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1Chapter 1 Introduction
2Financial markets are one type of structure through which funds flow
3Financial markets can be distinguished along two divisions
4	Primary vs secondary markets
5Primary markets – markets in which users of funds (corporations and governments) raise funds by issuing financial instruments (stocks and bonds)
6Secondary markets – markets where existing financial instruments are traded among investors (eg exchange traded NYSE and over-the-counter: NASDAQ)
7	Money vs capital markets
8Money markets – markets that trade debt securities with maturities of 1 yr or less (eg CDs and US Treasury bills), with little or no risk of capital loss, but low return
9Capital Markets – markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year, has substantial risk of capital loss but higher promised return
10Foreign Exchange FX Markets
11	FX Markets – trading one currency for another (dollar to yen)
12	Spot FX – the immediate exchange of currencies at current exchange rates
13Forward FX – the exchange of currencies in the future on a specific date and at a pre-specified exchange date
14Derivative Security – a financial security whose payoff is linked/”derived” from another security or commodity
15	Generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future
16	The main purpose of derivative markets is to transfer risk between market participants
17	Examples of derivative securities
18		Exchange listed derivatives
19			Many options
20			Future contracts
21		Over the counter derivatives
22			Forward contracts
23			Forward rate agreements
24			Swaps
25			Securitized loans
26Financial Institutions – institutions through which suppliers channel money to users of funds
27	Financial institutions are distinguished by
28		Whether they accept insured deposits (depository vs non depository FIs)
29		Whether they receive contractual payments from customers
30	Depository Institutions – commercial banks, savings associations, savings banks, credit unions
31	Non-depository institutions
32		Contractual
33			Insurance companies
34			Pension funds
35		Non-contractual 
36			Securities firms
37			Investment banks
38			Mutual funds
39	FI benefit suppliers of funds
40		Reduce monitoring costs
41		Increase liquidity and lower price risk
42		Reduce transaction costs
43		Provide maturity intermediation
44		Provide denomination intermediation
45	FI benefit overall economy
46		Conduit through which Federal Reserve conducts monetary policy
47		Provides efficient credit allocation
48		Provide for intergenerational wealth transfers
49		Provide payment services
50	Risks Faced by Financial Institutions
51		Credit				Off-balance-sheet
52		Foreign exchange		Liquidity
53		Country or sovereign		Technology
54		Interest rate			Operational
55		Market				Insolvency
56		Volcker Rule: insured institutions may not engage in proprietary trading
57	Regulation of financial institutions
58		FIs are heavily regulated to protect society at large from market failures
59Regulations imposes a burden on FIs; before the financial crisis, US regulatory changes were deregulatory in nature
60Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation
61		Dodd-Frank Bill
62			Promote robust supervisions of FIs
63				Financial Service Oversight Council to identify and limit systematic risk
64				Broader authority for Federal Reserve to oversee non-bank FIs
65				Higher equity capital requirements
66				Registration of hedge funds and private equity funds
67			Comprehensive supervision of financial markets
68				New regulations for securitization and over the counter derivatives
69				Additional oversight by Fed of payment systems
70			Establishes a new Consumer Financial Protection Agency
71			New methods to resolve non-bank financial crises
72				More oversight of Fed bailout decisions
73Increase international capital standards and increased oversight of international operations of FIs
74Globalization of Financial Markets and Institutions
75	Pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before
76	Information on foreign markets and investments is becoming readily accessible and deregulation across the glove is allowing even greater access to foreign markets
77	International mutual funds allow diversified foreign investment with low transaction costs
78	Global capital flows are larger than ever
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108Chapter 7 Notes – Mortgage Markets
109Mortgages are loans to individuals or businesses to purchase homes, land, or other real property
110	Many mortgages are securitized
111Many mortgages pooled and sold and then mortgage payments are used to collateralize mortgage-backed securities
112	Mortgages differ from bonds and stocks
113		Mortgages are backed by a specific piece of real property
114		Primary mortgages have no set size or denomination
115		Comparatively little information exists on mortgage borrowers
116Four basic types of mortgages are issued by financial institutions
117	Home mortgages are used to purchase one-to-four family dwellings
118Multifamily dwellings mortgages are used to purchase apartment complexes, townhouses, and condominiums
119	Commercial mortgages are used to financial the purchase of real estate for business purposes
120	Farm mortgages are used to financial the purchase of farms
121Mortgage Characteristics
122	Collateral – lenders place liens against properties that prevent sale until loans are fully paid off
123Down payment – portion of the purchase price of the property a financial institution requires the borrower to pay up front
124Private mortgage insurance PMI – generally required when the loan-to-value ratio is more than 80%
125	Federally insured mortgages
126Repayment is guaranteed by either the Federal Housing Administration FHA or the Veteran Administration VA
127	Conventional mortgages – mortgages that are NOT federally insured
128Amortized mortgages have fixed principal and interest payments that fully pay off the mortgagee by its maturity date
129		Fully amortized mortgage maturities are usually either 15 or 30 years
130Balloon payment mortgages require fixed monthly payments for 3-5 whereupon full payment of the mortgage principal is due	
131	Fixed-rate mortgages lock in the borrower’s interest rate
132		Required monthly payments are fixed over the life of the mortgages
133		Lenders assume interest rate risk
134Adjustable rate mortgages ARMs tie the borrowers interest rate to some market interest rate or interest rate index
135Required monthly payments can change over the life of the mortgage, although they may initially be fixed for a set time period (for example 5/1 ARMs and 3/1 ARMs are popular)
136			For example, cap on a 5/1 ARM may be stated as 5/2/5
137		Borrowers assume interest rate risk with an ARM
138		ARMs can increase default risk
139	Discount points – fees or payments made when a mortgage loan is issued
140		Each point costs the borrower 1 percent of the principal value
141The lender reduces the interest rate used to determine the payments on the mortgage In exchange for points paid
142	The longer the borrower takes to pay off the mortgage, the more likely to choose points and a lower mortgage rate - offering points mortgage lender decreases probability the mortgage borrower will prepay mortgage - paying mortgage off early reduces present value of monthly savings to mortgage borrower
143	Other fees
144Application fee, title search, title insurance, appraisal fee, loan origination fee, closing agent and review fees, VA/FHA loan guarantees, PMI
145	Mortgage Refinancing - when a borrower takes out a new mortgage and uses the proceeds to 	pay off an existing mortgage
146		Mortgages are most often refinanced when an existing mortgage has an interest rate 		than current rates
147		Borrowers must balancve the savings of a lower monthly paymenr with costs(fees) of 		refinancing
148		Rule of Thumb: New interest rate should be 2 percentage points less than refinanced 		mortgage rate
149Mortgage Amortization
150	Each fixed monthly payment consists partly of repayment of the principal and partly of the 	interest on the outstanding mortgage balance
151	An amortization schedule shows how the fixed monthly payments are split between principal 	and interest
152Mortgage Payments
153Other types of mortgages
154	Jumbo mortgage - mortgages for loan amounts that exceed the maximum 'conforming' limits 	allowed by the mortgage agencies Fannie Mae and Freddie Mac ($410,000 in 2014)
155	Subprime Mortgages - mortgages where borrowers do not qualify for a "prime" credit rating 	because of a low credit score arising from prior credit problems such as delinquencies and 	defaults
156		Or they may simply lack credit history or proper income
157	Alt-A mortgages - mortgages that are riskier than prime but not as risky as subprime
158		Incomplete documentation (liar loans)
159		Lower credit scores
160		Lower loan to value ratios
161		Interest rates usually between Prime and Subprime rates
162	Option ARMs (pick n pay mortages) - give homebuyers initial choice of payment options
163		Minumum payment 1% interest rate for 12 months, then variable rate, capitalization of 			unpaid interest, growing loan balance
164		Interest only payment: pay interest only at an adjustable rate for first 5-10 years of loan, 		payments will increase substantially when IO term expires
165		15/30 year fully amortizing payment	
166	Second mortgages and home equity loans
167		Subordinated claims to senior mortgages
168	Reverse-annuity mortgages (RAMs)
169		Retirees or homeowners with a substantial amount of equity in their home can sell back 		the equity back to a bank over time
170		Various payment options available
171		Costs/servicing fees are higher
172Secondary Mortgage Markets
173	FIs remove mortgages from their balance sheets through 2 mechanisms
174		Pooling recently originated mortgages together and selling them in secondary market
175		By securitizing mortgages (issuing securities backed by newly originated mortgages)
176	Advantages of securitization
177		FIs can reduce the liquidity risk, interest rate risk, and credit risk of their loan portfolios
178		FIs generate income from origination and service fees
179	US govt established Federal National Mortgage Assocation FNMA Fannie Mae in 1930s to buy 		FHA and VA mortgages from thrifts so they could make more mortgage loans
180	US govt established Federal Home Loan Mortgage Corporation FHLMC Freddie Mac in 1968 to 		facilitate financing of conventional mortgages
181	Government National Mortgage Assocation GNMA Ginnie Mae in 1960s
182		Encouraged continued expansion of housing market, mainly lower income housing
183		GNMA does not securitize mortgage, rather provides direct and indirect guarantees that 		allow private entities to create mortgage-backed securities
184	Securitization and Congressional goals to increasing funding for housing to lower income 	individuals led to weakning credit standards and increases in the number of high risk loans 	(subprime mortages)
185		Beginning in 06, problems in subprime mortgage market lead to 07/08 financial crisis
186		May 05 and Feb 07 subprime mortgage default rates increased from 5.37% to 10.09%
187		Subprime mortage holders 60+ days behind in payments hit 17.1% in Jun 07, 20% by 			August
188		Problems in subprime market spilled over to broader mortgage markets and helped fuel 		nationwide declines in home prices which put many homeowners underwater and lead 		to bankruptcies of many major financial institutions
189		Sept 7 08 Federal Housing Finance Agency FHFA put both Fannie Mae and Freddie Mac 		in government conservatorship
190Purpose of Government Involvement
191	Purpose in Residential mortgage markets
192		Provides affordable housing to as many potential homeowners as possible
193			Created a national market for mortage finance
194		Unforeseen costs?
195		Competition for bond market
196		Implicit & explicit government mortgage liability
197Ethics Issues
198	Bank of America BofA under investigation for mishandling low quality mortgages and potentially 	misrepresenting value of mortgage backed securities during crisis
199	JP Morgan already paid $13 billion in fines/civil settlements for similar issues
200Mortgage-backed securities
201	Pass-through securities - "pass-through" promised principal and interest payments to investors
202	Three agenties are directly involved in creation of pass-through securities
203		Ginnie Mae, Fannie Mae, Freddie Mac
204	Private mortgage pass-through issuers - create pass-throughs from nonconforming mortgages
205	Collateralized mortgage obligations CMOs are multiclass pass-throughs with multiple bond 	holder classes or tranches
206		Each bond holder class has a different guaranteed coupon
207		Mortgage prepayments retire only one tranche at a time, so all other tranches are 		sequentially prepayment protected
208	Mortgage-backed bonds MBBs 
209		MBBs allow FIs to raise long-term low-cost funds without removing mortgages from 		their balance sheets
210		A group of mortgage assets is pledged as collateral against a MBB issue, but there is no 		direct link between cash flow of mortgages and cash flows on the MBB
211International Trends in Securitization
212	Europe is world's second largest and most developed securitization market
213		UK is biggest MBS issuer in European Market, followed by Germany
214		Advent of Euro has accentuated trend in securitization of Europe
215	Parts of Europe/Asian real estate markets were not as affected by mortgage crisis because they 	lacked substantial subprime lending
216	Banks in Britian, Ireland, Iceland, Spain, Netherlands, Switzerland, and Germany did have 	substantial mortgage related losses that resulted in bailouts and passage of economic stimulus 	programs
217	Securitization overseas is often structured differently, with originators retaining title to the 	mortgages even after securitization
218	Securitization has declined due to the crisis but will continue in the future		
219Mortgage Sales
220	FIs have sold mortgages among themselves for over 100 years
221	Large part of correspondent banking involves small banks selling parts of large loanms to larger 	banks
222	Large banks often sell parts of their loans (participations) to smaller banks
223	Mortgage sales occur when an FI originates a mortgage and sells it to an outside buyer
224		Loan sale is made with recourse if the loan buyer can sell the loan back to the originator, 		should it go bad
225	Mortgage sellers: money center banks, smaller banks, foreign banks, investment banks
226	Mortgage sales allow FIs to manage credit risk, achieve better asset diversification, and improve 	their liquidity and interest rate positions
227	FIs are encouraged to sell loans for economic and regulatory reasons
228		Sold mortgages can still generate fee income for bank
229		Sold mortgages reduce the cost of reserve and capital requirements
230	Mortgage buyers: foreign and domestic banks, insurance companies, pension funds, closed-end 	bank mutual funds, nonfinancial corporations
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244Chapter 5 - Money Markets
245Money markets involve debt instruments with original maturities of one year or less
246Money market debt
247	issued by high quality (low default risk) economic units that require short-term funds
248	purchased by economic units that have excess short-term funds
249	little or no chance of principal loss
250	low rates of return
251Most money market instruments have active secondary markets to provide liquidity
252Money Market Yields
253	Money Market securities use special rate quoting conventions
254		Discounting yields (Id) Interest rate is quoted on an annual basis assuming 360 day year 		as a percent of redemption price or face value
255		Single payment yields (Isp) Interest rate is quoted on an annual basis assuming 360 day 		year as a percent of purchase price
256	Both may be converted to a bond equivalent yiield (Ibe) for comparison with bonds
257	Treasury bills and commercial paper rates are quoted as discount yields
258	Discount yield formula: (F1)
259
260	Compare discount securities to bonds with bond equivalent yields (Ibe) (F2)
261	Convert bond equivalent yields into effective annual returns (EAR) (F3)
262	Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (Isp) (F1)
263	To convert a single-payment yield to a bond equivalent yield
264		Ibe = Isp (365/360)
265	To directly convert a single payment yield to an EAR (F3 but with Ibe replaced with above
266Money Market Instruments
267	Treasury bills (T-bills) - short term debt obligations issued by US government
268		virtually default risk free, highly liquid, and have little interest rate risk
269		Fed reserve buys and sells T-bills to implement monetary policy
270		Strong international demand for T-bills as safe haven investment
271		T-Bill auctions - 13 and 26 week T-bills are auctioned weekly, other maturities available
272			Bids submitted by government securities dealers, financial and nonfinancial 			corporations, and individuals
273			Bids can be competitive or noncompetitive
274				Competitive bids specify the bid price an desired quantity of T-bills
275				Noncompetitive bids get preferential allocation and agree to pay lowest 				price of the winning competitive bids
276			Secondary market for T-bills - largest secondary market for any US money 			market instrument
277				21 primary dealers "make" a market in t-bills by buying the majority sold 				at an auction and by creating an active secondary market
278					primary dealers trade for themselves and customers
279					T-bill purchases and sales are book-entry transactions 						conducted over Fedwide
280				T-bills are sold on a discount basis
281		T-bill prices can be calculated from quotes (WallStreetJournal) by arranging discount 		yield equation
282	Federal Funds (Fed funds) - target rate in the conduct of monetary policy
283		Fed fund transactions are short-term (overnight) unsecured loans
284		Banks with excess reserves lend fed funds, while banks with deficient reserves borrow 		fed funds
285		Multimillion dollar loans may be arranged in a matter of minutes
286		Fed funds are single-payment loans and thus single-payment yields
287	Repurchase Agreements (repos or RP) - sale of a security with an agreement to buy the security 	back at a set price in the future
288		Repos are short-term collateralized loans (typical collateral is US Treasury securities)
289			Similar to a fed fund loan, but collateralized
290			Funds may be transferred over FedWire system
291			If collateralized by risky assets, the repo may involve a "haircut"
292		Typical denominations on repos that are 1 week or less are $25 million
293			Longer term ones have $10 million denominations
294		Reverse repurchase agreement is purchase of security with an agreement to sell it back 		in the future
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296	Commercial Paper (CP)- unsecured short-term corporate debt issued to raise short-term funds 	(for working capital)
297		Generally sold in large denominations (100,000 to 1 million) with maturities 1-270 days
298		CP is usually sold to investors indirectly through brokers and dealers (78% of time)
299		CP is usually held by investors until maturity and has no active secondary market
300		Yields are quoted on a discount basis (like T-bills)
301		Asset-backed commercial paper - type of commercial paper backed by assets of issuing 		firm
302			Grew rapidly prior to financial crisis, much of it was backed by mortgage assets
303			Market collapsed during financial crisis
304	Negotiable certificates of deposit (CD) - bank-issued time deposit that specifies interest rate and 	maturity date
305		CDs are bearer instruments and thus are salable in the secondary market
306		Denominations range from $100,000 to $10 million; $1 million most common
307		Often purchased by money market mutual funds with pools of funds from individual 		investors
308	Banker acceptances (BA) - time draft payable to a seller of goods with payment guaranteed by a 	bank
309		Used in international trade transactions to finance trade in goods that have yet to be 		shipped from a foreign exporter (seller) to a domestic importer (buyer)
310		Foreign exporters prefer that banks act as payment guarantors before sending goods to 		importers
311		Banker's acceptances are bearer instruments and thus are salable in secondary markets
312Money market participants
313	US Treasury
314	Federal Reserve
315	Commercial Banks
316	Money market mutual funds
317	Brokers and dealers
318	Corporations
319	Other financial institutions
320	Dealers
321International Money Markets
322	US dollars held outside the US are tracked among multinational banks in the Eurodollar market
323	The rate offered for sale on Eurodollar Funds is the London Interbank Offered Rate LIBOR
324	Eurodollar Certificates of Deposit are US dollar-denominated CDs held in foreign banks
325	Eurocommercial paper (EuroCP) issued in Europe and can be local currencies or US dollars
326	The LIBOR is the rate on interbank loans between British banks
327	LIBOR is the base rate on trillions of dollars of derivativbes and is the base rate for many loans
328	Large banks manipulated LIBOR to profit on derivatives positions and/or to appear less risky 	during the crisis
329		Bank profits from misquoting LIBOR may have exceeded $75 billion
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377Chapter 10 – Derivative Securities Markets
378	Derivative – a contract between two parties whose value is based on some underlying asset 	price or market condition
379	In many derivatives, two parties agree to exchange a standard quantity of an asset at a 	predetermined price at a specific date in the future
380	Derivatives are leveraged instruments where participants put up a small amount of money and 	obtain the gain or loss on a much larger position
381	Derivatives are used for speculation and for hedging
382		Speculation – buying or selling a derivative contract in order to earn a leveraged rate of 		return with increased risk
383		Hedging – entering into a derivatives contract to reduce the risk associated with 			positions or commitments in their line of business
384	Derivatives Markets
385		Agricultural product features and options go back to ancient history (began US in 19th 		century)
386		Options on stocks began in the US in the late 19th century
387		Modern derivatives
388			The first wave were foreign currency futures introduced by the International 			Monetary Market IMM followed the Smithsonian Agreements of 1971 and 1973
389			The second wave were interest rate futures introduces by the Chicago Board of 			Trade CBT with the increase rate volatility in the late 1970s
390			The third wave occurred in the 1980s with the advent of stock index derivatives
391			The fourth wave occurred in 1990s with credit derivatives
392		Substantial corporate use to reduce risk
393Spot contract – an agreement to transact involving the immediate exchange of assets and funds
394Forward contract – nonstandardized agreement to buy or sell and asset in the future with the terms of the deal set when the contract is created
395	Not very marketable
396Forwards are:
397	Custom contracts; lack standard terms
398	Not trade, so participants must perform
399	Risky; have potential counterparty credit risk
400Futures contract – standardized, exchange-traded version of a future contract
401	Future contracts differ from forwards in that futures are:
402		Marketable	
403		Have no default risk
404		Employ margin requirements and daily marking to market
405			Margin requirement is a performance bond posted by a buyer and a seller of a 			futures contract
406	Future contract trading occurs in trading “pits” using an open-outcry auction among exchange 	members
407		Floor brokers place trades for the public
408		Professional traders – trade for their own accounts
409		Position traders take a position in the futures market based on their expectations about 		the future direction of the prices of the underlying assets
410		Day traders take a position within a day and liquidate it before the day’s end
411		Scalpers take positions for very short positions of time (minutes), in attempt to profit 		from active trading
412	Price volatility and trading interest determines which contracts are offered
413	Profit pressures for derivatives exchange to merge
414		CME Group contains CME, CBOT, NYMEX, and COMEX
415	Electronic trading – is increasingly dominating “pit” trading Intercontinental Exchange only has 	electronic trading
416	Long position – purchase of futures contract
417	Short position – sale of futures contract
418	Clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made 	by the exchange
419	Open interest is the total number of the future, put options, or call options outstanding at 	beginning of day
420	Initial margin is a deposit required on future trades to ensure that the terms of the contract will 	be met
421	The maintenance margin is the margin a futures trader must maintain once a futures position is 	taken
422		If losses occur such that margin accounts fall below the maintenance margin, the 		customer is required to deposit additional funds in the margin account to keep position 		open
423Options
424	Option - contract that gives the holder the right but not the obligation to buy or sell the 	underlying asset at a specified price within a specified period of time
425	Call option - option that gives purchaser the right but not the obligation, to buy the underlying 	security from the writer of the option at a specified exercise price on (or up to) a specified date
426	Put option - option that gives the purchaser the right, but not the obligation to sell the 	underlying security to the writer of the option at a specified exercise price on (or up to) a 	specified date
