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588 Name three finance functions important to the firms overall operations and performance. The three functions important to the firms overall operations health would be forecasting financial needs, working with the budget process and establishing controls. Forecasting financial needs deals with short term and long term forecasting as well as cash flow forecasting. Short term forecasting predicts revenues, costs and expenses for a period of one year or less. This forecast is the foundation for most other financial plans, so its accuracy is critical, cash flow forecasts does exactly what it sounds like it does, forecasts future inflows and out flows of cash. Long term forecast predicts revenues, costs and expenses for a period longer than 1 year and sometimes as far as 5 or 10 years into the future. This plays a crucial role as you would imagine in the companies long term goals. What are the three primary financial problems that cause firms to fail? The three problems that cause firms to fail are undercapitalization, poor control over cash flow and inadequate expense control. Undercapitalization is when a firm does not have enough funds to adequately start the business. In what ways do short term and long term financial forecasts differ? Short term forecasts deal with issues a company may have no more than 1 year out. A long term forecast would deal with thing that could go out as far as 5 to 10 years and would deal with issues such as what technology should they invest in, where should they be in 5 years, should they buy a new plant and so forth. What is the organizations purpose in preparing budgets? Can you identify three different types of budgets? The organizations purpose in preparing budgets is to establish a viable financial plan that sets forth managements expectations and on the basis of those expectations allocates the use of specific resources throughout the firm. Without a budget in place a firm would go belly up in no time. A capital budget estimates a firms projected cash inflows and outflows that the firm can use to plan for any cash shortages or surpluses during a given period (e.g. monthly, quarterly). Cash budgets are important guidelines that assist managers in anticipating borrowing, debt repayment, operating expenses, and short term investments. The operating budget or master budget as it is sometimes called ties together all the firms other budgets and summarizes the business’s proposed financial activities. It can be defined more formally as the projection of dollar allocations to various costs and expenses needed to run or operate a business, given projected revenues. Finally a capital budget highlights a firms spending plans for major asset purchases that often require large sums of money. The capital budget primarily concerns itself with the purchase of such assets as property, buildings, and equipment.
Questions from page 592 Money is said to have a time value. What does this mean? The time value of money (TVM) or the discounted present value is one of the basic concepts of finance, developed by Leonardo Fibonacci in 1202. The time value of money is based on the premise that person prefers to receive a certain amount of money today, rather than the same amount in the future, all else equal. As a result, he demands interest when depositing money in a bank account or making any similar investment. Money received today is more valuable than money received in the future by the amount of interest the money can earn. If $90 today will accumulate to $100 a year from now, then the present value of $100 to be received one year from now is $90. TVM also takes into account risk aversion - both default risk and inflation risk. 100 monetary units today is a sure thing and can be enjoyed now. In 5 years that money could be worthless or not returned to the investor. There is a residual time value of money, beyond compensation for default and inflation risk that represents simply the preference for consumption now versus later. Inflation-indexed bonds notably carry no inflation risk. In the United States for instance, Treasury Inflation-Protected Securities carry neither inflation nor default risk, but pay interest. Three formulas are used to adjust for this time value: The present value formula is used to discount future money streams: that is, to convert future amounts to their equivalent present day amounts. The future value formula is used to compound today's money into the equivalent amount at some time in the future (i.e., to compound money...either a lump sum or streams of payments). The present value of an annuity formula is used to discount a series of periodic payments of equal amounts to the present day. Variations of this formula can find the future value of the annuity, or solve for the annuity given the present value (for example, finding monthly mortgage payments) or find the annuity given the future value (for example finding a monthly payment needed to reach a retirement savings goal).
Why are accounts receivable a financial concern to the firm? On a company’s balance sheet accounts receivable is the amount of money customers owe the firm, they are sometimes called trade receivables and are recorded on a company’s balance sheet as current assets. These can become quite important if they are not paid because they can affect the cash flow of a firm. If they are not paid the can be sold off to banks or other investors this is called factoring. What’s the primary reason an organization spends a good deal of its available funds on inventory and capital expenditures? A primary reason a firm will spend great amounts of available funds on capital expenditures are that these expenditures can help the firm to enter into markets by creating them or by obtaining them. Firms must also spend a great deal of money on inventory to satisfy customers since they intend to recapture their investment in inventory through sales to customers. What’s the difference between debt and equity financing?
Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy. A debt is created when a creditor agrees to loan a sum of assets to a debtor. In modern society, debt is usually granted with expected repayment; in many cases, plus interest. Historically, debt was responsible for the creation of indentured servants. Equity financing is money raised form within the firm (form operations) or through the sale of ownership in the firm (e.g. sale of stock). Questions from page 597 What does the term 2/10, net 30 mean? This means that the firm buying the product or service may receive a discount of 2% if the balance is paid within 10 days of receipt of bill. If they choose not to pay in 10 days they must pay the bill within 30 days of receipt. If a firm is able to pay by the 2/10 terms they would greatly save money on their financing of the products since there are 18, 20 periods in a year that would be an effective savings of 36% on the financing. What’s the difference between trade credit and a line of credit at a bank? Trade credit is the practice of buying goods and services now and paying for them later. A line of credit comes from a bank and gives a firm an amount of unsecured short term funds, so a firm can have funds readily available for when it is needed. What’s the difference between a secured loan and an unsecured loan? A secured loan is one where collateral is put up. Collateral is an asset such as a home. When you get a home mortgage the house is the collateral. If you do not pay your mortgage the bank may foreclose on your home and sell it to repay the mortgage you borrowed. And unsecured loan is one that is usually only given to clients that are long standing and are know to be able to repay the loan. What is factoring? What are some of the considerations involved in establishing a discount rate in factoring? Factoring is the process of selling accounts receivable for cash. Some considerations in establishing a discount rate in factoring would be how large the accounts receivable you are selling, the history of the customer by way of late pays. Firms can reduce the rate by assuming the risk of slow and non-pay customers. What are two major forms of debt financing available to a firm? Two ways a firm may obtain debt financing is through a tradition institutional lender or through issuing bonds. Firms that develop and establish a rapport with a bank, insurance company, pension fund, or commercial finance company are often able to secure a long term loan. Long-term loans are usually repaid within 3 to 7 years and may extend to 15 to 20 years. For such loans a firm must sign what is called a term-loan agreement, this is a promissory note. The higher the risk a lender takes the higher the rate of interest a lender requires in making the loan. This principal is known as risk/return trade-off. Another form of debt financing is through issuing bonds. If an organization is unable to
obtain financing through traditional means it may issue a bond. There are two basic types of bonds. A secured bond is a bond issued with some form of collateral and an unsecured bond is a bond backed only by the reputation of the issuer also called a debenture bond. How does debt financing differ form equity financing? Debt financing has to be paid back at a certain time and equity financing does not have to be paid back since you are selling ownership in the firm for the amount of money that you are trying to obtain. What are the major forms of equity financing available to a firm? Some forms of equity financing available to a firm are from selling ownership through and IPO, retained earnings or Venture Capita (VC). The first time a firm offers to sell stock to the public it is called and IPO or Initial Public Offering. Before a company can perform one of these they need approval from the SEC and state and local governments. Financing through retained earnings is financing through the companies profits or self financing. This is the favored type of financing since a firm does not have to repay anyone and does not have to sell ownership to get them money. VC is another form of financing. The hardest time for a business to raise money is when they are just starting out or are in early stages of expansion. VC is money that is invested in new or emerging companies that are perceived as having great profit potential. VC has helped firms like Intel and Apple Computers. What is leverage and why would firms choose to use it? Leverage is raising needed funds through borrowing to increase a firm’s rate of return. Firms are very concerned with the cost of capital. Cost of capital is the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders. Say a cereal company needed $500,000 they could use some equity financing or debt and equity financing. If they chose to use both they could sell 10% equity and 90% by issuing bonds and it would look something like this. Common Stock Bond (@ 10% interest) Total raised Earnings Less bond interest Net earnings/Income Return to Stockholders $50,000 $450,000 $500,000 $125,000 $45,000 $80,000
$80,000 $50,000 This would equal a return of 160% Common stock Earnings Net earnings/income $500,000 $125,000 $125,000
Return to stockholders
$125,000 $500,000 This equals a rate or return of 25% Chapter 20 Questions from page 614 Why are bonds considered to be a form of debt financing? Bonds are considered a form of debt financing because they raise money for a firm that must be paid back a certain time in the future just like a loan would need to be repaid. Bonds also pay interest on the money taken in. The interest money that is paid out on bonds is also tax deductible so bonds can prove an effective method of getting necessary money. What does it mean when a firm states that it is issuing a 9 percent debenture bond due in 2025? A debenture bond is a bond that does not require any collateral but instead relies on the creditworthiness of the firm and their reputation. The 9 percent referred to is the amount of interest paid on the bond, and the amount of the bond plus all accruable interest is due in 2025. Explain the difference between an unsecured and a secured bond. An unsecured bond is not back by collateral such as a plant or equipment; these are referred to as debenture bonds. Generally only well respected firms with excellent credit ratings can issue debenture bonds, since the only security the bond holder has is their reputation and credit history. Secured bonds are back by some tangible asset (collateral) that is pledged to the bondholder if bond interest isn’t paid or the principal isn’t paid back when promised. For example, a mortgage bond is a bond secured by company assets such as land and buildings. Why do companies like callable bonds? Why do investors dislike them? A callable bond is one that can be paid off before the maturity date; therefore investors don’t like them because they will not be able to realize the full amount of interest of the bond. Say a company wants to issue a $50 million bond in 20 year bonds in 2005 and at rate of 10%. The yearly interest rate expense would be $5 million, if market conditions change in 2010 and bonds issued with the same quality are paying 7% the issuing company would in essence be overpaying due to the fact that current market conditions are cheaper. If the company did not pay off the bond and reissue the remaining part they would be overpaying 3% per year or $1.5 million per year. The company could choose to either pay off the bond and reissue the remainder or keep paying the bond as is. They may only choose to do so if significant tax implications are at hand since interest paid on bonds is tax deductible. Why are convertible bonds so attractive to investors?
