Finance 421 HW Ch: 1,4,5,6,7,9

Banker's Acceptances. Explain how each of the following would use banker's acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors.

ANSWER: A banker's acceptance can (a) protect an exporter from the risk of nonpayment by the importer, (b) protect importing firms from the risk of paying for goods without ever receiving them, (c) enable banks to offer exporters and importers a service for which it charges a fee, and (d) offer investors an investment instrument (when exporters sell the acceptance in the secondary market).

Fed Response to Fiscal Policy. Explain how the Fed's monetary policy could depend on the fiscal policy that is implemented. [

ANSWER: A fiscal policy that involves much government borrowing could place upward pressure on interest rates. If the Fed wants to keep interest rates low in order to stimulate the economy, it may need to use a loose monetary policy to offset the fiscal policy effect on interest rates.

#14 CH1 Mutual Funds. What is the function of a mutual fund? Why are mutual funds popular among investors? How does a money market mutual fund differ from a stock or bond mutual fund?

ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in a portfolio of securities. Mutual funds are popular because they can help individuals diversify while using professional expertise to make investment decisions. A money market mutual fund invests in money market securities, whereas other mutual funds normally invest in stocks or bonds.

28. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy on a firm's cost of capital.

ANSWER: A stimulative monetary policy is normally intended to reduce interest rates. Since lower interest rates tend to reduce the cost of debt and the cost of equity, a stimulative monetary policy reduces the cost of capital.

#3 CH5 Choice of Monetary Policy. When does the Fed use a stimulative monetary policy and when does it use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive?

ANSWER: A stimulative monetary policy may be used to stimulate the economy, especially if inflation is not a concern. A restrictive monetary policy may be used to slow economic growth in order to reduce inflationary fears. A stimulative-monetary policy may result in higher inflation. The risk of a restrictive monetary policy is a potential slowdown in the economy. A restrictive monetary policy may result in higher interest rates, reduced borrowing, and reduced spending to an excessive degree.

#23 CH4 The Fed and Commercial Paper. Why and how did the Fed intervene in the commercial paper market during the credit crisis?

ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial paper it had issued, investors feared that other financial institutions with large holdings of mortgage-backed securities might default on their commercial paper. Therefore, investors stopped buying commercial paper in the secondary market, causing it to become illiquid and making credit increasingly hard to obtain. The Fed purchased large amounts of commercial paper to boost investor confidence and restore liquidity to the market.

#11 CH5 Impact of Money Supply Growth. Explain why an increase in the money supply can affect interest rates in different ways. Include the potential impact of the money supply on the supply of and the demand for loanable funds when answering this question.

ANSWER: An increase in money supply increases the supply for loanable funds and therefore can place downward pressure on interest rates. Yet, it can also cause inflationary expectations, resulting in an increased demand for loanable funds and upward pressure on interest rates.

$6 CH4 Reserve Requirements. How is money supply growth affected by an increase in the reserve requirement ratio?

ANSWER: An increase in the reserve requirement ratio reduces the proportion of deposited funds that a financial institution can lend out. Consequently, it reduces the rate by which money can multiply.

#24 CH1 24. Influence of Financial Markets. Some countries do not have well established markets for debt securities or equity securities. Why do you think this can limit the development of the country, business expansion, and growth in national income in these countries?

ANSWER: Businesses rely on financial markets to expand. If they cannot issue debt or equity securities, they cannot obtain funding to expand. Local investors who have money to invest will likely invest their money in other countries if the financial markets are not developed in their home market. Thus, they will essentially help other countries grow instead of helping their own country grow.

Commercial Paper. Who issues commercial paper? What types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? What criteria affect the decision to create such a department?

ANSWER: 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.

#12 Credit Unions. With regard to the profit motive, how are credit unions different from other financial institutions? CH1

ANSWER: Credit unions are non-profit financial institutions.

#16 CH1 Comparing Financial Institutions. Classify the types of financial institutions mentioned in this chapter as either depository or nondepository. Explain the general difference between depository and nondepository institution sources of funds. It is often stated that all types of financial institutions have begun to offer services that were previously offered only by certain types. Consequently, many financial institutions are becoming more similar. Nevertheless, performance levels still differ significantly among types of financial institutions. Why?

