SOLUTIONS MANUAL for Financial Markets & Institutions 13th Edition by Jeff Madura by StudyGuide

SOLUTIONS MANUAL for Financial Markets & Institutions 13th Edition by JeB Madura

Chapter 1 Role of Financial Markets and Institutions Outline Role of Financial Markets Accommodating Corporate Finance Needs Accommodating Investment Needs

Securities Traded in Financial Markets Money Market Securities Capital Market Securities Derivative Securities Valuation of Securities Securities Regulations on Financial Disclosure International Financial Markets Government Intervention in Financial Markets

Role of Financial Institutions Role of Depository Institutions Role of Nondepository Financial Institutions Comparison of Roles among Financial Institutions Relative Importance of Financial Institutions Consolidation of Financial Institutions Systemic Risk Among Financial Institutions

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Chapter 1: Role of Financial Markets and Institutions  2

Key Concepts 1. Explain the role of financial intermediaries in transferring funds from surplus units to deficit units. 2. Introduce the types of financial markets available and their functions. 3. Introduce the various financial institutions that facilitate the flow of funds. 4. Provide a preview of the course outline. Emphasize the linkages between the various sections of the course.

POINT/COUNTER-POINT: Will Computer Technology Cause Financial Intermediaries to Become Extinct? POINT: Yes. Financial intermediaries benefit from access to information. As information becomes more accessible, individuals will have the information they need before investing or borrowing funds. They will not need financial intermediaries to make their decisions. COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financial intermediaries specialize in credit analysis so that they can make wise choices when offering loans. Surplus units will continue to provide funds to financial intermediaries rather than make direct loans, because they are not capable of credit analysis, even if more information about prospective borrowers is available. Some financial intermediaries no longer have physical buildings for customer service, but they still require agents who have the expertise to assess the creditworthiness of prospective borrowers. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Computer technology may reduce the need for some types of financial intermediaries such as brokerage firms, because individuals can make transactions on their own (if they prefer to do so). However, loans will still require financial intermediaries because of the credit assessment that is needed.

Questions 1. Surplus and Deficit Units. Explain the meaning of surplus units and deficit units. Provide an example of each. Which types of financial institutions do you deal with? Explain whether you are acting as a surplus unit or a deficit unit in your relationship with each financial institution. ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds from the financial markets. Surplus units include households with savings, while deficit units include firms or government agencies that borrow funds. This exercise allows students to realize that they constantly interact with financial institutions, and that they often play the role of a deficit unit (on car loans, tuition loans, etc.).

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 1: Role of Financial Markets and Institutions  3 2. Types of Markets. Distinguish between primary and secondary markets. Distinguish between money and capital markets. ANSWER: Primary markets are used for the issuance of new securities while secondary markets are used for the trading of existing securities. Money markets facilitate the trading of short-term (money market) instruments while capital markets facilitate the trading of long-term (capital market) instruments. 3. Imperfect Markets. Distinguish between perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries. ANSWER: With perfect financial markets, all information about any securities for sale would be freely available to investors, information about surplus and deficit units would be freely available, and all securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and deficit units do not have free access to information, and securities cannot be unbundled as desired. Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficit units. They have the information to provide this service and can even repackage deposits to provide the amount of funds that borrowers desire. 4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain. ANSWER: If markets are efficient then prices of securities available in these markets properly reflect all information. We should expect markets to be efficient because if they weren’t, investors would capitalize on the discrepancy between what prices are and what they should be. This action would force market prices to represent the appropriate prices as perceived by the market. Efficiency is often defined with regard to publicly available information. In this case, markets can be efficient, but investors with inside information could possibly outperform the market on a consistent basis. A stronger version of efficiency would hypothesize that even access to inside information will not consistently outperform the market. 5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment decisions? Explain. ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant financial information on publicly offered securities and prevent fraudulent practices when selling these securities. The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared a variety of deceptive practices illegal but does not prevent poor investments. 6. International Expansion. Discuss why many financial institutions have expanded internationally in recent years. What advantages can be obtained through an international merger of financial institutions? ANSWER: Many financial institutions have expanded internationally to capitalize on their

expertise. Commercial banks, insurance companies, and securities firms have expanded

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through international mergers. An international merger between financial institutions enables the merged company to offer the services of both entities to its entire customer base. 7. Stock Valuation. What type of information do investors rely on in order to determine the proper value of stocks? ANSWER: Since the valuation of a stock at a future point in time is uncertain, so is the selling

price of a stock at a future point in time. Investors often rely on financial statements by firms in order to assess how stock prices might change in the future. In particular, investors rely on accounting reports of a firm’s revenue, expenses, and earnings as a basis for estimating its future cash flows. Firms with publicly traded stock are required to disclose financial information and financial statements. 8. Securities Firms. What are the functions of securities firms? Many securities firms employ brokers and dealers. Distinguish between the functions of a broker and those of a dealer and explain how each type of professional is compensated. ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) that either enhances a borrower’s ability to borrow funds or an investor’s ability to invest funds. Brokers are commonly compensated with commissions on trades, while dealers are compensated on their positions in particular securities. Some dealers also provide brokerage services. 9. Mis-valuation of Marijuana Stocks. Explain why some stocks in the marijuana industry were misvalued when several states legalized the recreational use of marijuana. ANSWER: Recently, as several states legalized the recreational use of marijuana, some

companies with very little experience in any business related to marijuana announced that they were positioned to capitalize on the expected growth in this market. Many investors wanted to benefit from this potential growth and quickly purchased the stocks of companies in the industry. However, some investors did not carefully check the business plan, operations, or financial condition of these companies. Consequently, the strong demand by investors for stocks of marijuana companies without much experience caused their stock prices to increase dramatically, only to crash upon a closer review. 10. Marketability. Commercial banks use some funds to purchase securities and other funds to make loans. Why are the securities more marketable than the loans in the secondary market? ANSWER: Securities are more standardized than loans and therefore can be more easily sold in the secondary market. The excessive documentation on commercial loans limits a bank’s ability to sell loans in the secondary market. 11. Depository Institutions. Explain the primary use of funds for commercial banks versus savings institutions. ANSWER: Savings institutions have traditionally concentrated in mortgage lending, while commercial banks have concentrated in commercial lending. Savings institutions are now allowed to diversify their asset portfolio to a greater degree and will likely increase their concentration in

Chapter 1: Role of Financial Markets and Institutions  5 commercial loans (but not to the same degree as commercial banks). 12. Credit Unions. With regard to the profit motive, how are credit unions different from other financial institutions? ANSWER: Credit unions are non-profit financial institutions. 13. Nondepository Institutions. Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds. ANSWER: Finance companies sell securities to obtain funds, while insurance companies receive insurance premiums and pension funds receive employee/employer contributions. Finance companies use funds to provide direct loans to consumers and businesses. Insurance companies and pension funds purchase securities. 14. Mutual Funds. What is the function of a mutual fund? Why are mutual funds popular among investors? How does a money market mutual fund differ from a stock or bond mutual fund? ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in a portfolio of securities. Mutual funds are popular because they can help individuals diversify while using professional expertise to make investment decisions. A money market mutual fund invests in money market securities, whereas other mutual funds normally invest in stocks or bonds. 15. Secondary Market for Debt Securities. Why is it important for long-term debt securities to have an active secondary market? ANSWER: An active secondary market is especially desirable for debt securities that have a

long-term maturity, because it allows investors flexibility to sell them at any time prior to maturity. Many investors would not even consider investing in long-term debt securities if they were forced to hold these securities until maturity.

Advanced Questions 16. Comparing Financial Institutions. Classify the types of financial institutions mentioned in this chapter as either depository or nondepository. Explain the general difference between depository and nondepository institutions as sources of funds. It is often stated that all types of financial institutions have begun to offer services that were previously offered only by certain types. Consequently, many financial institutions are becoming more similar. Nevertheless, performance levels still differ significantly among types of financial institutions. Why? ANSWER: Depository institutions include commercial banks, savings and loan associations, and credit unions. These institutions differ from nondepository institutions in that they accept deposits. Nondepository institutions include finance companies, insurance companies, pension funds, mutual funds, and money market funds. Even though financial institutions are becoming more similar, they often differ distinctly from each other in terms of sources and uses of funds. Therefore, their performance levels differ as well.

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17. Financial Intermediation. Look in a recent business periodical for news about a recent financial transaction that involves two financial institutions. For this transaction, determine the following: a. How will each institution’s balance sheet be affected? b. Will either institution receive immediate income from the transaction? c. Who is the ultimate user of funds? d. Who is the ultimate source of funds? ANSWER: This exercise will force students to understand how the balance sheet and income statement of a financial institution are affected by various transactions. When a financial institution simply acts as an intermediary, income (fees or commissions) is earned, but the institution’s asset portfolio is not significantly affected. 18. Role of Accounting in Financial Markets. Integrate the roles of accounting, regulations, and financial market participation. That is, explain how financial market participants rely on accounting, and why regulatory oversight of the accounting process is necessary. ANSWER: Financial market participants rely on financial information that is provided by firms. The financial statements of firms must be audited to ensure that they accurately represent the financial condition of the firm. However, the accounting standards are loose, so financial market participants can benefit from strong accounting skills that may allow them to more properly interpret financial statements. 19. Factors That Influence Liquidity. Which factors influence a security’s liquidity? ANSWER: Debt securities with shorter maturities are more liquid. Debt securities and stocks with a more active secondary market are more liquid. 20. Impact of Credit Crisis on Institutions. Explain why mortgage defaults during the credit crisis in 2008 and 2009adversely affected financial institutions that did not originate the mortgages. What role did these institutions play in financing the mortgages? ANSWER: Some financial institutions participated by issuing mortgage-backed securities that represented mortgages originated by mortgage companies. Mortgage-backed securities performed poorly during the credit crisis in 2008 because of the high default rate on mortgages. Some financial institutions that held a large amount of mortgage-backed securities suffered major losses at this time. 21. Impact of Fraudulent Financial Reporting on Market Liquidity Explain why financial markets may be less liquid if companies are not forced to provide accurate financial reports. ANSWER: If companies are allowed to engage in fraudulent financial reporting by exaggerating earnings or hiding debt, this could cause investors to overpay when purchasing securities issued by those companies. If investors recognize that they cannot trust financial disclosure by companies, they may be unwilling to participate in financial markets. The lack of trust can cause markets to be less liquid, because of very limited investor participation. 22. Impact of a Country’s Laws on Its Market Liquidity Describe how a country’s laws can influence the degree of its financial market liquidity.

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ANSWER: The financial markets are much more developed in some countries than in others, and they also vary in terms of their liquidity. Each country has its own laws regarding shareholder rights. Investors may be more willing to participate in their local country’s financial markets if they have the right to take civil action against a local firm that engaged in fraudulent financial disclosure. Each country also has its own level of enforcement of securities laws. Investors may be more willing to participate in their local country’s financial markets if they believe that their local government enforces the securities laws that are imposed in that country. 23. Global Financial Market Regulations. Assume that countries A and B are of similar size, that they have similar economies, and that the government debt levels of both countries are within reasonable limits. Assume that the regulations in country A require complete disclosure of financial reporting by issuers of debt in that country, whereas regulations in country B do not require much disclosure of financial reporting. Explain why the government of country A is able to issue debt at a lower cost than the government of country B. ANSWER: Investors are more willing to invest in debt securities issued by the government of country A because there is more transparent information that would suggest country A can cover its payments owed on its debt. If the government of Country B does not disclose its financial information, investors cannot assess the financial condition and ability of the government to cover its payments owed on its debt. Thus, they are less willing to invest in debt securities issued by country B, so country B will have to offer a higher yield to entice investors. 24. Influence of Financial Markets Some countries do not have well established markets for debt securities or equity securities. Why do you think this can limit the development of the country, business expansion, and growth in national income in these countries? ANSWER: Businesses rely on financial markets to expand. If they cannot issue debt or equity securities, they cannot obtain funding to expand. Local investors who have money to invest will likely invest their money in other countries if the financial markets are not developed in their home market. Thus, they will essentially help other countries grow instead of helping their own country grow. 25. Impact of Systemic Risk Different types of financial institutions commonly interact. Specifically, they may provide loans to each other, and take opposite positions on many different types of financial agreements, whereby one will owe the other based on a specific financial outcome. Explain why these kinds of relationships cause concerns about systemic risk. ANSWER: When financial institutions interact through transactions, the failure of one financial institution can cause financial problems for others. As one financial institution fails, it defaults on payments owed on financial agreements with other financial institutions. Those institutions may have been relying on those payments to cover other obligations to another set of financial institutions. Thus, many financial institutions might be unable to cover their obligations, and this spreads fear that the financial system might collapse. 26. Uncertainty Surrounding Stock Price Assume that your publicly traded company attempts to be completely transparent about its financial condition, and provides thorough information about its debt, sales, and earnings every quarter. Explain why there still may be much uncertainty surrounding your company’s stock price.

Chapter 1: Role of Financial Markets and Institutions  8 ANSWER: The value of a company is based on the present value its future cash flows. Investors may attempt to use financial statements to predict future cash flows. But even when investors are presented with information value your company’s stock, they may interpret the information in different ways. They commonly derive different interpretations of the same information, which leads to different valuations of the firm, reflects uncertainty surrounding the firm’s stock price. 27. Financial Institution’s Roles as Intermediaries Explain how each type of financial

institution serves as a financial intermediary. ANSWER: Deposits from surplus units are transformed by depository institutions into loans for deficit units. Purchases of securities (commercial paper) issued by finance companies that are transformed into finance company loans for deficit units. Purchases of shares issued by mutual funds are used to purchase debt and equity securities of deficit units. Because insurance companies and pension funds purchase massive amounts of stocks and bonds, they finance much of the expenditures made by large deficit units, such as corporations and government agencies. 28. Systemic Risk During a Financial Crisis Explain why financial institutions are highly exposed to systemic risk during a financial crisis. ANSWER: Systemic risk exists because financial institutions invest their funds in similar types

of securities and therefore have similar exposure to large declines in the prices of these securities. For example, in the credit crisis of 2008 and 2009, mortgage defaults affected financial institutions in several ways. First, many financial institutions that originated mortgages shortly before the crisis sold them to other financial institutions (i.e., commercial banks, savings institutions, mutual funds, insurance companies, securities firms, and pension funds). Therefore, even financial institutions that were not involved in the mortgage origination process experienced large losses because they purchased the mortgages originated by other financial institutions. Second, many other financial institutions that invested in mortgage-backed securities received lower payments as mortgage defaults occurred. Third, some financial institutions (especially securities firms) relied heavily on short-term debt to finance their operations and used their holdings of mortgage-backed securities as collateral. But when the prices of mortgage-backed securities plummeted, they could not issue new short-term debt to pay off the principal on maturing debt. Fourth, as mortgage defaults increased, there was an excess of unoccupied housing. There was no need for construction of new homes, so construction companies laid off many employees. The economy weakened and prices of many equity securities declined by more than 40 percent. Thus most financial institutions that invested heavily in equities experienced large losses on their investments during the credit crisis. Fifth, financial institutions commonly engage in various loan and guarantee arrangements that causes one financial institution to rely on others for payment. Thus, the bankruptcy of one large financial institution can cause defaults on payments to several other financial institutions, which might reduce their ability to cover their respective obligations to other financial institutions. This can result in bankruptcy for many financial institutions.

Chapter 1: Role of Financial Markets and Institutions  9 CRITICAL THINKING QUESTION Impact of a Financial Crisis on Market Liquidity During a financial crisis, liquidity in financial markets declines dramatically, and many surplus units no longer participate in financial markets. Nevertheless, if the markets are efficient, securities prices should decline due to existing economic conditions, which should make these securities appealing to potential investors. Yet, many investors typically are no longer willing to participate in the financial markets under these conditions. Write a short essay that explains the logic behind why participants may temporarily disappear during a financial crisis even though security prices are low, causing illiquidity in financial markets. ANSWER: Even if the market prices reflect existing conditions, a crisis can cause fear that prices will decline substantially. While this might allow the possibility for large profits from pronounced changes in the prices of securities, many market participants may be uncomfortable in a market in which they could lose 30% or more of their investment in a short period of time. Market illiquidity complicates market conditions, but there is usually another event that occurs first that causes market illiquidity. For example, the defaults on many mortgages in 2008 triggered fear among market participants about the possible continuation of defaults in all debt markets, the likelihood of a weaker economy, and the possible weakness in equity prices. Consequently, the fear encouraged many market participants to discontinue serving as surplus units until economic conditions improved.

Interpreting Financial News “Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street analysts and portfolio managers who participate in the financial markets. Interpret the following: a. “The price of Apple stock will not be affected by the announcement that its earnings have increased as expected.” The earnings level was anticipated by investors, so that Apple’s stock price already reflected this anticipation. b. “The lending operations at Bank of America should benefit from strong economic growth.” High economic growth encourages expansion by firms which results in a strong demand for loans provided by Bank of America. c. “The brokerage and underwriting performance at Goldman Sachs should benefit from strong economic growth.” High economic growth may result in a large volume of stock transactions in which Goldman Sachs may serve as a broker. Also, Goldman Sachs underwrites new securities that are issued when firms raise funds to support expansion; firms are more willing to issue new securities to expand during periods of high economic growth.

Managing in Financial Markets As a financial manager of a large firm, you plan to borrow $70 million over the next year.

Chapter 1: Role of Financial Markets and Institutions  10 a. What are the more likely alternatives for you to borrow $70 million? You could attempt to borrow $70 million from commercial banks, savings institutions, or finance companies in the form of commercial loans. Alternatively, you may issue debt securities. b. Assuming that you decide to issue debt securities, describe the types of financial institutions that may purchase these securities. Financial institutions such as mutual funds, pension funds, and insurance companies commonly purchase debt securities that are issued by firms. Other financial institutions such as commercial banks and savings institutions may also purchase debt securities. c. How do individuals indirectly provide the financing for your firm when they maintain deposits at depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions? Individuals provide funds to financial institutions in the form of bank deposits, investment in mutual funds, purchases of insurance policies, or investment in pensions. The financial institutions may channel the funds toward the purchase of debt securities (and even equity securities) that were issued by large corporations, such as the one where you work.

Flow of Funds Exercise Roles of Financial Markets and Institutions This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that require the application of concepts learned within the chapter, as related to the flow of funds. Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and ten other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rates on those loans are tied to market interest rates and are adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. The company has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems. Carson Company has assets valued at approximately $50 million and generates sales of nearly $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because it expects the economy to be strong in the future, Carson plans to grow by expanding its business and making more acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through obtaining loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value. a. In what way is Carson a surplus unit?

Chapter 1: Role of Financial Markets and Institutions  11 Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuer of those securities. b. In what way is Carson a deficit unit? Carson has borrowed funds from financial institutions. c. How might finance companies facilitate Carson’s expansion? Finance companies can provide loans to Carson so that Carson can expand its operations. d. How might commercial banks facilitate Carson’s expansion? Commercial banks can provide loans to Carson so that Carson can expand its operations. e. Why might Carson have limited access to additional debt financing during its growth phase? Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to lend more funds to Carson if it has too much debt. f.

How might securities firms facilitate Carson’s expansion? First, securities firms could advise Carson on its acquisitions. In addition, they could underwrite a stock offering or a bond offering by Carson.

g. How might Carson use the primary market to facilitate its expansion? It could issue new stock or bonds to obtain funds. h. How might it use the secondary market? It could sell its holdings of Treasury securities in the secondary market. i.

If financial markets were perfect, how might this factor have allowed Carson to avoid financial institutions? It would have been able to obtain loans directly from surplus units. It would have been able to assess potential targets for acquisitions without the advice of investment securities firms. It would be able to engage in a new issuance of stock or bonds without the help of a securities firm.

The loans that Carson has obtained from commercial banks stipulate that Carson must receive the banks’ approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company? The purpose is to prevent Carson from using the funds in a manner that would be very risky, as Carson may default on its loans if it takes excessive risk when using the funds to expand its business. The owners of the firm may prefer to take more risk than the lenders will allow, because the owners would benefit directly from risky ventures that generate large returns. Conversely, the lenders simply hope to receive the repayments on the loan that they provided, and do not receive a share in the profits. They would prefer that the funds be used in a conservative manner so that Carson will definitely generate sufficient cash flows to repay the loan.

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Chapter 2 Determination of Interest Rates Outline Loanable Funds Theory Household Demand for Loanable Funds Business Demand for Loanable Funds Government Demand for Loanable Funds Foreign Demand for Loanable Funds Aggregate Demand for Loanable Funds Supply of Loanable Funds Equilibrium Interest Rate

Factors That Affect Interest Rates Impact of Economic Growth on Interest Rates Impact of Inflation on Interest Rates Impact of Monetary Policy on Interest Rates Impact of the Budget Deficit on Interest Rates Impact of Foreign Flows of Funds on Interest Rates

Forecasting Interest Rates

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Key Concepts 1. Explain the Loanable Funds Theory by deriving demand and supply schedules for loanable funds. 2. Explain the Fisher Effect and tie it in with Loanable Funds Theory by explaining how inflation affects the demand and supply schedules for loanable funds. 3. Provide additional applications (especially current events) one at a time to help illustrate how events can affect the demand and supply schedules, and therefore influence interest rates. 4. Explain how forecasts of interest rates are needed to make financial decisions, which require forecasts of shifts in the demand and supply schedules for loanable funds. 5. Introduce several possible events simultaneously to illustrate how difficult it can be to forecast interest rate movements when several events are occurring at once.

POINT/COUNTER-POINT: Does a Large Fiscal Budget Deficit Result in Higher Interest Rates? POINT: No. In some years (such as 2008), the fiscal budget deficit was large and interest rates were very low. COUNTER-POINT: Yes. When the federal government borrows large amounts of funds, it can crowd out other potential borrowers, and the interest rates are bid up by the deficit units. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: A large budget deficit does not automatically cause high interest rates. However, it does result in a large demand for funds, which will place upward pressure on interest rates unless there are offsetting forces.

Questions 1. Interest Rate Movements. Explain why interest rates changed as they did over the past year. ANSWER: This exercise should force students to consider how the factors that influence interest rates have changed over the last year and assess how these changes could have affected interest rates. 2. Interest Elasticity. Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why? ANSWER: Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates.

Chapter 2: Determination of Interest Rates  3 The federal government demand for loanable funds should be less interest elastic than the consumer demand for loanable funds, because the government’s planned borrowings will likely occur regardless of the interest rate. Conversely, the quantity of loanable funds by consumers is more responsive to the interest rate level. 3. Impact of Government Spending. If the federal government planned to expand the space program, how might this change affect interest rates? ANSWER: An expanded space program would (a) force the federal government to increase its budget deficit, (b) possibly force any firms involved in facilitating the program to borrow more funds. Consequently, there is a greater demand for loanable funds. The additional spending could cause higher income and additional saving. Yet, this impact is not likely to be as great. The likely overall impact would therefore be upward pressure on interest rates. 4. Impact of a Recession. Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they react to recessionary periods. Explain this reaction. ANSWER: During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result. 5. Impact of the Economy. Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation. ANSWER: The interest rate in the future should increase if economic growth and inflation are expected to rise or decrease if economic growth and inflation are expected to decline. 6. Impact of the Money Supply. Would increasing the money supply growth place upward or downward pressure on interest rates? ANSWER: If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply). 7. Impact of Exchange Rates on Interest Rates. Assume that if the U.S. dollar strengthens, it can place downward pressure on U.S. inflation. Based on this information, how might expectations of a strong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is there any reason to think that expectations of a strong dollar could also affect the supply of loanable funds? Explain. ANSWER: As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanable funds, and therefore reduce interest rates. The expectations of a strong dollar could also increase the supply of funds because it may encourage saving (there is less concern to purchase goods before prices rise when inflationary expectations are reduced). In addition, foreign investors may invest more funds in the United States if they expect the dollar to strengthen, because that could increase their return on investment. 8. Nominal versus Real Interest Rate. What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

Chapter 2: Determination of Interest Rates  4 ANSWER: The nominal interest rate is the quoted interest rate, while the real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the recent nominal interest rate minus the recent inflation rate. Investors require a positive real return, which suggests that they will only invest funds if the nominal interest rate is expected to exceed inflation. In this way, the purchasing power of invested funds increases over time. As inflation rises, nominal interest rates should rise as well since investors would require a nominal return that exceeds the inflation rate. 9. Real Interest Rate. Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain. ANSWER: This exercise forces students to measure last year’s nominal interest rate and inflation rate. If inflation is overestimated, the real interest rate will be relatively high. Investors had required a relatively high nominal interest rate because they expected inflation to be high (according to the Fisher effect). 10. Forecasting Interest Rates. Why do forecasts of interest rates made by experts differ? ANSWER: Various factors may influence interest rates, and changes in these factors will affect interest rate movements. Experts disagree about how various factors will change. They also disagree about the specific influence these factors have on interest rates.

Advanced Questions 11. Impact of Stock Market Crises. During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how a massive selloff of stocks leads to lower interest rates. ANSWER: When investors shift funds out of stocks, they move it into money market securities, causing an increase in the supply of loanable funds, and lower interest rates. 12. Impact of Expected Inflation. How might expectations of higher prices in the U.S. affect the demand for loanable funds, the supply of loanable funds, and interest rates in the U.S.? Offer a logical explanation of why such an impact on interest rates in the U.S. might spread to other countries. ANSWER: The expectations of higher prices will cause concern about the possible increase in inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds now before prices increase and before interest rates increase. Consumers may use their savings now to buy products before the prices increase. Therefore, the demand for loanable funds should increase, the supply of loanable funds should decrease, and interest rates should increase in the U.S.

Chapter 2: Determination of Interest Rates  5 The higher interest rates in the U.S. might encourage institutional investors in some other countries to invest some of their funds in the U.S., which reduces the supply of funds that is available within each of those countries, and therefore could cause interest rates to rise in each of those countries. 13. Global Interaction of Interest Rates. Why might you expect the interest rate movements of various industrialized countries to be more highly correlated in recent years than they were in earlier years? ANSWER: Interest rates among countries are expected to be more highly correlated in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country’s interest rates. The international flow of funds caused this type of reaction. 14. Impact of War. War tends to cause significant reactions in financial markets. Why might a war in the Middle East place upward pressure on U.S. interest rates? Why might some investors expect a war like this to place downward pressure on U.S. interest rates? ANSWER: A war places upward pressure on U.S. interest rates because it may (1) increase inflationary expectations in the United States if oil prices increase abruptly, and (2) increase the expected U.S. budget deficit as government expenditures were necessary to boost military support. However, it may also cause some analysts to revise their forecasts of economic growth downward. The slower economy reflects a reduced corporate demand for funds, which by itself places downward pressure on interest rates. If inflation was not a concern, the Fed may attempt to increase money supply growth to stimulate the economy. However, the inflationary pressure can restrict the Fed from increasing the money supply to stimulate the economy (since any stimulative policy could cause higher inflation). 15. Impact of September 11. Offer an argument for why the terrorist attack on the United States on September 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argument for why those attacks could have placed upward pressure on U.S. interest rates. ANSWER: The terrorist attack could cause a reduction in spending related to travel (airlines, hotels), and would also reduce the expansion by those types of firms. This reflects a decline in the demand for loanable funds, and places downward pressure on interest rates. Conversely, the attack increases the amount of government borrowing needed to support a war, and therefore places upward pressure on interest rates. 16. Impact of Government Spending. Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, the deficit would still be very large. Because Jayhawk believed that the deficit’s impact would more than offset the effects of other factors, it forecast interest rates to increase by 2 percent. Comment on Jayhawk’s logic. ANSWER: A reduction in the deficit should free up some funds that had been used to support the government borrowings. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates.

Chapter 2: Determination of Interest Rates  6 17. Decomposing Interest Rate Movements. The interest rate on a one-year loan can be decomposed into a one-year risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is usually affected by changing economic conditions to a greater degree than the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury, and (b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation? Why? ANSWER: The weaker economy will likely reduce the risk-free component and will increase the risk premium. The overall cost of borrowing is reduced for a loan to the Treasury and a loan to a corporation. There is a partial offsetting effect on the interest rate of the loan to the corporation. However, the Treasury does not have risk of default so there is no effect on the risk premium on a loan to the Treasury. The weaker economy will have a more pronounced impact on the interest rate of the loan to the Treasury, because there is no offsetting effect. 18. Forecasting Interest Rates Based on Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on these conditions, do you think interest rates will likely increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the greatest impact on interest rates? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 19. Impact of Economic Crises on Interest Rates. When economic crises in countries are due to a weak economy, local interest rates tend to be very low. However, if the crisis is caused by an unusually high rate of inflation, the interest rate tends to be very high. Explain why. ANSWER: A weak economy causes a reduction in the demand for loanable funds, because corporations reduce their expansion plans as they anticipate a reduced demand for their products. The reduced demand for loanable funds results in lower interest rates. However, if a crisis is caused by high inflation, corporations and households engage in heavy borrowing and spending before prices rise further. Thus, the strong demand for loanable funds places upward pressure on interest rates. 20. U.S. Interest Rates During the Credit Crisis. During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should have resulted in a higher number of feasible projects, which should have encouraged businesses to borrow more money and expand. Yet, many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, therefore discouraging businesses from expanding? ANSWER: Businesses recognized that the cash flows to be generated from their projects would be low because the demand for their products and services was limited. Households could not afford to purchase more products. Thus, while low interest rates allow businesses to borrow funds cheap, many possible projects were not feasible because the expected cash flows were not sufficient.

Chapter 2: Determination of Interest Rates  7 21. Political Influence on Interest Rates. Offer an argument for why a political regime that favors a large government will cause interest rates to be higher. Offer at least one example of why a political regime that favors a large government will cause interest rates to be lower [Hint: Recognize that the government intervention in the economy can influence other factors that affect interest rates.] ANSWER: A political regime that favors a large government will have more government expenditures. Assuming that taxes are not affected, the fiscal budget deficit will be larger. As the government borrows more to cover the fiscal budget deficit, it increases the demand for loanable funds, and this causes interest rates to be higher. However, if the government’s programs improve economic conditions, this could affect other factors that influence interest rates. For example, if the economic conditions are improved as a result of the government programs, this might result in more income to households and lower income, and lower unemployment (lower unemployment compensation paid by the government). Under these conditions, a larger government will not necessarily result in a larger fiscal budget deficit. 22. Impact of Stock Market Uncertainty. Consider a period in which stock prices are very high, such that investors begin to think that stocks are overvalued and their valuations are very uncertain. If investors decide to move their money into much safer investments, how do you think this would affect general interest rate levels? In your answer, use the loanable funds framework by explaining how the supply or demand for loanable funds would be affected by the investor actions, and how this would affect general interest rate levels. In your answer, use the loanable funds framework to

explain how the supply of or demand for loanable funds would be affected by the investor actions, and how this force would affect interest rates. ANSWER: If investors sell their stocks, they receive cash and may deposit their cash in banks. This results in an increase in the supply of loanable funds, which places downward pressure on interest rates. 22. Impact of the European Economy. Use the loanable funds framework to explain how European economic conditions might affect U.S. interest rates. ANSWER: Weak European conditions could weaken U.S. economic conditions, because the economies are integrated through international trade and investment. If the European economy causes economic conditions in the U.S. to weaken, it can reduce the demand for loanable funds in the U.S. In addition, the weak European economy might cause European firms to borrow fewer funds from the U.S. market. Either of the forces explained here reflect a decline in the demand for loanable funds, which places downward pressure on interest rates.

CRITICAL THINKING QUESTION

Forecasting Interest Rates Given your knowledge of how interest rates are influenced by various factors reflecting the demand for funds and the supply of funds available in the credit markets, write a short essay to explain how and why interest rates will change over the next three months.

Chapter 2: Determination of Interest Rates  8 ANSWER There is no perfect answer, but the exercise forces students to consider how factors that affect U.S. interest rates might change, and then understand how those changes would affect interest rates in the U.S. This exercise will help them understand how forecasts by experts are created, and also that a forecast of interest rates can be wrong because of inaccurate forecasts of the factors that affect interest rates.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “The flight of funds from bank deposits to U.S. stocks will pressure interest rates.” As the supply of loanable funds declines (due to bank deposit withdrawals), there will be upward pressure on interest rates. b. “Since Japanese interest rates have recently declined to very low levels, expect a reduction in U.S. interest rates.” As Japanese interest rates decline, Japanese savers invest more loanable funds in the United States, which places downward pressure on U.S. interest rates. c. “The cost of borrowing by U.S. firms is dictated by the degree to which the federal government spends more than it taxes.” As the federal government spends more than it taxes, it borrows the difference; the greater the amount borrowed, the higher the pressure on U.S. interest rates.

Managing in Financial Markets As the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. Your company plans to borrow funds and it may use the forecast of interest rates to determine whether it should obtain a loan with a fixed interest rate or a floating interest rate. The following information can be considered when assessing the future direction of interest rates:  Economic growth has been high over the last two years, but you expect that it will be stagnant over the next year.

Chapter 2: Determination of Interest Rates  9  Inflation has been 3 percent over each of the last few years, and you expect that it will be about the same over the next year.  The federal government has announced major cuts in its spending, which should have a major impact on the budget deficit.  The Federal Reserve is not expected to affect the existing supply of loanable funds over the next year.  The overall level of savings by households is not expected to change. a. Given the preceding information, assess how the demand for and the supply of loanable funds would be affected (if at all), and predict the future direction of interest rates. The demand for loanable funds should decline in response to: (1) stagnant economic growth (because a relatively low level of borrowing will be needed), and (2) a major cut in government spending. The supply of loanable funds should remain unchanged because the savings level is not expected to change, and the Fed is not expected to affect the existing money supply. Given a large decline in the demand for loanable funds and no significant change in the supply of loanable funds, U.S. interest rates should decline. b. Your company can obtain a one-year loan at a fixed-rate of 8 percent or a floating-rate loan that is currently at 8 percent but its interest rate would be revised every month in accordance with general interest rate movements. Which type of loan is more appropriate based on the information provided? Since interest rates are expected to decline, you should prefer the floating-rate loan. As interest rates decline, the rate charged on this type of loan would decline. c. Assume that Canadian interest rates have abruptly risen just as you have completed your forecast of future U.S. interest rates. Consequently, Canadian interest rates are now 2 percentage points above U.S. interest rates. How might this specific situation place pressure on U.S. interest rates? Considering this situation along with the other information provided, would you change your forecast of the future direction of U.S. interest rates? This situation could encourage U.S. individuals and firms to withdraw their savings from U.S. financial institutions and send their funds to Canada to earn a higher interest rate (although they would have to convert their U.S. dollars into Canadian dollars and are therefore exposed to exchange rate risk). To the extent that savings are withdrawn from U.S. financial institutions, there would be a reduction in the supply of loanable funds in the U.S. Consequently, this specific situation places upward pressure on the U.S. interest rates. While this specific situation places upward pressure on U.S. interest rates, the economic growth and the budget deficit are expected to place downward pressure on interest rates. Therefore, you would still forecast a decline in U.S. interest rates, unless you believe that the impact of the Canadian situation would overwhelm the impact of the economic growth and the budget deficit

Problems 1. Nominal Rate of Interest. Suppose the real interest rate is 6 percent and the expected inflation is 2 percent. What would you expect the nominal rate of interest to be?

Chapter 2: Determination of Interest Rates  10

ANSWER: i = E(INF) + ir i = 2% + 6% = 8% 2. Real Interest Rate. Suppose that Treasury bills are currently paying 9 percent and the expected inflation is 3 percent. What is the real interest rate? ANSWER: i = E(INF) + ir ir = i – E(INF) ir = 9% – 3% = 6%

Flow of Funds Exercise How the Flow of Funds Affects Interest Rates Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus, its cost of obtaining funds is sensitive to interest rate movements. Given its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to pay for this growth, and it plans to borrow additional funds either through loans or by issuing bonds. The company is considering the issuance of stock to raise funds in the next year. a. Explain why Carson should be very interested in future interest rate movements. The future interest rate movements affect Carson’s cost of obtaining funds, and therefore may affect the value of its stock. b. Given Carson’s expectations, do you think that the company anticipates that interest rates will increase or decrease in the future? Explain. Carson expects the U.S. economy to strengthen, and therefore should expect that interest rates will increase (assuming other things held constant). c. If Carson’s expectations of future interest rates are correct, how would this affect its cost of borrowing on its existing loans and on future loans? Carson’s cost of borrowing will increase, because the interest rate on prevailing and future loans would be tied to market interest rates. d. Explain why Carson’s expectations about future interest rates may affect its decision about when to borrow funds and whether to obtain floating-rate or fixed-rate loans.

Chapter 2: Determination of Interest Rates  11 If Carson expects rising interest rates, it may prefer to lock in today’s interest rate for a period that reflects the length of time that it will need funds. In this way, the cost of funds borrowed would be insulated from the changes in market interest rates.

Chapter 3 Structure of Interest Rates Outline Why Security Debt Yields Vary Credit (Default) Risk Liquidity Tax Status Term to Maturity

Modeling the Yield to be Offered on a Debt Security A Closer Look at the Term Structure Pure Expectations Theory Liquidity Premium Theory Segmented Markets Theory Research on Term Structure Theories Integrating the Theories of the Term Structure Use of the Term Structure How the Yield Curve Has Changed over Time

International Structure of Interest Rates

Chapter 3: Structure of Interest Rates  2

Key Concepts 1. Use a current Wall Street Journal or other newspaper to show how yields vary among securities. The chapter helps to explain the disparity in yields. 2. Provide logic behind how default risk, liquidity, tax status, and maturity can affect yields. 3. Offer various theories for the term structure of interest rates, and then combine these theories to provide an integrated explanation.

POINT/COUNTER-POINT: Should a Yield Curve Influence a Borrower’s Preferred Maturity of a Loan? POINT: Yes. If there is an upward-sloping yield curve, then a borrower should pursue a short-term loan to capitalize on the lower annualized rate charged for a short-term period. The borrower can obtain a series of short-term loans rather than a single loan to match the desired maturity. COUNTER-POINT: No. The borrower will face uncertainty regarding the interest rate charged on subsequent loans that are needed. An upward-sloping yield curve would suggest that interest rates will rise in the future, which will cause the cost of borrowing to increase. Overall, the cost of borrowing may be higher when using a series of loans than when matching the debt maturity to the time period in which funds are needed. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Either side could be correct. If you believe that the yield curve provides a reasonable forecast of future interest rates, then the counter-point is a more valid argument.

Questions 1. Characteristics That Affect Security Yields. Identify the relevant characteristics of any security that can affect the security’s yield. ANSWER: The relevant characteristics are: 1. default risk 2. liquidity 3. tax status 4. maturity 2. Impact of Credit Risk on Yield. How does high credit risk affect the yield on securities? ANSWER: Investors require a higher risk premium on securities with a high default risk. 3. Impact of Liquidity on Yield. Discuss the relationship between the yield and the liquidity of securities.

Chapter 3: Structure of Interest Rates  3 ANSWER: The greater the liquidity of a security, the lower is the yield, other things being equal. 4. Tax Effects on Yields. Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? Do municipal bonds or corporate bonds offer a higher before-tax yield at a given point in time? Why? Which has the higher after-tax yield? If taxes did not exist, would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity? Why? ANSWER: High-tax bracket investors benefit more from tax-exempt securities because their tax savings from avoiding taxes is greater. Corporate bonds offer a higher before-tax yield, since they are taxable by the federal government. The municipal bonds may have a higher tax yield for investors subject to a high tax rate. For low-tax bracket investors, the corporate bonds would likely have a higher after-tax yield. If taxes did not exist, Treasury bonds would offer a lower yield than municipal bonds because they are perceived to be risk-free. Thus, the required return on Treasury bonds would be lower than on municipal bonds. 5. Pure Expectations Theory. Explain how a yield curve would shift in response to a sudden expectation of rising interest rates, according to the pure expectations theory. ANSWER: The demand for short-term securities would increase, placing upward (downward) pressure on their prices (yields). The demand for long-term securities would decrease, placing downward (upward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now have a steeper slope as a result of the expectation. If it was originally downward sloped, it would now be more horizontal (less steep), or may have even become upward sloping. 6. Forward Rate. What is the meaning of the forward rate in the context of the term structure of interest rates? Why might forward rates consistently overestimate future interest rates? How could such a bias be avoided? ANSWER: The forward rate is the expected interest rate at a future point in time. If forward rates are estimated without considering the liquidity premium, it may overestimate the future interest rates. If a liquidity premium is accounted for when estimating the forward rate, the bias can be eliminated. 7. Pure Expectations Theory. Assume an expectation of lower interest rates in the future arises quite suddenly. What would be the effect on the shape of the yield curve? Explain. ANSWER: The demand for short-term securities would decrease, placing downward (upward) pressure on their prices (yields). The demand for long-term securities would increase, placing upward (downward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now be more horizontal (less steep). If it was downward sloped, it would now be more steep. 8. Liquidity Premium Theory. Explain the liquidity premium theory. ANSWER: If investors believe that securities with larger maturities are less liquid, they will require a premium when investing in such securities to compensate. This theory can be combined with the other theories to explain the shape of a yield curve.

Chapter 3: Structure of Interest Rates  4 9. Impact of Liquidity Premium on Forward Rate. Explain how consideration of a liquidity premium affects the estimate of a forward interest rate. ANSWER: When considering a liquidity premium, the estimate of a forward interest rate will be reduced. 10. Segmented Markets Theory. If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets? ANSWER: A downward-sloped yield curve suggests that the demand for short-term funds is high relative to the supply of short-term funds, causing a high yield. In addition, the demand for long-term funds is low relative to the supply of long-term funds, causing a low yield. 11. Segmented Markets Theory. If the segmented markets theory causes an upward-sloping yield curve, what does this imply? If markets are not completely segmented, should we dismiss the segmented markets theory as even a partial explanation for the term structure of interest rates? Explain. ANSWER: An upward-sloped yield curve caused by segmented markets implies that the demand for short-term funds is low relative to the supply of short-term funds. In addition, the demand for longterm funds is high relative to the supply of long-term funds. Even if markets are not completely segmented, investors and borrowers may prefer a particular maturity market. Therefore, they may only switch to a different maturity if there is sufficient compensation (such as a higher return for investors or a lower cost of borrowing for borrowers). 12. Preferred Habitat Theory. Explain the preferred habitat theory. ANSWER: The preferred habitat theory suggests that while investors and borrowers may prefer a natural maturity, they may wander from that maturity under conditions where they can benefit from selecting a different maturity. 13. Yield Curve. What factors influence the shape of the yield curve? Describe how financial market participants use the yield curve. ANSWER: The yield curve’s shape is affected by the demand and supply conditions for securities in various maturity markets. Expectations of interest rates, the desire for liquidity, and the desire by investors or borrowers for a specific maturity will influence the demand and supply conditions. The yield curve can be used to determine the market’s expectations of future interest rates. Market participants can compare their own expectations to the market’s expectations in order to determine their borrowing or investing decisions.

Advanced Questions 14. Segmented Markets Theory. Suppose that the U.S. Treasury decided to finance its deficit with mostly long-term funds. How could this decision affect the term structure of interest rates? If shortterm and long-term markets are segmented, would the Treasury’s decision have a more or less pronounced impact on the term structure? Explain.

Chapter 3: Structure of Interest Rates  5 ANSWER: If the Treasury borrowed heavily in the long-term markets, it could place upward pressure on long-term rates without having as much of an impact on short-term rates. If the markets are segmented, the effect of the Treasury’s actions would be more pronounced. 15. Yield Curve. If liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market’s perception of future interest rates? ANSWER: A flat yield curve without consideration of a liquidity premium would represent no expected change in interest rates according to the pure expectations theory. Therefore, if the flat yield curve reflects the existence of a liquidity premium, this curve would actually have a slight downward slope when removing the liquidity premium. This suggests expectations of a slight decline in future interest rates. 16. Global Interaction among Yield Curves. Assume that the yield curves in the United States, France, and Japan are flat. If the U.S. yield curve suddenly becomes so positively sloped, do you think the yield curves in France and Japan would be affected? If so, how? ANSWER: The yield curves in other countries would also be affected if the event precipitating the shift in the U.S. yield curve affects either actual or expected interest rates in other countries. If longterm interest rates in the United States rise in response to a greater U.S. demand for long-term funds, then the yield curve may have an upward slope. To the extent that this event attracts long-term funds in other countries, there would be a smaller supply of long-term funds in those countries, which could cause higher long-term rates there. Consequently, their yield curves would have an upward slope. 17. Multiple Effects on the Yield Curve. Assume that (1) investors and borrowers expect that the economy will weaken and that inflation will decline, (2) investors require a small liquidity premium, and (3) markets are partially segmented and the Treasury currently has a preference for borrowing in short-term markets. Explain how each of these forces would affect the term structure, holding other factors constant. Then explain the effect on the term structure overall. ANSWER: The weak economy creates the expectation of a decline in interest rates, so according to expectations theory, there would be a downward-sloping yield curve. The liquidity premium results in a slight upward slope to the yield curve. The Treasury’s preference would result in a downward-sloping demand yield curve, when other factors are held constant. Overall, there would be a downward-sloping yield curve because the expectations and segmented markets effects would overwhelm the liquidity effect. 18. Effect of Crises on the Yield Curve. During some crises, investors shift their funds out of the stock market and into money market securities for safety, even if they do not fear that interest rates will rise. Explain how and why these actions by investors affect the yield curve. Is the shift due to the expectations theory, liquidity premium theory, or segmented markets theory? ANSWER: The movement into money market securities results in a larger supply of short-term funds and lowers short-term interest rates. Thus, the yield curve becomes more steeply sloped. The shift in the yield curve is due to a preference for investors to move their funds into safe short-term securities, which reflects segmented markets theory, a preference for liquidity.

Chapter 3: Structure of Interest Rates  6 19. How the Yield Curve May Respond to Prevailing Conditions. Consider how economic conditions affect the credit risk premium. Do you think the credit risk premium will likely increase or decrease during this semester? How do you think the yield curve will change during this semester? Offer some logic to support your answers. ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 20. Assessing Interest Rate Differentials among Countries. In some countries where there is high inflation, the annual interest rate is more than 50 percent, while in other countries such as the U.S. and many European countries, the annual interest rates are typically less than 10 percent. Do you think such a large interest rate differential is primarily attributed to country-specific differences in the risk-free rates or in the credit risk premiums? Explain. ANSWER: The risk-free foreign interest rates are determined by supply and demand for funds in their local currency. Inflationary expectations affect the risk-free interest rate. Thus, the difference in interest rates between the countries with very high interest rates versus low interest rates is primarily attributed to risk-free rate differentials. The credit risk premium is typically higher in the countries with very high interest rates, but that is not the primary reason for the large difference between countries with very interest rates versus low interest rates. 21. Applying the Yield Curve to Risky Debt Securities. Assume that the yield curve for Treasury bonds has a slight upward slope, starting at 6% for a 10-year maturity and slowly rising to 8% for a 30-year maturity. Create a yield curve that you believe would exist for A-rated bonds, and a corresponding yield curve for B-rated bonds. ANSWER: The yield curve for A-rated bonds would likely have a similar slope as the yield curve for Treasury securities but would be higher because of a credit risk premium. The yield curve for B-rated bonds would likely have a similar slope as the yield curve for A-rated bonds but would be higher because of a credit risk premium. 22. Changes to Credit Rating Process. Explain how credit rating agencies have changed their rating processes following criticism of their ratings during the credit crisis. ANSWER: In response to the criticism, credit rating agencies made some changes to improve their rating process and their transparency. They now disclose more information about how they derived their credit ratings. In addition, the employees of each credit rating agency that promotes the services of the agency are not allowed to influence the ratings assigned by the rating agency. They are giving more attention to sensitivity analysis in which they assess how creditworthiness might change in response to abrupt changes in the economy. CRITICAL THINKING QUESTION How a Credit Crisis Can Paralyze Credit Markets. The key components of a market interest rate

are the risk-free rate and the credit risk premium. During a credit crisis, these two components may change substantially, but in different ways. Write a short essay that describes how the riskfree rate and the risk premium may change during a credit crisis. Explain why the financial

Chapter 3: Structure of Interest Rates  7

markets can become paralyzed during a crisis. Is it because of changes in the risk-free rate or changes in the risk premium? ANSWER During a credit crisis, the Fed can ensure availability of funds in the financial system, by using monetary policy to expand money supply. This results in a large increase in the supply of funds available, and when combined with the decline in demand for funds, results in a decline in the risk-free interest rate. This type of effect is desirable because it may encourage corporations and consumers to borrow more money and spend money, which can stimulate the weak economy. However, the credit risk premium should increase during a credit crisis, because the defaults on debt are likely increasing, and surplus units that provide funding should require a larger premium to compensate for their higher exposure to credit risk. The high credit risk premium reflects a high level of uncertainty about the future economy and the ability of borrowers to repay their debt. While a low risk-free rate is very desirable for borrowers, those borrowers who are perceived to be risky cannot access funds at that rate and may not even be able to access funds at all.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “An upward-sloping yield curve persists because many investors stand ready to jump into the stock market.” Investors are holding short-term Treasury securities, and are unwilling to hold long-term Treasury securities, because they may liquidate these securities soon, and prefer liquid securities that are less susceptible to interest rate risk. b. “Low-rated bond yields rose as recession fears caused a flight to quality.” As investors selected safer bonds, they sold low-rated bonds, which placed downward pressure on prices of low-rated bonds and upward pressure on yields of low-rated bonds. Thus, the risk premium of low-rated bonds increased. c. “The shift from an upward-sloping yield curve to a downward-sloping yield curve is sending a warning about a possible recession.” If the shift is due to changes in interest rate expectations, it suggests that interest rates may now be expected to decline. Such expectations can occur when the market expects that economic growth is slowing or is negative.

Managing in Financial Markets

Chapter 3: Structure of Interest Rates  8 As an analyst at a bond rating agency, you have been asked to interpret the implications of the recent shift in the yield curve. Six months ago, the yield curve exhibited a slight downward slope. Over the last six months, the long-term yields declined, while short-term yields remained the same. Analysts stated that the shift was due to revised expectations of interest rates. a. Given the shift in the yield curve, does it appear that firms increased or decreased their demand for long-term funds over the last six months? The lower long-term yields may be attributed to a reduced demand for long-term funds. That is, firms may have reduced their issuance of long-term securities. b. Interpret what the shift in the yield curve suggests about the market’s changing expectations of future interest rates. The yield curve six months ago implied the expectation of a slight decline in interest rates. The yield curve today implied the expectation of a larger decline in interest rates. c. Recently, an analyst argued that the underlying reason for the yield curve shift was that many of the large U.S. firms anticipate a recession. Explain why an anticipated recession could force the yield curve to shift as it has. When the economic conditions are expected to deteriorate, the demand for loanable funds by firms tends to decrease (because firms reduce their borrowing when they cut back on their expansion plans). Therefore, the long-term yields decline, and the yield curve developed a steeper downward slope. So, this shift in the yield curve can indicate to the market that firms are reducing their amount of borrowing, in response to their assessment of future economic conditions. d. What could the specific shift in the yield curve signal about the ratings of existing corporate bonds? Which types of corporations would be most likely to experience a change in their bond ratings as a result of the specific shift in the yield curve? To the extent that the downward shift in the yield curve signals an anticipated recession (or at least a reduction in economic growth), it could also signal that the creditworthiness of some corporations will decline. Therefore, the bond ratings of some corporations would be downgraded. Corporations that are more sensitive to economic downturns would be more susceptible to a bond rating downgrade in response to a yield curve shift that signals an anticipated recession.

Problems 1. Forward Rate. a. Assume that as of today, the annualized two-year interest rate is 13 percent, while the one-year interest rate is 12 percent. Use this information to estimate the one-year forward rate.

Chapter 3: Structure of Interest Rates  9 ANSWER:

b. Assume that the liquidity premium on a two-year security is 0.3 percent. Use this information to estimate the one-year forward rate. ANSWER:

2. Forward Rate. Assume that as of today, the annualized interest rate on a three-year security is 10 percent, while the annualized interest rate on a two-year security is 7 percent. Use this information to estimate the one-year forward rate two years from now. ANSWER:

3. Forward Rate. If t i1 t i2 , what is the market consensus forecast about the one-year forward rate one year from now? Is this rate above or below today’s one-year interest rate? Explain. ANSWER: The one-year forward rate one year from now is:

If t i1 t i2 , then the one-year forward rate one year from now must be below today’s one-year interest rate. 4. After-tax Yield. You need to choose between investing in a one-year municipal bond with a 7 percent yield and a one-year corporate bond with an 11 percent yield. If your marginal federal income tax rate is 30 percent and no other differences exist between these two securities, which would you

Chapter 3: Structure of Interest Rates  10 invest in? ANSWER: Yat = Ybt(1 – T) Yat = 11%(1 – 0.30) = 7.7% [You should prefer the corporate bond.] 5. Deriving Current Interest Rates. Assume that interest rates for one-year securities are expected to be 2 percent today, 4 percent one year from now and 6 percent two years from now. Using only the pure expectations theory, what are the current interest rates on two-year and three-year securities? ANSWER: (1 + ti2 )2 = (1 + ti1)(1 + t+1r1) (1 + ti2 )2 = (1 + 0.02)(1 + 0.04) (1 + ti2 )2 = 1.0608 1+ ti2 = 1.02995 ti2 = 0.0299 (1 + ti3)3 = (1 + ti1)(1 + t+1r1)(1 + t+2r1) (1 + ti3)3 = (1 + 0.02)(1 + 0.04)(1 + 0.06) (1 + ti3)3 = 1.124448 1 + ti3 = 1.0398 ti3 = 0.0398 6. Commercial Paper Yield. a. A corporation is planning to sell its 90-day commercial paper to investors offering an 8.4 percent yield. If the three-month Treasury bill’s annualized rate is 7 percent, the credit risk premium is estimated to be 0.6 percent and there is a 0.4 percent tax adjustment, what is the liquidity premium on the commercial paper? ANSWER: Ycp, n = Rf,n + DP + LP + TA LP = Ycp,n – Rf,n – DP – TA LP = 8.4% – 7% – 0.6% – 0.4% LP = 0.4% b. If due to unexpected changes in the economy the credit risk premium increases to 0.8 percent, what is the appropriate yield to be offered on the commercial paper (assuming no other changes occur)? ANSWER: Ycp,n = Rf,n + DP + LP + TA Ycp,n = 7% + 0.8% + 0.4% + 0.4% = 8.6%

Chapter 3: Structure of Interest Rates  11 7. Forward Rate. a. Determine the forward rate for various one-year interest rate scenarios if the two-year interest rate is 8 percent, assuming no liquidity premium. Explain the relationship between the one-year interest rate and the one-year forward rate, holding the two-year interest rate constant. ANSWER: As the one-year interest rate rises, the forward rate declines. The one-year forward rate is zero once the one-year interest rate is equal to the two-year interest rate, and it becomes negative if the one-year interest rate exceeds the two-year interest rate. The forward rate is reduced when using higher levels of a one-year interest rate, holding a two-year interest rate constant. The smaller the differential between the two-year and one-year interest rates, the lower is the interest rate in the second year that is needed so that the combination of the two one-year rates are equal to the two-year rate. b. Determine the one-year forward rate for the same one-year interest rate scenarios in question (a), assuming a liquidity premium of 0.4 percent. Does the relationship between the one-year interest rate and the forward rate change when the liquidity premium is considered?? ANSWER: The general relationship between the one-year interest rate and the one-year forward rate still holds. c. Determine how the one-year forward rate would be affected if the quoted two-year interest rate rises, while both the quoted one-year interest rate and the liquidity premium are held constant. Explain the logic of this relationship. ANSWER: The forward rate increases for higher levels of a two-year interest rate. The greater the differential between the two-year and one-year interest rates, the greater is the interest rate in the second year that is needed so that the combination of the two one-year rates are equal to the two-year rate. d. Determine how the one-year forward rate would be affected if the liquidity premium rises, holding the quoted one-year interest rates constant. Also, hold the two-year interest rate constant. Explain the logic of this relationship. ANSWER: The forward rate is reduced for higher levels of the liquidity premium, holding the oneyear and two-year interest rates constant. The higher the liquidity premium, the greater the proportion of the interest rate differential (two-year rate minus one-year rate) that is due to interest rate expectations, and the lower is the one-year forward rate. 8. After-tax Yield. Determine how the after-tax yield from investing in a corporate bond is affected by higher tax rates, holding the before-tax yield constant. Explain the logic of this relationship. ANSWER: The after-tax yield is reduced for higher levels of the tax rate, holding the before-tax yield constant. The higher the tax rate, the greater the proportion of the before-tax yield that is allocated for taxes, and the smaller the proportion of the before-tax yield retained by the investor. 9. Debt Security Yield. a. Determine how the appropriate yield to be offered on a security is affected by a higher risk-free rate. Explain the logic of this relationship. ANSWER: The appropriate yield to be offered on a security would need to be increased if the riskfree rate rises. A higher yield would be necessary to place the security, as investors still want a particular premium above the risk-free rate.

Chapter 3: Structure of Interest Rates  12 b. Determine how the appropriate yield to be offered on a security is affected by a higher default risk premium. Explain the logic of this relationship. ANSWER: The appropriate yield to be offered on a security would need to be increased if the default premium on the security increased, because the investors would require a higher return to compensate for the higher default risk.

Flow of Funds Exercise Influence of the Structure of Interest Rates Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on these loans are tied to the six-month Treasury bill rate (and includes a risk premium) and are adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. Because of its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to finance its growth and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year. a.

Assume that the market’s expectations for the economy are similar to those of Carson. Also assume that the yield curve is primarily influenced by interest rate expectations. Would the yield curve be upward sloping or downward sloping? Why? The yield curve would be upward sloping to reflect the expectations or rising interest rates along with a liquidity premium for debt securities with longer maturities.

If Carson could obtain more debt financing for its10-year projects, would it prefer to obtain credit at a long-term fixed interest rate, or at a floating rate. Why? The prevailing interest rate would be lower on loans than on the bonds, but the interest rate on loans would increase over time if market interest rates rise. Therefore, Carson may be willing to lock in the cost of debt by issuing bonds rather than be subjected to the uncertainty if it obtains floating-rate loans.

If Carson attempts to obtain funds by issuing 10-year bonds, explain what information would help the company to estimate the yield it would have to pay on 10-year bonds. That is, which key factors would influence the rate it has pay on the 10-year bonds? The key factors are the risk-free rate on 10-year bonds, the risk premium, and any special provisions on the bond. The yield to be offered is equal to a risk-free rate on ten-year bonds plus a risk premium to reflect the possibility of Carson’s default, plus an adjustment for any special features of the bond.

If Carson attempts to obtain funds by issuing loans with floating interest rates every six months, explain what information would help the company estimate the yield it would have to pay over the next ten years. That is, what are the key factors that would influence the rate it would pay over the 10year period? The key factors are the risk-free rate on six-month T-bills, and the risk premium. The cost of debt

Chapter 3: Structure of Interest Rates  13 in this case changes over time and is dependent on how T-bill rates move over time. e.

An upward-sloping yield curve suggests that the initial rate that financial institutions could charge on a long-term loan to Carson would be higher than the initial rate that they could charge on a loan that floats in accordance with short-term interest rates. Does this imply that creditors should prefer to provide a fixed-rate loan rather than a floating-rate loan to Carson? Explain why Carson’s expectations of future interest rates are not necessarily the same as those of some financial institutions. Creditors may prefer to provide fixed-rate loans if they expect interest rates to decline (so that they could lock in today’s rate on their loan) and floating-rate loans if they expect interest rates to increase. Creditors may have different opinions than Carson Company about the macroeconomic conditions in the future, and how those conditions will affect interest rates. Therefore, they may have different expectations about future interest rates.

Solution to Integrative Problem for Part 1 Interest Rate Forecasts and Investment Decisions 1. The appropriate recommendation requires a rational forecast of U.S. interest rates based on the information provided. A rational forecast can be created by recognizing what factors will or will not influence future interest rates and weighing the potential influence of any relevant factors. Each of the nine pieces of information provided to the student is addressed below: 1. Movements in interest rates over the year surely affected bond prices, but this information does not help forecast future interest rates. 2. Changes in economic conditions over the last year affected interest rates (and therefore bond prices), but this information does not help forecast future interest rates. 3. A slight decline in the U.S. savings rate should place slight upward pressure on U.S. interest rates, other things being equal. 4. No impact anticipated. 5. A stronger U.S. economy should place upward pressure on U.S. interest rates, regardless of the economy two years ago. What is important is the change in the future U.S. economy relative to present conditions, because U.S. bond prices today reflect present U.S. interest rates. Any change in the U.S. demand for loanable funds will change the U.S. interest rates, forcing investors to revalue U.S. bonds. 6. An increase in the annual U.S. budget deficit (relative to the present period) causes an increase in U.S. demand for loanable funds, and therefore places upward pressure on U.S. interest rates. 7. An increase in the U.S. inflation rate causes an increase in the demand for loanable funds, and therefore places upward pressure on U.S. interest rates. 8. The expectation of a weaker dollar by investors around the world could cause foreign investors to reduce their investing in the United States, causing a net decline in the supply of funds in the

Chapter 3: Structure of Interest Rates  14 United States provided by foreign investors. Consequently, there is upward pressure on U.S. interest rates. 9. The market’s expectations about future interest rates in the United States are implied by the U.S. yield curve. Based on the downward slope, and an assumed small liquidity premium, the U.S. interest rates are expected by the market to decline. However, recall that you are basing your decision on your own assessment of future interest rates, not the market’s assessment. Therefore, you should not use the yield curve as input to your decision. Overall, Numbers 1, 2, 4, and 9 should have no influence on your forecast of U.S. interest rates. Number 3 suggests a slight decline in U.S. interest rates, while Numbers 5, 6, 7, and 8 suggest an increase in U.S. interest rates. The net effect is an expected increase in U.S. interest rates. 2. Following the same procedure as stated in Question 1, you can develop a rational forecast of Canadian interest rates. The assessment of Canadian bonds must be separated from the assessment of U.S. bonds since Canadian Treasury bond values will not always move in tandem with U.S. Treasury bond values. Most of the information is either irrelevant for forecasting future interest rates in Canada or suggests no change. The only factors that influence Canadian interest rates and are expected to change are Canadian inflation and the value of the Canadian dollar. The expected decline in Canadian inflation should place downward pressure on Canadian interest rates. The appreciation of the Canadian dollar anticipated by investors around the world could cause the supply of funds in Canada to increase (as Canadian investors retain more funds in Canada, and U.S. investors may shift some of their investment to Canada to capitalize on the exchange rate effect). Consequently, there is downward pressure on Canadian interest rates. 3. The yield on newly issued U.S. corporate bonds should rise to a greater degree than newly issued U.S. Treasury bonds, because the change in the yield of newly issued corporate bonds should reflect not only the increase in the risk-free rate, but also the increase in the risk premium.

