Study For All

DEPOSITORY INSTITUTIONS: ACTIVITIES AND CHARACTERISTICS - Financial Institutions and Markets by Fabozzi

noreply@blogger.com (Study For All) — Thu, 27 Dec 2012 10:12:00 +0000

CHAPTER 3

DEPOSITORY INSTITUTIONS:

ACTIVITIES AND CHARACTERISTICS

ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS

These institutions seek to earn spread income, which is a positive spread or margin between the returns on their assets and the costs of their liabilities. In generating spread income, a depository institution faces several risks. These include credit risk, regulatory risk, and interest rate risk.

Interest Rate Risk

Interest rate risk or funding risk is the mismatching of assets and liabilities in terms of their maturities. For example, this can arise because the deposits are short-term and assets long term. An increase in expected interest rates will reduce the spread between the return on assets and the deposit costs. Floating rate long-term assets can reduce this problem since they make long-term assets behave like short-term funds that match deposit terms to maturity.

Liquidity Concerns

Liquidity concern is the possibility of withdrawal of funds by depositors or insufficient funds available to meet lending needs. It can be handled by: (1) attracting more deposits; (2) borrowing from federal agency or other institution (Federal Funds Market); (3) raising short-term funds in the money market; (4) selling or liquidating securities and other assets. Securities held for the purpose of satisfying net withdrawals and customer loan demands are sometimes referred to as secondary reserves.

COMMERCIAL BANKS

Today, banks are regulated and supervised by several federal and state government entities. At the federal level, supervision is undertaken by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. The assets of a bank are insured by the Federal Deposit Insurance Corporation.

As of 2d quarter 2007, 7350 commercial banks were operating in the United States. Only about 25% were national banks, but these held the majority of the bank assets (65%).

Bank Services

Banks provide numerous services and are broadly defined as follows: (1) individual banking; (2) institutional banking; (3) global banking.

Individual banking includes consumer lending, mortgage lending (mortgage banking), credit card financing, brokerage services, student loans, and individual-oriented financial investment services. Institutional banking Institutional banking includes commercial real estate financing, leasing activities, and factoring. Global banking includes corporate financing, capital market and foreign exchange products and services. At one time, some of these activities were restricted by the Glass-Steagall Act. But this statute was repealed by the Gramm-Leach-Bliley Act in November 1999.

Bank Funding

Funds are obtained mainly from three sources: (1) deposits, (2) nondeposit, (3) common stock and retained earnings.

Deposits: There are several types of deposit accounts. Demand deposits (checking) pay no interest and can be withdrawn upon demand. Savings deposits pay interest, typically below market rates, and can be withdrawn upon demand. Time deposits, also called certificates of deposit, have a fixed maturity date and pay either a fixed or floating interest rate. The market for short-term debt obligations is called money market. A money market demand account is designed to compete with money market mutual funds.

Reserve requirements and borrowing in the federal funds market: The reserve ratio is the specified percentage of deposits in non-interest bearing account at one of the 12 Federal Reserve Banks that a bank must maintain. The dollar amount based on the reserve ratio is the required reserve. To determine the reserve, the Federal Reserve has established a two-week period called the deposit computation period. If actual reserves exceed required reserves, the difference is referred to as excess reserves. Banks temporarily short of their required reserves can borrow reserves from banks that have excess reserves. The market where banks can borrow or lend reserves is called the federal funds market. The interest rate charged to borrow funds is called the federal funds rate.

Borrowing at the Fed discount window: The Federal Reserve is the bank of last resort. Banks temporarily short of funds can borrow from the Fed at its discount window. Collateral is needed to borrow, and the Fed sets the criteria for collateral quality. The interest rate that the Fed charges to borrow funds at the discount window is called the discount rate.

Other nondeposit borrowing: Other nondeposit borrowing can be short term in the form of issuing obligations in the money market, or intermediate to long term in the form of issuing securities in the bond market. Banks that raise most of their funds from the domestic and international money markets, relying less on depositors for funds, are called money center banks. A regional bank is one that relies primarily on deposits for funding.

Capital Requirements for Banks

Commercial banks are typically highly leveraged, i.e., equity constitutes a small fraction (about 8%) of the bank’s assets. The organization that plays the primary role in establishing risk and management guidelines for banks throughout the world is the Basel Committee on Banking Supervision. The capital requirements that resulted from other guidelines published by the Basel Committee are called the risk-based capital requirements. In July 1988, the Basel Committee released its first guidelines, the Capital Accord of 1988, commonly called Basel I Framework. In June 2004, comprehensive amendments, Basel II Framework, were published to improve on the rules as set forth in the Basel I Framework by bringing risk-based capital requirements more in line with the underlying risks to which banks are exposed.

Credit risk and risk-based capital requirements: The risk-based capital guidelines attempt to recognize credit risk by segmenting and weighting requirements. First, capital is categorized as Tier 1 and Tier 2 capital. Tier 1 is the core capital. Tier 2 is the supplementary capital. Second, the guidelines establish a credit risk weight for all assets.

SAVINGS AND LOAN ASSOCIATIONS

S&Ls originated to gather savings and pool depositor funds to finance home mortgages. They are either mutually owned (by the depositor themselves) or stockholder-owned (thereby making the depositors creditors of the firm). They are state or federally chartered, and they are regulated by the Office of Thrift Supervision (OTS). As in the case of banks, their deposits are insured, but by the Savings Association Insurance Fund (run by the FDIC). Traditionally, most S&L assets have been in home mortgages, the long-term nature of which insulated the S&Ls from interest rate risk for many years. Since the early 1980s, however, they have made several other types of loans and investments to some degree they compete with banks. Their funding has traditionally come from several forms of savings accounts, such as NOW, MMDA, and time deposits. Deregulation in the 1980s forced higher funding costs upon them.

Assets

Traditionally, the only assets in which S&Ls were allowed to invest have been mortgages, mortgage-backed securities, and US government securities. S&Ls became one of the major buyers of junk bonds. Under FIRREA, S&Ls are no longer permitted to invest new money in junk bonds.

Funding

Deregulation expanded the types of accounts that may be offered by S&Ls: negotiable order of withdrawal (NOW) accounts, and money deposit accounts (MMDA). S&Ls can raise funds from the money market. They can borrow in the federal funds market and have access to the Fed’s discount window. They also can borrow from the Federal Home Loan Banks. These borrowings are called advances, which can be short term or longterm in maturity.

Regulation

Federal S&Ls are chartered under the provisions of the Home Owners Loan Act of 1933. Federally chartered S&Ls are supervised by the Office of Thrift Supervisor. The Depository Institutions Deregulation and Monetary Control Act of 1980 deregulated interest rates on deposit accounts. It also expanded the Fed’s control over the money supply by imposing deposit reserve requirements on S&Ls. Subsequent legislation not only granted thrifts the right to offer money market demand accounts, but also broadened the types of assets in which S&Ls could invest. Permission to raise funds in the money market and the bond market was granted by the Federal Home Loan Board in 1975.

There are two sets of capital adequacy standards for S&Ls as for banks. The risk-based capital guidelines are similar to those for banks. Instead of two tiers of capital, there are three: Tier 1 (tangible capital), Tier 2 (core capital), and Tier 3 (supplementary capital). As with commercial banks, there are risk-based requirements based on interest rate risk.

The S&L Crisis

During the 1980’s, many savings and loans failed or became technically insolvent. Deposit insurance funds ran dry and federal help was needed to clean up the mess and help the depositors. Several factors contributed to the crisis, but the following causes were most apparent:

1. Disintermediation: as short-term interest rates rose in the money market depositors withdrew their low-yield funds for higher-yield market investments such as MMDAs. Because of interest rate restrictions the S&Ls could not compete for such funds.

2. Deregulation in the early 1980s lifted interest also rate restrictions, allowing S&Ls to compete in the marketplace for short-term funds. But their long-term asset structure its predominantly fixed-rate returns limited the cost increases for liabilities that S&Ls could afford. Moreover, after years of being in a safe market niche of home mortgages S&Ls suddenly found they had to compete directly with banks for funds and asset allocations. Many such savings institutions were simply not up to the task.

3. Faced with rising liability costs, many S&Ls went after high return, high risk assets, such as commercial real estate and junk bonds. Such high default risk projects were undertaken prior to an economic downturn. The result was depressed regions of the Southwest, compounded by the fact that for a number of years, regulators did little to ameliorate the problem. A major and costly bailout occurred in the early 1990s. The Resolution Trust Corporation (RTC) was established in the FIRREA Act of 1989 and assigned the task to sell off the assets of the failed institutions.

SAVINGS BANKS

These financial institutions are similar to S&Ls in some respects. They are either mutually- or stockholder-owned and are either federally- or state-chartered. But their asset portfolio is more diversified given that their origin was primarily as a place for small deposits at a time when banks showed little interest in taking small customer accounts. Yet, residential mortgages now constitute a large part of their portfolio. These institutions have not necessarily been immune from the factors that caused the S&L crisis. But as a group they came out better because they were predominantly on the East Coast and had more diversified asset portfolios.

CREDIT UNIONS

Credit unions are the smallest and newest of the financial depositories. They are either state- or federally-chartered. But they are mutual in organization. They exist for their members’ savings and borrowing needs. The shares (deposits) are insured. Deposits from members are by far their major source of funds, but they can borrow for short-term liquidity needs. Their assets consist primarily of small consumer loans made to their members. Time has been hard on them lately, since their borrowing and lending activities are effectively restricted to their membership bases. But their shorter-term and less risky loan portfolios have helped them to avoid the S&L crisis.

