Friday, March 26, 2010

CHAPTER 8 – UNDERSTANDING FINANCIAL MARKETS AND INSTITUTIONS

Questions

1. Classify the following transactions as taking place in the primary or secondary markets:

a. IBM issues $200 million of new common stock – primary market

b. The New Company issues $50 million of common stock in an IPO – primary market

c. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio – secondary market

d. The Magellan Fund buys $100 million of previously issued IBM bonds – secondary market

e. Prudential Insurance Co. sells $10 million of GM common stock – secondary market


2. Classify the following financial instruments as money market securities or capital market securities:

a. Federal Funds – money market security

b. Common Stock – capital market security

c. Corporate Bonds – capital market security

d. Mortgages – capital market security

e. Negotiable Certificates of Deposit – money market security

f. U.S. Treasury Bills – money market security

g. U.S. Treasury Notes – capital market security

h. U.S. Treasury Bonds – capital market security

i. State and Government Bonds – capital market security

3. What are the different types of financial institutions? Include a description of the main services offered by each.


The different types of


Commercial Banks: depository institutions whose major assets are loans and whose major liabilities are deposits. Commercial bank loans cover a broader range, including consumer, commercial, and real estate loans, than do loans from other depository institutions. Because they are larger and more likely to have access to public securities markets, commercial bank liabilities generally include more nondeposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions.


Thrifts: depository institutions including savings associations, savings banks, and credit unions. Thrifts generally perform services similar to commercial banks, but they tend to concentrate their loans in one segment, such as real estate loans or consumer loans. Credit unions often operate on a not-for-profit basis for particular groups of individuals, such as a labor union or a particular company’s employees.

Insurance Companies: protect individuals and corporations (policyholders) from financially adverse events. Life insurance companies provide protection in the event of untimely death or illness, and help in planning retirement. Property casualty insurance protects against personal injury and liability due to accidents, theft, fire, and so on.


Securities Firms and Investment Banks: underwrite securities and engage in related activities such as securities brokerage, securities trading, and making markets in which securities trade.


Finance Companies: make loans to both individuals and businesses. Unlike depository institutions, finance companies do not accept deposits, but instead rely on short- and long-term debt for funding, and many of their loans are collateralized with some kind of durable good, such as washer/dryers, furniture, carpets and the like.

Mutual Funds: pool many individuals’ and companies’ financial resources and invest those resources in diversified asset portfolios.


Pension Funds: offer savings plans through which fund participants accumulate savings during their working years. Participants then withdraw their pension resources (which have presumably earned additional returns in the interim) during their retirement years. Funds originally invested in and accumulated in a pension fund are exempt from current taxation. Participants pay taxes on distributions taken after age 55, when their tax brackets are (presumably) lower.


4. How would economic transactions between suppliers of funds (e.g., households) and users of funds (e.g., corporations) occur in a world without FIs?

In such a world, suppliers of funds (e.g., households), generating excess savings by consuming less than they earn, would have a basic choice. They could either hold cash as an asset or directly transfer that cash by investing in the securities issued by users of funds (e.g., corporations, governments, or retail borrowers). In general, demanders (users) of funds issue financial claims (e.g., equity and debt securities) to finance the gap between their investment expenditures and their internally generated funds, such as retained earnings or tax receipts. In a world without financial institutions, we would have direct transfers of funds from fund suppliers to fund users. In return, financial claims would flow directly from fund users to fund suppliers.


Problems

8-1 Determinants of Interest Rate for Individual Securities A particular security=s default risk premium is 2 percent. For all securities, the inflation risk premium is 1.75 percent and the real interest rate is 3.5 percent. The security=s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent.

The security has no special covenants. Calculate the security=s equilibrium rate of return.

ij* = 1.75% + 3.50% + 2.00% + 0.25% +0.85% = 8.35%


8-2 Determinants of Interest Rate for Individual Securities You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.25 percent. Your broker has determined the following information about economic activity and Moore Corporation bonds:

Real interest rate = 2.25%

Default risk premium = 1.15%

Liquidity risk premium = 0.50%

Maturity risk premium = 1.75%

a. What is the inflation premium?

Expected (IP) = i – RIR = 3.25% - 2.25% = 1.00%

b. What is the fair interest rate on Moore Corporation 30-year bonds?

ij* = 1.00% + 2.25% + 1.15% + 0.50% + 1.75% = 6.65%


8-3 Determinants of Interest Rate for Individual Securities Dakota Corporation 15-year bonds have an equilibrium rate of return is 8 percent. For all securities, the inflation risk premium is 1.75 percent and the real interest rate is 3.5 percent. The security=s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the bond=s default risk premium.


8.00% = 1.75% + 3.50% + DRP + 0.25% + 0.85%

=> DRP = 8.00% - (1.75% + 3.50% + 0.25% + 0.85%) = 1.65%


8-4 Determinants of Interest Rate for Individual Securities A 2-year Treasury security currently earns 4.14 percent. Over the next two years, the real interest rate is expected to be 2.25 percent per year and the inflation premium is expected to be 1.75 percent per year. Calculate the maturity risk premium on the 2-year Treasury security.


4.14% = 1.75% + 2.25% + 0.00% + 0.00% + MP

=> MP = 4.14% - (1.75% + 2.25% + 0.00% + 0.00%) = 0.14%

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