427	Black-Scholes option pricing model (model most commonly used to price and value options) is a 	function of:		(NOT REQUIRED TO CALCULATE IN THIS COURSE)
428		The spot price of the underlying asset
429		The exercise price on the option
430		the option's exercise date
431		the price volatility of the underlying asset
432		the risk-free rate of interest
433	The intrinsic value of an option is the difference between an option's excercise price and the 	underlying asset price
434		The intrinsic value of a call option = max{S-X, 0}
435		The intrinsic value of a put option = max{X-S, 0}
436	The underlying asset on a stock option is the stock of a publicly traded company
437	The underlying asset of a stock index option is the value of a major stock market index
438	The underlying asset of a futures option is a futures contract
439	Credit spread call options
440		The value of a credit spread call option increases as the default (risk) premium or yield 		spread on a specified benchmark bond of the borrower increases above some exercise 		spread
441	A digital default option pays a stated amount in the event of a loan default
442Option Markets
443	Chicago Board of Options Exchange CBOE opened in 1973 as first exchange devoted solely to the 	trading of stock option
444	Options on futures contracts began trading in 1982
445	An American Option can be exercised at any time before (and on) before the expiration date
446	A European option can be exercised only on the expiration date (S&P 500 Index Option)
447	The trading process for options is similar to that for futures contracts
448Swaps
449	A swap is an agreement between two parties to exchange asset or series of cash flows for a 	specific period of time at a specified interval
450	A plain vanilla interest rate swap is an exchange of fixed-interest payements for floating-interest 	payments by two counterparties
451		The swap buyer makes periodic fixed interest rate payment on a stated notional 		principal amount
452		The swap seller makes a periodic floating-rate interest payments on the same stated 		notional principal amount
453		No principal is exchanged
454	A currency swap is a periodic exchange for one currency for another between the parties
455		Usually associated with borrowing money
456		the exchanges can be at a fixed or variable rate of interest as negotiated in the contract, 		but the exchanges occur at a known currency exchange rate
457		Used to hedge exchange rate risk from mismatched currencies of assets and liabilities
458	Credit default swaps CDS allow financial institutions to hedge credit risk
459		A CDS buyer is buying insurance on a loan or bond
460			A CDS seller receives periodic payments from the CDS buyer
461			If the insured loan or bond defaults, the CDS seller pays the par value of the loan 			or bond to the CDS buyer
462		CDS played a major role in the financial crisis, AIG and others were major sellers of CDS 		that insured mortgage-backed securities, but lacked capital and could not pay when the 		mortgage securities failed
463Swap Markets
464	Swaps are not standardized contracts
465	Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or 	by taking positions themselves
466	The International Swaps and Derivatives Association ISDA is an association among 56 countries 	that sets codes of standards for swap documentation
467Caps, Floors, and Collars
468	Financial institutions use options on interest rates to hedge interest rate risk
469		A cap is a call option on interest rates, often with multiple exercise dates
470		A floor is a put option on interest rates, often with multiple exercise dates
471		A collar is a position taken simultaneously in a cap and a floor (usually by buying a cap 		and selling a floor)
472Regulators of Derivatives
473	The primary regulator of futures markets is the Commodity Futures Trading Commission CFTC
474	The Securities Exchange Commission (SEC) is the primary regulator of stock options and stock 	index option
475	The CFTC is the regulator of options on futures contracts
476	Until the Dodd-Frank Act neither the SEC nor the CFTC directly regulated OTC derivatives such as 	swaps
477	Under the new law OTC derivatives may be required to be traded on exchange and as such 	would come under the purview of the SEC and CFTC
478	Bank regulators will presumably more tightly regulate bank usage of derivatives
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520Chapter 8 Notes - Stock Markets
521Primary stock markets allow suppliers of funds to raise equity and capital (through new issues of stock)
522	Usually through investment banks
523	Investment banks act as distribution agents in best efforts underwriting
524	Investment banks act as principals in firm commitment underwriting
525		Gross proceeds - net proceeds = underwriter's spread
526	A syndicate is a group of investment banks working in concert to issue stock; the lead 		underwriter is the originating house
527	Initial public offering IPO is the first public issue of financial instruments of a firm
528	Seasoned offering is a sale of additional securities by a firm whose securities are already publicly 	traded
529		Preemptive rights - give existing stockholders the ability to maintain their proportional 		ownership
530	Shelf registration - allows firms to offer multiple issues of stock over a two-year period with only 	registration statement
531Secondary stock markets are the most closely watched and reported of all financial markets
532	Markets in which stocks, once issued, are traded among investors
533	US has several (NYSE, NASDAQ, BATS/DirectEdge)
534		NYSE Euronext - trading occurs on a specific place on the floor called trading post
535		Each stock has a special market maker called a specialist (designated market maker 		DMM) that maintains liquidity for the stock at all times
536		Three types of transactions happen at trading posts
537			Market order - order to transact at best price available when order reaches 			trading post
538			Limit order - order to transact at a specified price
539			Specialists transacting for their own account
540		Program trading - simultaneous buying and selling of a portfolio of at least 15 stocks 		valued at more than $1 million using computer programs to initiate the trades
541		Circuit breakers give investors time to make informed choices during periods of high 		market volatility
542		Exchange Traded Funds ETFs - index funds that are listed on exchange and can be traded 		intraday and shorted
543		Prices may not exactly match an index
544	NASDAQ was world's first electronic market - has no physical floor
545		Provides continuous trading for the most active stocks traded over the counter OTC
546		Primarily as a dealer market where many, often more than 20 dealers act as market 		makers
547		A small order execution system SOES provides automatic order execution for orders of 		less or equal to 1000 shares
548		NASD maintains electronic OTC bulletin board and pink sheets for small firms that are 		not part of the NASDAQ
549	Choice of market listings - 
550		NYSE has extensive listing requirements (firm market value and 	trading volume)
551		NASDAQ - easier/cheaper requirements and can be met by smaller firms with less active 		trading
552	Electronic communication networks ECNs - normal trading 930am-4pm EST
553		Extended hours trading through alternative trading systems ATSs (other ECNS)
554		BATS Better Alternate Trading System - now its own exchange
555	Online trading via the internet is growing in popularity with both individuals and professionals
556	Flash Trading - May 6 2010 market crashed by 5% and recovered nearly instantly
557		definite cause not known, but suspected $4.1 billion S&P futures contract cause
558		Flash trading - traders allowed to see incoming buy or sell orders milliseconds earlier 		than general market traders
559		Flash traders then use computerized statistical analysis to generate high frequency 		trading strategies that are excuted
560		Pros: Flash trading creates more liquidty and possibility of price improvement
561		Cons: Disadvantage for regular traders and investors, high volume of trading by multiple 		flash trading can lead to another flash crash
562		As result of the flash crash, SEC imposed circuit breaker rules for individual stocks
563			Trading halted if price breaks price band calculated as
564			Price band = Reference Price +/- [Reference Price * Percentage Parameter]
565	Naked access - occurs when brokers and exchanges allow some traders to engage in high 	frequency trades anonymously using broker's access code
566	Dark Pools - trades that occur on alternative trading platforms (such as electronic 	communication networks) that do not report details of trade on order books (est 15% daily 	trades)
567	SEC considering requiring greater disclosure of dark pool trading and requiring high frequency 	traders to register as broker/dealers
568Stock Market indexes
569	Stock market index - composite value of a group of secondary market-traded stocks
570	Price-weighted index - DOW Jones Industrial Average DJIL composed is 30 companies is most 	widely known stock market index
571	Value-weighted indexes
572		NYSE Composite
573		S&P 500
574		NASDAQ composite
575		Wilshire 5000
576Households and mutual funds are largest US holders of corporate stock
577Market efficiency refers to the extent and speed with which financial security prices reflect unexpected news events
578	Weak form market efficiency - if an investor can use historical news or historical price/volume 	information, to consistency predict future stock price changes, then markets are not weak form 	efficient
579	Semistrong form market efficiency - if one can use any publicly available information, including 	forecasts based on public information to consistently predict future stock price changes, then 	markets are not semistrong form efficient
580	Strong form market efficiency - if one can use any information, including inside information to 	consistently predict future stock price changes, then markets are not strong form efficient
581Stock Market Regulations
582	The Securities and Exchange Commission SEC is primary regulator of stock markets
583		Promote full and fair disclosure of information on securities and ensure fair treatment 		of investors
584		Enforce Securities Acts of 1933/1934
585		Prosecute Inside Trading
586		SEC failed to uncover Madoff fraud, significant turnover of personnel since
587		SEC failed to implemtent many changes required by Dodd-Frank bill
588	Financial Industry Regulatory Authority FINRA is regulator of all US securities firms
589		Oversees registering and educating brokers and dealers, examining securities firms, 		promulagating rules, enforcing federal securities laws, and conducting dispute 			arbitration
590International Aspects of Stock Markets
591	US Stock markets are worlds largest
592	Euro markets have increased but were hurt by Euro area crisis
593	UK, Canada, Japan, Pacific Basin showing strong growth
594	International stock markets allow investors to diversify by holding stocks issued by corporations 	in foreign countries
595	International diversification can increase risk due to incomplete information about foreign 	stocks as well as foreign exchange and political risk
596American Depository Receipts ADRs - certificant that represents ownership of a foreign stock
597	Created by US bank, after acquiring stock in foreign corporations in their domestic currencies
598	The bank then issues dollar ADRs backed by the shares of the foreign stock, investors earn 	returns in US dollars
599	Currently 1200~ ADRs in foreign corporations available to US investors representing $2.79trillion
600	Three types of ADRs
601		Level 1 - trade OTC and not required to meet US GAAP nor issue annual reports
602		Level 2 - trade on exchanges and must meet exchange requirements and adhere to US 		reporting standards
603		Level 3 - meet same reporting standards as Level 2 and must register with SEC and file 		the equivalent of 10K forms, these firms allowed to raise public capital in the US
604Foreign exhange risk - changes in currency values can significantly impact returns on foreign investments
605Stockholders are the legal owners of a corporation
606	Have a right to share in the firm's profits (dividends)
607		Discretionary, not guaranteed
608	are residual claimants
609		lowest priority claim in event of bankruptcy
610	have limited liability
611		common stockholders can lose no more than their original investment
612	have voting rights (to elect board of directors)
613		control firm activity indrectly by electing like-minded directors
614Common stock is fundamental ownership claim in a public or private corporation
615Dual-class firms have two classes of common shares outstanding, with two different voting rights assigned to each class
616	With cumulative voting, the number of votes assigned to each stockholder equals the number of 	shares held multiplied by the number of directors elected
617		Number of shares needed to elect p directors Np is
618		Np = [(p * # of shares outstranding) / (# of directors to be elected + 1) ]   + 1
619	If number of minority shares outstanding under cumulative voting is known, number of directors 	that can be elected can be determined
620		Number of directors that can be elected		
621		[(Shares owned - 1) * (Total number of directors to be elected +1)] / # of shares 											     outstanding
622	Proxy vote allows stockholders to vote by absentee ballot
623Stock Returns
624	Return on stock over one period Rt can be divided into capital gains and dividend returns	
625Right to purchase new shares
626	Holders of common stock must be given first option to buy new shares
627		Ensures management cannot subvert position of present stockholders (maintain ratio)
628Use of rights in Financing
629	Used by many US companies and is popular as fund raising method in Europe
630	Stockholders may choose to sell their rights to buy shares, rather than exercise them
631Preferred stock - hybrid security that has characteristics of both bonds and common stock
632	Has fixed dividends that are paid quarterly
633	Does not have voting rights unless dividend payments are missed
634	Nonparticipating vs Pariticipating
635	Cumulative vs Noncumulative
636
637Chapter 7 Excel formulas
638Mortgage Monthly Payment
639	=-PMT(Rate/payments per year;Term(years)*payments per year;Loanamount)
640Amorization Schedule
641	Beg Balance, Payment, Interest, Principal, Ending Balance
642	Beginning Balance = principal  (or previous year's ending balance)
643	Interest
644		=Rate*BeginningBalance/Payments per year
645	Principal
646		= MonthlyPayment - Interest
647	Ending Balance
648		=Beginning Balance - Principal
649	Total Payments
650		=MonthlyPayment*Term(years)*PaymentsPerYear
651	Amount Interest Paid over Life
652		=TotalPayments-LoanAmount
653`	Loan Amount with Points Reduction (remember to take away down% first)
654		=LoanAmount*Points/100
655	Point Difference Amount
656		=CostofPoints1stOption-CostofPoints2ndOption
657	Payment Difference
658		=PaymentOption1-PaymentOption2
659	PV Savings
660		=PV(Rate/12;PaymentsPerYear*Term(Years);-PaymentSaveDiff
661	Interest Saving
662		=InterestOption1-InterestOption2
663	Average Interest Saved
664		=AVERAGE(all the interest saved each payment)
665	Break Even
666		=NPER(Rate/12;AverageInterestSaved;-PointsDiffAmount)/12
667Chapter 5 Excel Formulas
668Discount Yield
669	=(FaceValue-MarketPrice)/FaceValue*360/DaystoMaturity
670Bond Equivalent Yield
671	=(FaceValue-MarketPrice)/MarketPrice*365/DaystoMaturity
672EAR
673	=(1+BEYield/(365/DaystoMaturity))^(365/DaystoMaturity)-1
674Bid Price Formula
675	=FaceValue-(BidRate*DaystoMaturity/360*FaceValue)
676Repo Yield Formula
677	=(BuyBackPrice-BuyPrice)/BuyPrice*360/DaystoMaturity
678
679Chapter 10 Excel Formulas
680Margin call
681	Long position +/- increaseordecrease in value = new value
682	closing margin requirement = (margin requirement% * new value)
683	Opening margin = long position * margin requirement
684	closing margin - opening margin = margin surplus or deficit
685	Margin Surplus or Deficit +/- loss in value = margin call
686
687
688Chapter 8 Excel Formulas
689Number of directors that can be elected by one person
690	=(# shares oustanding person1 controls - 1)*( # of directors that can be elected)/(#shares 		outstanding by person 1 + shares controlled by person 2 ....  + # remaining shares)
691Number of directors that can be elected by one person (if person gets proxies for uncommitted votes)
692	=(# shares oustanding person1 controls +# of shares outstanding person 2 controlls- 1)*( # of 	directors that can be elected)/(#shares outstanding by person 1 + shares controlled by person 	2 ....  + # remaining shares)
693Straight Voting
694	(Number of votes/2)   + 1
695Cumulative voting shares required
696	[(# of directors desired * # shares outstanding) / (total number of directors to be elected) ] +1
697
698Value of a Right
699	(Market value of stock - purchase price of new share) / (# shares owned + 1)
700Value before rights offering
701	(Stock value) + (extra cash on hand)
702Value based on diluted value(ex rights)
703	(Market value of stock - Value of a right)
704Sell the rights but keep stock at diluted value, value of portfolio
705	(#shares owned * value based on diluted value)  + (#shares owned * value of right) + (extra cash)
706
707Chapter 19 - Types of Risks Incurred by Financial Institutions
708
709Risks at Financial Institutions
710One of the major objectives of a financial institution's (FI)'s managers is to increase FI returns for its owners
711Increased returns typically come at the cost of increased risk, which comes in many forms
712
713Credit Risk- risk that promised cash flows from loans and securities held by FIS may not be paid in full
714	FIs make loans or buy bonds backed by small percentage of capital
715		Thus banks/thrifts/insurance companies can be significantly hurt even by minor amounts 		of loan losses
716	Many financial claims issued by individuals or corporations have
717		Limited upside return
718		Large downside risk with low probability
719	A key role in FIs involves screening and monitoring loan applicants ensure only credit worthy receive loans
720		FIs also charge interest rates commensurate with riskiness of borrower
721	Effects of credit risk are evidenced by net-charge offs
722		Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare 			bankruptcy
723	FIs can diversify away some individual firm-specific credit risk, but not systematic credit risk
724		Firm-specific credit risk - risk of default for borrowing firm associated with specific 			types of project risk taken by that firm
725		Systematic credit risk- risk of default with general economy-wide or macroeconomic 			conditions affecting all borrowers	
726Liquidity Risk - risk that sudden/unexpected increase in liability withdrawals or unexpected loan demand may require FI to liquidate assets in a very short period of time at low prices
727	Day-to-day withdrawals and loan demand are generally predictable
728	FIs may hold liquid assets and/or rely on purchased funds
729		Purchased funds include short-term borrowing such as federal funds loans and brokered 			deposits
730	Unusually large withdrawals by liability holders can create liquidity problems:
731		Cost of purchased and/or borrowed funds rises for FIs
732		Supply of purchased/borrowed funds declines
733		FIs may be forced to sell less liquid assets at "fire-sale" prices
734Interest Rate Risk - risk incurred by FI when maturities of its assets and liabilitites are mismatched and interest rates are volatile
735	Asset transformation involves an FI issuing secondary securities or liabilities to fund the purchase of primary securities or assets
736	If an FI's assets are longer-term than its liabilities, it faces refinancing risk (risk that the cost of 	rolling over or reborrowing funds will rise above the returns being earned on asset investments)
737	If an FI's assets are shorter-term than its liabilities, it faces reinvestment risk (risk that returns on 	funds to be reinvested will fall below the cost of funds)
738	Net Interest Margin = [(Average assets earning - Liabilities paying)*fixed earning assets] / fixed 	earning assets
739	All FIs face price/market risk (risk that price of security changes when interest rates change
740	FIs can hedge/protect themselves against interest rate risk by matching maturity of assets and 	liabilities
741		Approach is inconsistent with asset transformation function
742		They may match the rate sensitivity of their assets and liabilities
743		May match duration of assets and liabilities
744	Changes Occur because of fixed rate bond changes with market rates
745	Interest expense also changes because CD rates change when CD is reissued each year
746Market Risk- risk incured in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices
747	Closely related to interest and foreign exchange risk
748	Adds risk of trading activity (market risk incremental risk incurred by an FI in addition to 	interest rate or foreign exchange risk, caused by an active trading strategy
749	FIs trading portfolios are differentiated from their investment portfolios on the basis of time 	horizon and liquidity
750		trading assets, liabilities, and derivatives are highly liquid
751		investment portfolios are relatively illliquid and are usually held for longer periods of 			time
752	Declines in traditional banking activity and income at large commercial banks have been offset 	by increases in trading activities and income
753	Declines in underwriting and brokerage income at large investment banks have been offset by 	increases in trading activity and income
754	Certain types of MFs such as REITS are also exposed to market risk
755	FIs are concerned with fluctuations in trading account assets and liabilities
756		Value at risk VAR - and dailty earnings at risk DEAR are measured used to assess 			market risk exposure
757	Market risk exposure has caused some higly publicized losses
758		2012 JP Morgan $6 billion loss on credit default swaps
759		7.2 billion loss Societe Generale 2008
760		buyouts of lots of banks in 07/08
761Off-Balance-Sheet Risk - risk incurred by an FI as result of activities related to contingent assets and liabilities
762	Commercial banks held 233.853 trillion in 2013
763	OBS activity can increase FI's interest rate risk, credit risk, and foreign exchange risk
764	OBS activity can used to hedge/reduce FI's interest rate risk, credit risk, and foreign exchange 	risk
765	OBS activities can affect the future shape of FIs balance sheets
766		OBS items can become on-balance-sheet items only if some future event occurs
767		Letter of Credit LOC is a credit guarantee issued by an FI for a fee on which payment is 		contingent on some future event occuring, most notably default of the agent that 				purchases the LOC
768		Other examples
769			Loan commitments by banks
770			Mortgage servicing contracts by savings institutions
771			Positions in forwards, futures, swaps, and other derivatives held by almost all 				large FIs
772	The effect of OBS activity can materially affect equity value and bank risk exposure
773	Large commercial banks engage in OBS activity
774	Losses on OBS commitments in the financial crisis indicate that banks had excessive risks in 	their derivatives activities and did not have sufficient capital to back these commitments
775	Very complex derivatives sold by banks
776		In some cases the securities were so complicated that ratings agencies and regulators had 		to rely on banker's assessment of riskiness of securities
777Foreign Exchange Risk - risk that exchange rate changes can affect the value of an FI's assets and liabilities denominated in foreign currencies
778	FIs can reduce risk through domestic-foreign activity/investment diversification
779	FIs can expand globally through
780		Acquiring foreign firms or opening new branches in foreign countries
781		Investing in foreign financial assets
782	Returns on domestic and foreign direct and portfolio investment are not perfectly correlated
783		Underlying technologies of various economies differ
784		Exchange rate changes are not perfectly correlated across countries
785	A Net Long position in a foreign currency involves holding more foreign assets than liabilities
786		FI losses when foreign currency falls relative to US dollar
787		FI gains when foreign currency appreciates relative to US dollar
788	A Net Short position in a foreign currency involves holding less foreign assets than liabilities
789		FI gains when foreign currency falls relative to US dollar
790		FI losses when foreign currency appreciates relative to US dollar
791	A FI is fully hedged if it holds equal foreign currency denominated assets and liabilities (same 	maturity)
792Country/Sovereign Risk - risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments
793	differs from credit risk of FI's domestic assets
794		with domestic assets, FIs usually have some recourse through bankruptcy courts - FIs 			can recoup some of their losses when defaulted firms are liquidated or restructured
795	Foreign corporations may be unable to pay principal/interest even if they would desire to do so
796		Foreign governments may limit/prohibit debt repayment due to foreign currency 				shortages or adverse political events
797	Thus FI claimholder may have little to no recourse to local bankruptcy courts or to international 	claims court
798	Measuring sovereign risk includes analyzing:
799		Trade policy of foreign government
800		Fiscal stance of foreign government
801		Potential government intervention in the economy
802		Foreign governments's monetary policy
803		Capital flows and foreign investment
804		Foreign country's current and expected inflation rates
805		Structure of the foreign country's financial system
806Technology Risk - risk incurred by an FI when it's technological investments do not produce anticipated cost savings
