Financial Markets and Institutions: Chapter 1, Chapter 2, Chapter 3

Explain the liquidity premium theory.

If investors believe that securities with larger maturities are less liquid, they will require a premium when investing in such securities to compensate. This theory can be combined with the other theories to explain the shape of a yield curve.

Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time?

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.

If liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market's perception of future interest rates?

A flat yield curve without consideration of a liquidity premium would represent no expected change in interest rates according to the pure expectations theory. Therefore, if the flat yield curve reflects the existence of a liquidity premium, this curve would actually have a slight downward slope when removing the liquidity premium. This suggests expectations of a slight decline in future interest rates.

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?

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.

If the segmented markets theory causes an upward-sloping yield curve, what does this imply? If markets are not completely segmented, should we dismiss the segmented markets theory as even a partial explanation for the term structure of interest rates? Explain.

An upward-sloped yield curve caused by segmented markets implies that the demand for short-term funds is low relative to the supply of short-term funds. In addition, the demand for long-term funds is high relative to the supply of long-term funds. Even if markets are not completely segmented, investors and borrowers may prefer a particular maturity market. Therefore, they may only switch to a different maturity if there is sufficient compensation (such as a higher return for investors or a lower cost of borrowing for borrowers).

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?

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.

Should increasing money supply growth place upward or downward pressure on interest rates?

If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply).

Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years?

Interest rates among countries are expected to be more highly correlated in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country's interest rates. The international flow of funds caused this type of reaction.

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.

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.

Assume there is a sudden expectation of lower interest rates in the future. What would be the effect on the shape of the yield curve? Explain.

The demand for short-term securities would decrease, placing downward (upward) pressure on their prices (yields). The demand for long-term securities would increase, placing upward (downward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now be more horizontal (less steep). If it was downward sloped, it would now be more steep.

Explain the preferred habitat theory.

The preferred habitat theory suggests that while investors and borrowers may prefer a natural maturity, they may wander from that maturity under conditions where they can benefit from selecting a different maturity.

The interest rate on a one-year loan can be decomposed into a one-year risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is normally affected by changing economic conditions to a greater degree than the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury, and (b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation?

The weaker economy will likely reduce the risk-free component and will increase the risk premium. The overall cost of borrowing is reduced for a loan to the Treasury and a loan to a corporation. There is a partial offsetting effect on the interest rate of the loan to the corporation. However, the Treasury does not have risk of default so there is no effect on the risk premium on a loan to the Treasury. The weaker economy will have a more pronounced impact on the interest rate of the loan to the Treasury, because there is no offsetting effect.

What factors influence the shape of the yield curve? Describe how financial market participants use the yield curve.

The yield curve's shape is affected by the demand and supply conditions for securities in various maturity markets. Expectations of interest rates, the desire for liquidity, and the desire by investors or borrowers for a specific maturity will influence the demand and supply conditions. The yield curve can be used to determine the market's expectations of future interest rates. Market participants can compare their own expectations to the market's expectations to determine their borrowing or investing decisions.

Assume that the yield curves in the United States, France, and Japan are flat. If the U.S. yield curve suddenly becomes so positively sloped, do you think the yield curves in France and Japan would be affected? If so, how?

The yield curves in other countries would also be affected if the event precipitating the shift in the U.S. yield curve affects either actual or expected interest rates in other countries. If long-term interest rates in the United States rise in response to a greater U.S. demand for long-term funds, then the yield curve may have an upward slope. To the extent that this event attracts long-term funds in other countries, there would be a smaller supply of long-term funds in those countries, which could cause higher long-term rates there. Consequently, their yield curves would have an upward slope.

Perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries.

With perfect financial markets, all information about any securities for sale would be freely available to investors, information about surplus and deficit units would be freely available, and all securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and deficit units do not have free access to information, and securities cannot be unbundled as desired. Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit units. They have the information to provide this service and can even repackage deposits to provide the amount of funds that borrowers desire.

If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets?

A downward-sloped yield curve suggests that the demand for short-term funds is high relative to the supply of short-term funds, causing a high yield. In addition, the demand for long-term funds is low relative to the supply of long-term funds, causing a low yield.

Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, Jayhawk believed that the deficit's impact would more than offset the effects of other factors, so it forecast interest rates to increase by 2 percent. Comment on Jayhawk's logic.

A reduction in the deficit should free up some funds that had been used to support the government borrowings. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates.

War tends to cause significant reactions in financial markets. Why might a war in the Middle East place upward pressure on U.S. interest rates? Why might some investors expect a war like this to place downward pressure on U.S. interest rates?