ANSWER: Depository institutions include commercial banks, savings and loan associations, and credit unions. These institutions differ from nondepository institutions in that they accept deposits. Nondepository institutions include finance companies, insurance companies, pension funds, mutual funds, and money market funds. Even though financial institutions are becoming more similar, they often differ distinctly from each other in terms of sources and uses of funds. Therefore, their performance levels differ as well.

#21 CH1 Regulation of Financial Institutions. Financial institutions are subject to regulations to ensure that they do not take excessive risk and they can safely facilitate the flow of funds through financial markets. Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to facilitate their financial transactions. Why do you think the existing regulations were ineffective at ensuring a safe financial system?

ANSWER: During the credit crisis in 2008, the failure of some financial institutions caused concerns that others might fail, and disrupted the flow of funds in financial markets. The primary cause was that financial institutions experienced massive mortgage defaults. They should have recognized that subprime mortgages (unqualified borrowers, low down payment) may default. In addition, regulators should have recognized that subprime mortgages may default and could have imposed regulations to limit an institution's exposure to subprime mortgages.

Impact of Credit Crisis on Risk Premiums. Explain how the credit crisis affected the credit risk premium in the commercial paper market.

ANSWER: During the credit crisis, some institutional investors avoided commercial paper issued by financial institutions because of the financial problems they were experiencing. Thus, the premium that some financial institutions had to pay when issuing commercial paper increased.

#13 Nondepository Institutions. Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds.

ANSWER: Finance companies sell securities to obtain funds, while insurance companies receive insurance premiums and pension funds receive employee/employer contributions. Finance companies use funds to provide direct loans to consumers and businesses. Insurance companies and pension funds purchase securities.

#18 CH1 Role of Accounting in Financial Markets. Integrate the roles of accounting, regulations, and financial market participation. That is, explain how financial market participants rely on accounting, and why regulatory oversight of the accounting process is necessary.

ANSWER: Financial market participants rely on financial information that is provided by firms. The financial statements of firms must be audited to ensure that they accurately represent the financial condition of the firm. However, the accounting standards are loose, so financial market participants can benefit from strong accounting skills that may allow them to more properly interpret financial statements.

#17 CH4 Impact of FOMC Statement. How might the FOMC statement (following the committee's meeting) stabilize financial markets more than if no statement were provided?

ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the FOMC meeting, and there would be more uncertainty regarding the Fed's future monetary policy. The statement makes the Fed's plans more transparent.

#4 Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain. CH1

ANSWER: If markets are efficient then prices of securities available in these markets properly reflect all information. We should expect markets to be efficient because if they weren't, investors would capitalize on the discrepancy between what prices are and what they should be. This action would force market prices to represent the appropriate prices as perceived by the market. Efficiency is often defined with regard to publicly available information. In this case, markets can be efficient, but investors with inside information could possibly outperform the market on a consistent basis. A stronger version of efficiency would hypothesize that even access to inside information will not consistently outperform the market.

18. Economic Indicators. Stock market conditions serve as a leading economic indicator. Assuming the U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator be inaccurate?

ANSWER: If stock prices are a leading economic indicator, then the stock market will move up before the economy begins to recover from a recession. An improvement in the stock market may signal that the economy is about to recover. This indicator may be inaccurate because the investors who push stock prices higher may have had unrealistic expectations.

#2 CH5 Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its economic goals.

ANSWER: In general, a stimulative monetary policy can increase economic growth and reduce unemployment, but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment.

#22 CH1 Impact of the Greece Debt Crisis. European debt markets have become integrated over time, so that institutional investors (such as commercial banks) commonly purchase debt issued in other European countries. When the government of Greece experienced problems in meeting its debt obligations in 2010, some investors became concerned that the crisis would spread to other European countries. Explain why integrated European financial markets might allow a debt crisis in one European country to spread to other countries in Europe.

ANSWER: Integration results in more international trade and capital flows, including loans extended from European banks to Greece. The crisis in Greece may prevent the Greek government from making its loan payments to banks in other countries. Thus, these banks may suffer major losses, which could cause financial problems or even failure, and this can affect economic conditions in other countries.

Commercial Paper Rates. Explain how investors' preferences for commercial paper change during a recession. How should this reaction affect the difference between commercial paper rates and T-bill rates during recessionary periods?

