M&B Ch. 6, 7, 9

Predict what will happen to the risk premiums on corporate bonds if brokerage commissions are lowered in the corporate bond market.

A reduction in commission fees reduces the cost of buying and selling bonds making them more liquid. The increase in liquidity increases the demand for the bonds so the price of corporate bonds rises and the interest rate falls.

If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

An increase in the slope of the yield curve indicates that people have revised their expectation of the average of short-term interest rates upward.

A depository institution has $100 million of rate sensitive assets and $150 million of rate sensitive liabilities. If interest rates rise by 2 percentage points, how much do income from assets and payments on liabilities each rise? what happens to profits?

Income from rate sensitive assets rise .02 x $100 million = $2 million while payments on rate sensitive liabilities rise .02 x $150 million = $3 million. The change in profits = the change in income minus the change in payments = $2 million - $3 million = -$1 million.

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

Since the default risk on corporate bonds is lower, the demand for them will rise. The increase in demand will raise the price of and reduce the interest rate on corporate bonds. As people buy more of the corporate bonds, the demand for Treasury bonds will fall. This decreases the price of and so raises the interest rate on Treasury bonds.

The bank you own has the following balance sheet Assets -Reserves $75 million -Loans $525 million Liabilities -Deposits $500 million -Bank Capital $100 million If the bank suffers a deposit outflow of $50 million with a required reserve ratio of 10%, what actions should it take?

The $50 million reduction in deposits reduces deposits to $450 million and reserves to $25 million. So, the bank is required to hold .10 x $450 million = $45 million as reserves but only holds $25 million on reserve. To rebuild reserves, you could borrow from other banks or from corporations. If you had used some of the funds from deposits and capital to buy bonds, you could have sold bonds. You could borrow from the Federal Reserve at the discount rate. Or you could sell loans to other banks.

Which would have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating?

The one with the C rating. The rating indicates it has a higher risk of default. With greater default its price should be lower and its interest rate higher than comparable bonds with lower risk.

What basic principle of finance can be applied to the valuation of any asset?

The price equals the present value of expected future cash flows.

During economic expansions, the expected growth rate of dividends should a. rise. Other things the same this increase should raise stock prices. b. rise. Other things the same this increase should reduce stock prices. c. fall. Other things the same this decrease should raise stock prices. d. fall. Other things the same this decrease should reduce stock prices.

a

If interest rates rise what happens to a bank's profits?

Since most of a bank's liabilities are short term and have variable rates, while most of its assets are long-term and have fixed rates the rise in the interest rate will raise the bank's interest payments on liabilities by more than it raises the bank's interest income on assets. So, the bank's costs have risen more than revenues and its profits fall.

IBM announces that it made $100 million last quarter, people were expecting it would announce that it had made $50 million of profits. Other things the same this announcement should a. raise the expected growth rate of dividends and so raise the price of IBM stock. b. raise the expected growth rate of dividends and so reduce the price of IBM stock. c. reduce the expected growth rate of dividends and so raise the price of IBM stock. d. reduce the expected growth rate of dividends and so reduce the price of IBM stock.

a

If a bank raised more funds from depositors and used those deposits to make loans and purchase securities, then its a. equity multiplier and return on equity capital would rise. b. equity multiplier would rise and its return on equity capital would fall. c. equity multiplier would fall and its return on equity capital would rise. d. equity multiplier and return on equity would fall.

a

If the default risk on one type of bond rises, but remains the same on other types of bonds then the interest rate a. rises only on the bond with higher default. b. rises only on the bond with no change in default. c. rises on both bonds. d. does not rise on either bond.

a

Interest rate risk for banks is a. the reduction in bank profits if interest rates rise. b. the increased probability of default when interest rates on variable rate loans rise. c. the risk that falling interest rates will reduce the value of a bank's securities. d. None of the above are correct.

a

Its net profits after taxes divided by its assets is a bank's a. return on assets. b. return on bank equity capital. c. equity multiplier. d. the equity multiplier times the return on assets.

a

If default risk on corporate bonds falls, the difference between the yield on corporate bonds and the yield on Treasury bonds a. rises b. does not change c. falls

c

If the income tax rate falls, then the demand for tax exempt bonds shifts a. right so their yield rises. b. right so their yield falls. c. left so their yield rises. d. left so their yield falls.

