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68 Cards in this Set

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  • Back

Is everybody worse off when interest rates rise?


Borrowers worse off, Savers better off

What types of risks do financial institutions face?

changes in interest rate, stock prices, foreign exchange rates

Why do managers of financial institutions care so much about the activities of the Federal Reserve System?

because the Fed affects interest rates, inflation, and the business cycle, all of which impact the profitability of financial institutions

If there were no asymmetry in the information that a borrower and a lender had, could there still be a moral hazard problem?


Even if you know that a borrower is taking actions that'd jeopardize paying off the loan, you must still stop the borrower from doing so. Because that might be costly, you may not spend the time and effort to reduce moral hazard, so moral hazard remains a problem

“In a world without information and transaction costs, financial intermediaries would not exist.”

Is this statement true, false, or uncertain? Explain your answer.


If no information or transaction costs, then people would make loans to each other at no cost and would thus have no need for financial intermediaries

If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

Long-term bonds.

Because of longer-duration, long-term bonds are more sensitive to changes in interest rates, so they would increase more when rates go down, giving them a higher return.

If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

More likely.

Real rate was 3% (5% minus 2%), is now 1% (10% minus 9%). Thus, real cost of financing is lower, even though mortgage rates have risen

Explain why you'd be more or less willing to buy a share of Polaroid stock in the following situations:

a. Your wealth falls.

a. Less willing (lower wealth = decreased demand)

Explain why you'd be more or less willing to buy a share of Polaroid stock in the following situations:

b. You expect it (Polaroid stock) to appreciate in value.

b. More willing (higher expected return = increased demand)

Explain why you'd be more or less willing to buy a share of Polaroid stock in the following situations:

c. The bond market becomes more liquid.

c. Less willing (increased liquidity of bond market relative to stock market = stock market less attractive = decreased demand for stocks)

Explain why you'd be more or less willing to buy a share of Polaroid stock in the following situations:

d. You expect gold to appreciate in value.

d. Less willing (higher expected return for gold = lower expected return of Polaroid relative to gold = decreased demand for stocks)

Explain why you'd be more or less willing to buy a share of Polaroid stock in the following situations:

e. Prices in the bond market become more volatile.

e. More willing (more volatility/risk in bond market = less risk in stock market relative to bond market = increased demand for stocks)

“The more risk-averse people are, the more likely they are to diversify.”

Is this statement true, false, or uncertain? Explain your answer.


Benefits to diversification are greater for person who cares more about reducing risk.

An important way in which the Federal Reserve
decreases the money supply is by selling bonds to the public.

Using a supply-and-demand analysis for bonds, show what effect this action has on interest rates.

If the Fed sells bonds to the public, then it increases the supply of bonds. This increases quantity demanded and decreases bond prices. If bond prices go down, then interest rates go up.

In the aftermath of the global financial crisis, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for many years.

Does this make sense? Why or why not?


Increase in budget deficits increased supply of bonds, which would decrease bond prices and increase interest rates. HOWEVER, weak economy b/c of financial crisis caused investment opportunities to shrink so dramatically that it decreased supply, which results in higher bond prices and lower interest rates. This overwhelmed the impact from higher government deficits.

Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.

Interest rates will rise.

Stock prices will produce a higher expected return relative to bond prices, so demand for bonds will decrease. This will decrease bond prices and therefore increase interest rates.

If yield curves, on average, were flat, what would this say about the liquidity premiums in the term structure?

Would you be more or less willing to accept the pure expectations theory?

Risk premium on long-term relative to short-term bonds would be zero.

More willing to accept the pure expectations theory.

If a yield curve looks like the one shown here (flat ST, up LT), what is the market predicting about the movement of future short-term interest rates?

What might the yield curve indicate about the market’s predictions about the inflation rate in the future?

Flat YC at short maturities = short-term interest rates expected to fall moderately in the near future, while steep upward slope of YC at longer maturities indicates that interest rates further into the future are expected to rise.

Interest rates and expected inflation move together, so YC suggests that market expects inflation to fall moderately in the near future but to rise later on.

If a yield curve looks like the one below (up ST, down LT), what is the market predicting about the movement of future short-term interest rates?

What might the yield curve indicate about the market’s predictions about the inflation rate in the future?

Steep upward-sloping YC at shorter maturities = ST interest rates expected to rise modestly in the near future b/c the initial, steep upward slope indicates that the average of expected ST interest rates in the near future is above the current ST interest rate.

The downward slope for longer maturities indicates that ST interest rates are expected to fall sharply. With a positive risk premium on LT bonds, as in the liqudity preference theory, a downward slope of YC occurs only in the avg of expected ST rates is declining, which occurs only if ST interest rates far into the future are falling.