Chapter 4 Functions of the Fed Outline Overview

Organizational Structure of the Fed Federal Reserve District Banks Member Banks Board of Governors Federal Open Market Committee (FOMC) Advisory Committees Integration of Federal Reserve Components Consumer Financial Protection Bureau

Fed Control of the Money Supply Decision Process Role of the Fed’s Trading Desk Control of M1 Versus M2 How Fed Operations Affect All Interest Rates Alternative Monetary Policy Tools The Fed’s Intervention During the Credit Crisis Fed Loans to Facilitate Rescue of Bear Stearns Fed’s Strategy of Quantitative Easing Perceptions of the Fed’s Intervention During the Crisis

Global Monetary Policy A Single Eurozone Monetary Policy Global Central Bank Coordination

2  Chapter 4: Functions of the Fed

Key Concepts 1. Describe the role and the organization of the Fed. 2. Explain how monetary policy tools are used by the Fed to control economic conditions. 3. Explain why the Fed’s monetary policy can not ignore international conditions.

POINT/COUNTER-POINT: Should There Be One Global Central Bank? POINT: Yes. One global central bank could serve all countries in the manner that the European Central Bank now serves several European countries. If there was a single central bank, there could be a single monetary policy across all countries. COUNTER-POINT: No. A global central bank could create a global monetary policy only if there was a single currency used throughout the world. Moreover, all countries would not agree on the monetary policy that is appropriate.

WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: While there may be some benefits if the monetary policy was consistent among countries, it would be impossible to get agreement among all countries about the policy to be used. Countries would not want to give up their power to control their own money supply.

Questions 1. The Fed. Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks. ANSWER: Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and early 1900s, several bank panics occurred, which encouraged another attempt. In 1913, the Federal Reserve Act was passed and specified 12 districts across the United States, as well as a city in each district where a Federal Reserve district bank was to be established. The Fed district banks facilitate operations within the banking system by clearing checks, replacing old currency, and providing loans to depository institutions in need of funds. 2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to achieve these goals? ANSWER: The main goals of the FOMC are to promote high employment, economic growth, and price stability. 3. Open Market Operations. Explain how the Fed increases the money supply through open market operations.

Chapter 4: Functions of the Fed  3 ANSWER: The Fed can increase money supply by purchasing securities in the secondary market. 4. Policy Directive. What is the policy directive, and who carries it out? ANSWER: A policy directive is established by the Fed and submitted to the Trading Desk. The manager of the Trading Desk must ensure that the directive is achieved. 5. The Beige Book. What is the Beige book and why is it important to the FOMC? ANSWER: The Beige book is a consolidated report of regional economic conditions in each of the 12 districts. This book is sent to FOMC members before their meeting so that they are updated on regional conditions before they decide on monetary policy. 6. Fed’s Lending Facility. Describe the purpose of the Fed’s lending facility. ANSWER: The Fed maintains a lending facility in which it provides short-term loans (usually overnight) to depository institutions. 7. Control of Money Supply. Describe the characteristics that a measure of money should have if it is to be manipulated by the Fed. ANSWER: A desirable measure of money is one that can be precisely controlled by the Fed and has a predictable impact on economic variables. 8. FOMC Economic Presentations. What is the purpose of the economic presentations made during a POMC meeting? ANSWER: Economic presentations offer the FOMC information about the prevailing economic conditions, so that the FOMC can decide whether it should attempt to revise money supply growth in order to improve the economy. 9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money supply. ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions. 10. Open Market Operations. Why do the Fed’s open market operations have a different effect on money supply than do transactions between two depository institutions? ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution, money is transferred to the depository institution without any offset at another institution. However, a similar transaction between depository institutions would increase the account balance at one institution and decrease the account balance at the other institution. 11. Fed’s Indirect Influence on Many Types of Interest Rates The Fed focuses its control on

the federal funds rate, yet indirectly influences many other types of interest rates. Explain. ANSWER:

Since banks now have more funds available, they may want to use their excess funds by offering new loans to businesses and households. They may lower their loan rates in order to appeal to potential borrowers. They may also lower the interest rates offered on deposits.

4  Chapter 4: Functions of the Fed

When the Fed buys Treasury bills as a means of increasing the money supply, it places upward pressure on their market prices. Because these securities offer a fixed value to investors at maturity, a higher price translates into a lower yield for investors who buy them and hold them until maturity. As the yields on Treasury bills and bank deposits decline, investors will move some of their funds into other short-term debt securities (such as commercial paper), but then the yields of those securities will also decline. 12. The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions that are near bankruptcy? ANSWER: The Fed might argue that the credit crisis is a threat to the financial system and that it needed to intervene to prevent a bigger crisis. Some critics might argue that the Fed has too much power and that Congress should be involved in decisions regarding the use of taxpayer funds to rescue financial institutions. 13. Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the Fed during the credit crisis? ANSWER: Some supporters of a government rescue would argue that the credit crisis would be worse if the large financial institutions were not rescued. However, others might argue that the government rescue encourages financial institutions to take risk, with the hope of being bailed out if the strategies backfire. 14. The Fed's Impact on Unemployment. Explain how the Fed's monetary policy affects the unemployment level. ANSWER: The Fed's monetary policy affects interest rates, which affect the cost of borrowing by households and businesses, and therefore affect their level of spending for products and services. The aggregate demand for products and services affects the number of people employed by businesses and therefore affects the unemployment level. 15. The Fed's Impact on Home Purchases. Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers? ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on mortgages. When the Fed reduces interest rates, it reduces the monthly payment to be made on new mortgages. Thus, it may increase the demand for homes by consumers. If it increases interest rates, it may reduce the demand for homes. 16. The Fed's Impact on Security Prices. Explain how the Fed's monetary policy may indirectly affect the prices of equity securities. ANSWER: The Fed's monetary policy influences the aggregate demand for products and services, and therefore affects the cash flows generated by publicly-traded businesses. The value of the stock of a business is influenced by expectations of its future cash flows. 17. Impact of FOMC Statement. How might the FOMC statement (issued following the committee's meeting) stabilize financial markets more than if no statement were provided?

Chapter 4: Functions of the Fed  5

ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the FOMC meeting, and there would be more uncertainty regarding the Fed's future monetary policy. The statement makes the Fed's plans more transparent. 18. Fed Facility Programs During the Credit Crisis. Explain how the Fed's facility programs improved liquidity in some debt markets. ANSWER: The Fed established facilities that provided loans to financial institutions that were willing to invest in some types of debt securities, such as bonds that were backed by consumer loans. In this way, the Fed increased the liquidity of these markets, which allowed easier access for consumers who wanted to borrow funds. The Fed also used some of its own funds to purchase commercial paper, which restored the liquidity of the commercial paper market. 19. Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established, and housed within the Federal Reserve. Explain the role of this bureau. ANSWER: The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. The existence of a bureau can act more quickly to protect consumers from deceptive practices than waiting for Congress to pass new laws. 20. Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its independent monetary policy and control over its domestic interest rates. ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the European Central Bank (ECB), which controls the supply of euros in the banking system. The ECB influences the interest rate on euros regardless of the country. If the interest rate on euros was higher in one eurozone country, funds would flow to that country until the supply and demand conditions caused the interest rate there to be the same as in other euro countries.

21. The Fed’s Power. What should be the Fed’s role? Should it focus only on monetary policy? Or should it engage in the trading of various types of securities in an attempt to stabilize the financial system when securities markets are suffering from investor fears and the potential for high credit (default) risk? ANSWER: This is open ended, as there is no perfect answer. Students should recognize that the Fed’s role during the financial crisis went far beyond monetary policy. Yet, it can be argued that if the Fed did not take such an initiative, the adverse impact of the crisis on financial markets could have been much worse. The Fed’s intervention appeared to stabilize financial markets. 22. Fed Purchases of Mortgage-Backed Securities Explain the motivation behind the Fed’s policy of purchasing massive amounts of mortgage-backed securities during the 2008 credit crisis. What could this policy accomplish that its traditional monetary policy might not accomplish? ANSWER Many financial institutions were heavily exposed to mortgages during the credit crisis, but were able to reduce their exposure as a result of selling some of their holding of mortgage-backed securities to the Fed. As the Fed increased its purchases of mortgage-backed securities, the prices

6  Chapter 4: Functions of the Fed of these securities increased. In addition, other investors slowly began to return to the risky debt securities markets, which resulted in higher liquidity in the market for these securities. The Fed’s actions stabilized the housing market.

23. The Fed’s Purchases of Commercial Paper Why and how did the Fed intervene in the commercial paper market during the credit crisis?

ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial paper it had issued, investors feared that other financial institutions with large holdings of mortgage-backed securities might default on their commercial paper. Therefore, investors stopped buying commercial paper in the secondary market, causing it to become illiquid and making credit increasingly hard to obtain. The Fed purchased large amounts of commercial paper to boost investor confidence and restore liquidity to the market. 24. The Fed’s Trading of Long-term Treasury Securities Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed’s usual operations?

ANSWER: The Fed’s purchases of long-term Treasury securities differed from its normal open market operations, which focus on short-term Treasury securities. By purchasing longterm securities, the Fed hoped to reduce long-term Treasury bond yields, which would ultimately result in lower long-term borrowing rates. These lower borrowing rates would in turn stimulate the economy by encouraging more long-term borrowing by firms for capital expenditures and by individuals to purchase homes. 25. The Fed and TALF What was TALF, and why did the Fed create it? ANSWER: TALF was the term asset–backed facility that the Fed created in 2008 to provide financing to financial institutions purchasing high-quality bonds backed by consumer, credit card, or automobile loans. The secondary market for these loans had become inactive during the credit crisis, thereby discouraging lenders from making these loans because they could not readily sell the loans in the market. By providing financing to institutions that purchased these loans, TALF increased the market’s liquidity and thus indirectly encouraged lenders to make more consumer loans. 26. The Fed’s Quantitative Easing Strategies. Explain how the Fed’s “quantitative easing” strategies differed from the traditional strategy of buying short-term Treasury securities. ANSWER: The quantitative easing strategies were unique because they were not solely focused on purchases of short-term Treasury securities. They included purchases of debt securities that exhibited default risk, such as mortgage-backed securities, corporate bonds, and commercial paper. They also included purchases of long-term Treasury securities. They were intended to increase liquidity in specific markets for risky debt securities, and to reduce long-term interest rates.

Chapter 4: Functions of the Fed  7 CRITICAL THINKING QUESTION Fed’s Intervention During the Crisis. The Fed intervened heavily in the credit crisis. Write a short essay explaining whether you believe the Fed’s intervention improved conditions in financial markets or made conditions worse. ANSWER The Fed infused the financial system with a massive amount of funds, which is what caused market interest rates to be very low. In general, this action is generally viewed to have a favorable economic impact. However, some critics suggest that the Fed’s programs to intervene were too generous toward financial institutions, and that they may signal that financial institutions could be bailed out again in the future if another credit crisis occurs. There is no perfect answer to this question, but students should understand the tradeoffs involved when regulators intervene during a crisis.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “The Fed’s future monetary policy will be dependent on the economic indicators to be reported this week.” The Fed makes policy decisions based on expectations about economic conditions, and its expectations are influenced by the economic indicators. b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.” The Fed attempts to prevent the economy from becoming too strong by slowing the economy down during periods of excessive growth; in this way, it reduces the upward pressure on prices (inflation). c. “Inflation will likely increase because real short-term interest rates currently are negative.” Negative real short-term interest rates imply that the inflation rate exceeds the existing nominal interest rate. Under these conditions, savers may not perceive saving to be worthwhile because interest rates are too low, and borrowers may borrow even more because of relatively low interest rates. Therefore, inflation could increase in response to the high degree of spending.

Managing in Financial Markets As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic conditions so that you can forecast the demand for products sold by your firm. You realize that the Federal Reserve

8  Chapter 4: Functions of the Fed implements monetary policy, whereas the federal government implements spending and tax policies, (fiscal policy) to affect economic growth and inflation. However, it is difficult to achieve high economic growth without igniting inflation. Although the Fed is often said to be independent of the administration in office, there is much interaction between monetary and fiscal policies. Assume that the economy is currently stagnant and that some economists are concerned about the possibility of a recession. Yet some industries are experiencing high growth, and inflation is higher this year than in the previous five years. Assume that the Fed’s chair’s term will expire in four months and that the President will have to appoint a new chairman (or reappoint the existing chair). It is widely known that the existing chair would like to be reappointed. Also assume that next year is an election year for the administration. a. Given the circumstances, do you expect that the administration will be more concerned about increasing economic growth or reducing inflation? While answers may vary among students, the administration is normally most concerned with resolving the unemployment problem by increasing economic growth. This would be especially true just before an election year. b. Given the circumstances, do you expect that the Fed will be more concerned about increasing economic growth or reducing inflation? The Fed tends to focus on maintaining a low level of inflation, because of the possibility that sustained high inflation can cause high interest rates, which may result in a sluggish economy in the long run. It is not unusual for the Fed to focus on fighting inflation while the administration is more concerned about economic growth. However, given that the chair of the Fed wants to be reappointed, he may be more willing to endorse a monetary policy that is desired by the administration (assuming that he is politically motivated). c. Your firm is relying on you for some insight into how the government will influence economic conditions and therefore the demand for your firm’s products. Given the circumstances, what is your forecast of how the government will affect economic conditions? There is no definite answer, but some possible expectations are as follows. First, both policies may focus on economic growth for political or other reasons. In this case, there is a high probability that the policies will be somewhat successful. Alternatively, the Fed may focus more on solving inflation while the administration focuses on economic growth. In this case, it is difficult to know whether either policy will be successful. Thus, there may not be much of an effect on the economic conditions. The key to this question is to create class discussion, and make sure students realize how difficult it is to forecast the impact of the government. Students should also recognize how politics can play a role in the effect on the economy.

Flow of Funds Exercise Monitoring the Fed Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making acquisitions. The company expects that it will need substantial long-term financing and plans to borrow

Chapter 4: Functions of the Fed  9 additional funds either through loans or by issuing bonds. The Carson Company is also considering the issuance of stock to raise funds in the next year. Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets. Carson recently received an alert from the service indicating that the Fed has been selling large holdings of its Treasury securities in the secondary Treasury securities market. a.

How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on the price of Treasury securities? Explain. The actions will place downward pressure on Treasury securities prices, because of an increase in supply of securities for sale in the secondary market.

Will these actions place upward or downward pressure on Treasury yields? Explain. The actions will place upward pressure on Treasury yields, because a lower price is paid for the securities.

Will these actions place upward or downward pressure on interest rates? Explain. The actions will place upward pressure on interest rates because there would be a reduction in bank balances as investors use funds to buy the Treasury securities. The payments to the Fed are maintained outside of the banking system.

Chapter 5 Monetary Policy Outline Input Used to Determine Monetary Policy Monitoring Indicators of Economic Growth Monitoring Indicators of Inflation Implementing a Stimulative Monetary Policy How a Stimulative Monetary Policy Reduces Interest Rates How Lower Interest Rates Increase Business Investment How Lower Interest Rates Lower the Business Cost of Equity Summary of Stimulative Monetary Policy Effects Why a Stimulative Monetary Policy Might Fail

Implementing a Restrictive Monetary Policy Comparing a Restrictive Versus Stimulative Monetary Policy Tradeoff in Monetary Policy Impact of Other Forces that Affect the Tradeoff How Monetary Policy Responds to Fiscal Policy Proposals to Focus on Inflation

Monitoring the Impact of Monetary Policy Impact on Financial Markets

Global Monetary Policy Impact of the Dollar Impact of Global Economic Conditions Transmission of Interest Rates

Chapter 5: Monetary Policy  2

Key Concepts 1. Describe the common monetary policy used to correct a weak economy or high inflation. 2. Explain the tradeoff involved in the Fed’s use of a stimulative or restrictive monetary policy. 3. Explain how financial market participants would react to a particular monetary policy. 4. Explain how fiscal policy may influence the monetary policy.

POINT/COUNTER-POINT: Can the Fed Prevent U.S. Recessions? POINT: Yes. The Fed has the power to reduce market interest rates and can use such adjustments to encourage more borrowing and spending. In this way, it stimulates the economy. COUNTER-POINT: No. When the economy is weak, individuals and firms are unwilling to borrow regardless of the interest rate. As a consequence, borrowing (by those who are qualified) and spending will not be influenced by the Fed’s actions. The Fed should not intervene, but rather let the economy work itself out of a recession. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: It is difficult to determine how long a recession would last if the Fed did not intervene. However, most people (especially the unemployed) would prefer that the Fed make an effort to stimulate the economy. There is some concern that a stimulative monetary policy may cause more inflation, but this is a risk that the Fed must take in order to cure a recession.

Questions 1. Impact of Monetary Policy. How does the Fed’s monetary policy affect economic conditions? ANSWER: The Fed’s monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore affect the demand for loanable funds by influencing inflationary expectations. 2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its economic goals. ANSWER: In general, a stimulative monetary policy can increase economic growth and reduce unemployment but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment.

Chapter 5: Monetary Policy  3 3. Choice of Monetary Policy. When does the Fed use a stimulative monetary policy and when does it use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive? ANSWER: A stimulative monetary policy may be used to stimulate the economy, especially if inflation is not a concern. A restrictive monetary policy may be used to slow economic growth in order to reduce inflationary fears. A stimulative-monetary policy may result in higher inflation. The risk of a restrictive monetary policy is a potential slowdown in the economy. A restrictive monetary policy may result in higher interest rates, reduced borrowing, and reduced spending to an excessive degree. 4. Active Monetary Policy. Describe an active monetary policy. ANSWER: An active monetary policy reflects actions taken by the Fed to adjust money supply in order to affect economic conditions. 5. Passive Monetary Policy. Describe a passive monetary policy. ANSWER: A passive monetary policy means that the Fed does not attempt to adjust money supply in order to improve economic conditions. 6. Fed Control. Why might the Fed have difficulty in controlling the economy in the manner desired? Be specific. ANSWER: The Fed has difficulty in controlling the economy because it cannot always maintain money growth within its target boundaries. In addition, the impact of monetary growth on the economy may be different than what was anticipated. 7. Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag. ANSWER: The recognition lag represents the time from when a problem exists until it is recognized by the Fed. It occurs because the economic statistics that are monitored to detect problems are only reported periodically. The implementation lag occurs when the Fed recognizes a problem but does not implement a policy to solve the problem until later. 8. Fed’s Control of Inflation. Assume that the Fed’s primary goal is to reduce inflation. How can it achieve its goal? What is a possible adverse effect of such action by the Fed (even if it achieves this goal)? ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will reduce economic growth and inflationary pressure. A possible adverse effect is an increase in the unemployment rate.

Chapter 5: Monetary Policy  4 9. Monitoring Money Supply. Why do financial market participants closely monitor money supply movements? ANSWER: Money supply movements can affect interest rates and other economic variables that influence security prices. Therefore, financial market participants can monitor money policy to develop forecasts of future security prices. Financial market participants may incorrectly forecast money supply movements, causing them to incorrectly forecast economic variables. Yet, even if they forecast money supply movements correctly, they may incorrectly anticipate the impact of money supply movements on economic variables. 10. Monetary Policy During the Credit Crisis. Describe the Fed’s monetary policy response to the credit crisis that began in 2008. The Fed used a stimulative monetary policy during the credit crisis because economic conditions were very weak. Specifically, the Fed’s policy resulted in lower interest rates in the U.S. 11. Impact of Money Supply Growth. Explain why an increase in the money supply can affect interest rates in different ways. Include the potential impact of the money supply on the supply of and the demand for loanable funds when answering this question. ANSWER: An increase in money supply increases the supply for loanable funds and therefore can place downward pressure on interest rates. Yet, it can also cause inflationary expectations, resulting in an increased demand for loanable funds and upward pressure on interest rates. 12. Confounding Effects. Which factors might be considered by financial market participants who are assessing whether an increase in money supply growth will affect inflation? ANSWER: Any factors that could offset or magnify the impact should be considered, such as expected oil prices, the strength or weakness of the dollar, and the strength of the economy. 13. Fed Response to Fiscal Policy. Explain how the Fed’s monetary policy could depend on the fiscal policy that is implemented. [ ANSWER: A fiscal policy that involves much government borrowing could place upward pressure on interest rates. If the Fed wants to keep interest rates low in order to stimulate the economy, it may need to use a loose monetary policy to offset the fiscal policy effect on interest rates.

Advanced Questions 14. Interpreting the Fed’s Monetary Policy. When the Fed increases money supply to lower the federal funds rate, do you think this will the cost of capital of U.S. companies be reduced? Explain how the segmented markets theory regarding the term structure of interest rates (as explained in Chapter 3) could influence the degree to which the Fed’s monetary policy affects long-term interest rates. ANSWER: A change in the federal funds rate will likely cause a change in other short-term interest rates. However, it might not result in a change in long-term interest rates, because the direct impact is only on short-term rates. To the extent that maturity markets are segmented, the effect will be isolated on short-term rates.

Chapter 5: Monetary Policy  5 15. Monetary Policy Today. Assess the economic situation today. Is the current presidential administration more concerned with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain. ANSWER: This question allows students to understand how the goals of the administration and the goals of the Fed can differ. 16. Impact of Foreign Policies. Why might a foreign government’s policies be closely monitored by investors in other countries, even if the investors plan no investments in that country? Explain how monetary policy in one country can affect interest rates in other countries. ANSWER: Country economies have become highly integrated over time, so that one country’s economy can affect others. Thus, a foreign country’s government policies may affect its own economy, which in turn affects other economies and therefore security prices. If the monetary policy in one country (such as the U.S.) places upward pressure on the country’s interest rates, investors from other countries may shift their funds there to capitalize on the high interest rates. This results in a reduced supply of funds in the foreign countries. Given the degree of integration between countries, the higher interest rates in one country can place upward pressure on interest rates of other countries as well. 17. Monetary Policy During a War. Consider a discussion during FOMC meetings in which there is a weak economy and a war, with potential major damage to oil wells. Explain why this possible effect would have received much attention at the FOMC meetings. If this situation was perceived to be highly likely at the time of the meetings, explain how it may have complicated the decision about monetary policy at that time. Given the conditions stated in this question, would you suggest that the Fed use a restrictive monetary policy, or a stimulative monetary policy? Support your decision logically and acknowledge any adverse effects of your decision. ANSWER: Normally a weak economy will cause FOMC members to push for a loose money policy that is intended to reduce interest rates, encourage more borrowing (and spending), and stimulate the U.S. economy. However, if oil wells were damaged, there could be an oil shortage. Under these conditions, oil prices would rise, and inflation would likely rise as well. The Fed usually does not want to use a loose money policy in a period when there is high inflation. Thus, it has a dilemma of either adding fuel to the higher inflation with a loose monetary policy or leaving the money supply as is, which offers no cure for the slow economy. The student’s decisions will likely be: (1) leave the monetary policy as is, which offers no cure for the economy, or (2) use a loose money policy that could stimulate the economy but cause more inflation. The key is that they recognize the tradeoff. 18. Economic Indicators. Stock market conditions serve as a leading economic indicator. Assuming the U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator be inaccurate? ANSWER: If stock prices are a leading economic indicator, then the stock market will move up before the economy begins to recover from a recession. An improvement in the stock market may signal that the economy is about to recover. This indicator may be inaccurate because the investors who push stock prices higher may have had unrealistic expectations.

Chapter 5: Monetary Policy  6 19. How the Fed Should Respond to Prevailing Conditions. Consider the existing economic conditions, including inflation and economic growth. Do you think the Fed should increase interest rates, reduce interest rates, or leave interest rates at their present levels? Offer some logic to support your answer. ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 20. Impact of Inflation Targeting by the Fed. Assume that the Fed adopts an inflation-targeting strategy. If oil prices rise abruptly by 15 percent in response to an oil shortage, describe how the Fed’s monetary policy would be affected by this situation. Do you think the inflation-targeting strategy would be more or less effective in this case than if the Fed balances its inflation concerns with unemployment concerns? Explain. ANSWER: If the Fed uses an inflation targeting strategy, it will need to use a tight (restrictive) monetary policy in response to the oil price shock so that it can attempt to slow economic growth and reduce pressure on inflation. However, in this situation, the inflation is caused by an oil shortage, not by an excessive demand for products. Therefore, the policy will not necessarily cure the oil price shock and could also cause a recession. 21. Predicting the Fed’s Actions. Assume the following conditions. The last time the FOMC met, it decided to raise interest rates. At that time economic growth was very strong, and inflation was relatively high. Since the last meeting, economic growth has weakened, and the unemployment rate will likely rise by one percentage point over the quarter. The FOMC’s next meeting is tomorrow. Do you think the FOMC will revise its targeted federal funds rate? If so, how? ANSWER: The Fed would likely not change the target. It probably raised interest rates at the last meeting in order to reduce inflation. It realizes that the use of a restrictive monetary policy may reduce economic growth, so it will not feel the need to correct a slowdown in the economy in this situation. 22. The Fed’s Impact on the Housing Market. In periods when home prices declined substantially, some homeowners blamed the Fed. In other periods when home prices increased, homeowners gave credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a substantial increase in the general inflation level affect the Fed’s monetary policy and thereby affect home prices? ANSWER: The Fed influences interest rates, which affects the cost of borrowing, and this affects the ability of consumers to purchase a home. If interest rates are too high, some consumers are unable to afford the type of home they wish to purchase, because they can not afford the monthly payments on the mortgage. A sudden increase in inflation could prompt the Fed to use a restrictive monetary policy to slow economic growth, whereby interest rates are increased. The higher interest rates could reduce consumer demand for homes and may reduce home prices. In addition, if the Fed slows economic growth, this could also reduce demand for homes and home prices.

Chapter 5: Monetary Policy  7 23. Targeted Federal Funds Rate. The Fed uses a targeted federal funds rate when implementing monetary policy. However, the Fed's main purpose in its monetary policy is typically to have an impact on the aggregate demand for products and services. Reconcile the Fed's targeted federal funds rate with its goal of having an impact on the overall economy. ANSWER: Even though the federal funds rate is the interest rate that is targeted by the Fed, other interest rates are affected as well because they are also affected by supply and demand for funds in the banking system. When depository institutions experience an increase in supply of funds due to the Fed's stimulative monetary policy, they have more funds than they need, and reduce the deposit rate that they are willing to offer on new bank deposits. They also reduce their rates on loans in order to attract more potential borrowers so that they can make use of the funds that they have available. The lower loan rates cause a higher demand for loanable funds by households and businesses, which can increase aggregate demand for products and services. 24. Monetary Policy During Credit Crisis. During the credit crisis of 2008, the Fed used a stimulative monetary policy. Why do you think the total amount of loans to households and businesses did not increase as much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in the total amount of loans extended to households and businesses? ANSWER: The Fed was successful at reducing interest rates. However, under very bad economic conditions, many potential business projects may not be feasible even at the lower cost of borrowing, because the potential cash flows from these projects are not sufficient to make the projects worthwhile. Also, the lending institutions were cautious when granting loans because of the high potential for default risk when lending to households or businesses during such a weak economy. Lending institutions should not extend loans unless they have confidence that the loans will be repaid.

25. Stimulative Monetary Policy During a Credit Crunch. Explain why a stimulative monetary policy might not be effective during a weak economy in which there is a credit crunch. ANSWER: A credit crunch implies that banks are very careful in their credit analysis of potential borrowers and are restricting the amount of credit they will provide. The ability of the Fed to stimulate the economy is partially influenced by the willingness of banks to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank’s qualification standards. 26. Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly implements a stimulative monetary policy to lower interest rates and presumes that firms will be more willing to borrow money. Even if banks are willing to lend such funds, why might such a presumption about the willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong? ANSWER: The presumption about firms borrowing may be wrong because in a weak economy, firms may be concerned that they may fail if they increase their debt. They may prefer not to borrow more funds until the economy improves. Consequently, firms will not correct the weak economy by spending more money, and the Fed’s stimulative policy may be ineffective. 27. Fed Policy Focused on Long-term Interest Rates Why might the Fed want to focus its efforts on reducing long-term interest rates rather than short-term interest rates during a weak economy?

Chapter 5: Monetary Policy  8 Explain how it might use a monetary policy focused on influencing long-term interest rates. Why might such a policy also affect short-term interest rates in the same direction? ANSWER: Firms incur a cost of debt that is highly influenced by the long-term Treasury rates, not the short-term Treasury rates. If the Fed wants to encourage them to borrow more funds, it may want to focus on lowering long-term interest rates. To achieve this goal, it may need to use a stimulative policy that is focused on reducing the long-term Treasury yields. The long-term loan rates are based on the long-term Treasury rate plus a risk premium. Money flows between short-term and long-term Treasury markets, which means that it is difficult for the Fed to have one type of impact in the long-term market that is different than the short-term market. 28. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy on a firm’s cost of capital. ANSWER: A stimulative monetary policy is normally intended to reduce interest rates. Since lower interest rates tend to reduce the cost of debt and the cost of equity, a stimulative monetary policy reduces the cost of capital. 29. Effectiveness of Monetary Policy Which circumstances might cause a stimulative monetary policy to be ineffective? ANSWER: The ability of the Fed to stimulate the economy is partially influenced by the willingness of depository institutions to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers; the result is a credit crunch. Banks provide loans only after confirming that the borrower’s future cash flows will be adequate to make loan repayments. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank’s qualification standards.

Chapter 5: Monetary Policy  9 CRITICAL THINKING QUESTION Fed’s Exposure to Political Agendas. The Fed attempts to use monetary policy to control the level

of inflation and economic growth in the United States. Write a short essay on how the government’s fiscal policy can make the Fed’s role more difficult. Specifically, assume that the administration plans to implement a new program that will expand the government benefits provided to most people in the country. The new program will likely increase the budget deficit. Discuss the impact of this policy on interest rates and explain how this makes the Fed’s role more challenging. ANSWER The Fed might be concerned that the government’s excessive spending will increase the budget deficit, which could increase interest rates. Thus, it might feel forced to use a stimulative monetary policy in which it increases money supply in order to offset the excess government demand for loanable funds. While the Fed is supposed to be independent of the administration, its actions may sometimes be triggered by the administration’s fiscal policy.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Lately, the Fed’s policies are driven by gold prices and other indicators of the future rather than by recent economic data.” The Fed would like to focus on expectations of the future rather than on historical data. Gold prices are perceived to reflect expectations of future inflation. Conversely, recent historical data may not necessarily represent economic conditions in the future. b. “The Fed cannot boost money growth at this time because of the weak dollar.” The weak dollar places upward pressure on U.S. inflation. The Fed may be concerned that high money growth will add to this pressure. c. “The Fed will be forced to accommodate the excessive borrowing triggered by fiscal policy.” The Fed will need to enact a loose money policy in order to place downward pressure on interest rates in order to offset the upward pressure caused by the excessive borrowing by the U.S. Treasury.

Managing in Financial Markets As a manager of a firm, you are concerned about a potential increase in interest rates, which would reduce the demand for your firm’s products. The Fed is scheduled to meet in one week to assess the economic conditions and set monetary policy. Economic growth has been high, but inflation has also increased from 3 percent to 5 percent (annualized) over the last four months. The level of unemployment is so low so that

Chapter 5: Monetary Policy  10 it cannot possibly go much lower. a. Given the situation, is the Fed likely to adjust monetary policy? If so, how? The Fed would likely use a more restrictive monetary policy in order to reduce inflation. While this could cause higher interest rates, it may be necessary to dampen inflation, even if it also slows economic growth. Given that economic growth is high, and that unemployment is very low, the Fed may believe that it could afford to slow the economy down without creating any major adverse effects. b. Recently, the Fed has allowed the money supply to expand beyond its long-term target range. Does this affect your expectation of what the Fed will decide at its upcoming meeting? This gives the Fed one more reason for using a more restrictive monetary policy, because it encourages the Fed to reduce money supply growth in order to meet the existing target range. c. Suppose that the Fed has just learned that the Treasury will need to borrow a larger amount of funds than originally expected. Explain how this information may affect the degree to which the Fed changes the monetary policy. The increased borrowing by the Treasury may place upward pressure on interest rates. Therefore, the Fed may not have to restrict money supply growth as much because the Treasury’s actions will help push interest rates higher. In this case, the Fed may still decide to cut back on money supply growth, but the cut may be smaller as a result of the expected actions of the Treasury.

Flow of Funds Exercise Anticipating Fed Actions Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The company also considers issuing stock to raise funds in the next year. An economic report recently highlighted the strong growth in the economy, which has led to nearly full employment. In addition, the report estimated that the annualized inflation rate increased to 5 percent, up from 2 percent last month. The factors that caused the higher inflation (shortages of products and shortages of labor) are expected to continue. a.

How will the Fed’s monetary policy change, based on the report? The Fed will likely focus more on reducing inflation, even if this means that it must reduce economic growth.

How will the likely change in the Fed’s monetary policy affect Carson’s future performance? Could it affect Carson’s plans for future expansion?

Chapter 5: Monetary Policy  11 Carson’s future performance will not be as strong as expected, because the Fed’s actions will likely result in higher interest rates, which will increase the cost of borrowing. In addition, the Fed’s actions will slow economic growth, which could reduce the demand for Carson’s products, and will reduce Carson’s sales. If higher interest rates occur and slow down economic growth, Carson may not expand as much as it had planned because the demand for its products could be less than what it had expected. c.

Explain how a tight monetary policy could affect the amount of funds borrowed at financial institutions by deficit units such as Carson Company. How might it affect the credit risk of these deficit units? How might it affect the performance of financial institutions that provide credit to such deficit units as Carson Company? A tight (restrictive) monetary policy could reduce economic growth, and therefore reduce the aggregate demand for products and services. Firms like Carson Company would perform worse under these conditions, and some firms may not generate sufficient sales to cover their debt payments. If economic growth is stalled, the financial institutions that provide credit are adversely affected for two reasons. First, the demand for loans is reduced, so they do not generate as much business in loans. Second, a higher percentage of their loans will default as some borrowers experience financial problems.

Solution to Integrative Problem for Part 2 Fed Watching 1. There is no perfect answer to this question, but some factors deserve to be considered. The Fed may prefer to stimulate the economy, but the dilemma involves inflationary pressure. At the present time, the economy is almost at full employment, even though the GDP has declined slightly in the last two quarters. Inflation is assumed to be 5 percent prior to the expectation of a large increase in oil prices. Therefore, the expected inflation will now exceed 5 percent. The past inflation occurred in the presence of a strong dollar. If the dollar weakens at all (which could happen if U.S. oil prices rise), there would be additional pressure on U.S. inflation. Overall, there would be much concern that stimulating the economy could cause further inflationary pressure. While the Fed does not necessarily desire a decline in GDP, it may not be as concerned about that as inflation. Thus, the Fed is not likely to use a stimulative policy yet. If economic conditions get worse, it may need to reconsider. 2. If the Fed does not stimulate the economy, the economy will decline further, which would normally reduce interest rates. It was assumed that changes in economic growth tend to have a greater impact on interest rates than the impact of inflation. Thus, the upward pressure of increased inflationary expectations on interest rates should be offset by the downward pressure caused by a slow economy. Overall, there does not seem to be any urgency to dump bonds. The future values of stocks may be dependent on whether the Fed uses a stimulative monetary policy. Following the logic of the answer to the preceding question, the Fed is not likely to use a monetary policy. Based on this logic, there is no reason to switch to stocks.

Chapter 6 Money Markets Outline Money Market Securities Treasury Bills Commercial Paper Negotiable Certificates of Deposit (NCDs) Repurchase Agreements Federal Funds Banker’s Acceptances

Institutional Use of Money Markets Globalization of Money Markets International Interbank Market Eurodollar Market

Chapter 6: Money Markets  2

Key Concepts 1. Explain the main role of money market securities. 2. Identify the more popular money market securities and elaborate where necessary. 3. Explain how financial institutions participate in money markets.

POINT/COUNTER-POINT: Should Firms Invest in Money Market Securities? POINT: No. Firms are supposed to use money in a manner that generates an adequate return to shareholders. Money market securities provide a return that is less than that required by shareholders. Thus, firms should not use shareholder funds to invest in money market securities. If firms need liquidity, they can rely on the money markets for short-term borrowing. COUNTER-POINT: Yes. Firms need money markets for liquidity. If they do not hold any money market securities, they will frequently be forced to borrow to cover unanticipated cash needs. The lenders may charge higher risk premiums when lending so frequently to these firms. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own

opinion. ANSWER: Firms should not hold an excessive amount of money in the form of money market securities. But they should invest in money market securities so that they have access to funds before being forced to rely on short-term loans.

Questions 1. Primary Market. Explain how the Treasury uses the primary market to obtain adequate funding from the U.S. government. ANSWER: The Treasury issues Treasury bills through a weekly auction. Investors can submit competitive bids, where the Treasury will accept the highest bids first. Alternatively, investors can submit noncompetitive bids, which will automatically be accepted. The price to be paid by noncompetitive bidders is the weighted average price of accepted bids. 2. T-bill Auction. How can investors using the primary T-bill market be assured that their bid will be accepted? Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills? ANSWER: Noncompetitive bids in the Treasury auction ensure acceptance by the Treasury. Large corporations make competitive bids because noncompetitive bidders are limited to the size of noncompetitive bids.

Chapter 6: Money Markets  3 3. Secondary Market for T-bills. Describe the activity in the secondary T-bill market. How can this degree of activity benefit investors in T-bills? Why might a financial institution sometimes consider T-bills as a potential source of funds? ANSWER: The secondary market for Treasury bills is very active, which makes Treasury bills more attractive because it enhances their liquidity. Financial institutions that have previously purchased Treasury bills can sell these securities in the secondary market whenever they need cash. 4. Commercial Paper. Who issues commercial paper? Which types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? Which criteria affect the decision to create such a department? ANSWER: Commercial paper is normally issued by well-known, creditworthy firms. Bank holding companies and finance companies commonly issue commercial paper. Those firms that issue commercial paper may decide to establish a department that can directly place the paper. In this way, the firms can avoid the transactions costs incurred when commercial paper dealers issue commercial paper. Such a strategy is only worthwhile if the firms continuously issue commercial paper. 5. Commercial Paper Ratings. Why do ratings agencies assign ratings to commercial paper? ANSWER: Ratings are assigned to designate the degree of default risk associated with commercial paper. Companies issuing commercial paper pay rating services in order to have their paper rated. 6. Commercial Paper Rates. Explain how investors’ preferences for commercial paper change during a recession. How would this reaction affect the difference between commercial paper rates and T-bill rates during recessionary periods? ANSWER: Investors are less interested in commercial paper during a recession because the probability of default increases. Consequently, issuers of commercial paper must offer a higher premium above the prevailing risk-free rate in order to make the paper attractive to investors. 7. Negotiable CDs. How can small investors participate in investments in negotiable certificates of deposits (NCDs)? ANSWER: Money market funds can pool invested funds by individual investors and purchase NCDs. In this way, small investors can invest in NCDs. 8. Repurchase Agreements. Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why? ANSWER: Repurchase agreements with a similar maturity as commercial paper would likely have a slightly lower yield, since they are typically backed by Treasury securities. 9. Banker’s Acceptances. Explain how each of the following would use banker’s acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors.

Chapter 6: Money Markets  4 ANSWER: A banker’s acceptance can (a) protect an exporter from the risk of nonpayment by the importer, (b) protect importing firms from the risk of paying for goods without ever receiving them, (c) enable banks to offer exporters and importers a service for which it charges a fee, and (d) offer investors an investment instrument (when exporters sell the acceptance in the secondary market). 10. Foreign Money Market Yield. Explain how the yield on a foreign money market security would be affected if the foreign currency denominating that security declined to a significant degree. ANSWER: The foreign money market yield would be reduced if the foreign currency denominating the security depreciates to a greater degree, since the U.S. investors would have to pay a higher exchange rate for the currency than the exchange rate at which the currency is converted back to dollars. 11. Motive to Issue Commercial Paper. The maximum maturity of commercial paper is 270 days. Why would a firm issue commercial paper instead of longer-term securities, even if it needs funds for a long period of time? ANSWER: The firm may be unwilling to lock in the prevailing long-term yield on bonds, perhaps because it expects that long-term interest rates (and yields offered on new bonds) will decline in the near future. 12. Risk and Return of Commercial Paper. You have the choice of investing in top-rated commercial paper or commercial paper that has a lower risk rating. How do you think the risk and return performances of the two investments differ? ANSWER: The commercial paper with the lower rating should have a higher rate of return and also a higher degree of default risk. 13. Commercial Paper Yield Curve. How do you think the shape of the yield curve for commercial paper and other money market instruments compares to the yield curve for Treasury securities? Explain your logic. ANSWER: The shape of the commercial paper yield curve is generally upward sloping, but it only applies up to a 270-day (9-month) maturity. The yields on commercial paper are normally slightly higher than yields on T-bills with the same maturity, so the yield curve on commercial paper would be very similar to the yield curve of Treasury bills up to the 9-month maturity, except that it would be slightly higher.

Advanced Questions 14. Influence of Money Market Activity on Working Capital. Assume that interest rates for most maturities are unusually high. Also assume that the net working capital (defined as current assets minus current liabilities) levels of many corporations are relatively low in this period. Explain how the money markets play a role in this relationship between the interest rates and the level of net working capital. ANSWER: When interest rates are relatively high, corporations are unwilling to issue long-term debt because they do not want to lock in long-term interest rates. Therefore, they use more short-term financing until interest rates decline. Their increase in short-term debt results in a reduction in their net working capital.

Chapter 6: Money Markets  5 15. Applying Term Structure Theories to Commercial Paper. Apply the term structure of interest rate theories that were discussed in Chapter 3 to explain the shape of the existing commercial paper yield curve. ANSWER: The yields offered on commercial paper can vary because of liquidity differences, segmented maturity markets, or interest rate expectations. Other things being equal, longer-term commercial paper should have a slightly higher annualized yield because it is less liquid (longer time until maturity). If firms need funds for a particular short-term period (such as a one-month period) at a given point in time, the yield for that specific maturity should be higher than other maturities of commercial paper. If interest rates are expected to risk, shorter-term commercial paper will have lower annualized yields because investors will prefer shorter-term maturities under these conditions and firms will prefer to issue longer-term commercial paper under these conditions. If interest rates are expected to decrease, the opposite forces would occur. 16. How Money Market Rates Should Respond to Prevailing Conditions. How have money market rates changes since the beginning of the semester? Consider the existing economic conditions. Do you think money market rates will increase or decrease during the semester? Offer some logic to support your answer. ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 17. Impact of Lehman Brothers Failure. Explain how the bankruptcy of Lehman Brothers (a large securities firm) reduced the liquidity of the commercial paper market. ANSWER: In September 2008, Lehman Brothers (a large securities firm) defaulted on its commercial paper, which temporarily scared many investors away from the commercial paper market. 18. Bear Stearns and the Repo Market. Explain the lesson to be learned about the repo market based on the experience of Bear Stearns. ANSWER: The repo market funding requires collateral that is trusted by investors, and when economic conditions are weak, some securities may not serve as adequate collateral to obtain funding. 19. Impact of Credit Crisis on Liquidity. Explain why the credit crisis affected the ability of financial institutions to access short-term financing in the money markets. ANSWER: The credit crisis of 2008 had a major impact on the perceived credit risk of money market securities. Given the financial problems of some financial institutions in this period (government bailout of Bear Stearns in March 2008 and bankruptcy of Lehman Brothers in September 2008), it was difficult for financial institutions to raise funds in this market. 20. Impact of Credit Crisis on Risk Premiums. Explain how the credit crisis affected the credit risk premium in the commercial paper market. ANSWER: During the credit crisis, some institutional investors avoided commercial paper issued by financial institutions because of the financial problems they were experiencing. Thus, the premium that some financial institutions had to pay when issuing commercial paper increased.

Chapter 6: Money Markets  6 21. Systemic Risk. Explain how systemic risk is related to the commercial paper market. That is, why did problems in the market for mortgage-backed securities affect the commercial paper market? ANSWER: Some issuers of asset-backed commercial paper used mortgage-backed securities (MBS) as collateral. As the value of MBS declined during the credit crisis, institutional investors were no longer willing to invest in commercial paper secured by MBS. Thus, some financial institutions that were heavily invested in MBS could no longer issue commercial paper because they had no other assets available to post as collateral. 22. Commercial Paper Credit Guarantees. Explain why investors that provided guarantees on commercial paper were exposed to so much risk during the credit crisis. ANSWER: During the credit crisis, the financial institutions providing credit guarantees were also exposed to high risk because they provided guarantees for issuers that had excessive exposure to mortgages. The guarantors would incur substantial costs on their credit guarantees if issuers of commercial paper default due to the mortgages and other assets they were holding .

CRITICAL THINKING QUESTION Money Market Funding During a Credit Crisis. Many financial institutions borrow heavily in the money markets using mortgages and mortgage-backed securities as collateral. Write a short essay about the lessons of the credit crisis to the deficit units and the surplus units that participate in the money markets? Should money markets be regulated to a greater degree to ensure proper collateral in money markets? ANSWER Deficit units need higher quality mortgages to serve as collateral, because surplus units were unwilling to provide funding during the crisis based on mortgages of questionable quality. Deficit units that constantly roll over their short-term debt may not be able to use the money markets as a long-term source of funds if they cannot continually access funds in money markets. They need better collateral to prevent liquidity problems. Surplus units should recognize the potential default risk associated with some mortgages, and therefore recognize that mortgages do not necessarily serve as adequate collateral to back any financing provided to deficit units. Regulation of the collateral may not be necessary, as long as the surplus units require better collateral.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Money markets are not used to get rich, but to avoid being poor.” Money markets provide a low return but have low risk. Investors maintain investments in money market securities for safety and liquidity.

Chapter 6: Money Markets  7 b. “Until conditions are more favorable, investors are staying on the sidelines.” Investors are investing in money market securities, waiting to move their funds into stocks or bonds once conditions are more promising. c. “My portfolio is overinvested in stocks because of the low money market rates.” Portfolio managers may invest more funds in stocks than they prefer if yields on money market securities are very low.

Managing in Financial Markets As a treasurer of a corporation, one of your jobs is to maintain investment in liquid securities such as Treasury securities and commercial paper. Your goal is to earn as high a return as possible, but without taking much of a risk. a. The yield curve is currently upward sloping, such that 10-year Treasury bonds have an annualized yield 3 percentage points above the annualized yield of three-month T-bills. Should you consider using some of your funds to invest in 10-year Treasury securities? No, unless you are willing to bear the risk. Ten-year Treasury bonds are subject to a high degree of interest rate risk. If interest rates rise, the value of the bonds will decline. If you have to liquidate the Treasury securities after their value has declined, you may have to take a loss on your investment. Even though these securities are free from default risk, they can still generate significant losses, especially when a Treasurer may need to liquidate them on short notice. b. Assume that your firm has substantially more cash than it would possibly need for any liquidity problems. Your boss suggests that you consider investing the excess funds in some money market securities that have a higher return than short-term Treasury securities, such as negotiable certificates of deposit (NCDs). Even though NCDs are less liquid, this would not cause a problem if your firm has more funds than it needs. Given the situation, which use of the excess funds would benefit the firm the most? The excess funds should not be invested in money market securities. If these funds are not needed for liquidity purposes, they should be used to support the firm’s operations (and therefore reduce the amount of funds that have to be borrowed). c. Assume that commercial paper is presently offering an annualized yield of 7.5 percent, while Treasury securities are offering an annualized yield of 7 percent. Economic conditions have been stable, and you expect conditions to be very favorable over the next six months. Given this situation, would you prefer to hold T-bills, or a diversified portfolio of commercial paper issued by various corporations? Given that economic conditions are favorable, commercial paper would be a good investment. It provides a .5 percent premium over Treasury bills, and the probability of default is low given your expectations of the economy. d. Assume that commercial paper typically offers a premium of 0.5 percent above the T-bill rate. Given that your firm typically maintains about $10 million in liquid funds, how much extra will

Chapter 6: Money Markets  8 you generate per year by investing in commercial paper versus T-bills? Is this extra return worth the risk that the commercial paper could default? Given an extra .5 percent per year, you would generate an extra $50,000 per year, as long as the commercial paper did not default. There will be mixed opinions about whether the extra return is worth the risk. Consider that some Treasurers may simply invest in Treasury bills because there is not much reward for earning a slightly higher return. Also, a default on an investment could result in some form of a penalty to the Treasurer. Those Treasurers who are encouraged to take some risk when making their decisions are more willing to invest in the commercial paper. The decision will also depend on the Treasurer’s view of the probability that the commercial paper may default.

Problems 1. T-bill Yield. Assume an investor purchased a six-month T-bill with a $10,000 par value for $9,000 and sold it ninety days later for $9,100. What is the yield? ANSWER:

2. T-bill Discount. Newly issued three-month T-bills with a par value of $10,000 sold for $9,700. Compute the T-bill discount. ANSWER:

Chapter 6: Money Markets  9 3. Commercial Paper Yield. Assume an investor purchased six-month commercial paper with a face value of $1,000,000 for $940,000. What is the yield? ANSWER:

4. Repurchase Agreement. Stanford Corporation arranged a repurchase agreement in which it purchased securities for $4,900,000 and will sell the securities back for $5,000,000 in 40 days. What is the yield (or repo rate) to Stanford Corporation? ANSWER:

5. T-bill Yield. You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield? What is the T-bill discount? ANSWER: T-bill yield YT = (SP – PP/PP)(365 / n) YT = [(100,000 – 98,000)/(98,000)] x (365/120) = 6.2% T-bill discount = (Par – PP/Par)(360 / n) T-bill discount = (100,000 – 98,000)/100,000 x (360/120) T-bill discount = 0.06 = 6%. 6. T-bill Yield. The Treasury is selling 91-day T-bills with a face value of $10,000 for $9,900. If the investor holds them until maturity, calculate the yield. ANSWER: YT = [(SP – PP)/PP)](365/n) YT = [(10,000 – 9,900)/(9,900)] x (365/91) = 4.05% 7. Required Rate of Return. A money market security that has a par value of $10,000 sells for $8,816.60. Given that the security has a maturity of two years, what is the investor’s required rate of return?

Chapter 6: Money Markets  10 ANSWER: $8,816.6 = 10,000/(1 + r)2 $8,816.6 (1 + r)2 = 10,000 (1 + r)2 = 1.1342 (1 + r) = 1.0649 r = 0.0649 = 6.49% 8. Effective Yield. A U.S. investor obtains British pounds when the pound is worth $1.50 and invests in a one-year money market security that provides a yield of 5 percent (in pounds). At the end of one year, the investor converts the proceeds from the investment back to dollars at the prevailing spot rate of $1.52 per pound. Calculate the effective yield. ANSWER: % change in S = 1.52 – 1.50/1.50 = 0.0133 = 1.33% Ye = (1 + Yf)(1 + % change in S) – 1 Ye = (1.05)(1.0133) – 1 = 0.064 = 6.4% 9. T-bill Yield. a. Determine how the annualized yield of a T-bill would be affected if the purchase price were lower. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is increased if the purchase price is lower, because the amount returned to the investor would represent a larger gain relative to a smaller investment. b. Determine how the annualized yield of a T-bill would be affected if the selling price were lower. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is reduced if the selling price is lower, because the amount returned to the investor would represent a smaller gain relative to the investment. c. Determine how the annualized yield of a T-bill would be affected if the number of days were reduced, holding the purchase price and selling price constant. Explain the logic of this relationship. ANSWER: The annualized Treasury bill yield is increased if the number of days of the investment is shorter, because the amount returned to the investor is earned over a shorter amount of time. 10. Return on NCDs. Phil purchased an NCD a year ago in the secondary market for $980,000. The NCD matures today at a price of $1,000,000, and Phil received $45,000 in interest. What is Phil’s return on the NCD? ANSWER:

Chapter 6: Money Markets  11

Flow of Funds Exercise Financing in the Money Markets Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It previously purchased Treasury securities that it could sell if it experiences any liquidity problems. If the economy continues to be strong, Carson may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering the issuance of stock or bonds to raise funds in the next year. a.

The prevailing commercial paper rate on paper issued by large publicly traded firms is lower than the rate Carson would pay when using a line of credit. Do you think that Carson could issue commercial paper at this prevailing market rate? No. Carson has a large amount of debt and would not be able issue commercial paper. It relies on debt to obtain additional funds and would probably need to go public (issue stock) before it would be able to issue commercial paper.

b. Should Carson obtain funds to cover payments for supplies by selling its holdings of Treasury securities or by using its credit line? Which alternative has a lower cost? Explain. Carson should consider selling its holdings of Treasury securities, because the cost of forgoing the return on these securities is lower than the cost incurred when using a line of credit. w

Chapter 7 Bond Markets Outline Background on Bonds Institutional Participation in Bond Markets Bond Yields

Treasury and Federal Agency Bonds Treasury Bond Auctions Trading Treasury Bonds Stripped Treasury Bonds Inflation-Indexed Treasury Bonds Savings Bonds Federal Agency Bonds

Municipal Bonds Credit Risk of Municipal Bonds Variable-Rate Municipal Bonds Tax Advantages of Municipal Bonds Trading and Quotations of Municipal Bonds Yields Offered on Municipal Bonds

Corporate Bonds Corporate Bond Offerings Secondary Market for Corporate Bonds Characteristics of Corporate Bonds How Corporate Bonds Finance Restructuring Collateralized Debt Obligations (CDOs)

Globalization of Bond and Loan Markets Global Government Debt Markets Other Types of Long-term Debt Securities Structured Notes Exchange-Traded Notes Auction-Rate Securities

Chapter 7: Bond Markets  2

Key Concepts 1. Explain how financial institutions participate in bond markets. 2. Identify the more popular types of bonds and elaborate where necessary. 3. Provide some opinions on potential problems with using excessive financial leverage, which lead to leveraged buyouts. Explain the role of the bond markets in facilitating corporate capital restructuring.

POINT/COUNTER-POINT: Should Financial Institutions Invest in Junk Bonds? POINT: Yes. Financial institutions have managers who are capable of weighing the risk against the potential return. They can earn a significantly higher return when investing in junk bonds than the return on Treasury bonds. Their shareholders benefit when they increase the return on the portfolio. COUNTER-POINT: No. The financial system is based on trust in financial institutions and confidence that the financial institutions will survive. If financial institutions take excessive risk, the entire financial system is at risk. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: The answer may depend on the type of financial institution of concern. Lending institutions are expected to provide credit to creditworthy customers, and junk bonds may be viewed as a form of gambling. These institutions do not invest in junk bonds. Insurance companies may invest in junk bonds, but there is some concern that the confidence in insurance companies could be shaken if there are failures because of defaults on junk bonds held by insurance companies. Perhaps the ideal type of institutional investor in junk bonds is a mutual fund that specializes in investing in junk bonds, since the fund’s objective would be clearly communicated to investors, and only those investors who wanted to accept the high risk would invest in these types of mutual funds.

Questions 1. Bond Indenture. What is a bond indenture? What is the function of a trustee, with respect to the bond indenture? ANSWER: The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. It is designed to address all matters related to the bond issue, such as collateral, and call provisions. A trustee represents the bondholders in all matters concerning the bond issue, including the monitoring of the issuing firm’s activities to assure compliance with the terms of the indenture. 2. Sinking-Fund Provision. Explain the use of a sinking-fund provision. How can it reduce the investor’s risk? ANSWER: A sinking-fund provision is a requirement that the firm retire a certain amount of the bond issue each year. This reduces the payments necessary at maturity and therefore can reduce the risk of investors.

Chapter 7: Bond Markets  3 3. Protective Covenants. What are protective covenants? Why are they needed? ANSWER: Protective covenants are restrictions placed on the firm issuing bonds, in order to protect the bondholders. For example, they may limit the dividends or corporate officer salaries, or limit the amount of debt the firm can issue. Protective covenants are needed to reduce the risk of bonds. 4. Call Provisions. Explain the use of call provisions on bonds. How can a call provision affect the price of a bond? ANSWER: A call provision allows the issuing firm to purchase its bonds back prior to maturity at a specific price (the call price). Investors require a higher yield to compensate for this provision, other things being equal. 5. Bond Collateral. Explain the use of bond collateral and identify the common types of collateral for bonds. ANSWER: Bond collateral may be established by the bond issuer as a means of backing the bond. If the issuer defaults on the bonds, the investors would have a claim on the collateral. Some of the more common types of collateral for bonds are mortgages or real property (land and buildings). 6. Debentures. What are debentures? How do they differ from subordinated debentures? ANSWER: Debentures are backed only by the general credit of the issuing firm. Subordinated debentures are junior to the claims of regular debentures, and therefore may have a higher probability of default than regular debentures. 7. Zero-Coupon Bonds. What are the advantages and disadvantages to a firm that issues low- or zerocoupon bonds? ANSWER: From the perspective of the issuing firm, low, or zero coupon, bonds have the advantage of requiring low or no cash outflow during the life of the bond. The issuing firm is allowed to deduct the amortized discount as interest expense for federal income tax purposes, which adds to the firm’s cash flow. However, the lump-sum payment made to bondholders at maturity can be very large and could cause repayment problems for the firm. 8. Variable-Rate Bonds. Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain. Would a firm that needs to borrow funds consider issuing variable-rate bonds if it expects interest rates to decrease in the future? Explain. ANSWER: If investors expect interest rates to decrease, they would avoid variable-rate bonds because the return to the investors would be tied to market interest rates. The investors would prefer fixed-rate bonds if interest rates are expected to decrease. If a firm expects that interest rates will decrease, it may consider issuing variable-rate bonds, because the interest paid on the bonds would decline over time with the decline in market interest rates.

Chapter 7: Bond Markets  4 9. Convertible Bonds. Why can convertible bonds be issued by firms at a higher price than other bonds? ANSWER: Convertible bonds allow investors to exchange the bonds for a stated number of shares of the firm’s common stock. This conversion feature offers investors the potential for high returns if the price of the firm’s common stock rises. Because of this feature, the bonds can be issued at a higher price. 10. Global Interaction of Bond Yields. If bond yields in Japan rise, how might U.S. bond yields be affected? Why? ANSWER: If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before. 11. Impact of the Credit Crisis on Junk Bonds. Explain how the credit crisis that began in 2008 affected the default rates of junk bonds and the risk premiums offered on newly issued junk bonds. ANSWER: Many junk bonds defaulted during the credit crisis, as economic conditions weakened, and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time. 12. Guidelines for Credit Rating Agencies. Explain the guidelines for credit rating agencies That resulted from the Financial Reform Act of 2010. ANSWER: Credit rating agencies are subject to new reporting requirements in which they must disclose their methodology for determining ratings. They must consider credible information from sources other than the issuer when determining the rating of the issuer's debt. They must establish new internal controls over their operations. They must disclose the performance of their ratings over time and are to be held accountable if they experienced poor performance. Their ratings analysts are required to take qualifying exams. 13. Impact of Greece Crisis. Explain the conditions that led to the debt crisis in Greece. ANSWER: In spring of 2010, Greece experienced a credit crisis, because of its weak economic conditions and large government budget deficit. As its deficit grew and its economy weakened, investors were concerned that the government of Greece would not be able to repay its debt. In addition, credit rating agencies reduced the ratings on the Greek debt several times. 14. Bond Downgrade. Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors who currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future. ANSWER: If corporate debt is downgraded, the required rate of return by investors would increase, as the bonds are now perceived to have a higher degree of default risk. Consequently, the price of those bonds would drop, resulting in a capital loss for current investors in those bonds. New investors in these bonds can purchase the bonds at a relatively low price, as this low price compensates for their recognition that the default risk of the bonds has increased.

Chapter 7: Bond Markets  5

Advanced Questions 15. Junk Bonds. Merrito Inc. is a large U.S. firm that issued bonds several years ago. Its bond ratings declined over time, and about a year ago, the bonds were rated in the junk bond classification. Yet, investors continued to buy the bonds in the secondary market because of the attractive yield they offered. Last week, Merrito defaulted on its bonds, and the prices of most other junk bonds declined abruptly on the same day. Explain why news of Meritto’s financial problems could cause the prices of junk bonds issued by other firms to decrease, even when those firms had no business relationships with Merrito. Explain why the prices of those junk bonds with less liquidity declined more than those with a high degree of liquidity. ANSWER: The financial problems of Merrito Inc. signaled that other firms classified in the junk bond category might also experience cash flow problems. Investors quickly sold their holdings because of this signal and other investors were no longer interested in purchasing these bonds at the prevailing price. The price had to decline to a new equilibrium, which reflects a higher yield that provides a higher risk premium to investors who purchase the junk bonds under these conditions. The impact on the bond prices would be more pronounced for those bonds that have less liquidity, because there are fewer willing buyers of these bonds. Thus, the price has to decline more to attract more buyers that would be willing to buy the bonds that are being unloaded in the secondary market. 16. Event Risk. An insurance company purchased bonds issued by Hartnett Company two years ago. Today, Hartnett Company has begun to issue junk bonds and is using the funds to repurchase most of its existing stock. Why might the market value of those bonds held by the insurance company be affected by this action? ANSWER: This question is related to event risk. The bonds held by the insurance company will now be more susceptible to default, because Hartnett Company is more likely to experience cash flow problems. Therefore, the required rate of return on those bonds will increase, and the market value of the bonds will decrease. 17. Exchange-traded Notes. Explain what exchange-traded notes are and how they are used. Why are they risky? ANSWER: Exchange-traded notes (ETNs) are debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index after deducting specified fees. Thus, ETNs have more flexibility to use leverage, which means that the funding for the portfolio of debt instruments is complemented with borrowed funds. This creates higher potential return for investors in ETNs, but also results in higher risk. 18. Auction-Rate Securities. Explain why the market for auction-rate securities suffered in 2008. ANSWER: Some of the financial institutions that made a market for the securities were unwilling to find other buyers and no longer wanted to repurchase the securities. Consequently, when investors wanted to sell their securities at an auction, the financial institutions told them that their investment was frozen and could not be sold because there was not sufficient demand. 19. Role of the Bond Market Explain how the bond market facilitates a government’s fiscal policy. How do you think the bond market could discipline a government and discourage the government from borrowing (and spending) excessively?

