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Review for Final Chapter 1 Overview of course and financial markets

Review for Final Chapter 1 Overview of course and financial markets Role of financial markets in helping match borrowers and lenders and to facilitate trade Intermediating Savings and Investment Chapter 3

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Review for Final Chapter 1 Overview of course and financial markets

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  1. Review for Final • Chapter 1 • Overview of course and financial markets • Role of financial markets in helping match borrowers and lenders and to facilitate trade • Intermediating Savings and Investment • Chapter 3 • A simple model of capital markets modeling the choice of current consumption versus future consumption • Understand the losses from removing capital markets, the affect of changes in interest rates, the affect of shocks to investment opportunities.

  2. Review for Final • Chapter 4 • Real versus nominal interest rates • Empirical evidence relating interest rates and inflation • Darby and Mundell affects between inflation and interest rates • How to measure inflation • Why is inflation important • Proxies needed for real rates and inflation rates, ie. past inflation, surveys, LT vs. ST, commodity and inflation indexed bonds • Chapter 5 • Spot and forward rates: calculate for one year or several years • Arbitrage of negative forward rates • Converting between rates with different compounding and horizons.

  3. Review for Final • Chapter 5 (cont.) • Properties of term structures: location of forward rates with respect to spot rates, the shifts in long-term versus short-term rates • Term structure theories: pure expectations, liquidity, preferred habitat • You will not be required to figure out the expected profits under the liquidity preference theory • You should understand and compare the different theories of term structure • Chapter 6 • Bond pricing using spot rates, forward rates, and YTM • Discount, Par, Premium bonds, YDB, Current Yield • Annuity, perpetuity, consol • Inflation indexed bonds • Backing out rates from bond prices • Arbitrage possibilities from mispriced bonds

  4. Review for Final • Chapter 7 • Pricing fixed coupon bonds when interest rates are uncertain • Finding spot rates when interest rates are uncertain • Simulation method and lattice tree • Pricing interest sensitive cashflows: mortgages, callable bonds • Chapter 8 • Duration measures the change in price relative to a change in interest rates. Often Modified duration and Macaulay’s duration are compared to maturity • Two methods of calculating duration for riskless cashflows: • (1) term structure and (2) actual price changes from interest changes • Three measurements of duration for riskless cashflows: • (1) dollar duration (2) modified duration (3) Macaulay’s duration • Need to calculate duration for a zero coupon and coupon bond • Estimate the change in price from a change in interest rate using duration

  5. Review for Final • Chapter 8 (cont). • Properties of duration in relation to YTM, Coupon size, and maturity • Convexity measures the curvature of a price change to a change in interest rate. Because duration is only an approximation of a change in price for a change in interest rates, convexity is another measure used to reduce the estimation error. • Two methods of finding convexity: • (1) term structure and (2) actual price changes from interest changes • Two measures of convexity: • (1) Dollar Gains from Convexity (2) Gains from Convexity • Find the expected change in price from a change in interest rates using both duration and convexity. • Effective dollar duration and effective duration is used for assets with interest sensitive cashflows such as a mortgage or callable bonds • Immunization of bond portfolios using duration • Use duration to hedge price risk from interest rate changes

  6. Review for Final • Chapter 9 • Several other types of risks aside from interest risk: (1) default (2) liquidity (3) uncertain cashflow • Several measures of default risk: (1) analyst assessments (2) use prices to estimate default probabilities (3) Breakeven rates (4) zero-coupon curve (5) par coupon spread • Liquidity risk is measured by bid-ask spreads • The uncertainty of cashflows is measured by option-adjusted spread. • Chapter 11 • Money market • Auction market of treasury bills • Understand Treasury bills, CP, CDs, REPOs, BAs, Agency discount notes, short-term municipals securities, fed funds or bank rate • Which ones pay interest? Which are more risky? • Converting YDB to effective annual yields for money market instruments with and without interest

  7. Review for Final • Chapter 12 • Auction market for coupon bearing bonds • Understand treasury debt, agency debt, long-term municipals, corporate bonds (Call provisions, bond indenture, sinking fund) • Important ratios in determining corporate bond ratings • Pricing of callable bonds (application of Chapter 7) • Chapter 16 • Floating rate securities change their coupons in relation to an interest rate index. For example, an increase in the interest rate will increase the coupon paid. Because the coupon moves with interest rates, interest rate risk is minimized. • Types of floating rate instruments (FRNs, Variable coupon bonds, perpetual floaters, inverse floaters, Variable coupon renewable bonds) • Swaps, swaptions, warrants can also have variable payments • Valuing a FRN with credit changes

