Financial Markets Exam 1 (chapter 1 & 2)

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EAR

=(1+r/c)^c -1

The 2 types of securities that investors most often associate with capital markets are _________ and __________.

Stocks; bonds

The Volcker Rule was passed as part of what important Act of Congress?

The Wall Street Reform and Consumer Protection Act of 2010.

*All else equal, as the coupon rate on a bond increases, the bond's sensitivity to changes in interest rates______.

Decreases

How do secondary markets support primary markets?

IPO= primary no original issuer, trading between investors=secondary

True or false: in the US., most money securities are traded "Over the counter" rather than on organized exchanges.

True

T/F: The originate and distribute model contributed to the financial crisis because it allowed FI's to issue risky mortgages knowing they could sell them before they defaulted.

True. (this is called "moral hazard")

*Which of the following is NOT a likely impact of expansionary policies implemented by the Fed?

an increase in interest rates

When FI's trade assets rather than hold them to maturity, they're exposed to market risk or

asset price risk

During the past 30 years, reversal of some trends that have reshaped the financial industry are:

changes in regulatory barriers, financial innovation changes, and changes in technology.

In primary markets, the users of funds are frequently:

corporations needing funds for new projects

The risk that an asset held by a financial institution may default and not be repaid is called:

credit risk

The difference between the nominal rate quoted on a security and the rate quoted on a Treasury security with similar characteristics is called the

credit risk premium and the default risk premium

What are the risks associated with financial intermediation?

default risk, liquidity risk, insolvency risk

Traditional depository institutions find it difficult to compete with other financial institutions due to:

higher costs due to regulation

The __________ the default risk of a security, the _________ the interest rate demanded by the buyer

higher; higher lower; lower

The __________ the interest rate "r", the _______ the future value of the annuity.

higher; higher lower; lower

When government monetary policy is restrictive and the money supply is constricted, interest rates will

increase

Returns with simple interest rates

interest earned on principal only

Similarities between money markets and capital markets?

issued by gov and corp's;

The risk that a financial institution may have inadequate cash to meet requests for demand deposit withdrawal is called

liquidity risk

The decline of the share of assets held by commercial banks between 1949 and 2016 is due to

low interest rates, regulations imposed during the financial crisis, and strict capital regulations.

Due to the value of the conversion option, convertible securities generally pay a __________ rate of interest than similar non-convertible securities

lower

The ___________ the interest rate "r", the ____________ the value of PV.

lower; higher higher; lower

The theory that argues that investors have specific maturity preferences and must be paid a premium to hold securities of a different maturity is the:

market segmentation theory

Both the unbiased expectations theory and the liquidity premium theory ignore investor preferences regarding the __________ of the securities they hold.

maturity

When non-price restrictions on borrowing are reduced, borrowers will demand _________ funds and interest rates will ________.

more; increase

Long maturity securities have more__________ than short maturity securities

price risk

The claims issued by FI's to investors often guarantee principal and a fixed rate of interest, compared to the riskier securities in which the FI invests the investor's funds. This form of asset transformation relieves the investor from:

price risk

Specialty Covenants (provisions)

provisions such as convertibility and taxability that alter the interest rate on a security. An SCP captures the effects of these provisions.

The FI's that experienced a dramatic increase in their share of total FI assets during the period of 1948 to 2016 are

securities brokers/dealers, investment companies, and pension funds

Security markets offer issuers of securities important information about how the issuer is performing and how much it will cost to raise additional capital. This information is conveyed through the:

security market price

In the "originate and distribute" model, financial institutions issue loans then

sell the loans quickly

The loanable funds theory views the level of interest rates as being determined by:

supply and demand for funds

Maturity intermediation may expose FI's to

interest rate risk

In the "originate and hold" model, FI's are exposed to risks, including:

interest rate risks, liquidity risk, and credit risk.

The preference of fund suppliers to choose to hold cash vs. investing in long-term securities increases the cost of long-term borrowing. This cost can best be described as

liquidity cost

UET equation=

Geometric average=[(1+r)(1+r)(1+r)]^(1/n)-1]

*Which of the following is not a characteristics of secondary markets?