Since 1970, the shares of all federally chartered credit unions have been insured by the National Credit Union Share Insurance Fund (NCUSIF) for up to $100,000 and $250,000 for retirement accounts, the same as for commercial banks. The principal federal regulatory agency is the National Credit Union Administration (NCUA). Playing a role similar to the Fed, the lender of last resort is the Central Liquidity Facility (CLF). Credit unions can make investments in corporate credit unions. Federal and state chartered credit unions are called natural person credit unions because they provide financial services to qualifying members of the general public. Corporate credit unions provide a variety of services only to national person credit unions.

ANSWERS TO QUESTIONS FOR CHAPTER 3

(Questions are in bold print followed by answers.)

1. Explain the ways in which a depository institution can accommodate withdrawal and loan demand.

A depository institution can accommodate loan and withdrawal demands first by having sufficient cash on hand. In addition it can attract more deposits, borrow from the Fed or other banks, and liquidate some of its other assets.

2. Why do you think a debt instrument whose interest rate is changed periodically based on some market interest rate would be more suitable for a depository institution than a long-term debt instrument with a fixed interest rate?

This question refers to asset-liability management by a depository institution. An adjustable rate can eliminate or minimize the mismatch of maturity risk. As interest rates rise, the institution would have to pay more for deposits, but would also receive higher payments from its loan.

3. What is meant by:

a. individual banking

b. institutional banking

c. global banking

a. Individual banking is retail or consumer banking. Such a bank emphasizes individual deposits, consumer loans and personal financial trust services.

b. An institutional bank caters more to commercial, industrial and government customers. It issues deposits to them and tries to meet their loan needs.

c. A global bank encompasses many financial services for both domestic and foreign customers. It is much involved in foreign exchange trading as well as the financial of international trade and investment.

a. What is the Basel Committee for Bank Supervision?

b. What do the two frameworks, Basel I and Basel II, published by the Basel Committee for Bank Supervision, address regarding banking?

a. It is the organization that plays the primary role in establishing risk and management guidelines for banks throughout the world.

b. The frameworks set forth minimum capital requirements and standards.

5. Explain each of the following:

a. reserve ratio

b. required reserves

a. The reserve ratio is the percentage of deposits a bank must keep in a non-interest-bearing account at the Fed.

b. Required reserves are the actual dollar amounts based on a given reserve ratio.

6. Explain each of the following types of deposit accounts:

a. demand deposit

b. certificate of deposit

c. money market demand account

a. Demand deposits (checking accounts) do not pay interest and can be withdrawn at any time (upon demand).

b. Certificates of Deposit (CDs) are time deposits which pay a fixed or variable rate of interest over a specified term to maturity. They cannot be withdrawn prior to maturity without a substantial penalty. negotiable CDs (large business deposits) can be traded so that the original owner still obtains liquidity when needed.

c. Money Market Demand Accounts (MMDAs) are basically demand or checking accounts that pay interest. Minimum amounts must be maintained in these accounts so that at least a 7-day interest can be paid. Since many persons find it not possible to maintain this minimum (usually around $2500) there are still plenty of takers for the non-interest-bearing demand deposits.

7. How did the Glass-Steagall Act impact the operations of a bank?

The Glass-Steagall Act prohibited banks from carrying out certain activities in the securities markets, which are principal investment banking activities. It also prohibited banks from engaging in insurance activities.

8. The following is the book value of the assets of a bank:

Asset	Book Value (in millions)
U.S. Treasury securities	$ 50
Municipal general obligation bonds	50
Residential mortgages	400
Commercial loans	200
Total book value	$700

a. Calculate the credit risk-weighted assets using the following information:

Asset	Risk Weight
U.S. Treasury securities	0%
Municipal general obligation bonds	20
Residential mortgages	50
Commercial loans	100

b. What is the minimum core capital requirement?

c. What is the minimum total capital requirement?

a. The risk weighted assets would be $410

	BV	Weight	Product
US T Sec.	$50	0%	0
MB	50	20%	10
RM	400	50%	200
CL	200	100%	200
Total	700		410

b. The minimum core capital is $28 million (.04X700) i.e., 4% of book value.

c. Minimum total capital (core plus supplementary capital) is 32.8 million, .08X410, which is 8% of the risk-weighted assets.

9. In later chapters, we will discuss a measure called duration. Duration is a measure of the sensitivity of an asset or a liability to a change in interest rates. Why would bank management want to know the duration of its assets and liabilities?

a. Duration is a measure of the approximate change in the value of an asset for a 1% change in interest rates.

b. If an asset has a duration of 5, then the portfolio’s value will change by approximately 5% if interest rate changes by 100 basis points.

10.

a. Explain how bank regulators have incorporated interest risk into capital requirements.

b. Explain how S&L regulators have incorporated interest rate risk into capital requirements.

a. The FDIC Improvement Act of 1991, required regulators of DI to incorporate interest rate risk into capital requirements. It is based on measuring interest rate sensitivity of the assets and liabilities of the bank.

b. The OST adopted a regulation that incorporates interest rate risk for S&L. It specifies that if thrift has greater interest rate risk exposure, there would be a deduction of its risk-based capital. The risk is specified as a decline in net profit value as a result of 2% change in market interest rate.

11. When the manager of a bank’s portfolio of securities considers alternative investments, she is also concerned about the risk weight assigned to the security. Why?

The Basel guidelines give weight to the credit risk of various instruments. These weights are 0%, 20%, 50% and 100%. The book value of the asset is multiplied by the credit risk weights to determine the amount of core and supplementary capital that the bank will need to support that asset.

12. You and a friend are discussing the savings and loan crisis. She states that “the whole mess started in the early 1980s.When short-term rates skyrocketed, S&Ls got killed—their spread income went from positive to negative. They were borrowing short and lending long.”

a. What does she mean by “borrowing short and lending long”?

b. Are higher or lower interest rates beneficial to an institution that borrows short and lends long?

a. In this context, borrowing short and lending long refers to the balance sheet structure of S&Ls. Their sources of funds (liabilities) are short-term (mainly deposits) and their uses (assets) are long-term in nature (e.g. residential mortgages).

b. Since long-term rates tend to be higher than short-term ones, stable interest rates would be the best situation. However, rising interest rates would increase the cost of funds for S&Ls without fully compensating higher returns on assets. Hence a decline in interest rate spread or margin. Thus lower rates, having an opposite effect, would be more beneficial.

13. Consider this headline from the New York Times of March 26, 1933: “Bankers will fight Deposit Guarantees.” In this article, it is stated that bankers argue that deposit guarantees will encourage bad banking. Explain why.

The barrier imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach Bliley Act of 1999. This act modified parts of the BHC Act so as to permit affiliations between banks and insurance underwriters. It created a new financial holding company, which is authorized to engage in underwriting and selling securities. The act preserved the right of state to regulate insurance activities, but prohibits state actions that have would adversely affected bank-affiliated firms from selling insurance on an equal basis with other insurance agents.

14. How did the Gramm-Leach-Bliley Act of 1999 expand the activities permitted by banks?

a. Deposit insurance provides a safety net and can thus make depositors indifferent to the soundness of the depository recipients of their funds. With depositors exercising little discipline through the cost of deposits, the incentive of some banks owners to control risk-taking accrue to the owners. It becomes a “heads I win, tails you lose” situation.

b. One the positive side, deposit insurance provides a comfort to depositors and thus attracts depositors to financial institutions. But such insurance carries a moral hazard, it can be costly and, unless premiums are risk-based, it forces the very sound banks to subsidize the very risky ones.

15. The following quotation is from the October 29, 1990 issue of Corporate Financing Week:

Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming the last major consumer bank to plan to access the growing market, Street asset-backed officials

Said…Asset-backed offerings enable banks to remove credit card or other loan receivables from their balance sheets, which helps them comply with capital requirements.

a. What capital requirements is this article referring to?

b. Explain why asset securitization reduces capital requirements.

a. The capital requirements mentioned are risk based capital as specified under the Basel Agreement, which forces banks to hold minimum amounts of equity against risk-based assets.

b. Securitization effectively eliminates high risk based loans from the balance sheet. The capital requirements in the case of asset securitization are lower than for a straight loan.

16. Comment on this statement: The risk-based guidelines for commercial banks attempt to gauge the interest rate risk associated with a bank’s balance sheet.

This statement is incorrect. The risk-based capital guidelines deal with credit risk, not interest-rate risk, which is the risk of adverse changes of interest rates on the portfolio position.

17.

a. What is the primary asset in which savings and loan associations invest?

b. Why were banks in a better position than savings and loan associations to weather rising interest rates?

a. Savings and Loans invest primarily in residential mortgages.

b. During 1980's, although banks also suffered from the effects of deregulation and rising interest rates, relatively they were in a better position than S&L association because of their superior asset-liability management.

18. What federal agency regulates the activities of credit unions?

The principal federal regulatory agency is the National Credit Union Administration.

FINANCIAL INSTITUTIONS, FINANCIAL INTERMEDIARIES, AND ASSET MANAGEMENT FIRMS - Financial Institutions and Markets by Fabozzi

noreply@blogger.com (Study For All) — Thu, 27 Dec 2012 10:11:00 +0000

CHAPTER 2

FINANCIAL INSTITUTIONS,

FINANCIAL INTERMEDIARIES,

AND ASSET MANAGEMENT FIRMS

FINANCIAL INSTITUTIONS

Financial institutions perform several important services:

1. Transforming financial assets acquired through the market and constituting them into a different, and more widely preferable, type of asset, which becomes their liability. This is the function performed by financial intermediaries.

2. Exchange financial assets for their customers, typically a function of brokers and dealers.

3. Exchange financial assets for their own account.

4. Create financial assets for their customers and sell them to other market participants—the underwriter this role.

5. Give investment advice to others and manage portfolios of customers.

6. Managing the portfolio of other market participants.

Financial intermediaries including depository institutions, which acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits, insurance companies, pension funds, and finance companies.

