FIN 3100 Chapters 4,5,6 Questions WMU

What are the functions performed by Federal Reserve Banks?

Assist in monetary policy, supervise banks, consumer protection, provide services to U.S. Treasury, issue currency, check clearing, wire transfer services, conduct economic research.

What is the discount rate?

The interest rate charged on loans the Federal Reserve makes to depository institutions.

What is the discount window?

The facility through which banks borrow reserves from the Federal Reserve.

How is the Board of Governors structured?

Seven members appointed by the U.S. President, confirmed by the Senate, serving staggered 14-year terms. All serve on FOMC

What are the primary responsibilities of the Federal Reserve Board?

Conduct monetary policy, supervise bank holding companies, approve discount rates, set reserve requirements, administer consumer credit regulations.

What are the primary responsibilities of the FOMC?

Main monetary policymaking body, sets targets for open market operations, sets federal funds rate, monitors discount rate and reserve requirements.

What are the major liabilities of the Federal Reserve System?

Currency in circulation and depository institution reserves.

Why did reserve deposits become the largest liability in the late 2000s?

Due to massive liquidity injections during the financial crisis and banks holding liquidity as excess reserves.

What are the major assets of the Federal Reserve System?

Treasury securities, government agency/MBS securities, gold and foreign exchange holdings, treasury currency, interbank loans.

Why did U.S. government agency securities become the largest asset in the late 2000s?

The Fed purchased up to $1.25 trillion of MBS to stabilize housing and mortgage markets.

What tools does the Federal Reserve use to implement monetary policy?

Open market operations, discount rate, reserve requirements.

How does a decrease in the discount rate affect credit and money supply?

Lowers borrowing costs for banks, increases bank lending, expands money supply, increases credit availability.

Why does the Fed rarely use the discount rate?

Discount borrowing is voluntary, associated stigma, open market operations are more flexible.

What were the changes to discount window policy in the early 2000s vs. late 2000s?

Early 2000s: Introduction of primary credit at above-market rates. Late 2000s: Creation of emergency lending facilities.

What is the most frequently used monetary policy tool and why?

Open Market Operations, because they allow precise control of reserve balances and interest rates.

What are the effects of expansionary Federal Reserve activities?

Increases bank reserves, expands money supply, lowers interest rates, increases credit availability.

What are the effects of contractionary Federal Reserve activities?

Decreases bank reserves, reduces money supply, raises interest rates, reduces credit availability.

What monetary policy measures were taken by central banks during the global financial crisis?

Injected liquidity, guaranteed deposits, nationalized banks, conducted interest rate cuts, implemented asset purchase programs.

What are the three characteristics common to money market securities?

Short maturities (≤1 year), high liquidity, low default (credit) risk.

What is the difference between discount yield and bond-equivalent yield?

Discount yield uses a 360-day year based on face value; bond-equivalent yield uses a 365-day year to annualize true return.

Which yield is used for T-bill quotes?

Discount yield.

Why can discount yields not be compared to yields on other securities?

They use face value instead of price and a 360-day year, making them not directly comparable.

What is the difference between a single-payment yield and a bond-equivalent yield?

Single-payment yield uses price-based interest calculation; bond-equivalent yield converts returns to a standardized 365-day annual rate.

Describe the T-bill auction process.

Issued weekly by the U.S. Treasury, sold at discount with maturities of 4, 13, 26, and 52 weeks; investors submit competitive or non-competitive bids in a uniform-price auction.

What is the difference between competitive and noncompetitive bids in T-bill auctions?

Noncompetitive bids guarantee allocation at the auction yield; competitive bids specify yield and are filled only if below the cutoff yield.

How are T-bills traded in secondary markets?

Actively traded OTC, very liquid with narrow bid-ask spreads, heavy participation by banks, dealers, and institutional investors.

What are federal funds?

Unsecured overnight loans between banks to meet reserve requirements.

How are federal funds recorded on bank balance sheets?

Fed funds sold = asset; Fed funds purchased = liability.

Describe the two types of fed funds transactions.

Overnight loans (most common) and term federal funds (longer than overnight, up to a week).

What is the primary risk of trading in the fed funds market?

Counterparty credit risk due to unsecured lending.

How did the primary risk in the fed funds market play into the 2008-2009 crisis?

Banks feared each other's solvency, leading to dried-up lending, spiked fed funds rate, and liquidity collapse.

What is the difference between a repurchase agreement and a reverse repurchase agreement?

Repo involves selling securities with an agreement to repurchase; reverse repo involves buying securities with an agreement to resell.

Describe the trading process for repurchase agreements.

Bilateral agreement between dealer and investor, collateral posted (usually T-bills), rate agreed (repo rate), typically held to maturity.

Why do commercial paper issues have maturities of 270 days or less?

To avoid SEC registration, which is required for maturities greater than 270 days.

Why do commercial paper issuers almost always obtain a rating?

Investors require ratings for unsecured short-term debt; higher ratings lead to lower borrowing costs and wider investor base.

