Final

Question 1

ch1: financial market 9s () finance

what does it do

Answer 1

1. suppliers and demanders of funds interact

2. set prices for financial assets

Question 2

4 financial organizations in financial market

Answer 2

financial market
savers (assets)
borrower’s IOU
intermediaries

Question 3

4 functions of the financial system

Answer 3

1. matches savers with borrowers
2. liquidity (allow people to hold financial claims + increases liquidity by providing trading systems)
3. information cost
4. risk-sharing (diversity portfolios)

Question 4

primary markets

1. what does it trade
2. enhance/create liquidity

Answer 4

1. newly issued claims
2. creates
3. does not provide other services

Question 5

secondary markets

1. enhance/create liquidity

Answer 5

1. enhance liquidity; risk sharing, promoting liquidity and information

Question 6

capital markets include () and ()

short-term instrument w/ m<1 is traded in ()

Answer 6

1. auction market (competitive bidding)
2. OTC (computerized & NASDAQ)
3. MONEY MARKET

Question 7

fin institutions

1. how does it make money
2. how does it enhance liquidity

Answer 7

1. interest rate spread

2. checking accounts

Question 8

fin. institutions
1. how does it make money
2. how does it enhance liquidity

Answer 8

1. interest rate spread

2. checking accounts

Question 9

ch2: 
what 5 criteria define money 
1. common medium of exchange (4 criteria)
2. unit of account
3. store of value 
4. the standard of deferred payment 

what does money enable (specialization)

Answer 9

1. acceptable + standard quality + durable + valuable relative to weight + divisible

Question 10

what determines acceptability

Answer 10

1. universal faith (fulfilling expectations)

Question 11

what is inflation? (hyperinflation –> Zimb)

deflation?

Answer 11

1. decrease in the purchasing power of money

2. increase in the purchasing power of money

Question 12

payment system
1. definitive $
(physical goods + system)

2. fiat money vs. legal tender
3. checks
4. setting and clearing transactions (electronic funds)

Answer 12

1. money that does not have to be converted to a more basic medium of exchange

Question 13

measuring the money supply
1. M1

2. M2(best measure of money supply + increases more rapidly than M1)
3. M3

Answer 13

1. liquid assets (checkable deposits + cash + traveler’s checks)
2. M1 + short-term investment account

Question 14

CH3

IR must cover oppor.cost

Answer 14

1. inflation
2. default risk
3. opportunity cost

Question 15

yld (def)

Answer 15

1. yield = PV of return == PV today

Question 16

when YTM < Coupon

Answer 16

premium

Question 17

when YTM = couplon

Answer 17

par

Question 18

YTM > coupon

Answer 18

discount

Question 19

capital gain/ loss formula

Answer 19

FV - P

Question 20

current yld

1. C/P move in the same direction as YLD

Answer 20

C/P

increase in P, decrease in CY

Question 21

F = P –> capital gain/ loss = () –> coupon rate = () –> current yld =()

Answer 21

1. 0, current yld, ytm

Question 22

F<p> capital () –> coupon rate () current yild )_ ytm</p>

Answer 22

loss, >, >

Question 23

F>P –> capital() –> coupon rate () current yld () YTM

Answer 23

gain,

Question 24

the longer the time until a bond matures, the () the potential price change caused by a change in YTM

Answer 24

GREATER

Question 25

the negative impact of a () in i on P increases with n

Answer 25

rise

Question 26

TIPS | pays () a year at a fixed rate

Answer 26

offers low return

Question 27

TIPS | pays () a year at a fixed rate

Answer 27

offers a low return

Question 28

Jeremy Siegal 1. why are TIPS bad investment 2. when are TIPS an awful investment

Answer 28

1. when inflation is high 2. according to the Fisher equation, inflation can be a sign of economic growth --> increase in real rate --> decrease in PV of TIPS

Question 29

how does the treasury benefit from issuing TIPS

Answer 29

1. avoid having to pay inflation risk premium | 2. provide useful reading of interest rates

Question 30

drawbacks of tips

Answer 30

1. difficulty adjusting to a new asset class 2. low liquidity 3. supply trends

Question 31

drawbacks of tips

Answer 31

1. difficulty adjusting to a new asset class 2. low liquidity 3. supply trends

Question 32

pros of strips

Answer 32

1. no periodic cost | 2. match information

Question 33

5 determinants of portfolio choice

Answer 33

1. wealth 2. exp. return 3. liquidity 4. risk 5. cost to acquire information

Question 34

for every p that clears the () market, there is an equivalent () that clears the () market 2. demand in B == () in LF 3. Supply in B == () in LF

