Exam I

Financial markets are markets in which funds are transferred
from those who have excess funds available (________)
to those who have a shortage of available funds (_________)

lenders / borrowers

Interest rates are important to financial institutions
since _________________ increases the cost of acquiring funds and
increases the income from assets

an interest rate increase

Changes in stock prices:

affect people's wealth and their willingness to spend
affect firms' decisions to sell stock to finance investment spending.
are characterized by considerable fluctuations.

Foreign Exchange Rate:

Is the price of one country's currency in terms of another's

A weaker dollar
benefits American businesses and hurts American consumers.

Dollar goes down ___________ US made goods cheaper (overseas)

Monetary policy is chiefly concerned with:

the level of interest rates and the nation's money supply

Financial institutions (examples)

Banks
Insurance companies
Finance companies

Financial markets have the basic function of:

bringing together
people with funds to lend and people who want to borrow funds.

Long-term debt and equity instruments are:

traded in the capital market

Foreign bonds:

Bonds sold outside a borrower's country and denominated in the currency of the country in which they are sold.

Eurobonds:

Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which they are sold

Eurodollars:

U.S. dollars deposited in foreign banks
outside the United States or in foreign branches of U.S.

The main sources of financing for businesses, in order of importance, are:

1. financial intermediaries
2. issuing bonds
3. issuing stocks.

The country whose banks are the most restricted in the range of
assets they may hold is:

the United States

Dollars received in the future:

are worth less than dollars received today.

The process of calculating
what dollars received in the future are worth today is called:

discounting

The interest rate that equates the present value of the cash flow
received from a debt instrument with its market price today is:

the yield to maturity

Example:
If a $5,000 coupon bond has a coupon rate of 13 percent,
then the coupon payment every year is $650.

$5000 x 13% = 650

When a bond's price falls:

its yield to maturity rises and its current yield rises

Reinvestment risk:

is the risk that a bond's future coupon payments may have to be invested at a rate lower than the bond's yield to maturity

The Concept of Duration

Duration: The average lifetime of a debt security's stream of payments.
Developed by: Frederick Macaulay

The duration of a ten-year, 10 percent coupon bond when the interest rate is 10 percent is 6.76 years.
What happens to the price of the bond if the interest rate falls to 8 percent?
Answer: It rises 12.3 percent. How?

0

An _________ is a piece of property that is a store of ______.

asset / value

Expected Returns

An increase in an asset's expected return
relative to that of an alternative assets, holding everything else unchanged
raises the quantity demanded of an asset.

If Expected Return goes up;

Quantity demanded of an asset goes up.

Expected Return =

Probability x Return + Probability x Return

A risk-averse person:

prefers stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night stock (the riskier asset), even though the stocks have the
same expected return, 10%.

Liquidity:

Increased liquidity of bonds results in an increased demand for bonds,
and the demand curve shifts to the right.

Increased liquidity of ____________ lowers the demand for bonds
and shifts the demand curve to the left.

alternative assets

The supply curve for bonds has the usual ___________, indicating that
as the price rises, ceteris paribus, the quantity supplied increases.

upward slope; meaning if prices goes up, the quantity supplied goes up.

Market equilibrium:

occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price.

Bond prices and interest rates are:

inversely related.

Bonds:

movements along the curve will be due to interest rate (or price) changes.

Lower expected
interest rates ( i )
in the future:

increase the demand
for long-term bonds
and shift the demand
curve to the right.

When people begin to expect
a large run up in stock prices,
the demand curve for bonds
shifts to the _____ and the interest rate ____.

left / rises

An increase in the liquidity of stocks (other assets)
would cause demand curve for bonds to:

shift to the left.

During a recession, the supply of bonds decreases and the supply curve shifts to the left.

...

During a recession, the supply of bonds ________ and the supply curve shifts to the ________.

decreases / left

The economist Irving Fisher, after whom the Fisher effect is named, explained why:

interest rates rise as the expected rate of inflation increases.

When the economy slips into a recession,
normally the demand for bonds _________,
the supply of bonds ___________ ,
and the interest rate ________.

decreases / decreases / falls

Milton Friedman contends that it is entirely possible:

when the money supply rises,
interest rates may rise if liquidity effect is more than offset by changes in income, the price level, and expected inflation.

Risk Structure of Interest Rates:

The relationship among interest rates on bonds .with same term to maturity bur different risk. Note** Risk: Different
Term: Same

Term Structure of Interest Rates

The relationship among interest rates on bonds with different terms to maturity, but similar risk. Note** Risk: Similar
Term: Different

Bonds with relatively high risk of default are called:

junk bonds.

If Moody's or Standard and Poor's downgrades its rating on a corporate bond:

the demand for the bond decreases and its yield increases.

Interest rates on corporate bonds
- Interest rates on Treasury bonds

#NAME?

