Saunders Chapter Two

Treasury Bond

A bond which is taxable at the federal level but not at the state or local (city) levels

Corporate Bond

A bond whose interest payments are taxable at the state and local levels as well as federal levels

Truee

A change in the supply or demand curve for loanable funds causes interest rates to move. True or False?

Term Structure of Interest Rates

A comparison of interest rates/market yields on securities, assuming all characteristics except maturity are the same

the opportunity to exchange one security for another type of the issuer's securities at a preset price; holder of this requires a lower interest rate than a comparable nonconvertible security holder (all else equal)

A convertible (special) feature of a security offers the holder what opportunity?

True.

Because the expected inflation rate is difficult to estimate accurately, the real interest rate can be difficult to measure accurately as well, since investors' expectations are not always realized. T/f?

Increase/s.

Because the longer the maturity on a security the greater its risk, the liquidity premium increases as maturity _________(Increase / Decrease / No Effect)

by issuing debt and other financial instruments

Businesses demand funds to finance investments in long-term (fixed) assets and for short-term working capital needs usually by?

1. their prices (present values) are more sensitive to interest rate changes than short-term securities 2. it has greater exposure to price risk (loss of capital value) as interest rates change.

A different type of liquidity risk premium may also exist if investors dislike long-term securities because?

Annuity

A series of equal cash flows received at fixed intervals over the investment horizon

Lump sum payment

A single cash payment received at the beginning or end of some investment horizon

Supply of loanable funds

A term commonly used to describe funds provided to the financial markets by net suppliers of funds.

Demand for loanable funds

A term used to describe the total net demand for funds by fund users

Future Value

A value at the end of the investment horizon

inverse/negative

A/An ______ impact means that as the factor increases (decreases) the equilibrium interest rate decreases (increases).

direct/postive

A/An ______ impact on equilibrium interest rates means that as the "factor" increases (decreases) the equilibrium interest rate increases (decreases)

Unbiased expectations theory

According to this theory, at a given point in time the yield curve reflects the market's current expectations of future short-term rates

unbiased expectations theory

According to this theory, if future one-year rates are expected to rise each successive year into the future, then the yield curve will slope upwards. Specifically, the current four-year T-bond rate or return will exceed the three year bond rate, which will exceed the two-year bond rate, and so on.

False. Not all

All securities exhibit default risk. True or False?

Price Risk

Also known as loss of capital value

Forward rate

An expected or "implied" rate (quoted today) on a short-term security that is to be originated at some point in the future

f, they also change.

As interest rates change, the values of financial securities remain the same. t/f?

True!!!

As interest rates increase, future values increase at an increasing rate. True or False?

True!!

As interest rates increase, the present value of the investment decrease at a decreasing rate. True or False?

competitive forces are allowed to operate freely in a financial system

As long as __________________, the interest rate that equates the aggregate quantity of loanable funds supplied with the aggregate quantity of loanable funds demanded for a financial security, the y-axis value in the intersection point is the equilibrium interest rate for that security.

decreases; decreases; decreases; decreases; decreases; down, left

As the nonprice restrictions put on borrowers as a condition of borrowing increases: (choices: Increase / Decrease / No Effect) 1. the willingness of market participants to borrow _____ 2. the absolute dollar value borrowed _____ 3. demand for loanable funds _____ 4. equilibrium interest rate ____ 5. equilibrium quantity of funds traded ____ 6. direction of shift

True~

As the number of compounding periods per year increases, the future value of a present amount increases. True or False?

decreases; increases; decreases; up, left

As the risks of a financial security increase: (choices: Increases / Decreases / No Effect) 1. the supply for loanable funds at every available interest rate ____ 2. equilibrium interest rate ____ 3. equilibrium quantity of funds loaned (traded) ____ 4. direction of shift

steeper

As the supply of securities decreases in the short - term market and increases in the long - term market, the slope of the yield curve becomes? (the opposite applies to increase)

Increase

As the total wealth of a consumer increases, the total supply of loanable funds from that consumer will also ________(Increase / Decrease / No effect)

increases; increases; decreases; increases; down, right

As the total wealth of financial market participants increases: (choices: Increases / Decreases / No Effect) 1. the absolute dollar value available for investment purposes _______ 2. the supply for loanable funds at every available interest rate ____ 3. equilibrium interest rate ____ 4. equilibrium quantity of funds loaned (traded) ____ 5. direction of shift

Increases; Decreases; increases; down, right

As the underlying economic conditions themselves improve in a country relative to other countries: (choices: Increase / Decrease / No Effect) 1. the supply for loanable funds at every available interest rate ____ 2. equilibrium interest rate ____ 3. equilibrium quantity of funds loaned (traded) ____ 4. direction of shift

increases; increases; increases; increases; increases; up, right

As the utility derived from an asset purchased with borrowed funds increases: (choices: Increase / Decrease / No Effect) 1. the willingness of market participants to borrow _____ 2. the absolute dollar value borrowed _____ 3. demand for loanable funds _____ 4. equilibrium interest rate ____ 5. equilibrium quantity of funds traded ____ 6. direction of shift

[ (1+i)^c ] - 1 where c = # of compounding periods per year

EAR equation

F, they are nominal rates.

