Chapter 5 The Financial Environment: Markets, Institutions

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Chapter 5
                            The Financial Environment:
                       Markets, Institutions, and Interest Rates

5-1       a. A money market is a financial market for debt securities with
             maturities of less than one year (short-term).   The New York money
             market is the world's largest.    Capital markets are the financial
             markets for long-term debt and corporate stocks. The New York Stock
             Exchange is an example of a capital market.

          b. Primary markets are the markets in which newly issued securities are
             sold for the first time. Secondary markets are where securities are
             resold after initial issue in the primary market. The New York Stock
             Exchange is a secondary market.

          c. In private markets, transactions are worked out directly between two
             parties and structured in any manner that appeals to them. Bank loans
             and private placements of debt with insurance companies are examples of
             private market transactions. In public markets, standardized contracts
             are traded on organized exchanges.      Securities that are issued in
             public markets, such as common stock and corporate bonds, are
             ultimately held by a large number of individuals.       Private market
             securities are more tailor-made but less liquid, whereas public market
             securities are more liquid but subject to greater standardization.

          d. Derivatives are claims whose value depends on what happens to the value
             of some other asset. Futures and options are two important types of
             derivatives, and their values depend on what happens to the prices of
             other assets, say IBM stock, Japanese yen, or pork bellies. Therefore,
             the value of a derivative security is derived from the value of an
             underlying real asset.

          e. An investment banker is a middleman between businesses and savers.
             Investment banking houses assist in the design of corporate securities
             and then sell them to savers (investors) in the primary markets.
             Financial service corporations offer a wide range of financial services
             such as brokerage operations, insurance, and commercial banking.

          f. A financial intermediary buys securities with funds that it obtains by
             issuing its own securities. An example is a common stock mutual fund
             that buys common stocks with funds obtained by issuing shares in the
             mutual fund.

          g. A mutual fund is a corporation that sells shares in the fund and uses
             the proceeds to buy stocks, long-term bonds, or short-term debt
             instruments. The resulting dividends, interest, and capital gains are

Harcourt, Inc. items and derived items copyright  2002 by Harcourt, Inc.   Answers and Solutions: 5 - 1
           distributed to the fund's shareholders after the deduction of operating
           expenses. Different funds are designed to meet different objectives.
           Money market funds are mutual funds which invest in short-term debt
           instruments and offer their shareholders check writing privileges;
           thus, they are essentially interest-bearing checking accounts.

       h. Organized security exchanges, such as the New York Stock Exchange,
          facilitate communication between buyers and sellers of securities.
          Each organized exchange is a physical entity and is governed by an
          elected board of governors. The over-the-counter market consists of
          all the facilities that provide for security transactions not conducted
          on the organized exchanges.     These facilities are, basically, the
          relatively few dealers who hold inventories of over-the-counter
          securities, the thousands of brokers who act as agents in bringing
          these dealers together with investors, and the communications network
          that links the dealers and agents.

       I. Production opportunities are the returns available within an economy
          from investment in productive assets.      The higher the production
          opportunities, the more producers would be willing to pay for required
          capital. Consumption time preferences refer to the preferred pattern
          of consumption. Consumer's time preferences for consumption establish
          how much consumption they are willing to defer, and hence save, at
          different levels of interest.

       j. The real risk-free rate is that interest rate which equalizes the
          aggregate supply of, and demand for, riskless securities in an economy
          with zero inflation. The real risk-free rate could also be called the
          pure rate of interest since it is the rate of interest that would exist
          on very short-term, default-free U.S. Treasury securities if the
          expected rate of inflation were zero. It has been estimated that this
          rate of interest, denoted by k*, has fluctuated in recent years in the
          United States in the range of 2 to 4 percent. The nominal risk-free
          rate of interest, denoted by kRF, is the real risk-free rate plus a
          premium for expected inflation. The short-term nominal risk-free rate
          is usually approximated by the U.S. Treasury bill rate, while the long-
          term nominal risk-free rate is approximated by the rate on U.S.
          Treasury bonds.    Note that while T  -bonds are free of default and
          liquidity risks, they are subject to risks due to changes in the
          general level of interest rates.

       k. The inflation premium is the premium added to the real risk-free rate
          of interest to compensate for the expected loss of purchasing power.
          The inflation premium is the average rate of inflation expected over
          the life of the security.

       l. Default risk is the risk that a borrower will not pay the interest
          and/or principal on a loan as they become due. Thus, a default risk
          premium (DRP) is added to the real risk-free rate to compensate
          investors for bearing default risk.