Chapter 7: Bond Markets  6 ANSWER: The bond market enables the Treasury to finance government expenditures by issuing Treasury notes and bonds in exchange for funding that can be spent. The Treasury notes and bonds market consists of investors that are willing to receive a low yield on their investment in order to avoid credit risk. However, there may be a debt limit at which those investors begin to fear that the U.S. government might not be capable of making its debt payments, under which those investors are no longer willing to accept the risk-free rate on Treasury notes and bonds. CRITICAL THINKING QUESTION Integration of Bond Markets Write a short essay on the integration of bond markets. Explain why adverse conditions within one bond market (such as a particular country) commonly spread to other bond markets. ANSWER When creditors provide funding in the bond market, it is for a long period of time. There is much uncertainty surrounding the ability of the borrowers to repay debt over a long period of time. Creditors look to other related markets for signals. When one country is unable to repay its debt, creditors question whether other countries have a similar profile and may also experience similar problems in the future. In addition, the economic conditions in one country can spread to other countries because that country might normally purchase a large volume of imports from other countries. The demand for imports will likely decline if the country experiences financial problems. This could reduce the amount of sales generated by the exporting countries. Furthermore, many banks in other countries might have provided loans to one country’s government, so all of those banks could experience financial problems when their loans are not repaid.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The values of some stocks are dependent on the bond market. When investors are not interested in junk bonds, the values of stocks ripe for leveraged buyouts decline.” The likelihood of a firm engaging in an LBO is dependent on whether it can obtain debt financing. If the junk bond market is inactive, the likelihood of obtaining debt financing is low and so is the chance of engaging in an LBO. The market value of the firm’s stock may decline if the likelihood of a takeover is reduced. b. “The recent practice in which firms use debt to repurchase some of their stock is a good strategy as long as the firms can withstand the stagnant economy.” When firms use debt to repurchase some of their stock, they create a higher degree of financial leverage. While this can enhance the firm’s return to its remaining shareholders, it results in higher debt payment, and can therefore increase default risk, especially when the economy is stagnant. c. “Although yields among bonds are related, today’s rumors of a tax cut caused an increase in the yield on municipal bonds, while the yield on corporate bonds declined.”

Chapter 7: Bond Markets  7

If investors expect a tax cut, they recognize that the benefits from tax-free municipal bonds will be reduced. Therefore, they sell municipal bonds immediately in response to this expectation and purchase corporate bonds. The sale of municipal bonds causes lower prices and higher yields of municipal bonds, while the purchase of corporate bonds results in higher prices and lower yields of corporate bonds.

Managing in Financial Markets As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: (1) 10-year coupon bonds issued by the U.S. Treasury, (2) 20-year zero-coupon bonds issued by the Treasury, or (3) one-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon would be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly. a. If your expectations are correct, how will the return of each investment be affected over a oneyear horizon? The U.S. interest rates will decline if the U.S. inflation rate declines. Consequently, bond prices should rise. This would increase the one-year return on 10-year bonds and 20-year zero-coupon bonds. The return on one-year securities over a one-year horizon is not affected because the securities will mature at the end of the one-year investment horizon. b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why? The 20-year zero-coupon bond would have the highest expected return for a one-year horizon. Longer-term bonds are more sensitive to interest rate movements, and zero-coupon bonds are more sensitive than coupon bonds to interest rate movements. While the expected returns of both types of bonds for a one-year horizon would increase, the zero-coupon bonds would generate a higher return. c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon. Your expectations about inflation and therefore interest rates could be wrong. If inflation rises over the one-year period, or other economic conditions (such as economic growth or the budget deficit) change, interest rates could increase during the one-year period. Consequently, the zerocoupon bonds would generate the lowest return over the one-year horizon because they are most sensitive to interest rate movements. Even though you expect the zero-coupon bonds to generate the highest return over the one-year horizon, those bonds are subject to the most interest rate risk.

Problems

Chapter 7: Bond Markets  8 1. Inflation-Indexed Treasury Bond. An inflation-indexed Treasury bond has a par value of $1,000 and a coupon rate of 6 percent. An investor purchases this bond and holds it for one year. During the year, the consumer price index increases by 1 percent every six months. What are the total interest payments that the investor will receive during the year? ANSWER: Principal of bond after six months: $1,000 + (1% × $1,000) = $1,010 Interest received during first six months: $1,010 × 3% = $30.30 Principal of bond at the end of the year: $1,010 + (1% × $1,010) = $1,020.10 Interest received during the last six months: $1,020.10 × 3% = $30.60 Total interest received = $30.30 + $30.60 = $60.90 2. Inflation-Indexed Treasury Bond. Assume that the U.S. economy experienced deflation during the year, and that the consumer price index decreased by 1 percent in the first six months of the year, and by 2 percent during the second six months of the year. If an investor had purchased inflation-indexed Treasury bonds with a par value of $10,000 and a coupon rate of 5 percent, how much would she have received in interest during the year? ANSWER: Principal of bond after six months: $1,000 – (1% × $1,000) = $990 Interest received during first six months: $990 × 2.5% = $24.75 Principal of bond at the end of the year: $990 – (2% × $990) = $970.20 Interest received during the last six months: $970.20 × 2.5% = $24.26 Total interest received: $24.75 + $24.26 = $49.01 Note that the investor would have received $50 if prices had remained stable during the year.

Flow of Funds Exercise Financing in the Bond Markets If the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering the issuance of stock or bonds to raise funds in the next year. a.

Assume that Carson has two choices to satisfy the increased demand for its products. On the one hand, it could increase production by 10 percent with its existing facilities. In this case, it could obtain short-term financing to cover the extra production expense and then use a portion of the revenue received to finance this level of production in the future. On the other hand, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity.

Chapter 7: Bond Markets  9 Carson should not buy a larger facility unless it feels confident that it can fully utilize the space. It should consider using up the excess capacity in its existing facility in the short term and monitoring economic growth. In this way, it only needs to obtain short-term financing, and can avoid the long-term debt for now. If demand does not increase as anticipated, then it can simply retire the short-term debt when it matures. Conversely, if Carson is confident that demand will increase and continue to be strong in the long run, it can issue long-term bonds to finance its expansion. b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the same in both markets? No. There is an upward-sloping yield curve, so Carson could obtain short-term financing at a lower interest rate than long-term financing. c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds? The benefit of the call provision is that Carson could retire its bonds before maturity if it wanted to reduce its debt or if interest rates declined and it wanted to refinance at lower rates. Carson would have to pay a higher yield to compensate bondholders if it includes a call provision on the bonds. d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? Which type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain. Carson could consider a private placement, as it may be able to reduce its transaction costs if it can find an institutional investor that would purchase the bonds. A pension fund or insurance company might be willing to participate as an investor in the private placement market. The investor would need to accept the lack of a secondary market for the bond. Carson would probably have to pay a slightly higher yield on the privately placed bonds to reflect the lack of liquidity (no secondary market) for their bond. e. Financial institutions such as insurance companies and pension funds commonly purchase bonds. Explain the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company. Insurance companies receive funds from policyholders who pay insurance premiums. They invest the funds until they are needed to cover insurance claims. They use a portion of their funds to purchase bonds. Thus, the money pay for insurance premiums is channeled to the corporations that issue bonds. Pension funds receive money that they invest for employees until the money is withdrawn after the employees retire. The pension funds purchase bonds. Thus, the money contributed by the employees or their respective employers are channeled to the corporations that issue bonds.

Chapter 8 Bond Valuation and Risk Outline Bond Valuation Process Impact of the Discount Rate on Bond Valuation Impact of the Timing of Payments on Bond Valuation Valuation of Bonds with Semiannual Payments

Relationships between Coupon Rate, Required Return, and Bond Price Explaining Bond Price Movements Factors That Affect the Risk-free Rate Factors That Affect the Credit (Default) Risk Premium Summary of Factors Affecting Bond Prices Implications for Financial Institutions

Sensitivity of Bond Prices to Interest Rate Movements Bond Price Elasticity Duration

Bond Investment Strategies Matching Strategy Laddered Strategy Barbell Strategy Interest Rate Strategy

Valuation and Risk of International Bonds Influence of Foreign Interest Rate Movements Influence of Credit Risk Influence of Exchange Rate Fluctuations International Bond Diversification

Chapter 8: Bond Valuation and Risk  2

Key Concepts 1. Explain the logic behind how bond prices are affected by interest rates. 2. Use the bond valuation equations to explain how the sensitivity of bond prices to interest rate movements is a function of bond characteristics (such as maturity and coupon rate). 3. Explain the common strategies that are used to invest in bonds.

POINT/COUNTER-POINT: Does Governance of Firms Affect the Prices of Their Bonds? POINT: No. Bond prices are primarily determined by interest rate movements and therefore are not affected by the governance of the firms that issued bonds. COUNTER-POINT: Yes. Bond prices reflect the risk of default. Firms that impose more effective governance may be able to reduce their default risk and therefore increase the price of the bond. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: A bond’s price is based on the investor’s required rate of return, and investors may accept a lower return on bonds issued by firms that are subject to a higher degree of governance. Thus, governance can affect the price of the firm’s bonds.

Questions 1. Bond Investment Decision. Based on your forecast of interest rates, would you recommend that investors purchase bonds today? Explain. ANSWER: Students that expect interest rates to rise should expect bond prices to decline in the future, and therefore not recommend that investors purchase bonds today. Conversely, students that expect interest rates to decrease should expect bond prices to rise in the future, and therefore recommend that investors purchase bonds. 2. How Interest Rates Affect Bond Prices. Explain the impact of a decline in interest rates on: a. An investor’s required rate of return. ANSWER: An investor’s required rate of return should decrease. b. The present value of existing bonds. ANSWER: The present value of existing bonds should increase. c. The prices of existing bonds. ANSWER: The prices of existing bonds should increase.

Chapter 8: Bond Valuation and Risk  3 3. Relevance of Bond Price Movements. Why is the relationship between interest rates and bond prices important to financial institutions? ANSWER: Most financial institutions maintain a portfolio of bonds or mortgages that provide fixed payments over time. Because the market values of these securities are very sensitive to interest rate movements, financial institutions must understand the relationship between interest rates and security prices. 4. Source of Bond Price Movements. Determine the direction of bond prices over the last year and explain the reason for it. ANSWER: If prices of existing bonds have increased, this is normally because interest rates have declined. If prices of existing bonds have decreased, this is normally because interest rates have increased. A thorough answer would identify factors that caused the interest rates to change. 5. Exposure to Bond Price Movements. How would a financial institution with a large bond portfolio be affected by falling interest rates? Would it be affected by a greater degree than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain. ANSWER: The market value of the financial institution’s bond portfolio will increase. A financial institution that has a greater concentration of bonds would be even more favorably affected because the market value of its portfolio would be more sensitive to interest rates. 6. Comparison of Bonds to Mortgages. Since fixed-rate mortgages and bonds have similar payment flows, how is a financial institution with a large portfolio of fixed-rate mortgages affected by rising interest rates? Explain. ANSWER: A financial institution with a large portfolio of fixed-rate mortgages is adversely affected by rising interest rates, because the market value of its mortgage portfolio is reduced. 7. Coupon Rates. If a bond’s coupon rate is greater than the investor’s required rate of return on the bond, would the bond’s price be greater than or less than its par value? Explain. ANSWER: When a bond’s coupon rate is above the investor’s required rate of return, the price of the bond would be above its par value because the coupons provide more than the return required. 8. Bond Price Sensitivity. Is the price of a long-term bond or the price of a short-term security

more sensitive to a change in interest rates? Why? ANSWER: The price of a long-term bond is more sensitive to a change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time. Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities. The same is true for the disadvantage of fixed payments during a period of rising rates. 9. Required Return on Bonds. Why does the required rate of return for a particular bond change over time? ANSWER: The required rate of return on a bond changes because of a change in interest rates, or a change in the risk of the bond.

Chapter 8: Bond Valuation and Risk  4 10. Inflation Effects. Assume that inflation is expected to decline in the near future. How could this affect future bond prices? Would you recommend that financial institutions increase or decrease their concentration in long-term bonds based on this expectation? Explain. ANSWER: Since lower inflation normally causes a decline in interest rates (other things being equal), financial institutions would benefit if they increase their concentration of long-term bonds before this occurs. 11. Bond Price Elasticity. Explain the concept of bond price elasticity. Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the same yield to maturity? Why? What does this suggest about the market value volatility of mutual funds containing zero-coupon Treasury bonds versus high-coupon Treasury bonds? ANSWER: Bond price elasticity measures the percentage change in a bond’s price in response to a percentage change in interest rates. The percentage change in the price (as measured by present value) of the zero-coupon bonds would be more sensitive to interest rate movements than the high-coupon bonds. Thus, a mutual fund containing zero-coupon bonds would likely have a more volatile market value over time. 12. Economic Effects on Bond Prices. An analyst recently suggested that there will be a major economic expansion that will favorably affect the prices of high-rated fixed-rate bonds, because the credit risk of bonds will decline as corporations improve their performance. Assuming that the economic expansion occurs, do you agree with the conclusion of the analyst? Explain. ANSWER: The decline in the credit risk will result in slightly lower bond premiums, which would favorably affect the price if other things are held constant. However, the major economic expansion will likely result in higher interest rates, which could cause a major decline in bond prices. The interest rate effect on the bond prices will likely overwhelm the risk premium effect. 13. Impact of War. When tensions rise or war erupts in the Middle East, bond prices in many countries tend to decline. What is the link between problems in the Middle East and bond prices? Would you expect bond prices to decline more in Japan or in the United Kingdom as a result of the crisis? (The answer is tied to how interest rates may change in those countries.) Explain. ANSWER: The crisis led to an anticipated shortage of oil, which can fuel inflation. Those countries that rely on imported oil would be most affected. Since Japan imports all of its oil while the United Kingdom is self-reliant, Japan’s inflation was more susceptible to the crisis. Therefore, Japan’s bond prices would be expected to experience a greater decline (which they did). 14. Bond Price Sensitivity. Explain how bond prices may be affected by money supply growth, oil prices, and economic growth. ANSWER: Any factors that affect inflationary expectations may affect interest rate expectations and therefore affect the demand for bonds. Higher oil prices, excessive money supply growth, and strong economic growth contribute to higher inflationary expectations. Thus, interest rates would be expected to increase under these conditions (holding other factors constant), the demand for bonds would decline, and bond prices would decline. Lower oil prices or a weak economy could reduce inflationary expectations and result in an increased demand for bonds, causing bond prices to rise.

Chapter 8: Bond Valuation and Risk  5 15. Impact of Oil Prices. Assume that oil-producing countries have agreed to reduce their oil production by 30 percent. How would bond prices be affected by this announcement? Explain. ANSWER: Reduced oil production implies higher oil prices, higher interest rates, and lower bond prices. Thus, bond portfolio managers would sell bonds immediately causing immediate downward pressure on the bond prices. 16. Impact of Economic Conditions. Assume that breaking news causes bond portfolio managers to suddenly expect much higher economic growth. How might bond prices be affected by this expectation? Explain. Now assume that breaking news causes bond portfolio managers to suddenly anticipate a recession. How might bond prices be affected? Explain. ANSWER: Higher economic growth places upward pressure on interest rates and downward pressure on bond prices. As bond portfolio managers sell their bonds based on this expectation, there is immediate downward pressure on bond prices. A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and higher prices of existing bonds. As bond portfolio managers purchase bonds to capitalize on this expectation, there is immediate upward pressure on bond prices.

Advanced Questions 17. Impact of the Fed on Bond Prices. Assume that the bond market participants suddenly expect the Fed to substantially increase the money supply. a. Assuming no threat of inflation, how would this expectation affect bond prices? ANSWER: Without the threat of inflation, an increase in the money supply could reduce interest rates and bond prices would increase. Thus, bond portfolio managers would purchase more bonds now, causing immediate upward pressure on bond prices. b. Assuming that inflation may result, how would bond prices be affected? ANSWER: If inflation increases, interest rates will likely increase, and prices of existing bonds will decline. Therefore, bond portfolio managers would sell bonds now, causing immediate downward pressure on bond prices. c. Given your answers to (a) and (b), explain why expectations of the Fed’s increase in the money supply may sometimes cause bond market participants to disagree about how bond prices will be affected. ANSWER: Some bond market participants may expect that the Fed’s actions will cause higher inflation (and therefore higher interest rates), and therefore expect bond prices to decline. Other bond market participants may expect that the Fed’s actions will not cause higher inflation, and therefore expect bond prices to increase. 18. Impact of a Weak Dollar on Bond Prices. The value of the dollar is monitored by bond market participants over time.

a. Explain why expectations of a weak dollar could reduce bond prices in the U.S.

Chapter 8: Bond Valuation and Risk  6 ANSWER: If the dollar weakens, U.S. inflation may rise, and U.S. interest rates may rise. Thus, bond portfolio managers sell bonds, placing downward pressure on bond prices.

b. On some occasions, news of the dollar weakening did not have any impact on bond markets. Assuming that no other information offsets the impact, explain why the bond markets may not have responded to the announcement. ANSWER: If the weakening of the dollar was already anticipated by the bond market, the announcement does not offer any additional information. Therefore, the market does not react. Existing bond prices already reflect the market’s expectations. 19. International Bonds. A U.S. insurance company purchased British 20-year Treasury bonds instead of U.S. 20-year Treasury bonds because the coupon rate was 2 percentage points higher on the British bonds. Assume that the insurance company sold the bonds after five years. Its yield over the five-year period was substantially less than the yield it would have received on the U.S. bonds over the same five-year period. Assume that the U.S. insurance company had hedged its exchange rate exposure. Given that the lower yield was not because of default risk or exchange rate risk, explain how the British bonds could have generated a lower yield than the U.S. bonds. (Assume that either type of bond could have been purchased at the par value.) ANSWER: If British interest rates increased or remained constant while U.S. interest rates declined, the U.S. bonds could have been sold at a much higher price than British bonds. Thus, while default risk and exchange rate risk are not relevant in this case, the interest rate risk had different effects on the two types of bonds. 20. International Bonds. The pension fund manager of Utterback (a U.S. firm) purchased German 20year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percent lower on the German bonds. Assume that the manager sold the bonds after five years. The yield over the fiveyear period was substantially more than the yield it would have received on the U.S. bonds over the same five-year period. Explain how the German bonds could have generated a higher yield than the U.S. bonds for the manager, even if the exchange rate is stable over this five-year period. (Assume that the price of either bond was initially equal to its respective par value). Be specific. ANSWER: The German interest rates could have declined while U.S. interest rates increased, so that the value of the German bonds was higher than the value of U.S. bonds after five years. Even if interest rates in both countries moved in the same direction, the German bonds could have generated a higher yield. If both interest rates increased, the U.S. interest rates could have increased to a higher degree. If both interest rates decreased, the U.S. interest rates could have decreased by a smaller degree.

Chapter 8: Bond Valuation and Risk  7 21. Implications of a Shift in the Yield Curve. Assume the yield curve experiences a sudden shift, such that the new yield curve is higher and more steeply sloped today than it was yesterday. If a firm issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds yesterday? Explain. ANSWER: A higher and steeper yield curve implies that long-term bond yields have increased. The firm would have to sell the bonds for lower prices to entice investors with a high yield today. 22. How Bond Prices May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on these conditions, do you think bond prices will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on bond prices? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 23. Interaction Between Bond and Money Markets. Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same. a. How would you rebalance your portfolio between bonds and money market securities? ANSWER: Based on your expectations, bond prices will decline. You should rebalance your portfolio by selling bonds and purchasing more money market securities. b. If the market suddenly recognizes that long-term interest rates will rise tomorrow, and that they respond in the same manner as you, explain how the demand for these securities (bonds and money market securities), the supply of these securities for sale, and the prices and yields of these securities will be affected. ANSWER: Bond prices will decline, while the prices of money market securities will rise as investors rebalance their portfolios. Consequently, the yield offered on bonds will rise, and the yield offered on money market securities will decline. c. Assume that the yield curve is flat today. Explain how the slope of the yield curve will change tomorrow in response to the market activity. ANSWER: The yield curve will become upward-sloping because the yield offered on bonds will rise, while the yield offered on money market securities will decline. 24. Impact of the Credit Crisis on Risk Premiums. Explain how the prices of bonds were affected by a change in the risk-free rate during the credit crisis that began in 2008. Explain how bond prices were affected by a change in the credit risk premium during the credit crisis. ANSWER: The risk-free rate declined, which placed upward pressure on bond prices. However, the credit risk premium increased, which placed downward pressure on bond prices.

Chapter 8: Bond Valuation and Risk  8 25. Systemic Risk. Explain why systemic risk is a source of concern in the bond and other debt markets. Also explain how the Financial Reform Act of 2010 was intended to reduce systemic risk. ANSWER: Systemic risk refers to the potential collapse of the entire market or financial system. Many financial institutions rely heavily on debt to fund their operations, and they are interconnected by financing each other's debt positions. If some of these financial institutions cannot repay their debt, they may create cash flow problems for those other financial institutions from which they borrowed funds. In addition, if they took positions in derivative securities to offer insurance to another party in case of debt default, they may suffer major losses. The Financial Reform Act of 2010 resulted in the creation of the Financial Stability Oversight Council, consisting of heads of agencies that oversee key participants in the debt markets. This council is responsible for identifying risks in the U.S. financial system and making regulatory recommendations that could reduce these risks. 26. Link between Market Uncertainty and Bond Yields When stock market volatility is high, corporate bond yields tend to increase. Which market forces cause the increase in corporate bond yields under these conditions? ANSWER: The high stock market volatility partially reflects high uncertainty of investors about corporate performance in the future, so corporate risk premiums on bonds may rise. 27. Fed's Impact on Credit Risk The Fed’s open market operations can change the money supply, which can affect the risk-free rate offered on bonds. Why might the Fed’s policy also affect the risk premium on corporate bonds? ANSWER: If the Fed’s actions reduce interest rates, they may increase economic growth, which could reduce the uncertainty surrounding the economy, and lower the risk premium on corporate bonds.

28. Contagion Effects Explain why a credit crisis in one country may be transmitted to other countries. ANSWER: Economic conditions are often correlated between countries (due to international trade and flows of funds), so a weak economy in one country can possibly cause a weak economy in another country. A weak economy tends to cause concerns about credit risk, so if one country has a credit crisis, it could not only cause a weak economy in another country but could also cause a credit crisis in the other country as well. Furthermore, the borrowers in one country where the credit crisis began might rely heavily on financial institutions (creditors) from another country, which exposes that country’s creditors to credit risk (they could default on their debt if they due not receive repayment of the loans they provided). CRITICAL THINKING QUESTION Impact of Credit Crisis on Bond Markets. The credit crisis was caused by the mortgage market, yet it had a serious impact on bond markets. Write a short essay on how the bond market was affected and offer your opinion on how the bond market may attempt to insulate itself from a credit crisis in the future. ANSWER

Chapter 8: Bond Valuation and Risk  9 The credit crisis resulted from excessive credit that was granted in the mortgage market in the 2004-2006 period, which resulted in a housing bubble. During 2008, it was obvious that many of these mortgages were going to default. Just as credit was too loose in the mortgage market when economic conditions were favorable, it was also too loose in the bond market. Furthermore, once the credit problems in the mortgage market surfaced, financial institutions that invest in bonds began to sell some of their bond holdings, fearing possible defaults. This caused a decline in the values of some outstanding bonds. The bond market began to lose liquidity as investors questioned the creditworthiness of borrowers. Credit markets tend to freeze when there is much uncertainty, and the mortgage market problems created fear in the bond market, which limited the amount of funds that creditors were willing to lend in the bond market.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “Given the recent uncertainty about future interest rates, investors are fleeing from zero-coupon bonds.” Zero-coupon bonds are most sensitive to interest rate movements; investors who were concerned about an increase in interest rates sold their holdings of zero-coupon bonds. b. “Catrell Insurance Company invests heavily in bonds, and its stock price increased substantially today in response to the Fed's signal that it plans to reduce interest rates.” Some of Catrell’s assets are long-term bonds, which increase in value when interest rates decrease. The stock valuation is influenced by the increase in the market value of its assets.

Chapter 8: Bond Valuation and Risk  10 c. “Bond markets declined when the Treasury flooded the market with its new bond offering.” If the Treasury issues new bonds, the supply of bonds may exceed the demand, causing a decline in the price of bonds. That is, the yields to be offered on any new bonds must be raised to attract buyers.

Managing in Financial Markets As an investor, you plan to invest your funds in long-term bonds. You have $100,000 to invest. You may purchase highly rated municipal bonds at par with a coupon rate of 6 percent; you have a choice of a maturity of 10 years or 20 years. Alternatively, you could purchase highly rated corporate bonds at par with a coupon rate of 8 percent; these bonds also are offered with maturities of 10 years or 20 years. You expect that you will not need the funds for five years. At the end of the fifth year, you will definitely sell the bonds since you will need to make a large purchase at that time. a. What is the annual interest you would earn (before taxes) on the municipal bond? On the corporate bond? You would earn $6,000 per year on the municipal bond, or $8,000 on the corporate bond. b. Assume that you are in the 20 percent tax bracket. If the level of credit risk and the liquidity for the municipal and corporate bonds are the same, would you invest in the municipal bond or the corporate bond? Why? Invest in the corporate bond. The after-tax annual interest earned on the corporate bond is $6,400 (computed as $8,000  [1.20]). This exceeds the $6,000 after-tax annual interest on a municipal bond. c. Assume that you expect all yields paid on newly issued notes and bonds (regardless of maturity) to decrease by a total of 4 percentage points over the next two years, and to increase by a total of 2 percentage points over the following three years. Would you select the 10-year maturity or the 20-year maturity for the type of bond you plan to purchase? Why? Select the 20-year bond as long as you are confident about your expectations. The general level of interest rates in five years should be lower than today, which should increase the value of your bond. The value of the 20-year bond will be more sensitive than the value of the 10-year bond, and therefore should experience a higher increase in value by the time you need to sell the bond. The expected interest rate at the end of the fifth year is crucial to your decision. Even though the interest rates were expected to rise over the third, fourth, and fifth years, the general level of interest rates was expected to be lower at the end of the fifth year than when you first purchased the bonds.

Problems 1. Bond Valuation. Assume the following information for an existing bond that provides annual coupon payments: Par value = $1,000 Coupon rate = 11%

Chapter 8: Bond Valuation and Risk  11 Maturity = 4 years Required rate of return by investors = 11% a. What is the present value of the bond? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 11%,n = 4) + $1,000(PVIFi = 11%,n = 4) = $110(3.1024) + $1,000(.6587) = $341 + $659 = $1,000 b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 14%,n = 4) + $1,000(PVIFi = 14%,n = 4) = $110(2.9137) + $1,000(.5921) = $321 + $592 = $913 c. If the required rate of return by investors were 9 percent, what would be the present value of the bond? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 9%,n = 4) + $1,000(PVIFi = 9%,n = 4) = $110(3.2397) + $1,000(.7084) = $356 + $708 = $1,064 2. Valuing a Zero-Coupon Bond. Assume the following information for existing zero-coupon bonds: Par value = $100,000 Maturity = 3 years Required rate of return by investors = 12% How much should investors be willing to pay for these bonds? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $0 + 100,000(PVIFi = 12%,n = 3) = $100,000(.7118) = $71,180

Chapter 8: Bond Valuation and Risk  12 3. Valuing a Zero-Coupon Bond. Assume that you require a 14 percent return on a zero-coupon bond with a par value of $1,000 and six years to maturity. What is the price you should be willing to pay for this bond? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $0 + 1,000(PVIFi = 14%,n = 6) = $1,000(.4556) = $455.60 4. Bond Value Sensitivity to Exchange Rates and Interest Rates. Cardinal Company, a U.S.-based insurance company, considers purchasing bonds denominated in Canadian dollars, with a maturity of six years, a par value of C$50 million, and a coupon rate of 12 percent. The bonds can be purchased at par by Cardinal and would be sold four years from now. The current exchange rate of the Canadian dollar is $0.80. Cardinal expects that the required return by Canadian investors on these bonds four years from now will be 9 percent. If Cardinal purchases the bonds, it will sell them in the Canadian secondary market four years from now. The exchange rates are forecast as follows: Year

Exchange Rate of C$ 1 2 3 4 5 6

$0.80 0.77 0.74 0.72 0.68 0.66

a. Refer to earlier examples in this chapter to determine the expected U.S. dollar cash flows to Cardinal over the next four years. Refer to Chapter 3 to determine the present value of a bond. ANSWER: PV of C$ Cash Flows =

C$6,000,000 C$56,000,000 (1 + .09)1 + (1 + .09)2 in 4 years

= C$5,504,587 + C$47,134,080 = C$52,638,667 Year

C$6,000,000

C$6,000,000 +C$52,638,667

Forecasted exchange rate of C$

$0.80

$0.77

$0.74

$0.72

U.S. $ cash flows anticipated

$4,800,000

$4,620,000

$4,440,000

$42,219,840

C$ cash flows anticipated

Chapter 8: Bond Valuation and Risk  13 b. Does Cardinal expect to be favorably or adversely affected by the interest rate risk? Explain. ANSWER: Cardinal Co. will be favorably affected if Canadian interest rates decline as expected because the bonds will sell for a higher price at the end of the fourth year as a result. c. Does Cardinal expect to be favorably or adversely affected by exchange rate risk? Explain. ANSWER: Cardinal Co. is adversely affected by the exchange rate movements, because a weaker Canadian dollar over time results in less U.S. dollar cash flows to be received. 5. Predicting Bond Values. (Use the chapter appendix to answer this problem.) Bulldog Bank has just purchased bonds for $106 million that have a par value of $100 million, three years remaining to maturity, and an annual coupon rate of 14 percent. It expects the required rate of return on these bonds to be 12 percent one year from now. a. At what price could Bulldog Bank sell these bonds for one year from now? ANSWER: PV of Bonds One Year from Now

PV of Remaining = Coupon Payments + PV of Principal = $14,000,000(PVIFAi = 12%,n = 2) + $100,000,000(PVIFi = 12%,n = 2) = $14,000,000(1.6901) + $100,000,000(.7972) = $23,661,400 + $79,720,000 = $103,381,400

b. What is the expected annualized yield on the bonds over the next year, assuming they are to be sold in one year? ANSWER: $106,000,000 = ($14,000,000 + $103,381,400)(PVIFi = ?,n = 1) .903 = (PVIFi = ?,n = 1) i = between 10% and 11% 6. Predicting Bond Values. (Use the chapter appendix to answer this problem.) Sun Devil Savings has just purchased bonds for $38 million that have a par value of $40 million, five years remaining to maturity, and a coupon rate of 12 percent. It expects the required rate of return on these bonds to be 10 percent two years from now. a. At what price could Sun Devil Savings sell these bonds for two years from now? ANSWER: PV of Bonds in 2 Years

PV of Remaining = Coupon Payments + PV of Principal = $4,800,000(PVIFAi = 10%,n = 3) + $40,000,000(PVIFi = 10%,n = 3) = $4,800,000(2.4869) + $40,000,000(.7513) = $11,937,120 + $30,052,000 = $41,989,120

Chapter 8: Bond Valuation and Risk  14 b. What is the expected annualized yield on the bonds over the next two years, assuming they are to be sold in two years? ANSWER: $38,000,000 = $4,800,000(PVIFAi = ?,n = 2) + ($41,989,120)(PVIFi = ?,n = 2) By trial and error, i = about 17%. This can also be done with some calculators. c. If the anticipated required rate of return of 10 percent in two years is overestimated, how would the actual selling price differ from the forecasted price? How would the actual annualized yield over the next two years differ from the forecasted yield? ANSWER: If the required rate of return is overestimated, then the actual selling price will be higher than what is forecasted. Therefore, the annualized yield will be higher than what is forecasted. 7. Predicting Bond Values. (Use the chapter appendix to answer this problem.) Spartan Insurance Company plans to purchase bonds today that have four years remaining to maturity, a par value of $60 million, and a coupon rate of 10 percent. Spartan expects that in three years, the required rate of return on these bonds by investors in the market will be 9 percent. It plans to sell the bonds at that time. What is the expected price it will sell the bonds for in three years? ANSWER: PV of Bonds in 3 Years

PV of Remaining = Coupon Payments + PV of Principal = ($6,000,000 + $60,000,000)(PVIFi = 9%,n = 1) = $66,000,000(.9174) = $60,548,400

8. Bond Yields. (Use the chapter appendix to answer this problem.) Hankla Company plans to purchase either (1) zero-coupon bonds that have ten years to maturity, a par value of $100 million, and a purchase price of $40 million, or (2) bonds with similar default risk that have five years to maturity, a 9 percent coupon rate, a par value of $40 million, and a purchase price of $40 million. Hankla can invest $40 million for five years. Assume that the market’s required return in five years is forecasted to be 11 percent. Which alternative would offer Hankla a higher expected return (or yield) over the five-year investment horizon? ANSWER: The PV of zero-coupon bonds five years from now is based on the PV of the par value to be received 5 years after that point in time: PV of ZeroCoupon Bonds

= $100,000,000(PVIFi = 11%,n = 5) = $100,000,000(.5935) = $59,350,000

The discount rate at which the anticipated cash flows from the zero-coupon bonds will equal today’s price is:

Chapter 8: Bond Valuation and Risk  15

$40,000,000 = $59,350,000(PVIFi = ?,n = 5) (PVIFi = ?,n = 5) = .6740 i = about 8% The second alternative offers a yield to maturity of 9 percent, which exceeds the yield to maturity of about 8 percent on the zero-coupon bonds. 9. Predicting Bond Values. (Use the chapter appendix to answer this problem.) The portfolio manager of Ludwig Company has excess cash that is to be invested for four years. He can purchase either (1) four-year Treasury notes that offer a 9 percent yield, or (2) new 20-year Treasury bonds for $2.9 million that offer a par value of $3 million and an 11 percent coupon rate with annual payments. The manager expects that the required return on these same 20-year bonds will be 12 percent four years from now. a. What is the forecasted market value of the twenty-year bonds in four years? ANSWER: PV of 20-Year PV of Remaining Bonds as of 4 = Coupon Payments + PV of Principal Years from Now = $330,000(PVIFAi = 12%,n = 16) + $3,000,000(PVIFi = 12%,n = 16) = $330,000(6.9740) + $3,000,000(.1631) = $2,301,420 + $489,300 = $2,790,720 b. Which investment is expected to provide a higher yield over the four-year period? ANSWER: Ludwig could achieve a yield of 9 percent on the Treasury notes with certainty. By discounting the cash flow resulting from the alternative investment (20-year bonds) over the four-year investment horizon at 9 percent, we can determine whether the bonds offer a higher or lower yield. The PV of the bonds as of today using a 9 percent discount rate is: = $330,000(PVIFAi = 9%,n = 4) + $2,790,720(PVIFi = 9%,n = 4) = $330,000(3.2397) + $2,790,720(.7084) = $1,069,101 + $1,976,946 = $3,046,047 Since Ludwig would pay less today for these bonds than the present value estimated here, this implies that the yield to maturity on the bonds exceeds 9 percent. Therefore, the bonds offer a higher yield. 10. Predicting Bond Portfolio Value. (Use the chapter appendix to answer this problem). Ash Investment Company manages a broad portfolio with this composition:

Zero-coupon bonds 8% Treasury bonds 11% corporate bonds

Par Value $200,000,000 300,000,000 400,000,000

Present Market Value $ 63,720,000 290,000,000 380,000,000 $733,720,000

Years Remaining to Maturity 12 8 10

Chapter 8: Bond Valuation and Risk  16 Ash expects that in four years, investors in the market will require an 8 percent return on the zerocoupon bonds, a 7 percent return on the Treasury bonds, and a 9 percent return on corporate bonds. Estimate the market value of the bond portfolio four years from now. ANSWER: PV of Zero-Coupon Bonds in 4 Years

= $200,000,000(PVIFi = 8%,n = 8) = $200,000,000(.5403) = $108,060,000

PV of Treasury Bonds in 4 Years = $24,000,000(PVIFAi = 7%,n = 4) + $300,000,000(PVIFi = 7%,n = 4) = $24,000,000(3.3872) + $300,000,000(.7629) = $81,292,800 + $228,870,000 = $310,162,800 PV of Corporate Bonds in 4 Years = $44,000,000(PVIFAi = 9%,n = 6) + $400,000,000(PVIFi = 9%,n = 6) = $44,000,000(4.4859) + $400,000,000(.5963) = $197,379,600 + $238,520,000 = $435,899,600 PV of Portfolio in 4 Years

= $108,060,000 + $310,162,800 + $435,899,600 = $854,122,400

11. Valuing a Zero-Coupon Bond. a. A zero-coupon bond with a par value of $1,000 matures in 10 years. At what price would this bond provide a yield to maturity that matches the current market rate of 8 percent? ANSWER: PV PV PV = $463.19 b. What happens to the price of this bond if interest rates fall to 6 percent? ANSWER: PV

Chapter 8: Bond Valuation and Risk  17

PV PV = $558.39 c. Given the changes in the price of the bond and the interest rate descried in part (b), calculate the bond price elasticity. ANSWER:

12. Bond Valuation. You are interested in buying a $1,000 par value bond with 10 years to maturity and an 8 percent coupon rate that is paid semiannually. How much should you be willing to pay for the bond if the investor’s required rate of return is 10 percent? ANSWER: PV = C(PVIFA k = 5%, n = 20) + FV(PVIFk = 5%, n = 20) PV = 40(12.4622) + 1,000(0.3769) PV = $875.39 13. Predicting Bond Values. You are interested in a bond that pays an annual coupon of 4 percent, has a yield to maturity of 6 percent and has 13 years to maturity. If interest rates remain unchanged, at what price would you expect this bond to be selling 8 years from now? Ten years from now? ANSWER: PV = C(PVIFAk = 6%, n = 5) + FV(PVIFk = 6%, n = 5) PV = 40(4.2124) + 1,000(0.7473) PV = $915.796 PV = C(PVIFAk = 6%, n = 3) + FV(PVIFk = 6%, n = 3) PV = 40(2.6730) + 1,000(0.8396) PV = $946.52 14. Sensitivity of Bond Values. a. How would the present value (and therefore the market value) of a bond be affected if the coupon payments are smaller and other factors remain constant? ANSWER: The bond would have a lower present value, since the future cash flows would be smaller.

Chapter 8: Bond Valuation and Risk  18 b. How would the present value (and therefore the market value) of a bond be affected if the required rate of return is smaller and other factors remain constant? ANSWER: The bond would have a higher present value, since the cash flows would be discounted at a lower discount rate. 15. Bond Elasticity. Determine how the bond elasticity would be affected if the bond price changed by a larger amount, holding the change in the required rate of return constant. ANSWER: The bond elasticity would be higher, meaning that there is a greater sensitivity of bond prices to a change in required rates of return. This would occur for bonds with longer terms to maturity. 16. Bond Duration. Determine how the duration of a bond be affected if the coupons were extended over additional time periods. ANSWER: The longer the coupon payments are extended, the greater is the duration, because the investor is more exposed to changes in the required rate of return. 17. Bond Duration. A bond has a duration of 5 years and a yield to maturity of 9 percent. If the yield to maturity changes to 10 percent, what should be the percentage price change of the bond? ANSWER: First compute the modified duration of the bond:

Next, compute the percentage price change of the bond if the yield increases to 10 percent:

Consequently, the bond should decrease in price by 4.59%. 18. Bond Convexity. Describe how bond convexity affects the theoretical linear price-yield relationship of bonds. What are the implications of bond convexity for estimating changes in bond prices? ANSWER: Bond convexity illustrates that the price-yield relationship is not linear, but convex. This is particularly pronounced for bonds with low coupons and long maturities. From a bond pricing perspective, bond convexity leads to estimation errors in the price change of a bond, although the effect is negligible for small yield changes. Specifically, using modified duration to estimate the percentage price change of a bond yields to an underestimation of bond price increases when yields drop and an overestimation of bond price decreases when yields increase.

Chapter 8: Bond Valuation and Risk  19

Flow of Funds Exercise Interest Rate Expectations, Economic Growth, and Bond Financing If the economy continues to be strong, Carson Company may need to increase its production capacity by approximately 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The company needs funding to cover payments for supplies. It is also considering the issuance of stock or bonds to raise funds in the next year. a. At a recent meeting, the Chief Executive Officer (CEO) stated his view that the economy will remain strong, as the Fed’s monetary policy is not likely to have a major impact on the interest rates. For this reason, he wants to expand the business to benefit from the expected increase in demand for Carson’s products. The next step would be to determine how to finance the expansion. The Chief Financial Officer (CFO) stated that if Carson Company needs to obtain long-term funds, issuing fixed-rate bonds would be ideal strategy at this point in time because he expects that the Fed’s monetary policy to reduce inflation and will cause long-term interest rates to rise. If the CFO is correct about future interest rates, what does this suggest about the future economic growth, the future demand for Carson’s products, and the need to issue bonds? If the Fed’s monetary policy causes higher interest rates, the economic growth will be reduced and the demand for Carson’s products would be adversely affected. Thus, it may not need to issue bonds. b. If you were involved in the meeting described here, what do you think needs to be resolved before deciding to expand the business? There should be a clear conclusion about the Fed’s impact on interest rates. If the CEO is correct about the Fed’s monetary policy not affecting interest rates, then the economy should stay strong, and Carson should pursue expansion. However, the CFO’s argument for financing with longterm fixed rates should be questioned, because the CEO’s view of the Fed’s monetary policy conflicts with the CFO’s view. Both officers cannot be correct. c. At the meeting described here, the Chief Executive Officer (CEO) stated the following: “The decision to expand should not be dictated by whether interest rates are going to increase. Bonds should be issued only if the potential increase in interest rates is attributed to a strong demand for loanable funds rather than the Fed’s reduction in the supply of loanable funds.” What does this statement mean? If interest rates rise as a result of the Fed’s actions, its monetary policy is intended to slow economic growth as a means of reducing inflation. In this case, Carson should not expand because it will not be able to fully utilize its production capacity. However, if the interest rates rise because of a strong demand for loanable funds, that reflects a strong economy, which should result in a strong demand for Carson’s products. In this case, Carson should expand.

Chapter 9 Mortgage Markets Outline Background on Mortgages How Mortgages Facilitate the Flow of Funds Criteria Used to Measure Creditworthiness Classifications of Mortgages

Types of Residential Mortgages Fixed-Rate Mortgages Adjustable-Rate Mortgages Graduated Payment Mortgages Growing Equity Mortgages Second Mortgages Shared Appreciation Mortgages Balloon Payment Mortgages

Valuation of Mortgages Credit Risk Interest Rate Risk Prepayment Risk Mortgage Backed Securities The Securitization Process Types of Mortgage-Backed Securities Valuation of Mortgage-Backed Securities Credit Crisis Impact of the Crisis on Fannie Mae and Freddie Mac Impact of Credit Crisis on Exposed Financial Institutions Systemic Risk Due to the Credit Crisis Who Is to Blame for the Credit Crisis? Government Programs in Response to the Crisis Financial Reform Act of 2010

Chapter 9: Mortgage Markets  2

Key Concepts 1. Identify the more popular types of mortgages and elaborate where necessary. 2. Describe how financial institutions participate in mortgage markets. 3. Explain how the mortgage problems led to the credit crisis.

POINT/COUNTER-POINT: Is the Trading of Mortgages Similar to the Trading of Corporate Bonds? POINT: Yes. In both cases, the issuer’s ability to repay the debt is based on income. Both types of debt securities are highly influenced by interest rate movements. COUNTER-POINT: No. The assessment of corporate bonds requires an analysis of financial statements of the firms that issued the bonds. The assessment of mortgages requires an understanding of the structure of the mortgage market (CMOs, etc.). WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: The question is primarily intended to make students compare mortgages to bonds. There are some similarities, but an institutional investor who manages a corporate bond portfolio would not be able manage a mortgage portfolio without adequate training, and vice versa.

Questions 1. FHA Mortgages. Distinguish between FHA and conventional mortgages. ANSWER: FHA mortgages guarantee loan repayment, thereby covering against the possibility of default by the borrower. The guarantor is the Federal Housing Administration. Conventional mortgages are not federally insured, but they can be privately insured. 2. Mortgage Rates and Risk. What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate themselves against interest rate movements. ANSWER: There is a high positive correlation between mortgage rates and long-term government security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.

Chapter 9: Mortgage Markets  3 3. ARMs. How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixedrate mortgages? Why? Explain how caps on ARMs can affect a financial institution’s exposure to interest rate risk. ANSWER: An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds. 4. Mortgage Maturities. Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year mortgage or a 30-year mortgage? Why? ANSWER: The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15year mortgage exists for only half the period. 5. Balloon-Payment Mortgage. Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage? ANSWER: A balloon mortgage payment requires interest payments for a three- to five-year period. At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages. 6. Graduated-Payment Mortgage. Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage? ANSWER: The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period. Homeowners whose incomes will rise over time may desire this type of a mortgage. 7. Growing-Equity Mortgage. Describe the growing-equity mortgage. How does it differ from a graduated-payment mortgage? ANSWER: A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage. The mortgage lifetime is reduced because of the accelerated payment schedule, whereas a GPM’s life is not reduced. 8. Second Mortgages. Why are second mortgages offered by some home sellers? ANSWER: A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default.

Chapter 9: Mortgage Markets  4 9. Shared-Appreciation Mortgage. Describe the shared-appreciation mortgage. ANSWER: A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates. In return, the lender providing the loan will share in the price appreciation of the home. 10. Exposure to Interest Rate Movements. Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what? ANSWER: When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited. 11. Mortgage Valuation. Describe the factors that affect mortgage prices. ANSWER: Mortgage prices are affected by changes in interest rates and risk premiums. Factors such as economic growth, money supply and inflation affect interest rates and therefore affect mortgage prices. A change in economic growth may also affect the risk premium. 12. Selling Mortgages. Explain why some financial institutions prefer to sell the mortgages they originate. ANSWER: Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. They do not have sufficient funds to maintain all the mortgages they originate. 13. Secondary Market. Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level. ANSWER: The secondary market for stocks and bonds is facilitated by an organized exchange such as the New York Stock Exchange. The prices of these securities sold in the secondary market are more transparent. The prices of mortgages sold in the secondary market are not transparent. However, the secondary market for mortgages has been enhanced because of securitization. This allows for the sale of smaller loans that could not be as easily sold if they were not packaged. 14. Financing Mortgages. What types of financial institutions finance residential mortgages? What type of financial institution finances the majority of commercial mortgages? ANSWER: Commercial banks and savings and loan associations dominate the one- to four-family mortgages. Commercial banks dominate the commercial mortgages. 15. Mortgage Companies. Explain how a mortgage company’s degree of exposure to interest rate risk differs from other financial institutions. ANSWER: Mortgage companies concentrate on servicing mortgages rather than investing in mortgages. Thus, they are not as concerned about hedging mortgages over the long run. However, they are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates change over this period, the price at which they can sell the mortgages will change.

Chapter 9: Mortgage Markets  5

Advanced Questions 16. Mortgage-Backed Securities. Describe how mortgage-backed securities are used. ANSWER: A financial institution that purchases or originates a portfolio of mortgages can sell mortgages by packaging them and issuing mortgage-backed securities. The mortgages serve as collateral for the debt securities issued. The interest and principal payments on the mortgages are transferred (passed through) to the owners of the securities, after deducting fees for servicing. 17. CMOs. Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular. ANSWER: Collateralized mortgage obligations (CMOs) are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences. 18. Maturities of MBS. Explain how the maturity of mortgage-backed securities can be affected by interest rate movements. ANSWER: When interest rates decline, prepayments on mortgages occur because some homeowners refinance with a new mortgage with a lower interest rate. If these mortgages were financed with passthrough securities, the payments will be channeled to the investors that purchased the pass-through securities. 19. How Secondary Mortgage Prices May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on the prevailing conditions, do you think the values of mortgages that are sold in the secondary market will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the values of existing mortgages? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 20. CDOs. Explain collateralized debt obligations (CDOs). ANSWER: A CDO represents a package of debt securities backed by collateral that is sold to investors. A CDO commonly combines a variety of debt securities, including subprime mortgages, prime mortgages, automobile loans other credit card loans. It was a popular means by which a creditor could originate a loan and even service it without lending its own funds. 21. Motives for Offering Subprime Mortgages. Describe the characteristics of subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages before the credit crisis? ANSWER: Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. Thus, these mortgages enabled more people with relatively lower income, or high existing debt, or a small down payment to purchase homes. Many financial institutions such as mortgage companies were willing to provide subprime loans because it allowed

Chapter 9: Mortgage Markets  6 them a way to expand their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgage in order to compensate for the risk of default. 22. Subprime Versus Prime Mortgages. How did the repayment of subprime mortgages compare to the repayment of prime mortgages during the credit crisis? ANSWER: In 2008, about 25 percent of all outstanding subprime mortgages had late payments of at least 30 days, versus less than 5 percent for prime mortgages. In addition, about 10 percent of outstanding subprime mortgages were subject to foreclosure in 2008, versus less than 3 percent for prime mortgages. 23. MBS Transparency. Explain the problems that arise in valuing MBS. ANSWER: There is no centralized reporting system that reports the trading of MBS in the secondary market, as there is for other securities such as stocks and Treasury bonds. The only participants who know the price of MBS that was traded is the buyer and the seller. 24. Contagion Effects of Credit Crisis. Explain how the credit crisis adversely affected many other people and institutions beyond homeowners and mortgage companies. ANSWER: Mortgage insurers incurred expenses from foreclosures of the property they insured. Individual investors whose investments were pooled by mutual funds, hedge funds, and pension funds and used to purchase MBS experienced losses. Investors who invested in stocks of financial institutions experienced losses. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. Home builders went bankrupt and many employees in the home building industry lost their jobs. 25. Blame for Credit Crisis. Many investors that purchased the mortgage-backed securities just before the credit crisis believed that they were misled, because these securities were riskier than they thought. Who was at fault? ANSWER: Answers might include the households that applied for mortgages but could not afford them, the originators of mortgages, the financial institutions that packaged mortgages into tranches, the rating agencies, and the financial institutions that invested in mortgage-backed securities. Each party could be partially accountable for not recognizing the high potential for default risk. 26. Avoiding Another Credit Crisis. Do you think that the U.S. financial system will be able to avoid a credit crisis in the future? ANSWER: A credit crisis is triggered by fear of investors that purchase debt securities. A credit crisis could occur again in the future in response to a weak economy or to various events that cause concerns that issuers of debt will not repay their debt. 27. Role of Credit Ratings in Mortgage Market. Explain the role of credit rating agencies in facilitating the flow of funds from investors into the mortgage market (through mortgage-backed securities). ANSWER: Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent.

Chapter 9: Mortgage Markets  7 28. Fannie and Freddie Problems. Explain why Fannie Mae and Freddie Mac experienced mortgage problems during the credit crisis. ANSWER: Fannie Mae and Freddie Mac are major investors in mortgages. However, they made poor investment decisions by using funds to invest in many mortgages that involved high risk. 29. Rescue of Fannie and Freddie. Explain why the rescue of Fannie Mae and Freddie Mac improved the ability of mortgage companies to originate mortgages. ANSWER: Without a strong secondary market for mortgages, financial institutions that originate mortgages would not be able to sell mortgages, and therefore may have to finance them on their own. This would severely limit the amount of funding for new mortgages. Thus, while the government rescue is primarily focused on ensuring a more liquid secondary market, this action indirectly encourages more originations of new mortgages. 30. U.S. Treasury Bailout Plan. The U.S. Treasury attempted to resolve the credit crisis by establishing a plan to buy mortgage-backed securities held by financial institutions. Explain how the plan could improve the situation for mortgage-backed securities. ANSWER: The secondary market for mortgage-backed securities was inactive during the credit crisis, because of the high level of mortgage defaults. Investors were afraid to purchase these securities because of the risk involved. The Treasury’s purchase of the mortgage-backed securities corrected the imbalance (excessive supply) in the secondary market. 31. Assessing the Risk of MBS. Why do you think it is difficult for investors to assess the financial condition of a financial institution that has purchased a large amount of mortgage-backed securities? ANSWER: The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements. 32. Mortgage Information During the Credit Crisis. Explain why mortgage originators have been criticized for their behavior during the credit crisis. Should other participants in the mortgage securitization process have recognized that lack of complete disclosure in mortgages? ANSWER: This question that is intended to make students consider the process from the point mortgages are originated to the point at which investors purchase mortgage-backed securities. In general, there is clear evidence that some mortgage originators did not fully disclose the information that could have been used to assess risk. However, one might also argue that the investment banks who packaged the MBS, the ratings agencies who rated the MBS, the insurers who insured MBS, and institutional investors that purchased MBS should have recognized that the mortgage information was incomplete. 33. Short Sales. Explain how short sales work in the mortgage markets. Are short sales fair to homeowners? Are they fair to mortgage lenders? ANSWER: In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage. The lender appraises the home and informs the homeowner of the price it is willing to accept on the home. Lenders involved in this program do not recover the full amount owed on the mortgage. However, they may minimize their losses because they do not have to go through the foreclosure process, and the homeowners reduce the potential damage to their credit report.

Chapter 9: Mortgage Markets  8

Short sales serve as a reasonable compromise between homeowners and mortgage lenders, but student answers about fairness of short sales may vary substantially depending on their perspective. 34. Government Intervention in Mortgage Markets. The government intervened to resolve problems in the mortgage markets during the credit crisis. Summarize the advantages and disadvantages of the government intervention during the credit crisis. Should the government intervene when mortgage market conditions are very weak? ANSWER: Some government programs stabilized the market for mortgage-backed securities, and therefore helped the financial institutions that invested in them. To the extent that the government’s intervention stabilized the housing market, many homeowners benefitted. The government budget deficit increased due to the intervention, although one could argue that the deficit could have been worse due to a more pronounced crisis if the government did not intervene at all. Whether the government should intervene is an open-ended question intended to generate discussion and alternative perspectives. 35. Financial Reform Act and Credit Ratings of MBS. Explain how the Financial Reform Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies. ANSWER: The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. The agencies are also required to provide an annual report about their internal controls used to ensure an unbiased process of rating securities. The act also prevents the SEC from relying on ratings within its regulations, so that it has to use its own assessment of risk. CRITICAL THINKING QUESTION Regulation in Mortgage Markets. Many critics argue that greed in the mortgage markets caused the credit crisis. Yet, many market advocates suggest that greed is good, as the thirst for profits by firms that participate in mortgage markets allows for economic growth. Write a short essay on how regulations can allow for greed while also ensuring proper transparency in the mortgage markets so that another credit crisis does not occur. ANSWER: Many mortgage companies were viewed as greedy by granting mortgages to unqualified home buyers that could not afford the mortgage payments. The mortgages were commonly packaged and then rated by rating agencies for a profit. Then they were sold by securities firms for a profit. At each step along the way, the participants should have known that the packages of mortgages were very risky. The information about the mortgages was limited, as the application process for mortgages should have required much more disclosure by the home buyers. The securities firms that packaged and sold the mortgages should have required more information on the mortgages and should have disclosed more information about the mortgages. The rating agencies should have required more information about the mortgages. Greater transparency (along with stronger guidelines to qualify for a mortgage) should allow for the participants to make better decisions in the buying or selling of mortgages.

Chapter 9: Mortgage Markets  9

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “If interest rates continue to decline, the interest-only CMOs will take a hit.” When interest rates decline, mortgages are commonly prepaid, and the interest payments on those mortgages are terminated. Therefore, payments to investors holding the interest-only CMOs are terminated as well. b. “Estimating the proper value of CMOs is like estimating the proper value of a baseball player; the proper value is much easier to assess five years later.” The future value of a CMO is dependent on the future interest rate movements. Since interest rate movements are difficult to forecast, it is difficult to properly value a CMO. It would be easier to look back in time after recognizing how interest rates moved to determine what the value of the CMO should have been. c. “When purchasing principal-only (PO) CMOs, be ready for a bumpy ride.” The values of principal-only CMOs adjust abruptly to changes in interest rates. Therefore, they exhibit a high degree of volatility (risk) .

Managing in Financial Markets As a manager of a savings institution, you must decide whether to invest in collateralized mortgage obligations (CMOs). You can purchase interest-only (IO) or principal-only (PO) classes. You anticipate that economic conditions will weaken in the future and that government spending (and therefore government demand for funds) will decrease. a. Given your expectations, would IOs or POs be a better investment? POs would be a better investment. Given your expectations, interest rates are likely to decrease. This would result in mortgage prepayments, which causes interest payments on those mortgages to be terminated. Therefore, payments on the IOs are terminated as well. An investment in POs would result in accelerated payment of the principal during a period in which interest rates are declining, as mortgages are prepaid. b. Given the situation, is there any reason why you might not purchase the class of CMOs that you selected in the previous question? If you are not confident about the future interest rate movements, you may prefer to avoid any investment in CMO classes, because the returns on CMO classes are subject to a high degree of interest rate risk. c. Your boss suggests that the value of CMOs at any point in time should be the present value of their future payments. He says that since a CMO represents mortgages, its valuation should be simple. Why is your boss wrong?

Chapter 9: Mortgage Markets  10 CMOs are segmented into classes, and each class has a specific payback priority. Yet, the timing of the payback on any particular CMO class is uncertain, which makes it difficult to properly discount the future payments.

Problem 1. Monthly Mortgage Payment. Use an amortization table (go to www.bankrate.com and click on “amortization calculator” under “Mortgages” or use another online source) that determines the monthly mortgage payment based on a specific interest rate and principal with a 15-year maturity, and then for a 30-year maturity. Is the monthly payment for the 15-year maturity twice the amount as for the 30-year maturity, or less than twice the amount? Explain. ANSWER: The monthly mortgage payment on a 15-year mortgage is less than twice the payment on a 30-year mortgage, because the principal is paid off at a faster rate.

Flow of Funds Exercise Mortgage Financing Carson Company currently has a mortgage on its office building through a savings institution. It is attempting to determine whether it should convert its mortgage from an adjustable rate to a fixed rate. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The fixed rate that it would pays if it refinances is higher than the prevailing short-term rate, but lower than the rate it would pay from issuing bonds. a.

What macroeconomic factors could affect interest rates and therefore the company’s mortgage refinancing decision? Any indicators of economic growth, the budget deficit, and inflation would affect interest rates and therefore could influence the refinancing decision.

If Carson refinances its mortgage, it also must decide on the size of a down payment. If it uses more funds for a larger down payment, it will need to borrow more funds to finance its expansion. Should Carson use a minimum down payment or a larger down payment if it refinances the mortgage? Why? It should use a minimum down payment, because it can obtain long-term funds through the mortgage at a lower rate than if it issued bonds. Thus, it should obtain as much funding as possible from the mortgage so that it does not have to obtain as much funding from other sources in which the cost of funds is higher.

Who is indirectly providing the money that is used by companies such as Carson to purchase office buildings? That is, what is the source of the money that the savings institutions channel into mortgages come from? The money comes from individual depositors and is pooled by savings institutions to provide mortgage loans.

Chapter 9: Mortgage Markets  11

Solution to Integrative Problem for Part 3 Asset Allocation 1. The supply of available funds in the United States will decline. Given a smaller supply of funds in the United States, and the same demand for loanable funds, the equilibrium interest rate in the United States should rise. 2. If U.S. interest rates rise, the quantity of loanable funds demanded will decline. Consequently, the amount of spending by businesses and households will decline. If interest rates rise, the values of existing securities may decline because the required return by investors would have increased. 3. If the event causes a net decrease in the Japanese investment in U.S. Treasury securities, the Japanese demand for U.S. dollars is reduced, which should place downward pressure on the value of the dollar with respect to the Japanese yen. One may try to argue that once U.S. interest rates are higher, Japanese investment will flow back to the U.S. However, the case assumes that a flow of funds back to the U.S. will not occur for at least a few years. Currencies other than the Japanese yen may also be affected. Once U.S. interest rates rise, investors from other countries could attempt to capitalize on the high interest rates, which would place upward pressure on the value of the dollar against those currencies. 4. An increase in U.S. interest rates results in an increase in the required rate of return by U.S. investors on all types of securities. The market value of existing U.S. securities should decrease in response to the higher required rate of return. Yet, the prices of some securities will be affected more than others. For example, prices of bonds will be affected more than prices of money market securities. 5. If the U.S. economy weakens (in response to higher U.S. interest rates), the risk premium would increase, causing an even higher required rate of return on risky securities. This would further reduce the present value of risky securities. Thus, risky securities would be more adversely affected than risk-free securities with a similar maturity. A weaker economy also affects the expected cash flows to be received by a firm. The value of a stock is the discounted value of future cash flows. The value would not only be affected by a higher required rate of return (resulting from the higher interest rate and possibly a higher risk premium), but also by lower expected cash flows. 6. The answer is somewhat subjective. However, there is some rationale for prescribing only the minimum 20 percent to bonds, and to stocks. Both types of securities will be more adversely affected by the increased required rate of return than money market securities. Therefore, the remaining 60 percent of funds could be allocated to money market securities. 7. Investment in low-risk bonds and money market securities is more appropriate, since the risk premium is expected to increase, which will have a greater adverse impact on prices of riskier securities. 8. Based on expectations that the dollar will weaken against the yen and strengthen against other currencies, it may be feasible to invest in Japanese securities. In particular, it would be wise to invest

Chapter 9: Mortgage Markets  12 in the type of Japanese securities that will be purchased by Japanese investors who would have normally purchased U.S. Treasury securities. Investment in any type of Japanese securities should benefit from the expected appreciation of the yen (from a U.S. investor’s perspective). Japanese bonds would probably be a good investment because the expected increase in the supply of funds in Japan (resulting from the expected decrease in investment in U.S. Treasury securities) will place downward pressure in Japanese interest rates in the future. 9. An increase in the demand for loanable funds in the United States would also have placed upward pressure on U.S. interest rates. However, the impact on economic conditions could have been different, because the interest rates would have been driven by a strong demand, which reflects a high level of borrowing and spending. The equilibrium quantity of loanable funds would have been larger in this case. The bond prices would still be expected to decline because of the expectation of higher interest rates. However, there would not be an increase in the risk premium since economic conditions are still favorable.

