Financial Markets Exam 1 (chapter 1 & 2)
EAR
=(1+r/c)^c -1
The 2 types of securities that investors most often associate with capital markets are _________ and __________.
Stocks; bonds
The Volcker Rule was passed as part of what important Act of Congress?
The Wall Street Reform and Consumer Protection Act of 2010.
*All else equal, as the coupon rate on a bond increases, the bond's sensitivity to changes in interest rates______.
Decreases
How do secondary markets support primary markets?
IPO= primary no original issuer, trading between investors=secondary
True or false: in the US., most money securities are traded "Over the counter" rather than on organized exchanges.
True
T/F: The originate and distribute model contributed to the financial crisis because it allowed FI's to issue risky mortgages knowing they could sell them before they defaulted.
True. (this is called "moral hazard")
*Which of the following is NOT a likely impact of expansionary policies implemented by the Fed?
an increase in interest rates
When FI's trade assets rather than hold them to maturity, they're exposed to market risk or
asset price risk
During the past 30 years, reversal of some trends that have reshaped the financial industry are:
changes in regulatory barriers, financial innovation changes, and changes in technology.
In primary markets, the users of funds are frequently:
corporations needing funds for new projects
The risk that an asset held by a financial institution may default and not be repaid is called:
credit risk
The difference between the nominal rate quoted on a security and the rate quoted on a Treasury security with similar characteristics is called the
credit risk premium and the default risk premium
What are the risks associated with financial intermediation?
default risk, liquidity risk, insolvency risk
Traditional depository institutions find it difficult to compete with other financial institutions due to:
higher costs due to regulation
The __________ the default risk of a security, the _________ the interest rate demanded by the buyer
higher; higher lower; lower
The __________ the interest rate "r", the _______ the future value of the annuity.
higher; higher lower; lower
When government monetary policy is restrictive and the money supply is constricted, interest rates will
increase
Returns with simple interest rates
interest earned on principal only
Similarities between money markets and capital markets?
issued by gov and corp's;
The risk that a financial institution may have inadequate cash to meet requests for demand deposit withdrawal is called
liquidity risk
The decline of the share of assets held by commercial banks between 1949 and 2016 is due to
low interest rates, regulations imposed during the financial crisis, and strict capital regulations.
Due to the value of the conversion option, convertible securities generally pay a __________ rate of interest than similar non-convertible securities
lower
The ___________ the interest rate "r", the ____________ the value of PV.
lower; higher higher; lower
The theory that argues that investors have specific maturity preferences and must be paid a premium to hold securities of a different maturity is the:
market segmentation theory
Both the unbiased expectations theory and the liquidity premium theory ignore investor preferences regarding the __________ of the securities they hold.
maturity
When non-price restrictions on borrowing are reduced, borrowers will demand _________ funds and interest rates will ________.
more; increase
Long maturity securities have more__________ than short maturity securities
price risk
The claims issued by FI's to investors often guarantee principal and a fixed rate of interest, compared to the riskier securities in which the FI invests the investor's funds. This form of asset transformation relieves the investor from:
price risk
Specialty Covenants (provisions)
provisions such as convertibility and taxability that alter the interest rate on a security. An SCP captures the effects of these provisions.
The FI's that experienced a dramatic increase in their share of total FI assets during the period of 1948 to 2016 are
securities brokers/dealers, investment companies, and pension funds
Security markets offer issuers of securities important information about how the issuer is performing and how much it will cost to raise additional capital. This information is conveyed through the:
security market price
In the "originate and distribute" model, financial institutions issue loans then
sell the loans quickly
The loanable funds theory views the level of interest rates as being determined by:
supply and demand for funds
Maturity intermediation may expose FI's to
interest rate risk
In the "originate and hold" model, FI's are exposed to risks, including:
interest rate risks, liquidity risk, and credit risk.
The preference of fund suppliers to choose to hold cash vs. investing in long-term securities increases the cost of long-term borrowing. This cost can best be described as
liquidity cost
UET equation=
Geometric average=[(1+r)(1+r)(1+r)]^(1/n)-1]
*Which of the following is not a characteristics of secondary markets?