807	Major objectives of technological expansion are to allow the FI to exploit potential economies 	of scale and scope by
808		Lowering operating costs
809		Increasing profits
810		Capturing new markets
811Operational Risk - risk that existing technology or support systems may malfunction or break down
812Insolvency Risk- risk that an FI may not have enough capital to offset a sudden decline in the value of it's assets relative to it's liabilities
813	Insolvency risk - consequence or an outcome of one or more of the risks previously described:
814		Interest rate, market, credit, OBS, technological, foreign excahnge, sovereign, and/or 			liquidity risk
815	Generally the more equity capital to assets an FI has, the less insolvency risk it is exposed to
816	Both regulators and managers focus on capital adequacy as a measure of an FI's ability to 	remain solvent
817Other risks and interactions among risk
818	In reality all of the previous defined risks are interdependent
819		example - liquidity risk can be a function of interest rate and credit risk
820	When managers take actions to mitigate one type of risk, they must consider effects on other 	risks
821	Charges in regulatory policy constitute another type of discrete or event-specific risk
822		War, revolutions, sudden market collapses, theft, malfeasance, breach of fiduciary trust
823	Macroeconomic risks - increased inflation, interest rate rolatility, unemployment, recent 	financial crisis
824
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891Chapter 20 - Managing Credit Risk on Balance Sheet
892
893Asset Transformation
894	Financial Institutions FIs transform financial claims of household savers efficiently into claims 	issued to corporations, individuals, and governments
895		Size - multiple small claims into fewer large claims
896		Maturity - short term into longer term
897	FIs process and evaluate information and control and monitor borrowers at lowest possible cost to all parties
898Risk Management
899	Price asset for expected/mean risk		(risk premium)
900	Manage portfolio to minimize variability of actual risk
901		Diversificiation and law of large numbers
902	Credit allocation
903		FIs accept risks of loans in return for interest that is expected to cover operating costs 			and the costs of funding net of defaults
904Credit Risk Management
905	Credit quality of many FI lending and investment decisions has been questioned in past 25 years
906		Problems of real estate/junk bond lending at banks/thrifts/insurance in late 80s early 90s
907		Concerns of rapid increase of credit cards and auto lending in late 90s
908		Commercial lending standards decline late 90s, lead to increases in high yield business 				loan delinquiencies 
909		Concern shifting to technology loans in late 90s and early 00s
910		Mortgage delinquencies (subprime) surged in 06-08, with mortgage and credit card 				delinquencies still a concern, but have improved recently
911	Larger banks are generally more likely to accept riskier loans than small banks (diversification)
912	Larger banks are more exposed to counterparty risk off-the-balance-sheet than smaller banks
913	Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan porfolio
914	At the extreme, credit risk can lead to insolvency as large loan losses can wipe an FI's equity 	capital
915	Losses from both on and off-balance sheet claims resulting from subprime crisis reached $2.3 			trillion worldwide
916	Net charge-off rates reached record highs at end of 08 at 1.95%, 2010 2.54%, 0.52% 2014
917	Lots of bank failures in 09-13
918Credit Analysis
919	Real Estate Lending
920		Mortgage loan applicants are among most standard of all credit applications
921		Decisions to approve or disapprove depend on
922			Applicant's ability and willingness to make timely interest/prinicipal payments
923			Value of borrower's collateral
924		Ability to maintain mortgage payements measured by
925			GDS - gross debt service
926				Equal to total accomodation expenses (mortgage, lease, condominium, 					management fees, real estate taxes, etc) divided by gross income
927				Acceptable threshold generally around 25%-30% max
928			TDS - Total debt service
929				Equal to the total accommodation expenses plus all other debt service 					payments divided by gross income
930				Acceptable threshold generally set around 35%-40% max
931		FIs also use credit scoring systems to evaluate potential borrowers (willingness)
932			Mathematical models that use observed loan applicants charactertistics to 				calculate a score that represents the applicants probability of default
933			Loan officers can often give immediate "yes" or "no" answers along with 					justificiations for the decision
934		Lender may use standard FICO credit scores
935			FICO scores run from 350-850, with majority from 600-800
936			Scores of 720 or higher are usually sufficient to receive good mortgage rate
937			ADD FICO SCORE FACTORS SLIDE 19 (lot of them)
938		Credit scores based on historical data
939			Evaluation based on historic default rates
940			Do not include macroeconomic variables (change in GPD and unemployment)
941		FIs also verify borrower's financial statements
942		Perfecting collateral - process of ensuring that collateral used to secure a loan is free and 		clear to the lender should borrower default on the loan
943			Before FI accepts a mortgage it:
944				Confirms title and legal description of the property
945				Obtains a surveyor's certificate confirming house is within property 						boundaries
946				Checks with tax office to confirm that no property taxes are unpaid
947				Requests a land title search to determine that there are no other claims 						against property
948				Obtains independent appraisal to confirm purchase price is in line with 						market value of property
949		FIs do not desire to become involved in loans that are likely to go into default
950		In event of default, lenders usually have recourse
951			Foreclosure - process of taking possession of mortgaged property in satisfaction 				of defaulting borrower's indebtedness and forgoing claim to any deficiency
952			Power of sale - process of taking proceedings of forced sale of mortgaged 				property in satisfaction of indebtedness and returning to the mortgagor the excess 			over the indebtedness of claiming any shortfall as an unsecured creditor
953	Consume and small business lending
954		Techniques similar to mortgage lending
955		However nonmortgage consumer loans focus on ability to repay rather on the property
956			Credit models put more emphasis on personal characteristics
957			Often a fully automated process
958		Small-business loan decisions often combine financial analysis of borrower financial 			statements (computer based) with behavorial analysis of the business owner (credit 			score)
959	Mid-market commercial and industrial lending		
960		Generally a profitable market for credit-granting FIs
961		Typically mid-market corporates:
962			Have sales revenues from $5 million to $100 million per year
963			Have recognizable corporate structure
964			Do not have ready access to deep and liquid capital markets
965		Commercial loans can be as short as a few weeks to as long as 8+ years
966			Short-term loans are used to finance working capital needs
967			Long-term loans are used to finance fixed asset purchases
968		Generally at least 2 loan officers must approve a new loan customer
969		Large credit requests are presented formally to a credit approval officer/committee
970		FIs perform cash flow analyses, which provide information regarding an applicant's 			expected cash receipts and disbursements
971		Statement of cash flows separate cash flows into:
972			Cash flows from operating activities
973			Cash flows from investing activities
974			Cash flows from financing activities
975		FIs may also perform ratio analyses
976			Time-series analyses
977			Cross-sectional analyses
978		Common ratio analysis includes:
979			Liquidity ratios (current ratio and quick ratio ie the acid test)
980			Asset management ratios
981				Number of days in receivables
982				Number of days in inventories
983				Sales to working capital
984				Sales to fixed assets
985				Sales to total assets (asset turnover ratio)
986			Debt and solvency ratios
987				Debt-to-assets ratio
988				Times interest earned ratio
989				Cash-flow-to-debt ratio
990			Profitability ratios
991				Gross margin
992				Operating profit margin
993				Return on assets ROA
994				Return on equity ROE
995				Dividend payout ratio
996		Ratio analysis has limitations
997			Diverse firms are difficult to compare versus benchmarks
998			Different accounting methods can distort industry comparisons
999			Applicants can distort financial statements
1000		Common-size analysis and growth rates
1001			Common-size financial statements present values as percentages to facilitate 				comparison vs competitors
1002			Year-to-year growth rates can identify trends
1003		Loan covenants can be used as part of the loan agreement to mitigate credit risk
1004		Proforma financial statements
1005			Income statement, balance sheet, cash flows, often quartly, how will borrower 				generate cash to repay loan, evaluate proforma statements using actual historial 				statements
1006		Following approval, account officers ensures conditions precedent have been cleared
1007			(conditions that must be fulfilled before drawings permitted)
1008				(includes title searches, perfecting collateral, etc)
1009		FIs typically wish to develop permanent, long-term mutually beneficial relationships 			with their mid-market commercial and industrial customers
1010	Large commercial and industrial lending
1011		Fees and spreads are smaller relative to small and mid-size corporate loans, but 				transaction sizes are large to make them worthwhile
1012		FIs relationships with large clients often center around broker/dealer/advisor activities 			with lending playing a lesser role
1013		Large corporations often use:
1014			Loan commitments
1015			Performance guarantees (letters of credit)
1016			Term loans
1017		Account officers often rely on rating agencies and market analysts to aid credit analysis
1018		Altman's score  Z - 1.2x1 + 1.4x2 + 3.3X3 + 0.6x4+1.0x5
1019			X1= working capital ÷ total assets
1020			X2= retained earnings ÷ total assets
1021			X3= earnings before interest and taxes ÷ total assets
1022			X4= market value of equity ÷ book value of long-term debt
1023			X5= sales ÷ total assets
1024			Higher z-score, lower probability of default
1025			Less than 1.81 high default risk, 2.99+ low default risk
1026				Between is indeterminate
1027		Z-score is historically based and does not consider state of economy
1028		Market based approaches
1029			Moody analystics KMV - uses option pricing model of Merton/Black/Scholes to 				calculate expected default frequencies 
1030			EDF predicts probability of whether market value of firm's assets will fall below 				required debt repayments in one year
10315 Cs of Credit
1032	Character - will loan applicant try to honor the loan obligations
1033	Capacity - ability to repay the loan
1034	Collateral - sufficient collateral that can be used to repay the loan in event of default
1035	Conditions - general economic trends/regional sector issues that might affect ability of loan 			applicant ability to repay?
1036	Capital - does general financial condition of loan applicant indicate that applicant will be able 			repay loan
1037Calculating return on a loan
1038	Return on assets ROA approach - uses contractually promised gross return on a loan K per 	dollar lent
1039		ADD 20-45 FORMULA
1040	Risk-adjusted return on assets RAROC model balances loan expected income against expected 	risk
1041		RAROC = one-year income on a loan / loan (asset) risk or value at risk
1042		RAROC is compared to lenders tax adjusted return on equity ROE
1043			If RAROC>ROE make loan
1044			If RAROC<ROE adjust loan so that it matches above or decline the loan
1045Loan portfolio risk and management
1046	Expected portfolio return is weighted average of expected returns of various loans in portfolio
1047		Rp = SigmaNi=1 XiRi  (ADD FORMULA SLIDE 52)
1048	Expected portfolio variance
1049		O2p = SigmaNi=1 X2iO2i + XiXjOij (ADD FORMULA SLIDE 52)
1050	FI managers can reduce loan risk by changing mix of loans to reduce the correlation among 	various types of loans
1051		Southeast bank (commercial real estate), Continential illnois bank (oil production), Bank 		of new england (centrated in New England)
1052	Increasing size permits greater diversification
1053		Industry
1054		Geography
1055		Customers
1056	Diversification may allow FI to increase returns with little increase in risk
1057
1058
1059			
1060
1061
1062
1063
1064
1065
1066
1067
1068
1069
1070
1071
1072
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1074
1075
1076Chapter 17 - Mutual Funds and Hedge Funds
1077
1078Mutual funds - pool resources of many small investors, sell them shares, use proceeds to buy securities
1079Mutual Fund Structure - shareholders/owners of the mutual fund are the investors
1080	Board of directors oversees the fund's activities, hires investment advisor, underwriter, etc to 	manage day to day activities of the fund	
1081	Investment companies offer number of different types of mutual funds
1082	Investors can often move investments among these funds without penalty
1083	Complexes often issue consolidated statements for investors
1084First Mutual Fund was established in Boston in 1924
1085	1970 - 360 MFs held about 50 billion in assets
1086	Money Market Mutual Funds MMMFs were introduced in 1970
1087	Tax-exempt MMMFs were introduced 1979
1088	By 2013, 7700+ MFs held over $15 trillion in assets
1089Cash flows into MFs are highly correlated with return on stock markets
1090	Growth has also resulted from the rise in retirement funds under management by MFs
1091		MFs managed ~25% of retirement fund assets in 2013
1092	MFs are the second most important group of FIs as measured by asset size, 2nd to only 	commercial banks
1093		Banks' share of all MF assets was 6% in 2013
1094		Insurance companies managed 5% of MF industry assets in 2013
10955 Major Benefits of Mutual Funds
1096	1 - Liquidity Intermediation
1097		investors can quickly convert instruments into cash
1098		still invest for long term
1099	2 - Denomination intermediation
1100		Investors can participate in equity and debt offerings that individually require more 			capital than they possess
1101	3 - Diversification
1102		Investors immediately realize benefits of diversification even for small investments
1103	4 - Cost advantages
1104		Mutual fund can negotiate lower transaction fees than available to individual investor
1105	5 - Managerial expertise
1106		Many investrors prefer to rely on professional money managers to select investments
1107Primary Reserve Money Fund
1108	Sept 08 Primary Reserve Fund - money market mutual fund "broke the buck" - had its share 	value fall below standard $1 due to losses on large commercial paper issued by Lehman 	Brothers
1109	Led to contagion and run on money funds over $200 billion outflows over next few days
1110	Treasury guaranteed payments on money funds for one year to stop the runs. Insurance ran out 	Sep 19 09
1111	Proposed new rules by SEC mandate mf shares fluctuate with value of fund holdings to prevent runs
1112Net asset value - total value of mutual fund stocks/bonds/cash/other assets minus liabilities (such as accrued fees), divided by number of shares outstanding
1113Barriers to entry in MF industry are low
1114	Largest MF sponsors have not increased their market share recently
1115		Largest 25 MF companies managed 73% of industry assets in 95 and 13
1116	Composition of top 25 firms industry has changed
1117		15 of the largest 25 firms in 13 were not among top 25 in 90
1118	MF Industry has 2 sectors
1119		Short-term funds invest in securities with original maturities less than 1 year
1120			Money market mutual funds
1121			Tax-exempt money market mutual funds
1122		Long-term funds invest in portfolios of securities with original maturities larger 1 year
1123			Equity funds (common and preferred stock)
1124			bond funds (fixed income capital market debt securities)
1125			hybrid funds (stock and bond securities together)
1126	in 2013 there were 373 index funds managing 1.3 trillion
1127		Index funds are funds in which managers buy securities in proportions to those included 			in a specific major index
1128		Index funds involve little research or management, which results in lower management 				fees and higher returns than actively managed funds
1129	Exchange traded funds ETFs are designed to replicate market indexes
1130		traded on exchanges at prices determined by the market
1131		management fees are lower than actively traded funds
1132		unlike index funds, ETFs can be traded during the day, sold short, and purchased on 				margin
1133	Money Market Mutual Funds MMMFs provide alternative investment to interest-bearing 		deposits at commercial banks
1134		bank deposits are relatively less risky, because they are FDIC insured, and generally 			offer lower returns than MMMFs
1135	Households own majority of MFs
1136		owned 57.4% long term 2013, 38.4% short term
1137		44.4% of all US households owned MFs in 2010 (53.8 million households)
1138			typical owner has $80,000 invested in 4 funds, most do not buy or sell online
1139	MF Managers must specify their fund's investment objectives in a prospectus (formal summary 		of a proposed investment), which is made available to potential investors
1140		holds list of securities invested by the funds
1141		in 98 SEC mandated prospectuses must be written in "plain English", not "legalese"
1142	Mutual Funds are required to publish specific objectives of fund in prospectus
1143	No investor should invest in a fund without carefully reading the prospectus
1144	Prospectus will contain historical return information (1,3,5 yr periods, sometimes longer)
1145	Prospectus must also show historical fees and effect of those fees on given investment over time
1146	Little information on the risk is usually provided
1147Other investment companies
1148	Open-end MF - fund for which supply of shares is not fixed, but can increase/decrease daily 			with purchases and redemptions of shares
1149	Closed-end investment company - specialized investment company that has a fixed supply of 			outstanding shares, but invests in the securities and assets of other firms
1150			13 there were 265 billion in 600 closed end funds
1151	Unit Trust / Real Estate Investment Trust - closed-end investment company that specializes in 		investing in mortgages, property, or real estate company shares
1152		These funds have a static composition and a fixed termination date
1153		13 there were $72 billion in 5000+ UITs
1154Fund Returns
1155	Investor returns from MF ownership reflect 3 components
1156		Income and Dividends on portfolio assets
1157		capital gains on assets bought and sold at higher prices
1158		capital appreciation on assets held in the fund
1159	MF assets are marked to market daily
1160		prices are adjusted once per day to reflect changes in the current market prices of 				portfolio assets	
1161	Net Asset Value NAV is MF share equal to market value of the assets in the MF portfolio less 			liabilities divided by the number of shares outstanding	
1162Mutual Funds (again)
1163	MFs charge investors fees for services they provide
1164		Sales loads (front or back end)
1165		12b-1 fees are related to distribution costs of MF shares
1166			cannot exceed 1% of average net assets for load funds
1167			cannot exceed 0.25% of average annual net assets for no load funds
1168		MFs may offer different share classes with different combinations of loads
1169	A load fund is a MF with an up-front sales or commission charge that the investor must pay
1170	A no-load fund is an MF that does not charge up-front sales or commission charges on the sale 			of mutual fund shares to investors	
1171Mutual fund quotes
1172	MF quotes are similar to stock quotes, most provide NAV, investment objective, expense ratio, 			and load charges (if any)
1173	Morningstar ranks fund returns within the investment objective
1174	Historial rankings are not predictive of future performance
1175Effect of costs on MF Returns (FORMULA)
1176	Amount initially invested AII= $amount placed - (%load * $amount placed)
1177	Amount after gross return AAGR = AII * (1+ gross return%)
1178	Average asset value for year AAVFY = (AAGR + AII) / 2
1179	Fees  = AAVFY * annual expense%
1180	Ending amount after fees EAAF = AAGR - Fees
1181	Net Rate of return (first year) = (EAAF - $amount placed) - 1
1182Mutual Fund Regulations
1183	MFs are heavily regulated because they manage and invest small investor savings
1184		The SEC is primary regulator
1185			SEC Acts of 1933 and 1934
1186		Investment Advisers Act and Investment Company Act of 1940
1187		Insider Trading and Securities Fraud Enforcement Act of 1988
1188		Market Reform Act of 1990
1189		National Securities Market Improvement Act NSMIA of 1996
1190	Even with heavy regulation, investor abuses still occur
1191		Market timing- short term trading that profits from out-of-date values on securities in 				fund porfolio
1192		Late trading- buys and sells long after prices have been set at 4PM ET
1193		Directed brokerage - occurs when brokers improperly influence investors on fund 				recommendations
1194		Improperly assessed fees - occurs when brokers trick customers into thinking they are 				buying no-load funds or fail to provide discounts properly
1195
1196Global Issues
1197	During 90s mutual funds were fastest growing FI in US
1198	Growth slowed in 01, reversing decade long trend, but picked up in mid 00s, declining again 	during the crisis
1199	Late 2000s growth in non-US investments outpaced growth in US funds
1200	Total assets of non-US mutual funds were 162.6 billion in 92, 2013 is 14.18 trillion
1201	Mutual funds overseas focused in Japan, France, Australia, and Great Britain
1202Hedge Funds
1203	Hedge Funds HFs are investment pools that solicit funds from wealthy individuals and other 		investors (commercial banks) and invest these funds on their behalf
1204		Similar to MFs, but smaller funds under $100 million in assets are not required to 			register with SEC	
1205		Subject to less regulatory oversight than mutual funds and generally can (and do) take 			signficantly more risk than MFs
1206		Do not have to publicly disclose activities to third parties and thus offer higher privacy
1207	HF avoid regulation by limiting investors to less than 100 and requiring investors to be 	"accredited"
1208		meaning net worth of $1 million+ or annual income 200,000+(300k if married)
1209	HFs use more aggressive trading strategies than MFs such as short selling, leverage, program 			trading, arbitrage, and use of derivatives
1210	Because not all HFs are registered, industry and firm data cannot be accurately tracked
1211		8000HFs in US 2013, with 2.25 trillion in assets
1212		new asset flows track market performance
1213	Three basic types of HFs
1214		More risky, market directional - these funds seek high returns using leverage, typically 			investing based on anticipated events
1215		Moderate risk, market neutral or value orientation - these funds have moderate exposure 		to market risk, typically favoring a longer-term investment strategy
1216		Risk avoidance - market neutral - these funds strive for moderate, consistent returns with 		low risk
1217	Management fees on HFs are computed as percent of assets under management, often 1.5%-2%
1218	Performance fees give fund managers share of any positive returns earned
1219		Average is 20%, but performance fees vary substantially depending on HF
1220		Hurdle rate - benchmark that must be ralized before performance fee can be taken
1221		High-water mark - when manager does not receive performance fee unless value of fund 			exceeds the highest NAV is has previously achieved
1222	Offshore HFs are attractive to investors because anonymouse and not subject to US taxes
1223	HFs under $100 million in assets are excempt from registration requirements set by ICA 1940
1224		HFs less than 100 investors, accredited investors, sold only as private placements
1225	HFs are prohibited from abusive (illegal) trading practices
1226	Dodd-Frank requires HFs with more than $100 million register with SEC under current IAA
1227	Large fund advisors must now report financial information on the funds they manage to the 			FSOC to help limit systematic risk in the economy
1228	Federal Reserve can also exercise oversight of funds deemed large enough or interconnected 			enough to present a systematic risk
1229	Financial crisis reduced amount of assets in HF because of losses, although a few did well 			during the crisis
1230	HFs as a whole underperformed the S&P500 in 09 in raw returns
1231	Recent HF performance generally lagged behind overall stock market
1232High Profile HF Problems
1233	Collapse of Bear Stearns HF lead to losses of 1.6 billion and bankruptcy
1234	Madoff $65 billion ponzi scheme		Galleon Group LLC closed insider trading in 09
1235
1236
1237
1238
1239
1240
1241
1242
1243
1244
1245
1246
1247
1248
1249
1250
1251
1252
1253
1254
1255
1256
1257
1258
1259
1260Chapter 21 - Managing Liquidity Risk on the Balance Sheet
1261Liquidity Risk Management
1262	Unlike other risks, liquidity risk is a normal aspect of everyday management of FIs
1263	At extreme, liquidity rsk can lead to insolvency
1264	Some FIs are more exposed to liquidity risk than others
1265		Depository institutions DIs are highly exposed
1266		Mutual funds, pension funds, life insurers & propery-casualty insurers are lower risk
1267	One type of liquidity risk arises when FI's liability holders seek to withdraw their claims
