Final Exam - Slate Financial Markets

What is the risk structure of interest rates?

Explains why yields differ across bonds of the same maturity due to different levels of default risk, liquidity, and tax status.

What are the three components of the risk structure?

Default Risk - probability the issuer won’t pay

Liquidity - ease of converting to cash quickly

Tax Status - federal/state tax treatment of interest income

What is the three-step sequence when default risk rises on corporate bonds?

1. Demand for corporate bonds fall → prices drop, corporate yields rise

2. Demand for treasuries rises (flight to quality) → Treasury prices rise, yields fall

3. The risk premium (yield spread) widens between the two

Name the three major credit rating agencies and their top investment-grade ratings.

Moody’s → Aaa

S&P → AAA

Fitch → AAA

Why do Baa bonds have higher yields than Aaa bonds of the same maturity?

They have a higher default risk (investors demand a larger risk premium for higher risk)

How does the Aaa-Baa yield spread behave across the business cycle?

Narrows in expansions (rising confidence, more demand for corporates)

Widens in recessions (fear rises, more demand for treasuries)

Why do municipal bonds trade at lower coupon rates than comparable corporate bonds?

Municipal bond interest is exempt from federal income tax

What happens to muni bond demand and yields if the top federal tax bracket falls?

The tax benefit of munis shrink → demand decreases → muni prices fall → muni yields rise

What is flight-to-quality?

Investors sell risky assets and buy U.S. Treasuries

In the First Brands case (automotive company), what happened to loan prices as credit quality deteriorated?

As default risk rose, loan prices fell pre-bankruptcy.

What is the term structure of interest rates?

Explains why yields differ across bonds of DIFFERENT maturities but similar credit quality - the relationship is plotted as the yield curve.

What are the three empirical facts about interest rates any term structure theory must explain?

1. Rates of different maturities move together over time

2. Short-term rates are more volatile than long-term rates

3. The yield curve is usually upward-sloping

Expectations Theory

Assumption: bonds of different maturities are perfect substitutions

Implication: the long-term rate equals the average of expected future short-term rates

What does an inverted yield curve signal under Expectations theory?

Expected future short-term rates are below current levels

Market Segmentation Theory

Assumption: bonds of different maturities trade in separate, independent markets with distinct supply and demand

Liquidity Premium Theory

Long-term rate = average of expected short-term rates + a liquidity premium that increases with maturity

What does an upward-sloping yield curve signal?

Expected future short-term rates are rising, or the shape simply reflects the liquidity premium. Associated with a healthy/growing economy.

What does an flat yield curve signal?

Expected future short-term rates are roughly unchanged; often a transitional state between expansion and contraction.

What does it mean that a stockholder is a residual claimant?

Stockholders have the LAST claim on assets in bankruptency

What are the two sources of stockholder return?

1. Dividends (periodic cash payments)

2. Capital Appreciation/Depreciation (change in stock markets price)

One-Period Valuation Model

P0 = (D1 + P1) / (1 + K) where K=required return & P0 is what price today is

Gordon Growth Model

P0 = D1 / (K - g) where D1 = D0 x (1+g)

Why does the terminal price’s contribution approach zero as the holding period approaches infinity?

Each successive future price is discounted by an increasingly large factor.

Adaptive vs. Rational Expectation

Adaptive: uses past data, slow to update when new info arrives

Rational: uses ALL available info immediately - forecasts are unbiased on average and adjust instantly to the news

EMH - Weak Form

Past prices are fully reflected in current prices

EMH - Semi-Strong Form

All publicly available info is already reflected in prices

EMH - Strong Form

All info (public and private ie. insider) is reflected in prices

What is the Random Walk hypothesis?

Stock price changes are random and unpredictable; past movements give no info about future movements.

What evidence supports the EMH?

The majority of actively managed funds underperform their benchmarks over long horizons

What is arbitrage within the EMH framework?

When a mispricing appears, arbitrageurs buy the underprices asset and sell the overprices one, driving prices back to fair value.

March 2026 CPI Report

• Headline inflation diverged from core; energy was s significant contributor

• A softer core print reshaped Fed rate-cut expectations and pushed yields lower, signaling reduced pipeline inflation pressure

March 2026 PPI Report

• Goods and services PPI Diverged; the downside surprise indicated softer producer-level inflation feeding into future CPI

US - Iran / Straight of Hormuz market impacts

Straight of Hormuz → energy price shock → broader market volatility → drove more investors into treasuries

How does the ceasefire announcement illustrate EMH and Rational Expectations?

Markets quickly repriced

How do soft CPI and PPI prints reshape the yield curve?

Reduced inflation expectations → markets price in Fed rate cuts sooner → short-term yields fall → curve shape changes

What do observable prices accomplished in financial markets?

Signal asset values, enable price discovery, allow investors to compare investments, verify valuation assumptions, and serve as benchmarks.

