Exsm 2 FI&M

Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage?

A balloon mortgage payment requires interest payments for a three- to five-year period. At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages.

Explain the use of call provisions on bonds.

A call provision allows the issuing firm to purchase its bonds back prior to maturity at a specific price.

Explain why fiscal policy is not normally effective in stimulating the economy of a European country that is experiencing debt repayment problems.

A country with debt repayment problems is typically attempting to reduce its government expenditures in order to correct its budget deficit. Therefore, it is restricted from implementing a very expansionary fiscal policy (large government expenditures combined with lower tax rates) because this type of policy would increase its budget deficit and would require more financing.

Describe the growing-equity mortgage. How does the growing-equity mortgage differ from a graduated-payment mortgage?

A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage. The growing-equity mortgage lifetime is reduced because of the accelerated payment schedule, whereas a GPM's life is not reduced.

Assume that there is a sudden shift in the yield curve, such that the new yield curve is higher and more steeply sloped today than it was yesterday. If a firm issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds yesterday? Explain.

A higher and steeper yield curve implies that long-term bond yields have increased. Therefore, the firm would have to sell the bonds for lower prices. Moreover, selling the bonds for lower prices entices investors with a high yield today.

Bond portfolio managers closely monitor the trade deficit figures, because the trade deficit can affect exchange rates, which can affect inflationary expectations and therefore interest rates. When the trade deficit figure is lower than anticipated, bond prices typically increase. Explain why this reaction may occur.

A lower trade deficit figure signals the possibility of continued low trade deficits, which would place upward pressure on the dollar. As the dollar strengthens, U.S. inflation may decline, and U.S. interest rates may decline. Thus, bond portfolio managers buy bonds, placing upward pressure on bond prices.

Assume that breaking news causes bond portfolio managers to suddenly anticipate a recession. How might bond prices be affected by this expectation? Explain.

A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and higher prices for existing bonds. As bond portfolio managers purchase their bonds based on this expectation, there is immediate upward pressure on bond prices.

Why are second mortgages offered by some home sellers?

A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default.

Describe the shared-appreciation mortgage.

A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates. In return, the lender providing the loan will share in the price appreciation of the home.

Explain the use of a sinking-fund provision. How can it reduce the investor's risk?

A sinking-fund provision is a requirement that the firm retire a certain amount of the bond issue each year. This reduces the payments necessary at maturity and therefore can reduce the risk of investors.

How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution's exposure to interest rate risk.

An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds.

Explain the impact of an increase in interest rates on:

An investor's required rate of return should increase. The present value of existing bonds should decrease. The prices of existing bonds should decrease.

Explain how bond prices may be affected by money supply growth, oil prices, and economic growth.

Any factors that affect inflationary expectations may affect interest rate expectations and therefore affect the demand for bonds. Higher oil prices, excessive money supply growth, and strong economic growth contribute to higher inflationary expectations. Thus, interest rates would be expected to increase under these conditions (holding other factors constant), the demand for bonds would decline, and bond prices would decline.

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will decline substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same.

Based on your expectations, bond prices will rise. You should rebalance your portfolio by selling money market securities and purchasing more bonds. Bond prices will rise, while the prices of money market securities will decline as investors rebalance their portfolios. Consequently, the yield offered on bonds will decline, and the yield offered on money market securities will rise. The yield curve will become downward-sloping because the yield offered on bonds will decline, while the yield offered on money market securities will rise

Explain the use of bond collateral, and identify the common types of collateral for bonds.

Bond collateral is intended to back the bond if the issuer defaults on the bonds. Some of the more common types of collateral for bonds are mortgages or real property.

Explain the concept of bond price elasticity. Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the same yield to maturity? Why? What does this suggest about the market value volatility of mutual funds containing zero-coupon Treasury bonds versus high-coupon Treasury bonds?

Bond price elasticity measures the percentage change in a bond's price in response to a percentage change in interest rates. The percentage change in the price (as measured by present value) of the zero-coupon bonds would be more sensitive to interest rate movements than the high-coupon bonds. Thus, a mutual fund containing zero-coupon bonds would likely have a more volatile market value over time.

Who issues commercial paper?

Commercial paper is normally issued by well-known, creditworthy firms. Bank holding companies and finance companies commonly issue commercial paper. Those firms that issue commercial paper may decide to establish a department that can directly place the paper. In this way, the firms can avoid the transactions costs incurred when commercial paper dealers issue commercial paper. Such a strategy is only worthwhile if the firms continuously issue commercial paper.

