ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
CHAPTER 6
1. If you know interest rates are going to rise in the future, would you rather own a long- or a short-term
bond? Explain.
Answer: If rates are rising, bond prices will fall. For any given change in interest rates, long-term
bonds exhibit more price volatility than short-term bonds. Thus, it is better to hold short-term bonds
when rates are rising because their prices will fall more slowly than those of long-term bonds.
2. Suppose the spot rate on four-year bonds is 11 percent and the spot rate on five-year bonds is 12
percent. What forward rate is implied on a one-year bond delivered four years from now?
Solution:
(1  t R n ) n
1
(1  t R n -1 ) n - 1
t  n -1 f 1 
(1.12) 5
1.7623
1
 1  0.1609  16.09%
4
1.5181
(1.11)
3. What bond portfolio adjustments would investors make if interest rates are expected to decline in the
future? How do these adjustments cause the yield curve to change?
Answer: Profit-maximizing investors will shift their holdings from short-term to long-term bonds.
Selling pressure drives the prices of short-term bonds down and the yields up. Buying pressure drives
the prices of long-term bonds up and the yields down. If short-term rates are increasing while longterm rates are decreasing, we would see the yield curve flatten or perhaps become downward-sloping.
4. How does the existence of a liquidity premium affect the shape of the yield curve?
Answer: The liquidity premium puts an upward bias in the slope of the yield curve that causes yield
curves to tend toward an upward slope.
5.
Under the market segmentation theory, why do investors not shift their holdings into the securities with
the highest returns? Under the preferred-habitat theory, what is necessary for investors to shift their
holdings away from their preferred maturities?
Answer: Financial institutions that face regulatory capital requirements may desire to hold only those
securities whose durations match their holding periods. Such a strategy minimizes their interest rate
risk and protects their capital position. Therefore, these participants may restrict themselves to a
particular maturity segment. Under the preferred habitat theory, investors will consider leaving their
preferred maturity segments if other maturities offer a sufficient premium in the form of higher yields.
1. Suppose the yield on a 30-year corporate bond rated Aaa is 8.86 percent and the yield on a 30-year
Treasury bond is 8.27 percent. What is the default risk premium? Would you expect a higher or lower
default risk premium on an A-rated bond?
Solution: Use: DRP = i - irf = 8.86% - 8.27% = 0.59% or 59 basis points.
The default risk premium is expected to be higher for A-rated bonds because these bonds have more
1
default risk than Aaa-rated bonds.
2. How does the yield spread between Treasury bonds and risky corporate bonds vary over the business
cycle? Can you provide a logical explanation for the cyclical behavior of the spread?
Answer: The spread contracts when the economy expands and widens when the economy slows
down. Probability of default is increasing during recessions when most businesses tend to have lower
cash flows. Because investors are risk-averse, they may sell their corporate bonds and substitute them
with Treasury securities during recessions. The selling pressure drives down the prices of corporate
bonds and drives up their yields. At the same time, buying pressure on Treasury bonds drives their
prices up and yields down. Thus, the spread widens during recessions. As the economy improves,
investors may be more willing to hold the more risky (corporate) bonds. They buy more corporate
bonds and less Treasury bonds, causing the spread to narrow in expansions.
3. What factors do rating agencies consider when assigning bond ratings?
Answer: The most important factors are (1) the firm’s expected cash flow; (2) the amount of the firm’s
fixed contractual cash payments, such as interest and principal payments or lease payments; (3) the length
of time the firm has been profitable; and (4) the variability of the firm’s earnings.
4.
At what marginal tax rate would you be indifferent between an A-rated, ten-year corporate bond
offering a yield of 10 percent and an A-rated, ten-year municipal bond offering a yield of 6 percent?
Why does the municipal bond offer a lower rate if it has the same bond rating and maturity as the
corporate bond?
Solution: The market indifference tax rate is 1 - (Muni rate/Corp rate) or 1 – (0.06/0.10) = 40%.
The municipal bond can offer a lower rate than the corporate bond of the same rating and maturity
because interest income on municipal bonds is not taxable at the federal level. This means that the
municipal bond still offers a competitive after-tax return compared to the corporate bond.
1. Which securities tend to have higher yields, those that are more marketable or those that are less
marketable? Why?
Answer: Less marketable securities have higher yields because of the additional premium associated
with infrequently traded securities.
2. At what stage of the business cycle would you expect issuers to call in bonds? At what stage of the
business cycle would you expect the call interest premium to be the highest? Explain.
Answer: Issuers find it profitable to call bonds and refund with new bonds when interest rates are
low. This tends to happen during economic recession. A callable bond issued at the top of the business
cycle tends to carry a higher call interest premium. This is when interest rates tend to be at a cyclical
peak. Investors, therefore, rationally anticipate the falling interest rates to come and the increased
likelihood of issuers calling bonds. To compensate for the increased call risk, investors require a higher
call interest premium.