Chapter 10 Stock Offerings and Investor Monitoring Outline Private Equity Financing by Venture Capital Funds Financing by Private Equity Funds Financing by Crowdfunding

Public Equity Ownership and Voting Rights How Stock Markets Facilitate Corporate Financing Participation in Stock Markets Secondary Market for Stocks Investor Reliance on Information

Initial Public Offerings Process of Going Public Underwriter Efforts to Ensure Price Stability Abuses in the IPO Market Long-Term Performance Following IPOs

Stock Offerings and Repurchases Secondary Stock Offerings Stock Repurchases

Stock Exchanges Organized Exchanges Over-the-Counter Market Extended Trading Sessions Stock Quotations Provided by Exchanges Stock Index Quotations Private Stock Exchanges Monitoring Publicly Traded Companies Role of Analysts Sarbanes-Oxley Act Shareholder Activism Limited Power of Governance Market for Corporate Control Use of LBOs to Achieve Corporate Control Barriers to the Market for Corporate Control

Chapter 10: Stock Offerings and Investor Monitoring  2

Globalization of Stock Markets Privatization Emerging Stock Markets Variation in Characteristics Among Stock Markets Methods Used to Invest in Foreign Stocks

Key Concepts 1. Explain the role of venture capital funds and private equity funds provide equity financing to firms. 2. Describe the process of an engaging in an initial public offering. 3. Describe the process of engaging in a secondary offering. 4. Explain how firms are monitored within the stock market.

POINT/COUNTER-POINT: Should a Stock Exchange Enforce Some Governance Standards on the Firms Listed on the Exchange? POINT: No. Governance is the responsibility of the firms, not the stock exchange. The stock exchange should simply ensure that the trading rules of the exchange are enforced and should not intervene in the firms’ governance issues. COUNTER-POINT: Yes. By enforcing governance standards such as requiring a listed firm to have a majority of outside members on its board of directors, a stock exchange can enhance its own credibility. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: An exchange and the listed firms can be viewed as more credible if there are governance standards. However, the credibility of an exchange is questionable if it cannot properly monitor itself properly (as was the case for the NYSE when the board allowed some excessive compensation to executives who managed the exchange).

Questions 1. Shareholder Rights. Explain the rights of common stockholders that are not available to other individuals. ANSWER: Common stockholders are permitted to vote on key matters concerning the firm such as the election of the board of directors, authorization to issue new shares of common stock, approval of amendments to the corporate charter, and adoption of by-laws. 2. Stock Offerings. What is the danger of issuing too much stock? What is the role of the securities firm that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?

Chapter 10: Stock Offerings and Investor Monitoring  3 ANSWER: The issuance of too much stock can cause dilution of ownership and can depress stock prices because the supply of stock may now exceed demand. Securities firms distribute or place stock for corporations. They serve as intermediaries since corporations issuing stock typically do not have the expertise to place their own stock. They have experience to know how much stock can be digested by the market. 3. IPOs. Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs in other periods? ANSWER: Firms engage in IPOs when they have feasible expansion plans but are already near their debt capacity. The transaction cost (fees) is normally about 7 percent of the gross proceeds received by the issuing firm. Firms prefer to engage in IPOs when business conditions and market conditions are favorable. They avoid IPOs if business conditions are poor, because they do not need funds to expand if the business outlook is poor. Also, when business conditions are poor, the market conditions are weak, meaning that they would have to sell their shares at a low price. 4. Venture Capital. Explain the difference between obtaining funds from a venture capital firm and engaging in an IPO. Explain how the IPO may serve as a means by which the venture capital firm can cash out. ANSWER: Before a firm engages in an IPO, it may obtain equity funding from a venture capital firm for a period of two to five years. An IPO allows other shareholders to invest in the equity of the firm. Venture capital firms tend to sell off their shares shortly after the firm engages in an IPO. After the shares are publicly traded, the venture capital firm may sell its shares in the secondary market. 5. Prospectus and Road Show. Explain the use of a prospectus developed before an IPO. Why does a firm do a road show before its IPO? What factors influence the offer price of stock at the time of the IPO? ANSWER: A prospectus specifies how the proceeds of the offering are to be used, the past performance of the issuing firm, the risk involved in the firm’s business, and the price range in which the shares will be offered. The firm does a road show to promote its offering. That is, it explains to various institutional investors how it will use the funds to support its expansion. The goal of the road show is to convince some large investors to invest in the shares of the firm. The offer price is influenced by market conditions, industry conditions, and the prevailing market multiples (such as price/earnings ratio). Firms prefer to engage in an IPO when market conditions allow for a high offer price. 6. Bookbuilding. Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a means of setting the offer price?

Chapter 10: Stock Offerings and Investor Monitoring  4 ANSWER: The lead underwriter engages in bookbuilding by soliciting indications of interest in the IPO by institutional investors, so as to determine demand. The bookbuilding process used in the United States is sometimes criticized because it dictates an offer price that is lower than what some institutional investors would pay. 7. Lockups. Describe a lockup provision and explain why it is required by the lead underwriter. ANSWER: Describe the pressure of the share price at the lockup expiration date. The lockup provision restricts insiders and venture capital firms from selling their shares until a specified period (usually 6 months) after the IPO. Once the lockup provision expires, the insiders and venture capital firms can sell the shares that they own, which sometimes places downward pressure on the price of the stock at that time. 8. Initial Return. What is the meaning of an initial return for an IPO? ANSWER: The initial return is the return from the offer price until the end of the first day of trading. 9. Flipping. What does it mean to “flip” shares? Why would investors want to flip shares? ANSWER: Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them at the IPO. Some institutional investors attempt to flip shares to take advantage of an initial return over the first day. IPO performance tends to be unusually high on the first day, followed by a downward drift. Some investors want to earn the initial return and then sell out. They may earn a very high return without tying their funds up for a long period of time. 10. Performance of IPOs. How do IPOs perform over the long run? ANSWER: IPOs perform poorly on average when compared to other firms over the long-term period. 11. Asymmetric Information. Discuss the concept of asymmetric information. Explain why it may motivate firms to repurchase some of their stock. ANSWER: Asymmetric information may allow a firm’s managers to realize when its stock is undervalued, and they may repurchase shares at that time. 12. Stock Repurchases. Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares. ANSWER: Stock repurchases may signal that the firm’s managers believe the stock is undervalued, so the investors may purchase the stock based on this signal, and that places upward pressure on the stock price. 13. Corporate Control. Describe how the interaction between buyers and sellers affects the market value of a firm and explain how that value can subject a firm to the market for corporate control. ANSWER: If a firm’s business performance is weak, investor demand for shares will typically be weak, and the firm’s stock price will be weak. Another firm’s managers may consider purchasing the weak firm at its prevailing weak price, and then improving that firm’s performance by replacing managers and reorganizing that firm. Managers of the weak firm have an incentive to improve their firm to prevent the firm from being acquired.

Chapter 10: Stock Offerings and Investor Monitoring  5

14. ADRs. Explain how ADRs enable U.S. investors to become part owners of foreign companies. ANSWER: American depository receipts (ADRs) are certificates that represent ownership of a foreign stock. They are traded in the United States. U.S. investors can purchase ADRs as a method of investing in foreign securities. 15. NYSE. Explain why stocks traded on the NYSE generally exhibit less risk than stocks that are traded on other exchanges. ANSWER: Stocks traded on the NYSE tend to represent larger firms. These stocks also have a large trading volume, which enhances their liquidity. 16. Role of Organized Exchanges. Are organized stock exchanges used to place newly issued stock? Explain. ANSWER: Organized exchanges are used to facilitate secondary market transactions. They are not used to place newly issued stock.

Advanced Questions 17. Role of IMFs. How have international mutual funds (IMFs) increased the international integration of capital markets among countries? ANSWER: International mutual funds (IMFs) have allowed investors easy access to foreign securities, since the firm sponsoring the IMFs makes the portfolio decisions and executes the transactions. Even small investors can easily invest in foreign securities by purchasing shares of IMFs. Consequently, international capital markets have become more integrated. 18. Spinning and Laddering. Describe spinning and laddering in the IPO market. How do you think these actions influence the price of a newly issued stock? Who is adversely affected as a result of these actions? ANSWER: Spinning is the process in which an investment bank allocates shares from an IPO to corporate executives who may be considering an IPO or other business that would require the help of an investment bank. Laddering involves investors placing bids for IPO shares on the first day that are above the offer price. Laddering ultimately results in upward price momentum, which may or may not accurately reflect the fair value of the underlying stock. If spinning occurs at favorable stock prices, this may keep the stock price from achieving its fair value. The initial owners of the firm may be adversely affected because the firm may not receive as much proceeds from the IPO due to spinning and laddering. Spinning may result in shares sold at a lower than market price. Laddering might only occur if there is an unusually strong demand for the shares. If there is such a strong demand, the IPO price must be too low. 19. Impact of Accounting Irregularities. How do you think accounting irregularities affect the pricing of corporate stock in general? From an investor’s viewpoint, how do you think the information used to price stocks changes in response to accounting irregularities? © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 10: Stock Offerings and Investor Monitoring  6

ANSWER: Generally speaking, accounting irregularities introduce additional uncertainty and risk. Consequently, investors would require a higher rate of return, which would result in a lower stock price. The existence of accounting irregularities probably results in closer scrutiny of financial statements for investors. Furthermore, investors will probably seek additional sources of information and opinions in addition to the firm’s financial statements as part of their decision-making process. 20. Impact of Sarbanes-Oxley Act. Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss how this act affects the monitoring performed by shareholders. ANSWER: The Sarbanes-Oxley Act: 1) Prevents a public accounting firm from auditing a client firm whose employees were employed by the client firm within one year prior to the audit. 2) Requires that only outside board members of a firm be on the firm’s audit committee. 3) Prevents the members of a firm’s audit committee from receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board. 4) Requires that the CEO and CFO of firms that are of at least a specified size level to certify that the audited financial statements are accurate. 5) Specified major fines or imprisonment for employees who mislead investors or hide evidence. 6) Prevents public accounting firms from offering non-audit services to an audit client if the client’s audit committee pre-approves the non-audit services to be rendered before the audit begins. The Act prevents accounting irregularities by firms and should improve the ability of shareholders to monitor firms. 21. IPO Dilemma. Denton Co. plans to engage in an IPO and will issue 4 million shares of stock. It is hoping to sell the shares for an offer price of $14. It hires a securities firm, which suggests that the offer price for the stock be $12 per share to ensure that all the shares can be easily sold. Explain the dilemma here for Denton Co. What is the advantage of following the securities firm’s advice? What is the disadvantage? Is the securities firm’s incentive to place the shares aligned with that of Denton Co.? ANSWER: The advantage is that Denton Co. wants to have a successful offering in which it can sell all of its shares, and it wants investors to believe that they made a good investment. This could help Denton engage in a secondary offering at some point in the future when it needs to raise more funds. The disadvantage of using an offer price of $12 instead of $14 is that Denton gives up $2 per share, and therefore may receive $8 million less in proceeds from selling the stock. The securities firm wants to place all the shares for Denton. However, it does not suffer the loss in proceeds when it lowers the offer price, although its fees from performing the underwriting function may be reduced slightly. In addition, the underwriter can benefit when institutional investors invest in shares at a low price and earn high returns, because they may subscribe to future offerings by the investment bank. Denton understands that the securities firm needs to set the offer price low enough to attract enough investors to sell the entire number of shares, but any discount beyond that point may be perceived as “leaving money on the table.” When investors buy a stock at an IPO for less than its fundamental value, they gain at the expense of the firm that issued the stock.

Chapter 10: Stock Offerings and Investor Monitoring  7 22. Variation in Investor Protection among Countries. Explain how shareholder protection varies among countries. Explain how enforcement of securities laws varies among countries. Why do these characteristics affect the valuations of stocks? ANSWER: Shareholders in some countries have more voting power and can have a stronger influence on management of corporations. The legal protection of shareholders also varies substantially among countries. Shareholders in some countries can more effectively sue publicly traded firms if their executives or directors commit financial fraud. In general, common law countries such as the U.S., Canada, and the United Kingdom allow for more legal protection than civil law countries such as France or Italy. If a country has securities laws but no enforcement, the laws are useless. Investors have more power to ensure that management serves their interests if they have more protection, and therefore can ensure that managers make decisions that are intended to maximize the firm’s value. 23. International ETFs. Describe international ETFs and explain how ETFs are exposed to exchange rate risk. How do you think an investor decides whether to purchase an ETF representing Japan, Spain, or some other country? ANSWER: Exchange-traded funds are passive funds that track a specific index. By investing in an international exchange-traded fund, investors can invest in a specific index representing a foreign country’s stock market. The ETFs are denominated in dollars. However, the net asset value of an international ETF is determined by translating the foreign currency value of the foreign securities into dollars. Thus, a weaker foreign currency will reduce the net asset value in dollars. The decision to purchase a specific ETF for a specific country is based on expected return and risk, which may be determined based on an assessment of the country’s economic and political conditions, and the expectations about whether its local currency will weaken (which reduces the net asset value of the ETF). 24. VC Fund Participation and Exit Strategy. Explain how venture capital (VC) funds finance private businesses, as well as how they exit from their participation in a firm. ANSWER: VC funds review proposals by private businesses that need funding. If they provide the business with an equity investment, they may attempt to exit about 4 or 7 years later by selling its equity stake to the public after the business engages in a public stock offering. Many VC funds sell their shares of the businesses in which they invest during the first 6 to 24 months after the business goes public. Alternatively, the VC fund may cash out if the company is acquired by another firm, as the acquirer will purchase the shares owned by the VC fund. 25. Dilemma of Stock Analysts. Explain the dilemma of stock analysts who work for securities firms and assign ratings to large corporations. Why might they prefer not to assign low ratings to weak but large corporations? ANSWER: Although analysts can provide useful information for investors, they have historically been very generous when rating stocks. In the past, the bonuses paid to analysts were sometimes based on how much business they generated for their employer and not on the accuracy of their stock ratings. Stock exchange rules prevent such forms of compensation to analysts now. Yet, analysts are in an awkward situation when assigning low ratings to a corporation. If the corporation wants to hire

Chapter 10: Stock Offerings and Investor Monitoring  8 a securities firm to help it places new shares of stock or merge with another firm, it is unlikely to hire the securities firm whose analyst assigned it a low rating. 26. Limitations of an IPO. Businesses valued at less than $50 million or so rarely go public. Explain the limitations to such businesses if they did go public. ANSWER: A public offering of stock may be feasible only if the firm will have a large enough shareholder base to support an active secondary market. With an inactive secondary market, the shares would be illiquid. Investors who own shares and want to sell them would be forced to sell at a discount from the fundamental value, almost as if the firm were not publicly traded. This defeats the purpose of being public. 27. Private Equity Funds. Explain the incentive for private equity funds to invest in a firm and improve its operations. ANSWER Managers of a private equity fund typically take a percentage of the profits they earn from their investments in return for managing the fund. They also charge an annual fee for managing the fund. If they were able to improve the business substantially while they managed it, they should be able to sell their stake to another firm for a much higher price than they paid for it. Alternatively, they may be able to take the business public through an initial public offering (IPO) and cash out at that time. 28. VCs and Lockup Expiration Following IPOs. Venture capital firms commonly attempt to cash out as soon as possible following IPOs. Describe the likely effect that would have on the stock price at the time of lockup expiration. Would the effect be different for a firm that relied more heavily on VC firms than on other investors for its funds? ANSWER: If many VC firms are selling their shares at lockup expiration, there is downward pressure on the stock price. The downward pressure might be especially pronounced for firms that received a proportionately large amount of funding from VC firms before they went public. 29. Impact of SOX on Going Private. Explain why some public firms decided to go private in response to the passage of the Sarbanes-Oxley (SOX) Act. ANSWER: For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per year. Many small, publicly traded firms decided to revert back to private ownership as a result of the act. These firms perceived that they would have a higher value if they were private, rather than publicly held, because they could eliminate the substantial reporting costs required of publicly traded firms. 30. Pricing Facebook’s IPO Stock Price. Describe the dilemma of securities firms that served as underwriters for Facebook’s IPOs, when attempting to satisfy Facebook and the institutional investors that invested in Facebook’s stock. Do you think that the securities firms satisfied Facebook or its investors in the IPO? Explain. ANSWER: Based on the stock price movements over the first few months after the IPO, one may argue that Facebook benefitted to a greater degree than its institutional investors. The stock price declined by about 50% within a few months after the IPO. These results suggest that the stock price was set too high at the time of the IPO. The investors paid that price, while Facebook received that price, so Facebook gained while investors lost. However, the stock price of Facebook rose

Chapter 10: Stock Offerings and Investor Monitoring  9 substantially by 2015, so the underwriters could argue that the stock price might not have been set too high at the time of the IPO. 31. Private Stock Market. What are some possible disadvantages to investors who invest in stocks listed on a private stock market? ANSWER: Investors need to register with the private stock exchange and prove that they have sufficient income (such as about $200,000 per year) and sufficient net worth (such as at least $1 million). Second, there is limited transparency because the required disclosure of information by private firms listed on private stock exchanges may be less than what is required when firms go public. Firms are required to have their financial statements audited when their shares are publicly traded. Third, the trading volume in a private stock market is very limited. With such limited participation by investors, it is difficult to determine the appropriate market price. 32. Use of Financial Leverage by Private Equity Funds Explain why private equity funds use a very high degree of financial leverage, and how this affects their risk and potential return on investment. ANSWER: Private equity funds tend to rely heavily on borrowing to finance their investments. This enables them to purchase larger companies or to buy more businesses with a given level of equity. Their use of financial leverage also magnifies the return that they earn on their equity investment. However, if they incur a loss on their investment, the loss will be magnified (will reflect a larger proportion of their equity) as a result of using a high degree of financial leverage. For many IPOs, the lead underwriter has an overallotment option, in which it can allocate an additional 15 percent of the firm’s shares for a period of up to 30 days after the IPO. This option is also referred to as the Greenshoe option, in reference to the Green Shoe Manufacturing Co. for whom this option was first applied to during its IPO in 1960. For example, Twitter’s IPO was initially planned for 70 million shares, but its lead underwriter was allowed to sell an additional 10.5 million shares (15% of the original plan). Many issuers do not mind issuing additional shares at the time of their IPO if they can do so without causing a decline in the stock price, and if they can make good use of the extra cash that they will receive. 33. Overallotment Option in IPOs. Explain how underwriters use the overallotment option in IPOs. ANSWER: The overallotment option gives the lead underwriter the right to purchase those extra shares from the issuing firm at the IPO offer price. A lead underwriter who has an overallotment option issues the additional shares to investors at the offer price, so it does not gain or lose from issuing these shares but earns a commission on the extra shares that are sold. If the market price of the stock declines below the offer price, the lead underwriter purchases all or a portion of the extra shares at a lower price than the offer price in which it initially sold those shares. The underwriter’s actions can stabilize the stock price. 34. Designated Market Maker on NYSE. Describe the role of the designated market maker on the New York Stock Exchange. ANSWER: © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 10: Stock Offerings and Investor Monitoring  10 In 2008, the specialist was replaced with the designated market maker (DMM). The DMMs can match orders of buyers and sellers. In addition, they can buy or sell stock for their own account and thereby create more liquidity for the stock. They are required to maintain an orderly market by accommodating orders requested by investors. They stand ready to buy or sell shares of the stock to which they are assigned, and for this reason, they are sometimes referred to as liquidity providers. There is one designated market maker per listed stock on the NYSE.

CRITICAL THINKING QUESTION Valuations of IPOs. Write a short essay explaining why there is so much uncertainty surrounding the valuation of a firm that is engaged in an IPO. Why do you think some investors overvalue firms at the time of their IPO? ANSWER Firms that pursue IPOs tend to be young firms that have grown substantially in recent years and need additional funding to support their growth. The valuation of a company is highly dependent on how much it grows over time. Yet, the growth rate is subject to much uncertainty. Some investors are caught up in the hype surrounding a firm that is going public. They presume that the firm will continue its growth without recognizing the possible exposure to problems in the future. If the company continues to grow at a very high rate, it may deserve a very high valuation. However, astute investors will question whether such growth can be sustained over a long-term period. Other competitors may enter the market and take some of the market share. The management of the company might be less effective when the managers are employees of the public company, as opposed to when the company was privately owned.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers: a. “The recent wave of IPOs is an attempt by many small firms to capitalize on the recent run-up in stock prices.” Firms prefer to go public when stock market conditions are favorable so that they can benefit from high valuations in the market. Their stock will sell for a higher price if the prices of other similar publicly traded firms are high. b. “IPOs transfer wealth from unsophisticated investors to large institutional investors who get in at the offer price and get out quickly.” Some institutional investors invest in IPOs at the offer price, and then quickly sell (flip) their shares to individual investors who were not able to buy shares at the offer price. The individual investors pay a much higher price and the long-term performance of IPOs is poor, especially for individual investors who pay the price that exists a day of two after the IPO. Thus, the institutional investors gain while the individual investors lose.

Chapter 10: Stock Offerings and Investor Monitoring  11 c. “Firms must be more accountable to the market when making decisions because they are subject to indirect control by institutional investors.” If a firm performs poorly, the institutional investors with a large stake in that firm may engage in shareholder activism to improve the firm’s performance.

Managing in Financial Markets As a portfolio manager of a financial institution, you are invited to numerous road shows at which firms that are going public promote themselves, and the lead underwriter invites you to invest in the IPO. Beyond any specific information about the firm, what other information would you need to decide whether to invest in the upcoming IPO? Market conditions should be assessed. As stock market conditions change, valuations change. In addition, industry conditions change over time, which affect valuations of firms within a particular industry.

Problem 1. Dividend Yield. Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend yield for Calzone stock? ANSWER: Dividend yield =

Flow of Funds Exercise Contemplating an Initial Public Offering (IPO) Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate this increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year. a. If Carson issued stock now, it would have the flexibility to obtain more debt and would also be able to reduce its cost of financing with debt. Why? If Carson supports some of its growth with stock, it changes its capital structure to include more equity that does not require a cash outflow (no interest payments). Thus, it can more easily cover its debt payments. In addition, financial institutions would be more willing to provide more credit because Carson has more equity to support its business and is less likely to default on debt.

Chapter 10: Stock Offerings and Investor Monitoring  12 b. Why would an IPO result in heightened concerns in financial markets about Carson Company’s potential agency problems? When the firm is publicly owned, management is at least partially separated from ownership. Managers are agents who are supposed to be serving shareholder interests. Yet, the managers may be tempted to make decisions that are in their own best interests rather than maximize shareholder wealth. If there are agency problems, the firm’s performance may suffer, and its stock price would be reduced. Shareholders who own stock are adversely affected by agency problems. c. Explain why institutional investors such as mutual funds and pension funds that invest in stock for long-term periods (at least a year or two) may prefer to invest in IPOs rather than to purchase other stocks that have been publicly traded for several years? Institutional investors may believe that the market does not properly price newly issued stock, and they can capitalize on this discrepancy by investing in IPOs. d. Given that institutional investors such as insurance companies, pension funds, and mutual funds are the major investors in IPOs, explain the flow of funds that results from an IPO. That is, what is the original source of the money that is channeled through the institutional investors and provided to the firm going public? The money invested by insurance companies comes from insurance premiums paid by policyholders. The money invested by pension funds comes from retirement accounts of employees and their respective employers. The money invested by mutual funds comes from shareholders who want the mutual fund to invest their money.

Chapter 11 Stock Valuation and Risk Outline Stock Valuation Methods Price-Earnings (PE) Method Dividend Discount Model Adjusted Dividend Discount Model Free Cash Flow Model

Required Rate of Return on Stocks Capital Asset Pricing Model

Factors That Affect Stock Prices Economic Factors Market-Related Factors Firm-Specific Factors Tax Effects Integration of Factors Affecting Stock Prices Gaining an Edge in the Valuation Process

Stock Risk Volatility of a Stock Beta of a Stock Value at Risk

Measuring Risk-Adjusted Stock Performance Sharpe Index Treynor Index

Stock Market Efficiency Forms of Stock Market Efficiency Tests of the Efficient Market Hypothesis

Foreign Stock Valuation and Performance Valuation of Foreign Stocks International Market Efficiency Measuring Performance from Investing in Foreign Stocks Performance from Global Diversification

Chapter 11: Stock Valuation and Risk  2

Key Concepts 1. Explain stock valuation models. 2. Explain how to assess the risk of stocks and stock portfolios.

POINT/COUNTER-POINT: Is The Stock Market Efficient? POINT: Yes. Investors fully incorporate all available information when trading stocks. Thus, the prices of stocks fully reflect all information. COUNTER-POINT: No. The high degree of stock price volatility offers evidence of how much disagreement there is among stock prices. The fact that many stocks declined by more than 40 percent over a few months in some periods suggests that stock prices are not always properly valued to reflect available information. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: There is no perfect answer, and there are valid arguments for and against whether markets are efficient. However, an abrupt decline of stock prices does not refute market efficiency. If new information about stock market conditions (such as a weakening economy) occurs, prices could possibly fully reflect all information and yet adjust abruptly as the new information becomes available.

Questions 1. Price-Earnings Model. Explain the use of the price-earnings (PE) ratio for valuing a stock. Why might investors derive different valuations for a stock when using the price-earnings method? Why might investors derive an inaccurate valuation of a firm when using the price-earnings method? ANSWER: Investors can value a stock by applying the industry PE ratio to the firm’s expected earnings for the next year. This method implicitly assumes that the growth in earnings in future years will be similar to that of the industry. This method has several variations, which can result in different valuations. For example, investors may use different forecasts for the firm’s earnings or the mean industry earnings over the next year. The previous year’s earnings are often used as a base for forecasting future earnings, but the recent year’s earnings do not always provide an accurate forecast of the future. A second reason for different valuations when using the PE method is that investors disagree on the proper measure of earnings. Some investors prefer to us operating earnings or exclude some unusually high expenses that result from one-time events. A third reason is that investors may disagree on the firms that should represent the industry norm. Some investors use a narrow industry composite composed of firms that are very similar (in terms of size, lines of business, etc.) to the firm being valued; other investors prefer a broad industry composite. Consequently, even if investors agree on a firm’s forecasted earnings, they may still derive different values for that firm as a result of

Chapter 11: Stock Valuation and Risk  3 applying different PE ratios. Furthermore, even if investors agree on the firms to include, they may disagree on how to weight each firm. 2. Dividend Discount Model. Describe the dividend discount valuation model. What are some limitations when using this model? ANSWER: The dividend discount valuation model measures the value of a firm as the present value of future expected dividends to be received by the investor. The model can account for uncertainty by allowing dividends to be revised in response to revised expectations about a firm’s cash flows, or by allowing the required rate of return to be revised in response to changes in the required rate of return by investors. The dividend discount model may result in an inaccurate valuation of a firm because of potential errors in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this model are more pronounced when valuing firms that retain most of their earnings rather than distribute them as dividends, because the model relies on the dividend as the base for applying the growth rate. For example, many Internet-related stocks retain any earnings to support growth and thus are not expected to pay any dividends. 3. Impact of Economic Growth. Explain how economic growth affects the valuation of a stock. ANSWER: The firm’s value should reflect the present value of its future cash flows. Because earnings are a primary component of corporate cash flows, many investors use forecasted earnings to determine whether a firm’s stock is over- or undervalued. 4. Impact of Interest Rates. How are the interest rate, the required rate of return on a stock, and the valuation of a stock related? ANSWER: Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate. The relation between interest rates and stock prices is not constant over time. However, most of the largest stock market declines have occurred in periods when interest rates increased substantially. Furthermore, the stock market’s rise in the late 1990s is partially attributed to the low interest rates during that period, which encouraged investors to shift from debt securities (with low rates) to equity securities. 5. Impact of Inflation. Assume that the expected inflation rate has just been revised upward by the market. Would that change affect the required return by investors who invest in the stocks? Explain. ANSWER: An increase in expected inflation can increase the risk-free interest rate, which is a key component of the required rate of return on stocks. Therefore, it should cause an increase in the required rate of return on stocks. 6. Impact of Exchange Rates. Explain how the value of the dollar affects stock valuations. ANSWER: The value of the dollar can affect U.S. stock prices for a variety of reasons. First, foreign investors tend to purchase U.S. stocks when the dollar is weak and sell them when it is near its peak. Thus, the foreign demand for any given U.S. stock may be higher when the dollar is expected to strengthen, other things being equal. Also, stock prices are affected by the impact of the dollar’s changing value on cash flows. Stock prices of U.S. firms primarily involved in exporting could be

Chapter 11: Stock Valuation and Risk  4 favorably affected by a weak dollar and adversely affected by a strong dollar. U.S. importing firms could be affected in the opposite manner. Stock prices of U.S. companies may also be affected by exchange rates if stock market participants measure performance by reported earnings. A multinational corporation’s consolidated reported earnings will be affected by exchange rate fluctuations even if the company’s cash flows are not affected. A weaker dollar tends to inflate the reported earnings of a U.S.-based company’s foreign subsidiaries. Some analysts argue that any effect of exchange rate movements on financial statements is irrelevant unless cash flows are also affected. The changing value of the dollar can also affect stock prices by affecting expectations of economic factors that influence the firm’s performance. For example, if a weak dollar stimulates the U.S. economy, it may enhance the value of a U.S. firm whose sales are dependent on the U.S. economy. A strong dollar could adversely affect such a firm if it dampens U.S. economic growth. Because inflation affects some firms, a weak dollar value could indirectly affect a firm’s stock by putting upward pressure on inflation. A strong dollar would have the opposite indirect impact. 7. Investor Sentiment. Explain why investor sentiment can affect stock prices. ANSWER: Investor sentiment represents the general mood of investors in the stock market. Since the stock valuations reflect expectations, there are some periods in which the stock market performance is not highly correlated with existing economic conditions. For example, stock prices may rise when the economy is weak if most investors expect that the economy will improve in the near future. 8. January Effect. Describe the January effect. ANSWER: Because many portfolio managers are evaluated over the calendar year, they tend to invest in riskier small stocks at the beginning of the year and shift to larger (more stable) companies near the end of the year to lock in their gains. This tendency places upward pressure on small stocks in January of every year, causing the so-called January effect. 9. Earnings Surprises. How do earnings surprises affect valuations of stocks? ANSWER: Favorable earnings surprises increase the values of stocks. Negative earnings surprises decrease the values of stocks. 10. Impact of Takeover Rumors. Why can expectations of an acquisition affect the value of the target’s stock? ANSWER: The expected acquisition of a firm typically results in an increased demand for the target’s stock and therefore raises the stock price. Investors recognize that the target’s stock price will be bid up once the acquiring firm attempts to acquire the target’s stock.

11. Emerging Markets. hat are the risks of investing in stocks in emerging markets? ANSWER: Stocks in emerging markets are more exposed to major government turnover and other forms of political risk. They also expose U.S. investors to a high degree of exchange rate risk because their local currencies are typically very volatile. 12. Stock Volatility During the Credit Crisis. Explain how stock volatility changed during the credit crisis of 2008-2009. ANSWER: Stock prices became much more volatile due to uncertainty about economic conditions. The prices of some stocks were frequently changing by more than 5 percent on a single day.

Chapter 11: Stock Valuation and Risk  5

13. Stock Portfolio Volatility. Identify the factors that affect a stock portfolio’s volatility and explain their effects. ANSWER: A stock portfolio has more volatility when its individual stock volatilities are high, other factors held constant. In addition, a stock portfolio has more volatility when its individual stock returns are highly correlated, other factors held constant. A stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because the stocks will not experience peaks and troughs simultaneously. Some offsetting effects will occur, smoothing the returns of the portfolio over time. 14. Beta. Explain how to estimate the beta of a stock. Explain why beta serves as a measure of the stock’s risk. ANSWER: The beta of a stock can be estimated by obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive the slope coefficient as in this model: Rjt = B0 + B1Rmt + ut where

Rjt = return of stock j in time t Rmt = market return B0 = intercept B1 = regression coefficient that serves as an estimate of beta ut = error term

Some investors or analysts prefer to use monthly returns rather than quarterly returns to estimate the beta. The choice is dependent on the holding period for which one wants to assess sensitivity. If the goal is to assess sensitivity to monthly returns, then monthly data would be more appropriate. The regression analysis estimates the intercept (B0) and the slope coefficient (B1), which serves as the estimate of beta. Beta serves as a measure of the stock’s risk because it measures sensitivity to the market. The higher the sensitivity, the more likely that the stock will perform poorly under adverse market conditions. 15. Wall Street. In the movie Wall Street, Bud Fox is a broker who conducts trades for Gordon Gekko’s firm. Gekko purchases shares of firms that he believes are undervalued. Various scenes in the movie offer excellent examples of concepts discussed in this chapter. a. Bud Fox makes the comment to Gordon Gekko that a firm’s breakup value is twice its market price. What is Bud suggesting in this statement? How would employees of the firm respond to Bud’s statement? ANSWER: Bud is suggesting that the firm could be acquired and separated into divisions and sold to various firms. The combined value of the individual divisions (when sold) would be worth more than

Chapter 11: Stock Valuation and Risk  6 the firm’s prevailing market value. Employees of a firm are concerned about comments like this because it means that they may subject to reorganization (although some employees might benefit from this). b. When Bud informs Gekko that another investor, Mr. Wildman, is secretly planning to acquire a target firm in Pennsylvania, Gekko tells Bud to buy a large amount of this stock. Why? ANSWER: Gekko wants to accumulate much of the stock before Mr. Wildman attempts to acquire the target. In this way, Wildman will need to purchase stock from Gekko at a premium to obtain those shares held by Gekko. This strategy is known as greenmail. c. Gekko says “Wonder why fund managers can’t beat the S&P 500? Because they are sheep.” What is Gekko’s point? How does it relate to market efficiency? ANSWER: Gekko is implying that all fund managers use the same type of information, which is already known by the market. The market prices should already reflect that information. Gekko focuses on obtaining information that is not known by the market to outperform other investors in the market. 16. Market Efficiency. Explain the difference between weak-form, semistrong-form, and strong-form efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be refuted? Explain how to test weak-form efficiency in the stock market. ANSWER: The weak form suggests that security prices reflect recent price movements and trading information. The semistrong form suggests that security prices reflect all publicly traded information. The strong form suggests that security prices reflect public and private information. Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices. If future price movements can be predicted by assessing the past movements, a market inefficiency is detected. 17. Market Efficiency. A consulting firm was hired to determine whether a particular trading strategy could generate abnormal returns. The strategy involved taking positions based on recent historical movements in stock prices. The strategy did not achieve abnormal returns. Consequently, the consulting firm concluded that the stock market is weak-form efficient. Do you agree? Explain. ANSWER: Students have their own opinions, but a test of one strategy does not allow for a definite conclusion that weak-form efficiency exists. Some other strategy may still achieve abnormal returns.

Advanced Questions 18. Value at Risk. Describe the value-at-risk method for measuring risk. ANSWER: Value at risk is a risk measurement that estimates the largest expected loss to a particular investment position for a specified confidence level. It is intended to warn investors about the potential maximum loss that could occur. If the investors are uncomfortable with the potential loss that could occur in a day or a week, they can revise their investment portfolio to make it less risky. The value at risk is also commonly used to measure the risk of a portfolio. Some stocks may be perceived to have high risk when assessed individually, but low risk when assessed as part of a

Chapter 11: Stock Valuation and Risk  7 portfolio. This is because the likelihood of a large loss in the portfolio is influenced by the probabilities of simultaneous losses in all of the component stocks for the period of concern. 19. Implied Volatility. Explain the meaning and use of implied volatility. ANSWER: Investors can derive the stock’s implied standard deviation (ISD) from the stock option pricing model. The premium on a call option for a stock is dependent on factors such as the relationship between the current stock price and the exercise (strike) price of the option, the number of days until the expiration date of the option, and the anticipated volatility of the stock price movements. There is a formula for estimating the call option premium based on various factors. The actual values of these factors are known, except for the anticipated volatility. However, by plugging in the actual option premium paid by investors for that specific stock, it is possible to derive the anticipated volatility level. Participants may use this measurement as their own forecast of that specific stock’s volatility. 20. Leveraged Buyout. At the time that a management group of RJR Nabisco initially considered engaging in a leveraged buyout, RJR’s stock price was less than $70 per share. Ultimately, RJR was acquired by the firm Kohlberg, Kravis, and Roberts (KKR) for about $108 per share. Does the large discrepancy between the stock price before an acquisition was considered versus after the acquisition mean that RJR’s price was initially undervalued? If so, does this imply that the market was inefficient? ANSWER: The stock price may have been appropriate under the conditions of unchanged management. However, when management is changed in a manner that will reduce the waste and improve cash flows, the firm’s value increases, and investors revalue the stock higher. Thus, the market could still be efficient even though there was a discrepancy in price. 21. How Stock Prices May Respond to Prevailing Conditions. Consider the prevailing conditions that could affect the demand for stocks, including inflation, the economy, the budget deficit, and the Fed’s monetary policy, political conditions, and the general mood of investors. Based on prevailing conditions, do you think stock prices will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on stock prices? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 22. Application of the CAPM to Stock Pricing. Explain (using intuition instead of math) why stock prices may decrease in response to a higher risk-free rate according to the CAPM. In some periods, the risk-free rate rises in response to higher economic growth. Explain (using intuition instead of math) why stock prices may increase in this situation even though the risk-free rate increases. ANSWER: When the risk-free rate rises, the required rate of return rises, and therefore expected cash flows generated by the stock are discounted at a higher discount rate, which results in a lower value. If the economic growth increases, there may be an increase in expected cash flows. This favorable effect can overwhelm the unfavorable effect of a rise in the discount rate used to discount cash flows.

Chapter 11: Stock Valuation and Risk  8 23. Impact of SOX on Stock Valuations. Use a stock valuation framework to explain why the SarbanesOxley Act (SOX) could improve the valuation of a stock. Why might SOX cause a reduction in the valuation of a stock? (See the chapter appendix). ANSWER: The Sarbanes-Oxley Act of 2002 was intended to improve the reporting of financial statements. It may allow firms to detect problems that they would not have recognized otherwise, so that they can increase their cash inflows. However, the costs of complying with SOX result in higher cash outflows. 24. Interpretation of VIX. Explain why participants in the stock market monitor the VIX index. What does a decline in VIX imply about a change in expected volatility by market participants? ANSWER: At a given point in time, VIX measures investor’s expectation of the stock market volatility over the next 30 days. Some investors refer to VIX as an indicator of stock market fear. As VIX decreases, it indicates a lower expected level of stock market volatility. Since VIX simply measures the expectations of investors in general, it will not necessarily provide a perfectly accurate forecast of the stock market volatility over the next 30 days. Nevertheless, many investors may believe that it is a useful indicator of expected stock market volatility. CRITICAL THINKING QUESTION Credit Crisis versus Equity Crisis The credit crisis that occurred in 2008-2009 could also be called an equity crisis due to systemic risk. Write a short essay to explain the impact of the credit markets on the equity markets during the crisis. ANSWER The credit crisis was triggered by large defaults of debt securities (especially mortgages), which caused major losses to the financial institutions that provide debt financing. Consequently, many of these types of institutions were no longer willing to provide debt financing. As credit markets dried up, many corporations could not obtain funding to expand or even to support their existing operations. In addition, individuals could not obtain financing to make purchases. Consequently, the general level of spending declined substantially, and corporation revenue and profits declined as well. This led to a sharp decline in the valuations of corporations, as reflected in a large decline in the prices of their stocks.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “The stock market’s recent climb has been driven by falling interest rates.” The value of a stock may be measured as the present value of future cash flows provided to investors. The present value is increased when using a lower discount rate. If interest rates decline, the required rate of return by investors declines, and so does the discount rate used to value stocks.

Chapter 11: Stock Valuation and Risk  9 b. “Future stock prices are dependent on the Fed’s policy meeting next week.” The Fed’s monetary policy affects the values of stocks in various ways. First, it can affect economic conditions, which affect the cash flow generated by a firm. Second, the Fed’s monetary policy can affect the interest rates, which affect the discount rate used as the required rate of return when valuing stocks. c. “Given a recent climb in stocks that cannot be explained by fundamentals, a correction is inevitable.” The recent climb in stocks occurred without any fundamental change in the performance of firms. Stock prices will revert because there is no reason for their climb, and once investors recognize this, they will sell stocks (which causes the reversal).

Managing in Financial Markets As an investment manager, you frequently make decisions about investing in stocks versus other types of investments, and about types of stocks to purchase. a. You have noticed that investors tend to invest more heavily in stocks after interest rates have declined. You are considering this strategy as well. Is it rational to invest more heavily in stocks once interest rates have declined? One argument is that investors are unwilling to accept a very low interest rate on debt securities, and are more willing to invest in stocks simply because their opportunity cost (what they forgo) on debt securities is low. The value of stocks may rise in response to lower interest rates, simply because the present value of dividends should rise with a lower interest used as the discount rate. However, it is risky for investors to heavily invest in the stock market simply because they have no other type of investment that is acceptable. This type of behavior can force stock prices to exceed their fundamental values, and create a speculative bubble that will break in the future. b. Assume that you are about to select a specific stock that will perform well in response to an expected runup in the stock market. You are very confident that the stock market will perform well in the near future. Recently, a friend recommended that you consider purchasing stock of a specific firm because it had decent earnings over the last few years, it has a low beta (reflecting a low degree of systematic risk), and its beta is expected to remain low. You usually rely on beta as a measurement of a firm’s systematic risk. Should you seriously consider buying that stock? Explain. No. Given that you expect the stock market to perform well, you would not be so interested in a low-beta stock. You would consider stocks that would be more sensitive to market conditions so that you can benefit from the expected market run-up. c. You are considering an investment in an initial public offering by Marx Co., which has performed very well recently, according to its financial statements. The firm will use some of the proceeds from selling stock to pay off some of its bank loans. How can you apply stock valuation models to estimate this firm’s value, when its stock is not yet publicly traded? Once you estimate the value of the firm, how can you use this information to determine whether to invest in it? What are some limitations involved in estimating the value of this firm?

Chapter 11: Stock Valuation and Risk  10

There are numerous possible solutions, but most solutions would involve the estimation of the firm’s future cash flows and deriving a present value of those cash flows. You can apply the dividend discount model by assessing past earnings to generate forecasts of future earnings. Then, the amount of earnings to be retained can be estimated so dividends can be estimated. Next, the dividend discount model can be used to estimate the present value of all future dividends that are to be paid. Once you estimate the value of the firm, estimate the value of stock by dividing the firm value by the number of shares outstanding. This provides an estimated value per share. Compare this value to the prevailing price per share of stock in the IPO. There are limitations in using past earnings as a forecast of future earnings, and in selecting the proper required rate of return to discount future cash flows. Consequently, the estimate of the firm’s value is subject to error. d. In the past, your boss assessed your performance based on the actual return on the portfolio of U.S. stocks that you manage. For each quarter in which your portfolio generated an annualized return of at least 20 percent, you received a bonus. Now your boss wants you to develop a method for measuring your performance in managing the portfolio. Offer a method that accurately measures your performance. There are many possible solutions. The method should include some control for the stock market movements over the period of concern. For example, your performance may be measured as an excess return beyond the return of some stock index representing U.S. stocks. If your portfolio is supposed to be focused on one particular industry, your performance should be measured relative to that industry norm (perhaps compared to the return on an industry index). You may also wish to account for risk by measuring a risk-adjusted return of your portfolio and the comparable index. e. Assume that you were also asked to manage a portfolio of European stocks. How would your method for measuring your performance in managing this portfolio differ from the U.S. stock portfolio in the previous question? The European portfolio return should be compared to a European stock index. The reason is that you have no control over the general stock market conditions in Europe. You only have control over the European stocks to include in your portfolio. Your performance should be measured relative to the group of stocks that were available. You may also wish to account for risk by deriving a risk-adjusted return of your portfolio and comparing that to a risk-adjusted return of the index. A Sharpe index might be applied to derive risk-adjusted returns.

Problems 1. Risk-Adjusted Return Measurements. Assume the following information over a five-year period.  Average risk-free rate = 6%  Average return for Crane stock = 11%  Average return for Load stock = 14%  Standard deviation of Crane stock returns = 2%  Standard deviation of Load stock returns = 4%  Beta of Crane stock = 0.8  Beta of Load stock = 1.1

Chapter 11: Stock Valuation and Risk  11 Determine which stock has higher risk-adjusted returns according to the Sharpe Index. Which stock has higher risk-adjusted returns according to the Treynor Index? Show your work. ANSWER: Sharpe Index of Crane stock:

Sharpe Index of Load stock:

Treynor Index of Crane stock:

Treynor Index of Load stock:

Crane stock has a higher Sharpe Index while Load stock has a higher Treynor Index. 2. Measuring Expected Return. Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent, and the market return is 10 percent, what is the expected return on Mess stock? ANSWER:

Chapter 11: Stock Valuation and Risk  12

Expected return = 7% + 1.2(10% – 7%) = 10.6% 3. Using the PE Method. You discovered that Olmsted Stock is expected to generate earnings of $4.38 per share this year, and that the mean PE ratio for its industry is 27.195. Use the PE valuation method to determine the value of Olmsted shares. ANSWER: Value = (Expected earnings of IBM per share) × (Mean industry P/E ratio) Value = $4.38  27.195 Value = $119.114 4. Using the Dividend Discount Model. Suppose that you are interested in buying the stock of a company that has a policy of paying a $6 per share dividend every year. Assuming no changes in the firm’s policies, what is the value of a share of stock if the required rate of return is 11 percent? ANSWER: PVof stock = D/k = 6/0.11 = $54.5 per share 5. Using the Dividend Discount Model. Micro, Inc. will pay a dividend of $2.30 per share next year. If the company plans to increase its dividend by 9 percent per year indefinitely, and you require a 12 percent return on your investment, what should you pay for the company’s stock?

ANSWER: PVof stock = D1/(k – g) PVof stock = 2.3/(0.12 – 0.09) = $76.67 per share 6. Using the Dividend Discount Model. Suppose you know that a company just paid a dividend of $1.75 per share on its stock and that the dividend will continue to grow at a rate of 8 percent per year. If the required return on this stock is 10 percent, what is the current share price? ANSWER: D1 = D0(1 + g) D1 = 1.75(1 + 0.08) = 1.89 PV of stock = D1/(k – g) PV of stock = 1.89/(0.10 – 0.08) = $94.5 per share

Chapter 11: Stock Valuation and Risk  13

7. Deriving the Required Rate of Return. The next expected dividend for Sun, Inc., will be $1.20 per share and analysts expect the dividend to grow at a rate of 7 percent indefinitely. If Sun stock currently sells for $22 per share, what is the required rate of return? ANSWER: PV of stock = D1/(k – g) k = (D1/PV of stock) + g k = (1.20/22) + 0.07 = 0.1245 = 12.45% 8. Deriving the Required Rate of Return. A share of common stock currently sells for $110. Current dividends are $8 per share and are expected to grow at 6 percent per year indefinitely. What is the rate of return required by investors in the stock? ANSWER: D1 = D0(1 + g) D1 = $8.00(1 + 0.06) = $8.48 k = (D1/PV of stock) + g k = (8.48/110) + 0.06 = 0.137 = 13.7% 9. Deriving the Required Rate of Return. A stock has a beta of 2.2, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Using the CAPM, what would you expect the required rate of return on this stock to be? What is the market risk premium? ANSWER: Rj = Rf + Bj(Rm – Rf ) Rj = 6% + 2.2(12% – 6%) Rj = 19.2% The market risk premium is 6 percent. 10. Deriving the Stock’s Beta. You are considering investing in a stock that has an expected return of 13 percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what is the beta of this stock? ANSWER: Rj = Rf + Bj(Rm – Rf ) 0.13 = 0.05 + Bj (0.07) Bj = 1.142 11. Measuring Stock Returns. Suppose you bought a stock at the beginning of the year for $76.50. During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25. What is the total percentage return from investing in that stock over the year?

Chapter 11: Stock Valuation and Risk  14 ANSWER:

12. Measuring the Portfolio Beta. Assume the following information: Beta of Stock D = 1.31 Beta of Stock E = 0.85 Beta of Stock F = 0.94 If you invest 40 percent of your money in Stock D, 30 percent in Stock E and 30 percent in Stock F, what is your portfolio’s beta? ANSWER: Portfolio beta = 0.4(1.31) + 0.3(0.85) + 0.3(0.94) = 0.524 + 0.255 + 0.282 = 1.061 13. Measuring the Portfolio Beta. Using the information from Problem 12, suppose that you instead decide to invest $20,000 in Stock D, $30,000 in Stock E and $50,000 in Stock F. What is the beta of your portfolio now? ANSWER: Portfolio beta

14.

= [(0.2  1.31) + (0.3  0.85) + (0.5  0.94)] = (.262 + .255 + .47) = 0.987

Value at Risk. Assume that the standard deviation of daily returns for a particular stock in

a recent historical period is 1.8 percent. Assume that the expected daily return of the stock is 0.01 percent. Estimate the maximum percentage one-day loss based on a 95 percent confidence level. ANSWER: Based on an expected daily return of 0.01 percent, the maximum percentage one-

day loss is

0.01% – [1.65 ´ (1.8%)] = –2.96%

Chapter 11: Stock Valuation and Risk  15 15. Value at Risk. Assume that in the previous problem, an investor has invested $10 million in

the stock of concern. Estimate the maximum dollar one-day loss based on a 95 percent confidence level. ANSWER: If an investor has a $10 million investment in that stock, the maximum dollar one-day

loss can be determined by applying the maximum percentage loss to the value of the investment. Since the maximum percentage loss was determined to be -2.96% in the previous problem, the maximum dollar one-day loss is estimated to be (–2.97%) ´ $10,000,000 = -$297,000 16. Dividend Model Relationships. a. When computing the price of the stock with the dividend discount model, how would the price of a stock be affected if the required rate of return is increased. Explain the logic of this relationship. ANSWER: The price of the stock is reduced, because the cash flows would be discounted at a higher rate. b. When computing the price of a stock using the constant-growth dividend discount model, determine how the price of a stock would be affected if the growth rate is reduced. Explain the logic of this relationship. ANSWER: The price of the stock is reduced, because the expected future cash flows in distant periods are reduced if the growth rate is revised downward. 17. CAPM Relationships. a. When using the CAPM, how would the required rate of return on a stock be affected if the riskfree rate were lower. ANSWER: The required rate of return would be lower, because it should reflect a premium above the risk-free rate (which is now lower). b. When using the CAPM, how would the required rate of return on a stock be affected if the market return were lower. ANSWER: The required rate of return would be lower, because the premium that is added to the riskfree rate would now be lower. c. When using the CAPM, how would the required rate of return on a stock be affected if the beta were higher. ANSWER: The required rate of return would be higher, because a given premium above the risk-free rate would now be higher. 18. Value at Risk. a. How is the maximum expected loss on a stock affected by an increase in the volatility (standard deviation), based on a 95 percent confidence interval?

Chapter 11: Stock Valuation and Risk  16 ANSWER: The maximum expected loss would now be more pronounced (worse) than before, because the larger standard deviation creates a greater deviation from (below) the expected outcome. b. Determine how the maximum expected loss on a stock would be affected by an increase in the expected return of the stock, based on a 95 percent confidence interval. ANSWER: The maximum expected loss would now be less pronounced than before, because the expected outcome is higher and the deviation from that will result in a maximum loss that is not as bad.

Flow of Funds Exercise Valuing Stocks Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by approximately 50 percent over the next few years to satisfy demand for its products. It would need financing to expand and accommodate this increase in production. The yield curve is currently upward sloping and Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The company is also considering issuing stock or bonds to raise funds in the next year. If Carson goes public, it might even consider using its stock as a means of acquiring some target firms. It would also consider engaging in a secondary offering at a future point in time if the IPO is successful and if its growth continues over time. It would also change its compensation system to compensate most of its managers with shares of its stock that would represent about 30 percent of their compensation and would pay the remainder of the compensation as salary. a.

At the present time, the price-earnings (PE) ratio (stock price per share divided by earnings per share) of other firms in Carson’s industry is relatively low but should rise in the future. Why might this information affect the time at which Carson issues its stock? Carson would like to attempt to issue the shares when the valuation of its stock is favorable. Investors who buy shares may apply the industry PE ratio to Carson’s earnings ratio to value the shares. Under these conditions, it receives a higher level of proceeds for a given number of shares issued.

Assume that Carson Company believes that issuing of stock is an efficient means of circumventing the potential for high interest rates. Even if long-term interest rates have increased by the time it issues stock, Carson thinks that it would be insulated from the effects of this increase by issuing stock instead of bonds. Is this view correct? No. If interest rates increase, the risk-free interest rate that can be earned by investors has increased. The required rate of return by investors when investing in a new stock contains a risk premium. As the risk-free rate rises, the required rate of return should increase. Thus, the amount that investors would be willing to pay for a stock should decline when the required rate of return increases. An alternative argument is that the higher interest rates will increase the cost of Carson’s debt, which may reduce cash flows and therefore reduce the value of the firm.

Carson Company recognizes the importance of a high stock price at the time it engages in an IPO (if it goes public). But why would its stock price be important to Carson Company even after the IPO? First, Carson Company may do a secondary offering someday, and the stock price at the time of the secondary offering would affect the amount of proceeds it would receive from selling a

Chapter 11: Stock Valuation and Risk  17 specific number of shares. Second, Carson could use its shares instead of cash to acquire companies, and a higher stock price allows it to make an acquisition with fewer shares. Third, a high stock price means more compensation for its managers and may motivate them to perform well. d.

If Carson Company goes public, it may be able to motivate its managers by granting them stock as part of their compensation. Explain why the stock may motivate managers to perform well. Then explain why the use of stock as compensation may motivate them to use a very focus on short-term goals, even though they are supposed to focus on maximizing shareholder wealth over the long run. How can a firm provide stock as a motivational tool, yet prevent its managers from adopting a very short-term focus? Stock compensation can motivate managers to make decisions that maximize the stock price, because the managers benefit directly when they hold shares of the firm’s stock. Yet, some managers may be tempted to use accounting gimmicks so that the stock price is overvalued, so that they can sell their shares and capitalize on the overvalued stock. To prevent this strategy, firms that provide options as compensation could make managers hold the stock for a specified number of years.

Answers to Appendix Discussion Questions 1. Should an accounting firm be prohibited from offering both auditing services and consulting services to the same client? Explain your answer. If an accounting firm offered only one service, could there still be conflicts of interest due to referrals (and finder’s fees)? ANSWER: The goal is to allow students to present advantages and disadvantages of the SEC’s proposal for accounting firms to provide only auditing or consulting services. Even if the accounting firms are only allowed to offer one service, there could be a conflict of interest if they have an agreement with other firms. For example, they may serve as auditors but refer consulting firms for a fee. In this case, their audit is not really independent because the firm may be pressured to sign off if it received a finder’s fee for referring a consultant that influenced the firm’s financial statements. 2. Should members of Congress be allowed to enact laws on accounting and financial matters while receiving donations from related lobbying groups? ANSWER: This answer has no clear solution and will likely result in some animated discussion. Students should at least recognize the potential conflicts of interest here. 3. What alternative sources of information about a firm should investors rely on if they cannot rely on financial statements? ANSWER: The alternative sources of information about a firm come from securities firms and other research firms, but most of that information is derived from the financial statements created by the firm. Therefore, if they do not trust the financial statements, they probably should not trust these reports by other sources. 4. Should investors have confidence in ratings by analysts who are affiliated with securities firms that provide consulting services to firms? Explain.

Chapter 11: Stock Valuation and Risk  18 ANSWER: If analysts are unwilling to assign a true rating to a firm, then investors cannot rely on them for information. To the extent that analysts must appease firms that they rate so that their employer may possibly receive some consulting business from the firms, analysts are unable to serve investors. 5. Does an analyst employed by a securities firm to rate firms face a conflict of interest? If so, can the conflict be resolved? ANSWER: There is a conflict of interests if analysts must appease firms that they rate so that their employer may possibly receive some consulting business from the firms. One possible solution is for investors to rely only on analysts who are not affiliated with an employer that pursues consulting business with the firms that are rated. 6. How might a firm’s board of directors discourage its managers from attempting to manipulate financial statements to create a temporarily high stock price? ANSWER: The firm could implement a compensation system that prevents managers from selling any of their holdings of the firm’s stock in a short period of time. That is, managers would only be allowed to sell the stock holdings in small increments over time. With this system, there would be limited benefits from creating a superficially high price for a firm over a short period, because the managers would not be able to sell much of their stock over that period. 7. How can the compensation of a firm’s board of directors be structured so that the board will not be tempted to allow accounting or other managerial decisions that could cause a superficially high price over a short period? ANSWER: The firm could implement a compensation system that prevents board members from selling any of their holdings of the firm’s stock in a short period of time. That is, board members would only be allowed to sell the stock holdings in small increments over time. There would be limited benefits from creating a superficially high price for a firm over a short period, because the board members would not be able to sell much of their stock over that period. Thus, they would not be tempted to allow a short-term manipulation of the stock price if they are not able to benefit directly from that manipulation.

Chapter 12 Market Microstructure and Strategies Outline Stock Market Transactions Placing an Order Margin Trading Short Selling

How Stock Transactions Are Executed Floor Brokers Market Makers The Spread on Transaction Costs Electronic Communication Networks (ECNs) High Frequency Trading Program Trading Bots and Algorithms Impact of High Frequency Trading on Stock Volatility High Frequency Insider Trading High Frequency Front Running Impact of High Frequency Trading on Spreads

Regulation of Stock Trading Circuit Breakers Trading Halts Taxes Imposed on Stock Transactions Securities and Exchange Commission (SEC)

Trading International Stocks Reduction in Transaction Costs Reduction in Information Costs

Chapter 12: Market Microstructure and Strategies  2

Key Concepts 1.

Explain how transactions are executed, from the point of the order until the trade is made.

Explain the development of electronic communication networks (ECNs), and how they can improve the structure for executing transactions.

Explain how regulation is needed to ensure orderly and fair trading.

POINT/COUNTER-POINT: Is a Market-maker Needed? POINT: Yes. A market-maker can make a market by serving as the counterparty on a transaction. Without market-makers, stock orders might be heavily weighted toward buys or sells, and price movements would be more volatile. COUNTER-POINT: No. Market-makers do not prevent stock prices from declining. A stock that has more selling pressure than buying pressure will experience a decline in price, as it should. The electronic communication networks can serve as the intermediary between buyer and seller. WHO IS CORRECT? Use the Internet or some other source search engine to learn more about this issue

and then formulate your own opinion. ANSWER: While there are some arguments that the market-maker stabilizes the market, yet there is no evidence that they stand ready to buy up stocks that experience major selling pressure.

Questions 1. Orders. Explain the difference between a market order and a limit order. ANSWER: A market order is an order to execute a transaction at the prevailing market price. A limit order is an order to execute a transaction only if the price reaches a specified level. 2. Margins. Explain how margin requirements can affect the potential return and risk from investing in a stock. What is the maintenance margin? ANSWER: Margin requirements specify a proportion of funds to be invested that are borrowed versus paid in cash. Borrowing increases the return earned from the investment in a particular stock. However, it also increases the risk, because it magnifies the potential loss (negative return) that could occur as a result of investing in a stock. The maintenance margin is the minimum amount of the margin that must be maintained over the time the investor holds the investment. 3. Short Selling. Under what conditions might investors consider short selling a specific stock? ANSWER: Investors consider short selling when they expect that a stock’s price to decrease. Investors submit the order to their broker who borrows the stock on behalf of the investors and sells

Chapter 12: Market Microstructure and Strategies  3 the stock. The investors will ultimately need to purchase the stock that they borrowed. Their gain is the difference between the price at which they sold the stock and the price at which they purchased it. If the stock price declined over time, they should have been able to purchase the stock for a lower price at which they sold it. 4. Short Selling. Describe the short selling process. Explain the short interest ratio. Investors can engage in short selling by selling a stock that they do not own. They must borrow the stock that they sell. ANSWER: The short interest ratio is equal to the number of shares that were sold short divided by the average number of shares traded per day. A large short interest ratio implies a large amount of short selling relative to the volume of trading for the stock. 5. Stock Trading. Describe the roles of market makers. ANSWER: Market-makers commonly take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation of the stock. When many uninformed investors take buy or sell positions that push a stock’s price away from its fundamental value, the stock price is distorted as a result of the “noise” caused by the uninformed investors (called “noise traders”). Market-makers may take the opposite position of the uninformed investors, and therefore stand to benefit if their expectations are correct. 6. ECNs. What are electronic communication networks (ECNs)? ANSWER: Electronic communication networks (ECNs) are automated systems for disclosing and sometimes executing stock trades. They were created in the mid-1990s to publicly display buy and sell orders of stock. They were adapted to facilitate the execution of orders, and normally service institutional rather than individual investors. In 1997, the Securities and Exchange Commission (SEC) allowed ECNs complete access to the orders placed in the NASDAQ market. The SEC required that any quote provided by a market-maker must be made available to all market participants. This eliminated more favorable quotes that were exclusive to proprietary clients. It also resulted in significantly lower spreads between the bid and ask prices quoted on NASDAQ. 7. SEC Structure and Role. Briefly describe the structure and role of the Securities and Exchange Commission (SEC). ANSWER: The SEC is composed of five commissioners appointed by the president of the United States and confirmed by the Senate. Each commission serves a five-year term. The terms are staggered, so that one commissioner’s term is added each year and replaced by a new appointee. The president also assigns one of the five commissioners the role of Chairman. The commissioners meet to assess whether the existing regulations are successfully preventing abuses, and to revise the existing regulations. Specific staff members of the SEC may be assigned the role of developing a proposal for a new regulation to prevent a particular abuse that is occurring. New regulations can be adopted within the commission, and then distributed to the public for feedback before final approval. Some of the more critical proposals are subject to Congressional review before final approval. 8. SEC Enforcement. Explain how the Securities and Exchange Commission attempts to prevent violations of SEC regulations.

Chapter 12: Market Microstructure and Strategies  4 ANSWER: The Division of Enforcement assesses possible violations of the SEC's regulations

and can take action against individuals or firms. An investigation can involve the examination of securities data or transactions. When the SEC finds that action is warranted, it may negotiate a settlement with the individuals or firms that are cited for violations, file a case against them in federal court, or even work with law enforcement agencies if the violations involve criminal activity. 9. Circuit Breakers. Explain how circuit breakers are used to reduce the likelihood of a large stock market crash. ANSWER: Stock exchanges can impose circuit breakers, which are restrictions on trading when stock prices or a stock index reaches a specified threshold level. The NYSE has experimented with different types of circuit breakers since the stock market crash of October 1987. The prevailing circuit breakers have three threshold levels for a daily change in the Dow Jones Industrial Average (DJIA) from its previous closing price: Level 1 (10 percent), Level 2 (20 percent), and Level 3 (30 percent). If the Level 1 threshold is reached, there is brief (30- or 60-minute) halt in trading. If the Level 2 threshold is reached, there is slightly longer (1- to 2-hour) halt in trading. If the Level 3 threshold is reached, the market will be closed for the day. The NASDAQ market and other regional exchanges impose similar circuit breakers. 10. Trading Halts. Why are trading halts sometimes imposed on particular stocks? ANSWER: Stock exchanges may impose trading halts on particular stocks when they believe market participants need more time to receive and absorb material information that could affect the value of a stock. They have imposed trading halts on stocks that are associated with mergers, earnings reports, lawsuits, and other news. A trading halt does not prevent a stock from experiencing a loss in response to news. Instead, the purpose of the halt is to ensure that the market has complete information before trading on the news.

