Business Finance Chapter 6

All else equal, we should expect interest rates to be higher during periods when investors are anticipating high inflation.

True

All else equal, we would expect convertible bonds to have lower yields (interest rates) and callable bonds to have higher yields (interest rates).

True

Primary markets are essential for raising money

True

Secondary markets are essential for raising money

True

The 2 factors that are likely to be different on bonds with different maturities are the maturity premium and the inflation premium. The longer the time to maturity, the greater the maturity premium will be. The inflation premium will depend on inflation expectations.

True

The FED supervises and regulates the activities of banks and other financial institutions.

True

The premium give us a framework for explaining why different bonds have different yields.

True

Inflation Premium

-A % above the real risk-free rate of interest that allows the investor/saver to compensate for any loss in purchasing power due to inflation. -Its based on the expected average annual rate of inflation over the length of the investment.

Special Characteristics Premium

-Accounts for any special features that may be attractive or unattractive to investors. -There could be a call provision- limits the investors upside potential when interest rates go down, but doesn't help the investor if interest rates increase.

Choose the correct statement regarding the default risk premium.

-All else equal, the greater the likelihood of default, the greater the default risk premium. -Treasury bonds should have a zero (or close to it) default risk premium.

Choose the correct statement regarding the financial system.

-Both capital and securities flow both ways between financial markets and financial intermediaries. -When capital and securities flow between suppliers and demanders of capital through financial intermediaries, the securities issued/sol by the demanders of capital or often different than the securities purchased by the suppliers of capital.

Liquidity Risk Premium

-Compensates investors for the difficulty of turning their investments into cash on a timely basis for close to fair market value. -The more liquid an asset is, the more valuable. -Treasury securities are very liquid.

Default Risk Premium

-Compensates investors for the risk of a borrower defaulting on their loan. -There is a strong relationship between default premiums and bond ratings. The weaker the bond rating, the higher the default risk premium.

Financial Markets

-Help to bring together suppliers and demanders of capital in a more efficient manner if these suppliers and demanders of capital meet certain characteristics with respect to the financial securities that are being traded. -Work most efficiently if the # of identical financial securities are large, there are a large # of potential buyers and sellers for a particular security. -Stock Markets (NASDAQ, NYSE), etc.

Money Markets vs. Capital Markets

-Money- include all markets in which securities with 1-year or less remaining until maturity trade. Ex. and Treasury Bills and Commercial Paper which are both short-term debt securities issued by the fed. gov.. -Capital- includes all markets in which securities with more than 1-year remaining until maturity. Examples are stock markets, treasury bond markets, and corporate bond markets.

I recently took out a new car loan from my bank. Choose the correct statement regarding this transaction.

-My bank is acting as the financial intermediary in this transaction. -I am acting as the demander of capital

Primary Markets vs. Secondary Markets

-Primary- markets in which the security is sold for the first time. The security changes hands from the corporation that issues the security to the investor that purchases the security. Example is IPO market in which a firm issues shares of stock for the first time. A security can only trade in the primary market one time. -Secondary- markets in which the security is sold between investors. The firm that originally issued the stock or bond is not involved in the transaction and receives no money. Example is NYSE. The secondary market accounts for the bulk of trading activity in the financial markets.

Maturity Risk Premium

-Recognizes that longer-term securities are more risky than shorter-term securities.

Yield Curve

-Refers to a graph of interest rates on securities with different times to maturity. -Designed to illustrate the difference between long-term and short-term interest rates.

Real Risk-Free Rate of Interest

-Should represent the amount of compensation that investors feel is necessary to forego consumption today and instead save/invest that capital. This is typically a small amount in the range of 1% to 3% per year. -Fluctuates over time, but at any point in time should be approximately the same across all securities. -This is sometimes referred to as the "PURE RATE".