ROLE OF FINANCIAL INTERMEDIARIES

Intermediaries obtain funds from customers and invest these funds. Such a role is called direct investment. Customers who give their funds to the intermediaries and who thereby hold claims on these institutions are making indirect investments. A commercial bank accepts deposits and uses the proceeds to lend funds. Financial intermediaries, such as investment companies, play a basic role of transforming financial assets which are less desirable for a large part of the public into other financial assets which are broadly preferred by the public. By doing so they provide at least one of the following four economic functions: (1) providing maturity intermediation, (2) reducing risk via diversification, (3) reducing costs of contracting and information process, (4) providing a payment mechanism.

Maturity Intermediation

The customer (depositor) often wants only a short-term claim, which the intermediary can turn into a claim on long-term assets. In other words, the intermediary is willing and able to handle the liquidity risk more readily than the customer. This is called maturity intermediation.

Risk Reduction Via Diversification

By pooling funds from many customers the financial intermediary can better achieve diversification of its portfolio than its customers.

Reduced Costs of Contracting and Information Processing

Financial institutions provide expert analysis, better data access, and loan enforcement. Costs of writing loan contracts are referred to as contracting costs. Also there are information processing costs. They also benefit from economies of scale.

Providing a Payments Mechanism

Financial depositories provide a payment mechanism, e.g. checking accounts, credit cards, certainty debt cards, and electronic transfers of funds.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

All intermediaries face asset/liability management problems. The nature of the liabilities dictates the investment strategy a financial institution will pursue.

Nature of Liabilities

The liabilities of a financial institution mean the amount and time of the cash outlays that must be made to satisfy the contractual terms of the obligations issued. These liabilities can be categorized into four types.

Type I Liabilities: Both amounts of cash outflows and timing are known, e.g., fixed-rate certificates of deposit and guaranteed investment contracts. The former are among liabilities of financial depositories. Life insurance companies offer the latter.

Type II Liabilities: Cash outflows are known, but timing is not, e.g. life insurance policies.

Type III Liabilities: Cash outflows are not known, but timing is known, e.g. floating-rate certificates of deposit.

Type IV Liabilities: Neither cash outflows nor timing are known, e.g., auto or home insurance policies.

Liquidity Concerns

Due to different degrees of certainty about timing and outlay, some institutions must have deposits more cash on hand or accessible in order to satisfy their obligations, e.g. the offering of demand means customers can obtain whatever amount of their funds whenever they wishplays . The greater the concern over liquidity, the fewer less-liquid investments an intermediary can hold.

CONCERNS OF REGULATORS

The risks of a financial institution are: credit, settlement, market, liquidity, operational, and legal.

Credit risk is the risk that the obligor of a financial instrument held by a financial institution will fail to fulfill its obligation. Settlement risk is the risk that when there is a settlement of a trade or obligation, the transfer fails to take place. Counterparty risk is the risk that a counterparty fails to satisfy its obligation.

Liquidity risk in the context of settlement risk means that the counterparty can eventually meet its obligations, but not at the due date. Liquidity risk has two forms. Market liquidity risk is the risk that a financial institution is unable to transact in a financial instrument at a price near its market value. Funding liquidity risk is the risk that the financial institution will be unable to obtain funding to obtain cash flow necessary to satisfy its obligations.

Market risk is the risk of a financial institution’s economic well being that results from an adverse movement in the market price of the asset it owns or the level or the volatility of market prices. There are measures that can be used to gauge this risk. One such measure endorsed by bank regulators is value-at-risk.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition of operational risk includes legal risk. This is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. Sources of operation risk include: employees, business process, relationships, technology, and external factors.

ASSET MANAGEMENT FIRMS

Asset management firms manage the funds of individuals, businesses, endowments and foundations, and state and local governments. Types of funds managed by asset management firms include regulated investment companies, insurance company funds, pension funds, and hedge funds. Asset management firms are ranked based on assets under management. These firms receive compensation primarily from management fees charged based on the market value of the assets managed for clients. Also, they are increasingly adopting performance-based management fees for other types of accounts.

Hedge Funds

There is not a single definition of hedge fund. There are several characteristics.

1. The word “hedge” is misleading. Many funds do not hedge risk at all, but engage in highly risk, leveraged transactions.

2. Hedge funds use a wide range of trading strategies and techniques to earn a superior return. These strategies include: leverage, short selling, arbitrage, and risk control.

3. Hedge funds operate in all of the financial markets: cash markets for stocks, bonds, and currencies and the derivatives markets.

4. The management fee structure for hedge funds is a combination of a fixed fee based on the market value of assets managed plus a share of the positive return.

5. Investors are interested in the absolute return generated by the asset manager, not the relative return. Absolute return is simply the return realized. Relative return is the difference between the absolute return and the return on some benchmark or index.

Types of hedge funds: There are various ways to categorize the different types of hedge funds.

1. A market directional hedge fund is one in which the asset manager retains some exposure to systemic risk.

2. A corporate restructuring hedge fund is one in which the asset manager positions the portfolio to capitalize on the anticipated impact of a significant corporate event. These funds include: (1) hedge funds that invest in the securities of a corporation that is either in bankruptcy or is highly likely in the opinion of the asset manager to be forced into bankruptcy; (2) hedge funds that focus on merger arbitrage, (3) hedge funds that seek to capitalize on other types of broader sets of events impacting a corporation.

3. A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields, an arbitrage strategy. Technically, arbitrage means riskless profit. Some strategies used by hedge funds do not really involve no risk, but instead low risk strategies of price misalignments.

4. An opportunistic hedge fund is one that has a broad mandate to invest in any area that it sees opportunities for abnormal returns. These include fund of funds, and global macro hedge funds that invest opportunistically on macroeconomic considerations in any world market.

Concerns with hedge funds in financial markets: There is concern that the risk of a severe financial crisis due to the activities and investment strategies of hedge funds, most notably the use of excess leverage. The best known example is the collapse of Long-Term Capital Management in September 1998. Most recently, in June 2007, there was the collapse of two hedge funds sponsored by Bear Stearns. Obviously, subsequent market develops in 2008 relate to the concern with hedge fund activities in financial markets.

ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through diversification and taking advantage of fund expertise.

4. “All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.” Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual might have:

a. car insurance policy

b. variable-rate certificate of deposit

c. fixed-rate certificate of deposit

d. a life insurance policy that allows the holder’s beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000

a. Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability

b. Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is Type II liability.

c. Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is Type I liability.

d. Life insurance policy: time of payout is not known, but the amount is certain, which is Type III liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled “Settlement Risk in Foreign Exchange Transactions” that offers a practical approach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.

9. The following appeared in the Federal Reserve Bank of San Francisco’s Economic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe “hedge funds” misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a. Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns.

b. The term is not described in US securities laws, and hedge funds are not regulated by the SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. What was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.

FINANCIAL ASSETS - Financial Institutions and Markets by Fabozzi

noreply@blogger.com (Study For All) — Thu, 27 Dec 2012 10:09:00 +0000

CHAPTER 1

INTRODUCTION

FINANCIAL ASSETS

An asset is any possession that has value in an exchange. It can be tangible or intangible, the latter being a financial asset. Specifically, a financial asset is a claim to a future benefit. For example, in the case of an automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows.

Debt versus Equity Instruments

A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim) obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid. Some securities combine both debt and equity features, such as preferred stock or convertible debt.

Price of a Financial Asset and Risk

The price (or value) of any financial asset is equal to the present value of expected cash flows. The return on an asset is the amount paid to the investor relative to the price paid by him. Related to return is the degree of risk, namely the certainty of expected cash flows. The degree of risk ranges from very low -- as in the case of payments on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds. Uncertainty or risk takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign exchange risk.

Financial Assets versus Tangible Assets

Both types of assets are expected to generate cash flows to their owners. They are also linked in the sense that tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial buildings. The use of the offices generates income that helps pay off the loan.

Role of Financial Assets

The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings).

FINANCIAL MARKETS

Financial markets where financial assets are exchanged. Delivery of the actual asset may occur immediately (spot or cash market) or in the future (future or forward market).

Role of Financial Markets

Financial markets provide the following functions.

1. Price discovery process. Price is determined by supply and demand, the interaction of buyers and sellers. The returns provide signals for funds allocations among investments;

2. Liquidity. Well-developed markets provide an opportunity to convert a financial asset into cash at close to real value of the asset;

3. Reduced transactions costs. In the price discovery process, searching for counter parties and information costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally efficient market exists when prices reflect all information known by market participants.

Classification of Financial Markets

There are various ways to classify financial markets.

Maturity of claim. Money market for financial instruments a year or less to maturity. Capital market for securities longer than a year.

Seasoning of claim. Primary market is for new or first issue market. Secondary market involves sales of previously marketed claims.

Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or cash market) or later (futures or forward market).

Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory. In intermediated markets, financial institutions sell their own securities issues to customers and invest the proceeds.

Market Participants

Participants run the full range, from households, non-financial business firms, financial institutions, and public regulators.

GLOBALIZATION OF FINANCIAL MARKETS

The existence of foreign financial markets permits raising and investing funds outside of the domestic market. There is a trend toward integration of financial markets throughout much of the world. The factors that have led to integration are:

1. Deregulation or liberalization of markets to encourage competition;

2. Technological advances permit more information flows and rapid execution of orders;

3. Increased participation of financial institutions in global markets relative to individuals. Such firms are more willing and able to transfer funds to diversify their portfolios and to take advantage of possible mis-pricing in markets.

Classification of Global Financial Markets

Financial markets can be classified as either internal or external.

Internal: securities issued in the domestic or foreign markets. Foreigners can issue securities in other country markets, subject to national regulations, e.g., Japanese firms can issue dollar-denominated securities in the United States, but they must follow U.S. regulations, which apply to nationals and foreigners alike.

