Thursday, July 30, 2009

the commercial loan theory, or Real Bills Doctrine

A bank has a problem that is best described as the liquidity-earnings dilemma.If a bank desired to be a totally safe haven for all its depositor‘S funds. It would simply hold all those funds in its vault (i.e., as a perfectly liquid asset). Then, whenever a depositor requested cash from his or her bank, the banker would merely let down the drawbridge. cross the moat to the vault, and return to place the cash in the customer‘s hand. The problem is that no earnings would be generated for the bank if it were only a storehouse of cash.
Bankers could take a position at the other extreme. They could employ all the funds deposited with them to make a loan to finance a high-risk venture by company seeking to find a cure for the common cold virus. Such a loan might have a high earnings potential for the bank, but the loan probably will not be liquid. It would be difficult to liquidate (sell) the assets to obtain cash when depositors wanted to make withdrawals.
To resolve the liquidity-earnings problems, bankers long ago recognized the advantage of making self-liquidating loons (otherwise Known as real bills, or claims on real resources). A loan was considered self-liquidating if it was secured by goods in the process of production or by finished goods in transit to their final destination for resale. When the goods were sold, the loan could be repaid. loans of this type could ensure the banks continuous liquidity and earn profits. Thus, liquidity and earnings were simultaneously gained. (note, however, that no loan is truly automatically self-liquidating, because there may not be a market for the goods produced.) Banks that limit themselves to making self-liquidating loans subscribe to the commercial loan theory of bank management (or the real bills doctrine).
the commercial loan philosophy, however, suffers from the fallacy of composition:
Such a system can keep one bank liquid, but if all banks follow this procedure, overall liquidity needs will not be met during times of crisis. thus, a loan secured by goods cannot be repaid if the goods can‘t be sold.Or if the customer borrowers the funds to purchase the goods,the banking system is no more liquid or less liquid than before the transaction. In the absence of central bank that stands ready to supply needed liquidity to the system as a whole, the commercial loan theory is incomplete.
Although commercial loans continue to be an important component of banks‘ asset portfolios, the development of other uses of their funds has caused the operating methods of modern banks to change considerably.

Wednesday, July 29, 2009

the need for countercyclical monetary policy

TO understand the basis of Friedman‘s reasoning,Suppose for the sake of argument that the Federal Reserve‘s main goal is to stabilize the price level. By definition, then, monetary policy actions would stabilize prices if the level of prices is less variable in the presence of policy actions than it would have been if there had been no policy actions at all. that is, successful Federal Reserve stabilization policies must make the price level less variable than it would have been if the Fed had undertaken no policies in the first place.
clearly, then, the very worst policy that the Federal Reserve could follow would be to undertake actions either that increase the price level when it already is rising or that reduce the price level during a time when it already is declining. If the Fed did this, it would be conducting procyclical monetary policy, meaning that its actions would reinforce existing tendencies for prices to rise or fall over time. Because a procyclical policy would add to variability of the price level, this would be a wrongheaded policy for the Fed to pursue.
Instead, successful Federal Reserve stabilization policies require that the Fed conduct countercyclical monetary policy actions when they are needed. Countercyclical monetary policy actions when they are needed.Countercyclical monetary policy actions automatically offset movements in real output that otherwise would have occurred in the absence of Fed policy making. Consequently, countercyclical policy making by the Fed requires the Fed to contract the Quantity of money when prices are rising and to increase the quantity of money when prices are falling.

Monetary policy Discretion

Now that we defined a monetary policy rule, defining monetary policy discretion is straightforward. Simply stated, monetary policy discretion allows for Federal Reserve policy making in the absence of monetary policy rule.
for example, we the Fed ‘s Federal Open market Committee meets eight times each year. Between meetings, a few FOMC members and staff officials confer daily. One type of discretionary monetary policy would entail day-to-day variations of Fed policy in light of economic events as they transpire, with minimal constraints on Open-market operations, discount window policy, or reserve requirements.
More generally, Fed discretion occurs whenever the Fed decides to respond to economic events in ways it had not previously planned. Most policy makers, including the Fed, Plot out broad strategies for their policies. If they stick closely to these strategies, then they follow policy rules. If They depart from them, however, they use their discretion. They respond to economic events as they occur, rater than turing a blind eye to temporary economic fluctuations.

Tuesday, July 28, 2009

monetary policy rules

A monetary policy rule. this is a policy strategy to which a central bank such as the Federal reserve might bind or commit itself. By this we mean that the Fed would, if it adopted a monetary policy rule, follow that rule no matter what occurs in the economy, such as an economic expansion or an economic contraction.
there are many possible rules for monetary policy. in fact, the potential number of rules is infinite. For instance, the Fed could commit itself to keeping the federal fund rate constant at 6 percent indefinitely . alternatively, it could commit itself to increasing the quantity of money by 10 percent for every 1-percentage-point increase in the federal funds rate. Or it could maintain a 2-percent-point spread between the federal funds rate and the discount rate. Or it could itself to increasing the quantity of money at a rate of 2 percent annually.
Note that monetary policy rule does not necessarily require that the Fed keep an instrument, intermediate target, or ultimate policy goal at some constant level.What a rule involves is making a percommitment to follow a particular strategy and sticking with that strategy irrespective of what may happen to economic variables. a monetary policy rule need not be simple; what makes it a rule is the Fed commits to the rule and does not depart from it whether the economy does well or poorly.

Monday, July 27, 2009

the European monetary system

a significant development in international monetary arrangements began in march 1979 with the inauguration of the European monetary system (EMS). This system was an outgrowth of the joint float( sometimes called the "European Snake" because of the wavelike movements of the six currencies as a unit against other currencies) that had begun in 1972. the first key feature of the EMS of the European Community members was the creation of a new monetary unit, the European currency unit or ecu, in terms of which central rates for the countries‘ currencies were defined. The value of the ecu was a weighted average of EMS member currencies and the ecu was used as the unit of account for recording transactions among EMS central banks.
A second key feature of the original EMS was that each currency was generally to be kept within 2.25 percent of the centeral rates against the other participating currencies, and a mechanism was put in place requiring central bank action as exchange rates approached the limits of divergence permitted from centeral rates. there were also provisions for periodic realignments of centeral rates. Third, the EMS participating currencies were to move as a unit in floating fashion against other currencies, including the U.S. dollar. this set of exchange rate rules was known as the exchange rate mechanism (ERM) of the EMS. Finally, the European Monetary Cooperation Fund (EMCF), a "banker’s bank" similar to the IMF, was established for receiving deposits of reserves from the EMS members and making loans to members with BOP difficulties.
the European monetary system was conceived as a means of promoting greater exchange rate stability within Europe and, because of this stability and certainty, for generating more stable and soundly based economic growth. Because greater stability in exchange rates requires some degree of harmonization in macroeconomic policies, the EMS also promoted convergence of policies and inflation rates.

Eurodollar cross-currency interest rate swaps

the Eurodollar cross-currency interest rate swaps is a financial derivative that permits the holder of a floating interest rate investment or debt denominated in one currency to change it into a fixed-rate instrument is a second currency. It, of course, can also permit the holder of a fixed-rate debt in one currency to convert it to a floating-rate debt in a second currency. it thus links several segments of international capital markets. It has all the characteristics of a normal interest rate swap except that it is a combination of an interest rate swap and currency hedge.

Eurodollar interest rate swaps

A Eurodollar interest rate swaps is similar to FRA but involves several future periods. in this case parties agree to exchange interest rate of two different kinds for several periods in the future, each usually three or six months long. Again, one of the rates is generally the appropriate LIBOR rate, and the contract often involves the exchange of a fixed rate for a floating rate, as is the case in the one-period FRA. However, an interest rate swap can also involve an exchange of two floating interest rates where one is LIBOR and the second is another interest rate or an index of a package of rates, such as index of Eurocommercial paper rates.
the case in which both sides are contracting a floating rate is referred to as a basis swap or a floating-floating swap. An interest rate swap works as follows;Suppose Ms. smith has a three-year Eurodollar-based loan at 8 percent and wishes that it were a variable-rate debt (perhaps because she expects interest rates to fall in the future)and Mr.Brown has a eurodollar loan on which he is paying six-month LIBOR plus 30 basis points (0.3 percent)and wishes to have a fixed-rate debt. Under the agreed-upon swap arrangement, Smith agrees to pay Brown the six-month LIBOR plus 0.3 percent every six months and brown in turn agrees to pay Smith the 8 percent (perhaps plus some additional amount, for example, 50 basis points per annum). smith has thus converted her fixed-rate commitment to a variable rate and Brown has converted his variable rate to a fixed rate. If interest rates decline, Smith will benefit by obtaining a cheaper loan. Brown feels relieved to have obtained a fixed rate more cheaply than obtaining a formal, new fixed-rate loan refinancing, and he effectively has reduced his interest rate exposure. should interest rate fall during the swap contract and threaten to rise again, smith could phone a swaps trader and enter into a second swap arrangement to again fix the interest rate commitment but this time at the new, lower level.

