Solution Manual for Financial Markets and Institutions, 13th Edition

Preview (31 of 286 Pages)

100%

Purchase to unlock

Loading page image...

Chapter 1Role of Financial Markets and InstitutionsOutlineRoleof Financial MarketsAccommodating Corporate Finance NeedsAccommodating Investment NeedsSecurities Traded in Financial MarketsMoney Market SecuritiesCapital Market SecuritiesDerivative SecuritiesValuation of SecuritiesSecurities Regulationson Financial DisclosureInternationalFinancial MarketsGovernment Intervention in Financial MarketsRole of Financial InstitutionsRole of Depository InstitutionsRole of Nondepository Financial InstitutionsComparison of Rolesamong Financial InstitutionsRelative Importance of Financial InstitutionsConsolidation of Financial InstitutionsSystemic Risk AmongFinancial Institutions

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖2Key Concepts1.Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.2.Introduce the types of financial markets available and their functions.3.Introduce the various financial institutions that facilitate the flow of funds.4.Provide a preview of the course outline. Emphasize the linkages between the various sections of thecourse.POINT/COUNTER-POINT:WillComputerTechnologyCauseFinancialIntermediaries toBecomeExtinct?POINT: Yes. Financial intermediaries benefit from access to information. As information becomes moreaccessible, individuals will have the information they need before investing or borrowing funds. They willnot need financial intermediaries to make their decisions.COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financialintermediaries specialize in credit analysis so that they can makewise choices when offeringloans.Surplus units will continue to provide funds to financial intermediaries rather than make direct loans,because they are not capable of credit analysis, even if more information about prospective borrowers isavailable. Some financial intermediaries no longer have physical buildings for customer service, but theystill requireagentswho have the expertise to assess the creditworthiness of prospective borrowers.WHO IS CORRECT? Use the Internetto learn more about this issueand then formulateyour ownopinion.ANSWER: Computer technology may reduce the need for some types of financial intermediaries such asbrokerage firms, because individuals can make transactions on their own (if they prefer to do so).However, loans will still require financial intermediaries because of the credit assessment that is needed.Questions1.Surplus and Deficit Units.Explain the meaning of surplus units and deficit units. Provide anexample of each. Which types of financial institutions do you deal with? Explain whether you areacting as a surplus unit or a deficit unit in your relationship with each financial institution.ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds fromthe financial markets. Surplus units include households with savings, while deficit units include firmsor government agencies that borrow funds.This exercise allows students to realize that they constantly interact with financial institutions, andthat they often play the role of a deficit unit (on car loans, tuition loans, etc.).

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖32.Types of Markets.Distinguish between primary and secondary markets. Distinguish between moneyand capital markets.ANSWER: Primary markets are used for the issuance of new securities while secondary markets areused for the trading of existing securities.Money markets facilitate the trading of short-term (money market) instruments while capital marketsfacilitate the trading of long-term (capital market) instruments.3.Imperfect Markets.Distinguish between perfect and imperfect security markets. Explain why theexistence of imperfect markets creates a need for financial intermediaries.ANSWER: With perfect financial markets, all information about any securities for sale would be freelyavailable to investors, information about surplus and deficit units would be freely available, and allsecurities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus anddeficit units do not have free access to information, and securities cannot be unbundled as desired.Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficitunits. They have the information to provide this service and can even repackage deposits to providethe amount of fundsthatborrowers desire.4.Efficient Markets.Explain the meaning of efficient markets. Why might we expect markets to beefficient most of the time? In recent years, several securities firms have been guilty of using insideinformation when purchasing securities, thereby achieving returns well above the norm (even whenaccounting for risk). Does this suggest that the security markets are not efficient? Explain.ANSWER: If markets are efficient then prices of securities available in these markets properly reflectall information. We should expect markets to be efficient because if they weren’t, investors wouldcapitalize on the discrepancy between what prices are and what they should be. This action wouldforce market prices to represent the appropriate prices as perceived by the market.Efficiency is often defined with regard to publicly available information. In this case, markets can beefficient, but investors with inside information could possibly outperform the market on a consistentbasis. A stronger version of efficiency would hypothesize that even access to inside information willnot consistently outperform the market.5.Securities Laws.What was the purpose of the Securities Act of 1933? What was the purpose of theSecurities Exchange Act of 1934? Do these laws prevent investors from making poor investmentdecisions? Explain.ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant financialinformation on publicly offered securities and prevent fraudulent practices when selling these securities.The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. Italso declared a variety of deceptive practices illegal but does not prevent poor investments.6.International Expansion.Discuss why many financial institutions have expanded internationally inrecent years. What advantages can be obtained through an international merger of financialinstitutions?ANSWER:Many financial institutions have expanded internationally to capitalize on theirexpertise. Commercial banks, insurance companies, and securities firms have expandedthrough international mergers. An international merger between financial institutions enables

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖4the merged company to offer the services of both entities to its entire customer base.7.Stock Valuation.What type of information do investors rely on in order to determine the propervalue of stocks?ANSWER:Since the valuation of a stock at a future point in time is uncertain, so is the sellingprice of a stock at a future point in time. Investors often rely on financial statements by firmsin order to assess how stock prices might change in the future. In particular, investors rely onaccounting reports of a firm’s revenue, expenses, and earnings as a basis for estimating itsfuture cash flows. Firms with publicly traded stock are required to disclose financialinformation and financial statements.8.Securities Firms.What are the functions of securities firms? Many securities firms employ brokersand dealers. Distinguish between the functions of a broker and those of a dealer and explain how eachtype of professionalis compensated.ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) thateitherenhancesa borrower’s ability to borrow funds or an investor’s ability to invest funds.Brokers are commonly compensated with commissions on trades, while dealers are compensated ontheir positions in particular securities. Some dealers also provide brokerage services.9.Mis-valuation of Marijuana Stocks.Explain whysome stocks in the marijuana industry were mis-valued when several states legalized the recreational use of marijuana.ANSWER:Recently, as several states legalized the recreational use of marijuana, somecompanies with very little experience in any business related to marijuana announced thatthey were positioned to capitalize on the expected growth in this market. Many investorswanted to benefit from this potential growth and quickly purchased the stocks of companiesin the industry. However, some investors did not carefully check the business plan,operations, or financial condition of these companies. Consequently, the strong demand byinvestors for stocks of marijuana companies without much experience caused their stockprices to increase dramatically, only to crash upon a closer review.10.Marketability.Commercial banks use some funds to purchase securities and other funds to makeloans. Why are the securities more marketable thantheloans in the secondary market?ANSWER: Securities are more standardized than loans and therefore can be more easily sold in thesecondary market. The excessive documentation on commercial loans limits a bank’s ability to sellloans in the secondary market.11.Depository Institutions.Explain the primary use of funds for commercial banks versus savingsinstitutions.ANSWER: Savingsinstitutionshave traditionally concentrated in mortgage lending, whilecommercial banks have concentrated in commercial lending. Savingsinstitutionsare now allowed todiversify their asset portfolio to a greater degree and will likely increase their concentration incommercial loans (but not to the same degree as commercial banks).

