FIN 3303 Exam 2 Ch 8-11, 23

Does governance of firms affect prices of their bonds?

Bond price is based on req'd return, and investors may accept lower return on bonds issued by firms that are subject to governance. Therefore, it does.

How does price change in relation to interest rates?

When interest rates rise, price goes down. When interest rates fall, price goes up. Do not purchase bonds if you expect interest rates to rise, rather purchase when you expect interest rates to fall.

Explain impact of a decline in interest rates:

Investor's req'd rate of return: decrease
Present value of existing bonds: increase
Price of existing bonds: increase

Why is the relationship between interest rates and bond prices important to financial institutions?

Most FI's maintain a portfolio of bonds or mortgages. Because the market values of these securities are very sensitive to interest rate movements, FI's must understand the relationship between interest rates and security prices.

An FI with a large bond portfolio would be affected by falling interest rates in the following way:

Market value of FI's bond portfolio will increase. An FI with 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.

How is an FI with a large portfolio of fixed-rate mortgages affected by rising interest rates?

It is adversely affected, because market value of its mortgage portfolio is reduced when interest rates go up.

When a bond's coupon rate is above the req'd rate of return:

it is above par value because the coupons provide more than the return req'd.

Is the price of a long-term bond more or less sensitive to a change in interest rates than te price of a short-term security?

More sensitive, because it provides fixed payments for a longer period of time and will continue to do so whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturit

Why does the req'd rate of return for a particular bond change over time?

Change in interest rates or change in the risk of the bond.

How does inflation affect bond prices?

Lower inflation normally causes a decline in interest rates; FI's should increase their concentration of long-term bonds before this occurs.

Explain bond price elasticity.

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 of zero-coupon bonds would be more sensitive to interest rate movements than high-coupon bonds.

Describe economic effects on bond prices.

A decline in credit risk will result in slightly lower bond premiums. A major economic expansion will likely result in higher interest rates, and could lead to a major decline in bond prices. The interest rate effect on bond prices will likely overwhelm t

What is the link between problems in the Middle East and bond prices (when tensions rise or war erupts)?

The crisis will lead to an anticipated shortage of oil, which can fuel inflation. Countries that rely on imported oil would be most affected, and their bond prices would be expected to experience a greater decline.

Explain how bond prices may be affected by money supply growth, oil prices, and economic growth.

Higher oil prices, excessive money supply growth, and strong economic growth contribute to higher inflationary expectations. Thus, interest rates would be expected to increase, and the demand for bonds and their prices would decline.

How would bond prices be affected by a reduction in oil production?

Higher oil prices, higher itnerest rates, lower bond prices. Bond portfolio managers would sell bonds immediately causing immediate downward pressure on the bond prices.

How would bond prices be affected by expected higher economic growth?

Higher economic growth places upward pressure on interest rates and downward pressure on bond prices. As bond portfolio managers sell bonds, there is immediate downward pressure on bond prices. Recession causes lower interest rates and higher prices of bo

If the Fed is expected to increase money supply substantially, what would happen to bond prices?

With no threat of inflation, interest rates would be reduced, prices would increase, and bond portfolio managers would purchase. If inflation increases, interest rates will increase, prices will go down, and bond portfolio managers would sell.

When trade deficit is higher than anticipated, bond prices decline. Explain.

Higher trade deficit signals possibility of continued high trade deficit, placing downward pressure on the dollar. If the dollar weakens, US inflation and interest rates rise. Bond portfolio managers sell, driving price down.

What are the implications of a higher and steeper yield curve?

Long-term bond yields have increased. The firm should sell the bonds for lower prices to entice investors.

How should you rebalance your portfolio if you expect long-term interest rates will rise substantially in the future, while short-term interest rates will remain the same?

Sell bonds and purchase more money market securities. If other investors behave the same way, price of money market security will increase as they rebalance portfolio. Yield offered on bonds will then rise, and the yield on money market securities will de

How were bond prices affected by a change in the risk-free rate during the credit crisis?

Risk-free rate decline, placing upward pressure on bond prices. However, credit risk premium increased, placing downward pressure on bond prices.

Note:

Zero-coupon bonds are most sensitive to interest rate movements; investors who are concerned about an increase in interest rates usually sell their holdings of zero-coupon bonds.