External: securities issued outside jurisdiction of any country, e.g., offshore or Eurodollar offerings can be dollar-denominated. They thereby fall outside of foreign rules, which are designed to deal with domestic financial concerns. The external market is sometimes called the offshore market or Euromarket.

Motivation for Foreign and Eurodollar Markets

Some funds needs cannot be met in small country markets, e.g. giant firm Philips cannot raise all the funds it needs if it is restricted to the Dutch capital market. Also, many underdeveloped nations simply do not have a sizeable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations as would be the case in the U.S. market.

DERIVATIVE MARKETS

A derivative instrument is a financial asset whose value derives from the value of some other asset, index, or interest rate. A futures transaction is a contract that exchanges an asset or commodity at a fixed price in the future. In an option, owner has right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. In a swap, parties exchange one form of cashflow for another, typically a fixed cashflow for a variable one.

Role of Derivative Instruments

Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2) lower transactions costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash market.

ROLE OF THE GOVERNMENT IN FINANCIAL MARKETS

Justification for Regulation

The government plays a significant role in the financial markets. It regulates the financial markets. One justification for regulation is market failure, when the market’s pricing mechanism is incapable of maintaining all the requirements of a competitive, efficient market. Regulation has several purposes: (1) to prevent issuers of securities from defrauding investors; (2) to promote competition and fairness in trading; (3) to promote the stability of financial institutions; (4) to restrict the activities of foreign concerns in domestic markets and institutions; (5) to control the level of economic activity.

Disclosure regulation is the form of regulation that requires issuers of securities to make public a large amount of financial information to investors. This addresses the problem of asymmetric information and the problem of agency.

Financial activity regulation consists of rules on trading financial assets.

Regulation of financial institutions is that form of governmental monitoring that restricts these institutions’ activities in the vital areas of lending, borrowing and funding.

Regulation of foreign participants is that form of governmental activity that limits the roles foreign forms can have in domestic markets and their ownership or control of financial institutions. Authorities use banking and monetary regulation to try to control changes in a country’s money supply.

Regulation in the United States

Regulation in the United States is largely due to the stock market crash of 1929 and the Great Depression of the 1930s.

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows. The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons. These include accounting measures, possibility of default of the issuer, and embedded options in the security. Interest payments can also change over time. There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows. These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds. Funds providers share the risks of expected cash flows generated by tangible assets.

7. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a. They make it possible for corporations and governmental units to raise capital.

b. They help to allocate capital toward productive uses.

c. They provide an opportunity for people to increase their savings by investing in them.

d. They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.

e. They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1. “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2. “they help to allocate capital toward productive uses” -- function 3;

3. “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4. “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5. “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

8. Explain the difference between each of the following:

a. money market and capital market

b. primary market and secondary market

c. domestic market and foreign market

d. national market and Euromarket

a. The money market is a financial market of short-term instruments having a maturity of one year or less. The capital markets contain debt and equity instruments with more than one year to maturity;

b. The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c. The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded. Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d. In a national market securities are traded in only one country and are subject to the rules of that country. In the Euromarket, securities are issued outside of the jurisdiction of any single country. For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a. General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b. The U.S. Treasury issues a security with 10 years to maturity.

c. Microsoft Corporation issues common stock.

d. The State of Alaska issues a financial instrument with eight months to maturity.

a. GMAC issue trades in the money market.

b. U.S. security trades in the capital market.

c. Microsoft stock trades in the capital market.

d. State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement. Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true. There is no default (credit) risk of U.S. government securities. However, it is not free of purchasing power or inflation risk. There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14. 14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons. These include:

a. Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b. Technological innovations to provide globally-available information and to speed transactions;

c. Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a. The two basic types of derivative instruments are futures and options contracts. They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b. The statement implies that derivative instruments can be used only for speculative purposes. Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.

Financial Institution - Chapter No. 8 - INVESTMENT COMPANIES AND EXCHANGE TRADED FUNDS

noreply@blogger.com (Study For All) — Mon, 19 Mar 2012 04:17:00 +0000

CHAPTER 8

INVESTMENT COMPANIES

AND EXCHANGE-TRADED FUNDS

TYPE OF INVESTMENT COMPANIES

Open-End Funds (Mutual Funds)

More popularly known as mutual funds. As open-end funds they stand ready to buy and redeem shares at a price based on net asset value, which is total asset value less liabilities. Prices are quoted on a bid/offer basis. For a no-load fund the bid/offer prices will be the same. The net asset value (NAV) per share equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors.

There are several important characteristics of open-end or mutual fund. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager actively manages the portfolio. Third, the share price is the NAV. Fourth, the NAV is determined only once each day, at the close of the day.

In the case of a load fund the offer price will exceed the bid price by the amount of a sales commission charged upon purchases of shares. Some funds have back-end loads, wherein commissions are charged upon redemption of funds within a few years. Others, known as Section 12b-1 funds, charge a small percentage of assets annually to cover sales costs. In any case, all funds earn small percentage annual fees to cover administrative costs. These funds comprise the third largest group of financial institutions, behind banks and insurance companies.

Closed-End Funds

These funds issue a limited number of shares and are very similar to shares of common stock. They are then sold on the open market like other securities. Investors pay a broker’s commission. The NAV of closed-ended funds is determined by supply and demand. The market price of these shares may thus differ from net asset value, often at a discount from it. The discount results from large tax liabilities on capital gains that swell the net asset value, while investors are pricing future after-tax distributions. Premiums can result because such funds often have inexpensive access to overseas stocks.

Under the Investment Company Act of 1940, closed-end funds are capitalized only once. They make an IPO, and then their shares are traded on the secondary market, just like any corporate stock.

The relatively new exchange traded funds (ETFs) pose a threat to both mutual funds and closed-end funds. ETFs are essentially hybrid closed-end vehicles, which trade on exchanges but typically trade very close to NAV.

Unit Trusts

A unit trust is similar to a closed-end fund in that the number of unit certificates is fixed. They are different from closed-end funds in the following. First, they typically invest in bonds. Second, they do not trade. Third, a fixed amount of securities is assembled with a defined termination date. The major benefit of such funds is lower operating costs due to the absence of trading.

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

There are two types of costs borne by investors in mutual funds. The first is shareholders fee, usually called the sales charge. This type of charge is related to the way the fund is sold and distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund's expenses. The largest of which is for investing managements. Other expenses include primarily the cost of, 1) custody 2) the transfer agent cost, 3) independence public accountant fee, and 4) directors’ fee. The sum of annual management fee, the annual distribution fee and other expenses is called the expense ratio.

Sales Charge

Sales charges on mutual funds are related to their method of distribution. The two types of distribution were sales force and direct. Sales force occurs via an intermediary agent. Direct distribution takes place without an intermediary. Funds with no sales charges are called no-load mutual funds. Some have speculated that load funds would eventually disappear, but the trend has gone the other way. Among the recent adaptations of the sales load are back-end loads.

Annual Operating Expenses (Expense Ratio)

The operating expense, also called the expense ratio, is debited annually from the investor’s fund balance by the fund sponsor. Operating expenses are deducted from NAV and therefore reduce the reported return. The management fee, also called the investment advisory fee, is the fee charged by the investment advisor for managing a fund’s portfolio. In 1980, the SEC approved the imposition of a fixed annual fee, called the 12b-1 fee, which intended to cover distribution costs. Such 12b-1 fees are now imposed by many mutual funds.

Multiple Share Classes

Share classes were first offered in 1989 following the SEC’s approval of multiple share class. Initially share classes were used primarily by sales-force funds to offer alternatives to front-end load as a means of compensating brokers. Later, some of the funds used additional share classes as a means of offering the same fund or portfolio through alternative distribution channels in which some fund expenses varied by channel.

ECONOMIC MOTIVATIONS FOR FUNDS

An investment company is a financial intermediary because it pools the funds of market participants and uses those funds to buy a portfolio of securities. They provide at least one of the following six economic functions: (1) risk reduction via diversification, (2) lower costs of contracting and processing information, (3) professional portfolio management, (4) liquidity, (5) variety, (6) payments mechanism.

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

Investment funds tend to have a variety of investment objectives. In general, there are stock funds, bond funds, money market funds and others. They seek to accommodate a wide range of desires and needs, among them income, capital gains, growth, and income. Some funds specialize by securities, examples of which are indexed funds, government bond funds, municipal bond funds, corporate bond funds, money market mutual funds, and balanced funds--combination of bonds and stocks.

CONCEPT OF FAMILY OF FUNDS

Now many management companies offer investors a choice of numerous funds. Some firms provide a choice of funds and objectives. Changing from one to the other to reflect changing needs can then be accomplished at low or no cost to the investor. The funds in a family usually include choices ranging from money market funds to global funds, and funds devoted to particular industries such as medical technology or gold mining companies. Concentration in the mutual funds industry continues to increase.

INVESTMENT VEHICLES FOR MUTUAL FUNDS

Mutual funds may be included in different investment vehicles. An investment vehicle can be a non-qualified vehicle because it does not quality for tax advantages. The same fund can also be included in a retirement plan such as 401(k), Roth 401(k), IRA or Roth IRA. These retirement plans are called qualified plans.

MUTUAL FUND COSTS

From 1980 to 2006, the measure of mutual fund costs declined from 2.32% to 1.07% for stock funds and from 2.05% to 0.84% for bond funds. There were three reasons for this decline. First, loads in general declined. Second, no-load mutual funds grew. Third, mutual fund expenses have also declined due to economies of scale and intense competition.

TAXATION OF MUTUAL FUNDS

Mutual funds must distribute at least 90% of their net investments income earned, exclusive of realized capital gains or losses to shareholders to be considered a regulated investment company (RIC) and, thus not be required to pay taxes at the fund level prior to distribution to shareholders. Consequently, funds make these distributions. Capital gains distributions must occur annually, and typically occur late during the calendar year. New investors in the fund may assume a tax liability even though they have no gains. The investors must also pay ordinary income taxes on distribution of income.