Why can convertible bonds be issued by firms at a higher price than other bonds?

Convertible bonds allow investors to exchange the bonds for a stated number of shares of the firm's common stock. This offers investors the potential for high returns if the price of the firm's common stock rises. So, these bonds can be issued at a higher price.

What are debentures?

Debentures are backed only by the general credit of the issuing firm. Subordinated debentures are junior to the claims of regular debentures, and therefore may have a higher probability of default than regular debentures.

Explain what exchange-traded notes are and how they are used. Why are they risky?

Exchange-traded notes (ETNs) are debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index after deducting specified fees. These instruments have more flexibility to use leverage, which creates a higher potential return for investors, but also results in a higher risk.

Why some financial institutions prefer to sell the mortgages they originate?

Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. Financial institutions may sell their mortgages if they do not have sufficient funds to maintain all the mortgages they originate.

What are the advantages and disadvantages to a firm that issues low- or zero-coupon bonds from the perspective of the issuing firm?

From the perspective of the issuing firm, low- or zero-coupon bonds have the advantage of requiring low or no cash outflow during the life of the bond. The issuing firm is allowed to deduct the amortized discount as interest expense for federal income tax purposes, which adds to the firm's cash flow. However, the lump-sum payment made to bondholders at maturity can be very large, and could cause repayment problems for the firm. Low or no interest payments - A Deduction of the amortized discount as interest expense - A Lump-sum payment made to bondholders at maturity - DA

A U.S. insurance company purchased British 20-year Treasury bonds instead of U.S. 20-year Treasury bonds because the coupon rate was 2 percentage points higher on the British bonds. Assume that the insurance company sold the bonds after five years. Its yield over the five-year period was substantially less than the yield it would have received on the U.S. bonds over the same five-year period. Assume that the U.S. insurance company had hedged its exchange rate exposure. Given that the lower yield was not because of default risk or exchange rate risk, explain how the British bonds could have generated a lower yield than the U.S. bonds. (Assume that either type of bond could have been purchased at the par value.)

If British interest rates increased or remained constant while U.S. interest rates declined, the U.S. bonds could have been sold at a much higher price than British bonds. Thus, while default risk and exchange rate risk are not relevant in this case, the interest rate risk had different effects on the two types of bonds.

If bond yields in Japan rise, how might U.S. bond yields be affected? Why?

If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before.

Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors that currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future.

If corporate debt is downgraded, the required rate of return by investors would increase, as the bonds are now perceived to have a higher degree of default risk. Consequently, the price of those bonds would drop, resulting in a capital loss for current investors in those bonds. New investors in these bonds can purchase the bonds at a relatively low price, as this low price compensates for their recognition that the default risk of the bonds has increased.

Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain.

If investors expect interest rates to decrease, they would avoid variable-rate bonds because the return to the investors would be tied to market interest rates. The investors would prefer fixed-rate bonds if interest rates are expected to decrease. If a firm expects that interest rates will decrease, it may consider issuing variable-rate bonds, because the interest paid on the bonds would decline over time with the decline in market interest rates.

Prices of existing bonds have decreased. Explain the reason for it.

If prices of existing bonds have decreased, this is normally because interest rates have increased.

The Fed's open market operations can change the money supply, which can affect the risk-free rate offered on bonds. Why might the Fed's policy also affect the risk premium on corporate bonds?

If the Fed's actions reduce interest rates, they may increase economic growth, which could reduce the uncertainty surrounding the economy, and lower the risk premium on corporate bonds.

If you expect that interest rates will fall, would you recommend that investors purchase bonds today? Explain.

If you expect that interest rates will fall, you should expect bond prices to increase in the future, and therefore recommend that investors purchase bonds today.

Explain how the bankruptcy of Lehman Brothers (a large securities firm) reduced the liquidity of the commercial paper market.

In September 2008, Lehman Brothers (a large securities firm) defaulted on its commercial paper, which temporarily scared many investors away from the commercial paper market.

Explain short sales in the mortgage markets.

In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage.

Explain the conditions that led to the debt crisis in Greece.

In spring of 2010, Greece experienced a credit crisis, because of its weak economic conditions and large government budget deficit. As its deficit grew and its economy weakened, investors were concerned that the government of Greece would not be able to repay its debt. In addition, credit rating agencies reduced the ratings on the Greek debt several times.

