10: Questions & Answers

Contrast investors' use of capital markets with their use of money markets.

(1) Institutions operating in the capital markets access them to raise capital for long-term purposes, such as for a merger or acquisition, to expand a line of business or enter into a new business, or for other capital projects. Entities that are raising money for these long-term purposes come to one or more capital markets. In the bond market, companies may issue debt in the form of corporate bonds, while both local and federal governments may issue debt in the form of government bonds. Similarly, companies may decide to raise money by issuing equity on the stock market. (2) While investors are willing to take on more risk and have patience to invest in capital markets, money markets are a good place to "park" funds that are needed in a shorter time period - usually one year or less. The financial instruments used in capital markets include stocks and bonds, but the instruments used in the money markets include deposits, collateral loans, acceptances and bills of exchange. Institutions operating in money markets are central banks, commercial banks and acceptance houses, among others. Liquidity is often the main purpose for accessing money markets. When short-term debt is issued, it is often for the purpose of covering operating expenses or working capital for a company or government and not for capital improvements or large scale projects. Companies may want to invest funds overnight and look to the money market to accomplish this, or they may need to cover payroll and look to the money market to help. The money market plays a key role in ensuring companies and governments maintain the appropriate level of liquidity on a daily basis, without falling short and needing a more expensive loan or without holding excess funds and missing the opportunity of gaining interest on funds.

How can a change in interest rates affect the profitability of financial institutions?

1. A change in interest rates affects the cost of acquiring funds for financial institution 2. It changes the income on assets such as loans, both of which affect profits 3. It affect the price of assets such as stock and bonds that the financial institution owns that can lead to profits or losses

Is everybody worse off when interest rates rise?

1. Borrowers are worse off because it costs them more to finance their purchase such as a house 2. Savers benefit because they can earn higher interest rates on their savings

When interest rates rise, how might businesses and consumers change their economic behaviour?

1. Businesses would cut investment spending because the cost of financing this spending is now higher 2. Consumers would be less likely to purchase a house or a car because the cost of financing their purchase is higher

1. Explain why you would be more or less willing to buy a share of Polaroid stock in the following situations: 1. Your wealth falls 2. You expect it to appreciate in value 3. The bond market becomes more liquid. 4. Prices in the bond market become more volatile.

1. Less willing because your wealth falls 2. More willing because its relative expected value increases 3. Less willing because it becomes less liquid relative to bonds 4. More willing because it becomes less risky relative to bonds

2. Explain why you would be more or less willing to buy a house under the following circumstances: 1. You just inherited a fortune 2. Real estate commissions fall from 6% of the sales price to 4% of the sales price 3. You expect Polaroid stock to double in value next year 4. You expect housing prices to fall

1. More willing because your wealth has increased 2. More willing because it has become more liquid 3. Less willing because its expected return relative to other investments has reduced 4. Less because its expected return has fallen

What is a sinking fund? Do investors like bonds that contain this feature? Why?

A provision in many bond contracts that require the issuer to pay off a portion of the bond issue each year. Investors like sinking funds because it reduces probability of default when issue matures.

Give one example each of moral hazard and adverse selection in private insurance arrangements.

A reckless driver is more likely to crash his car than a non-reckless driver. If a private insurance company does not vary prices according to recklessness, its private insurance will be a better buy reckless drivers than for non-reckless drivers. So reckless drivers may be more likely to buy insurance from that company, or may tend to buy larger amounts than non-reckless drivers, thereby raising the average car accidents of the combined policyholder group above that of the insured population in general, and leading to losses for the company and/or higher prices for all that company's customers. After purchasing the insurance, the reckless driver will drive even more recklessly - someone else now bears the burden of his risk - thereby increasing the risk accidents.

11. If the income tax exemption on municipal bonds were abolished, what would happen to the interest rate on these bonds? What effect would it have on the rates of US treasury securities?

Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.

9. Which bond will produce a greater return if the expectations theory were to hold true, a two-year bond with an interest rate of 15% or two 1-year bonds with sequential interest payments of 13% and 17%?

According to the textbook's approximation these two bonds will produce the same return. In reality the two year bond will yield (1.15)^2=1.3225 and the two 1-year sequential bonds will yield (1.13)(1.17) = 1.3221. Thus the two year bond produces a greater return.

