Financial Markets and Institutions, 7th Edition Solution Manual

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Part IIntroduction

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Chapter 1Why Study Financial Marketsand Institutions?Why Study Financial Markets?Debt Markets and Interest RatesThe Stock MarketThe Foreign Exchange MarketWhy Study Financial Institutions?Structure of the Financial SystemFinancial CrisesCentral Banks and the Conduct of Monetary PolicyThe International Financial SystemBanks and Other Financial InstitutionsFinancial InnovationManaging Risk in Financial InstitutionsApplied Managerial PerspectiveHow WeWill Study Financial Markets and InstitutionsExploring the WebCollecting and Graphing DataWeb ExerciseConcluding Remarks◼Overview and Teaching TipsBefore embarking on a study of financial markets and institutions, the student must be convinced that thissubject is worth studying. Chapter 1 pursues this goal by showing the student that financial markets andinstitutions is an exciting field because it focuses on phenomena that affect everyday life. An additionalpurpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will becovered in later chapters. The chapter also provides the students with a guide as to how they will be studyingfinancial markets and institutions with a unifying, analytic framework and an applied managerial perspective.In teaching this chapter, the most important goal should be to get the student excited about the material. I havefound that talking about the data presented in the figures helps achieve this goal by showing the students thatthe subject matter of financial markets and institutions has real-world implications that they should care about.In addition, it is important to emphasize to the students that the course will have an applied managerialperspective, which they will finduseful latter in their careers. Going through the web exercise is also a way ofencouraging the students to use the web to further their understanding of financial markets and institutions.

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Chapter 1Why Study Financial Markets and Institutions?3◼Answers to End-of-Chapter Questions1.Because they channel funds from those who do not have a productive use for them to those who do,thereby resulting in higher economic efficiency.2.Businesses would cut investment spending because the cost of financing this spending is now higher,and consumers would be less likely to purchase a house or a car because the cost of financing theirpurchase is higher.3.A change in interest rates affects the cost of acquiring funds for financial institution as well aschanges the income on assets such as loans, both of which affect profits. In addition, changes ininterest rates affect the price of assets such as stock and bonds that the financial institution ownswhich can lead to profits or losses.4.No. People who borrow to purchase a house or a car are worse off because it costs them more to financetheir purchase; however, savers benefit because they can earn higher interest rates on their savings.5.The lower price for a firm’s shares means that it can raise a smaller amount of funds, and so investmentin plant and equipment will fall.6.Higher stock prices mean that consumers’ wealth is higher and so they will be more likely to increasetheir spending.7.It makes foreign goods more expensive and so British consumers will buy less foreign goods andmore domestic goods.8.It makes British goods more expensive relative to American goods. American businesses will find iteasier to sell their goods in the United States and abroad, and the demand for their products will rise.9.Changes in foreign exchange rates change the value of assets held by financial institutions and thuslead to gains and losses on these assets. Also changes in foreign exchange rates affect the profitsmade by traders in foreign exchange who work for financial institutions.10.In the mid to late 1970s and the late 1980s and early 1990s, the value of the dollar was low, makingtravel abroad relatively more expensive; that would have been a good time to vacation in the UnitedStates and see the Grand Canyon. As the dollar’s value rose in the early 1980s, travel abroad becamerelatively cheaper, making it a good time to visit the Tower of London.11.Banks accept deposits and then use the resulting funds to make loans.12.Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutualfunds, pension funds, and finance companies.13.Answers will vary.14.The profitability of financial institutions is affected by changes in interest rates, stock prices, andforeign exchange rates; fluctuations in these variables expose these institutions to risk.15.Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which havean important impact on the profitability of financial institutions.

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4Mishkin/Eakins•FinancialMarkets and Institutions,Seventh Edition◼Quantitative Problems1.The following table listsforeign exchange rates between U.S. dollars and British pounds duringApril:DateU.S. Dollars per GBPDateU.S. Dollars per GBP4/11.95644/181.75044/41.92934/191.72554/51.9144/201.69144/61.93744/211.6724/71.9614/221.66844/81.89254/251.66744/111.88224/261.68574/121.85584/271.69254/131.7964/281.72014/141.79024/291.75124/151.7785Which day would have been the best day to convert $200 into British pounds?Which day would have been the worst day? What would be the difference in pounds?Solution:The best day is 4/25. At a rate of $1.6674/pound, you would have £119.95. The worstday is 4/7. At $1.961/pound, you would have £101.99, or a difference of £17.96.

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Chapter 2Overview of the Financial SystemFunction of Financial MarketsStructure of Financial MarketsDebt and Equity MarketsPrimary and Secondary MarketsExchanges and Over-the-Counter MarketsMoney and Capital MarketsInternationalization of Financial MarketsInternational Bond Market, Eurobonds, and EurocurrenciesGlobal Box: Are U.S. Capital Markets Losing Their Edge?World Stock MarketsFunction of Financial Intermediaries: Indirect FinanceTransaction CostsFollowing the Financial News: Foreign Stock Market IndexesGlobal Box: The Importance of Financial Intermediaries Relative to SecuritiesMarkets: An International ComparisonRisk SharingAsymmetric Information: Adverse Selection and Moral HazardTypes of Financial IntermediariesDepository InstitutionsContractual Savings InstitutionsInvestment IntermediariesRegulation of the Financial SystemIncreasing Information Available to InvestorsEnsuring the Soundness of Financial IntermediariesFinancial Regulation Abroad◼Overview and Teaching TipsChapter 2 is an introductory chapter that contains the background information on the structure and operationof financial markets that is needed in later chapters of the book. This chapter allows the instructor to branchoutto various choices of later chapters, thus allowing different degrees of coverage of financial marketsand institutions.

