Econ 640 Study for Test 1
Complete the formula that is used to calculate the present value on a twenty-year 5% coupon bond with a $1,000 face value that sells for $2,500. (Fill in the blanks with the appropriate numerical value in the formula provided below.)
$2500 = $50/(1+i) + C/(1+i)^2 +...+ C/(1+i)^20 + $1000/(1+i)^20
1. The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations: Bd: Price = −0.8Quantity + 1,140 Bs: Price = Quantity + 710 Suppose that, as a result of monetary policy actions, the Federal Reserve sells 100 bonds that it holds. Assume that bond demand and money demand are held constant. Which of the following statements is true? 2. Calculate the effect on the equilibrium interest rate in this market, as a result of the Federal Reserve action.
1. 710 - 100 = 610 So: If the Fed increases the supply of bonds in the market by 100, at any given price, the bond supply equation will become Price = Quantity + 610 2. As a result of the federal reserve action, the new equilibrium quantity is given as: -0.8Quantity + 1,140 = Quantity + 610 1.8Quantity = (1,140 - 610) = 530 Quantity = (530/1.8) = 294 (whole number only) Using the bond supply curve: Price = 294 + 610 = 904 Thus, the expected interest rate on a one-year discount bond with a face value of 1,000 and a current price of 904 is given as: (1,000-904)/904 = 0.1062 or 10.62%
What is the price of a perpetuity that has a coupon of $70 per year and a yield to maturity of 3%?
70/0.03 = $2,333 (nearest whole number)
If the yield to maturity doubles, what will happen to its price?
70/0.06 = 1167 (nearest whole number)
What are Eurobonds?
A bond denominated in a currency other than that of the country in which it is sold long dash —for example, a bond denominated in US dollars sold in London.
If you were going to get a loan to purchase a new car, which financial intermediary would you use? (Check all that apply.)
A credit union and a pension fund. You would likely use a credit union if you are a member, since their primary business is consumer loans. In some cases, it is possible to borrow direct from pension funds, but it can come with high borrowing costs and tax implications. Investment banks do not provide loans to the general public.
What effect might a fall in stock prices have on business investment?
A fall in stock prices might cause businesses to decrease investment. A higher price for a firm's shares means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment.
What is a primary market?
A financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
What is a money market?
A financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded.
What is a secondary market?
A financial market in which securities that have been previously issued can be resold.
What is a Capital Market?
A market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded.
What is a debt market?
A market where bonds or mortgages, which are contractual agreements by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when a final payment is made, are traded.
What effect might a rise in stock prices have on consumers' decisions to spend?
A rise in stock prices will generally lead to more consumer spending. Fluctuations in stock prices affect the size of people's wealth and as a result may affect their willingness to spend. As they feel more wealthy, they tend to increase their spending.
Choose the correct description for the following money market instrument. A Treasury bill is:
A short-term instrument issued by the United States Government to cover immediate spending obligations
Financial markets improve economic welfare because:
A. they channel funds from savers to investors B. they allow consumers to time their purchases better Financial markets allow funds to move from people who lack productive investment opportunities to people who have such opportunities. These markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy. Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. They provide funds to young people to buy what they need and can eventually afford without forcing them to wait until they have saved up the entire purchase price. Financial markets that are operating efficiently improve the economic welfare of everyone in the society.
When there is an increase in the value of the Japanese yen, all else equal:
American businesses will see an increase in demand for their goods in the United States and in foreign countries.
Much of the U.S. government debt is held as Treasury bonds and bills by foreign investors. How do fluctuations in the dollar exchange rate affect the value of that debt held by foreigners?
As the dollar becomes stronger relative to a foreign currency, for a given face value of bond holdings, it will yield more home currency to foreigners, so the asset will be worth more to foreign investors.
The maturity of a debt instrument is the number of years (term) until that instrument's expiration date. Identify the term to maturity of the following financial instruments:
A 30-year corporate bond. Long-term A money-market instrument with a maturity of 6 months. Short-term A Treasury note with a maturity of 5 or 10 years. Intermediate-term A 90-day Treasury bill. Short-term
Why do managers of financial institutions care so much about the activities of the Federal Reserve System?
Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.
What are foreign bonds?
Bonds sold in a foreign country and denominated in that country's currency.
How can changes in foreign exchange rates affect the profitability of financial institutions? (Check all that apply.)