Convertible bonds are attractive to investors due to the fact that they can be converted into shares of common stock. If the company’s common stock is on the rise the bond holders may want to convert the bond to common shares and may make more money that way. Companies can also see this as positive by the fact that they no longer owe any debt, and can later on repurchase shares from the investors if market conditions turn adverse for cheap. It is rare that an opportunity like this would arise if it ever did, but hypothetically if a convertible bond was issued and like in the bull market of the late 90’s bondholders converted the bonds to stock they would make large sums of money, but when the market crashed the companies could by the stock back from them very cheap and ride out the market and even end up making money on the original bond they issued. Don’t know if this has ever happened but why couldn’t it? Questions from page 617 Name at least two advantages and disadvantages of issuing stock as a form of equity financing. The following are forms of advantages by issuing stock as a form of equity financing: As owners of the business, stockholders never need to be repaid. There's no legal obligation to pay dividends to stockholders, therefore, income (retained earnings) can be reinvested in the firm for future financing needs. Selling stock can improve the condition of a firm’s balance sheet since issuing stock creates no debt. (A corporation may also buy back its stock to improve its balance sheet and make the company appear stronger financially) Some disadvantages of issuing stock are as follows: As owners, stockholders (usually common stockholders) have the right to vote for the company’s board of directors. Typically one vote is granted per one share of stock held. Hence, the direction and control of the firm can be altered by the sale of additional shares of stock. Dividends are paid out of profit after tax and are not tax deductible. Management’s decisions can be affected by the need to keep shareholders happy. What are the major differences between preferred stock and common stock? Preferred stock is stock that gives its owners preference in the payment of dividends and an earlier claim on assets than common stockholders if the company is forced out of business and its assets sold. Preferred stock dividends differ from common stock dividends in several ways. Preferred stock is generally issued with a par value that becomes the base for the dividend the firm is willing to pay. For example, if a preferred stocks par value is $100 a shares and is dividend rate is 4 percent, the firm is committing to pay $4 per share in dividends. Common stock which is the most common form of ownership in a firm; it confers voting rights and the right to share in the firms profits through dividends, if offered by the firms board of directors. In what way are bonds and preferred stock similar? Bonds and preferred stock are similar in a sense that they both have a face value and both have a fixed rate of return. Also like bonds rating agencies can rate preferred stock according to risk.
Questions from page 625 What is the primary purpose of a stock exchange? Can you name the largest stock exchange in the United States? The purpose of a stock exchange is actually two fold. First companies need to sell stock the public through what is known as an IPO. This is the primary market for stocks. There is also a secondary market where stocks and various other instruments are traded between individual investors with the proceeds going to them not the company. The largest stock exchange in the United States is the NYSE, New York Stock Exchange “The World Puts It’s Stock In Us” What does NADAQ stand for? How does this exchange work? NASDAQ stands for National Association of Securities Dealers Automated Quotations. The NASDAQ is a telecommunications network. It links dealers across the nation so that they can buy and sell securities electronically rather than in person. Today NASDAQ handles major companies such as Dell and Starbucks. For a company to be listed on the NASDAQ they must meet certain requirements. These are some of them: Total market value of all shares of $8 million; 400 shareholders holding at least 100 shares. ECNs were created out of the NASDAQ Market Makers Antitrust Litigation led by lawyer William Lerach. The litigation alleged collusion between Wall Street traders, and was proven in 1998, leading to a $1 billion settlement from major Wall Street firms. At the time of the settlement, the SEC also put in a new regulation, the Limit Order Display Rule (rule 11Ac1-4), which authorized "electronic communication networks," or ECNs. Major ECNs that became active at this time were Instinet and Island, (which were since merged into INET and acquired by NASDAQ), Archipelago Exchange (which was acquired by the NYSE), and Brut (now acquired by NASDAQ). ECNs increased competition amongst trading firms by lowering transaction costs, giving clients full access to their order books, and offering order matching outside of traditional exchange hours. What is the key advantage of online investing? What do investors need to remember if they decide to do their investing online? The commissions charged by online firms are far less than those of regular stockbrokers. Trades that used to cost hundreds of dollars now can cost as little as $4 on the web. Online services will provide information but how much is decided on the size of your account and how much activity you produce for them. Also if you decide to use online investing you need to do your own objective research as you will not have the assistance of a broker. Questions from page 630 What services do such companies such as Standard & Poor’s and Moody’s Investor Service provide in bond markets? Standard and Poor’s and Moody’s provide services in the bond market by way of rating bonds and companies risk levels, naturally the higher the risk the higher the rate of return.
What is a stock split? Why do companies sometimes split their stock? A stock split is when a companies stock is trading at a high price say $100 a share and the market is not responding well to the price because it is to high. The company could do a 2 for 1 forward split and the shares would now be worth $50 per share. This is good for the investors as well as the company if they are buying shares before the split. Now if an investor has 1,000 shares at $100 they will now have 2,000 shares at $50. Now every time the stock goes up $1 they are now making twice as much as they were before. This also allows a company to grow its market cap without having to issue any more shares. What is a mutual fund and how do such funds benefit from small investors? A mutual fund is an organization that buys stocks and bonds and then sells shares in those securities to the public. A mutual fund is an investment company that pools investor’s money together to buy stocks and bonds. In 2000 bond and stock mutual funds controlled $7.47 trillion of investor’s money. What is meant by buying stock on margin? When stock is bought on margin an investor can buy some of the stock by borrowing money from the brokerage. The margin is the amount of money an investor must invest in the stock. The board of governors of the Federal Reserve System sets the margin rates in the US market. Why would manufacturers of products such as candy, coffee, and bread be interested in the futures market? Futures markets are a commodities market that involves the purchase and sale of goods for delivery sometime in the future. Say you own a cereal company and need to by wheat; you would purchase a futures contract so that you could plan your budget accordingly, and you know how much the wheat is going to cost you in the future so you are able to set up your future budget. Questions from page 636 What exactly does the Dow Jones Industrial Average (DJIA) measure? Why is it important? The DJIA is a broad index of about 30 companies and it is an indicator for the overall market condition. The Dow Jones Industrial Average (NYSE: DJI) is one of several stock market indices created by Wall Street Journal editor and Dow Jones & Company founder Charles Dow. Dow compiled the index as a way to gauge the performance of the industrial component of America's stock markets. It is the oldest continuing U.S. market index. Today, the average consists of 30 of the largest and most widely held public companies in the United States. The "industrial" portion of the name is largely historical —many of the 30 modern components have little to do with heavy industry. To compensate for the effects of stock splits and other adjustments, it is currently a weighted average, not the actual average of the prices of its component stocks. Why do the 30 companies comprising the Dow average change periodically?
