Fina318: Essay Questions Test 2

Why inflation is important to savers and explain how savers can protect themselves against inflation

*Purchasing power* - Low inflation is good for savers, but only if they can find returns greater than inflation. - An unexpected increase in the inflation rate can unfairly hurt savers, since the inflation might not be factored into interest they receive. If you save money in an account to use for future spending, you want it to increase in purchasing power, so you have to *make sure the rate of return you earn is adjusted for expected inflation.*

Explain the importance of bond ratings and how ratings are used by markets and investors.

Agencies rate bonds based on default risk. As default risk increases, the rating drops. As the rating drops, the required rate of return (rd) on bonds rises. As rd rises, prices on outstanding bonds fall and new debt must be issued with a higher coupon rate. Bond rating Co.'s - Moody's, S&P - Investment grade - AAA (Aaa) - BBB (Baa) - Junk Bonds - BB (Ba) or lower. Many institutional *investors* are not allowed to invest in "junk" bonds.

Explain what a call provision is and how it affects both the borrower and the lender.

Allows borrower to retire the debt before maturity, sometimes at a premium (amount greater than par value). So, if borrower "calls" bonds, they pay off amount equal to or greater than par value, but they don't have to make any more annual interest payments. Companies are not likely to call bonds unless interest rates have declined significantly since the bonds were issued. Supposed a company sold bonds when interest rates were relatively high. Provided the issue is callable, the company could sell a new issue of low-yielding securities if and when interest rates drop, use the proceeds of the new issue to retire the high-rate issue, and thus reduce its interest expense.

Capital markets

Are the markets where long-term financial assets are traded. Long-term assets have a maturity of greater than one year, such as stocks and bonds.

Money markets

Are the markets where short-term securities are traded. Short-term assets have a maturity of one year or less, such as certificates of deposit.

Primary markets

Are where brand-new security issues are traded for the very first time. This is how corporations raise capital.

Secondary markets

Are where securities are traded among investors. The issuing firm is not involved in the transaction. This is where individual investors make or lose money.

What is a discount bond and when do bonds sell at discounts?

Bond is selling for less than par value. Vb < M This happens when *required rate of return is greater than coupon interest rate.*

What is a premium bond and when do bonds sell at premiums?

Bond is selling for more than par value. Vb > M This happens when required rate of return is less than coupon interest rate.

Explain why interest rates affect the stock market.

Businesses are significant borrowers of funds, so interest rates are costs. High interest rates -> lower cash flows Low interest rates -> higher cash flows Which in turn affects the stock market: Rising interest rates -> stock prices fall Falling interest rates -> stock prices rise

The difference between capital markets and money markets.

Capital Markets - Long-term, maturity of greater than one year (i.e. stocks and bonds). Money Markets - short-term, have a maturity of one year or less (i.e. certificates of deposit).

The difference between the coupon interest rate and the market interest rate.

Coupon interest rate: Annual interest rate, given as a percent of par value and normally fixed over the life of the contract. Market interest rate: In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a real risk-free rate, r*, plus several premiums that reflect inflation, the security's risk, its liquidity (or marketability), and the years to its maturity. This relationship can be expressed as follows: Quoted interest rate = r = r*+IP+DRP+LP+MRP

How the financial system functions.

For Direct transfers: Demanders send *securities (stocks or bonds)* over to Suppliers. In return, suppliers give money to demanders.

How does time to maturity affect bond values?

It affects its rate of interest you earn on your investment.

Explain the difference between mortgage bonds and debentures. Which has more risk and why would investors agree to buy bonds with greater risk?

Mortgage bonds - bond secured by assets. If borrower defaults, lenders seize specified assets. Have lowest default risk. Debentures - unsecured bond. If borrower defaults, lenders can claim property leftover after mortgage bonds are paid off. *Default risk is higher than mortgage (secured) bonds.* It will be reflected in their interest rates.

What happens when a borrower becomes insolvent?

Not enough funds meet interest payments. Lenders can force insolvent borrowers to either: - Reorganize: Negotiate with lenders to reduce debt, reduce interest rates and payments, etc. Reorganization allows firms to stay in business. - Liquidate: Sell all assets and "close up shop"

The purpose of the financial system.

Our financial system is a complex organization of institutions and markets with the basic goal of bringing together *suppliers (Savers) and demanders (Business) of money*.

What is default risk premium and why is it important?

Premium associated with *risk that borrower won't pay back the money borrowed.* It affects the market interest rate on a bond: The greater the bond's risk of default; the higher the market rate. // Borrowers are more likely to have a hard time paying off their debts.

What is liquidity risk premium and why is it important?

Premium associated with *securities that are hard to buy and sell.* A "liquid" asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but different financial assets vary in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on different debt securities.

What is maturity risk premium and why is it important?

Premium associated with *securities that have a long time to maturity.* Securities with longer time to maturity usually require a higher rate of return.

The difference between primary markets and secondary markets and who the participants are in both markets.

Primary markets - *Corporations* raise new capital. Secondary markets - Existing, already outstanding securities are traded among *investors*.

What is reinvestment rate risk and why is it important to investors?

Risk related to reinvesting money when bonds mature. Short term investments must be regularly reinvested, so they are subject to more reinvestment rate risk than long term bonds. Callable, long term bonds are also subject to high reinvestment rate risk. Reinvestment risk affects the income of the portfolio.

What is default risk and how can investors gauge default risk? Explain what happens to bond values when default risk changes.

Risk that borrower won't make interest payments or payoff par value. Investors can measure a bond's risk of default by using the interest coverage ratio. // To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk. If default risk of firm changes, *the value of bonds will change because the required rate of return (rd) changes.*

The role of a *commercial bank* in the financial system.

The commercial bank acts as the financial intermediary. In notes: Serve individual customers through savings accounts, checking accounts, certificates of deposit, loans, and etc. In Textbook: Transfers can also be made through a financial intermediary such as a bank, an insurance company, or a mutual fund. Here the intermediary obtains funds from savers/suppliers in exchange for its securities. The intermediary uses this money to buy and hold businesses' securities, while the savers hold the intermediary's securities.

The role of an *investment bank* in the financial system.

The facilitators, underwriters; traditionally help companies raise capital. From notes: Help businesses design and sell financial securities (such as stocks and bonds) in the financial market in order to raise money. From Textbook: They (a) help corporations design securities with features that are currently attractive to investors, (b) buy these securities from the corporation, and (c) resell them to savers.

What is interest rate risk and why is it important to investors?

The risk of capital losses to which investors are exposed because of changing interest rates. Since interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall, and vice versa. Bond investors, specifically those who invest in long-term fixed-rate bonds, are more directly susceptible to interest rate risk.

Explain the difference between yield to maturity, yield to call and current yield.

YTM - Rate of return you earn if you buy bond today at market price (Vb) and hold to maturity. YTC - Solving rate of return if you buy bond today at market price (Vb) and firm "calls" bond before maturity. Current yield is an investment's annual income (interest or dividends) divided by the current price of the security. This measure examines the current price of a bond, rather than looking at its face value.