1268		FIs must meet the withdrawals with stored or borrowed funds
1269		Alternatively, FIs may have to sell assets to generate cash, which can be costly if assets 			can only be sold at fire-sale price
1270	Second type of liqudity arises from exercise of off-balance-sheet committments made by FI
1271		Unexpected loan demand can occur when off-balance-sheet loan commitments are 				drawn down suddenly in large volumes
1272		FIs are contractually obliged to supply funds through loan commitments immediately 				should they be drawn down
1273Liquidity Risk and Depository Institutions DIs
1274	DIs balance sheets typically have
1275		Large amount of short-term liabilities such as deposits and other transaction accounts 				that must be paid out immediately if demanded by depositors	
1276		Large amounts of relatively illiquid long-term assets like commercial loans/mortgages
1277	DIs know that normally only a small portion of demand deposits will be withdrawn on any 		given day
1278		Most demand deposits are core deposits - they are stable and long-term funding source
1279	Deposit withdrawals are normally offset by inflow of new deposits
1280	DI managers monitor net deposit drains - amount by which cash withdrawals exceed additions; 			a net cash outflow
1281	DIs manage liquidity needs by two methods;
1282		Stored liquidity
1283			Maintaining liquid assets to meet cash needs
1284			Primary method for community banks
1285			Liquidating cash stores and and selling existing assets
1286			Banks hold cash reserves in vaults and at Fed in excess of minimum requirement
1287			When managers use stored liquity to fund deposit drains, size of balance sheet is 					reduced and composition changes
1288		Purchased liquidity
1289			Rely on ability to acquire funds from brokered deposits and borrowings
1290			Used primarily by largest banks with access to money market and other 						nondeposit sources of funds
1291			Using interbank market for short-term loans
1292				Fed-funds
1293				repurchase agreements
1294			Acquiring fixed-maturity certificate of deposits
1295			Issuing notes and bonds
1296			Allows FIs maintain overall size of balance when faced with liquidity demands
1297			Purchased liquidity may be expensive relative to stored liquidity and adds 					volatility of interest expense
1298		Most DIs utilize a combination of both stored and purchased liquidity management
1299	Loan commitments and other credit lines can cause liquidity needs
1300		as with liability side liquidity risk, asset size liquidity risk can be managed with srtored 			or purchased liquidity
1301	If stored liquidity is used to fund commitments, the composition of the asset side of the balance 		sheet changes, but not the size of the balance sheet
1302	If purchased liquidity is used to fund commitments, the composition of both the asset and 			liability sides of the balance sheet changes, and the size of the balance sheet increases
1303Measuring Liquidity Risk Exposure
1304	Liquidity position of banks is measured by managers on a daily basis
1305	Net liquidity statement lists sources and uses of liquidity
1306	Peer group ratio comparisons are used compare bank's liquidity position against its competitors
1307		Ratios are often compared to banks of similar size and location
1308		Ratios for peer groups of similar banks can be constructed at FFIEC website
1309	Liquidity index measures potential losses a bank could suffer from a sudden or fire-sale disposal 		of assets vs the sale of same assets at fair market value under normal market conditions
1310	Financing Gap - difference between bank's average loans and average(core) deposits
1311		If financing gap is positive, bank must borrow to fund gap
1312		Financing gap funding = -Liquid assets + Borrowed funds
1313	Financing requirement is financing gap plus a bank's liquid assets
1314		Financing gap lending = -Liquid assets + borrowed funds
1315		Thus financing requirement(or borrowed funds) = Financing Gap + Liquid Assets
1316		A widening financing gap can be an indicator of future liquidity problems
1317	New Liquidity Risk Measures by BIS
1318		Liquidity Coverage Ratio LCR
1319			= Stock of high quality assets  
1320		   total net cash outflows over next 30 days                 >100%
1321		LCR ensures that DIs can survie severe liquidity stress scenarios for 30 days
1322	High quality liquid assets:
1323			Must remain liquid in times of stress
1324			convertible into cash at little loss of value and can be used at central bank 					discount window as collateral
1325			must be "unemcumbered"
1326		Divided into Level 1 and Level 2
1327			Level 1 has no cap
1328				Cash + central bank reserves + sovereign debt
1329			Level 2 capped at 40% of total liquid assets
1330				Minimum 15% "haircut" has to be applied to value of each lv2 asset
1331					Max of 85% value included
1332			Level 2 assets may not aggregate account for more than 40% of a bank's stock of 				high-quality liquid assets
1333			2A = mortgage-backed securities with govt guarantee + corp bonds (vanilla) 					rated at least AA
1334			2B = Residential mortgage-backed securities that are not government guaranteed 				+ lower rated corporate bonds (vanilla) + blue chip equities
1335				Level 2B may not account for more than 15% of bank's stock of high-						quality liquid assets
1336	Potential cash outflows
1337		Retail deposits = stable + less stable
1338			Stable = deposits covered by deposit insurance
1339				minimum run-off factor of 3%
1340			Less stable = deposits not covered by deposit insurance
1341				minimum run-of f factor of 10%
1342			Retail deposits with maturity > 30 days and no early withdrawal
1343				0% runoff factor
1344		Unsecured wholesale funds with < 30 days maturity (callable by funds provider)
1345			100% runoff factor
1346		Secured funds backed by level 1 assets
1347			0% runoff factor
1348		Backed by level 2 assets
1349			15% runoff factor
1350		Loss of funding on commercial paper if maturity <30 days 
1351			(100% runoff)
1352		All debt maturing within 30days 
1353			(100% runoff)
1354		Loan commitment (draw-down) factors:
1355			5% drawdowns on committed credit and liquidity facilities to retail and small 					business customers
1356			10% draw-downs on committed credit facilities to nonfinancial corporate, 					sovereign, and central banks, public sector entities, and multilateral 					development banks
1357			30% drawdowns on committed liquidity facilities to nonfinancial corporate, 					sovereign, and central banks, public sector entities, and multilateral 					development banks
1358			40% drawdowns on committed credit and liquidity facilities to other legal entities
1359				FIs (including banks, securities firms, and insurance companies)
1360				Conduits and special purpose vehicles
1361				Fiduciaries beneficiaries
1362		Cash outflows relating to operating costs
1363			0% runoff factor
1364		Include only inflows for sources where no default is expected in next 30 days
1365		75% cap on inflows meeting outflows so DIs do not rely on just inflows for liquidity
1366		No lines of credit on other banks can be drawn on (0% inflow)
1367		100% inflow received on wholesale loans
1368		50% inflow on retail loans from counterparties
1369		100% inflow on known derivative payments
1370		Total net cash outflows (denominator of LCR ratio) over next 30 days =
1371			Outflows = Min(Inflows; 75% of outflows)
1372	New Liquidity Risk Measures by BIS
1373		Net Stable Funding Radio NSFR
1374			NSFR = Available amount of stable funding	
1375				 Required amount of stable funding        > 100%
1376		Intraday liquidity requirements for large internationally active banks
1377Available Stable Funding
1378	Bank Capital - preferred stock with maturity > 1 year
1379		Preferred stock not included in Tier 2 included taking into account any explicit or 			embedded options that would reduce expected maturity to less than 1 year
1380	Liabilities with maturities > 1 year
1381	Portion of retail deposits and wholesale deposits expected to stay with the bank during a period 			of idiosyncratic stress
1382	"Stable" nonmaturity (demand) deposits and/or term deposits (as defined in the LCR) with 			residual maturities of less than one year provided by retail customers and small business 		customers
1383		ASF factor of 90%
1384	"Less stable" (as defined by LCR) nonmaturity (demand) deposits and/or term deposits with 			residual maturities of less than one year provided by retail customers and small business 		customers
1385		ASF Factor of 80%
1386	Unsecured wholesale funding, nonmaturity deposits and/or term deposits with a residual 			maturity of less than one year, provided by nonfinancial corporates, sovereigns, cental 			banks, multilateral development banks, and PSEs
1387		ASF Factor of 50%
1388Stable Funding Required
1389	Required amount of stable funding is sum of
1390		Value of on-balance-sheet assets held and funded by DI, multiplied by specific required 				stable funding RSF factor assigned to each particular asset type
1391		Amount of off-balance-sheet OBS activities (or potential liquidity exposure) multiplied 				by the associated RSF factor
1392	RSF factor applied to reported values of each asset or OBS exposure is the amount of that item 	that supervisors believe should be supported with stable funding
1393Assets not Requiring Funding (RSF = 0%)
1394	Cash not currently encumbered as collateral and not held for planned use
1395	Unencumbered short-term unsecured instruments and transactions with outstanding maturities 			less than one year
1396	Unencumbered securities with slated remaining maturities of less than one year
1397	REPOs
1398Assets Requiring 5% funding (RSF 5%)
1399	Unencumbered marketable securities with residual maturities of one year or greater representing 		claims on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, etc with 0% 		Basel III rating	
1400	Off-balance-sheet exposures require little long-term funding
1401		Revocable and irrevocable credit and liquidity facilities to any client
1402Assets Requiring 20% Funding (RSF 20%)
1403	Unencumbered corporate bonds or covered bonds rated AA- or higher with residual maturities 			of one year or greater satisfying all of the conditions for Level 2 assets in the LCR
1404	 Unencumbered marketable securities with residual maturities of one year or greater 				representing claims on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, 		etc with 20% Bazel III rating satisfying all conditions for Level 2 assets in the LCR
1405Assets Requiring 50% Funding (RSF 50%)
1406	Unencumbered gold
1407	Unencumbered equity securities, not issued by financial institutions or their affiliates, listed on 			a recognized exchange and included in a large cap market index
1408	Unencumbered loans to nonfinancial corporate clients, sovereigns, central banks, and PSEs 			having a remaining maturity of less than 1 year
1409	Unencumbered corporate bonds and covered bonds that satisfy all of the following:
1410		Central bank eligibility to intraday liquidity needs and overnight liquidity shortages in 				relevant jurisdictions
1411		Not issued by financial institutons or their affiliates (except for covered bonds)
1412		Not issued by the respective firm itself or its affiliates
1413		Low credit risk assets
1414			Credit assessment by a recognized ECAI of A+ to BBB
1415			Do not have a credit assessment by a recognized ECAI and are internally rated as 				having a PD corresponding to a credit assessment of A+ to BBB-
1416			Traded in large, deep, active markets characterized by low level of concentration
1417Assets Requiring 65% Funding (RSF 65%)
1418	Unencumbered residential mortgages any maturity that qualify for Bazel III rating 35% or less
1419	Other unencumbered loans, exclusing loans to financial institutions, with remaining maturity of 		1 year or greater, that quality for Basel III rating 35% or less
1420Assets Requiring 85% Funding (RSF 85%)
1421	Unencumbered loans to retail customers and small business customers (as defined in LCR) 			having remaining maturity of less than 1 year (other than those qualifying for 65% RSF)
1422Assets Requiring 100% Funding (RSF 100%)
1423	All other assets not included in the preceeding categories
1424Liquidity Planning - allows managers to make important borrowing priority decisions before liquidity problems arise
1425	Lowers cost of funds by determining optimal funding mix
1426	Minimizes amount of excess reserves a bank needs to hold
1427	Liquidity plan components
1428		Delineation of managerial responsibilities
1429		List of fund providers most likely to withdraw funds and a pattern of fund withdrawals
1430		Identify size of potential deposit and fund withdrawals over various time horizons	
1431		Internal limits on separate subsidiaries and branches' borrowing as well as acceptable 				risk premiums to pay in each market
1432Liquidity Risk
1433	Major liquidity problems arise if deposit drains are abnormally large and unexpected
1434	Abnormal deposit drains can occur because:
1435		Concerns about bank's solvency
1436		Failure of another bank (contagion effect)
1437		Sudden changes in investors' preferences regarding holding nonbank financial assets 			relative to bank deposits
1438	Bank run - sudden an unexpected increase in deposit withdrawals from a bank
1439IndyMac  08
1440	Schmuer's letters warning of problems at bank became public
1441	Next 11 days depositors withdrew 1.3 billion from Indymac
1442	Schmuer was right; bank was in trouble due to mortgage holdings
1443	Problems in credit spilled over into liquidity problems when investors lost confidence in bank
1444Liquidity Risk
1445	Demand deposits are first-come, first serve contracts
1446	Incentives for depositors to withdraw funds at first sign of trouble creates fundamental 			instability in banking system
1447		Bank panic - systematic or contagious run on deposits of banking industry as a whole
1448	Regulatory mechanisms in place to ease bank liquidity problems and to deter bank runs/panics
1449		FDIC (250,000 since 08/09 financial crisis)
1450		Discount window
1451Deposit Insurance
1452	Deposit insurance was first introduced in US in 1933 with coverage up to $2500
1453	Coverage increased to $100,000 in 1980
1454	2011 FDIC increases every year based on Consumer Price Index CPI
1455	FDI reform act 2005 increased from $100000 to $250,000
1456	Individuals can achieve many times the 250,000 limit by creatively structuring deposits on 			multiple banks
1457	FDIC uses risk-based deposit insurance to evaluate and assign deposit insurance programs
1458	Some states operate guaranteed funds to insure investments made with insurance firms, but they 		are not federally backed
1459Discount Window
1460	Federal Reserve provides "Discount Window" lending facility
1461	Historically borrowing rate was below market rates and borrowing was restricted
1462	Response to liquidity problem in 07/08, Fed announced it would lend $200 billion to both 			commercial and investment banks through Primary Dealer Credit Facility PDCF
1463	New federal borrowing programs emerged over succeeding months providing funding to money 		market mutual funds, commercial paper, insurance companies, and others
1464	Fed also lowered interest rates to near 0 and reduced spread between discount rate and Fed 			Funds rate
1465Liquidity Risk and Insurance Companies
1466	Life insurance companies hold cash reserves and other liquid assets
1467		Meets policy payments
1468		Meet cancellation (surrender) payments
1469			Surrender value of a life insurance policy is amount insurance policyholder 				receives when cashing in policy early
1470		Fund working capital needs (which can be unpredictable)
1471	Property-casualty P&C insurance companies
1472		Claims against P&C insurers are hard to predict
1473		Thus P&C insurance companies have a greater need for liquidity than life insurance 				companies
1474	Mutual funds MFs can be subject to dramatic liquidity if investors become nervous about true 		value of fund's assets
1475		However way MFs are valued reduces incentive of fund shareholders to engage in bank-			like runs on any given day
1476			assets are distributed pro-rata basis (rather than first-come first serve)
1477			losses are incurred to shareholders on a proportional basis
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1525Chapter 11 - Commercial Banks Industry Overview
1526
1527Commercial Banks are largest group of financial institutions in terms of total assets
1528	Major assets are loans
1529	Major liabilitites are federally insured deposits - they are considered depository institutions
1530	Perform services essential to US financial markets
1531		Play key role in transmission of monetary policy
1532		provide payment services
1533		provide maturity intermediation
1534	Banks are regulated to protect against distruptions to the services they perform and to protect 	government insured deposits
1535Commercial Bank Assets
1536	Loans generate the most revenue for banks
1537		Commercial and industrial loans are declining because of nonbank substitutes 					(commercial paper)
1538		Mortgages have increased in importance over long term
1539	Investment securities generate revenue and provide banks with liquidity
1540	Cash assets are held to meet reserve requirements and to provide liquidity
1541	Other assets include premises and equipment, other real estate owned, etc
1542	Four main categories of assets are
1543		Cash, investments, loans, and other assets
1544	Total loans fell as result of financial crisis, safe investments and cash rose
1545	Real estate loans are about 50.5% of loans
1546	Commercial banks face unique risks because of their asset structure
1547		Credit(default) risk is risk that loans are not repaid
1548		liquidity risk - risk that depositors will demand cash than banks can immediately provide
1549		interest rate risk- risk that interest rate changes erode profitability or net worth
1550		Credit/liquidity/interest risk contribute to a commercial bank's level of insolvency risk
1551Commercial Bank Liabilities
1552	Transaction accounts are sum of noninterest-bearing demand deposits and interest-baring 	checking accounts
1553		Transaction accounts are about 17.58% of deposits
1554		Checkable interest-bearing deposit accounts are called negotiatble order of withdrawal 			(NOW) accounts
1555	Household (retail) savings/time deposits have declined in recent years because of MMMFs
1556		Passbook savings accounts
1557		Real time deposits
1558	Large time deposits - negotiable CDs are fixed-maturity interest-bearing deposits with face 			values of $100,000 or more that can be resold in secondary market
1559	Non-deposit liabilities
1560		Fed funds purchased
1561		Repos
1562		Notes and Bonds
1563Commercial Bank Equity
1564	Minimum levels of equity capital are required by regulators to act as a buffer against losses
1565		common and preferred stock
1566		surplus or additional paid-in capital
1567		retained earnings
1568Liabilities & Equity
1569	Deposits are the main source of funds
1570	Equity has increased since financial crisis and is now over 11% of assets
1571	TARP program resulted in capital injections into banks of $386 billion
1572Off-balance-sheet activities
1573	Commercial banks engage in many fee-related activities that are conducted off the balance sheet
1574		Guarantees such as letters of credit
1575		Future commitments to lend
1576		Derivative transactions (futures, forwards, options, and swaps)
1577	Off-balance-sheet assets
1578		When an event occurs, this item moves onto the asset side of the balance sheet or 			income is realized on the income statement
1579	Off-balance sheet liabilities
1580		When an event occurs, this item moves onto the liabilility side of the balance sheet or 			an expense is realized on the income statement
1581Commercial Banks
1582	Reigle-Neal Act 1994 allowed nationwide branch networks to evolve
1583		nearly 15000 banks with some 60000 branches in 84
1584		6000 banks with some 83000 branches in 2013
1585	Financial Services Modernization Act of 1999
1586		Gave commercial banks full authority enter investment banking and insurance business
1587	Industrial loan corporations (ILCs) are considered "non-bank" banks
1588	Retail banking is consumer oriented
1589		Residential and consumer loans are funded by accepting small deposits
1590		Community banks specialize in retail banking
1591	Wholesale banking is business oriented
1592		Commercial and industrial loans are often funded with purchased funds
1593		Regional or superregional banks engage complete array of wholesale banking activities
1594		Money center banks rely heavily on nondeposit or borrowed sources of funds, often 			borrowed in the fed funds market
1595Commercial Banks Performance Measures
1596	Interest rate spread = difference between lending and deposit rates
1597	Net interest margin =(interest income - interest expense) / earning assets
1598	Net non-interest margin = (non interest income - non interest expense ) / earning assets 
1599	Net charge-offs is percent of loans written off as uncollectable
1600	Return on assets = net income / assets
1601	Return on equity = net income / equity
1602Commercial Bank Size and Performance
1603	Because larger banks generally lend to larger corporations, with more funding options larger 			banks often are required to have lower interest rate spreads and net interest margins than 		those of smaller banks
1604	Large banks pay higher salaries and invest more in buildings and premises than small banks
1605	Large banks tend to diversify operations and generate more noninterest income than smallbanks
1606	1.5% of the largest banks control about 83% of industry assets
1607Industry Performance
1608	US commercial banks flourished during economic expansion of 90s
1609	Economic downturn of early 2000s caused performance to deteriorate slightly
1610	By 03 ROA and ROE reached all time highs
1611	In Q4 06 mortgage delinquencies (subprime mainly) surged
1612	Losses from falling subprime mortgage values caused Q4 07 net income to hit 16-year low
1613	In 08 ROA was poor 0.13%, 09 0.09%, before fixing itself 2010 0.60%
1614	ROE 1.33% 08, 0.85% 09, 5.44% 2010
1615	Problem was not interest spreads as the net interest margin remained high (3.87% 2010)
1616	Problem remained in credit losses
1617	Long run of low interest rates has allowed banks to bank good profits unrelated to credit losses
1618	Growth in non-interest income, low levels of non-interest expense, and low securities losses all 			contributed to strong profitability in 2013
1619	Number of bank failures and 'problem banks' continues to fall
1620Regulators
1621	Federal Deposit Insurance Corporation FDIC insures deposits of commercial banks
1622	US has a dual banking system - banks can be either nationally or state-chartered
1623		Office of Comptroller of Currency OCC charters and regulates national banks
1624		State agencies charter and regulate state banks
1625	Federal Reserve System FRS has regulatory power over nationally chartered banks and their 		holding companies and state banks that opt in to the Federal Reserve System
1626		holding company is a parent company that owns controlling interest in subsidiary bank 			or other FI
1627International Commercial Banking
1628	Advantages of International Expansion
1629		Risk diversification
1630		Economies of scale
1631		distribute new product innovations internationally
1632		opportunity to find cheapest and most available sources of funds
1633		service the needs of domestic multinational corporations
1634		regulatory avoidance
1635	Disadvantages of international expansion
1636		Information and monitoring costs are generally higher in foreign markets
1637		foreign assets may be subject to nationalization or expropriation by host country govts
1638		Fixed costs of establishing foreign organizations may be extremely high
1639Global Banking Performance
1640	Banks in most regions of the world posted strong performance in early/mid 2000s but suffered 			from the financial crisis in the US and later European debt crisis
1641	Large banks in UK, ireland, netherlands, switzerland, iceland, spain recorded annual losses 			during crisis
1642	Led to sovereign debt problems in Europe with continued subpar growth in Europe
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1726Chapter 12 Commercial Banks' Financial Statements and Analysis
1727
1728CAMELS
1729	Regulators use CAMELS ratings to evaluate safety and soundness of banks
1730	CAMELS ratings rely heavily on financial statement data
1731	Components
1732		Capital Adequacy
1733			Risk-based capital requirements now used. Regulators also evaluate bank's loss 				experience, amount of problem assets in relation to capital, and institution's 				access to capital
1734		Asset Quality
1735			Banks are required to classify assets according to soundness and to allocate loss 				reserves based on their evaluation of the quality of their assets
1736		Management Quality
1737			Technical competence of management, their history of compliance, adequacy of 				internal controls, compensation and experience
1738		Earnings Quality
1739			Stability and growth rate of earnings, peer group comparisons of profitability and 			interest rate exposure
1740		Liquidity
1741			Turnover rates of the bank's sources of funds, particular deposit turnover
1742			% Core deposits vs "hot money" sources, the amount of loan commitments, and 					volume of liquid assets held by the bank
1743		Sensitivity to market risk
1744			Exposure of earnings and capital to changes in interest rates, foreign exchange 				rates, and commodity or equity prices
1745
1746	CAMELS ratings ranging from 1-5
1747		Composite 1 - banks are basically sound in every aspect
1748		Composite 2 - banks are fundamentally sound but may have modest weaknesses 					correctable in the normal course of business