Changes in foreign exchange rates: change the value of assets held by financial institutions. affect the profits made by traders in foreign exchange who work for financial institutions.
What does the Comptroller of the Currency do?
Charters and examines the books of federally chartered commercial banks and imposes restrictions on assets they can hold.
How do conflicts of interest make the asymmetric information problem worse?
Competing interests may lead a financial institution to conceal information or disseminate misleading information, which prevents financial markets from channeling funds into the most productive investment opportunities.
Who benefits and who is hurt when interest rates rise?
Corporations with immediate capital construction needs are worse off. Any institution that needs to borrow to finance expensive capital acquisition programs will be hurt by rising interest rates as the cost of borrowing increases. Households with little debt, saving a significant fraction of annual income for retirement, are better off The federal government running persistent budget deficits is worse off Black-market entrepreneurs operating on a 'cash-only' basis are worse of
What was the main cause of the recession that began in 2007?
Defaults in subprime residential mortgages
Complete the following table related to the structure of financial markets
Direct finance savers buys securities, and direct finance borrowers sell securities. Indirect finance savers make deposits and Indirect finance borrowers take out loans. Financial markets facilitate the purchase of securities (stocks and bonds) by lender-savers and the sale of these same instruments by borrower-spenders. Financial intermediaries accept deposits from lender-savers and make loans to borrower-spenders.
What does the Federal Reserve do?
Examines the books of commercial banks that are members of the Federal Reserve System and sets reserve requirements for all banks.
What does the Office of Thrift Supervision do?
Examines the books of savings and loan associations and imposes restrictions on assets they can hold.
Retired persons often have much of their wealth placed in savings accounts and other interest-bearing investments, and complain whenever interest rates are low. Which of the following, if true, would be a valid complaint?
Expected inflation is falling at a slower rate than nominal interest rates.
Calculate the present value of a $1,400 discount bond with 4 years to maturity if the yield to maturity is 3%
FV = 1400, I = 0.03, n = 4 1400/(1+0.03)^4 = 1243.88
Suppose that you buy, and one year later sell, a foreign (British) bond under the following circumstances: When you buy the bond the exchange rate is $2.00 = £1. You pay £45($90.00) for the British bond. You sell the bond for £50. No interest payment was expected or received. When you sell the bond, the exchange rate is $2.30 = £1
First convert the proceeds from the bond sale into dollars by multiplying the selling price in pounds by the new exchange rate. Then to compute the gain or loss, subtract the purchase price in dollars from the selling price in dollars. 45*2 = 90 50*2.3 = 115 115-90 = 25, which is the answer.
The US economy borrowed heavily from the British in the nineteenth century to build a railroad system. What was the principal debt instrument used?
Foreign bonds were the principal debt instrument used to finance the railroad system. The principal debt instruments used were foreign bonds, which were sold in Britain and denominated in pounds. The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads.
What is Eurocurrency?
Foreign currencies deposited in banks outside the home country.
How does a fall in the value of the pound sterling affect British consumers?
Foreign goods are now relatively more expensive; British consumers are hurt. A weaker currency makes foreign goods (US) more expensive to domestic (British) consumers. With the price of domestic goods unchanged, these imports are now relatively more expensive and British exports are relatively cheaper to foreign consumers.
Would you be more or less willing to buy gold under the following circumstances:
Gold again becomes acceptable as a medium of exchange. More willing Prices in the gold market become more volatile. Less willing You expect inflation to rise, and gold prices tend to move with the aggregate price level. More willing You expect interest rates to rise. More willing
Assume you just deposited $1,150 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year. What nominal rate would you require from the bank over the next year? How much money will you have at the end of one year?
I = 2%+6% = 8% 1150*1.08 = 1242
Calculate the yield to maturity (YTM) for a one-year bond with a purchase price of $800, a face value of $1,000, and a current yield of 5%
I = yield to maturity = (1000+40-800)/800 = 0.300 or 30% The yield to maturity on the bond given above is greater than the YTM of a similar $1,000 20-year bond with a current yield of 10% selling for $800.
What about an American company that is in the business of importing electronic consumer goods into the United States?
Importers of electronic goods into the United States are happier when the dollar is stronger
Refer to the diagram to the right. In which years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London?
