FIN 371 Midterm

A weaker dollar leads to _____ foreign goods

more expensive

A strong dollar means US goods exported abroad will cost _____ in foreign countries

more

Monetary policy

the management of interest rates and the quantity of money, affects interest rates, inflation, and business cycles

Interest rates

the cost of borrowing funds, the time value of money, tradeoff (relative price) of consuming now versus in the future, equilibriating market for loanable funds

Debt

IOU, loans and bonds, interest payment

Equity

partial ownership, stocks, dividends and capital gains, claim on future earnings

Exchanges

standardized rules, central location, brokers

Over the Counter Markets

network, customized contracts

Money Markets

short-term, liquidity management

Capital Markets

longer-term, finance major investment projects

Adverse selection

lenders may attract riskiest borrowers (health insurance attracts the sickest)

Moral Hazard

borrowers may take action that increases lenders’ risk (more careless with someone else’s money)

Direct finance

borrowers borrow funds directly from lenders in the financial markets by selling them securities

Securities

claims on the borrower’s future income or assets

Brokers

agents of investors who match buyers with sellers of securities

Dealers

link buyers and sellers by buying and selling securities at the stated prices

Why are financial intermediaries important

transaction costs, risk sharing, diversification

Types of financial intermediaries

depository institutions (banks), contractual savings institutions (life insurance, pension funds, government retirement funds)

Duration meaning

when, on average, do I receive my payments/the weighted average of the maturities of the cash payments

Maturity meaning

when do I get my final payment

Maturity increases, Duration

increases

Coupon increases, Duration

decreases

Yield increases, Duration

decreases

Interest rate risk

vulnerability to a change in interest rates

Term Structure of Interest Rates

relationship between maturity and interest rates

In an over-the-counter market, who typically stands ready to buy and sell securities

dealers at different locations with inventories who buy/sell at their prices

Eurodollars

US dollars deposited in foreign banks outside the US

Consequence of the internationalization of financial markets for the US

foreign investors provide funds to US corporations and help finance the federal government

Indirect Finance

funds flow via a financial intermediary that borrows from lender-savers and lends to borrower-spenders

How do financial intermediaries perform risk sharing

they create and sell assets with risk levels investors prefer, then use proceeds to by riskier assets

Credit Union

a small cooperative serving a specific group and primarily makes consumer loans

Why do contractual savings institutions tend to invest primarily in long-term securities

they can predict benefit payouts, so need less liquidity

Money market mutual funds are similar to checking accounts because

their ability for shareholders to write checks against their shareholdings, which provides deposit-like liquidity

Underwriting

done by an investment bank, purchasing securities from a corporation at a predetermined price and reselling them

Securities and Exchange Commission (SEC)

regulatory agency that requires corporations issuing securities to disclose information and restricts insider trading

Which two types of credit market instruments make payments only at their maturity dates

simple loans and discount (zero-coupon) bonds

Yield to Maturity

interest rate that equates the present value of a debt instrument’s future cash flows with its current value (equalizes the present value equation)

YTM for a one-period simple loan

the simple interest rate on the loan

Price of a perpetuity =

annual coupon / yield

Relationship between bond’s current price and YTM

inverse

nominal interest rate

not adjusted for inflation

Real interest rate

adjusted for inflation by subtracting expected changes in the price level so that it more accurately reflects the cost of borrowing

Fisher equation states

the nominal interest rate equals the real interest rate plus expected inflation

Rate of Capital Gain

the change in the bond’s price relative to the initial purchase price

Return on a bond =

current yield + rate of capital gain

Rate of Return

payments to the owner plus the change in its value, expressed as a fraction of its purchase price

A fall in bond prices results in capital losses on bonds whose terms to maturity are

longer than the holding period

The more distant a bond’s maturity…

the greater the size of the price change and the lower the rate of return

Why does a bond whose time to maturity equals the investor’s holding period have no interest-rate risk

because its price at the end of the holding period is fixed at the face value

Why does a holding period longer than a bond’s maturity create reinvestment risk

proceeds must be reinvested at an uncertain future interest rate

Equation for relationship between price and interest rates

(change in P)/P = -D * (change in i) / (1+i)

Macaulay Duration for a coupon bond

the weighted average time until the bond’s cash payments, using each payment’s present-value share as the weight

A security with greater duration will experience a ____ percentage price change for a given change in interest rates

larger

Effective Maturity

estimated actual repayment timeline, by factoring in early repayment risks

Expected rate of return of an asset is

the probability-weighted average of possible returns, so each possible return is multiplied by its probability and those products are summed.