Shapes of Yield Curves

-The normal shape of the yield curve is upward sloping (due to the maturity premium). -Steep upward slope (more than a 1-2% yield difference between short-term and long-term bonds), that indicates that investors anticipate rising inflation (and, in turn, interest rates) in the future. -Flat or declining yield curve, that indicates that investors anticipate declining inflation (and interest rates) in the future. -Downward sloping yield curve is an indicator of a potential recession.

Financial Intermediaries

-act to process transactions between suppliers of capital and demanders of capital in which the financial markets are not efficient. -Examples- credit unions, commercial banks, mutual funds, life insurance companies, credit card companies.

The Federal Reserve System

-the central bank of US. created in 1913. -major goals today include full employment, stable prices, and moderate long-term interest rates.

Yield Curve Importance's:

-things like the default risk and liquidity risk should be held as constant as possible along the yield curve. -You want to draw a yield curve entirely with Treasury bonds or entirely wit BB-rate corporate bonds, but not a mix.

Functions of the FED

1. Open Market Operations- most common; FED purchases and sells US government and federal agency securities such as Treasury bills. 2. Discount Rate- FED can change this rate it charges on the loans made to commercial banks. 3. Reserve Requirements-

When I purchase 100 shares of Exxon I am acting as a supplier of capital and participating in the financial markets.

True

A downward sloping yield curve is a sign that expected inflation is highest on long-term securities than it is on short-term securities.

False

Because firms raise capital in the primary market and not the secondary market, the secondary market is essentially a casino where investors can bet on which stocks will go up or down. This "casino" may have a big impact on the wealth of individual investors, but is not important to firms as they have already received their capital when they originally issued the shares in the primary market.

False

Securities that can be sold quickly for fair market value are said to be liquid and therefore will have high liquidity premiums.

False

Suppliers of Capital

Refer to those people/institutions that have extra income during the current time period that they are not using on current consumption. Example- saving money for retirement, that is acting as a supplier of capital.

Liquidity

Refers to the ability to sell an asset quickly and for fair market value. Investors like liquidity.

Financial System

Refers to the complex of markets and institutions which help move capital (or cash) from suppliers of capital to demanders of capital.

Demanders of Capital

Refers to those people/institutions that need extra capital in order to meet their planned spending for the period an individual that is borrowing money for a new car, a firm that is issuing stock to expand production, etc.

The FED is divided into 12 districts. Each district has 1 main FED Bank which examines the activities of member banks located in their own district.

True-

"Since firms do not raise money in the secondary market, the secondary market provides no benefit to the financial system." Identify whether or not this statement is accurate and explain why. Note that you will not receive credit for part A without the explanation.

This statement is not accurate for the following reasons. For starters, the secondary market holds the majority of trading activities within the financial markets. A big perk that secondary markets bring to the table is that they are essential for providing liquidity and valuation information. Without having the secondary market, there would be no liquidity which would mean no more buying of securities on the primary market. Lastly, secondary markets also provide valuation information so this helps us understand the stock prices that people are keen on selling and/or buying.

You know that the Yield-to-Maturity (interest rate) on a particular bond is 6.28%. You estimate that expected inflation over the life of the bond is expected to average 2.78%. The default risk premium for this bond is 2.20%. The maturity risk premium for this bond is 0.2% The liquidity risk premium for this bond is 0.2%. There are no special characteristic premiums. Based on this, calculate the real rate of interest.

YieldA = k* + IP + DRP + LRP + MRP + SCP -->6.28% = k* + 2.78% + 2.20% + 0.2% + .02% + 0 K= 0.9%

Determinates of Interest Rates: k= k* + IP + DRP + LRP + MRP + SCP krf= k* +IP

k*= the real risk-free rate of interest krf= the risk-free rate of interest IP= the inflation premium DRP= the default risk premium LRP= the liquidity premium MRP= the maturity risk premium SCP= the special characteristics premium

Which of the following would be classified as a money-market security? -a zero coupon bond issued by GE that matures in 2018. -a share of common stock issued by Apple. -a 10% coupon bond issued by Exxon that matures in 2020. -a share of preferred stock issued by GM. -non of the above

none of the above