Money Markets and Financial Instruments

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Questions and Answers

What is the primary purpose of money markets?

To invest in long-term projects

To warehouse surplus funds for short time periods (correct)

To manage foreign exchange rates

To facilitate government financing

Which of the following incurs counterparty credit risk?

Secured funds

Unsecured funds (correct)

Repo agreements

Overnight lending

What is a repurchase agreement (repo)?

A method for government borrowing

A loan secured by financial assets (correct)

An unsecured loan between banks

A type of stock trading

How does the reserve requirement affect money markets?

It determines liquidity levels in the banking system Signup and view all the answers

In a repo agreement, what does Bank B receive at the end of the agreement?

The original asset plus interest Signup and view all the answers

Which one of the following is an example of unsecured funds?

Commercial paper Signup and view all the answers

What kind of funding is primarily used for liquidity management in banks?

Money market instruments Signup and view all the answers

What is the function of standing facilities in money markets?

To provide quick access to funds for banks Signup and view all the answers

What is the primary function of financial markets?

To facilitate the allocation of resources and price discovery Signup and view all the answers

Which of the following best describes the euro money market?

A market that includes various instruments like repurchase agreements and interbank loans Signup and view all the answers

How does the monetary policy of the ECB affect the money market?

By influencing interest rates and liquidity in the market Signup and view all the answers

What significant developments have occurred in the bond markets since the monetary union began?

An increase in the complexity and availability of different bond types Signup and view all the answers

Which market focuses on the trading of stock shares and provides companies with capital?

The equity market Signup and view all the answers

What instruments are typically found in the derivatives market?

Options and futures contracts Signup and view all the answers

Which statement accurately describes the foreign exchange market?

It permits the trading of currencies at varying prices Signup and view all the answers

Which of the following is a key aspect of financial regulation and supervision?

Ensuring the stability and integrity of financial systems Signup and view all the answers

What reflects the negative interest rate environment for 4-year maturities?

Negative yields Signup and view all the answers

During which crisis did the yield curve shift upward due to increased default risk?

Sovereign debt crisis of 2011 Signup and view all the answers

What has resulted from unconventional ECB policies after the Global Financial Crisis?

Shift of the yield curve downwards Signup and view all the answers

Which bond yields are typically higher than government bonds since the Global Financial Crisis?

Corporate bonds Signup and view all the answers

What is one goal of securitisation in alternative finance?

Credit risk transfer Signup and view all the answers

What distinguishes financial bond yields from nonfinancial bond yields since the Global Financial Crisis?

Financial bonds consistently yield more Signup and view all the answers

Which type of rankings reflects the potential risk/return lens as discussed?

Corporate Bonds > Government Bonds Signup and view all the answers

What factor increases liquidity risk in bond markets?

Tight credit conditions Signup and view all the answers

Which of the following best describes the link between sovereign and banking crises?

Banking crises can lead to sovereign crises when banks default on government bonds. Signup and view all the answers

What is a primary characteristic of financial crises?

They often involve a sudden loss of confidence in financial institutions. Signup and view all the answers

Which theory best explains the phenomenon of bank runs?

Diamond and Dybvig model. Signup and view all the answers

What does pro-cyclicality of the financial system refer to?

Increased lending during economic expansions can lead to greater risk during downturns. Signup and view all the answers

What was a significant mechanism of contagion during the 2007-2009 financial crisis?

Contagion via interconnectedness of global financial institutions. Signup and view all the answers

What is the main purpose of the Main Refinancing Operations (OMOs) conducted by the ECB?

To provide short-term liquidity to banks Signup and view all the answers

Which financial instrument was EONIA replaced by?

ESTER Signup and view all the answers

What risk is primarily associated with bonds due to their varying prices and interest rates?

Interest rate risk Signup and view all the answers

Which of the following best describes the term premium in a yield curve?

The additional return for longer maturities Signup and view all the answers

Which type of bond is most likely to have a lower credit quality rating?

Corporate bonds Signup and view all the answers

What does the EUREPO rate refer to in financial terms?

A secured interbank rate for repurchase agreements Signup and view all the answers

What kind of risk is primarily associated with the ease of selling bonds?