What is the National Association of Securities Dealers Automated Quotation System (NASDAQ)?

An ECN providing current bid and ask prices on about 3,000 actively traded securities. Dealers "make a market" in these stocks by buying for inventory when investors want to sell and selling from inventory when investors want to buy. These dealers provide small stocks with the liquidity that is essential to their acceptance in the market. Total volume on the NASDAQ is usu- ally slightly lower than on the NYSE; however, NASDAQ volume has been growing and occasionally exceeds NYSE volume.

Discuss the features that differentiate organized exchanges from the over-the-counter market.

An exchange centralizes the communication of bid and offer prices to all direct market participants, who can respond by selling or buying at one of the quotes or by replying with a different quote. Depending on the exchange, the medium of communication can be voice, hand signal, a discrete electronic message, or computer-generated electronic commands. When two parties reach agreement, the price at which the transaction is executed is communicated throughout the market. The result is a level playing field that allows any market participant to buy as low or sell as high as anyone else as long as the trader follows exchange rules. Some exchanges designate certain participants as dedicated market makers and require them to maintain bid and ask quotes throughout the trading day. Unlike exchanges, OTC markets have never been a "place." Dealers act as market makers by quoting prices at which they will sell (ask or offer) or buy (bid) to other dealers and to their clients or customers. Moreover, dealers in an OTC security can withdraw from market making at any time, which can cause liquidity to dry up, disrupting the ability of market participants to buy or sell. Exchanges are far more liquid because all buy and sell orders as well as execution prices are exposed to one another. OTC markets are less transparent and operate with fewer rules than do exchanges. Market makers are compensated by the spread between the bid price (the price they pay for stocks) and ask price (the price they sell the stocks for).

6. One year T-bill rates are expected to steadily increase by 150 basis points per year over the next six years. Determine the required interest rate on a three-year T-bond and a six-year T-bond if the current 1-year interest rate is 7.5%. Assume that the expectations hypothesis for interest rates holds.

Assuming that the T-Bill rates are discount rates and that the T-bonds are annual coupon paying. See problem 2 for the T-bill yield to maturity conversion formula. The expected forward rates become 8.23%, 10.04%, 11.19%, 13.85%, 15.85% and 17.94%. The three year bond has a yield to maturity of 10.0515% and the 6 year bond has a yield to maturity of 12.9233%.

What is the basic activity of banks?

Banks accept deposits and then use the resulting funds to make loans.

3. Why do banks not eliminate the need for money markets?

Banks have higher costs than the money market owing to the need to maintain reserve requirements. The lower cost structure of the money markets, coupled with the economies of scale resulting from high volume and large-denomination securities, allows for higher interest rates.

Why do managers of financial institutions care so much about the activities of the Federal Reserve System?

Because the actions of the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.

Why might you be willing to make a loan to your neighbor by putting funds in a savings account earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest rate rather than lend her the funds yourself?

Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able to earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor.

How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Because you know your family member better than a stranger, you know more about the borrower's honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.

What is the document called that lists the terms of a bond?

Bond indenture.

The U.S. Treasury issues bills, notes, and bonds. How do these three securities differ?

Bonds are US government debt with a maturity of more than 10 years. Notes are US government debt with a maturity of 1 to 10 years. Bills are US government debt with a maturity of less than 1 year.

7. Why do businesses use the money markets?

Businesses both invest and borrow in the money markets. They borrow to meet short-term cash flow needs, often by issuing commercial paper. They invest in all types of money market securities as an alternative to holding idle cash balances.

"In a world without information and transaction costs, financial intermediaries would not exist." Is this statement true, false or uncertain? Explain your answer.

By looking at the three reasons for financial intermediaries to exist one can see that this deals with the transaction costs and adverse selection issues. Risk sharing may still be an issue. A small investor may not be able to build a well-diversified portfolio and thus a financial intermediary may be necessary to construct this for him.

How can changes in foreign exchange rates affect the profitability of financial institutions?

Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets. Also changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions.

What bank regulation is designed to reduce adverse selection problems for deposit insurance? Will it always work?