Note:

Long-term bonds increase in value when interest rates decrease.

Note:

If the Treasury issues new bonds, the supply of bonds may exceed the demand, causing a decline in the price of bonds. Yields to be offered on any new bonds must be raised to attract buyers.

How would actual selling price differ from the forecasted price?

If req'd rate of return is overestimated, then the actual selling price will be higher than what is forecasted. The annualized yield will be higher than what is forecasted.

How would the PV of a bond be affected if the coupon payments are smaller?

Lower PV since future cash flows are smaller.

How would the PV of a bond be affected if the req'd rate of return is smaller?

PV would be higher, since cash flows would be discounted at a lower discount rate.

How would bond elasticity be affected if the bond price changed by a large amount.

Bond elasticity would be higher, meaning there is a greater sensitivity of bond prices to a change in req'd rates of return. Occur for bonds with longer terms to maturity.

How would the duration of a bond be affected if the coupons are extended over additional time periods?

Greater duration because investor is more exposed to changes in req'd rates of return.

How does bond convexity affect the theoretical linear price-yield relationship of bonds?

Bond convexity illustrates price-yield relationship is not linear, but convex. Particularly pronounced for bonds with low coupons and long maturities. Bond convexity leads to estimation errors in price change, but is negligible in small yield changes. Usi

Distinguish between FHA and conventional mortgages.

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.

What is the general relationship between mortgage rates and long-term gov't security rates?

High positive correlation
Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates because of their cost of financing would increase while interest revenues would not change. Lenders could reduce exposure to

How and why does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed rate mortgages?

An ARM offers lower initial rates than a fixed-rate mortgage to compensate borrowers for incurring interest rate risk. Caps on ARMs limit the degree to which the interest rate charged can move from the original rate at the time the mortgage was originiate

Why is a 15-year mortgage so attractive.

Potential reduction in total interest expenses paid on a mortgage with shorter lifetime.

Explain a balloon-payment mortgage.

Requires interest payments for 3-5 years. At the end of that period, full payment is required. Interest rate risk is lower for FI's

Describe the graduated-payment mortgage

Allows borrowers to repay loans on a graduated basis over the first 5-10 years. Those whose incomes will rise over time may desire this type of mortgage.

Describe growing-equity mortgage

Requires continual increasing mortgage payments throughout the life of the mortgage. Lifetime is reduced because of the accelerated payment schedule.

Why are second mortgages offered by some home sellers?

Usually offered when Fi's provide a first mortgage that does not fully cover the amount of funds the borrower needs. Falls behind the first mortgage in priority claim against the property in the event of default.

Describe a shared-appreciation mortgage

Allows home purchaser to obtain a mortgage at an interest rate below market rates. In return, the lender will share in the price appreciation of the home.

Why are benefits to mortgage lenders with fixed-rate mortgages limited when interest rates decline?

A large proportion of mortgages are refinanced when interest rates drop.

What factors affect mortgage prices?

Changes in interest rates and risk premiums. Economic growth, money supply and inflation affect interest rates. Change in economic growth affects risk premiums.

Why do some financial institutions prefer to sell the mortgages they originate?

To enhance liquidity, or if they expect interest rates to increase.

Why is there a difference in the activity level between secondary markets for mortages and capital market instruments?

Securitization enhances secondary market for mortgages, which allows for sale of smaller loans that could not be as easily sold if they were not packaged.

What types of FI's finance residential mortgages/commercial mortgages?

Commercial banks and savings and loan associations dominate residential. Commercial banks dominate commercial.

How is a mortgage company's degree of exposure to interest rate risk different from other FI's?

Mortgage companies concentrate on servicing rather than investing. Not concerned about hedging over the long run. They are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates changed d

How are mortgage-backed securities used?

An FI that purchases or originates a portfolio of mortgages can finance these mortgages issue mortgage-backed securities. They serve as collateral for the securities. The interest and principal payments on the mortgages are transferred to the owners of th

Describe how collaterilzed mortgage obligations (CMOs) are used and why they have been popular

They are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors are able to choose a class that fits their maturity preferences.

How are the maturity on pass-through securities affected by interest rate movements?