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖512.Credit Unions.With regard to the profit motive, how are credit unions different from other financialinstitutions?ANSWER: Credit unions are non-profit financial institutions.13.Nondepository Institutions.Compare the main sources and uses of funds for finance companies,insurance companies, and pension funds.ANSWER: Finance companies sell securities to obtain funds, while insurance companies receiveinsurance premiums and pension funds receive employee/employer contributions. Finance companiesuse funds to provide direct loans to consumers and businesses. Insurance companies and pensionfunds purchase securities.14.Mutual Funds.What is the function of a mutual fund? Why are mutual funds popular amonginvestors? How does a money market mutual fund differ from a stock or bond mutual fund?ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in aportfolio of securities. Mutual funds are popular because they can help individuals diversify whileusing professional expertise to make investment decisions.A money market mutual fund invests in money market securities, whereas other mutual fundsnormally invest in stocks or bonds.15.Secondary Market for Debt Securities.Why is it important for long-term debt securities to have anactive secondary market?ANSWER:An active secondary market is especially desirable for debt securities that have along-term maturity, because it allows investors flexibility to sell them at any time prior tomaturity. Many investors would not even consider investing in long-term debt securities ifthey were forced to hold these securities until maturity.Advanced Questions16.Comparing Financial Institutions.Classify the types of financial institutions mentioned in thischapter as either depository or nondepository. Explain the general difference between depository andnondepository institutions assources of funds. It is often stated that all types of financial institutionshave begun to offer services that were previously offered only by certain types. Consequently, manyfinancial institutions are becoming more similar.Nevertheless,performance levels still differsignificantly among types of financial institutions. Why?ANSWER: Depository institutions include commercial banks, savings and loan associations, andcredit unions. These institutions differ from nondepository institutions in that they accept deposits.Nondepository institutions include finance companies, insurance companies, pension funds, mutualfunds, and money market funds.Even though financial institutions are becoming more similar, they often differ distinctly from eachother in terms of sources and uses of funds. Therefore, their performance levels differ as well.17.Financial Intermediation.Look in a recent business periodical for news about a recent financial

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖6transaction that involves two financial institutions. For this transaction, determine the following:a.How will each institution’s balance sheet be affected?b.Will either institution receive immediate income from the transaction?c.Who is the ultimate user of funds?d.Who is the ultimate source of funds?ANSWER: This exercise will force students to understand how the balance sheet and incomestatement of a financial institution are affected by various transactions. When a financial institutionsimply acts as an intermediary, income (fees or commissions) is earned, but the institution’s assetportfolio is not significantly affected.18.Role of Accounting in Financial Markets.Integrate the roles of accounting, regulations, andfinancial market participation. That is, explain how financial market participants rely on accounting,and why regulatory oversight of the accounting process is necessary.ANSWER: Financial market participants rely on financial information that is provided by firms. Thefinancial statements of firms must be audited to ensure that they accurately represent the financialcondition of the firm. However, the accounting standards are loose, so financial market participantscan benefit from strong accounting skills that may allow them to more properly interpret financialstatements.19.Factors That InfluenceLiquidity.Whichfactors influence a security’s liquidity?ANSWER:Debt securities with shorter maturities are more liquid. Debt securities and stocks with amore active secondary market are more liquid.20. Impact of Credit Crisis on Institutions.Explain why mortgage defaults during the credit crisisin2008 and 2009adversely affected financial institutions that did not originate the mortgages. What role didthese institutions play in financing the mortgages?ANSWER:Some financial institutions participated by issuing mortgage-backed securities thatrepresented mortgages originated by mortgage companies. Mortgage-backed securities performedpoorly during the credit crisis in 2008 because of the high default rate on mortgages. Some financialinstitutions that held a large amount of mortgage-backed securities suffered major losses at this time.21.Impact of Fraudulent Financial Reporting on Market LiquidityExplain why financialmarkets may be less liquid if companies are not forced to provide accurate financial reports.ANSWER: If companies are allowed to engage in fraudulent financial reporting by exaggeratingearnings or hiding debt, this could cause investors to overpay when purchasing securities issued bythose companies. If investors recognize that they cannot trust financial disclosure by companies, theymay be unwilling to participate in financial markets. The lack of trust can cause markets to be lessliquid, because of very limited investor participation.22.Impact of a Country’s Laws on Its Market LiquidityDescribe how a country’s laws caninfluence the degree of its financial market liquidity.ANSWER:The financial markets are much more developed in some countries than in others, andthey also vary in terms of their liquidity. Each country has its own laws regarding shareholder rights.Investors may be more willing to participate in their local country’s financial markets if they have the

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖7right to take civil action against a local firm that engaged in fraudulent financial disclosure. Eachcountry also has its own level of enforcement of securities laws. Investors may be more willing toparticipate in their local country’s financial markets if they believe that their local governmentenforces the securities laws that are imposed in that country.23. Global Financial Market Regulations.Assume that countries A and B are of similar size,that theyhavesimilar economies, andthatthe government debt levels of both countries are within reasonablelimits. Assumethatthe regulations in country A require complete disclosure of financial reporting byissuers of debt in that country,whereasregulations in country B do not require much disclosure offinancial reporting. Explain why the government of country A is able to issue debt at a lower costthan the government of country B.ANSWER: Investors are more willing to invest in debt securities issued by the government of countryA because there is more transparent information that would suggest country A cancover its paymentsowed on its debt.If the government of Country B does not disclose its financial information, investorscannot assess the financial condition and ability of the government to cover its payments owed on itsdebt. Thus, they are less willing to invest in debt securities issued by country B, so country B willhave to offer a higher yield to entice investors.24.Influence of Financial MarketsSome countries do not have well established markets for debtsecurities or equity securities. Why do you think this can limit the development of the country,business expansion, and growth in national income in these countries?ANSWER:Businesses rely on financial markets to expand. If they cannot issue debt or equitysecurities, they cannot obtain funding to expand. Local investors who have money to invest will likelyinvest their money in other countries if the financial markets are not developed in their home market.Thus, they will essentially help other countries grow instead of helping their own country grow.25.Impact of Systemic RiskDifferent types of financial institutions commonly interact.Specifically,theymayprovide loans to each other, and take opposite positions on many different types of financialagreements, whereby one will owe the other based on a specific financial outcome. Explain why thesekinds ofrelationships cause concerns about systemic risk.ANSWER:Whenfinancial institutions interact through transactions, the failure of one financialinstitution can cause financial problems for others. As one financial institution fails, it defaults onpayments owed on financial agreements with other financial institutions. Those institutions may havebeen relying on those payments to cover other obligations to another set of financial institutions.Thus,many financial institutions might be unable to cover their obligations, and this spreads fear thatthe financial system might collapse.26.Uncertainty Surrounding Stock PriceAssume that your publicly traded company attempts tobe completely transparent about its financial condition, and provides thorough informationabout its debt, sales, and earnings every quarter. Explainwhy there still may be muchuncertainty surrounding your company’s stock price.ANSWER:The value of a company is based on the present value its future cash flows. Investors mayattempt to use financial statements to predict future cash flows. But even when investors arepresented with information value your company’s stock, they may interpret the information indifferent ways. They commonly derive different interpretations of the same information, which leadsto different valuations of the firm, reflects uncertainty surrounding the firm’s stock price.