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6Mishkin/Eakins•Financial Markets andInstitutions,Seventh EditionThe most important point to transmit to the student is that financial markets and financial intermediariesare crucial to a well-functioning economy because they channel funds from those who do not have aproductive use for them to those who do. Some instructors will want to teach this chapter in detail, andthose who focus on international issues will want to spend some time on the section “Internationalizationof Financial Markets.” However, those who slant their course to public policy issues may want to give thischapter a more cursory treatment. No matter how much class time is devoted to this chapter, I have foundthat it is a good reference chapter for students. You might want to tell them that if in later chapters they donot recall what particular financial intermediaries do and who regulates them, they can refer back to thischapter, especially to tables, such as Tables 1 and 3.◼Answers to End-of-Chapter Questions1.The share of Microsoft stock is an asset for its owner because it entitles the owner to a share of theearnings and assets of Microsoft. The share is a liability for Microsoft because it is a claim on itsearningsand assets by the owner of the share.2.Yes, I should take out the loan, because I will be better off as a result of doing so. My interest paymentwill be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead ofthe game by $5,500. Since Larry’s loan-sharking business can make some people better off, as in thisexample, loan sharking may have social benefits. (One argument against legalizing loan sharking,however, is that it is frequently a violent activity.)3.Yes, because the absence of financial markets means that funds cannot be channeled to people whohave the most productive use for them. Entrepreneurs then cannot acquire funds to set up businessesthat would help the economy grow rapidly.4.The principal debt instruments used were foreign bonds which were sold in Britain and denominatedin pounds. The British gained because they were able to earn higher interest rates as a result oflending to Americans, while the Americans gained because they now had access to capital to start upprofitable businesses such as railroads.5.This statement is false. Prices in secondary markets determine the prices that firms issuing securitiesreceive in primary markets. In addition, secondary markets make securities more liquid and thuseasier to sell in the primary markets. Therefore, secondary markets are, if anything, more importantthan primary markets.6.You would rather hold bonds, because bondholders are paid off before equity holders, who are theresidual claimants.7.Because you know your family member better than a stranger, you know more about the borrower’shonesty, propensity for risk taking, and other traits. There is less asymmetric information than witha stranger and less likelihood of an adverse selection problem, with the result that you are more likelyto lend to the family member.9.Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that mightjeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage inmoral hazard.10.They might not work hard enough while you are not looking or may steal or commit fraud.

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Chapter 2Overview of the Financial System711.Yes, because even if you know that a borrower is taking actions that might jeopardize paying off theloan, you must still stop the borrower from doing so. Because that may be costly, you may not spendthe time and effort to reduce moral hazard, and so moral hazard remains a problem.12.True. If there are no information or transaction costs, people could make loans to each other at nocost and would thus have no need for financial intermediaries.13.Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check,and so on), you will probably not be able to earn 5% on the loan after your expenses even though ithas a 10% interest rate. You are better off depositing your savings with a financial intermediary andearning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bankrather than lending themto your neighbor.14.Increased discussion of foreign financial markets in the U.S. press and the growth in markets forinternational financial instruments such as Eurodollars and Eurobonds.

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Part IIFundamentals of Financial Markets

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Chapter 3What Do Interest Rates Mean andWhat Is Their Role in Valuation?Measuring Interest RatesPresent ValueFour Types of Credit Market InstrumentsYield to MaturityGlobal Box: Negative T-Bill Rates? It Can HappenThe Distinction Between Real and Nominal Interest RatesThe Distinction Between Interest Rates and ReturnsMini-Case Box: With TIPS, Real Interest Rates Have Become Observable in the United StatesMaturity and the Volatility of Bond Returns: Interest-Rate RiskReinvestment RiskMini-Case Box: Helping Investors to Select Desired Interest-Rate RiskSummaryCalculating DurationDuration and Interest-Rate Risk◼Overview and Teaching TipsIn my years of teaching financial markets and institutions, I have found that students have trouble withwhat I consider to be easy material because they do not understand what an interest rate is—that it isnegatively associated with the price of a bond, that it differs from the return on a bond, and that there isan important distinction between real and nominal interest rates.This chapter spends more time on these issues than does any other competing textbook. My experiencehas been that giving this material so much attention is well rewarded. After putting more emphasis on thismaterial in my financial markets and institutions course, I witnessed a dramatic improvement in students’understanding of portfolio choice and asset and liability management in financial institutions.An innovative feature of the textbook is the set of over twenty special applications called, “The PracticingManager.” These applications introduce students to real-world problems that managers of financialinstitutions have to solve and make the course both more relevant and exciting to students. They are notmeant to fully prepare students for jobs in financial institutions—it is up to more specialized courses suchas bank or financial institutions management to do this—but these applications teach them some of thespecial analytical tools that they will need when they enter the business world.