Wednesday, July 22, 2009

types of open-market operations

whatever the aim of open market operations, the fed uses two basic types of open market transaction:
1. Outright purchases or sales.
2. Purchases under repurchase agreements (RPs) and sales under matched sales-purchase agreements (reverse RPs,also Known as matched transaction)
Outright Purchases or sales
Outright purchases or sales are what you might expect,the fed buys or sells securities in the open market with no strings attached to the transaction. if the fed purchases a security, it is not obligated to sell it back at a later date. if the Fed sells a security to a buyer, the buyer is not obligated to resell it to the fed at a later date.
Repurchase agreements and Reserve Repurchase Agreements
In a repurchase agreement the Fed buys securities from a dealer and dealer agrees to repurchases the securities at a specified date and price. In effect, such a transaction is a loan by the Fed to the dealer; the interest rate is set bu auction among the dealers.A fed purchase under a repurchase agreement by the dealer is referred to as an RP transaction.
The counterpart to the RP is the reserve RP, or matched sales-purchase transaction. In such transaction, the fed sells securities to a dealer and also agrees to buy back the securities at a specified price and date. this amounts to a loan to the fed by the dealer.
RPs and reverse RPs are typically very short-term contracts. the fed usually conducts RPs for fewer than 15 days (usually 7 days), and it typically terminates reverse RPs in 7 days or less.Originally, large commercial banks and government securities dealers primarily used RPs as an alternative means of financing their government securities inventories. Now, however, a variety of institutional investors regularly use RPs, and the federal reserve bank of New York uses RP transactions to implement monetary policy directives and to make investments for foreign officials and monetary authorities.
the duration of RPs and reserve RPS indicate that they are used when the Fed wants to alter depository institutions reserves temporarily.

Effects of open-market operations(2)

Interest rate changes as the price of a bill or bond changes, so, too, does its yield. An increase in the purchase of bonds will cause bond prices to rise, which amounts to a decrease in bond yields. A decrease in pond purchases causes bond prices to fall and bond yields to rise.
Because the Fed is a large buyer\seller relative to all other buyer\seller of U.S. government securities, the fed can (usually) affect the price of a bill or bond directly. It follows that the fed can also influence interest rates. In principal, the Fed could, if inflation expectations were constant. Change short-, medium-, or long-term interest rates by buying or selling securities aggressively in any of these markets. To maintain a give price (and therefore interest rate) for a bill, all the fed need do is to be prepared to buy or to sell as much as the rest of the traders care to sell or to buy at that "going" security price (interest rate)
Changes in expectations an "announcement effect" exists for open-market operations, as well as for the other monetary tools. " Fed watchers"- stock market analysts, brokerage house employees, general investors, corporate treasurers, and a host of other individuals, including university professors-monitor open-market operations and make their predictions about the future effects of open-market operations on such economic variables as interest rates and inflation. Unfortunately, complete agreement does not exist among economists a bout how expectations change specifically when specific open-market operation changes occur. On the one hand, one might interpret an increase in Fed purchases of securities as an expansionary monetary policy that will cause lower interest rates, increased business production and investment, and increased consumer spending. On the other hand, expansionary monetary policy might induce expectations of still higher future increase in the money stock and the anticipation of inflation. The expectation of higher rates of inflation will encourage money lenders to place an inflationary premium on interest rates; nominal interest rates will then rise. Moreover, an expectation of increased inflation may well discourage business investment and consumer spending.
Nonetheless, the view that open-market purchases are expansionary, even accounting for adjustments, remains the dominant view within the economic profession.

Effects of open-market operations(1)

When the Fed purchases or sells securities on the open market, the economy is affected in three direct ways:
1. Depository institutions reserves changes.
2. The price (and, therefore, the yield) of securities.
3. Economy wide expectations change.
Changes in Reserves the Fed purchases of treasury bills from a depository institution change that depository institution's reserves. Briefly, if the Fed purchases $1 million worth of T-bills from a depository institution, the fed eventually pays by increasing the reserve account of that institution. That means that the depository institution changes its asset portfolio's structure. It now has $1 million less in T-bills and 1$ million more in reserve deposits at the fed. The Fed has a 1$ million increase in its assets (T-bills) and in its liabilities (deposit obligations to the selling depository institutions).
A depository institution's reserves also increase if the fed purchase the 1 $ million T-bill from the private sector. Thus, whenever the fed purchases U.S. government securities, depository institution reserves increase by exactly the amount of the purchase, furthermore, other things being constant, the quantity of money will expand by some multiple of the original Fed purchase. This increase in the money stock may, ultimately, lead to an increase in the level of economic activity.
Complementary reasoning indicates that the sale of a T-bill by the fed to depository institution or to the nonbank public decreases overall depository institution reserves and normally leads to a multiple contraction in the quantity of money. This contraction in the money stock eventually may.lead to a reduction in economic activity

the anticipated income theory

another theory of bank management of assets was developed in the 1950s in reaction to the apparent insufficient liquidity provided by the making of commercial loans and the holding of money market securities. using the doctrine of anticipated income,bankers again began to look at their loan portfolio as a source of liquidity. the anticipated income theory encouraged bankers to treat long-term loans as potential sources of liquidity.
How can a banker consider a mortgage loan as a source of liquidity when, typically, it has such a long maturity? Using the anticipated income theory, these loans are typically paid off by the borrower in a series of installments. Viewed in this way, the bank‘S loan portfolio provides the bank with continuous flow of funds that adds to the bank‘s liquidity. Moreover, even though the loans are long term, in a liquidity crisis the bank can sell the loans to obtain needed cash in secondary markets.
In a sense, mortgage loans (as well as consumer and business loans for some specified period of time ) are now considered to be equivalent to short-term business loans that finance inventories.Basically,the anticipated income theory is much like the commercial loan theory except that it embraces a broader base of securities from which liquidity may be obtained. That broader base now includes longer-maturity loans that contribute regularly to liquidity.

the shift ability theory

the shift ability theory recognized that liquidity could be provided if a certain portion of deposits were used to acquire such assets as loan and securities for which a secondary market exists. Thus, if a bank requirements, these highly liquid assets could be sold. Such securities are called secondary reserve, and they include U.S. Treasury bills, commercial paper,and bankerُ s acceptances. By adhering to the shift ability theory, bank managers justified the making of longer-term loans,which extended the average maturity of the loan portfolio.
This shifting of assets from less liquid loans to more liquid money market instruments is effective only if all banks are not at the same time selling liquid money market instruments to obtain cash. Everyone cannot be a seller of T-bills simultaneously. someone must be a buyer. An attempt to increase the total liquidity of the banking system through this process is doomed to failure unless an institution such as centeral bank will purchase T-bills when all banks are attempting to increase their liquidity.
the shift ability theory, theory, then, contains the same defect that plagues the commercial loan theory. Both must early on third party, such as the fed, to increase the supply of total liquidity when necessary.For, without the fed, what will provide instant liquidity for one or a few banks at most cannot provide a source of increased liquidity for the banking system as q whole.The fed must be a ready buyer of securities from any and all banks for total liquidity to increase.

the secondary market for treasury bills

treasury bills are traded actively in a secondary market, because some buyer (households, businesses,banks,the fed) prefer to sell their 91-day (or other) treasury bills before the maturity date. the existence of a large secondary market in T-bills allows for their transfer before maturity. this secondary market makes T-bills the most liquid , next to money itself, of all financial assets. there are specialized dealers in government securities who are ready to buy and sell existing T-bills to ultimate lenders at all times.
These dealers compile information about the bid and asked T-bill (discout) rates for currently outstanding T-bills. These discount rates are not the same as the already indicated approximate coupon yields, which give the rates in primary market. Rather they are a means of determining the prices at which existing T-bills will be traded in the secondary market.

Tuesday, July 21, 2009

Discretionary Monetary policy and inflation

many economist find Friedmanُ s argument persuasive. Nevertheless, most believe that the fed conducts discretionary monetary policies. Indeed, economists at the fed-a few of whom even had Milton Friedman as a professor in years past- commonly defend fed discretion, arguing that fed has done much to reduce the durations of the various time lags. If the time lag problem is , or has been, solved , they contend, discretion is preferable to fixed policy rules.
In light of Friedman‘s model that we discussed above, this view has its merits. if the Fed could always learn quickly about the need for a policy action and respond quickly to that need, it might be able to conduct truly countercylical monetary policies.
It turn out, however, that there is another potential problem with discretionary policy making by the fed. As we explain below, monetary policy discretion may contribute to inflation. That is, a discretionary monetary policy maker may adopt inflationary policies that wanted result from a lack of a monetary policy rule. Furthermore, this could happen even if the fed does not want high inflation.Hence, rules still may be better than discretion.

the federal funds rate

The federal fund is the rate at which depository institutions borrow and lend reserve in the federal fund market, the market for inter bank lending. In fact, there is no signal "federal funds rate"; the federal funds rate reported daily in the wall street Journal and other news sources really is an average of rates across institutions. Different depository institutions typically pay different rates to borrow or lend federal funds, a phenomenon known as tiering of the federal funds rate.
This tiering results, in part, from the fact that the federal funds market is somewhat segmented. That is, there are different parts of federal funds market that are interlinked but function differently, leading to differentials between the federal funds rates paid by different financial institutions. A large segment of market transactions on any given day are "brokered" trades in which depository institutions make bids to buy or sell funds through intermediating federal funds brokers who process information and assist in matching borrowers and lenders of federal funds.
Another segment of the federal funds market is dominated by large depository institutions that function as major dealers of federal funds. These dealers stand ready both to borrow from and to lend to other depository institutions that are said to constitute the retail portion of this segment of the market. These dealing banks then profit from differentials between the rates at which they lend and borrow federal funds.
Another reason for tiering in the federal funds rate is that some depository institutions are regarded as better risks than others. Those that are widely regarded poorer risks often must pay a risk premium to borrow federal funds. This means that they must pay a higher interest rate than those depository institutions that lenders believe are much safer borrowers.
The federal funds rate is important not only to the depository institutions that trade federal funds. It also has been an important variable in the conduct of monetary policy. Indeed, at various times it has represented the most important gauge of the intent of monetary policy actions by the Federal Reserve System.
An interesting development in recent years has been the very gradual unfolding of an intraday federal funds market- a market for federal funds loans with maturities of a few hours during the day. There are two key reasons that depository institutions have begun to make such trades. One is that computer and communications technology of modern payments systems has made such exchanges easier and safer to conduct. The second is that, for a variety of reasons, some depository institutions are finding that funds of such short maturities have intraday value for which they are willing to pay interest.

