FINA4000 - MIDTERM Practice Problems
Interest Rate
the price of money an opportunity cost of early spending a reward for postponing one's consumption names: discount rate, rate of return, yield, YTM, cost of capital
Money Supply / Money as a legal tender
1. Currency in circulation (paper notes + coins) 2. Monetary Base (currency + com.bank reserve balance) 3. M2 Money Supply (MB + MM funds) USD as a legal tender (backed by government assets) Money is a : Medium of Exchange (used to trade/exchange real assets) Store of Value (means of storing purchasing power) Unit of Account (other assets are denominated in terms of money) Main Role - to facilitate trade (barter trade is NOT very efficient) Crypto currency fails because it is a medium of exchange but is not a store of value or unit of account.
What are the differences between M1 and M2? Why are there different measures of money?
1.M1 focuses on money as a medium of exchange—demand deposits and currency. M2 expands the meaning of money to include its use as a short-term store of value. To the elements of M1 it adds savings deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, noninstitutional money market mutual funds, and small time deposits. The Fed wants to know what definition of money has the greatest impact on interest rates, unemployment, and inflation.
What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?
3.The goals of the Federal Reserve Act of 1913 were to create: (1) a reliable mechanism for adjusting the money supply to the needs of the economy; (2) a lender of last resort that could furnish liquidity to banks in times of financial crisis; (3) an efficient payment system for clearing and collecting checks at face value throughout the country; and (4) a more vigorous bank supervision system to reduce the risk of bank failures. Relatively low rates of inflation since the early 1980s are evidence of success with goal #1. The Fed was a true lender of last resort (goal #2) to financial institutions (including non-banks) and even some non-financial companies during the 2007-2009 financial crisis. The U.S. payment system—goal #3— operates so reliably as to be taken for granted. The financial services industry faced a major challenge during the 2007-2009 crisis, with numerous bank failures and near failures. The Fed worked hard to prevent failures of systemically important banks (goal #4) and other financial institutions and restore confidence in the financial markets..
What is a credit spread? What happened to credit spreads during the financial crisis of 2007-2009?
A credit spread is the difference between yields of otherwise similar debt securities with different credit risk. The credit spreads started to widen in the middle of 2007 and peaked in December 2008. The Baa-Treasury spread widened much more than the Aaa-Treasury spread. This is a manifestation of a flight to quality. The credit spreads narrowed in the second half of 2009 and 2010, when the bond markets returned to relative normalcy.
The following annual inflation rates have been forecast for the next 5 years: Year 1 3% Year 2 4% Year 3 5% Year 4 5% Year 5 4% Use the average annual inflation rate and a 3% real rate to calculate the appropriate contract rate for a 1-year and a 5-year loan. How would your contract rates change if the Year 1 inflation forecast increases to 5%? Discuss the difference in the impact on the contract rates from the change in inflation.
A lender would require compensation for both opportunity cost and loss of purchasing power. The sum of the real rate, 3%, plus the expected rate of inflation, 3%, would be roughly 6% and accurately, (1.03)(1.03) -1 = 6.09%. The 5-year rate would be the sum of the real rate plus the average inflation rate expected: (1.03)(1.04197) - 1 = 7.32%. If the 1-year expected inflation rate were 5%, the geometric average expected rate of inflation would be 4.6%, found as [(1.05)(1.04)(1.05)(1.05)(1.04)]1/5 - 1 = [(1.05)3(1.04)2]1/5 - 1 = 0.046, and the contract rate would likely be (1.03)(1.046) -1 = 7.74%. Nominal rates include the real rate plus the expected inflation rate.
How do financial intermediaries generate profits?
Investment Banks: sell new debt or equity in financial markets; broker-dealer services (buying and selling securities) for already issued securities.
Explain why the banking system was so unstable prior to establishment of the Fed in 1914.
After termination of the Second Bank of the United States in 1836, the U.S. was without a central bank until passage of the Federal Reserve Act in late 1913. Thus there was no overall control of the size or quality of the money supply. Until the National Banking and Currency Acts (1862-64), banks were largely unregulated and free not only to engage in unsound lending practices, but to issue banknotes—IOUs against themselves—without restraint. Over-issue of this "private currency" prompted hoarding of gold and silver, causing the money supply to be "inelastic"—unevenly distributed and not easily adjustable. Frequent bank failures exacerbated downturns in the normal business cycle. The National Banking apparatus was a step forward, but the need for a central bank became more evident as the post-Civil War economy cycled through boom, bust, and financial panic.
