FIN 310 Exam 2 Frank Smith

Impact of Monetary policy

can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and thereforeaffect the demand for loanable funds by influencing inflationary expectations

Trade-offs of Monetary policy

n general, a stimulative monetary policy can increase economic growth and reduce unemployment but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment

Lagged Effects of Monetary policy

Rhe recognition lag represents the time from when a problem exists until it is recognizedby the Fed. It occurs because the economic statistics that are monitored to detect problems are onlyreported periodically.The implementation lag occurs when the Fed recognizes a problem but does not implement a policyto solve the problem until later.

Monetary policy during the Credit Crisis

Describe the Fed's monetary policy response to thecredit crisis that began in 2008.The Fed used a stimulative monetary policy during the credit crisis because economic conditionswere very weak. Specifically, the Fed's policy resulted in lower interest rates in the U.S

Feds Response to Fiscal policy

fiscal policy that involves much government borrowing could place upward pressure oninterest rates. If the Fed wants to keep interest rates low in order to stimulate the economy, it may need to use a loose monetary policy to offset the fiscal policy effect on interest rates.

Economic Indicators

Key indicators include interest rates, inflation rates, stock market performance, and consumer spending, which collectively provide insights into economic trends and potential risks for investors.

Why Monetary Policy might not work

might not work effectively due to factors such as time lags, where the impact of policy changes takes time to materialize, and limitations in the transmission mechanism, which can hinder how changes in interest rates influence spending and investment. Additionally, in a liquidity trap, low interest rates may not stimulate borrowing or spending, and structural issues in the economy can diminish the effectiveness of monetary interventions.

Primary Market as relates to Treasury funding

The Treasury issues Treasury bills through a weekly auction. Investors can submit competitive bids, where the Treasury will accept the highest bids first. Alternatively, investors can submit noncompetitive bids, which will automatically be accepted. The price to be paid by noncompetitive bidders is the weighted average price of accepted bids

Commercial paper

short-term, unsecured debt instrument issued by corporations, typically with maturities ranging from a few days to up to 270 days. Cost-effective way for companies to finance working capital and manage cash flow, often lower interest rates compared to bank loans, and is usually sold at a discount to face value.

Commercial paper ratings

Commercial paper ratings assess the creditworthiness of issuers and indicate the likelihood of timely repayment. These ratings, assigned by agencies like Moody's, S&P, and Fitch, range from high-grade (indicating low credit risk) to lower grades, helping investors gauge the risk associated with purchasing a company's commercial paper.

Negotiable CDs

time deposits offered by banks that can be sold in the secondary market, making them more liquid than traditional CDs. They typically have fixed interest rates and maturities ranging from a few weeks to several years, allowing investors to earn interest while maintaining the option to sell them before maturity.

Repurchase Agreements

agreements involving the sale of securities by one party to another with a promise by the seller to repurchase the same securities from the buyer at a specified date and price

Banker's Acceptances are:

short-term time drafts issued by banks to corporations

Reasons for Firms Issuing Commercial paper vs. other debt

due to its lower cost and flexibility, as it typically offers lower interest rates and quicker access to funds compared to bank loans or long-term bonds. Additionally, commercial paper allows companies to meet short-term liquidity needs without collateral, making it a convenient option for financing working capital.

Risk of Commercial paper

include credit risk, which is the potential for the issuing company to default on repayment, and liquidity risk, where an investor may find it difficult to sell the paper in the secondary market. Additionally, during economic downturns or financial crises, the market for commercial paper can become less liquid, increasing the risk for investors.

Calculate T-bill yield

T-Bill Yield={(Face Value−Purchase Price)/ Purchase Price}​×Days to Maturity/360​

Calculate Commercial Paper Yield

Commercial Paper Yield={(Face Value−Discount Price)/Discount Price}​×Days to Maturity/360​

Calculate REPO yield

Repo Yield={(Repurchase Price−Initial Price)/Initial Price}​×Days of Repo/360​

Bond Indenture

he bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. It is designed to address all matters related to the bond issue, such as collateral, and call provisions.A trustee represents the bondholders in all matters concerning the bond issue, including the monitoring of the issuing firm's activities to assure compliance with the terms of the indenture.

sinking fund provision

sinking-fund provision is a requirement that the firm retire a certain amount of the bond issue each year. This reduces the payments necessary at maturity and therefore can reduce the risk of investors.

Protective Covenants

Protective covenants are restrictions placed on the firm issuing bonds, in order to protectthe bondholders. For example, they may limit the dividends or corporate officer salaries, or limit theamount of debt the firm can issue.Protective covenants are needed to reduce the risk of bonds

call provision

call provision allows the issuing firm to purchase its bonds back prior to maturity at a specific price (the call price). Investors require a higher yield to compensate for this provision, other things being equal

Bond Collateral

Bond collateral may be established by the bond issuer as a means of backing the bond. Ifthe issuer defaults on the bonds, the investors would have a claim on the collateral.Some of the more common types of collateral for bonds are mortgages or real property (land andbuildings).