A war places upward pressure on U.S. interest rates because it may (1) increase inflationary expectations in the United States if oil prices increase abruptly, and (2) increase the expected U.S. budget deficit as government expenditures were necessary to boost military support. However, it may also cause some analysts to revise their forecasts of economic growth downward. The slower economy reflects a reduced corporate demand for funds, which by itself places downward pressure on interest rates. If inflation was not a concern, the Fed may attempt to increase money supply growth to stimulate the economy. However, the inflationary pressure can restrict the Fed from increasing the money supply to stimulate the economy (since any stimulative policy could cause higher inflation).

If the federal government planned to expand the space program, how might this affect interest rates?

An expanded space program would (a) force the federal government to increase its budget deficit, (b) possibly force any firms involved in facilitating the program to borrow more funds. Consequently, there is a greater demand for loanable funds. The additional spending could cause higher income and additional saving. Yet, this impact is not likely to be as great. The likely overall impact would therefore be upward pressure on interest rates.

During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should result in a higher number of feasible projects, which should encourage businesses to borrow more money and expand. Yet, many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, therefore discouraging businesses from expanding?

Businesses recognized that the cash flows to be generated from their projects would be low because the demand for their products and services was limited. Households could not afford to purchase more products. Thus, while low interest rates allow businesses to borrow funds cheap, many possible projects were not feasible because the expected cash flows were not sufficient.

With regard to the profit motive, how are credit unions different from other financial institutions?

Credit unions are non-profit financial institutions.

Identify the relevant characteristics of any security that can affect the security's yield.

Default risk, liquidity, tax status, maturity

Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they react to recessionary periods. Explain this reaction.

During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result.

Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds.

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.

Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? Do municipal bonds or corporate bonds offer a higher before-tax yield at a given point in time? Why? Which has the higher after-tax yield? If taxes did not exist, would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity? Why?

High-tax bracket investors benefit more from tax-exempt securities because their tax savings from avoiding taxes is greater. Corporate bonds offer a higher before-tax yield, since they are taxable by the federal government. The municipal bonds may have a higher tax yield for investors subject to a high tax rate. For low-tax bracket investors, the corporate bonds would likely have a higher after-tax yield. If taxes did not exist, Treasury bonds would offer a lower yield than municipal bonds because they are perceived to be risk-free. Thus, the required return on Treasury bonds would be lower than on municipal bonds.

In what way could the international flow of funds cause a decline in interest rates?

If a large volume of foreign funds was invested in the United States, it could place downward pressure on U.S. interest rates. Without this supply of foreign funds, U.S. interest rates would have been higher.

If barriers to international securities markets are reduced, will a country's interest rate be more or less susceptible to foreign lending and borrowing activities?

If international securities market barriers are reduced, a country's interest rate will likely become more susceptible to foreign lending and borrowing activities. Without barriers, funds will flow more freely in between countries. Funds would seek out countries where expected returns are high. Then, the amount of foreign funds invested in any country could adjust abruptly and affect interest rates.

Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates. The federal government demand for loanable funds should be less interest elastic than the consumer demand for loanable funds, because the government's planned borrowings will likely occur regardless of the interest rate. Conversely, the quantity of loanable funds by consumers is more responsive to the interest rate level.

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.

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.

What effect does a high credit risk have on securities?

Investors require a higher risk premium on securities with a high default risk.

Money and capital markets

Money markets facilitate the trading of short-term (money market) instruments while capital markets facilitate the trading of long-term (capital market) instruments.

Primary and secondary markets

Primary markets are used for the issuance of new securities while secondary markets are used for the trading of existing securities.

Explain the primary use of funds for commercial banks versus savings institutions.

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).

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?

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.

Why do you think securities are commonly standardized? Explain why some financial flows of funds cannot occur through the sale of standardized securities. If securities were not standardized, how would this affect the volume of financial transactions conducted by brokers?

Securities can be more easily traded when they are standardized because the specifics of the security transaction are well known. If securities were not standardized, transactions would be slowed considerably as participants would have to negotiate all the provisions. If securities were not standardized, the volume of financial transactions conducted by brokers would be reduced, because the documentation would be greater.

What are the functions of securities firms? Many securities firms employ brokers and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how each is compensated.

Securities firms provide a variety of functions (such as underwriting and brokerage) that either enhances a borrower's ability to borrow funds or an investor's ability to invest funds. Brokers are commonly compensated with commissions on trades, while dealers are compensated on their positions in particular securities. Some dealers also provide brokerage services.

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?

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.

Surplus units and deficit units

Surplus units provide funds to the financial markets while deficit units obtain funds from the financial markets. Surplus units include households with savings, while deficit units include firms or government agencies that borrow funds.

Explain how a yield curve would shift in response to a sudden expectation of rising interest rates, according to the pure expectations theory.

The demand for short-term securities would increase, placing upward (downward) pressure on their prices (yields). The demand for long-term securities would decrease, placing downward (upward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now have a steeper slope as a result of the expectation. If it was originally downward sloped, it would now be more horizontal (less steep), or may have even become upward sloping.