Since interest rates and expected inflation move together, YC suggests that market expects inflation to rise modestly in near future, but fall later on.

Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that when you see that the money supply has had a sharp rise in the past week, you should go out and buy stocks?

Why or why not?


According to efficient market hypothesis, if money supply has already increased then this is publicly available information and therefore is already reflected in stock prices.

“If most participants in the stock market do not follow what is happening to the monetary aggregates, prices of common stocks will not fully reflect information about them.”

Is this statement true, false, or uncertain? Explain your answer.


All that's required for market to be efficient so that prices reflect information on monetary aggregates if that some market participants eliminate unexploited profit opportunities. Not everyone in a market has to be knowledgeable for market to be efficient.

If higher money growth is associated with higher future inflation and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think would happen to long-term bond prices?


Inflation less than expected = expectations of future interest rates also lower = increase in bond prices.

A company just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $5 bn with 100 mn shares outstanding. Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split?

If the actual market price immediately following the split is $17.00 per share, what does this tell us about market efficiency?

Value of the company still $5 bn. Number of shares outstanding now 300 mn. Price per share should be $16.67.

Either (a) markets are inefficient or (b) stock split conveys new information about the company, as investors might believe stock price / share is about to increase significantly, and that is why the firm did the stock split.

If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced?

Stock price will go up because loss is less than expected

How can economies of scale help explain the existence of financial intermediaries?

Lower transaction costs

Mutual funds - lower commissions b/c scale of purchases higher vs. individual

Banks - keep legal and computing costs per transaction low

Describe two ways in which financial intermediaries help lower transaction costs in the economy.


- computer technology so can inexpensively provide liquidity services such as checking accounts that lower transaction costs for depositors

Economies of scale

- lower transaction costs

Would moral hazard and adverse selection still
arise in financial markets if information were not asymmetric? Explain.


Even if know borrower not using funds appropriately, still costly to stop them from doing so.

How can the existence of asymmetric information provide a rationale for government regulation of financial markets?

B/c of asymmetric info & free rider problem, not enough information in financial markets.

Adverse selection - rationale for gov't to encourage info production thru regulation so it's easier to screen out good from bad borrowers.

Moral hazard - enforcing standard accounting principles, prosecuting fraud

How does the concept of asymmetric information help to define a financial crisis?

Asym. info always present, don't normally prevent financial system from efficiently channeling funds from lender-savers to borrowers.

In financial crisis, however, asymmetric info problems intensify to such a degree that resulting financial frictions lead to flows of funds being halted/severly disrupted, with harmful consequences for economic activity.

How does an unanticipated decline in the price level cause a drop in lending?

Read burden of indebtedness increases while there's no increase in real value of assets. Resulting decline in firm's net worth increases adverse selection & moral hazard problems facing lenders, making it more likely fin crisis will occur in which financial markets not work efficiently to get funds to firms with productive investment opps.

How does a deterioration in balance sheets of financial institutions cause a decline in economic activity?

Results in substantial contraction in capital; w/ fewer resources to lend, lending declines, which leads to decline in investment spending, which slows econ activity.

When there's simulatenous failures of fin institutions, loss of info production in fin mkts, direct loss of banks' financial intermediation

Decrease in bank lending during crisis decreases supply of funds avail to borrowers, leads to higher interest rates, increases asymmetric info problems, lead to further contraction in lending / econ activity.

What is a credit spread?

Why do credit spreads rise during financial crises?

Credit spread = difference between interest rates on corporate bonds and treasury bonds of similar maturity that have no default risk

Rise during fin crisis b/c escalation of asym info problems that make it harder to judge riskiness of corporate borrowers and weakens ability of the financial mkts to channel funds to borrowers with productive investment opportunities

Why do bank panics worsen asymmetric information problems in credit markets?

Fewer banks operating = information about crediworthiness of borrowers shrinks = more severe moral hazard / adverse selection problems

What role do weak financial regulation and supervision play in causing financial crises?

Financial institutions will take on excessive risk b/c market discipline weakened by existence of government safety net

When risky loans go sour, causes deterioration in financial institutions' balance sheets, means these institutions cut back lending and economic activity declines

What technological innovations led to the development of the subprime mortgage market?

Data mining - give households numeric credit scores used to predict defaults

Computer technology - bundle together many small mortgage loans cheaply and package them into securities

True, false, or uncertain: Financial engineering always leads to a more efficient financial system.


FE may create financial products so complex that it can be hard to value the CF of underlying assets for a security or determine who actually owns the assets

Increased complexity can actually destroy information, making asym info worse, incr severity of adv selection / moral hazard probs

What is the shadow banking system, and why was it an important part of the 2007–2009 financial crisis?