Interest rises, prepayments on mortgages occur. If they were financed with pass-through securities, payments will be channeled to the investors that purchased the pass-through securities.

Explain collateralized debt obligations (CDOs)

Represents a package of debt securities backed by collateral that is sold to investors. Commonly combines a variety of debt securities including subprime, prime, auto loans, and other credit card loans. Popular means by which a creditor could originate a

Explain subprime mortgages.

Provided by mortgage companies to borrowers who would not have qualified from prime loans. Enabled more people with relatively lower income, or high existing debt, or a small down payment to purchase homes. Allowed FI's to expand business. Could charge hi

How did repayment of subprime mortgages compare to that of prime mortgages during the credit crisis?

In 2008, about 25% of all outstanding subprime mortgages had late payments of at least 30 days, vs. less than 5% for prime. About 10% of outstanding subprime mortgages were subject to foreclosure, vs. less than 3% for prime.

Explain the problems in valuing MBS

No centralized reporting system that reports trading of MBS in secondary market as is for other securities. Only ones who know the price is the buyer and seller.

Who was adversely affected by the credit crisis, other than mortgage companies and homeowners?

Mortgage insurers: expense from foreclosure of insured properties
Individual investors: investments pooled by mutual funds, hedge funds, and pension funds and used to purchased MBS; those that invested in stocks of FI's
FI: bankruptcy, employees lost jobs

What could cause a credit crisis?

Triggered by fear of investors that purchase dept securities. Could occur in response to weak economy or to various events that cause concern that issuers of debt will not repay their debt.

What is the role of credit ratings in mortgage markets?

Rate tranches of mortgage-backed securities based on mortgages they represent.

Why did Fannie Mae and Freddie Mac experience mortgage problems?

Major investors that made poor investment decisions by using funds to invest in many morgages that involved high risk.

Why did the rescue of Fannie Mae and Freddie Mac improve the ability of mortgage companies to originate mortgages?

Without a strong secondary market for mortgages, FI's that originate mortgages would be able to sell mortgages and therefore may have to finance them on their own. Would limit the amount of funding for new mortgages. While gov't rescue is primarily focuse

How did the Treasury's purchase of the MBSs improve the situation for MBSs?

Secondary market for MBSs was inactive because of high level of defaults. Investors afraid to purchase. Treasury's purchase corrected imbalance (excessive supply).

Why is it difficult to assess the financial condition of an FI that has purchased a large amount of MBSs?

Risk of MBSs is dependent on underlying mortgages, details of these mortgages are not disclosed in financial statements.

Note:

When interest rates decline, mortgages are commonly prepaid, and interest payments on them are terminated. Therefore, payments to investors holding the interest-only CMOs are terminated as well.

Note:

The future value of a CMO is dependent on future interest rates movements.

Note:

The values of principal-only CMOs adjust abruptly to changes in interest rates. They exhibit a high degree of volatility (risk).

If you expect economic conditions to weaken in the future and the gov't will decreased spending, are IOs or POs a better investment?

POs. Interest rates decrease, resulting in mortgage prepayments which causes interest payments to be terminated and therefore IOs as well. Investment in POs would result in accelerated payment of principal during a period in which interest rates are decli

What happens to the equilibrium interest rate if there is a smaller supply of funds and the same demand for loanable funds?

Rise

What happens to quantity of loanable funds if interest rates rise?

Decline

What happens to req'd rate of return if interest rates rise?

Increase, causing market value to decrease.

What happens to the risk premium if the economy weakens (in response to rising interest rates)?

Increase, causing higher req'd rate of return on risky securities. Would reduce present value on these securities.

If the risk premium is expected to increase, what type of investment would be most appropriate?

Low-risk bonds and money market securities.

If the US dollar weakens against a foreign currency, what type of security should US investors purchase?

The country to whom the foreign currency belongs, and the type of that country's securities that will be purchased by a citiizen who would have normally purchased US Treasury securities.

What happens to interest rates when there is an increase in the demand for loanable funds?

Increase

What are the rights of common stockholders not available to others?

Permitted to vote on key matters concerning firm

What is the danger of issuing too much stock?

Can cause dilution of ownership, and can depress stock prices because the supply may now exceed demand.

Why do firms engage in IPOs?

When they have feasible expansion plans but are already near their debt capacity; when business/market conditions are favorable.