Monday, July 20, 2009

the interdependence of bank loan and deposit markets

our above discussion has considered the markets for loans and deposits in isolation from one another, for instance, our analysis of the loan market was predicated on the assumption that the deposit rate was equal to 0.07, even though we saw in our discussion of the deposit market that the equilibrium deposit rate can vary with changes in deposit market conditions. Likewise, our analysis of the deposit market assumed throughout that the loan rate was equal to 0.10, even though we saw in our discussion of the loan market that variations in loan market conditions can causes the equilibrium loan rate to change.
In fact, events that take place in the loan market influence events in the deposit market, and vice versa, it turns out that this interdependence between events in the loan and deposit markets helps explain why loan and deposit interest rates commonly (though not always) move in the same general direction over time.

Sunday, July 19, 2009

risk structure of interest rates

For given term to maturity, different bonds will earn different interest rates if, as we have already indicated, they are subject to different default risk,different of liquidity, or different tax treatment.
Different default risk consider two bonds, A and B, for which everything is the same; they have the same degree of liquidity, have the same term to maturity, and have the same tax treatment, and so on. Given this situation, the bonds will have the same market value, p; and because they have the same coupon payment, they will yield the same interest rate. Now suppose that corporation B, which issued bond B, experience some financial or economic woes and the bond rating services Lower Corporation B is ratings. Because the default risk is now relatively higher for bond B than for bond A, the demand for bond B will fall-causing its price to fall and its interest rate yield to rise. At the same time there will be an increase in the demand for bond A, causing its price to rise and its interest rate to fall. In short, there will now be an interest rate spread (difference) between bond A and bond B that reflects a risk premium.
Note that the interest rate on bond B will exceed the interest rate on bond A because each bond generates the same coupon payments but the price of bond A I higher than the price of bond B. another way to view this is to note that because the default risk is higher on bond B, investors require a higher interest yield on B. The prices of such bonds will adjust until the interest rate spread reflects their differential default risks. We conclude that different bonds yield different interest rate, in part because they are subject to different default risks.
different of liquidity Again consider two bonds, for which the circumstances are identical in all respects, bond c and bond D. suppose now that bond D becomes more liquid, perhaps because it is more widely traded. Following our previous analysis, we conclude that the demand for bond D rises while the demand for bond D rises while the demand for bond C falls , that the price of bond D rises while the prices of bond C rises. (Remember, if both bonds pay the same coupon value and their prices differ, they now yield different interest rates.)
We conclude that if different bonds are subject to different degrees of liquidity, they will earn different interest rates. Specifically, those bonds that are more liquid, other things constant, will earn lower interest rates than those bonds that are less liquid. Stated differently, investors will require a lower interest rate on bonds that are more liquid, other things constant.
This analysis explains why U.S. government securities, which are more liquid than corporation bonds (the market for an individual corporation is bonds (the market for an individual corporation is bonds is much thinner than the market for government securities), pay relatively low interest rates. Of course, U.S. government securities also sell at a low interest because of their extremely low default risk.
Different tax treatment Tax treatment securities are available for purchase. The value of the tax-exempt status of the income from bonds issued by municipal government is directly proportional to one is marginal tax bracket. As of 1991 there were only three brackets for federal personal income tax purposes: 15 percent, 28, and 31 percent, although because of a variety of phaseouts of deductions and exemptions the actual marginal tax rate can be as high as 35 percent for certain individuals. The value of nontaxable income is less for someone in the 15 percent bracket than in the 31 percent bracket.
In the marketplace, individuals in higher marginal tax brackets did up the price of the tax-free municipal bonds so that their yields fall below yields on equivalent taxable bonds. On the margin, actual yields of tax-exempts will reflect the marginal tax bracket of the marginal buyer of such bonds. That is why, on any given day, tax-exempt yields are less than taxable yields. Thus everyone who buys tax-exempts implicitly pays a tax, which is the difference between the interest yield on a municipal bond and the interest yield on an equivalent corporate bond. The purchase of tax-exempts only allows investors to escape explicit taxation.

the nominal interest rate as an intermediate target

Among all possible intermediate target variables, nominal interest rates stand out for several reasons. First, interest rates may be observed frequently by the fed. Average data on interest rate on financial instruments are available to the fed daily, and the fed can track some interest rates by the hour. As we noted above, measurability and timeliness are key criteria for an intermediate target, and so nominal interest rate clearly fit the bill on these points.
The fed also has considerable ability to influence nominal interest rate through purchases and sales of government securities. Consequently, the fed may be able to exercise significant control over nominal interest rates, at least in the short run. In principal, then, nominal interest rates appear to be potentially controllable by the fed.
The key issue, then, is whether or not a nominal interest rate target is consistent with the fed‘s ultimate goals.

the corporate bond rate

Another important interest rate is the paid on high-grade (low-risk) corporate bonds. Suppose that a corporation such as International Chemical corporation (ICC) wants to expand its production facilities and must borrow money to do this. one way to raises that money is to borrow it by issuing IOUs in the form of ICC corporate bond. ICC sells these bonds for,say,$1000 apiece and agrees to pay back the principal to the lenders at the end of 10 years.During those years, Icc also promises to pay annual interest on the loan. That annual interest payment, divided by the price of the bond, is the corporate bond rate. Different corporations borrow at different bond rates,depending on the financial soundness (creditworthiness) of the institution backing the rate.
Bond Rating services Risk ratings for corporate(and state and local government)bonds are provided by Moody‘s investors service and standard & poor‘s corporation. The Moody‘s rating consist of nine different classes or grades, rating from Aaa (best quality), to Baa (lower-medium quality), to Caa (poor standing), to C (extremely poor prospect). The ratings are based on detailed studies designed to assess the financial soundness of a particular corporation (or government) to determine how risky its bonds are for investor. more precisely, the studies are designed to assess the ability of a government or corporation to make its interest and principal payments on schedule.Each corporate issue is given a particular rating.
published corporate bond rates are usually given only for the highest-grade bonds-those that are rated Aaa By Moody‘s (orAAA by standard&poor‘s).

Saturday, July 18, 2009

Right of common shareholders

despite the fact that shareholders are the ultimate owners of the company, they have very little influence on its day-to-day operations. the managers appointed by the board of directors perform the day-to-day management. Since the shareholders vote only for the board, and not the day-to-day managers of the company, the amount of influence on day-to-day operations by the shareholders is very limited and very indirect.
common stock generally provides four rights to the owners of the common shares:
1- voting - common shareholders can vote at the annual shareholder‘s meeting. what specifically they get to vote on will depend on the year and the company, but they generally vote on the board of directors, the external auditor and any other significant business issues.
there are two methods that can be used for voting for the board of directors. The voting for the board is unique because more than one board member will be elected, so this is not a simple "yes" or "no" vote. the method to use will be designated in the registration documents of the company or the shares.
a- in straight voting, the maximum number of votes that can be given for anyone candidate is the number of shares the shareholder owns. In straight voting of one shareholder owns 50.1% of the shares, that shareholder will be able to elect all of the board members.
b- in cumulative voting, each individual share receives a number of votes that is equal to the number of board members to be elected. The shareholder can cast all of his or her votes for anyone candidate. Cumulative voting enables minority shareholder to elect member of the board of directors.
2- Receipt of dividends- dividends mayor not be paid in a given year, and the shareholders are not guaranteed to receive dividends in any given year. However, if the company declares dividends on common shares, the common shareholder has a right to receive that dividend.
3- preemptive rights - these are right that allow an existing shareholder to purchase newly issued shares when the corporation issues them. when this right is granted to shareholders (it is not always granted), the shareholders are given the right to purchase the same percentage of the newly issued shares that they held of the old shares before the issuance. this enables the shareholders to protect their percentage of ownership from dilution when new shares are issued. this simply the right to buy them. If a shareholder does not have the necessary cash to purchase the shares, the shares will be sold to others, and the ownership percentage of the shareholder will be reduced.
4-Distribution of assets- in the case of the liquidation of the company, common shareholders have a right to receive any of asset remaining after the settlement of all debts. common shareholders are the last category of parties to receive money in liquidation, so if the liquidation takes place in bankruptcy, it is possible that the common shareholders will not receive anything from the company.