Hedge funds, investment banks, other nondepository financial firms NOT subject to tight regulation framework of traditional banks. So, had lower cap requirements, take on a lot more risk vs. other fin firms.

Important b/c large amount of funds flowed thru shadow banking system to support low interest rates, which fueled housing bubble.

B/c of large presence in fin mkts, when credit markets tightened, funding from SBS decreased sig, further reduced access to credit

Why are more resources not devoted to adequate, prudential supervision of the financial system to limit excessive risk taking, when it is clear that this supervision is needed to prevent financial crises?

Powerful domestic business interests want it that way so can take more risk, allowing them to earn higher returns, but pass losses to taxpayer if loans go sour

How can a sovereign debt crisis make an economic contraction more likely?

Governments pursue austerity to balance budgets, leading to contractionary fiscal policy

Losses on soverign debt held by fin institutions weakens their balance sheets, can be a factor in causing financial crisis

What characteristics define the money markets?

Securities that trade in one year or less, are of large denominations, and are very liquid

Is a Treasury bond issued 29 years ago with six
months remaining before it matures a money market instrument?


Original maturity needs to be of less than one year

Why do banks not eliminate the need for money

Money markets have lower costs vs. banks b/c banks need to maintain reserve requirements

Money markets also have economies of scale (high volume, large denomination securities) - allows for higher interest rates

Distinguish between a term security and a demand security.

Term security - specific maturity date (6 month CD)

Deposit security - redeemed at any time (checking account)

What motivated regulators to impose interest ceilings on bank savings accounts?

What effect did this eventually have on the money markets?

Following GD, regulators concerned with stopping banks from failing. By removing interest rate competition, bank risk substantially reduced.

Problem - when mkt int rates rose above interest rate ceiling, investors withdrew funds from banks

Why does the U.S. government use the money markets?

Sells large number of securities in MM to support government spending

- spend more than receives in tax revenues, borrows to fund that

Why do businesses use the money markets?

Borrow - meet ST CF needs, often issue CP

Invest - alternative to holding idle cash balances

What purpose initially motivated Merrill Lynch to offer money market mutual funds to its customers?

ML felt it could better service its regular customers by making it easier to buy/sell securities from account held at the brokerage house. Brokerage could offer market interest rate on these funds by investing them in the money markets.

Why are more funds from property and casualty
insurance companies than funds from life insurance companies invested in the money markets?

P&C - cannot predict natural disasters that cause large payouts on policies, need more liquid securities

Life insurance - can invest LT b/c timing of liabilities known with reasonable accuracy

Which of the money market securities is the most liquid and considered the most risk-free? Why?

Treasury bills

- Backed by strength of US government

- Trade in extremely large volumes

Distinguish between competitive bidding and non-competitive bidding for Treasury securities.

Competitive - buyers submit bids

Noncompetitive - buyer accepts avg of the rate paid by competitive bidders

Who issues federal funds, and what is the usual purpose of these funds?

Sold by banks to other banks

Used to:

- Invest excess reserves

- Raise reserves if a bank is short

Does the Federal Reserve directly set the federal
funds interest rate?

How does the Fed influence this rate?


Influences rate by adding funds to or withdrawing reserves from the economy

Who issues commercial paper and for what purpose?

Large businesses w/ very good credit standing sell CP to raise ST funds

Most common use of funds is to extend ST loans to customers for purchase of firms products

Why are banker’s acceptances so popular for international transactions?

Substitute the creditworthiness of a bank for that of a business

When company sells a product to a company that its unfamiliar with, often prefers to have the promise of a bank that the payment will be made

What would be your annualized discount rate % and your annualized investment rate % on the purchase of a 182-day Treasury bill for $4,925 that pays $5,000 at maturity?

D = 2.967%

I = 3.054%

D = (F - P)/F x (360/n)

I = (F - P)/P x (365/n)

If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91-day Treasury bill that pays $5,000 at maturity?


Use D = (F - P)/F x (360/n) to solve for P

The annualized discount rate on a particular money market instrument is 3.75%. The face value is $200,000, and it matures in 51 days. What is its price? What would be the price if it had 71 days to maturity?

51 days = $198,937.50

71 days = $198,520.83

Use D = (F-P)/F x (360/n) to solve for P in both scenarios

The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16%, and 17.5%.

Using the expectations theory, what will be the interest rates on a three-year bond, a six-year bond, and a nine-year bond?