1749		Composite 3 - banks exhibit financial, operational, or compliance weakness ranging 				from moderately severe to unsatisfactory
1750		Composite 4 - banks have an immoderate volume of serious financial weakness or a 				combination of other conditions that are unsatisfactory
1751		Composite 5 - banks have extremely high immediate or near-term probability of failure
1752Financial Statements
1753	Federal Financial Institutions Examination Council FFIEC - prescribes uniform principals, 		standards, and report forms for depository instituions
1754		balance sheets amd income statements are reported on Report of Conditions
1755		commercial banks report contigent assets and liabilities on OBS-reports
1756	Retail banks focus business activities on consumer banking relationships
1757	Wholesale banks focus business activities on commercial banking relationships
1758Commercial Bank Assets
1759	Cash and balances due from other depository institutions
1760	Investment securities
1761		short-term securities (treasury bills and fed funds sold)
1762		long-term securities (treasury bonds, munis, MBSs)
1763	Loans
1764		commercial and industrial
1765		real estate
1766		consumer
1767		other loans
1768	Provision for loan losses PLL
1769		PLL is a deduction from current earnings made by management to offset loans that 			management believes will go bad in the upcoming quarter
1770		PLL was 19.8% of net income in 2013
1771	Net charge offs NCOs
1772		Actual write-offs of loans
1773		34.6% of net income in 2013
1774	Unearned Income
1775		income that the bank has received on a loan but has not yet earned nor recorded as 			income on the income statement
1776	Allowance for loan and lease losses
1777		Management's estimate of total amount of loans that will not be repaid
1778	Other assets (fixed assets, goodwill, etc)
1779Commercial Bank Liabilities
1780	Core deposits
1781		Demand deposits
1782		negotiable order of withdrawal (NOW) accounts
1783		money market deposit accounts (MMDAs)
1784		other savings deposits
1785		retail certificates of deposits
1786	Other deposits
1787		wholesale certificates of deposits
1788			negotiable instruments traded in secondary markets
1789			brokered deposits
1790	Non-deposit liabilities
1791		borrowed funds
1792			fed funds purchased and repos
1793			other borrowed funds (bankers acceptances, commercial paper, discount window)
1794		subordinated notes and debentures
1795		other liabilities
1796Commercial Bank Equity
1797	Equity
1798		Preferred and common stock
1799		Surplus or additional paid in capital
1800		Retained earnings
1801Off-Balance-Sheet Items
1802	Off balance sheet items are contingent assets and liabilities that may affect a commercial bank's 		balance sheet and/or income statement
1803	Loan commitments
1804		Up-front fees are charged for making funds available
1805		Commitment fees are charged on the unused portion of a loan commitment
1806	Letters of Credit
1807		commercial letters of credit
1808		standby letters of credit
1809	Loans Sold
1810		Loans can be sold or without recourse
1811	Derivative contracts
1812		Futures, forwards, swaps, and options
1813Income Statement
1814	Net interest income = interest income - interest expense
1815	Net noninterest income = noninterst income - noninterest expense
1816	Income before taxes and extraordinary items EBTEI
1817		Net interest income - provision for loan loses + net interest income
1818	Net income = EBTEI - income taxes - extraordinary loans
1819	Directly relationship between income statement and balance sheet of commercial banks
1820		(ADD FORMULA FROM SLIDE 15)
1821Financial Statement Analysis
1822	Financial statement analysis is based on accounting ratios
1823	Time series analysis is the analysis of financial statements over a period of time
1824	Cross-sectional analysis is the analysis of financial statements comparing one firm with others
1825		Uniform Bank Performance Report UBPR maintained by FFIEC allows banks to 			observe competitor financial statements
1826	Most financial statement analyses is a combination of time series and cross-sectional analyses
1827Return on Equity (ROE) Framework (Dupont Analysis)
1828	Return on Equity analysis begins with ROE and then breaks it down into its components
1829	ROE measures overall profitability of the bank per dollar of equity
1830		ROE = net income / total equity capital
1831	ROE can be broken down into following components
1832		ROE=		Net Income	*	Total Assets		= ROA x EM
1833				Total Assets		Total Equity Capital
1834	Return on Assets ROA measures profit generated relative to bank's assets
1835	Equity Multiplier EM measures extent to which assets are funded with equity relative to debt
1836		measure of leverage
1837	ROA can also be broken down into two components
1838		ROA=		Net Income	                 *	Total Operating Income= PM x AU
1839			 Total Operating Income	              Total Equity Capital
1840	Profit Margin PM measures ability to pay expenses and generate net income from interest and 	noninterest income is composed of
1841		Interest expense ratio
1842		Provision for loan loss ratio
1843		Noninterest expense ratio
1844		Tax ratio
1845	Asset Utilization (AU) measures the amount of interest and noninterest income generated per 	dollar of total assets and is composed of 
1846		Interest income ratio
1847		Noninterest income ratio
1848Other Ratios
1849	Net interest margin NIM measures net return on bank's earning assets
1850		NIM = 	Net Interest Income  =        Investment Income - Interest Expense
1851				  Earning Assets	    Investment Securities + net loans and losses
1852	The Spread measures the difference between the average yield on earning assets and average 	cost on interest bearing liabilities
1853		Spread = 	Interest Income                    Interest Expense
1854				  Earning Assets	    Interest - bearing liabilities
1855	Overhead efficiency measures a bank's ability to generate noninterest income to cover 	noninterest expenses
1856		= noninterest income / noninterest expense
1857	Many additional ratios are commonly used to analyze commercial banks by breaking down the 	components of ROE even further (table 12-6 and 12-7)
1858Application of ROE Analysis
1859	Compare Heartland Bank and Trust HBT with Bank of America BOA
1860	HBT
1861		Profitable and efficient retail bank
1862		Invests mainly in real estate loans
1863		Uses more retail deposits to fund its assets
1864		Holds relatively more equity capital than BOA
1865	BOA
1866		Both retail and wholesale bank
1867		Has a relatively more diversified portfolio than HBT
1868		Uses broader array of deposits + more purchased funds (fewer core deposits) than HBT
1869		Offers a broad spectrum of financial services
1870	HBT has a substantially higher ROE and ROE (highly leveraged, larger equity multiplier)
1871		HBT higher ROA is driven by substantially higher profit margin PM & component ratios
1872		Even though income to assets ratio is higher at HBT, the AU ratio is lower at HBT 				because of substantially lower level of noninterest income to total assets ratio as 				comparable to BOA
1873Impact of Market Niche and Size
1874	Retail and Wholesale commercial banks operate in different market niches that should be noted 			when performing financial statement analyses
1875	Large banks have greater access to purchased funds and usually maintain more liquid assets
1876	Large banks typically carry lower amounts of equity
1877	At times, the ROA of large banks is less than for small banks because large banks operate in 			more competitive markets
1878	Large Banks have higher salary expense% and typically have higher percentage cost for 				premises
1879	Large banks have more noninterest income than smaller banks but also tend to have more 			noninterest expense
1880
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1918FORMULAS
1919CHAPTER 19
1920Net Interest Margin (if change, replace variables in places needed)
1921= [(Assets earning average%-Liabilities paying%)*fixed earning assets] / fixed earning assets
1922Interest received in foreign currency = [foreign currency assets * interest on foreign asset]
1923Interest expense in foreign currency = [foreign currency liabilities * interest on foreign liabilities]
1924Net Interest Margin in a specific currency
1925= Interest received in foreign currency - Interest expense in foreign currency
1926Before Devaluation
1927	Interest Received in dollars = Interest received in foreign currency / spot rate of foreign/dollars
1928	Interest expense in dollars = interest expense in foreign currency / spot rate of foreign/dollars
1929	Net interest margin in dollars = Interest received in dollars - Interest expense in dollars
1930After devaluation (recalculate using end of yr spot rate) (Change in NIM = difference between before and after)
1931Net Assets = Assets - Liabilities
1932	If in foreign currency, divde assets and liabilities by current spot rate
1933Recalculate after devaluation, calculate before and after and find difference for change in Net assets
1934
1935Original dollar amount lent = Foreign amount loaned / initial exchange rate
1936Borrower repayment foreign amount = Foreign amount loaned * (1+fixed interest rate)
1937Converted back to dollar = Borrower Repayment foreign amount / later exchange rate
1938Bank dollar rate of return on a loan 
1939	= (Converted back to dollar amount - original dollar amount lent) / original dollar lent
1940
1941Interest Income = Bond Assets * Bond Coupon Rate
1942Interest Expense = CD Liabilities * CD Interest Rate
1943Net Interest Income = Interest Income - Interest Expense
1944New CD Rate = Current CD Rate + [(Next Year Market Interest Rate Inc/100)/100]
1945Recalculate interest expense, get new net interest income (change is refinancing risk)
1946Bond Value
1947=-PV(BondCouponRate+(New BasisPoints/100)/100;BondMaturityYears-1;Interest Income;BondAssets)
1948Loss or Gain in market value of bond = Bond Assets - Bond value
1949Market value of equity = Equity - LossorGain in MV of Bond
1950
1951
1952Chapter 20
1953(Pass/Fail)
1954Gross Debt Service Ratio (25-30) = (Monthly mortgage payments*12 + property taxes) / gross income
1955Total Debt Service Ratio (35-40) =  (Sum of all annual payments) / annual gross income
1956	Monthly mortgage payments may need to be made annual
1957
1958CF Operations +/- CF Investing +/- CF Financing = Change in Cash
1959CF Operating = Net Income + Interest Expense + Depreciation + Change AR* + Change Inventory + Change in Acc wages and taxes + Change in AP
1960CF Investing = Change in Gross Fixed Assets 
1961CF Financing = Interest Expense* + Increase in Notes Payable + Increase in Long Term Debt + Increase in common stock + Pay of common stock dividends*
1962
1963EBIT = Sales - Costs - Depreciation	EBT = EBIT - Interest +/- Expense
1964Net Income = EBT - Taxes	Change RE = Net Income - Dividends
1965
1966Liquidity Ratios
1967	Current Ratio = Current Assets / Current Liabilities
1968	Quick Ratio (acid test) = (Cash + Cash Equivalents + Receivables) / Current liabilities
1969Asset Management ratios
1970	Days sales in receivables = (receiveables * 365) / Credit sales
1971	Days in inventory = (inventory * 365) / COGS
1972	Sales to Working Capital = Sales / (Current assets - current liabilities)
1973	Sales to fixed assets = Sales / Fixed Assets
1974	Asset turnover = Sales / Total Assets
1975Debt (long term solvency) ratios
1976	Debt to asset (total debt ratio) = Total Liabilities / Total assets
1977	Times Interest Earned = EBIT / Interest Expense
1978	Cash flow to debt ratio = (EBIT + Depreciation) / Debt
1979Profitability ratios
1980	Gross margin = gross profit / sales
1981	Operating profit margin = operating profit / sales
1982	Net profit margin = Earnings After Taxes / Sales
1983	Return on assets = EAT / Average total assets
1984	Return on equity = EAT / Total Equity
1985	Dividend Payout = Dividends / EAT
1986
1987Altman's Z Score = Z= 1.2X1+ 1.4X2+ 3.3X3+ 0.6X4+ 1.0X5
1988where X1= working capital ÷ total assets	X2= retained earnings ÷ total assets
1989X3= earnings before interest and taxes ÷ total asset
1990X4= market value of equity ÷ book value of long-term debt	X5= sales ÷ total assets
1991<1.81 = fail, >2.91, great, in between needs to be evaluated
1992
1993Return on Assets ROA approach   1 + k    =   1 +   f + (BR) + m
1994 			            1- b (1-RR)
1995f= the loan origination fee		b= the compensating balance requirement
1996RR= the reserve requirement ratio	BR= the base lending rate
1997m= the credit risk premium on the loan
1998
1999Risk-adjusted return on assets RAROC model
2000	RAROC = One year income on a loan / loan(asset) risk or value at risk
2001The RAROC is compared vis-à-vis the lender’s tax-adjusted return on equity (ROE)
2002o if RAROC > ROE, make the loan
2003o if RAROC < ROE, either adjust the loan such that RAROC > ROE or decline the loan
2004
2005True Cost = Stated Rate / (1 - Comp balance)
2006
2007Expected Portfolio Return
2008	ENi = XiRi
2009Expected Portfolio Variance
2010O2p = Eni X2iO2i + EniEji XiXjOij
2011
2012GDS - gross debt service
2013Equal to total accomodation expenses (mortgage, lease, condominium, 	management fees, real estate taxes, etc) divided by gross income
2014	Acceptable threshold generally around 25%-30% max
2015TDS - Total debt service
2016Equal to the total accommodation expenses plus all other debt service payments divided by gross income
2017	Acceptable threshold generally set around 35%-40% max
2018
2019Chapter 17
2020Net Asset Value = [MF's (Stocks+ bonds+ Cash +other assets) - MFliabilities ] /#shares outstanding
2021
2022Effect of costs on MF Returns (FORMULA)
2023	Amount initially invested AII= $amount placed - (%load * $amount placed)
2024	Amount after gross return AAGR = AII * (1+ gross return%)
2025	Average asset value for year AAVFY = (AAGR + AII) / 2
2026	Fees  = AAVFY * annual expense%
2027	Ending amount after fees EAAF = AAGR - Fees
2028	Net Rate of return (first year) = (EAAF - $amount placed) - 1
2029
2030Profit or Loss on Sale = Sell price - Buy Price
2031Total Income = Profit/Loss on Sale + Dividend + CG Dist
2032Net Return = Total Income - Fee
2033ROI = Net Return / Buy Price
2034
2035Total Value = Closing Price of Stock * # of Shares of that stock outstanding
2036NAV = Total Value / Total Shares outstanding
2037If new closing prices arise, recalculate Total Value and NAV in same fashion
2038New NAV - Old NAV = change in NAV
2039
2040Unreal gain = end of year NAV - beginning of year NAV
2041ROI = (Unreal gain + Income distributions + CG distirbutions) / NAV beginning of year
2042Cash flows = Income distributions + CG distributions
2043Annual ROI (IRR) =  =IRR(-NAV beginning of year + sum of cash flows)
2044Average ROI = AVG of all ROIs in problem
2045
2046Load = Load% * Investment		Net Investment = Investment - Load
2047Gain = Return% * Net Investment	Net Gain = Gain - Load
2048ROI = Gain / Investment		Redemption Fee = Redemption Fee% * (Investment + Gain)
2049Net Gain = Gain - Redemption Fee
2050
2051Chapter 21
2052Liquidity Index
2053Sumof[(Wi)(Pi/Pi*)]
2054wi= the percent of each asset i in the FI’s portfolio	Pi = the price it gets if an FI liquidates asseti today
2055Pi*= the price it gets if an FI liquidates asset i under normal market conditions
2056
2057Financing Gap Funding = -Liquid Assets + Borrowed Funds
2058Financing Requirement = Financing Gap + Liquid Assets
2059
2060Total Assets = Fed deposit + Tbills + Mortgage loans
2061Index = (Fed Deposit/Total Assets*Fed Deposit ST Liq Value%)+(T Bills/Total Assets*T bills St liq value%)+(Mortage loans/total assets*mortgage loan st liq value%)
2062
2063Assets = Cash + Fed Deposits + Tbonds, marketable securities, GNMA bonds, AA- corp loans, mortgages, premises
2064L&E = stable retail deposits, less stable deposits, CD maturity 6 months, unsecured wholesale funding
2065Level 1 assets have no cap
2066Level 2 Assets (dont matter?)  Level 2 cap at 40% of level 1
2067Highly Liquid assets = Level 1 + Level 2 cap at 40% of level 1
2068Potential Cash outflows (stable, less stable, cds maturing correct) + (unsecured stable 5%, less stable 10%, nonfinancial corporates 75%)
2069Net Potential cash outflows over next 30 days = Potential cash outflows - cash inflows over next 30 days
2070
2071For Required stable funding factor, times them by their required factors and make sure both sides add up properly
2072
2073Chapter 11
2074Interest rate spread = Lending Rate - Deposit Rate
2075Net Interest Margin = (Interest income - Interest Expense) / earning assets
2076Net non-interest margin = (noninterest income - non interest expense) / earning assets
2077Net charge offs = % of loans that are uncollectable
2078Return on assets = Net income / assets
2079Return on equity = net income / equity
2080
2081Chapter 12
2082Income before taxes and extraordinary items (EBTEI)
2083	=Net interest income - Provision for loan losses + Net noninterest income
2084Net income = EBTEI - Income taxes - extraordinary items
2085
2086Direct relationship between income statement and balance sheet of commercial banks
2087NI = Σ rn An - Σ rm Lm - P + NII - NIE - T
2088NI= net income			An= dollar value of the bank’s nth asset
2089Lm= dollar value of the bank’s mth liability		rn= rate earned on the bank’s nth asset
2090rm=rate paid on the bank’s mth liability		P = provision for loan losses
2091NII = non-interest income earned, including income from OBS activities
2092NIE = non-interest expenses			T=taxes and extraordinary items
2093N= number of assets the bank holds		M = number of liabilities the bank holds
2094
2095ROE can be broken down into following components
2096	ROE=	Net Income	*	Total Assets		= ROA x EM
2097		Total Assets		Total Equity Capital
2098ROE = NI / Equity        NI = ROE*Equity	      NI Taxes = Tax rate * NI 	            T = NI Taxes / (1 - Tax rate)
2099Interest Rev - Int Exp = Net Int Inc	Net Int Inc - PLL(P) + NNII@ = IBT	IBT - Tax = NI
2100
2101Debt Ratio = Total Debt / TA		TA = Total Debt / Debt Ratio		TE = TA - Total Debt
2102ROE = Net Income / TE
2103
2104ROA can also be broken down into two components
2105	ROA=	Net Income	                 *	Total Operating Income   = PM x AU
2106		Total Operating Income	    Total Equity Capital
2107	ROA = NI / Total Assets
2108Assets = Cash + Dep FI + Invest + FF Sold + Loans - Res LL + Premises
2109L&E = DDA + STD + Jumbo CD + FF Purch + Equity
2110Earning assets = Invest + FF Sold + Loans - Res LL	Net Income = Int Income-Int Exp-PLL+NII-NIE-Taxes
2111Operating Income = Interest Income + NII		AU = Operating Income / Total Assets
2112Spread = Interest Income/Earn Assets-Int Exp/(STD+JumboCD+FFPurch)
2113Net Interest Margin = (Int Income - Int Exp) / Earn Assets		EM = Total assets / Equity
2114PM = Net Income / Operating Income	IE Ratio = Interest Expense / Operating Income
2115PLL Ratio = PLL / Operating Income	NIE Ratio = NIE/Operating Income
2116Tax Ratio = Taxes / Operating Income	OhE = NII / NIE
2117
2118Net interest margin NIM measures net return on bank's earning assets
2119	NIM = 	Net Interest Income  =        Investment Income - Interest Expense
2120	    	Earning Assets                Investment Securities + net loans and losses
2121The Spread measures the difference between the average yield on earning assets and average 	cost on interest bearing liabilities
2122	Spread = 	Interest Income                    Interest Expense
2123	                        Earning Assets                Interest - bearing liabilities
2124Overhead efficiency = noninterest income / noninterest expense
2125
2126Chapter 22 – Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
2127Interest Rate Risk
2128	Asset transformation function performed by FIs often exposes them to interest rate risk
2129	FIs use two main methods to measure interest rate exposure
2130		Repricing aka funding gap model- examines impact of interest rate changes on net interest income 		NII
2131Duration model – examines impact of interest rate changes on the overall market value of an FI and thus on net worth
2132	Modern development
2133		The Fed Reserve monetary policy is most direct influence on level and movement of short term 			interest rates
2134		Changes in the Fed’s target Fed Funds rate affect all interest rates throughout the economy
2135			Expansionary monetary policy involves decreases in target fed rate
2136			Contractionary monetary policy involves increases in target fed funds rate
2137Repricing Model
2138	Funding gap is the difference between
2139		Those assets whose interest rates will be repriced over some future period AND
2140		Liabilities whose interest rates will be repriced over some future period
2141	Used by most FIs
2142	Larger and more sophisticated FIs moving towards duration gap
2143	Quarterly reporting of commercial bank assets and liabilities detailed by repricing (maturity) bucket (or 	bin)
2144		One day
2145		1+ day to 3 months
2146		3+ months to 6 months
2147		6+ months to 12 months
2148		1+ year to 5 years
2149		5+ years
2150Gap in each bucket or bin is measured as the difference between rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSL)
2151	Rate-sensitivity measures the time to repricing of an asset or liability
2152Cumulative gap CGAP is the sum of the individual maturity bucket gaps
2153Cumulative gap effect is the relation between changes in interest rates and changes in net interest income
2154	Change in NII for any given bucket is
2155	â–³Nii =  (GAP) â–³Ri = (RSAi-RSLi) â–³Ri
2156GAP = dollar size of the gap between the book value of rate-sensitive assets and rate-sensitive liabilities in maturity bucket i
2157â–³Ri = the change in level of interest rates impacting assets and liabilities in the ith maturity bucket
2158	Common cumulative gap of interest to commercial bank managers is the one-year repricing gap estimate
2159		â–³NII 0 (1yrRSA-1yrRSL) â–³Ri
2160Where â–³Nii is the cumulative change in net interest income from all rate-sensitive assets and liabilities that are repriced with a year given a change in interest rates â–³Ri
2161Spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change
2162	△NIIi – (RSAi x △Rrsa) – (RSLi x △Rrsl)
2163For a positive repricing gap, interest rates and profitability move in the same direction
2164For a negative repricing gap, interest rates and profitability move in the opposite direction
2165Repricing model has some major weaknesses
2166	RPM measures only short-term profit changes, not shareholder wealth changes
2167	Maturity buckets are arbitrarily chosen
2168	All assets and liabilities that mature within the maturity bucket considered equally rate-sensitive
2169	Some accounts such as demand deposits are not easily classified
2170	RPM ignores runoffs
2171		Receipts of cash on FRA or payments due on FRLs that occur during the maturity bucket 			period
2172		This cash must be reinvested by the intermediary and is rate-sensitive
2173	Ignores prepayments
2174	Ignores cash flows generated from OBS activities
2175Duration Model
2176	Duration measures the interest rate sensitivity of an asset or liability’s value to small changes in interest 	rates
2177		D = % â–³ in the market value of a security / [â–³R / (1+R)]
2178	Duration gap is a measure of overall interest rate risk exposure for an FI
2179	To find duration of the total portfolio of assets (Da) or liabilities (Dl) for a FI
2180		First determine the duration of each asset (or liability) in the portfolio
2181		Then calculate the market value weighted average of the duration of assets or liabilities in the 			portfolio
2182	Duration (Dur) for a fixed-income security that pays interest annually can be written as
2183		INSERT 3-21 FORMULA HERE
2184	Duration and coupon interest – the higher the coupon payment, the lower the bond duration
2185	Duration and yield to maturity – the higher the yield to maturity, the lower the bond duration
2186	Duration and maturity – duration increases with maturity but at a decreasing rate
2187	Change in market value of the asset portfolio for a change in the interest rates is
2188		â–³A = A x (-Da) x (â–³R / (1+r))
2189	Similarly, the change in the market value of the liability portfolio for a change in the interest rates is:
2190		â–³L = L x (-Dl) x (â–³R / (1+r))
2191Finally, the change in the market value of equity of an FI given a change in the interest rates is determined from a basic balance sheet equation
2192	A = L + E  ->  â–³A = â–³L + â–³E
2193By substituting and rearranging, the change in net worth is given as
2194	△E = - (Da – kDl) x A x (△R / (1+r))
2195		Where k is L/A	a measure of the FI’s leverage
2196Effect of interest rate changes on the market value of equity or net worth of an FI breaks down to three effects
2197	Leveraged adjusted duration gap (Da – kDl)
2198		Measured in years
2199		Reflects duration mismatch on an FI’s balance sheet
2200		Larger the gap, the more exposed the FI to interest rate risk
2201	Size of the FI
2202	Size of the interest rate shock
2203Difficulties in applying the duration model to real-world FI balance sheets
2204Duration matching (immunization) can be costly as restructuring balance sheet is time consuming, costly, and generally not desirable
2205Immunization is a dynamic problem
2206	Duration of assets and liabilities change as they approach maturity
2207			Rate at which duration of assets and liabilities change may not be the same
2208		Duration is not accurate for large interest rates changes unless convexity is modeled into the 			measure
2209			Convexity is the degree of curvature of the price-yield curve around some interest rate level
2210Insolvency Risk
2211	To ensure survival, an FI manager must protect against risk of insolvency
2212	Primary protection against the risk of insolvency is equity capital
2213		Capital is a source of funds
2214Capital is a necessary requirement for growth under existing minimum capital-to-asset ratios set by regulators
2215	Managers prefer low levels of capital in order to generate higher return on equity ROE