REGULATION OF FUNDS

All investment companies are regulated under the Investment Company Act of 1940. They must register with the SEC and file periodic reports. No taxes are levied on funds, which distribute 90% of their income. There are minimum diversification and liquidity requirements as well as maximum fees that can be applied. Currently under consideration is a proposal allowing less redemption over a quarter, thus permitting funds to hold smaller proportions of liquid assets.

Among the recent SEC priorities, which directly affect mutual funds, are:

1. Reporting after taxes.

2. More complete reporting fee.

3. More accurate and consistent reporting of investment performance.

4. Requiring fund investment practices to be more consistent with the name of a fund to more accurately reflect their investment objectives.

5. Disclosing portfolio practices such as "window dressing".

6. Various rules to increase the effectiveness of independent fund boards.

STRUCTURE OF A FUND

A mutual fund organization is structured as follows: (1) board of directors, (2) mutual fund, (3) investment advisor, (4) distributor, (5) other service providers. The role of the board of directors is to represent the fund shareholders. External advisers are called subadvisers, and they are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

Distribution Channels

Traditionally, funds were sold direct or through a sales force. However, funds have moved increasingly to nontraditional sources of sales.

Supermarkets: The organizer of a supermarket, like Charles Schwab, offers funds from a number of different mutual fund families.

Wrap programs: Wrap accounts are managed accounts, typically mutual funds or ETFs, wrapped in a service package. The service provided is often asset allocation counsel, i.e., advice on the mix of managed funds or ETFs.

Fee-based financial advisors: Fee-based financial advisors are independent financial planners who charge a fee rather than a transaction charge for investment services. These fees are typically a percentage of assets under management or alternatively an hourly fee or a fixed retainer.

Variable annuities: Variable annuities represent another distribution channel.

Changes in the Costs of Purchasing Mutual Funds

The purchase cost of mutual funds has declined significantly. In general, load funds responded to the competition of no-load funds by lowering distribution cost.

Mix and Match

The investors’ demands for choice and convenience, and also the distributors’ need to appear objective, have motivated essentially all institutional users of funds and distribution organizations to offer funds from other fund families in addition to their own.

Domestic Acquisitions in the US Funds Market

There merger and acquisition business in the

asset management business has been active. The

asset management business continues to grow and consolidate across the various types of asset management firms.

Internationalization of the US Funds Business

The combination of a

fund company and international asset manager could occur in either two directions, i.e., with either being the acquirer. But the dominant direction has been the acquisition of US funds by international institutions.

EXCHANGE TRADED FUNDS

While mutual funds have become very popular with investors, they are often criticized for two reasons. First, mutual funds shares are priced at, and can be transacted only at the end of day (closing) price. The second relates’ to taxes and the investors’ control over taxes. Withdrawals by some shareholders may cause taxable realized capital gain for shareholders who maintain their positions.

Closed-end funds trade all during the day on stock exchange, but there is often a difference between the NAV and the price of the closed-end funds. Both mutual funds and closed-end funds are similar in that they are instruments based on the portfolio of their securities, but closed-end funds are transacted continuously throughout the day.

An investment that embodies a combination of the desirable aspects of mutual funds (open-end funds) and closed-end funds is the exchange-traded fund (ETF). These are mostly index funds. They are traded on an exchange, and they are like open-end funds in that the number of shares can change.

ETC Creation/Redemption Process

For ETCs, individuals do not deal directly with the provider of the ETF. That privilege is reserved for a few very large investors called authorized participants (AP) who are arbitragers. Authorized participants are mainly large institutional traders who have contractual agreements with ETF funds. They are the only investors who may create or redeem shares of an ETF with the ETF sponsor and then only in large specified quantities called creation/redemption units. These unit sizes range from approximately 50,000 to 100,000 ETF shares.

ETF Sponsors

Like mutual funds, ETFs require a company to sponsor them. The ETF sponsor must (1) develop the index, (2) retain the authorized participants, (3) provide seed capital to initiate the ETF, (4) advertise and market the ETF, (5) engage in other activities.

Mutual Funds versus ETFs: Their Relative Advantages

The following are ETF advantages. Mutual funds are priced only once a day. But ETFs are traded on an exchange and so there is continuous pricing. Both passive mutual funds and ETFs have low fees, but ETF fees tend to be somewhat lower. All ETFs trade on an exchange and incur commission. As to taxes, mutual funds may lead to capital gains taxes for investors who do not even liquidate their fund. Because of the unique structure of ETFs, ETFs can fund redemptions by in-kind transfers without selling their holdings, which have no tax consequences.

Mutual funds have the following advantages. While ETFs have been exclusively passive or indexes, mutual fund families offer many types of active funds as well as passive funds. Additionally, no-load mutual funds, both active and passive, permit transactions with no loads or commissions.

Separately Managed Accounts

Many high net worth people object to mutual funds because (1) lack of control over taxes, (2) lack of any input into investment decision, (3) absence of services. The use of separately managed accounts responds to all these limitations of mutual funds.

ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. An investment company has $1.05 million of assets, $50,000 of liabilities, and 10,000 shares outstanding.

What is its NAV?
Suppose the fund pays off its liabilities while at the same time the value of its assets double. How many shares will a deposit of $5,000 receive?

a. Net asset value = (Total assets minus liabilities) / numbers of shares

= 1,050,000 – 50,000 = $100

10,000

b. Net asset value = 2,100,000 – 0 = $210

10,000

No of shares = 5000 = 23.81 shares.

210

2. “The NAV of an open-end fund is determined continuously throughout the trading day.” Explain why you agree or disagree with this statement.

Disagree. NAV of open-ended fund is the closing price of the day.

3. What are closed-end funds?

These funds issue a limited number of shares, are sold on the open market.

4. Why do some closed-end funds use leverage to raise more funds rather than issue new shares like mutual funds?

Under the 1940 Act, these funds are capitalized only once. The number of shares is fixed. Thus many funds become leveraged to raise more funds without issuing new (additional) shares.

5. Why might the price of a share of a closed-end fund diverge from its NAV?

The price of closed-end funds may differ from NAV (often at a discount) because the fund has a large built-in tax liabilities and investors are discounting the share’s price for future tax liabilities. Leverage may be another factor for price below NAV.

6. What is the difference between a unit trust and a closed-end fund?

With a unit trust a number of securities are assembled in a portfolio package and held for a specified number of years and then liquidated. The charges are low since there is no trading of securities or redemption prior to maturity.

Describe the following: front-end load, back-end load, level load, 12b-l fee, management fee.
Is there a limit on the fees that a mutual fund may charge?

a. Back-end load funds charge sales fees upon redemption within a period of a few years. Front end is commissioned charged up front of the time of sale. A level load is amount of sales commission a fund may charge. A 12b-1 fund is a no-load fund that charges an annual sales fee of around 1.5% annually.

b. Yes the security rule specifies these fees.

8. Why do mutual funds have different classes of shares?

Different classes of shares offered by mutual funds is determined by the needs of the investors and their risk preferences. It permits the distributor and its client to select the type of load they prefer.

9. What is an index fund?

An index fund e.g. Fidelity Magellan and Vanguard S&P 500 are mutual funds, which invests in stocks included in S&P 500, and aim to achieve its performance to the benchmark S&P500 returns.

10.

What is meant by a target-date fund?
What is the motivation for the creation of such a fund?

a. Target date funds are mutual funds that base their asset allocations on a specific date, the assumed retirement date for the investor, and then rebalance to a more conservative allocation as that date approaches.

b. These funds are designed to be “one-size-fits-all” portfolios for investors with a given number of years to retirement.

11. What are the costs incurred by a mutual fund?

Costs typically incurred by an investment company (Mutual fund) include advisory fees, selling/marketing expenses, custodial/accounting fees, and transactions costs. There are two types of costs borne by investors in mutual funds. The first is shareholder fee, usually called the sales charge. This type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense usually called the expense ratio, which covers the fund’s expenses. The largest of which is for investing managements.

12. Why might the investor in a mutual fund be faced with a potential tax liability arising from capital gains even though the investor did not benefit from such a gain?

Investor in a closed fund is faced with a potential tax gain on capital gains that swell the net asset value. The investor is pricing future-tax distributions.

13. Does an investment company provide any economic function that individual investors cannot provide for themselves on their own? Explain your answer.

Yes. An investment company provides risk reduction through diversification and lower costs of transactions and information processing, which is hardly to come by an individual investor.

14. Why might a family of funds hire subadvisors for some of its funds?

They are used because (1) to develop a fund in an area in which the fund family has no expertise, (2) to improve performance, (3) to increase assets under management, (4) to obtain an attractive manager at a reasonable cost.

15.

How can a fund qualify as a regulated investment company?
What is the benefit in gaming this status?

a. A regulated investment company must provide information on its fees and its objectives. It must file financial reports and indicate amount of income distributed.

b. A regulated investment company is exempt from taxation on all its ordinary and capital gains income as long as at least 90% of these funds are distributed to the stockholders. Such distributions are then taxable to the stockholders.

16. What is an ETF?

An exchanged traded fund is a new investment vehicle that is similar to mutual funds but trade like a stock on an exchange. The price is determined continuously rather than the closing price e.g. QQQ.

17. What are the advantages of an ETF relative to open-end and closed-end investment companies?

As said earlier, price is continuously changing during the trading period.

18. Explain the role of the authorized participant in an ETF.

The role of the authorized participants is to engage in arbitrage transactions that maintain the market price of the ETF as compared to an index portfolio.

19. Why is tracking error important for an ETF?

Since ETFs are based on passive indexes where value is represented by the NAV, investors in ETFs expect their return to be equal to that of the portfolio’s NAV. Large tracking error s are bad for ETFs because it undermines the investor’s expectation.