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Chapter 3What Do Interest Rates Mean and What is Their Role in Valuation?11This chapter contains the Practicing Manager application on “Calculating Duration to Measure Interest-Rate Risk.” The application shows how to quantify interest-rate risk using the duration concept and isa basic tool for managers of financial institutions. For those instructors who do not want a managerialemphasis in their financial markets and institutions course, this and other Practicing Manager applicationscan be skipped without loss of continuity.◼Answers to End-of-Chapter Questions1.$2000=$100/(1+i)+$100/(1+i)2++$100/(1+i)20+$1000/(1+i)20.2.You would rather be holding long-term bonds because their price would increase more than the priceof the short-term bonds, giving them a higher return.3.No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in pricethat their return might be quite low, possibly even negative.4.People are more likely to buy houses because the real interest rate when purchasing a house has fallenfrom 3 percent (=5 percent–2 percent) to 1 percent (=10 percent−9 percent). The real cost of financingthe house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interestpayments is allowed for, then it becomes even more likely that people will buy houses.)◼Quantitative Problems1.Calculate the present value of a $1,000 zero-coupon bond with 5 years to maturity if the requiredannual interest rate is 6%.Solution:PV=FV/(1+i)nwhereFV=1000,i=0.06,n=5PV=747.252.A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the firstpayment is made immediately, what is this grand prize really worth? Use a discount rate of 6%.Solution:This is a simple present value problem. Using a financial calculator,N=20;PMT=500,000;FV=0;I=6%;Pmtsin BEGIN mode.ComputePV:PV=$6,079,058.253.Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table:Years to MaturityDiscount RateCurrent Price3537679799

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12Mishkin/Eakins•Financial Markets and Institutions,Seventh EditionWhat relationship do you observe between yield to maturity and the current market value?Solution:Years to MaturityYield to MaturityCurrent Price35$1,054.4637$1,000.0067$1,000.0095$1,142.1699$880.10When yield to maturity is above the coupon rate, the band’s current price is below its facevalue. The opposite holds true when yield to maturity is below the coupon rate. For a givenmaturity, the bond’s current price falls as yield to maturity rises. For a given yield tomaturity, a bond’s value rises as its maturity increases. When yield to maturity equals thecoupon rate, a bond’s current price equals its face value regardless of years to maturity.4.Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currentlyselling for $1,150 and has 8 years to maturity. What is the bond’s yield to maturity?Solution:To calculate the bond’s yield to maturity using a financial calculator,N=8;PMT=10000.10=100;FV=1000;PV=1150ComputeI:I=7.445.You are willing to pay $15,625 now to purchase a perpetuity which will pay you and your heirs$1,250 each year, forever, starting at the end of this year. If your required rate of return does notchange, how much would you be willing to pay if this were a 20-year, annual payment, ordinaryannuity instead of a perpetuity?Solution:To find your yield to maturity, Perpetuity value=PMT/I.So, 15,625=1,250/I;I=0.08The answer to the final part using a financial calculator:N=20;I=8;PMT=1,250;FV=0ComputePV:PV=12,272.696.The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price would fall tohalf its previous value, to $1000 = $50/.05.7.Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you justbought a $100,000 home, what is thePVofallthe future property tax payments? Assume that thehouse remains worth $100,000 forever, property tax rates never change, and that a 9% discount rateis used for discounting.Solution:The taxes on a $100,000 home are roughly 100,0000.0266=2,660.ThePVof all future payments=2,660/0.09=$29,555.55 (a perpetuity).8.Assume you just deposited $1,000 into a bank account. The current real interest rate is 2% andinflation is expected to be 6% over the next year. What nominal interest rate would you require fromthe bank over the next year? How much money will you have at the end of one year? If you aresaving to buy a stereo that currently sells for $1,050, will you have enough to buy it?

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Chapter 3What Do Interest Rates Mean and What is Their Role in Valuation?13Solution:The required nominal rate would be:e2%6%8%.rii=+=+=At this rate, you would expect to have $1,0001.08, or $1,080 at the end of the year.Can you afford the stereo? In theory, the price of the stereo will increase with the rate ofinflation. So, one year later, the stereo will cost $1,0501.06, or $1,113. You will beshort by $33.9.A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Computeyour rate of return if you sell the bond next year for $880.10.Solution:170880.10871.650.09,or9%.871.65tttCPPRP++−+−===10.You have paid $980.30 for an 8% coupon bond with a face value of $1,000 that mature in five years.You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment,what price must you sell the bond for? Is this realistic?Solution:To find the price, solve:11180980.300.09for.988.53.980.30tttPPP++++−==Although this appears possible, the yield to maturity when you purchased the bond was8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the yieldwould have to drop to 8.35% for the price to be $988.53.11.Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume that allmarket interest rates are 7%.Solution:Year123SumPayments60.0060.001060.00PVof Payments56.0752.41865.28973.76Time WeightedPVof Payments56.07104.812595.83Time WeightedPVof PaymentsDivided by Price0.060.112.672.83This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76,which is the sum of the individual “PVof payments.”12.Consider the bond in the previous question. Calculate the expectedprice change if interest ratesdrop to 6.75% using the duration approximation. Calculate the actual price change using discountedcash flow.Solution:Using the duration approximation, the price change would be:

