Eco 29 HW (Ch. 1,2,4,5,6,7) – Flashcards
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What is the typical relationship between interest rates on 6-month Treasury bills, 10-year Treasury notes, and Baa corporate bonds?
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They tend to move together over time with the corporate bond having the highest rate of interest
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What function do financial intermediaries perform?
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They provide a channel for linking those who want to save with those who want to invest
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Evidence from business cycle fluctuations in the United States indicates that:
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Recessions have been preceded by a decline in the growth rate of money
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A share in Microsoft common stock is:
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An asset for its owner, which Microsoft shows as shareholder equity on its balance sheet
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What are some functions/services provided by secondary markets?
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Providing liquidity to owners of existing financial instruments, providing information to borrowers and lenders about expectations and attitudes of the economic climate, & determining the price of the security that the issuing firm seeks in the primary market
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What is a primary market?
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A financial market in which new issues of a security, such as a bond or stock, are sold to initial buyers by the corporate or gov't agency borrowing the funds
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What is a capital market?
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A market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded
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What is a money market?
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A financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded
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What is a secondary market?
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A financial market in which securities have been previously issued can be resold
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What is a debt market?
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A market where bonds or marriages, which are contractual agreements but he borrower to pay the holder of the instrument fixed dollar amounts at regular intervals until a specified date when a final payment is made, are traded
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What is government security?
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These long-term debt instruments are issued by the US Treasury to finance the deficits of the federal gov't
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What are stocks?
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These are equity claims on the net income and assets of a corporation
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What are agency securities?
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These long-term bonds are issued by institutions such as Ginnie Mae, the Federal Farm Credit Bank, and the TVA. May of these securities are guaranteed by he federal gov't
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What are corporate bonds?
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These long-term bonds are issued by corporations with very strong credit ratings
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What are mortgages?
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These are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans
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What are foreign bonds?
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Bonds sold in a foreign country and denominated in that country's currency
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What is eurocurrency?
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Foreign currencies deposited in banks outside the home country
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What are eurodollars?
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US dollars deposited in foreign banks outside the US or in foreign branches of US banks
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What are eurobonds?
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A bond denominated ina currency there than that of the country in which it is sold - for example, a bond denominated in US dollars sold in London
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How do financial intermediaries benefit by providing risk-sharing services?
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They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold
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What is adverse selection?
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Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome - the bad credit risks - are the one who most actively seek out a loan and are thus most likely to be selected
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What is asymmetric information?
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A situation where one party often does not know enough about the other party to make accurate decisions
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What is moral hazard?
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A situation where the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back
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What is a commercial bank (financial intermediary)?
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These financial intermediaries raise funds primarily by issuing checkable deposits, savings deposits, and time deposits. They then use these funds to make commercial, consumer, and mortgage loans and to buy US gov't securities and municipal bonds
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What are Savings and Loan financial intermediaries?
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These depository institutions obtain funds primarily through savings deposits. Int he past, these institutions were constrained in their activities and mostly made mortgage loans for residential housing
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What is a credit union?
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These financial institutions are very small cooperative lending institutions organized around a particular group: union members, employees of a firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans.
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What is a Mutual Fund?
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These financial intermediaries acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds
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How do you calculate Yield to Maturity?
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PV = CF / (1+i)^n PV - amount borrowed CF - cash flow n - number of years
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How do you calculate perpetuity?
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ic = C / Pc C - yearly payment Pc - price or perpetuity (consol)
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How do you calculate interest rate?
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ir = i - (pi)^e i - nominal interest rate (pi)^e - expected inflation rate
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True or false: with a discount bond, the return on a bond is equal to the rate of capital gain
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True: a discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain
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When the federal gov't sells a Treasury bond in the primary market - via Treasury auction, it is:
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Seeking to finance gov't spending as an alternative to raising taxes
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When the price level falls, the _____ curve for nominal money _____, and interest rates _____, everything else held constant.
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demand; decreases; fall
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When an individual or institution buys a corporate bond in the primary market:
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she is making a loan to the corporation issuing the bond
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Will there be an effect on interest rates if brokerage commissions on stocks fall?
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Yes, interest rates would rise because stocks become more liquid than before, which would reduce the demand for bonds
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What effect will a sudden increase int eh volatility of gold prices have on interest rates?
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Interest rates will decrease because bonds will become relatively less risky, which increases the demand for bonds
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What will happen to interest rates if the public suddenly expects a large increase in stock prices?
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Interest rates will fall because the expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds decreases
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Suppose there is downward revision of inflation expectations. What happens to the bond market?
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The effect of this shock will likely cause bond yields to decrease
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If interest rates rise, this opportunity cot will _____, and individual swill hold, ____ cash balances.
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increase; smaller
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For every $1,000 of annual income, households maintain average cash balances (their demand for money) of $200. How will growth in GDP affect interest rates, holding the money supply constant?
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Money demanded will shift to the right.
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If the next chair of the Fed Reserve Board has a reputation or advocating an even slower rate of money growth than the current chair, what will happen to interest rates?
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Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income, price level, and inflation will tend to lower interest rates
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How might a sudden increase in people's expectations of future real state prices affect interest rates?
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Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which could cause the demand for for bonds to decrease
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What will happen to interest rates if prices in the bond market become more volatile?
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When bond prices become more volatile, bonds become riskier and the demand for bonds will fall, which causes interest rates to rise
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Why do US Treasury bills have lower interest rates than large-denomination negotiable bank CDs?
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Treasuries are considered to be risk-free debt instruments
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If junk bonds are "junk", then why would investors buy them?
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Junk bonds can provide high yields
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If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?
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You would raise your predictions of future interest rates
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Risk premiums on corporate bonds are usually anti cyclical; that is they decrease during business cycle expansions and increase during recessions. Why is this so?
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As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt
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What would happen to the risk premium on corporate bonds if brokerage commissions were lowered int eh corporate bond market?
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Lower brokerage commissions for corporate bonds would make them more liquid and this increase demand, which would lower the risk premium
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What effect would reducing income tax rates have on the interest rates of municipal bonds?
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Interest rates would rise because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds
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Would interest rates of Treasury securities be affected by the tax rate change?
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Yes, because the reduction in the tax-exemp privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable
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What is the expectations theory?
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The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
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What is preferred habitat?
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The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond
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What are segmented markets?
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The interest rate for each bond with a different maturity is determined by he supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities
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Identify the cash flows available to an investor in stock
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Dividends and capital gains
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What basic principle of finance can be applied to the valuation of any investment asset?
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Present value
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Consider tight money policy and its effects on stock prices via the simplified Gordon growth model equation. Which of the following accurately describes the effects of tight money policy on stock prices, according to this model?
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The return on bonds and the required return on an equity investment (ke) would rise, while the price of stock (P0) would fall
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Again, consider the effect of tight money policy on stock prices. Which of the following accurately describes the effects of tight money policy on stock prices, according to this model
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The economy would slow down, causing an increase in the denominator of the simplified Gordon growth model and a decrease in the price of stock (P0)