c

If you deposit a $1,000 check in a checking account at a bank, what's the immediate impact on the bank's assets? a. checkable deposits rise by $1,000. b. reserves rise by $1,000 c. cash items in the process of collection rise by $1,000 d. reserves rise by $1,000 times the reserve requirement ratio

c

In the short run an increase in the money supply causes a. interest rates and output to rise. b. interest rates to rise and output to fall. c. interest rates to fall and output to rise. d. interest rates and output to fall

c

Liquidity management refers to a bank a. holding as many liquid assets as possible. b. holding as many liquid liabilities as possible. c. balancing the revenue lost by holding reserves instead of other assets against the costs of using other methods to raise funds to meet deposits outflows. d. None of the above is correct.

c

The price of a bond rises, which of the following each could have caused this? a. it became more risky, and it became more liquid. b. it became more risky and it became less liquid. c. it became less risky and it became more liquid. d. it became less risky and it became less liquid.

c

The price of a share of stock is equal to a. the sum of its future payments. b. the value of the corporation's current assets divided by the number of stocks it has issued. c. the present value of its future dividends. d. None of the above is correct.

c

Which of the following is true concerning bank equity capital? a. It can't be used to reduce the chances of becoming insolvent. b. There are no laws concerning how much bank equity capital banks must hold. c. For a given level of assets and a given return on assets the less bank equity capital a bank holds, the higher its return on equity. d. None of the above are correct.

c

Which of the following list all the items banks can count as reserves to meet the reserve requirement? a. vault cash, deposits at the Fed, Treasury securities, and deposits at other banks b. vault cash, deposits at the Fed, and Treasury securities c. vault cash and deposits at the Fed d. vault cash

c

Which of the following would raise interest rates on long-term bonds? a. inflation is expected to be lower next year. b. real GDP is expected to fall next quarter c. people believe that it is more likely that the Federal Reserve will raise short-term interest rates in a few months. d. None of the above is correct

c

A bank could raise its equity capital multiplier by a. paying out larger dividends to shareholders. b. raising more funds from depositors and lenders to lend out or buy securities with. c. buying back shares of the banks stock from shareholders. d. All of the above raise the equity capital multiplier.

d

Bad economic news such as unexpectedly low growth in other economies a. raises the expected growth rate of dividends and so raises stock prices. b. raises the expected growth rate of dividends and so reduces stock prices. c. reduces the expected growth rate of dividends and so raises stock prices. d. reduces the expected growth rate of dividends and so reduces stock prices.

d

Dividends a. are gains from the sale of stock. b. the difference between the value of a stock and the price paid for it. c. the fees to purchase stock. d. periodic payments to stock holders as determined by the company's managers.

d

IBM announces that it made $50 million last quarter, people were expecting it would announce that it made $100 million of profits. Other things the same this announcement should a. raise the expected growth rate of dividends and so raise the price of IBM stock. b. raise the expected growth rate of dividends and so reduce the price of IBM stock. c. reduce the expected growth rate of dividends and so raise the price of IBM stock. d. reduce the expected growth rate of dividends and so reduce the price of IBM stock.

d

If default risk on a bond rises a. supply of the bond shifts right. b. supply of the bond shifts left. c. demand for the bond shifts right. d. demand for the bond shifts left.

d

If the interest on some type of bond was not tax exempt, but then became tax exempt, the demand for other bonds would a. shift right so their prices would rise. b. shift right so their prices would fall. c. shift left so their prices would rise. d. shift left so their prices would fall.

d

In managing bank assets banks should a. be very conservative by only lending to the most highly qualified borrowers to avoid default. b. hold very limited types of assets and lend most of their funds to a small number of borrowers c. Both a and b are correct. d. None of the above is correct.

d

If a bank is falling short of its capital requirements by $1 million what can it do to raise its capital relative to assets (or equivalently reduce its equity multiplier).

1. Raise capital by selling new stock. 2. Retain a greater share of earnings and so pay out less in dividends. 3. Reduce its assets by lending less and selling off securities it holds while raising fewer funds from depositors and lenders or paying back existing lenders and then not raising new funds.

If a bank has a reserve requirement of 10% and 2 billion dollars in deposits subject to the reserve requirement, what are its required reserves? What can it count towards meeting its required reserves?

10 percent of 2 billion is 200 million. The bank can use only vault cash and deposits at the Fed to meet its reserve requirements.