2216		Moral hazard problem exacerbates this tendency
2217		Result is an increased likelihood of insolvency
2218	Capital Purchase Problem CPP was part of TARP funding in 08-09
2219		Treasury purchased over $200 billion of senior preferred equity under the program
2220	The CPP was designed to help FIs increase their capital with the aim of increasing lending to the general 	public
2221Lending fell in 08-10, so in this sense the program was a failure, although assumed lending would have fallen further without it and more failures may have occurred	
2222	Economic meaning of capital is net worth
2223Net worth is equal to difference between the market value MV of an FI’s assets and market value of it’s liabilities
2224Market value or mark-to-market value basis uses balance sheet values that reflect current rather than historical prices
2225	Regulatory and account-defined capital is based in whole or in part on historical or book values BV
2226	Market value of capital and credit risk
2227		Decreases in current and expected future cash flows on loans lowers the MV of an FI’s assets
2228		Decreases in the MV of assets are directly charged against the equity owners capital or net worth
2229		Liability holders are only hurt when asset losses exceed equity capital levels
2230Thus, equity capital acts as “insurance” protecting liability holders (and guarantors such as FDIC) against insolvency risk
2231	Market value of capital and interest rate risk
2232Rising interest rates decrease the value of an FI’s assets more than the value of the FI’s liabilities when duration gap of the FI’s balance sheet is positive
2233Losses are first charged against equity capital
2234	Book value of equity capital is the difference between BV of assets and BV of liabilities
2235BV of equity is usually composed of par value of equity shares, the surplus value of equity shares, and retained earnings
2236BV of equity does not equal market value of equity
2237Managers can manipulate BV of equity by
2238	Using discretion when timing recognition of loan losses
2239	Selectively selling assets to inflate reported earnings (and this capital)
2240	Interest rate changes have no impact on book values of assets and liabilities
2241		FIs can be solvent from a BV perspective, but massively insolvent from an economic perspective
2242	Degree to which the BV of equity deviates from the MV of equity depends on
2243		Interest rate volatility
2244		Examination and enforcement
2245		Loan trading
2246	Discrepancy between the MV and BV of equity is measured by the market-to-book ratio
2247	Arguments against using market value account include
2248Difficult to implement
2249			Especially for small FIs that are not publicly traded
2250		Introduces variability into reported earnings
2251FIs claim they may be less willing to accept longer-term asset exposures if they must be continually marked-to-market
2252Industry argues the lack of liquidity in recent crisis led to unrealistically low market values of assets and marking to market imposed excessive losses on institutions
2253Consequently, Financial Accounting Standards Board FASB allows management to rely on internal estimates of cash flows to estimate fair value
2254	As of April 09, FASB allows DIs to not recognize losses in earnings and regulatory capital on accounts that 	are
2255		Designated as held for investment rather than sale
2256		Temporarily impaired in value due to market conditions rather than underlying credit deterioration
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2260
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2295
2296
2297
2298
2299
2300
2301
2302Chapter 23 – Managing Risk off the Balance Sheet with Derivative Securities
2303Managing Risk off the Balance Sheet
2304	Managers are increasingly turning to OBS instruments such as forwards, futures, options, and swaps to 	hedge the risks their financial institutions FIs face
2305		Interest rate risk
2306		Foreign Exchange Risk
2307		Credit risk
2308	FIs also generate free income from derivative securities transactions
2309	Spot contract is an agreement to transact involving the immediate exchange of assets and funds
2310	Forward Contract is a negotiated agreement to transact at a point in the future with the terms of the deal set 	today
2311		Any amount can be negotiated
2312		Not generally liquid, so each party must perform
2313		Counterparty default risk can be significant
2314	Futures contract is an exchange-traded agreement to transact involving the future exchange of a set amount 	of assets for a price that is fixed today
2315		Futures are liquid, most traders close their position before the delivery date so the underlying 			transaction may never take place
2316		Futures contracts are marked-to-market daily, the traders gains and losses on outstanding futures 			contracts are realized each day as future prices change
2317		Exchange clearinghouse stands behind all contracts so there is no counterparty default risk and 			trading is anonymous
2318Hedging with Forwards
2319	Naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract
2320	Managers can predict capital loss Change in P using duration formula
2321		INSERT 23-5 FORMULA
2322	Microhedging is using futures or forwards contracts to hedge a specific risk or liability
2323		Basis risk- residutual risk that occurs in a hedged position because the movement in an asset's spot 		price if not perfectly correlated with the movement in the price of the asset delivered under a future 		or forwards contract
2324	Macrohedging - heding the entire (leverage adjusted) duration gap of an FI
2325Hedging Considerations	
2326	Microhedging and macrohedging
2327		Risk-return consideration
2328			FIs hedge based on expectations of future interest rate movements
2329			FIs may microhedge, macrohedge, or even overhedge
2330		Accounting rules can influence hedging strategies
2331			97 FASB required that all gains and losses from derivatives used to hedge must be 				recognized immediately
2332			US companies must report derivative-related trading actively in annual reports
2333			Future contracts are not subject to risk-based capital requirements imposed by bank 				regulators (forwards can be)
2334		In a full hedge the bank eliminates all or most of all its risk exposure such as interest rate risk
2335		Most managers engage in partial hedging where some risks are reduced and other are borne by the 		institution
2336Macro-Heding with Futures Contracts
2337	INSERT 23-12
2338Risk-Miniizing Futures Position
2339	INSERT 23-13 and 23-14
2340Options
2341	Buying a call option on a bond
2342		As interest rates fall, bond prices rise, and the call option buyer ha a large profit potential
2343		As interest rates rise, bond prices fall, and call options are no larger than the call option premium
2344	Writing a call option on a bond
2345		As interest rates fall, bond prices rise, call option writer has a very large potential loss
2346		As interest rates rise, bond prices fall, call option gains will be no larger than call option premium
2347	Buying a put option on a bond
2348		As interest rates rise, bond prices fall, and put option buyer has a large profit potential
2349		As interest rates fall, bond prices rise, but the put option losses are bounded by put option premium
2350	Writing a put option on a bond
2351		As interest rates rise, bond prices fall, and the put option writer has large potential losses
2352		As interest rates fall, bond prices rise, but the put option gains are bounded by put option premium
2353	Many types of options are used by FIs to hedge
2354		Exchange-traded options
2355		Over the counter OTC options
2356		Caps, collars, and floors
2357	Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets
2358		The put option truncates the downside losses
2359		The put option scales down the upside profits, but still leaves the upside profit potential
2360	Similarly, buying a call option on a bond can hedge interest rate risk exposure relating to bonds held on the 	liability side of the balance sheet
2361Caps, Floors, and Collars
2362	Buying a cap means buying a call option, or a succession of call options, on interest rates rather than on bond prices
2363		Like buying insurance against an excessive increase in interest rates
2364	Buying a floor is akin to buying a put option on interest rates
2365		Seller compensates the buyer should interest rates fall below the floor rate
2366		Like caps floors can have one or a succession of exercise dates
2367	Collar amounts to a simultaneous position in a cap and a floor
2368		Usually involves buying a cap and selling a floor to offset cost of cap
2369Contingent Credit Risk - risk that counterparty defaults on payment obligations
2370	Forward contracts and all OTC derivatives are exposed to counterparty default as they are nonstandard 	contracts entered into bilaterally
2371Swaps
2372	Swap agreements - contracts where two parties agree to exchange a series of payments over time
2373	Several types of swaps
2374		Interest rate swaps
2375			Parties agree to swap interest rate payments on a stated notional principal amount for a set 			period of time (some can be for more than 5 years) (no principal is exchanged)
2376		Currency swaps
2377			Parties agree to swap interest and principal payments in different currencies and preset 				exchange rate
2378		Credit default swaps (credit swaps)
2379			Total Return Swap TRS
2380				TRS buyer agrees to make a fixed rate payment to the seller plus capital gain or 					minus capital loss on the underlying payment
2381				In exchange, TRS seller may pay a variable or fixed rate of interest to the buyer
2382			Pure Credit Swap PCS
2383				Swap buyer makes fixed payments to the seller and the seller pays the swap buyer 				only in the event of default. This payment is usually equal to par - secondary market 				value of underlying instrument
2384	Credit swaps and the Crisis
2385		Lehman Bros and AIG sold credit swaps worth billions of dollars insuring mortgage-backed 			securities MBS
2386		When mortgage security values collapsed, required outflows at these firms far exceeded capital
2387		Other institutions invested more heavily in MBS because they were insured; exposure to mortgage 		markets was more widespread than it would have been otherwise
2388	Credi swaps may cause lenders to make loans they would not make otherwise make and earn fee income on 	other services offered to borrowers
2389	Market for swaps has grown enormously in recent years
2390		Nominal value of swap contracts outstanding at US commercial value banks was more than $141.7 		trillion 	in 03
2391	Hedging with interest rate swaps
2392		Money center bank MCB may have floating-rate loans and fixed-rate liabilities
2393			MCB has a negative duration gap
2394		Savings bank SB may have fixed-rate mortgages funded by short-term liabilities such as retail 			deposits
2395			SB has positive duration gap
2396		Accordingly, interest swap can be entered into between the MCB and SB either
2397			directly between the two FIs
2398			OR
2399			indirectly through a broker or agent who charges a fee to accept credit risk exposure and 				guarantee cash flows
2400	Plain vanilla swap - standard agreement where one participant pay a fixed rate of interest and the other 	party pays a variable rate of interest on a stated notional principal; no principal is exchanged
2401	SB sends fixed-rate interest payments to the MCB
2402		Thus the MCBs fixed-rate inflows are now matched to the fixed-rate payments
2403	MCB sends variable-rate interest payments to the SB
2404		Thus the SBs variable-rate inflows are now matched to its variable rate payments
2405	Hedging with currency swaps
2406		Consider US FI with fixed-rate $ denominated assets and fixed-rate Euro denominated liabilities
2407		Also consider a UK FI with fixed-rate Euro denominated assets and fixed-rate $ denominated 			liabilities
2408		The FIs can engage in a currency swap to hedge their foreign exchange exposure
2409			That is, the FIs agree on a fixed change rate at the inception of the swap agreement for the 				exchange of cash flows at some point in the future
2410		Both FIs have effectively hedged their foreign exchange exposure by matching the denominations 		of their cash flows
2411Credit Swaps
2412	Credit swaps to hedge credit risk
2413		Involvement of other FIs in the credit risk shift
2414	Total return swap
2415		Swap interest payments for total return to a bond or loan, hedging possible change in credit risk 			exposure
2416	Pure credit swap
2417		Interest-rate sensitive element stripped out, leaving only the credit risk
2418Swaps and Credit Risk Concerns
2419	Credit risks concerns partially mitigated by netting of swap payments, with financial crisis elevated 	concerns
2420		Scale of individual firm exposures is large
2421		Lehman bros $700 billion and large exposure to AIG in particular
2422	Due to the role of swaps in the crisis, greater regulation resulted
2423		OTC Derivatives Market Act
2424Credit Risk on Swaps
2425	Growth of the OTC swap market was a major factor underlying the imposition of the BIS risk-based capital 	requirements
2426		Fear was that out-of-the-money counterparties would have incentives to default
2427		BIS now requires capital to be held against interest rate, currency, and other swaps
2428	Credit risk on swaps differs from that on loans
2429		Netting - only if the difference between the fixed and the floating payments is exchanged between 		swap parties
2430		Payment flows are often interest and not principal
2431		Standby letters of credit are required of poor-quality swap participants
2432Comparing Hedging Methods
2433	Writing vs Buying Options
2434		Writing options limits upside profits, but not downside losses
2435		Buying options limits downside losses, but not upside profits
2436	Futures vs Options Hedging
2437		Future produce symmetric gains and losses
2438		Options protect against losses, but do not fully reduce gains
2439	Swaps vs Forwards, futures, and gains
2440		Swaps and forwards are OTC contracts, unlike options and futures
2441		Futures are marked to market daily
2442		Swaps can be written for longer-time horizons
2443Regulation
2444	Regulators specify "permissible activities" that FIs may engage in
2445	Institutions engaging in permissible activities are subject to regulatory oversight
2446	Regulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy 	regulation
2447	SEC and Commodity Future Trading Comission CFTC are functional regulators of derivatives securities 	markets
2448	Dodd-Frank Act 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all 	parties
2449	Act also requires OTC derivatives to be regulated by SEC and/or CFTC
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2451
2452
2453
2454
2455
2456
2457
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2469
2470
2471Chapter 15 Insurance Companies
2472Insurance Companies (ICs)
2473	The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, 	in exchange for premiums paid
2474		Insurance underwriters assess and price risk
2475		Insurance brokers sell insurance contracts
2476	Insurance is broadly classified into two groups
2477		Life insurance policies provide protection against untimely death or illness, and/or transfer wealth 		through time to retirement
2478		Property-casualty insurance protects against property damage, personal injury associated with 			specific events
2479	Insurance companies also sell a variety of investment products similar to other FIs
2480Life Insurance Companies
2481	Approx 1000 life insurance companies exist in the US in 2010s
2482		Compared to 2300 in 88
2483		Industry has seen consolidation to take advantage of scale and scope economies
2484	Aggregate industry assets were 5.73 trillion $ at the start of 2013
2485		Compared to 1.1$ trillion in 88
2486	Life insurers pool the risks of individuals to diversify away some of the customer specific risk
2487		Thus they are able to offer insurance services at a cost lower than any individual could achieve on 		their own
2488		This allows transfer of income related uncertainties from individual to the group
2489	Other activities of life insurance companies
2490		Sell annuities, which are savings contracts that involve the liquidation of those funds saved over 			time
2491		Manage pension plans (tax-deferred savings plans)
2492		Provide accident and health insurance
2493	Insurance companies accept or underwrite risk at a pre-specified event will occur in return for insurance 	premiums
2494		Underwriting decisions determine which risks are accepted and which are not
2495		Underwriting decisions determine how much to charge (in the form of premiums) for accepted risk
2496	Adverse selection problem – customers who apply for insurance are more likely to be in need of coverage
2497	Moral hazard – after an insurer and customer enter into insurance contract, insured engages in risky 	behavior because risk is covered
2498	Actuaries reduce risks of underwriting insurance
2499		With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money 		tools to price life insurance annuities and endowment policies
2500		With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc
2501	Ordinary life insurance is marketed to individuals, policyholders make periodic premium payments in 	exchange for coverage
2502		Term life
2503			Beneficiary receives payout at time of death
2504			If insured lives beyond term of contract, no benefits are paid
2505		Whole life
2506			Policy protects over entire lifetime
2507			Beneficiary receives face value of contract upon death
2508		Endowment life
2509			Beneiciary receives payment at time of death
2510			If insured lives beyond term of contract, insured receives face value of contract
2511		Variable life
2512			Premiums are invested in market securities
2513			Value of policy depends on value of securities
2514		Universal life 
2515			Allows the insured to change both the premiums and the maturity of the contract
2516		Variable universal life
2517			Universal policy where premiums are invested in variable rate earning assets
2518	Group life insurance covers a large number of persons under a single policy
2519		Contributory – both employer and employee cover share of premiums
2520		Noncontributory – costs are borne entirely on the employer
2521	Credit life insurance – protects lenders against borrower death
2522	Other life insurance activities
2523		Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time
2524			Annuity sales were $356 billion in 2012
2525		Private pension funds compete with other financial service companies
2526			In 2013 insurers administered more than $2.9 trillion of pension fund assets
2527			Guaranteed investment contracts GICs are instrumental in many of these plans
2528		Accident and health insurance accounted for 25% of premiums written in 2012
2529			Life insurers write over 50% of all health premiums
2530ANNUTIES EXAMPLE AND FORMULA SLIDE 15-14
2531Life insurance balance sheet – 
2532policy loans are loans made by an insurance company to its policyholders using policy as collateral
2533	Long term nature of assets matches liabilities
2534	Policy reserves reflect expected payment commitments on existing policy contracts
2535	Funds in separate account business are monies for which the insurer maintains separate accounting 	(annuities and certain insurance policies)
2536Insurers and 08-09 financial crisis
2537	Life insurance industry performed well during the mid-00s while stock markets and economy were doing 	well
2538	As crisis began insurers experienced losses on mortgage-backed securities, commercial loans, particularly 	commercial real estate, and on corporate bonds
2539	Result was very large profit declines in 08 (50% declines in 07) and continuing poor conditons in 09 on 	more losses and investments
2540	Industry conditions improved in 10 through 12, in 12 premium income stopped falling, net income rose to 	$40.9 billion up fron $28 bllion in 10
2541Life insurance regulation
2542	McCarren-Ferguson Act 1945 – confirmed primacy of states over federal regulation of ICs
2543		State insurance commissions charter and examine ICs
2544		National Association of Insurance Commissioners NAIC has developed coordinated examination 		system
2545	States promote insurance guarantee funds
2546		Funds are run by the insurance companies themselves
2547		Contributions are paid only when an IC falls (except in NY)
2548	Financial Services Modernizattion Act FSMA of 99 allowed CBs, IBs, and ICs to exist as subsidiaries 	under one Financial Holding Company FHC
2549	During financial crisis Congress considered adding federal regulator of the insurance industry, but left 	regulation to the states
2550	Dodd-Frank created Federal Insurance Office FIO that reports to Congress and President on Insurance 	industry
2551		FIO is supposed to identify systematic risks arising from insurers, monitor international insurance 		events, eliminate state regulatory gaps and encourage the offering of insurance products to 			underserved segment
2552		2013 Financial Stability Oversight Council FSOC designated AID, Metlife, and Prudential as 			systematically important non-banks
2553Property-Casualty P&C Insurance Companies
2554	Currently 2700 P&C sellers
2555		Top 10 firms have 53% market share
2556		Top 200 firms have 94% market share
2557	Property insurance involves coverage related to loss of real and personal property
2558	Casualty insurance offers protection against legal liability exposure
2559	Balance sheets of P&C
2560		Reinsurance – insurance companies can attempt to share risks by buying insurance from other 			insurance companies
2561		Generally shorter term investments than life insurers
2562		Policy surplus is equity
2563		Loss reserves and loss adjustment expenses
2564			Loss reserves are set aside to meet losses from underwriting
2565			Loss adjustment expenses represent administrative and adjusting costs associated with 				settling claims
2566		Unearned premiums
2567			Includes premiums that have been paid before insurance coverage has been provided
2568	P&C Insurance
2569		Underwriting risk – risk that premiums are insufficient to cover losses and administrative expenses 		after taking into account investment income
2570			Underwriting risk may result from
2571				Unexpected increases in loss rates
2572				Unexpected increases in expenses
2573				Unexpected decreases in investment profits
2574		Loss risk – function of actuarial predictability
2575				Property vs liability
2576				Severity vs frequency
2577				Long-tail vs Short-tail
2578				Product inflation vs social inflation
2579			Loss risk is a measure of pure losses incurred to premiums earned
2580				Premiums earned are premiums received and earned on insurance contracts because 				timer has passed with no claim filled
2581		Expense risk occurs from two major sources
2582			Loss adjustment expenses LAE
2583			Commissions and other expenses
2584		Combined ratio is a measure of overall profitability
2585			Equals loss ratio plus LAE to premiums written plus commissions and other expenses to 				premiums written
2586		Investment yield is measured as net interest income divided by premiums earned
2587		Operating ratio is also a measure of overall profitability
2588			Combined ratio minus investment yield
2589FORMULAS ON SLIDE 15-28
2590		Many catastrophes of historically high severity have occurred recently
2591		Underwriting cycle is a pattern that profits in P&C industry tend to follow
2592		Federal govt has consistently increased role of providing compensation and reconstruction 			assistance following natural disasters
2593P&C insurance regulation
2594	P&C insurers are chartered at state level
2595	P&C insurers are registered by state commissioners
2596	State guarantee funds provide (some) protection to policyholders
2597	NAIC provides services to state regulatory commissionsn such as Insurance Regulatory Information 	System IRIS
2598Global issues
2599	About 59% of total global life insurance premiums written are generated by 5 countries: US. Japan, UK, 	France, Germany
2600	Globally in 11 and 12 were bad years for insurance industry with insurred losses of $111 billion in 11 and 	$65 billion in 12
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2645Chapter 16 – Securities Firms and Investment Banks
2646Securities Firms and Investment Banks IBs
2647	Investment Banks IBs help corporations and governments riase capital through debt and equity security 	issues in the primary market
2648		Underwriting is assisting in issuing new securities
2649		IBs also advise on mergers and acquisitions M&As and corporate restructuring
2650	Securities firms assist in the trading of securities in secondary markets
2651		Broker-dealers assist in the trading of existing securities
2652	Size of industry is usually measured by the equity capital of firms rather than total asset size
2653		Equity capital in the industry in 12 was $223 billion
2654	Number of firms in the industry changed due to economies of scale and scope, losses with the economy, 	scandals at some firms, and regulations that allowed both inter- and intra-industry mergers
2655		5248 firms in 80, 9515 firms in 87, 5063 firms in 10
2656	As with commercial banks, consolidation has largely occurred through mergers and acquistions
2657	Commercial bank holding companies that opereate diversified national full-line firms
2658		Service both retail and wholesale customers by acting as broker-dealers
2659		Service corporate customers by underwriting security issues
2660	National full-line firms specializing in corporate finance
2661		Second largest group of firms are full-service firms that specialize in corporate finance or primary 		market activity ( focus less on secondary market activities)
2662	Large investment banks
2663		Have only limited branch networks concentrated in major cities and service primarily financial 			institution charts
