Financial Engineering and Investment Products in the 2000s
The 2000s witnessed a dramatic increase in Financial Engineering that produced a wide range of new loans and investment products.
- What is Financial Engineering?
Financial Engineering is the use of mathematical techniques to solve financial problems.
- Provide examples of Financial Engineering that have produced new consumer loan products and investment securities.
Examples of consumer loan products:-
Auto Loan -This loan is used to buy New, Used or Refinance your personal vehicle.
Motorcycles Loan – This loan is used to buy New, Used or Refinance motorcycles.
Student Loan Program – This loan is offered for schooling.
Examples of Investment Securities are as follow:-
Stocks – Stocks are the best known equity security. You’re purchasing an ownership interest in a company when you buy stock.
Corporate Bonds – A corporate bond is a debt instrument issued by a company.
Government Bonds – Government bonds are issued by the US federal government.
- How did Financial Engineering affect Adverse Selection and Moral Hazard problems prior to 2008 Financial Crisis?
Currency exchange stability is an important goal of the Saudi Ministry of Commerce and Industry.
- What are the advantages of “strong” currency exchange stability for Saudi Arabia? Explain with examples.
- What are the disadvantages of “strong” currency exchange stability for Saudi Arabia? Explain with examples.
D- Saudi Arabia has its currency Riyal pegged against dollar. For example, it will have to maintain foreign reserves at all time to manage its currency value.
- How does Saudi Arabia maintain currency exchange stability? Explain with examples.
Saudi arabia tackled the problem by imposing tax cuts, and applying a new monetary policy which increased supply.
Bank regulators are required to examine and report on the health of financial institutions.
- How does the bank reserve ratio requirement affect its lending ability?
A required reserve ratio is the fraction of deposits that regulators require a bank to hold in reserves and not loan out.By changing the required reserve ratio the fed can change banks excess reserves and therefore banks lending ability.
- How does a “Sweep Account” system help banks avoid their reserve requirements?
It is the innovation that enables banks to avoid the tax from reserve requirements is the sweep account.In this areangement any balances above a certain amount in corporations checking account at the end of business day are ‘swept out’ of the account and invested in overnight securities that pay the corporation interest.Because the swept out funds are no longer classified as checkable deposits,they are not subject to reserve requirements and thys are not taxed.
- How do money market mutual funds allow banks to avoid reserve requirements? Money market mutual funds issue shares that are redeemable at a fixed price usually at $1 by writing checks. they are not legally deposits and so are not subject to reserve requirements or prohibitions on intersst payments.
The political independence of central banks is an increasingly important issue in the global economy.
- What is the global trend in the political independence of central banks?
Political autonomy of central banks in developing countries is much lower than in emerging markets and advanced countries. It has only marginally increased and is generally low. It is difficult to precisely quantify the evolution political independence overtime. For all country groups, there is a general shift that confirms the broad-based strengthening in both economic and political components of CBA (Central Bank Autonomy), and the shift is clearly more uniform in case of advanced countries.
- Is this good or bad for the global economy? Explain with examples.
In a way autonomy to central banks has helped economies to develop. Its Good
For examble:- Central banks in advanced countries like USA continue to enjoy greater CBA than those in the emerging markets and developing nations.
However, all country groups exhibit a higher level of CBA at present than that reached by advanced countries in the late 1980s.
- What are the advantages and disadvantages to individual countries? Explain with examples.
1)The advantages of central bank autoomy is that they can take the right decisions when it comes to monetary policies. Can be cautious of taking an expansionary policy that would lead to inflation and boom and bust of economic cycles.
An apt example:- is that in 1977, the Labor Party gave the Bank of England full independence framing monetary policy.
2) The disadvantage may be the independence itself.
For example:-, there is no general agreement about independence of Bank of Canada. The extensive research shows that there is a reverse relationship between inflation rate and autonomy of central bank
National or “Central” Banks are the ‘Lenders of Last Resort.’
- What is the importance of being the Lender of Last Resort?
In an economic crisis when banks are fearful to lending to each other due to perceived credit risk, the interbank/ repo market shuts down and impedes flow of credit in the system, with adverse effects on the economy. The lender of the last resort, the Central Bank, then steps in to lend money to banks at the repo rate in order to keep the system running and prevent a panic.
- What role did the US Treasury play in stabilizing the US Financial System?
he Federal Reserve initiated TARP, QE, and cut down the federal funds rate to 0% during the heights of the recession in 2007-08. Due to this, it bought over troubled mortgages and such securities from the banks and provided liquidity to the banks when the interbank system dried up. QE and the cutting of the federal funds rate was done to stimulate the economy via lower interest rates and encouraging money to flow into higher yielding assets like stocks.
- What is your biggest fear of this role of Central banks?
The risk is that of moral hazard, since the banks don’t lose by taking big risks (the Federal Reserve bails them out). In addition, very low interest rates result in loss of income to savers, retirees, and insurance companies plus squeeze the net interest margins of banks. Pension funds are affected as the return on their bond portfolio is drastically reduced which can lead to shortfall in assets over liabilities.
The management of risk is crucial to the profitability of banks.
The most important risk management principles that involve approving loans:
lending can expose a bank’s earnings and capital to all of the risks. Therefore, it is important that the examiner assigned LPM understands all the risks embedded in the loan portfolio and their potential impact on the institution.
Credit risk is the most growing risk
1-Credit Risk:
2-Interest Rate Risk
3-Liquidity Risk
4- PriceRisk
5-Foreign Exchange Risk
6-Transaction Risk
7-Compliance Risk
8-Strategic Risk
What is Adverse Selection? What is Moral Hazard? Why do they make the underwriting process for lending more complicated?
Adverse selection occur when the selectes group proves to be wrong and there is a lack of information symmetry between between buyer and seller whereas on the moral hazard part there is information assymetry and change of behavior of one party after a deal is struck.
In these cases underwriting is difficult and passing of loans or credit becomes difficult.
Is the loan approval process different in Western/International banks in comparison to Islamic banks? Explain with examples.
loan approval process in islamic state is concentrated on the concept that the wealth should be deposit or shared among the people and not to only business. The islamic borrowing process is also different.