Liquidity risk Signup and view all the answers

What is the primary difference between unsecured and secured overnight borrowing?

Secured borrowing comes with collateral Signup and view all the answers

Which type of financial entity is the largest group of bond issuers?

National governments Signup and view all the answers

What does the term 'liquidity risk' refer to in the context of bonds?

The risk of not being able to sell bonds quickly Signup and view all the answers

What characterizes retail payment systems compared to wholesale payment systems?

They consist of card-based payment systems. Signup and view all the answers

Which of the following best describes a push transaction in a payment system?

Initiated by the payer to transfer funds. Signup and view all the answers

What is the main function of real-time gross settlement (RTGS) systems like TARGET2?

To immediately settle payments on a gross basis. Signup and view all the answers

Which economic feature describes the concept of 'lock-in' for consumers switching payment network providers?

Switching costs incurred when changing providers. Signup and view all the answers

Which payment system primarily involves net settlement between EU banks?

EURO1. Signup and view all the answers

What role do payment schemes play in retail payment systems?

Set interbank rules, standards, and practices. Signup and view all the answers

How do economies of scope benefit financial institutions in payment systems?

By allowing for shared costs over a wider range of products and services. Signup and view all the answers

Which of the following statements about correspondent banking is true?

Payments are settled through an intermediary. Signup and view all the answers

Study Notes

Part II: Money, Credit and Banking

This section of notes covers topics related to money, credit, and banking.
The notes were presented by Carola Theunisz on November 26, 2024 and December 3, 2024

Part II MCB: Overview Lectures

This section is an overview of lectures related to Money, Credit, and Banking
Specific areas covered include Financial Markets and Infrastructure, Financial Crises, and Policies for the Financial Sector
This topic focuses on parts of DSW (presumably a textbook or course material) Chapters 1, 2, 5, 7, 12, and 13.
Video lectures include Big Short (Financial Markets and Infrastructure), DD 1983 (Financial Crises), and SVB 2023 (Policies for the Financial Sector).
Lecture 6 of the course was also presented on December 3, 2024.
The various financial markets & CDOs, wholesale/retail payment systems, and post-trading markets are discussed.

Learning Goals: DSW Chapter 5

Explain the purpose and structure of financial markets
Describe the euro money market, including functions and interest rates
Explain how ECB monetary policy affects the money market
Discuss important developments in bond markets since monetary union
Discuss important developments in equity markets since monetary union
Describe the essentials of the derivatives market
Describe the foreign exchange market

Learning Goals: DSW Chapter 7

Define what a payment system is
Explain differences between wholesale and retail payment systems
Describe the various steps of the post-trading process
Understand economic characteristics of payment/securities market infrastructures
Explain how characteristics influence the EU market structure
Assess the extent to which different elements of EU financial infrastructure are integrated
Understand the growing importance of central counterparties (CCPs) and related concentration risk

Primary functions of financial markets

Price discovery: providing information to facilitate price agreement between buyers and sellers
Trading mechanism: creating marketplaces or platforms to facilitate agreements (quote-driven vs. order-driven markets)
Clearing and settlement: providing infrastructure to ensure agreements are honored

Price discovery

Present value (PV) of a security represents future payments
PV formula: PV = E(Cash Flow) / (1+r)^t
Expected cash flows are affected by size and risk
Prices reflect publicly available information (Efficient Market Theory)
Insider trading is forbidden by law (ESMA in Europe, SEC in USA)

Participants in the financial market

Public investors: ultimate owners of securities, motivated by returns
Brokers: act as intermediaries, motivated by commission fees, don't own securities
Dealers: own and trade on their accounts, motivated by profit differences between buy and sell prices.

Trading mechanisms

Quote-driven markets: dealer markets (e.g., bond, commodities), investors trade directly with dealers or brokers, buyer pays ask, seller gets bid
Order-driven markets: auction model (e.g., stock exchanges), prices determined by supply and demand in specific time frames (e.g., IPO), continuous auction market, limit orders and market orders
Hybrid markets: order-driven markets with quote-driven features to increase liquidity and efficiency

Five principal financial markets

Money markets
Bond markets
Equity markets
Derivatives markets
Foreign exchange markets

Relative importance

European bond markets are larger than European equity markets

What's so special about bond markets?