Type of common stock

There are types of common stock based on whether or not they have "per" value. Par value is essentially the stated value of stock that is printed on the share itself. However, the par value does not impact the selling price of the stock. The par value is assigned to the shares when they are registered and does not need to be any specific amount. In fact, par value is usually a small amount because of what it represents (covered below). When the shares are sold, the par value of the shares will be put into common account.
There are two types of shares based on the existence of a par value:
- par (or stated), par value is the specified value printed on the share itself. Par value is the maximum amount of a shareholder's liability to the creditors of the company. The par value of all shares issued and subscribed represents the legal or stated capital of a company. Legal capital is the portion of contributed capital that is required by statue to be retained in business. This capital cannot be distributed as dividends. Because of this restriction on distribution, companies may choose to have a very low par value.
- no-par value, for stock that does not have a par value, the legal capital is the total amount received to the common stock account.

federal home loan banks and the secondary mortgage market

the most recent entrant into the secondary mortgage market market is an institution that does back to the 1930s.Originally, the system of 12 Federal Home Loan bank(FHLBs) was created to provide liquidity to savings and loan associations. they are privately owned by their members (originally,thrift institution) the GSEs, borrow as if they were backed by the U.S. government. Thus, they enjoy a low cost of funds. moreover, since their stock is not publicly traded, they do not need the same level of earnings as the GSEs. As the savings and loan industry receded, the FHLB System was reconstituted to serve as the "wholesale" lender (i.e., provider of liquidity)to all thrifts, banks who elect to become members,insurance companies , and credit unions. In the late 1990s, the FHLBs developed a secondary mortgage market operation. while still small in 2003, this program has the possibility of growing into a competitor of the two GSEs, for the business of its members.

Thursday, July 16, 2009

Monetary Policy Goals

In the Federal Reserve Act, passed in 1913, the attainment of "an elastic currency" was given as one goals of this new central bank. The national Banking system, then effect, had as one of its major defects an inelastic currency, i.e., a currency that would not expand and contract with the needs of trade. In subsequent years, however, particularly after the economic debacle of the early 1930‘s and the emphasis placed on full employment and economic growth in the post-world war II period, broader and more sophisticated economic goals were assumed by the federal reserve system.
Four Major Goals
There appear to be four major policy goals of this central bank in the 1970‘s:(1) to preserve the value of the dollar over time ,i.e., minimize inflation of the price level,(2) to maintain full employment ,i.e., to keep unemployment from rising very much above 4to5 percent, (3)to achieve a significant rate of economic growth ,i.e., to help maintain a real growth rate of output of 5 to 6 per cent year, and (4)to help achieve equilibrium in the American balance of payments. It should not be thought that the Federal Reserve System has imagined that it could a chive even one of these goals solely by the manipulation of the monetary policy weapons at its disposal. It is fully understood in the Federal Reserve System that the achievement of any, or all, of these public policy goals requires a coordinated effort by many governmental agencies.
FISCAL POLICY VERSUS MONETARY POLICY In the case of a budget deficit, the powerful demand effects of fiscal policy could overwhelm the resulting effects of the monetary policy. Then, inflation of price level could continue, even though interest rates were still rising, e.g., in 1973-1974. On the other hand, assuming that the Federal Reserve is successful in its deflationary efforts, some undesirable side effect may occur. Although the desired goal of credit restraint by the monetary authorities is to slow down or eliminate inflation, a slowdown in output and employment may also result.
THE PHILLIPS CURVE the trade-off between unemployment and the price level can be summarized in a Phillips curve, named after the English economist who first performed the critical empirical research. Studies not only in England but in unites state as well, have shown that money wages, and indeed the price level, tend to rise more rapidly when unemployment is reduced, and vice versa. Hence, part of the cost of restraining inflation may be to rising unemployment.
Price stability and full employment are thus seen to be incompatible, conflicting goals. Nevertheless, some economists and some policy makers in the 1970‘s came to believe that a permanently lower unemployment rate could be achieved by paying the price of some constant rate of inflation, and that wage price guideposts and\or manpower policies could shift the Phillips curve toward the origin and thus reduce the amount of inflation related to any given unemployment rate. Other economists; especially Milton Friedman, argued that inflationary expectations would render any such trade-off policy ineffective.
Friedman believed tat there was a "natural rate of unemployment," which was the equilibrium rate for the economy. Temporarily, workers might have an expected rate of inflation below the actual rate of inflation and thereby permit their real wages to be reduced, so that employers would hire more workers and thus reduce the unemployment rate. Believing, however, that workers would not suffer a "money illusion" in the long run, the ultimate effect of public policies to reduce the unemployment rate would be a return to the "natural rate of unemployment," but at a higher rate of inflation than formerly.
Most economists came to agree that there were families of short-run Phillips curves, and that these curves could shift to alter the inflation-unemployment relationship. Nevertheless, the dominant view still seemed to be that there was such a trade-off in the long run, though the price of full employment might be a high (or even unacceptable) rate of price inflation, while the price of price level stability might be a high (or even unacceptable) rate of unemployment.
ADVERSE EFFECT OF INFLATION ON BALANCE OF PAYMENTS inflation at home is also unlikely to be compatible with a satisfactory equilibrium in country‘s balance payments which is the accounting statement that records all the flows of goods, services, and capital between one country and the rest of the world. An increase in export prices more repaid than that of one‘s major foreign competitors would likely lead to a diminution of growth in exports and a rise in imports. An inflationary growth of income in a country thus has both price and income effects on the country‘s balance of payment. A rise in prices of most goods also result in arise in prices of goods exported, which will tend to adversely affect exports. Also, the rise in income will tend to increase imports. If the country already has equilibrium in its balance of payments, a deficit in the balance of payments will now result.
GOAL OF ECONOMIC GROWTH An emphasis on economic growth as a major concern of the monetary authorities in the united states did not develop until the late 1950‘s and early 1960‘s. by that time, the soviet Union was seen as an importance economic, as well as ideological, competitor of the U.S. Hence, the United States came to look at its rate of economic growth as compared with that of the Soviet Union. By the early 1960‘S, the Federal Reserve, along with other parts of the federal government, was determined to assist in the attainment of higher rate of economic growth.
HIGHER PRICE ECONOMIC GROWTH Until The Mid-1960‘s, It Seemed That a higher rate of economic growth And a lower unemployment rate might be compatible with stable prices, or at least a slowly rising price level. After the Vietnam escalation began in 1965, government military expenditures began to rise sharply, and welfare spending was also increased. The subsequent added rise in private investment expenditures and consumer expenditures also increased the fuel feeding the inflationary fires that were earlier ignited. After several years of strong economic growth, the unemployment rate was finally reduced below 5 per cent in late 1973. Unfortunately, as the unemployment rate fell, the rate of inflation accelerated.
In 1973, consumer prices rose more than 6 per cent. In 1974 and 1975 they rose in many months at double-digit rates. Prices, which rose by 12 per cent or more 1974, increased on the average by 9.3 per cent in 1975. It took the severe recession of 1973-1975, which produced higher unemployment rates, not only then but also in 1976 and 1977, to reduce the inflation rate to more acceptable levels. In 1976 prices rose at an annual rate at the retail level in excess of 5 per cent and in 1977 about 6.5 percent.
By the 1970‘s, therefore, a higher rate of economic growth, with the low rates of unemployment accompanying it, was also seen as somewhat incompatible with price level stability. The trade-off problem for the monetary policy makers had become clearly established, both for the United States and Great Britain.

Wednesday, July 15, 2009

mortgage backed securities

perhaps the most important innovation that occurred in residential mortgage markets since world war II was the development of the market for mortgage-backed securities (MBSs). pass-through MBSs are created bu pooling a group of similar mortgages. the owner then uses the mortgage pool as collateral for the issuance of a new security- the MBS. for example,a mortgage banker assembles a $100 million pool of 7.5 percent,30-year, level-payment mortgages. the mortgage banker then sells an undivided interest, or participation, in the mortgage pool to many investors who are promised an 7 present rate of interest on their invested capital. the issuer continues to service the underlying mortgages, collecting payment from borrowers and "passing through" to each security holder(1)its pro rate (proportionate) share of any principal repayments on the underlying mortgages and (2) 7 percent interest on its share of any outstanding principal that the issuer of the MBS has not returned to the investors. the difference between the 7.5 percent rate on the underlying mortgages and the 7 percent rate paid to investors is kept by the MBS issuer. This "spread" must cover the issuer is issuance and servicing costs. and the costs of absorbing the default risk in the pool of mortgages. when a mortgage is used as collateral for the issuance of a MBS, the underlying mortgage is said to be "securitized." Agencies and private companies that pool mortgage and sell MBSs are sometimes called conduits.
between one-half and two-thirds of all residential mortgage loans originated in the United states are now sold into the secondary mortgage market and used as collateral for the issuance of mortgage-backed securities. this securitization of pools of standardized residential mortgage has greatly increased the liquidity and efficiency of the mortgage market. By attracting nontraditional investors, such as pension funds, life insurance companies, and mutual funds, MBSs have brought many new sources of investment capital into the residential mortgage market.

private mortgage insurance

private mortgage insurance (PMI)Protects lender against losses due to default on the loan.It gives no other protection;that is, it does not protect against legal threat to the lender's mortgage claim, nor does it protect against physical hazards. It indemnifies the lender, but not the borrower. Lenders generally require private mortgage insurance for conventional loans over 80 percent of the value of the security property. private mortgage insurance companies provide such insurance, which usually covers the top 20 percent of other words, if a borrower defaults and the property is foreclosed and sold for less than the amount of the loan, the PMI will reimburse the lender for a loss up to 20 percent of the loan amount. Thus, the net effect of PMI from the lender's perspective is to reduce default risk. this reduction of the default risk was sufficient to make LPMs a viable risk for lenders where they had never been before.