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖827.Financial Institution’sRoles as IntermediariesExplain how each type of financialinstitution serves asa financialintermediary.ANSWER: Deposits from surplus units are transformed by depository institutions into loans fordeficit units.Purchases of securities (commercial paper) issued by finance companies that aretransformed into finance company loans for deficit units.Purchases of shares issued by mutualfundsare used to purchase debt and equity securities of deficit units.Because insurance companies and pension funds purchase massive amounts of stocks and bonds,they finance much of the expenditures made by large deficit units, such as corporations andgovernment agencies.28.Systemic Risk During a Financial CrisisExplain why financial institutions are highlyexposed to systemic risk during a financial crisis.ANSWER:Systemic riskexists because financial institutions invest their funds in similar typesof securities and therefore have similar exposure to large declines in the prices of thesesecurities.For example, inthe credit crisis of 2008 and 2009, mortgage defaults affectedfinancial institutions in several ways. First, many financial institutions that originated mortgagesshortly before the crisis sold them to other financial institutions (i.e., commercial banks, savingsinstitutions, mutual funds, insurance companies, securities firms, and pension funds). Therefore,even financial institutions that were not involved in the mortgage origination processexperienced large losses because they purchased the mortgages originated by other financialinstitutions.Second, many other financial institutions that invested in mortgage-backed securities receivedlower payments as mortgage defaults occurred. Third, some financial institutions (especiallysecurities firms) relied heavily on short-term debt to finance their operations and used theirholdings of mortgage-backed securities as collateral. But when the prices of mortgage-backedsecurities plummeted, they could not issue new short-term debt to pay off the principal onmaturing debt.Fourth, as mortgage defaults increased, there was an excess of unoccupied housing. There wasno need for construction of new homes, so construction companies laid off many employees. Theeconomy weakened and prices of many equity securities declined by more than 40 percent. Thusmost financial institutions that invested heavily in equities experienced large losses on theirinvestments during the credit crisis.Fifth, financial institutions commonly engage in various loan and guarantee arrangementsthat causes one financial institution to rely on others for payment. Thus, the bankruptcy of onelarge financial institution can cause defaults on payments to several other financial institutions,which might reduce their ability to cover their respective obligations to other financialinstitutions. This can result in bankruptcy for many financial institutions.CRITICAL THINKING QUESTIONImpact of a Financial Crisis on Market LiquidityDuring a financialcrisis, liquidity in financialmarkets declines dramatically, andmany surplus units no longer participate in financial markets.Nevertheless, if the markets are efficient,securitiesprices shoulddeclinedueto existing economic

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖9conditions,which should make these securities appealing to potential investors. Yet, many investorstypically are no longer willing to participate in the financial markets under these conditions. Write ashort essay that explains the logic behind why participants may temporarily disappearduring afinancial crisis even though security prices are low, causing illiquidityin financial markets.ANSWER:Even if the market prices reflect existing conditions, a crisis can cause fear that prices willdecline substantially. While this might allow the possibility for large profits from pronounced changes inthe prices of securities, many market participants may be uncomfortable in a market in which they couldlose 30% or more of their investment in a short period of time.Market illiquidity complicates market conditions, but there is usually another event that occurs first thatcauses market illiquidity. For example, the defaults on many mortgages in 2008 triggered fear amongmarket participants about the possible continuation of defaults in all debt markets, the likelihood of aweaker economy, and the possible weakness in equity prices. Consequently, the fear encouraged manymarket participants to discontinue serving as surplus units until economic conditions improved.Interpreting Financial News“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Streetanalysts and portfolio managers who participate in the financial markets. Interpret the following:a.“The price ofApplestockwill not be affected by the announcement that its earnings haveincreased as expected.”The earnings level was anticipated by investors, so thatApple’s stock price already reflected thisanticipation.b.“The lending operations at BankofAmerica should benefit from strong economic growth.”High economic growthencourages expansion by firmswhichresults in a strong demand for loansprovided by BankofAmerica.c.“The brokerage and underwriting performance at Goldman Sachsshould benefit from strongeconomic growth.”High economic growth may result in a large volume of stock transactions in which GoldmanSachsmay serve as a broker. Also, Goldman Sachsunderwrites new securities that are issuedwhen firms raise funds to support expansion; firms are more willing to issue new securities toexpand during periods of high economic growth.Managing in Financial MarketsAs a financial manager of a large firm, you plan to borrow $70 million over the next year.a.What are the more likely alternatives for you to borrow $70 million?You could attempt to borrow $70 million from commercial banks, savings institutions, or financecompanies in the form of commercial loans. Alternatively, you may issue debt securities.

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖10b.Assuming that you decide to issue debt securities, describe the types of financial institutions thatmay purchase these securities.Financial institutions such as mutual funds, pension funds, and insurance companies commonlypurchase debt securities that are issued by firms. Other financial institutions such as commercialbanks and savings institutions may also purchase debt securities.c.How do individuals indirectly provide the financing for your firm when they maintain deposits atdepository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?Individuals provide funds to financial institutions in the form of bank deposits, investment inmutual funds, purchases of insurance policies, or investment in pensions. The financialinstitutions may channel the funds toward the purchase of debt securities (and even equitysecurities) that were issued by large corporations, such as the one where you work.Flow of Funds ExerciseRoles of Financial Markets and InstitutionsThis continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) inthe financial markets. It illustrates how financial markets and institutions are integrated and facilitate theflow of funds in the business and financial environment.At the end of every chapter, this exerciseprovides a list of questions about Carson Company that require the application of concepts learnedwithin the chapter, as related to the flow of funds.Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carsonfamily.Itwas initially financed with an equity investment by the Carson family and ten other individuals.Over time, Carson Company has obtained substantial loans from finance companies and commercialbanks. The interest rates on thoseloansaretied to market interest rates andareadjusted every six months.Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements.The companyhas a credit line with a bank in case it suddenly needs to obtain funds for a temporaryperiod. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.Carson Company has assets valued at approximately$50 million and generates sales ofnearly$100million per year. Some of its growth is attributed to its acquisitions of other firms. Because it expectstheeconomy to bestrongin the future, Carson plans togrow byexpandingits business andmaking moreacquisitions.It expects that it will need substantial long-term financing and plans to borrow additionalfunds either throughobtainingloans or by issuing bonds. It is also considering the issuance of stock toraise funds in the next year. Carson closely monitors conditions in financial markets that could affect itscash inflows and cash outflows and therebyaffect its value.a.In what way is Carson a surplus unit?Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuerof those securities.b.In what way is Carson a deficit unit?Carson has borrowed funds from financial institutions.

Loading page image...

Chapter 1: Role of Financial Markets and Institutions❖11c.How might finance companies facilitate Carson’s expansion?Finance companies can provide loans to Carson so that Carson can expand its operations.d.How might commercial banks facilitate Carson’s expansion?Commercial banks can provide loans to Carson so that Carson can expand its operations.e.Why might Carson have limited access to additional debt financing during its growth phase?Carson may have already borrowed up to its capacity. Financial institutions may be unwilling tolend more funds to Carson if it has too much debt.f.How mightsecurities firmsfacilitate Carson’s expansion?First,securities firmscould advise Carson on its acquisitions. In addition, they could underwritea stock offering or a bond offering by Carson.g.How might Carson use the primary market to facilitate its expansion?It could issue new stock or bonds to obtain funds.h.How might it use the secondary market?It could sell its holdings of Treasury securities in the secondary market.i.If financial markets were perfect, how might thisfactorhave allowed Carson to avoid financialinstitutions?It would have been able to obtain loans directly from surplus units. It would have been able toassess potential targets for acquisitions without the advice of investmentsecurities firms. It wouldbe able to engage in a new issuance of stock or bonds without the help of asecurities firm.j.The loans that Carson has obtained fromcommercial banksstipulatethat Carsonmustreceivethebanks’approvalbefore pursuing any large projects. What is the purpose of this condition? Doesthis condition benefit the owners of the company?The purpose is to prevent Carson from using the funds in a manner that would be very risky, asCarson may default on its loans if it takes excessive risk when using the funds to expand itsbusiness. The owners of the firm may prefer to take more risk than the lenders will allow, becausethe owners would benefit directly from risky ventures that generate large returns. Conversely, thelenders simply hope to receive the repayments on the loan that they provided, and do not receivea share in the profits. They would prefer that the funds be used in a conservative manner so thatCarson will definitely generate sufficient cash flows to repay the loan.

Loading page image...

