Assignment 7 TopHat: Financial Markets and International Capital Flows

Fred purchases a bond, newly issued by the Big Time Corporation, for $10,000. The bond pays $400 to its holder at the end of the first, second, and third years and pays $10,400 upon its maturity at the end of four years. The principal amount of this bond is __________, the coupon rate is __________, and the term of this bond is __________.

$10,000; 4 percent; four years

Sydney purchases a newly-issued, two-year government bond with a principal amount of $10,000 and a coupon rate of 6% paid annually. One year before the bonds matures (and after receiving the coupon payment for the first year), Sydney sells the bond in the bond market. What price (rounded to the nearest dollar) will Sydney receive for his bond if the prevailing interest rate is 5%?

$10,095

You expect a share of EconNews.Com to sell for $65 a year from now. If you are willing to pay $62.73 for one share of the stock today, and you expect a dividend payment of $4, what rate of return do you require?

10%

One year before maturity, the price of a bond with a principal amount of $1,000 and a coupon rate of 5 percent paid annually fell to $981. The one-year interest rate must be:

7%

You expect a share of EconNews.Com to sell for $65 a year from now. If you are willing to pay $61.06 for one share of the stock today, you expect a dividend payment of $4, and the rate of return on safe assets is 5 percent, how much is your risk premium?

8%

How are capital inflows and outflows related to domestic investment in new capital goods?

A capital inflow leads to funds flowing into a country, which in turn can be used for domestic investment in new capital goods. A capital inflow allows a country whose productive investment opportunities are greater than domestic savings to finance those investment opportunities by borrowing from abroad, increasing the total amount of investment in new capital goods. Domestic countries who finance domestic capital formation largely through capital inflows must pay interest and dividends to the foreign lenders in the future, which could impose a future burden on the domestic country. However, the hope is that the investment in new capital goods will increase domestic productivity, allowing the borrowing country to pay back its loans while benefiting from increased output and incomes in the meantime. Capital outflows have the opposite effect on investment in new capital. A capital outflow leaves less domestic savings to finance investment opportunities, leading to less investment in new capital goods.

A country's domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment and the real interest rate.

Equilibrium in the market for saving and investment requires S + KI = I (1,500 + 2,000r) + (-100 + 6,000r) = 2,000 - 4,000r 12,000r = 600 r= 0.05 = 5% Given that the real interest rate is 5%, we can find that domestic saving is 1,500 + 2,000(0.05) = 1,600, capital inflows are -100 + 6,000(0.05) = 200, and investment is 2,000 - 4,000(0.05) = 1,800.

Explain with examples why a country's net capital inflow must equal its trade deficit in any given period.

If a country imports a good or service, it must pay for that import somehow. If it pays for the import by selling an export of equal value, then the trade balance is zero and the capital inflow is also zero. If it pays for the import by selling a financial asset or by borrowing from abroad, then the country experiences a capital inflow equal in value to the import. Thus its net capital inflow equals its trade deficit.

Suppose that you are much less concerned about risk than the typical person. Are stocks a good financial investment for you? Why or why not?

Stock values are fairly volatile and so carry a risk premium. In other words, the typical investor will hold stocks only if she expects to earn a higher return on average holding stocks than holding a safer asset, such as government bonds. If the relative riskiness of stocks does not bother you, then stocks are a good financial investment because of the higher return that you can expect to earn (on average, but not for certain) by holding them.

A country's domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r Repeat part a, assuming that desired national saving declines by 120 at each value of the real interest rate. What effect does a reduction in domestic saving have on capital inflows?

Suppose now that S = 1,380 + 2,000r. The condition S+ KI = I becomes (1,380 + 2,000r) + (-100 + 6,000r) = 2,000 - 4,000r 12,000r= 720 r = 0.06 = 6% Now domestic saving is 1,380 + 2,000(0.06) = 1,500, capital inflows are -100 + 6,000(0.06) = 260, and investment is 2,000 - 4,000(0.06) = 1,760. The reduced domestic saving has raised the domestic real interest rate, which has attracted additional capital inflows from abroad (KI rises from 200 to 260). The extra capital inflows partially offset the decline in domestic saving.

A country's domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r Concern about the economy's macroeconomic policies cause capital inflows to fall sharply so that now KI = - 700 + 6000r. Repeat part a. What does a reduction in capital inflows do to domestic investment and the real interest rate?

The condition S + KI = I becomes (1,500 + 2,000r) + (-700 + 6,000r) = 2,000 - 4,000r 12,000r = 1200 r = 0.10 = 10% Domestic saving is 1,500 + 2,000(0.10) = 1,700; capital inflows are -700 + 6,000(0.10) = -100 (that is, there is a net capital outflow); and investment is 2,000 - 4,000(0.10) = 1,600. Note that the reduction in capital inflows has raised the real interest rate and reduced domestic investment. This illustrates why "capital flight" (sharp increases in capital outflows) is of particular concern for developing countries.