3. Why do you think investors are willing to accept lower yields on putable bonds? Explain.
Answer: The put option, giving the investors the right to sell the bond back to the issuer, protects
2
investors from unanticipated events that increase the bond’s risk. Thus, putable bonds are less risky
and therefore tend to carry lower yields.
4. Holding the price of the firm’s stock constant, would you be more likely to convert bonds into stock
when interest rates are rising or falling? Explain.
Answer: If the stock price is held constant, when interest rates rise, the price of the firm’s bonds
will fall relative to the value of the stock. Obviously, it is advantageous to convert the bonds to
stock in such an environment.
CHAPTER 7
1. Given the economic role of the money market, explain the importance of the typical characteristics of
money market securities.
Answer: Money market securities are liquid, short-term, high quality debt securities issued by high
quality borrowers and are used to store liquidity by investors around the world. All of these
characteristics are important to money market investors because they have very low risk tolerance due to
the temporary nature of their cash surplices.
2. Using the median yield figure from Exhibit 7.4, calculate the price of a 13-week T-bill and express it
as a percentage of face value.
Solution: At the median yield of 5.02%, the price (% of face value) of a 13-week T-bill on a discount
basis is:
(See eq. 7.3)
n

P0  Pf   y d 
 Pf
360

91



  100  (0.0502) * 360 *100  98.731
3. Refer to Exhibit 7.6. On February 21, 2007, what is the price of the T-bill maturing on August 2,
2007? Calculate the price two ways, using both the asked yield and the bid yield. Assume a face value
of $10,000.
Solution: The price of the T-bill, discount basis is:
n


P0  P f   yd 
 Pf 
360


161


*100  97.7907%  $10,000  $9,779.07
360


161


*100  97.7863%  $10,000  $9,778.63
The bid price is: 100  (0.0495) *
360


The ask price is: 100  (0.0494) *
4. Assuming a face value of $10,000, what is the price of a T-bill with 161 days to maturity if its bond
equivalent yield is 1.99 percent?
Solution: The price of the T-bill, discount basis is:
3
P0 
Pf
 
n 
1   ybe * 365 

 

10,000
161 

1  0.0199 * 365 



10,000
 $9,912.99
1.0088
5. Why is the bond equivalent yield of a T-bill higher than the yield calculated on a discount basis?
Answer: First, the bond equivalent yield uses a 365-day year versus a 360-day year. Any periodic
yield multiplied by a smaller fraction, 161/365 versus 161/360, will have a higher yield. Second, the
bond equivalent yield is based on the purchasing price of a security, which in the case of discount
securities is always lower than their face value, on which the discount yield is based.
1. Why do issues of securities by U.S. government agencies tend to have higher interest rates than similar
issues of debt by the U.S. Treasury?
Answer: The U.S. government agencies have the explicit guarantee of the government but lower
marketability (and thus liquidity) than U.S. Treasury securities of equivalent term. Governmentsponsored agencies do not have the explicit guarantee of the government, nor the
liquidity/marketability of U.S. Treasury issues. See Federal Reserve Bulletin, Table A30.
2.
Why would you never observe a U.S. Treasury bill paying the same quoted rate of interest as a
negotiable CD of the same maturity?
Answer: First, the negotiable CD has a some default risk – as even an insured CD is guaranteed only
up to $100,000 by the Federal Deposit Insurance Corporation, and many negotiable CDs are much
larger than that. Second, because of the mathematics involved in computing discount interest rates, the
T-bill discount rate understates the true rate of return paid by the T-bill, while the CD does not have
the same problem.
3. Why is a repo like a secured loan?
Answer: The borrower of the money sells a government security to the lender along with an
agreement to repurchase it at a future time at a predetermined higher price that is based on the repo
rate. Thus the lender of the money owns the security until the money is paid back with interest, so the
security serves as collateral for the loan.
4. How and why do banker’s acceptances frequently arise in international trade transactions?
Answer: Exporters of goods and services often trust the guarantee of an international bank more than
they trust an importer’s agreement to pay them in the future. Thus, exporters often ask importers to
obtain a letter of credit from a well-known bank that will agree to pay the importer’s obligation. When
the exporter complies with all terms of the transaction, the bank “accepts” the obligation to make
payment to complete the transaction if the importer does not. Because the bank’s credit is good, the
banker’s acceptance can be sold easily in the money markets before maturity.
CHAPTER 8
4
1. Why do businesses use the capital markets?
Answer: Businesses use the capital markets to finance long-term investments and to provide a "market
value" evaluation of company performance. The use of long-term securities allows issuers to be certain
of the cost of funds for the life of the investment and reduces refinancing problems.