Chartering banks is the bank regulation that helps reduce the adverse selection problem because it attempts to screen proposals for new banks to prevent risk prone entrepreneurs and crooks from controlling them. It will not always work because risk prone entrepreneurs and crooks have incentives to hide their true nature and thus may slip through the chartering process.

Identify the cash flows available to an investor in stock. How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to estimating bond cash flows. Which security would you predict to be more volatile?

Dividends and the future sales price. Dividends are frequently changed when firm earnings either rise or fall. The future sales price is also difficult to estimate, since it depends on the dividends that will be paid at some date even farther in the future. Bond cash flows also consist of two parts, periodic interest (coupon) payments and a final maturity payment. These payments are established in writing at the time the bonds are issued and cannot be changed without the firm defaulting and being subject to bankruptcy. (Exceptions include variable coupon rate bonds) Stock prices tend to be more volatile, since their cash flows are subject to more change.

3. Risk premiums on corporate bonds are usually anti-cyclical; that is they decrease during business cycle expansions and increase during recessions? Why?

During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

What are the primary capital market securities, and who are the primary purchasers of these securities?

Equity and long-term bonds. Capital market securities, such as stocks and long-term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.

In addition to Treasury securities, some agencies of the government issue bonds. List three such agencies, and state what the funds raised by the bond issues are used for.

Fannie Mae and Freddie Mac fund mortgage loans. Sallie Mae funds student loans.

12. Who issues federal funds, and what is the usual purpose of these funds?

Federal funds are sold by banks to other banks. They are used to invest excess reserves and to raise reserves if a bank is short.

5. What was the purpose motivating regulators to impose interest ceilings on bank savings accounts? What effect did this eventually have on the money markets?

Following the Great Depression, regulators were primarily concerned with stopping banks from failing. By removing interest-rate competition, bank risk was substantially reduced. The problem with these regulations was that when market interest rates rose above the established interest-rate ceiling, investors withdrew their funds from banks.

What are the significant risks to investing?

Here are several - there is interest rate risk. If you lend at 7% and interest rates go to 10% then on a present value basis you will have lost money. There is credit risk - first you are lending on an unsecured basis, second it is not clear what happens to your loan if Prosper.com goes under. There is asymmetric information risk - the information that the borrower gives to take out the loan is not verified. There is liquidity risk. There is a secondary market but it is not clear whether it is liquid. There is also prepayment risk - the risk that a borrower pays back the loan early. To think about this risk imagine that you have lent money at 10% and then interest rates fall to 5% halfway through the life of the loan. If the borrower prepays the loan then you will only be able to reinvest the money at a similar yield by taking on additional risk.

What effect might a fall in stock prices have on business investment?

Higher stock prices mean that consumers' wealth is higher and so they will be more likely to increase their spending

14. The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him

If the public believes the president's program will be successful, interest rates will fall. The president's announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases and the demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd, causes the equilibrium bond price to rise and the interest rate to fall.

5. If yield curves, on average, were flat, what would this say about the liquidity premiums in the term structure? Would you be more or less willing to accept the pure expectations theory?

If yield curves on average were flat and the risk premium on long-term relative to short term bonds were positive then one would expect interest rates to fall more often than rise. Given that rates are as likely to rise as to fall this would force the risk premium to be zero. Thus we would be more willing to accept the pure expectations theory.

Distinguish between the primary market and the sec- ondary market for securities.

In the primary market, investors buy securities directly from the company issuing them. In the secondary market, investors trade securities among themselves, and the company with the security being traded does not participate in the transaction.

Discuss some of the manifestations of the globalization of world capital markets.

Increasing globalization of financial intermediaries such as banks and other institutions. Interconnectedness of financial markets such as stock markets etc (one can observe a high degree of correlation between these). Also disruption in a major foreign market can cause disruption in the US and vice versa.

Describe the two ways whereby capital market securities pass from the issuer to the public.

Initial public offerings in which firms sell their securities for the very first time. Secondary markets where the sale of previously issued securities take place.

As interest rates in the market change over time, the market price of bonds rises and falls. The change in the value of bonds due to changes in interest rates is a risk incurred by bond investors. What is this risk called?

