Study Guide for Mid-term Exam 1

Chapter 1: Introduction
1. What are financial market surplus unit and deficit unit?
Surplus unit- participants who receive more money than they spend,
provide savings to financial markets
Deficit unit- participants who spend more money than they receive, access
funds from financial markets
2. What are the different types of financial markets?
Primary Markets- facilitate the issuance of new securities
Secondary markets- facilitates the trading of existing securities, which
allows for a change in the ownership of the securities
3. What are the major types of capital market securities?
Money market securities- debt securities that have a maturity of one year
or less
Capital market securities- commonly issued to finance the purchase of
capital assets, such as buildings, equipment, or machinery
Bonds- long-term debt securities issued by the Treasury, government
agencies, and corporations to finance their operations
Mortgages- long-term debt obligations created to finance the purchase of
real estate
Mortgage-Backed Securities- debt obligations representing claims on a
package of mortgages
Stocks- equity securities, represent partial ownership in the corporations
that issue them
Derivatives- financial contracts whose values are derived from the values
of underlying assets (such as debt securities or equity securities)
4. What are the main depository and non-depository institutions?
Depository
o Commercial banks
o Savings institutions
o Credit unions
Nondepository
o Finance companies
o Mutual funds- dominant Nondepository financial institution
o Securities firms
o Insurance companies
o Pension funds
Chapter 2: Determination of Interest Rate
1. Be able to explain loanable funds theory.

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The market interest rate is determined by the factors that affect the supply
and demand for loanable funds. The sum of the quantities demanded by
the separate sectors at any given interest rate is the aggregate demand for
loanable funds.
Who demand funds? Who supply funds? What are the characteristics related to
each demander and supplier?
Demanders
o Households- finance housing expenditures, automobiles,
household items (inverse relationship, high interest rate = low
demand)
o Businesses- invest in fixed assets and short term assets, evaluate
projects using NPV (inverse relationship)
o Government- planned expenditures are not covered by incoming
revenues (interest inelastic)
o Foreign- influenced by the interest rate differential between
countries (inverse relationship)
Suppliers
o Households (net suppliers of funds)
o Government units and businesses (net borrowers of funds)
o Direct relationship graphs, positive correlation
How economic growth affect interest rate?
Shifts the demand schedule outward (to the right)
Increase in equilibrium interest rate
How inflation affect interest rate?
Shifts the supply schedule inward (to the left), households increase
consumption now if inflation is expected to increase
Shifts the demand schedule outward (to the right), households and
businesses borrow more to purchase products before prices rise
What is Fisher Effect? Be able to calculate real, nominal rate using fisher
equation.
The relationship between interest rates and expected inflation
How interest rate changed after September 11?
Firms cut back on expansion plans, households cut back on borrowing
plans, the demand of loanable funds declined
Reduced demand for loanable funds, the Fed increased the money supply
growth, interest rates reached very low levels
How budge deficit affect interest rate?
A high deficit means a high demand for loanable funds by the
government shifts the demand schedule outward (to the right)
The government may be willing to pay whatever is necessary to borrow
funds, but the private sector may not
How foreign flow of funds affect interest rate?
The interest rate for a currency is determined by the demand for and
supply of that currency

Shifts in the flows of funds between countries cause adjustments in the

supply of funds available in each country
9. How Net Demand (ND) for fund affect interest rate?
A positive disequilibrium in ND will be corrected by an increase in
interest rates
A negative disequilibrium in ND will be corrected by a decrease in interest
rates
Chapter 3: Structure of interest rate
1. How default risk, liquidity, tax status, term to maturity, and some special features
of debt securities affect interest rate?
Default risk- higher degree of risk = higher yield
Liquidity- lower liquidity = offer higher yield to be preferred
Tax status- taxable securities must offer a higher before-tax yield than taxexempt securities, the extra compensation required on taxable securities
depends on the tax rates of individual and institutional investors
Term to maturity- maturity differs among debt securities
2. Know the yield differentials and how to estimate yield.
Yield differentials are often measured in basis points 100 basis points =
1%
Money Market Securities
o The yields offered on commercial paper are slightly higher than TBill rates, since investors require a slightly higher return (10-40
basis points on an annualized basis) to compensate for credit risk
and less liquidity
o Negotiable certificates of deposit offer slightly higher rates than
yields on T-Bills with the same maturity because of their lower
degree of liquidity and higher degree of credit risk
Capital Market Securities
o Municipal bonds have the lowest before-tax yield, yet their after
tax yield is typically above that of Treasury bonds from the
perspective of investors in high tax brackets
o Treasury bonds are expected to offer the lowest yield because they
are free from credit risk and can easily be liquidated in the
secondary market
o Investors prefer municipal or corporate bonds over Treasury bonds
only if the after-tax yield is sufficiently higher to compensate for
the higher credit-risk and lower degree of liquidity
3. What are the three theories explaining term structure? Explain each of them.
Pure expectations theory- the shape of the yield curve is determined solely
by expectations of future interest rates
o Forward rates are unbiased estimators of future interest rates
o If forward rates are biased, investors should attempt to capitalize
on the discrepancy