Explain how investors' preferences for commercial paper change during a recession.

Investors are less interested in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors

Explain why investors that provided guarantees on commercial paper were exposed to much risk during the credit crisis.

Investors were exposed to much risk during the credit crisis because they provided guarantees for commercial paper issuers that had excessive exposure to mortgages.

Explain how the credit crisis affected the default rates of junk bonds and the risk premiums offered on newly issued junk bonds.

Many junk bonds defaulted during the credit crisis, as economic conditions weakened and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time.

Explain why monetary policy is not normally effective in stimulating the economy of a European country that is experiencing debt repayment problems.

Monetary policy in the eurozone serves several countries that use the euro as their home currency, and is not focused on serving a single European country's preferences.

How can small investors participate in investments in negotiable certificates of deposits (NCDs)?

Money market funds can pool invested funds by individual investors and purchase NCDs. In this way, small investors can invest in NCDs.

Is the relationship between interest rates and bond prices important to financial institutions?

Most financial institutions maintain a portfolio of bonds or mortgages that provide fixed payments over time. Because the market values of these securities are very sensitive to interest rate movements, financial institutions must understand the relationship between interest rates and security prices.

An analyst recently suggested that there will be a major economic expansion that will favorably affect the prices of high-rated fixed-rate bonds, because the credit risk of bonds will decline as corporations improve their performance. Assuming that the economic expansion occurs, do you agree with the conclusion of the analyst? Explain.

No, you should disagree with the conclusion of the analyst, because, despite the increase in the price due to lower credit risks, the price will decline as the major economic expansion tends to generate upward pressure on interest rates and the overall effect is not obvious.

Explain how systemic risk is related to the commercial paper market. That is, why did problems in the market for mortgage-backed securities affect the commercial paper market?

Problems in the market for mortgage-backed securities affect the commercial paper market because some issuers of asset-backed commercial paper used mortgage-backed securities as collateral and, with a decrease in the yield of MBS, investments in commercial papers secured by MBS decreased

What are protective covenants? Why are they needed?

Protective covenants are restrictions placed on the firm issuing bonds. For example, they may limit the dividends or corporate officer salaries, or limit the amount of debt the firm can issue. They are needed to reduce the risk of bonds.

Assume that oil-producing countries have agreed to reduce their oil production by 30 percent. How would bond prices be affected by this announcement? Explain.

Reduced oil production implies higher oil prices, higher interest rates, and lower bond prices. Thus, bond portfolio managers would sell bonds immediately causing immediate downward pressure on the bond prices.

Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why?

Repurchase agreements with a similar maturity as commercial paper would likely have a slightly lower yield, since they are typically backed by Treasury securities.

Assume that inflation is expected to increase in the near future. How could this affect future bond prices? Would you recommend that financial institutions increase or decrease their concentration in long-term bonds based on this expectation? Explain.

Since higher inflation normally causes an increase in interest rates (other things being equal), financial institutions would benefit if they decrease their concentration of long-term bonds before this occurs.

Why is the 15-year mortgage attractive to homeowners?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-year mortgage exists for only half the period.

Describe the conditions imposed by the European Central Bank (ECB) when it provides credit to European country governments with debt repayment problems.

The ECB expects that a government with debt repayment problems will reduce its budget deficit so that it does not need to borrow so much money in the future.

Distinguish between FHA and conventional mortgages.

The Federal Housing Administration protects FHA mortgages against the possibility of default by the borrower, while conventional mortgages doesn't.

The pension fund manager of Utterback (a U.S. firm) purchased German 20-year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percent lower on the German bonds. Assume that the manager sold the bonds after five years. The yield over the five-year period was substantially more than the yield it would have received on the U.S. bonds over the same five-year period. Explain how the German bonds could have generated a higher yield than the U.S. bonds for the manager, even if the exchange rate is stable over this five-year period. (Assume that the price of either bond was initially equal to its respective par value).

The German interest rates could have declined while U.S. interest rates increased, so that the value of the German bonds was higher than the value of U.S. bonds after five years. Even if interest rates in both countries moved in the same direction, the German bonds could have generated a higher yield. If both interest rates increased, the U.S. interest rates could have increased to a higher degree. If both interest rates decreased, the U.S. interest rates could have decreased by a smaller degree.

Explain how the Treasury uses the primary market to obtain adequate funding

The Treasury issues Treasury bills through a weekly auction. Individual investors can submit competitively or noncompetitively bids for newly issued T-bills.