The original issuer of the securities raises funds traded in secondary markets
When an FI hires employees to monitor fund users on behalf of fund providers, they are said to be acting as
delegated monitors
*A one-year, $1000 par value corporate bond has a coupon rate of 8% (paid semiannually). The real rate of interest is 2%. This year's inflation rate was 2% and is expected to increase to 3% over the coming year. The Default Risk Premium on similar corporate bonds is 2%. This bond's price (fair value) is:
$1009.50 (insert how to solve)
*Through open market operations, the Fed purchases Treasury securities totaling $200 million. If the reserve requirement is 10%, what is the total change in the money supply associated with these Treasury purchases?
$2 Billion (change in money supply= (1/reserve requ.) x (change in reserves) =(1/.10) x 200M=$2,000M, or $2 Billion
the supply of loanable funds ___________ with increasing interest rates
increases
*Investment XYZ pays 5 percent simple interest for 10 years. Investment ABC pays 4.50 percent compound interest for 10 years. As an investor with $10,000, you would choose investment ______ and earn an additional _____ in interest.
ABC; $529.69 (Simple Interest= [r*PV]*t) Compound interest=A[(1+r)^t-1])
True or false: the original issuers of financial instruments obtain additional funds when those instruments are resold on the secondary market
False (original issuers receive no funds from secondary market transactions between unrelated parties)
Fisher Equation
I= RIR(real i rate) + Expected inflation (IP)
*Typically, during periods of uncertainty in financial markets (high unemployment, recessions) the price of the Treasury securities will ________ while default risk premium (DRP) will _______.
Increase; widen (uncertainty=contractionary policies=higher DRP and higher prices)
Returns with compound interest rates
Interest earned on principal and reinvested interest FV=PV(1+r/n)^nt
The _____________ the interest rate "r", the ________ the present value of the annuity.
Lower; higher higher; lower
What are the differences between money markets and capital markets?
MM=<1 year, low interest rates (Treasury bills, fed funds, repurchase agreements, commercial paper, negotiable CD's) CM=>1 year (CM=corp. stock, mortgages, corp bonds, Treasury bonds, state and local gov. bonds, us gov agency bonds, bank and consumer loans; MM=(Treasury bills, fed funds, repurchase agreements, commercial paper, negotiable CD's))
Financial institutions frequently transform short-maturity liabilities provided by investors into a portfolio of long-maturity assets. This is known as:
Maturity Intermediation
In a world without financial institutions where suppliers provided funds directly to users, suppliers of funds would face 3 types of risks/costs. These are:
Price risk, Monitoring cost, and liquidity cost
Financial institutions encourage investment by savers by offering investments in __________, _____________, and __________.
annuities, pension funds, and life insurance.
Consolidation of financial services such as commercial banking, insurance, and investment banking under one roof has led to the creation of a business entity called the:
financial services holding company
The tendency of foreign investors to invest their funds in risk-free US government securities during times of crisis is referred to as
flight to quality
The major supplier(s) of securities for capital markets (i.e. users of funds) are:
governments and corporations
The risk that a financial institution will not have enough capital reserves to offset a sudden loss is called:
insolvency risk
(MP) Term to Maturity
interest rate are also related to term to maturity. (The yield curve is the relationship between a security's interest rate and its term to maturity).
the mismatch of maturities between liabilities and assets of financial institutions exposes them to
interest rate risk
Nominal Interest rates
interest rates actually observed (and quoted) in financial markets. (examples: bank prime rate and federal funds rate. They incorporate all the potential risks that the cash flows of the security may/may not produce at PV.)
*According to the liquidity premium theory of interest rates:
long term spot rates are higher than the average of current and expected future short term rates
The ______________ the annuity payment "PMT", the ____________ the present value of the annuity
lower; lower higher; higher
A single payment received at the beginning or end of an investment period is called a
lump sum payment
The difference between the required yield on long and short-term securities of the same characteristics except maturity is called the
maturity premium
The prices of securities with longer maturities are ____________ sensitive to changes in interest rates when compared to shorter maturity securities
more
Implied Forward Rate=
nf1=[(1+R)^n/(1+R)^(n-1)]-1 (implied forward rates apply to UET)
Factors affecting interest rates:
real rate of interest (RIR) DRP Liquidity risk premium Special Provisions (SCP) Term to Maturity (MP)
Investors demand more funds at lower interest rates because
the cost of borrowing funds is lower
Real Interest Rates
the rate that compensates for the opportunity cost of forgone consumption.
In addition to commercial banks, __________ also showed a decline in their share of total FI assets between 1948 and 2016.
thrifts
Nominal interest rates tend to __________ over time
vary