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14Mishkin/Eakins•Financial Markets and Institutions,Seventh Edition0.0025DUR2.83973.766.44.11.07iPPi−= −= −=+The new price would be $980.20. Using a discounted cash flow approach, the price is980.23—only $.03 different.Year123SumPayments60.0060.001060.00PVof payments56.2152.65871.3980.2313.The duration of a $100 million portfolio is 10 years. $40 million dollars in new securities are added tothe portfolio, increasing the duration of the portfolio to 12.5 years. What is the duration of the$40 million in new securities?Solution:First, note that the portfolio now has $140 million in it. The duration of a portfolio is theweighted average duration of its individual securities. LetDequal the duration of the$40 million in new securities. Then, this implies:12.5(100/14010)(40/140D)12.57.1425 + 0.285718.75DD=+==The new securities have a duration of 18.75 years.14.A bank has two, 3-year commercial loans with a present value of $70 million. The first is a $30 millionloan that requires a single payment of $37.8 million in 3 years, with no other payments until then.The second is for $40 million. It requires an annual interest payment of $3.6 million. The principal of$40 million is due in 3 years.a.What is the duration of the bank’s commercial loan portfolio?b.What will happen to the value of its portfolio if the general level of interest rates increased from8% to 8.5%?Solution:The duration of the first loan is 3 years since it is a zero-coupon loan. The duration of thesecond loan is as follows:Year123SumPayment3.603.6043.60PVof Payments3.333.0934.6141.03Time WeightedPVof Payments3.336.18103.83Time WeightedPVof PaymentsDivided by Price0.080.152.532.76The duration of a portfolio is the weighted average duration of its individual securities.So, the portfolio’s duration=3/7(3)+4/7(2.76)=2.86If rates increased,0.005DUR2.8670,000,000926,852.11.08iPPi= −= −= −+

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Chapter 3What Do Interest Rates Mean and What is Their Role in Valuation?1515.Consider a bond that promises the following cash flows. The required discount rate is 12%.Year01234Promised Payments160170180230You plan to buy this bond, hold it for 2½ years, and then sell the bond.a.What total cash will you receive from the bond after the 2½ years? Assume that periodic cashflows are reinvested at 12%.b.If immediately after buying this bond, all market interest rates drop to 11% (including yourreinvestment rate), what will be the impact on your total cash flow after 2½ years? How doesthis compare to part (a)?c.Assuming all market interest rates are 12%, what is the duration of this bond?Solution:a.You will receive 160 reinvested for 1.5 years, and 170 reinvested for 0.5 years. Then you willsell the remaining cash flows, discounted at 12%. This gives you:1.50.50.51.5180230160(1.12)170(1.12)$733.69.1.121.12+++=b.This is the same as part (a), but the rate is now 11%.1.50.50.51.5180230160(1.11)170(1.11)$733.74.1.111.11+++=Notice that this is only $0.05 different from part (a).c.The duration is calculated as follows:Year1234SumPayments160.00170.00180.00230.00PVof Payments142.86135.52128.12146.17552.67Time WeightedPVof Payments142.86271.05384.36584.68Time WeightedPVof PaymentsDivided by Price0.260.490.701.062.50Since the durationand the holding period are the same, you are insulated from immediatechanges in interest rates! It doesn’t always work out this perfectly, but the idea is important.

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Chapter 4Why Do Interest Rates Change?Determinants of Asset DemandWealthExpected ReturnsRiskLiquiditySummarySupply and Demand in the Bond MarketDemand CurveSupply CurveMarket EquilibriumSupply-and-Demand AnalysisChanges in Equilibrium Interest RatesShifts in the Demand for BondsShifts in the Supply of BondsCase: Changes in the Interest Rate Due to Expected Inflation: The Fisher EffectCase: Changes in the Interest Rate Due to a Business Cycle ExpansionCase:Explaining Low Japanese Interest RatesCase: Reading theWall Street Journal“Credit Markets” ColumnFollowing the Financial News: The “Credit Markets” ColumnThe Practicing Manager: Profiting from Interest-Rate ForecastsFollowing the Financial News: Forecasting Interest RatesAppendix 1: Models of Asset PricingAppendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of GoldAppendix 3: Loanable Funds FrameworkAppendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework◼Overview and Teaching TipsAs is clear in the Preface to the textbook, I believe that financial markets and institutions is taught effectivelyby emphasizing a few analytic principles and then applying them over and over again to the subject matterof this exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand.It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth,expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assetsis, in fact, an extremely powerful one. It is used continually throughout the study of financial markets andinstitutions and makes it much easier for the student to understand how interest rates are determined, how