The individual components of the DJIA are occasionally changed as market conditions warrant. They are selected by the editors of The Wall Street Journal. When companies are replaced, the individual weightings are adjusted so that the value of the average is not directly affected by the change. The Dow Jones Industrial Average consists of the following 30 companies:
• • • • • • • • • • • • • • • • • • • • • • • • • • • • • •
3M Co. (NYSE: MMM) (conglomerates, "manufacturing") ALCOA Inc. (NYSE: AA) (aluminum) Altria Group, Inc. (NYSE: MO) (tobacco, foods) American International Group, Inc. (NYSE: AIG) (property & casualty insurance) American Express Co. (NYSE: AXP) (credit services) AT&T Inc. (NYSE: T) (telecoms) Boeing Co., The (NYSE: BA) (aerospace/defense) Caterpillar, Inc. (NYSE: CAT) (farm & construction equipment) Citigroup, Inc. (NYSE: C) (money center banks) Coca-Cola Co. (NYSE: KO) (beverages) E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals) Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas) General Electric Co. (NYSE: GE) (conglomerates, media) General Motors Corporation (NYSE: GM) (auto manufacturers) Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems) Home Depot, Inc. (NYSE: HD) (home improvement stores) Honeywell International, Inc. (NYSE: HON) (conglomerates) Intel Corp. (NASDAQ: INTC) (semiconductors) International Business Machines Corp. (NYSE: IBM) (diversified computer systems) JPMorgan Chase and Co. (NYSE: JPM) (money center banks) Johnson & Johnson Inc. (NYSE: JNJ) (consumer and health care products conglomerate) McDonald's Corp. (NYSE: MCD) (restaurant franchise) Merck & Co., Inc. (NYSE: MRK) (drug manufacturers) Microsoft Corp. (NASDAQ: MSFT) (software) Pfizer, Inc. (NYSE: PFE) (drug manufacturers) Procter & Gamble Co. (NYSE: PG) (consumer goods) United Technologies Corp. (NYSE: UTX) (conglomerates) Verizon Communications (NYSE: VZ) (telecoms) Wal-Mart Stores, Inc. (NYSE: WMT) (discount, variety stores) Walt Disney Co., The (NYSE: DIS) (entertainment)
Explain program trading and the problems it can create? Program trading is casually defined as the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. More precisely, the New York Stock Exchange defines a program trade as a basket of stocks having either a total value of $1M (or more) and where the total number of stocks in the basket is 15 or greater. Based on the definition above, it should be noted here that the term "program" in the context program trading is referring to a basket, portfolio or a collection shares or securities,
rather than a computer program, contrary to a common misconception. Program trades need to be specifically marked as such when submitted to the exchanges, and there are certain restrictions placed on programs that do not apply to non-program trades (NYSE rule 80-A, for example). In recent times, there has been a subset of program trading called algorithmic trading. This is when a very complex computer program takes an order and breaks it up into very small pieces (typically 100-300 shares per piece) and gradually submits these pieces into the market. The goal is to trade quickly enough to get your order done before others "catch on" to what you're doing, and at the same time to trade slowly enough so that you do not impact the stock by "walking the boork". Through the 1970s and early 1980s, computers were becoming more important on Wall Street. They allowed instantaneous execution of orders to buy or sell large batches of stocks and futures. The most popular explanation for the 1987 crash was selling by program traders. Many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Program trading is extremely popular amongst hedge funds in which traders can partake in sophisticated strategies. Long or short positions are taken as desired technical conditions arise. Strategies are often based off of historical price activity. Computers allow traders to back test their strategies on decades of historical data. Chapter 21 Questions from page 650 What is money? Money is anything that people generally accept as payment for goods and services. In the past, objects as diverse as salt, feathers, stones, rare shells, tea and horses have been used as money. In fact, until the 1880’s, cowries’ shells were one of the world’s most abundant currencies. What are the characteristics of useful money? For money to be useful it needs to carry certain characteristics. Money is generally considered to have the following three characteristics: 1. It is a medium of exchange When something is consistently used as an intermediate object of trade, as opposed to direct barter, then it is regarded as a medium of exchange. Such a thing simplifies the process of trade by allowing trade to take place without the need for double coincidences. 2. It is a unit of account When the value of a market good is frequently used to measure or compare the value of other goods or where its value is used to denominate debts then it is functioning as a unit of account. A debt or an IOU can not serve as a unit of account because its value is specified by comparison to some external reference value, some actual unit of account that may be used for settlement. Unless, of course, the debt or IOU is also an accepted medium of exchange, in which case we have money. For example, if in some culture people are inclined to measure the worth of things with reference to goats then we would regard goats as the dominant unit of account in that culture. For instance we may say that today a horse is worth 10 goats and a good hut is
worth 45 goats. We would also say that an IOU denominated in goats would change value at much the same rate as real goats. 3. It is a store of value When something is purchased primarily to store value for future trade then it is being used as a store of value. For example, a sawmill might maintain an inventory of lumber that has market value. Likewise it might keep a cash box that has some currency that holds market value. Both would represent a store of value because through trade they can be reliably converted to other goods at some future date. Most non-perishable goods have this quality. Most goods are capable of possessing all of the characteristics outlined above to a greater or lesser degree. However, the more successful a money is the greater the degree in which it will typically satisfy all three criteria. What is the money supply and why is it important? Money supply ("monetary aggregates", "money stock"), a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. The monetary sector, as opposed to the real sector, concerns the money market. The same tools of analysis can be applied as to other markets: supply and demand result in an equilibrium price (the interest rate) and quantity (of real money balances). When thinking about the "supply" of money, it is natural to think of the total of banknotes and coins in an economy. That, however, is incomplete. In the United States, coins are minted by the United States Mint, part of the Department of the Treasury, outside of the Federal Reserve. Banknotes