Chapter 2Determination of Interest RatesOutlineLoanable Funds TheoryHousehold Demand for Loanable FundsBusiness Demand for Loanable FundsGovernment Demand for Loanable FundsForeign Demand for Loanable FundsAggregate Demand for Loanable FundsSupply of Loanable FundsEquilibrium Interest RateFactorsThat Affect Interest RatesImpact of Economic Growth on Interest RatesImpact of Inflation on Interest RatesImpact of Monetary Policyon Interest RatesImpact of the Budget Deficit on Interest RatesImpact of Foreign Flows of Funds on Interest RatesForecasting Interest Rates

Loading page image...

Chapter 2: Determination of Interest Rates❖2Key Concepts1.Explain the Loanable Funds Theory by deriving demand and supply schedules for loanable funds.2.Explain the Fisher Effect and tie it in with Loanable Funds Theory by explaining how inflation affectsthe demand and supply schedules for loanable funds.3.Provide additional applications (especially current events) one at a time to help illustrate how eventscan affect the demand and supply schedules, and therefore influence interest rates.4.Explain how forecasts of interest rates are needed to make financial decisions, which require forecastsof shifts in the demand and supply schedules for loanable funds.5.Introduce several possible events simultaneously to illustrate how difficult it can be to forecastinterest rate movements when several events are occurring at once.POINT/COUNTER-POINT:Does aLargeFiscalBudgetDeficitResult inHigherInterestRates?POINT: No. In some years (such as 2008), the fiscal budget deficit was large and interest rates were verylow.COUNTER-POINT: Yes. When the federal government borrows large amounts of funds, it can crowd outother potential borrowers, and the interest rates are bid up by the deficit units.WHO IS CORRECT? Use the Internetto learn more about this issueand then formulateyour ownopinion.ANSWER: A large budget deficit does not automatically cause high interest rates. However, it does resultin a large demand for funds, which will place upward pressure on interest rates unless there are offsettingforces.Questions1.Interest Rate Movements.Explain why interest rates changed as they did over the past year.ANSWER: This exercise should force students to consider how the factors that influence interestrates have changed over the last year and assess how these changes could have affected interest rates.2.Interest Elasticity.Explain what is meant by interest elasticity. Would you expect federalgovernment demand for loanable funds to be more or less interest-elastic than household demand forloanable funds? Why?ANSWER: Interest elasticity of supply represents a change in the quantity of loanable funds suppliedin response to a change in interest rates. Interest elasticity of demand represents a change in thequantity of loanable funds demanded in response to a change in interest rates.

Loading page image...

Chapter 2: Determination of Interest Rates❖3The federal government demand for loanable funds should be less interest elastic than the consumerdemand for loanable funds, because the government’s planned borrowings will likely occur regardlessof the interest rate. Conversely, the quantity of loanable funds by consumers is more responsive to theinterest rate level.3.Impact of Government Spending.If the federal government planned to expand the space program,how might thischangeaffect interest rates?ANSWER: An expanded space program would (a) force the federal government to increase its budgetdeficit, (b) possibly force any firms involved in facilitating the program to borrow more funds.Consequently, there is a greater demand for loanable funds. The additional spending could causehigher income and additional saving. Yet, this impact is not likely to be as great. The likely overallimpact would therefore be upward pressure on interest rates.4.Impact of a Recession.Explain why interest rates tend to decrease during recessionary periods.Review historical interest rates to determine how they react to recessionary periods. Explain thisreaction.ANSWER: During a recession, firms and consumers reduce their amount of borrowing. The demandfor loanable funds decreases and interest rates decrease as a result.5.Impact of the Economy.Explain how the expected interest rate in one year dependson yourexpectation of economic growth and inflation.ANSWER:The interest rate in the future should increase if economic growth and inflation areexpected to rise or decrease if economic growth and inflation are expected to decline.6.Impact of the Money Supply.Would increasingthemoney supply growth place upward ordownward pressure on interest rates?ANSWER: If one believes that higher money supply growth will not cause inflationary expectations,the additional supply of funds places downward pressure on interest rates. However, if one believesthat inflation expectations do erupt as a result, demand for loanable funds will also increase, andinterest rates could increase (if the increase in demand more than offsets the increase in supply).7.Impact of Exchange Rates on Interest Rates.Assume that if the U.S. dollar strengthens, it canplace downward pressure on U.S. inflation. Based on this information, how might expectations of astrong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is thereany reason to think that expectations of a strong dollar could also affect the supply of loanable funds?Explain.ANSWER: As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanablefunds, and therefore reduce interest rates. The expectations of a strong dollar could also increase thesupply of funds because it may encourage saving (there is less concern to purchase goods beforeprices rise when inflationary expectations are reduced). In addition, foreign investors may invest morefunds in the United States if they expect the dollar to strengthen, because that could increase theirreturn on investment.8.Nominal versus Real Interest Rate.What is the difference between the nominal interest rate andreal interest rate? What is the logic behind the implied positive relationship between expectedinflation and nominal interest rates?

Loading page image...

Chapter 2: Determination of Interest Rates❖4ANSWER: The nominal interest rate is the quoted interest rate, while the real interest rate is definedas the nominal interest rate minus the expected rate of inflation. The real interest rate represents therecent nominal interest rate minus the recent inflation rate.Investors require a positive real return, which suggests that they will only invest funds if the nominalinterest rate is expected to exceed inflation. In this way, the purchasing power of invested fundsincreases over time. As inflation rises, nominal interest rates should rise as well since investors wouldrequire a nominal return that exceeds the inflation rate.9.Real Interest Rate.Estimate the real interest rate over the last year. If financial market participantsoverestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.ANSWER: This exercise forces students to measure last year’s nominal interest rate and inflationrate.If inflation is overestimated, the real interest rate will be relatively high. Investors had required arelatively high nominal interest rate because they expected inflation to be high (according to theFisher effect).10.Forecasting Interest Rates.Why do forecasts of interest ratesmade byexpertsdiffer?ANSWER: Various factors may influence interest rates, and changes in these factors will affectinterest rate movements. Experts disagree about how various factors will change. They also disagreeabout the specific influence these factors have on interest rates.Advanced Questions11.Impact of Stock Market Crises.Duringperiods wheninvestors suddenly become fearful that stocksare overvalued, they dump their stocks, and the stock market experiences a major decline. Duringthese periods, interest ratesalsotend to decline. Use the loanable funds framework discussed in thischapter to explain howamassive selloffof stocksleadsto lower interest rates.ANSWER: When investors shift funds out of stocks, they move it into money market securities,causing an increase in the supply of loanable funds, and lower interest rates.12.Impact of Expected Inflation.How might expectations of higher pricesin the U.S.affect thedemand for loanable funds, the supply of loanable funds, and interest rates in the U.S.?Offer a logicalexplanation of why such an impact on interest rates in the U.S. might spread to other countries.ANSWER:The expectations of higher prices will cause concern about the possible increase ininflation. Since higher inflation can increase interest rates, it will cause an expectation of higherinterest rates in the U.S. Firms and government agencies may borrow more funds now before pricesincrease and before interest rates increase. Consumers may use their savings now to buy productsbefore the prices increase. Therefore, the demand for loanable funds should increase, the supply ofloanable funds should decrease, and interest rates should increase in the U.S.

Loading page image...

