Money Credit Finance: Chapter 2

Implied foward Rates

-A forward rate (f) is an expected rate on a short-term security that is to be originated at some point in the future. -The one-year forward rate for any year, N years into that future

Real Riskless Interest Rates

-Additional purchasing power required to forego current consumption -Irving Fisher first postulated that interest rates contain a premium for expected inflation

Loanable Funds Theory

-Explains interest rates and interest rate movements -Views level of interest rates as resulting from factors that affect the supply of and demand for loanable funds -Categorizes financial market participants: Consumers, businesses, governments, and foreign participants (as net suppliers or demanders of funds)

Who are the suppliers of loanable funds?

-Household Sector -Governments -Foreign Investors

Whoa re the demanders of loanable funds?

-Households -Businesses -Governments -Foreign Participants

Market Segmentation Theory

-Individual investors and FIs have specific maturity preferences -Interest rates are determined by distinct supply and demand conditions within many maturity segments -Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so.

What are six factors that determine the nominal interest rate on a security?

-Inflation -Real Risk-Free Rate -Default Risk -Liquidity Risk -Special Provisions -Term Maturity

Nominal Interest Rates:

-The interest rates actually observed in financial markets. -Used to determine fair present value and prices of securities -Two Components: Opportunity Cost Adjustments for individual security characteristics

What should happen to a security's nominal interest rate as the securities liquidity risk increases?

-The nominal interest rate on a security reflects it's relative liquidity, with highly liquid assets carrying the lowest interest rates. (all other characteristics remain the same) -Likewise, if a security is liquid, investors add a liquidity risk premium (LRP) to the interest rate on the security

The three explanations for the shape of the Yield Curve

-Unbiased Expectations Theory -Liquidity Premium Theory -Market Segmentation Theory

What factors cause the demand curve to shift?

-Utility derived from asset purchased with borrowed funds -Restrictiveness of non price conditions -Economic Conditions

What factors cause the supply fund curve to shift?

-Wealth -Risk of Financial Security -Near-Term Spending Needs -Monetary Expansion -Economic Conditions

Determinants of Household Savings

1) Interest rates and tax policy 2) income and wealth: the greater the wealth or income, the greater the amount saves 3) Attitudes about saving vs borrowing 4) Credit availability: the greater the amount of easily obtainable consumer credit the lower the need to save 5) Job security and belief in soundness of entitlements

Business Demand for Funds

1) Level of interest rates: When the cost of loanable funds is high, businesses finance internally 2) Expected future profitability vs risk: The greater the number of profitable projects available to businesses, the greater the demand for loanable funds 3) Expected economic growth

Determinants of Foreign Funds Invested in the US

1) Relative interest rates and returns on global investments 2) Expected exchange rate changes 3) Safe haven status of US investments 4) Foreign central bank investments in the US

You go to the Wall Street Journal and notice that yields on almost all corporate and Treasury bonds have decreased. The yield decreases may be explained by which of the following:

A decrease in US inflationary expectations

If we observe one year treasury security rate higher than the two year rate, what can we infer about the one year rate expected one year from now:

According to the pure expectations theory, the one year Tate one year from now is expected to be less than one year rate today.

What is a forward interest rate?

An expected or "implied" rate on a short term security that is to be originated at some point in the future.

Market Segmentation Theory

Assumes that investors don't consider securities with different maturities as perfect substitutes. Rather individual investors and FIs have preferred investment horizons dictated by the nature of the liabilities they hold. Thus interest rates are determined by distinct supply and demand conditions within a particular maturity segment.

Unbiased Expectations Theory

At any given point in time, the yield curve reflects the market's current expectations of short term rates. The return for holding a four year bond to maturity should equal the expected return for investing in for successive one year bonds (as long as markets are at equilibrium)

Liquidity Premium Theory

Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity.

Unbiased Expectations Theory

Current long-term interest rates are geometric averages of current and expected future short-term interest rates

Present Value of a Lump Sum

Discount future payments using current interest rates to find the present value (PV)

Everything else equal, the interest rate required on a callable bond will be less than the interest rate on a convertible bond:

False

We expect liquidity premiums to move inversely with interest rate volatility:

False

Which of the following would normally be expected to result in an increase in the supply of funds, all else equal? I. The perceived riskiness of all investments decreases II. Expected inflation increases III. Current Income and wealth levels increase IV. Near term spending needs of households increase as energy costs rise

I and III only

Simple Interest

Interest earned on an investment is not reinvested

Compound interest

Interest earned on an investment is reinvested, most common

Time Value of Money

Is based on the notion that a dollar received at some future date

Liquidity Premium Theory

Long-term rates are equal to geometric averages of current and expected short term rates, plus liquidity risk premiums that increase with the securities maturity. Longer maturities on securities mean greater market and liquidity risk. So investors will hold long term maturities only when they are offered a premium to compensate for future uncertainty in the security's value. Liquidity premium increases as maturity increase.

According to the liquidity premium theory of interest rates:

Long-term spot rates are higher than the average of current and expected future short-term rates

Which of the following bond types pays interest that is exempt from federal taxation?

Municipal Bonds

An annuity and an annuity due with the same number of payments have the same future value if r = 10%. Which one has the higher payment?

The annuity has the higher payment

Future Value of a Lump Sum

The future value (FV) of a lump sum received at the beginning of the investment horizon

Future Value of an Annuity

The future value of a series of equal cash flows received at equal intervals throughout the investment horizon

Present Value of an Annuity

The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon

What is the relationship between the present values and interest rates as interest rate increases?

The present value of the investment decrease as a decreasing rate. There is an inverse relationship between interest rates and the present value of security investments is neither linear or proportional

How does the liquidity premium theory of the term structure of interest rates differ from the unbiased expectations theory? In a nominal economic environment, that is an upward slowing yield curve, what is the relationship of liquidity premiums for successive years into the future? Why?

The unbiased expectations theory asserts that long term rates are geometric average of current and expected short term rates. The liquidity premium theory assets the long term rates are a geometric average of current and expected short term rates plus a liquidity risk premium. The premium is assuming to increase with the maturity of the security because of the uncertainty of future return grows as maturity increases.

An increase in the marginal tax rates for all US taxpayers would probably result in reduce supply of funds by households:

True

An investor earned a 5% nominal risk-free rate over the year. however, over the year, prices increased by 2%. The investor's real risk-free rate was less than his nominal rate of return:

True

For any positive interest rate, the present value of a given annuity will be less than the sum of the cash flows, and the future value of the same annuity will be greater than the sum of cash flows:

True

The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption:

True