Financial Markets and Institutions

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General Principles of Bank Management
1. Liquidity management
2. Asset management
* Managing credit risk
* Managing interest-rate risk
3. Liability management
4. Managing capital adequacy
Liquidity management:
1. Borrow from other banks or corporations
2. Sell securities
3. Borrow from Fed
4. Call in or sell off loans
Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. 1. Get borrowers with low default risk, paying high interest rates 2. Buy securities with high return, low risk

3. Diversify
4. Manage liquidity
Liability Management: managing the source of funds, from deposits, to CDs, to other debt. 1. Important since 1960s
2. No longer primarily depend on deposits
3. When see loan opportunities, borrow or issue CDs to acquire funds Managing capital adequacy: why don’t banks hold want to hold a lot of capital?? 1. Higher is bank capital, lower is return on equity

* ROA = Net Profits/Assets
* ROE = Net Profits/Equity Capital
* EM = Assets/Equity Capital
* ROE = ROA EM
* Capital , EM , ROE
2. Tradeoff between safety (high capital) and ROE
3. Banks also hold capital to meet capital requirements
what should a bank manager do if she feels the bank is holding too much capital? 1. Buy back stocks, callable
2. Increase dividends to reduce retained earnings
3. Increase asset growth via debt (like CDs)
what should a bank manager do if she feels the bank is holding too little capital? 1. Issue stock
2. Decrease dividends to increase retained earnings
3. Slow asset growth (retire debt)
There are four basic types of credit instruments which incorporate present value concepts: 1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond
Yield to maturity = interest rate that equates today's value with present value of all future payments. Present Value Concept: Simple Loan Terms
* Loan Principal: the amount of funds the lender provides to the borrower. * Maturity Date: the date the loan must be repaid; the Loan Term is from initiation to maturity date. * Interest Payment: the cash amount that the borrower must pay the lender for the use of the loan principal. Simple Interest Rate: the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Convention is to express on an annual basis, irrespective of the loan term Relationship Between Price and Yield to Maturity

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par value Maturity and the Volatility of Bond Returns
1. Only bond whose return = yield is one with
maturity = holding period
2. For bonds with maturity > holding period, i P
implying capital loss
3. Longer is maturity, greater is price change associated with interest rate change
4. Longer is maturity, more return changes with change in interest rate 5. Bond with high initial interest rate can still have negative return if i 6. Prices and returns more volatile for long-term bonds because have higher interest-rate risk 7. No interest-rate risk for any bond whose maturity equals holding period Reinvestment Risk

1. Occurs if hold series of short bonds over long holding period 2. i at which reinvest uncertain
3. Gain from i , lose when i

Risk Management in Financial Institutions:( Credit Risk, Interest-Rate Risk) I)Managing Credit Risk:
1)Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal.
+adverse selection : is a problem in the market for loans because those with the highest credit risk have the biggest...
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