Chapter 2: Determination of Interest Rates❖5The higherinterest rates in the U.S. might encourage institutional investors in some other countries toinvest some of their funds in the U.S., which reduces the supply of funds that is available within eachof those countries, and therefore could cause interest rates to rise in each of those countries.13.Global Interaction of Interest Rates.Why might you expecttheinterest rate movements of variousindustrialized countries to be more highly correlated in recent years thanthey werein earlier years?ANSWER: Interest rates among countries are expected to be more highly correlated in recent yearsbecause financial markets are more geographically integrated. More international financial flows willoccur to capitalize on higher interest rates in foreign countries, which affects the supply and demandconditions in each market. As funds leave a country with low interest rates, this places upwardpressure on that country’s interest rates. The international flow of funds caused this type of reaction.14.Impact of War.War tends to cause significant reactions in financial markets. Why might awar in the Middle East place upward pressure on U.S. interest rates? Why might some investorsexpect a war like this to place downward pressure on U.S. interest rates?ANSWER: A warplacesupward pressure on U.S. interest rates because itmay(1) increaseinflationary expectations in the United Statesifoil prices increase abruptly, and (2) increase theexpected U.S. budget deficit as government expenditures were necessary to boost military support.However, it mayalso cause some analysts to revise their forecastsof economic growth downward.The slower economy reflects a reduced corporate demand for funds, which by itself places downwardpressure on interest rates. If inflation was not a concern, the Fed may attempt to increase moneysupply growth to stimulate the economy. However, theinflationary pressure can restrictthe Fed fromincreasing the money supply to stimulatethe economy (since any stimulative policy could causehigher inflation).15.Impact of September 11.Offer an argument for why the terrorist attack on the United States onSeptember 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argumentfor whythoseattackscould have placed upward pressure on U.S. interest rates.ANSWER: The terrorist attack could cause a reduction in spending related to travel (airlines, hotels),and would also reduce the expansion by those types of firms. This reflects a decline in the demand forloanable funds, and places downward pressure on interest rates. Conversely, the attack increases theamount of government borrowing needed to support a war, and therefore places upward pressure oninterest rates.16.Impact of Government Spending.Jayhawk Forecasting Services analyzed several factors that couldaffect interest rates in the future. Most factors were expected to place downward pressure on interestrates. Jayhawk alsoexpectedthat although the annual budget deficit was to be cut by 40 percent fromthe previous year,the deficitwould still be very large.BecauseJayhawk believed that the deficit’simpact would more than offset the effectsof other factors, itforecast interest rates to increase by 2percent. Comment on Jayhawk’s logic.ANSWER: A reduction in the deficit should free up some funds that had been used to support thegovernment borrowings. Thus, there should be additional funds available to satisfy other borrowingneeds. Given this situation plus the other information, Jayhawk should have forecasted lower interestrates.

Loading page image...

Chapter 2: Determination of Interest Rates❖617.Decomposing Interest Rate Movements.The interest rate on a one-year loan can be decomposedinto a one-year risk-free (free from default risk) component and a risk premium that reflects thepotential for default on the loan in that year. A change in economic conditions can affect the risk-freerate and the risk premium. The risk-free rate isusually affected by changing economic conditions to agreater degree than the risk premium. Explain how a weaker economy will likely affect the risk-freecomponent, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury,and (b) a corporation.Will the change in the cost of borrowing be more pronounced for the Treasuryor for the corporation? Why?ANSWER: The weaker economy will likely reduce the risk-free component and will increase the riskpremium. The overall cost of borrowing is reduced for a loan to the Treasury and a loan to acorporation. There is a partial offsetting effect on the interest rate of the loan to the corporation.However, the Treasury does not have risk of default so there is no effect on the risk premium on aloan to the Treasury.The weaker economy will have a more pronounced impact on the interest rate ofthe loan to the Treasury, because there is no offsetting effect.18.Forecasting Interest Rates Based on Prevailing Conditions.Consider the prevailing conditions forinflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy thatcould affect interest rates. Based ontheseconditions, do you think interest rates will likely increase ordecrease during this semester? Offer some logic to support your answer. Which factor do you thinkwill have thegreatest impact on interest rates?ANSWER:This question is open-ended. It requires students to apply the concepts that were presentedin this chapter in order to develop their own view. This question can be useful for class discussionbecause it will likely lead to a variety of answers, which reflects the dispersed opinions of marketparticipants.19.Impact of Economic Crises on Interest Rates.When economic crises in countries are due to a weakeconomy, local interest rates tend to be very low. However, if the crisisiscaused by an unusuallyhigh rate of inflation,theinterest rate tendsto be very high. Explain why.ANSWER: A weak economy causes a reduction in the demand for loanable funds, becausecorporations reduce their expansion plans as they anticipate a reduced demand for their products. Thereduced demand for loanable funds results in lower interest rates.However, if a crisis is caused by high inflation, corporations and households engage in heavyborrowing and spending before prices rise further. Thus, the strong demand for loanable funds placesupward pressure on interest rates.20. U.S. Interest Rates DuringtheCredit Crisis.During the credit crisis, U.S. interest rates wereextremelylow, which enabledbusinesses to borrow at a low cost. Holding other factors constant, thisshouldhaveresultedin a higher number of feasible projects, which shouldhaveencouragedbusinesses to borrow more money and expand. Yet, many businesses that had access to loanablefunds were unwilling to borrow during the credit crisis. What other factorchanged during this periodthat more than offset the potentially favorable effect of the low interest rates on project feasibility,therefore discouragingbusinesses from expanding?ANSWER: Businesses recognized that the cash flows to be generated from their projects would below because the demand for their products and services was limited. Households could not afford topurchase more products. Thus, while low interest rates allow businesses to borrow funds cheap, manypossible projects were not feasible because the expected cash flows were not sufficient.

Loading page image...

Chapter 2: Determination of Interest Rates❖721.Political Influence on Interest Rates.Offer an argument for why a political regime that favors alarge government will cause interest rates to be higher. Offer at least one example of why a politicalregime that favors a large government will cause interest rates to be lower [Hint:Recognize that thegovernment intervention in the economy can influence other factors that affect interest rates.]ANSWER:A political regime that favors a large government will have more governmentexpenditures. Assuming that taxes are not affected, the fiscal budget deficit will be larger. As thegovernment borrows more to cover the fiscal budget deficit, it increases the demand for loanablefunds, and this causes interest rates to be higher.However, if the government’s programs improve economic conditions, this could affect other factorsthat influence interest rates. For example, if the economic conditions are improved as a result of thegovernment programs, this might result in more income to households and lower income, and lowerunemployment (lower unemployment compensation paid by the government). Under theseconditions, a larger government will not necessarily result in a larger fiscal budget deficit.22.Impact of Stock Market Uncertainty.Consider a period in which stock prices are very high,such that investors begin to think that stocks are overvalued and their valuations are very uncertain. Ifinvestors decide to move their money into much safer investments, how do you think this wouldaffect general interest rate levels? In your answer, use the loanable funds framework by explaininghow the supply or demand for loanable funds would be affected by the investor actions, and how thiswould affectgeneralinterest ratelevels.In your answer, use the loanable funds framework toexplain how the supply of or demand for loanable funds would be affected by the investoractions, and how this force would affect interest rates.ANSWER:If investors sell their stocks, they receive cash and may deposit their cash in banks. Thisresults in an increase in the supply of loanable funds, which places downward pressure on interestrates.22.Impact of the European Economy.Use the loanable funds framework to explain how Europeaneconomic conditions might affect U.S. interest rates.ANSWER:Weak European conditions could weaken U.S. economic conditions, because theeconomies are integrated through international trade and investment. If the European economy causeseconomic conditions in the U.S. to weaken, it can reduce the demand for loanable funds in the U.S. Inaddition, the weak European economy might cause European firms to borrow fewer funds from theU.S. market. Either of the forces explained here reflect a decline in the demand for loanable funds,which places downward pressure on interest rates.CRITICAL THINKING QUESTIONForecasting Interest RatesGiven your knowledge of how interest rates are influenced byvarious factors reflecting the demand for funds and the supply of funds available in the creditmarkets, write a short essay to explain how and why interest rates will change over the next threemonths.

Loading page image...