Interest rate risk.

9. What effect will a sudden increase in the volatility of gold prices have on interest rates?

Interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase. The demand curve, Bd, shifts to the right and the equilibrium bond price rises and the interest rate falls.

16. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices?

Interest rates will rise. The expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds falls. The demand curve, Bd, shift to the left and the equilibrium bond price falls and the interest rate rises.

17. Predict what will happen to interest rates if prices in the bond market become more volatile

Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall. The demand curve Bd will shift to the left, and the equilibrium bond price falls and the interest rate will rise.

10. How might a sudden increase in people's expectations of future real estate prices affect interest rates?

Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve Bd shifts to the left, and the equilibrium bond price falls, so the interest rate rises.

A call provision on a bond allows the issuer to redeem the bond at will. Investors do not like call provisions and so require higher interest on callable bonds. Why do issuers continue to issue callable bonds anyway?

Issuers issue callable bonds as protection against a decline in interest rates: If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate of interest - in this case, company will call its current bonds and reissue them at a lower rate of interest.

How does an increase in the value of the pound sterling affect American businesses?

It makes British goods more expensive relative to American goods. American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise. If, however, an American business depends on supplies/parts from British companies these products will increase their costs.

How does a decline in the value of pound sterling affect British consumers?

It makes foreign goods more expensive and so British consumers will buy less foreign goods and more domestic goods

14. Who issues commercial paper and for what purpose?

Large businesses with very good credit standings sell commercial paper to raise short-term funds. The most common use of these funds it to extend short-term loans to customers for the purchase of the firm's products.

9. Why are more funds from property and casualty insurance companies than funds from life insurance companies invested in the money markets?

Life insurance companies can invest for the long term because the timing for their liabilities is known with reasonable accuracy. Property and casualty insurance companies cannot predict the natural disasters that cause large payouts on policies.

Why do loan sharks worry less about moral hazard in connection with their borrowers than some other lenders do?

Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage in moral hazard.

10. Predict what would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market

Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium.

2. Is a Treasury Bond issued 29 years ago with 6 months remaining before it matures a money market instrument?

Money market securities have an original maturity of less than one year, so the bond would not be considered a money market security.

3. How does the after-tax yield on a $1,000,000 municipal bond with a coupon rate of 8% paying interest annually, compare with that of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume you are in the 25% tax bracket

Municipal bond coupon payments equal $80,000 per year. No taxes are deducted; therefore, the yield would equal 8%. The coupon payments on a corporate bond equal $100,000 per year. But you only keep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yield is only 7.5%

3. A financial advisor has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the financial advisor necessarily correct?

No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price that their return might be quite low, possibly even negative.

When the coupon rate is equal to the yield to maturity then the current bond price is equal to the bond's face value for any maturity. When the yield to maturity is above the annual coupon then the bond's current price is below the face value. When it is below then the bond's current price is above the face value. If the yield to maturity is not equal to the coupon rate and is kept constant for different maturities then the shorter maturity bond will have a price closer to the current price than the longer maturity bond.

PV = 50/2.5% = $2,000 If the yield doubles then the PV is cut in half - PV = 50/5% = $1,000.

A bond provides information about its par value, coupon interest rate, and maturity date. Define each of these.

Par value is the price the issuer will pay the holder when the bond matures. Coupon interest rate is the interest rate stated on a bond when it is issued. Maturity date is the date the par value (principal) will be paid by the issuer to the holder.

4. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (=5 percent -2 percent) to 1 percent (=10 percent − 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)

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

Present value which is the value today of all cash flows the investment will generate over its life.

4. I own a professional football team, and I plan to diversify in either a company that owns a professional basketball team or a pharmaceutical company. Which of these two investments is more likely to reduce the overall risk I face? Why?

Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both.

How does risk sharing benefit both financial intermediaries and private investors?

Risk sharing benefits financial intermediaries because they are able to earn a spread between the returns they earn on risky assets and they returns they pay on the less-risky assets they sell. Investors benefit because they are able to invest in a better diversified portfolio then would otherwise be available.

What are other important financial intermediaries in the economy besides banks?

Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies

What distinguishes stocks from bonds?