Advanced Questions 11. Reg FD. What are the implications of Regulation FD? ANSWER: Reg FD prevents a firm’s managers from disclosing relevant information to a select group of people. It must disclose all relevant information to the general public, so that no one has a comparative advantage over other investors. 12. Stock Exchange Transaction Costs. Explain how foreign stock exchanges have reduced transactions costs. ANSWER: Some stock exchanges are now fully computerized, so a trading floor is not needed. Orders by investors to buy or sell flow to financial institutions that are certified members of the exchange. The details of the orders, such as the stock’s name, the number of shares to be bought or sold, and the price at which the investor is willing to buy or sell, are fed into a computer system. The system matches buyers and sellers and then sends information confirming the transaction to the financial institution, which then informs the investor that the transaction is completed.

Chapter 12: Market Microstructure and Strategies  5 When there are many more buy orders than sell orders for a given stock, the computer will not be able to accommodate all orders. Some buyers will then increase the price they are willing to pay for the stock. Thus, the price adjusts in response to the demand (buy orders) for the stock and the supply (sell orders) of the stock for sale, as recorded by the computer system. Similar dynamics occur on a trading floor, but the computerized system has documented criteria by which it prioritizes the execution of orders, whereas traders on a trading floor may execute some trades in ways that favor themselves at the expense of investors. 13. Bid-Ask Spread of Penny Stocks. Your friend just told you about a penny stock that he purchased, which increased in price from $0.10 to $0.50 per share. You start investigating penny stocks, and after conducting a large amount of research, you find a stock with a quoted price of $0.05. Upon further investigation, you notice that the ask price for the stock is $0.08 and that the bid price is $0.01. Discuss the possible reasons for this wide bid-ask spread. ANSWER: There are several reasons penny stocks often have wide bid-ask spreads. First, penny stocks are often extremely risky and volatile. Second, order costs for those stocks tend to be higher, since they often do not trade on an organized exchange or on NASDAQ. Third, penny stocks often have zero or few market-makers and little competition. Fourth, penny stocks tend to be illiquid, which makes it hard to sell those stocks at any given time. 14. Ban on Short Selling. Why did the SEC impose a temporary ban on short sales of specific stocks in 2008? Do you think a ban on short selling is effective?

ANSWER: This action was intended to prevent stock prices from being pushed down solely by actions of short sellers, which could cause fear about these firms, and could disrupt the financial system. Even if short sales are banned, speculators have other methods of betting against a stock (such as put options on stock) that could possibly place downward pressure on a stock’s price. 15. Dark Pools. What are dark pools? How can they help investors accumulate shares without other investors knowing about the trades? Why are dark pools criticized by public stock exchanges? Explain the strategy used by public stock exchanges to compete with dark pools. ANSWER: Dark pools are private stock markets that can be used by institutional investors. It may be easier for an investor to accumulate a large number of shares of a particular stock without the public’s knowledge of these trades. Thus, the investor may be more able to accumulate all the shares without placing excessive upward pressure on the stock price. Conversely, if the investor executed these trades to accumulate the shares on a public stock exchange, the trades are publicized. The public stock markets such as the NYSE and Nasdaq have criticized dark pools for reducing transparency, thereby making it more difficult for investors to asses existing demand and supply conditions for a particular stock. In August 2012, the NYSE initiated a trading program that allowed its members to offer stock price improvements (better prices than the prevailing quotes) for retail customers. The trades are not visible to the public. This program enabled the NYSE to be more competitive with the dark pools offered by private stock markets. The Nasdaq market followed with a similar type of program. 16. Inside Information. Describe inside information as applied to the trading of stocks. Why is it illegal to trade based on inside information? Describe the evidence that suggests some investors use inside information.

Chapter 12: Market Microstructure and Strategies  6 ANSWER: Insiders of a publicly traded company (such as managers or board members) sometimes have inside information about the company, which has not yet been publicized. For example, they might know that a company has just invented a patent that will be very valuable. It is illegal for insiders to take positions in the stock based on their inside information, because this would give them an unfair advantage over other investors. It is also illegal for insiders to pass the inside information on to other investors, or for those investors to take positions in the stock based on that information. Investors who can obtain the stock before an acquisition bid is announced can sometimes earn a return of 30% or more in just a few weeks. In many cases, the stock price of a public company that is targeted for an acquisition experiences an increase in stock price of 10% or more a few weeks before the acquisition announcement. Such an abnormal increase in price for many targeted companies suggests that some traders have inside information that the company will be acquired, and their trades to obtain shares place upward pressure on the stock price. 17. Galleon Insider Trading Case. Explain how the Galleon Fund case led to stronger enforcement against insider trading. ANSWER: In October 2009, the SEC (with the help of other government agencies such as the Justice Department and FBI) charged many defendants connected with the Galleon Fund (a hedge fund) with trading based on inside information. The Galleon case received special attention because the government effectively used wiretap evidence to prosecute insider trading cases. In addition, the government exposed the illegal activities of some insiders that were hired on the side as consultants or experts by hedge funds. Furthermore, the penalties to defendants who were found guilty of insider trading (or related charges) were much more severe than in previous years.

18. Strategy of HFT Firms Explain the strategy of high frequency trading firms. Describe the typical time horizon of an investment that is relevant to high frequency traders, and how that varies from other institutional investors. ANSWER: High frequency trading firms attempt to exploit stock pricing patterns or discrepancies, which is dependent on its algorithms created by its employees. They employ many mathematicians, engineers, and computer programmers who develop the algorithms to detect unusual pricing patterns in stock prices that can be exploited. However, there is clearly a risk that previous patterns will not persist in the future. Some algorithms might only be applied within a specific period of the day in which a particular stock price pattern was thought to be more consistent, such as within the first hour or in the last hour of trading each day. While some institutional investors such as pension funds and mutual funds might assess the potential performance of any particular stock over the next several months over years, the relevant investment horizon to high frequency traders is only the next few seconds or minutes. 19. Flash Crash of May 6, 2010 Describe the Flash Crash on May 6, 2010 and explain why it caused so much concern to investors and regulators. ANSWER: On May 6, 2010, stock prices by more than 9 percent on average before reversing and recovering most of those losses on that same day, when more than 19 billion shares were traded. It appears that the flash crash was triggered by high frequency trading. Computers (Bots) of high frequency traders were programmed (with algorithms) to trade stocks based on specific trigger points, which pushed the stock levels lower, and triggered additional sales by other computers that contained similar types of algorithms. Most of this activity occurred in a 30-minute period, the most volatile half hour in the history of the New York Stock Exchange.

Chapter 12: Market Microstructure and Strategies  7 This trading activity was especially a concern because it could not be explained or justified by an underlying economic crisis event, but there was panic based on the interpretations of algorithms contained within the Bots. To the extent that such trading activity could occur without any major crisis, it caused concern that it could happen again on any normal day and might be even worse if there is news of some type of crisis. 20. Front Running by High Frequency Traders Explain how some high frequency traders used a form of front running to capitalize on faster access to specific markets. ANSWER: When an investor submits an order to various markets, the speed at which it reaches each market is dependent on the length of the fiber optic connection path from the investor to these markets. When traders with access to the market orders receive the order first, they may have programmed subsequent trades that can beat that order to some other exchanges. Even though a set of orders might happen within one second, the priority (sequence) by which the orders are received and executed across stock markets can determine the price paid for each of those orders, and whose orders were executed or not executed. 21. Impact of HFT on Spreads Explain how and why high frequency trading affects spreads. ANSWER: High frequency traders may be willing to serve as intermediaries (similar to market makers) by accommodating orders in which they believed would ultimately result in profits. They might accommodate a sell order by purchasing the stock if their algorithm sensed that this stock’s price would rise in the next few seconds or minutes (at which time they could close out their position with another investor). They might accommodate a buy order by selling a particular stock if their algorithm sensed that this stock’s price would decline in the next few seconds or minutes (at which time they could close out their position). Thus, they are common participants in trades in which they essentially replace market makers. In fact, they have taken market share from the market makers because of the large spreads quoted by market makers in the past. The spreads have declined as a result of the participation by high frequency traders. CRITICAL THINKING QUESTION Regulation of Insider Trading. Some critics argue that insider trading should not be regulated, because it allows market prices to more quickly reflect the inside information. Write a short essay that supports or refutes this opinion. ANSWER If illegal insider trading was allowed, it would allow those traders with the inside information to have a comparative advantage over all other traders. Consequently, many traders may no longer participate in the markets in which they are at a disadvantage relative to others. This would cause a reduction in market liquidity. There are many problems associated with market illiquidity, such as volatile security price movements because of a lack of depth of buyers and sellers for any particular security.

Interpreting Financial News

Chapter 12: Market Microstructure and Strategies  8 Interpret the following comments made by Wall Street analysts and portfolio managers. a. “Individual investors who purchase stock on margin might as well go to Vegas.” Purchasing stock on margin is risky as it magnifies the returns, whether positive or negative. b. “During a major market downturn, market makers are suddenly not available.” Market makers do not offset the imbalance of sell orders versus buy orders. If they take a position in a stock, it is because they believe they can profit from the position. If not, they will let market forces push the stock price to a lower equilibrium price. c. “The trading floor may become extinct due to ECNs.” ECNs can serve a floor broker role and therefore may allow trades to be conducted without the use of a trading floor.

Managing in Financial Markets Focus on Heavily Shorted Stocks. As a portfolio manager, you commonly take short positions in stocks that have a high short interest margin. What is the advantage of focusing on these types of firms? What is a possible disadvantage? ANSWER: To the extent that other short sellers recognize that these firms are overvalued, you can benefit from following their actions. However, it is possible that some short sellers are wrong, and therefore following their actions may necessarily lead to favorable results on your short positions.

Problems 1. Buying on Margin. Assume that Vogl stock is priced at $50 per share and pays a dividend of $1 per share. An investor purchases the stock on margin, paying $30 per share and borrowing the remainder from the brokerage firm at 10 percent annualized interest. If after one year, the stock is sold at a price of $60 per share, what is the return to the investors?

ANSWER:

Chapter 12: Market Microstructure and Strategies  9

2. Buying on Margin. Assume that Duever stock is priced at $80 per share and pays a dividend of $2 per share. An investor purchases the stock on margin, paying $50 per share and borrowing the remainder from the brokerage firm at 12 percent annualized interest. If after one year, the stock is sold at a price of $90 per share, what is the return to the investor? ANSWER:

3. Buying on Margin. Suppose that you buy a stock for $48 by paying $25 and borrowing the remaining $23 from a brokerage firm at 8 percent annualized interest. The stock pays an annual dividend of $0.80 per share, and after one year, you are able to sell it for $65. Calculate your return on the stock. Then, calculate the return on the stock if you had used only personal funds to make the purchase. Repeat the problem, assuming that only personal funds are used, and that you sell the stock for $40 at the end of one year. ANSWER:

If only personal funds are used:

Chapter 12: Market Microstructure and Strategies  10

If only personal funds are used, and you sell stock for $40:

4. Buying on Margin. How would the return on a stock be affected by a lower initial investment (and higher loan amount)? Explain the relationship between the proportion of funds borrowed and the return. ANSWER: The return is increased when there is a lower initial investment, as the gain on the investment would be higher. The gain as a percentage of the investment is higher when the size of the investment is smaller. However, a negative return is also more pronounced when there is a lower investment (a higher level of borrowing), which represents the tradeoff when buying stock on margin.

Flow of Funds Exercise Shorting Stocks Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by approximately 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering the issuance of stock or bonds to raise funds in the next year. a. In some cases, a stock’s price is too high or too low because of asymmetric information, information known by the firm but not by investors. How can Carson attempt to minimize asymmetric information? It could provide timely and detailed financial reports and could use a reporting system that allows for transparency so that its operations can be easily monitored. b. Carson Company is concerned that if it issues stock, its stock price over time could be adversely affected by certain institutional investors that take large short positions in a stock. When this is happening, the stock’s price may be undervalued because of the pressure on the price caused by the large short positions. What can Carson do to counter major short positions taken by institutional investors if it really believes that its stock price should be higher? What is the potential risk involved in this strategy? It could repurchase some of its shares in the market, which would allow it to obtain shares at a low price. It could issue more shares later once the share price rises. Its actions would be beneficial to its shareholders.

Chapter 12: Market Microstructure and Strategies  11

The risk is that Carson is wrong in its perception, which could cause it to repurchase shares before the price declines further. In this case, its actions would not satisfy shareholders.

Solution to Integrative Problem for Part 4 Stock Market Analysis 1. Olympic stock’s future earnings should improve because it will not incur the restructuring charges in the future. Its most recent earnings were reduced due to a one-time restructuring charge, so it could be undervalued if its stock price is only six times the recent earnings. Once the restructuring is completed, Olympic stock may benefit. Its price is probably affected by the one-time hit on earnings, but its price should rise once earnings rise. 2. Kenner stock deserves its low P/E because its growth prospects are lower than the competition. Since it has not kept up with technology, its growth prospects are limited. A P/E ratio implicitly captures the growth in the earnings. A relatively low P/E ratio for a firm is appropriate when the earnings are expected to be relatively low, because future cash flows will not grow as much as another firm that has kept up with technology (and is poised to gain market share). 3. While the discount rate used to discount future cash-flows generated by stocks may increase, the cash flows should also increase. Thus, it is not clear whether stock prices would decline because of the reason (higher economic growth) for the expected increase in interest rates. Investors should incorporate the expected effects of increased economic growth on cash flows, and the effects of a higher discount rate to determine how the value of any particular stock may change. Some stocks whose cash flows are more sensitive to changes in economic growth may benefit from the anticipated conditions.

Chapter 13 Financial Futures Markets Outline Background on Financial Futures Popular Futures Contracts Market for Financial Futures Purpose of Trading Financial Futures Institutional Trading of Financial Futures Trading Process

Interest Rate Futures Contracts Valuing Interest Rate Futures Speculating with Interest Rate Futures Hedging with Interest Rate Futures Stock Index Futures Valuing Stock Index Futures Speculating in Stock Index Futures Hedging with Stock Index Futures Dynamic Asset Allocation with Stock Index Futures Arbitrage with Stock Index Futures Circuit Breakers on Stock Index Futures

Single Stock Futures Risk of Trading Futures Contracts Market Risk Basis Risk Liquidity Risk Credit Risk Prepayment Risk Operational Risk Systemic Risk

Globalization of Futures Markets Non-U.S. Participation in U.S. Futures Contracts Foreign Stock Index Futures Currency Futures Contracts

Chapter 13: Financial Futures Markets  2

Key Concepts 1. Explain why speculators take positions in financial futures, and how the outcome is determined. 2. Explain how institutional investors hedge with interest rate futures, and the tradeoff involved. 3. Explain how stock index futures can be used by institutional investors.

POINT/COUNTER-POINT: Has the Futures Market Created More Uncertainty for Stocks? POINT: Yes. Futures contracts encourage speculation on indexes. Thus, an entire market can be influenced by the trading of speculators. COUNTER-POINT: No. Futures contracts are commonly used to hedge portfolios, and therefore can reduce the effects of weak market conditions. Moreover, investing in stocks is just as speculative as taking a position in futures markets. WHO IS CORRECT? Use the Internet to learn more about this issue. Offer your own opinion on this issue. ANSWER: While excessive speculation could affect the underlying stock price or stock index, more informed investors should be able to correct for any mispricing, and therefore push the price toward its fundamental value. In addition, speculators could trade the underlying stocks as well and could have a direct effect on the stock price.

Questions 1. Futures Contracts. Describe the general characteristics of a futures contract. How does a clearinghouse facilitate the trading of financial futures contracts? ANSWER: A futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date. The clearinghouse records all transactions and guarantees timely payments on futures contracts. This precludes the need for a purchaser of a futures contract to check the creditworthiness of the contract seller. 2. Futures Pricing. How does the price of a financial futures contract change as the market price of the security it represents changes? Why? ANSWER: As the market price of the security changes, so does the futures price, in a similar manner. The futures price should reflect the expectation as of settlement date, and expectations will change in accordance with changes in the prevailing market price. 3. Hedging with Futures. Explain why some futures contracts may be more suitable than others for hedging exposure to interest rate risk.

Chapter 13: Financial Futures Markets  3 ANSWER: Ideally, the underlying instrument represented by the futures contract would be similarly sensitive to interest rate movements as the assets that are being hedged. 4. Treasury Bond Futures. Will speculators buy or sell Treasury bond futures contracts if they expect interest rates to increase? Explain. ANSWER: Speculators should sell Treasury bond futures contracts. If they expected interest rates to increase, this implies expectations of lower bond prices. Thus, if security prices decline so will futures prices. Speculators could then close out their position by purchasing an identical futures contract. 5. Gains from Purchasing Futures. Explain how purchasers of financial futures contracts can offset their position. How is their gain or loss determined? What is the maximum loss to a purchaser of a futures contract? ANSWER: Purchasers of financial futures contracts can offset their positions by selling the identical contracts. Their gain is the difference between what they sold the contracts for and their purchase price. The maximum loss is the amount to be paid at settlement date as specified by the contract. 6. Gains from Selling Futures. Explain how sellers of financial futures contracts can offset their position. How is their gain or loss determined? ANSWER: Sellers of financial futures contracts can offset their positions by purchasing identical contracts. Their gain is the difference between the selling price specified when they sold futures contracts versus the purchase price specified when they purchased futures contracts. 7. Hedging with Futures. Assume a financial institution has more rate-sensitive assets than ratesensitive liabilities. Would it be more likely to be adversely affected by an increase or decrease in interest rates? Should it purchase or sell interest rate futures contracts in order to hedge its exposure? ANSWER: It would be more adversely affected by a decrease in interest rates. Thus, it should purchase interest rate futures contracts to hedge its exposure. 8. Hedging with Futures. Assume a financial institution has more rate-sensitive liabilities than ratesensitive assets. Would it be more likely to be adversely affected by an increase or a decrease in interest rates? Should it purchase or sell interest rate futures contracts so as to hedge its exposure? ANSWER: It would be more adversely affected by an increase in interest rates. Thus, it should sell interest rate futures contracts to hedge its exposure. 9. Hedging Decision. Why do some financial institutions remain exposed to interest rate risk, even when they believe that the use of interest rate futures could reduce their exposure? ANSWER: Some financial institutions prefer not to hedge because they wish to capitalize on their exposure. For example, a financial institution with rate-sensitive liabilities and rate-insensitive assets will benefit from its exposure to interest rate risk if interest rates decline.

Chapter 13: Financial Futures Markets  4 10. Long versus Short Hedge. Explain the difference between a long hedge and a short hedge used by financial institutions. When is a long hedge more appropriate than a short hedge? ANSWER: A long hedge represents a purchase of financial futures and is appropriate when assets are more rate-sensitive than liabilities. A short hedge represents a sale of financial futures and is appropriate when liabilities are more rate-sensitive than assets. 11. Impact of Futures Hedge. Explain how the probability distribution of a financial institution’s returns is affected when it uses interest rate futures to hedge. What does this imply about its risk? ANSWER: The probability distribution of returns narrows as a result of using interest rate futures to hedge. This implies less exposure to interest rate movements. 12. Cross-Hedging. Describe the practice of cross hedging and explain when this strategy might

be used. ANSWER: Cross-hedging represents the use of financial futures on one instrument to hedge a different instrument. For example, a firm could sell a futures contract on Treasury bonds to hedge

the interest rate risk of corporate bonds if it believes that prices of Treasury bonds and its holdings of corporate bonds are similarly affected by rising interest rates. 13. Hedging with Bond Futures. How might a savings and loan association use Treasury bond futures to hedge its fixed-rate mortgage portfolio (assuming that its main source of funds is short-term deposits)? Explain how prepayments on mortgages can limit the effectiveness of the hedge. ANSWER: It may enact a short hedge in which it sells interest rate futures. If interest rates rise, its spread is reduced, but that can be offset by the gain on its futures position. If interest rates decline, it will incur a loss on its futures position, which can be offset by an increase in the spread. However, if mortgages are prepaid (as homeowners refinance mortgages at the lower interest rates), the spread will not necessarily increase to offset the loss on the futures position. 14. Stock Index Futures. Describe stock index futures. How could they be used by a financial institution that is anticipating a jump in stock prices but does not yet have sufficient funds to purchase large amounts of stock? Explain why stock index futures may reflect investor expectations about the market more quickly than stock prices. ANSWER: The institution could purchase stock index futures. If the stock market experiences increased prices, the stock index will rise. Thus, the stock index futures position will generate a gain. As new information becomes available, investors can purchase stock index futures with a small upfront payment. The purchase of actual stocks may take longer because a larger investment would be necessary, and because time may be needed to select specific stocks. 15. Selling Stock Index Futures. Why would a pension fund or insurance company consider selling stock index futures? ANSWER: If a pension fund or insurance company anticipates a temporary decline in stock prices, it may attempt to hedge its stock portfolio by selling stock index futures.

Chapter 13: Financial Futures Markets  5

16. Systemic Risk. Explain systemic risk as it relates to the futures market. Explain how the Financial Reform Act of 2010 attempted to improve the monitoring of systemic risk in the futures market and other markets. ANSWER: Financial institutions could take excessive risks by speculating in the futures market. If they have agreements over the counter, the failure of one party might prevent payment to another party. This could cause a string of bankruptcies. The Financial Reform Act in 2010 resulted in

the creation of the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the U.S. and makes regulatory recommendations that could reduce any risks to the financial system. The council consists of 10 members that represent the head of regulatory agencies that regulate key components of the financial system, including the Commodity Futures Trading Commission (CFTC), which regulates financial futures trading. 17. Circuit Breakers. Explain the use of circuit breakers. ANSWER: Circuit breakers are trading restrictions imposed on specific stocks or stock indices when prices decline abruptly, which prohibit trading for short time periods. This allows investors to determine whether the rumors causing the decline are true and provides some time to work out credit arrangements if they received a margin call.

Advanced Questions 18. Hedging with Futures. Elon Savings and Loan Association has a large number of 30-year mortgages with floating interest rates that adjust on an annual basis and obtains most of its funds by issuing fiveyear certificates of deposit. It uses the yield curve to assess the market’s anticipation of future interest rates. Elon believes that expectations of future interest rates are the major force affecting the yield curve. Assume that a downward-sloping yield curve with a steep slope exists. Based on this information, should Elon consider using financial futures as a hedging technique? Explain. ANSWER: The yield curve reflects expectations of declining interest rates. Since Elon’s assets are more rate sensitive than its liabilities, it should consider hedging with financial futures, as it will be adversely affected by declining interest rates. Specifically, Elon would buy financial futures to hedge. 19. Hedging Decision. Blue Devil Savings and Loan Association has a large number of 10-year fixedrate mortgages and obtains most of its funds from short-term deposits. It uses the yield curve to assess the market’s anticipation of future interest rates. It believes that expectations of future interest rates are the major force in affecting the yield curve. Assume that an upward-sloping yield curve exists with a steep slope. Based on this information, should Blue Devil consider using financial futures as a hedging technique? Explain. ANSWER: Blue Devil should expect interest rates to rise, since the yield curve is upward sloping. Thus, it should sell financial futures to hedge the potential adverse effects of rising interest rates on its spread. 20. How Futures Prices May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and other conditions that could affect the values of futures contracts. Based on these conditions, would you prefer to buy or sell

Chapter 13: Financial Futures Markets  6 Treasury bond futures at this time? Would you prefer to buy or sell stock index futures at this time? Assume that you would close out your position at the end of this semester. Offer some logic to support your answers. Which factor is most influential for your decision regarding Treasury bond futures and for your decision regarding stock index futures? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 21. Use of Interest Rate Futures When Interest Rates Are Low Short-term and long-term interest rates are presently very low. You believe that the Fed will use a monetary policy to maintain these interest rates at a very low level. Do you think financial institutions that could be adversely affected by a decline in interest rates would benefit from hedging their exposure with interest rate futures? Explain. ANSWER: The financial institutions with this type of exposure would not benefit much from hedging, because interest rates could not decline much further. CRITICAL THINKING QUESTION Stock Index Futures and Systemic Risk. Write a short essay explaining how financial futures might reduce systemic risk, and how financial futures might increase systemic risk within financial markets. ANSWER Systemic risk may be reduced as a result of the financial futures market, because futures allow participants to bet against the market. Thus, futures could prevent excessive prices in markets as represented by indexes for which futures contracts are available. However, systemic risk could rise as a result of the financial futures market, because the futures may allow some investors to invest in the same direction as the underlying index, but with even more financial leverage. The use of financial leverage could be dangerous because during a credit crisis, investors who own some contracts may be required to post more collateral and may even be forced to liquidate their holdings if they cannot post more collateral. This could cause a more pronounced crash.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “The existence of financial futures contracts allows our firm to hedge against temporary market declines without liquidating our portfolios.” Investors can protect their portfolios by selling index futures on the underlying investments that reflect the securities in the investor’s portfolio. By selling futures on indexes, they protect against a temporary decline in values of their securities. Yet, they did not need to sell these securities. Thus, institutional investors can protect their portfolios without major sell offs of their securities, which may prevent large declines in the prices of their securities.

Chapter 13: Financial Futures Markets  7 b. “Given my confidence in the market, I plan to use stock index futures to increase my exposure to market movements.” Stock index futures may be purchased by portfolio managers along with other stocks. The futures require only a small initial investment, and yet the value can change substantially. There is much leverage in futures, but the investors do not have to purchase the index itself when they take a futures position the way they would with stocks. Instead, they only invest the initial margin, but stand to incur large gains or losses when the futures contracts are closed out. As a result of this leverage, the gains or losses are magnified more than if the manager simply used their funds to purchase stock. c. “We used currency futures to hedge the exchange rate exposure of our international mutual fund focused on German stocks.” A portfolio manager can sell futures contracts on euros to hedge German stock investments. If the euro depreciates against the dollar, the market value of the portfolio (as measured in dollars) is reduced. However, there would be a gain on the futures position, which could help offset the adverse effect on the stock portfolio.

Managing in Financial Markets As a portfolio manager, you are monitoring previous investments that you made in stocks and bonds of U.S. firms, and in stocks and bonds of Japanese firms. Although you plan to keep all of these investments over the long run, you are willing to hedge against adverse effects on your investments that result from economic conditions. You expect that over the next year, U.S. and Japanese interest rates will decline, the U.S. stock market will perform poorly, the Japanese stock market will perform well, and the Japanese yen (the currency) will depreciate against the dollar. a. Should you consider taking a position in U.S. bond index futures to hedge your investment in U.S. bonds? Explain. No. Interest rates are expected to decline in the United States, so that the investment in U.S. bonds should not be hedged. b. Should you consider taking a position in Japanese bond index futures to hedge your investment in Japanese bonds? Explain. No. Interest rates are expected to decline in the United States, so that the investment in Japanese bonds should not be hedged. c. Should you consider taking a position in U.S. stock index futures to hedge your investment in U.S. stocks? Explain. Yes. You should consider selling U.S. stock index futures to hedge your investments against the expected decline in the U.S. stock market. d. Should you consider taking a position in Japanese stock index futures to hedge your investment in Japanese stocks? (Note: The Japanese stock index is denominated in yen, so it is used to hedge stock movements, not currency movements).

Chapter 13: Financial Futures Markets  8

No. The Japanese stock market is expected to perform well, so a hedge is not needed. e. Should you consider taking a position in Japanese yen futures to hedge the exchange rate risk of your investment in Japanese stocks and bonds? Yes. The Japanese stocks and bonds are denominated in yen. Even if the stocks and bonds perform well from a Japanese perspective, they may be adversely affected from a U.S. perspective by a decline in the value of the yen. Therefore, you should consider selling yen futures contracts to hedge the exchange rate risk.

Problems 1.________________________________________ ANSWER: Purchase price Selling price Profit

= $935,000 = $947,500 = $947,500 – $935,000 = $12,500

2.________________________________________ ANSWER: Purchase price Selling price Profit

= $950,000 = $936,000 = $936,000 – $950,000 = –$14,000

3.________________________________________ ANSWER: Selling price = $940,000 Purchase price = $932,000 Profit = $940,000 – $932,000 = $8,000 4.________________________________________ ANSWER: Selling price = $932,600 Purchase price = $939,000 Profit = $932,600 – $939,000 = –$6,400

Problems

Chapter 13: Financial Futures Markets  9 1. Profit from T-Bond Futures Spratt Company purchased Treasury bond futures contracts when the quoted price was 93-50. When this position was closed out, the quoted price was 94-75. Determine the profit or loss per contract, ignoring transaction costs. ANSWER: Purchase price Selling price Profit

= $935,000 = $947,500 = $947,500 – $935,000 = $12,500

2. Profit from T-Bond Futures Suerth Investments, Inc., purchased Treasury bond futures contracts when the quoted price was 95-00. When this position was closed out, the quoted price was 93-60. Determine the profit or loss per contract, ignoring transaction costs. ANSWER: Purchase price Selling price Profit

= $950,000 = $936,000 = $936,000 – $950,000 = –$14,000

3. Profit from T-Bond Futures Toland Company sold Treasury bond futures contracts when the quoted price was 94-00. When this position was closed out, the quoted price was 93-20. Determine the profit or loss per contract, ignoring transaction costs. ANSWER: Selling price Purchase price Profit

= $940,000 = $932,000 = $940,000 – $932,000 = $8,000

4. Profit from T-Bond Futures Rude Dynamics, Inc., sold T-bill futures contracts when the quoted price was 93-26. When this position was closed out, the quoted price was 93-90. Determine the profit or loss per contract, ignoring transaction costs. ANSWER: Selling price Purchase price Profit

= $932,600 = $939,000 = $932,600 – $939,000 = –$6,400

5. Profit from T-bond Futures. Egan Company purchased a futures contract on Treasury bonds that specified a price of 91-00. When this position was closed out, the price of the Treasury bond futures contract was 90-10. Determine the profit or loss, ignoring transaction costs. ANSWER: Purchase price Selling price Profit

= $91,000 = $90,312 = $90,312 – $91,000 = –$688

Chapter 13: Financial Futures Markets  10 6. Profit from T-bill Futures. R. C. Clark sold a futures contract on Treasury bonds that specified a price of 92-10. When the position was closed out, the price of Treasury bond futures contract was 93-00. Determine the profit or loss, ignoring transaction costs. ANSWER: Selling price Purchase price Profit

= $92,312 = $93,000 = $92,312 – $93,000 = –$688 7. Profit from Stock Index Futures. Marks Insurance Company sold stock index futures that specified an index of 1690. When the position was closed out, the index specified by the futures contract was 1,720. Determine the profit or loss, ignoring transaction costs. ANSWER: Selling price Purchase price Profit

= $250  1,690 = $422,500 = $250  1,720 = $430,000 = $422,500 – $430,000 = –$7,500

Flow of Funds Exercise Hedging with Futures Contracts Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by approximately 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. Carson currently relies mostly on commercial loans with floating interest rates for its debt financing. a.

How could Carson use futures contracts to reduce the exposure of its cost of debt to interest rate movements? Be specific about whether it would use a short hedge or a long hedge. Carson could sell Treasury bond (or Treasury bill) futures contracts. If interest rates rise, the values of Treasury bonds decrease, and the values of Treasury bond futures contracts decrease. A short position will result in a profit for Carson if interest rates increase, which can offset the higher cost of debt financing.

Will the hedge that you described in the previous question perfectly offset the increase in debt costs if interest rates increase? Explain what drives the profit from the short hedge, versus what drives the higher cost of debt to Carson if interest rates increase. No. The short position is not a perfect hedge. The profit from the short hedge is influenced by the movement in Treasury security prices, while the cost of debt is influenced by the short-term interest rate on commercial loans (which may be influenced by the rate the banks pay on shortterm CDs. There is not a perfect offsetting effect.

Chapter 14 Options Markets Outline Background on Options Comparison of Options and Futures Markets Used to Trade Options How Option Trades Are Executed Types of Orders Stock Option Quotations Institutional Use of Options

Determinants of Stock Option Premiums Determinants of Call Option Premiums Determinants of Put Option Premiums How Option Pricing Can Derive a Stock's Volatility Explaining Changes in Stock Option Premiums

Speculating with Stock Options Speculating with Call Options Speculating with Put Options Excessive Risk from Speculation

Hedging with Stock Options Hedging with Covered Call Options Hedging with Put Options

Options on ETFs and Stock Indexes Hedging with Stock Index Options Using Index Options to Measure the Market’s Risk

Options on Futures Contracts Speculating with Options on Futures Hedging with Options on Interest Rate Futures Hedging with Options on Stock Index Futures

Options as Executive Compensation Limitations of Option Compensation Programs Globalization of Options Markets Currency Options Contracts

Chapter 14: Options Markets  2

Key Concepts 1. Explain why speculators take positions in stock options and how the outcome is determined. 2. Explain why institutional investors take positions in stock options and the tradeoff involved. 3. Explain how stock index options are used by institutional investors. 4. Explain how options on financial futures are used by institutional investors.

POINT/COUNTER-POINT: If You Were a Major Shareholder of a Publicly Traded Firm, Would You Prefer That Stock Options Be Traded on That Stock? POINT: No. Options can be used by investors to speculate, and excessive trading of the options may push the stock price away from its fundamental price. COUNTER-POINT: Yes. Options can be used by investors to temporarily hedge against adverse movements in the stock, so they may reduce the selling pressure on the stock in some periods. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Either argument has some validity. The main point is that students recognize the interaction between the stock price and option price. The trading of options can affect the stock price, but it may also stabilize the trading of the underlying stock.

Questions 1. Options versus Futures. Describe the general differences between a call option and a futures contract. ANSWER: A call option requires a premium above and beyond the price to be paid for the financial instrument, whereas a financial futures contract does not contain such a premium. In addition, the call option represents a right but not an obligation, whereas a futures contract represents an obligation. 2. Speculating with Call Options. How do speculators use call options? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a call option? ANSWER: Call options are purchased by speculators when the price of the underlying stock is expected to increase in the near future. If the stock price declines, the strategy of purchasing a call option can backfire. Call options are sold by speculators when the price of the underlying stock is expected to decrease in the near future. If the stock price increases, the strategy of selling a call option would backfire. The maximum loss to a purchaser of a call option is the premium paid for the call option.

Chapter 14: Options Markets  3 3. Speculating with Put Options. How do speculators use put options? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a put option? ANSWER: Put options are purchased by speculators when the price of the underlying stock is expected to remain stable or decrease in the near future. If the stock price increases, the strategy of purchasing a put option would backfire. Put options are sold by speculators when the price of the underlying stock is expected to remain stable or increase in the near future. If the stock price decreases, the strategy of selling a put option can backfire. The maximum loss to a purchaser of a put option is the premium paid for the put option. 4. Selling Options. Under what conditions would speculators sell a call option? What is the risk to speculators who sell put options? ANSWER: Speculators sell call options if they expect the price of the underlying stock to remain stable or decline in the near future. The risk to speculators that sell put options is that the price of the underlying stock declines. 5. Factors Affecting Call Option Premiums. Identify the factors affecting the premium paid on a call option. Describe how each factor affects the size of the premium. ANSWER: The greater the volatility of the underlying stock’s price, the higher the premium. The higher the stock’s existing price relative to the exercise price, the higher the premium. The longer the term to the expiration, the higher the premium. 6. Factors Affecting Put Option Premiums. Identify the factors affecting the premium paid on a put option. Describe how each factor affects the size of the premium. ANSWER: The greater the volatility of the underlying stock’s price, the higher the premium. The lower the stock’s existing price relative to the exercise price, the higher the premium. The longer the term to the expiration date, the higher the premium. 7. Leverage of Options. How can financial institutions with stock portfolios use stock options when they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more stock? ANSWER: They could purchase stock options on various stocks to lock in the maximum price they will have to pay for those stocks. Once they have sufficient funds to purchase stocks, they can exercise their options (if it is feasible to do so). 8. Hedging with Put Options. Why would a financial institution holding Hinton stock consider buying a put option on that stock rather than simply selling it?

Chapter 14: Options Markets  4 ANSWER: If a financial institution is concerned about a possible temporary decline in ABC stock, but has favorable long-term expectations for the stock, it may purchase put options on ABC stock rather than sell its ABC stock. 9. Call Options on Futures. Describe a call option on interest rate futures. How does it differ from purchasing a futures contract? ANSWER: A call option on interest rate futures provides the right to purchase a specified financial futures contract that contains a specified price. The ownership of a call option on a financial futures contract allows one the right to purchase the underlying instrument on the settlement date specified by the futures contract. However, there is no obligation to do so unless the option is exercised. If one purchased a financial futures contract rather than a call option on the futures contract, there would be an obligation. 10. Put Options on Futures. Describe a put option on interest rate futures. How does it differ from selling a futures contract? ANSWER: A put option on interest rate futures provides the right to sell a specified interest rate futures contract that contains a specified price. The ownership of a put option on an interest rate futures contract allows one the right to sell the underlying instrument on the settlement date specified by the futures contract, if the put option on futures is exercised. However, there is no obligation unless the put option on futures is exercised.

Advanced Questions 11. Hedging Interest Rate Risk. Assume a savings institution has a large number of fixed-rate mortgages and obtains most of its funds from short-term deposits. How could it use options on financial futures to hedge its exposure to interest rate movements? Would futures or options on futures be more appropriate if the institution is concerned that interest rates will decline, causing a large number of mortgage prepayments? ANSWER: The financial institution could purchase put options on interest rate futures. If interest rates increase over time, the reduced spread (between interest revenues and interest expenses) could be offset by the gain on a short position in futures. If interest rates decrease over time, the short position in futures would result in a loss. However, the put option on futures allows the financial institution the flexibility to avoid a short position in futures. The put option on futures is intended to hedge against increasing interest rates but remain exposed to interest rates if they decline in order to benefit from the decline. If interest rates decrease, and mortgage prepayments increase, a put option on futures would be preferable to a sale of futures. The sale of futures would cause a loss on the futures position, whereas the put option on futures could go unexercised. 12. Hedging Effectiveness. Three savings and loan institutions (S&Ls) have identical balance sheet compositions: a high concentration of short-term deposits that are used to provide long-term, fixedrate mortgages. The S&Ls took the following positions one year ago.

Chapter 14: Options Markets  5 Name of S&L LaCrosse Stevens Point Whitewater

Position Sold financial futures Purchased put options on interest rate futures Did not take any position in futures

Assume that interest rates declined consistently over the last year. Which of the three S&Ls would have achieved the best performance based on this information? Explain. ANSWER: Whitewater would have achieved the best performance because its long-term, fixed-rate mortgages are insensitive to the lower interest rates, but its cost of funds would decline. While Stevens Point can let its put options expire to avoid a short position in interest rate futures, it would have paid premiums on the options sold. Therefore its performance is not as high as Whitewater’s. 13. Change in Stock Option Premiums. Explain how and why the option premiums may change in response to a surprise announcement that the Fed will increase interest rates even if stock prices are not affected. ANSWER: The option premiums will increase in response to increased uncertainty. A stock’s value may remain the same while the uncertainty increases, which can result in higher premiums. 14. Speculating with Stock Options. The price of Garner stock is $40. There is also a call option on Garner stock that is at the money, with a premium of $2.00. There is a put option on Garner stock that is at the money, with a premium of $1.80. Why would investors consider writing this call option and this put option? Why would some investors consider buying this call option and this put option? ANSWER: If the investors expected that the stock price would remain somewhat stable, they could benefit from selling both options. They would receive more from premiums than their cost of fulfilling their obligations if the stock price remains close to its prevailing value. Some other investors may expect that the stock price will be very volatile, although they do not know which direction the price will move. Therefore, they expect that they will exercise only one of their options, but a large price movement could earn a large gain that would more than offset the premiums they paid for both options. 15. How Stock Index Option Prices May Respond to Prevailing Conditions. Consider the prevailing conditions that could affect the demand for stocks, including inflation, the economy, the budget deficit, and the Fed’s monetary policy, political conditions, and the general mood of investors. Based on prevailing conditions, would you consider purchasing stock index options at this time? Offer some logic to support your answer. Which factor do you think will have the biggest impact on stock index option prices? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 16. CBOE Volatility Index. How would you interpret a large increase in the CBOE volatility index (VIX)? Explain why the VIX increased substantially during the credit crisis that began in 2008.

Chapter 14: Options Markets  6 The CBOE volatility index (VIX) represents the implied volatility derived from options on the S&P 500 index (an index of 500 large stocks). An increase in the index suggests that market fear has increased, as investors who sell stock index options demand a high premium to incur the risk that the stock index might move substantially above or below the exercise price. The VIX increased substantially during the credit crisis because there was much uncertainty surrounding the economy and stock valuations. CRITICAL THINKING QUESTION 17. Strategy for Investing in CBOE Volatility Index An investment newsletter suggests that because the prevailing stock market conditions are subject to much uncertainty, investors should purchase call options on the CBOE volatility index (VIX). Write a short essay on the logic behind how the valuation of VIX is influenced by market uncertainty. Also support or refute the advice provided by the newsletter and offer a strategy for investing in call options on the VIX based on expectations of changes in market uncertainty. ANSWER When market uncertainty is high, the implied market volatility is high. Under these conditions, the premium on the CBOE volatility index is high. Since the premium already reflects high uncertainty, the advice of the newsletter is not necessarily useful. A more meaningful recommendation would be based on expectations of a change in the stock market uncertainty. If you expect a large increase in market uncertainty, you should expect a large increase in the premium of the CBOE volatility index. Thus, you may consider purchasing call options of the CBOE volatility index under these conditions, but the performance of your strategy will be determined by the accuracy of your prediction.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Our firm took a hit because we wrote put options just before the stock market crash.” Writers of put options on stocks are obligated to purchase those stocks at a specified exercise price if the options are exercised. The writers may then sell the stocks in the market at market price. When the market crashed, put option were exercised, and the writers were forced to pay for stocks at the exercise prices, which were much higher than the market prices (at which they could sell the stocks) after the crash. b. “Before hedging our stock portfolio with options on index futures, we search for the index that is most appropriate.” The ideal index option would represent the same composition of stocks as the portfolio, so that any decline in the value of the portfolio could be offset by an equal increase in the value of put options. However, the options will not completely hedge against a market downturn because the underlying index will not normally be exactly the same as the portfolio being hedged. Therefore, the gain on the put options on an index during a market downturn will not exactly offset the loss on the portfolio.

Chapter 14: Options Markets  7

c. “We prefer to use covered call writing to hedge our stock portfolios.” Covered call writing involves the sale of call options on stocks that are already owned. If the prices of the stocks decline, the losses are partially offset by the gains (premiums) earned from selling call options. If stock prices decline substantially, covered call writing will not offset the losses as much as the alternative hedging strategy of purchasing put options. However, if stock prices remain somewhat stable, covered call writing would normally have better results because there would be gains from the premiums received. Conversely, the strategy of purchasing puts would have required premiums to be paid, and the options would possibly remain unexercised.

Managing in Financial Markets As a stock portfolio manager, you have investments in many U.S. stocks and plan to hold these stocks over a long-term period. However, you are concerned that the stock market may experience a temporary decline over the next three months, and that your stock portfolio will probably decline by about the same degree as the market. The following options on a stock index futures contract are available and have an expiration date about three months from now: Exercise Price 1372 1428

Call Premium 40 24

Put Premium 24 40

The options on the stock index futures contract are priced at $250 times the quoted premium. Currently, the stock index level is 1400. The exercise price of 1372 represents a 2 percent decline from the prevailing index level, and the exercise price of 1428 represents an increase of 2 percent above the prevailing index level. a. Assume that you wanted to take an options position to hedge your entire portfolio, which is currently valued at about $700,000. How many index option contracts should you take a position in to hedge your entire portfolio? The prevailing index is worth 1400, so that $250 times the index is $350,000. If the underlying index represents $350,000, it would take two options contracts to create an underlying value of $700,000. b. Assume that you want to create a hedge so that your portfolio will lose no more than 2 percent of its present value. How could you take a position in options on index futures to achieve this goal? What is the cost to you as a result of creating this hedge? You could purchase two put option contracts on index futures with a strike price of 1372, which reflects a decline of about 2 percent from the present index value. Since the index was assumed to move in tandem with your portfolio, you are essentially hedging against movements in the index in order to hedge your portfolio. If the index level declines below 1372 (reflecting a decline of more than 2 percent), you may consider exercising the put options on index futures, which gives

Chapter 14: Options Markets  8 you the right to sell the index futures for a price of 1372. At the settlement date of the futures contract, you would receive $250 times the differential between the futures price of 1372 and the index level. This creates the hedge for you, after a 2 percent loss. There is a cost of creating this hedge. Since the put premium is 224  $250 = $6,000 for one option contract, your cost is $12,000 for two options on futures contracts. c. Given your expectations of a weak stock market over the next three months, how can you generate some fees from the sale of options on stock index futures to help cover the cost of purchasing options? You could sell call options on stock index futures with a strike price of 1428 at a premium of 24. You would receive a payment of $6,000 per contract (computed as 12  $250), or $12,000 for two contracts. The payments received could cover the payments needed to purchase put options on the stock index futures contracts. However, by selling the call options, you are obligated to make a payment to the owner of the call options who exercises the option and purchases stock index futures. On the settlement date of the futures contract, you would pay an amount that is equal to the differential between the prevailing stock index level and the strike price of 1428 (assuming that the index level exceeds 1428 as of the settlement date). That is, if the index exceeds 1428 as of the settlement date, any further gain on your stock portfolio would be offset by the amount paid to the purchaser of the stock index futures. The strategy of selling call options on index futures is worth considering when you anticipate that the stock market will experience a decline, because under these conditions the call options that you sell would not be exercised.

Problems 1. Writing Call Options. A call option on Illinois stock specifies an exercise price of $38. Today’s price of the stock is $40. The premium on the call option is $5. Assume the option will not be exercised until maturity, if at all. Complete the following table: Assumed Stock Price at the Time the Call Option Is About to Expire $37 $39 $41 $43 $45 $48

Net Profit or Loss per Share to Be Earned by the Writer (Seller) of the Call Option

Chapter 14: Options Markets  9 ANSWER: Assumed Stock Price at the Time the Call Option Is About to Expire $37 $39 $41 $43 $45 $48

Net Profit or Loss per Share to Be Earned by the Writer (Seller) of the Call Option $5 $4 $2 $0 –$2 –$5

2. Purchasing Call Options. A call option on Michigan stock specifies an exercise price of $55. Today the stock’s price is $54 per share. The premium on the call option is $3. Assume the option will not be exercised until maturity, if at all. Complete the following table for a speculator who purchases the call option: Assumed Stock Price at the Time the Call Option Is About to Expire $50 $52 $54 $56 $58 $60 $62

Net Profit or Loss per Share to Be Earned by the Speculator

ANSWER: Assumed Stock Price at the Time the Call Option Is About to Expire $50 $52 $54 $56 $58 $60 $62

Net Profit or Loss per Share to Be Earned by the Speculator –$3 –$3 –$3 –$2 $0 $2 $4

3. Purchasing Put Options. A put option on Iowa stock specifies an exercise price of $71. Today the stock’s price is $68. The premium on the put option is $8. Assume the option will not be exercised until maturity, if at all. Complete the following table for a speculator who purchases the put option (and currently does not own the stock): Assumed Stock Price at the Time the Put Option Is About to Expire $60 $64 $68 $70 $72 $74 $76

Net Profit or Loss per Share to Be Earned by the Speculator

Chapter 14: Options Markets  10 ANSWER: Assumed Stock Price at the Time the Put Option Is About to Expire $60 $64 $68 $70 $72 $74 $76

Net Profit or Loss per Share to Be Earned by the Speculator $3 –$1 –$5 –$7 –$8 –$8 –$8

4. Writing Put Options. A put option on Indiana stock specifies an exercise price of $23. Today the stock’s price is $24. The premium on the put option is $3. Assume the option will not be exercised until maturity, if at all. Complete the following table: Assumed Stock Price at the Time the Put Option Is About to Expire $20 $21 $22 $23 $24 $25 $26

Net Profit or Loss per Share to Be Earned by the Writer (Seller) of the Put Option

ANSWER: Assumed Stock Price at the Time the Put Option Is About to Expire $20 $21 $22 $23 $24 $25 $26

Net Profit or Loss per Share to Be Earned by the Writer (Seller) of the Put Option $0 $1 $2 $3 $3 $3 $3

5. Covered Call Strategy. a. Evanston Insurance Inc. has purchased shares of Stock E at $50 per share. It will sell the stock in six months. It considers using a strategy of covered call writing to partially hedge its position in this stock. The exercise price is $53, the expiration date is six months, and the premium on the call option is $2. Complete the following table. Possible Price of Stock E in 6 Months $47 $50 $52 $55 $57 $60

Profit or Loss per Share If a Covered Call Strategy Is Used

Profit or Loss per Share If a Covered Call Strategy Is Not Used

Chapter 14: Options Markets  11 ANSWER: Possible Price of Stock E in 6 Months $47 $50 $52 $55 $57 $60

Profit or Loss per Share If a Covered Call Strategy Is Used –$1 $2 $4 $5 $5 $5

Profit or Loss per Share If a Covered Call Strategy Is Not Used –$3 $0 $2 $5 $7 $10

b. Assume that each of the six stock prices in the table's first column has an equal probability of occurring. Compare the probability distribution of the profits (or losses) per share when using covered call writing versus not using it. Would you recommend covered call writing in this example? Explain. ANSWER: There is a 50 percent chance that covered call writing will result in an additional $2 per share gain. There is a 16.7 percent chance that the two possible strategies will generate the same gain. There is a 33.3 percent chance that covered call writing will result in a lower gain. 6. Put Options on Futures. Purdue Savings and Loan Association purchased a put option on Treasury bond futures with a September delivery date and an exercise price of 91-16. Assume the put option has a premium of 1-32. Assume that the price of the Treasury bond futures decreases to 88-16. Should Purdue exercise the option or should it let the option expire? What is Purdue’s net gain or loss after accounting for the premium paid on the option? ANSWER: Purdue should purchase a T-bond futures contract at 88-16 and exercise its put option to sell the contract at 91-16. Thus, it earns 3-00 per contract, which is 3.00 percent of $100,000 = $3,000. The option premium was 1-32 or 1.50 percent of $100,000 = $1,500. Therefore, the net gain is $3,000 – $1,500 = $1,500. 7. Call Options on Futures. Wisconsin Inc. purchased a call option on Treasury bond futures at a premium of 2-00. The exercise price is 92-08. If the price of the Treasury bond futures rises to 93-08, should Wisconsin Inc. exercise the call option or should it let the option expire? What is Wisconsin’s net gain or loss after accounting for the premium paid on the option? ANSWER: Wisconsin Inc. should exercise its call option in order to purchase Treasury bond futures at 92-08, and then sell the futures at the existing price of 93-08. The gain is 1-00 or 1 percent of $100,000 = $1,000. Since Wisconsin paid a premium of 2-00 or $2,000, its net gain is $1,000 – $2,000 = –$1,000. 8. Call Options on Futures. DePaul Insurance Company purchased a call option on a stock index futures contract. The option premium is quoted as $6. The exercise price is $1,430. Assume the index on the futures contract becomes $1,440. Should DePaul exercise the call option or let it expire? What is the net gain or loss to DePaul after accounting for the premium paid for the option (assume the value is measured as $250 times the index)?

Chapter 14: Options Markets  12 ANSWER: DePaul should exercise its call option by purchasing the stock index futures index for $1,430 and then selling the index at $1,440. The net gain is 4 (10 minus the $6 premium). Since the stock index contract represents $250 times the index, the gain is $1,000 ($250 times 4). 9. Covered Call Strategy. Coral Inc. has purchased shares of stock M at $28 per share. It will sell the stock in six months. It considers using a strategy of covered call writing to partially hedge its position in this stock. The exercise price is $32, the expiration date is six months, and the premium on the call option is $2.50. Complete the following table: Possible Price of Stock M in 6 Months $25 $28 $33 $36

Profit or Loss per Share If a Covered Call Strategy Is Used

Possible Price of Stock M in 6 Months $25 $28 $33 $36

Profit or Loss per Share If a Covered Call Strategy Is Used –$0.50 $2.50 $6.50 $6.50

ANSWER:

10. Hedging with Bond Futures. Smart Savings Bank desired to hedge its interest rate risk. It was considering two possibilities: (1) sell Treasury bond futures at a price of 94-00, or (2) purchase a put option on Treasury bond futures. At the time, the price of Treasury bond futures was 95-00, and the face value was $100,000. The put option premium was 2-00, and the exercise price was 94-00. Just before the option expired, the Treasury bond futures price was 91-00, and Smart Savings Bank would have exercised the put option at that time, if at all. This is also the time when it would offset its futures position, if it had sold futures. Determine the net gain to Smart Savings Bank if it had sold Treasury bond futures versus if it had purchased a put option on Treasury bond futures. Which alternative would have been more favorable, based on the situation that occurred? ANSWER: Results from Selling T-Bond Futures: Selling Price of T-Bond Futures – Purchase Price of T-Bond Futures = Net Gain

$94,000 (94.00% of $100,000) – $91,000 (91.00% of $100,000) $ 3,000 per contract

Results from Purchasing a Put Option on T-Bond Futures: Selling Price of T-Bond Futures $94,000 – Purchase Price of T-Bond Futures – $91,000 – Premium Paid for Put Option – $ 2,000 = Net Gain $ 1,000 per contract The results from selling the T-Bond futures were more favorable than the results from purchasing a put option on T-bond futures.

Chapter 14: Options Markets  13

Chapter 14: Options Markets  14

Flow of Funds Exercise Hedging with Options Contracts Carson Company would like to acquire Vinnet Inc., a publicly traded firm in the same industry. Vinnet’s stock price is currently much lower than the prices of other firms in the industry, because it operates inefficiently. Carson believes that it could restructure Vinnet’s operations and improve the company’s performance. It is about to contact Vinnet to determine whether Vinnet will agree to an acquisition. Carson is somewhat concerned that investors may learn of its plans and buy Vinnet stock in anticipation that Carson will need to pay a high premium (perhaps a 30 percent premium above the prevailing stock price) to complete the acquisition. Carson decides to call a bank about its risk, as the bank has a brokerage subsidiary that can help it hedge with stock options. a. How can Carson use stock options to reduce its exposure to this risk? Are there any limitations to this strategy, given that Carson will ultimately have to buy most or all of the Vinnet stock if the acquisition occurs? Carson could purchase call options on Vinnet stock so that it would lock in the amount it would pay for the stock if the acquisition occurs. Carson would not be able to buy call options on all of the stock. In addition, by purchasing a large amount of call options, it will likely place upward pressure on the premium of the call options. There is a limited amount of call options that would be sold at the prevailing price and Carson will have to increase its price to buy a larger amount of call options on Vinnet stock. b. Describe the maximum possible loss that may be directly incurred by Carson as a result of engaging in this strategy. The maximum loss is the premium paid for the call options. c. Explain the results of the strategy you offered in the previous question if Vinnet plans to avoid the acquisition attempt by Carson. Carson would still have the call options. It may be able to profit from the strategy if it can sell the stock for a high enough price in the market before expiration in order to recapture the premium paid for the call options. If its acquisition attempt caused investors to bid up the price of the stock, it may not necessarily lose from its effort to hedge.

Chapter 15 Swap Markets Outline Background Use of Swaps for Hedging Use of Swaps to Accommodate Financing Use of Swaps for Speculating Participation by Financial Institutions

Types of Swaps Plain Vanilla Swaps Forward Swaps Callable Swaps Putable Swaps Extendable Swaps Zero-Coupon-for-Floating Swaps Rate-Capped Swaps Equity Swaps Tax Advantage Swaps

Risks of Interest Rate Swaps Basis Risk Credit Risk Sovereign Risk

Pricing Interest Rate Swaps Prevailing Market Interest Rates Availability of Counterparties Credit and Sovereign Risk

Performance of Interest Rate Swaps Interest Rate Caps, Floors, and Collars Interest Rate Caps Interest Rate Floors Interest Rate Collars

Credit Default Swaps Secondary Market for CDS Contracts Collateral on CDS Contracts Payments on a Credit Default Swap How CDSs Affect Debtor-Creditor Negotiations

Chapter 15: Swap Markets  2

Impact of the Credit Crisis on the CDS Market Reform of CDS Contracts Globalization of Swap Markets Currency Swaps

Key Concepts 1. Remind students as to how interest rate movements can adversely affect the performance of various financial institutions. 2. Describe how financial institutions participate in swap markets. 3. Explain in general terms how interest rate swaps can hedge interest rate risk. 4. Identify the various types of interest rate swaps, and the advantages of each.

POINT/COUNTER-POINT: Should Financial Institutions Engage in Interest Rate Swaps for Speculative Purposes? POINT: Yes. They have expertise in forecasting future interest rate movements and can generate gains for their shareholders by taking speculative positions. COUNTER-POINT: No. They should use their main business to generate gains for their shareholders. They should serve as intermediaries for swap transactions only to generate transaction fees or take a position only to hedge their exposure to interest rate risk. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own

opinion. ANSWER: Either argument has some validity. There is risk from speculating in interest rate swaps. A financial institution could incur losses from its speculative positions, which may offset some or all of its gains from its other operations. In addition, its credit rating may be reduced if it takes excessive risk.

Questions 1. Hedging with Interest Rate Swaps. Bowling Green Savings & Loan uses short-term deposits to fund fixed-rate mortgages. Explain how Bowling Green can use interest rate swaps to hedge its interest rate risk. ANSWER: Bowling Green could engage in a fixed-for-floating swap. If interest rates rise, its inflow payments resulting from the swap will rise while its outflow payments will remain stable. Thus, its gain from the swap arrangement can offset any reduction in its profits that result from a higher cost of funds.

Chapter 15: Swap Markets  3 2. Decision to Hedge with Interest Rate Swaps. Explain the types of cash flow characteristics that would cause a firm to hedge interest rate risk by swapping floating-rate payments for fixed payments. Why would some firms avoid the use of interest rate swaps, even when they are highly exposed to interest rate risk? ANSWER: Interest rate swaps can possibly reduce potential returns. Consider a savings institution that uses short-term deposits to finance fixed-rate mortgages. This institution will typically experience higher profits when interest rates decline. Under these conditions, a fixed-for-floating interest rate swap would generate a loss, since its inflow payments from the swap would decline over time while its outflow payments would be stable. 3. Role of Securities Firms in Swap Market. Describe the possible roles of securities firms in the swap market. ANSWER: Securities firms can act as an intermediary by matching up firms that have opposite swap needs. They also can act as a dealer by taking the counter-position in a swap desired by a client. If a firm’s business resulted in fixed-rate outflows and floating-rate inflows, it would be adversely affected by a decline in interest rates. To hedge against this form of interest rate risk, it could swap floating-rate payments in exchange for fixed-rate payments. 4. Hedging with Swaps. Chelsea Finance Company receives floating inflow payments from its provision of floating-rate loans. Its outflow payments are fixed because of its recent issuance of longterm bonds. Chelsea is concerned that interest rates will decline in the future. Yet, it does not want to hedge its interest rate risk, because it believes interest rates may increase. Recommend a solution to Chelsea’s dilemma. ANSWER: Chelsea could negotiate a putable swap, which represents a floating payment in exchange for fixed payments, with an option to terminate the swap. If interest rates rise, Chelsea could terminate the swap. If interest rates fall, Chelsea will benefit from the swap. 5. Basis Risk. Comiskey Savings provides fixed-rate mortgages of various maturities, depending on what customers want. It obtains most of its funds from issuing certificates of deposit with maturities ranging from one month to five years. Comiskey has decided to engage in a fixed-for-floating swap to hedge its interest rate risk. Is Comiskey exposed to basis risk? ANSWER: Yes. Comiskey’s liabilities are more rate-sensitive than its assets, but it is difficult to determine the degree. Thus, the interest rate swap will not completely eliminate its interest rate risk. 6. Fixed-for-Floating Swaps. Shea Savings negotiates a fixed-for-floating swap with a reputable firm in South America that has an exceptional credit rating. Shea is very confident that there will not be a default on inflow payments because of the very low credit risk of the South American firm. Do you agree? Explain. ANSWER: No. While the credit risk is low, the sovereign risk may be high, since the government could possibly restrict the firm from sending payments.

Chapter 15: Swap Markets  4 7. Fixed-for-Floating Swaps. North Pier Company entered into a two-year swap agreement, which would provide fixed-rate payments for floating-rate payments. Over the next two years, interest rates declined. Based on these conditions, did North Pier Company benefit from the swap? ANSWER: No. The fixed-rate payments owed by North Pier over the two years would likely have exceeded the floating-rate payments received as a result of the swap arrangement. 8. Equity Swap. Explain how an equity swap could allow Marathon Insurance Company to capitalize on expectations of a strong stock market performance over the next year without altering its existing portfolio mix of stocks and bonds. ANSWER: An equity swap involves the exchange of interest payments (based on a specified interest rate) for payments linked to the degree of change in a stock index. Marathon Insurance Company could engage in an equity swap in which it exchanges interest payments for payments linked to the appreciation in the S&P 500 index. If the S&P 500 index appreciates over the next year by a percentage that exceeds the interest rate specified in the swap arrangement, Marathon will receive a dollar amount that equals the differential (percentage increase in stock index value minus the specified interest rate) multiplied by the notional principal value specified in the swap arrangement. 9. Swap Network. Explain how the failure of a large commercial bank could cause a worldwide swap credit crisis. ANSWER: Assume the commercial bank has taken positions in numerous swaps and guaranteed payments on other swaps. As it fails, it will default on its swap payments. The counterparties of these swaps may experience cash flow problems if they do not receive the payments dictated by the swap agreement. Consequently, they may default on other swap agreements or on other financial agreements, causing cash flow problems for other firms. The globalized swap network could allow the problems of one large intermediary to spread across countries. 10. Currency Swaps. Markus Company purchases supplies from France once a year. Would Markus be favorably affected if it establishes a currency swap arrangement and the dollar strengthens? What if it establishes a currency swap arrangement and the dollar weakens? ANSWER: Markus could engage in a currency swap arrangement in which it agrees to swap dollars for euros once a year. The currency swap arrangement would have backfired on Markus in the period when the dollar strengthened. However, it would have been beneficial to Markus in the period when the dollar weakened. 11. Basis Risk. Explain basis risk as it relates to a currency swap. ANSWER: Basis risk would reflect the hedging of a position in a foreign currency with a swap in a highly correlated currency (assuming that a swap does not exist for the currency in which the firm has a position). Basis risk occurs because the two currencies probably do not move in perfect tandem. 12. Sovereign Risk. Give an example of how sovereign risk is related to currency swaps. ANSWER: An example of sovereign risk is that the government of a country could suspend the convertibility of the home currency. Consequently, a counterparty on a currency swap arrangement may be restricted from meeting its obligation.

