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Brokerage firms buy and sell securities as instructed by their clients. Commercial banks provide deposit, payment, lending and investment management services. Investment banks help clients raise capital by issuing securities, while life insurance companies offer investment services along with their core life insurance products.
Exchanges are physical or virtual locations where brokerage firms "meet" to complete trades. Exchanges compete with ECNs (electronic communications networks), which are a type of alternative trading system (ATS). Finance companies issue loans but cannot accept deposits, so they must gather funding from other sources. Reinsurance companies offer insurance companies the ability to lay off a portion of their risk.
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The primary market involves the original issuance of securities, including the issuing of preferred stock by a corporation and the issuing of stock as part of an IPO. Transactions between investors after a security is issued are secondary market transactions, including selling stocks to a market maker and buying bonds at an exchange.
Depositary receipts are certificates representing shares in a foreign company. Eurobonds are bonds issued outside an issuer’s home country, and high-yield bonds are non-investment grade bonds that pay a higher rate of interest to compensate investors for assuming a higher level of risk. In a repo (repurchase agreement), an institution sells securities with the promise to buy them back within a few days.
Forward contracts commit two parties to buy or sell assets on a specific date at a specific price. Futures are standardized contracts to buy or sell an asset on a specific date at a specific price. Options give the owner the right to buy or sell a specific security at the strike price before the expiration date, and swaps are an agreement to exchange cash flows.
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A balance sheet shows a bank’s assets (things the bank owns, such as its investment portfolio), a bank’s liabilities (things the bank owes to others, such as securities sold under repurchase agreements) and a bank’s equity (what’s left after liabilities are subtracted from assets). Revenue a bank earns (such as gains on the bank’s investment portfolio) and expenses a bank pays (such as equipment expenses) are found on a bank’s profit and loss statement.
The cost-income ratio measures the cost to a bank for generating revenue. ROA (return on assets) measures the profitability a bank is able to generate from its assets. ROE (return on equity) measures the return on investment an institution is providing to its shareholders, and spread measures the difference between the average yield a bank earns on its assets and the average cost it pays for its funds.
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A borrower that cannot repay a loan is an example of credit risk. A financial institution losing money because of a change in currency rates is an example of market risk. An insurance company issuing an insurance contract with a premium that is too low for the amount of risk assumed is an example of underwriting risk.
An insurer not having cash to pay claims is an example of liquidity risk. A bank employee transferring funds into the wrong account is an example of operational risk, and a national government deciding to regulate interest rates is an example of political risk.
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Central banks are responsible for overseeing national payment systems along with their other responsibilities. The Basel Committee is part of the Bank for International Settlements (BIS) and is a group of banking supervisors that makes recommendations for banking regulation and supervision. The IOSCO (International Organization of Securities Commissions) is an international organization composed of national securities regulators.
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Very good! Your answer is correct. Financial institutions manage interest rate risk. They don’t eliminate it. The complete elimination of interest rate risk is impractical due to the high costs of completely hedging the institution’s exposure to movements in interest rates. The Asset Liability Management Committee (ALCO) is responsible for setting strategic direction and guidelines associated with acceptable levels of interest rate risk.
A positive gap indicates the institution has more interest-sensitive assets than interest-sensitive liabilities. This exposes the institution to drops in interest rates, since more assets than liabilities would reprice if interest rates drop (i.e., interest income would drop faster than interest expense, leading to a lower net interest income).
The asset/liability management (ALM) group is responsible for ensuring the institution has sufficient liquidity to meet it obligations, for managing the gap between interest-sensitive assets and liabilities and for identifying the assumptions used in VaR and sensitivity analysis models. Trading limits are established by the risk management group.
Finance evaluates the financial impact of a proposed solution. The Legal (or Compliance) group is responsible for communicating changes in regulations to employees. Marketing conducts customer satisfaction surveys, while IT (Information Technology) has responsibility for software and databases.