The primary and secondary mortgage markets

The market for home mortgage loans can be divided into the primary mortgage market and the secondary mortgage market. The primary mortgage market is the loan origination market, in which borrowers and lenders come together. Numerous institutions supply money to borrowers in the primary mortgage market, including savings and loan associations, commercial banks, credit union, and mortgage banking companies. Increasingly, this lending has been done through a mortgage broker.
Mortgage originators can either hold the loans in their portfolios or sell them in the secondary mortgage market. The largest purchasers of residential mortgages in the secondary mortgage market are Fannie Mae and Freddie Mac. These government-sponsored enterprises (GSEs) were created by acts of congress to promote an active secondary market for home mortgage by purchasing mortgage from local originators. The existence of a well-functioning secondary market makes the primary mortgage market more efficient. If mortgage originators are able to sell their mortgage investments quickly, they obtain funds to originate more loans in the primary market. In today is world, the secondary market institutions, especially the GSEs, play a leading role in the home mortgage market. The menu of loans that the GSEs are willing to buy heavily influences the menu of loans that lenders are willing to originate.

The Mechanics of Adjustable Rate Mortgages

the interest rate on Adjustable Rate mortgages originated in the united states must be tied to a published index of interest rates that is beyond the control of the lender. the most common indexes are averages of U.S. treasury rates and average cost of funds for thrift institutions. At a predetermined change date, the loan interest rate will fall or rise as the index falls or rises.
when the Adjustable Rate mortgage Market first began to develop in the early 1980s in response to high and volatile interest rate, lenders and borrowers experimented with numerous ARM designs. Between 400 and 500 different types of ARM products were being offered in early 1984. over time, the terms of Adjustable Rate mortgages have become more uniform. One of the most popular is a one-year ARM based on a 30-year amortization. with a one-year ARM, the initial contract rate remains in effect for one year and adjusts annually thereafter.

installment sale financing

A popular method of deferring the taxes due on the sale of commercial property is the installment sale financing. Under this method, the seller allows the to pay the purchase price over a number of years. in effect, the seller collects a down payment and then loans the buyer the remainder of the purchase price. Subsequent to the sale, the buyer makes periodic payments to the seller (lender) that consist of both interest and principal amortization. Because the seller receives the sale proceeds (i.e.,the principal on the installment loan)over a number of years, the internal revenue service(IRS)allows the seller to recognize the taxable gain from sale as the sale proceeds are collected from the buyer.Spreading the recognition of the taxable gain over several years reduces the present value of the tax payments.
there is a potential cost, however,associated with this strategy:the seller does not immediately receive the full amount of the sale proceeds from the buyer. if the interest rate the seller charges the buyer is less than the seller's risk-adjusted opportunity cost, the seller's wealth is decreased by the installment sale loan.this loss would need to be balanced against the benefits of tax deferral. Nevertheless, the availability of installment sale tax treatment allows investors to pursue market timing and poryfolio reallocation strategies without triggering large capital gains.
Because the installment sale may provide the seller with significant tax benefits, the seller may be willing to offer the buyer-investor a below-market rate of interest. Installment sales are also popular with buyers because the seller often uses underwriting standard that are less strict than those used by traditional third party lenders(e.g., banks,insurance companies). this underwriting flexibility may allow the investor to increase the ratio of total debt to total property value, thereby minimizing the investor's required down payment.

A floating-rate mortgage

Some commercial mortgages have adjustable, or floating, interest rate. The index on a floating-rate mortgage is typically the prime rate- the rate banks charge their best customers-or, increasingly, the London Inter bank offer Rate-commonly referred to as LIBOR. Floating-rate loan decrease the lender's interest rate risk, which tends to reduce the rates on floating-rate loans relative to fixed-payment mortgage, all else being the same. However, floating-rate mortgage can increase the default risk of a mortgage because the borrower may not be able to continue to service the debt if payments on the loan increase significantly.

commercial loan officer

An important function closely related to the commercial real estate industry is that making loans. Commercial lending takes on many forms in today's complex and competitive world. Commercial loans are usually originated at either a bank or savings institution, by a mortgage banker or broker, or by life insurance company or pension fund.
Banks and savings institution generally hire their own loan originators and processors, as do some of the larger life insurance companies and pension funds. However, mortgage brokers often represent smaller life insurance companies, pension funds, and other lenders that cannot efficiently originate their own commercial loans. Loan officers employed by banks and savings institutions usually earn a regular salary, with bonuses sometimes available. lending officers who work for mortgage bankers or brokers generally work on commission basis and are paid after successfully placing mortgage loans that meet the needs of the borrower(e.g., developer investor) and lender(e.g., life insurance company or pension fund)
Commercial mortgage lending requires more business education and analytical skills than residential lending. Since mortgage brokers negotiate loans between borrowers and lenders, they must have strong communication skills.

mortgage and Description of the property

the mortgaged property must be described unambiguously.
three methods of property description generally are considered acceptable for this for this purpose. these are description by metes and bounds, by government rectangular survey, or by recorded subdivision plat lot and block number. Tax parcel number or street address are insufficient if used alone, since they can be erroneous or ambiguous.

mortgage and Insurance clause

An insurance clause requires a mortgagor to maintain property casualty insurance acceptable to the lender, giving the lender joint control in the use of the proceeds in case of major damage property.

mortgage and Escrow clause

the Escrow clause, or impound clause, requires a borrower to make monthly deposits into an escrow account of money to pay such obligations as property taxes,casualty insurance premiums, or community association fees. the lender can use these escrow funds only for the purpose of paying the expected obligations on behalf of the borrower. Note that the obligations involved in some manner affect the ability of the lender to rely on the mortgaged property as security for the debt. the insurance must be paid to protect tax and association dues must be paid because both are secured by superior claims to the property, as explained below.

Tuesday, July 14, 2009

what is interest?

When a bank or other financial institution lends you money, it requires you to repay the funds lent (the principal), plus an additional payment called interest. The timing of the payment of interest and principal are negotiable and vary form one loan another. However, virtually all loans (except perhaps loans from close friends or relatives) require some payment in addition to the principal.
The interest rate on a loan is the ratio of the interest payment on the loan to the principal amount (the amount borrowed). In other words, it is the cost of borrowing funds as a percentage of the amount borrowed. if you borrow $500 to buy a fancy stereo and pay the money back next year plus $50 interest, you have paid an interest rate of 10 percent, calculated as $50\500= 10%. This example oversimplifies, however. To compare the interest rate on loans with different maturities (such as 1-year and 30-year loans), we need to calculate the interest rate for a given time span. for this reason, interest rates are stated as interest rates per year (the so-called "annual rate of interest' you have probably seen in TV ads or on sign at your bank).the interest rate is the amount over and above the principal amount that is paid in a given year, expressed as a percentage of the principal amount. Also, interest can be indirect.
When you consider interest charges on a loan, you need to realize that interest is charged because funds available for use in the future. This is because people prefer to satisfy their desires today to waiting until later. (Would you prefer to receive a $1,000 gift today or $1, 00 gifts in 30 years?) Borrowers want funds for use today and promise to repay those funds in the future. But a lender requires more than that: A lender requires interest from the borrower's compensation for the lost use of the funds for the length of the loan. In essence, interest is the price of borrowing money. The interest rate expresses this price as the percentage of the principal amount that the borrower pays to use someone else is money. A brief description of how interest payments are structured on some common types of loan contracts follows.

primary financial markets

The issuance of stocks and bonds in the primary securities market is aided by so-called investment bankers (who often also act as brokers and dealers in secondary markets). An investment banker undertakes what is called an underwriting of a new issue. Underwriting means that the investment banker normally guarantees to the issuing corporations and governments a fixed price and (in the case of a bond) a fixed yield. The underwriting investment banker publicly announces the upcoming new issue in financial publications and elsewhere.
Underwriters will attempt to sell the underwritten stocks or bonds within a day or so of the date of issuance. The investment bankers underwriting the new issues in the primary securities market earn their profit by attempting to "buy cheap and sell dear." they attempt to sell the new issues at a price higher than the price they have guaranteed to the issuer. Note, however, that investment bankers are not true bankers, and they do not carry out investment spending. Rather, they are simply market makers in the sense that they make sure a market exists for about-to-be-issued new securities. Investment bankers do not accept deposits, nor do they make commercial or consumer loans. In fact, commercial bankers were prohibited from underwriting corporate securities by the Glass-Steagall Act of 1933, which separated commercial banking and investment banking. commercial banks can do participate in underwriting the bonds of state and municipal governments, because their securities are presumed to be relatively safe-even though at times the governments of NEW YORK city,Cleveland,Boston,and the state of Michigan were more or less teetering on the brink of bankruptcy. Virtually all types of individuals, households, and businesses buy new issues. Some of the assets owned by financial intermediaries, for example, will have been purchased in the primary securities market.
The actual marketplace for the underwriting of new securities is the conference suites of investment banking firms, which are linked by telephone with each other and with the corporations or governments that are issuing the new securities. The investors (for example, large insurance companies and pension plan) will also be in communication via telephone with the underwriting investment banking firms. By far the most important commodity sold by investment banking firms is information about the yield required to sell an issue and the identity of prospective buyers.
Investment bankers are able to underwriting new issues not because they have acquired funds from deposits, but rather because they have enough of their own capital to buy up what is not sold to buyers at the guaranteed price. Consider an example: the big investment Banking firm underwrites XYZ Corporation is issuance of 1000 bonds with a face value of $10,000 offering a coupon rate of 10 percentage per year for 10 years. The big Investment Banking firm guarantees that the bonds will sell for at least their face value of $10,000 apiece. As it turns out, the bonds can only be sold at a discount. The average price is $9,000. The big investment Banking firm will incur a loss of $ 1,000 on each bond, for a total loss of $1,000,000.