Chapter 15: Swap Markets  5 13. Use of Interest Rate Swaps. Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they prefer to make? ANSWER: In some cases, the premium paid by a risky firm when issuing fixed-rate bonds may be higher than if it issues variable-rate bonds. Thus, it may prefer to issue variable-rate bonds even if it desires to make fixed payments. An interest rate swap will allow the firm to receive variable-rate inflows for fixed-rate outflows. The inflows could be used to cover its payments to bondholders. Some firms may prefer to issue a variable-rate bond but have an advantage in issuing fixed-rate bonds. Thus, it would issue fixed-rate bonds and engage in a swap to exchange variable-rate payments for fixed-rate payments. The fixed-rate payments received could be used to make payments to bondholders. 14. Use of Currency Swaps. Explain why some companies that issue bonds engage in currency swaps. Why do they not simply issue bonds in the currency that they would prefer to use for making payments? ANSWER: Companies may not be well known in the country where the bonds denominated in a particular currency could most easily be placed. Therefore, they may issue bonds in a different country and denominated in a different currency. They could agree to swap whatever currency they normally receive in the form of cash inflows for the currency they will need to pay coupon payments or principal on the bonds at specified points in time.

Advanced Questions 15. Rate-Capped Swaps. Bull and Finch Company wants a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and remain very high until the swap maturity date. Should it consider negotiating for a rate-capped swap with the cap set at two percentage points above the fixed rate? Explain. ANSWER: Bull and Finch should not consider the rate-capped swap because it would restrict the potential interest payments received. Based on its expectations, it would forgo large payments with a cap, which would more than offset the up-front fee received for agreeing to a cap. 16. Forward Swaps. Rider Company negotiates a forward swap to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates rise substantially over the next two years? That is, would Rider be better off by using this forward swap than if it had simply waited two years before negotiating the swap? Explain. ANSWER: Rider would have been better off with the forward swap, because the fixed rate specified in the forward swap would be lower than the fixed rate specified two years later (since the fixed rate negotiated at any time will be somewhat dependent on prevailing rates at that time). By using a forward swap, Rider would have been able to lock in a lower rate on its fixed outflow payments in the swap arrangement. 17. Swap Options. Explain the advantage of a swap option to a financial institution that wants to swap fixed payments for floating payments. ANSWER: A swap option would allow the financial institution to terminate the swap arrangement prior to maturity. If interest rates were declining instead of rising, this institution may be better off without a swap arrangement.

Chapter 15: Swap Markets  6 18. Callable Swaps. Back Bay Insurance Company negotiated a callable swap involving fixed payments in exchange for floating payments. Assume that interest rates decline consistently up until the swap maturity date. Do you think Back Bay might terminate the swap prior to maturity? Explain. ANSWER: Back Bay Co. would probably have terminated the swap since the inflow payments received were consistently declining while the outflow payments made were constant. 19. Credit Default Swaps. Credit default swaps were once viewed as a great innovation could make mortgage markets more stable. However, the swaps were sometimes criticized for making the credit crisis worse. Why? ANSWER: Credit default swaps protect securities against default, but the protection is only as strong as the seller of the swaps. Some financial institutions that sold credit default swaps were subject to failure, which means that all the securities that they were protecting might not be protected. Therefore, the credit default swaps encouraged some investors to take the risk of buying risky mortgage-backed securities that they thought were backed by the swap, which led to even more risk when considering that the sellers of swaps might default. 20. Credit Default Swap Prices. Explain why the failures of Lehman Brothers caused prices on credit default swap contracts to increase. ANSWER: The credit crisis illustrated how protection provided to buyers of a CDS is only as good as the creditworthiness of the CDS seller. Participants recognized that the government will not automatically rescue all large financial institutions. Sellers of new CDS contracts required higher payments because the risk premium on the CDS contracts increased. The sellers were only willing to sell CDS contracts if they received higher payments in order to compensate for the higher risk. 21. Reform of CDS Contracts. Explain how the Financial Reform Act of 2010 and the rules issued to implement it attempted to reduce the risk in the financial system resulting from the use of credit default swaps. ANSWER: As a result of the Financial Reform Act of 2010, derivative securities such as swaps are to be traded on an exchange or clearinghouse. One obvious result of having derivatives traded on an exchange or clearinghouse instead of over-the-counter is that the derivative contracts should become more standardized. Second, the pricing of these contracts should become more transparent, as the exchange should post prices paid for the standardized derivative contracts that are traded on the exchange. Third, the use of standardized contracts should increase the trading volume, which should reduce the uncertainty surrounding the price of a standardized derivative contract. Fourth, market participants and regulators should be more informed about the usage of particular swap contracts if they are traded on an exchange, because the exchange should publicize the trading volume per contract.

CRITICAL THINKING QUESTION Credit Default Swaps and the Credit Crisis A critic recently mentioned that the creation of credit default swaps caused the credit crisis in the 2008-2009 period. Write a short essay that supports or refutes this statement.

Chapter 15: Swap Markets  7 ANSWER Credit default swaps allowed investors to bet that valuations of mortgages and MBS would decline. This might have expedited the correction of the housing bubble because it allowed some investors to capitalize on their expectations of high mortgage default rates. Yet, even if credit default swaps did not exist, the housing bubble would burst. Home prices were too high because they were pushed upward by a temporary excessive demand by homeowners who should not have been allowed as much credit as they were given. Thus, the defaults on the mortgages were inevitable regardless of whether the credit default swaps existed.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The swaps market is another Wall Street-developed house of cards.” There is a concern that the swaps market could overexpose some banks so if swap arrangements are adversely affected, banks will be devastated. Many swap arrangements are linked in various ways, so that defaults could cause a domino effect throughout the banks in this market. b. “As a dealer in interest rate swaps, our bank takes various steps to limit our exposure.” Any provisions that could force clients to meet their swap obligations would help protect banks. Regulators could assess the historical default rate on swaps and force banks to maintain a capital level that would absorb the possible losses under most conditions. c. “The regulation of commercial banks, securities firms, and other financial institutions that participate in the swaps market could create a regulatory war.” Regulations vary across financial institutions, so that one dealer in swaps may receive more favorable treatment (less regulation) than another dealer.

Managing in Financial Markets As a manager of a commercial bank, you have just purchased a three-year interest rate collar, with LIBOR as the interest rate index. The interest rate cap specifies a fee of 2 percent of notional principal valued at $100 million and an interest rate ceiling of 9 percent. The interest rate floor specifies a fee of 3 percent of the $100 million notional principal and an interest rate floor of 7 percent. Assume that LIBOR is expected to be 6 percent, 10 percent, and 11 percent, respectively, at the end of each of the next three years. a. Determine the net fees paid, as well as the expected net payments to be received as a result of purchasing the interest rate collar.

Chapter 15: Swap Markets  8 The net payments are derived as follows: 0

Purchase of Interest Cap:

LIBOR

10%

11%

Interest Rate Ceiling

9%`

LIBOR’s Percentage Points Above the Ceiling

Payments Received (Based on $100 Million of Notional Principal)

$1,000,000

$2,000,000

LIBOR’s Percentage Points Below the Floor

Payments Made (Based on $100 Million of Notional Principal)

$1,000,000

Fee Paid

$2,000,000

Sale of Interest Interest Rate Rate Floor: Floor

Fee Received

$3,000,000

Chapter 15: Swap Markets  9 b. Assuming you are very confident that interest rates will rise, should you consider purchasing a callable swap instead of the collar? Explain. The interest collar is most appropriate if you are confident that interest rates will rise. The callable swap allows you flexibility to terminate the swap agreement in the event that interest rates do not rise. However, you pay a premium for this flexibility in the form of a higher fixed interest rate. You should not be willing to pay this premium if you do not expect to capitalize on the flexibility. c. Explain the conditions under which your purchase of an interest rate collar could backfire. If interest rates decline rather than rise, you will not receive any payments on the interest rate cap. Yet, you would have to make payments because of your obligation to the party that purchased an interest rate floor from you.

Problems 1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent, respectively, at the end of each of the next three years. a. Determine the net dollar amount to be received (or paid) by Cleveland each year. ANSWER: End of Year: 1

LIBOR

10%

Floating Rate Received

10%

11%

Fixed Rate Paid

Swap Differential

Net Dollar Amount Received (Based on a Notional Value of $50 Million)

$1,000,000

$1,500,000

b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate swap each year based on the assumed forecasts of LIBOR. ANSWER: Year 1 = $0; Year 2 = $1,000,000 paid; Year 3 = $1,500,000 paid 2. Interest Rate Caps. Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 8 percent, 10 percent, 12 percent, and 13 percent, respectively, at the end of each of the next four years. a. Determine the initial fee paid, as well as the expected payments to be received by Northbrook if LIBOR moves as forecasted.

Chapter 15: Swap Markets  10 ANSWER: End of Year: 0

LIBOR

10%

12%

13%

Interest Rate Ceiling

$1,000,000

$3,000,000

$4,000,000

LIBOR’s Percentage Points Above the Ceiling Payments to be Received (Based on $100 Million of Notional Principal Fee Paid

$3,000,000

b. Determine the dollar amount to be received (or paid) by the seller of the interest rate cap based on the assumed forecasts of LIBOR. ANSWER: End of Year 0 Year 1 Year 2 Year 3 Year 4

= = = = =

$3,000,000 received $0 $1,000,000 paid $3,000,000 paid $4,000,000 paid

3. Interest Rate Floors. Iowa City Bank purchases a three-year interest rate floor for a fee of 2 percent of notional principal valued at $80 million, with an interest rate floor of 6 percent, and LIBOR representing the interest rate index. The bank expects LIBOR to be 6 percent, 5 percent, and 4 percent respectively at the end of each of the next three years. a. Determine the initial fee paid, as well as the expected payments to be received by Iowa City if LIBOR moves as forecasted. ANSWER: End of Year: 0

LIBOR

Interest Rate Floor

LIBOR’s Percentage Points Below the Floor

Chapter 15: Swap Markets  11 Payments to be Received (Based on $80 Million of Notional Principal) Fee Paid

$800,000

$1,600,000

b. Determine the dollar amounts to be received (or paid) by the seller of the interest rate floor based on the assumed forecasts of LIBOR. ANSWER: End of Year 0 Year 1 Year 2 Year 3

= = = =

$1,600,000 received $0 $800,000 paid $1,600,000 paid

Flow of Funds Exercise Hedging with Interest Rate Derivatives Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by approximately 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping and that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. Carson currently relies mostly on commercial loans with floating interest rates for its debt financing. It has contacted Blazo Bank about the use of interest rate derivatives to hedge the risk. a.

How could Carson use interest rate swaps to reduce the exposure of its cost of debt to interest rate movements? Carson could engage in a swap of fixed interest rates in exchange for floating interest rates. If interest rates increased as anticipated, Carson would receive higher inflow payments from the swap arrangement over time, but its outflow payments would remain constant. This would help to offset its higher cost of debt financing as the interest rate charged on its floating-rate loans increases.

b. What is a possible disadvantage of Carson using the interest rate swap hedge as opposed to no hedge? If interest rates decline, Carson would incur lower debt financing costs on its floating-rate loans. Yet, the reduction in debt financing costs would be partially offset by the cost of an interest rate swap, as its fixed outflow payments would exceed its floating inflow payments from the swap. c. How could Carson use an interest rate cap to reduce the exposure of its cost of debt to interest rate movements?

Chapter 15: Swap Markets  12

Carson could purchase an interest rate cap, in which it would receive payments if market interest rates increased beyond a specified level. These payments could help to offset the higher cost of the debt financing. d. What is a possible disadvantage of Carson using the interest cap hedge as opposed to no hedge? If interest rates decline, Carson would still incur a cost from the interest rate cap but would not receive any benefits. The reduction in debt financing costs would be partially offset by the cost of an interest rate cap. e.

Explain the tradeoff from using an interest rate swap versus an interest rate cap. The profit from an interest rate swap would be more closely matched to the increase in debt financing costs from the use of a floating-rate loan. Conversely, the cap does not offset any increase in debt financing costs until the interest rates exceed a specific level. However, if interest rates decline, the interest rate swap used by Carson would require net outflow payments, while the interest rate cap would not require additional payments.

Chapter 16 Foreign Exchange Derivative Markets Outline Foreign Exchange Markets and Systems Spot Market Forward Market Institutional Use of Foreign Exchange Markets Types of Exchange Rate Systems Eurozone Arrangement Cryptocurrencies Virtual Currencies

Factors Affecting Exchange Rates Differential Inflation Rates Differential Interest Rates Central Bank Intervention

Forecasting Exchange Rates Technical Forecasting Fundamental Forecasting Market-Based Forecasting Mixed Forecasting

Foreign Exchange Derivatives Forward Contracts Currency Futures Contracts Currency Swaps Currency Options Contracts Comparing Foreign Exchange Derivatives for Hedging Comparing Foreign Exchange Derivatives for Speculating

International Arbitrage Locational Arbitrage Triangular Arbitrage Covered Interest Arbitrage

Chapter 16: Foreign Exchange Derivative Markets  2

Key Concepts 1. Identify factors that influence exchange rates. 2. Explain how various foreign exchange derivatives can be used to hedge against exchange rate movements. 3. Explain how arbitrage can assure that currency values are not mispriced.

POINT/COUNTER-POINT: Do Financial Institutions Need to Consider Foreign Exchange Market Conditions When Making Domestic Security Market Decisions? POINT: No. If there is no exchange of currencies, there is no need to monitor the foreign exchange market. COUNTER-POINT: Yes. Foreign exchange market conditions can affect an economy or an industry and therefore affect the valuation of securities. In addition, the valuation of a firm can be affected by currency movements because of its international business. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own

opinion. ANSWER: The counter-point is correct. Students should not view the foreign exchange market as an isolated market.

Questions 1. Exchange Rate Systems. Explain the exchange rate system that existed during the 1950s and 1960s. How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system differ from the earlier system? ANSWER: The 1950s and 1960s were part of the Bretton Woods era, in which currency values were maintained within 1 percent of a specified rate. In 1971, the Smithsonian Agreement called for a widening of the boundaries to 2-1/4 percent around each currency’s specified rate. These boundaries were eliminated in 1973. Today, there are no explicit boundaries. 2. Dirty Float. Explain the difference between a freely floating system and a dirty float. Which type is more representative of the United States system? ANSWER: A free float implies that currencies are market determined without government intervention. A dirty float implies that currency values can fluctuate but are subject to government intervention. The dirty float is more representative of the United States. 3. Impact of Quotas. Assume that European countries impose a quota on goods imported from the United States, and that the United States does not plan to retaliate. How could this affect the value of the euro? Explain.

Chapter 16: Foreign Exchange Derivative Markets  3 ANSWER: A quota on goods imported from the United States by Europe will reduce the supply of euros for sale (to be exchanged for dollars) and places upward pressure on the euro. 4. Impact of Capital Flows. Assume that stocks in the United Kingdom become very attractive to U.S. investors. How could this affect the value of the British pound? Explain. ANSWER: U.S. investors would convert dollars to pounds to purchase British stocks. Thus, the value of the pound may appreciate against the dollar in response to the increased U.S. demand for pounds. 5. Impact of Inflation. Assume that Mexico suddenly experiences high and unexpected inflation. How could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory? ANSWER: High Mexican inflation would cause an increased Mexican demand for U.S. goods (increased supply of pesos for sale) and a reduced U.S. demand for Mexican goods (and therefore a reduced demand for Mexican pesos). Both forces place downward pressure on the value of the peso. 6. Impact of Economic Conditions. Assume that Switzerland has a very strong economy, placing upward pressure on both its inflation and interest rates. Explain how these conditions could place pressure on the value of the Swiss franc and determine whether the franc’s value will rise or fall. ANSWER: A stronger economy will cause an increased Swiss demand for U.S. goods, which places downward pressure on the value of the franc. A higher Swiss inflation rate will also increase the Swiss demand for U.S. goods, which places downward pressure on the franc’s value. Higher Swiss interest rates may attract U.S. funds and place upward pressure on the franc’s value. The first two factors relate to international trade while the third factor relates to capital flows. If trade flows are larger, the franc’s value is expected to depreciate. 7. Central Bank Intervention. The Bank of Japan desires to decrease the value of the Japanese yen against the U.S. dollar. How could it use direct intervention to achieve this goal? ANSWER: The Bank of Japan could flood the foreign exchange market with yen by selling yen in exchange for U.S. dollars, causing downward pressure on the yen’s value. 8. Conditions for Speculation. Explain the conditions under which a speculator would like to take a speculative position in which it will invest in a foreign currency today, even when the speculator has no use for that currency in the future. ANSWER: A speculator may invest in a currency if it expects the currency to appreciate. 9. Risk from Speculating. Seattle Bank just took speculative positions by borrowing Canadian dollars and converting the funds to invest in Australian dollars. Explain a possible future scenario that could adversely affect the bank’s performance. ANSWER: If the Canadian dollar appreciates against the U.S. dollar, while the Australian dollar depreciates against the U.S. dollar, this implies that the Canadian dollar is appreciating against the Australian dollar. Seattle Bank would be adversely affected by this scenario. If the Australian dollar inflows from closing out the long position are used to cover the short position in Canadian dollars, they will be worth fewer Canadian dollars (because of the Australian dollar’s assumed depreciation).

Chapter 16: Foreign Exchange Derivative Markets  4 10. Impact of a Weak Dollar. How does a weak dollar affect U.S. inflation? Explain. ANSWER: A weak dollar tends to cause higher prices paid by U.S. firms for foreign supplies and materials. It also reduces foreign competition and allows U.S. producers to raise prices more easily without concern about losing business. Both forces reflect upward pressure on U.S. inflation. 11. Speculating With Foreign Exchange Derivatives. Explain how foreign exchange derivatives could be used by U.S. speculators to speculate on the expected appreciation of the Japanese yen. ANSWER: U.S. speculators could attempt to lock in an exchange rate at which they could exchange dollars for yen at a future point in time. This could be accomplished by purchasing forward contracts or futures contracts on Japanese yen, negotiating a swap for yen, or purchasing yen call options. They could also sell yen put options to capitalize on their expectations.

Advanced Questions 12. Interaction of Capital Flows and Yield Curve. Assume a horizontal yield curve exists. How do you think the yield curve would be affected if foreign investors in short-term securities and long-term securities suddenly anticipate that the value of the dollar will strengthen? (You may find it helpful to refer to the discussion of the yield curve in Chapter 3.) ANSWER: Open-ended. Foreign investors may purchase more U.S. securities than before to benefit from their expectations. A stronger dollar tends to place downward pressure on inflation and therefore on future interest rates. Therefore, foreign investors could benefit more from purchase long-term bonds than from purchasing short-term securities. While there could be an increased demand for short-term and long-term U.S. securities, the demand for long-term securities should be greater. Thus, while both short-term and long-term rates should decline, long-term rates will decline by a greater degree. The result is a new yield curve that is lower than the previous yield curve and is sloped downward. 13. How the Euro’s Value May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, interest rates, and any other factors that could affect exchange rates. Based on prevailing conditions, do you think the euro’s value will likely appreciate or depreciate against the dollar for the remainder of this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the euro’s exchange rate? ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 14. Obtaining Credit from the European Central Bank. What are the consequences to a government in the Euroone when it obtains credit from the ECB? ANSWER: When the ECB provides credit to a country, it imposes austerity conditions that are intended to help the government resolve its budget deficit problems over time. These conditions may include a reduction in government spending and higher tax rates on citizens.

Chapter 16: Foreign Exchange Derivative Markets  5 15. Impact of Abandoning the Euro on Eurozone Conditions. Explain the possible signal that would be transmitted to the market if a country abandoned its use of the euro. ANSWER: If a country abandoned use of the euro, it might signal the possible abandonment by other countries that presently participate in the euro. If MNCs and large institutional investors outside of the Eurozone feared other countries would follow, they may not be willing to invest any more funds in the Eurozone, because they might fear the collapse of the euro. This might encourage them to sell their assets in the Eurozone now so that they could move their money into their home currency or another currency before the euro weakens. CRITICAL THINKING QUESTION Central Bank Intervention as a Policy Tool Recently, a government official in Europe stated that the European Central Bank needs to weaken the euro so as to improve the European economy. Write a short essay that explains the logic behind this recommendation, and state whether you believe the strategy would be successful. ANSWER A weak euro would make other currencies expensive for European companies and consumers, which can discourage them from buying other currencies to import products or to invest in other countries. Thus, it may encourage them to spend within Europe, which can stimulate Europe’s economy. In addition, a weak euro can attract investment from other countries into Europe and can also encourage other countries to purchase products produced in Europe. This can also stimulate Europe’s economy. However, it may be a challenge for the European Central Bank (ECB) to weaken the euro against other currencies. Other governments may not want their local currency to strengthen against the euro. Thus, they could engage in intervention to offset intervention that is implemented by the ECB. All countries cannot simultaneously weaken their local currency against other currencies.

Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “Our use of currency futures has completely changed our risk-return profile.” The use of currency futures to hedge reduces a firm’s risk, but also reduces its expected return. b. “Our use of currency options resulted in an upgrade in our credit rating.” The use of currency options resulted in lower exchange rate risk, so the firm’s credit rating was upgraded. c. “Our strategy to use forward contracts to hedge backfired on us.” The use of forward contracts can reduce overall profits by hedging the firm’s position that may have performed better if it was not hedged.

Chapter 16: Foreign Exchange Derivative Markets  6

Managing in Financial Markets You are the manager of a stock portfolio for a financial institution, and approximately 20 percent of your stock portfolio is in British stocks. You expect the British stock market to perform well over the next year, and you plan to sell the stocks one year from now (and will convert the British pounds received to dollars at that time). However, you are concerned that the British pound may depreciate against the dollar over the next year. a. Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks. You could negotiate a forward contract to sell pounds one year from now. You would specify an amount of pounds in the forward contract that you expect to have in one year. b. If interest rate parity holds, does this limit the effectiveness of a forward rate contract as a hedge? Interest rate parity does not limit the effectiveness of a forward hedge on a portfolio of British stocks. It simply suggests that the forward premium, or discount, reflects the interest rate differential. c. Explain how you could use an options contract to hedge the exchange rate risk associated with your position in stocks. You could purchase put option contracts on pounds that would allow you to sell pounds at a specified price (the exercise price). This locks in the minimum exchange rate at which the pounds can be sold. If the spot rate of the pound exceeds this exercise price at the time the pounds are sold, you would not exercise the put option, but would instead sell the pounds at the prevailing spot rate. d. Assume that while you are concerned about the potential decline in the pound’s value, you also believe that the pound could appreciate against the dollar over the next year. You would like to benefit from the potential appreciation of the pound but wish to hedge against the possible depreciation of the pound. Should you use a forward contract or options contracts to hedge your position? Explain. You should purchase put options on pounds so that you have the flexibility to let the options expire if the pound appreciates over the year; the put options could be exercised if the pound depreciates over the year.

Problems 1. Currency Futures. Use the following information to determine the probability distribution of per unit gains from selling Mexican peso futures.  The spot rate of peso is $.10.  The price of peso futures per unit is $.102 per unit.  Your expectation of peso spot rate at maturity of futures contract is:

Chapter 16: Foreign Exchange Derivative Markets  7 Possible Outcome for Future Spot Rate .09 .095 .11

Probability 10% 70% 20%

ANSWER: Possible Outcome for Future Spot Rate $.09 .095 .11

Gain per Unit from Selling Futures Contracts $.102 – $.09 = $.012 $.102 – $.095 = $.007 $.102 – $.11 = –$.008

Probability 10% 70 20

2. Currency Call Options. Use the following information to determine the probability distribution of net gains per unit from purchasing a call option on British pounds:  The spot rate of the British pound = $1.45  The premium on the British pound option = $.04 per unit  The exercise price of British pound option = $1.46  Your expectation of British pound spot rate prior to the expiration of option is: Possible Outcome for Future Spot Rate $1.48 1.49 1.52

Probability 30% 40% 30%

ANSWER: Possible Outcome for Future Spot Rate $1.48 1.49 1.52

Gain per Unit from Purchasing a Call Option (After Accounting for Premium Paid) –$.02 –$.01 $.02

Probability 30% 40 30

3. Locational Arbitrage. Assume the following exchange rate quotes on British pounds: Orleans Bank Kansas Bank

Bid $1.46 1.48

Ask $1.47 1.49

Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the exchange rates. ANSWER: One could purchase pounds at Orleans Bank for $1.47 and sell them to Kansas Bank for $1.48. As locational arbitrage occurs, Orleans Bank will increase its ask price while Kansas Bank reduces its bid price, causing a realignment of the exchange rates.

Chapter 16: Foreign Exchange Derivative Markets  8

4. Covered Interest Arbitrage. Assume the following information:  British pound spot rate = $1.58  British pound one-year forward rate = $1.58  British one-year interest rate = 11%  U.S. one-year interest rate = 9% Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 9 percent. What would be their yield? Explain how the spot and forward rates of the pound would change as covered interest arbitrage occurs. ANSWER: U.S. investors would purchase pounds for $1.58 in the spot market, invest the pounds at 11 percent, and simultaneously sell pounds forward at $1.58. The yield would be 11 percent. As covered interest arbitrage occurs, the spot rate of the pound will increase, and the forward rate will decrease. 5. Covered Interest Arbitrage. Assume the following information:  Mexican one-year interest rate = 15%  U.S. one-year interest rate = 11% If interest rate parity exists, what would be the forward premium or discount on the Mexican peso’s forward rate? Would covered interest arbitrage be more profitable to U.S. investors than investing at home? Explain. ANSWER: If interest rate parity exists, the forward premium (discount) is:

Covered interest arbitrage would not be feasible since the forward discount offsets the higher interest rate in Mexico. U.S. investors could earn 9 percent by investing in the United States, which is the same yield they would earn using covered interest arbitrage.

Flow of Funds Exercise Hedging With Foreign Exchange Derivatives Carson Company expects that it will receive a large order from the government of Spain. If the order occurs, Carson will be paid about 3 million euros. Since all of its expenses are in dollars. Carson would like to hedge this position. Carson has contacted a bank, with brokerage subsidiaries that can help it hedge with foreign exchange derivatives. a.

How could Carson use currency futures to hedge its position? Carson could sell currency futures, so that it could lock in the future sale of 3 million euros.

Chapter 16: Foreign Exchange Derivative Markets  9 b.

What is the risk of hedging with currency futures? If Carson does not receive the order, it will still need to sell 3 million euros as of the settlement date at the exchange rate specified in the futures contract. It can offset this sale of a futures contract by buying an identical contract. Yet, it may incur a loss if the euro’s value increased by the time it created the offsetting position, as the price to be paid for euros on the settlement date exceeds the price at which it is contracted to sell euros as of the settlement date.

c. How could Carson use currency options to hedge its position? Carson could purchase put options on euros, which allow it the option to sell euros at a specified exchange rate. d. Explain the advantage and disadvantage to Carson of using currency options instead of currency futures. Currency put options do not obligate Carson to sell euros in the future. Therefore, if Carson does not receive the order and the euro’s value declines over time, it can let the option contract expire. If it receives the order and the euro’s value is higher at the time it receives payment than the rate specified in the option contract, it can let the option expire and sell the euros in the spot market. The futures contract does not allow such flexibility, as it would obligate to sell euros on a specified settlement date at the rate specified in the futures contract. However, Carson has to pay a premium for put options, so the cost of the hedge is more expensive than selling futures contracts.

Solution to Integrative Problem for Part 5 Choosing Among Derivative Securities 1. The scenario suggests that the United States will rebound from the recession, which should place upward pressure on interest rates (primarily because of an increase in the demand for loanable funds, as spending increases). If interest rates rise, the savings institution should hedge. Assuming that interest rates are expected to increase for at least a few years, the fixed-for-floating swap would be appropriate. While this may limit the return to the institution, it provides a proper hedge. The floating-for-fixed swap is not appropriate because it would expose the institution to even more interest rate risk. The put option on futures could be a useful hedge, but a premium must be paid for the option. The option offers more flexibility than the interest rate swap because it does not have to be exercised. Yet, if interest rates are almost definitely expected to rise, there is no reason to pay a premium for the extra flexibility. 2. Economic conditions will likely improve, so that stock prices will rise. While this is a subjective assessment, there is no reason to expect a major decline in stock prices. Therefore, a hedge (such as selling stock index futures) is not appropriate. The insurance company should remain unhedged. 3. Since interest rates will likely increase, there is reason to consider hedging the bond portfolio. The proper hedge would be to sell bond index futures. The pension fund would not wish to buy bond index futures because it would be even more exposed to interest rate risk.

Chapter 16: Foreign Exchange Derivative Markets  10 Some people might suggest that hedging the bond portfolio of a pension fund is not necessary because the income received will ultimately be transferred to participants. The situation is different than that of a savings institution, which attracts deposited funds (at a cost) to make investments that are exposed to interest rate risk. The pension fund receives its funds from contributions and therefore may not be as concerned about rising interest rates over time (since it does not pay an interest rate on incoming funds). Nevertheless, it could be better off by hedging in this situation if it is confident that interest rates will rise. The proper hedge is to sell bond index futures. 4. A short position (selling bond index futures) in a U.S. bond index will not necessarily be an effective hedge against the interest rate risk of non-U.S. bonds. Interest rates in the United Kingdom will not always move in tandem with U.S. interest rates. Therefore, prices of these bonds could decline even more than those of U.S. bonds, as the respective interest rates in the U.K. could possibly increase by a higher degree. A sale of a particular bond index futures contract would not be an effective hedge under such circumstances. Exchange rate risk is also an important risk to consider. If the British pound weakens against the dollar, the dollar value of the international mutual fund will decline, and the dollar value of each share will decline. According to the background information given, the dollar was weak. Yet, if U.S. interest rates begin to rise, there may be some upward pressure on the value of the dollar, which would reduce the fund’s value. To hedge against the risk of a stronger dollar (a weaker pound), the manager could sell currency futures contracts on the pound. If the pound’s value declines, there would be a gain on the currency futures position, which can offset the adverse effect on the value of the international mutual fund. If the manager desired a hedge with more flexibility, put options on the pound could be purchased. In the event that the pound strengthens, the options would not be exercised. The value of the international mutual fund would increase when the pound appreciates, since its value is measured in dollars. The currency options offer more flexibility than currency futures, but a premium must be paid for the options.

Chapter 17 Commercial Bank Operations Outline Background on Commercial Banks Bank Market Structure

Bank Sources of Funds Transaction Deposits Savings Deposits Time Deposits Money Market Deposit Accounts Federal Funds Purchased Borrowing from the Federal Reserve Banks Repurchase Agreements Eurodollar Borrowings Bonds Issued by the Bank Bank Capital Distribution of Bank Sources of Funds

Uses of Funds by Banks Cash Bank Loans Investment in Securities Federal Funds Sold Repurchase Agreements Eurodollar Loans Fixed Assets Proprietary Trading Distribution of Bank Uses of Funds

Off-Balance Sheet Activities Loan Commitments Standby Letters of Credit Forward Contracts on Currencies Interest Rate Swap Contracts Credit Default Swap Contracts

International Banking International Expansion Impact of the Euro on Global Competition International Exposure

Chapter 17: Commercial Bank Operations  2

Key Concepts 1. Before discussing the chapter, emphasize the shift from a market orientation to a focus on particular financial institutions. 2. Explain how each type of financial institution may now be part of a financial conglomerate. 3. Identify the main sources of bank funds and elaborate where necessary. 4. Identify the main uses of bank funds and elaborate where necessary.

POINT/COUNTER-POINT: Should Banks Engage in Other Financial Services Besides Banking? POINT: No. Banks should focus on what they do best. COUNTER-POINT: Yes. Banks should increase their value by engaging in other services. They can appeal to customers who want to have all their financial services provided by one financial institution. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Many banks have expanded their services by acquiring other types of financial institutions that can provide the services. However, they sometimes pay too much for the institutions that can offer these services. In general, offering additional services can be beneficial if the bank does not incur excessive costs from offering these services.

Questions 1. Bank Balance Sheet. Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds). ANSWER: Liabilities 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts 5. Federal funds purchased 6. Repurchase agreements 7. Eurodollar borrowings Assets 1. Cash 2. Loans 3. Investment securities

Chapter 17: Commercial Bank Operations  3 4. 5. 6. 7.

Federal funds sold Repurchase agreements Eurodollar loans Fixed assets

2. Bank Sources of Funds. What are four major sources of funds for banks? Which alternatives does a bank have if it needs temporary funds? What is the most common reason that banks issue bonds? ANSWER: 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts Sources of temporary funds include: 1. Federal funds market 2. Discount window 3. Repos 4. Eurodollar borrowings Banks may issue bonds to purchase fixed assets. 3. CDs. Compare and contrast the retail CD and the negotiable CD. ANSWER: Retail CDs and negotiable CDs (NCDs) both specify a minimum deposit, a stated maturity, and a stated interest rate. Yet, NCDs differ from retail CDs because their minimum investment is much higher. In addition, they can be sold in a secondary market, whereas there is no secondary market for retail CDs. 4. Money Market Deposit Accounts. How does the money market deposit account differ from other bank sources of funds for banks? ANSWER: MMDAs differ from conventional time deposits in that they do not specify a particular maturity. In addition, a limited number of checks can be written against these accounts. 5. Federal Funds. Define federal funds, the federal funds market, and the federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday? ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository institution) to another at an interest rate known as the federal funds rate. The federal funds rate is not directly set by anyone but is determined by the market. The rate changes frequently in response to changing supply and demand conditions. The Fed influences the federal funds rate by adjusting the money supply. The federal funds market is active on Wednesday because depository institutions use the market to adjust their required reserve position on that day (it is the final day of the settlement period for required reserves).

Chapter 17: Commercial Bank Operations  4 6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations. ANSWER: The federal funds market is used by depository institutions that experience a temporary shortage of funds and desire to borrow from other depository institutions. It is also used by institutions that have excess funds and desire to lend those funds out. 7. Borrowing at the Federal Reserve. Describe the process of borrowing from the Federal Reserve. What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve? ANSWER: “Borrowing at the discount window” represents the borrowing by depository institutions from the Federal Reserve. The interest rate charged on these loans is known as the discount rate and is set by the Fed. Banks tend to prefer the federal funds market over the discount window because the Fed may monitor the bank’s reasons for borrowing. The Fed’s discount window is intended to accommodate banks that experience “unanticipated” shortages of funds. 8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the federal funds market? Why? ANSWER: Repo rates are usually slightly lower than federal fund rates because a repo is backed by securities. 9. Bullet Loan. Explain the advantage of a bullet loan. ANSWER: A bullet loan represents a loan whose principal is paid off in one lump sum. That is, a bullet loan specifies a balloon payment at a future point in time. This type of loan is useful for a borrower will have limited funds in the near future. 10. Banks’ Use of Funds. Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset? Explain. ANSWER: Securities provide a bank with liquidity, because they can often be sold easily in the secondary market. In addition, many securities purchased by banks have low risk. Therefore, the securities can be used to minimize liquidity risk and default risk. The optimal allocation of funds is dependent on a bank’s degree of risk aversion and anticipated economic conditions. There is no formula to determine the optimal allocation. Banks must weigh the higher potential return from some uses of funds against the lower return and lower risk of other uses of funds. 11. Bank Capital. Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain this difference? ANSWER: Banks may prefer a low level of capital because they can possibly achieve a higher return to shareholders (higher earnings per share). However, regulators enforce minimum capital requirements so that a bank’s capital is sufficient to absorb operating losses that could occur.

Chapter 17: Commercial Bank Operations  5 Banks are more highly leveraged (less capital and more liabilities) than manufacturing companies because their future cash inflows are much more predictable. They can handle the future payments due to liabilities, because they know the future level of cash inflows. 12. HLTs. Would you expect a bank to charge a higher rate on a term loan or a highly leveraged transaction (HLT) loan? Why? ANSWER: It would charge a higher rate for a highly leverage transaction (HLT) loan since this type of loan has a higher level of risk. 13. Credit Crisis. Explain how some mortgage operations by some commercial banks (along with other financial institutions) played a major role in instigating the credit crisis that began in 2008. ANSWER: There were many defaults on subprime mortgages. Banks and other financial institutions were required to take ownership of the homes, which led to an excess supply of homes in the housing market. Consequently, the prices of homes declined substantially, which further reduced the collateral value of the homes taken back by banks. Thus, banks that originated mortgages and held them as assets were adversely affected by the credit crisis. 14. Bank Use of Credit Default Swaps. Explain how banks use credit default swaps. ANSWER: Some commercial banks and other financial institutions buy credit default swaps in order to protect their own investments in debt securities against default risk. Other banks and financial institutions sell them. The banks that sell credit default swaps receive periodic coupon payments for the term of the swap agreement. If there are defaults on the debt securities, the sellers of credit default swaps must make payment to the buyers to cover the damages. CRITICAL THINKING QUESTION Bank Operations During the Credit Crisis. During the credit crisis in the 2008-2009 period, banks were criticized for restricting their credit. Write a short essay to explain why you think banks should or should not be allowed to restrict their credit during the credit crisis. ANSWER Before the crisis, many banks extended their credit too far, which is why they were heavily exposed to high default rates on mortgages. They deserve the criticism they received for their high risk taking during the housing boom in the 2004-2006 period. However, once the credit crisis occurred, they should not continue to make the same mistake. They recognized that their lending standards were too liberal, and restricted credit in order to minimize their future credit losses. There is no benefit in sending good money after bad money. There are some special cases in which they attempted to work with some home buyers who were likely to default on their loans. But in general, banks are in business to give loans only when there is a high probability of receiving payback. Their shareholders expect them to make decisions like a business, and not to subsidize homeowners. Some students may have different opinions, which can lead to interesting class discussion. For example, students who believe banks should accommodate any customers who want to borrow money (even if they are unlikely to repay the loan) should be asked if they would want to be a shareholder of these banks.

Chapter 17: Commercial Bank Operations  6

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Lower interest rates may reduce the size of banks.” Lower interest rates are beneficial because they can increase the spread between the interest banks earn on their assets versus the interest they pay on their liabilities. However, when interest rates are very low, many households may withdraw bank deposits and invest their money in stock mutual funds or in other investments to earn a higher return. Bank assets could be reduced as a result of the withdrawals. b. “Banks are no longer as limited when competing with other financial institutions for funds targeted for the stock market.” A bank’s traditional services do not include investing funds for individuals in the stock market. However, banks are now commonly affiliated with brokerage firms or mutual funds and can offer services through them that serve individuals that invest in stocks. c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial banks can accommodate the demand.” If loan demand rises, interest rates on deposits and loans will increase. Thus, the high deposit rate will attract more funds, while the high loan rate will discourage some potential borrowers from obtaining loans. The interest rate adjusts to the point at which the supply of deposits is adequate to accommodate loan demand.

Managing in Financial Markets As a consultant, you have been asked to assess a bank’s sources and uses of funds, and to offer recommendations on how it can restructure its sources and uses of funds to improve its performance. This bank has traditionally focused on attracting funds by offering certificates of deposit (CDs). It offers checking accounts and money market deposit accounts (MMDAs), but it has not advertised these accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage points more on its CDs than on its money market deposit accounts, but the bank prefers knowing the precise length of time that it can use the deposited funds. (The CDs have a specified maturity whereas the MMDAs do not.) The bank’s cost of funds has historically been higher than that of most banks, but it has not been concerned because its earnings have been relatively high. The bank’s use of funds has historically been focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans have provided a very high return over the last several years. However, the demand for real estate in the local area has slowed. a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other types of deposits? It should push its checking accounts and its MMDAs. While the bank does not know the precise length of time that it can use funds from these accounts, it should have easy access to other funds (if it experiences a shortage) in the federal funds market. Also, the bank should incur a lower cost

Chapter 17: Commercial Bank Operations  7 of funds because the checking accounts do not pay interest and the MMDAs pay lower interest rates than the CDs. b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans, where should the funds be allocated? The bank should not focus on real estate loans, because the loan portfolio will be affected by a decline in the real estate market. Many loan defaults could occur at once. The real estate loans had provided a high return because the real estate market performed well, but since the demand for real estate has declined, the performance of real estate loans may be poor. The bank may consider using its funds to invest in local business loans. It could also invest in Treasury securities but it must recognize that the return on Treasury securities and some other low-risk securities will have a low return. c. How will the potential return on the bank’s uses of funds be affected by your restructuring of the asset portfolio? How will the cost of funds be affected by your restructuring of the bank liabilities? The potential return will likely be smaller because the interest rates on real estate loans are relatively high. However, the risk (uncertainty) surrounding the return may be reduced once the loan portfolio is restructured to reduce the amount of real estate loans. The cost of funds should decline if there is less emphasis on the CDs and more emphasis on checking accounts or MMDAs.

Flow of Funds Exercise Services Provided by Financial Conglomerates Carson Company is attempting to compare the services offered by different banks, as it would like to have all services provided by one bank. a. Explain how a bank and its financial service subsidiaries can help Carson Company obtain funding so as to expand its business. Carson may rely on a bank for loans, and it can rely on its securities subsidiaries to help it issue bonds, and issue stock., b. Explain how a bank and its financial service subsidiaries can help Carson Company hedge its exposure to risk. The bank and its subsidiaries can execute transactions in financial futures that may hedge Carson’s exposure to bonds or stocks. They can also execute transactions in foreign exchange derivatives in order to hedge Carson’s exposure to exchange rate movements.

Chapter 18 Bank Regulation Outline Regulatory Structure Regulators Regulation of Bank Ownership Regulation of Bank Operations Regulation of Deposit Insurance Regulation of Deposits Regulation of Bank Loans Regulation of Bank Investment in Securities Regulation of Securities Services Regulation of Insurance Services Regulation of Off-Balance Sheet Transactions Regulation of the Accounting Process

Regulation of Capital How Banks Satisfy Regulatory Requirements Basel I Accord Basel II Framework Basel III Framework Use of the Value-at-Risk Method to Determine Capital Levels Stress Tests Used to Determine Capital Levels

How Regulators Monitor Banks CAMELS Ratings Corrective Actions by Regulators Treatment of Failing Banks Government Funding During the Crisis Troubled Asset Relief Program (TARP) Protests of Government Funding for Banks

Chapter 18: Bank Regulation  2 Financial Reform Act of 2010 Mortgage Origination Sales of Mortgage-backed Securities Financial Stability Oversight Council Orderly Liquidations Consumer Financial Protection Bureau Limits on Bank Proprietary Trading Trading of Derivative Securities Limitations of Regulatory Reform Global Bank Regulations Compliance with Basel III

Chapter 18: Bank Regulation  3

Key Concepts 1. Describe how the more important bank regulations have affected bank sources and uses of funds. 2. Describe why more stringent capital requirements can improve the banking system. Then, offer some disadvantages. 3. Describe why government rescues of banks can improve the banking system. Then, offer some disadvantages. 4. Explain the effects of the removal of regulatory barriers.

POINT/COUNTER-POINT: Should Regulators Intervene to Take Over Weak Banks? POINT: Yes. Intervention could turn a bank around before weak management results in failures. Bank failures require funding from the FDIC to reimburse depositors up to the deposit insurance limit. This cost could be avoided if the bank’s problems are corrected before it fails. COUNTER-POINT: No. Regulators will not necessarily manage banks any better. Also, this would lead to excessive government intervention each time a bank experienced problems. Banks would use a very conservative management approach to avoid intervention, but that approach would not necessarily appeal to their shareholders who want high returns on their investment. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Regulators intervene to a limited degree by periodically assessing banks and imposing some conditions that a bank must meet if it experiences financial problems. The optimal solution is not obvious, but different opinions will likely emerge and allow for good class discussion.

Questions 1. Regulation of Bank Sources and Uses of Funds. How are banks’ balance sheet decisions regulated? ANSWER: Banks are required to pay a premium on deposits, and to maintain a minimum level of capital, and are restricted to a maximum loan amount to any single borrower. They cannot use borrowed or deposited funds to purchase common stock. They can only invest in bonds that are considered “investment-grade” quality. 2. Off-Balance Sheet Activities. Provide examples of off-balance sheet activities. Why are regulators concerned about them? ANSWER: Off-balance sheet commitments occur when a bank guarantees a customer payment, through a standby letter of credit, or an interest rate swap, or foreign exchange commitments. Under some economic conditions, the bank could be exposed to too much risk. For example, if it guaranteed payments to back corporations that issued commercial paper, and those corporations fail, it will have

Chapter 18: Bank Regulation  4 to make the payments. Regulators are concerned about this risk.

Chapter 18: Bank Regulation  5 3. Moral Hazard and the Credit Crisis. Explain why the moral hazard problem may have received so much attention during the credit crisis. ANSWER: Moral hazard was a serious problem during the credit crisis because the government was attempting to prevent failures of banks. Yet, some critics argued that the government should not bail out banks because it could send a signal that banks can take excessive risk without worry about failure. 4. FDIC Insurance. What led to the establishment of FDIC insurance? ANSWER: During the 1930–1932 Depression period, there was a run on bank deposits, causing many bank failures. The establishment of FDIC insurance in 1933 was intended to prevent such bank deposit runs. 5. Glass-Steagall Act. Briefly describe the Glass-Steagall Act, and then explain how the related regulations have changed since it was enacted. ANSWER: The Glass-Steagall Act (1933) separated banking and securities activities, in response to problems during the Great Depression when banks (1) sold poor-quality securities to their trust accounts, and (2) used inside information on loan activities to make decisions on securities to purchase or sell. The regulations have changed to allow banks to offer securities activities. Yet, there are still regulations that prevent the bank’s use of inside information from the banking business for making investment decisions in its securities business. 6. DIDMCA. Describe the main provisions of the DIDMCA that relate to deregulation. ANSWER: The provisions allowed deposit rates to be deregulated. In addition, all depository institutions were able to offer checking account services and provide some commercial loans. 7. CAMELS Ratings. Explain how the CAMELS ratings are used. ANSWER: Regulators monitor banks periodically so that if any deficiencies are detected, they may be corrected before the bank fails. CAMELS ratings are used to assess the capital, asset quality, management, earnings potential, liquidity, and sensitivity of banks. 8. Uniform Capital Requirements. Explain how the uniform capital requirements can discourage banks from taking excessive risk. ANSWER: The capital requirements were imposed among numerous countries so that banks from any of these countries would be subject to the same rules and would not have an unfair advantage. In addition, the capital requirements varied according to risk levels so banks that took more risk were required to maintain more capital. The capital requirements are set as a percentage of a bank’s assets. However, assets are weighted differently according to perceived risk. The riskier assets are weighted heavier so that more capital will be needed to support those assets. Banks with less risky assets will not have to hold as much capital.

Chapter 18: Bank Regulation  6 9. Value at Risk. Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital. ANSWER: In general, a bank defines the VaR as the estimated potential loss from its trading businesses that could result from adverse movements in market prices. Banks estimate the VaR by assessing the probability of specific adverse market events (such as an abrupt change in interest rates) and the sensitivity of responses to those events. Banks with a higher maximum loss (based on a 99 percent confidence interval) are subject to higher capital requirements. 10. HLTs. Describe highly leveraged transactions (HLTs) and explain why regulators closely monitor a bank’s exposure to HLTs. ANSWER: HLTs are loan transactions in which the borrower’s liabilities are valued at more than 75 percent of total assets. Regulators monitor bank exposure to HLTs, because HLTs are frequently thought to be riskier than other loans (given the high proportion of debt relative to the borrower’s equity). 11. Bank Underwriting. Given the higher capital requirements imposed on them, why might banks be even more interested in underwriting corporate debt issues? ANSWER: Underwriting can generate cash flow without requiring more capital, given that the bank can use its existing assets to support the underwriting business. 12. Moral Hazard. Explain the “moral hazard” problem as it relates to deposit insurance. ANSWER: While deposit insurance helps to prevent bank deposit runs, it encourages banks to take more risk. Thus, the risky banks are subsidized by the more conservative banks. This situation reflects the moral hazard problem. Risk-based insurance premiums have alleviated this problem. 13. Economies of Scale. How do economies of scale in banking relate to the issue of interstate banking? ANSWER: If banks need to maximize growth to fully achieve economies of scale, they would need to grow nationwide. Interstate banking restrictions could prevent them from fully achieving economies of scale. 14. Contagion Effects. How can the financial problems of one large bank affect the market’s risk evaluation of other large banks? ANSWER: The financial problems of one large bank can cause the public to change its risk perception about the banking industry in general. Consequently, the risk of other banks is perceived to be higher than before. 15. Regulating Bank Failures. Why are bank regulators more concerned about a large bank failure than a small bank failure? ANSWER: Large bank failures can carry indirect costs, such as a change in the public’s risk perception of the banking industry, which in turn could affect bank deposit runs and the risk of other banks.

Chapter 18: Bank Regulation  7 16. Financial Services Modernization Act. Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations, and how it changed the competitive landscape among financial institutions. ANSWER: The Financial Services Modernization Act of 1999 allowed banks to merge with other financial service firms such as insurance companies and securities firms. Banks can now offer a more diversified product line as a result of merging with securities firms and insurance companies. They can serve as a one-stop shop. Financial institutions can now expand into other services that were previously off limits. Consequently, there is more competition among financial institutions for each type of financial service. 17. Impact of SOX on Banks. Explain how the Sarbanes-Oxley (SOX) Act improved the transparency of banks. Why might the act have a negative impact on some banks? ANSWER: Some of the key provisions of the SOX Act require that banks improve their internal control process to establish a centralized database of information. They must implement a system that automatically checks data for unusual discrepancies relative to norms. They must speed the process by which all departments and all subsidiaries have access to the data that they need. Their executives are now more accountable for financial statements by personally verifying their accuracy. One negative effect of the SOX Act is that publicly traded banks have incurred expenses of more than $1 million per year to comply with the costs of satisfying the SOX provisions. 18. Conversion of Securities Firms to BHCs. Explain how the conversion of securities firms to a bank holding company (BHC) structure might reduce their risk. ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. The bank holding company structure allows the securities firms to also offer commercial banking services, including federally insured deposits. It also results in a greater degree of regulatory oversight by the Federal Reserve, including stringent capital requirements. 19. Capital Requirements During the Credit Crisis. Explain how the accounting method applied to

mortgage-backed securities made it more difficult for banks to satisfy capital requirements during the credit crisis of 2008–2009. ANSWER: Banks are required to periodically mark their assets to market in order to determine the revised needed capital based on the reduced market value of the assets. The fair value accounting method forced them to “write down” the value of their assets. Given a decline in the bank’s book value of assets, and no associated change in its book value of liabilities, a bank’s balance sheet is balanced by reducing its capital. Thus, many banks were required to replenish their capital in order to meet the capital requirements, and some of them were subject to extra scrutiny by regulators. 20. Fed Rescue of Bear Stearns. Explain why regulators might argue that the assistance they provided to Bear Stearns during the credit crisis was necessary. ANSWER: Bear Stearns facilitated many transactions in financial markets, and its failure would have delayed these financial transactions, and would have caused liquidity problems for many individuals and firms that were to receive cash as a result of the transactions.

Chapter 18: Bank Regulation  8 21. Fed Rescue of Nonbanks. Should the Fed have the power to rescue firms such as Bear Stearns that are not commercial banks? ANSWER: Some critics (including Paul Volcker, a previous chair of the Fed) suggested that the rescue of a firm other than a commercial bank should be the responsibility of Congress and not the Fed. The Fed’s counter was that it recognized the potential financial transactions that would be frozen if it did not rescue Bear Stearns. Thus, its argument is based on its role of attempting to stabilize the financial system rather than its role of regulating commercial banks. 22. Bank Regulation of Credit Default Swaps. Why were bank regulators concerned with credit default swaps? ANSWER: Regulators became concerned with credit default swaps because of the lack of transparency regarding the exposure of each commercial bank, and the credibility of the counterparties on the swaps. They increased their oversight of this market and requested that commercial banks provide more information. 23. Impact of Bank Consolidation on Regulation. Explain how bank regulation can be more effective when there is consolidation of banks and securities firms. ANSWER: Some major securities firms such as Bear Stearns and Merrill Lynch were acquired by commercial banks, while others such as Goldman Sachs and Morgan Stanley applied to become bank holding companies (BHCs). This consolidation improved the stability of the financial system because regulations on bank holding companies are generally more stringent than the regulations on independent securities firms. 24. Concerns about Systemic Risk During the Credit Crisis. Explain why the credit crisis caused concerns about systemic risk. ANSWER: During the crisis, many banks were failing. The financial problems of a large bank failure can be contagious to other banks. This so-called systemic risk occurs because of the interconnected transactions between banks. 25. Troubled Asset Relief Program (TARP). Explain how the TARP was expected to help resolve problems during the credit crisis. ANSWER: During the 2008-2010 period, the Troubled Asset Relief Program (TARP) was implemented to alleviate the financial problems experienced by banks and other financial institutions with excessive exposure to mortgages or mortgage-backed securities. The Treasury injected more than $300 billion into banks and financial institutions, primarily by purchasing preferred stock. The injection of funds qualified as Tier 1 capital, and therefore boosted the capital levels of banks, so that banks could more easily offset some of their existing loan losses. The injection of funds was also intended to encourage addition lending by the banks and other financial institutions. In addition, the Treasury purchased some "toxic" assets that had declined in value, and even guaranteed against losses of other assets at banks and financial institutions. 26. Financial Reform Act. Explain how the Financial Reform Act is intended to prevent some problems that contributed to the credit crisis. ANSWER: In July 2010, the Financial Reform Act (also referred to as Wall Street Reform Act or Consumer Protection Act) was implemented. It requires that banks and other financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before

Chapter 18: Bank Regulation  9 approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy, so that it can prevent another credit crisis in the future. The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the U.S. and makes regulatory recommendations to regulators that could reduce any risks to the financial system. The council can recommend methods to ensure that banks do not rely on regulatory bailouts, which may prevent situations where a large financial institution is viewed as too big to fail. The act also assigned specific regulators with the authority to determine that any particular financial institution should be liquidated. This expedites the liquidation process and can limit the losses incurred by a failing financial institution. The act calls for the creation of an orderly liquidation fund that can be used to finance the liquidation of a financial institution that is not covered by the Federal Deposit Insurance Corporation. The act mandates that commercial banks must limit their proprietary trading, whereby they pool money received from customers and use it to make investments for their clients. It also requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter. 27. Bank Deposit Insurance Reserves. How did the Financial Reform Act of 2010 change the reserve requirements of the FDIC’s Deposit Insurance Fund? ANSWER: The Financial Reform Act requires that the Deposit Insurance Fund should maintain reserves of at least 1.35% of total insured bank deposits, to ensure that it always has sufficient reserves to cover losses. If the reserves fall below that level, the FDIC is required to develop a restoration plan to boost reserves to that minimum level. The act also requires that if the Deposit Insurance Fund’s reserves exceed 1.50 % of total insured bank deposits, the FDIC should distribute the excess as dividends to banks. 28. Basel III Changes to Capital and Liquidity Requirements. How did Basel III change capital and liquidity requirements for banks? ANSWER: Basel III recommended that banks maintain an extra layer of Tier 1 capital (called a capital conservation buffer) of at least 2.5% of risk-weighted assets by 2016. Banks that do not maintain this extra layer could be restricted from making dividend payments, repurchasing stock, or granting bonuses to executives. In addition to the increased capital requirements, Basel III also called for liquidity requirements. Some banks that specialize in low risk loans and have adequate capital might not have adequate liquidity to survive an economic crisis. Basel III proposes that banks maintain sufficient liquidity so that they could easily cover their cash needs under adverse conditions. 29. Regulation of Financial Disclosure Lehman Brothers continued to report positive earnings throughout the spring of 2008, even though mortgage valuations were clearly declining. Nevertheless, some institutional investors were concerned that Lehman Brothers might have been overstating its earnings in 2007 and early 2008. Explain why more complete and accurate disclosure by banks and other financial institutions may help to resolve financial problems. Could managers’ compensation incentives discourage banks from fully disclosing their financial condition? Why or why not? ANSWER: As the mortgage markets began to experience weakness near the end of 2007, Lehman continued to report positive earnings. Yet, in May 2008, some institutional investors questioned the accuracy of their financial statements, and Lehman Brothers refuted those claims. Some critics suggested that Lehman was using creative accounting to embellish its financial position during 2008 when compiling its financial statements. Lehman Brothers refuted those claims. But in June 2008, and in September 2008, Lehman announced massive quarterly losses, and on September 15, 2008, it

Chapter 18: Bank Regulation  10 announced that it was filing for bankruptcy. Had it offered more accurate financial disclosure in 2007, it might have had more time to seek solutions. Compensation incentives are commonly based on earnings. Some managers of financial institutions may not wish to fully acknowledge their financial condition if it reduces the reported earnings level, because their compensation may be reduced. 30. Regulatory Dilemma Involving AIG Explain the government’s dilemma regarding whether it should rescue American International Group (AIG) during the credit crisis. ANSWER: AIG had a very large amount of credit default swap contracts with banks and other financial institutions, whereby each contract assigned it to be the insurer against the possibility of default of a specific pool of mortgages specified within the contract. As of September 2008, its exposure to credit default swaps exceeded $400 billion. Once the government was aware of AIG’s financial problems, it worried about the high degree of systemic risk that was caused by AIG’s contracts. Many financial institutions attempted to hedge against the default risk of mortgage portfolios with credit default swap contracts through AIG, but if AIG failed, they would not receive their payments. The government decided to rescue AIG rather than allow it to fail, so that the counterparties to these credit default swap contracts with AIG would have the backing to cover against their mortgage defaults. 30. Government’s Injection of Capital into Large Banks Describe the U.S. government’s efforts to infuse capital in all of the very large banks during the credit crisis. ANSWER: Large banks sold preferred stock to the Treasury. They were required to make dividend payments to the Treasury, but they could repurchase the preferred stock once their financial position improved. By 2011, most of the banks that sold preferred stock to the Treasury had repurchased their preferred stock, thereby removing the partial government ownership. CRITICAL THINKING QUESTION Proprietary Trading by Banks The Volcker Rule is intended to prevent banks from engaging in proprietary trading. Write a short essay offering your opinion on whether banks should be allowed to engage in proprietary trading. ANSWER An argument for proprietary trading is that it may allow banks to capitalize on a special skill and generate more profits for their shareholders. It enables them to diversity their operations and may also allow them to compete with foreign banks. However, since banks are regulated, there is a concern that regulators would have to bail out some large banks that are failing, because the failure could cause systemic risk. The government and therefore taxpayers should not be obligated to save banks that fail because of taking such large risks through proprietary trading. The rule against proprietary trading is intended to make banks safer, so that there are substantially lower odds of a large bank failure that would require a bailout.

Chapter 18: Bank Regulation  11

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The FDIC recently subsidized a buyer for a failing bank, which had different effects on FDIC costs than if the FDIC closed the bank.” Closing a bank would have resulted in the liquidation of assets. In this case, the FDIC would use the proceeds of liquidation to pay off depositors, and it would make up the difference. By assuming temporary control, the FDIC can search for a buyer and does not have to liquidate the assets. However, it has to provide some financial support to potential buyers to encourage the acquisition of the failed bank. b. “Bank of America has pursued the acquisitions of many failed banks, because it sees potential benefits from these deals.” The FDIC would have to support the acquisition, so that a bank may be able to acquire the operations of failed banks at a low price. The acquiring bank could shed the bad loans and restructure the operations to make the bank more efficient. c. “By allowing a failing bank time to resolve its financial problems, it imposes an additional tax on taxpayers.” An advantage is that if a failed bank resolves its problems on its own, the FDIC would not need to provide financial support. However, a disadvantage is that a failed bank’s losses may increase, which would ultimately increase the amount of financial support to be provided by the FDIC.

Managing in Financial Markets A bank has asked you to assess various strategies it is considering and explain how they could affect its regulatory review. Regulatory reviews include an assessment of capital, asset quality, management, earnings, liquidity, and sensitivity to financial market conditions. Many types of strategies can result in more favorable regulatory reviews based on some criteria, but less favorable regulatory reviews based on other criteria. The bank is planning to issue more stock, retain more of its earnings, increase its holdings of Treasury securities, and reduce its business loans. IT has historically been rated favorably by regulators, but the bank believes that these strategies will result in an even more favorable regulatory assessment. a. Which regulatory criteria will be affected by the bank’s strategies? How? The capital level will increase, asset quality will improve, and liquidity will improve. However, the bank’s expected earnings will probably decline. b. Do you believe that the strategies planned by the bank will satisfy shareholders? Is it possible for the bank to use strategies that would satisfy both regulators and shareholders? Explain.

Chapter 18: Bank Regulation  12 No. The bank’s strategies reflect less risk, which may satisfy regulators but may be viewed as too conservative by shareholders. Given that the bank did not need to become more conservative to satisfy bank regulators, there is no need to reduce risk further. It is possible to satisfy regulators and shareholders. The shareholders recognize that the bank must abide by regulatory guidelines; however, they do not want the bank to focus so much on exceeding regulatory guidelines that it ignores the goal of maximizing shareholder wealth. c. Do you believe that the strategies planned by the bank will satisfy the bank’s managers? Explain. Open-ended. Conservative strategies are desirable in that they may reduce the risk of failure and increase job security. However, the strategies will likely reduce earnings, which could result in less compensation for some bank managers. Also, the bank could become a takeover target if it does not achieve its earnings potential (some other bank may believe that it is undervalued and acquire it). In this case, the managers may not have job security.