How are the Treasury and federal agency securities different? What difference primarily explains the yield differential between the two securities?
Agency securities have greater default risk and are less marketable than Treasury securities. As a result, Agency securities sell at lower prices (have higher yield) than similar Treasury securities.
Calculate the bond equivalent yield for a 180-day T-bill that is purchased at a 6% asked yield. If the bill has a face value of $10,000, calculate its price.
Amount in $ Bond equivalent yield = (Face value - Price)/price * 365/ d Bond equivalent yield = 6% Price = ? Number of days = 180 days Hence price is 0.06 = (10,000- price)/ Price * 365/180 0.06* 180/365 = (10,000- price)/ Price 0.029589 * Price = 10000 - Price price = 10000/ 0.029589 Price = 9,712.613
If the money supply is increased, what happens to the level of interest rates?
An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates (at least in the short term).
The 1-year real rate of interest is currently estimated to be 4 percent. The current annual rate of inflation is 6 percent, and market forecasts expect the annual rate of inflation to be 8 percent. What is the current 1-year nominal rate of interest?
Assuming the Fisher effect, the current 1-year nominal rate should be 12 percent, the sum of the real rate (4%) plus the expected inflation rate (8%), an approximate but illustrative way of estimating the answer. The correct way to deal with compounding rates is to multiply (1+.04)(1+.08) - 1 = 12.32%.
What do bond ratings measure? Explain some of the important factors in determining a security's bond rating.
Bond ratings measure default risk. Among the important determinants of a firm's bond rating are: (1) the firm's expected cash flows; (2) the amount of the firm's fixed contractual cash payments; (3) the length of time the firm has been profitable; and (4) the variability of the firm's earnings.
Why is a bank line of credit necessary to back up an issue of commercial paper?
Back-up lines of credit would be used if the firm experiences financial difficulties or if credit market conditions become tight. Back-up lines of credit are often required by investors to assure protection of their principal and liquidity of the investment.
Why have mortgage market interest rates become more uniform across the country in recent years?
Because mortgage-backed securities have been able to compete for funds directly in the capital markets, lenders' costs of funds have become more uniform across the country as such securities have developed. Competition then ensures that equal costs of funds will be translated into roughly equal mortgage loan rates in each market area.
Explain the economic role of brokers, dealers, and investment bankers. How does each make a profit?
Brokers, dealers, and investment bankers make markets at both primary and secondary stages. Funds are raised and claims issued in primary markets with the help of investment bankers, who purchase securities from issuers at one price and sell them to the investing public at a higher price, earning the underwriter's spread. In secondary markets brokers help bring buyers and sellers of financial claims together, charging commissions, and dealers trade claims in volume, providing liquidity and price discovery and earning the difference between ask and bid price (the bid-ask spread).
What features make municipal bonds attractive to certain groups of investors? Why don't other groups invest much in municipal securities?
Interest income from municipal bonds is tax-exempt at the federal level. All other factors being equal, investors select the security that provides the highest after-tax yield. In general, investors in high tax brackets find municipal bonds attractive investments - they have higher after-tax yields compared to similar taxable securities. Investors in low tax brackets may not find municipal bonds attractive compared to corporate bonds.
What factors determine the real rate of interest?
The real rate of interest is determined by: (a) individual time preference for consumption, and (b) the return that firms expect to earn on their real capital investments. In equilibrium, the real rate of interest is determined when desired saving equals desired investment.
Define default risk. How does the default risk premium vary over the business cycle? Explain your answer.
Default risk is the variability of realized yields to an investor because of delays or failure to collect the contracted amount of interest and/or principal promised by the borrower. Default risk premium becomes larger during economic recessions, when more borrowers tend to default on their debt.
Are Yankee bonds and Samurai bonds examples of Eurobonds? Why or why not?