How might expectations of higher global oil prices affect the demand for loanable funds, the supply of loanable funds, and interest rates in the United States? Will this affect the interest rates of other countries in the same way?

The expectations of higher oil prices will cause concern about the possible increase in inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds now before prices increase and before interest rates increase. Consumers may use their savings now to buy products before the prices increase. Therefore, the demand for loanable funds should increase, the supply of loanable funds should decrease, and interest rates should increase in the U.S. The impact of higher global oil prices in other countries is not necessarily the same. If the country produces its own oil, it can set the oil prices in its country. If it can prevent high oil prices in its country, then the prices of products (gasoline) and services (transportation) may not be affected. Therefore, interest rates may not be affected.

What is the meaning of the forward rate in the context of the term structure of interest rates? Why might forward rates consistently overestimate future interest rates? How could such a bias be avoided?

The forward rate is the expected interest rate at a future point in time. If forward rates are estimated without considering the liquidity premium, it may overestimate the future interest rates. If a liquidity premium is accounted for when estimating the forward rate, the bias can be eliminated.

Discuss the relationship between the yield and liquidity of securities.

The greater the liquidity of a security, the lower is the yield, other things being equal.

Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.

The interest rate in the future should increase if economic growth and inflation are expected to rise, or decrease if economic growth and inflation are expected to decline.

What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

The nominal interest rate is the quoted interest rate, while the real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the recent nominal interest rate minus the recent inflation rate. Investors require a positive real return, which suggests that they will only invest funds if the nominal interest rate is expected to exceed inflation. In this way, the purchasing power of invested funds increases over time. As inflation rises, nominal interest rates should rise as well since investors would require a nominal return that exceeds the inflation rate.

In some countries where there is high inflation, the annual interest rate is more than 50 percent, while in other countries such as the U.S. and many European countries, the annual interest rates are typically less than 10 percent. Do you think such a large interest rate differential is primarily attributed to the difference in the risk-free rates or to the difference in the credit risk premiums between countries?

The risk-free foreign interest rates are determined by supply and demand for funds in their local currency. Inflationary expectations affect the risk-free interest rate. Thus, the difference in interest rates between the countries with very high interest rates versus low interest rates is primarily attributed to risk-free rate differentials. The credit risk premium is typically higher in the countries with very high interest rates, but that is not the primary reason for the large difference between countries with very interest rates versus low interest rates.

Offer an argument for why the terrorist attack on the United States on September 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argument for why that attack could have placed upward pressure on U.S. interest rates.

The terrorist attack could cause a reduction in spending related to travel (airlines, hotels), and would also reduce the expansion by those types of firms. This reflects a decline in the demand for loanable funds, and places downward pressure on interest rates. Conversely, the attack increases the amount of government borrowing needed to support a war, and therefore places upward pressure on interest rates.

Assume that (1) investors and borrowers expect that the economy will weaken and that inflation will decline, (2) investors require a small liquidity premium, and (3) markets are partially segmented and the Treasury currently has a preference for borrowing in short-term markets. Explain how each of these forces would affect the term structure, holding other factors constant. Then explain the effect on the term structure overall.

The weak economy creates the expectation of a decline in interest rates, so according to expectations theory, there would be a downward-sloping yield curve. The liquidity premium results in a slight upward slope to the yield curve. The Treasury's preference would result in a downward-sloping demand yield curve, when other factors are held constant. Overall, there would be a downward-sloping yield curve because the expectations and segmented markets effects would overwhelm the liquidity effect.

Assume that the yield curve for Treasury bonds has a slight upward slope, starting at 6% for a 10-year maturity and slowly rising to 8% for a 30-year maturity. Create a yield curve that you believe would exist for A-rated bonds. Create a yield curve that you believe would exist for B-rated bonds.

The yield curve for A-rated bonds would likely have a similar slope as the yield curve for Treasury securities, but would be higher because of a credit risk premium. The yield curve for B-rated bonds would likely have a similar slope as the yield curve for A-rated bonds, but would be higher because of a credit risk premium.

Use the loanable funds framework to explain how European economic conditions might affect U.S. interest rates.

Weak European conditions could weaken U.S. economic conditions, because the economies are integrated through international trade and investment. If the European economy causes economic conditions in the U.S. to weaken, it can reduce the demand for loanable funds in the U.S. In addition, the weak European economy might cause European firms to borrow fewer funds from the U.S. market. Either of the forces explained here reflect a decline in the demand for loanable funds, which places downward pressure on interest rates.

Explain how consideration of a liquidity premium affects the estimate of a forward interest rate.

When considering a liquidity premium, the estimate of a forward interest rate will be reduced.

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.

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.

During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.

When investors shift funds out of stocks, they move it into money market securities, causing an increase in the supply of loanable funds, and lower interest rates.