2664	Smaller specialized firms such as:
2665		Regional investment bankers (boutiques)
2666		Discount brokers
2667		Internet brokers
2668		Venture capital brokers
2669		Exchange floor specialists
2670		Dealers in off exchange trading
2671Lines of Business
2672	Investment banking
2673		First time debt and equity issues occur through initial public offerings IPOs
2674		New issues from ma firm whose debt or equity is already traded is called seasoned equity offerings 		SEOs
2675		Private placement is securities issue that paced with one or a few large institutional investors
2676		Public offerings are offered to the public at large
2677		IBs act only as an agent in best efforts underwriting
2678		IBs act as principals in firm commitments
2679		Public vs Private?
2680			Public offering represents sale to public at large
2681			Private involves sale of securities to one or several large investors such as an insurane 				company or pension fund
2682	Venture Capital VC – professionally managed pool of money used to finance new (start up) and often high-	risk firms
2683		VC usually purchases equity stake in start-up
2684		Usually becomes active in the management of the start-up
2685		Institutional venture capital firms find and fund most promising new firms
2686			Venture capital limited partnerships
2687			Financial venture capital firms
2688			Corporate venture capital firms
2689	Private equity investments
2690		Private equity PE differs from VC in funds sources and in types of investments
2691			PE Firms raise funds by selling securities rather than commingling private funds
2692			PE firms often acquire established existing firms rather than purchase startups
2693	Market making involves creation of secondary markets for issue of securities
2694		Agency transactions are two-way transactions on behalf of customers, here company takes no risk
2695		With principal transactions market seeks to profit for their own accounts, company capital at risk in 		these transactions
2696		Goldman Sachs managed $43 trillion in derivatives in securities in 2013 (18% of total held by FIs)
2697	Trading involves taking an active net position in an asset
2698		Position trading – involves relatively long-term positions in assets
2699		Pure arbitrage – involves attempts at profit from price discreptancies
2700		Risk arbitrage – involves attempts at profit by forecasting information release
2701		Program trading – simulatenous buying and selling of at least 15 different stocks valued at $1 			million or more
2702		Stock brokerage involves trading on behalf of customers
2703		Electronic brokerage offers customers direct access via the internet to the trading floor
2704	Investing involves managing pools of assets such as closed- and open-end mutual funds
2705		As agents
2706		As principals
2707	Cash management involves deposit-like accounts such as money market mutual funds MMMFs that offer 	check writing privileges
2708	Merger and acquisition M&A assistance
2709		M&A activity bring large fees to bankers
2710		M&A business remains very cyclical and depends on economy
2711	Other Service functions
2712		Security custodian services
2713		Clearance and settlement services
2714		Escrow services, research and advice on divertitures and asset sales 
2715Pure vs Risk Arbitrage
2716	Pure arbitrage- immediate buying and selling of similar assets trading at different prices
2717	Risk arbitratge- investor buys an asset in anticipation of some information release
2718	If investor sees gold selling in London for $1318 an ounce and $1325 in new York, can make a $7 profit
2719		Pure arbitrage
2720		This success depends on transaction costs, bid-ask spread, and how fast investor can execute 			transaction before others do the same and prices move to regular levels
2721 Industry Performance
2722	Industry trends heavily on the state of the stock market and the economy
2723		Commission income fell after the 1987 stock market crash and 01-02 stock market decline
2724		Improvments in the US economy in the mid 00s led to increases in commission income, but income 		fell with the stock market in 06-08 because of rising oil prices and the subprime mortgage collapse
2725		Revenues and profits fell record amounts in 08 but rebounded sharply in 09
2726		Industry employment fell sharply
2727		Low interest rates and strong stock market helped fuel profit recovery
2728		Profits began to reover in 10 but the fiscal cliff prolem and euro area probblems hurt profits in 11 		and 12 but profits improved in 13
2729Regulation of Securities Firms and Investment Banks IBs
2730	Securities And Eexchange Commisison SEC is primary regulator of securities industry
2731	National Securities Market Improvement NSMIA 96 reaffrmed federal over state authority
2732		Even so state attorneys generally intervene through securities-related investiations that have led to 		many highly publicized criminal cases
2733	Sabarnes-Oxley Act SOX 02
2734		Created independent auditing oversight board under the SEC
2735		Increased penalties for corporate wrongdoers
2736		Forced faster and more extensive financial disclosure
2737		Created avenues of recourse for aggrieved shareholders
2738	SEC sets rules governing underwriting and trading activity
2739		SEC rule 144A defines boundaries between public offerings and private placements
2740		SEC investigating “dark pool” trading and high frequency flash trading
2741	Two self-regulatory organizations ooversee day-to-day regulation of trade practices
2742		New York Stock Exchange NYSE
2743		Financial Industry Regulatory Authority FINRA
2744	USA Patroit Act became effective in 03
2745		Firms must verify identity of customers
2746		Firms must maintain records of identities of customers
2747		Firms must verify ustomers are not on suspect terrorlist lists
2748	Investors in industry are protected by Securities Investor Protection Corporation SIPC
2749		Protect investors against losses up to $500,000 due to security firm failures (but not against poor 			investment decisions)
2750		Created following passage in Security Investor Protection Act of 70
2751	Under Dodd-Frank, Financial Services Oversight Council FSOC has oversight of systematic risk of 	industry
2752		More investment advisors will have to be registered with either the SEC or state advisors
2753		Securitization markets should now have more oversight and originators will have to retain a greater 		interest in loans that will be resold
2754		Greater transparency and regulation for OTC derivatives
2755	Government can also mandate higher capital requirements fofr larger and interconnected banks
2756		Govt oversight of industry has increased as a result of the law
2757	Executive compensation imposed by Obama administration
2758		Strengthen independence of the compensation committee from senior management
2759		Shareholders now also have a non-binding vote on executive compensation package
2760		Administration has a say on executive pay for firms that accepted bailout money
2761Global Issues
2762	Securities firms and investment banks are by far the most global of any group of financial institutions
2763	US Firms are increasingly lookin to expand their business abroad – particularly into China/India
2764	Increase in cross-border strategic alliances
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2826Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
2827
2828Loan Sales and Securitization
2829	FIs use loan sales and securitzation to hedge credit, interest rate, and liquidity risk exposure
2830	Loan sale - occurs when FI originates a loan and then sebsequently sells it
2831	Loan securitization - packaging and selling of loans and other assets backed by securities issued by an FI
2832	Mortgage securitzation generally takes one of three forms:
2833		Pass-through securities
2834		Collateralized mortgage obligations (CMOs)
2835		Mortgage-backed bonds (MBBs)
2836	Large part of correspondent banking involves small FIs making large loans and selling (or syndicating) 	parts of the loans to the large banks
2837		Correspondent banking - relationship between a small bank and a large bank in which the large 			bank provides a number of deposit, lending, and other services
2838	Large banks also sell parts of their loans, called participations, to smaller FIs
2839	Syndicated loan market is the buying and selling of loans once they have been originated
2840	Syndicated loan market participants
2841		Market makers
2842			Generally large commercial banks CBs and investment banks IBs
2843		Active traders
2844			Mainly IBs, CBs, and vulture funds
2845		Occasional sellers and investors
2846	Syndicated loan market grew rapidly in the early 1980s due to the expansion of HLT loans
2847		Highly leveraged transaction HLT loans are loans that finance a merger and acquisition: a leveraged 		buyout results in a high leverage ratio for the borrower
2848
2849Correspondent Banking Model
2850	Small banks
2851		Limited loan demand
2852			Want to buy loans
2853		Large loans that exceed lending limits
2854			Need to sell part to meet reg req
2855		Need help with complex products
2856		Inadequate loan diversification
2857	Large banks
2858		Can generate more loans than capital can support
2859	Small banks develop relationships with a major bank
2860		Big bank buys participation in large loans of small bank
2861		Small bank buys participation of loans of large bank
2862			Added loans
2863			Increased diversification
2864			Absorb part of excess loans of large bank
2865		Big bank provides services to smaller banks
2866	Becoming less important as markets become more sophisticated
2867
2868Loan Sales
2869	Loan sale - Sale of a loan originated by a bank with or without recourse
2870		Recourse - ability of a loan buyer to sell the loan back to the originator in case it goes bad
2871	Types of loan sale contracts
2872		Participation in a loan is the act of buying a share in a loan syndication with limited contractual 			control and rights over the borrower
2873		Assignment is the purchase of a share in a loan syndication with some contractual control and rights 		over the borrower
2874	Traditional short-term loan sales
2875		Secured by assets of the borrower
2876		Borrowers are investment grade
2877		Original maturities 90 days or less
2878		Sold in units of $1 million+
2879		Loan rates are closely tied to commercial paper rates
2880	HLT loan sales
2881		secured by assets of borrower
2882		original maturity of 3-6 years
2883		Interest rates are floating
2884		Have strong covenant protection
2885		May be distressed or nondistressed
2886	LDC loan sales
2887		LDC loans are loans made to less developed countries
2888	Factors encouraging future loan sales growth
2889		Fee income from originating loans is reported as current income, while interest earned on the loans 		is reported only when received in future periods
2890		Liquidity risk: creating a second market for loans reduces the illiquidity of loans held as assets
2891		Capital costs: regulatory capital ratios can be increased by reducing the overall size of the balance 		sheet
2892		Reserve requirements: reducing the overall size of the balance sheet can reduce the amount of 			reserves a bank must hold against its deposits
2893	Factors discouraging future loan sales growth
2894		Access to commercial paper (CP) market: many firms now rely on CP rather than bank loans
2895		Legal concerns such as fraudulent conveyance
2896
2897Loan Buyers
2898	Loan buyers
2899		Investment banks are predominant buyers of HLT loans
2900			Adept at the analysis required to value these types of loans
2901			Often are closely associated with the HLT borrower
2902		Vulture funds are specialized funds that invest in distressed loans
2903		Other domestic banks
2904			Traditional correspondent relationships are breaking down as markets get more competitive
2905			Counterparty risk and moral hazard have increased
2906			Barriers to nationwide banking have eroded and fewer smaller banks exist now than in the 			past
2907		Foreign banks - dominant buyer of US bank loans
2908		Insurance companies and pension funds buy long-term loans
2909		Closed-end bank loan mutual funds - buy US bank loans
2910		Nonfinancial corporations: predominantly financial service arms of the very largest companies
2911	Loan Sellers
2912		Money center banks - dominate loan sales
2913		Small regional or community banks sell loans to diversify community risks
2914		Foreign banks
2915		Investment banks and hedge funds sell HLT loans
2916		US govt and agencies
2917
2918LDC Debt
2919	In recent years three market segments of sovereign debt have emerged
2920		Sovereign bonds (government issued debt)
2921		Performing loans - sovereign loans that are collecting interest and principal
2922		Deep discount nonperforming loans which are sovereign loans that are not currently collecting 			interest and principal
2923	LDC loan-for-bond restructuring programs are called debt-for-debt swaps
2924		Developed under the US Treasury Brady Plan and under organizations such as the international 			monetary fund IMF
2925			A Brady Bond is a bond that is swapped for an outstanding loan to an LDC
2926		Once FIs loans are swapped for bonds, the bonds can be sold in the secondary market
2927	LDC bonds
2928		have much longer maturities than that have promised on the original loans
2929		have lower promised original coupons (yields) than the interest rates on the original loans
2930	
2931Loan Securitization
2932	Securitization - process of transforming loans (or other debt instruments) into marketable securities
2933	About 50-60% of single family mortgages are securitized
2934	Pass-through mortgage securities "pass-through" promised payments by households of principal and 	interest on pools of mortgages created by FIs to secondary market investors holding an interest in these 	pools
2935		Each pass-through security represents a fractional ownership in a mortgage pool
2936		Pass-through securitization was original developed by government-sponsored programs to enhance 		the liquidity of residential mortgages
2937			Ginnie Mae (GNMA)
2938			Fannie Mae (FNMA)
2939			Freddie Mac (FHLMC)
2940
2941GNMA Pass-Through Security Creation
2942	Suppose 1000 mortgages for $100,000 each are originated by an FI
2943	As a result of the mortgages (and from having to fund the mortgages with deposits)
2944		The FI faces the regulatory burden of capital requirements, reserve requirements, and FDIC 			insurance premiums
2945		The FI is exposed to interest rate risk and liquidity risk
2946	The FI can avoid regulatory burden and risk exposure by securitizing the loans and thus removing them 	from the balance sheet
2947		1.	Loans are packaged together into a mortgage pool
2948		2.	Mortgage pool is removed from the balance sheet by placing it with a third-party trustee
2949		3.	GNMA guarantees, for a fee, the timing of interest and principal payments associated with 			pool of mortgages
2950		4.	The FI continues to service the pool of mortgages, for a fee, even after the mortgages are 				placed in trust
2951		5.	GNMA issues pass-through securities backed by the mortgage pool
2952		6.	Securities are sold to outside investors and the proceeds go to the originating FI
2953
2954Prepayment Risk
2955	Most mortgages are fully amortized
2956		Full amortization is the equal, periodic repayment on a loan that reflects part interest and part 			principal over the life of a loan
2957	Most mortgages are paid off prior to maturity because borrowers move or refinance their mortgages
2958		To prepay is to pay back a loan before its maturity
2959		Thus realized cash flows can deviate from expected cash flows
2960
2961Creation of a Three-Class CMO
2962	CMOs are usually created by placing existing pass-through securities in a trust off-the-balance sheet
2963	The trust issues three different classes, each with a different level of prepayment risk
2964		Class A - CMO holders have the leas prepayment protection as all principal prepayments are first 		paid to this tranche until they have been paid off in full
2965			After all Class A are paid, Class B receive principal prepayment cash flows
2966		Class B - receive payment after all Class A have been retired
2967		Class C - has the most prepayment protection as they are last tranche to receive principal payments
2968		Each class also receives regular coupon (interest) payments
2969
2970Collateralized Mortgage Obligations
2971	Collateralized Mortgage Obligations CMOs are mortgage-backed securities issued in multiple classes or 	tranches to provide prepayment protection
2972		In a 'sequential pay CMO' tranches are differentiated by the order in which each class is paid off
2973		Each class has a guaranteed coupon payment buy prepayment of principal occurs sequentially to 			only one class of bondholder at a time
2974			Thus some classes of bondholders are more protected against prepayment risk than others
2975	Sum of prices at which CMO classes can be sold normally exceeds that of the original pass-through
2976		CMOs restructured prepayment risk makes each class more attractive to specific classes of investors
2977		CMOs with up to 17 different classes have been created
2978	CMOs often contain a Z-class that accrues, but does not pay interest (or principal) until all other classes 	that have been fully retired
2979	Another special CMO class is a Planned Amoritzation Class PAC
2980		Produces a constant cash flow within a band of prepayment rates
2981		Offers greater predictability of cash flows
2982		Has priority in receiving principal payments
2983	Most CMOs today are created as real estate mortgage investment conduits (REMICs)
2984		REMICs pass-through all interest and principal payments before taxes are levied
2985	Mortgage pass-through strips are a special type of CMO with only two classes
2986		Principal component of the pass-through is separated from the interest component
2987			Interest only IO strip is a CMO with claim to the interest
2988			Principal only PO strip is a CMO with claim to the principal
2989	Special features of IO strips
2990		When prepayment occurs
2991			The amount of interest payments the IO investor receives falls as the outstanding principal 			in the mortgage pool falls
2992			The number of interest payments the IO investor receives may also shrink
2993		Because the values of IO strips can fall when interest rates decline, IO strips are a rare security with 		negative convexity
2994			This unique feature makes IO strips useful as a portfolio-hedging device
2995
2996Mortgage Backed Bonds
2997	MBBs are bonds collateralized by a pool of mortgages
2998		MBBs differ from pass-throughs and CMOs
2999			Mortgages remain on the balance sheet
3000			Mortgages collateralize MBBs but are not directly related to the associated cash flows
3001		FIs usually back MBBs with excess collateral, which results in a higher investment rating for the 			MBB than for the issuing FI
3002		MBB costs
3003			MBBs tie up mortgages on the balance sheet for long periods of time
3004			FI is subject to prepayment risk on the underlying mortgages
3005			FI continues to face capital adequacy and reserve requirement taxes as the mortgages remain 			on the balance sheet
3006
3007Securitization of Other Assets
3008	The same securitization techniques applied to mortgages have been used to securitize other assets:
3009		Automobile loans
3010		Credit card receivables (CARDs)
3011		Small Business Administration guaranteed small business loans
3012		Commercial and industrial loans
3013		Student loans
3014		Equipment loans
3015		Junk bonds
3016		Time share loans
3017		Adjustable-rate mortgages
3018
3019Collateralized Debt Obligations CDOs
3020	The CDO originator purchases a pool of assets and using the pool as collateral, issues different claims or 	'tranches' to CDO investors
3021		Tranches have different levels of security
3022		Senior tranches often had AAA ratings but were collateralized by mortgage-backed securities that 		turned out to be riskier than believed
3023		When mortgage markets collapsed, CDO claims could not be paid and tranche holders expected the 		CDO issuer, such as a bank, to continue to pay
3024		Many CDOs failed during the crisis and issuance fell from over $500 billion per year to around $8 		billion in 2010
3025		If the primary assets are loans, the structure is termed a collateralized loan obligation CLO
3026
3027Costs and Benefits of Securitization (24-36 add)
3028
3029Final Words on Securization & Derivatives
3030	Using CDOs allowed banks to create more mortgages overall and more poorer credit quality
3031	As found out 07-08 banks still had responsibility for these mortgages, even though they were not required to hold capital to back them since they had been shifted off the balance sheet (now changed)
3032	Derivatives and securitization undoubtly made the financial crisis of 07-09 worse than it would have been otherwise and regulators and bank boards probably did not understand the risks involved
