FINS1612 Study Guide - Final Guide: Loanable Funds, Yield Curve, Economic Indicator

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5 Nov 2018

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An introduction to interest rate determination and forecasting. T initially, an easing of monetary policy will result in a fall in interest rates, but as economic activity increases, the income and inflation effects are likely to result in an increase in interest rates. F economic indicators such as the level of employment provide market participants with clear and certain indication as to the future direction of economic activity and growth. F a coincident economic indicator is one that might be used to indicate the future direction in which the economy is headed. T in the loanable funds approach to interest rates, the demand for funds originates from the business sector and the government sector. T the supply of loanable funds is derived from the savings of the household sector, changes in the money supply and dishoarding. F an increase in the money supply would permanently shift the supply curve of loanable funds to the right.

Related Questions

The study of finance consists of the following interrelated area(s):

a) Financial markets and institutions

b) Financial services

c) Investments

d) Managerial (business finance)

e) All of the above

The liquidity asset is one that can be easily converted to __________ without significant loss of its original value.

a) Bonds

b) Cash

c) Gold

d) Liquid

e) Silver

A goal of financial intermediaries is to improve the economic well-being. Other benefits include:

a) Diversification (risk)

b) Financial flexibility

c) Funds divisibility/pooling

d) Reduced costs

e) Related services

f) All of the above

4.____________ represents the current value of some future amount.

a)Assumed value

b)Future value

c)Present value

d)Zero value

The cost of money (interest rates) is based on (1) the rate of return that borrowers expect to earn on their investments, (2) saversâ preferences to spend income in the current period rather than delay consumption until some future period, _____________________________, and (4) expected inflation.

a) the level of economic activity

b) the risks associated with investments/loans

c) the trade deficit

d) the yield, or return that is earned on an investment

6.Short-term debt includes all of the following EXCEPT:

a)Bankerâs Acceptances

b)Certificates of Deposits (CDâs)

c)Commercial Paper

d)Eurodollar Deposits

e)Federal Funds

f)Government Bonds

g)Money Market Mutual Funds

h)Repurchase Agreements (Repos)

i)Treasury Bills (T-bills)

7.Common stockholders are usually referred to as the owners of the firm because investors in common stock have certain rights and privileges generally associated with ________________.

a)Contracts

b)Income stocks

c)Property ownership

d)Treaties

8.The concept of reducing the stand-alone risk of an individual investment by combining it with other investments to form a portfolio is called ______________.

a)Correlation coefficient

b)Diversification

c)Realized rate of return

d)Risk aversion

9.A _____________ is defined as the cash flows that could be generated from assets the firm already owns if they are not used for the project in question.

a)Balance Sheet

b)Budget

c)Income Statement

d)Opportunity Cost

e)Sunk Cost

To determine its required rate of return, the firm must compute the cost of each source of funds of capital that investors provide; that is, the firm must compute the ___________, the cost of preferred stock, the cost of retained earnings, and the cost of new common equity.

a) Cost of debt

b) Cost of equity

c) Cost of living

d) Cost of unemployment

ivorybat714

PROBLEMS, GRAPGHING

1. Suppose a candidate who runs on a platform of âsoak the richâ wins the 2016 presidential election. After being elected, he or she persuades Congress to raise the top marginal tax rate on the federal personal income tax to 65%.

a. Use one graph to show the effect of this change in tax rates on the market for municipal bonds and another graph to show the effect on the market for U.S. Treasury bonds.

b. What happened to the interest rate spread between municipal bonds and U.S. Treasury bonds and why?

Suppose that, holding yield constant, investors are indifferent as to whether they hold bonds issued by the federal government or bonds issued by state or local governments (they consider the bonds the same with respect to default risk and liquidity). Suppose that state government issued console with $60 annual payments and that the federal government has also issued console with $60 annual payments.

a. If the federal and state consoles have both the same after-tax yields of 6%, what are their pretax yields? (Assume that the federal income tax rate is 36%)

2. Suppose it is 2020 and 1-year interest rate is 5 percent. You observe that the interest rate on 2-year bond is 4.5%. Assume there is no liquidity premium and the interest rates are determined according to expectation hypothesis of the yield curve

a. Based on the interest rates above, what is the expected 1-year interest rate, starting one year from today?

b. If the interest rate on 3-year bond is 4%., what is the expected 1-year interest rate starting 2 years from today?

c. If the interest rate on 4-year bond is 4%., what is the expected 1-year interest rate starting 3 years from today?

d. Draw the yield curve for the next four years.

e. Is the yield curve for the next four years upward sloping or downward sloping? Explain why

f. What might the yield curve today indicate about future interest rates?

g What might the yield curve today indicate about future economic activity? Explain why?

h. What might the yield curve indicate about the marketsâ prediction for inflation rate in the next four years?

i. What might the yield curve indicate about monetary policy today?

j. What might the yield curve indicate about a long-term bonds price? Expected return on long-term bonds? Explain

k. Given the slope of the yield curve today, would you rather be lender or borrower in the next five years? Why?