What factors caused commercial paper outstanding to increase and decrease?

Increases due to strong corporate growth and low interest rates; decreases due to recession and financial crisis.

What is the process through which negotiable CDs are issued?

Bank issues large-denomination time deposit with fixed interest rate, maturity 2 weeks-1 year, becoming a negotiable instrument.

Describe how a banker's acceptance is created.

Bank accepts a draft guaranteeing payment, used in international trade to finance shipments, can be sold at discount in money markets.

Who are the major issuers of and investors in money market securities?

Issuers: U.S. Treasury, corporations, banks, dealers; Investors: banks, money market funds, corporations, institutional investors, governments, international investors.

What issues regarding the validity of the LIBOR rate arose before and during the financial crisis?

Banks misreported borrowing rates to appear healthier, making LIBOR unreliable as a benchmark and leading to a widespread rate manipulation scandal.

What are Eurodollar CDs?

U.S. dollar-denominated negotiable CDs issued outside the U.S.

What is Eurocommercial paper?

Short-term unsecured paper issued outside the U.S., denominated in dollars or other major currencies.

What are capital markets, and how do bond markets fit this definition?

Capital markets trade long-term debt and equity instruments. Bonds are the primary long-term debt instruments, so bond markets are a fundamental component of capital markets.

What are the differences among T-bills, T-notes, and T-bonds?

T-bills: Maturity ≤1 year. T-notes: Maturity 2-10 years, pay semiannual coupons. T-bonds: Maturity >10 years, pay semiannual coupons.

What is STRIPS?

STRIPS are separate trading of registered interest and principal securities: zero-coupon bonds created by stripping interest and principal payments from Treasury securities.

What are the advantages and disadvantages of investing in T-notes/T-bonds?

Advantages: Default-risk free, highly liquid, predictable coupons. Disadvantages: Subject to interest rate risk, subject to inflation risk.

Describe the process through which T-notes/T-bonds are issued in primary markets.

Issued through Treasury auctions: investors submit bids, securities sold at uniform price, minimum denomination $100, quoted in 32nds.

What is the difference between general obligation bonds and revenue bonds?

General obligation bonds are backed by the full taxing authority of the issuer (e.g., municipalities). Revenue bonds are repaid from specific project revenues (e.g., toll roads).

Would a municipal bond issuer want to purchase insurance?

Yes—bond insurance reduces default risk, increases credit rating, and lowers borrowing costs.

How does bond underwriting differ from best-efforts underwriting?

Underwriting (firm commitment): Investment bank buys entire issue—bank bears risk. Best efforts: Bank sells what it can—issuer bears risk.

What is a bond indenture?

A legal contract describing the bond's terms: coupon, maturity, covenants, collateral, rights of bondholders/issuer.

What is the difference between bearer bonds and registered bonds?

Bearer bonds are paid to whoever holds the certificate. Registered bonds have the owner's name recorded; interest and principal paid electronically.

What is the difference between term bonds and serial bonds?

Term bond: Entire principal repaid at one maturity date. Serial bond: Portions of principal repaid over multiple dates.

What type of mortgage-backed bond has the highest risk to investors?

Subordinated debentures—paid only after senior securities; highest default risk.

Who has the rights listed?

Right to get the bond back early: Issuer (callable bonds). Last claim in default: Subordinated debenture holders. Highest yield: Subordinated debenture holders.

Why are convertible bonds more or less attractive?

Attractive to investors because of equity upside + lower coupon. Less attractive to issuer due to potential dilution but lowers interest cost.

When is a callable bond more attractive to investors?

A callable bond is less attractive to investors unless it offers higher yield to compensate for reinvestment risk.

Explain the meaning of yield to maturity, current yield, and call provision.

YTM: Total return if held to maturity. Current yield: Annual coupon ÷ price. Call provision: Allows issuer to repay early.

What is the difference between an investment-grade bond and a junk bond?

Investment-grade: Rated BBB/Baa or above. Junk bond: Rated below BBB/Baa; higher yield, higher credit risk.

What happens to the price of a bond when interest rates increase?

Bond prices fall due to the inverse relationship between price and yield. Longer-term bonds experience greater price drops (duration effect).

What happens to the price of a bond when the required rate of return decreases?

Bond prices rise; again, the inverse relationship applies.

Which bond's price is more affected by interest rate changes—short-term or long-term? Why?

Long-term bonds—because of higher duration, making price more sensitive to yield changes.

How did the corporate bond market change during the financial crisis?

Spreads widened dramatically, default risk concerns increased, and liquidity fell as investors fled to safe assets.

How do rising rates affect bond prices and yields?

Rising interest rates lead to falling bond prices and rising yields. YTM increases as price falls.

What is the difference between a Eurobond and a foreign bond?

Foreign bond: Issued in another country's market using that country's currency. Eurobond: Issued outside the currency's home country.

How did sovereign bonds perform during the 2000s?

Sovereign spreads widened during crises (Greek debt crisis, emerging market volatility), reflecting increased perceived default risk.