Stock represents ownership in a company and so is a claim to share in its profits. A bond represents indebtedness of the issuer to its holder and so is a tradable "I owe you".

13. Does the Federal Reserve directly set the federal funds interest rate? How does the Fed influence this rate?

The Federal Reserve cannot directly set the federal funds rate of interest. It can influence the interest rate by adding funds to or withdrawing reserves from the economy.

6. Why does the U.S. Government use the money markets?

The U.S. government sells large numbers of securities in the money markets to support government spending. Over the past several decades, the government has spent more each year than it has received in tax revenues. It makes up the difference by borrowing. Part of what it borrows comes from the money markets.

7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just bought a $100,000 home, what is the PV of all future property tax payments? Assume that the house remains worth $100,000 forever, property tax rates never change and that a 9% interest rate is used for discounting.

The annual payment is $2,660. To value a perpetuity you have PV = 2,660/0.09 = $29,556

1. Which should 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? Why?

The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond.

5. Debt is issued by Southeastern Corporation currently yields 12%. A municipal bond of equal risk currently yields 8%. At what marginal tax rate would an investor be indifferent between these two bonds?

The corporate bond yield is adjusted by (1-marginal tax rate). Thus the marginal tax rate is 33%

6. If a yield curve looks like the one shown here, what is the market predicting about future short-term interest rates? What might the yield curve indicate about the inflation rate in the future?

The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.

9. 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?

The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

What bank regulations are designed to reduce moral hazard problems created by deposit insurance? Will they completely eliminate the moral hazard problem?

The government uses a mix of regulations in an attempt to reduce the moral hazard problem of deposit insurance. The moral hazard problem of deposit insurance comes from the fact that protected depositors have no incentive to monitor the behavior of their banks. Knowing this, bank managers take on riskier asset positions. Thus, the deposit insurance creates its own moral hazard problem. The primary regulation that the government uses to solve this problem in a minimum capital requirement. There are also disclosure requirements that forces banks to release information about their balance sheet. Restrictions on risky asset holdings are also directed at minimising moral hazard created by deposit insurance by restricting banks from taking risky asset positions.

12. Using a supply and demand analysis for bonds, show what the effect is on interest rates when the riskiness of bonds rises

The increased riskiness of bonds lowers the demand for bonds. The demand curve Bd shifts to the left, the equilibrium bond price falls and the interest rate rises.

11. Explain what effect a large federal deficit might have on interest rates

The increased riskiness of bonds lowers the demand for bonds. The demand curve shifts to the left and the equilibrium bond price falls and the interest rate rises.

15. The chairman of the Fed announces that interest rates will rise sharply next year, and the market believes him. What will happen to today's interest rate on AT&T bonds, such as the 8 1/8s of 2022

The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, the expected return on long-term bonds such as the 8 1/8s of 2022 will fall, and the demand for these bonds will decline. The demand curve Bd will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

1. What characteristics define the money markets?

The money markets can be characterized as having securities that trade in one year or less, are of large denomination, and are very liquid.

8. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2%, and inflation is expected to be 6% over the next year. What nominal rate would you require from the bank over the next year? How much money will you have at the end of 1 year? If you are saving to buy a stereo that currently sells for $1,050, will you have enough to buy it?

The nominal interest rate needs to be 2%+6%=8%. At the end of one year you will have $1,080 in your bank account but the stereo will now cost $1,050*(1.06) = 1,113. You will be short by 33 dollars.

What types of risks do financial institutions face?

The profitability of financial institutions is affected by changes in interest rates, stock prices, and foreign exchange rates; fluctuations in these variables expose these institutions to risk. Financial institutions also face credit risk to counterparties with whom the trade and clients to whom they lend.

8. What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected, and, if so, how?

The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?

The share of Microsoft stock is an asset for its owner because it entitles the owner to a share of the earnings and assets of Microsoft. The share is a liability for Microsoft because it is a claim on its earnings and assets by the owner of the share.

7. If the yield curve looks like the one below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the inflation rate in the future?

The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future is above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.

If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result?

