Introduction to Financial Systems and Markets
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Questions and Answers

What is a primary characteristic of money markets?

  • High illiquidity
  • Long-term tenure
  • Complex securities
  • Low default risk (correct)

Which of the following is NOT an instrument typically found in money markets?

  • Negotiable Certificates of Deposit
  • Commercial Paper
  • Banker's Acceptances
  • Common Stocks (correct)

Who are the major investors in commercial paper?

  • Pension funds (correct)
  • Mutual funds
  • Corporate investors
  • Retail investors

What usually indicates a higher yield on negotiable certificates of deposit compared to T-bills?

<p>Higher credit risk (C)</p> Signup and view all the answers

What is a potential risk for investors concerning reinvestment rate?

<p>Interest rates may drop, affecting reinvestment returns (A)</p> Signup and view all the answers

Which of the following best describes banker's acceptances?

<p>They are orders to pay that create liabilities for banks. (D)</p> Signup and view all the answers

Which group of entities primarily issues bonds in capital markets?

<p>Primarily corporations and governments (D)</p> Signup and view all the answers

What main factor influences the interest rates of negotiable certificates of deposit?

<p>Issuer's creditworthiness (C)</p> Signup and view all the answers

What was a significant effect of deregulation in the financial sector related to subprime mortgages?

<p>More money available for subprime borrowers (B)</p> Signup and view all the answers

How did the rating agencies classify securitized subprime mortgages?

<p>AAA due to expected stability (D)</p> Signup and view all the answers

What economic condition contributed to the creation of an asset bubble in housing?

<p>Abnormally low interest rates (A)</p> Signup and view all the answers

What is a consequence of lenders suffering from adverse selection and moral hazard?

<p>Increased uncertainty in the economy (C)</p> Signup and view all the answers

What can cause a bank run during a financial crisis?

<p>Significant losses in a bank's portfolio (D)</p> Signup and view all the answers

What impact did the collapse of Lehman Brothers in 2008 have on financial markets?

<p>Exacerbated recession and increased uncertainty (B)</p> Signup and view all the answers

What was one purpose of the Emergency Economic Stabilization Act in 2008?

<p>To stabilize the financial system (B)</p> Signup and view all the answers

What were homeowners more likely to do due to low interest rates and rising housing prices?

<p>Refinance their homes (D)</p> Signup and view all the answers

What is the primary goal of credit assessment in a bank?

<p>To determine if a company can repay its loan (B)</p> Signup and view all the answers

Which of the following is NOT a characteristic of an optimal loan candidate?

<p>High levels of debt (C)</p> Signup and view all the answers

What does the 'moat' refer to in the context of a company's market position?

<p>The competitive advantage protecting profitability (B)</p> Signup and view all the answers

Which of the following factors is NOT considered when determining credit ratings?

<p>Customer satisfaction (A)</p> Signup and view all the answers

What is the role of leverage ratios in debt covenants?

<p>Assess the company's financial risk (B)</p> Signup and view all the answers

What distinguishes default covenants from incurrence tests?

<p>Incurrence tests restrict further borrowing during a breach (C)</p> Signup and view all the answers

What is the implication of a high leverage ratio for a company?

<p>Denotes worse credit quality (D)</p> Signup and view all the answers

What does a credit risk premium signify?

<p>Increased returns demanded by investors for higher risk (C)</p> Signup and view all the answers

Which of the following describes a negative covenant in debt agreements?

<p>Prohibits certain actions that could jeopardize repayment (D)</p> Signup and view all the answers

Which of the following best describes the state of Germany's banks as compared to the global industry?

<p>Less profitable with less pressure on profit maximization (B)</p> Signup and view all the answers

What was a major contributing factor to Deutsche Bank's downfall?

<p>Aggressive competition in the US market (C)</p> Signup and view all the answers

What impact does a company's credit rating have on its debt pricing?

<p>Credit ratings influence the terms and interest rates of debt (B)</p> Signup and view all the answers

Why is it challenging for a company to maintain a credit rating higher than the country it operates in?

<p>Because the country's credit rating significantly influences company ratings (A)</p> Signup and view all the answers

What does EBITDA/Interest measure in a company's finances?

<p>Debt repayment capability (A)</p> Signup and view all the answers

What is a characteristic of secondary market transactions?

<p>Existing owners sell securities to another party. (B)</p> Signup and view all the answers

Which type of offering requires registration with the SEC?