Compared to Stock markets: Bond markets have:
- Risk sharing, price discovery, transparency, big investments, many traders, trading not urgent, but volatile volume
Compared to Money/Debt markets: Bond markets have:
- Lending/liquidity provision, avoiding price discovery, information insensitive, opaque, modest investment, few traders, trading urgent, stable volume

Money markets

A place for warehousing surplus funds for short time periods
Low-cost, short-term funds (maturities ≤ 12 months)
Dominated by banks for liquidity management
Strongly influenced by monetary policy tools (standing facilities, OMOs, reserve requirements)
Two segments: unsecured funds (no collateral, e.g., interbank deposits) and secured funds (collateral, e.g., repos)

Repo agreement

Bank A (dealer) needs cash and sells an asset (e.g., bonds) to Bank B (buyer) for a loan of cash.
Bank A agrees to repurchase the asset at a specified later date for a higher price.

Euro money market interest rates

Various rates exist based on the type of deposit and maturity, set differently and by different entities - deposit facility, marginal lending, main refinancing operations (OMOs), EUREPO, ESTER, EURIBOR.

Bond issuers

Governments and financial institutions are the largest groups of issuers

Yield curves

AAA-rated government bonds with different maturities have upward sloping yield curves reflecting term premiums
Expected short-term interest rates in 2011 were negative after the GFC
Credit risk was apparent during the sovereign debt crisis of 2011
Liquidity risk was evident after the GFC due to unconventional ECB monetary policies addressing liquidity.

Relative bond yields and credit risk premia

Corporate bond yields have been greater than government bond yields since the Global Financial Crisis of 2008, often with financial bonds yielding more than non-financial bonds.

Rise of Alternative Finance (DSW Chapter 1, Section 1.3)

Securitization: Credit risk transfer and funding through bundling and tranching of assets sold to investors, including off-balance sheet vehicles (SPVs), and issues like asset-backed commercial paper (CDOs). Low-risk and high-risk structures (e.g., residential mortgages).

Global Financial Crisis of 2008-2009

U.S. sub-prime mortgages drove mispricing of housing, creating a real estate bubble that led to a banking crisis.
Mortgages were bundled into CDOs and sold in the secondary market to numerous European institutions (e.g., Lehman Brothers, Bear Stearns).
Large interconnectedness and contagion were significant.

Financial Infrastructure (DSW Chapter 7)

Post-trading systems: arrangement of ownership transfer and payment in security markets following trade. Includes confirmation, clearance (CSD), and settlement (payment and delivery).
Payment systems: transferring money between economic actors for goods/services. Divided into retail (e.g., card systems, TARGET2) and wholesale (e.g., correspondent banking, EURO1) systems.
Economic features: economies of scale, scope, network externalities, switching costs.

Learning Goals: DSW Chapter 2

Explain the characteristics of various financial crises.
Understand the link between sovereign and banking crises including the pro-cyclicality of the financial system.
Explain the main theoretical models of banking crises, drivers, and contagion of the financial crisis of 2007-2009, and the Euro crisis.

Types of financial crises

Banking crisis: Bank insolvency due to various reasons (investment losses, panics)
Sovereign debt crisis: Government default of meeting debt obligations
Currency crisis: sudden drop in currency value

Twin and triple crises

Statistics show the percentage occurrence of banking, debt, and currency crises, showing interconnectedness.
Periods T-3 to T+3 represent various time periods covering banking crises occurrence.

Banking crises

Banks transform short-term funding into long-term loans causing maturity mismatches. Wholesale and retail runs, liability-side versus asset-side are discussed.
Panics and runs are caused by sunspots (self-fulfilling prophecies) and business cycle shocks.
Classic models, including those related to Diamond & Dybvig (1983) on bank runs, deposit insurance, and liquidity, are discussed.
Examples of bank runs (1930, Silicon Valley, Northern Rock, First Republic) are included.

Simple, classic model with major insights

Discusses the role of banks as liquidity creators in the financial system.
Highlights bank runs as possible equilibria.
Shows how deposit insurance and central bank lender-of-last-resort facilities are mechanisms to prevent/mitigate bank runs.