20. Comment on the following statement: “Exchange traded funds are typically actively managed funds.”

Since they are mostly index funds, they are passively managed.

21. Briefly describe the following in the context of mutual funds:

supermarket
wrap program
segregated managed accounts
family of funds

a. Supermarkets: The introduction of the first mutual fund supermarket in 1992 by Charles Schwab & Co. introduced its One Source service. These supermarkets allow investors to purchase funds from participating companies without investors having to contact each fund company.

b. Wrap program: Wrap accounts are managed accounts, typically mutual funds “wrapped” in a service package. The service provided is often asset allocation counsel; that is advice on the mix of managed funds.

c. Segregated managed accounts: are in response to individuals who object to mutual funds because of their lack of control over taxes and other investment decisions. Many investors with medium-size portfolio are utilizing segregated accounts.

d. Family of funds: In the U.S. system, a family of funds consists of an investment company that offers several different funds. In Japan the family fund allows investors to buy new certificates in a grouping of existing unit trusts.

How to setup a new company in Peachtree

noreply@blogger.com (Study For All) — Mon, 12 Mar 2012 05:59:00 +0000

What you have to say about this? sahre your answer

sETUP OF A nEW cOMPANY IN pEACHTREE

noreply@blogger.com (Study For All) — Mon, 12 Mar 2012 05:51:00 +0000

Setup of Company

After the start of the Peachtree Program you have to set up a new company before entering data. For this click on File menu and select New Company

After you have selected a new company following introductory screen will appear to guide you the rest of the process and tell you what informations are required for setting up of the company.

You have to click the Next button. After that you will find the following screen. Hereyou will decide about the Peachtree Product.

Setup of Company in Peachtree

noreply@blogger.com (Study For All) — Mon, 12 Mar 2012 05:42:00 +0000

Setup of Company

After the start of the Peachtree Program you have to set up a new company before entering data. For this click on File menu and select New Company

After you have selected a new company following introductory screen will appear to guide you the rest of the process and tell you what informations are required for setting up of the company.

You have to click the Next button. After that you will find the following screen. Hereyou will decide about the Peachtree Product.

Again by clicking Next button you will find the following screen. Here you will type the Company name, Address, Telephone, fax number, business type, website and email address. These information will be printed on every report. This information may be edited after the creation of the company.

After typing all the above information you will be clicking the Next button and following window will appear.

You need to establish how your new company will be set up:

Use a sample business type that closely matches your type of company: Select this option to copy basic setup information, particularly a chart of accounts, from a sample company. You can select either a simplified chart of accounts that contains only the basic accounts you need to get started; or you can choose a detailed chart. Depending on which version of Peachtree you are using your selections will vary. You can modify the accounts later, according to your needs.

Copy settings from an existing Peachtree company: Select this option if you want to copy setup information from another Peachtree company or you are rebuilding a Peachtree company.

Convert a company from another accounting program: Select this option if you want to import company data from some other program.

Build your own company: Select this option if you want to create a company from scratch. This option is only recommended for experienced users who are comfortable setting up accounting information. For users coming from a paper ledger, it is recommend that they select a business type (see above) that most closely matches their existing chart of accounts and then modify it as they have need.

If you select this option, make sure you set up your chart of accounts prior to setting up any other part of the company.

After you have decided about the method to create a company click Next. In the next window you will have to decide about the accounting method. The available accounting methods are Accrual and Cash.

Accrual Accounting: Income is recorded as you invoice customers, and expenses are recorded when you receive bills from vendors, regardless of when cash is actually exchanged. This presents a truer picture of income and expenses. Most companies use this method.

Cash-Basis Accounting: Income is recorded when cash (checks, money orders, or currency) is received, and expenses are recorded when paid. However, unpaid credit sales and purchases do not show on ledgers, which can present a misleading picture of income and expenses.

After deciding about the accounting method click next button. Following window will appear. Here you will be deciding about the Posting method. The software provides you two posting methods i.e. Real Time and Batch.

Real-Time Posting: Transactions are posted to the journals and the general ledger as they are entered and saved. This method can save you time and is best for most business and network environments. Most companies use this method.

Batch Posting: Transactions are saved by the program and then posted in a group. When you use batch posting, you can print registers and check the batch of transactions before posting them to the journals.

You can switch posting methods at any time.

To continue setting up the company click Next following window will appear. Here chose an accounting period structure. Normally it is 12 month accounting periods per year.

Again click Next button and choose the first period (Month) of the fiscal year.

After clicking Next button you will find following finish window and buy clicking finish button the software will create you company.

General Ledger

Now you have setup your company in Peachtree, it is recommended to establish Chart of accounts, General Ledger Defaults and Beginning Balance if any.

To establish the charts of accounts click the Maintains menu and select “Chart of Accounts...”

The following window will displayed

Here you have to type Account ID, Description and the most Important Account Type.

Enter an account ID and description for the account. The account ID determines how the account is identified and sorted in the chart of accounts list and the General ledger account is displayed as typed in description. Most charts of accounts are set up with specific account types grouped together.

Account types define how the account will be grouped in reports and financial statements. They also control what happens during fiscal year-end.

General Ledger accounts are assigned types on the General tab of the Maintain Chart of Accounts window. Select an account type from the drop-down list and select Save to save the account. The account type should be selected carefully. If you are entering a Revenue account then its type will be Income so on. A simplified chart of account with Account ID, Description and Account Type is given at the end of the chapter.

You can enter the Beginning Balances on the General tab. Select the Beginning Balances button. Peachtree displays the Select Period window.

Select the period in which you want to enter beginning balances. You can select from previous, current, or future periods.

Select OK. Peachtree displays the Chart of Accounts Beginning Balances window.

Click or tab to any of the white cells in the grid to add an amount. (The gray cells are for viewing purposes only.)

Enter all the beginning balances for the accounts. Scroll the list box to make sure the account amounts are correct.

If you are out of balance in the Beginning Balances for General Ledger Accounts window, Peachtree displays a warning message indicating that an equity account will be created (or updated) to contain the difference or out-of-balance amount.

This account will be named Beginning Balance Equity, and its type is Equity-Doesn't Close. This account does not appear in the Beginning Balances window, but it will appear in the list of accounts and on financial statements and general ledger reports.

Try to find the reason for the out-of-balance situation, and correct it if possible. (Select Cancel when Peachtree displays the warning message.) If you are entering beginning balances from financial statements supplied by your previous accounting system or by your accountant, you most likely made an error in data entry. Make sure you didn't leave out an account or balance and that you entered all amounts correctly.

When done close the window.

Add a New Account in G/L Beginning Balances

In the Beginning Balances window accessed from the Maintain Chart of Accounts window, select the New button. Peachtree displays the Enter New Account window.

Enter an account ID and description for the account and also chose the appropriate account type and select OK.

Delete an Account from the Chart of Accounts

In order to delete an account from the chart of accounts, there must be no transactions posted to the general ledger that reference the account ID. If an account has a nonzero balance, you must delete or remove transactions associated with it. These can include beginning-balance entries.

If an account has a nonzero balance, you can enter an adjusting G/L transaction in the General Journal to bring the account's balance to zero. Then, after two year-end closings, you can purge or delete the account.

To make the account inactive

You can make the account inactive to ensure that no further transactions are associated with it. Then after two year-end closings, you can purge the account.

From the Maintain menu, select Chart of Accounts. Peachtree displays the Maintain Chart of Accounts window.

Select the account you want to make inactive. To display a list of existing accounts, type ? in the G/L Account ID field, or select the Lookup button.

Select the Inactive check box to the right of the account ID. (There is an mark in the check box when it is selected.)

Sample Charts of Accounts

100	Current Assets	Account Type
105	Cash in bank	Cash
109	Petty cash	Cash
110	Accounts receivable	Accounts Receivable
118	Allowance for doubtful accts	Accounts Receivable
120	Inventory	Inventory
130	Prepaid expenses	Other Current Assets
140	Property and Equipment
141	Land	Fixed Assets
142	Building	Fixed Assets
143	Leasehold improvements	Fixed Assets
144	Furniture and fixtures	Fixed Assets
145	Equipment	Fixed Assets
146	Automotive equipment	Fixed Assets
150	Accumulated Depreciation	Accumulated Depreciation
152	Depr-building	Accumulated Depreciation
153	Depr-leasehold improvements	Accumulated Depreciation
154	Depr-furniture and fixtures	Accumulated Depreciation
155	Depr-equipment	Accumulated Depreciation
156	Depr-automotive equipment	Accumulated Depreciation
160	Other Assets
162	Long-term investments	Other Assets
168	Due from officer	Other Assets

200	Current Liabilities	Account Type
202	Notes payable	Other Current Liability
210	Accounts payable	Accounts Payable
212	Accrued expenses payable	Other Current liability
220	Wages payable	Other Current liability
221	Income Tax Payable	Other Current liability
222	Sales Tax Payable	Other Current liability
250	Long-Term Liabilities
252	Mortgage payable	Long Term Liability
261	Long-term note payable	Long Term Liability
271	Due to officer	Long Term Liability
300	Stockholders’ Equity
381	Common stock	Equity does not close
390	Retained earnings	Equity retained earning
392	Dividends	Equity gets close
400	Revenue
410	Sales	Income
500	Cost of Sales
510	Cost of goods sold	Cost of Sale
600	Operating Expenses
610	Salaries and wages	Expense
621	Advertising	Expense
622	Amortiz leasehold improv.	Expense
623	Automobile expense	Expense
626	Bad debts expense	Expense
627	Bank service charge	Expense
632	Commissions	Expense
638	Depreciation expense	Expense
640	Dues and subscriptions	Expense
643	Entertainment	Expense
650	Insurance	Expense
655	Interest expense	Expense
657	Licenses and permits	Expense
659	Miscellaneous expense	Expense
660	Office expense	Expense
666	Postage	Expense
667	Professional fees	Expense
668	Rent expense	Expense
669	Rental of equipment	Expense
672	Repair and maintenance	Expense
690	Telephone	Expense
691	Travel	Expense
695	Utilities	Expense
700	Other Income (Expense)
710	Interest income	Income
790	Miscellaneous income	Income
895	Income tax expense	Expense

Financial Institution

noreply@blogger.com (Study For All) — Fri, 02 Mar 2012 10:50:00 +0000

CHAPTER 5

Central Bank

AND THE CREATION OF MONEY

CENTRAL BANKS AND THEIR PURPOSE

The primary role of a central bank is to maintain the stability of the currency and money supply for a country or a group of countries. The role of central banks can be categorized as: (1) risk assessment, (2) risk reduction, (3) oversight of payment systems, (4) crisis management.