______________is sometimes called a risk and liquidity premium.

risk premium

The _____________________ of interest rates
is the relationship among interest rates on bonds
with different maturities but similar risk.

term structure

Yield Curve:

A plot of the yields on bonds with different terms to maturity but the same risk ,liquidity, and tax considerations. Example: Govt. bonds

When the yield curve is ________________, short-term interest rates are expected to rise in the future.

upward-sloping

Short rates are as likely to fall in future as rise,
so average of expected future short rates ___________ be higher than current short rate: therefore, yield curve will not usually slope upward.

will not usually

Bonds of different maturities are ________________ at all.

not substitutes /
Market Segmentation

The interest rate for each bond with a different maturity is then determined by the ______________ of that bond.

supply and demand /
Market Segmentation

Investors' strong preference for short-term relative to long-term bonds explains why yield curves typically ______________.

slope upward./
Market Segmentation

Liquidity Premium Theory:

Bonds of different maturities are substitutes, but are not perfect substitutes.

Efficient market hypothesis:

The current price of a financial security fully reflects all available relevant information.

In Evidence on Efficient Market Hypothesi, stock prices and exchange rates close to ___________.

random walk

Performance of Investment Analysts and Mutual Funds
should__________ be able to _________ beat the market.

not / consistently

A positive announcement about a company
will_________ , on average, raise the price of its stock.

not

In random walk behavior, Future changes in stock prices should, for all practical purposes,
be _______________ .

unpredictable

To say that stock prices follow a "___________" is to argue that stock prices cannot be predicted based on past trends.

random walk

The EMH suggests that technical analysis is ________________.

a waste of time

Tests used to rate the performance of rules developed in technical analysis conclude that technical analysis _________________________ the overall market.

does not outperform

Do stock prices always rise when there is good news?

NO!

Efficient Markets prescription for investor states, investors ___________ try to outguess the market by constantly buying and
selling securities.

should not

EMP states and investor should pursue a _________________.

buy and hold" strategy

This will lead to the same returns, on average, but the investor's net profits will be higher because fewer _________________ will have to be paid.

brokerage commissions

A __________ is a situation in which the price of an asset differs from its fundamental market value.

bubble

EMH suggests that "smart money" would engage in short sales to combat overpriced securities, yet _____________ is low, leading to behavior theories about "loss aversion.

short sale volume

__________________
An arrangement with a broker to borrow stocks from them and then sell it in the market, with the hope that they earn a profit by buying the stock back again after it has fallen in price.

Short sales:

Financial intermediaries, particularly ________, are the ___________ source of external funds used to finance businesses.

banks / most important

______________ is a prevalent feature of debt contracts for both households and businesses.

Collateral

Property that is pledged to the lender in the event that
a borrower cannot make his or her debt payment.

Collateral

_______________ : Occurs when one party in a transaction has better information than the other party, before transaction occurs.

Adverse Selection

_______________: Occurs when one party has an incentive to behave differently once an agreement is made between parties, after transaction occurs.

Moral Hazard

Monitoring and Enforcement of Restrictive Covenants:

*discourage undesirable behavior
*encourage desirable behavior
*keep collateral valuable

Example of restrictive covenants:

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance.

______________: can be used to an advantage by reducing transaction cost.

Economies of scale

__________________: A financial institution can achieve cost savings by engaging in multiple
activities.

Economies of Scope

Investment banks serve two client groups:

*Issuers of securities
*investors of those securities

Established an oversight board to supervise accounting firms (dealt with conflict of interest).

Sarbanes-Oxley Act of 2002

In an advanced economy, a financial crisis can begin in several ways:

*mismanagement of financial liberalization or innovation
*asset price booms and busts
*a general increase in uncertainty caused by failures of major financial institutions

Stage two of a financial crisis in an advanced economy
usually involves a____________________.

banking crisis

Most financial crises in the United States have begun with:

* a steep stock market decline.
* an increase in uncertainty resulting from the failure of a major firm.

________________is a type of insurance against bond defaults

Credit Default Swap

Europe experienced a more severe __________ that the U.S.

downturn

The impact of the 2007-2009 financial crisis was widespread, including:

-the first major bank failure in the UK in over 100 years.
-the failure of Bear Stearns, the fifth-largest U.S. investment bank
-the bailout of Fannie Mae and Freddie Mac by the U.S. Treasury.

Stage three: An unexpected _____________ devaluation increases their debt burden,leading to a decline in their net worth.

currency

This crisis, along with the currency crisis, leads the country into _______________.

a full-fledged financial crisis

An important factor led up to the ______________ financial crisis of 1994
was the deterioration in banks' balance sheets due to increasing loan
loses.

Mexican

So the factors led up to the Mexican financial crisis of 1994 were:

-a rise in domestic interest rates and in foreign interest rates
- a deterioration in bank balance sheets
-domestic stock market declines

The ____________ of the government weakened the banking system balance sheet when the government forced banks to take on gov't debt.

fiscal problems

Argentina's 2001-2002 financial crisis was precipitated by difficulty financing a _________.

large budget deficit