In the mid- to late 1970s and in the late 1980s and early 1990s, the value of the dollar was low, making travel abroad relatively more expensive. Thus, this was a good time to vacation in the United States and see the Grand Canyon. With the rise in the dollar's value in the early 1980s, travel abroad became relatively cheaper, making it a good time to visit the Tower of London.
Prior to 2008, mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?
Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.
How does the size of the U.S. budget deficit in 2010 compare to the time period since 1950?
It has expanded dramatically since 2007. In 2010, the deficit-to-GDP ratio was 10 percent, well above the historical average of around 2 percent since 1950.
In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit on insured losses to bank depositors from $100,000 per account to $250,000 per account. How would this help stabilize the financial system?
It would reassure depositors that their money was safe in banks and prevent a possible bank panic.
When there is a decrease in the value of the American dollar relative to the Japanese yen, all else equal:
Japanese goods will become more expensive relative to American goods.
One of the factors contributing to the financial crisis of 2007-2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection?
Lenders loaned money to a pool of potential homeowners with the highest credit risk and lowest net wealth.
What would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market?
Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium
Which of the following is not a function or service provided by secondary markets?
Matching lenders (savers) with borrowers in need of funds
What is the difference between a mortgage and a mortgage-backed security?
Mortgages are loans, whereas mortgage-backed securities are bond-like debt instruments
Why would a life insurance company be concerned about the financial stability of major corporations or the health of the housing market?
Most life insurance companies hold large amounts of corporate bonds and mortgage assets. Most life insurance companies hold large amounts of corporate bonds and mortgage assets, thus poor corporate profits or a downturn in the housing market can significantly adversely impact the value of asset holdings of insurance companies. Some companies purchase corporate stocks, but the amount they can hold is restricted.
Given the following business plan information: I need to borrow $5,000 for a car because it enables me to get a job as a traveling anvil seller. Larry the Loan Shark will loan me the $5,000 at an interest rate of 90%. Principle and interest are due in exactly 12 months. With the car, I will be able to earn $10,000 in extra income over the next 12 months. What is the net cash flow by taking out the loan?
Net income is calculated as: Net Income = Additional Income minus − [Principle + (Principle times × Interest Rate)], where principle equals the amount borrowed. This is $500
A financial adviser has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the financial adviser necessarily right?
No. If interest rates rise sharply in the future, long-term bonds may suffer a sharp fall in price, causing their return to be quite low.
Which of the following statements is true?
Only a coupon bond can have a negative nominal interest rate, but not a perpetuity
If the interest rate is 15%, what is the present value of a security that pays you $1,125 next year, $1,210 the year after, and $1,338 the year after that?
PV = 1125/(1+0.15) + 1210/(1+0.15)^2 + 1338/(1+0.15)^3 = 2772.95
A lottery claims its grand prize is $20 million, payable over 5 years at $4,000,000 per year. If the first payment is made immediately, what is the grand prize really worth? Use an interest rate of 7%
PV = 4,000,000 + $4,000,000/(1.07) + $4,000,000/(1.07)^2 + $4,000,000/(1.07)^3 + $4,000,000/(1.07)^4 = $17,548,845
Property taxes in a particular district are 2% of the purchase price every year. If you just purchased a $300,000 home, what is the present value of all the future property tax payments? Assume that the house remains worth $300,000 forever, property tax rates never change, and that a 4% interest rate is used for discounting.
Property taxes on a $300,000 home equal: Tax = $300,000×0.02 = $6,000 per year The present value of all future payments equals: PV = $6,000/0.04 = $150,000 (a perpetuity)
What does the FDIC do?
Provides insurance of at $250,000 for each depositor at a bank, examines the books of insured banks, and imposes restrictions on assets they can hold.
Suppose you have just inherited $10,000 and are considering different options for investing the money to maximize your return. If you are risk-neutral (that is, neither seek out or shy away from risk), which of the following options should you choose to maximize your expected return? Suppose the only possibility is to loan the money to one of your friends' roommates. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying or not, would you pay the $100? What does the previous answer say about the value of better information regarding risk?
Put the money in an interest-bearing checking account, which earns 1%. The FDIC insures the account against bank failure. Yes, it is worth it, because it increases your expected return and reduces the downside risk that the loan will default. Paying a small amount to improve risk assessment can be very beneficial.
If history repeats itself and we see a decline in the rate of money growth as shown between 1980 and 1993, what might you expect to happen to
Real output: Uncertain The inflation rate: Decline Interest rates: Uncertain
What does the SEC do?