The original issuer of the securities raises funds traded in secondary markets

When an FI hires employees to monitor fund users on behalf of fund providers, they are said to be acting as

delegated monitors

*A one-year, $1000 par value corporate bond has a coupon rate of 8% (paid semiannually). The real rate of interest is 2%. This year's inflation rate was 2% and is expected to increase to 3% over the coming year. The Default Risk Premium on similar corporate bonds is 2%. This bond's price (fair value) is:

$1009.50 (insert how to solve)

*Through open market operations, the Fed purchases Treasury securities totaling $200 million. If the reserve requirement is 10%, what is the total change in the money supply associated with these Treasury purchases?

$2 Billion (change in money supply= (1/reserve requ.) x (change in reserves) =(1/.10) x 200M=$2,000M, or $2 Billion

the supply of loanable funds ___________ with increasing interest rates

increases

*Investment XYZ pays 5 percent simple interest for 10 years. Investment ABC pays 4.50 percent compound interest for 10 years. As an investor with $10,000, you would choose investment ______ and earn an additional _____ in interest.

ABC; $529.69 (Simple Interest= [r*PV]*t) Compound interest=A[(1+r)^t-1])

True or false: the original issuers of financial instruments obtain additional funds when those instruments are resold on the secondary market

False (original issuers receive no funds from secondary market transactions between unrelated parties)

Fisher Equation

I= RIR(real i rate) + Expected inflation (IP)

*Typically, during periods of uncertainty in financial markets (high unemployment, recessions) the price of the Treasury securities will ________ while default risk premium (DRP) will _______.

Increase; widen (uncertainty=contractionary policies=higher DRP and higher prices)

Returns with compound interest rates

Interest earned on principal and reinvested interest FV=PV(1+r/n)^nt

The _____________ the interest rate "r", the ________ the present value of the annuity.

Lower; higher higher; lower

What are the differences between money markets and capital markets?

MM=<1 year, low interest rates (Treasury bills, fed funds, repurchase agreements, commercial paper, negotiable CD's) CM=>1 year (CM=corp. stock, mortgages, corp bonds, Treasury bonds, state and local gov. bonds, us gov agency bonds, bank and consumer loans; MM=(Treasury bills, fed funds, repurchase agreements, commercial paper, negotiable CD's))

Financial institutions frequently transform short-maturity liabilities provided by investors into a portfolio of long-maturity assets. This is known as:

Maturity Intermediation

In a world without financial institutions where suppliers provided funds directly to users, suppliers of funds would face 3 types of risks/costs. These are:

Price risk, Monitoring cost, and liquidity cost

Financial institutions encourage investment by savers by offering investments in __________, _____________, and __________.

annuities, pension funds, and life insurance.

Consolidation of financial services such as commercial banking, insurance, and investment banking under one roof has led to the creation of a business entity called the:

financial services holding company

The tendency of foreign investors to invest their funds in risk-free US government securities during times of crisis is referred to as

flight to quality

The major supplier(s) of securities for capital markets (i.e. users of funds) are:

governments and corporations

The risk that a financial institution will not have enough capital reserves to offset a sudden loss is called:

insolvency risk

(MP) Term to Maturity

interest rate are also related to term to maturity. (The yield curve is the relationship between a security's interest rate and its term to maturity).

the mismatch of maturities between liabilities and assets of financial institutions exposes them to

interest rate risk

Nominal Interest rates

interest rates actually observed (and quoted) in financial markets. (examples: bank prime rate and federal funds rate. They incorporate all the potential risks that the cash flows of the security may/may not produce at PV.)

*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

The ______________ the annuity payment "PMT", the ____________ the present value of the annuity

lower; lower higher; higher

A single payment received at the beginning or end of an investment period is called a

lump sum payment

The difference between the required yield on long and short-term securities of the same characteristics except maturity is called the

maturity premium

The prices of securities with longer maturities are ____________ sensitive to changes in interest rates when compared to shorter maturity securities

more

Implied Forward Rate=

nf1=[(1+R)^n/(1+R)^(n-1)]-1 (implied forward rates apply to UET)

Factors affecting interest rates:

real rate of interest (RIR) DRP Liquidity risk premium Special Provisions (SCP) Term to Maturity (MP)

Investors demand more funds at lower interest rates because

the cost of borrowing funds is lower

Real Interest Rates

the rate that compensates for the opportunity cost of forgone consumption.

In addition to commercial banks, __________ also showed a decline in their share of total FI assets between 1948 and 2016.

thrifts

Nominal interest rates tend to __________ over time

vary


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