The Federal Reserve System, Interest Rates, Security Valuation, and Loanable Funds Theory

Flashcards covering Chapter 4 (Federal Reserve System and Monetary Policy), Chapter 3 (Interest Rates and Security Valuation), and Chapter 2 (Determinants of Interest Rates) for FIN 333.

What are the four primary duties of the Federal Reserve as established under the Federal Reserve Act of 1913?

1. Conducting monetary policy\n2. Supervising and regulating depository institutions\n3. Maintaining the stability of the financial system\n4. Providing payment and other financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

What is the organizational structure and appointment process for the Federal Reserve Board of Governors?

The Board of Governors consists of 7 members located in Washington, D.C. Each member is appointed by the president of the U.S. and confirmed by the Senate to serve a nonrenewable 14-year term.

What are the primary responsibilities and meeting requirements of the Federal Open Market Committee (FOMC)?

The FOMC is required to meet at least four times each year in Washington, D.C. Its main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade, as well as setting guidelines regarding open market operations.

What is the function of the Federal Reserve's Beige Book?

The Beige Book summarizes information on current economic conditions by Federal Reserve district.

What are the eight primary functions performed by Federal Reserve Banks (FRBs)?

1. Assistance in the conduct of monetary policy\n2. Supervision and regulation\n3. Consumer protection and community affairs\n4. Government services\n5. New currency issue\n6. Check clearing\n7. Wire transfer services\n8. Research services.

What constitutes the Fed's monetary base on its balance sheet?

The monetary base (or money base) is the sum of currency in circulation and total reserves (which consists of required reserves and excess reserves).

What are the major assets held on the Federal Reserve's balance sheet?

Major assets are Treasury securities, government agency securities (e.g., Fannie Mae, Freddie Mac), Treasury currency, and gold and foreign exchange.

Through which Federal Reserve entity and document are open market operations executed?

When a target is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a policy directive, which instructs traders on daily open market transactions.

What are the three lending programs offered through the Federal Reserve's discount window?

1. Primary credit: available to generally sound depository institutions on a very short-term (typically overnight) basis at a rate above the target fed funds rate.\n2. Secondary credit: available to meet backup liquidity needs.\n3. Seasonal credit: available to institutions with recurring intrayearly swings in funding needs.

What was authorized by the Financial Services Regulatory Relief Act of 2006 regarding bank reserves?

It authorized the Federal Reserve to pay interest on reserve balances, including interest on excess reserves (IOER) and interest on required reserves (IORR).

How does a change in the reserve requirement ratio affect bank deposits through the multiplier effect?

The multiplier effect formula is $\text{Change in bank deposits} = \left(\frac{1}{\text{New reserve requirement}}\right) \times \text{Change in reserves}$. A decrease (increase) in the reserve ratio causes a multiple expansion (contraction) of bank deposits and the money supply.

According to the Taylor rule, what three conditions determine short-term interest rate targets?

1. Where actual inflation is relative to the Fed's targeted level\n2. The extent to which the economy is above or below its full employment level\n3. What short-term interest rates should be to achieve full employment.

How do expansionary monetary policy activities impact reserves, money supply, credit availability, interest rates, and security prices?

Expansionary activities (open market purchases, discount rate decreases, reserve requirement ratio decreases) increase reserves ($\uparrow$), increase money supply ($\uparrow$), increase credit availability ($\uparrow$), decrease interest rates ($\downarrow$), and increase security prices ($\uparrow$).

What action did the Bank of England take in August 2016 following the Brexit vote?

The Bank of England cut interest rates for the first time in more than seven years to a new record low of $0.25\%$ as part of a four-point plan to prevent a post-Brexit recession.

What is the required rate of return ($r$) and how is its fair present value ($PV$) calculated?

The required rate of return ($r$) is the ex-ante interest rate used to find the fair present value of a financial security based on its risks. The formula is $PV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}$.

What is the expected rate of return ($E(r)$) for a financial security?

The expected rate of return ($E(r)$) is the interest rate a market participant expects to earn by buying the security at its current market price ($\bar{P}$), receiving all projected cash flows ($CF_t$), and selling it at the end of their investment horizon. It satisfies $\bar{P} = \sum_{t=1}^{n} \frac{CF_t}{[1 + E(r)]^t}$.

How is the realized rate of return ($\bar{r}$) defined and evaluated relative to the required rate of return ($r$)?

The realized rate of return ($\bar{r}$) is an ex-post measure of the actual return earned on an investment. If $\bar{r} > r$ ($\bar{r} < r$), the investor earned more (less) than was needed to compensate for the expected risk.

What is market efficiency in the context of security valuation?

Market efficiency refers to the speed with which financial security prices adjust to unexpected news to maintain equality with the fair present value of the security.

What conditions classify a bond as trading at a premium, at par, or at a discount?

• Premium (above par): Bond Price $>$ Face Value, occurs when Coupon Rate $>$ Yield to Maturity.\n- Par (at par): Bond Price $=$ Face Value, occurs when Coupon Rate $=$ Yield to Maturity.\n- Discount (below par): Bond Price $<$ Face Value, occurs when Coupon Rate $<$ Yield to Maturity.

What is the formula for calculating the present value ($V_b$) of a zero-coupon bond with semiannual compounding?