are printed by the Bureau of Engraving & Printing on behalf of the Federal Reserve as symbolic tokens of electronic credit-based money that has already been created or more precisely, issued by private banks through fractional reserve banking. In this respect, all banknotes in existence are systematically linked to the expansion of the electronic credit-based money supply. However, coinage can be increased or decreased outside this system by Legal Mandate or Legislative Acts. However, at present the coin base is held in check and used as a complementary system rather than a competitive system with private bank issue of electronic credit-based money. The common practice is to include printed and minted money supply in the same metric M0. The more accurate starting point for the concept of money supply is the total of all electronic credit-based deposit balances in bank (and other financial) accounts (for more precise definitions, see below) plus all the minted coins and printed paper. The M1 money supply is M0, plus the total of all non-paper or coin deposit balances. The relationship between the M0 and M1 money supplies is the money multiplier — basically, the ratio of cash and coin in people's wallets and bank vaults and ATMs to Total balances in their financial accounts. The gap and lag between the two (M0 and M1 - M0) occurs because of the system of fractional reserve banking. So we can see that money supply is very critical to the US economy, to much money and inflation will grow at a rate that could be uncontrollable and to little money the economy could suffer severe deflation. What are the various ways the Fed controls the money supply, and how do they work? The Fed can control money trough various means but does so primarily through raising the rates it charges retail banks for money which will directly correlate to the amount of
money available for use in the economy. The Federal Reserve System controls the size of the money supply by conducting open market operations, in which the Federal Reserve engages in the lending or purchasing of specific types of securities with authorized participants, known as the Fed's primary dealers. All Open Market Operations in the United States are conducted by the Open Market Desk at the Federal Reserve Bank of New York with an aim to making the federal funds rate as close to the target rate as possible. For a detailed look at the process by which changes to a reserve account held at the Fed affect the wider monetary supply of the economy, see money creation. The Open Market Desk has two main tools to adjust the monetary supply, repurchase agreements and outright transactions. To smooth temporary or cyclical changes in the monetary supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the transaction, the Fed deposits money in a primary dealer’s reserve account, and receives the promised securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer’s reserve account for the principal and accrued interest. The term of the repo (the time between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days, though the Fed will most commonly conduct overnight and 14-day repos. Since there is an increase of bank reserves during the term of the repo, repos temporarily increase the money supply. The effect is temporary since all repo transactions unwind, with the only lasting net effect being a slight depletion of reserves caused by the accrued interest (think one day of interest at a 4.5% annual yield, which is 0.0121% per day). The Fed has conducted repos almost daily in 2004-2005, but can also conduct reverse repos to temporarily shrink the money supply. In a reverse repo the Fed will borrow money from the reserve accounts of primary dealers in exchange for Treasury securities as collateral. At maturity, the Fed will return the money to the reserve accounts with the accrued interest, and collect the collateral. Since this drains reserves, reverse repos temporarily contract the monetary supply, except, again, for the extremely small lasting increase caused by the accrued interest. The other main tool available to the Open Market Desk is the outright transaction. Outrights differ from repos in that they permanently alter the money supply. Outright transactions overwhelmingly involve the purchase of Treasury securities in the secondary market. In an outright purchase, the Fed will buy Treasury securities from primary dealers and finance these purchases by depositing newly created money in the dealer’s reserve account at the Fed. Since this operation does not unwind at the end of a set period, the resulting growth in the monetary supply is permanent. The Fed also has the authority to sell Treasuries outright, but this has been exceedingly rare since the 1980s. The sale of Treasury securities results in a permanent decrease in the money supply, as the money used as payment for the securities from the primary dealers is removed from their reserve accounts, thus working the money multiplier process in reverse. What are the major functions of the Fed? What other functions does it perform? The main tasks of the Federal Reserve System are to: Supervise and regulate banks, implement monetary policy by open market operations, setting the discount rate, and setting the reserve ratio, maintain a strong payments system, Control the amount of currency that is made and destroyed on a day to day basis (in conjunction with the Mint
and Bureau of Engraving and Printing) Other tasks include: Economic research, Economic education, Community outreach Questions from page 657 Why did the US need a Federal Reserve Bank? By the time of the Civil War the US banking system was a mess. The first institution with responsibilities of a central bank in the U.S. was the First Bank of the United States, chartered in 1791. Later, in 1816, the Second Bank of the United States was chartered. From 1837 to 1862, in the Free Banking Era there was no formal central bank, while from 1862 to 1913, a system of national banks was instituted by the 1863 National Banking Act. A series of bank runs later provided the impetus for the creation of a more centralized banking system. After the Panic of 1907 came close to shutting down the national banking system, bankers turned to Europe for ideas on how to implement central banking. Impetus for the System came from the voluminous reports (1909-1912) of the National Monetary Commission created by the Aldrich-Vreeland Act in 1908. Senator Nelson W. Aldrich was the Republican leader in the Senate. It took the political clout of Woodrow Wilson to get the bankers' plan passed over the objections of agrarian leader William Jennings Bryan. Wilson started with the bankers' plan that had been designed for conservative Republicans by banker Paul M. Warburg. Wilson had to outmaneuver the powerful agrarian wing of the party, led by William Jennings Bryan, which strenuously denounced banks and Wall Street. They wanted a government owned central bank which could print paper money whenever Congress wanted; Wilson convinced them that because Federal