Chapter 2: Determination of Interest Rates❖8ANSWERThere is no perfect answer, but the exercise forces students to consider how factors that affect U.S.interest rates might change, and then understand how those changes would affect interest rates in the U.S.This exercise will help them understand how forecasts by experts are created, and also that a forecast ofinterest ratescan be wrong because of inaccurate forecasts of the factors that affect interest rates.Interpreting Financial NewsInterpret the following comments made by Wall Street analysts and portfolio managers.a.“The flight of funds from bank deposits to U.S. stocks will pressure interest rates.”As the supply of loanable funds declines (due to bank deposit withdrawals), there will be upwardpressure on interest rates.b.“Since Japanese interest rates have recently declined to very low levels, expect a reduction inU.S. interest rates.”As Japanese interest rates decline, Japanese savers invest more loanable funds in the UnitedStates, which places downward pressure on U.S. interest rates.c.“The cost of borrowing by U.S. firms is dictated by the degree to which the federal governmentspends more than it taxes.”As the federal government spends more than it taxes, it borrows the difference; the greater theamount borrowed, the higher the pressure on U.S. interest rates.Managing in Financial MarketsAs the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. Yourcompanyplansto borrow funds anditmay use the forecast of interest rates to determine whetheritshouldobtain a loan with a fixed interest rate or a floating interest rate. The following information can beconsidered when assessing the future direction of interest rates:Economic growth has been high over the last two years, but you expect that it will be stagnantover the next year.

Loading page image...

Chapter 2: Determination of Interest Rates❖9Inflation has been 3 percent over each of the last few years, and you expect that it will be aboutthe same over the next year.The federal government has announced major cuts in its spending, which should have a majorimpact on the budget deficit.The Federal Reserve is not expected to affect the existing supply of loanable funds over the nextyear.The overall level of savings by households is not expected to change.a.Given the preceding information,assesshow the demand for and the supply of loanable fundswould be affected (if at all), andpredictthe future direction of interest rates.The demand for loanable funds should decline in response to: (1) stagnant economic growth(because a relatively low level of borrowing will be needed), and (2) a major cut in governmentspending. The supply of loanable funds should remain unchanged because the savings level is notexpected to change, and the Fed is not expected to affect the existing money supply. Given a largedecline in the demand for loanable funds and no significant change in the supply of loanablefunds, U.S. interest rates should decline.b.Your companycan obtain a one-year loan at a fixed-rate of 8 percent or a floating-rate loan that iscurrently at 8 percent butits interest ratewould be revised every month in accordance withgeneral interest rate movements. Which type of loan is more appropriate based on the informationprovided?Since interest rates are expected to decline, you should prefer the floating-rate loan. As interestrates decline, the rate charged on this type of loan would decline.c.Assume that Canadian interest rates have abruptly risen just as you have completed your forecastof future U.S. interest rates. Consequently, Canadian interest rates are now 2 percentage pointsabove U.S. interest rates. How might this specific situation place pressure on U.S. interest rates?Considering this situation along with the other information provided, would you change yourforecast of the future direction of U.S. interest rates?This situation could encourage U.S. individuals and firms to withdraw their savings from U.S.financial institutions and send their funds to Canada to earn a higher interest rate (although theywould have to convert their U.S. dollars into Canadian dollars and are therefore exposed toexchange rate risk). To the extent that savings are withdrawn from U.S. financial institutions,there would be a reduction in the supply of loanable funds in the U.S. Consequently, this specificsituation places upward pressure on the U.S. interest rates.While this specific situation places upward pressure on U.S. interest rates, the economic growthand the budget deficit are expected to place downward pressure on interest rates. Therefore, youwould still forecast a decline in U.S. interest rates, unless you believe that the impact of theCanadian situation would overwhelm the impact of the economic growth and the budget deficitProblems1.Nominal Rate of Interest.Suppose the real interest rate is 6 percent and the expected inflation is 2percent. What would you expect the nominal rate of interest to be?

Loading page image...

Chapter 2: Determination of Interest Rates❖10ANSWER:i=E(INF) +iri= 2% + 6% = 8%2.Real Interest Rate.Suppose that Treasury bills are currently paying 9 percent and the expectedinflation is 3 percent. What is the real interest rate?ANSWER:i=E(INF) +irir=i–E(INF)ir= 9%–3% = 6%Flow of Funds ExerciseHow the Flow of Funds Affects Interest RatesRecall that Carson Company has obtained substantial loans from finance companies and commercialbanks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus,its cost of obtaining funds is sensitive to interest rate movements.Givenits expectations that the U.S.economy will strengthen, Carson plans to grow in the future by expanding its business and throughacquisitions. Carson expects that it will need substantial long-term financing topay for thisgrowth, anditplans to borrow additional funds either through loans or by issuing bonds.The companyis consideringthe issuance of stock to raise funds in the next year.a.Explain why Carson should be very interested in future interest rate movements.The future interest rate movements affect Carson’s cost of obtaining funds, and therefore mayaffect the value of its stock.b.Given Carson’s expectations, do you think thatthe company anticipates thatinterest rateswillincrease or decrease in the future? Explain.Carson expects the U.S. economy to strengthen, and therefore should expect that interest rateswill increase (assuming other things held constant).c.If Carson’s expectations of future interest rates are correct, how would this affect its cost ofborrowing on its existing loans and on future loans?Carson’s cost of borrowing will increase, because the interest rate on prevailing and future loanswould be tied to market interest rates.d.Explain why Carson’s expectations about future interest rates may affect its decision about whento borrow funds and whether to obtain floating-rate or fixed-rate loans.

Loading page image...

Chapter 2: Determination of Interest Rates❖11If Carson expects rising interest rates, it may prefer to lock in today’s interest rate for a periodthat reflects the length of time that it will need funds. In this way, the cost of funds borrowedwould be insulated from the changes in market interest rates.

Loading page image...

Chapter 3Structure of Interest RatesOutlineWhy Security DebtYields VaryCredit (Default) RiskLiquidityTax StatusTerm to MaturityModelingthe Yieldto be Offered on a Debt SecurityA Closer Look at the Term StructurePure Expectations TheoryLiquidity Premium TheorySegmented Markets TheoryResearch on Term Structure TheoriesIntegrating the Theories of the Term StructureUse of the Term StructureHow the Yield Curve Has Changedover TimeInternational Structure of Interest Rates

Loading page image...

Chapter 3:Structure of Interest Rates❖2Key Concepts1.Use a currentWall Street Journalor other newspaper to show how yields vary among securities. Thechapter helps to explain the disparity in yields.2.Provide logic behind how default risk, liquidity, tax status,andmaturity can affect yields.3.Offer various theories for the term structure of interest rates, and then combine these theories toprovide an integrated explanation.POINT/COUNTER-POINT:Should aYieldCurveInfluence aBorrower’sPreferredMaturity of aLoan?POINT: Yes. If there is an upward-sloping yield curve,thena borrower should pursue a short-term loanto capitalize on the lower annualized rate charged for a short-term period. The borrower can obtain aseries of short-term loans rather thana singleloan to match the desired maturity.COUNTER-POINT: No. The borrower will face uncertainty regarding the interest rate charged onsubsequent loans that are needed. An upward-sloping yield curve would suggest that interest rates willrise in the future, which will cause the cost of borrowing to increase. Overall, the cost of borrowing maybe higher when using a series of loans than when matching the debt maturity to the time period in whichfunds are needed.WHO IS CORRECT?Use the Internetto learn more about this issueand then formulateyour ownopinion.ANSWER: Either side could be correct. If you believe that the yield curve provides a reasonable forecastof future interest rates, then the counter-point is a more valid argument.Questions1.Characteristics That Affect Security Yields.Identify the relevant characteristics of any security thatcan affect the security’s yield.ANSWER:The relevant characteristics are:1.default risk2.liquidity3.tax status4.maturity2.Impact of Credit Risk on Yield.Howdoes high credit riskaffect the yieldon securities?ANSWER: Investors require a higher risk premium on securities with a high default risk.3.Impact of Liquidity on Yield.Discuss the relationship between the yield andtheliquidity ofsecurities.