ANSWER: 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.

#23 CH1 Global Financial Market Regulations. Assume that countries A and B are of similar size, that they have similar economies, and that the government debt levels of both countries are within reasonable limits. Assume that the regulations in country A require complete disclosure of financial reporting by issuers of debt in that country, but that regulations in country B do not require much disclosure of financial reporting. Explain why the government of country A is able to issue debt at a lower cost than the government of country B.

ANSWER: Investors are more willing to invest in debt securities issued by the government of country A because there is more transparent information that would suggest country A can cover its payments owed on its debt. If the government of Country B does not disclose its financial information, investors cannot assess the financial condition and ability of the government to cover its payments owed on its debt. Thus, they are less willing to invest in debt securities issued by country B, so country B will have to offer a higher yield to entice investors.

#19 CH1 Impact of Credit Crisis on Liquidity. Explain why the credit crisis caused a lack of liquidity in the secondary markets for many types of debt securities. Explain how such a lack of liquidity would affect the prices of the debt securities in the secondary markets.

ANSWER: Investors were less willing to invest in many debt securities because they were concerned that these securities might default. As the investors reduced their investments, the secondary markets for these debt securities became illiquid. If there are many sellers of debt securities in the secondary market, and not many buyers, the prices of these securities should decline.

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

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

T-bill Auction. How can investors using the primary T-bill market be assured that their bid will be accepted? Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills?

ANSWER: Noncompetitive bids in the Treasury auction ensure acceptance by the Treasury. Large corporations make competitive bids because noncompetitive bidders are limited to the size of noncompetitive bids.

#2 Types of Markets. Distinguish between primary and secondary markets. Distinguish between money and capital markets. -CH1

ANSWER: Primary markets are used for the issuance of new securities while secondary markets are used for the trading of existing securities. Money markets facilitate the trading of short-term (money market) instruments while capital markets facilitate the trading of long-term (capital market) instruments.

Commercial Paper Ratings. Why do ratings agencies assign ratings to commercial paper?

ANSWER: Ratings are assigned to designate the degree of default risk associated with commercial paper. Companies issuing commercial paper pay rating services in order to have their paper rated.

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

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

#11 Depository Institutions. Explain the primary use of funds for commercial banks versus savings institutions. CH1

ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while commercial banks have concentrated in commercial lending. Savings institutions are now allowed to diversify their asset portfolio to a greater degree and will likely increase their concentration in commercial loans (but not to the same degree as commercial banks).

#10 Marketability. Commercial banks use some funds to purchase securities and other funds to make loans. Why are the securities more marketable than loans in the secondary market? CH1

ANSWER: Securities are more standardized than loans and therefore can be more easily sold in the secondary market. The excessive documentation on commercial loans limits a bank's ability to sell loans in the secondary market.

#20 CH1 Impact of Credit Crisis on Institutions. Explain why mortgage defaults during the credit crisis adversely affected financial institutions that did not originate the mortgages. What role did these institutions play in financing the mortgages?

ANSWER: Some financial institutions participated by issuing mortgage-backed securities that represented mortgages originated by mortgage companies. Mortgage-backed securities performed poorly during the credit crisis in 2008 because of the high default rate on mortgages. Some financial institutions that held a large amount of mortgage-backed securities suffered major losses at this time.

Systemic Risk. 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?

ANSWER: Some issuers of asset-backed commercial paper used mortgage-backed securities (MBS) as collateral. As the value of MBS declined during the credit crisis, institutional investors were no longer willing to invest in commercial paper secured by MBS. Thus, some financial institutions that were heavily invested in MBS could no longer issue commercial paper because they had no other assets available to post as collateral.

#3 CH4 Open Market Operations. Explain how the Fed increases the money supply through open market operations.

ANSWER: The Fed can increase money supply by purchasing securities in the secondary market.

#9 CH4 Open Market Operations. Explain how the Fed uses open market operations to reduce the money supply.

ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions.

#18 CH4 Fed Facility Programs During the Credit Crisis. Explain how the Fed's facility programs improved liquidity in some debt markets.