Eurobonds are denominated in currencies other than the currency of the country in which they are sold. Yankees and samurais are sold in the U.S. and Japan and denominated in dollars and yen, respectively, which are the domestic currencies for the respective countries. Thus, they are not Eurobonds. An example of a Eurobond would be a dollar-denominated bond sold in Japan or a yen-denominated bond sold in the US.
Explain how the Fed changes the money supply with an open-market purchase of Treasury securities.
Every Fed transaction with the private sector clears through the "bank reserve account". When the Fed buys securities, it pays for them in a way no other financial system participant can: It unilaterally creates new money by crediting new reserves in the amount of the purchase to the reserve account of the depository bank of the securities dealer. Thus, open market purchases increase total reserves in the banking system directly, immediately, and dollar-for-dollar. During the financial crisis of 2007-2009, the Fed expanded open market operations from using only Treasury securities to buying large amounts of federal agency debt and mortgage-backed securities. The importance of open market operations is illustrated in Exhibit 2.6: The Fed's portfolios of these securities are by far its largest asset categories.
An investor purchased a 1-year Treasury security with a promised yield of 10 percent. The investor expected the annual rate of inflation to be 6 percent; however, the actual rate turned out to be 10 percent. What were the expected and the realized real rate of interest for the investor?
Expected rate = [(1+.10 ) * (1+.06)] - 1 = [1.1 * 1.06 ] -1 = 1.166- 1 = .166 or 16.60% Realized return = 10% vs. The expected real rate is re = (1+i)/(1+ΔPe) - 1 = (1.1/1.06) - 1 = 3.77%; the realized real rate is (1.1/1.1) - 1 = 0.
Explain the concept of financial intermediation. How does the possibility of financial intermediation increase the efficiency of the financial system?
Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient.
Explain how you believe economic activity would be affected if we did not have financial markets and institutions.
Financial markets and institutions make transactions more cost and time efficient since they specialize in transactions. Since it's more efficient, this increases economic activity so... a lack of financial markets and institutions would result in a decrease in economic activity.
What is fiscal policy? How does fiscal policy compare to monetary policy?
Fiscal policy is the control over government spending and taxes over the business cycle. Congress and President determine, and the Treasury Department carries out fiscal policy in the U.S. Monetary policy, on the other hand, boils down to the control of money supply; it is determined and carried out by central banks such as the Federal Reserve System in the U.S. or the European Central Bank in the Euro-zone.
A commercial bank made a five-year term loan at 13 percent. The bank's economics department forecasts that one and three years in the future, the two-year interest rate will be 12 percent and 14 percent, respectively. The current one-year rate is 7 percent. Given that the bank's forecast is reliable, has the bank set the five-year rate correctly?
Given the bank's forecast, the five-year rate (tR5) should be equal to 10.64 percent using Equation (6.1):[(1.07)(1.12)2(1.14)2]1/5 -1 = 11.77%. The bank's loan rate is higher, likely to compensate the bank for the default risk of the loan.
Why does the Fed not use the discount rate to conduct monetary policy? How does the Fed use the discount rate?
In the early 20th century, long before modern money markets evolved, "discounting" was a common way to retrieve liquidity from financial instruments (e.g., factoring accounts receivable), and commercial banks did not have many "non-deposit" funding choices. When the Fed was formed, the discount rate was the primary tool of monetary policy because it was the cost of member banks' main non-deposit source of funds—loans at the Discount Window. The Fed would discount (lend less than the face value of) loans and other financial instruments held by member banks, providing liquidity. Because the banking industry had few other funding choices but was the primary source of operating credit to farms and businesses, Fed discount policy was a reasonably effective direct control on the money supply. As money markets evolved, the Fed Funds market in particular developed, and the FOMC developed its processes, "discounting" in its foundational sense faded into history. Today changes in the discount rate merely signal policy intent; open market operations directly increase or reduce the money supply. Loans "at the Window" are still available, but depository institutions have many funding choices and are wary of "Window scrutiny"—questions regulators might have about early or regular trips to the Window. Discount Window loans outstanding are now just a tiny fraction of the Fed's total assets.
How has the government encouraged the development of secondary mortgage markets?
Indirectly, the government has helped such markets through the development of FHA and VA mortgage insurance. Directly, the government has aided the development of second mortgage markets by supporting the development of FNMA and FHLMC, which buy large quantities of mortgages in the secondary markets and issue mortgage-backed bonds and pass-through securities. In addition, the government established GNMA, which initiated government guaranteed pass-through securities specifically so those securities could be sold in the secondary mortgage markets.
