Financial Markets and Monetary Economics Vocabulary Flashcards

Vocabulary and key financial concepts flashcards generated from the multiple-choice practice exam transcript.

Flight to Quality

A shift in investor capital toward safer assets, such as U.S. Treasury bonds, which occurred during the collapse of the subprime mortgage market and widened the yield spread on Baa bonds.

Fisher Effect

The principle explained by economist Irving Fisher stating that nominal interest rates rise as the expected rate of inflation increases, holding everything else constant.

Downward Sloping Yield Curve

A yield curve condition where short-term interest rates are higher than long-term interest rates, indicating that short-term interest rates are expected to decline sharply and the economy is more likely to enter a recession.

Primary Market

The financial market in which new issues of a security are sold to initial buyers by investment banks, allowing corporations to acquire new funds.

Secondary Market

A financial market in which previously issued securities can be resold among investors.

Liquidity Premium Theory

A term structure theory stating that investors prefer shorter to longer maturities, meaning long-term interest rates equal the average of expected future short-term rates plus a term premium.

Real Rate of Interest

The interest rate adjusted for expected inflation; calculated as nominal interest rate minus expected inflation (e.g., a $2\%$ nominal rate with $-10\%$ expected inflation gives a real rate of $12\%$).

Commodity Money

Money made of valuable commodities that can be used for purposes other than a medium of exchange, such as gold coins that can be melted into jewelry.

Over-the-Counter (OTC) Market

A market structure where dealers at different locations buy and sell securities to anyone willing to accept their posted prices.

Liquidity

The relative ease and speed with which an asset can be converted into a medium of exchange.

Risk Structure of Interest Rates

The relationship among interest rates on bonds with the same maturity but different risk characteristics.

Double Coincidence of Wants

A fundamental requirement and major disadvantage of the barter system, where each party to a trade must want the specific good offered by the other.

Commercial Paper

A short-term debt instrument issued directly by well-known, large corporations.

Junk Bonds

Bonds with high risk of default that offer higher yields to attract investors.

Capital Market

The financial market in which longer-term debt instruments and equity instruments (stocks) are traded.

Money Market

A financial market in which short-term debt instruments, such as U.S. Treasury bills, are traded.

Consol

A perpetual bond with no maturity date that pays a fixed annual coupon payment forever.

Coupon Rate

The dollar amount of the yearly coupon payment expressed as a percentage of the bond's face value.

Flight to Quality

A shift in investor capital toward safer assets, such as U.S. Treasury bonds, which occurred during the collapse of the subprime mortgage market and widened the yield spread on Baa bonds.

Fisher Effect

The principle explained by economist Irving Fisher stating that nominal interest rates rise as the expected rate of inflation increases, holding everything else constant.

Downward Sloping Yield Curve

A yield curve condition where short-term interest rates are higher than long-term interest rates, indicating that short-term interest rates are expected to decline sharply and the economy is more likely to enter a recession.

Primary Market

The financial market in which new issues of a security are sold to initial buyers by investment banks, allowing corporations to acquire new funds.

Secondary Market

A financial market in which previously issued securities can be resold among investors.

Liquidity Premium Theory

A term structure theory stating that investors prefer shorter to longer maturities, meaning long-term interest rates equal the average of expected future short-term rates plus a term premium.

Real Rate of Interest

The interest rate adjusted for expected inflation; calculated as nominal interest rate minus expected inflation (e.g., a $2\%$ nominal rate with $-10\%$ expected inflation gives a real rate of $12\%$).

Commodity Money

Money made of valuable commodities that can be used for purposes other than a medium of exchange, such as gold coins that can be melted into jewelry.

Over-the-Counter (OTC) Market

A market structure where dealers at different locations buy and sell securities to anyone willing to accept their posted prices.

Liquidity

The relative ease and speed with which an asset can be converted into a medium of exchange.

Risk Structure of Interest Rates

The relationship among interest rates on bonds with the same maturity but different risk characteristics.

Double Coincidence of Wants

A fundamental requirement and major disadvantage of the barter system, where each party to a trade must want the specific good offered by the other.

Commercial Paper

A short-term debt instrument issued directly by well-known, large corporations.

Junk Bonds

Bonds with high risk of default that offer higher yields to attract investors.