3 year = [(3% + 4.5% + 6%)]/3 = 4.5%

6 year = [(3% + 4.5% + 6% + 7.5% + 9% + 10.5%)]/6 = 6.75%

9 year = [(3% + 4.5% + 6% + 7.5% + 9 % + 10.5% + 13% + 14.5%+ 16%)]/9 = 9.333%

Which bond would produce a greater return if the expectations theory were to hold true, a two-year bond with an interest rate of 15% or two one-year bonds with sequential interest payments of 13% and 17%?


Two two year bonds = (13% + 17%)/2 = 15%

One-year T-bill rates over the next four years are
expected to be 3%, 4%, 5%, and 5.5%.

If four-year T-bonds are yielding 4.5%, what is the liquidity premium on this bond?


4.5% = [(3% + 4% + 5% + 5.5%)]/4 + LP

4.5% = 4.375% + LP

If the interest rates on one- to five-year bonds are currently 4%, 5%, 6%, 7%, and 8%, and the term premiums for one- to five-year bonds are 0%, 0.25%, 0.35%, 0.40%, and 0.50%, predict what the one-year interest rate will be two years from now.


[(1 + 6% - 0.35%)^3 / (1 + 5% - 0.25%)^2] - 1 = 7.5%

You wish to hire Ricky to manage Dallas ops. The profits from the operations depend partially on how hard Ricky works (if lazy, 60% profit = $10,000, 40% profit = $50,000; if hard worker, 20% profit = $10,000, 40% profit = $50,000). If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity. However, Ricky would view working hard as a “personal cost” valued at $1,000. What fixed percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected payment less any “personal cost.”


If lazy, exp. pmt = 60% x $10,000 x P + 40% x $50,000 x P = $26,000 P

If hard worker, exp. pmt. = 20% x $10,000 x P + 80% x $50,000 x P -$1,000 = $42,000P - $1,000

$42,000P - $1,000 > $26,000P; P > 6.25%

Calculate the duration of a $1,000, 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%.

2.83 years

sum of (PV of individual CF's / price of bond x t)

Consider the bond in the previous question. Calculate the expected price change if interest rates drop to 6.75% using the duration approximation. Calculate the actual price change using discounted cash flow.


chg(P) = -Duration x (chg i)/(1 + i) x P

A bank has two 3-year commercial loans with a present value of $70 million. The first is a $30 million loan that requires a single payment of $37.8 million in three years, with no other payments till then. The second loan is for $40 million. It requires an annual interest payment of $3.6 million. The principal of $40 million is due in three years.

a. What is the duration of the bank’s commercial loan portfolio?

b. What will happen to the value of its portfolio if the general level of interest rates increases from 8% to 8.5%?

a. Duration = 2.86

- First loan = 3

- Second loan = 2.76 (solving it out)

- Total = (30/70) x 3 + (40/70) x 2.76 = 2.86

b. -$926,852

chg(P) = -Duration x (chg i)/(1 + i) x P

You own a $1,000-par zero-coupon bond that has five years of remaining maturity. You plan on selling the bond in one year and believe that the required yield next year will have the following probability distribution: (10% of 6.6% yield, 20% 6.75%, 40% 7%, 20% 7.2%, and 10% 7.45%).

a. What is your expected price when you sell the bond?
b. What is the standard deviation of the bond price?

a. Price = $763.07

- Solve for prices ($1,000 / [(1 + r)^4]) x prob

- Sum all the prices

b. $6.79

- variance = prob x [(price - exp. price)^2]

- std dev = square root of variance

Consider a $1,000-par junk bond paying a 12% ann. coupon with 2 yrs to maturity. Issuing company has 20% chance of defaulting this yr, in which case bond pays nothing. If company survives yr 1, paying the annual coupon payment, it then has a 25% chance of defaulting in the yr 2. If company defaults in yr 2, neither the final coupon payment nor par value of the bond will be paid.
a. What price must investors pay for this bond to expect a 10% YTM?
b. At that price, what's expected holding period return & std dev? Assume that periodic CF reinvested at 10%.

a. Price = $642.64

- CF at t = 1 is 0.2(0) + 0.8(120) = 96

- CF at t = 2 is 0.4(0) + 0.6(1,120) = 672

- 96/1.1 + 672/(1.1^2) = 642.64

b. return = 21%, std dev = 91%

An economist has concluded that, near the point of equilibrium, the demand curve and supply curve for one-year discount bonds can be estimated using the following equations:

Bd: P = -2/5 x Q + 940

Bs: P = Q + 500

a. What is the expected equilibrium P and Q of bonds in this market?

b. Given answer to part (a), which is the expected int. rate in this mkt?

a. -2/5 x Q + 940 = Q + 500

-7/5 x Q = -440

Q = 314.2857

P = 814.2857

b. i = 22.8%

i = 1,000/814.2857 - 1 =22.8%