FIN435 Final Exam Concepts Review

What are money markets?

Short-term financial markets used for borrowing and lending (≤ 1 year)

Purpose of Money Markets

Provide short-term funding and liquidity

what are Money Market Securities

Low-risk, short-term, highly liquid instruments

what is Liquidity

Ability to quickly buy or sell an asset with little price impact

What are treasury bills?

Short term government securuties wit no default risk

What is commerical papers

Short term unsecured debit issued by the corporations

What is certificate of deposit?

Bank issued time deposits with fixed interest rates

What is the money market risk level?

Low risk and low return

What is the federal reserve?

Central bank of the US that controls money supply and interest rates

What is the primarty goal of the Fed?

Promote stable prices, full employment, and economic growth

What is open markets?

Buying/selling government securities to control money supply

What id the fed fund rate?

Interest rate banks charge each other for overnight loans to maintain money levels at a specific bank,

—overnight because the banks need to maintain levels daily

What is the effect of fed buying securities?

Money supply increase —> interest rates decrease

What is the effect of fed selling securities

Money supply decreases —> interest rates increase

What is the effect of higher interest rates?

Decreases economic activity

What is the effect of lower interest rates?

Increases economic activity

What is the Nominal rate? (R)

Rate adjusted for inflation (dollar return)R

Real rate ®

Rate adjusted for inflation (purchasing power)

What is inflation rate?

Rate at which price increases over time (h)

What is Fisher’s equation?

1+R=(1+r)(1+h)

Interaction terms for Nominal rates

r x h makes exact nominal rate slightly higher

What is unexpected inflation effect? (UET)

Higher than expected inflation benefits borrowers, but hurts lenders

What is a yield curve?

Graph showing interest rates across different maturities

What does a upward sloping yield curve mean?

Future short term rates are expected to increase

What does a downward sloping yield curve mean?

Future short term rates are expected to decrease

What does a flat yield curve mean?

Future short term rates are expected to remain constant

What is the Unbiased Expectation Theory (UET)

Long term rates = average of expected future short term rates

KEY UET Assumption

No risk premium (pure expectations only)

What is a forward rate?

Expected future short term interest rates

r(1,2)

What is spot rate?

Current interest rate for a given maturity

KEY UET Formula

(1+RN​)N=(1+R1​)(1+E(r1​))(1+E(r2​))...(1+E(rN−1​))

• RN​ → long-term rate today

• R1R_1R1​ → rate today

• E(r)E(r)E(r) → future expected rates

• Forward rate is (r1,2)

  • expected 1-year rate from year 1 to year 2

What are interest rate risk?

Risk that bond prices change when interest rates change

What is the inverse relation shi between interest rates and bond prices?

Interest rates increase but bond prices decrease

What is Duration? (D)

Measure of bond price sensitivity to interest rates

What is duration interpreation?

Higher duration—> higher interest rate risk

What is the duration formula?

PΔP​≈−D⋅1+rb​Δrb​​

What factors increaes duration?

Longer maturity, lower coupon, lower interest rates

What are factors of decreasing duration?

Higher coupon, higher interest rates

What is a mortgage?

Loan SECURED by real estate

What is collateral?

Asset pledged to secure a loan

What is foreclosure?

Process where lenders take properties after missing payments

What is a mortgage risk for a lender?

Default risk (borrower fails to repay

If actual inflation is greater than expected that means what for the power of oney?

Money is worth less than expected

Borrowers repay with less valuable dollars which means lenders

They receive less purchasing power

REMEMBER THIS

Keep in mind what year rate the question is asking as some year rates wont apply to the question

Ex:

what is the expected year 3 rate

You wouldn’t need to plug in the rate for year one as its not the most recent years, year 2 and year 3

Under UET, if long term rates are higher than short term rates, does that ALWAYS mean rates will rise?

NO, because other factors like liquidity premiums can also cause long term rates to be higher

What is the generic rate of return formula?

Rate of Return = (Ending value - Beginning Value)/Beginning Value x 100%

What is the rate of return formula for BOND/Money Market version

Return = (Face Value - Price paid today)/ (Face Value)

What is the formula for rate of return for INCOME

Return = (Income + (P1 + P0)/(P0)

P0= initial price

P1= final price

Inflation and deflation are ___ and not tools

OUTCOMES

What is the main tool the Fed Reserve uses to control interest rates?

Open market operation

Do banks use the fed rate as their rate for lending and borrowing money rom other banks?

No, they can use it as a foundation and will prolly increase their rates to make a profit on the difference

what is the main risk to the lender of a mortgage?

The borrower defaults risk

What type of mortgage has a fixed interest rate for the entire life of the loan?

Fixed-Rate mortgage

What type of mortgage has a fixed interest rate for the entire life of the loan?

Adjustable-rate mortgage (ARM)

ARM = rates move with the market

Which mortgage type is riskier for the borrower

ARM

Which mortgage type is riskier for the lender

Fixed rate

What does owning a stock (share) represent?

Ownership of a portion of the company

If you are shareholder of a stock you may receive, this is how investors of a stock make money?

Dividends and capital gains

What is a dividend?

A cash payment made by a company to its shareholders

What is capital gain?

Profit from selling a stock at a higher price than the purchase price

What is the main risk of owning stocks?

Market Risk aka Losing money

Which is generally riskier:

👉 Stocks or bonds?

Why

• Stock prices are more volatile

• No guaranteed payments

• Last to get paid if company fails

Stocks = higher risk, higher return

Why do investors still choose stocks if they are riskier?

(1 line — key idea)

Higher potential returns

• Stocks offer:

  • Capital gains

  • Dividends

• Greater upside than bonds