There would be adverse selection, because people who might want to burn their property for some personal gain would actively try to obtain substantial fire insurance policies. Moral hazard could also be a problem, because a person with a fire insurance policy has less incentive to take measures to prevent fire

Why are financial markets important to the health of the economy?

They channel funds from those who do not have a productive use for them to those who do, thereby resulting in *higher economic efficiency*

7. The one year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16% and 17.5%. Using the expectations theory, what will be the interest rates on a 3-year, 6-year and 9-year bond?

This can be solved by taking the average of the appropriate rates 3-year bond = [(3 + 4.5 + 6)]/(3) = 4.5% 6-year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 6.75% 9-year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 9.333%

"Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets." Comment.

This statement is false. Prices in secondary markets determine the prices that firms issuing securities receive in primary markets. In addition, secondary markets make securities more liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if anything, more important than primary markets.

10. Which of the money market securities is the most liquid and considered the most risk-free? Why?

Treasury bills are usually viewed as the most liquid and least risky of securities because they are backed by the strength of the U.S. government and trade in extremely large volumes.

5. "No one who is risk-averse will ever buy a security that has a lower expected return, more risk and less liquidity than another security." Is this statement true, false or uncertain? Explain your answer

True, because for a risk adverse person, more risk, a lower expected return, and less liquidity make a security less desirable.

3. "The more risk-averse people are, the more likely they are to diversify." Is this statement true, false or uncertain? Explain your answer

True, because the benefits to diversification are greater for a person who cares more about reducing risk.

4. "If bonds of different maturities are close substitutes, their interest rates are more likely to move together." Is this statement true, false or uncertain? Explain your answer

True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.

2. Why do U.S. Treasury Bills have lower interest rates than large-denomination negotiable bank CDs?

U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.

6. An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply-and-demand analysis for bonds, show what effect this action has on interest rates

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve Bs to the right. The result is that the intersection of the supply and demand curves Bs and Bd occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises.

3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table. What relationships do you observe between maturity and discount rate and the current price?

When the coupon rate is equal to the yield to maturity then the current bond price is equal to the bond's face value for any maturity. When the yield to maturity is above the annual coupon then the bond's current price is below the face value. When it is below then the bond's current price is above the face value. If the yield to maturity is not equal to the coupon rate and is kept constant for different maturities then the shorter maturity bond will have a price closer to the current price than the longer maturity bond.

7. Using the supply-and-demand for bonds framework show why interest rates are pro-cyclical (rising when the economy is expanding and falling during recessions

When the economy booms, the demand for bonds increases: The public's income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions, that is, interest rates are procyclical.

If I can buy a car today for $5,000 and it is worth $10,000 in extra income next year to me because it enables me to get a job as a traveling anvil seller should I take out a loan from Larry the loan shark at 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan-sharking?

Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $500. Since Larry's loan-sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.)

If there were no asymmetry in the information that a borrower and a lender had, could there still be a moral hazard problem?

Yes, because even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so moral hazard remains a problem.

Some economists suspect that one of the reasons that economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow.

13. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer

Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise

If you are an employer, what kinds of moral hazard problems might you worry about with your employees?

You would be concerned that they would carry out their responsibilities - removing a poorly performing employee is an expensive endeavor. They might steal or commit fraud.

If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return.

If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?

You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.

1. Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of 1 to 5 years and plot the resulting yield curves for the following series of 1-year interest rates over the next 5 years a) 5% 7% 7% 7% 7% b) 5%, 4%, 4%, 4%, 4% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

a) The yield to maturity for a 1 year bond would be 5%, 5.9953% for a 2 year bond, 6.3291% for a three-year bond, 6.4965% for a four year bond and 6.5970% for a 5-year bond, b) The yield to maturity would be 5% for a one-year bond, 4.4988% for a two-year bond, 4.3323% for a three-year bond, 4.2491% for a four-year bond, and 4.1992% for a five-year bond The upward-sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward-sloping yield curve in (b) would be less steep and might even have a slight positive upward slope if the long-term bonds have a positive risk premium.

9. A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Coupon your rate of return if you sell the bond next year for $880.10.

as you have only a single payment you know that 871.65 = (880.10+70)/(1+I) → I = (950.10-871.65)/871.65 = 9%