What is the difference between obtaining funds from a venture capital firm and engaging in an IPO?

Before engaging in IPO, may obtain equity funding from a venture capital firm for 2-5 years. IPO allows other shareholders to invest in equity of the firm. Venture capital firms sell off shares shortly after frm engages in IPO and then sell its shares in

What is a prospectus?

Specifies how proceeds of offering are to be used, pas performance of issuing firm, risk, price range. Offer price influenced by market conditions, industry conditions, and prevailing market.

Describe process of bookbuilding.

Lead underwriter engages by soliciting indications of interest in the IPOs by institutional investors to determine demand.

What is a lockup provision?

Restricts insiders and venture capital firms from selling their shares until a specified period (usually 6 months) after the IPO. Can sometimes place downward pressure on price of stock

What is the initial return for an IPO?

Return from the offer price until the end of the first day of trading.

What is "flipping shares?

Selling shares shortly after obtaining them at the IPO. Used to take advantage of an initial return. IPO performance unusually high on first day followed by downward drift.

How do IPOs perform over the long run?

Poorly when compared to other firms

Why may asymmetric information motivate firms to repurchase some of their stock?

Realize when its stock is undervalued

Why may stock price rise when firm announces it is repurchasing shares?

May signal that firm's managers believe stock is undervalued, encouragin investors to purchase stock, placing upward pressure on price

How do ADRs enable US investors to become part owners of forein companies?

American depository receipts (ADRs) are certificates that represent ownership of a foreign stock. They are traded in the US as a method of investing in foreign securities

Explain why stocks traded on NYSE exhibit less risk than those traded on other exhanges

They represent larger firms, have large trading volume, which enhances liquidity

Are organized stock exchanges used to place newly issued stock?

No, they are used to facilitate secondary market transactions.

How have international mutual funds (IMFs) increased international integration of capital markets among countries?

IMFs allow investors easy access to foreign securities because the firm sponsoring IMF makes the portfolio decisions and executes the transactions.

Describe spinning and laddering in the IPO market.

Spinning is process in which investment bank allocates shares from IPO to corp executives. Laddering involves investors placing bids for IPO shares on first day that are above the offer price. Laddering results in upward price momentum. Spinning can keep

How do accounting irreularities affect pricing of corp stock?

Introduce additional uncertainty and risk, causing investors to require higher rate of return, lowering stock price.

Describe provisions of Sarbanes-Oxley Act

1) prevents public accounting firm from auditing a client fir whose employees were employed by the client firm within one year prior to audit
2) requires that only outside board members of a firm be on the firm's audit committee
3) prevents members of fir

Price-earnings model

Applies industry PE ratio to firm's expected earning for the next year to value stock.

Dividen discount model

Measure value of firm as PV of future expected dividends to be received by investor.

How does economic growth affect the valuation of stock?

Because investor's use forecasted earning to determine if stock is over- or undervalued

How are the interest rate, req'd rate of return, and the valuation of stock related?

Stocks should be purchased if they are appropriately priced to reflect sufficiently high expected return above risk free rate. Relation between interest rates and stock prices is not constant over time. Most of largest stock market declines have occurred

Would req'd return be affected by an increased expected inflation rate?

Can increase risk-free interest rate, therefore should cause an increase in req'd rate of return

What is investor sentiment?

Represents general mood of investors in the stock market.

What is the January effect?

Porfolio managers are evaluated over calendar year and tend to invest in riskie small stocks at beginning of year and shift to larger more stable companies near end to lock in gains. Places upward pressure on small stocks in January

Why can expectations of an acquisition affect value of target's stock?

Results in increased demand for target's stock therefore raises stock price. investors recognize target's stock price will be bid up once acquiring firm attempts to acquire target stock

What are the risks of investing in stocks in emerging markets?

More exposed to major gov't turnover and other forms of political risk. US investors exposed to higher degree of exchange rate risk because their local currencies typically volatile.

How did stock volatility change during the credit crisis?

Increased due to uncertainty about economic conditions. Prices frequently changing by more than 5% on a single day.

What factors affect a stock portfolio's volatility?

When its individual stock volatilities are high, when individual stock returns highly correlated. stock portfolio containing some stocks with low or negative correlation will exhibit less volatility because they will not experience peaks and troughs simul

Explain how to estimate the beta of a stock.