Debentures (unsecured bonds)

Debentures are backed only by the general credit of the issuing firm. Subordinateddebentures are junior to the claims of regular debentures, and therefore may have a higher probabilityof default than regular debentures.

Zero-coupon bonds

From the perspective of the issuing firm, low, or zero coupon, bonds have the advantage of requiring low or no cash outflow during the life of the bond. The issuing firm is allowed to deduct the amortized discount as interest expense for federal income tax purposes, which adds to the firm's cash flow. However, the lump-sum payment made to bondholders at maturity can be very large and could cause repayment problems for the firm.

convertible bonds

Convertible bonds allow investors to exchange the bonds for a stated number of shares ofthe firm's common stock. This conversion feature offers investors the potential for high returns if theprice of the firm's common stock rises. Because of this feature, the bonds can be issued at a higherprice

Impact of Credit Crisis on Junk Bonds

Many junk bonds defaulted during the credit crisis, as economic conditions weakened, and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time

Bond Downgrades

If corporate debt is downgraded, the required rate of return by investors would increase, as the bonds are now perceived to have a higher degree of default risk. Consequently, the price of those bonds would drop, resulting in a capital loss for current investors in those bonds. New investors in these bonds can purchase the bonds at a relatively low price, as this low price compensates for their recognition that the default risk of the bonds has increased.

junk bonds

High-risk, high-interest bonds

TIPS

Treasury Inflation-Protected Securities, are U.S. government bonds designed to protect investors from inflation. Their principal value adjusts based on changes in the Consumer Price Index (CPI).

How interest rates affect bond prices

inverse relationship: when interest rates rise, bond prices typically fall, and when interest rates decline, bond prices usually rise

Coupon rates and premium bonds

Coupon rates refer to the fixed interest payments that a bond issuer makes to bondholders, expressed as a percentage of the bond's face value.

Premium Bonds: These are bonds that are sold for more than their face value, typically because their coupon rate is higher than current market interest rates. Investors are willing to pay more for the higher returns.

discount bonds

These bonds are sold for less than their face value, often because their coupon rate is lower than prevailing market rates. Investors pay less upfront, anticipating the bond will still pay its full face value at maturity.

Bond price sensitivity

The price of a long-term bond is more sensitive to a change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time.Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities.The same is true for the disadvantage of fixed payments during a period of rising rates.

Inflation effects on bond prices

Inflation negatively affects bond prices by eroding the purchasing power of fixed interest payments, making them less attractive to investors. As inflation rises, investors demand higher yields to compensate for this loss of value, leading to a decline in existing bond prices since newer bonds may be issued with higher coupon rates

Choice of Monetary Policy

stimulative monetary policy may be used to stimulate the economy, especially ifinflation is not a concern. A restrictive monetary policy may be used to slow economic growth inorder to reduce inflationary fears

How the Fed Should Respond to Prevailing Conditions

This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of marketparticipants.

Monetary Policy During Credit Crisis.

he Fed was successful at reducing interest rates. However, under very bad economic conditions, many potential business projects may not be feasible even at the lower cost of borrowing ,because the potential cash flows from these projects are not sufficient to make the projects worth while. Also, the lending institutions were cautious when granting loans because of the high potential for default risk when lending to households or businesses during such a weak economy.Lending institutions should not extend loans unless they have confidence that the loans will be repaid

Stimulative Monetary Policy During a Credit Crunch

credit crunch implies that banks are very careful in their credit analysis of potential borrowers and are restricting the amount of credit they will provide. The ability of the Fed to stimulate the economy is partially influenced by the willingness of banks to lend funds. Even if theFed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank's qualification standards

Commercial Paper

Commercial paper is normally issued by well-known, creditworthy firms. Bank holding companies and finance companies commonly issue commercial paper.Those firms that issue commercial paper may decide to establish a department that can directly place the paper. In this way, the firms can avoid the transactions costs incurred when commercial paper dealers issue commercial paper. Such a strategy is only worthwhile if the firms continuously issue commercial paper

Commercial Paper Rates

Investors are less interested in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors

Motive to Issue Commercial Paper

The firm may be unwilling to lock in the prevailing long-term yield on bonds, perhaps because it expects that long-term interest rates (and yields offered on new bonds) will decline in the near future

Impact of Credit Crisis on Risk Premiums

During the credit crisis, some institutional investors avoided commercial paper issued by financial institutions because of the financial problems they were experiencing. Thus, the premium that some financial institutions had to pay when issuing commercial paper increased.