2. What is the difference among a T-bill, a T-note, and a T-bond?
Answer: There are two major factors that differentiate T-bill, T-notes, and T-bonds: term and interest
payments. T-bills are offered in maturities of four, 13, and 26 weeks and are zero-coupon securities
selling at a discount relative to the face value. T-notes are intermediate-term coupon-paying securities
with original maturities of two, five, and ten years. T-bonds have maturities greater than 10 years and,
similar to T-notes, pay interest regularly.
3. What is a STRIP? Explain how they are created.
Answer: A Separate Trading of Registered Interest and Principal (STRIPS) is a Treasury security
that has been separated into its component parts: each interest payment and the principal payment
become a separate zero-coupon securities. Treasury securities dealers buy Treasury securities whole at
auction and then create STRIP components to meet customer demands. Each newly created zerocoupon security is registered with the Treasury upon the dealer’s request.
4. Explain how STRIPs can be used to immunize portfolios against interest rate risk.
Answer: STRIPS are zero-coupon bonds and a portfolio of STRIPS will have its duration equal to its
maturity. If a bond is held to its duration, the realized YTM equals the expected YTM, eliminating
reinvestment and price risk.
1. Explain why sinking funds on corporate bond issues play the same role as the serial structure found on
municipal bond issues.
Answer: Sinking funds, an old term dating back to the days when companies accumulated funds to
pay off bonds at maturity, today effectively pay off bonds periodically (called or purchased in the
market). Serial bonds are bonds issued with varying maturities, so that part of the bond issue matures
every year, beginning in a certain year.
2.
When buying bonds, explain why investors should always make a tax-exempt and taxable comparison.
What are the ground rules for making the comparison?
Answer: Everything else the same, the investor is seeking the higher after-tax return. To determine
which bond offers the higher after-tax return, calculate the after-tax return of the corporate using the
investor's marginal tax rate and compare it to the rate on the municipal bond.
3. Why are commercial banks large investors in municipal bonds and property and casualty insurance
companies are not?
Answer: Until the Tax Reform Acts in the 1980's commercial banks were major investors in munis.
Households are the major investor in munis today with mutual funds second and property/casualty
insurance companies third. P/C companies have high tax exposure and seek tax sheltering via
5
preferred stock and muni bonds. Life insurance companies, with considerable tax shelters coming
from whole life policies, invest in taxable corporate bonds.
4. How do the secondary markets differ between municipal bonds and corporate bonds?
Answer: The secondary market for municipals is a dealer market and is quite thin, as are many
corporate bond issues. There are more large-issues of corporate bonds, some listed on exchanges,
which trade more frequently in dealer markets.
5. Explain how and why the junk bond market had an impact on commercial bank lending?
Answer: Prior to the development of the junk bond market, low credit quality firms depended on bank
loans for their funds. Banks would only offer short-term or variable rate medium-term loans regardless
of the borrowers’ need, thus passing on any interest rate risk to the borrower. These firms had no
alternative until the junk bond market developed and allowed them to replace bank loans with
marketable debt with longer maturities matching their cash flow needs.
1. Why are asset-backed securities becoming increasingly important in capital markets?
Answer: Many ABS have characteristics that many capital market investors value highly, such as
financial guarantees, predictable cash flows, or floating rates, and thus are willing to pay a premium
for them. This is especially true in the mortgage market where the credit enhancements
reduce default risk to investors in mortgage-backed securities. Since these characteristics
are highly desirable, more ABS are being created.
2. Why are financial guarantees becoming increasingly important in financial markets both domestically
and internationally?
Answer: Investors need only to ascertain the creditworthiness of the guarantor and not the
creditworthiness of each underlying asset. Furthermore, the interest cost saving from the improved
credit-enhanced credit rating exceeds the cost of the guarantee. Financial guarantees are increasingly
important in international markets as the creditworthiness of the guarantor is often easier to assess than
the creditworthiness of the borrower. Also, because collection activities across borders are problematic,
it often will be easier to collect from a guarantor that has a financial reputation to protect than from a
defaulting borrower in another country. Because of the reduction in default risk, guaranteed securities
are more marketable than non-guaranteed securities and enable issuers to pay lower yields.
3. What types of credit enhancement can be obtained to make asset-backed securities more desirable?
Answer: Financial guarantees such as bond insurance, standby letters of credit, the use of cash
collateral accounts, the use of subordinated tranches that enhance senior tranches by bearing the
default risk, and setting aside profits and servicing fee accruals to protect buyers of tranches against
future losses all make ABS more desirable.