Interest on municipal bonds is a. not exempt from Federal income tax making their interest rates higher than otherwise. b. not exempt from Federal income tax making their interest rates lower than otherwise. c. exempt from Federal income tax making their interest rates higher than otherwise. d. exempt from Federal income tax making their interest rates lower than otherwise.

d

The rate of return on equity capital equals A. the rate of return on assets x assets/equity capital B. the rate of return on assets x equity capital/assets C. the rate of return on assets/equity capital D. None of the above are correct.

a

Which of the following is a bank asset? a. cash items in the process of collection b. customers' deposits at the bank c. borrowings it had made from the fed d. all of the above are bank assets

a

Which of the following would both increase the slope of the yield curve? a. an increase in expected future short-term interest rates, an increase in the liquidity premium. b. an increase in expected future short-term interest rates, a decrease in the liquidity premium. c. a decrease in expected future short-term interest rates, an increase in the liquidity premium. d. a decrease in expected future short-term interest rates, a decrease in the liquidity premium.

a

Which types of securities do banks either not hold or hold in very small amounts? a. municipal bonds and stocks b. municipal bonds and corporate bonds c. government agency bonds and stocks d. stocks and corporate bonds

d

Rank the following bank assets from most to least liquid. A. commercial loans B. securities C. reserves D. physical capital

C, B, A, D

Risk premiums on corporate bonds are usually anticyclical that is they decrease during business cycle expansions and increase during recessions. Why is this so?

During recessions sales fall so revenues fall making it more likely that a corporation will not be able to make payments on bonds.Note. Even if the risk premium rises, it is still the case that interest rates tend to be lower during recessions. The interest on corporate bonds fall by less than the interest on Treasury bonds.

Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans. Is this statement true, false, or uncertain? Explain your answer.

False. Diversification reduces risk, but if a bank specializes in making a specific type of loan, its experience will allow it to better judge credit risks and so reduce the problems created by moral hazard and adverse selection. Also, branches of a bank or loan officers within a branch could specialize.

Suppose that a stock becomes more risky. What does this to do the required return? What does this change in the required return do to the price of the stock? Is this consistent with what happens to the price of a bond if it becomes more risky?

If stock becomes more risky, stock buyers will want a higher return.According to the Gordon model the current price of a stock = D1/(ke - g)where ke is the required return on equity. Since potential stock buyers require a higher return, ke rises, which increases the denominator in the equation above and so reduces the price of stock. A similar result holds for bonds. If bonds become more risky, demand for them will fall so the price of them falls and the interest rate rises.

Explain what happens to stock prices if the Fed increases the interest rate.

If the Fed increases the interest rate, the required return on stock rises. The increase in the interest rate reduces spending and so reduces the expected earnings and so the expected dividends of firms. Both changes reduce the price of stock.

Suppose that a bank doubles its capital and its ROA stays constant what will happen to its ROE?

If the bank doubles its capital but uses the addition to capital to reduce its borrowings and or rely less on deposits, then the EM = assets/capital would fall in half. Since the ROE = EM x ROA, and ROA is fixed, if the EM drops by half, the return on equity drops by half. If the bank doubles its capital and uses the new capital to make loans and buy securities assets rise and capital rises. But since assets would have been larger than capital (provided the bank had at least some liabilities) the percentage change in assets will be smaller than the percentage change in capital. So, the equity multiplier will fall and so the return on equity will also fall.

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

If the tax exemption were abolished, municipal bonds would be less desirable, so demand would shift left which would reduce the price, so the interest rate would rise. Given that municipal bonds lose their tax-exempt status, Treasury bonds become relatively more desirable and so demand for them shifts right which raises their price and so reduces the interest rate.

What are the two main sources of cash flows for a stockholder? How reliably can these flows be estimated? Compare the problem of estimating stock cash flows to estimating bond cash flows. Which security would you predict to have the more volatile price?

The price of stock is based on expected future dividends and expected future price. The expected future price depends on expected future dividends. Dividends and stock prices tend to rise when a corporation is doing well and fall when a corporation is doing poorly. Which direction the profitability of a corporation will change in the future is nearly impossible to predict with any accuracy. Coupon payments and the face value of bonds are fixed, so the only issue estimating them is determining if the corporation will remain profitable enough to make the payments. By the arguments above we'd expect stock prices to be more volatile than bond prices.

Suppose that the interest rate on a two-year bond selling today is 6%. The interest rate on a one year bond is 5% and the liquidity premium is .2%. According to liquidity premium theory, what is the expected interest rate on a one-year bond to be sold in one year? What slope does the yield curve have?