Reserve notes were obligations of the government, the plan fit their demands. Southerners and westerners learned from Wilson that the system was decentralized into 12 districts and surely would weaken New York and strengthen the hinterlands. One key opponent Congressman Carter Glass, was given credit for the bill, and his home of Richmond, Virginia, was made a district headquarters. Powerful Senator James A. Reed of Missouri was given two district headquarters in St. Louis and Kansas City. Congress passed the Federal Reserve Act in late 1913. Wilson named Warburg and other prominent bankers to direct the new system, pleasing the bankers. The New York branch dominated the Fed and thus power remained in Wall Street. The new system began operations in 1915 and played a major role in financing the Allied and American war efforts. What’s the difference between a bank, savings and loan association and a credit union? Commercial banks are profit-seeking institutions that receive deposits from individuals and corporations in the form of checking and savings accounts and then use some of these funds to make loans. Some deposits would be demand deposits which are the technical term for a checking account, the money in a demand deposit can be withdrawn anytime on demand from the depositor. A time deposit is the technical name for a savings account; the bank can require prior notice before the owner withdraws money from a time deposit. There are also CD’s or certificates of deposit. This is a time deposit account that earns interest to be delivered at the end of the certificates maturity date, which helps to enforce the principal of Money Time Value. Savings and loan associations are financial institutions that accept both savings and checking deposits and provides
home mortgage loans. They are also commonly known as thrift institutions since their original purpose was to promote thrift and home ownership. Credit unions to which is something I belong to, are member-owned financial cooperatives that offer the full variety of banking services to their members, today the 10,000 or so credit unions in the US serve some 83 million clients. Credit unions have grown at four times the rate of the commercial banking industry. Typically, credit unions offer their members interestbearing checking accounts at relatively high rates, short-term loans at relatively low rates, financial counseling, life insurance policies, and a limited number of home mortgage loans. What is a consumer finance company? Non-bank financial companies (NBFCs) also known as a non-bank or a non-bank bank, are financial institutions that provide banking services without meeting the legal definition of a bank, i. e. one that does not hold a banking license. Operations are, regardless of this, still exercised under bank regulation. However this depends on the jurisdiction, as in some jurisdictions, such as New Zealand, any company can do the business of banking, and there are no banking licenses issued. Non-bank institutions frequently acts as suppliers of loans and credit facilities, however they are typically not allowed to take deposits from the general public and have to find other means of funding their operations such as issuing debt instruments. In India, most NBFCs raise capital through Chit Funds. Questions from page 663 What’s the difference between FDIC and SAIF? FDIC stands for Federal Deposit Insurance Corporation. It is an independent agency of the US government that insures bank deposits. If a bank were to fail, the FDIC would arrange to have that bank’s accounts transferred to another bank or pay off depositors up to a certain amount ($100,000 per account) The FDIC covers about 13,000 institutions, mostly commercial banks. What would happen if one of the top 10 banks in the US were to fail? The FDIC has a contingency plan to nationalize the bank so that it wouldn’t fail. The idea is to maintain confidence in banks so that others do not fail if one happens to falter. The SAIF is the Savings Association Insurance Fund. It insures holders of accounts in savings and loan associations. It’s now part of the FDIC. It was originally called the Federal Savings and Loan Insurance Corporation (FSLIC) and was an independent agency. Both of these agency’s were started in the early 1930’s/ Describe an electronic funds transfer system (ETF) and its benefits. Electronic funds transfer or EFT refers to the computer-based systems used to perform financial transactions electronically. The term is used for a number of different concepts: cardholder-initiated transactions, where a cardholder makes use of a payment card, electronic payments by businesses, including salary payments, electronic check (or check) clearing Credit cards
EFT may be initiated by a cardholder when a payment card such as a credit card or debit card is used. This may take place at an automated teller machine (ATM) or point of sale (POS), or when the card is not present, which covers cards used for mail order, telephone order and internet purchases. Card-based EFT transactions are often covered by the ISO 8583 standard. Transaction types: A number of transaction types may be performed, including the following: Sale, where the cardholder pays for goods or service. Refund: where a merchant refunds an earlier payment made by a cardholder. Withdrawal: the cardholder withdraws funds from their account, e.g. from an ATM. The term Cash Advance may also be used, typically when the funds are advanced by a merchant rather than at an ATM. Deposit: where a cardholder deposits funds to their own account (typically at an ATM). Cash back: where a cardholder withdraws funds from their own account at the same time as making a purchase. Inter-account transfer: transferring funds between linked accounts belonging to the same cardholder) Payment: transferring funds to a third party account. Inquiry: a transaction without financial impact, for instance balance inquiry, available funds inquiry, linked accounts inquiry, or request for a statement of recent transactions on the account. Administrative: this covers a variety of non-financial transactions including PIN change. The transaction types offered depend on the terminal. An ATM would offer different transactions from a POS terminal, for instance. Authorization EFT transactions require communication between a number of parties. When a card is used at a merchant or ATM, the transaction is first routed to an acquirer, then through a number of networks to the issuer where the cardholder's account is held. A transaction may be authorized offline by any of these entities through a stand-in agreement. Stand-in authorization may be used when a communications link is not available, or simply to save communication cost or time. Stand-in is subject to the transaction amount being below agreed limits. These limits are calculated based on the risk of authorizing a transaction offline, and thus vary between merchants and card types. Offline transactions may be subject to other security checks such as checking the card number against a 'hotcard' (stolen card) list, velocity checks (limiting the number of offline transactions allowed by a cardholder) and random online authorization. A transaction may be authorized via a pre-authorization step, where the merchant requests the issuer to reserve an amount on the cardholder's account for a specific time, followed by completion, where the merchant requests an amount blocked earlier with a pre-authorization. This transaction flow in two steps is often used in businesses such as hotels and car rental where the final amount is not known, and the pre-authorization is made based on an estimated amount. Completion may form part of a settlement process, typically performed at the end of the day when the day's completed transactions are submitted.