3. The following is from an article in the Wall Street Journal, describing events in the market for Treasury securities on the given day: âTreasury prices were mixed, with the shorter end of the yield curve falling and the longer- dated Treasury rising in pricesâ.

a. Draw Treasury yield curve, showing the situation on that day as described in the sentence above.

Explain why prices of Treasury were mixed with the shorter end of the yield curve rising in prices and the longer- dated Treasury falling in prices.

Given the latest data on the state of the U.S. economy, assume that the Fed signals the next increase in the target for the federal funds. The increase wonât happen until the Fedâs meeting in summer of 2016.

Will the Treasury yield curve become more or less steep today?

Which of the following would you expect in the market for Treasury? Explain your choice

- There will be an increase in demand for bond today?

There will be a decrease in supply of bonds today?

There will be a decrease in demand for bonds today?

There will be an increase in supply of bonds today?

What will happen to the yields on Treasury? Explain

4. The table below shows current and expected future one-year interest rates, as well as current interest rates on n-year bonds

Year One-year Bond Rate N-Year Bond Rate Liquidity premium

1 2% 2% _______

2 3% 3% _______

3 4% 5% _______

4 6% 6% _______

5 7% 8% _______

Assume the expectation theory of the term structure and calculate interest rates in the term structure for maturities of one to five years.

Draw the yield curve for the next four years.

Is the yield curve for the next four years upward sloping or downward sloping? Explain why

What might the yield curve today indicate about future interest rates?

What might the yield curve today indicate about future economic activity? Explain why?

What might the yield curve indicate about the marketsâ prediction for inflation rate in the next four years?

Calculate the liquidity premium for each n-year bond

What does the liquidity premium stay for?

Compare the liquidity premium in 2-year bond and 5-year bond. Why is the liquidity premium on 2-year bond lower than the liquidity premium on 5-year bond?

5. A Suppose that you are the manager of the Bank One. Assume required reserve ratio 10 percent. The bank has the following balance sheet:

Assets Liabilities

Reserves $ 65 million Deposits $ 400 million

Loans $ 425 million Bank capital $ 90 million

Is Bank One meeting the reserve requirement?

By how much can Bank One increase its loans?

Suppose Bank One suffers a deposit outflow of $40 million .Illustrate numerically the effect of the deposit outflow of $40 million on the bankâs deposits and reserves

Does the bank now hold excess reserves?

Is the bank meeting a required reserve ratio of 10 percent?

What action must you take to meet the reserve requirement? List three or more actions. work

If a borrower defaults on a loan of $10 million, will be the bank able to sustain the loss?

Why no, why yes?

If Bank One ROA is 7%, what is the bank profit? What is the bank ROE?

How can you increase the bankâs ROE, what trade âoff do you face?

6. Suppose that you are the manager of the Bank One that has $30 million of fixed assets, $20 million of variable interest rate assets, $15 million of fixed liabilities and $25 million of variable interest rate liabilities.

a. Is the rate sensitivity gap positive or negative? Explain

b. Explain verbally and show numerically what will happen to the bank profits if interest rates rise by 4 percent.

c. What action would you take to reduce the bankâs interest-rate risk? Explain

d. Explain and show numerically what happens to the bank profit if interest rates fall by 4 percent

e. What action would you take to reduce the bankâs interest-rate risk? Explain

f. Given the bank assets and liabilities explain how you can use the interest rate swaps to reduce the bank interest rate risk. Would you trade variable- rate payments for fixed- rate payment? Why yes, why not?

7. Assume the following information about the banking system

Quantities in billions of dollars

Currency (C) = $762

Excess Reserves ( R ) = $66

Required reserves (RR) = $0

Checking deposits (D ) = $604

Give the numerical answer to the following questions:

a. What is the size of the monetary base?

b. What is the money supply in the economy?

c. What is the size of the money multiplier?

Assume that the currency to deposit ratio rises to 1.5

a. Compute the effect of the change in currency ratio on the money multiplier, m

b. What will be the money supply now given the monetary base?

If the Fed wants to keep the money supply at the initial level in part b, how must the Fed respond? Explain

Would the Fed adjust the money multiplier, the monetary base or both to keep the money supply at the initial level?

How much would the Fed buy or sell in the government bonds to keep the money supply at the initial level?

8. Assume that the MB = $828, Money supply = $1366, Currency in the circulation = $ $762, Deposit = $$604, the currency to deposits ratio c is 1.262, the excess reserve ratio is 0.109, the required reserve ratio is 0, and the money multiplier m= 1.650. The non-bank public shifts $40B from currency to deposits, and the Fed wishes to keep the money supply at the level of $1366 B. Explain verbally and show numerically the effect of the currency shift on the following

a. The level of reserves in the banking system

b. The monetary base

c. The size of the money multiplier

d. How should the Fed respond given his goal of keeping the money supply at the level of $1366? Explain

e. How much in the government bonds should the Fed buy or sell to keep the money supply at the level of $1366?