A portfolio perspective on real estate investment

Real estate does not in isolation from other possessions and pursuits. For example, owing rental houses may be a good investment for person with financial liquidity, stable job, low expected mobility, and the time and skill to manage the properties. But it can be risky and unrewarding for a person with low financial liquidity, a changing job outlook, a time-intensive job, or the need to be able to relocate upon short notice. For similar reasons, home ownership makes good investment sense to most households at some point in their life, but not to all households at all times.
Real estate investment in the context of the owner's other assets and the owner's overall situation may be thought of as a portfolio perspective on real estate investment-that is,the real estate investment is valued in context of all the other assets and characteristics of the investor's portfolio, including human capital .From the example above,it should be clear that this portfolio perspective can be very important to consider in any real estate decision. As further examples,the desirability of investment in home improvements can depend on the needs and expectations of the household. A family with children a bout to leave home certainly views the addition of a swimming pool or another bedroom differently than a family with young children. A household that is mobile and expects to move within a few years also will view a home expansion differently from a household that expects to remain in the house for a longer time. Similarly, a mobile family is more likely than a nonmobile family to place greater value on a residence that is easily resalable.
The portfolio perspective is important in commercial real estate as well. For example, a person who expects to move frequently is less likely to be comfortable investing in local rental properties because of unfamiliarity with the local market and the risk of managing property at a long distance. This person might find investment in real estate through a publicly traded real estate investment trust (REIT) a much more a much more satisfactory option. In addition,the knowledge and experience of the investor can be very important in determining what is a good real estate investment? For example, persons familiar with industrial and manufacturing activity may want to restrict investment to industrial properties because they have a better chance of detecting, assessing, and mitigating risks in that sphere.

Monday, July 13, 2009

accounting for changes in accounting principles

An accounting change for the purposes of income statement is a change from one GAAP accepted method to another GAAP accepted method. Therefore, a change in accounting policy only occurs in area where there is more than one acceptable method. The most common examples are: inventory, fixed assets depreciation and long-term contract.
A change from a non-GAAP method to a GAAP method (for example, from not depreciating fixed assets to the straight-line method) is not a change in accounting policy. Rather, it is the correction of an error.
An entity shall report a change in accounting principle trough retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires the following:
- the cumulative effect of the change to new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
- An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
- Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.

recording long-term contracts on the balance sheet

Even if no profit has been recognized, the long-term contract itself must be recognized on the balance sheet to extent that it represents a net asset or liability. In these journal entries, the asset is the CIP account and the liability is the BCA.BCA is the liability because by sending an invoice to the customer, the contractor is promising to deliver something in the future to the customer. The difference between the construction in progress (CIP) AND the billings on construction account (BCA) Accounts is reported on the balance sheet as either an asset or liability.
If CIP > BCA, the difference is reported as a current asset (inventory)
If CIP < BCA the amount is reported as a current liability.

income statement Definition

the income statement is a summary of all of a company's transactions during a period of time that involves income, expenses,gains or losses.
the income statement is prepared using the concept of accruals accounting. this means that income can be recognized before the actual receipt of cash, and expenses can be recognized before the actual expenditure of cash. item on the income statement will be recorded as they occur,not when cash is transacted.
the income statement gives the results of operations for a period of time. when people talk about net income, they usually mean the period of time of one year, but income statements are also prepared on a quarterly or monthly basis as well as annually.
the accounts that are used to record revenues,expenses,gains and losses throughout the year are temporary accounts. this means that means that they are closed to a permanent account (retained earnings)at the end of each period. After they are closed, temporary accounts have a zero balance and therefore are not shown individually on the balance sheet. the retained earnings account, which is presented on the balance sheet as part of owner's equity , represents the profit of the company.

Sunday, July 12, 2009

limitations of financial statement analysis

Although financial statement analysis is highly useful tool, it has two limitations that we must mention before proceeding any further. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.
Comparison of financial data
Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies' financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of financial data such as inventory valuations and cost of goods sold between the two companies may be misleading. Sometimes enough data is presented in footnotes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusions. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
The need to look beyond ratios
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any questions by themselves.
In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself. A recent change in a key management position for example, might provide a basis for optimism about the future, even though the past performance of the company (as shown by its ratios) may have been mediocre.

cost classifications of financial statements

The financial statements prepared by a manufacturing company are more complex than the statement prepared by a merchandising company because a manufacturing company must produce its goods as well as market them. The production process involves many costs that do not exist in a merchandising company, and somehow these costs must be accounted for on the manufacturing company's financial statement. In the section, we focus our attention on how this accounting is carried out in the balance sheet .
The balance sheet
The balance sheet or statement of financial position, of a manufacturing company is similar to that of a merchandising company. However, the inventory accounts differ between the two types of companies. A merchandising company has only class of inventory- goods purchased from suppliers that are a waiting resale to customers. In contrast, manufacturing companies have three classes of inventories- raw materials, work in process, and finished goods. Raw materials, as we have noted, are the materials that are used to make a product. Work in process consists of units of product that are only partially complete and will require further work before they are ready for sale to a customer. Finished goods consist of units of product that have been completed but have not yet been sold to customers. The overall inventory figure is usually broken down into these three classes of inventories in a footnote to the financial statements

lease option to renew

Renewal options grant the tenant the right, but not the obligation, to renew lease. Tenants would prefer. All else being equal, the option to renew the lease with the same terms and conditions as the original lease, including the rental rate. Owners, of course, are reluctant to agree to such renewal options for several reasons. First, market rents may increase, perhaps significantly, over the first lease term; thus, owners could be forced to renew the lease at below-market rental rates. This potential loss is not offset by the probability that tenants will renew at above-market rents if market rents decline over the first lease term. Why? Because if rents decline, tenants will not exercise the option to renew at the original contract rental rate. therefore, this option-like all option-has a one-sided (asymmetric)payoff: If rents decline the payoff to the owner is negative; if rents rise the payoff will be zero because the tenant will not exercise the option to renew. In short, from the owner's perspective this renewal option has a negative net present value. Thus, owners are reluctant to grant such option unless the buyer is willing to pay for it in the form of a higher initial base rent. Assume a law firm has negotiated a five-year office lease with a flat rental payment of $18 per square foot. The property owner also has agreed to include an option clause that permits the tenant to renew the lease at expiration for a second five-year term at $18 per square foot. Thus, $18 is referred to as the exercise price of the option.
If market rents in five years are less $18, the tenant will not exercise her renewal option at the $18 exercise price. Thus, the option pay off to the tenant and cost to the owner would zero. In option terminology, the option is said to be "out-of-the-money" if prevailing rents are below $18 per square foot. However, if market rents exceed $18 in five years, the option is "in-the-money" and the tenant will likely exercise her option to renew at $18, assuming she still requires the space. The higher market rents are in five years, the greater the payoff or benefit to the tenant from exercising her renewal option. Note that the owner's negative payoff from option exercise mirrors the positive payoff to the tenant.
A more common from of the renewal option gives the tenant the right to renew the lease, but at prevailing market rate. Granting this option is much less costly in present value terms for the owner. However, the expected payoff on the option is still negative. Why? Because the option, if exercised, does not permit the owner to lease the space to an alternative tenant whose business might better match the owner's current marketing and leasing strategy. As previously discussed, the owner's ability to alter the tenant mix is potentially valuable, especially in retail in retail properties and, to a lesser extent, office properties.

political pressure and monetary policy

while the fed is partially insulated from political pressure by its structure, it's not totally insulated. presidents place enormous pressure on the fed to use expansionary monetary policy (especially during an election year) and blame the fed for any recession. when interest rates rise, the fed takes the pressure, and if any members of the board of governors are politically aligned with the president, they find it difficult to persist in contractionary policy when the economy is in a recession.
one way central banks have tried to avoid that political pressure is through inflation targeting, where they set an inflation target they are required to meet. this means that their reaction to events is prescribed before the event, and the central banks can blame the inflation targeting rule they have to follow, rather than taking the blame themselves. the hope is that setting the target will add credibility to the policy and convince people that inflation will not occur, thereby reducing inflationary expectations and inflationary pressures. the problem is that if the policy is not believed, or if the wrong inflation target is chosen, the existence of the target can either limit the central bank's response or force the central banks to abandon their target, which can reduce rather than enhance credibility.

duties of the fed

In legislation establishing The Fed, Congress Gave It Six Explicit Functions:
1- Conducting Monetary Policy (Influencing The Supply Of the money and credit in the economy).
2- supervising and regulating financial institutions.
3- serving as a lender of the last resort to financial institutions.
4- providing banking services to the U.S. government.
5- Issuing coin and currency.
6- providing financial services (such as check clearing) to commercial banks, savings and loan associations, savings banks, and credit unions.
Of these functions, the most important one is conducting monetary policy.