Direct vs. Indirect Capital Market Access

Direct: lower cost but requires execution capability and bears transaction risk

Indirect: intermediary required higher cost but reduces execution complexity and counterparty risk

Primary vs. Secondary Market

Primary: the issuer receives the proceeds

Secondary: investors trade among themselves

Broker vs. Dealer

Broker: matches buyers and sellers, earns a commission, takes no inventory risk

Dealer: buys/sells from own inventory

Money Markets vs. Capital Markets

Money Markets : short-term instruments (less than 1 year), lower risk, highly liquid (T-bills, commercial paper)

Capital Markets: long-term instruments (bonds/equities), higher risk, wider investor base

What is shadow banking and why does it matter in 2026?

Non-bank financial intermediaries (hedge funds, private credit, pawn shops) that perform bank-like functions with less regulatory oversight.

Systematic risk remains a concern.

Why is liquidity considered the most under appreciated risk?

Liquidity can vanish suddenly even from normally liquid markets.

What are the three functions of money?

1. Medium of exchange - facilitates transactions without barter

2. Unit of account - common measure of value

3. Store of value - preserves purchasing power over time

Money vs. Wealth vs. Income

Money - a liquid asset

Wealth - a stock (total assets minus liabilities)

Income - a flow of earnings over a period of time

What are the components of M1 (most liquid)?

Currency in circulation

Demand Deposits

Checkable deposits

What does M2 (near money) add to M1?

M2 = M1 + savings deposits + small time deposits (CDs) + retail money market fund shares

What is the key distinction between M1 and M2?

M1 is immediately spendable (most liquid). M2 includes M1 plus less liquid near-money assets

M2 is always larger than M1.

Why is interest rate NOT the same as a return?

Return accounts for price changes during the holding period. You can earn the stated coupon rate but still have a negative return if the bond’s price falls.

What is duration risk?

The risk that a bond’s price will fall when interest rates rise. Longer-maturity bonds are MORE sensitive to rate changes and carry a higher duration risk.

Fisher Relationship

Nominal rate = Real rate + expected inflation

Negative real rates benefit borrowers and harm lenders.

How do higher interest rates shift investment decisions?

Higher rates raise the return on savings and increase the cost of borrowing — tipping decisions towards saving and away from investment and consumption across asset classes.

Real vs. Nominal interest rates

Nominal rate: the stated rate on a financial instrument

Real rate: purchasing power adjusted return

Theory of Portfolio Choice - 4 demand drivers

1. Wealth — more wealth → more bond demand

2. Expected Return relative to alternatives

3. Risk — inverse (more risk → less demand)

4. Liquidity — more liquid → more demand

Why do risk premiums exist in real markets?

Most investors are risk-averse — they require extra expected return (risk premium)

What shifts the bond SUPPLY cureve?

Changes in expected profitability of investment, expected inflation, and government budget deficits

What shifts bond DEMAND curve?

Changes in wealth, expected return on bond vs. alternatives, expected inflation, risk, and liquidity

Fisher Effect

Rising expected inflation → lower expected real return on bonds → demand falls while returns on real assets rise → bond supply increase

Net result: interest rates rise

Why do interest rates move like the economy?

During expansions, investment demand rises, profits rise, and inflation expectation increases — bond S&D shift in ways that push rates higher.

What are the 3 structural parts of the Federal Reserve System?

1. Board of Governors (7 members, DC)

2. 12 Regional Federal Reserve Banks

3. Federal Open Market Committee (FOMC & NY is permanent)

Why are Fed Governors given 14-year non-renewable terms?

To insulate monetary policy from short-term political pressure.

What is the Fed’s Dual Mandate?

maximum employment AND stable prices (2% inflation)

What is the composition of the FOMC?

7 Governors + 5 of the 12 Reserve Bank Presidents (NY President is a permanent member)

What is monetary base?

Currency held by the public + reserves held by commercial banks at the fed.

How does an open market purchase expand the monetary base?

The Fed buys treasury securities → credits bank reserves → reserves and monetary base increase → downward pressure on the Fed Funds rate

What is IORB and why doesn’t paying it automatically multiply the monetary base?

Interest on Reserve Balances — the rate the Fed pays banks on reserves. Paying IORD incentivizes banks to hold excess reserves rather than lend.

What are the 4 tools of monetary policy?

1. Open Market Operations

2. Discount Rate

3. Reserve Requirements

4. Interest on Reserve Balances

What is the corridor system?

The Fed Funds rate is bounded by:

Ceiling = Discount Rate

Floor = IORB

The market rate trades within the 2.

What is SOFR and why is it the benchmark overnight rate?

Secured Overnight Financing Rate — based on actual overnight Treasury-backed repo transacations

TVM Formula

PV = CF / (1 + I)^n

Liquidity Premium Theory Formula

in​=n1​(i1e​+i2e​+⋯+ine​)+ln​

• in​ = interest rate on an nnn-period bond

• i1e,i2e,…,inei_1^e, i_2^e, \dots, i_n^ei1e​,i2e​,…,ine​ = expected future short-term interest rates

• lnl_nln​ = liquidity premium for an nnn-period bond (increases with maturity)

FV Formula

FV = PV x (1 x i)^n

Total Interest Earned

Total Interest = FV - PV

Total Return on a Bond

Current Yield = C / P0

Capital Gail Yield = (P1-P0)/P0

Total Return = Current Yield + Capital Gain Yield