EFT transactions may be accompanied by methods to authenticate the card and the cardholder. The merchant may manually verify the cardholder's signature, or the cardholder's Personal identification number (PIN) may be sent online in an encrypted form for validation by the card issuer. Other information may be included in the transaction, some of which is not visible to the cardholder (for instance magnetic stripe data), and some of which may be requested from the cardholder (for instance the cardholder's address or the CVV2 value printed on the card). EMV cards are smartcardbased payment cards, where the smartcard technology allows for a number of enhanced authentication measures. What are the limitations of online banking? One of the greatest hurdles of online banking is Security. I can attest to this by the fact that on July the 4th I received a call from VISA that an authorization had been put on my debit card for $100. Now of course the money never came out of my account but I had a physical location to resort to where I could talk to some one face to face. If you use and online exclusive bank you may have a problem doing this. What are the roles of the World Bank and IMF? The World Bank is primarily responsible for financing economic development; also known as the International Bank for Reconstruction and Development. The IMF is an organization that assists the smooth flow of money among nations. The World Bank Group is a group of five international organizations responsible for providing finance and advice to countries for the purposes of economic development and poverty reduction, and for encouraging and safeguarding international investment. The group and its affiliates have their headquarters in Washington, D.C., with local offices in 124 member countries. Together with the separate International Monetary Fund, the World Bank organizations are often called the "Bretton Woods" institutions, after Bretton Woods, New Hampshire, where the United Nations Monetary and Financial Conference that led to their establishment took place (1 July-22 July 1944). The Bank came into formal existence on 27 December 1945 following international ratification of the Bretton Woods agreements. Commencing operations on 25 June 1946, it approved its first loan on 9 May 1947 ($250m to France for postwar reconstruction, in real terms the largest loan issued by the Bank to date). Its five agencies are the International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), International Development Association (IDA), Multilateral Investment Guarantee Agency (MIGA), and the International Centre for Settlement of Investment Disputes (ICSID). The IMF describes itself as "an organization of 184 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty". With the exception of North Korea, Cuba, Liechtenstein, Andorra, Monaco, Tuvalu and Nauru, all UN member states either participate directly in the IMF or are represented by other member states. In the 1930s, as economic activity in the major industrial countries dwindled, countries started adopting mercantilist practices, attempting to defend their economies by increasing restrictions on imports. To conserve dwindling reserves of gold and foreign exchange, some countries curtailed foreign imports, some devalued their currencies, and some introduced complicated restrictions on foreign exchange accounts held by their
citizens. These measures were arguably detrimental to the countries themselves as the Ricardian comparative advantage states that everyone gains from trade without restrictions. It is noteworthy to mention that, although the "size of the pie" is enhanced according to this theory of free trade, when distributional concerns are taken into account, there are always industries that lose out even as others benefit. World trade declined sharply, as did employment and living standards in many countries. Chapter 22 Questions from page 677 What are the six steps you can take today to control your finances? First you need to take an inventory of you financial assets. You need to develop a balance sheet for yourself. Remember; a balance sheet starts with the fundamental accounting equation: Assets = Liabilities + Owners equity. Next you need to keep track of all expenses right down to the last penny. This is the only way you will be able to trace where your money goes if you need to track you’re spending or if you run into a problem in the future. Once you know what your financial situation is you must prepare a balanced budget. Budgets as you remember are financial plans. Some important items would include mortgage, utilities, food, clothing and vehicle expenses just to name a few. Next you must have a plan in place to pay off your debts. You should always start with the ones that carry the highest interest rate. Next you need to start a savings plan. It’s important to set aside some money each month in a separate account for large purchases you’re likely to make such as a new car or house. Finally you should only borrow money to pay for assets that have the potential to increase in value or generate income. Only the most unexpected of expenses should cause you to borrow money to pay for them. What steps should a person follow to build capital? One of the easiest yet most underutilized ways of building capital is to reduce the amount of money spent on miscellaneous items that produce no income for you. Why is real estate a good investment? First of all real estate is the only investment you can live in. Secondly once you buy a home, the payments are relatively fixed (though taxes and utilities may go up). As your income rises, the house payments get easier to make, but renters often find that rent goes up at least as fast as income. Home ownership is also tax deductible, in other words the interest you pay on the mortgage may be deducted from your taxes. Questions from page 688 What are three advantages of using a credit card? Credit cards are needed to build credit and can help in keeping track of expenses. Credit cards may also be used as a form of identification. Finally a credit card is more convenient than cash or checks. If you lose the CC you will not be at risk since you can call the institution and have them cancel the card and issue you another one. What kind of life insurance is recommended for most people?