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Chapter 4Why Do Interest Rates Change?17financial institutions manage their assets and liabilities, why financial innovation takes place, how pricesare determined in the stock market and the foreign exchange market.One teaching device that I have found helps students develop their intuition is the use of summary tables,such as Table 1, in class. I use the blackboard to write a list of changes in variables that affect the demandfor an asset and then ask students to fill in the table by reasoning how demand responds to each change.This exercise gives them good practice in developing their analytic abilities. I use this device continuallythroughout my course and in this book, as is evidenced from similar summary tables in later chapters.I recommend this approach highly.The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using thesupply and demand in the bond market. An important feature of the analysis in this chapter is that supplyand demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in theprofessional journals almost always analyzes the determination of prices in financial markets with anasset-market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is thatkeeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in termsof flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using astock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with moderntreatment of asset markets by financial economists.Another important feature of this chapter is that it lays out supply and demand analysis of the bond marketat a similar level to that found in principles of economics textbooks. The ceteris paribus derivations ofsupply and demand curves with numerical examples are presented, the concept of equilibrium is carefullydeveloped, the factors that shift the supply and demand curves are outlined, and the distinction betweenmovements along a demand or supply curve and shifts in the curve is clearly drawn. My feeling is that thestep-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basictool throughout the study of financial markets and institutions. I have found that even those students whohave had excellent training in earlier courses find that this chapter provides a valuable review of supplyand demand analysis.An additional innovative feature of the book that first appears in this chapter are the special applications,“Case: theWall Street Journal.” These cases show students how the analytical framework in the bookcan be used directly to understand the daily columns in the United States’ leading financial newspaper.The students particularly like the case on reading the credit markets column because it shows them thatthe concepts developed in the chapter are actually used in the real world. In teaching my class, I bring theprevious day’sWall Street Journalcolumns into class and then use them to conduct a case discussionalong the lines of the “ Case: theWall Street Journal“ in the text. My students very much like theresulting case discussions and have told me that they are better than case discussions in other classesbecause the material is so current.The Practicing Manager application at the end of the chapter shows how interest rate forecasts can be usedby managers of financial institutions to increase profits. This application shows students how the analysisthey have learned is useful in the real world.This chapter has an extensive set of appendices on the web to enhance its material. Appendix 1 providesmodels of asset pricing in case an instructor wants to make use of the capital asset pricing model or thearbitrage pricing model in this course. Appendix 2 shows how the analysis developed in the chapter can beapplied to understanding how any asset’s price is determined. Students particularly like the application tothe gold market because this commodity piques almost everybody’s interest. Appendix 3 provides ananother interpretation of the supply and demand analysis for bonds using a different terminology involvingthe supply and demand for loanable funds. Appendix 4 provides an alternative approach to interest ratedetermination developed by John Maynard Keynes, known as the liquidity preference framework.

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18Mishkin/Eakins•Financial Markets and Institutions,Seventh Edition◼Answers to End-of-Chapter Questions1.a.Less, because your wealth has declinedb.More, because its relative expected return has risenc.Less, because it has become less liquid relative to bondsd.Less, because its expected return has fallen relativeto golde.More, because it has become less risky relative to bonds2.a.More, because your wealth has increasedb.More, because it has become more liquidc.Less, because its expected return has fallen relative to Polaroid stockd.More, because it has become less risky relative to stockse.Less, because its expected return has fallen3.True, because the benefits to diversification are greater for a person who cares more about reducing risk.4.Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because thecorrelation of returns on my investment in a football team with the returns on the pharmaceuticalcompany shares should be low. By contrast, the correlation of returns on an investment in a footballteam and an investment in a basketball team are probably pretty high, so in this case there would belittle risk reduction if I invested in both.5.True, because for a risk averse person, more risk, a lower expected return, and less liquidity make asecurity less desirable.6.When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supplycurveBsto the right. The result is that the intersection of the supply and demand curvesBsandBdoccurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interestrate rises.7.When the economy booms, the demand for bonds increases: The public’s income and wealth riseswhile the supply of bonds also increases, because firms have more attractive investment opportunities.Both the supply and demand curves (BdandBs) shift to the right, but as is indicated in the text, thedemand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly,when the economy enters a recession, both the supply and demand curves shift to the left, but thedemand curve shifts less than the supply curve so that the bond price rises and the interest rate falls.The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions,that is, interest rates are procyclical.8.Interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative togold and causes the demand for bonds to increase. The demand curve,Bd, shifts to the right and theequilibrium bond price rises and the interest rate falls.9.Interest rates would rise. A sudden increase in people’s expectations of future real estate pricesraises the expected return on real estate relative to bonds, so the demand for bonds falls. Thedemand curveBdshifts to the left, and the equilibrium bond price falls, so the interest rate rises.

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Chapter 4Why Do Interest Rates Change?1910.Interest rates might rise. The large federal deficits require the Treasury to issue more bonds; thus thesupply of bonds increases. The supply curve,Bs, shifts to the right and the equilibrium bond pricefalls and the interest rate rises. Some economists believe that when the Treasury issues more bonds,the demand for bonds increases because the issue of bonds increases the public’s wealth. In this case,the demand curve,Bd, also shifts to the right, and it is no longer clear that the equilibrium bond priceor interest rate will rise. Thus there is some ambiguity in the answer to this question.11.The increased riskiness of bonds lowers the demand for bonds. The demand curve shifts to the leftand the equilibrium bond price falls and the interest rate rises.12.The increased riskiness of bonds lowers the demand for bonds. The demand curveBdshifts to theleft, the equilibrium bond price falls and the interest rate rises.13.Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds,and the demand for bonds will fall. The demand curveBdwill therefore shift to the left, and theequilibrium bond price falls and the interest rate will rise.14If the public believes the president’s program will be successful, interest rates will fall. The president’sannouncement will lower expected inflation so that the expected return on goods decreases relativeto bonds. The demand for bonds increases and the demand curve,Bd, shifts to the right. For a givennominal interest rate, the lower expected inflation means that the real interest rate has risen, raisingthe cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supplycurve,Bs, and the rightward shift of the demand curve,Bd, causes the equilibrium bond price to riseand the interest rate to fall.15.The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, theexpected return on long-term bonds such as the188sof 2022 will fall, and the demand for thesebonds will decline. The demand curveBdwill therefore shift to the left, and the equilibrium bondprice falls and the interest rate will rise.16.Interest rates will rise. The expected increase in stock prices raises the expected return on stocksrelative to bonds and so the demand for bonds falls. The demand curve,Bd, shift to the left and theequilibrium bond price falls and the interest rate rises.17.Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand forbonds will fall. The demand curveBdwill shift to the left, and the equilibrium bond price falls andthe interest rate will rise.◼Quantitative Problems1.You own a $1,000-par zero-coupon bond that has 5 years of remaining maturity. You plan on sellingthe bond in one year and believe that the required yield next year will have the following probabilitydistribution:ProbabilityRequired Yield0.16.60%0.26.75%0.47.00%0.27.20%0.17.45%