Equilibrium int rates are, by default, effective rates. T/f?

1.Inflation 2.Real Interest Rate 3.Default Risk 4.Liquidity Risk 5.Special Provisions 6.Term to Maturity

Factors that affect differences in interest rates across the range of real-world financial markets / DETERMINANTS OF INTEREST RATES FOR INDIVIDUAL SECURITIES

1.Utility derived from assets purchased with borrowed funds 2.The restrictiveness of nonprice conditions on borrowing 3.Economic conditions

Factors that cause the demand curve for loanable funds to shift

1.Wealth of fund suppliers 2.Risk of the financial security 3.Future spending needs 4.Monetary policy objectives 5.Economic conditions

Factors that cause the supply curve of loanable funds to shift, at any given interest rate (5)

Increase

In general, the quantity of loanable funds supplied increases as interest rates _______(Increase / Decrease / No Effect)

distinct supply and demand conditions within a particular maturity segment

In market segmentation theory, interest rates are determined by?

1.Consumer Price Index (CPI) 2.Producer Price Index (PPI)

In the United States, inflation is measured using indexes, such as the ________ and the __________

Simple Interest

Interest earned on an investment is not reinvested

Compound Interest

Interest earned on an investment is reinvested

False. They are important.

Interest rate forecasts are not important for the financial wealth of both FIs and individuals. True or False?

Truee.

Interest rates affect the price or value the seller of a security receives and the buyer of a security pays in organized financial markets. True or False?

False

Interest rates are not related to the term to maturity of a security. True or False?

False. They do.

Interest rates do not have a direct and immediate effect on the value of virtually all financial securities. True or False?

Tru

Interest rates play a major part in the determination of the value of financial instruments. True or False?

Habitats

Investment horizons are also known as?

Term to Maturity

Length of time a security has until maturity

governments

Loanable funds are also supplied by some ______.

T

Loanable funds theory is commonly used to explain the interest rates and interest rate movements. True or False?

False. It can be positive, negative or zero.

Maturity Premium (MP) cannot be negative. True or False?

business sector

Most foreign borrowing in U.S. financial markets comes from what sector?

"On the run" securities

New securities are also known as?

Real Interest Rate

Nominal interest rate that would exist on a security if no inflation were expected

alter the: 1. availability of funds 2. growth in the money supply; 3. and thus the rate of economic expansion of the economy

One method used by the Federal Reserve to implement monetary policy

increase/s.

Present values of the security investment decrease as interest rates ________(Increase / Decrease / No Effect)

"Off the run" securities

Previously issued securities are also known as?

when market participants expect the inflation rate to be zero

RIR = nominal interest rate only ?

investment horizons dictated by the nature of the liabilities they hold

Rather than securities with different maturities, individual investors and FIs have preferred?

Liquidity Risk

Risk that a security cannot be sold at a predictable price with low transaction costs at short notice

Default Risk

Risk that a security issuer will default on the security by missing an interest or principal payment

lower.

Special provisions that provide benefits to the security holder are associated with ____ (lower/higher) interest rates. True or False?

higher.

Special provisions that provide benefits to the security issuer are associated with ____ (lower/higher) interest rates. True or False?

T.

T/F: As the risks of a financial security decrease , it becomes more attractive to suppliers of funds.

T

T/F: Given the impact a change in interest rates has on security values, financial institution and other firm managers spend much time and effort trying to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time.

TTT

T/F: In actual practice, "annuity" payments can be paid more frequently than once a year—so that the term annuity really means a constant payment received at equal intervals throughout an investment horizon.

Truetrue

T/F: Many bonds, however, do not trade on a regular basis or on organized exchanges such as the NYSE. As a result, if investors wish to sell these bonds quickly, they may get a lower price than they could have received if they had waited to sell the bonds. Consequently, investors demand a liquidity premium on top of all other premiums to compensate for the bond's lack of liquidity and the potential price discount from selling it early.

Tttt

T/F: The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure.

The yield curve

Term Structure of Interest Rates is also known as?