A whole life insurance policy is something that can be very helpful to people that have trouble saving money as some of the premium goes towards insurance and some goes towards a savings plan. A universal life policy lets you choose how much of your payment should go to insurance and how much to investments. The investments traditionally were very conservative but paid a steady interest rate. What are the advantages of investing in a 401(k) account and IRA and a Keogh account? The 401(k) plan is a type of employer-sponsored retirement plan named after a section of the United States Internal Revenue Code. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money or earnings until withdrawal. Comparable types of salary-deferral retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 457 plans which cover employees of state and local governments and certain tax-exempt entities. Starting in the 2006 tax year, employees can opt to use the Roth 401(k), Roth 403(b) to have the same tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. Therefore, the following discussion does not involve Roth 401(k) accounts unless specified. The employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return. In 2004, this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g. deductions). Furthermore, earnings from the investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time. An Individual Retirement Account (or IRA) is a retirement plan account that provides some tax advantages for retirement savings in the United States. There are a number of different types of IRAs which may be either employer provided plans and self-provided plans. The types include: Roth IRA - contributions are made with after-tax assets, all transactions within the IRA are tax-free, and withdrawals are usually tax-free. Named for Senator William Roth. Traditional IRA - contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA are tax-free, and withdrawals at retirement are taxed as income (except for contributions that were not deducted). SEP IRA - a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name. SIMPLE IRA - a simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately. An IRA can only be funded with cash or cash equivalents. Attempting to transfer any other type of asset into the IRA is a prohibited transaction and disqualifies the IRA from its beneficial tax treatment. (Of course, rollovers, transfers, and conversions between IRAs and other retirement accounts can include any asset.) The maximum for an IRA contribution in the year 2006 is $4,000 for an individual under the age of 50.
Individuals aged 50 and older can contribute up to $5000. Keep in mind, this limit is for Roth IRAs, traditional IRAs, or some combination of the two. You cannot put more than $4,000 into your Roth and traditional IRA combined. So if you are 45 and put $3,500 into your traditional IRA this year so far, you can either put $500 more into your traditional IRA or $500 in your Roth IRA- no more. However, because this is still before the filing deadline (April 15, 2007) for calendar year 2006, the cash method taxpayer could get the full $4000 limit for the Roth by simply calling the $3,500 a Roth and NOT claiming the $3,500 above the line (i.e reduces AGI) deduction and making the remaining $500 a Roth. There may be an additional administrative step needed so that the trustee which holds the IRA proceeds actually retitles or transfers the $3500 Traditional proceeds into the Roth category for their internal book keeping to survive an IRS audit. The same is true of individuals over 50, but the combined limit is currently (2006) $5,000. Keogh plans are designed for self employed people, and are similar to an Individual Retirement Account (IRA). They are funded completely by wage earner contributions and provide either a lump sum payment or periodic withdrawals upon retirement. Penalties apply for early withdrawal. Keogh plans generally have the same investment opportunities as traditional IRAs. Contributions to Keogh plans are tax deductible within limitations. They have fallen out of favor in recent years to investment vehicles that have much less cumbersome paperwork. What are the main steps to take in estate planning? It is never to early to begin thinking about estate planning, although you may be far from the time when you may retire. You may even help your parents or others to do such planning. If so, you need to know some basics. An important first step is to select a guardian for you minor children. That person should have a genuine concern for your children as well as a parental style and moral beliefs that you endorse. A second step is to prepare a will. A will is a document that names the guardian for your children, states how you want your assets distributed and names the executor for your estate. And executor assembles and values your estate. Files income and other taxes, and distributes assets. A third step is to prepare a durable power of attorney. This document gives an individual you name the power to take over your finances if you become incapacitated. A durable power of attorney for health care delegate’s power to a person named to make health decisions for you if you are unable to make such decisions yourself.