ANSWER: The Fed established facilities that provided loans to financial institutions that were willing to invest in some types of debt securities, such as bonds that were backed by consumer loans. In this way, the Fed increased the liquidity of these markets, which allowed easier access for consumers who wanted to borrow funds. The Fed also used some of its own funds to purchase commercial paper, which restored the liquidity of the commercial paper market.

#15 CH 4 The Fed's Impact on Home Purchases. Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers?

ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on mortgages. When the Fed reduces interest rates, it reduces the monthly payment to be made on new mortgages. Thus, it may increase the demand for homes by consumers. If it increases interest rates, it may reduce the demand for homes.

The Fed's Impact on the Housing Market. In periods when home prices declined substantially, some homeowners blamed the Fed. In other periods when home prices increased, homeowners gave credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a substantial increase in the general inflation level affect the Fed's monetary policy and thereby affect home prices?

ANSWER: The Fed influences interest rates, which affects the cost of borrowing, and this affects the ability of consumers to purchase a home. If interest rates are too high, some consumers are unable to afford the type of home they wish to purchase, because they can not afford the monthly payments on the mortgage. A sudden increase in inflation could prompt the Fed to use a restrictive monetary policy to slow economic growth, whereby interest rates are increased. The higher interest rates could reduce consumer demand for homes and may reduce home prices. In addition, if the Fed slows economic growth, this could also reduce demand for homes and home prices.

#22 CH 4 The Fed and Mortgage-Backed Securities How has the Fed used mortgage-backed securities in recent years, and what has it been trying to accomplish?

ANSWER: The Fed purchased large amounts of mortgage-backed securities during 2008 and 2009 in an attempt to calm investors' fears that the value of these securities would decline due to the high default rate on mortgages. The Fed has continued to purchase mortgage-backed securities in an effort to stimulate the housing market by creating a demand for mortgages and mortgage-backed securities.

24. Monetary Policy During Credit Crisis. During the credit crisis, the Fed used a stimulative monetary policy. Why do you think the total amount of loans to households and businesses did not increase as much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in the total amount of loans extended to households and businesses?

ANSWER: The Fed was successful at reducing interest rates. However, under very bad economic conditions, many potential business projects may not be feasible even at the lower cost of borrowing, because the potential cash flows from these projects are not sufficient to make the projects worthwhile. Also, the lending institutions were cautious when granting loans because of the high potential for default risk when lending to households or businesses during such a weak economy. Lending institutions should not extend loans unless they have confidence that the loans will be repaid.

#14 CH4 The Fed's Impact on Unemployment. Explain how the Fed's monetary policy affects the unemployment level.

ANSWER: The Fed's monetary policy affects interest rates, which affect the cost of borrowing by households and businesses, and therefore affect their level of spending for products and services. The aggregate demand for products and services affects the number of people employed by businesses and therefore affects the unemployment level.

#1 CH5 Impact of Monetary Policy. How does the Fed's monetary policy affect economic conditions?

ANSWER: The Fed's monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore affect the demand for loanable funds by influencing inflationary expectations.

#16 CH4 The Fed's Impact on Security Prices. Explain how the Fed's monetary policy may indirectly affect the prices of equity securities.

ANSWER: The Fed's monetary policy influences the aggregate demand for products and services, and therefore affects the cash flows generated by publicly-traded businesses. The value of the stock of a business is influenced by expectations of its future cash flows.

#24 CH4 The Fed and Long-Term Treasury Securities. Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed's usual operations?

ANSWER: The Fed's purchases of long-term Treasury securities differed from its normal open market operations, which focus on short-term Treasury securities. By purchasing long-term securities, the Fed hoped to reduce long-term Treasury bond yields, which would ultimately result in lower long-term borrowing rates. These lower borrowing rates would in turn stimulate the economy by encouraging more long-term borrowing by firms for capital expenditures and by individuals to purchase homes.

#19 CH4 Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established, and housed within the Federal Reserve. Explain the role of this bureau.

ANSWER: The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. The existence of a bureau can act more quickly to protect consumers from deceptive practices than waiting for Congress to pass new laws.

Risk and Return of Commercial Paper. 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?

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

Impact of Credit Crisis on Liquidity. Explain why the credit crisis affected the ability of financial institutions to access short-term financing in the money markets.