3033
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3062Chapter 18 - Pension Funds
3063Pension Funds
3064	Pension Funds PFs offer savings plans through which participants accumulate tax deferred savings during their working years before withdrawing them in their retirement years
3065		Earnings on funds invested are excempt from current taxation (during working years)
3066		tax payments are not made until funds are withdrawn by participant (during retirement)
3067	PFs were first established in the US in 1759 to benefit widows/children of church ministers
3068	First corporate PF was American Express Co in 1875
3069	40s around 400 pfs existed (railroad, banking, public utilities)
3070	2013 - over 680,000 pfs exist
3071		34% of US households financial assets were PFs
3072		compared to 5% in 1950
3073	Financial crisis reduced global pension from $25 trillion to $20 trillion
3074		US retirement fell by $2 trillion causing many to postpone retirement and reduce spending
3075	Two distinct PF sectors
3076		Private PFs are funds administered by private corporations (insurance companies or mutual funds)
3077			Total financial assets 13 were $10423.8 billion
3078		Public PFs are funds administered by federal, state, or local governments (social security)
3079			Total financial assets 13 were $8312.8 billion
3080	Pension plan governs operation of pension fund
3081	Pension funds broadly classified into two categories:
3082		Definied Benefit plans - fund in which employer agrees to provide employee with a specific cash 		benefit upon retirement
3083			Flat benefit formula - PF pays a flat amount for every year of employment
3084				Flat benefit x # of years
3085			Career average formula - PF pays benefits based on employee average salary over entire 				period of employment
3086				Flat percentage of average
3087					Average salary over entire career x 60% average
3088				Flat percentage 4% average adjusted by years of service
3089					Average salary over entire career x 0.04 x number of years
3090			Final pay formula - PF pays benefits based on percentage of average salary during specified 			number of years at end of employee's career times number of years of service
3091				Variant: figure benefit based on percentage of average salary during specified 					number of years when employees earnings were highest times number years of 					service
3092				Flat percentage of 4% of last 5 years
3093					Final salary over last years x 0.04 x # of years
3094			Fully funded PF has sufficient funds available to meet all expected future payment 				obligations based on actuarial projections
3095			Underfunded PF does not have sufficient funds available to meet all future promised 				payments
3096			Overfunded PF has more than enough funds available to meet required future payouts
3097		Defined Contribution: PF is a fund which the employer agrees to make a specified contribution to 		the pension fund during the employee's working years
3098			fixed-income funds offer guaranteed rate of return
3099			variable-income funds- all profits and losses on underlying securities are passed through to 			the fund participants
3100			the PF shifts investment risk from employer to employee
3101				Most DC plans allow employee to select mix of investments
3102					Mutual funds allow for diversification
3103					Many require employer contribution to be invested in company stock 						(diversification risk)
3104				Requires investment sophistication most people do not have
3105Pension Fund Administration
3106	Pension funds may be insured or noninsured
3107		Insured pension fund is administered by life insurance company
3108		noninsured pension is administerd by some other type of financial institution
3109	Private pension funds are created by private entities and administered by private corporations
3110		$10423.8 billion in totoal financial assets in 2013
3111	
3112Private Pension Funds
3113	401k and 403b plans are employer-sponsored plans that supplement a firm's basic retirement plan
3114		allow for both employer and employee contributions
3115		401k plans offered to employees of taxable firms
3116		403b plans offered to employees of tax exempt employers
3117		contributions are made on a pretax basis
3118		most plans transferable if employee changes jobs
3119		participants generally make their choice of the allocation of assets from both employee and 			employer contributions	
3120			young participants generally invest more in equitiyies while older participants generally 				invest more in fixed-income securities
3121
3122Calculating Return on 401k
3123	Employee gross contributution 1 = Salary * contribution
3124	Tax savings 2 = 1 * tax bracket %
3125	3 Employee net of tax contribution = 1 - 2
3126	Employer contribution 4 = Salary * company match * of first x%
3127	5 Total 401k plan investment at year start = 1 + 4
3128	One-year earnings = 5 * rate of return%
3129	7 total 401k investment at year-end = 1 + 4 + 6
3130	8 employee's one year return = (7 - 3)/3
3131	401k worth when retired = 5{[1+rate of return)^ years) - 1]/rate of return}
3132	Employee net of tax contributions = 3 * years
3133
3134Effect of Asset Allocation ADD SLIDE 18-21/22
3135
3136IRAs
3137	Individual retirement accounts IRAs are self directed retirement accounts set-up by employees who may 	also be covered by employer-sponsored pension plans
3138		contributions are made strictly by employee
3139		first introd in 81 to supplement employer-sponsored programs
3140		2013- max contributon 5500 per year
3141	Roth IRAs introd in 98
3142		08 max 5500 yearly contribution per individual
3143		contributions are taxed in the year of contributions while withdrawals are tax-free asl ong as tehy 		have been invested at least five years and account holders if 59 1/2 years old
3144		income test for availability
3145Pension funding problem 12-28 slide
3146Public Pension Funds
3147	State/local government pension funds
3148		"pay as you go" in the current employee contributions fund current retiree benefits
3149		because of an increasing number of retirees relative to workers, some funds current payments 			exceed current contributions
3150	Federal government pension funds
3151		Civil service funds cover all federal employees not in armed forces
3152			such employees not covered by social security
3153		Military pension fund covers career military personnel
3154			military personnel are also covered by social security
3155			military personnel are eligible after 20 years of military service
3156	Social security aka Old Age and Survivors Insurance Fund
3157		provides benefits to almost all employees and self-employed individuals in the US
3158		established 1935 provide minimum level of retirement income to all retirees
3159		funded on a "pay as you go" basis
3160		historically contributions have exceeded disbursements
3161			FICA contributions are 7.65% of the fire $115,500 earned in 2013 (matched by employer 				contribution of 7.65%)
3162			Self-employed individuals pay full 15.30%
3163		Social security disbursements exceeded contributions first time in 2010
3164			Excess contributions placed in social security trust fund
3165			system expected to run out by 2034 (benefits reduced)
3166		Contributions are invested in low risk and low-return US treasury securities
3167			coupled with slow population growth and increasing retirement, long-term viability of social 			security is in question
3168		Social security restructured in mid 90s
3169			Required contributions increased
3170			Benefits decreased
3171				Full retirement aged increased to 67 people born after 1959
3172				Dollar amount of income subject to FICA increases every year
3173			Future changes to Social Security slow to occur
3174				increasing contributions/decreasing benefits are unpopular with public
3175				economic downturn in the US has shifted spotlight away from SS
3176
3177Pension Fund Regulation
3178	Employee Retirement Security Act ERISA 1974 - focuses on 5 areas of reform
3179		Pension plan funding
3180			Prior to ERISA, regulation did not require PFs to be adequately funded
3181			ERISA established guidelines for funding and set penalties for fund deficiencies
3182				contributions must be sufficient to meet all annual costs and expenses
3183				PFs must fund any unfunded historical liabilities over 30 year period
3184				any new underfunding must be funded over 15-year period
3185		Vesting of benefits
3186			Vested employee is an employee who is eligible to receive pension benefits because he or 			she has worked for a stated period of time
3187				prior to ERISA, vesting could take 25 years
3188				ERISA set maximum of 10 years
3189		Fiduciary responsibilities of fund administrators
3190			PF fiduciary is a trustee or investment advisor that manages a PF
3191			ERISA requires that PF contributions be invested with the same diligence, skill, and 				care as a "prudent person"
3192			sole objective of PF management is to provide promised benefits of plan participants		
3193		Pension fund transferability
3194			ERISA allows employees to transfer pension credits from one employer to another when 				switching jobs
3195		Pension fund insurance
3196			ERISA established Pension Benefit Guaranteed Corporation PBGC
3197				PBGC insures participants of defined benefit pension plans
3198				employers paid $1 in premiums per employee when PBGC created in 1974
3199			Due to chronic deficits the Retirement Protection Act of 94 attempted to strengthen PBGC
3200				by 2000 PBGC operated at surplus of 9.7 billion
3201			Large bankruptcies in early 2000s resulted in the agency posting a $23.3 billion deficit and a 			call for additional reform in 05
3202		Pension Protection Act of 06
3203			increased annual premiums from $19 to $30 per employee for fully funded firms, now as 				high as $49 in 2013
3204			underfunded plans now pay $9 per $1000 of underfunding
3205			gives companies 5 years to make up shortfalls in defined benefit pension plans
3206			requires companies to tell investors and employees well before plans become significantly 			underfunded
3207
3208
3209	
3210
3211
3212
3213
3214
3215
3216
3217
3218
3219
3220
3221
3222
3223
3224
3225
3226
3227
3228
3229
3230
3231
3232
3233
3234
3235
3236
3237
3238
3239FINAL FORMULA SHEET
3240Ch22
3241The change in net interest income for any given bucket i(ΔNIIi) is measured as:
3242ΔNIIi= (GAPi)ΔRi= (RSAi– RSLi)ΔRi
3243where
3244GAPi = the dollar size of the gap between the book value of rate-sensitive assets and rate-sensitive liabilities in maturity bucket i
3245ΔRi = the change in the level of interest ratesimpacting assets and liabilities in the ith maturity bucket
3246
3247Common cumulative gap of interest to commercial bank managers is the one-year repricing gap estimate
3248ΔNII = (ΣRSAi - (ΣRSLi) ΔRi
3249where ΔNII is the cumulative change in net interest income from all rate-sensitive assets and liabilities that are repriced within a year given a change in interest rates ΔRi
3250
3251Bank balance sheet/repricing gap
3252Assets = Cash and due from + short-term consumer loans (1yr) + long-term consumer loans (2yr) + 3mo t bills + 6mo t notes + 3y t bonds + 10yr fixed-rate mortgages + 30yr floating-rate mortgaes + premises
3253Liabilities = 2yr time deposits + demand deposits + passbook savings + 3mo CDs + 3mo banker acceptances + 6mo commercial paper + 1yr time deposits + equity capital
3254
3255The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change
3256ΔNIIi= (RSAi x ΔRRSA) – (RSLi x ΔRRSL)
3257
3258Duration - measures interest rate sensitivity of an asset or liability's value to small changes in interest rates
3259D = - %Δ in the market value of a security / (ΔR / (1+R))
3260Duration for a fixed-income security that pays interest annually
3261Dur = {[(CFt x t) / (1+r)^t ]  / P0 } = (PVt x t) / P0
3262P0= Current price of the security
3263t= 1 to T, the period in which a cash flow is received
3264T= the number of years to maturity
3265CFt= cash flow received at end of period t
3266r= yield to maturity or required rate of return
3267PVt= present value of cash flow received at end of period t
3268
3269Duration Model
3270Change in market value of asset portfolio for change in interest rates
3271ΔA = A x (-Da) x (ΔR / (1+R)
3272Change in market value of liability portfolio for change in interest rates
3273ΔL = L x (-Dl) x (ΔR / (1+R)
3274
3275A = L + E   ->  ΔA = ΔL + ΔE
3276Change in net worth = ΔE = -(Da - kDl) x A x (ΔR / (1+R))
3277 
3278Leverage adjusted duration gap = (Da - kDl)
3279
3280ΔNet Int Inc = (RSA - RSL) (increase in interest rates)
3281
3282NII at current rates = Interest income - Intersest expense
3283Interest income = (floating rate mortgages * their current rate*) +(30yr fixed loans * their current rate)
3284Interest expense = (1 yr time deposits * current rate) + (3yr time deposits * current rate)
3285Future rates add the % to the current rate for floating rate mortgages & 1yr time deposits
3286
3287Chapter 18
3288Flat benefit pension formula = Flat amount x # of years served
3289Career average, flat % = average salary * % of average salary
3290Career average, flat% adjusted = average salary * lower% of average salary * # of years
3291Final pay = Final salary * lower% of salary * # of years
3292
3293Calculating Return on 401k
3294Employee gross contributution 1 = Salary * contribution
3295Tax savings 2 = 1 * tax bracket %
32963 Employee net of tax contribution = 1 - 2
3297Employer contribution 4 = Salary * company match * of first x%
32985 Total 401k plan investment at year start = 1 + 4
3299One-year earnings = 5 * rate of return%
33007 total 401k investment at year-end = 1 + 4 + 6
33018 employee's one year return = (7 - 3)/3
3302401k worth when retired = 5{[1+rate of return)^ years) - 1]/rate of return}
3303Employee net of tax contributions = 3 * years 
3304
3305Impact of Asset Allocation on 401k
3306(Employee Contributions + Employer Contributions) = A
3307(A(% of equities){[(1+%allocation to equity)^years) - 1]/%allocation to equity}) + (A(% of bonds){[(1+%allocation to bonds)^years) - 1]/%allocation to bonds}) + (A(% of mms){[(1+%allocation to mms)^years) - 1]/%allocation to mms})
3308
3309Annual payment = Average Salary (increased by # of retire in years) * % per year * (Current years + Retire in years)
3310
3311Total investment = Your contribution (which is salary * 401k contributions) + (employer match% * your contribution)
3312Your Contribution - Tax Savings(tax bracket * your contribution) = AT cost
3313Investment earnings = ROI * total investment
3314Value at end of year = Total investment + investment earnings
3315Emp return = (Investment earnings +employer match + tax savings) / AT cost
3316Invest at retirement = FV(ROI;Yrs to retire;-Total investment)
3317
3318Ch15
3319Annuity Monthly Payment = (Policy Amount) / [(1-(1/[(1+(r/12))^#ofmonths] / (r/12) ]
3320=PMT(InterestRate/Pmtsperyr;# of years*pmtsperyr;-Amount invested
3321
3322Loss Ratio = Losses/Premiums
3323Expense Ratio = Expenses / Premiums
3324Dividend Ratio = Dividends
3325Comb ratio aft div = Loss Ratio + Expense Ratio + Div Ratio
3326Investment Ratio = Investment Income / Premiums
3327Operating Ratio = Combined Ratio - Investment Ratio
3328Overall profitability = 1 - Operating Ratio
3329NII Required = Expenses + Losses + (Dividends * Premiums) - Premiums
3330Nii Ratio Req = NII Req / Premiums
3331
3332Min Inv Ratio = Loss Ratio + Loss Adj Ratio + (Comm/Div) - Break even
3333
3334Chapter 16
3335
3336Proceeds = Shares * price
3337Bank profits = (Price to public - price to person) * shares
3338Best Efforts Proceeds = Best Effort Sales * (Price to person - best efforts commission per sale)
3339
3340After a rate increase
3341Interest payment = (Face value / pmts pr year) * coupon % rate
3342New rate = Coupon rate % * (rate change / 10000)
3343Mkt price = =PV(NewRate/Pmtspryear;term years*pmtsperyear;-interestpayment;-Facevalue
3344Loss or gain = difference of face and new mkt price
3345
3346Chapter 23
3347
3348Capital Loss (ΔP = -D x P x (ΔR / (1+r))
3349P = initial value of asset	D = duration of asset	R = interest rate
3350ΔE=-(DA-kDL) ×A×ΔR/(1 + R)
3351ΔE = change in FI's net worth
3352Da = duration of asset portfolio
3353Dl = duration of liability
3354k = ratio of an FI's liab to assets (L/A)
3355A = assets
3356ΔR/(1+r) = shock to interest rates
3357
3358Risk-minimizing future position
3359ΔF/F = -Df * ΔR/(1+R)
3360ΔF = -Df * (ΔR / (1+R)) * F
3361ΔF = change in $ value of future contracts
3362F = dollar value
3363Df = duration of bond to be delivered
3364ΔR = expected shock to interest rates
33651+R = 1 + current interest
3366
3367Cost of CAD = Loan Amount CAD * Spot$/CAD
3368Hedged Dollar = 6 mo future $/CAD * Loan amount CAD
3369Hedged - Cost of CAD = Gain or Loss
3370Interest CAD = (Rate*LoanAmountCAD)/2
3371Interest $ = Interest CAD * 6 mo future $/CAD
3372Earnings on loan = Gain or loss + Interest$
3373ROI = Earnings on loan / (Cost of CAD * 2)
3374
3375Price of Treasuries at time = (1+/- change in treasuries) * current price of treasuries contract
3376Proceed from sale of X contracts = Current price * X
3377Purchase cost at time = X * price of treasuries at time
3378Gain/loss on future contracts = proceeds from sale - purchase cost
3379Net impact of rate rise = Gain/loss on future contract +/- change in interest expense
3380Portion of cost hedged = Gain/loss on future contract / change in interest expense
3381
3382Nf = -(Da-kDl)A/Df*Pf
3383Nf =ROUNDDOWN(-((DurationAssets-k*DurationLiabilities)*Assets/Liabilities/(Df*Pf$100 /100;0)
3384ΔE = -DGAP[DR/(1+R)]A
3385Change in E aka Gain/Loss on interest change=-DGAP*((ChangeIntRatesBP/10000)/(1+MarketIntRate))*Assets
3386ΔBond Price = -Df * (%Δif *A)
3387Change in Bond Price = -Df*((ChangeIntRatesBP/10000)/(1+If))*Pf$100*FaceofContract/100
3388k = Liabilities / assets
3389DGAP =Asset Duration-K*LiabilityDuration
3390Gain/loss on contracts = Change in Bond Price * Nf
3391Net Gain = Gain/loss on contracts + Gain/loss on interest charge
3392ΔA = -Da*(ΔR/(1+R0)*Assets)
3393ΔL = -Dl*(ΔR/(1+R0L)*Liabilities)
3394ΔE = ΔA + ΔL   	ΔE = -DurGap*Assets*(ΔR/(1+R)) 		ΔE = ΔF*Nf
3395Nf = rounddown(-ΔE/ΔF;0)	ΔF = Df*(ΔR/(1+R))*Pf*1000
3396
3397CD Interest = Deposit Value*DepositRate*(TermMonths/12)
3398CD Amount Due = CD Interest + Deposit Value
3399Bond SKr Interest = Bond Principal * (Bond Rate /2)
3400Bond SKR Due = Bond Principal + Bond SKr Interest
3401Bond with hedge$ = 6mofwd$/Skr * Bond SKr Due
3402Gain or Loss = BondwithHedge$-CDAmountDue
3403Spread/year = (GainorLoss*12/TermMos)/BondValue
34046mogain @given%ann spread = (Spread/yr given/2)  * deposit value
3405Bond Int & princ @ fwd rate = CD Amount Due + 6MoGain
3406Fwd Rate = Bond Int / Bond SKR Due
3407
3408
3409
3410Chapter 24
3411Annual interest payment = Loan rate % * Principal
3412Sale proceeds WR = PV(Disct rate recourse;termyrs;-annual interst payment;-principal)
3413Sale proceeds WOR = PV(Disct rate wo recourse;termyrs;-annual interst payment;-principal)
3414Expected proceeds = Sale prceeds WR * (1-PDefault)	If proceeds less than sale proceeds WR, sell with recourse
3415
3416Guarantee Fee = Guarantee BP / 10000
3417Servicing Fee = Servicing BP / 10000
3418Net to Investor = Coupon% - Guarantee Fee - Servicing Fee
3419Mo pmt to investor = PMT=(Nettoinvestor/12;Termyears*pmtsperyr;-Face)
3420PV of GNMA = PV(Market rate/pmtsperyear;Termyears*pmtsperyear;-Mopmttoinvestor;0)
3421
3422I&P on amort = PMT(Net to investor/12;termyrs*12;-Face/2;0)
3423Int pmt on unamort = Net to investor/Pmtperyr * Face/2
3424Mo pmt to investor (amoritzed) = I&P pmt on amort + Int Pmt on unamort
3425
3426Quarterly Payment = PMT(CouponRate/Pmtspryr;Termyrs*pmtspryr;Facevalue;0)
3427Quarterly Chart = Beginning Balance - > Int Payment - > Principal Pmt - Ending Balance (becomes new beg bal)
3428Int payment = Beginning balance * (Coupon rate / Pmts pr year)
3429Principal Pmt = Quarterly Pmt - Int pmt
3430End balance = Beg balance - Principal pmt
3431
3432Tranche 1st int pmt = (TrancheRate%/Pmtspryr)*TranchePrincipal
3433
3434Equity Funding Captital Requirement = New loans*Req Cap Asset% * Capital coverage of commercial loans (100%?)
3435Depository Funding = New loans - equity funding
3436Deposits Needed = Depository funding / (1 - reserve requirement ratio)
3437
3438Annual payment = PMT(Loan rate%;Loanratematurity;-Loan value)
3439Rate to investor = Loan rate% - (basis points / 10000)
3440Annual payment = PMT(Ratetoinvestor;Loanratematurity;-Loan value)
3441
3442Monthlypayment = PMT(LoanRate%/Pmtspryr;LoanMaturity*Pmtsperyr;-Loanvalue)
3443Yield = LoanRate%-[(GNMA basispts + Serving basispts)/10000]
3444Monthly Rate = Yield/12  Monthly payment with monthly rate replaced
3445Month 1 servicing or ins fee = (Servicing fee or ins fee/10000)/12 * Loanvalue
3446
3447Da = (Dcash*weightcash) + (D current loans * weight current loans) + (D new loan * weight new loan