4. Why are financial markets regulated, and who is the principal U.S. regulator?
Answer: Financial markets are regulated so people will retain confidence in them and continue to
supply money to them. The Securities and Exchange Commission (SEC), established in 1933 after the
Great Depression, is the principal regulator at the federal level. There are also regulators at the state
6
level in every state who focus on consumer protection issues. In addition, there are self-regulatory
bodies like the National Association of Securities Dealers (NASD) which were established to protect
the integrity of the markets and the industries involved.
CHAPTER 9
1. If you had a 6 percent, $100,000, 15-year mortgage and you paid it as scheduled, how much interest
would you pay in the first month of the sixth year on that mortgage? How much principal would you
pay?
Solution: The total monthly required payment is $843.86 (on a financial calculator, enter 0.5% for the
periodic rate (I), 180 for the number of payments (N), and 100,000 for the initial balance (PV), then
solve for the payment (PMT)). The interest paid in the first month is 0.5% of the initial balance, or
$500. The remainder of the payment, $343.86, is used to pay down the principal.
2. What would your principal and interest payments be if the mortgage were a 30-year mortgage at 6
percent?
Solution: The total monthly required payment is $599.55 (on a financial calculator, enter 0.5% for the
periodic rate (I), 360 for the number of payments (N), and 100,000 for the initial balance (PV), then
solve for the payment (PMT)). The interest paid in the first month is 0.5% of the initial balance, or
$500. The remainder of the payment, $99.55, is used to pay down the principal.
3. If you had a mortgage with an initial rate of 2 percent that adjusted its rate once a year to equal the oneyear Treasury bill rate plus 2.75 percent, with a cap on rate increases of 2 percent per year and 5 percent
rate increase cap over the life of the mortgage, what rate would you pay in the second year of the
mortgage if the one-year Treasury bill rate was 1.5 percent when the new rate was calculated?
Solution: 4 percent. Due to the 2 percent cap on annual rate increases, the rate could not exceed 4
percent even though 1.5 percent plus 2.75 percent would imply a rate of 4.25 percent if the mortgage
rate increases were not capped.
4. In the mortgage described in Question 3, what is the maximum rate you could be charged if the Treasury
bill rates rose to 10 percent and stayed there?
Solution: 7 percent, which equals the initial 2 percent rate plus the 5 percent lifetime cap.
1. If you owned a $100,000 security interest in a pass-through mortgage pool that contained $200,000,000
in mortgages and received $20,000,000 in interest payments and $2,000,000 in principal payments in
its first year, how much principal and interest would you receive (if there were no mortgage servicing
costs) that year?
Solution: You own a 1/2,000 of the pool so you receive 1/2,000 of the interest ($10,000) plus 1/2,000
of the principal ($1,000), since you receive principal and interest on a “pro rata” basis according to your
ownership interest in the pool.
2. If your security interest in the mortgage pool described above were a PO security rather than a regular
pass-through security, how much would you have received after the first year?
7
Solution: You would receive $1,000, which 1/2,000 of the principal payments, your “pro rata” share.
3. Why are securitized mortgage-backed securities often more attractive to investors than pass-through
securities on the same pool of mortgages would be?
Answer: On some tranches, payments may be more certain or predictable than payments on the mortgage
pool as a whole. Conversely, on other tranches, payments may be less certain but promised rates of
return are higher. Alternatively, payments on some tranches may be credit-enhanced to reduce their
risk; while on other tranches, greater risk is compensated for with higher promised rates of return. In
addition, some mortgage pools may be structured in such a way that people who pay high taxes on interest
receive only principal repayments, or vice versa. Finally, payments on fixed-interest mortgages may be
restructured so that some tranches receive variable rates of interest while others receive interest returns that
vary inversely with market interest rates. Both types of securities may appeal to different types of
investors. Thus, by restructuring payments flow from pools of mortgages, various tranches can be derived
that have greater appeal to buyers than the original pool of mortgages and thus can be sold for a higher
combined value in the nation’s capital markets.
4. Why is government or private insurance important to the mortgage markets?
Answer: Buyers of mortgages need only check the creditworthiness of the insurer of the mortgages and
need not go to the trouble and expense of checking the credit of each individual mortgage borrower in
the pool of mortgages that back the mortgage-backed securities or the individual mortgages they are
buying.
CHAPTER 10
1. What characteristics of an asset determine the type of secondary market in which it is most likely to
trade?
Answer: New issues of securities are sold in the primary market. Any subsequent transaction in the
security takes place in the secondary market. In the money markets, all securities are dealer-traded
short-term debt securities; while the capital market is divided between debt (bonds and mortgagerelated) and equity markets.
2. What are the four types of secondary markets?
Answer: The four types are (1) direct search, (2) brokered, (3) dealer, and (4) auction markets.
3. Explain the differences between the OTC market, NASDAQ, and a stock exchange.
Answer: The major difference is that most stock exchanges are auction markets, whereas the OTC
market or NASDAQ are dealer markets. NASDAQ stands for the National Association of Securities
Dealers Automated Quotation system and it provides continuous bid/ask information. NASDAQ is an
electronic pink sheet.