  8. Review for Final • Chapter 16 (cont.) • Creating inverse floater and floating rate note from a fixed income security. • Interest rate risk involved when creating an inverse floater and floating rate note. Higher interest rates mean the coupon on the floating rate note is increases whereas the inverse floater has a minimal value of zero. • A cap is often purchased to offset the risk when interest rates increase. • Pricing a cap and floor • Relating cap prices with maturity, volatility, and cap level • Constructing caps from floors and swaps • Chapter 17 • Primary market: Creating new securities: private placements, underwriting of a public offering, merchant banking • Secondary market: exchange, OTC, shadow markets, • Clearing facilities: Understand the role of a broker and clearinghouse in eliminating counterparty risk (SIPC)

  9. Review for Final • Chapter 21 • Role and reason for banks • What makes banks specials? • Liability and Asset structure of commercial banks and its contribution to bank runs • Should be able to compare balance sheet of a commercial bank with an insurance company • Causes of a banking panic and preventions of it. Does insurance help? • Regulation that banks tried to avoid: (1) limitations in the businesses banks could be involved in especially investment banking; (2) OBS • In the US, commercial banks wanted access to investment banking. In Canada, commercial banks wanted to form Bank Holding Co. and access to automobile lending and insurance distribution through branches. • Understand the different types of OBS activities: SBL, Revolving credit, underwriting, NIFs--Why did these add risk? • Regulators in the US included Comptroller of the Currency and Superintendent of banks

  10. Review for Final • Chapter 21--Regulation of banks • Regulators in the US included Comptroller of the Currency and Superintendent of banks. • Regulators in Canada included OSFI and provincial bodies, Bank of Canada has limited control of clearing and payments system, Department of Finance links commercial bank regulation to the govt. • FDIC and CDIC are insurances offered in the US and Canada. • BIS (Basle Committee) provides a suggested capital requirement for banks around the world • Before 1988, leveraged capital standards. (Flat 8% on-balance sheet assets) • Between 1988-1998, risk-based capital stanadards. • After 1998, BIS allowed the use of VAR measures to calculate capital standards • Capital is required to be at least 4% of Tier 1 and no more than 4% of Tier 2. • Compare and contrast the different methods of calculating capital standards and evaluate their benefits and criticisms.

  11. Review for Final • Chapter 21--Regulation of banks • Calculate risk-based capital and convert off-balance sheet to on-balance sheet. Calculate leveraged capital standards. • Chapter 21--MacKay Report • You are only responsible for what was covered in class • What were the main issues raised by the MacKay report? • What were some conclusions reached by the MacKay report? • On what basis did the MacKay report evaluate commercial banks? • Chapter 22 • Understand the causes and historical account of the thrift crisis. What lessons can be learned? • Differences between regulation in Canada and the US of other depository institutions is the separate regulation of the institutions in the US versus a single regulator in Canada.

  12. Review for Final • RiskMetrics • VaR for an asset • VaR for portfolio with correlation, without correlation, with correlation =1 • VaR proxy using CAPM, duration, and “delta” method for equities, fixed income, and options • Changing from 1 day to 10 day horizons • Using VaR to calculate capital requirements • Backtesting • List problems and benefits of RiskMetrics

  13. Review for Final • CreditMetrics • Understand the transition matrices and be able to calculate for a portfolio • Calculate the value of bonds and a portfolio in one year • Calculate the expected value and standard deviation of an asset or portfolio in one year • Calculate VaR using percentile and standard deviation method • Two year probabilities of default • Three types of limits set: (1) Marginal St.Dev. (%) (2) Market Value (3) Marginal St. Dev ($) (referred to as absolute risk) • What are benefits and criticisms of CreditMetrics?

  14. Review for Final • Chapter 23 • Types of insurance companies (life, property/casualty, reinsurance) and their organizational structure (mutual versus stock) • Insurance products • Gradual build up of reserves with insurance premiums • Basic differences between balance sheet of life insurers, property insurers, and banks • Three additional businesses of insurance companies includes: pension plans, annuities, and disability • You do not need to know anything about the capital requirements of insurance companies. • Pension funds have two main types of plans: defined benefit and defined contribution

  15. Review for Final • Chapter 23 (Mutual Funds) • Closed-End, Open-End, and Closed funds • Research findings of underperformance and persistent performance • Types of Open-end funds • Accounting differences between money market and equity funds • Various fees charged by mutual funds and how they affect net returns • Incentives of managers to increase asset size. • The huge benefit of being a top performing funds may mean managers are taking on excess risks or may be playing with fees to move into a top performing fund. • If a fund performs exceedingly well it is likely to attract both active and inactive investors. Inactive investors are unlikely to leave when performance is poorer.

  16. Review for Final • Chapter 26/27 • Four roles of the central bank: (1) lender of last resort (2) ensures the integrity of a financial system (3) banker’s bank (4) controls the money supply • Three ways to control the money supply: (1) discount rate (2) reserve requirement (3) open market operations • Multiplicative effect of expanding reserves on the money supply (deposits) in the economy

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