One of the major ways a central bank accomplishes its goals is through monetary policy. For this reason, central banks are sometimes called monetary authority. In implementing monetary policy, central banks, acting as a reserve bank, require private banks to maintain and deposit the required reserves with the central bank. In times of financial crisis, central banks perform the role of lender of last resort for the banking system. Countries throughout the world may have central banks. Additionally, the European Central Bank is responsible for implementing monetary policy for the member countries of the European Union.

There is widespread agreement that central banks should be independent of the government so that decisions of the central bank will not be influenced for short-term political purposes such as pursuing a monetary policy to expand the economy but at the expense of inflation.

In implementing monetary and economic policies, the United States is a member of an informal network of nations. This group started in 1976 as the Group of 6, or G6: US, France, Germany, UK, Italy, and Japan. Thereafter, Canada joined to for the G7. In 1998, Russia joined to form the G8.

THE CENTRAL BANK OF THE UNITED STATES: THE FEDERAL RESERVE SYSTEM

The Federal Reserve System consists of 12 banking districts covering the entire country. Created in 1913, the Federal Reserve is the government agency responsible for the management of the US monetary and banking systems. It is independent of the political branches of government. The Fed is managed by a seven-member Board of Governors, who are appointed by the President and approved by Congress.

The Fed’s tools for monetary management have been made more difficult by financial innovations. The public’s increasing acceptance of money market mutual funds has funneled a large amount of money into what are essentially interest-bearing checking accounts. Securitization permits commercial banks to change what once were illiquid consumer loans of several varieties into securities. Selling these securities gives the banks a source of funding that is outside the Fed’s influence.

INSTRUMENT OF MONETARY POLICY: HOW THE FED INFLUENCES THE SUPPLY OF MONEY

The Fed has three instruments at its disposal to affect the level of reserves.

Reserve Requirements

Under our fractional reserve banking system have to maintain specified fractional amounts of reserves against their deposits. The Fed can raise or lower these required reserve ratios, thereby permitting banks to decrease or increase their lending and investment portfolios. A bank’s total reserves equal its required reserves plus any excess reserves.

Open Market Operations

The Fed’s most powerful instrument is its authority to conduct open market operation. It buys and sells in open debt markets government securities for its own accounts. The Fed prefers to use Treasury bills because it can make its substantial transactions without seriously disrupting the prices or yields of bills.

The Federal Open Market Committee, or FOMC, is the unit that decides on the general issues of changing the rate of growth in the money supply, by open market sales or purchases of securities. The implementation of policy through open market operations is the responsibility of the trading desk of the Federal Reserve Bank of New York.

Open Market Repurchase Agreements

The Fed often employs variants of simple open market purchases and sales, these are called the repurchase agreement (or repo) and the reverse repo. In a repo, the Fed buys a particular amount of securities from a seller that agrees to repurchase the same number of securities for a higher price at some future time. In a reverse repo, the Fed sells securities and makes a commitment to buy them back at a higher price later.

Discount Rate

A bank borrowing from the Fed is said to use the discount window. The discount rate is the rate charged to banks borrowing directly from the Fed. Raising the rate is designed to discourage such borrowing, while lowering should have the opposite effect.

DIFFERENT KINDS OF MONEY

Money is that item which serves as a numeraire. In a basic sense money can be defined as anything that serves as a unit of account and medium of exchange. We measure prices in dollars and exchange dollars for goods. Hence coins, currency, and any items readily exchanged into dollars (checking deposits or NOW accounts) constitute our money supply.

MONEY AND MONETARY AGGREGATES

Monetary aggregates measure the amount of money available to the economy at any time. The monetary base is defined as currency in circulation (coins and federal reserve notes) and reserves in the banking system. The instruments that serve as a medium of exchange can be narrowly defined as M₁, which is currency and demand deposits. M₂ is M₁ plus time and savings accounts, and money market mutual funds. Finally, M₃ is M₂ plus short-term Treasury liabilities. While all three aggregates are watched and monitored, M₁ is the most common form of the money supply, with its trait as being the most liquid. The ratio of the money supply to the economy’s income is known as the velocity of money.

THE MONEY MULTIPIER: THE EXPANSION OF THE MONEY SUPPLY

The money multiplier effect arises from the fact that a small change in reserves can produce a large change in the money supply. Through our fractional reserve system, a small increase will allow an individual bank, to lend out the greater part of these additional funds. These loans subsequently become deposits in other banks allowing them to expand proportionately. So, while one bank can expand its loans (or deposits) by an amount 1% of reserves required, all banks in the system can do likewise. Thus, in a simple format total change in deposits can be stated as change in reserves divided by the reserve requirement, which is also the formula for perpetuity. For example, if the change in the level of reserves is $100 and the reserve requirement is 20%, the change in total deposits will be $500 for a multiplier of 5. Of course, major assumptions are that banks will fully loan out their excess reserves and that depositors will not withdraw any of these extra reserves.

THE IMPACT OF INTEREST RATES ON THE MONEY SUPPLY

High rates of interest may make keeping excess reserves costly, since unused funds represent loans not made and interest not earned. High rates of interest will also affect the public’s demand for holding cash. If deposits pay competitive interest rates, customers will be more willing to hold such bank liabilities and less cash. Therefore, a higher rate of interest can actually spur growth of the money supply. More likely, however, it will deter borrowing and slow monetary growth.

THE MONEY SUPPLY PROCESS IN AN OPEN ECONOMY

In the modern era, almost every country has an open economy. Foreign commercial and central banks hold dollar accounts in the United States. Their purchases and sales of these deposits can affect exchange rates of the dollar against their own currency. The Fed has responsibility for maintaining stability in exchange rates. A purchase of foreign exchange with dollars depreciates the dollar’s value, but it also adds dollars to the accounts of foreign banks in this country, thus adding to the

U.S.

monetary base. Most central banks of large economies own or stand ready to own a large amount of each of the world’s major currencies, which are considered international reserves. Sales of foreign exchange transactions have monetary base implication and hence consequences for the domestic money supply, emphasis is given to coordinating monetary policies among developed nations.

ANSWERS TO QUESTIONS FOR CHAPTER 4

(Questions are in bold print followed by answers.)

1. What is the role of a central bank?

The role of a central bank has several functions: risk assessment, risk reduction, oversight of payment systems, and crisis management. It can do this through monetary policies, and through the implementation of regulations.

2. Why is it argued that a central bank should be independent of the government?

Central banks should be independent of the short-term political interests and political influences generally in setting economic policies.

3. Identify each participant and its role in the process by which the money supply changes and monetary policy is implemented.

The Fed determines monetary policy and seeks to implement it through changes in reserves. It is up to the nation’s banking system to act on changes in reserves thereby affecting deposits, which constitute the greater part of the M₁ definition of the money supply.

4. Describe the structure of the board of governors of the Federal Reserve System.

The Board of Governors of the Federal Reserve System consists of 7 members who are appointed to staggered 14-year terms. The Board reviews discount operations and sets legal reserve requirements. In addition, all 7 members of the Board serve on the Federal Open Market Committee (FOMC), which determines the direction and magnitude of open-market operations. Such operations constitute the key instrument for implementing monetary policy.

Explain what is meant by the statement “the United States has a fractional reserve banking system.”
How are these items related: total reserves, required reserves, and excess reserves?

a. A fractional reserve system requires that a fraction or percent of a bank’s reserve be placed either in currency in vault or with the Federal Reserve System.

b. Total reserves are the amounts that banks hold in cash or at the Fed. Required reserves are amounts required by the Fed to meet some specific or legal reserve ratio to deposits. Excess reserves are bank reserves in currency and at the Fed which are in excess of legal requirements. Since these amounts are non-interest bearing, banks are often willing to lend these surplus funds to deficit banks at the Fed funds rate.

6. What is the required reserve ratio, and how has the 1980 Depository Institutions Deregulation and Monetary Control Act constrained the Fed’s control over the ratio?

The required reserve ratio is the fraction of deposits a bank must hold as reserves. The DIDMCA constrained the Fed’s control over the ratio by letting Congress set ranges of reserves for demand and time deposits.

7. In what two forms can a bank hold its required reserves?

A bank can hold its reserves in the form of currency in vault or in deposit at the Fed.

What is an open market purchase by the Fed?
Which unit of the Fed decides on open market policy, and what unit implements that policy?
What is the immediate consequence of an open market purchase?

a. An open market purchase by the Fed consists of the purchase of U.S. Treasury securities.

b. The FOMC decides on open market policy and directs the Federal Reserve Bank of New York to implement it through sales and purchases of these securities.

c. The immediate consequence of an open market purchase is to supply the seller of the security with a check on the Federal Reserve System that he can deposit in his bank, thereby immediately increasing the excess reserves and thus nation’s money supply.

9. Distinguish between an open market sale and a matched sale (which is the same as a matched sale-purchase transaction or a reverse repurchase agreement).

A matched sale or reverse repo involves the sale of a Treasury security with an agreement to buy it back at a later date and at a higher price as the cost for borrowing the funds. This contrasts with an outright sale at some discounted or premium price.

