Operating in the U.S. – foreign banks subject tosame regulations as U.S. banks. Uniform Regulations across Europe – one set of rules for banks operating inEurope. Uniform Capital Adequacy Guidelines – 4% capital to assets ratio.Global Bank CompetitionsCompetitions in Foreign Countries – more competition in other companies.Competition in the U.S. – many foreign banks have established branches in the U.S.Impact of the Euro – increased competition for financial services across Europe.Risks of Multinational BanksCredit Risk – more difficult to obtain credit information abroad.Exchange Rate Risk – currency value and exchange controls.Country Risk – closely tied to political developments in a country.Settlement Risk – risk that it may not receive money due to default and have littlerecourse.Interest Rate Risk – forecasting becomes more difficult with the level of internationalinvolvement.Combining all Types of Risk – asset management becomes very complex.International Debt CrisisLatin and South America – many countries defaulted in the early 1980s.Reducing Bank Exposure to LDC Debt Selling LDC Loans
  56. 56. Chapter 21 – International Banking Student Notes56 Debt-Equity Swaps Boosting Loan Loss ReservesBrady Plan – voluntary debt-relief measures allowing banks various exit instruments. Brady Bonds – an exit bond that exchanged debt for lower principal and interestamounts.Country Risk AssessmentEconomic Indicators – evaluates the country’s economic environment.Debt Management – measures the fiscal policy of the country.Political Factors – risk of unexpected change in the political environment.Structural Factors – evaluation of the natural resources of the country.Overall Rating – each variable generates a rating which is then weighted to created anaverage score.

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