What types of firms issue commercial paper? What are the characteristics critical to being able to issue commercial paper?
Large businesses with high credit ratings issue commercial paper as an inexpensive source of short-term borrowing. Commercial paper is an alternative to borrowing from a commercial bank and, typically, the rates are lower than rates charged by banks. Because commercial paper is unsecured debt, most investors, in an attempt to protect their principal, only want paper with highest credit ratings. Rating agencies will quickly write down or remove their ratings for commercial paper if the financial conditions of a company deteriorate. The number of companies issuing commercial paper in the economic boom of the late 1990's shrunk considerably by 2001 as rating agencies pulled their commercial paper ratings. During the 2007-2009 financial crisis, issuers of asset-backed commercial paper (mostly financial institutions) had difficulty rolling over paper because investors had concerns about both the quality of assets backing the paper and the solvency of financial institutions issuing (and thus guaranteeing) the paper.
How has the development of secondary mortgage markets allowed mortgage issuers to attract additional funds from the capital markets?
Many mortgage-backed securities have characteristics similar to government bonds. Pass-throughs, participation certificates, and collateralized mortgage obligations are sold in standard denominations. Also, because they are guaranteed, they can be resold easily if desired. Further, mortgage-backed bonds and CMOs not only are of standard denomination, these also provide guaranteed repayment schedules. Because thesoe securities gain more characteristics of bonds, they become more readily interchangeable with bonds in investors' portfolios. As a result, they can compete more effectively with bonds for investors' funds.
Define marketability. Explain why marketability of a security is important to both investor and issuer.
Marketability refers to the ease with which an investor can sell an asset. For investors, marketability means that the security can be sold easily in some secondary market; for issuers, marketable securities have lower borrowing costs.
Explain the differences between the money markets and the capital markets. Which market would General Motors use to finance a new vehicle assembly plant? Why?
Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or "capital goods" are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to "store" cash in money market securities, which are generally, safe, liquid, and short-term.
Explain what the nominal rate of interest is and how it is related to the real rate of interest.
Nominal rates are the quoted interest rates we observe in the marketplace. A nominal rate includes the real rate plus expected inflation over the investment period.
Suppose the 7-year spot interest rate is 9 percent and the 2-year spot rate is 6 percent. The forecasted 3-year rate two years from now is 7.25 percent. What is the implied forward rate on a 2-year bond originating 5 years from now? {HINT: Under the expectations hypothesis, in equilibrium an investor with a 7-year holding period will be indifferent between investing in a 7-year bond or a combination of securities over the same period.}
One must calculate the rate on a 2-year bond (t+5f2) acquired after investments for two years (1.06)2 and three more years (1.0725)3 that makes an investor indifferent to a 7-year bond at 9 percent (1.09)7. 1.097 = 1.062 1.07253(1 + t+5f2)2 (1+ t+5f2)2 = 1.097/(1.062 1.0725)3 or (1+t+5f2) = [1.8280/1.3861]1/2 t+5f2 = (1.3188)1/2 - 1 = 14.84% Proof: 1.062 1.07253 1.14842 = 1.097
Why are private placements of securities often popular with both the buyer and the seller of the securities?
Private placements are direct sales between borrowers and the ultimate investors. The costly and time-consuming SEC registration is not required for private placements. In general, both issuers and investors believe they can negotiate a better deal than if they transacted in the public market.
Describe the steps in a typical banker's acceptance transaction. Why is the banker's acceptance form of financing ideal in foreign transactions?
See the discussion of Exhibit 7.7 for the steps in creating a banker's acceptance. Banker's acceptance provides two basic services: (a) financing, and (b) services and expertise specifically related to an international transaction. It is the latter that makes banker's acceptances an attractive means of financial international transactions.
Explain why the FOMC is the key policy group within the Fed.
The Federal Open Market Committee, comprising the 7 Governors, the president of the New York Fed, and 4 of the remaining 11 presidents of Federal Reserve Banks, sets monetary policy for one of the world's largest and most powerful countries, affecting interest rates, exchange rates, and economic growth. The Chairman of the Board of Governors sets the FOMC's agenda, runs its meetings, and is the Fed's face and voice to the outside world. Consequently, the Chairman is one of the world's most powerful figures.