Global Interaction of Bond Yields

If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before

Event Risk

This question is related to event risk. The bonds held by the insurance company will now be more susceptible to default, because Hartnett Company is more likely to experience cash flow problems. Therefore, the required rate of return on those bonds will increase, and the market value of the bonds will decrease

Inflation Effects

Since lower inflation normally causes a decline in interest rates (other things being equal),financial institutions would benefit if they increase their concentration of long-term bonds before thisoccurs

If the Fed attempts to reduce inflation, it would likelyincrease money supply growth.

a. True

b. False

False

The time lag between when an economic problem arises and when it is reported in economic statistics is the:

a. recognition lag

b. implementation lag

c. impact lag

d. open-market lag

A loose money policy tends to ____ economic growth and ____ the inflation rate.

a. stimulate; place downward pressure on

b. stimulate; place upward pressure on

c. dampen; place upward pressure on

d. dampen; place downward pressure on

b. stimulate; place upward pressure on

To correct excessive inflation, the Fed could use open market operations by buying Treasury securities in the secondary market.

a. True

b. False

b. false

The federal funds market allows depository institutions to borrow

a. short-term funds from each other.

b. short-term funds from the Treasury.

c. long-term funds from each other.d. long-term funds from the Federal Reserve.

e. B and D

a. short-term funds from each other.

Treasury Bills

a. have a maturity of up to five years.

b. have an active secondary market.

c. are commonly sold at par value.

d. commonly offer coupon payments.

b. have an active secondary market.

If an investor buys a T-bill with a 120-day maturity and $50,000 par value for $48,500 and holds it to maturity, what is the annualized yield?

a. Less than 6%

b. Between 6% and 9.5%

c. Between 9.51% and 12%

d. Between 12.01% and 14%

e. Greater than 14%

b. Between 6% and 9.5%

Assume investors require a 7 percent annualized return on a six-month T-bill with a par value of $10,000.The price investors would be willing to pay is $____.

a. 10,000

b. 9,524

c. 9,756

d. none of the above

d. none of the above

At any given time, the yield on commercial paper is ____ the yield on a T-bill with the same maturity.

a. slightly less than

b. slightly higher than

c. equal to

d. A and B both occur with about equal frequency

b. slightly higher than

Treasury notes have a maximum maturity of ____ days.

a. 45

b. 270

c. 360

d. none of the above

d. none of the above

A repurchase agreement calls for an investor to buy securities for $4,825,000 and sell them back in 60 days for $5,000,000.What is the yield?

a. Less than 6%

b. Between 6% and 8%

c. Between 8.01% and 10.5%

d. None of the above

d. none of the above

The so-called "flight to quality" causes the risk differential between risky and risk-free securities to be

a. eliminated.

b. reduced.

c. increased.

d. unchanged (there is no effect).

b. increased

The coupon rate of most variable-rate bonds is tied to

a. the prime rate.

b. the discount rate.

c. LIBOR.

d. the federal funds rate.

c. LIBOR.

When would a firm most likely call bonds?

a. after interest rates have declined

b. if interest rates do not change

c. after interest rates increase

d. just before the time at which interest rates are expected to decline

a. after interest rates have declined

A ten-year, inflation-indexed bond has a par value of $10,000 and a coupon rate of 5 percent. During the first sixmonths since the bond was issued, the inflation rate was 2 percent. Based on this information, the coupon paymentafter six months will be $____.

a.250

b. 255

c. 500

d. 510

b. 255

Under the STRIP program created by the Treasury, strippedsecurities are created and sold by the Treasury.

a. True

b. False

b. False

Everything else being equal, which of the following bond ratings is associated with the highest yield?

a.Baa

b. A

c. Aa

d. Aaa

a.Baa

The key difference between a note and a bond is that note maturities are usually less than one year, while bond maturities are one year or more.

a. True

b. False

b. False

Devin is, a private investor, purchases $1,000 par value bonds with a 10 percent coupon rate and a 9.5percent yield to maturity. Devin will hold the bonds until maturity. Thus, he will earn a return of ____percent.

a. 12

b. 9.5

c. 10.0

d. more information is needed to answer this question

c. 10.0

Lisa can purchase bonds with 15 years until maturity, a par value of $1,000, and a 7percent annualized coupon rate for $1,100. Lisa's yield to maturity is ____ percent.

a.9.33

b. 7.84

c. 9.00

d. none of the above

d. none of the above

Yield from investing pesos to dollar formula

(1+tield)x(1)+(final value-value at time of investment/value at time of investment)

Commercial paper is subject to

Interest rate risk and default risk

Interest rate charged on international interbank loans

LIBOR

ANNUALIZE YIELD BUYIJNGA A HOUSE

(SP-PP/(PP) x (365/HOLDING PERIOD)

T-bills and commercial paper are sold

@ discount from par value

Money market instrumemnts

banker acceptances, commercial paper, negotiable CDs, REPO agreements

Investors in Tearsury notes and bonds recience _______ interest payments from the treasuty

SEMI-ANNUAL

Interest earned from treasury bonds

EXEPMT from all STATE and LOCAL taxes

find coupon pmt

={PV (1+ inflation rate first 6 months) (Coupon rate)} 2 for semi annual

Munical general obligation bonds are

supported by the municiple governments ability to tax

Municpal revenue bonds are

supported by revenue generated from the project