Inflation of the general price index of goods and services (IP)

The (percentage) increase in the price of a standardized basket of goods and services over a given period of time

(1) any reduced purchasing power on funds lent (or principal lent) due to inflationary price change (2) an additional premium above the expected rate of inflation for foregoing present consumption (which reflects the real interest rate)

The Fisher effect theorizes that nominal interest rates observed in financial markets must compensate investors for?

True diz

The ability to predict or forecast interest rates is critical to the profitability of financial institutions and individual investors alike. True or False?

Time value of money

The basic notion that a dollar received today is worth more than a dollar received at some future date

Maturity Premium (MP)

The change in required interest rates as the maturity of a security changes

Inflation

The continual increase in the price level of a basket of goods and services

National Debt

The cumulative sum of past deficits

False. It does

The demand for loanable funds by households does not reflect the demand for financing purchases of homes (mort. loan), durable goods (car loan), and nondurable goods (educ. loan). True or False?

Default or Credit Risk Premium (DRP)

The difference between a quoted interest rate on a security and a Treasury security with similar maturity, liquidity, tax, and other features (such as callability or convertibility)

True

The effective or equivalent annual return (EAR) provides a more accurate measure of annual returns in time value of money calculations. True or False?

False. Only a temporary equilibrium

The equilibrium interest rate is a permanent equilibrium. True or False?

the security is bought

The first subscript indicates the period in which? (unbiased expectations theory)

Truee!

The greater the number of compounding periods per year, the smaller the present value of a future amount. True or False?

greater

The greater the number of profitable projects available to businesses, or the better the overall economic conditions, the ______ (greater or lesser) the demand for loanable funds

False. The lesser the households

The greater the perceived risk of securities investments, the greater the households are willing to invest at each interest rate. True or False?

truuee

The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure. True or False?

Truue

The higher the level of actual or expected inflation, the higher will be the level of interest rates. True or False?

Tru po

The higher the society's preference to consume today (i.e., the higher its time value of money or rate of time preference), the _____ (higher/lower) the real interest rate (RIR) will be. True or False?

T po.

The interest rate on a security reflects its relative liquidity, with highly liquid assets carrying the lowest interest rates (all other characteristics remaining the same). True or False?

False. Neither linear or proportional

The inverse relationship between interest rates and the present value of security investments can be linear or proportional. True or False?

False. More desirable instead

The lack of restrictive covenants makes the loan less desirable to the user of funds. True or False?

False. The theory does not consider

The market segmentation theory considers securities with different maturities as perfect substitutes. True or False?

An upward sloping yield curve

The most common yield curve

the percentage change in the buying power of a dollar

The real interest rate on an investment is?

The Fisher Effect

The relationship among the real interest rate, the expected rate of inflation, and the nominal interest rate

Effective or Equivalent Annual Return (EAR)

The return earned or paid over a 12-month period taking any within-year compounding of interest into account

the security matures

The second subscript indicates the period in which? (unbiased expectations theory)

Aggregate demand for loanable funds

The sum of the quantity demanded by the separate fund demanding sectors

Aggregate supply of loanable funds

The sum of the quantity supplied by the separate fund supplying sectors

True!

The time value of money concept specifically assumes that any interest or other return earned on a dollar invested over any given period of time is immediately reinvested. True or False?

1. The unbiased expectations theory 2. The liquidity premium theory 3. Market segmentation theory

Theories that explain the shape of the yield curve

Nominal interest rates

These affect the relationship between spot and forward foreign exchange rates as well

Special Provision

These are provisions that impact the security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions

nominal interest rates

These directly affect the value (price) of most securities traded in the money and capital markets, both at home and abroad

Changes in interest rates

These influence the performance and decision making for individual investors, businesses, and governmental units alike

Inverted yield curves

These yield curves do not generally last very long

The present value of an annuity equation

This equation converts a finite series of constant (or equal) cash flows received on the last day of equal intervals throughout the investment horizon into an equivalent (present) value as if they were received at the beginning of the investment horizon

The future value of an annuity equation

This equation converts a series of equal cash flows received at equal intervals throughout the investment horizon into an equivalent future amount at the end of the investment horizon

Market segmentation theory.

This theory argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium)

Market segmentation theory (MST)

This theory assumes that investors and borrowers are generally unwilling to shift from one maturity sector to another without adequate compensation in the form of an interest rate premium

Liquidity premium theory.

This theory is an extension of the unbiased expectations theory. It is based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security's value, which increase with an asset's maturity

Unbiased expectations theory.