<p>Public Offering (C)</p> Signup and view all the answers

What is the main feature of an underwritten offering?

<p>The underwriter guarantees a specific amount of capital. (A)</p> Signup and view all the answers

What does a 'Red Herring' represent in the context of securities offerings?

<p>Preliminary prospectus without final terms. (A)</p> Signup and view all the answers

Which type of contract is standardized in terms of amounts and delivery dates?

<p>Future contract (B)</p> Signup and view all the answers

What is the role of the Board of Governors in the Federal Reserve System?

<p>Sets the nation's monetary policy. (D)</p> Signup and view all the answers

What was a major outcome of the Emergency Economic Stabilization Act of 2008?

<p>It provided a bailout for the US financial system. (D)</p> Signup and view all the answers

Which is NOT a tool of monetary policy used by the Federal Reserve?

<p>Capital Gains Tax (A)</p> Signup and view all the answers

What term describes an agreement to buy or sell an asset at a future date and price?

<p>Forward contract (A)</p> Signup and view all the answers

What is the 'Too big to fail' problem addressed by the Dodd Frank Act?

<p>Systemic risk posed by larger financial firms. (C)</p> Signup and view all the answers

How does the Federal Reserve directly increase the money supply?

<p>By buying government securities. (D)</p> Signup and view all the answers

Which of the following best defines American Depository Receipts (ADRs)?

<p>Securities that enhance investment in foreign stocks. (A)</p> Signup and view all the answers

What is a characteristic of options in financial derivatives?

<p>They give the right, but not the obligation, to trade an asset. (D)</p> Signup and view all the answers

How does Basel III aim to improve the banking system?

<p>By establishing minimum capital and liquidity requirements. (A)</p> Signup and view all the answers

Which factor significantly lowers the default risk for a loan?

<p>Additional collateral (B)</p> Signup and view all the answers

What does matched-funding loan pricing help banks control?

<p>Interest rate risks (C)</p> Signup and view all the answers

Which of the following is NOT one of the Five Cs of Credit?

<p>Contribution (A)</p> Signup and view all the answers

Which statement about credit scoring is true?

<p>A high score signifies lower borrower risk. (B)</p> Signup and view all the answers

Which service provided by correspondent banking is primarily aimed at small banks?

<p>Check clearing and collection (C)</p> Signup and view all the answers

What is the primary benefit of securitization for banks?

<p>It provides a less expensive funding source. (B)</p> Signup and view all the answers

How is net interest margin calculated?

<p>Gross interest income minus gross interest expense (D)</p> Signup and view all the answers

Which of the following does NOT represent a risk in international lending?

<p>Market interest risk (A)</p> Signup and view all the answers

What is a syndicated loan?

<p>A loan funded by a group of banks to spread risk (D)</p> Signup and view all the answers

What is a characteristic of international loans?

<p>Often funded in the Eurocurrency market (D)</p> Signup and view all the answers

Which regulatory act allowed US banks to establish international banking facilities?

<p>DIMCA of 1980 (D)</p> Signup and view all the answers

What does the term 'off balance sheet banking' refer to?

<p>Loan commitments and contingent liabilities (B)</p> Signup and view all the answers

In terms of customer profitability, which group contributes the most to bank earnings?

<p>A customers (B)</p> Signup and view all the answers

What significant change occurred due to the Federal Reserve Act of 1913?

<p>National banks could branch outside the US (D)</p> Signup and view all the answers

What happens to the value of a bond when interest rates rise?

<p>The value of the bond decreases. (D)</p> Signup and view all the answers

Under what condition would an investor be indifferent between a short-term bond and a long-term bond?

<p>When spot rate is equal to forward rate. (C)</p> Signup and view all the answers

Which theory suggests that long-term bonds are more risky and therefore must offer a premium?

<p>Liquidity preference theory (C)</p> Signup and view all the answers

What is the primary assumption of expectations theory regarding investor behavior?

<p>Investors are risk neutral. (D)</p> Signup and view all the answers

How does the duration of a bond relate to its interest rate risk?

<p>Longer duration bonds have greater price volatility. (C)</p> Signup and view all the answers

What defines a zero coupon bond in relation to its duration?

<p>Duration equals its maturity. (D)</p> Signup and view all the answers

Which statement best describes the relationship between bond prices and yields?