Loading page image...

Chapter 3:Structure of Interest Rates❖3ANSWER: The greater the liquidity of a security, the lower is the yield, other things being equal.4.Tax Effects on Yields.Do investors in high tax brackets or those in low tax brackets benefit morefrom tax-exempt securities? Why? Do municipal bonds or corporate bonds offer a higher before-taxyield at a given point in time? Why? Which has the higher after-tax yield? If taxes did not exist,would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity?Why?ANSWER: High-tax bracket investors benefit more from tax-exempt securities because their taxsavings from avoiding taxes is greater.Corporate bonds offer a higher before-tax yield, since they are taxable by the federal government. Themunicipal bonds may have a higher tax yield for investors subject to a high tax rate. For low-taxbracket investors, the corporate bonds would likely have a higher after-tax yield.If taxes did not exist, Treasury bonds would offer a lower yield than municipal bonds because theyare perceived to be risk-free. Thus, the required return on Treasury bonds would be lower than onmunicipal bonds.5.Pure Expectations Theory.Explain how a yield curve would shift in response to a suddenexpectation of rising interest rates, according to the pure expectations theory.ANSWER:The supply of short-term loanable funds would increase, placing downwardpressure onthe short-term interest rate. The supply of long-term loanable funds would decrease, placing upwardpressure on the long-term interest rate . If the yield curve was originally upward sloped, it would nowhave a steeper slope as a result of the expectation. If it was originally downward sloped, it would nowbe more horizontal (less steep) or may have even become upward sloping.6.Forward Rate.What is the meaning of the forward rate in the context of the term structure of interestrates? Why might forward rates consistently overestimate future interest rates? How could such a biasbe avoided?ANSWER: The forward rate is the expected interest rate at a future point in time.If forward rates are estimated without considering the liquidity premium, it may overestimate thefuture interest rates. If a liquidity premium is accounted for when estimating the forward rate, the biascan be eliminated.7.Pure Expectations Theory.Assume anexpectation of lower interest rates in the futurearises quitesuddenly. What would be the effect on the shape of the yield curve? Explain.ANSWER: The demand for short-term securities would decrease, placing downward (upward)pressure on their prices (yields). The demand for long-term securities would increase, placing upward(downward) pressure on their prices (yields). If the yield curve was originally upward sloped, itwould now be more horizontal (less steep). If it was downward sloped, it would now be more steep.8.Liquidity Premium Theory.Explain the liquidity premium theory.ANSWER: If investors believe that securities with larger maturities are less liquid, they will require apremium when investing in such securities to compensate. This theory can be combined with theother theories to explain the shape of a yield curve.

Loading page image...

Chapter 3:Structure of Interest Rates❖49.Impact of Liquidity Premium on Forward Rate.Explain how consideration of a liquidity premiumaffects the estimate of a forward interest rate.ANSWER:When considering a liquidity premium, the estimate of a forward interest rate will bereduced.10.Segmented Markets Theory.If a downward-sloping yield curve is mainly attributed to segmentedmarkets theory, what does that suggest about the demand for and supply of funds in the short-termand long-term maturity markets?ANSWER: A downward-sloped yield curve suggests that the demand for short-term funds is highrelative to the supply of short-term funds, causing a high yield. In addition, the demand for long-termfunds is low relative to the supply of long-term funds, causing a low yield.11.Segmented Markets Theory.If the segmented markets theory causes an upward-sloping yield curve,what does this imply? If markets are not completely segmented, should we dismiss the segmentedmarkets theory as even a partial explanation for the term structure of interest rates? Explain.ANSWER: An upward-sloped yield curve caused by segmented markets implies that the demand forshort-term funds is low relative to the supply of short-term funds. In addition, the demand for long-term funds is high relative to the supply of long-term funds.Even if markets are not completely segmented, investors and borrowers may prefer a particularmaturity market. Therefore, they may only switch to a different maturity if there is sufficientcompensation (such as a higher return for investors or a lower cost of borrowing for borrowers).12.Preferred Habitat Theory.Explain the preferred habitat theory.ANSWER: The preferred habitat theory suggests that while investors and borrowers may prefer anatural maturity, they may wander from that maturity under conditions where they can benefit fromselecting a different maturity.13.Yield Curve.What factors influence the shape of the yield curve? Describe how financial marketparticipants use the yield curve.ANSWER: The yield curve’s shape is affected by the demand and supply conditions for securities invarious maturity markets. Expectations of interest rates, the desire for liquidity, and the desire byinvestors or borrowers for a specific maturity will influence the demand and supply conditions.The yield curve can be used to determine the market’s expectations of future interest rates. Marketparticipants can compare their own expectations to the market’s expectations in order to determinetheir borrowing or investing decisions.Advanced Questions14.Segmented Markets Theory.Suppose that theU.S.Treasury decided to finance its deficit withmostly long-term funds. How could this decision affect the term structure of interest rates? If short-term and long-term markets are segmented, would the Treasury’s decision have a more or lesspronounced impact on the term structure? Explain.

Loading page image...

Chapter 3:Structure of Interest Rates❖5ANSWER: If the Treasury borrowed heavily in the long-term markets, it could place upward pressureon long-term rates without having as much of an impact on short-term rates.If the markets aresegmented, the effect of the Treasury’s actions would be more pronounced.15.Yield Curve.If liquidity and interest rate expectations are both important for explaining the shape ofa yield curve, what does a flat yield curve indicate about the market’s perception of future interestrates?ANSWER: A flat yield curve without consideration of a liquidity premium would represent noexpected change in interest rates according to the pure expectations theory. Therefore, if the flat yieldcurve reflects the existence of a liquidity premium, this curve would actually have a slight downwardslope when removing the liquidity premium. This suggests expectations of a slight decline in futureinterest rates.16.Global Interaction among Yield Curves.Assume that the yield curves in the United States, France,and Japan are flat. If the U.S. yield curve suddenly becomesso positively sloped, do you think theyield curves in France and Japan would be affected? If so, how?ANSWER: The yield curves in other countries would also be affected if the event precipitating theshift in the U.S. yield curve affects either actual or expected interest rates in other countries. If long-term interest rates in the United States rise in response to a greater U.S. demand for long-term funds,then the yield curve may have an upward slope. To the extent that this event attracts long-term fundsin other countries, there would be a smaller supply of long-term funds in those countries, which couldcause higher long-term rates there. Consequently, their yield curves would have an upward slope.17.Multiple Effects on the Yield Curve.Assume that (1) investors and borrowers expect that theeconomy will weaken and that inflation will decline, (2) investors require a small liquidity premium,and (3) markets are partially segmented and the Treasury currently has a preference for borrowing inshort-term markets. Explain how each of these forces would affect the term structure, holding otherfactors constant. Then explain the effect on the term structure overall.ANSWER: The weak economy creates the expectation of a decline in interest rates, so according toexpectations theory, there would be a downward-sloping yield curve.The liquidity premium results in a slight upward slope to the yield curve.The Treasury’s preference would result in a downward-sloping demand yield curve, when otherfactors are held constant. Overall, there would be a downward-sloping yield curve because theexpectations and segmented markets effects would overwhelm the liquidity effect.18.Effect of Crises on the Yield Curve.During some crises, investors shift their funds out of the stockmarket and into money market securities for safety, even if they do not fearthatinterest rateswillrise. Explain how and why these actions by investors affect the yield curve. Is the shift due to theexpectations theory, liquidity premium theory, or segmented markets theory?ANSWER: The movement into money market securities results in a larger supply of short-term fundsand lowers short-term interest rates. Thus, the yield curve becomes more steeply sloped. The shift inthe yield curve is due to a preference for investors to move their funds into safe short-term securities,which reflects segmented markets theory, a preference for liquidity.