Duties and Structure of the Fed

Monetary policy is conducted by a central bank-a type of banker's bank. If the banks need to borrow money, they go to the central bank, just as when you need to borrow money, you go to a neighborhood bank. If there's a financial panic and a run on banks, the central bank is there to make loans to the banks until the panic goes away. Since its IOUs are cash, simply by issuing an IOU it can create money. It is this ability to create money that gives the central bank the power to control monetary policy. A central bank also serves as financial adviser to government. As is often the case with financial advisers, the government sometimes doesn't follow it.
In many countries, such as Great Britain, the central bank is a part of the government, just as this country's Department of the treasury and Department of commerce are part of the U.S. government. In the U.S. the central bank is not part of the government in the same way it is in some European countries.

Monetary Policy in the Circular Flow

wen the economy is operating at too low a level of income and when saving exceeds investment, in the absence of monetary policy, income will fall. expansionary monetary policy tries to channel more savings into investment so the fall in income stopped . it does so by increasing the available credit. lowering the interest rate, and increasing investment and hence income.
contractionary monetary policy is called for when savings is smaller than investment and the economy is operating at too high a level of income, causing inflationary pressures. in this case, monetary policy tries to restrict the demand for investment and consumer loans.

Calculation of depreciation

There are four methods of calculating deprecation expense. Each of these four methods is looked at in detail below, but some general information is needed before depreciation can be calculated under any of the methods. These terms and their definitions are below.
1- estimated useful life; this is how long we expect the asset to be useful and it is the period of time recognizes deprecation expense. At the end of its useful life the assets should have a book value equal to the expected salvage value. (This may also be called service life.).
2- Estimated salvage value; this is the value we expected the asset to have at the end of its value useful life. The book value of the asset may not be depreciation below the salvage value. Some companies have an accounting policy that the salvage value always equal to $0. (This may also be called residual value.)
3- Deprecation amount; this is the amount that must depreciate over the useful life of the asset. It is equal to the capitalized amount (this is the cost of the asset) minus the salvage value of the asset.

Saturday, July 11, 2009

subletting , assignment and lease

Tenants, especially those subject to long-term leases, may desire to assign or sublet all, or part, of their leased space. A lease assignment occurs when all of a tenant's rights and obligations are transferred to another party. However, the assignor remains liable for the promised rent unless relieved in writing of this responsibility by the owner.
A sublease occurs when the original tenant transfers only a subset of his or her rights to another. For example, the tenant may transfer only a portion of the leased premises or transfer occupancy rights for period of time less than the remaining lease term.
Usually, the new tenant pays rent to the original tenant, who in turn pays to the owner the rent stipulated in the original contract. Once again, however, the original tenant remains liable for fulfilling the terms of the original lease.
Unless otherwise prohibited in the lease contract, a tenant may assign the lease or sublet. However, commercial owners, as a condition of the lease, can prohibit assignment and subletting or, alternatively, clearly state the conditions under which one or both strategies may be employed.
There are numerous reasons why a tenant may wish to engage in a sublease or assignment. Perhaps the tenant has sold his or her business and no longer requires the space, or perhaps the tenant's business has grown to the point that more space is required. Conversely, the tenant's business may have encountered financial difficulties and, as a result, he or she is seeking to reduce the firm's leased space.
Assignment and subletting can be major problems in commercial leases. Owner must seek to control who occupies space in their building. Otherwise, unqualified tenants may default on sublease payments, engage in an unsafe or hazardous business, or disrupt the property's tenant mix

Essential elements of a lease

As with any valid contract, parties to a lease must be legally competent, the objective of the lease must be legal, there must be mutual agreement between the tenant and landlord to enter into the lease agreement, and something of value (i.e., consideration) must be given or promised by both parties. The promise to pay rent constitutes the tenant's consideration. Allowing the tenant to occupy the space or property constitutes the landlord's consideration.
Valid and enforceable leases also must include the following elements:
1-The name of landlord and tenant.
2-An adequate description of the leased premises.
3-An agreement to transfer possession of the property from the landlord to the tenant
4-The start and end dates of the agreements
5-A description of the rental payment
6-The agreement must be in writing
7-The agreement must be signed by all parties
The start end dates of the lease agreement and the agreed upon rental payments are both negotiated items, which we discus in detail below. The type of description required depends upon the nature of the property, but must be precise about the physical premises being leased. For residential and small commercial properties, a street address and\or apartment number is usually adequate. Descriptions for larger office and retail properties are more detailed and may include items such as floor plans, the total square footage of the leased premises, and description of parking areas.

lessee Accounting for capital leases

If the leasee is a capital lease, the lessee will account for this transaction in two parts. The first is the purchase of fixed asset and the second in the obtaining and repayment of a loan.
This means that the asset itself will be recorded on the books of the lessee (and the lessee will remove the asset from their books). The first calculation that needs to be made is the amount at which the asset will be recorded on their books. The lessee then must depreciate the asset and this will be done in the same way as other similar assets owned by the lessee.
The lessee also must account for the loan (or financing) part of this transaction. this is done as if the lessee is financing the purchase for the lessor. The lessee records a payable and each period will make a payment on this amount. Part of each payment made by the lessee will be recorded as interested expense, while
the remainder will be the reduction of the lease payable itself. (This is very similar to the accounting approach for bonds payable.)
This means that the lessee will:
1-Recorded a fixed asset on their books.
2-Depreciate that asset
3- recorded a payable representing their future lease payment, and because they have received a loan to purchase this asset from the lessor, the lessee will also need to recognize interest expense as the part of the lease payment each period.
Like the case with bonds, the amount of interest that is expensed on the income statement will be calculated from the amount of the loan that is still outstanding each period. This means that each period when a payment is made, part of the it is payment of interest and part of it is the reduction of the lease payable itself.
The lessor will need to do the following:
1- Remove the fixed assets from their books.
2- recognize revenue from the sale of the assets.
3- recognize a gain or a loss on the sale.
4- recoded a receivable, and recorded interest revenue each time a payment is received from the lessee

Friday, July 10, 2009

Lessee accounting for operating leases

If the lease is classified as an operating lease. The accounting for the lease is very simple as we are going to treat the lease payments as rent expense. The payments will be only rent expense for the lessee and rent revenue for the lessee and there is no interest in operating lease.
Each period there is an entry that is as follows:
Dr Rent expenses …………………………………X
Cr cash ………………………………………….. …….Y
Where X = the monthly (or yearly) expense calculated as outlined below.
Y= the amount cash that is paid.
For the lessor the entry is the opposite with rent revenue rather than expense.

the accounting criteria for capitalizing leases by the lessee

To record a lease as capital lease one or more of four criteria must be met:
1- transfers ownership to the lessee.
2- contains a bargain purchase option.
3- lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.
4- the present value of the minimum lease payments, equals or exceeds 90 percent of the fair value of the leased property.

The two type of leases

There are actually two different ways to account for a lease depending upon the specific details of the lease agreement. The first (and easiest) method is to account for the lease as if the transaction were simply a rental agreement. This is called an operating lease and is essentially a sort-term lease.
The second method is to account for the lease as if the transaction were essentially a purchase of the asset by the lessee that is being financed by the lessor. This is called capital lease and this is what was described above.
The lessee (buyer) and the lessor (seller) separately determine whether the lease is accounted for as an operating or capital lease.

what's advantage of leasing ?

leasing have many advantages such as :
1- 100% financing at fixed rates.
2- protection Aganist obsolesscance.
3- flixibiltiy.
4- less costly financing.
5- tax advantage
6- off-balance-sheet financing.

conceptual nature of a lease

Capitalize a lease that transfers substantially all of the benefits and risks of property ownership,provided the lease is noncancelable. leases that do not transfer substantially all the benefits and risks of ownership are operating leases.
accounting for lease transaction is based on the economic substance of the transaction, rather than the legal from of it. Essentially in a lease the following is happening - the lessee is buying the asset from the lessor,but rather than paying cash for the asset, the lessee is financing the purchase with a loan from lessor.
largest group of leased equipment involves:
- information technology.
- transportation (trucks,aircraft,rail).
- construction.
- Agriculture.
internal links:
1- this link about what's advantage of leasing ?
2- this link about The two type of leases
3- this link about lessee Accounting for capital leases
4- this link about Lessee accounting for operating leases
5- this link about the accounting criteria for capitalizing leases by the lessee
6- determining if the lease is capital or operating

lease definition

A lease is an agreement between a lessor (the lower of an asset) and a lessee(the person who is going to use the asset) that conveys the right to use specific property for a stated period of time in exchange for a stated payment.

accounting for Unearned Revenue

Unearned Revenue is actually not revenue and is therefore not reported on the income statement. Unearned revenue occurs when the seller receive the cash from the sale of the good or service before the company has to provide the good or service. When this occurs, the seller must set up an unearned revenue account (or deferred revenue) to record the liability rather than recognize the cash received as revenue. The liability is recognized because the company now has the liability of providing the good or services that the customer paid for.
This unearned revenue account is set up as follows:
Dr Cash xxx
Cr unearned revenue xxx
When the revenue is then later earned, the deferred revenue account is closed to revenue (this being the account on the income statement).
Dr unearned revenue xxx
Cr revenue xxx
Alternatively, theses entries can be done in the reserve order and the amount collected can be initially credited to revenue account. Then, at the end of the period, the amount of this unearned revenue must be reversed out of "revenue" into "deferred revenue". Either method will provide the same amount of unearned revenue on the balance sheet and revenue on the income statements.