<p>Bond prices move inversely to changes in yields. (A)</p> Signup and view all the answers

What does the term 'current yield' measure?

<p>The annual income from a bond as a percentage of its price. (A)</p> Signup and view all the answers

What is one consequence of a rising yield curve?

<p>It generally signals expectations of higher future interest rates. (C)</p> Signup and view all the answers

What does Macaulay's duration formula help to determine?

<p>The weighted average time until all cash flows are paid. (C)</p> Signup and view all the answers

What does the liquidity preference theory suggest about the forward rate?

<p>It includes a liquidity premium over expected short-term rates. (B)</p> Signup and view all the answers

Which of the following best describes the market segmentation theory?

<p>There are distinct markets for different maturities of securities. (B)</p> Signup and view all the answers

How do bond portfolios maintain their target duration under interest rate changes?

<p>They are rebalanced periodically to maintain target durations. (B)</p> Signup and view all the answers

What is the impact of holding period return on bond investments?

<p>It reflects total returns including price changes and reinvestment of coupons. (D)</p> Signup and view all the answers

Flashcards

Money Market Instruments

Short-term debt securities with maturities of less than one year. They are highly liquid and have low default risk.

Commercial Paper

A type of short-term loan used by businesses to raise cash quickly. They are often backed by banks and can be traded in the secondary market.

Negotiable Certificates of Deposit (CDs)

Large time deposits that can be sold and traded before maturity. They offer higher yields than Treasury bills but also have higher risk because they are dependent on the issuing institution’s creditworthiness.

Banker's Acceptance

An order to pay in the future that is guaranteed by a bank. They are used to facilitate international trade and provide a secure method for payment.

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Reinvestment Rate Risk

The risk that the interest rates earned on reinvested interest payments from bonds will be lower than the original interest rate.

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Bond Market

The market where bonds are traded. These bonds can be issued by governments, corporations, and other entities.

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Interest Rate Risk

The risk that the value of a bond will decrease due to changes in interest rates.

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Importance of Money Market Instruments to Banks

Money market instruments are valuable to banks because they offer a short-term, liquid asset that can be used to manage their daily liquidity needs.

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Spot Market

A market where trading occurs for immediate delivery at spot prices.

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Forward Market

A market where trading occurs for future delivery at forward prices.

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Forward Contract

An agreement to buy or sell a specific amount of an asset at a specific future date and price.

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Future Contract

An agreement to buy or sell an asset in the future, standardized in terms of amounts, delivery dates, and commodity grades.

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Option

The right to buy or sell an underlying asset on or before a specified date at a strike price.

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Call Option

The right to buy an underlying asset at a specified price.

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Put Option

The right to sell an underlying asset at a specified price.

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Swap

An agreement to exchange payment obligations, typically based on changes in interest rates.

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Monetary Policy

The process of a central bank adjusting the money supply in an economy to influence macroeconomic variables such as inflation, economic growth, and unemployment.

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Discount Rate

The rate at which financial institutions must pay to borrow reserve deposits from the Federal Reserve.

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Reserve Requirements

The amount of funds financial institutions must hold at the Federal Reserve to back their deposits.

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Interest on Reserves Balance Rate (IORB)

The rate paid on funds banks hold in their reserve balance account at the Federal Reserve.

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Overnight Interest Rate

The rate at which major financial institutions lend and borrow money from each other on an overnight basis.

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Open Market Operations

The process of a central bank buying and selling government securities in the open market to influence the money supply.

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Too Big to Fail

The potential for a single, large, failing institution to cause a crisis in the entire financial system.

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Deregulation of Mortgage Lending

The government loosened regulations on mortgage lending, making it easier for people with poor credit histories to get loans. This created a boom in subprime mortgages, which were high-risk, but attractive to banks due to higher interest rates.

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AAA Rating for Mortgage-Backed Securities

Subprime mortgages were bundled together and sold as securities with a AAA rating, implying very low risk. This rating was based on the belief that home prices would continue to rise, but when they fell, it led to huge losses for investors.

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Low Interest Rates and Housing Bubble

Low interest rates encouraged people to borrow money and buy homes, increasing demand and pushing prices up. When those rates eventually went up, borrowers struggled to repay their loans, further contributing to the housing bubble's burst.