Flow of Funds Exercise Impact of Regulation and Deregulation on Financial Services Carson Company relies heavily on commercial banks for funding and for some other services. a. Explain how the services provided by a commercial bank (just the banking services, not the nonbank services) to Carson may be limited because of bank regulation. Banks are discouraged from providing loans to firms whose borrowed funds represent more than 75 percent of their total assets. If Carson Company issued bonds, commercial banks could not buy them unless they received an investment grade rating (Baa by Moodys or BBB by Standard & Poor’s) from rating agencies. b. Explain the types of nonbank services that Carson Company can receive from the subsidiaries of a commercial bank as a result of recent deregulation. The nonbank services include underwriting of securities, insurance, and full-service brokerage. c. How might Carson Company be affected by the deregulation that allows subsidiaries of a commercial bank to offer nonbank services? Carson Company can have virtually all of its financial services provided by one financial conglomerate. In addition, the pricing of services should be more competitive now that banks can (through their subsidiaries) offer nonbank services.

Chapter 19 Bank Management Outline Bank Goals, Strategy, and Governance Aligning Managerial Compensation with Bank Goals Bank Strategy Bank Governance by the Board of Directors Other Forms of Bank Governance

Managing Liquidity Management of Liabilities Management of Money Market Securities Management of Loans Use of Securitization to Boost Liquidity

Managing Interest Rate Risk Methods Used to Assess Interest Rate Risk Whether to Hedge Interest Rate Risk Methods Used to Reduce Interest Rate Risk International Interest Rate Risk

Managing Credit Risk Measuring Credit Risk Tradeoff between Credit Risk and Expected Return Reducing Credit Risk

Managing Market Risk Measuring Market Risk Methods Used to Reduce Market Risk

Integrated Bank Management Application

Managing Risk of International Operations Exchange Rate Risk Settlement Risk

Chapter 19: Bank Management  2

Key Concepts 1. Create a simple example of how banks that attempt to maximize returns can be exposed to a high degree of liquidity risk, interest rate risk, and default risk. 2. Describe liquidity risk and explain how banks manage it. 3. Describe interest rate risk and explain how banks manage it. 4. Describe credit risk and explain how banks manage it.

POINT/COUNTER-POINT: Can Bank Failures be Avoided? POINT: No. Banks are in the business of providing credit. When economic conditions deteriorate, there will be loan defaults and some banks will not be able to survive. COUNTER-POINT: Yes. If banks focus on providing loans to creditworthy borrowers, loan defaults will inevitably occur during recessionary periods. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Many arguments are possible. A bank may be able to avoid a large amount of loan defaults by providing loans to only the highest rated firms. However, many banks would not be able to lend all the funds that they have if they only lend to the highest rated firms. Therefore, they provide some loans to weaker firms, and are susceptible to loan defaults when economic conditions are weak. There are many banks competing to give loans and it causes some banks to provide loans that are questionable. The competition is good for the industry because it ensures that deserving customers can receive funding at a competitive rate, but it leads to some bank failures.

Questions 1. Integrating Asset and Liability Management. What is accomplished when a bank integrates its liability management with its asset management? ANSWER: Integrating asset and liability decisions can improve performance. For example, the decision to focus on short-term CDs as a source of funds may result in a decision to concentrate on rate-sensitive assets, such as floating-rate loans. This strategy reduces interest rate risk. 2. Liquidity. Given the liquidity advantage of holding Treasury bills, why do banks hold only a relatively small portion of their assets as T-bills? ANSWER: Treasury bill yields are sometimes lower than a bank’s cost of obtaining funds. Thus, banks should not concentrate their investment in Treasury bills.

Chapter 19: Bank Management  3 3. Illiquidity. How do banks resolve illiquidity problems? ANSWER: Banks can resolve illiquidity by selling some assets to obtain funds or borrowing funds in the federal funds market or from the discount window. 4. Managing Interest Rate Risk. If a bank expects interest rates to decrease over time, how might it alter the rate sensitivity of its assets and liabilities? ANSWER: It may increase its concentration of rate-sensitive liabilities and reduce its concentration of rate-sensitive assets. 5. Rate Sensitivity. List some rate-sensitive assets and some rate-insensitive assets of banks. ANSWER: Rate-sensitive assets include floating-rate loans and short-term securities. Rate-insensitive assets include long-term fixed-rate loans and long-term securities. 6. Managing Interest Rate Risk. If a bank is very uncertain about future interest rates, how might it insulate its future performance from future interest rate movements? ANSWER: It can attempt to match the degree of rate sensitivity of assets and liabilities, through maturity matching, interest rate futures contracts, or interest rate swaps. 7. Net Interest Margin. What is the formula for the net interest margin? Explain why it is closely monitored by banks. ANSWER: The net interest margin is closely monitored by banks because it usually is the primary contributor to the bank’s return on assets.

8. Managing Interest Rate Risk. Assume that a bank expects to attract most of its funds through shortterm CDs and would prefer to use most of its funds to provide long-term loans. How could it follow this strategy and still reduce interest rate risk? ANSWER: It could use floating-rate loans, so that its assets are rate-sensitive even with long-term maturities. 9. Bank Exposure to Interest Rate Movements. According to this chapter, have banks been able to insulate themselves against interest rate movements? Explain. ANSWER: Banks can attempt to minimize their exposure to interest rate risk because they have the flexibility to use assets whose rate sensitivity is similar to the liabilities. Yet, banks are unable to perfectly match the rate sensitivity of assets and liabilities. Research has found that bank values are typically inversely related to interest rates. 10. Gap Management. What is a bank’s gap, and what does it attempt to determine? Interpret a negative gap. What are some limitations of measuring a bank’s gap?

Chapter 19: Bank Management  4 ANSWER: A bank gap is measured to determine its exposure to interest rate risk. A negative gap implies that a bank would be adversely affected by rising interest rates, since the value of ratesensitive liabilities exceeds the value of rate-sensitive assets. Value of Value of Gap = rate-sensitive – rate-sensitive assets liabilities It is difficult to classify some assets or liabilities as rate sensitive or rate insensitive, since the degree of rate sensitivity may vary within a given classification. 11. Duration. How do banks use duration analysis? ANSWER: Banks measure duration of assets and liabilities so that they can determine whether their assets are more or less rate-sensitive than their liabilities. 12. Measuring Interest Rate Risk. Why do loans that can be prepaid on a moment’s notice complicate the bank’s assessment of interest rate risk? ANSWER: A fixed-rate loan may be perceived as rate insensitive. Yet, if it is prepaid, the funds are loaned out to someone else at the prevailing rate. Therefore, this type of loan can be sensitive to interest rates. 13. Bank Management Dilemma. Can a bank simultaneously maximize return and minimize credit risk? If not, what can it do instead? ANSWER: Banks cannot maximize return unless they incur some credit risk, so they must balance the risk and return objectives, based on their degree of risk aversion. 14. Bank Exposure to Economic Conditions. As economic conditions change, how do banks adjust their asset portfolio? ANSWER: Expectations of a stronger economy may encourage banks to provide more risky loans, since the probability of default may decrease, and the potential return is higher. Expectations of a weaker economy may encourage banks to use a more conservative approach. Expectations of higher (lower) interest rates encourage banks to have more rate sensitive assets (liabilities). 15. Bank Loan Diversification. What are the two ways in which a bank should diversify its loans? Why? Is international diversification of loans a viable strategy for dealing with credit risk? Defend your answer. ANSWER: Banks should diversify across geographic regions and industries, to reduce exposure to specific events. Not necessarily. If the countries receiving loans tend to experience similar business cycles, international diversification of loans has only limited effectiveness. International diversification of loans to creditworthy borrowers has some merit, but the creditworthiness criterion should not be ignored just to achieve international diversification. 16. Commercial Borrowing. Do all commercial borrowers receive the same interest rate on loans? ANSWER: Interest rates on loans at a given point in time are dependent on the degree of risk of the © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 19: Bank Management  5 borrower. 17. Bank Dividend Policy. Why might a bank retain some excess earnings rather than distribute those funds as dividends? ANSWER: Banks retain earnings as a source of capital. 18. Managing Interest Rate Risk. If a bank has more rate-sensitive liabilities than rate-sensitive assets, what will happen to its net interest margin during a period of rising interest rates? During a period of declining interest rates? ANSWER: During a period of rising interest rates, the bank’s net interest margin will decline. During a period of declining interest rates, the bank’s net interest margin will increase. 19. Floating-Rate Loans. Does the use of floating-rate loans eliminate interest rate risk? Explain. ANSWER: The use of floating-rate loans may reduce interest rate risk, but not eliminate it, because the rate sensitivity on assets will still not match up perfectly with the rate sensitivity on liabilities. 20. Managing Exchange Rate Risk. Explain how banks become exposed to exchange rate risk. ANSWER: When banks accept deposits in one currency and provide loans in a different currency, they are exposed to exchange rate risk. Banks whose currency composition of assets differs from the currency composition of liabilities are exposed to exchange rate risk. Banks may also become exposed if they offer forward contracts that are not offset by opposite commitments.

Advanced Questions 21. Bank Exposure to Interest Rate Risk. Oregon Bank has branches overseas that concentrate in shortterm deposits in dollars and floating-rate loans in British pounds. Because it maintains rate-sensitive assets and liabilities of equal amounts, the bank believes it has essentially eliminated its interest rate risk. Do you agree? Explain. ANSWER: U.S. interest rates will not necessarily move in tandem with British interest rates. Thus, it is possible that British interest rates will decline while U.S. interest rates remain stable or rise. In this case, the bank will be adversely affected by interest rate movements. Oregon Bank has not eliminated its interest rate risk. 22. Managing Interest Rate Risk. Dakota Bank has a branch overseas with the following balance sheet characteristics: 50 percent of the liabilities are rate sensitive and denominated in Swiss francs; the remaining 50 percent of liabilities are rate insensitive and are denominated in dollars. With regard to assets, 50 percent are rate-sensitive and are denominated in dollars; the remaining 50 percent of assets are rate-insensitive and are denominated in Swiss francs. a. Is the performance of this branch susceptible to interest rate movements? Explain. ANSWER: Dakota Bank is susceptible to interest rate movements. If Swiss interest rates rise, the bank’s cost of funds increases. If U.S. interest rates decline, the bank’s interest revenues would decline. The two scenarios described above could occur simultaneously, causing lower earnings for Dakota Bank.

Chapter 19: Bank Management  6

b. Assume that Dakota Bank plans to replace its short-term deposits denominated in U.S. dollars with short-term deposits denominated in Swiss francs, because Swiss interest rates are currently lower than U.S. interest rates. The asset composition would not change. This strategy is intended to widen the spread between the rate earned on assets and the rate paid on liabilities. Offer your insight into how this strategy could backfire. ANSWER: The strategy could backfire if the Swiss franc appreciates against the dollar over time, because some of the dollars received from loan repayments etc. would have to be converted into Swiss francs to repay the deposits denominated in francs. c. One consultant has suggested to Dakota Bank that it could avoid exchange rate risk by making loans in whatever currencies it receives as deposits. In this way, it will not have to exchange one currency for another. Offer your insight on whether there are any disadvantages to this strategy. ANSWER: One disadvantage is that the bank may not be able to satisfy some potential borrowers who desire a loan denominated in some other currency. For example, if the bank receives mostly dollar deposits over the next month, it could not accommodate firms that need to borrow francs. Therefore, it would forgo some business because of its desire to avoid exchange rate risk.

CRITICAL THINKING QUESTION Managing Bank Capital Some bank managers argue that U.S. bank’s access to capital is restricted because the capital requirements imposed by U.S. regulators are too high. Write a short essay that can offer logical insight into why high capital requirements may restrict a bank’s access to capital. Also, describe why high capital requirements for all banks in the U.S. might actually allow the banks easier access to capital. Which of the arguments do you believe? ANSWER If capital requirements are high, the bank’s degree of financial leverage is more limited, and banks may generate a lower return on their equity. Consequently, some investors may be unwilling to invest in bank capital, because the return on the capital is not sufficient. However, a counter argument is that if banks are required to hold a higher level of capital, this can make the entire banking industry safer. Investors may be more willing to invest in banks if they believe that the banking system is safer, because there is less risk surrounding their investment. Students may vary as to which argument they support, but they all should be able to present the arguments for both sides.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The bank’s biggest mistake was that it did not recognize that its forecast of a strong local real estate market and declining interest rates could be wrong.”

Chapter 19: Bank Management  7 The bank apparently tried to capitalize on expectations of a strong real estate market by allocating a large amount of funds to real estate loans. It also apparently created a negative gap to benefit from an expected decline in interest rates. Since its forecast was wrong, its performance was poor. b. “Banks still need some degree of interest rate risk to be profitable.” If banks attempted to perfectly match the maturities of the liabilities with maturities of their assets, the interest rate spread might not be sufficient to cover their own expenses. Thus, they can benefit from an upward-sloping yield curve by borrowing short term and lending long term, assuming that interest rates do not increase substantially. In some periods when there is a threat of rising interest rates, they may partially hedge their interest rate risk. Yet, they will not hedge all their interest rate risk because it limits the potential returns. c. “The bank used interest rate swaps so that its spread is no longer exposed to interest rate movements. However, its loan volume and therefore its profits are still exposed to interest rate movements.” When interest rates rise, demand for the bank’s loans decline. Therefore, the bank’s profits are reduced when the loan demand rises.

Managing in Financial Markets As a manager of Stetson Bank, you are responsible for hedging Stetson’s interest rate risk. Stetson has forecasted its cost of funds as follows: Year 1 2 3 4 5

Cost of Funds 6% 5% 7% 9% 7%

The bank expects to earn an average rate of 11 percent on some assets that charge a fixed interest rate over the next five years. It is considering engaging in an interest rate swap in which it would swap fixed payments of 10 percent in exchange for variable-rate payments of LIBOR + 1 percent. Assume LIBOR is expected to be consistently 1 percent above Stetson’s cost of funds. a. Determine the spread that Stetson would earn each year if it uses an interest rate swap to hedge all of its interest rate risk. Would you recommend that Stetson use an interest rate swap?

Chapter 19: Bank Management  8 Stetson’s overall spread is derived as follows: Average rate earned on assets Fixed swap outflow payments Difference LIBOR Variable-rate swap inflow payment Cost of funds Difference Overall spread

Year 1

Year 2

Year 3

Year 4

Year 5

11%

10 1 7

10 1 6

10 1 8

10 1 10

10 1 8

8 6 2 3

7 5 2 3

9 7 2 3

11 9 2 3

9 7 2 3

Stetson should not use an interest rate swap because its expected spread is more favorable in most years if it does not hedge. b. Although Stetson has forecasted its cost of funds, it recognizes that its forecasts may be inaccurate. Offer a method that Stetson can use to assess the potential results from using an interest rate swap while accounting for the uncertainty surrounding future interest rates. Stetson could use sensitivity analysis to determine its performance based on a variety of possible interest rate scenarios. It might even develop a probability distribution of outcomes that could be derived from a probability distribution of interest rate scenarios. c. Stetson is exposed to interest rate risk because it uses some of its funds to make fixed-rate loans, as some borrowers prefer fixed rates. An alternative method of hedging interest rate risk is to use adjustable-rate loans. Would you recommend that Stetson use only adjustable-rate loans to hedge its interest rate risk? Explain. No. Stetson needs to accommodate the needs of its borrowers. If the borrowers prefer fixed-rate loans, Stetson should provide fixed-rate loans, and hedge the interest rate risk in some other manner .

Problems 1. Net Interest Margin. Suppose a bank earns $201 million in interest revenue but pays $156 million in interest expense. It also has $800 million in earning assets. What is its net interest margin? ANSWER:

Chapter 19: Bank Management  9 2. Calculating Return on Assets. If a bank earns $169 million net profit after tax and has $17 billion invested in assets, what is its return on assets? ANSWER:

3. Calculating Return on Equity. If a bank earns $75 million net profits after tax and has $7.5 billion invested in assets and $600 million equity investment, what is its return on equity? ANSWER:

4. Managing Risk. Use the balance sheet for San Diego Bank in Exhibit A (below and next page) and the industry norms in Exhibit B (page following Exhibit A) to answer the following questions: a. Estimate the gap and determine how San Diego Bank would be affected by an increase in interest rates over time. ANSWER: Gap = Rate-sensitive assets – Rate-sensitive liabilities = $0 – $18 billion = –$18 billion The bank would be adversely affected by rising interest rates. b. Assess San Diego Bank’s credit risk. Does it appear high or low relative to the industry? Would San Diego Bank perform better or worse than other banks during a recession? ANSWER: The bank has a greater proportion of commercial and consumer loans than the industry average, and therefore appears to have greater default risk. c. For any type of bank risk that appears to be higher than the industry, explain how the bank’s balance sheet could be restructured to reduce this risk.

Chapter 19: Bank Management  10 ANSWER: The bank could reduce its interest rate risk by using floating-rate loans and by trying to attract some funds through medium-term (one- to five-year) CDs. It could reduce the default risk by restructuring its asset portfolio to contain more Treasury and municipal securities, less consumer loans, and less commercial loans. Exhibit A: Balance Sheet for San Diego Bank (in Millions of Dollars) Assets Required reserves

Liabilities and Capital $800

Commercial loans Floating-rate

None

Fixed-rate

$7,000

Total

Demand deposits

$800

NOW accounts

$2,500

MMDAs

$6,000

$7,000 CDs

Consumer loans

$5,000

Mortgages Floating-rate

None

Fixed-rate

$2,000

Total

Short-term From 1 to 5 years years

$9,000 None

Total

$9,000

Federal funds

$500

Long-term bonds

$400

Capital

$800

$2,000

Treasury securities Short-term

None

Long-term

$1,000

Total

$1,000

Long-term corporate securities High-rated

None

Moderate-rated $2,000 Total

$2,000

Long-term municipal © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 19: Bank Management  11 securities High-rated

None

Moderate-rated $1,700 Total

$1,700

Fixed assets

$500

TOTAL ASSETS

$20,000

TOTAL LIABILITIES AND CAPITAL

$20,000

Chapter 19: Bank Management  12 Exhibit B: Industry Norms in Percentage Terms Assets Required reserves

Liabilities and Capital 4%

Commercial loans Floating-rate

20%

Fixed-rate

11%

Total

Demand deposits

17%

NOW accounts

10%

MMDAs

20%

31% CDs

Consumer loans

20%

Mortgages

Short-term

35%

From 1 to 5 years

10%

Total

Floating-rate

Fixed-rate

Total

45%

Long-term bonds

Capital

10%

Treasury securities Short-term

Long-term

Total

15%

Long-term corporate securities High-rated

Moderate-rated

Total

Long-term municipal securities High-rated

Moderate-rated

Total

Fixed assets

TOTAL ASSETS

100%

___ TOTAL LIABILITIES AND CAPITAL

100%

Chapter 19: Bank Management  13 5. Measuring Risk. Montana Bank wants to determine the sensitivity of its stock returns to interest rate movements, based on the following information: Quarter 1 2 3 4 5 6 7 8 9 10 11 12

Return on Montana Stock 2% 2 –1 0 2 –3 1 0 –2 1 3 6

Return on Market 3% 2 –2 –1 1 –4 5 1 0 –1 3 4

Interest Rate 6.0% 7.5 9.0 8.2 7.3 8.1 7.4 9.1 8.2 7.1 6.4 5.5

Use a regression model in which Montana’s stock return is a function of the stock market return and the interest rate. Determine the relationship between the interest rate and Montana’s stock return by assessing the regression coefficient applied to the interest rate. Is the sign of the coefficient positive or negative? What does it suggest about the bank’s exposure to interest rate risk? Should Montana Bank be concerned about rising or declining interest rate movements in the future? ANSWER: The coefficient for the market variable is 0.38, while the coefficient for the interest rate variable is –1.15. The t-statistics for the coefficients suggest significance at the 0.10 level for the market variable, and at the 0.05 level for the interest rate variable. The R-Squared statistic is about 0.75, which suggests that 75 percent of the variation in Montana’s stock returns can be explained by the market and interest rate variables. The sign of the interest rate coefficient is negative, which implies a negative relationship between the interest rate movements and the stock returns of Montana Bank. Therefore, Montana Bank would be concerned about a potential increase in interest rates. Some models use the change in the interest rate level rather than the interest rate level itself, but this example simply illustrates how the bank could assess exposure to economic variables.

Flow of Funds Exercise Managing Credit Risk Recall that Carson Company relies heavily on commercial banks for loans. When the company was first established with equity funding from its owners, Carson could easily obtain debt financing, because the financing was backed by some of the firm’s assets. However, as Carson expanded, it continually relied on extra debt financing, which increased its ratio of debt to equity. Some banks were unwilling to provide more debt financing because of the risk that Carson would not be able to repay additional loans. A few banks were still willing to provide funding, but they required an extra premium to compensate for the risk.

Chapter 19: Bank Management  14 a.

Explain the difference in the willingness of banks to provide loans to Carson Company. Why do banks sometimes differ in their conclusions when they are assessing the same information about a firm that wants to borrow funds? First, some banks may be more optimistic about economic conditions than other banks, and therefore expect that the strong economy will generate more sales for the firm in the future. Second, even if banks assess a given firm as having the same probability of defaulting on the loan, some banks may be willing to provide the loan while others may not. This is because banks have different threshold levels depending on their management style. A bank may be willing to take more risk than others, because it is striving for higher income and therefore higher returns for its shareholders.

Consider the flow of funds for a publicly traded bank that is a key lender to Carson Company. This bank received equity funding from shareholders, which it uses to establish its business. It channels bank deposit funds, which are insured by the FDIC, to provide loans to Carson Company and other firms. The depositors have no idea how the bank uses their funds. Yet, the FDIC does not prevent the bank from making risky loans. So, who is monitoring the bank? Do you think the bank is taking more risk than its shareholders desire? How does the FDIC discourage the bank from taking too much risk? Why might the bank ignore the FDIC’s efforts to discourage excessive risk taking? The bank is monitored by its shareholders. It is probably taking the risk that is desired by its shareholders. Yet, the FDIC may need to intervene if the bank experiences financial problems. The FDIC attempts to prevent excessive risk-taking by forcing banks with riskier asset portfolios to maintain more capital, and this effectively reduces the return on the bank’s capital. However, the bank can charge higher interest rates on its risky loans, which may satisfy the bank’s shareholders. The point is that the objectives of the depositors, bank shareholders, and bank regulators all have a different perspective. Thus, the bank managers serve bank shareholders within the constraints enforced by bank regulators.

Chapter 20 Bank Performance Outline Valuation of a Commercial Bank Factors That Affect Cash Flows Factors That Affect the Required Rate of Return by Investors Impact of the Credit Crisis on Bank Valuations

Assessing Bank Performance Interest Income and Expenses Noninterest Income and Expenses Reliance on the Bank’s Financial Information

Evaluation of a Bank’s ROA Reasons for a Low ROA Converting ROA to ROE

Chapter 20: Bank Performance  2

Key Concepts 1. Explain with the use of an income statement that the return on a bank’s assets is primarily a function of net interest margin, noninterest income and expenses, and loan losses. 2. Explain how performance is influenced by management decisions, which is influenced by their abilities to recognize risk and their incentives to take risk. 3. Explain how to evaluate a bank's performance.

POINT/COUNTER-POINT: Does a Bank’s Income Statement Clearly Indicate the Bank’s Performance? POINT: Yes. The bank’s income statement can be analyzed to determine its performance and the underlying reasons for its performance. COUNTER-POINT: No. The bank’s income statement can be manipulated because the bank may not fully recognize loan losses (will not write off loans that are likely to default) until a future period. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: There is some degree of manipulation that is possible for banks, but regulatory oversight may limit the inaccurate financial reporting. The accounting irregularities in recent years have been in other industries.

Questions 1. Interest Income. How can gross interest income rise, while the net interest margin remains somewhat stable for a particular bank? ANSWER: Gross expenses may rise during periods in which gross interest income rises, as both variables respond to increasing market interest rates. Under these conditions, the net interest margin may remain somewhat stable. 2. Impact on Income. If a bank shifts its loan policy to pursue more credit card loans, how will its net interest margin be affected? ANSWER: If the customers repay their loans, the net interest margin will increase. However, if many of them default on their loans, the net interest margin could decline, and the bank may experience greater loan losses. 3. Noninterest Income. What has been the trend in noninterest income in recent years? Explain. ANSWER: Noninterest income increased during the 1990s, as banks were providing more financial services (for which fees are charged). However, as competition among financial institutions has increased, noninterest income has leveled off or declined slightly.

Chapter 20: Bank Performance  3 4. Net Interest Margin. How could a bank generate higher income before tax (as a percentage of assets) when its net interest margin has decreased? ANSWER: Even if the net interest margin decreased, a bank could generate higher before-tax income (as a percentage of assets) by reducing noninterest expenses, increasing noninterest income, or reducing loan losses. 5. Net Interest Income. Suppose the net income generated by a bank is equal to 1.5 percent of assets. Based on past experience, would the bank experience a loss or a gain? Explain. ANSWER: This bank would experience a loss, because even though the bank will also have some noninterest income, the noninterest expenses and loan losses will more than offset the revenues. 6. Noninterest Income. Why have large money center banks’ noninterest income levels typically been higher than those of smaller banks? ANSWER: Money center banks have higher noninterest income levels (as a percentage of assets) because they offer more services such as insurance or brokerage that generate fee income. 7. Bank Leverage. What does the assets/equity ratio of a bank indicate? ANSWER: A bank’s assets/equity ratio is a measure of financial leverage, because it indicates how much assets it has per dollar of equity invested. The more debt that it uses, the more assets it can support with its equity. 8. Analysis of a Bank’s ROA. What are some of the more common reasons for a bank to experience a low ROA? ANSWER: A low ROA could occur because of excessive interest expenses, excessive noninterest expenses, low interest income, low noninterest income, and high loan losses. 9. Loan Loss Provisions. Explain why the loan loss provisions of most banks could increase in a particular period. ANSWER: Under poor economic conditions, loan prepayment problems would increase, and banks would boost their loan loss provisions in anticipation that they would have to write off more loans. 10. Bank Performance During the Credit Crisis. Why do you think some banks suffered larger losses during the credit crisis than other banks? ANSWER: Some banks suffered larger losses because they were more exposed to mortgage loans and more heavily invested in mortgage-backed securities. 11. Weak Performance. What are likely reasons for weak bank performance? ANSWER: Weak performance may be due to: 1. Inefficiency (high noninterest expenses); 2. A high loan default percentage; 3. Limited provision of services (low noninterest income). 12. Bank Income Statement. Assume that SUNY Bank plans to liquidate Treasury security holdings and use the proceeds for small business loans. Explain how this strategy will affect the different income statement items. Also identify any income statement items for which the effects of this strategy are more difficult to estimate.

Chapter 20: Bank Performance  4 ANSWER: Gross interest income would be expected to increase because small business loans generate higher interest revenues (assuming the loans are repaid). Noninterest expenses may increase because of an increase in loan applicant evaluations and processing. Loan losses would likely increase. The net income may be affected, depending on whether most of the small business loans are repaid. The net income would now be more uncertain because of the risk involved with small business loans. Treasury securities generate more predicted cash inflows for the bank than small business loans. CRITICAL THINKING QUESTION Bank Non-Interest Income In recent years, many banks are relying more heavily on non-interest income as a proportion of their total income. Write a short essay explaining whether banks that rely more heavily on non-interest income will have better or worse performance than banks that rely more heavily on traditional sources of income (such as loans)? ANSWER Banks that pursue non-traditional sources of income can generate more fee income, and this helps them to diversify their services. They can also benefit from cross-selling the various services. However, these banks have to invest funds to develop the facilities (such as insurance and brokerage) to generate the fees. Some banks that effectively manage their traditional bank services (such as lending) are less effective at offering non-traditional services. In general, the extra services allow banks more opportunities, but some banks struggles at managing a very wide set of services.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The three most important factors that determine a local bank’s bad debt level are the bank’s location, location, and location.” The bad debt level of a local bank is very susceptible to economic conditions within the local area. If economic conditions become poor, many loans that were expected to perform well may default, no matter how competent the debtor firms are or how competent the bank’s credit analysis is. b. “The bank’s profitability was enhanced by its limited use of capital.” The bank has a high degree of financial leverage so that its return on assets (ROA) converts into high return on equity (ROE). c. “Low risk is not always desirable. Our bank’s risk has been too low, given the market conditions. We will restructure operations in a manner to increase risk.” The bank expects that the economy will be strong, so it can make more loans to customers that might be viewed as risky. These customers will be more capable of repaying loans in a strong economy. The bank can increase its income by pursuing this strategy assuming that the economy strengthens and that the customers repay their loans.

Chapter 20: Bank Performance  5

Managing in Financial Markets As a manager of Hawaii Bank, you anticipate the following information provided to you:  Loan loss provision at end of year = 1 percent of assets  Gross interest income over the next year = 9 percent of assets  Noninterest expenses over the next year = 3 percent of assets  Noninterest income over the next year = 1 percent of assets  Gross interest expenses over the next year = 5 percent of assets  Tax rate on income (both federal and state) = 30 percent  Capital ratio (capital/assets) at end of year = 5 percent a. Forecast Hawaii Bank’s net interest margin. Net interest margin is 4 percent (see income statement in the answer to part e). b. Forecast Hawaii Bank’s earnings before taxes as a percentage of assets. Earnings before taxes as a percent of assets are 1 percent (see income statement in the answer to part e). c. Forecast Hawaii Bank’s earnings after taxes as a percentage of assets. Earnings after taxes as a percent of assets are 0.7 percent (see income statement in the answer to part e). d. Forecast Hawaii Bank’s return on equity. Return on equity = ROA  (Assets/Capital) = .7%  20 = 14% e. Hawaii Bank is considering a shift in its asset structure to reduce its concentration of Treasury bonds and increase its volume of loans to small businesses. Identify each income statement item that would be affected by this strategy and explain whether the forecast for that item would increase or decrease as a result. Gross interest income is now expected to be higher. Noninterest expenses are now expected to be higher because of increased efforts on loan evaluation. Loan losses are expected to be higher. Amount as a Percent of Assets

Gross interest income Gross interest expense Net interest margin Noninterest income Noninterest expense Loan loss provision Net income before taxes Tax (30% rate) Net income after taxes

9% – 5% 4% + 1% – 3% – 1% 1% – 3% .7%

Chapter 20: Bank Performance  6

Problems 1. Assessing Bank Performance. Select a commercial bank whose income statement data are available. Using recent income statement data about that bank, assess its performance. How does the performance of this bank compare to the performance of other banks? Compared with other banks, is its return on equity higher or lower than the ROE of other banks as reported in this chapter? What is the main reason why its ROE is different from the norm? (Is it due to its interest expenses? Its noninterest income?) ANSWER: Answer will vary with the bank chosen. This question gives students experience in assessing bank performance.

Flow of Funds Exercise How the Flow of Funds Affects Bank Performance In recent years, Carson Company has requested the services listed in part (a) from Blazo Financial, a financial conglomerate. These transactions have created a flow of funds between Carson Company and Blazo. a. Classify each service according to how Blazo benefits from the service.  advising on possible targets that Carson may acquire,  futures contract transactions,  options contract transactions,  interest rate derivative transactions,  loans,  line of credit,  purchase of short-term CDs,  checking account. All the services except for the purchase of short-term CDs may generate fees for Blazo Financial, and therefore generates non-interest income. Second, Blazo incurs an interest expense on the CD, but it channels the funds into loans or investments that pay interest income. Third, Blazo’s loans to Carson Company generate interest income. Fourth, Blazo incurs noninterest expenses from establishing the infrastructure and hiring the employees that can provide all of these services. b. Explain why Blazo’s performance from providing these services to Carson Company and other firms will decline if economic growth is reduced. If economic growth is reduced, the demand for advisory services, because there are less acquisitions. This reduces Blazo Bank’s non-interest income. There are fewer loans because there is expansion by firms. This reduces Blazo’s interest income. There may be more loan defaults. c.

Given the potential impact of slow economic growth on a bank’s performance, do you think that commercial banks would prefer that the Fed use a restrictive monetary policy or an expansionary monetary policy?

Chapter 20: Bank Performance  7 Normally, banks would prefer that the Fed use a loose money policy (assuming that inflation is not out of control).

Solution to Integrative Problem for Part 6 Forecasting Bank Performance 1. The interest income and expenses are determined by applying the specified interest rate on each asset and liability to the dollar amount for each Treasury bill rate scenario. The loan losses must be deducted from the loan amounts before determining the interest income on loans. The noninterest income and expenses were given in the question. The loan losses are determined by applying the assumed loan loss percentage to the dollar amount of each type of loan. The ROA for each of the three Treasury bill rate scenarios is derived in the following table: Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate Assets

Amount in Millions

10%

Small business loans

$4,000

548.80

588.00

627.20

Large business loans

$2,000

237.60

257.40

277.20

Consumer loans

$3,000

432.00

460.80

489.60

Treasury bills

$1,000

80.00

90.00

100.00

Treasury bonds

$1,500

150.00

165.00

180.00

Corporate bonds

$1,100

132.00

143.00

154.00

$1,580.40

$1,704.20

$1,828.00

Interest income Liabilities Demand deposits

$5,000

Time deposits

$2,000

120.00

One-year NCDs

$3,000

270.00

300.00

330.00

Five-year NCDs

$2,500

250.00

275.00

300.00

Interest expense

$640.00

$695.00

$750.00

Noninterest income

200.00

Noninterest expenses

740.00

Loan losses

220.00

Income before taxes

180.40

249.20

318.00

Tax (34%)

61.30

84.70

108.10

Chapter 20: Bank Performance  8

Net income ROA

[total assets = $13.5 billion] Interest Rate Scenario (Possible T-bill Rate) 8% 9% 10%

$119.10

$164.50

$209.90

.88%

1.22%

1.55%

Forecasted ROA .88% 1.22% 1.55%

Probability 30% 50% 20%

2. Next year’s ROA will be higher if interest rates are higher as of the beginning of the year. Much of the bank’s sources of funds (from its demand deposits and time deposits) are insensitive to interest rates. If interest rates in the upcoming year are higher, it will allow for higher interest revenues, but the interest expenses will not be affected as much. If required reserves were included in the forecasted interest revenue, ROA and ROE would have been lower. 3. The two NCD expense items change, allowing for slightly lower total interest expenses and therefore a slightly higher ROA, as shown in the following table: Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate Assets

Amount in Millions

10%

Small business loans

$4,000

548.80

588.00

627.20

Large business loans

$2,000

237.60

257.40

277.20

Consumer loans

$3,000

432.00

460.80

489.60

Treasury bills

$1,000

80.00

90.00

100.00

Treasury bonds

$1,500

150.00

165.00

180.00

Corporate bonds

$1,100

132.00

143.00

154.00

$1,580.40

$1,704.20

$1,828.00

Interest income Liabilities Demand deposits

$5,000

Time deposits

$2,000

120.00

One-year NCDs

$4,000

360.00

400.00

440.00

Five-year NCDs

$1,500

150.00

165.00

180.00

Chapter 20: Bank Performance  9 Interest expense

$630.00

$685.00

$740.00

Noninterest income

200.00

Noninterest expenses

740.00

Loan losses

220.00

Income before taxes

190.40

259.20

328.00

Tax (34%)

64.70

88.10

111.50

Net income

$125.70

$171.10

$216.50

.93%

1.26%

1.60%

ROA

[total assets = $13.5 billion] Interest Rate Scenario (Possible T-bill Rate) 8% 9% 10%

Forecasted ROA .93% 1.26% 1.60%

Probability 30% 50% 20%

4. Higher. 5. If interest rates rise over time, the interest paid on one-year NCDs will rise while the interest paid on five-year NCDs issued in previous years is unaffected. 6. The interest income and loan losses are affected because of the change in the asset composition. The new levels are shown in the following table. The total loan loss amount is increased by $20 million because of the increased allocation of small business loans. Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate Assets

Amount in Millions

10%

Small business loans

$5,000

686.00

735.00

784.00

Large business loans

$2,000

237.60

257.40

277.20

Consumer loans

$3,000

432.00

460.80

489.60

Treasury bills

90.00

Treasury bonds

$1,500

150.00

165.00

180.00

Corporate bonds

$1,100

132.00

143.00

154.00

$1,637.60

$1,761.20

$1,884.80

Interest income

Chapter 20: Bank Performance  10 Liabilities Demand deposits

$5,000

Time deposits

$2,000

120.00

One-year NCDs

$3,000

270.00

300.00

330.00

Five-year NCDs

$2,500

250.00

275.00

300.00

Interest expense

$640.00

$695.00

$750.00

Noninterest income

200.00

Noninterest expenses

740.00

Loan losses

220.00

240.00

220.00

Income before taxes

217.60

286.20

354.80

Tax (34%)

74.00

97.30

120.60

Net income

$143.60

$188.90

$234.20

1.06%

1.40%

1.73%

ROA

[total assets = $13.5 billion]

Interest Rate Scenario (Possible T-bill Rate) 8% 9% 10%

Forecasted ROA if an Extra $1 Billion is Used for Loans to Small Businesses 1.06% 1.40% 1.73%

Probability 30% 50% 20%

7. Higher. 8. The default rate on consumer loans may increase in the following years, causing the bank’s ROA to be lower with the extra consumer loans than it would have been if it purchased Treasury bills. 9. Noninterest expenses would likely be higher because of costs involved in evaluating the creditworthiness and servicing the additional small business loans. Noninterest revenues could be higher as well because of possible fees charged to the additional small businesses. 10. The interest income is higher as a result of the increased allocation of consumer loans, but loan losses are larger. The effects are offsetting to a degree, so that the ROA is adjusted just slightly, as shown in the following table: Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate Amount in

Chapter 20: Bank Performance  11 Assets

Millions

10%

Small business loans

$4,000

548.80

588.00

627.20

Large business loans

$1,000

118.80

128.70

138.60

Consumer loans

$4,000

576.00

614.40

652.80

Treasury bills

$1,000

80.00

90.00

100.00

Treasury bonds

$1,500

150.00

165.00

180.00

Corporate bonds

$1,100

132.00

143.00

154.00

$1,605.60

$1,729.10

$1,852.60

Interest income Liabilities Demand deposits

$5,000

Time deposits

$2,000

120.00

One-year NCDs

$4,000

360.00

400.00

440.00

Five-year NCDs

$1,500

150.00

175.00

180.00

Interest expense

$640.00

$695.00

$750.00

Noninterest income

200.00

Noninterest expenses

740.00

Loan losses

250.00

Income before taxes

175.60

244.10

312.60

Tax (34%)

59.70

83.00

106.30

Net income

$115.90

$161.10

$206.30

.86%

1.19%

1.53%

ROA

[total assets = $13.5 billion]

Chapter 20: Bank Performance  12 Possible ROA if an Interest Rate Scenario (Possible T-bill Rate) 8% 9% 10%

Extra $1 Billion is Used for Consumer Loans .86% 1.19% 1.53%

Probability 30% 50% 20%

11. If interest rates rise after the loans are provided, the interest received on consumer loans will be unaffected, while the interest received on business loans would rise (because their rates are tied to the T-bill rate). In this case, the consumer loans would not perform as well as the business loans. 12. Interest Rate Scenario (Possible Tbill Rate 8% 9% 10%

Forecasted ROE if Capital = $1 Billion 11.88% 16.47% 20.92%

Forecasted ROE if Capital = $1.2 Billion 9.90% 13.73% 17.44%

Probability 30% 50% 20%

The ROE will be lower if the capital level is increased.

Chapter 21 Thrift Operations Outline Background on Savings Institutions Ownership Regulation of Savings Institutions

Sources and Uses of Funds Sources of Funds Uses of Funds Balance Sheet of Savings Institutions Interaction with Other Savings Institutions Participation in Financial Markets Valuation of a Savings Institution Factors That Affect Cash Flows

Factors That Affect the Required Rate of Return Exposure to Risk Liquidity Risk Credit Risk Interest Rate Risk

Management of Interest Rate Risk Adjustable-Rate Mortgages (ARMs) Interest Rate Futures Contracts Interest Rate Swaps Conclusions about Managing Interest Rate Risk

Exposure of Savings Institutions to Crises Savings Institution Crisis in the Late 1980s Credit Crisis of 2008-2009 Reform in Response to the Credit Crisis

Credit Unions Ownership of Credit Unions Advantages and Disadvantages of Credit Unions Deposit Insurance for Credit Unions Regulatory Assessment of Credit Unions Credit Union Sources of Funds Credit Union Uses of Funds Exposure of Credit Unions to Risk

2  Chapter 21: Thrift Operations

Key Concepts 1. Describe the savings institution’s main sources and uses of funds. 2. Compare the sources and uses of funds between savings institutions and banks to explain why the savings institution’s exposure to risk differs from that of banks (especially interest rate risk). 3. Explain the cause of the credit crisis in 2008-2009, and the solutions. 4. Explain the sources and uses of funds for credit unions.

POINT/COUNTER-POINT: Can All Savings Institutions Avoid Failure? POINT: Yes. If savings institutions use conservative management by focusing on adjustable-rate mortgages with limited default risk, they can limit their risk and avoid failure. COUNTER-POINT: No. Some savings institutions will be crowded out of the market for high-quality adjustable-rate mortgages and will have to take some risk. There are too many savings institutions and some that have weaker management will inevitably fail. WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue and then formulate your own opinion. ANSWER: When economic conditions are weak, mortgage loan defaults will occur. When interest rates rise, savings institutions that provide fixed-rate mortgage loans will be adversely affected. Savings institutions can limit their exposure, but then their return may not be sufficiently high to satisfy shareholders. Therefore, some savings institutions will likely fail during a weak economy or rising interest rates.

Questions 1. SI Sources and Uses of Funds. Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions. ANSWER: Savings institutions obtain a large portion of their funds from savings deposits, more so than large commercial banks. While savings institutions can offer NOW accounts, they cannot offer the traditional demand deposits. Savings institutions concentrate on mortgages as their main use of funds. This differs from commercial banks, which concentrate on commercial loans and some consumer loans. Commercial banks offer a relatively small amount of mortgage loans compared to savings institutions.

Chapter 21: Thrift Operations  3

The major sources of funds for savings institutions are as follows: 1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts; 2. Borrowed funds, which come from either their district Federal Home Loan Bank for an extended length of time, the Federal Reserve discount window for very short-term loans, through repurchase agreements, and in the federal funds market; 3. Capital obtained by issuing stock and retaining earnings. The main uses of funds for savings institutions are: 1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to accommodate withdrawal requests of depositors; 2. Mortgages where the real estate represented serves as collateral to guard against default risk; 3. Mortgage-backed securities issued by other savings institutions that were in need of funds; 4. Investment securities like Treasury securities and corporate bonds that provide savings institutions with liquidity; 5. Consumer and commercial loans where consumer loans are typically for home improvements and education; the Garn-St Germain Act of 1982 allowed them to use up to 10 percent of their assets for commercial loans; 6. Other uses include providing temporary financing to other institutions through repurchase agreements, and the federal funds market. 2. Ownership of SIs. What are the alternative forms of ownership of a savings institution? ANSWER: Stock savings institutions are owned by shareholders, and mutual savings institutions are owned by depositors. 3. Regulation of SIs. What criteria do regulators use when examining a savings institution? ANSWER: Capital, asset quality, management ability, earnings potential, liquidity, and sensitivity to risk factors. 4. MMDAs. How did the creation of money market deposit accounts influence the savings institution’s overall cost of funds? ANSWER: Money market deposit accounts (MMDAs) increased a savings institution’s cost of funds, because some depositors switched their funds from savings accounts or NOW accounts to the higher yielding MMDAs. 5. Offering More Diversified Services. Discuss the entrance of savings institutions into consumer and commercial lending. What are the potential risks and rewards of this strategy? Discuss the conflict between diversification and specialization of savings institutions. ANSWER: Savings institutions that diversify their business may become less reliant on mortgage lending and therefore may be able to stabilize their earnings. However, by diversifying, they forgo their specialization in their area of expertise. There is a cost to learning other businesses, such as commercial lending. Yet, the costs may be worthwhile in the long run, as diversification of services may be a necessary goal for survival. Regulatory restrictions have been loosened, allowing savings institutions to offer commercial loans and consumer loans (although they still concentrate on mortgage lending). The potential risk to

4  Chapter 21: Thrift Operations savings institutions that now provide such loans is that they improperly assess creditworthiness due to inexperience. However, if they can properly perform the credit evaluation and other procedures such as loan documentation, they may reduce their risk. 6. Liquidity and Credit Risk. Describe the liquidity and credit risk of savings institutions and discuss how each is managed. ANSWER: Savings institutions experience liquidity risk since they commonly use short-term liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce their assets in order to increase liquidity. Since mortgages represent their primary asset, they are the main reason for default risk. Insurance is available for the many types of mortgages issued. In addition, savings institutions perform credit analysis and geographically diversity their mortgage loans to guard against default risk. 7. ARMs. What is an adjustable-rate mortgage (ARM)? Discuss the potential advantages that such mortgages offer a savings institution. ANSWER: An adjustable rate mortgage has an interest rate that is tied to some market-determined rate such as the one-year T-bill rate. The ARM rates are periodically adjusted in accordance with the formula stated in the ARM contract. ARMs are advantageous for savings institutions because they are used as a strategy to reduce interest rate risk. They enable savings institutions to maintain a more stable margin between interest earnings and interest expenses. ARMs also reduce the adverse impact of rising interest rates. 8. Use of Financial Futures. Explain how savings institutions could use interest rate futures to reduce interest rate risk. ANSWER: Savings institutions can sell financial futures in order to hedge against interest rate risk. If interest rates rise, the futures position will generate a gain that can offset the likely reduction in a savings institution’s spread. 9. Use of Interest Rate Swaps. Explain how savings institutions could use interest rate swaps to reduce interest rate risk. Will savings institutions that use swaps perform better or worse than those that were unhedged during a period of declining interest rates? Explain. ANSWER: A savings institution can swap fixed payments in exchange for variable payments. If interest rates rise, variable inflow payments to the savings institution increase while the outflow payments remain fixed. Thus, the favorable effect of the swap will offset the unfavorable effect of higher interest rates on the savings institution’s cost of funds. If interest rates declined, savings institutions that used swaps would perform worse than savings institutions that were unhedged. The favorable effect on the spread could be offset by lower swap payments received during a period of declining interest rates. 10. Risk. Explain why many savings institutions experience financial problems at the same

time. ANSWER: Many savings institutions have a similar composition of assets, such as long-term fixed rate mortgages. This causes them to have similar exposure to interest rate risk and credit risk, so they may be adversely affected at the same time if they do not use strategies to reduce their exposure.

Chapter 21: Thrift Operations  5 11. Hedging Interest Rate Movements. If market interest rates were expected to decline over time, will a savings institution with rate-sensitive liabilities and a large number of fixed-rate mortgages perform best by (a) using an interest rate swap, (b) selling financial futures, or (c) remaining unhedged? Explain. ANSWER: A savings institution would perform best by not hedging since it could benefit from lower interest rates. Its cost of funds would decline, and its spread would increase. The hedging techniques can offset adverse effects during periods of rising interest rates but also offset favorable effects during periods of declining interest rates. 12. Exposure to Interest Rate Risk. The following table discloses the interest-rate sensitivity of two SIs (dollar amounts are in millions).

Within 1 Year

Interest Sensitivity Period From From 1–5 5–10 Years Years

Over 10 Years

Lawrence S&L Interest-earning assets Interest-bearing liabilities

$ 8,000 11,000

$3,000 6,000

$7,000 2,000

$3,000 1,000

Manhattan S&L Interest-earning assets Interest-bearing liabilities

1,000 2,000

4,000 1,000

3,000 1,000

Based on this information only, which institution’s stock price would likely be affected more by a given change in interest rates? Justify your opinion. ANSWER: Manhattan S&L would likely be affected more by a given change in interest rates because its interest-rate sensitive liability level differs from its interest-rate sensitive asset level to a greater degree (as a proportion to total assets) for each interest sensitivity period. This can be verified by measuring the ratio of assets to liabilities within each category. This answer may surprise some students, since the dollar value of the gap is sometimes larger for Lawrence S&L. However, the different sizes of the two S&Ls must be accounted for. 13. SI Crisis. What were some of the more obvious reasons for the SI crisis? ANSWER: Some obvious reasons are: (1) rising interest rates in the late 1980s, which reduced the spread between interest earned on loans and interest paid on deposits; (2) fraud by managers or executives of some S&Ls; and (3) illiquidity, resulting from withdrawals by depositors. 14. FIRREA. Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) reduced the perceived risk of savings institutions. ANSWER: FIRREA prohibited investment by savings institutions into junk bonds. Second, it mandated an increase in capital requirements of savings institutions. Third, it helped to eliminate many of the troubled savings institutions.

6  Chapter 21: Thrift Operations 15. Background on Credit Unions. Who are the owners of credit unions? Explain the tax status of credit unions and the reason for that status. Why are CUs typically smaller than commercial banks or savings institutions? ANSWER: CUs are technically owned by the depositors. CUs are not taxed because they are nonprofit institutions. CUs are small because each CU is designed to accommodate a particular group or affiliation. 16. Sources of Credit Union Funds. Describe the main source of funds for credit unions. Why might the average cost of funds to credit unions be relatively stable even when market interest rates are volatile? ANSWER: The main sources of funds are (1) share deposits, with no specified maturity, and (2) share certificates, which specify a particular interest rate and maturity. The proportion of funds obtained through regular share deposits at CUs is relatively large. The rates offered on these accounts have remained somewhat stable while rates on share certificates move with the market. This allows CUs to obtain much of their funds at a relatively low and stable cost. 17. Regulation of Credit Unions. Who regulates CUs? What are the regulators’ powers? Where do credit unions obtain deposit insurance? ANSWER: CUs are regulated by the National Credit Union Administration (NCUA), which has the power to grant or revoke charters. It also examines the financial condition of CUs and supervises any liquidations or mergers. Most credit unions obtain insurance from the National Credit Union Share Insurance Fund. 18. Risk of Credit Unions. Explain how credit union exposure to liquidity risk differs from that of other financial institutions. Explain why credit unions are more insulated from interest rate risk than some other financial institutions. ANSWER: Credit unions must rely on members for future deposits. They cannot accept deposits from nonmembers and are therefore more limited than other depository institutions. This can limit their ability to resolve any illiquidity problems. Their interest rate risk of CUs is limited because they do not provide long-term loans with fixed rates. 19. Advantages and Disadvantages of Credit Unions. Identify some advantages of credit unions. Identify disadvantages of credit unions that relate to their common bond requirement. ANSWER: Possible answers are: 1. They offer attractive rates to members, as they are non-profit and not taxed. 2. Non-interest expenses are relatively low. 3. They have a small spread between loan and share deposit rates, which benefits savers and borrowers. A disadvantage is that the common bond requirement restricts a CU from growing beyond the potential size of that particular affiliation. It also limits the CUs ability to diversify among its balance sheet accounts and also geographically. 20. Impact of Credit Crisis. Explain how the credit crisis in the 2008-2009 period affected some savings institutions. Compare the causes of the credit crisis to the causes of the savings institution crisis in the late 1980s.

Chapter 21: Thrift Operations  7 ANSWER: Some subprime lenders did not anticipate that market interest rates would rise, or that the higher mortgage payments resulting from the higher market interest rates would cause so many loan defaults. Even the subprime lenders that sold all the mortgages they created were adversely affected by the credit crisis, because once the economy weakened, the level of mortgage originations declined substantially. Both crises were caused by lenders that attempted to generate very high returns without recognizing the risk involved. 21. Impact of Interest Rates on an SI. Explain why savings institutions may benefit when interest rates fall. ANSWER: The assets (such as consumer loans and fixed-rate mortgage loans) of savings institutions commonly have fixed rates, so interest income does not adjust to interest rate movements until those assets reach maturity or are sold. Therefore, when interest rates fall, an SI’s cost of obtaining funds declines more than the decline in the interest earned on its loans and investments. 22. Impact of Economic Growth on an SI. How does high economic growth affect an SI? ANSWER: High economic growth results in less risk for an SI because its consumer loans, mortgage loans, and investments in debt securities are less likely to default. CRITICAL THINKING QUESTION The Future of Thrift Operations Write a short essay on the future of thrift operations? Should they be merged into the banking industry, or should they remain distinctly different from commercial banks? ANSWER Thrift institutions are distinguished from commercial banks in that they specialize in providing mortgage financing to households. One might argue that the existence of thrift institutions ensures that households will be able to access mortgage financing. Yet, a counterargument is that commercial banks could easily provide this same type of service and would provide the service as long as there were creditworthy households that applied for mortgages. Students may vary on which argument they believe but they should all be able to present the argument for each side.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Deposit insurance can fuel a crisis because it allows weak SIs to grow.” Deposit insurance protected depositors, so that the protected depositors place deposits in risky SIs without worrying about how the SIs managed those funds. b. “Thrifts are no longer so sensitive to interest rate movements, even if their assets and liability compositions have not changed.”

8  Chapter 21: Thrift Operations

Thrifts now use derivatives such as interest rate swaps to hedge their exposure to interest rate risk. c. “Many SIs did not understand that higher returns from subprime mortgages must be weighed against risk.” SIs that provided subprime mortgages were betting that the economy would remain strong enough so that homeowners with questionable credit could make mortgage payments, but the SIs were wrong.

Managing in Financial Markets Hedging Interest Rate Risk As a consultant to Boca Savings & Loan Association, you notice that a large portion of 15-year, fixed-rate mortgages are financed with funds from short-term deposits. You believe the yield curve is useful in indicating the market’s anticipation of future interest rates and that the yield curve is primarily determined by interest rate expectations. At the present time, Boca has not hedged its interest rate risk. Assume that a steep upward-sloping yield curve currently exists. a. Boca asks you to assess its exposure to interest rate risk. Describe how Boca will be affected by rising interest rates and by a decline in interest rates. Boca should be adversely affected by rising interest rates in the future; it should benefit from a decline in interest rates. b. Given the information about the yield curve, would you advise Boca to hedge its exposure to interest rate risk? Explain. Boca should hedge its exposure to interest rate risk, because interest rates are expected to increase according to the slope of the yield curve. If interest rates increase, Boca’s spread will decline, and Boca’s value will be adversely affected. c. Explain why your advice to Boca may possibly backfire. Your advice to Boca could backfire if interest rates decline rather than rise. This could happen either because the yield curve was based on forces other than interest rate expectations by the market, or because the expectations by the market were incorrect. Consequently, a hedge will limit the potential gains that may have resulted if Boca’s exposure to interest rate risk was not hedged.

Flow of Funds Exercise Market Participation by Savings Institutions

Chapter 21: Thrift Operations  9 Rimsa Savings is a savings institution that provided Carson Company with a mortgage for its office building. Rimsa recently offered to refinance the mortgage if Carson Company would prefer a fixed-rate loan rather than an adjustable-rate loan. a. Explain the interaction between Carson Company and Rimsa Savings. Carson Company benefits from Rimsa because it has access to funds that it needs to pay for its office building. Rimsa obtains funds from depositors and benefits from channeling these funds to Carson because it charges a higher interest rate on the loan than it pays on the deposits. The spread also covers non-interest expenses incurred. b. Why is Rimsa willing to allow Carson Company to transfer its interest rate risk to Rimsa? [Recall that there is an upward-sloping yield curve.] Rimsa offers to provide a fixed-rate loan because the initial spread on the loan is increased. Rimsa may not expect interest rates to increase, so it will benefit from the conversion to a fixedrate loan. Alternatively, Rimsa can hedge the interest rate risk with interest rate futures contracts or interest rate swaps. In general, savings institutions may be more capable than other nonfinancial firms in hedging their interest rate risk. c. If Rimsa maintains the mortgage on the office building purchased by Carson Company, what is the ultimate source of the money that was provided for the office building? If Rimsa sells the mortgage in the secondary market to a pension fund, what is the source that is essentially financing the office building? Why would a pension fund be willing to purchase this mortgage in the secondary markets? If Rimsa maintains the mortgage, its depositors provide the money. If Rimsa sells the mortgage to a pension fund, the fund’s employees and employers provided the money. The pension fund benefits from the mortgage because the mortgage generates interest and principal payments for its participants.

Chapter 22 Finance Company Operations Outline Types of Finance Companies Consumer Finance Companies Business Finance Companies Captive Finance Companies Regulation of Finance Companies

Sources and Uses of Finance Company Funds Sources of Funds Uses of Funds Interaction with Other Financial Institutions Participation in Financial Markets

Valuation of a Finance Company Factors That Affect Cash Flows Factors That Affect the Required Rate of Return Exposure of Finance Companies to Risk Liquidity Risk Interest Rate Risk Credit Risk

Multinational Finance Companies

Chapter 22: Finance Operations  2

Key Concepts 1. Describe the types of finance companies. 2. Describe the finance company’s sources and uses of funds. 3. Discuss the participation of finance companies in financial markets.

POINT/COUNTER-POINT: Will Finance Companies be Replaced by Banks? POINT: Yes. Commercial banks specialize in loans and can provide the services that are provided by finance companies. The two types of financial institutions will ultimately merge into a single category. COUNTER-POINT: No. Finance companies tend to target a different market for loans than commercial banks. Commercial banks will not replace finance companies because they do not serve that market. WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue

and then formulate your own opinion. ANSWER: Finance companies tend to provide credit to borrowers that exhibit higher risk. They can charge the borrowers a higher interest rate and therefore have the potential to earn a higher return on the loans (if the borrowers repay the loans). Commercial banks are exposed to default risk, but not to the same degree. Their loan portfolios are monitored by regulators. Thus, they are unlikely to replace finance companies.

Questions 1. Exposure to Interest Rate Risk. Is the cost of funds obtained by finance companies very sensitive to market interest rate movements? Explain. ANSWER: The interest expenses on short-term funds obtained by issuing commercial paper and other short-term debt are sensitive to interest rate movements. The interest rate expenses on funds obtained from issuing bonds are not sensitive to interest rate movements. 2. Issuance of Commercial Paper. How are small and medium-sized finance companies able to issue commercial paper? Why do some well-known finance companies directly place their commercial paper? ANSWER: They can issue secured commercial paper, so that the debt is backed by assets. Even though they may have moderate risk, their commercial paper should be in demand if it’s backed. Finance companies can avoid commercial paper dealer fees by issuing commercial paper directly; it must develop an in-house system to do this. 3. Finance Company Affiliations. Explain why some finance companies are associated with automobile manufacturers. Why do some of these finance companies offer below-market rates on loans? © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 22: Finance Operations  3 ANSWER: Some finance companies specialize in providing financing for customers of automobile manufacturers. They may offer below-market rates if they can receive some type of rebate from the manufacturers. The below-market rates can increase the sales for the manufacturers. 4. Uses of Funds. Describe the major uses of funds by finance companies. ANSWER: The major uses of funds are consumer loans (including credit card loans), business loans, leasing, mortgages on commercial real estate, and second mortgages on residential property. 5. Credit Card Services. Explain how finance companies benefit from offering consumers a credit card. ANSWER: Finance companies finance the purchase by the consumer, charging an interest rate that compensates them for the loan provided. The offering of a credit card essentially creates several periodic loans to consumers. 6. Leasing Services. Explain how finance companies provide financing through leasing. ANSWER: Finance companies purchase machinery or equipment for the purpose of leasing it to businesses that prefer to avoid the additional debt on their balance sheet. Thus, the finance companies are essentially financing the utilization of assets by a company. 7. Regulation of Finance Companies. Describe the kinds of regulations that are imposed on finance companies. ANSWER: Finance companies that act as or are owned by bank holding companies are federally regulated. Otherwise, they are regulated by the state. They are subject to ceiling loan rates and maturities, imposed by the state regulators. They are subject to state regulations on intrastate business. 8. Liquidity Position. Explain how the liquidity position of finance companies differs from that of depository institutions such as commercial banks. ANSWER: Reliance on deposits by depository institutions can cause liquidity problems, because the timing of deposit withdrawals is often uncertain. Finance companies obtain funds by issuing bonds and commercial paper, and therefore can anticipate from the security maturities when they will need additional funds. In addition, they have quick access to funds because they are familiar with issuing securities. 9. Exposure to Interest Rate Risk. Explain how the interest rate risk of finance companies differs from that of savings institutions. ANSWER: Since finance company assets and liabilities share somewhat similar interest ratesensitivity, they are not overly exposed to interest rate movements. Conversely, many savings institutions still concentrate on long-term fixed-rate mortgages, which expose them to interest rate movements because their liabilities are rate sensitive. 10. Exposure to Credit Risk. Explain how the credit risk of finance companies differs from that of other lending financial institutions. ANSWER: Finance companies focus on consumer loans and on commercial loans that have moderate © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 22: Finance Operations  4 risk. Their concentrated loan portfolio exposes them to a relatively high degree of credit risk. CRITICAL THINKING QUESTION The Future of Finance Company Operations Write a short essay on the future of finance company operations? Should finance companies be merged into the banking industry, or should they remain distinctly different from commercial banks? ANSWER Finance companies are distinguished from commercial banks in that they specialize in providing consumer financing such as car loans. One might argue that the existence of finance company operations ensures that consumer financing will be available. Yet, a counterargument is that commercial banks could easily provide this same type of service, and would provide the service as long as there were creditworthy consumers that applied for car loans, etc. Students may vary on which argument they believe but they should all be able to present the argument for each side.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “During a credit crunch, finance companies tend to generate a large amount of business.” When commercial banks cut back on the amount of loans that they provide, some potential borrowers are unable to obtain bank financing and attempt to obtain loans from finance companies. b. “Some finance companies took a huge hit as a result of the last recession because they opened their wallets too wide before the recession occurred.” Some finance companies were too liberal in providing loans; a high percentage of the borrowers were unable to make payments on their loans, and the finance companies experienced large loan losses. c. “During periods of strong economic growth, finance companies generate unusually high returns without any hint of excessive risk; but their returns are at the mercy of the economy.” When the economy is strong, the default rate on loans by finance companies is low. Given the relatively high rate charged on finance company loans, the return is high during a strong economy. But if the economy suddenly weakens, there may be an abrupt increase in the loans provided by finance companies.