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20Mishkin/Eakins•Financial Markets and Institutions,Seventh Editiona.What is your expected price when you sell the bond?b.What is the standard deviation?Solution:ProbabilityRequired YieldPriceProbPriceProb(Price−Exp. Price)20.16.60%$774.41$ 77.4412.847762410.26.75%$770.07$154.019.7756681310.47.00%$762.90$305.160.0130175120.27.20%$757.22$151.446.8626095410.17.45%$750.02$ 75.0216.5903224$763.0746.08937999The expected price is $763.07.The variance is $46.09, or a standard deviation of $6.79.2.Consider a $1,000-par junk bond paying a 12% annual coupon. The issuing company has 20% chanceof defaulting this year; in which case, the bond would not pay anything. If the company survives thefirst year, paying the annual coupon payment, it then has a 25% chance of defaulting in the secondyear. If the company defaults in the second year, neither the final coupon payment nor par value ofthe bond will be paid. What price must investors pay for this bond to expect a 10% yield to maturity?At that price, what is the expected holding period return? Standard deviation of returns? Assume thatperiodic cash flows are reinvested at 10%.Solution:The expected cash flow att1=0.20 (0)+0.80 (120)=96The expected cash flow att2=0.25 (0)+0.75 (1,120)=840The price today should be:0296840781.491.101.10P=+=At the end of two years, the following cash flows and probabilities exist:ProbabilityFinal CashFlowHolding PeriodReturnProbHPRProb(HPR−Exp. HPR)20.2$0.00−100.00%−20.00%19.80%0.2$132.00−83.11%−16.62%13.65%0.6$1,252.0060.21%36.12%22.11%−0.50%55.56%The expected holding period return is almost zero (−0.5%). The standard deviation isroughly 74.5% (the square root of 55.56%).3.Last month, corporations supplied $250 billion in bonds to investors at an average market rate of11.8%.This month, an additional $25 billion in bonds became available, and market rates increased to 12.2%.Assuming a Loanable Funds Framework for interest rates, and that the demand curve remainedconstant, derive a linear equation for the demand for bonds, using prices instead of interest rates.

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Chapter 4Why Do Interest Rates Change?21Solution:First, translate the interest rates into prices.100011.8%,or894.454PiPP−===100012.2%,or891.266PiPP−===We know two points on the demand curve:891.266,275894.454,250PQPQ====So, the slope=891.266894.4540.12755275250PQ−==−Using the point-slope form of the line,Price=0.12755Quantity+Constant. We cansubstitute in either point to determine the constant. Let’s use the first point:891.2660.12755275 + Constant,orConstant856.189==Finally, we have:: Price0.12755Quantity856.189dB=+4.An economist has estimated that, near the point of equilibrium, the demand curve and supply curvefor bonds can be estimated using the following equations:2: PriceQuantity9405: PriceQuantity500dsBB−=+=+a.What is the expected equilibrium price and quantity of bonds in this market?b.Given your answer to part (a), which is the expected interest rate in this market?Solution:a.Solve the equations simultaneously:29405[500]70440,or314.28575PQPQQQ−=+−=+−=+=This implies thatP=814.2857.b.1000814.285722.8%814.2857i−==5.As in Question 6, the demand curve and supply curve for bonds are estimated using the followingequations:

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22Mishkin/Eakins•Financial Markets and Institutions,Seventh Edition2: PriceQuantity9405: PriceQuantity + 500dsBB−=+=

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Chapter 4Why Do Interest Rates Change?23Following a dramatic increase in the value of the stock market, many retirees started moving moneyout of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, suchthat the price of bonds at all quantities increased $50. Assuming no change in the supply equation forbonds, what is the new equilibrium price and quantity? What is the new market interest rate?Solution:The new demand equation is as follows:2: PriceQuantity9905dB−=+Now, solve the equations simultaneously:29905[500]70490,or350.005PQPQQQ−=+−=+−=+=This implies thatP=850.00.1000850.0017.65%850.00i−==6.Following Question 5, the demand curve and supply curve for bonds are estimated using thefollowing equations:Bd:Price=2 Quantity9905−+Bs: Price=Quantity+500As the stock market continued to rise, the Federal Reserve felt the need to increase the interest rates.As a result, the new market interest rate increased to 19.65%, but the equilibrium quantityremainedunchanged. What are the new demand and supply equations? Assume parallel shifts in the equations.Solution:Prior to the change in inflation, the equilibrium wasQ=350.00 andP=850.00. The newequilibrium price can be found as follows:100019.65%,or835.771PiPP−===This point (350, 835.771) will be common to both equations. Further since the shift was aparallel shift, the slope of the equations remains unchanged. So, we use the equilibriumpoint and the slope to solve for the constant in eachequation:Bd:835.771=2 350constant,orconstant975.7715−+=Bd: Price=2 Quantity975.7715−+andBs:835.771=350+constant,orconstant=485.771