This theory posits that current long-term interest rates are geometric averages of current and expected future short-term interest rates

Liquidity premium theory

This theory states that long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity risk premiums that increase with the maturity of the security

Loanable Funds Theory

Views the level of interest rates in financial markets as resulting from factors that affect the supply and demand for loanable funds

Decreases; decreases; increases; decreases; up, left

When financial market participants have increased near-term spending needs (choices: Increase / Decrease / No Effect) 1. the absolute dollar value of funds available to invest ____ 2. the supply for loanable funds at every available interest rate ____ 3. equilibrium interest rate ____ 4. equilibrium quantity of funds loaned (traded) ____ 5. direction of shift

internally generated funds rather than through borrowed funds

When interest rates are high, businesses prefer to finance investments with?

They increase their supply of funds to U.S. markets.

When interest rates are higher on U.S. financial securities than they are on comparable securities in their home countries, what do foreign investors do?

Increases; decreases; increases; down, right

When monetary policy objectives are to allow the economy to expand: (choices: Increase / Decrease / No Effect) 1. the Federal Reserve ___________ the supply of funds available in the financial markets 2. equilibrium interest rate ____ 3. equilibrium quantity of funds loaned (traded) ____ 4. direction of shift

increases; increases; increases; increases; up, right

When the domestic economy experiences a period of growth (converse: stagnant): (choices: Increase / Decrease / No Effect) 1. the willingness of market participants to borrow (heavily) 2. demand for loanable funds _____ 3. equilibrium interest rate ____ 4. equilibrium quantity of funds traded ____ 5. direction of shift

liquidity risk premium

added by investors to the interest rate on illiquid securities

federal government

also a large borrower partly to finance current budget deficits (expenditures greater than taxes) and partly to finance past deficits

time value of money concept

concept that can be used to convert cash flows earned over an investment horizon into a value at the end of the investment horizon

discounting future cash flows back to the present using the current market interest rate

conversion to present value is done by?

present value function (lump sum)

converts cash flows received over a future investment horizon into an equivalent value as if they were received at the beginning of the current investment horizon

interest rate or return

reflects the fact that people generally prefer to consume now rather than wait until later

Improvement of a country's underlying economic conditions in a country relative to other countries which increases the flow of funds to that country

reflects the lower risk (country or sovereign risk) that the country, in the guise of its government, will default on its obligation to repay funds borrowed

household (consumer) sector

sector which is the largest supplier of loanable funds in the United States

in the interest rates on securities that contain such provisions

special provisions that impact the security holder are reflected in?

debt instruments

state and local governments often issue ______ to finance temporary imbalances between operating revenues and budgeted expenditures

f, it will differ

t/f: if interest is paid or compounded more than once per year, the true annual rate earned or paid will be the same with the simple annual rate.

ttttt

t/f: the time value of money concept can be used to convert the value of future cash flows into their current or present values .

RIR x expected IP

term in the fisher effect formula (before negligence) which is the inflation premium for the loss of purchasing power on the promised nominal interest rate payments due to inflation and is negligible due to its small value

lower

the cost of borrowing funds is _____ (higher or lower)

longer-term securities are more sensitive to interest rate changes in the market than are shorter-term securities

the difference in price or liquidity risk between short-term & long term securities can be directly related to the fact that?

more expensive

the higher the rate of inflation, the _____ (more expensive or less expensive) the same basket of goods and services will be in the future

Nominal interest rate (or just interest rate)

the interest rates actually observed in financial markets

PV of an investment

the intrinsic value or price of the investment

an investor who buys a financial asset must earn a higher interest rate when inflation increases to compensate for the increased cost of forgoing consumption of real goods and services today and buying these more highly priced goods and services in the future

the intuition behind the positive relationship between interest rates and inflation rates

if investors have a four-year investment horizon, they could either buy a current, four-year bond and earn the current or spot yield on a four-year bond each year, or invest in four successive one-year bonds, but form expectations of the unknown future one-year rates

the intuition behind the unbiased expectations theory

additional government borrowing

the national debt and especially the interest payments on the national debt have to be financed in large part by?

term structure of interest rates or the yield curve

the relationship between interest rates and the term to maturity of a security is often called

higher

the reward for supplying funds is ________ (higher or lower)

Inflation Premium (IP) Real Interest Rate (RIR)

factors that are common to all financial securities (other factors can be unique to each security)