Building blocks of the model

Investment opportunities (banks invest in long-term assets)
Consumption preferences (individuals uncertain when they want to consume).
Value of liquidating assets at different dates.

Consumption by savers/consumers/investors

Two types of consumers (patient and impatient)
Understanding of utility function and risk-aversion
Banks aim to maximize depositors' expected utility.
Timeline and deposit contracts are discussed.

Examples (100 savers, 50% type I, R = 2)

Illustrates possible deposit contracts yielding utilities for different consumer types and bank profits.
Calculation demonstrates how deposit contracts affect bank distribution of available funds and outcomes for both consumer types.

Depositing or investing directly?

Discusses the decision of investors on whether they will deposit or invest directly by calculating utility for different scenarios.

Possibility of bank run

Assumes the bank offers specified terms to different investor types.
Discussion of how patient agents view expected withdrawals by other consumers.
Implications of inconsistent strategies for time and actions, as well as the Nash equilibrium nature of potential bank runs.

Possibility of bank run: payoff matrix

A matrix showing possible outcomes for 4 types of investors in different choices concerning whether to stay in the bank or withdraw.

Potential policy measures

Government deposit insurance has implications for moral hazard.
The importance of regulation and supervision is stressed.
Suspension of convertibility and lender of last resort policies (central banks) are discussed.

Questions cover identifying main market failures, intervention reasons, Basel Accords (objectives and instruments), internal risk-based approach for credit risk (Basel Accords), and countercyclical buffers.
Answers to quiz questions are included.

Financial Stability (DSW Chapter 13)

Macroprudential supervision: What was the Supervision of the stability of Financial Systems as a whole?

Protecting the consumer, investor, deposit holder, or policyholder.
Monitoring of systemic risk.
Understanding time-series and cross-sectional dimensions relating to financial cyclicality and interconnectedness.
Employing indicators and instruments to monitor risk & interconnectedness.

Macroprudential supervision: Instruments

Cyclical indicators: Credit-to-GDP gap, housing credit, housing prices, excessive credit growth and leverage.
Structural indicators: Indicators for large exposures, interconnectedness, and price contagion.
Indicators for excessive maturity mismatch, liquidity stress, interconnectivity of (Systemically Important Financial Institutions, or SIFIs).
How monitoring/intervention occurs concerning these indicators/instruments

Systemically Important Financial Institutions (SIFIs) Criteria

Criteria used to identify institutions with potential systemic importance include:
Cross-border activity's global presence
Relative asset size to GDP
Interconnections via exposures and funding
Substitutability (importance to system functioning)
Complexity (group structure and business models)

G-SIBs (as of November 2013)

A list of globally systemically important banks, ranked by size and listed.

Macroprudential toolkit: instruments

Explaining policy tools like restrictions related to borrower/instrument/activity, restrictions on financial balance sheet (assets/liabilities), capital requirements, provisioning, surcharges, taxation or specific levies, and other instruments (accounting, compensation, governance, etc.).
Explaining how these tools affect different phases of the financial cycle (expansionary, contractionary).

Countercyclical capital buffer

Stylized transmission of buffers during different phases in the financial cycle (build-up, release).

Crisis management (Global Financial Crisis of 2007-2009)

Public support, recapitalization, and asset relief, and lack of common powers and tools are discussed.
Procedures involved in preparing for bank interventions and how interventions occur (e.g., restructuring, bail-in) and cooperation and coordination between national competent authorities.
The Bank Recovery and Resolution Directive (BRRD).

Resolution tools

Tools used to resolve failing banks are discussed, along with explanation of private equity acquisition, transfer parts of bank, bail-in, liquidation of bad assets.
Also discussing ELA (Emergency Liquid Assistance), DGS (Deposit Guarantee Schemes), and other related tools.

Questions concern defining macroprudential supervision, financial stability, and systemic risk; identifying key indicators for stability, and the primary objective of resolution tools.
Quiz answers are included.

Studying That Suits You

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Description

This quiz covers essential concepts related to money markets, including their purposes, functions, and instruments used. It also explores the impact of monetary policies on these markets and various funding mechanisms banks employ for liquidity management.