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24Mishkin/Eakins•Financial Markets and Institutions,Seventh EditionBs: Price=Quantity+485.771

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Chapter 5How Do Risk and Term StructureAffect Interest Rates?Risk Structure of Interest RatesDefault RiskCase: The Subprime Collapse and the Baa-Treasury SpreadLiquidityIncome Tax ConsiderationsSummaryCase: Effects of the Bush TaxCut and Its Possible Repeal on Bond Interest RatesTerm Structure of Interest RatesFollowing the Financial News: Yield CurvesExpectations TheoryMarket Segmentation TheoryLiquidity Premium TheoryEvidence on the Term StructureSummaryMini-Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business CycleCase: Interpreting Yield Curves, 1980–2010The Practicing Manager: Using the Term Structure to Forecast Interest Rates◼Overview and Teaching TipsChapter 5 applies the tools the student learned in Chapter 4 to understanding why and how various interestrates differ.In courses that emphasize financial markets, this chapter is important because students arecurious about the risk and term structure of interest rates. On the other hand, professors who focus on publicpolicy issues might want to skip this chapter.The book has been designed so that skipping this chapter willnot hinder the student’s understanding of later chapters.A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data andtheory. As becomes clear in the discussion of the term structure, theories are modified because they cannotexplain the data. On the other hand, theories do help to explain the data, as the case on interpreting yieldcurves in the 1980–2010 period demonstrates.This chapter also has two cases that will pique students’ interest because they are so current. First is theeffect of the Bush tax and its possible repeal on bond interest rates. Since the topic of repeal of the Bushtax cuts is such a hot political issue, evaluating what impact the repeal might have on interest rates is sureto be of interest to students. Also students are particularly interested right now in how the recent financialcrisis has affected the economy, and this chapter has the first case that looks at this topic. The case on the

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24Mishkin/Eakins•Financial Markets and Institutions,Seventh Editionsubprime collapse applies the analysis in the chapter to show how the recent financial crisis led to adramatic increase in the spread between interest rates on Baa securities with credit risk relative to U.S.Treasury securities that do not.The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from theterm structure using the theories outlined here can be used by financial institutions managers to set interestrates on their financial instruments.◼Answers to End-of-Chapter Questions1.The bond with a C rating should have a higher risk premium because it has a higher default risk,which reduces its demand and raises its interest rate relative to that of the Baa bond.2.U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently,the demand for Treasury bills is higher, and they have a lower interest rate.3.During business cycle booms, fewer corporations go bankrupt and there is less default risk oncorporate bonds, which lowers their risk premium. Similarly, during recessions, default risk oncorporate bonds increases and their risk premium increases. The risk premium on corporate bonds isthus anticyclical, rising during recessions and falling during booms.4.True. When bonds of different maturities are close substitutes, a rise in interest rates for one bondcauses the interest rates for others to rise because the expected returns on bonds of differentmaturities cannot get too far out of line.5.If yield curves on average were flat, this would suggest that the risk premium on long-term relative toshort-term bonds would equal zero and we would be more willing to accept the pure expectationstheory.6.The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fallmoderately in the near future, while the steep upward slope of the yield curve at longer maturitiesindicates that interest rates further into the future are expected to rise. Because interest rates andexpected inflation move together, the yield curve suggests that the market expects inflation to fallmoderately in the near future but to rise later on.7.The steepupward-sloping yield curve at shorter maturities suggests that short-term interest rates areexpected to rise moderately in the near future because the initial, steep upward slope indicates thatthe average of expected short-term interest rates in the near future is above the current short-terminterest rate. The downward slope for longer maturities indicates that short-term interest rates areeventually expected to fall sharply. With a positive risk premium on long-term bonds, as in theliquidity premium theory, a downward slope of the yield curve occurs only if the average of expectedshort-term interest rates is declining, which occurs only if short-term interest rates far into the futureare falling. Since interest rates and expected inflation move together, the yield curve suggests that themarket expects inflation to rise moderately in the near future but fall later on.8.The reduction in income tax rates would make the tax-exempt privilege for municipal bonds lessvaluable, and they would be less desirable than taxable Treasury bonds. The resulting decline in thedemand for municipal bonds and increase in demand for Treasury bonds would raise interest rates onmunicipal bonds while causing interest rates on Treasury bonds to fall.

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Chapter 5How Do Risk and Term Structure Affect Interest Rates?259.The government guarantee will reduce the default risk on corporate bonds, making them moredesirable relative to Treasury securities. The increased demand for corporate bonds and decreaseddemand for Treasury securities will lower interest rates on corporate bonds and raise them onTreasury bonds.10.Lower brokerage commissions for corporate bonds would make them more liquid and thus increasetheir demand, which would lower their risk premium.11.Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative toTreasury bonds. The resulting decline in the demand for municipal bonds and increase in demand forTreasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasurybonds would fall.◼Quantitative Problems1.a.The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for athree-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond.b.The yield to maturity would be 5% for a one-year bond, 4.5%for a two-year bond, 4.33% for athree-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond.The upward-sloping yield curve in (a) would be even steeper if people preferred short-term bondsover long-term bonds because long-term bonds would then have a positive risk premium. Thedownward-sloping yield curve in (b) would be less steep and might even have a slight positiveupward slope if the long-term bonds have a positive risk premium.2.Government economists have forecasted one-year T-bill rates for the following five years as follows:Year1-year rate14.25%25.15%35.50%46.25%57.10%You have liquidity premium 0.25% for the next two years and 0.50% thereafter. Would you bewilling to purchase a 4-year T-bond at a 5.75% interest rate?Solution:Your required interest rate on a 4-year bond=Average interest on four 1-year bonds+Liquidity Premium=(4.25%+5.15%+5.50%+6.25%)/4+0.5%=5.29%+0.50%=5.79%At a rate of 5.75%, the T-bond is just below your required rate.3.What is the yield on a $1,000,000 municipal bond with acoupon rate of 8%, paying interest annually,versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually?Assume that you are in the 25% tax bracket.