Answers and Solutions: 5 - 2          Harcourt, Inc. items and derived items copyright  2002 by Harcourt, Inc.
          m. Liquidity refers to a firm's cash and marketable securities position,
             and to its ability to meet maturing obligations. A liquid asset is any
             asset that can be quickly sold and converted to cash at its "fair"
             value. Active markets provide liquidity. A liquidity premium is added
             to the real risk-free rate of interest, in addition to other premiums,
             if a security is not liquid.

          n. Interest rate risk arises from the fact that bond prices decline when
             interest rates rise. Under these circumstances, selling a bond prior
             to maturity will result in a capital loss, and the longer the term to
             maturity, the larger the loss. Thus, a maturity risk premium must be
             added to the real risk-free rate of interest to compensate for interest
             rate risk.

          o. Reinvestment rate risk occurs when a short-term debt security must be
             "rolled over."   If interest rates have fallen, the reinvestment of
             principal will be at a lower rate, with correspondingly lower interest
             payments and ending value. Note that long-term debt securities also
             have some reinvestment rate risk because their interest payments have
             to be reinvested at prevailing rates.

          p. The term structure of interest rates is the relationship between yield
             to maturity and term to maturity for bonds of a single risk class. The
             yield curve is the curve that results when yield to maturity is plotted
             on the Y axis with term to maturity on the X axis.

          q. When the yield curve slopes upward, it is said to be "normal," because
             it is like this most of the time. Conversely, a downward-sloping yield
             curve is termed "abnormal" or "inverted."

          r. The expectations theory states that the slope of the yield curve
             depends on expectations about future inflation rates and interest
             rates. Thus, if the annual rate of inflation and future interest rates
             are expected to increase, the yield curve will be upward sloping,
             whereas the curve will be downward sloping if the annual rates are
             expected to decrease.

          s. A foreign trade deficit occurs when businesses and individuals in the
             U. S. import more g  oods from foreign countries than are exported.
             Trade deficits must be financed, and the main source of financing is
             debt. Therefore, as the trade deficit increases, the debt financing
             increases, driving up interest rates. U. S. interest rates must be
             competitive with foreign interest rates; if the Federal Reserve
             attempts to set interest rates lower than foreign rates, foreigners
             will sell U.S. bonds, decreasing bond prices, resulting in higher U. S.
             rates. Thus, if the trade deficit is large relative to the size of the
             overall economy, it may hinder the Fed's ability to combat a recession
             by lowering interest rates.

5-2       Financial intermediaries are business organizations that receive funds in
          one form and repackage them for the use of those who need funds. Through

Harcourt, Inc. items and derived items copyright  2002 by Harcourt, Inc.   Answers and Solutions: 5 - 3
       financial intermediation, resources are allocated more effectively, and
       the real output of the economy is thereby increased.

5-3    Regional mortgage rate differentials do exist, depending on supply/demand
       conditions in the different regions. However, relatively high rates in
       one region would attract capital from other regions, and the end result
       would be a differential that was just sufficient to cover the costs of
       effecting the transfer (perhaps    of one percentage point). Differentials
       are more likely in the residential mortgage market than the business loan
       market, and not at all likely for the large, nationwide firms, which will
       do their borrowing in the lowest-cost money centers and thereby quickly
       equalize rates for large corporate loans.     If Congress were to permit
       nationwide branching, interest rates would become more competitive, making
       it easier for small borrowers, and borrowers in rural areas, to obtain
       lower cost loans.