4. What are the functions of market makers and specialists? How do they differ?
Answer: Dealers are said to make market in stocks they trade because they buy and sell securities on
their own account. To ensure that incoming orders are fulfilled, dealers carry inventory of stocks that
8
they make market in.
At NYSE, specialists are members of the exchange who combine the attributes of dealers and order
clerks. Specialists have an affirmative obligation to maintain bid and ask quotations for particular stocks
at all times. In this respect, specialist are similar to dealers, trading for their own account at their own
risk. NYSE specialists also maintain the book of limit orders, and in this respect they act as order clerks.
1. Describe the general approach to valuing a share of stock.
Solution: First, estimate the size and the timing of expected future cash flows. Second, decide upon the
appropriate discount rate to use in the present value calculation. Finally, apply the discount rate to the
cash flows in each period to obtain present values of expected cash flows and sum the present values to
obtain the price of the security.
2. What cash flows are relevant to the value of stock?
Solution: Dividends and capital gains are the sources of income from holding a stock.
3. Describe what happens to the total risk of a portfolio as the number of securities is increased.
Solution: As the number of securities increases, the diversification effect reduces the standard
deviation of portfolio return, a measure of the portfolio’s total risk. Total risk can be reduced, however,
only to the level of systematic risk, which cannot be diversified away because it is caused by general
market movements that tend to affect all stocks similarly.
4. Suppose a firm’s stock has a beta of 1.2. What will probably happen to the value of the stock if the
market decreases by 20 percent?
Solution: The value of the stock will probably decline by (1.2)20% = 24%. A positive beta means that
the stock is positively correlated with the market. Because the beta is greater than 1.0, the stock will
tend to have wider swings than the market, but in the same direction.
CHAPTER 11
1.
Explain the major differences between futures contracts and forward contracts.
Answer:
FORWARDS:
The forward market is unstructured
Forward contracts trade over the counter.
Unstandardized, tailored to the needs of the
counterparties.
Numerous dealers match individual buyers and
sellers and/or trade for their own accounts.
No margin is required.
FUTURES:
Futures transactions are conducted on an organized
exchange.
Contracts are made between buyers or sellers and
the exchange.
Margin requirements are imposed to ensure no one
will default when prices move adversely.
Very few contracts are settled by delivery.
The futures market is useful when it is necessary to
Most forward contracts are settled by delivery.
The forward market is useful when a set amount of
9
currency is needed on a specific date.
No marking to market
All elements of the contract are negotiated.
hedge price risk over a period of time.
Marked to market daily.
All elements of the contract are standardized (Only
price is variable).
Trade on exchanges, and are very liquid.
Clearing house guarantees delivery and payment.
Low default risk.
Highly illiquid because of customized features.
Default potential may be quite high.
2. What is the economic role of the margin account on a futures exchange?
Answer: The margin account protects futures market participants from default resulting from adverse
price movements. As contracts are marked to market daily, increases in value are added to the margin
account and decreases in value are subtracted. The exchange maintains these accounts so participants
needn’t worry about default risk.
3. What determines the size of the margin requirement for a particular futures contract?
Answer: The size of the margin requirement is determined by the price volatility of the underlying
asset.
4. What is the difference between hedging and speculating?
Answer: In the context of a futures transaction, a hedger will hold a position in the spot market
opposite to that in the futures market. For example, a shipping firm that is short in the spot fuel oil
market could hedge the price risk by going long in oil futures. Hedgers are primarily trying to reduce
price risk. Speculators, on the other hand, will be long or short a futures contract without holding an
offsetting position in the spot market. They are in effect accepting price risk in hopes of making money
on price movements.
1. Suppose you own a portfolio of stocks currently worth $100,000. The portfolio has a beta of 1.2.
Describe in detail the futures transaction you would undertake to hedge the value of your portfolio.
Which futures contract would you use? How many contracts would you buy or sell?
Answer: The investor should take a short position in S&P 500 futures contracts. Because the futures
contract is assumed to have a beta of 1.0, you would have to sell contracts worth 20 percent more than
the value of your portfolio to create the hedge.
2. Suppose your desired holding period is five years, but you find yourself with a bond portfolio having a
duration of seven years. Describe the futures transaction you would undertake to hedge the value of
your portfolio at the end of five years. What futures contract would you use? Would you buy or sell
these futures contracts to shorten the duration of your bond portfolio?
Answer: Since you are long in bonds, you should hedge the position by taking a short position in
futures contracts on similar bonds. You should pick the futures contract whose underlying bond most
closely resembles the bonds in your portfolio with respect to maturity and default risk. This will
minimize your basis risk.