10. What is the discount rate, and to what type of action by a bank does it apply?

The discount rate is the rate a bank pays to borrow at the “discount window” of the Fed. Such borrowings are often undertaken to meet temporary liquidity needs. Bank needs are monitored and the Fed likes to state that borrowing from it is a “privilege and not a right.”

11. Define the monetary base and M₂

The monetary base includes total bank reserves plus currency in the hands of the public. M₂ = M₁ (currency and demand deposits) + savings and time deposits.

12. Describe the basic features of the money multiplier.

The money multiplier is crucial to the concept of money creation and is analogous to the idea of the autonomous spending multiplier and formula for a perpetuity. It is the inverse of the required reserve ratio (1/rr). If the reserve ratio is .2 then the money supply will expand five times any increase in new deposits. The multiplier will be less if banks hold excess reserves or experience cash drains.

13. Suppose the Fed were to inject $100 million of reserves into the banking system by an open market purchase of Treasury bills. If the required reserve ratio were 10%, what is the maximum increase in M₁ that the new reserves would generate? Assume that banks make all the loans their reserves allow, that firms and individuals keep all their liquid assets in depository accounts, and no money is in the form of currency.

The maximum increase in M₁ will be $1 billion assuming no cash drains in the system, and banks are fully loaned up.

14. Assume the situation from question 13, except now assume that banks hold a ratio of 0.5% of excess reserves to deposits and the public keeps 20% of its liquid assets in the form of cash. Under these conditions, what is the money multiplier? Explain why this value of the multiplier is so much lower than the multiplier from question 13.

Substitute the given values of currency ratio, required reserves ratio, and excess reserves ratio of 20%, 10% and 0.5% respectively into the formula given on page 94 of the textbook. Now we have a lower multiplier value of 3.9=1.20/. 305. This is because public and banks do not deposit or lend, all they can.

Financial Institutions

noreply@blogger.com (Study For All) — Fri, 02 Mar 2012 10:46:00 +0000

Final Project Computerized Accounting

noreply@blogger.com (Study For All) — Thu, 12 Jan 2012 10:13:00 +0000

Following post should be ioon your Blog:

Set up of Company
Maintain Charts of Accounts
Maintain Customers and Vendors
Default information Customers and Vendors
Maintain Inventory Items
Default Information Inventory Items
Sales Quotation and Sales Order
Sales Invoice
Reciepts
Purchase Order
Purchase Recieve Inventory
Payments
Vendor Credit Memo
Credit Memo
General Journal Entry
Reports

Final Project for Advanced Financial Accounting

noreply@blogger.com (Study For All) — Tue, 10 Jan 2012 11:14:00 +0000

Final Project:
Details discussion on following arears on your own blog, followed by a comment on my blog here. Adjusting entries, Inventory, Propertyplant and equipment and cash flow statements. If the post has already been made on your blog, you may edit them to be a final project.
you may consult the site for PPT slides
http://www.studyforall.com/

Reciepts in Peachtree Accounting

noreply@blogger.com (Study For All) — Wed, 04 Jan 2012 10:19:00 +0000

Reciepts in Peachtree is used to record teh reciepts from Customers and even from Vendors.......

IAS 16 - Property, Plant and Equipment

noreply@blogger.com (Study For All) — Fri, 30 Dec 2011 07:17:00 +0000

According to IAS 16 - Property, Plant and Equipment the objective of IAS 16 is "to prescribe the accounting treatment for property, plant, and equipment. The principal issues are the recognition of assets, the determination of their carrying amounts, and the depreciation charges and impairment losses to be recognised in relation to them. "

you may have a very good article on Propert, Plant and Equipment at

www.studyforall.com/articles.htm

Bank Reconciliation Statements

noreply@blogger.com (Study For All) — Fri, 30 Dec 2011 03:13:00 +0000

Since there are timing differences between when data is entered in the banks systems and when data is entered in the individual's system, there is sometimes a normal discrepancy between account balances. The goal of reconciliation is to determine if the discrepancy is due to error rather than timing.

Sales Invoice - Peachtree

noreply@blogger.com (Study For All) — Mon, 26 Dec 2011 09:26:00 +0000

To record a sales invoice in Peachtree Accounting Software, you have to click on Task menu and then select Sales invoice. .................

Quotes and Sales Order - Peachtree

noreply@blogger.com (Study For All) — Thu, 22 Dec 2011 11:05:00 +0000

To build a Quote or Sales order in Peachtree, you click on Task menue ..................
you may find the details at:
http://www.studyforall.com/

IAS 2 - Inventories

noreply@blogger.com (Study For All) — Tue, 20 Dec 2011 04:09:00 +0000

Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials). .................

Maintain Inventory Item - Peachtree Accounting

noreply@blogger.com (Study For All) — Sat, 17 Dec 2011 10:58:00 +0000

Inventory item in Peachtree serve as subcidary ledger for Inventory......................

Peachtree - Maintain Vendor

noreply@blogger.com (Study For All) — Thu, 08 Dec 2011 10:44:00 +0000

Vendors are the parties who supply goods and services to the business. to maintain the vendors in peachtree .............................

Peachtree - Maintain Customers/Prospect

noreply@blogger.com (Study For All) — Thu, 08 Dec 2011 10:42:00 +0000

To maintain the customers/prospects, click on maintain menu and select "Customers/prospect".....................

Closing Entries

noreply@blogger.com (Study For All) — Mon, 21 Nov 2011 07:38:00 +0000

To update the balance in the owner's capital account, accountants close revenue, expense, and drawing accounts at the end of each fiscal year or, occasionally, at the end of each accounting period. For this reason, these types of accounts are called temporary or nominal accounts. Assets, liabilities, and the owner's capital account, in contrast, are called permanent or real accounts because their ending balance in one accounting period is always the starting balance in the subsequent accounting period. When an accountant closes an account, the account balance returns to zero. Starting with zero balances in the temporary accounts each year makes it easier to track revenues, expenses, and withdrawals and to compare them from one year to the next. There are four closing entries, which transfer all temporary account balances to the owner's capital account.

Close the income statement accounts with credit balances (normally revenue accounts) to a special temporary account named income summary.
Close the income statement accounts with debit balances (normally expense accounts) to the income summary account. After all revenue and expense accounts are closed, the income summary account's balance equals the company's net income or loss for the period.
Close income summary to the owner's capital account or, in corporations, to the retained earnings account. The purpose of the income summary account is simply to keep the permanent owner's capital or retained earnings account uncluttered.
Close the owner's drawing account to the owner's capital account. In corporations, this entry closes any dividend accounts to the retained earnings account. For purposes of illustration, closing entries for the Greener Landscape Group follow.

Accounting Cycle - Accounting

noreply@blogger.com (Study For All) — Fri, 18 Nov 2011 10:49:00 +0000

Complete the story.

Peachtree - Charts of Accounts - Account Type of Equity

noreply@blogger.com (Study For All) — Sat, 12 Nov 2011 12:17:00 +0000

Business Types and Equity Accounts

When we setup a new company on New Company Setup - Company Information window we have to select the business type. different business type use different equity accounts. which are as follows..

Corporation

When you select the Corporation business type during New Company Setup, the following equity accounts are automatically set up:

Common Stock (Equity doesn't close)
Retained Earnings (Equity – Retained Earnings)
Dividends Paid (Equity – gets closed)

S Corporation

When you select the S Corporation business type during New Company Setup, the following equity accounts are automatically set up:

Common Stock (Equity – doesn't close)
Retained Earnings (Equity – Retained Earnings)
Dividends Paid (Equity – gets closed)

Partnership

When you select the Partnership business type during New Company Setup, the following equity accounts are automatically set up:

Retained Earnings (Equity – Retained Earnings)
Partner's Contribution (Equity – gets closed)
Partner's Draw (Equity – gets closed)

Sole Proprietorship

When you select the Sole Proprietorship business type during New Company Setup, the following equity accounts are automatically set up:

Retained Earnings (Equity – Retained Earnings)
Owner's Contribution (Equity – gets closed)
Owner's Draw (Equity – gets closed)

Limited Liability Company (LLC)

When you select the Limited Liability Company business type during New Company Setup, the following equity accounts are automatically set up:

Retained Earnings (Equity – Retained Earnings)
Member's Contribution (Equity – gets closed)
Member's Draw (Equity – gets closed)

Adjusting Entries - Case 4.1 - Financial and Managerial Accounting by Williams et all 15e

noreply@blogger.com (Study For All) — Fri, 11 Nov 2011 05:35:00 +0000

Solution of the first two options are given here.
a.

No adjusting entry is needed, because although the revenue was collected in advance on September 1, it has all been earned prior to year-end. Thus, inclusion of the entire amount in revenue of the period is correct.

Three months’ revenue was collected in advance on December 1 and was credited to an unearned revenue account. At December 31, an adjusting entry is needed to recognize that one-third of this advance payment that has now been earned as revenue. The effects of this adjusting entry will be to reduce a liability (unearned revenue) and increase revenue recognized as earned in the period. Of course, recognizing revenue also increases owners’ equity.

Adjusting Entries - Case 4.1 - Financial and Managerial Accounting by Williams et all 15e

noreply@blogger.com (Study For All) — Fri, 11 Nov 2011 05:29:00 +0000

Solution of the first two options are given here.
a.

No adjusting entry is needed, because although the revenue was collected in advance on September 1, it has all been earned prior to year-end. Thus, inclusion of the entire amount in revenue of the period is correct.

Three months’ revenue was collected in advance on December 1 and was credited to an unearned revenue account. At December 31, an adjusting entry is needed to recognize that one-third of this advance payment that has now been earned as revenue. The effects of this adjusting entry will be to reduce a liability (unearned revenue) and increase revenue recognized as earned in the period. Of course, recognizing revenue also increases owners’ equity.