Requires disclosure of information of financial instruments traded in organized exchanges.
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
Risk premiums will fall in an economic expansion as business revenue and profits improve, making it easier for borrowers to make scheduled interest payments on their debt and increasing the likelihood that the business will repay the principle of that debt. Therefore, As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt.
If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates?
Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income, price level, and inflation will tend to lower interest rates.
A significant number of European banks held large amounts of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. Which of the following statements correctly describes the benefits of the internationalization of financial markets. (Check all that apply.)
The European banks that held U.S. mortgages earned a return on those holdings, and European banks provided needed capital to U.S. financial markets to support borrowing for new home construction. The international trade of mortgage-backed securities is generally beneficial because the European banks that held the mortgages could earn a return on those holdings, while providing needed capital to U.S. financial markets to support borrowing for new home construction and other productive uses. In this sense, both European banks and U.S. borrowers should have benefited.
Which of the following is not an important financial intermediary in the economy?
The Fed (Does not perform the same functions as an intermediary)
Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate rather than lend her the funds yourself?
The costs of writing up the loan contract might exceed the 5% difference between your deposit rate and the bank lending rate.
A bond has a face value of $1,000 and a 10% coupon rate, its current price is $940, and it is expected to increase to $960 next year. The current yield is:
The coupon payment equals: C = $1,000×0.1 = $100 Current yield = 100/940*100 = 10.6%
What would happen to the demand for Rembrandt paintings if the stock market undergoes a boom?
The demand for Rembrandt paintings would increase because of the increase in people's wealth
As a real estate speculator, you are planning and able to buy a house that costs $200,000, borrowing the full amount with no money down with the goal of selling this same property in exactly one year. Mortgage interest rates are 5%, and the expected increase in housing prices is 2%. (All rates and percentages are annual values.) What is your expected capital gain/loss when you flip the house in one year?
The expected selling price is $200,000(1 + Expected Δ in prices). 200000(1+0.02) = 204000 or a $4000 change
During 2008, the difference in yield (the yield spread) between 3-month AA-rated financial commercial paper and 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.
How much is $175 to be received in exactly one year worth to you today if the interest rate is 10%? This same $175 received in one year would be worth ______ to you today if the interest rate rose to 15%
The present value of a sum received in exactly one year is calculated as: PV = 175/(1+0.10)^1 = 159.09 Less
When interest rates decrease, how might businesses and consumers change their economic behavior?
There will be more consumption spending on interest-sensitive items and more investment by businesses. Consumption expenditure, or different forms of spending, will increase as interest rates decline. This is true for interest-sensitive purchases that might require increased borrowing at lower interest rates but also may lead to less saving activity
How do financial intermediaries benefit by providing risk-sharing services?
They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold
Why are financial markets important to the health of the economy?
They channel funds from savers to investors
What is the typical relationship between interest rates on 6-month Treasury bills, 10-year Treasury notes, and Baa corporate bonds?
They tend to move together over time with the corporate bond having the highest rate of interest. All interest rates tend to move together over time with similar increases or decreases affected by the rate of inflation, economic growth, and events in financial markets. Corporate rates tend to be higher than Treasury rates due to considerations of risk. Longer-term rates tend to be higher than short-term rates due to the economic uncertainty that exists with longer time horizons.
What is the basic activity of banks?
To facilitate the transfer of money from savers to borrowers
Would you be more or less willing to buy long-term AT&T bonds under the following circumstances:
Trading in these bonds increases, making them easier to sell. More willing You expect a bear market in stocks (stock prices are expected to decline). More willing Brokerage commissions on stocks fall. Less willing You expect interest rates to rise. Less willing Brokerage commissions on bonds fall. More willing
Has the inflation rate in the United States increased or decreased in the past few years?
Trend: Slowing down (Disinflation) . Volatility: Slightly erratic
"No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquidity than another security." Is this statement true, false, or uncertain?
True because for a risk-averse person, those characteristics make a security less desirable.
"The more risk-averse people are, the more likely they are to diversify." Is this statement true, false, or uncertain?
True because the benefits to diversification are greater for a person who cares more about reducing risk.
What are Eurodollars?
US dollars deposited in foreign banks outside the United States or in foreign branches of US banks.