In the United States saving is allocated to its most productive use by:

a decentralized, market-oriented financial system.

During the 1960s and 1970s, the U.S. trade balance was close to zero, but during the 1980s, the trade deficit ballooned to unprecedented levels due to:

a decline in national saving caused largely by rapidly rising government budget deficits.

When a U.S. oil company purchases oil from Saudi Arabia and the Saudi Arabian firm uses the proceeds from the sale to buy transportation services from the U.S., U.S. net exports __________ and the capital inflow to the United States __________.

are unchanged; is unchanged (The oil purchase by the U.S. company is an import to the U.S. On the other hand, the purchase by the Saudi Arabian firm of U.S. transportation services is an export for the U.S. These cancel out and there is no change in net exports or capital inflows.)

Each of the following is an example of a financial intermediary EXCEPT a:

bond market.

Financial intermediaries, such as commercial banks, provide benefits to:

both savers and borrowers.

When a Peruvian buys a U.S. government bond, from the perspective of US, this is a(n):

capital inflow.

When the Chinese government buys U.S. government bonds, from the perspective of China, this is a(n):

capital outflow

You own shares in a start-up internet company. If large swings in the stock market increase financial investors' concerns about market risk, then the price of your shares will __________, holding other factors constant.

decrease

In an open economy with a given level of real interest rates and risk, an increase in real interest rates abroad will __________ capital inflows and __________ the equilibrium domestic real interest rate.

decrease; increase

In an open economy, a decrease in the government's budget deficit will __________ the domestic real interest rate and __________ the level of capital investment in the country, holding other factors constant.

decrease; increase

When the interest rate on newly issued bonds increases, the price of existing bonds:

decreases

The sum of national saving and capital inflows from abroad must equal:

domestic investment in new capital goods. (Since S − NX = I, and NX + KI = 0, then S + KI = I.)

Two reasons savers keep deposits at banks are to:

earn a return on their savings and to facilitate making payments.

A trade deficit occurs when

imports exceed exports

When Federal Reserve actions cause interest rates on newly issued bonds to decrease from 6% to 5%, the prices of existing bonds:

increase

You originally required a risk premium of 6 percent in addition to the rate of return on safe assets before you would purchase shares of Techno Company stock. If you and other investors reduce the risk premium you require to 4 percent, the price of Techno Company stock will:

increase

You own shares in a well-managed and diversified company. If a booming economy decreases investors' concerns about market risk, then the price of your shares will __________, holding other factors constant.

increase

Holding constant risk and the real returns available abroad, higher domestic real interest rates __________ capital inflows, __________ capital outflows, and __________ net capital inflows.

increase; decrease; increase (Higher domestic real interest rates make investors domestic and foreign more likely to invest in the domestic economy compared to foreign economies. This reduces capital outflows and increases net capital inflows.)

In an open economy, a decrease in capital inflows __________ the equilibrium domestic real interest rate and __________ the quantity of domestic investment.

increases; decreases

The benefits of net capital inflows to a country include all of the following except:

interest and dividend payments owed to foreign investors.

The coupon rate is:

interest rate promised when a bond is issued.

The current price of a stock increases when:

interest rates decrease.

The financial system consists of financial __________, such as commercial banks, and financial markets, such as the stock market.

intermediaries

The coupon rate on newly issued bonds is usually higher for bonds with __________ terms and __________ risk that the borrower will go bankrupt.

longer; greater

A financial intermediary that sells shares in itself to the public, and then uses the funds to buy a wide variety of financial assets is called a:

mutual fund

If the United States has a $300 billion trade deficit, then there must be:

net capital inflows of $300 billion. (This follows from the accounting identity NX + KI = 0. Here, NX is net exports of -$300 billion and KI, net capital inflows, must be $300 billion.)

An economy with a trade surplus must also have:

positive net capital outflows.

The specialized information-gathering activities that banks use to evaluate borrowers are an example of the:

principle of comparative advantage.

Decentralized market-based financial systems improve the allocation of saving by:

providing information and risk-sharing services.

International capital flows are:

purchases or sales of real and financial assets across international borders.

The rate of return that financial investors require to hold a risky asset minus the rate of return on a safe asset is called the:

risk premium.

If domestic saving is less than domestic investment, then a country will have a __________ and positive net capital __________.

trade deficit; inflows (If domestic savings is less than domestic investment then capital inflows are positive. This follows from the equation S + KI = I. Since KI is positive, NX must be negative (there must be a trade deficit), as is shown by the equation NX + KI = 0.)

If domestic saving is greater than domestic investment, then a country will have a __________ and positive net capital __________.

trade surplus; outflows