5-4    It would be difficult for firms to raise capital.         Thus, capital
       investment would slow down, unemployment would rise, the output of goods
       and services would fall, and, in general, our standard of living would

5-5    The prices of goods and services must cover their costs. Costs include
       labor, materials, and capital.    Capital costs to a borrower include a
       return to the saver who supplied the capital, plus a mark-up (called a
       "spread") for the financial intermediary which brings the saver and the
       borrower together. The more efficient the financial system, the lower the
       costs of intermediation, the lower the costs to the borrower, and, hence,
       the lower the prices of goods and services to consumers.

5-6    Short-term rates are more volatile because (1) the Fed operates mainly in
       the short-term sector, hence Federal Reserve intervention has its major
       effect here, and (2) long-term rates reflect the average expected
       inflation rate over the next 20 to 30 years, and this average does not
       change as radically as year-to-year expectations.

5-7    Interest rates will fall as the recession takes hold because (1) business
       borrowings will decrease and (2) the Fed will increase the money supply to
       stimulate the economy. Thus, it would be better to borrow short-term now,
       and then to convert to long-term when rates have reached a cyclical low.
       Note, though, that this answer requires interest rate forecasting, which
       is extremely difficult to do with better than 50 percent accuracy.

5-8    a. If transfers between the two markets are costly, interest rates would
          be different in the two areas.     Area Y, with the relatively young
          population, would have less in savings accumulation and stronger loan
          demand. Area O, with the relatively old population, would have more
          savings accumulation and weaker loan demand as the members of the older
          population have already purchased their houses and are less consumption
          oriented. Thus, supply/demand equilibrium would be at a higher rate of
          interest in Area Y.

Answers and Solutions: 5 - 4         Harcourt, Inc. items and derived items copyright  2002 by Harcourt, Inc.
          b. Yes.   Nationwide branching, and so forth, would reduce the cost of
             financial transfers between the areas. Thus, funds would flow from
             Area O with excess relative supply to Area Y with excess relative
             demand.   This flow would increase the interest rate in Area O and
             decrease the interest rate in Y until the rates were roughly equal, the
             difference being the transfer cost.

5-9       A significant increase in productivity would raise                the rate of return on
          producers' investment, thus causing the investment                curve (see Figure 5-2
          in the textbook) to shift to the right. This would                increase the amount of
          savings and investment in the economy, thus causing               all interest rates to

5-10      a. The immediate effect on the yield curve would be to lower interest
             rates in the short-term end of the market, since the Fed deals
             primarily in that market segment. However, people would expect higher
             future inflation, which would raise long-term rates. The result would
             be a much steeper yield curve.

          b. If the policy is maintained, the expanded money supply will result in
             increased rates of inflation and increased inflationary expectations.
             This will cause investors to increase the inflation premium on all debt
             securities, and the entire yield curve would rise; that is, all rates
             would be higher.

5-11      a. S&Ls would have a higher level of net income with a "normal" yield
             curve.   In this situation their liabilities (deposits), which are
             short-term, would have a lower cost than the returns being generated by
             their assets (mortgages), which are long-term. Thus they would have a
             positive "spread."

          b. It depends on the situation.     A sharp increase in inflation would
             increase interest rates along the entire yield curve. If the increase
             were large, short-term interest rates might be boosted above the long-
             term interest rates that prevailed prior to the inflation increase.
             Then, since the bulk of the fixed-rate mortgages were initiated when
             interest rates were lower, the deposits (liabilities) of the S&Ls would
             cost more than the return being provided on the assets.        If this
             situation continued for any length of time, the equity (reserves) of
             the S&Ls would be drained to the point that only a "bailout" would
             prevent bankruptcy. This has indeed happened in the United States.
             Thus, in this situation the S&L industry would be better off selling
             their mortgages to federal agencies and collecting servicing fees
             rather than holding the mortgages they originated.

5-12      Treasury bonds, along with all other bonds, are available to investors as
          an alternative investment to common stocks. An increase in the return on
          Treasury bonds would increase the appeal of these bonds relative to common
          stocks, and some investors would sell their stocks to buy T-bonds. This
          would cause stock prices, in general, to fall. Another way to view this
          is that a relatively riskless investment (T-bonds) has increased its
          return by 7 percentage points. The return demanded on riskier investments

Harcourt, Inc. items and derived items copyright  2002 by Harcourt, Inc.   Answers and Solutions: 5 - 5
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