3. Why does cross-hedging lead to basis risk?
10
Answer: Basis risk exists if the value of an item being hedged does not always keep the same price
relationship to contracts purchased or sold in the futures market. Cross-hedging involves hedging with a
futures contract whose characteristics do not exactly match those of the hedger’s risk exposure. Because
the price movements of the hedged commodity are likely to be less than perfectly correlated with those
of the futures contract in a cross-hedge, basis risk results.
1. What are some considerations in the decision to use futures or options for hedging?
Answer: Gains and losses in futures contracts are virtually without limit. For that reason, some hedgers
prefer options. Options can be used as one-way hedges; they provide price protection that is not
available from futures. However, premiums on options may be high, and the value of options decays
over time. The buyer of protection must decide whether the insurance value provided by the option is
worth the price.
2. Explain the relationship between the time to expiration for a call option and the value of the option.
Answer: European options can only be exercised at maturity. American options can be exercised any
time before maturity.
3. Explain the relationship between the price variance of an asset and the value of an option written on
that asset.
Answer: The more price variability a stock has, the greater the chance that the option will advance into
the money or further into the money. Thus, options with greater price variance tend to be more valuable.
4. If you hold some shares of stock and would like to protect yourself from a price decline without giving
up a lot of upside potential, should you purchase call options or put options? Explain.
Answer: You should purchase put options. When the value of the stock goes below the exercise price,
the payoff from the put at maturity increases. This increased payoff offsets losses from holding the
stock.
CHAPTER 12
1.
Why should purchasing power parity exist? Why might it not hold?
Answer: (a) Because of the law of one price, the same good or equivalent goods should cost the same
amount except for transportation cost differences if the goods are in different places. Thus, exchange
rates between currencies should be such that equivalent sets of goods should cost approximately the
same in different countries after converting their prices from one currency to the other. (b) Short-term,
long-term, or politically motivated capital flows can cause exchange rates to diverge as funds flow
from one country to another. Furthermore, tariffs, quotas, export and import fees, and other non-tariff
barriers may prevent goods from being transferred from one market to another without incurring
substantial costs that require that they be sold at a higher price. As a result, prices for similar goods in
different markets may never be equalized.
2
What can cause a country to have a deficit in its current account balance of payments?
11
Answer: The deficit in a country’s current account balance of payments can be caused by: (1) a
deficit in the country’s balance of trade in goods and services that results from importing more goods
and services than the country exports, (2) a deficit in its investment income balance caused by paying
more interest and dividends to foreigners than receiving from abroad, and (3) a deficit caused by net
flows of unilateral transfers abroad in the form of gifts, aid, and other unilateral transfer payments.
3.
Is it always true that when a country has a deficit in its trade balance, the value of its currency will
decline? Explain.
Answer: Two types of fund flows impact foreign exchange rates: trade flows and capital flows. If,
as has been the case with the U.S. for many years, there is a deficit in the trade and current account,
foreign investors may demand the glut of dollars supplied from trade for the purchase of dollardenominated U.S. securities. For many years in the U.S. growing trade deficits and a strengthening
dollar existed.
4.
What types of capital flows exist between countries and what can motivate each type of flow?
Answer: Capital flows may be made in the form of direct investment (purchase of a plant), direct
financial investment (purchase of stock in a company), or from inter-governmental capital flows.
Short-term investment capital flows are usually motivated by difference in interest rates between
countries; long-term investment flows may result either from a change in perceived attractiveness of
investment in a country or from an increase in international holdings of that country’s currency.
5.
Why must the balance of payments always balance?
Answer: Just as "purchase" of assets (balance sheet) must be matched by "payments" of cash or an
IOU, so the balance of payments accounts must theoretically balance.
1.
What could a government do to support the value of its currency in the foreign exchange market?
Answer: It could buy its currency by selling some of its stock of reserve currencies or gold, or it
could borrow currencies from foreign countries and use the borrowed currencies to buy its domestic
currency in the exchange markets. Such interventions might only have a temporary effect, however,
unless the country addresses major problems by reducing money supply to raise interest rates to attract
foreign capital inflows and restrain domestic inflation.
2. How can a firm reduce its risk by using forward contracts?
Answer: It can reduce its risk that foreign currency values change adversely prior to making or
receiving payments in a foreign currency by entering a forward currency contract. Foreign currency
receivables can be hedged by selling the foreign currency forward, while payables are hedged by
buying the foreign currency forward. For example, a firm that expects to receive British pounds in the
future may sell the pounds forward at a prearranged exchange rate, such as $1.98 per pound, in order
to assure itself that the dollar revenues it receives will guarantee a profit on the transaction. If the
British pound were currently trading at $2.00 per pound, some might say that the firm would lose on
the forward transaction. However, the forward exchange rate will be lower than the spot rate primarily
because British interest rates are higher than domestic rates—usually because expected inflation is
greater in Britain than in the United States. If inflation is high, the pound will be losing purchasing
power over time—thus, pounds received in the future will be worth less than pounds received now.