Answer 34

1. bond, i, loanable funds

Question 35

5 factors that affect D in Bond mkt and S in LF mkt

Answer 35

1. wealth (w increases, Db & Slf shifts out) 2. expected return & exp. inflation (increase in expected inflation and return cause Db and Slf to shift in 3. risk 4. liquidity 5. information cost

Question 36

4 factors that affect the supply of bonds and demands of loanable funds

Answer 36

1. exp profitability (increase in prof. increase in supply of bonds / demand of lf) 2. business taxes (same as profitability) 3. expected inflation (high expected inflation means low real interest rate in borrowing --> supply of bonds and demand of lf shifts out) 4. government borrowing (increased deficit --> more savings --> shifts supply of bonds out

Question 37

why are interest rates low during recession 1. in the beginning of a recession --> the demand of bonds shifts () because economic activities are reduced. 2. meanwhile, the supply of the bonds also fall because shrinking business activities 3. ultimately the second effect would be > the first effect, causing interest rate to fall

Answer 37

1. in | 2. snow ball effect

Question 38

what happens to the loanable funds and bond mkts when expected inflation is high

Answer 38

1. demand of bonds falls 2. supply of bonds increases 3. interest rate increases

Question 39

pros of strips people who buy strips are (receive certain amount at a specific date, not concerned about receiving current income, do not want to worry about finding an appropriate reinvestment opportunity)

Answer 39

1. a promise at a certain date with reduced purchase price | 2. provide safety of principal

Question 40

cons of securities

Answer 40

1. interest rate risk (only gains and losses if strips are sold before maturity) 2 .less liquid 3. inflation risk

Question 41

the negative impact of a rise in i on p increases with n, because()

Answer 41

1. the change in present value is larger and further out into the future

Question 42

explain why increased liquidity premium would precede a recession

Answer 42

1. before recession --> economic activities slow down (less investment etc) --> higher default risk -> less demand for bonds --> lower Pbonds & higher i 2. people demand treasury bonds --> increase Dt-bills --> higher Pbills & lower i 3. premium = bondi - t-bill i > than before

Question 43

``` risk structure () maturity with differences in () factors ```

Answer 43

1. same | 2. liquidity, risk, info cost, tax

Question 44

``` term structure (only for government bonds) ()maturity with () factors ```

Answer 44

1. different | 2. same

Question 45

interest carry trade strategy and difficulty - expectation theory suggests that interest carry trade is not an ordinary road to riches 1. institutional investors can do this (i.e borrow at 1% and invest at 3%; however if expectation theory is applied, the short-term interest rate would rise. By the time the bond is matured, all profits are wiped out + interest rate risk )

Answer 45

1. the gap between the interest rate and the rate you can borrow can be small or negative

Question 46

reasons why yield curve is a good forecasting tool

Answer 46

1. predictive ability + supplement models 2. quick and simple 3. takes future and current monetary policy into account

Question 47

the required return on equity (Re)

Answer 47

1. expected return necessary to compensate for the risk of investing in stocks

Question 48

assumptions of GGM

Answer 48

1. receive dividend during the same period 2. dividend is constant 3. Re > g

Question 49

adaptive expectations vs. rational

Answer 49

1. make expectations based on past events

Question 50

under rational expectation, the expectation of an asset's future price = optimal price forecast, Pf

Answer 50

the random error still exists

Question 51

EMH 1. Under EMH, how does a price forecast translate into prices 2. equilibrium price of an asset = optimal forecast of its fundamental value

Answer 51

1. Self-interests drive the price to reach its fundamental value (Microsoft & 50 per share)

Question 52

adverse selection 1. in bond market 2. in stock market

Answer 52

1. higher interest rate attract high default risk borrowers --> credit rationings 2. lemon problem ( the cost of equity financing is higher)

Question 53

moral hazard 1. in bond market 2. in stock market

Answer 53

1. high-risk investments by managers because they can keep the additional profit (restrictive covenants = solution) 2. principal agent problem (publication of financial statements = solution)

Question 54

moral hazard 1. in bond market 2. in stock market

Answer 54

1. high-risk investments by managers because they can keep the additional profit (restrictive covenants = solution) 2. principal agent problem (publication of financial statements = solution)

Question 55

securitization 1. higher liquidity 2. spreading risk 3. specialization

Answer 55

1. involves the process of a sale of loans by the lender to a new agency who later sell the securities to investors. Putting smaller loans into standard debt and sell them to investors