ANSWER: The credit crisis of 2008 had a major impact on the perceived credit risk of money market securities. Given the financial problems of some financial institutions in this period (government bailout of Bear Stearns in March 2008 and bankruptcy of Lehman Brothers in September 2008), it was difficult for financial institutions to raise funds in this market.

Motive to Issue Commercial Paper. The maximum maturity of commercial paper is 270 days. Why would a firm issue commercial paper instead of longer-term securities, even if it needs funds for a long period of time?

ANSWER: The firm may be unwilling to lock in the prevailing long-term yield on bonds, perhaps because it expects that long-term interest rates (and yields offered on new bonds) will decline in the near future.

#2 CH4 FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to achieve these goals?

ANSWER: The main goals of the FOMC are to promote high employment, economic growth, and price stability.

Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly implements a stimulative monetary policy to lower interest rates, and presumes that firms will be more willing to borrow. Even if banks are willing to lend, why might such a presumption about the willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong?

ANSWER: The presumption about firms borrowing may be wrong because in a weak economy, firms may be concerned that they may fail if they increase their debt. They may prefer not to borrow more funds until the economy improves. Consequently, firms will not correct the weak economy by spending more money, and the Fed's stimulative policy may be ineffective.

#7 CH5 Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag.

ANSWER: The recognition lag represents the time from when a problem exists until it is recognized by the Fed. It occurs because the economic statistics that are monitored to detect problems are only reported periodically. The implementation lag occurs when the Fed recognizes a problem but does not implement a policy to solve the problem until later.

Bear Stearns and the Repo Market. Explain the lesson to be learned about the repo market based on the experience of Bear Stearns.

ANSWER: The repo market funding requires collateral that is trusted by investors, and when economic conditions are weak, some securities may not serve as adequate collateral to obtain funding.

Secondary Market for T-bills. Describe the activity in the secondary T-bill market. How can this degree of activity benefit investors in T-bills? Why might a financial institution sometimes consider T-bills as a potential source of funds?

ANSWER: The secondary market for Treasury bills is very active, which makes Treasury bills more attractive because it enhances their liquidity. Financial institutions that have previously purchased Treasury bills can sell these securities in the secondary market whenever they need cash.

#8 CH5 Fed's Control of Inflation. Assume that the Fed's primary goal is to reduce inflation. How can it achieve its goal? What is a possible adverse effect of such action by the Fed (even if it achieves this goal)?

ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will reduce economic growth and inflationary pressure. A possible adverse effect is an increase in the unemployment rate.

#1 CH4 The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks.

ANSWER: Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and early 1900s, several bank panics occurred, which encouraged another attempt. In 1913, the Federal Reserve Act was passed and specified 12 districts across the United States, as well as a city in each district where a Federal Reserve district bank was to be established. The Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans to depository institutions in need of funds.

#20 CH4 Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its independent monetary policy and control over its domestic interest rates.

ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the European Central Bank (ECB), which controls the supply of euros in the banking system. The ECB influences the interest rate on euros regardless of the country. If the interest rate on euros was higher in one eurozone country, funds would flow to that country until the supply and demand conditions caused the interest rate there to be the same as in other euro countries.

#25 CH1 25. Impact of Systemic Risk. Different types of financial institutions commonly interact. They provide loans to each other, and take opposite positions on many different types of financial agreements, whereby one will owe the other based on a specific financial outcome. Explain why their relationships cause concerns about systemic risk.

ANSWER: When financial institutions interact through transactions, the failure of one financial institution can cause financial problems for others. As one financial institution fails, it defaults on payments owed on financial agreements with other financial institutions. Those institutions may have been relying on those payments to cover other obligations to another set of financial institutions. Thus, many financial institutions might be unable to cover their obligations, and this spreads fear that the financial system might collapse.

#10 CH4 Open Market Operations. Why do the Fed's open market operations have a different effect on money supply than do transactions between two depository institutions?

ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution, money is transferred to the depository institution without any offset at another institution. However, a similar transaction between depository institutions would increase the account balance at one institution and decrease the account balance at the other institution.

#10 CH5 Monetary Policy During the Credit Crisis. Describe the Fed's monetary policy response to the credit crisis.

The Fed used a stimulative monetary policy during the credit crisis because economic conditions were very weak. Specifically, the Fed's policy resulted in lower interest rates in the U.S.