9. Use the graph of the market for reserves to analyze each of the following situations. Be sure that your graph clearly shows changes in the equilibrium federal funds rate, changes in the equilibrium level of reserves, any shifts in the demand and supply curves, and any change in equilibrium federal funds rate

Suppose that the Fed decides to increase the federal funds rate from 2%to 2.25%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that the Fed decides to decrease the federal funds rate from 2.25%to 2.%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that banks increase their demand for reserve. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose there is a switch from currency into deposits, everything else held constant. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose that the Fed decides to decrease the required reserve ratio. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged.

f. Suppose that banks decrease their demand for reserves. Show graphically and explain

verbally how the Fed can offset this change in order to keep the equilibrium federal funds

rate unchanged.

Consider the following model of the saving-investment balance. In this model, the following relationship must remain in balance: S + (M-X) = I + (G-T) where,

S is domestic saving by households and businesses

M is U.S. imports of goods and services

X is U.S. exports of goods and services

I is private domestic investment in capital goods

G is total federal, state and local government spending on goods and services, and

T is the net receipt of tax revenues by federal, state and local governments

The presentation: âLesson 1: The Savings and Investment Balanceâ in this weekâs lesson can help you understand this identity better.

Clearly, as with any high-level model, there are limitations but letâs try to understand how this model functions mechanically.Consider the model of the saving-investment balance only as an algebraic accounting identity (i.e., do not consider any economic repercussions or additional complications (those can come later)), What does the model predict will happen to gross private domestic investment (I) if:

a) Domestic saving by households was to decrease, everything else remaining the same?

b) U.S. net tax receipts were to increase, everything else remaining the same?

c) There was a sudden increase in exports from the U.S., everything else remaining the same?

d) Pre-tax business profits were to increase, everything else remaining the same?

e) Federal grants to state and local governments were to disappear, everything else remaining the same?

2. Examine the note and bond yields presented below for Treasury and Corporate AAA, AA and A-rate bonds. Why do the yields differ across the securities and within securities, across time? Which premiums or market expectations most appropriately explain those differences? In particular, what accounts for the differences in rates across securities types for the same maturities? And speculate on what factor or factors can best explain why the yields rise as maturities lengthen (within particular types of bonds). Finally, do any securities look out of place and, if so, which and why?

Treasuries

2 year 0.33%

5 year 1.39%

10 year 2.64%

20 year 3.42%

Corporate, AAA

2 year 0.40%

5 year 1.77%

10 year 3.52%

20 year 4.93%

(table continues on next page)

Corporate, AA

2 year 0.63%

5 year 1.91%

10 year 3.50%

20 year 4.43%

Corporate, A

2 year 0.84%

5 year 2.15%

10 year 3.67%

20 year 4.75%

3. Suppose that today the one-year Treasury note yields 0.12% (0.0012 in decimal form), the two-year note yields 0.40% (0.0040), the three-year note yields 0.78% (0.0078), the five-year note yields 1.60% (0.0160), the seven-year note yields 2.22% (0.0222) and the ten-year note yields 2.81% (0.0281). Under the pure expectations theory with no maturity risk:

a) What is the expected yield on a one-year note delivered one year from now?

b) What is the expected yield on a one-year note delivered two years from now?

c) What is the expected yield on a three-year note delivered two years from now?

d) What is the expected yield on a two-year note delivered five years from now?

e) What is the expected yield on a five-year note delivered five years from now?

f) What is the expected yield on a seven-year note delivered three years from now?

Note: This concept is discussed in Chapter 3 of the text and in âLesson 2: More On Yield Curves and Forward Rate Determinationâ in this weekâs online materials.

4. Assume that interest rate parity holds so that future or forward exchange rates adjust to eliminate investor arbitrage profits. If interest rates in Britain are higher than corresponding interest rates in Japan, would you expect an appreciating pound or a depreciating pound in the futures (forward) market relative to the current spot market rate? In terms of the supply and demand for pounds in the spot and forward currency markets, what is implicitly occurring in each as a result of interest rate parity? Is the pound selling forward at a premium or at a discount relative to the yen? (The presentation âLesson 3: On Exchange Ratesâ from this weekâs materials can help shed light on this subject. The portion on interest rate parity later in the presentation, so stick with it. Itâs also discussed in Chapter 16.)

5. The spot market rate for the euro is 1.4059 Canadian dollars per euro. The 3-month futures (forward) rate on the euro is 1.4147 Canadian dollars per euro. The yield on a 3-month Canadian government security is 1.16 percent (0.0116 decimal), annual percentage rate (APR). The yield on a 3-month euro area security is 0.24 percent (0.0024 decimal), annual percentage rate (APR). Show that interest rate parity (IRP) does not hold by solving for the forward rate that ensures IRP. How would you take advantage of the arbitrage opportunity arising from the actual data (i.e., borrow 1,000,000 euros, convert to Canadian dollars, invest in Canada, sell the proceeds forward and then repay your loan or borrow 1,000,000 Canadian dollars, convert to euros, invest in Europe, sell the proceeds forward and then repay your loan)?

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FINS1612 Study Guide - Final Guide: Loanable Funds, Yield Curve, Economic Indicator

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