Capital Market

The financial market in which longer-term debt instruments and equity instruments (stocks) are traded.

Money Market

A financial market in which short-term debt instruments, such as U.S. Treasury bills, are traded.

Consol

A perpetual bond with no maturity date that pays a fixed annual coupon payment forever.

Coupon Rate

The dollar amount of the yearly coupon payment expressed as a percentage of the bond's face value.

Effect of Economic Expansion on Bond Supply

During an economic expansion, business investment opportunities increase, causing corporations to issue more bonds and shifting the bond supply curve to the right.

Effect of Recession on Bond Market

During a recession, both bond demand and bond supply decrease, shifting both curves to the left and causing equilibrium interest rates to fall.

Quantity Theory of Money Inflation Rule

States that money supply growth equals the inflation rate plus the economic growth rate ($\%\Delta M = \pi + \%\Delta Y$); for example, with $3\%$ growth and $2\%$ target inflation, money supply must grow by $5\%$.

Relationship Between Bond Price and Yield to Maturity

When a bond's price is above its par value (face value), its yield to maturity is below its coupon rate.

Simple Yield to Maturity Calculation

The yield to maturity $i$ on a security selling for price $P$ paying payout $F$ next year is $i = \frac{F - P}{P}$; for example, a $100$ dollar security paying $110$ dollars yields $10\%$.

Effect of Price Volatility on Bond Demand

An increase in the price volatility of bonds makes them riskier, shifting the demand curve to the left and driving interest rates up.

Effect of Tax Rate Reductions on Municipal Bond Yields

When personal income tax rates are lowered, the tax-exempt advantage of municipal bonds decreases, raising their yield relative to U.S. Treasury securities.

Impact of Shifting Funds from Time Deposits to Checking Accounts

Because checking deposits are in M1 and small time deposits are in M2, transferring funds from a time deposit to a checking account increases M1 while M2 stays the same.

Currency in Monetary Aggregates

The common asset component contained in both the M1 and M2 definitions of the money supply.

Rate of Return on a Bond

Calculated as the sum of the coupon payment $C$ and capital gain $P_{t+1} - P_t$ divided by the initial price $P_t$: $R = \frac{C + P_{t+1} - P_t}{P_t}$.

Consol Valuation Formula

The price $P$ of a consol is equal to the annual coupon payment $C$ divided by the interest rate $i$ ($P = \frac{C}{i}$).

Impact of Expected Future Interest Rate Decline

If interest rates are expected to fall in the future, expected returns on long-term bonds rise today, shifting the demand curve for long-term bonds to the right.

Term Structure of Interest Rates

The relationship among interest rates on bonds with different terms to maturity but identical risk, liquidity, and tax characteristics.

Default Risk Effect on Yield Spread

An increase in the riskiness of corporate bonds lowers demand for corporate bonds and increases demand for Treasury bonds, raising corporate yields while reducing Treasury yields.

Impact of Stock Return Increase on Bond Demand

Holding the expected return on bonds constant, an increase in expected returns on common stocks causes investors to switch to stocks, shifting bond demand to the left.

Calculating Three-Year Bond Yield under Liquidity Premium Theory

Calculated as the average of expected short-term rates over three years plus the three-year term premium ($i_{3t} = \frac{i_t + i_{t+1}^e + i_{t+2}^e}{3} + L_{3t}$).

Default Risk

The probability that a bond issuer will be unable or unwilling to make interest payments or pay off the face value when the bond matures.

U.S. Treasury Bills

Short-term debt securities issued by the U.S. government that are traded in the money market and considered default-free.

Yield to Maturity vs Coupon Rate for Discount Bonds

When a bond sells for less than its face value (at a discount), its yield to maturity is greater than its coupon rate.

Disadvantages of Barter

Includes high transaction costs, lack of a standard measure of value, and the requirement of a double coincidence of wants.

Tax Advantage of Municipal Bonds

Interest payments on municipal bonds are exempt from federal income taxes, allowing them to offer lower yields than Treasury bonds while maintaining investor appeal.

Forward Rate Prediction in Term Structure

Using the liquidity premium theory, future one-year interest rates can be derived by subtracting the term premium from multi-year bond yields and solving for the expected rate.