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Consequently, it is only logical that the future receipt of pounds should be worth less than current
pound holdings— and that difference is reflected in the difference betwee spot and forward exchange
rates.
3. When a country has high inflation, why is it risky for a foreigner to invest in that country?
Answer: Because, over time, sustained inflation will cause the value of that country’s currency to
decline. Unless it is possible to earn returns that are higher than the possible loss in value caused by
currency devaluations, investments in that country may not earn positive net returns after accounting
for currency exchange losses. Furthermore, countries that experience balance of payments problems
often impose capital controls so people cannot take their funds out of the country easily just because
they fear the currency will be devalued. Thus, it may be easier to invest in the rapidly inflating
country than to repatriate the principal invested or earnings on the investment.
4.
Why might consumer groups support government policies that maintain a “strong” U.S. dollar?
Answer: A "strong" dollar buys more foreign consumer goods (clothing) and services (travel abroad)
than a "weak" dollar, but at the same time encourages the exportation of manufacturing jobs out of the
country. Those consumers that are working want a strong dollar.
5.
If the United States has a high rate of inflation, what happens to the value of the dollar? Why?
Answer: A rate of inflation higher than that of trading partners should, everything else the same,
produce a glut of dollars on the forex market and the dollar should depreciate. With higher inflation,
foreign prices are cheaper, creating a trade and service deficit, and depreciating the dollar on forex
markets.
CHAPTER 15
1. What are the reasons for growth in American banking overseas in recent decades?
Answer: There are at least three reasons for growth in American banking overseas. First, as large U.S.
corporations began expanding overseas in the 1960s, U.S. banks followed them customers to help
finance that expansion. Second, because of several federal programs designed to restrict the outflow of
funds from the United States, many U.S. banks opened overseas branches to tap international sources of
funds that U.S. banks could then lend overseas. And finally, domestic restrictions like regulation Q,
which limited interest rates that banks could pay on some deposits, forced some U.S. banks to open
foreign branches where they were free to pay market rates of interest to attract depositors.
2. What are the organizational forms banks use to deliver international banking services to their overseas
customer?
Answer: The organizational forms discussed in the text are: representative offices, shell branches,
correspondent banks, foreign branches, Edge Act corporations, foreign subsidiaries and affiliates, and
international banking facilities.
3. Compare the U.S. philosophy of bank regulation to that of other countries.
Answer: The U.S. philosophy has sought to maintain a separation of banking from other business
activities in order to promote soundness in banking and to prevent concentration of power. In other
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countries, banks are allowed to engage in a wider range of business activities. In addition, until recently,
other countries have focused on regulating the domestic operations of banks while ignoring their
overseas activities.
4. In many countries, banks provide broader services than are allowed within the United States. How might
an American bank decide to structure its overseas operations to best compete with these financial
institutions abroad?
Answer: One way for a U.S. bank to compete with local institutions overseas is to open an Edge Act
corporation. Such corporations operate under federal charter and are not subject to state banking laws.
Like many foreign banks, Edge Act corporations may undertake banking as well as some non-banking
activities. The most important of these nonbanking activities is investing in equities of foreign
corporations. Another way for an American bank to stay competitive with banks overseas is to partially
or fully acquire a foreign bank thus creating a subsidiary. Closely related to foreign subsidiaries are
foreign affiliate banks, which are locally incorporated banks owned in part, but not controlled, by a
foreign parent.
1.
In what ways may an international loan differ from a domestic loan?
Answer: International loans differ from domestic loans in at least one of the following characteristics:
(1) funding, (2) syndication, (3) pricing, and (4) collateral. Most large international loans are funded in the
Eurocurrency market, are syndicated, are priced based to LIBOR, and are unsecured (made without
specific collateral).
2. What is the difference between currency risk and country risk?
Answer: Country risk refers to the risk that political developments in a country will increase the
likelihood that a borrower defaults, refuses or is unable to service its debt obligations. Currency risk, on
the other hand, refers to the risk that the currency in which the loan is made declines in value between
the time the loan is made and the time it is repaid.
3.
Compare the strategies of pooling risk and diversification as methods of reducing the risks of
international lending.
Answer: Pooling risk is a process where several lenders fund a loan such that no single lender bears all
the risk associated with the loan. Diversification, on the other hand, refers to a lender making loans in
several countries, for example, so that in the event a borrower defaults, earnings from loans in other
countries minimize the effect of the loan loss on the bank’s total earnings.