The problem is set up as 6% = (5% + iet+1)/2 + .2%So, iet+1 = 6.6%. The slope of the yield curve is 1% point as a one-year increase in maturity is associated with a 1% point higher yield. The slope of the yield curve is greater than the liquidity premium indicating people expect short-term rates to rise.

If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?

The slope of the yield curve would decrease.

If a yield curve looks like the one shown in the figure below (upward sloping at short maturities and downward sloping at long ones), what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future?

The upward slope for the shorter maturities indicates that people are expecting short term rates to rise in the near future. The downward slope at longer maturities indicates people eventually expect short term interest rates to fall back towards their previous level. This may indicate the people are expecting inflation to rise for a while and then fall.

Bank equity capital is a. bank assets - bank liabilities, it is listed on the liability side of the bank's balance sheet b. bank assets-bank liabilities, it is listed on the asset side of the bank's balance sheet c. bank liabilities-bank assets, it is listed on the liability side of the bank's balance sheet d. bank liabilities - bank assets, it is list on the asset side of the bank's balance sheet

a

If a bank finds that its ROE is too low because it has too much bank capital (its Equity Multiplier is small), what three things can it do to raise its ROE?

To increase its rate of return on equity a bank needs either to fund a larger share of its assets with liabilities (by attracting more funds or borrowing more and the using these funds buy bonds or make loans) or decrease its equity capital the three ways a bank can reduce the size of its capital relative to assets and so raise the equity multiplier (become more leveraged) are: 1. Reduce capital by buying back some of the stock 2. Reduce capital by paying out higher dividends to shareholders 3. Raise additional funds from depositors and lenders, and then lend those funds out so assets increase.

A bank almost always insists that a firm it lends to holds compensating balances at the bank. Why?

When a business that borrows keeps a minimum amount in a checking account at the bank that gave it a loan, the balance acts as collateral, the bank builds a long- term relationship with the business, and the bank can monitor checking activities to reduce the possibility that the business will take on too much risk.

If tax rates fell, what would happen to: the price of municipal bonds, the interest rate on municipal bonds, the price of Treasury bonds, and the interest rate on Treasury bonds? (hints: would the decrease in tax rates make municipal bonds more or less appealing to bond holders? use bond supply and bond demand graphs)

When tax rates falls, the tax exemption on municipals will not be as desirable. So the demand for municipal bonds will fall and the demand for Treasury bonds will rise. So the price of municipal bonds falls and the price of Treasury bonds rises. So the interest rate on municipals bonds rises and the interest rate on Treasury bonds falls.

According to expectations theory, if the interest rate on a two-year bond is 5% in which case does the yield curve slope down? a. The expected interest rate on a one-year bond selling one year from today is 3% and the liquidity premium is 1⁄2%. b. The expected interest rate on a one-year bond selling one year from today is 5% and the liquidity premium is 1⁄4%. c. The expected interest rate on a one-year bond selling one year from today is 6% and the liquidity premium is 1⁄4%. d. The expected interest rate on a one-year bond selling one year from today is 7% and the liquidity premium is 1⁄2%.

a

An increase in the expected profitability of a corporation will a. likely benefit stock holders more than bond holders. b. likely benefit bond holders more than stock holders. c. benefit stock holders and bond holders equally. d. benefit neither stock holders or bond holders.

a

Bank equity capital comes from a. the value of the stock it has issued and retained earnings. b. the value of the stock it has issued but not retained earnings. c. retained earnings but not the value of the stock is has issued d. None of the above are correct

a

A bank's equity multiplier equals its a. bank equity capital divided by assets b. assets divided by its equity capital. c. equity capital divided by liabilities. d. liabilities divided by its equity capital.

b

A person who holds stock, a. can sell the stock to someone else, this sale raises new funds for the firm that issued the stock. b. can sell the stock to someone else, this sale does not raise new funds for the firm that issued the stock. c. cannot sell the stock to anyone else. d. can only sell the stock back to the corporation that issued it.

b

According to the Gordon growth model, if a stock is expected to pay a dividend of $1 in one year, dividends are expected to grow by 5% per year and the price is $20, what is the required rate of return? a. 5% b. 10% c. 15% d. 20%

b

Compensating balances a. is the difference between the amount of funds a lender requests and the amount the bank lends. b. are funds that borrowing firms must hold as collateral in a checking account. c. are the maximum amounts firms can borrow on an ongoing revolving basis. d. None of the above are correct.