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Effect of Rising Interest Rates on Variable Rate Mortgages

When interest rates rose, borrowers with variable rate mortgages found their monthly payments significantly higher. This made it harder for them to repay their loans and ultimately led to foreclosures.

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Lehman Brothers Collapse and Market Uncertainty

The collapse of Lehman Brothers, a major financial institution, shook investor confidence and created a widespread panic in the market. This fear caused lending to freeze, further damaging the economy.

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Adverse Selection and Moral Hazard in Lending

When lenders cannot tell good borrowers from bad borrowers, they become hesitant to lend money. This lack of trust damages the credit market and can lead to a financial crisis.

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Bank Runs & Asymmetric Information

When people lose confidence in a bank, they rush to withdraw their money. This can quickly drain a bank's reserves and lead to its collapse.

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Emergency Economic Stabilization Act and Deposit Insurance

The Emergency Economic Stabilization Act of 2008 aimed to stabilize the financial system by increasing deposit insurance. This gave people more confidence in their bank accounts, reducing the risk of bank runs.

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Bank Risk Management

A method banks use to ensure they don't take on excessive risk associated with a single entity, industry, country, credit quality, or currency. It involves diversifying loan portfolios.

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Credit Assessment

The process of assessing a company's ability to repay a loan, considering their financial health and future prospects.

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Strong Balance Sheet

A measure of a company's financial stability, including its ability to generate cash flow, manage debt, and maintain a strong balance sheet.

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Strong Management

A company's leadership team with a clear vision, proven track record of success, and expertise in financial management.

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Strong, Steady Cash Flows

A company's ability to generate consistent and substantial cash flow, often with high profit margins.

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Strong Industry

A company's ability to operate in an industry with a favorable economic outlook, stable demand, and low cyclical vulnerability.

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Significant Collateral Assets

A company's tangible assets that can be used as collateral in case of loan default.

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Diversifiable, Non-Core Assets

A company that holds assets that are not directly related to its core business activities and can be easily sold or disposed of.

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Credit Rating

A rating assigned to a company's debt, indicating its risk of defaulting on its obligations. It reflects the company's financial health and overall creditworthiness.

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Default Covenant

A financial covenant that requires a company to maintain certain financial ratios, failing which may lead to loan default.

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Incurrence Test

A financial covenant that restricts a company from taking on additional debt unless certain conditions are met.

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Cross Default Clause

An agreement that stipulates that default on one debt obligation automatically triggers default on all other obligations.

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Negative Pledge Clause

A clause that prevents a company from pledging its assets as collateral for other debt, ensuring priority for existing debt holders.

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Positive Covenants

Covenants that require a company to perform certain actions, like providing financial reports or maintaining liquidity levels.

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Bond value and Interest rates relationship

The value of a bond decreases when interest rates increase because the bond's future cash flows become less valuable relative to the prevailing market interest rates.

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Expectations Theory

The expected future short-term interest rates are embedded in the forward rate. Investors set interest rates to ensure that the forward rate equals the expected spot rate at that time.

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Liquidity Preference Theory

The forward rate incorporates a premium to compensate investors for the increased risk and lower liquidity associated with long-term bonds. This premium is known as the liquidity premium.

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Market Segmentation Theory

Short-term and long-term bonds are traded in separate markets, so the relationship between their interest rates can be limited.

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Duration

A measure of a bond's lifetime, stated in years, that accounts for the entire pattern (both size and timing) of the cash flows over the life of the bond.

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Bond Price Convexity

The relationship between bond prices and yields is not linear, it's curved. For smaller changes in yield, the linear approximation provided by duration is accurate, but for larger changes, it becomes less so.

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Target Date Immunization

A strategy used to mitigate interest rate risk by matching the duration of the bond portfolio with the investor's time horizon.

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Net Worth Immunization

A strategy used to ensure that the net worth of an institution remains constant despite changes in interest rates.

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Yield to Maturity (YTM)

The discount rate used to value bonds that makes the sum of the present value of the bond's promised cash flows equal to the current bond price.

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Current Yield

The cash income provided by the bond as a percentage of the bond price.

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Yield to Maturity (YTM)

Measures the total return an investor would earn if they held the bond until it matures, considering the bond's price, coupon payments, and maturity.

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Realized Compound Yield

The return actually achieved by an investor, taking into account the reinvestment rate of coupon payments.

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Income Effect

The effect of rate changes on the value of reinvested cash flows. Higher rates lead to a higher reinvested value.