Movement along the demand curve

when a change in the bond’s price or interest rate alters the quantity demanded

How would an increase in expected inflation affect the supply curve for bonds

shift to the right (real cost of borrowing falls at given nominal interest rate, so issuers are willing to supply more bonds at each price and the bond supply curve shifts to the right

If expected inflation increases, what happens to nominal interest rates

nominal interest rates fall

If a financial manager expects long-term interest rates to fall, which action would they most likely take for their asset portfolio?

purchase long-term bonds

Risk Premium

the spread between the interest rates on bonds with default risk and default-free bonds of the same maturity

Investment grade bonds

BBB or above

When the yield curve slops upward, long-term interest rates are ______ short-term interest rates

above

Expectations Theory key assumption

bonds of different maturities are perfect substitutes (no maturity preference)

In Expectations Theory, long-term rate equals

the average of short-term rates expected over the bond’s life (investors require the same expected return across maturities)

Market Segmentation Theory key assumption

bonds of different maturities are not substitutes, so each maturity’s interest rate is determined by supply and demand for that maturity

Limitation of market segmentation theory

it cannot explain why interest rates of different maturities move together

Liquidity premium

a positive premium that increases as a bond’s maturity lengthens

Liquidity Premium Theory key assumption

bonds of different maturities are substitutes, but it allows investors to prefer one bond maturity over another

Liquidity Premium Theory Equation for a 2 year bond

[(year 1 interest rate + year 2 interest rate) / number of years] + liquidity premium

What source provides the largest share of external funds for businesses in the US and other industrialized countries

loans from banks and other financial intermediaries

How do mutual funds lower transaction costs per dollar for individual investors

pooling many investor’s funds to buy large blocks of securities

Free Rider Problem

when people who do not pay for information take advantage of information others have paid for

Why can banks earn profits from producing information about borrowers

making private (nontraded) loans using produced information

Collateral

property promised to the lender if the borrow defaults

Firm’s Net Worth

difference between firm’s assets and liabilities

Costly state veritication

monitoring and auditing of a firm’s acivities

Why can venture-capital and private-equity firms reduce the moral hazard from free-riding more effectively than public shareholders

they hold private, nonmarketable equity so others cannot free-ride on monitoring

Why do debt contracts create moral hazard for borrowers

because borrowers keep profits above fixed payments and so prefer riskier projects with large upside

Demand Deposits (liabilities)

highly liquid

Loans (assets)

illiquid

Net Interest Margin

spread between borrowing short and lending long

Sarbanes-Oxley

established Public Company Accounting Oversight Board, increased SEC’s budget, reduced conflicts of interest, measures to improve the quality of information in financial markets

Global Legal Settlement of 2002

required investment banks to sever links between research and underwriting, banned spinning, incentives for investment banks not to exploit conflicts of interest, required investment banks make their analysts’ recommendations public, contract with at least 3 independent research firms that would provide research to their brokerage customers

Financial crisis characteristics

sharp declines in asset prices, failures of financial institutions, failures of nonfinancial firms, sever disruption of credit flows/intermediation

How do banks make money

borrowing short and lending long

Credit boom

financial institutions go on a lending spree due to elimination of restrictions on financial markets and institutions

Seeds of financial crisis often sown when

an economy introduces new types of loans or other financial products, or when countries engage in financial liberalization

Which development most directly increases banks’ moral hazard incentive to take greater risks

government safety nets (deposit insurance)

Direct consequence when an asset-price bubble bursts and prices fall back to fundamentals

firms’ net worth and collateral values fall, prompting banks to tighten lending and deleverage

How can depositor runs cause banks to become insolvent

withdrawals cause fire sales that lower asset prices and reduce net worth

Asset-price bubble

the rise of asset prices above their fundamental economic values

Fire sales

quick sale of assets to raise funds

Debt Deflation

occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness

Why does an unanticipated fall in the price level raise the real burden of a firm’s fixed nominal debt

the real value of fixed nominal liabilities rises while the real value of assets stays about the same

originate-to-distribute business model

the mortgage is originated by a separate party, typically a mortgage broker, and then distributed to an investor as an underlying asset in a security

Steps of a financial crisis

credit boom or bust, asset boom or bust, banking crisis, debt deflation

What problem arose after the Second Bank’s national charter ended in 1836

no lender of last resort to provide liquidity during banking crises

Federal Reserve Act 1913

created system to provide more elastic supply of currency and credit

Why system with 12 regional Federal Reserve Banks

fear that moneyed interest on Wall Street would manipulate an institution to gain control over whole economy, fear that federal operation of central bank would be too much government control

Each of 12 federal reserve banks belongs to

one main federal reserve bank or branch