Thursday, July 9, 2009

The emphasis on the interest rate

Because in the AS\AD model monetary policy works through the effect of interest rate on investment, our analysis focuses on the interest rate in judging monetary policy. A rising interest rate indicates a tightening of monetary policy. A falling interest rate indicates a loosening of monetary policy.
A natural conclusion is that the fed should target interest rates in setting monetary policy, for example, if the interest rate is currently 6 percent and fed wants to loosen monetary policy, it should buy bonds until the interest rate falls to, say,5.5 percent. If it wants to tighten monetary policy, it should sell bonds to make the interest rate go up to, say 6.5 percent.
There is a problem in using interest rates to measure whether monetary policy is contraction or expansionary. That problem is the real\nominal interest rate problem.
Nominal interest rates are the rates you actually see and pay. When a bank pays 7 percent interest, that 7 percent is nominal interest rate. What affects the economy is the real interest rate. Real interest rates are nominal interest rates adjusted for expected inflation.
For example, you get 7 percent interest from the bank, but the price level goes up 7 percent. At the end of the year you have $107 instead of $100, but you are no better off than before because the price level has risen-on average, things cost 7 percent more. What you would have paid $100 for last year now costs $107. (That's the definition of inflation.) Had the price level remained constant, and had you received o percent interest, you would be in the equivalent position to receiving 7 percent interest on your 100$when the price level rises by 7 percent. That o percent is the real interest rate. It is the interest rate you would expect to receive if the price level remains constant.
The real interest cannot be observed because it depends on expected inflation. To calculate the real interest rate, you must subtract what you believe to be the expected rate of inflation from the nominal interest rate. For example, if the nominal interest rate is 7 percent and expected inflation is 4 percent, the real interest rate is 3 percent. The relationship between real and nominal interest rates is important both for you study of economic and for your own personal finances:
Nominal interest rate = real interest rate + Expected inflation rate.

the conduct of monetary policy

Let's now consider how it does so. We need to look more specifically at the institutional structure of the banking system and role of the fed in that institutional structure.
Think back to our discussion of the banking system. Banks take in deposits; make loans, and any other financial assets, keeping a certain percentage of reserves for those transactions. Those reserve are IOUs of the fed-either vault cash or deposits at the fed. Vault cash, deposits of the fed, plus currency in circulation make up the monetary base. The monetary base held at banks serves as legal reserves of the banking system. By controlling the monetary base, the fed can influence the amount of money in the economy and activities banks.
The actual tools monetary policy will affect the amount reserves in the system. In turn, the amount of reserves in the system will affect the interest rate. Other things equal, as reserves decline, the interest rate will rise; and as reserves increase, the interest rate will decline. So monetary policy will also be associated with interest rates.

evolution of monetary policy

Monetary policy, as determined and executed in Great Britain by the bank of England and in the United States by the Federal Reserve System, has changed from decade to decade. (It has also changed year to year and sometimes even month to month.) The monetary policy problems of the 1930is were not the same problems faced by these monetary authorities during World War II. I likewise, the problems of the 1950is, 1960is, and 1970is have all been different. In the 1960is the earlier problems of stabilization were replaced by a greater concern for economic growth. By the 1970is, the trade-off problem between greater growth and lower rates of unemployment, on the one hand, and stabilization of price level, on the other hand, seemed very important to the monetary authorities.
Furthermore, as the policy orientation changed, so too did the use of short run objects in the use of open market operations. In particular, in the 1970is there has been a greater emphasis on seeking to attain the desired rate of growth in various monetary aggregates, or various definitions of the money supply, concern with stability in the money market and a day-by-day concern with certain key money market rates, such as the federal funds rate, also continued to be preoccupations of the monetary authorities.

Wednesday, July 8, 2009

the importance of monetary policy

Not only is monetary policy the most important function of the fed, it is probably the most used policy in macroeconomics. The fed conducts and controls monetary policy, whereas fiscal policy is conducted directly by the government. Both policies are directed toward the same: influencing the level of aggregate economic activity, hopefully in a beneficial manner. (In many other countries institutional arrangements are different; the central bank is a part of government, so both monetary and fiscal policy is directly conducted by the government, albeit by different branches of government.)
Actual decisions about monetary policy are made by the Federal open market Committee (FOMC), the fed's chief policy making body. All seven members of the board of governors, together with the president of the New York fed and a rotating group of four of the presidents of the other regional banks, vote on the FOMC. All 12 regional bank presidents attend and can speak at FOMC meetings. The financial press and business community follow their discussion closely. There are even Fed watchers whose sole occupation is to follow what the fed is doing and to tell people what it will likely do.

liquidity trap and monetary policies

A liquidity trap is a problem in the use of monetary policy - a situation in which increasing reserve does not increase the money supply, but simply leads to excess reserve. A liquidity trap occurs when individuals believe that interest rates are much more likely to rise than to fall. If interest rates rise, bond prices fall, which means that bond holders lose money, so individuals want to hold cash rather than bonds. This means that increases in reserves do not affect interest rates, and do not affect borrowing. This is what happened in Japan in the late 1990s and early 2000s. The bank of Japan (the Japanese central bank) lowered the interest rate (the one similar to the fed funds rate in the U.S.) to 0.01 percent with little effect on investment spending. The belief that increases in the money supply would be ineffective in the 1930s led early Keynesians to focus on fiscal policy rather than monetary policy as a way of expanding the economy. They likened expansionary monetary policy to pushing on a string. The same problem exists with using contractionary monetary policy. Banks have been very good at figuring out ways to circumvent cuts in the money supply, making the intended results of contractionary monetary policy difficult to achieve.

lags in monetary policy

Monetary policy, like fiscal policy, takes time to work its way through the economic system. First the fed must recognize what the situation in the economy is. That isn't easy because often the data are ambiguous. Some statistics suggest the economy is expanding; some statistics suggest it is contracting. Then. The FOMC must develop a consensus for action, and change the fed funds target. The fed funds rate only affects overnight loans; the interest rates that affect the economy are longer term interest rates such as mortgage rates, business loan rates, and long-term bond rates. These change more slowly, adding more time to the lag. Once the long-term rates have changed, businesses and individuals have to change their plans in response to the interest rate change; such changes are often difficult, adding yet another lag to the process. So it can often be months before the monetary policy affects spending significantly.

How do you use monetary policy effectively?

1-to use monetary policy effectively, you must know the potential level of income. Otherwise you won't know whether to use expansionary or concretionary monetary policy. Let's consider an example: mid 1991 the economy seemed to be coming out of a recession. The fed had to figure out whether to use expansionary monetary policy to speed up and guarantee the recovery, or use concretionary monetary policy and make sure inflation didn't start up again. Initially the fed tried to fight inflation, only to discover that the economy wasn't coming out of the recession. In early 1992, the fed switched from contractionary to expansionary monetary policy. It continued that policy through 1994, when fears of inflation caused it to start tightening the money supply slightly. In early 2000 the fed was again trying to decide whether to follow expansionary or contractionary policy. It decided to contract the money supply but quickly changed its stance when the economy slowed in stood ready to return to a more contractionary monetary policy stance at the first sign of inflationary pressure. As these examples show, monetary policy in an art. the need for expansionary or contractionary policy can change quickly.
2- To use monetary policy effectively, you must know whether the monetary policy you are using is expansionary or contractionaery. You might think that's rather easy, but it isn't. In our consideration of monetary policy tools, you now that the fed doesn't directly control the money supply. It indirectly controls it, generally through open market operations by changing the monetary base (the vault cash and reserve banks have at the fed). Then the money multiplier determines the amounts of M1, M2, and other monetary measures in the economy.
That money multiplier is influenced by the amount of cash that people hold as well as the lending process at the bank. Neither of those is the stable number that we used in calculating the money multipliers. They change from day to day and week to week, so even if you control the monetary base, you can never be sure exactly what will happen to M1and M2 in the short run. Moreover, the effects on M1 and M2 can differ; one measure is telling you that you are expanding the money supply and other measure is telling you you are contracting it.
Because money aggregates as a measure of monetary policy have become unreliable, the fed officially stopped targeting those 2000. Instead, if focuses on interest rates. Interest rates, however, have problems of their own. If interest rates rise, is it because of excepted inflation (which is adding an inflation premium to the nominal interest rates) or is it the real interest rate that is going up? There is frequent debate over which it is. Combined, these measurement problems make the fed often wonder not only about what policy it should follow but also what policy it is following.