Liquidity premium theory- the yield curve changes as the liquidity

premium changes over time due to investor preferences
o Short term securities are typically more liquid than long term
securities
o Investors who prefer short term securities will hold long term
securities only if compensated with a premium
o The preference for short term securities places upward pressure on
the slope of the yield curve
Segmented market theory- investors and borrowers choose securities with
different maturities
o Pension funds and life insurance companies prefer long term
investments
o Commercial banks prefer short term investments
4. Using pure expectation theory to explain the change of yield curve with
expectations of rising or falling interest rate.
The yield curve will become upward sloping if interest rates are expected
to rise
The yield curve will become downward sloping if interest rates are
expected to decline
5. Be able to calculate forward rate.
Chapter 4: Functions of the Fed
1. What are the five major components of Fed? What is the function of them?
Federal Reserve district banks- 12 banks, clear checks, replace old
currency, provide loans to depository institutions, and conduct research
Member banks- all national banks are required to be members of the Fed
Board of Governors- 7 members, regulate commercial banks, control
monetary policy
Federal Open Market Committee (FOMC)
o Consists of the 7 members of the Board of Governors plus the
presidents of five fed district banks
o Goals: promote high employment, economic growth, and price
stability achieved through the control of the money supply
Advisory Committees
o The Federal Advisory Council
1 member from each Federal Reserve district who
represents the banking industry
the council meets with the Board of Governors in
Washington D.C. at least 4x a year and makes
recommendations about economic and banking issues
o Consumer Advisory Council
Made up of 30 members who represent the financial
institutions industry and its consumers

Normally meets with the Board of Governors 4x a year to

discuss consumer issues
o The Thrift Institutions Advisory Council
Made up of 12 members who represent savings banks,
savings and loan associations, and credit unions
Purpose is to offer views on issues specifically related to
the aforementioned institutions
Meets with the Board of Governors 3x a year
What is open market operations? How does it affect money supply?
Fed purchase of securities total funds of commercial banks increase by
the dollar amount of securities purchased by the Fed = buy securities
increase money supply
Fed sale of securities total amount of funds in the baking system is
reduced by the market value of securities sold by the Fed = sell
securities decrease money supply, also places upward pressure on
federal funds rate
When Fed adjust discount rate, how does it affect money supply?
To increase the money supply the Fed can authorize a reduction in the
discount rate
o Encourages depository institutions to borrow from the Fed
To decrease the money supply the Fed can increase the discount rate
o Discouraged borrowing from the Fed
When Fed adjust reserve requirement ratio, how does it affect money supply?
Reserve requirement ratio reduced increases the proportion of a banks
deposits that can be lent out by depository institutions, a portion of the
funds lent out will return to the depository institutions as new deposits,
lower reserve requirement ratio causes funds to multiply by a greater
amount
Reserve requirement increased initial injection of funds to multiply
by a smaller amount
What is money multiplier and how does it work?
1/r

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Chapter 6 Money Market

1. What are the major types of money market securities?
Have maturities within 1 year
Are issued by corporations and governments to obtain short term funds
Are commonly purchased by corporations and government agencies that
have funds available for a short term period

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Provide liquidity to investors

Treasury bills, commercial paper, negotiable certificates of deposit,
repurchase agreements, federal funds, bankers acceptances
Know about the basics for T-bill the issuer, auction, face value, no interest
payment. Be able to calculate T-bill price, T-bill yield, T-bill discount.
Are issued by the U.S. Treasury
Are sold weekly through an auction
Have a par value of $1,000
Are attractive to investors because they are backed by the federal
government and are free of default risk
Pm=Par/(1+k)n
o P=price
o M=holding period
o K=return (%)
o N=period
Know about the basics for commercial paper. Be able to calculate commercial
paper yield.
Short-term debt instrument issued by well-known, creditworthy firms
Unsecured
Maturity= 1-270 days, over 270 days SEC filing
Calculation refer to formula sheet, plug in numbers
What is Negotiable CDs? Be able to calculate NCDs yield.
Issued by large commercial banks and other depository institutions as a
short term source of funds
Have a minimum denomination of $100,000
Often purchased by nonfinancial corporations
Sometimes purchased by money market funds
Typical maturity between 2 weeks and 1 year
Yield on NCD = (SP-PP+Interest)/PP
o SP = Selling price
o PP = Purchase Price
What is Repo and reverse Repo? Calculate Repo yield.
Repurchase agreement- one party sells securities to another with an
agreement to repurchase them at a specified date and price
o A loan backed by securities
Reverse repo- the purchase of securities by one party from another with an
agreement to sell them
Repo rate = [(SP-PP)/PP] x (360/n)
What is Federal Funds?
The federal funds market allows depository institutions to lend or borrow
short term funds from each other at the federal funds rate
What is Bankers acceptance? Know the international trading cycle where
Bankers acceptance exists.

A bank accepts responsibility for future payments

Used for international trade transactions
The return is equal to the difference between the discounted price paid and
the amount to be received in the future
Have an active secondary market facilitated by dealers
8. Be able to compute effective yield when valuing foreign money market securities.
Ye = (1+Yf) x (1+%S) 1
Yf = (SPf - PPf)/PPf
%S = percentage change in the spot exchange rate