Loading page image...

Chapter 3:Structure of Interest Rates❖619.How the Yield Curve May Respond to Prevailing Conditions.Consider how economic conditionsaffect thecreditrisk premium. Do you think thecreditrisk premium will likely increase or decreaseduring this semester? How do you think the yield curve will change during this semester? Offer somelogic to support your answers.ANSWER:This question is open-ended. It requires students to apply the concepts that were presentedin this chapter in order to develop their own view. This question can be useful for class discussionbecause it will likely lead to a variety of answers, which reflects the dispersed opinions of marketparticipants.20.Assessing Interest Rate Differentialsamong Countries.In some countries where there is highinflation, the annual interest rate is more than 50 percent, while in other countries such as the U.S.andmany European countries, the annual interest rates are typically less than 10 percent. Do youthink such a large interest rate differential is primarily attributed tocountry-specificdifferencesin therisk-free rates or in the credit risk premiums? Explain.ANSWER:The risk-free foreign interest rates are determined by supply and demand for funds in theirlocal currency. Inflationary expectations affect the risk-free interest rate. Thus, the difference ininterest rates between the countries with very high interest rates versus low interest rates is primarilyattributed to risk-free rate differentials. The credit risk premium is typically higher in the countrieswith very high interest rates, but that is not the primary reason for the large difference betweencountries with very interest rates versus low interest rates.21.Applying the Yield Curve to Risky Debt Securities.Assume that the yield curve for Treasurybonds has a slight upward slope, starting at 6% for a 10-year maturity and slowly rising to 8% for a30-year maturity. Create a yield curve that you believe would exist for A-rated bonds, and acorresponding yield curvefor B-rated bonds.ANSWER:The yield curve for A-rated bonds would likely have a similar slope as the yield curve forTreasury securities but would be higher because of a credit risk premium. The yield curve for B-ratedbonds would likely have a similar slope as the yield curve for A-rated bonds but would be higherbecause of a credit risk premium.22. Changes to Credit Rating Process.Explain how credit rating agencieshave changed theirratingprocessesfollowing criticism of their ratings during the credit crisis.ANSWER: In response to the criticism, credit rating agencies made some changes to improve theirrating process and their transparency. They now disclose more information about how they derivedtheir credit ratings. In addition, the employees of each credit rating agency that promotes the servicesof the agency are not allowed to influence the ratings assigned by the rating agency. They are givingmore attention to sensitivity analysis in which they assess how creditworthiness might change inresponse to abrupt changes in the economy.CRITICAL THINKING QUESTIONHow a Credit Crisis Can Paralyze Credit Markets.The key components of a market interest rateare the risk-free rate and the credit risk premium. Duringacredit crisis, these two componentsmaychange substantially, but in different ways. Write a short essaythat describeshow the risk-free rate and the risk premiummaychangeduring acredit crisis. Explain why the financial

Loading page image...

Chapter 3:Structure of Interest Rates❖7markets can become paralyzed during a crisis.Is it because of changes in the risk-free rate orchanges in the risk premium?ANSWERDuringacredit crisis, the Fedcanensure availability of funds in the financial system, by using monetarypolicy to expand money supply. This resultsin a large increase in the supply of funds available, and whencombined with the decline in demand for funds, resultsin a decline in the risk-free interest rate. This typeof effect is desirable because it may encourage corporations and consumers to borrow more money andspend money, which can stimulate the weak economy.However, thecreditrisk premiumshouldincreaseduring a credit crisis, because the defaults on debtarelikelyincreasing, and surplus units that provide fundingshouldrequire a larger premium to compensatefor their higher exposure to credit risk. The high credit risk premium reflectsa high level of uncertaintyabout the future economy and the ability of borrowers to repay their debt.While a low risk-free rate is very desirable for borrowers, those borrowers who are perceived to be riskycannot access funds at that rate and may not even be able to access funds at all.Interpreting Financial NewsInterpret the following comments made by Wall Street analysts and portfolio managers.a.“An upward-sloping yield curve persists because many investors stand ready to jump into thestock market.”Investors are holding short-termTreasury securities, and are unwilling to hold long-termTreasury securities, because they may liquidate these securities soon, and prefer liquid securitiesthat are less susceptible to interest rate risk.b.“Low-rated bond yields rose as recession fears caused a flight to quality.”As investors selected safer bonds, they sold low-rated bonds, which placed downward pressureon prices of low-rated bonds and upward pressure on yields of low-rated bonds. Thus, the riskpremium of low-rated bonds increased.c.“The shift from an upward-sloping yield curve to a downward-sloping yield curve is sending awarning about a possible recession.”If the shift is due to changes in interest rate expectations, it suggests that interest rates may nowbe expected to decline. Such expectations can occur when the market expects that economicgrowth is slowing or is negative.Managing in Financial Markets

Loading page image...

Chapter 3:Structure of Interest Rates❖8As an analystata bond rating agency, you have been asked to interpret the implications of the recent shiftin the yield curve. Six months ago, the yield curve exhibited a slight downward slope. Over the last sixmonths, the long-term yields declined, while short-term yields remained the same. Analysts stated that theshift was due to revised expectations of interest rates.a.Given the shift in the yield curve, does it appear that firms increased or decreased their demandfor long-term funds over the last six months?The lower long-term yields may be attributed to a reduced demand for long-term funds. That is,firms may have reduced their issuance of long-term securities.b.Interpret what the shift in the yield curve suggests about the market’s changing expectations offuture interest rates.The yield curve six months ago implied the expectation of a slight decline in interest rates. Theyield curve today implied the expectation of a larger decline in interest rates.c.Recently, an analyst argued that the underlying reason for the yield curve shift was that many ofthe large U.S. firms anticipate a recession. Explain why an anticipated recession could force theyield curve to shift as it has.When the economic conditions are expected to deteriorate, the demand for loanable funds byfirms tends to decrease (because firms reduce their borrowing when they cut back on theirexpansion plans). Therefore, the long-term yields decline, and the yield curve developed a steeperdownward slope. So,this shift in the yield curve can indicate to the market that firms arereducing their amount of borrowing, in response to their assessment of future economicconditions.d.What could the specific shift in the yield curve signal about the ratings of existing corporatebonds? Whichtypes of corporations would be most likely to experience a change in their bondratings as a result of the specific shift in the yield curve?To the extent that the downward shift in the yield curve signals an anticipated recession (or atleast a reduction in economic growth), it could also signal that the creditworthiness of somecorporations will decline. Therefore, the bond ratings of some corporations would bedowngraded.Corporations that are more sensitive to economic downturns would be more susceptible to abond rating downgrade in response to a yield curve shift that signals an anticipated recession.Problems1.Forward Rate.a. Assume that as of today, the annualized two-year interest rate is 13 percent, whilethe one-year interest rate is 12 percent. Use this information to estimate the one-year forward rate.

Preview Mode

This document has 286 pages. Sign in to access the full document!

Report

Study Now!

Document Details

Related Documents

Financial Markets And Institutions, Abridged, 11th Edition Solution Manual

Financial Markets and Institutions, 11th Edition Solution Manual

Texas Life and Health Insurance Exam 150 Questions

Understanding Obligation and Deobligation in Resou

Budgeting for Life After High School

Ch 4 les 1

Understanding Credit Reports Analyzing John's Fina

Financial Planning and Budget Analysis

Financial Research Report

WACC Project Verizon Communication Inc

Company

Explore

Study Tools