Consumers, businesses, governments, and foreign participants

financial market participants categories as categorized by loanable funds framework category

i = RIR + Expected IP

fisher effect formula

households businesses governments foreign agents

fund supplying sectors and fund demanding sectors

i {sub j} = f ( IP, RIR, DRP {sub j}, LRP {sub j}, SCP {sub j}, MP {sub j} ); where: IP = inflation premium RIR = real interest rate DRP {sub j} = Default risk premium on the j^th security LRP {sub j} = Liquidity risk premium on the j^th security SCP {sub j} = Special feature premium on the j^th security MP {sub j} = Maturity premium on the j^th security

general equation to determine the factors that functionally impact the fair interest rate [ i (subj) ] on an individual ( j^th) financial security

inversely/negatively related

how is the aggregate quantity of funds demanded related to interest rates?

positively related

how is the aggregate quantity of funds supplied related to interest rates?

the high savings rates of foreign households

it resulted in foreign market participants being major suppliers of funds to U.S. financial markets in recent years

1. prime commercial loan rate 2. three-month T-bill rate 3. high-grade corporate bond rate 4. home mortgage rate

key U.S. interest rates over the past 40 years

foreign borrowers

look for the cheapest source of dollar funds globally

real Interest Rate

measures society's relative time preference for consuming today rather than tomorrow

households

net suppliers of funds who also borrow funds in financial markets

when real interest rates are zero

nominal interest rates will be equal to the expected inflation rate only when?

Restrictive Covenants

nonprice condition that includes fees, collateral, or requirements or restrictions on the use of funds are so-called?

US business sector

often has excess cash, or working capital, that it can invest for short periods of time in financial assets

Loanable Funds theory

one model that is commonly used to explain interest rates and interest rate movements

inverse relationship between the (present) value of a financial instrument and interest rates

one of the most fundamental relationships in finance and is evident in the swings that occur in financial asset prices whenever major changes in interest rates arise

highly liquid assets

one that can be sold at a predictable price with low transaction costs and thus can be converted into its full market value at short notice

FV equation (lump sum)

translates a cash flow received at the beginning of an investment period to a terminal value at the end of an investment horizon

there is inflation

what happens when monetary policy objectives are to restrict the rate of economic expansion?

A shift in the supply or demand curve occurs

what happens when the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in another factor besides the interest rate?

inflation

when an investor purchases a security that pays interest, the nominal interest rate exceeds the real interest rate because of?

shortage; interest rates increasing, causing more suppliers of loanable funds to enter the market and some demanders of funds to leave the market

when the rate of interest is lower than the equilibrium interest rate, there is a ______ of loanable funds in the financial system; this results to

surplus; suppliers of funds lowering interest rate at which they are willing to lend and the demanders absorbing the loanable funds surplus

whenever the rate of interest is set higher than the equilibrium rate, the financial system has a ________ of loanable funds; this results to

various bond rating agencies

who evaluates and categorizes default risk on many corporate bonds?

due to smaller price fluctuations for a given change in interest rates

why do short term securities have less price risk?

due to their more active secondary market

why do short term securities provide greater marketability?

because as interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon; due to compounding of interest returns

why does FV increase as interest rate increases?

because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon

why does PV decrease as interest rates increase?

Yes

y/n: LPH yield curve is more upward sloping than UEH.

yes

y/n: UEH is more downward sloping than LPH.

y,

y/n: the yield curve of UEH can be flat.

Actual or Expected inflation rate in the economy

First factor to affect interest rates

Irving Fisher

Fisher effect was named for this economist. He identified the relationships in this effect early last century.

Truu

Foreign investors increasingly view the U.S. financial markets as alternatives to their domestic financial markets. True or False?

Terminal Value

Future value is also known as?

Increase/s

Future value of an investment increases as interest rates _________(Increase / Decrease / No Effect)

so true

Given that the yield curve represents the market's current expectations of future short-term interest rates, the unbiased expectations hypothesis can be used to forecast (short-term) interest rates in the future. t/f?

postpone borrowings and thus capital expenditures

Higher interest rates can cause state and local governments to?

Higher

Higher interest rates will also result in _____ (higher/lower) supplies of funds from the U.S. business sector

when they have excess income or want to reallocate their asset portfolio holdings

Households supply funds when?

Arbitrage Opportunity

If there is no equality in the unbiased expectations theory, a/an _________________ exists

lower; higher

In MST, the higher the yield on securities, the ___ lower/higher the price and the ___ lower/higher the demand for them

False. Short-term

In a world of uncertainty, long-term securities provide greater marketability and have less price risk than short term securities. True or False?

True, it should equal.

In equilibrium, the return to holding a four-year bond to maturity should equal the expected return to investing in four successive one-year bonds. (true/false)

decrease

In general, the quantity of loanable funds demanded increase as interest rates _________(Increase / Decrease / No Effect)