What is the Fisher effect? How does it affect the nominal rate of interest?
The Fisher effect is Irving Fisher's hypothesis that expected inflation is embodied in current nominal interest rates. Assuming the ability to forecast expected inflation, nominal rates should vary directly with expected inflation.
Define the following terms: (a) private placement, (b) asset-backed security, (c) callable securities, (d) sinking fund provisions, and (e) convertible features of securities.
The above terms are explained as follows: (a) private placement is the sale of bonds to a single investor or small group of sophisticated investors, that meet the guidelines for avoiding registration and disclosure requirements of the SEC and state laws. SEC requires that the issue be sold to no more than 35 investors to qualify as a private placement. (b) asset-backed securities are the financial claims issued when loans are securitized; (c) callable securities can be retired by the issuer's option prior to their stated maturity at a pre-specified price called the call price. Advantage is to issuers and investors have to be compensated with a call premium in the form of a higher yield. (d) sinking fund provisions require the issuer to retire a percentage of a bond issue on an annual basis. It reduces the risk of default to investors. (e) convertible features of securities are options of the investor to convert the security into another form of security, typically into an equity security
If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated?
The after tax yield on the taxable corporate bond is 6.48% or [9%(1-0.28)] and is the comparable rate of a tax-free municipal bond. For any added risk on the muni bond (e.g., lower marketability), the investor would pay less or require a higher rate of return (i.e., above 6.48%).
If the realized real rate of return turns out to be positive, would you rather have been a borrower or a lender? Explain in terms of the purchasing power of the money used to repay a loan.
The answer depends upon whether the lender (borrower) earns (pays) their expected real rate. If inflation were originally underestimated, borrowers would benefit at the cost of lenders—their real cost of borrowing would be less than anticipated. If inflation were overestimated, lenders would benefit at the cost of borrowers—real returns (borrowing costs) would be higher than originally anticipated.
Explain how repurchase agreement transactions provide short-term investments to businesses. In what sense is a repo a collateralized loan?
The corporate treasurer purchases government securities for the amount of the investment from a bank for a specified time period. The business would have idle cash deposit balances that it would transfer out to invest. The bank retains the funds by providing a repurchase transaction whereby it sells securities owned (stored offsite in depository) to the business and agrees to buy them back at a higher price, thus paying the money market rate for the business' funds. The purchase price and sale price are agreed upon at the time the deal is made. The interest paid the corporation is the difference between the purchase and repurchase price of the collateralized securities. See the textbook section on repos for the T-account entries. A repo is a collateralized loan in the sense that the securities sold serve as collateral.
Summarize the expectation theory and the preferred-habitat theory of the term structure of interest rates. Are these theories in any way related or are they alternative explanations of the term structure?
The expectation theory states that the shape of the yield curve is related to investors' expectations of future interest rate levels. The preferred-habitat theory is a less restrictive variant of the market segmentation theory; it asserts that investors may hold debt securities outside of their preferred maturity ranges if offered a sufficient yield premium. The preferred-habitat theory explains the absence of discontinuities in the yield curve. The expectation theory is related to the liquidity premium theory, but is not related to the preferred-habitat theory.
In your opinion, what were the three most important factors that caused the 2008 financial crisis?
The first of the most important factors was the U.S. housing price bubble that burst. Asset price bubbles occur when demand is over-inflated. The U.S. housing price bubble became possible due to the combination of low mortgage interest rates and lax lending standards. When many mortgages made during the housing price run-up started defaulting, it caused deterioration in the balance sheets of financial institutions that held these mortgages or mortgage-backed securities. It was the second major factor contributing to the crisis. The third major factor was the bankruptcy of the investment bank Lehman Brothers in September 2008. It signaled that the government was willing to allow large financial institutions to fail and caused major concerns about the U.S. financial services industry, bringing the financial system to the brink of collapse.
Give a concise definition for the following types of municipal bonds: (a) general obligation, (b) revenue, (c) industrial development, and (d) mortgage-backed.