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26Mishkin/Eakins•Financial Markets and Institutions,Seventh EditionSolution:Municipal bond coupon payments equal $80,000 per year. No taxes are deducted;therefore, the yield would equal 8%.The coupon payments on a corporate bond equal $100,000 per year. But you onlykeep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yieldis only 7.5%4.Consider the decision to purchase either a 5-year corporate bond or a 5-year municipal bond. Thecorporate bond is a 12% annual coupon bond with a par value of $1,000. It is currently yielding11.5%. The municipal bond has an 8.5% annual coupon and a par value of $1,000. It is currentlyyielding 7%. Which of the two bonds would be more beneficial to you? Assume that your marginaltax rate is 35%.Solution:Municipal BondPurchase Price=$1,061.50After-tax Coupon Payment=$85Par Value=$1,000Calculated YTM=7%Corporate BondPurchase Price=$1,018.25After-tax Coupon Payment=$78Par Value=$1,000Calculated YTM=7.35%The corporate bond offers a higher yield and is the better buy.5.Debt issued by Southeastern Corporation currently yields 12%. A municipal bond of equal riskcurrently yields 8%. At what marginal tax rate would an investor be indifferent between these twobonds?Solution:Corporate Bonds (1−Tax Rate)=Municipal Bonds12%(1−Tax Rate)=8%1−Tax Rate=0.67orTax Rate=0.336.1-year T-bill rates are expected to steadily increase by 150 basis points per year over the next 6 years.Determine the required interest rate on a 3-year T-bond and a6-year T-bond if the current 1-yearinterest rate is 7.5%. Assume that the Pure Expectations Hypothesis for interest rates holds.Solution:3 year bond:year 1 interest rate=7.5%year 2 interest rate=9.0%year 3 interest rate=10.5%number ofyears=3(7.5%+9.0%+10.5%)/3=9.0%6 year bond:year 1 interest rate=7.5%year 2 interest rate=9.0%year 3 interest rate=10.5%year 4 interest rate=12%year 5 interest rate=13.5%year 6 interest rate=15%

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Chapter 5How Do Risk and Term Structure Affect Interest Rates?27(7.5%+9.0%+10.5%+12%+13.5%+15%)/6=11.25%7.The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%,14.5%, 16%, 17.5%. Using the pure expectations theory, what will be the interest rates on a 3-yearbond, 6-year bond, and 9-year bond?Solution:3-year bond=[(3+4.5+6)]/(3)=4.5%6-year bond=[(3+4.5+6+7.5+9+10.5)]/(6)=6.75%9-year bond=[(3+4.5+6+7.5+9+10.5+13+14.5+16)]/(9)=9.333%8.Using the information from the previous question, now assume that the investor prefers holdingshort-term bonds. A liquidity premium of 10 basis points is required for each year of a bond’smaturity. What will be the interest rates on a 3-year bond, 6-year bond, and 9-year bond?Solution:To solve this problem, you will need to use the following equation:121eeettttnntntiiiiiln+++−+++    +=+3-year bond=(0.30)+[(3+4.5+6)]/(3)=4.8%6-year bond=(0.60)+[(3+4.5+6+7.5+9+10.5)]/(6)=7.35%9-year bond=(0.90)+[(3+4.5+6+7.5+9+10.5+13+14.5+16)]/(9)=10.233%9.Which bond would produce a greater return if the pure expectations theory was to hold true, a 2-year bondwith an interest rate of 15% or two 1-year bonds with sequential interest payment of 13% and 17%?Solution:Both of the bonds would produce the same return.Two 2-year bonds:=(13%+17%)/2=15%10.Little Monsters Inc. borrowed $1,000,000 for two years from NorthernBank Inc. at an 11.5% interestrate. The current risk-free rate is 2% and Little Monsters’s financial condition warrants a default riskpremium of 3% and a liquidity risk premium of 2%. The maturity risk premium for a two-year loan is1%, and inflation is expected to be 3% next year. What does this information imply about the rate ofinflation in the second year?Solution:If inflation were expected to remain constant at 3% over the life of the loan, the interestrate on the two-year loan would be 11%. Since the actual two-year interest rate is 11.5%,the one-year interest rate in year 2 must be 12%, since 11.5=(11+12)/2.The required rate of 12%=Rf+DRP+LP+MRP+Inflation Premium=2%+3%+2%+1%+Inflation PremiumSo, the Inflation Premium in year 2 is 4%. But this is an average premium over two years.Inflation Premium 4%=(Year 1 Inflation+Year 2 Inflation)/2=(3%+x)/2orx=5%11.One-year T-bill rates are 2% currently. If interest rates are expected to go up after 3 years by 2%every year, what should be the required interest rate on a 10-year bond issued today?

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