b

If a bank raises its equity capital relative to its assets, it is a. less likely to become insolvent and its return on equity rises. b. less likely to become insolvent, but its return on equity falls. c. more likely to become insolvent, but its return on equity rises. d. more likely to become insolvent and its return on equity falls.

b

If corporate bonds became more liquid, then a. their price and the price of other bonds rise. b. their price rises and the price of other bonds fall c. their price falls and the price of other bond rises. d. their price and the price of other bonds fall.

b

If the liquidity of some type of bond rises, the demand for that bond a. shifts right, so its interest rate rises. b. shifts right, so its interest rate falls. c. shifts left, so its interest rate rises. d. shifts left, so its interest rate falls.

b

If the yield on bonds rises, the required return on stocks will a. rise which raises stock prices. b. rise which reduces stock prices. c. fall which raises stock prices. d. fall which reduces stock prices.

b

The interest rate on a two year bond selling today is 4%, the liquidity premium is .50% and the expected interest rate on a one-year bond selling one year from today is 2.75%. a. The yield curve slopes down perhaps because people are expecting an economic expansion. b. The yield curve slopes down perhaps because people are expecting a recession. c. The yield curve slopes up perhaps because people are expecting an economic expansion. d. The yield curve slopes up perhaps because people are expecting a recession.

b

Which of the following is correct? a. Bank assets generally have shorter terms to maturity than bank liabilities. b. An increase in lending between banks and the development of large negotiable CD's have given banks more flexibility in raising funds. c. Since 1960 banks have decreased lending as a percentage of their liabilities and increased checkable deposits as a percentage of their assets. d. All of the above are correct.

b

Which of the following is the largest category of bank assets? a. reserves b. loans c. securities d. other assets including physical capital such as its buildings and equipment

b

Which of the following is true concerning stocks? a. They pay dividends in fixed amounts. b. They represent a share of ownership in a corporation. c. In case the firm is short on funds or goes bankrupt stockholders are paid before bondholders. d. All of the above are correct.

b

An increase in the default risk on a bond a. raises its price and yield. b. raises its price and reduces its yield. c. reduces its price and raises its yield. d. reduces its price and yield.

c

Assets are a. a source of funds and the interest earned on them is a major source of revenue. b. a source of funds and the interest paid on them is a major cost. c. a use of funds and the interest earned on them is a major source of revenue. d. a use of funds and the interest paid on them is a major cost.

c

Credit rationing a. is setting interest rates high enough that only borrowers with low risk of default will apply for loans. b. is a discriminatory practice where loans are denied based on non-economic reasons. c. Includes denying loans at the advertised interest rate to customers who are deemed bad credit risks. d. None of the above are correct.

c

Default risk on a bond refers to missed or delayed payments of a. interest, but not of face value. b. face value, but not of interest. c. face value or of interest.

c

The interest rate on a one year bond is 4% while the interest rate on a two year bond is 5%. According to expectations theory with no liquidity premium a. the yield curve slopes downward implying that people expect that the interest rate on a one-year bond issued one year from today will be less than 5%. b. the yield curve slopes downward implying that people expect the interest rate on a one-year bond issued one year from today will be greater than 5%. c. the yield curve slopes upward implying that people expect the interest rate on a one-year bond issued one year from today will be less than 5%. d. the yield curve slopes upward implying that people expect the interest rate on a one-year bond issued one year from today will be greater than 5%.

d

Which of the following can a bank do to meet deposit outflows? a. use its excess reserves b. borrow in the Federal Funds market c. borrow from the Fed d. All of the above.

d

Which of the following correctly lists items from highest to smallest percentage of the balance sheet? a. checkable deposits, non-transactions deposits, borrowings b. borrowings, checkable deposits, non-transactions deposits c. non-transactions deposits, checkable deposits, borrowings d. non-transactions deposits, borrowings, checkable deposits

d

Which of the following is a part of bank asset management? a. seek high returns b. reduce risk c. make adequate provisions for liquidity d. All of the above are correct.

d

Which of the following is correct? a. A law requires stocks to pay dividends, if stocks did not pay dividends they would have no value. b. A law requires stocks to pay dividends, but even if stocks did not currently pay dividends they would have value because people expect corporations to eventually pay dividends. c. No law requires stocks to pay dividends, but if stocks did not pay dividends they would have no value. d. No law requires stocks to pay dividends, but even if a stock did not currently pay dividends it would have value because people expect corporations to eventually pay dividends.

d