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Wealth Effect

The effect of rate changes on the price of a bond. Higher rates lead to a lower price.

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Bond Price and YTM Relationship

A bond's price moves inversely with its YTM. When YTM increases, the price decreases, and vice versa.

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Collateral

Lowering the default risk of a loan by requiring the borrower to pledge an asset that can be sold to recover losses if the loan is not repaid.

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Loan Commitment

A bank's agreement to lend a specific amount of money to a borrower over a given period, where the borrower draws on the loan as needed.

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Letter of Credit

A written promise by a bank to pay a third party on a client's behalf, typically used in international trade to ensure payment for goods or services.

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Derivatives

Financial instruments used to manage risks, such as forwards, futures, options, and swaps, allowing for offsetting potential losses by taking opposite positions in contracts.

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Loan Brokerage

The sale of loans that a bank has originated, allowing it to invest in and diversify across different types of loans.

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Securitization

The process of creating securities backed by pools of assets, such as loans, which are then sold to investors. Investors receive regular payments from the borrowers who are repaying their loans.

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Net Interest Margin

The difference between the interest earned on loans and other assets, and the interest paid on deposits and other liabilities. This is a key measure of bank profitability.

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Provision for Loan Losses

An expense for banks that accounts for credit quality problems in their loan portfolio. This provision is adjusted based on economic conditions and loan defaults.

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Return on Average Assets (ROAA)

A measure of bank profitability calculated by dividing net income by average total assets. It shows how efficiently a bank is utilizing its assets to generate profit.

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Return on Average Equity (ROAE)

A measure of bank profitability calculated by dividing net income by average equity capital. It indicates how well management has performed for the bank's owners.

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Credit Scoring

A system used to assess borrowers' risk by assigning them a score based on information in their credit report. A higher score indicates lower risk.

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Investment Income from Deposit Balances

Investment income earned from customer deposits, calculated as the difference between the rate the bank pays on deposits (e.g., savings accounts, CDs) and the rate it earns on investments (e.g., lending money).

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Fee Income

Fees charged to customers for various banking services, such as checking accounts, late payments, and overdrafts. These fees can make a significant contribution to a bank's revenue.

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Loan Interest and Base Lending Rates

The primary source of revenue for banks, it is the interest earned from loans made to customers. This interest rate is often based on a base lending rate and reflects the riskiness of the loan.

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Study Notes

Course Introduction

  • Financial System: Transfers funds efficiently
  • Two types of financing:
    • Indirect: Savers → intermediaries → borrowers
    • Direct: Savers → borrowers
  • Financial intermediaries:
    • Banks
    • Insurance companies
    • Pension funds
    • Mutual funds
  • Buy side vs. sell side institutions:
    • Buy side: Asset management (e.g., asset managers, pension funds, hedge funds, private equity)
    • Sell side: Service providers (e.g., banks, insurance companies)
  • Largest financial institutions by size:
    • Asset managers (BlackRock, Vanguard, Fidelity)
    • Banks (in China primarily)
    • Insurance companies (in Japan and China primarily)
    • Pension funds (in Japan, Norway and South Korea primarily)
    • Small: Hedge funds

Major Financial Markets

  • Money markets: Short-term, standardized securities, low default risk
  • Instruments: Commercial paper, negotiable certificates of deposit, banker's acceptances
  • Bond markets: Debt-based capital market
  • Major issuers/investors: corporations and governments / households and financial intermediaries
  • Investor considerations: long term, safety, tax considerations, reinvestment risk, interest rate movements
  • Bond indenture: collateral (mortgages, equipment, collateral bonds, debentures), provisions (sinking fund, call provision)
  • Types of bonds based on classification (collateral, debentures)

Security Sales

  • Underwritten: Firm commitment, Underwriter buys securities from company and resells at a higher price
  • Negotiated: Issuer negotiates better terms with investment banks
  • Public offering: Prospectus, Red Herring
  • Private placement: Sale to limited sophisticated buyers

Equity Markets

  • US has the largest equity market but the most listed companies are in Asia
  • Types of investors: Corporate, public, strategic and institutional

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Description

Explore the essentials of financial systems, including funding transfers and the roles of various financial intermediaries. This quiz covers key concepts in money and bond markets, as well as insights into buy side and sell side institutions. Test your knowledge on the largest financial institutions and the major financial markets.

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