Managing in Financial Markets As a manager of a finance company, you are attempting to increase the spread between the rate earned on your assets and the rate paid on your liabilities. a. Assume that you expect interest rates decline over time. Should you issue bonds or commercial © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 22: Finance Operations  5 paper to obtain funds? Issue commercial paper, because you can obtain funds at a lower rate once interest rates decline by using a short-term security. b. If you expect interest rates decline, will you benefit more from providing medium-term, fixedrate loans to consumers or floating-rate loans to businesses? The medium-term loans may be more desirable, because the rate will stay fixed even if interest rates decline. c. Why would you still maintain some balance between medium-term, fixed-rate loans and floatingrate loans to businesses, even if you anticipate that one type of loan will be more profitable under a cycle of declining interest rates? There may not be sufficient demand for consumer loans to simply focus on consumer loans. Also, you need to maintain good relations with businesses since there will be periods in which you want to provide more business loans. Finally, you must recognize that even though you would benefit more from medium-term consumer loans under a cycle of declining interest rates, your expectations could be wrong.

Flow of Funds Exercise How Finance Companies Facilitate the Flow of Funds Carson Company has sometimes relied on debt financing from Fente Finance Company. Fente has been willing to lend money even when most commercial banks were not. Fente obtains funding by issuing commercial paper and focuses mostly on channeling the funds to borrowers. a. Explain how finance companies are unique by comparing Fente’s net interest income, noninterest income, noninterest expenses, and loan losses to those of commercial banks. Fente’s net interest income is higher than that of banks because it provides riskier loans and can charge a higher interest rate on its loans. Fente’s noninterest income is lower than those of banks. Fente’s noninterest expenses are lower than that of commercial banks because it does not need as many employees and infrastructure to run its business. Fente’s loan losses are higher than that of commercial banks. b. Explain why Fente performs better than commercial banks in some periods. Fente performs better than banks in some periods when the economy is strong, because its loan losses are low in those periods. However, when the economy is weak, loan losses are high and more than offset its higher net interest margin. c. Describe the flow of funds channeled through finance companies to firms such as Carson Company. What is the original source of the money that is channeled to firms or households that borrow from finance companies?

Chapter 22: Finance Operations  6 The original source of money is buyers of commercial paper that is issued by finance companies. Mutual funds and commercial banks are common buyers of commercial paper, but they obtain their funds from other sources. Banks obtain their funds from households and mutual funds obtain their funds from individual shareholders.

Chapter 23 Mutual Fund Operations Outline Background on Mutual Funds

Pricing Shares of a Mutual Fund Mutual Fund Distributions to Shareholders Regulation of Mutual Funds Management of Mutual Funds Expenses Incurred by Mutual Fund Shareholders Governance of Mutual Funds Categories of Mutual Funds

Stock and Bond Mutual Funds Types of Stock Mutual Funds Types of Bond Mutual Funds Hybrid Funds

Money Market Funds

Asset Composition of Money Market Funds Risk of Money Market Funds Management of Money Market Funds

Hedge Funds Hedge Funds’ Use of Financial Leverage Hedge Fund Fees Hedge Funds’ Pursuit of Information Short Selling by Hedge Funds Madoff Fund Scandal Regulatory Reform of Hedge Funds

Other Types of Funds

Closed-end Funds Exchange-Traded Funds Venture Capital Funds Private Equity Funds Real Estate Investment Trusts

Valuation and Performance of Mutual Funds Valuation of Stock Mutual Funds Valuation of Bond Mutual Funds Performance from Diversifying among Funds Ratings on Mutual Funds Research on Mutual Fund Performance

Chapter 23: Mutual Fund Operations  2

Key Concepts 1. Describe the various types of mutual funds and elaborate where necessary. 2. Describe the various types of money market funds and elaborate where necessary. 3. Discuss the participation of mutual funds in financial markets.

POINT/COUNTER-POINT: Should Mutual Funds be Subject to More Regulation? POINT: No. Mutual funds can be monitored by their shareholders (just like many firms), and the shareholders can enforce governance. COUNTER-POINT: Yes. Mutual funds need to be governed by regulators, because they are accountable for such a large amount of money. Without regulation, there massive withdrawals from mutual funds could occur when unethical behavior by managers of mutual funds is publicized. WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue

and then formulate your own opinion. ANSWER: Recent scandals have found that some mutual funds were allowing their shares to be traded after the market closed but at the price that existed at the market close. More regulation can prevent future scandals. However, there is a fine line between enough regulation to prevent such abuses and too much regulation.

Questions 1. Mutual Fund Services. Explain why mutual funds are attractive to small investors. How can mutual funds generate returns to their shareholders? ANSWER: Mutual funds enable small investors to benefit from a portfolio manager’s expertise, and from diversification capabilities due to a large portfolio. Mutual funds can provide dividends or capital gain distributions to investors. In addition, investors also benefit from share price appreciation; they may be able to sell the shares at a higher price then they paid. 2. Open- versus Closed-End Funds. How do open-end mutual funds differ from closed-end funds? ANSWER: Shares of open-end mutual funds can be sold back to the sponsoring investment company, whereas shares of closed-end mutual funds cannot. 3. Load versus No-Load Mutual Funds. Explain the difference between load and no-load mutual funds. ANSWER: Load mutual funds require a fee to help pay for marketing commissions. No-load mutual funds do not require such a fee.

Chapter 23: Mutual Fund Operations  3 4. Use of Funds. Like mutual funds, commercial banks and stock-owned savings institutions sell shares; yet, proceeds received by mutual funds are used in a different way. Explain. ANSWER: Shares issued by commercial banks and savings institutions are used to obtain capital, which may be used to finance their fixed assets such as land and buildings. Shares issued by mutual funds are used to obtain funds, which are invested in the mutual fund portfolio. 5. Risk of Treasury Bond Funds. Support or refute the following statement: Investors can avoid all types of risk by purchasing a mutual fund that contains only Treasury bonds. ANSWER: A mutual fund containing Treasury bonds is susceptible to interest rate risk. If interest rates rise, the market value of the Treasury bonds contained in the mutual fund will decline. 6. Fund Selection. Describe the ideal mutual fund for investors who wish to generate tax-free income but also maintain a low degree of interest rate risk. ANSWER: A short-term municipal bond fund can avoid taxes and has a low degree of interest rate risk. 7. Exposure to Exchange Rate Movements. Explain how changes in foreign currency values can affect the performance of international mutual funds. ANSWER: As foreign currencies depreciate (appreciate) against the dollar, the prices of foreign stocks as measured in dollars decline (rise). Thus, depreciation (appreciation) of foreign currencies tends to decrease (increase) the net asset value of international mutual funds that are held by U.S. investors. 8. Reform of Hedge Funds. Explain how the Financial Reform Act of 2010 applies to hedge funds. ANSWER: The Financial Reform Act mandates that hedge funds managing more than $100 million are required to register with the Securities and Exchange Commission as investment advisors. These hedge funds must also disclose financial data that can be used by the Financial Stability Oversight Council (created by the Financial Reform Act) in order to assess systemic risk in the financial system. The act also restricts commercial banks from investing no more than 3% of their capital to invest in hedge fund institutions, private equity funds, or real estate funds. 9. Tax Effects on Mutual Funds. Explain how the income generated by a mutual fund is taxed when it distributes at least 90 percent of its taxable income to shareholders. ANSWER: The mutual fund is not taxed if it distributes at least 90 percent of taxable income to shareholders. 10. Performance. According to research, have mutual funds outperformed the market? Explain. Would mutual funds be attractive to some investors even if they are not expected to outperform the market? Explain. ANSWER: Mutual funds have not outperformed the market, based on a risk-return comparison with the market. Mutual funds provide diversification benefits that investors could not afford to achieve on their own. Mutual funds also allow investors to rely on someone else’s investment decisions rather than on their own judgment.

Chapter 23: Mutual Fund Operations  4 11. Money Market Funds. How do money market funds differ from other types of mutual funds in terms of how they use the money invested by shareholders? Which securities do money market funds invest in most often? How can a money market fund accommodate shareholders who wish to sell their shares when the amount of proceeds received from selling new shares is less than the amount needed to cover the withdrawals? ANSWER: Money market funds are composed of money market securities, such as Treasury bills, commercial paper, Eurodollar deposits, banker’s acceptances, repurchase agreements, or CDs. Conversely, mutual funds are composed of stocks and bonds. Money market funds invest more money in commercial paper than in any other type of security. Money market funds could sell some of their security holdings in order to generate sufficient funds to cover the redemptions. 12. Risk of Money Market Funds. Explain the relative risk of the various types of securities in which a money market fund may invest. ANSWER: Most money market securities exhibit some default risk, since the issuers of securities could go bankrupt. Eurodollar deposits, CDs and commercial paper are exposed to default risk. U.S. Treasury bills are free from default risk. 13. Interest Rate Risk of Funds. Is the value of a money market fund or a bond fund more susceptible to increasing interest rates? Explain. ANSWER: A bond fund is more susceptible to increasing interest rates because the securities contained in a bond fund have longer maturities than securities contained in a money market fund. 14. Diversification among Mutual Funds. Explain why diversification across different types of mutual funds is highly recommended. ANSWER: The performance of each type of mutual fund is influenced by a particular economic factor. Thus, diversifying within one specific type of mutual fund creates significant exposure to that factor. The stock market movements influence stock fund performance, interest rate movements influence bond fund performance, and exchange rates and foreign market movements influence international funds. Diversification across stock funds, bond funds, and international funds limits the exposure to any single economic factor. 15. Impact of Credit Crisis on Hedge Funds Explain why some hedge funds failed as a result of the credit crisis of 2008-s009. ANSWER: Some hedge funds failed because they invested heavily in mortgages during the credit crisis, and their investments were highly levered (supported with borrowed funds). 16. REITs. Explain the difference between equity REITs and mortgage REITs. Which type would likely be a better hedge against high inflation? Why? ANSWER: Equity REITs invest directly in properties, while mortgage REITs invest in mortgage and construction loans. Equity REITs would likely be a better hedge against inflation because rents and property (the sources of income for equity REITs) tend to rise with inflation.

Chapter 23: Mutual Fund Operations  5

Advanced Questions 17. Comparing Management of Open- Versus Closed-End Funds. Compare the portfolio managers of closed-end funds with an open-end fund. Given the differences in the fund characteristics, explain why the portfolio manager’s management of liquidity is different in the open-end fund as compared with the closed-end fund. Assume that the size of each fund is the same and that the goal is to invest in stocks and to earn a very high return. Which manager do you think will achieve higher increase in the fund’s net asset value? Explain. ANSWER: The closed-end fund manager does not need to worry about redemptions since the fund is closed, whereas the open-fund manager must worry about accommodating redemptions and therefore must always maintain some liquidity for this purpose. Therefore, the closed-end fund manager has more flexibility to invest. It can invest in illiquid stocks without having to worry about selling those stocks to accommodate redemptions. 18. Selecting a Type of Mutual Fund. Consider the prevailing conditions that could affect the demand for stocks, including inflation, the economy, the budget deficit, and the Fed’s monetary policy, political conditions, and the general mood of investors. Based on the current conditions, recommend a specific type of stock mutual fund that you think would perform well. Offer some logic to support your recommendation. ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. 19. Comparing Hedge Funds to Mutual Funds. Explain why hedge funds may be able to achieve higher returns for their investors than mutual funds do. Explain why the risk of hedge funds may differ from mutual funds. When the market is overvalued, why might hedge funds be better able to capitalize on the excessive market optimism than mutual funds can? ANSWER: The hedge funds are subject to fewer restrictions on what they can invest in than mutual funds. For example, they are not limited to just investing in stocks. They can engage in short selling and therefore take advantage of expectations that the stock prices will decline, while many mutual funds are not allowed to take such positions. Hedge funds typically have a high degree of risk because they are not subject to restrictions on their investment strategy. When hedge funds engage in short selling, there is downward pressure on the stock’s price. To the extent that the stock was overvalued, short selling can correct the price. Mutual funds are normally subject to restrictions on short selling. 20. How Private Equity Funds Can Improve Business Conditions. Money that had previously been invested by individual and institutional investors in stocks is now being invested in private equity funds. Explain why this should result in improved business conditions. ANSWER: Private equity funds pool money provided by individual and institutional investors and buy majority (or entire) stakes in businesses. They commonly purchase businesses that are struggling and have much potential to improve. This allows them to purchase the businesses cheap, revise their operations to them, and sell them at a much higher price than they paid for them. There is very limited information about private businesses, so that the private equity fund managers may see opportunities to buy a business cheap and improve it.

Chapter 23: Mutual Fund Operations  6 When investors invested in stocks, the focus was only on picking the stocks that would perform better, without any focus on improving businesses. Now more money is channeled through private equity funds and they do not simply buy stocks. They buy businesses with the goal of improving them so that they can sell them for more money than what they invested. 21. Source of Mutual Fund versus Private Equity Fund Returns. Explain the difference between how equity mutual funds generate returns for their investors, versus how private equity funds generate returns for their investors. Which fund do you think would be more capable of capitalizing on a weak publicly traded firm that has ignored all forms of shareholder activism? ANSWER: Equity mutual funds generate returns by purchasing stocks that they believe are undervalued and selling those stocks after their value increases. Private equity funds generate returns by purchasing businesses that they believe are undervalued and selling the business after the value increases. Private equity funds are commonly involved in the restructuring of operations of the business they purchase, while mutual funds are simply shareholders and do not have control of the firm. The private equity fund may be more capable of capitalizing on a weak publicly traded firm that ignores shareholder activism because it could attempt to acquire the firm and restructure it. Mutual funds are not in the business of acquiring firms. 22. Impact of Private Equity Funds on Market Efficiency. In recent years, private equity funds have grown substantially. Will the creation of private equity funds increase the semi-strong form of market efficiency in the stock market? Explain. ANSWER: Private equity funds commonly acquire private companies so they will not necessarily affect stock market efficiency. However, they could acquire some public companies that they believe are undervalued, which means that they could remove some stock market inefficiencies. 23. Hedge Fund Reliance on Expert Networks Explain the motivation of hedge funds to rely on expert networks in recent years. ANSWER: Some hedge funds rely on experts who have experience within a particular industry for information. Experts may be paid an hourly fee to offer their insight about the industry or specific firms within that industry. An expert might be able to offer valuable information that suggests how some companies are presently misvalued, which could allow a hedge fund to make investments that will capitalize on that information. There is a fine line between insight of experts that is derived from public information versus insight derived from private information.

Chapter 23: Mutual Fund Operations  7 CRITICAL THINKING QUESTION Hedge Fund Strategy A critic recently claimed that hedge funds cause market volatility to increase when they publicize (and document) that a public corporation exaggerated its earnings. The critic argued that hedge funds should not be allowed to make such public statements and should not be allowed to take short positions that bet against the firm that is being criticized. Write a short essay that supports or refutes this opinion.

ANSWER Some hedge funds generate profits by taking a short position on firms that they believe have misrepresented their financial statements. To the extent that the hedge fund has documented evidence that proves the public corporation is misrepresenting its financial condition, the hedge fund is doing a service for investors who are being misled by the public corporation. The hedge fund has a profit incentive to monitor public corporations and take short positions that can correct the valuations of these public corporations. If the hedge fund is misrepresenting the public corporation when it publicizes its concerns, it is understandable how that action might disrupt financial markets in a manner that is unfair to the public corporation and to all investors. This type of action may subject the hedge fund to penalties by regulators.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Just because a mutual fund earns 20 percent return in one year, that does not mean that investors should rush into it. The fund’s performance must be market-adjusted.” The fund’s performance may be more properly measured by comparing the fund’s return to the return on the market. In fact, the fund’s performance may even be compared to the performance of other funds with the same objective. b. “An international mutual fund’s performance is subject to conditions beyond the fund manager’s control.” An international mutual fund’s performance is partially influenced by the economic conditions of the country (or region) of concern. c. “Small mutual funds will need to merge to compete with the major players in terms of efficiency.” Small mutual funds are not normally as efficient as larger mutual funds, because larger mutual funds can achieve economies of scale. When mutual funds merge, they can combine their servicing centers and service a much larger customer base at lower cost per customer. They can also consolidate their portfolio management to reduce expenses per dollar of investment in the funds they manage.

Chapter 23: Mutual Fund Operations  8

Managing in Financial Markets As an individual investor, you are attempting to invest in a well-diversified portfolio of mutual funds, so that you will be somewhat insulated from any type of economic shock that may occur. a. An investment adviser recommends that you buy four different U.S. growth stock funds. Because these funds contain more than 400 different U.S. stocks, the adviser says that you will be well insulated from any economic shocks. Do you agree? Explain. This entire portfolio is subject to adverse U.S. stock market effects, and therefore is not a welldiversified portfolio. b. A second investment adviser recommends that you invest in four different mutual funds that are focused on different countries in Europe. The adviser says that you will be completely insulated from U.S. economic conditions, and that your portfolio will therefore have low risk. Do you agree? Explain. This portfolio may not be exposed to U.S. economic conditions, but it is highly exposed to European economic conditions. Even though the portfolio contains stocks of different European countries, all four mutual funds are subject to general economic conditions throughout Europe. c. A third investment adviser recommends that you avoid exposure to the stock markets by investing your money in four different U.S. bond funds. The adviser says that because bonds make fixed payments, these bond funds have very low risk. Do you agree? Explain. If U.S. interest rates increase, all of these bond funds will perform poorly. Even though the bond payments are fixed, the values of the bonds (and therefore the values of the bond mutual funds) will decline if U.S. interest rates rise. Therefore, this portfolio of mutual funds has a high degree of risk.

Flow of Funds Exercise How Mutual Funds Facilitate the Flow of Funds Carson Company is considering a private placement of bonds with Venus Mutual Fund. a. Explain the interaction between Carson and Venus. How would Venus Mutual Fund serve Carson’s needs, and how would Carson serve Venus’s needs? Venus receives funds from its shareholders and can use some funds to provide Carson with funding so that Carson can expand its business. In return, Carson agrees to make timely interest payments on its debt to Venus, and Venus will distribute the interest payments to its shareholders. Venus essentially serves as the agent for its shareholders who want to receive periodic income from their investment. b. Why does Carson interact with Venus Mutual Fund instead of trying to obtain the funds directly from individuals who invested in Venus Mutual Fund?

Chapter 23: Mutual Fund Operations  9 Individuals do not have sufficient funds to provide large loans or to buy large amounts of bonds. They also are not skilled at assessing creditworthiness. They are incapable of diversifying on their own. Venus Mutual Fund can pool funds, assess creditworthiness, and diversify. c. Would Venus Mutual Fund serve as a better monitor of Carson Company than the individuals who provided money to the mutual fund? Explain. Yes. One large investor has more at stake than many small investors. Venus recognizes that its performance could be affected if Carson or any other issuer of bonds fails to make its timely payments on the bonds held by Venus. The fund managers who decide how to invest money for the mutual fund could be fired if they invest in many bonds that default. A mutual fund has some power in ensuring that bond issuers make their payments. If the issuer is not complying with the terms of the bond, the mutual fund has the resources to take action, or could sell a large amount of these bonds in the secondary market, which may cause a decline in the bond price. Individuals who invest money in a mutual fund would not be effective monitors of Carson Company. They invest small amounts and are not capable of monitoring companies, nor do they want to use their time in that manner. They rely on the mutual fund to make the investment decisions and to monitor companies that issued the securities issued by the companies.

Chapter 24 Securities Operations Outline Services Provided by Securities Firms Facilitating Stock Offerings Facilitating Bond Offerings Securitizing Mortgages Advising Corporations on Restructuring Financing for Corporations Providing Brokerage Services Operating Mutual Funds Proprietary Trading Interaction with Other Financial Institutions Participation in Financial Markets Expanding Functions Internationally

Regulation of Securities Firms Stock Exchange Regulations Regulations that Affect Securities Firms

Valuation of a Securities Firm Factors That Affect Cash Flows Factors That Affect the Required Rate of Return

Exposure of Securities Firms to Risk Market Risk Interest Rate Risk Credit Risk Exchange Rate Risk Counterparty Risk Impact of Financial Leverage on Exposure to Risk

Impact of the Credit Crisis on Securities Firms Impact of the Crisis on Bear Stearns Impact of the Crisis on Merrill Lynch Impact of the Crisis on Lehman Brothers Impact of the Crisis on Regulatory Reform

Chapter 24: Securities Operations  2

Key Concepts 1. Describe the main functions of securities firms. 2. Explain how securities firms facilitate corporate acquisitions. 3. Explain how securities firms may be exposed to systemic risk and discuss the pros and cons of the Federal Reserve rescuing Bear Stearns during the credit crisis.

POINT/COUNTER-POINT: Should Analysts be Separated from Securities Firms to Ensure No Conflicts of Interest? POINT: No. Securities firms are known for their ability to analyze companies and value them. Investors may be more comfortable when analysts work within the securities firms, because they have access to substantial information. COUNTER-POINT: Yes. Analysts have a conflict of interests, because they may be unwilling to offer negative views about a company that is a client of their securities firm. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Most students are well aware of the conflicts of interest, and therefore have some strong opinions about this issue. The conflicts of interest were highly publicized in 2002 and 2003. New regulations were imposed to prevent the conflict of interests in the future. For example, analysts have to report whether they have a personal investment in the company they are rating. However, there is some question as to whether the rules will change analyst behavior. Even if the analysts were separated from securities firms, consider the potential conflict of interests that would still occur. A securities firm may need to pay an analyst to conduct an analysis of a firm for it recently underwrote the initial public offering. The analyst knows that the securities firm is hoping for a very favorable assessment over time, as that assessment may create more demand for the stock and ensure that the stock price remains high. Thus, even if analysts are not employed by the securities firm, they still have an interest in offering an opinion that will please the securities firms, so that that they receive future business from the securities firm.

Questions 1. Regulation of Securities Activities. Explain the role of the SEC, FINRA, and the stock exchanges in regulating the securities industry. ANSWER: The SEC regulates the issuance of securities and specifies disclosure rules for the issuers. The New York Stock Exchange (NYSE) and the Nasdaq market are regulated by the Financial Industry Regulatory Authority (FINRA), which monitors trading patterns and behavior by market makers and floor traders. FINRA also has enforcement divisions that investigate possible violations and can take disciplinary action. It can take legal action as well and sometimes works with the SEC to correct cases of market trading abuse.

Chapter 24: Securities Operations  3 2. SIPC. What is the purpose of the SIPC? ANSWER: The SIPC offers insurance on cash and securities deposited at brokerage firms. 3. Investment Banking Services. How do securities firms facilitate leveraged buyouts? Why are securities firms that are more capable of raising funds in the capital markets preferred by corporations that need advice on proposed acquisitions? ANSWER: Securities firms facilitate leveraged buyouts by: (1) assessing the appropriate market value of the firm, (2) arranging financing, and (3) offering additional advice when needed. Many acquisitions require outside financing. A securities firm that has more ability to raise funds can enhance the chances of a successful acquisition for the potential acquiring firm. 4. Origination Process. Describe the origination process for corporations that are about to issue new stock. ANSWER: A corporation about to issue new stock contacts an IBF, which recommends the amount of stock to issue along with the suggested price and other provisions. The corporation then registers with the SEC with a registration statement. 5. Underwriting Function. Describe the underwriting function of a securities firm. ANSWER: An IBF may be willing to underwrite the stock of an issuing corporation, which guarantees the price to be received by the corporation. The IBF assumes the risk that the securities could sell for a lower price than anticipated. 6. Best-Efforts Agreement. What is a best-efforts agreement? ANSWER: In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation, but only promises to offer its best efforts in selling the securities. Thus, the issuing corporation bears the risk that the securities may sell for a lower price than anticipated. 7. Failure of Lehman Brothers. Why did Lehman Brothers experience financial problems during the credit crisis? ANSWER: Lehman Brothers had much exposure to mortgage-backed securities. It had a relatively low level of cash, and its high degree of financial leverage created more pressure. For every dollar of equity, it had about $30 of debt. Furthermore, some of its debt was short-term and therefore could be cut off (not renewed) if creditors sensed that Lehman was experiencing potential financial problems. 8. Direct Placement. Describe a direct placement of bonds. What is an advantage of a private placement? What is a disadvantage? ANSWER: A direct placement involves the sale of securities directly to a specific investor (or investors) without offering securities to the general public. This is more likely for bonds than for stocks. A direct placement can avoid underwriting fees. However, the demand for securities that are directly placed may be low, since only a fraction of the market is targeted.

Chapter 24: Securities Operations  4 9. International Expansion. Explain why securities firms from the United States have expanded into foreign markets. ANSWER: U.S. securities have expanded overseas because: (1) their international presence allows them to place securities in various markets, (2) they can better assess potential international mergers for corporations, and (3) they can advise on foreign securities that their institutional investors should purchase. 10. Proprietary Trading. Explain the process of proprietary trading by securities firms. How was it

affected by the Volcker Rule? ANSWER: Securities firms can engage in proprietary trading, in which they use their own funds to make investments for their own account. They may invest in equity securities, bonds and other debt securities, or even in derivative securities. Their proprietary trading has often supplemented their income from other operations, but their investments expose them to risk, and have resulted in major losses in some cases. The Financial Reform Act contained a provision (referred to as the Volcker rule) that restricts the proprietary trading by commercial banks and securities firms that have become BHCs. The Volcker Rule restricts many short-term speculative investments, which formerly were an important part of financial institutions’ proprietary trading. As a result, the amount of proprietary trading has declined. 11. Asset Stripping. What is asset stripping? ANSWER: Asset stripping is a form of arbitrage in which after a firm is acquired, some of its divisions are sold. 12. Securities Firm's Use of Financial Leverage. Explain why securities firms have used a high level of financial leverage in the past. How does such leverage affect their expected return and their risk? ANSWER: Securities firms use a high level of financial leverage because it can enhance their return on equity. For a given return on assets, the return on equity will be magnified if a higher level of financial leverage is used. However, a negative return on equity will convert into a more pronounced loss (as a percent of equity) if a higher level of financial leverage is used. 13. Systemic Risk. Why was the Federal Reserve concerned about systemic risk due to the financial problems of Bear Stearns? ANSWER: The failure of Bear Stearns could have spread adverse effects throughout financial markets. Since Bear Stearns was a major provider of clearing operations for many types of financial transactions, its failure might have frozen or delayed many financial transactions, which could have resulted in a liquidity crisis for many individuals and firms that were to receive cash as a result of the transactions. Bear Stearns also served as a counterparty to various types of financial agreements. If Bear had defaulted on all of its counterparty positions, this could have caused problems for the financial institutions on the other side of those agreements, which could have created chaos in financial markets.

Chapter 24: Securities Operations  5 14. Access to Inside Information. Why do securities firms typically have some inside information that could affect future stock prices of other firms? ANSWER: Securities firms are often aware of which firms are targets to other acquiring firms. They may even identify what they believe to be undervalued targets for their clients. Also, when a firm plans to acquire a target, it may ask a securities firm to facilitate the financing and other tasks of the acquisition. The stock prices of target firms typically rise substantially prior to an acquisition. 15. Sensitivity to Stock Market Conditions. Most securities firms experience poor profit performance after periods in which the stock market performs poorly. Given what you know about securities firms, offer some possible reasons for these reduced profits. ANSWER: Profits are reduced because of (1) less stock transactions by investors, resulting in less commissions; (2) less issuances of new stock by firms (since their stock prices are so low, they do not want to sell new stock at that price), resulting in less underwriting fees; and (3) some securities firms had made major investments in some targets with their own equity. The market value of these equity positions had declined substantially. 16. Conversion to BHC Structure. Explain how the credit crisis of 2008-2009 encouraged some securities firms to convert to a bank holding company (BHC) structure. Why might the expected return on equity be lower for securities firms that convert to this bank holding company structure? ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. Also, the bank holding company structure results in a higher required capital and greater degree of regulatory oversight by the Federal Reserve. The securities firms may be viewed as safer because of their conversion to bank holding companies, and this may also allow for easier access to funding. 17. Financial Services Modernization Act. How did the Financial Services Modernization Act affect securities firms? ANSWER: The Financial Services Modernization Act resulted in the creation of more financial conglomerates that include securities firms. One of the key benefits to securities firms in a financial conglomerate is cross-listing. When individuals use brokerage services of a securities firm, that firm may steer them to do their banking with the affiliated commercial bank or to obtain a mortgage with the affiliated savings institution. When firms use investment banking services of a securities firm, that firm may steer them to do their banking with the affiliated commercial bank. The other types of financial institutions that form the conglomerate can reciprocate by steering their customers toward the securities firm. Thus, the bundling of financial services can generate more business for each type of financial institution that is part of the financial conglomerate. 18. Regulation FD. What impact has the SEC’s Regulation Fair Disclosure (FD) had on securities firms? ANSWER: As a result of Regulation FD, firms more frequently provide their information in the form of news releases or conference calls rather than leaking it to a few analysts. Those analysts who relied on inside information when providing their insight to clients have lost their competitive advantage, while analysts who relied on their own analysis rather than information leaks have gained a competitive edge.

Chapter 24: Securities Operations  6 CRITICAL THINKING QUESTION Regulation of Security Firms. Should large securities firms be allowed to be independent and insulated from bank regulation, or should they be required to register as bank holding companies, and subject to bank regulations? Write a short essay that supports your opinion. ANSWER Large securities firms engage in very similar operations as large commercial banks, and therefore should be regulated in a similar manner. If large securities firms such as Bear Stearns and Lehman Brothers had been subject to bank regulation, they might not have experienced such severe financial problems. If the large securities firms were allowed to avoid bank regulations in the future, some large banks might become securities firms just to avoid the bank regulations. All of these firms should be subject to similar regulations so that none of them have an unfair advantage.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The stock prices of most securities firms took a hit because of the recent increase in interest rates.” Some securities firms hold bonds, which decline in value when interest rates rise. Some securities firms may lose some underwriting business when interest rates rise, as corporations reduce their bond offerings. If the higher interest rates discourage investors from purchasing more stock, those securities firms that have large brokerage businesses will be adversely affected. b. “Now that commercial banks are allowed more freedom to offer securities services, there may be a shakeout in the underwriting arena.” If commercial banks are allowed more freedom to underwrite securities, this will create more competition in the underwriting business. The intensified competition will probably result in lower underwriting fees charged to clients, and some firms that cannot offer underwriting services efficiently will be pushed out of the market. c. “Chaos in the securities markets can be good for some securities firms.” Chaos may cause a substantial amount of trading in securities in the securities markets, if investors respond to the chaos instead of waiting it out. Those securities firms that generate much of their business from executing securities transactions can possibly benefit.

Managing in Financial Markets As a consultant for a securities firm, you are assessing the operations of a securities firm. a. This securities firm relies heavily on full-service brokerage commissions. Do you think that heavy reliance on these brokerage commissions is risky? Explain.

Chapter 24: Securities Operations  7 Brokerage commissions are dependent on the volume of transactions executed, which can change abruptly. Also, as new competitors enter the industry, the securities firm may lose market share. Therefore, the securities firm may benefit from diversifying its securities businesses. b. If this firm attempts to enter the underwriting business, would it be an easy transition? Full-service brokerage firms have some experience in valuing stocks, and therefore have some ability to advise corporations on what their stocks might be sold for if they issue stocks. However, the firm would need to hire additional employees at high salaries who would focus on the underwriting business. The transition may be logical but may take time to become profitable. c. In recent years, the stock market volume increased substantially, and this securities firm performed very well. In the future, however, many institutional and individual investors may invest in index funds or exchange-traded funds rather than in individual stocks. How would this affect the securities firm? Indexing would reduce the trading of stocks, and therefore could reduce brokerage commissions. Thus, this firm could be adversely affected if indexing becomes more popular.

Flow of Funds Exercise How Investment Banking Facilitates the Flow of Funds Recall that Carson Company has periodically borrowed funds, but contemplates a stock or bond offering so that it can expand by acquiring some other businesses. It contacted Kelly Investment Company, an investment bank. a. Explain how Kelly Investment Company can serve Carson and how it will also serve other clients when it serves Carson. Also explain how Carson Company can serve Kelly Investment Company. Kelly can underwrite stocks or bonds issued by Carson Company so that Carson can obtain funds to support its expansion. Kelly would place securities with investors who wanted to purchase stocks or bonds, so its underwriting function also serves investors. In addition, a secondary market for the securities is created, so that investors are able to sell these securities to other investors at a future point in time. Kelly can offer Carson advice about acquisitions, by conducting valuations of potential target companies and by negotiating with the companies in an effort to close a deal for Carson. Carson pays Kelly fees for any of the services offered here. Carson is unable to perform these specialized services on its own, so it relies on an investment bank to perform the services. b. In a securities offering, Kelly Investment Company would like to do a good job for its clients, which include both the issuer and institutional investors. Explain the dilemma. Kelly wants to ensure that the securities are offered at a high enough price to satisfy the issuer and a low enough price to satisfy the investors. If the investors earn a very high return on the first day of a securities offering, this may imply that Kelly priced the offering too low, which results in less proceeds to the issuer. If the investors earn a negative return on the first day, it may suggest that Kelly priced the offering too high. Kelly’s goal should be to price the securities near a level

Chapter 24: Securities Operations  8 that is consistent with what the market price becomes. In this way, it signals that it priced the securities at a level that properly anticipated the market supply and demand. c. The issuing firm in an IPO hopes that there will be a strong demand for its shares at the offer price, which will ensure that it receives a reasonable amount of proceeds from its offering. In some previous IPOs, the share price by the end of the first day was more than 80 percent higher than the offer price at the beginning of the day. This reflects a very strong demand relative to the price at the end of the day. In fact, it probably suggests that the IPO was fully subscribed at the offer price, and that some institutional investors who purchased the stock at the offer price flipped their shares near the end of the first day to individual investors who were willing to pay the market price. Do you think that the issuing firm would be pleased that its stock price increased by more than 80 percent on the first day? Explain. Who really benefits from the increase in price on the first day? If the price increases by 80 percent in one day, this may suggest that the underwriter used an offer price that was too low. Consequently, the issuer should have been paid more for the stock than it was paid. The major beneficiary is the institutional investor who purchased the stock and in one day earns a return of 80 percent. d. Continuing the previous question, assume that the stock price drifts back down to near the original offer price over the next three weeks (even though the general stock market conditions were stable over this period) and then moves in tandem with the market over the next several years. Based on this information, do you think the offer price was appropriate? If so, how can you explain the unusually high one-day return on the stock? Who benefited from this stock price behavior, and who was adversely affected? Given this information, it appears that the equilibrium stock price is near the offer price, which suggests that the offer price was a reasonable estimate of the equilibrium price. The high initial return is not due to major underpricing by the underwriter but is due to the excessive demand for the shares on the first day in the secondary market. Some individual investors were willing to pay much more for the stock than was appropriate, and the stock price was driven up as a result. Over the next few weeks, some investors sold their shares as they recognized that the price was too high. Thus, the institutional investors who paid the offer price and sold within the first few weeks benefited from the stock price behavior. The investors who purchased the stock in the secondary market on the first day or within the first few weeks were adversely affected.

Chapter 25 Insurance Operations Outline Setting Insurance Premiums Adverse Selection Problem Moral Hazard Problem

Regulation of Insurance Companies Assessment System Regulation of Capital Regulation of Failed Insurance Companies Regulation of Financial Services Offered Federal Insurance Office International Insurance Regulations

Life Insurance Operations Ownership Types of Life Insurance Sources of Funds Uses of Funds Asset Management of Life Insurance Companies Interaction with Other Financial Institutions

Other Types of Insurance Operations Property and Casualty Insurance Healthcare Insurance Business Insurance Bond Insurance Mortgage Insurance

Exposure to Risk Interest Rate Risk Credit Risk Market Risk Liquidity Risk Exposure to Risk During the Credit Crisis Government Rescue of AIG

Valuation of an Insurance Company Factors That Affect Cash Flows Factors That Affect Rate of Return by Investors Indicators of Value and Performance

Chapter 25: Insurance Operations  2

Key Concepts 1. Describe the role of insurance companies. 2. Explain how insurance companies are exposed to risk. 3. Describe how insurance companies participate in financial markets. 4. Describe the purpose of pension funds and how they participate in financial markets.

POINT/COUNTER-POINT: Should Insurance Companies Make Risky Investments? POINT: No. Insurance companies can best serve their policyholders by maintaining adequate reserves in case claims are filed. If they make risky investments, they could experience liquidity problems, and may not be able to serve their policyholders. COUNTER-POINT: Yes. Insurance companies can increase their return by investing in riskier securities, which may enhance their profits and valuation, and its stock price (if it is publicly traded). In this way, the investment policy maximizes the value of the insurance company for its owners. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Portfolio managers naturally prefer to take risks in order to strive for higher returns on their investments, which is beneficial to the owners. Yet, they need to ensure that their investment strategy can allow for a minimum level of reserves to satisfy future claims. For this reason, they should limit the risk that they take. Students should recognize the tradeoff involved, as serving policyholders can conflict with serving the owners of the insurance company.

Questions 1. Life Insurance. How is whole life insurance serve as a form of savings to policyholders? ANSWER: Whole life insurance is permanent as it protects the policyholder until death or as long as premiums are promptly paid. It is a form of savings as it builds a cash value the policyholder is entitled to even if the policy is canceled. 2. Whole Life versus Term Insurance. How do whole life and term insurance differ from the perspective of insurance companies? From the perspective of the policyholders? ANSWER: Term insurance provides insurance only over a specified term; it is not permanent like whole life insurance. Term insurance does not build a cash value, so it is not a savings mechanism. Also, term insurance is less expensive than whole life insurance.

Chapter 25: Insurance Operations  3 3. Universal Life Insurance. Identify the characteristics of universal life insurance. ANSWER: Universal life insurance specifies a time period over which the policy exists. It builds a cash value that interest is earned on until the policyholder uses those funds. Universal life insurance allows flexibility on the size and timing of premiums. 4. Group Plan. Explain group plan life insurance. ANSWER: Group life insurance can be provided to a group of employees by an insurance company. It can be distributed at a low cost because of the high volume. It sometimes covers dependents of the group members as well. Some unions and professional associations participate in group plans. 5. Assets of Life Insurance Companies. What are the main assets of life insurance companies? Identify the main categories. What is the main use of funds by life insurance companies? ANSWER: Life insurance companies invest in government securities, corporate securities, mortgages, real estate, and policy loans. The main investment by life insurance companies is corporate bonds. 6. Financing the Real Estate Market. How do insurance companies finance the real estate market? ANSWER: Life insurance companies hold all types of mortgages as assets. Mortgages are originated by other financial institutions and then are sold to insurance companies in the secondary market. Yet, they are serviced by the originating institutions. 7. Policy Loans. What is a policy loan? When is it popular? Why? ANSWER: A policy loan occurs as insurance companies lend funds to whole life policyholders based upon their cash value of the policy. They are popular during times of rising interest rates as they have a guaranteed rate of interest, so are less expensive sources of funds during these times. 8. Government Rescue of AIG Why did the U.S. government rescue AIG during the credit crisis in 2008? ANSWER: AIG had sold credit default swaps that were intended to cover against default for about $440 billion in debt securities, many of which represented subprime mortgages. In 2008, AIG experienced severe financial problems because many of these debt securities defaulted. If AIG failed, many of the counterparties whose securities were covered against default might have failed. Thus, the Fed's rescue of AIG was intended to prevent systemic risk in the financial system. 9. Managing Credit Risk and Liquidity Risk. How do insurance companies manage credit risk and liquidity risk? ANSWER: To deal with default risk, life insurance companies typically invest in securities with high ratings and then diversify among security issuers. To reduce liquidity risk, they diversify the age distribution of customers. 10. Liquidity Risk. Discuss the liquidity risk experienced by life insurance companies and by property and casualty (PC) insurance companies.

Chapter 25: Insurance Operations  4 ANSWER: Life insurance companies have somewhat predictable payouts over time. However, a high frequency of claims can cause the insurance companies to be illiquid. To boost liquidity, the companies could maintain some liquid assets. PC insurance companies have claims that are less predictable and need to maintain sufficient liquid assets to cover any payouts. 11. PC Insurance. What purpose do property and casualty (PC) insurance companies serve? Explain how the characteristics of PC insurance and life insurance differ. ANSWER: Property and casualty insurance companies protect against fire, theft, liability, and other events that result in economic or noneconomic damage. PC insurance differs from life insurance in the following ways: 1. Policies often last one year or less, as opposed to long-term or permanent life insurance. 2. PC insurance encompasses a wide variety of activities, whereas life insurance is more focused. 3. Future compensation amounts paid on PC insurance is more difficult to forecast. 12. Cash Flow Underwriting. Explain the concept of cash flow underwriting. ANSWER: Cash flow underwriting is a method of adapting prices to interest rates. As interest rates rise, PC companies tend to lower their premiums to acquire more premium dollars to invest. 13. Impact of Inflation on Assets. Explain how a life insurance company’s asset portfolio may be affected by inflation. ANSWER: When higher inflation causes higher interest rates, the market value of existing bonds decreases. However, the market values of real estate holdings tend to increase. If the life insurance company diversifies its asset portfolio, its asset portfolio will be less sensitive to inflation. 14. Reinsurance. What is reinsurance? ANSWER: Reinsurance permits companies to write large policies by allocating a portion of the risk to other insurance companies, but they then must share the return. 15. NAIC. What is the NAIC and what is its purpose? ANSWER: The NAIC is the National Association of Insurance Commissioners. It facilitates cooperation among the various state agencies when an insurance issue is of national concern. It is involved in common reporting issues to maintain uniformity and participates in legislative discussions. 16. Adverse Selection and Moral Hazard Problems in Insurance. Explain the adverse selection problem and the moral hazard problem in insurance. Gorton Insurance Co. wants to properly price the insurance for car accidents. If Gorton wants to avoid the adverse selection and moral hazard problems, do you think it should assess the behavior of insured people, uninsured people, or both groups? Explain. ANSWER: When insurance companies assess the probability of a condition that will result in a payment to the insured, they rely on statistics about the general population. However, an individual person has private information (about himself) that is not available to the insurance company. The individuals who have private information that makes them more likely to need insurance will buy it, while the individuals who have private information that makes them less likely to need insurance will

Chapter 25: Insurance Operations  5 not buy it. This is referred to as an adverse selection problem, which in general means that bad customers are selected. In the insurance industry, the moral hazard problem represents insured policyholders taking more risks because they are insured. If the insurance company did not consider this when setting insurance premiums, it may have set the premium too low. Thus, Gorton Insurance Co. should assess the sample of insured policyholders rather than the entire sample because this subsample more properly reflects the behavior of the people that it would insure. CRITICAL THINKING QUESTION

Investment Policy Incentives of Insurance Companies Consider a life insurance company that needs to ensure that it can make a steady stream of payments over time to beneficiaries of its policyholders. Assume that the compensation for the insurance company’s portfolio managers is tied to the return earned on the investments each year. Write a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the policyholders. ANSWER If portfolio managers are compensated based on the return on investment, they may be tempted to make investment decisions that maximize the expected return on investment. Yet, these strategies may be very risky, and therefore might not be capable of providing steady cash outflows to beneficiaries of policies. The portfolio managers should be assessed based on their ability to consistently generate the steady cash outflows to beneficiaries.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Insurance company stocks may benefit from the recent decline in interest rates.” Insurance companies typically hold a large amount of bonds, which should increase in value if interest rates decline. Therefore, the values of insurance company stocks may rise. b. “Insurance company portfolio managers may serve as shareholder activists to implicitly control a corporation’s action.” If an insurance company holds a large amount of a specific firm’s stock, it may have some influence on the corporation’s management, because the management does not want the portfolio managers to dump the corporation’s stock in the secondary market. c. “If a life insurance company wants a portfolio manager to generate sufficient cash to meet expected payments to beneficiaries, it cannot expect the portfolio manager to achieve relatively high returns for the portfolio.”

Chapter 25: Insurance Operations  6 If a portfolio manager must generate sufficient cash to meet expected payments to beneficiaries, the portfolio may be composed mostly of bonds that promise fixed payments. The portfolio may not be focused on growth stocks, because there is more uncertainty about the payments that these stocks could generate over time. Therefore, the manager has less flexibility, and must give up some potential return in order to satisfy the main goal of the portfolio.

Managing in Financial Markets As a consultant to an insurance company, you have been asked to assess the asset composition of the company. a. The insurance company has recently sold a large amount of bonds and invested the proceeds in real estate. Its logic was that these actions would reduce the exposure of the assets to interest rate risk. Do you agree? Explain. Some real estate can be highly sensitive to interest rate movements, since the demand for real estate could decline during periods of rising rates (when it is costly to borrow funds to finance real estate purchases). Therefore, the change in the asset composition may not necessarily reduce interest rate risk. b. This insurance company currently has a small amount of stock. The company expects that it will need to liquidate some of its assets soon to make payments to beneficiaries. Should it shift its bond holdings (with short terms remaining until maturity) into stock in an effort to achieve higher rate of return before it needs to liquidate this investment? The stock returns are very uncertain. It is not wise to shift into stock when you know that you will have to liquidate the investment in the near future. c. The insurance company maintains a higher proportion of junk bonds than most other insurance companies. In recent years, junk bonds have performed very well during a period of strong economic growth, as the yields paid by junk bonds have been well-above high-quality corporate bonds. Very few defaults have occurred over this period. Consequently, the insurance company has proposed that it invest more heavily in junk bonds, as it believes that the concerns about junk bonds are unjustified. Do you agree? Explain. The junk bonds have probably performed very well because of the strong economic growth that occurred, which allowed most firms that issued junk bonds to meet their payments. However, if economic conditions worsen, junk bonds may default at a much higher rate. Therefore, this insurance company should not increase its holdings of junk bonds unless it understands the risk involved.

Flow of Funds Exercise How Insurance Companies Facilitate the Flow of Funds Carson Company is considering a private placement of equity with Secura Insurance Company.

Chapter 25: Insurance Operations  7 a. Explain the interaction between Carson Company and Secura. How will Secura serve Carson’s needs, and how will Carson serve Secura’s needs? Secura receives funds from its customers, who pay insurance premiums in exchange for insurance. It can invest funds in Carson in an effort to earn a high return of the funds until the funds are needed to cover insurance claims. Carson benefits because it has the use of the funds to support its business expansion. b. Why does Carson interact with Secura instead of trying to obtain the funds directly from individuals who pay premiums to Secura? Individuals who purchase insurance premiums are not necessarily interested in investing in equity. They want insurance. The funds received by Secura are invested until they are needed. The capital market allows the financial institution to earn a return on the insurance premiums until insurance claims must be paid. c. Who will benefit if the stock purchased by Secura performs well—Secura’s shareholders or Secura’s policyholders who purchased term life insurance and property insurance? Is it worthwhile for Secura to closely monitor Carson’s management? Explain. Secura’s shareholders would benefit if the stock it purchased performs well. Its policyholders who purchased term and property insurance receive insurance in return for their premiums, and do not benefit directly from the investments made by the insurance company. It is worthwhile for Secura to monitor Carson Company’s management because it owns a large block of shares, and it can benefit directly from ensuring that Carson’s management makes decisions that have a favorable effect on Carson’s stock price.

Chapter 26 Pension Fund Operations Outline Types of Pension Plans Defined-Benefit Plans Defined-Contribution Plans Comparing Pension Plans

Pension Fund Participation in Financial Markets Governance by Pension Funds Regulation of Private Pension Plans Vesting of Private Pension Plans Transferability of Private Pension Plans Tax Benefits of Private Pension Plans Insurance on Private Pension Plans Underfunded Private Defined-Benefit Pensions

Underfunded Public Defined-Benefit Pensions Overestimated Rate of Return Political Motivation Possible Solutions to Underfunded Pensions

Corruption of Defined-Benefit Pension Funds Bribes to Trustees Payment of Excessive Benefits Ineffective Oversight by Trustees

Pension Fund Management Asset Allocation of Pension Funds Matched Versus Projective Funding Strategy

Performance of Pension Funds Pension Fund’s Stock Portfolio Performance Pension Fund’s Bond Portfolio Performance Evaluation of Pension Fund Performance

Chapter 26: Pension Fund Operations  2

Key Concepts 1. 2. 3. 4.

Explain the difference between defined-benefit and defined –contribution plans. Explain how pension funds are regulated. Describe how pension funds participate in financial markets. Describe how potential incentives of politicians and pension portfolio managers can adversely affect pension funds.

POINT/COUNTER-POINT: Should Pension Fund Managers be More Involved with Corporate Governance? POINT: No. Pension fund managers should focus more on assessing stock valuations and determining which stocks are undervalued or overvalued. If pension funds own stocks of firms that perform poorly, the pension fund managers can penalize those firms by dumping those stocks and investing their money in other stocks. If pension funds focus too much on corporate governance, they will lose sight of their goal of serving the pension recipients. COUNTER-POINT: Yes. To the extent that pension funds can use governance to improve the performance of the firms in which they invest, they can improve the fund performance. In this way, they also improve the returns to the pension recipients. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: There is a possible compromise. Pension funds can use most of their time to focus on making good investments. However, they have opportunities to vote on particular matters as shareholders and they can vote in a manner that will discipline corporate managers to maximize the stock price. They may also work with other institutional investors to prompt corporate managers or boards about possible changes that could improve corporate performance and therefore the firm’s stock price (which would be beneficial to the pension fund participants).

Questions 1. Private versus Public Pension Funds. Explain the general difference between the portfolio composition of private pension funds and public pension funds. ANSWER: State and local government pension funds tend to concentrate more on credit market instruments and less on corporate stock. 2. Defined-Benefit versus Defined-Contribution Plan. Describe a defined-benefit pension plan. Describe a defined-contribution plan and explain how it differs from a defined-benefit plan. ANSWER: A defined-benefit plan requires contributions that are dictated by the benefits that will eventually be provided. The retirement benefits are known during the time at which the employee is still working.

Chapter 26: Pension Fund Operations  3 The benefits provided by the defined-contribution plan are determined by the accumulated contributions and the return on the fund’s investment performance. This plan allows a firm to know with certainty the amount of funds to contribute. The retirement benefits are not known with certainty because they are dependent on the performance of the investments that were made with the funds that were contributed. 3. Pension Fund Participation in Financial Markets. Explain how pension funds participate in financial markets. ANSWER: Because pension fund portfolios are normally dominated by stocks and bonds, the participation of pension fund managers in the stock and bond markets is obvious. Pension fund managers also participate in money and mortgage markets to fill out the remainder of their portfolios. They sometimes utilize the futures and options markets as well in order to partially insulate their portfolio performance from interest rate and/ or stock market movements. 4. Governance by Pension Funds. Explain how a pension fund’s governance over corporations can help to enhance the performance of the pension fund. ANSWER: As pension funds exert some governance to ensure that the managers and board members of corporations serve the best interests of shareholders, they can possibly improve the performance of corporations. To the extent that their efforts boost the prices of the securities issued by the corporations, they benefit directly from their governance.

5. Pension Plan’s Vesting Schedule. Explain how a pension plan’s vesting schedule works and what its purpose is. ANSWER: A pension plan’s vesting schedule represents the time at which rights to assets that have accumulated in the employee’s pension fund cannot be taken away. Employees whose employment period is shorter than the vesting schedule are not allowed to retain the assets that accumulated within their respective pension funds. The rules for vesting in private pension plans were established by the Employee Retirement Income Security Act (ERISA) of 1974 (also called the Pension Reform Act) and its 1989 revisions.

6. ERISA. Explain how ERISA affects employees who change employers. ANSWER: Employees that changed employers could transfer any vested amount into the pension plan of their new employers. 7. Tax Benefits of Pension Plans. Explain how pension plans provide tax benefits. ANSWER: First, a portion of the income earned by the employee is contributed to the employee’s pension before taxes are imposed, so taxes are deferred until money is withdrawn from the fund after retirement. Second, since the annual income to the employee after retirement is likely to be lower than the annual income earned by the employee while employed, the income provided by the pension plan may be subject to a lower tax rate.

Chapter 26: Pension Fund Operations  4 8. Guidelines for a Trust. What type of general guidelines may be specified for a trust that is managing a pension fund? ANSWER: Guidelines may include the percentage of the portfolio allocated to stocks or bonds, a desired minimum portfolio rate of return, a maximum amount to be invested in real estate, minimum acceptable quality ratings for bonds, the average maturity of bonds, and the maximum amount to be invested in options. 9. Management of Pension Portfolios. Explain the general difference in the composition of pension portfolios managed by trusts versus those managed by insurance companies. Why does this difference occur? ANSWER: Pension portfolios managed by trusts offer potentially higher returns than insured plans and have a higher degree of risk. This difference occurs because assets managed by insurance companies (insured plans) are owned by the insurance companies and are designed to create annuities. Assets managed by trusts are still owned by the company providing the pension plan. 10. PBGC. What is the main purpose of the Pension Benefit Guarantee Corporation (PBGC)? ANSWER: The PBGC provides insurance on pension plans. If a pension plan is terminated, the PBGC takes control as the fund manager. 11. Exposure of Pension Funds to Interest Rate Risk. Why might pension funds be exposed to interest rate risk? How can pension funds reduce their exposure to interest rate risk? ANSWER: Pension funds commonly invest in bonds, so if interest rates rise, the valuation of these bonds may decline. Pension funds could reduce the average maturity of bonds held to reduce interest rate risk. They could also take positions in financial futures or options on futures as was described in earlier chapters. 12. Pension Fund Investment Performance Evaluation. McCanna Inc. has hired an investment company to manage its pension fund, which is invested in a stock portfolio and bond portfolio. Explain how McCanna can evaluate the performance of the investment company in managing its pension fund money.

ANSSWER: A pension fund’s performance can be evaluated by comparison to a passive strategy benchmark representing the same mix of securities. For example, assume that an actively managed pension fund presently has a stock portfolio and a bond portfolio. The riskadjusted returns on the fund’s actively managed stock portfolio could be compared to a benchmark stock index (such as an exchange-traded fund representing the stock index). In addition, the risk-adjusted returns on the pension fund’s actively managed bond portfolio could be compared to a benchmark bond index. This comparison can determine whether the portfolio managers of the pension fund are achieving better performance than if the pension fund used a passive management strategy. 13. Estimated Rate of Return and Underfunding. Explain how some government defined-benefit plans have become underfunded as a result of overestimating their rate of return on investment. ANSWER: Many government agencies assumed that they would earn a high rate of return on their

Chapter 26: Pension Fund Operations  5 pension fund investments, which justified setting aside a smaller amount of money to match the future obligation. Such a strategy may have been politically beneficial in the short run because the agencies were able to spend more money on government services. But, because they realized a lower rate of return on their investments than what they assumed, their pensions became more underfunded. This trend could have adverse consequences in the long run, because the agencies will have to raise taxes or cut government services later to make up for the underfunding.

Chapter 26: Pension Fund Operations  6 14. Potential Impact of an Underfunded Public Pension Fund on Debt. Explain how an underfunded public pension fund can affect the debt rating of a city or state. ANSWER: Underfunded pensions can cause large budget deficits. The credit rating agencies downgraded the credit rating of bonds issued by the state of Illinois because of its substantially underfunded pension plan. This forced the state of Illinois to pay a higher yield on the bonds it issued, which may impose an additional cost on the taxpayers in that state or cause a reduction in state government services in order to make up for the deficit. 15. Potential Corruption of Pension Fund Trustees. Explain the potential for corruption when a trustee has the power to determine who will manage a pension fund. ANSWER: The decision by one person or a few people overseeing the pension fund to allow a particular investment company to manage the pension fund’s money can generate millions of dollars in management fees for that investment company. Consequently, a trustee may be bribed by an investment company that wants to manage the pension fund. Some trustees of public pension plans are politicians who campaign for other political positions. Investment companies may make “contributions” to a trustee’s election campaign in the hope of being hired by the trustee as consultants to manage a portion of the pension funds. CRITICAL THINKING QUESTION Aligning Incentives of Pension Funds. Consider a state pension fund that needs to generate a series of fixed payments for its retirees. Yet, assume that its compensation for its portfolio managers is tied to the return earned on the investments each year. Write a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the retirees. ANSWER If portfolio managers are compensated based on the return on investment, they may be tempted to make investment decisions that maximize the expected return on investment. Yet, these strategies may be very risky, and therefore might not be capable of providing the retirees with the fixed payments that they were expecting. If the pension fund is serving retirees that are supposed to receive fixed payments, then the investment strategy should be designed to serve that objective. Pension fund managers should be assessed based on their ability to meet the objectives established for the retirees.

Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The city is now broke because of its pensions.” The city’s employees were granted large pension payments in the future, which underfunded. Therefore, the city has to correct the underfunding with other funds that were supposed to be used for other purposes.

Chapter 26: Pension Fund Operations  7 b. “Defined-contribution plans would prevent politicians from buying votes in a state.” A defined-contribution plan would clearly define how much money will be set aside for state employees. Therefore, there is no risk that politicians would attempt to promise excess employee benefits and cause underfunding if such a plan was used. c. “Public pension funds govern corporations but also need to govern themselves. .” Pension fund portfolio managers are major investors in corporations and therefore can govern the corporate management behavior. Yet, some public pension funds are underfunded because of very weak management or oversight, as they promised to provide more benefits than they can afford.

Managing in Financial Markets As a consultant to a state’s underfunded pension fund, you have been asked to search for solutions to prevent underfunding in the future. a. One explanation for the underfunding of the defined-benefit plan is that the economy was weak recently, and financial markets were weak, and this was the cause of the underfunding. If so, the underfunding may not be a problem in the future. Do you think this explanation is sufficient, such that there is no need to search for an alternative solution? Explain. A weak economy can occur again in the future, and underfunding might occur again as a result. So an alternative solution is needed. b. One possible solution is for the state’s defined-benefit plan to be converted into a definedcontribution plan. Explain why this could be a viable solution to the problem. The defined-contribution plan would require that the state set aside the proper funds for employees for their retirement as it provides paychecks to them. c. Some state workers prefer to be on a defined-benefit plan because they will likely make poor investments if they are forced to manage their own funds (as they would with a definedcontribution plan). Is that a sufficient reason to force a state to remain on a defined-benefit plan? Students can weigh the tradeoffs, but most students would likely say that just as the state should be responsible for providing its contribution (with the defined-contribution plan), the employees should be responsible for managing their retirement account.

Flow of Funds Exercise How Pension Funds Facilitate the Flow of Funds Carson Company has a defined-benefit pension plan in which it offers generous benefits to its employees upon retirement.

Chapter 26: Pension Fund Operations  8 a. Explain the role of the portfolio managers who manage the pension fund. What is their primary role? Their role is to generate sufficient returns on the portfolio so that retirement payments can be provided to the employees who have retired. b. Explain the tradeoff between investing in bonds versus in stock for the purpose of providing future retirement benefits. The bonds could generate more predictable returns, which may be useful when attempting to ensure sufficient funds to make payments to retirees. However, the expected return is probably lower on bonds than on stocks. However, the returns to be earned by the pension are very uncertain and could possibly cause the pension fund to be underfunded. c. Explain how investment decisions on the pension fund would change if the defined-benefit plan was changed to be a defined-contribution plan. The defined-contribution plan would contribute to the employee’s retirement but allow the employees to make their own investment decisions with the fund.

Solutions to Integrative Problem for Part 7 Assessing the Influence of Economic Conditions Across a Financial Conglomerate’s Units 1. The objective of this case is to force students to compare asset portfolios across units of the financial conglomerate and consider how each asset portfolio is exposed to default risk and interest rate risk. An overall comparison can only be made once these types of exposure are evaluated. Default Risk In comparing the effects of the recession, assess the composition of each unit’s asset portfolio. Regarding default risk, most units will be adversely affected, but some are more exposed than others. For example, finance company assets may be subject to a higher default rate than the other institutions. The default rate on mortgages (and on corporate bonds to a lesser degree) will dictate the performance of savings institutions, while the default rate on bonds (and mortgages to a lesser degree) will dictate the performance of insurance companies. It is difficult to precisely determine the impact without knowing more about the asset portfolio. An insurance company holding toprated corporate bonds would likely experience a lower default rate than an insurance company holding junk bonds. Mutual funds concentrating on safe debt securities would be somewhat insulated from default risk while mutual funds concentrating on junk bonds or other risky securities would be adversely affected. Yet, the shareholders of the mutual fund would bear most of the adverse effects, but the mutual fund’s performance from the conglomerate’s perspective is related to its growth, which will subside due to poor returns on its portfolio. Interest Rate Risk Regarding interest rate risk, the institutions that are more exposed to interest rate movements may benefit from the likely interest rate movements. As the recession begins, there will likely be a

Chapter 26: Pension Fund Operations  9 decline in the demand for funds, causing a decline in interest rates. Institutions that have debt securities with fixed interest rates can benefit from the decline in market interest rates, since the market value of those debt securities will rise. Therefore, the interest rate movements can favorably affect savings institutions that provide fixed-rate mortgages, finance companies that provide consumer loans, and insurance companies that maintain a bond portfolio. The bonds would likely benefit more than mortgages or consumer loans because their time to maturity is much longer (recall that the prepayment option may reduce the potential favorable effect on longterm mortgages). Another factor that influences the relative impact is the proportion of the institution’s assets that are held in the form of fixed-rate debt securities. The higher the proportion, the more pronounced is the effect. In addition, savings institutions that concentrate on variable-rate mortgages would not benefit from the expected movement in interest rates. Mutual funds concentrating on securities such as long-term bonds and mortgages could benefit from the decline in interest rates, while money market mutual funds would not benefit. Effect on Brokerage Firms and Investment Banking Firms A brokerage firm’s performance is mostly affected by its volume of brokerage transactions rather than its composition of assets, since its main function is that of an intermediary rather than an investor. If stock trading volume declines, so will the income of the brokerage firms. Investment banking firms will be adversely affected by the reduction in investment banking services needed. Summary Overall, insurance companies and mutual funds holding a large proportion of highly rated longterm bonds may perform better than most other financial institutions during the recession. They would benefit from their exposure to interest rate risk without being heavily exposed to default risk. Savings institutions with fixed-rate mortgages and most finance companies benefit from exposure to interest rate risk, but are adversely affected by default risk. Savings institutions with a high concentration of floating-rate mortgages do not benefit from lower interest rates because of low exposure to interest rate risk. Brokerage firms and investment banking firms will experience a reduction in business volume. This overall assessment is somewhat subjective. As with most cases, the goal of this case is not to focus on a precise answer, but to force students to use reasonable logic in developing an answer. 2. It is expensive and inefficient for each unit to have its own economists to provide forecasts. In addition, economists among units conduct redundant analyses and then may even create contradictory forecasts. Thus, one unit may be altering its asset portfolio in anticipation of higher interest rates while another alters its asset portfolio in anticipation of lower interest rates. The possible solution is anticipation of lower interest rates. The possible solution is for the holding company to employ the economists, and the forecasts denied by them are to be used by all units, who make their decisions based on those forecasts.