The important characteristics of the above bonds are: (a) general obligation bonds are backed by the full taxing ability of the states or municipalities; (b) revenue bonds default risk characteristics are determined by the expected revenue flow from the project the bonds are issued to finance; (c) industrial development bonds are essentially loans at the tax-exempt interest rate to businesses; and (d) mortgage-backed bonds are collateralized by mortgages and provide mortgage loans to individuals at the tax-exempt rate.
What did the Federal Reserve do to stabilize the money markets from 2007 to 2009?
The measures that directly impacted the money markets included expanding access to the discount window, auctioning short-term loans to depository institutions through the Term Auction Facility (TAF), paying interest on required and excess reserves of depository institutions, and buying commercial paper directly from issuers through the Commercial Paper Funding Facility (CPFF). The CPFF represented a major departure from the Fed's traditional ways because this facility, which was closed in February 2010, provided funds to firms that included nonfinancial corporations (central banks normally deal only with financial institutions). In December 2008, the Fed set the target federal funds rate as a range between 0 and 0.25% and started focusing on acquiring long-term assets.
Why are direct financing transactions more costly or inconvenient than many intermediated transactions?
The parties to direct finance have to find each other and negotiate a more or less exact match of preferences as to amount, maturity, and risk. Intermediaries provide all parties choices about financial activity, and drive costs down through competition, diversification, and economies of scale.
What are the six goals the Fed is required by government legislation to achieve? Which two goals are the most important? Why?
The six goals of the Fed are: price stability, full employment, economic growth, interest rate stability, stability of the financial system, and stability of foreign exchange markets. The most important goals are high employment and stable prices. High inflation (unstable prices) is destructive because it causes unintended transfers of purchasing power between parties of financial contracts and discourages people from engaging in economic activity due to high uncertainty. Full employment is important because it is critical to the well-being of the economy and the society, as well as its individual members.
What are the characteristics of money market instruments? Why must a financial claim possess these characteristics to function as a money market instrument?
The three fundamental characteristics of money market instruments are: (a) low default risk, (b) short-term to maturity, and (c) high marketability. These characteristics give money market instruments their characteristic of being low risk. Money market investors demand low-risk securities because their cash excesses are only temporary.
What is the value of money? How does the value of money vary with aggregate price-level changes?
The value of money is its purchasing power, or goods and services that can be bought with it. Price increases (decreases) decrease (increase) the value of money because a dollar can buy less (more).
Explain the statement, "A financial claim is someone's asset and someone else's liability."
There are always two sides to debt. To the issuer of the debt, it is a liability. To the owner of the debt, it is an asset. A financial asset always appears on two balance sheets; a real asset on just one.
Explain how mortgage-related securities have become more similar to capital market instruments over time.
They have become more standardized in terms of denomination - since GNMAs and PCs initially trade in evenly denominated units. In addition, most are well secured and/or guaranteed by well-known financial entities. Some are even rated by rating services. Finally, CMOs, REMICs and mortgage-backed bonds promise to make fixed payments over their life span, just like conventional bonds.
A new-issue municipal bond rated Aaa by Moody's Investor Service is priced to yield 8 percent. If you are in the 33 percent tax bracket, what yield would you need to earn on a taxable bond to be indifferent?
Using Equation 6.4: 8% = ibt (1-.33); find ibt = 8%/(1 - .33) = 11.94%
Suppose a trust is established to securitize $100 million in auto loans that paid 13% interest and the average rate paid on the tranches issued was 10%, whereas financial guarantees to protect against default on the loans cost 1.5%. How much money would the creator of the trust have available to pay for loan servicing and profits if the financial guarantee was purchased?
With a revenue rate of 13% and expenses of 11.5% (10% rate plus 1.5% guarantee cost), the annual cash flows available for loan servicing and profits is (0.13 - 0.115) x $100 million = $1.5 million.
What effects are decreases in reserve requirements likely to have on: a. bank reserves b. federal funds rates c. bank lending d. Treasury bill rates e. the bank prime rate?
a. none b. reduce them c. increase it d. reduce them e. reduce it Reductions in reserve requirements will provide depository institutions with additional excess reserves. As they lend or invest these excess reserves to earn an interest return, Fed Funds rates and other short-term rates will fall, stimulating demand for loanable funds.