What is a bond indenture? What is the function of a trustee, with respect to the bond indenture?

The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. A trustee represents the bondholders in all matters concerning the bond issue.

Explain how the bond market facilitates a government's fiscal policy.

The bond market enables the Treasury to finance government expenditures by issuing Treasury notes and bonds in exchange for funding that can be spent.

You have the choice of investing in top-rated commercial paper or commercial paper that has a lower risk rating. How do you think the risk and return performances of the two investments differ?

The commercial paper with the lower rating should have a higher rate of return and also a higher degree of default risk.

Merrito Inc. is a large U.S. firm that issued bonds several years ago. Its bond ratings declined over time, and about a year ago, the bonds were rated in the junk bond classification. Yet, investors were buying the bonds in the secondary market because of the attractive yield they offered. Last week, Merrito defaulted on its bonds, and the prices of most other junk bonds declined abruptly on the same day. Explain why news of Meritto's financial problems could cause the prices of junk bonds issued by other firms to decrease, even when those firms had no business relationships with Merrito.

The financial problems of Merrito Inc. signaled that other firms classified in the junk bond category might also experience cash flow problems. Investors quickly sold their holdings because of this signal, and other investors were no longer interested in purchasing these bonds at the prevailing price.

Explain how the yield on a foreign money market security would be affected if the foreign currency denominating that security declined to a greater degree

The foreign money market yield would be reduced if the foreign currency denominating the security depreciates to a greater degree, since the U.S. investors would have to pay a higher exchange rate for the currency than the exchange rate at which the currency is converted back to dollars.

Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage?

The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period. Homeowners whose incomes will rise over time may desire this type of a mortgage.

When stock market volatility is high, corporate bond yields tend to increase. What market forces cause the increase in corporate bond yields under these conditions?

The high stock market volatility partially reflects high uncertainty of investors about corporate performance in the future, so corporate risk premiums on bonds may rise.

How would a financial institution with a large bond portfolio be affected by rising interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain.

The market value of the financial institution's bond portfolio will decrease. A financial institution that has a greater concentration of bonds would be more adversely affected because the market value of its portfolio would be more sensitive to interest rates.

Is the price of a long-term bond or the price of a short-term security more sensitive to a change in interest rates? Why?

The price of a long-term bond is more sensitive to a change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time. Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities. The same is true for the disadvantage of fixed payments during a period of rising rates.

Explain how the prices of bonds were affected by a change in the risk-free rate during the credit crisis. Explain how bond prices were affected by a change in the credit risk premium during the credit crisis.

The risk-free rate declined, which placed upward pressure on bond prices. However, the credit risk premium increased, which placed downward pressure on bond prices.

What is the general relationship between mortgage rates and long-term government security rates?

There is a high positive correlation between mortgage rates and long-term government security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.

An insurance company purchased bonds issued by Hartnett Company two years ago. Today, Hartnett Company has begun to issue junk bonds and is using the funds to repurchase most of its existing stock. Why might the market value of those bonds held by the insurance company be affected by this action?

This question is related to event risk. The bonds held by the insurance company will now be more susceptible to default, because Hartnett Company is more likely to experience cash flow problems. Therefore, the required rate of return on those bonds will increase, and the market value of the bonds will decrease.

If a bond's coupon rate is above the investor's required rate of return on the bond, would the bond's price be above or below its par value? Explain.

When a bond's coupon rate is above the investor's required rate of return, the price of the bond would be above its par value because the coupons provide more than the return required.

Assume that interest rates for most maturities are unusually high. Also assume that the net working capital (defined as current assets minus current liabilities) levels of many corporations are relatively low in this period. Explain how the money markets play a role in this relationship between the interest rates and the level of net working capital.

When interest rates are relatively high, corporations are unwilling to issue long-term debt because they do not want to lock in long-term interest rates. Therefore, they use more short-term financing until interest rates decline. Their increase in short-term debt results in a reduction in their net working capital.

Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what?

When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited.

Assume that the bond market participants suddenly expect the Fed to substantially increase the money supply.

Without the threat of inflation, an increase in the money supply could reduce interest rates and bond prices would increase. Thus, bond portfolio managers would purchase more bonds now, causing immediate upward pressure on bond prices. If inflation increases, interest rates will likely increase, and prices of existing bonds will decline. Therefore, bond portfolio managers would sell bonds now, causing immediate downward pressure on bond prices.