Obtaining returns of the firm and the stock market over the last 12 quarters and applying regression analysis to derive slope coefficient

Explain difference between weak-form, semistrong-form, strong-form efficiency.

Weak form suggests security prices reflect recent price movement and trading information, semistrong suggests prices reflect all publicly traded info, strong suggests security prices reflect public and private info

Describe value at risk method for measuring risk.

Estimates that largest expected loss to a particular investment position for a specified confidence level. Intended to warn investors about potential maximum loss.

Why may stock prices decrease in response to a higher risk-free rate accordiang to the CAPM?

When risk-free rate rises, req'd rate of return rises, expected cash flows generated by stock are discounted at high rate, resulting in lower value. If economic growth increases, may be increase in expected cash flows whic can overwhelm unfavorable effect

Using the dividend discount model, how would the price of a stock be affected if the req'd rate of return is increased?

Reduced because cash flows would be discounted at a higher rate.

Using the constant-growth dividen discount model, how would the price of a stock be affected if the growth rate is reduced?

Reduced because expected future cash flows in distant periods are reduced if the growth rate is revised downward.

Using the CAPM, how would the req'd rate of return on a stock be affected if the risk-free rate is lower?

Lower because it should reflect a premium above the risk-free rate

Using CAPM, how would the req'd rate of return on a stock be affected if the market return is lower?

Lower because premium that is added to the risk-free rate would now be lower

Using CAPM, how wold req'd rate of return be affected if the beta is higher?

Higher because given premium above the risk-free rate would be higher

How can mutual funds generate returns to their shareholders?

Small investors can benefit from a portfolio manager's expertise and from diverstification capabilities due to a large portfolio. Can provide dividends or capital gain distribution to investors. May be able to sell at higher price than paid.

How do open-end mutual funds differ from closed-end mutual funds?

Shares of open-end can be sold back to sponsoring investment company, closed-end cannot

Explain difference between load and no-load mutual funds

Lowd requires fee to help pay for marketing commission, no-load does not

How do commercial banks and stock-owned savings institutions use proceeds differently than mutual funds?

Commercial banks issue shares to obtain capital, MFs issue shares to obtain funds to invest in mutual fund portfolio.

A MF containing Treasury bonds is susceptible to which type of risk?

Interest rate; if interest rates rise, market value will decline

The ideal MF for investors who wish to generate tax-free income and also maintain a low degree of interest rate risk is...

a short-term municipal bond fund

How can changing foreign currency values affect the performance of international MFs?

As foreign currencies depreciate against the dollar, prices of foreign stock as measured in dollars decline. Thus, depreciation of foreign currencies tends to decrease the net asset value of international MFs that are held by US investors

What type of security is dominant?

Common stock, followed by US gov't securities.

How is income generated by a MF taxed when it distributes at least 90% of its taxable income to shareholders?

MF is not taxed

Have MFs outperformed te market?

No, based on risk-return comparison with the market. They provide diversification benefits that investors could not afford to achieve on their own and allow investors to rely on someone else's investment decisions rather than on their own judgement.

How do money market funds differ from other types of MFs in terms of how they use the money invested by shareholders?

Money market funds are composed of money market securities such as Treasury bills, commercial paper, Eurodollar deposits, banker's acceptances, repurchase agreements, or CDs. MFs are composed of stocks and bonds.
Money market invest more in commercial pap

Explain the relative risk of the various types of securities in which a money market fund may invest.

Money market exhibit default risk, since issuers of securities could go bankrupt. Eurodollar deposits, CDs and commercial paper exposed to default risk. US Treasury bills are free from default risk.

Is the value of a money market fund or a bond fund more susceptible to increasing interest rates?

A bond fund because securities contained in a bond fund have longer maturities than securities contained in a money market fund.

Why is diversification across different types of mutual funds highly recommended?

Limits exposure to any single economic factor.

How is income generated by a money market fund taxed if it distribute at least 90% of its income to shareholders?

Exempt

Explain the difference between equity REITs and mortgage REITs.

Equity invest directly in properties while mortage invest in mortgage and construction loans. Equity would be a better hedge against inflation because rents and property tend to rise with inflation