Things to remember:
When the yield to maturity is greater than the coupon rate, the bond's current price is below its face value. The opposite holds true when the yield to maturity is below the coupon rate. For a given maturity, the bond's current price falls as the yield to maturity rises. For a given yield to maturity, a bond's value rises as its maturity increases. When the yield to maturity equals the coupon rate, a bond's current price equals its face value regardless of the number of years to maturity.
Which of the following statements correctly describes a disadvantage of the internationalization of financial markets.
With the sharp decline in the U.S. housing market, the value of mortgage-backed securities held by European banks fell sharply.
A fall in the value of the pound will cause American businesses to be
Worse off. A weaker currency makes foreign goods (US) more expensive to domestic (British) consumers. With the price of domestic goods unchanged, these imports are now relatively more expensive and British exports are relatively cheaper to foreign consumers.
When the dollar is worth less in relation to currencies of other countries, are you more likely to buy American-made or foreign-made electronics?
You are more likely to purchase American-made products
Would you be more or less willing to buy a house under the following circumstances:
You just inherited $100,000. More willing Real estate commissions fall from 6% of the sales price to 5% of the sales price. More willing You expect Microsoft stock to double in value next year. Less willing Prices in the stock market become more volatile. More willing You expect housing prices to fall. Less willing
If you suspect that an airline will go bankrupt next week, which would you rather hold, bonds issued by the company, or equities issued by the company?
You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.
Would you be more or less willing to buy a share of Microsoft stock in the following situations:
Your wealth falls. Less willing You expect the stock to appreciate in value. More willing The bond market becomes more liquid. Less willing You expect gold to appreciate in value. Less willing Prices in the bond market become more volatile. More willing
A share of Microsoft common stock is:
an asset for its owner, which Microsoft shows as shareholder equity on its balance sheet. The share of Microsoft stock is an asset for its owner because it entitles the owner to a share of the earnings and assets of Microsoft. It is counted as shareholder equity on Microsoft's balance sheet because it is a claim on its earnings and assets by the owner of the share.
As the price of stocks held by consumers increases:
consumer wealth and spending both increase.
A discount bond will have a negative nominal interest rate when the:
current bond price is greater than its face value.
The provision of several types of financial services by one firm may be beneficial because of:
economies of scope and problematic because of conflicts of interest.
Financial intermediaries have a role to play in matching savers and borrowers for all of the following reasons except:
information symmetries On the contrary, the problem in financial markets is not symmetric information, it is asymmetric information. In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked than the lender does.
Financial markets perform the basic function of:
matching savers with funds to lend to people who want to borrow funds
Assuming the terms of issuance to be the same for different types of loans, a government would choose to issue a:
perpetuity
The current yield is a good approximation to the yield to maturity when:
the maturity of the bond occurs over a ten-year period and/or when the bond price is very close to par. The current yield is the yearly coupon payment divided by the price of the security. So, the current yield would be a good approximation to the yield to maturity when the bond price is very close to par or when the maturity of the bond is over a ten-year period.
Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have commented that real interest rates were actually much higher in the mid- 1980s than in the late 1970s. Consider the diagram to the right that shows the nominal interest rate and the inflation rate. The real interest rate :
was higher in 1985 than 2005, when the real interest rate was zero. From about 1981 until 2002, the nominal rate exceeded the inflation rate, indicating a positive real rate. The difference widened in the mid 1980s, indicating an increase in the real rate. In 2005, the nominal rate and the inflation rate were the same, meaning the real rate was essentially zero.
What is the yield to maturity (YTM) on a $10,000-face-value discount bond maturing in one year that sells for $9,090.91?
yield = (face value - price)/price (10000-9090.91)/9090.91 = .0999... or 10%
If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds?
Long-term bonds because their price would increase more than the price of short-term bonds
Are US companies that manufacture semi-conductors happier when the dollar is strong or when it is weak?
Semi-conductor manufacturers are happier when the dollar is weak.
True or False: With a discount bond, the return on a bond is equal to the rate of capital gain.
True: A discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain.
Will there be an effect on interest rates if brokerage commissions on stocks fall?
Yes, interest rates would rise because stocks become more liquid than before, which would reduce the demand for bonds
Is it better for bondholders when the yield to maturity increases or decreases? Bondholders are better off when the yield to maturity:
decreases, since this represents an increase in the price of the bond and a decrease in potential capital losses.