$V_b = \frac{M}{\left(1 + \frac{r_b}{2}\right)^{2T}}$, where $M$ is the face value, $r_b$ is the annual required rate of return, and $T$ is the number of years to maturity.

What is the valuation formula ($P_0$) for a stock expecting constant growth ($g$) in dividends?

$P_0 = \frac{Div_1}{r_s - g} = \frac{Div_0(1 + g)}{r_s - g}$, where $Div_1$ is the dividend expected at the end of year 1 and $r_s$ is the required rate of return on the stock.

What are the three steps to find the present value of a stock with supernormal (nonconstant) dividend growth?

1. Find the present value of the dividends during the period of supernormal growth.\n2. Find the price of the stock at the end of the supernormal growth period using the constant growth model, and discount this price to a present value.\n3. Add the two present value components together.

How do time to maturity and coupon rate affect a bond's price sensitivity to interest rate changes?

• Time to maturity: As time remaining to maturity increases, price sensitivity increases at a decreasing rate.\n- Coupon rate: The higher the coupon rate, the smaller the price changes on the bond for a given change in interest rates.

What is duration and what is its general formula for a bond paying semiannual coupons?

Duration ($D$) is the weighted-average time to maturity on an investment using the relative present values of cash flows as weights. Formula: $D = \frac{\sum_{t=1/2}^{N} \frac{CF_t \times t}{\left(1 + \frac{r}{2}\right)^{2t}}}{\sum_{t=1/2}^{N} \frac{CF_t}{\left(1 + \frac{r}{2}\right)^{2t}}}$.

How does duration relate to a bond's coupon rate, rate of return, and maturity?

• Coupon rate: Higher coupon rate $\rightarrow$ shorter duration.\n- Rate of return: Higher rate of return $\rightarrow$ shorter duration.\n- Maturity: Duration increases with maturity, but at a decreasing rate.

What is the equation for percentage price change ($\frac{\Delta P}{P}$) using duration for semiannual compounding?

$\frac{\Delta P}{P} = -D \left(\frac{\Delta r_b}{1 + \frac{r_b}{2}}\right)$, or using modified duration ($MD$): $\frac{\Delta P}{P} = -MD \times \Delta r_b$.

What is convexity and why is it desirable for an investor?

Convexity is the degree of curvature of the price-interest rate curve around an interest rate level. It is desirable because the capital loss effect of large rate increases is smaller than the capital gain effect of large rate decreases.

What is Loanable Funds Theory?

A theory stating that equilibrium interest rates in financial markets are determined by the supply and demand for loanable funds among market participants (households, businesses, governments, and foreign investors).

According to 2019 data, which market participants were net suppliers and net demanders of loanable funds?

• Net Suppliers: Households ($+68.61$ trillion) and Foreign Investors ($+6.39$ trillion).\n- Net Demanders: Businesses ($-51.80$ trillion) and Governments ($-23.20$ trillion).

What is the Fisher Effect formula relating nominal interest rate ($i$), real risk-free rate ($RFR$), and expected inflation ($E(IP)$)?

$$i = RFR + E(IP)$$

What is the formula for calculating inflation ($IP$) using the Consumer Price Index ($CPI$)?

$$IP = \frac{CPI_{t+1} - CPI_t}{CPI_t} \times 100$$

What is the comprehensive functional equation for determining the fair interest rate ($i_j^*$) on an individual security $j$?

$i_j^* = f(IP, RFR, DRP_j, LRP_j, SCP_j, MP_j)$, where $IP$ is inflation premium, $RFR$ is real risk-free rate, $DRP_j$ is default risk premium, $LRP_j$ is liquidity risk premium, $SCP_j$ is special provisions, and $MP_j$ is maturity premium.

What are the three theories that explain the term structure of interest rates?

1. Unbiased Expectations Theory: Yield curve reflects current expectations of future short-term rates, assuming risk-neutral investors.\n2. Liquidity Premium Theory: Investors require a liquidity premium ($L_2 < L_3 < \dots < L_N$) to hold longer-term securities due to future uncertainty.\n3. Market Segmentation Theory: Investors and FIs have rigid maturity preferences based on liabilities and require a maturity premium to buy outside their preferred horizon.

What are the Present Value formulas for a lump sum and an annuity?

• Lump Sum: $PV = \frac{FV_t}{(1 + r)^t}$\n- Annuity: $PV = PMT \times \frac{1 - \frac{1}{(1 + r)^t}}{r} = \frac{PMT}{r} \left[1 - \frac{1}{(1 + r)^t}\right]$

According to this summary table, how do expansionary activities compare to contractionary activities across monetary policy impacts?

Expansionary activities (purchases, discount rate cuts, reserve ratio cuts) increase reserves, money supply, credit availability, and security prices, while decreasing interest rates. Contractionary activities (sales, discount rate hikes, reserve ratio hikes) decrease reserves, money supply, credit availability, and security prices, while increasing interest rates.

Based on Panel A and Panel B of this table, what is the impact on equilibrium interest rates when total wealth increases versus when economic conditions expand?

An increase in total wealth shifts the supply curve, causing an inverse impact on equilibrium interest rates (rates decrease). Improved economic conditions shift both the supply curve (inverse effect on rates) and the demand curve (direct effect on rates).