CHAPTER 19
1. What was the purpose of the Glass-Steagall Act?
Answer: The Glass-Steagall Act of 1933 sought to bring stability back to U.S. financial markets with
reforms such as separating commercial banking from investment banking, limiting commercial banks to
debt security investments of only investment-grade quality, and prohibiting commercial banks from
underwriting risky securities.
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2. Describe the steps entailed in underwriting a new security issue.
Answer: The investment bank (IB) will assist the company in preparing securities registration documents
after a due diligence analysis of the company (origination). As an underwriter, the IB will purchase the
securities from the issuer and sell/distribute the issue to the investing public.
3. In what activities other than underwriting new securities are investment banks involved?
Answer: Investment banking offer services to financing customers (usually corporations and
governments) and "investing" public. "Financing" customers are offered special financing arrangements,
such as private placements and merger assistance, while "investing" customers are offered brokerage
services, dealer market-making in securities, securities safekeeping, investment advice, margin credit, and
cash management services.
1. Why would an investor want to invest in a venture capital fund?
Answer: A venture capital investment provides the investor with (1) substantial control over management
decisions, (2) protection against downside risk and (3) a share of capital appreciation. This allows venture
capitalists to invest in future business trends that, if successful, will provide high returns that cannot be
earned in other investments. While expected returns are high, so is the risk.
2. What are the advantages and disadvantages of venture capital to an entrepreneur?
Answer: Entrepreneurs depend on capital from friends and family to initiate their idea. Once this is
exhausted, they are limited to seeking funds from venture capital sources as banks and other forms of
financing are usually not available to them because of the risk involved. While venture capitalists may
provide equity financing and often managerial advice, they have to cede control over management
decisions and a hefty share of any successful venture.
3. Why do venture capital fund managers follow such specialized strategies?
Answer: Venture capital investments involve a high degree of risk. While high returns are earned on
successful ventures, the rate of success is not very high. Thus, only a small percent of investment pays off.
This forces the fund managers to carefully study the business plans that are submitted to them for funding.
Valuation of such investments is hard and therefore it is harder to estimate required rates of return.
CHAPTER 20
1. What type of investment companies is more likely to sell at a price that diverges the most or the least
from its net asset value – a mutual fund with a load, a no-load fund, or a closed-end fund? Explain why
each type of fund might or might not sell at a price that diverges from its net asset value.
Answer: A closed-end fund may have a price that diverges the most from its net asset value.
Discounts from net asset value may reach 25% or more and premia often exceed 10%.
Discounts/premiums relative to the NAV may arise due to taxes on capital gains realized by the fund,
market access issues, and poor/superior management. No-load fund prices diverge the least from net
asset value as they sell for their net asset value, while load funds can have a price premium of as much
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as 8.5%.
2. What are the pros and cons of investments in mutual funds that try to match a general market index?
Answer: PROS:
 Index funds have low operating costs so investment returns are not reduced by high
administrative charges. Index funds do, on average, about as well as the market as a whole
so investors in such funds will generally do as well as the market as a whole. If markets
were truly efficient, one would find it difficult or impossible to consistently beat the
market as a whole. In addition, one should expect to get an average return from taking
average risk, and that is what an index fund provides. Due to high administrative costs and
possibly inferior investment choices, most mutual funds with discretionary management
have performed less well than index funds.
CONS:
 Index funds, in general, will never do substantially better than the market index to which
they are tied. Index funds generate average risk-return tradeoffs yet individuals may prefer
to take more or less risk. If everyone invested in the same index fund, there would be no
one left to evaluate the relative merits of various securities, since blind buying of
securities in the index might cause their risk-adjusted prices to rise relative to securities
that were not included in the index. That is, if no one analyzed the relative merits of
securities contained in the index relative to securities outside the index, the market would
not be efficient and mispricings could occur. Thus, index fund buyers might later find that
they had paid too much for stocks contained in the index if no one did any securities
analysis.
3. What are the various types of fees and charges that may be levied by different mutual funds?
Answer: Front-end loads are levied as sales charges when a fund is purchased. Back-end loads may
take the form of contingent deferred sales charges (CDSC) assessed as percentage fees levied on the
amount of money withdrawn from a fund. CDSC often diminish in percentage terms the longer that the
money has been invested in the fund prior to withdrawal. Other back-end loads may take the form of
redemption fees that are expressed as either fixed amounts or fixed percentages of the amount
withdrawn from the fund. Additional sales charges may take the form of 12b-1 fees that are levied each
year as a percentage of the assets managed by the fund in order to generate income so the fund
management company can pay for marketing expenses and pay salespeople. In addition, each fund will
levy advisory or management fees, usually expressed as a percentage of the assets under management,
each year. Finally, some funds may levy “account maintenance fees” on small balance accounts, or
“exchange fees,” when a fund balance is transferred from one fund to another within the same mutual
fund family.
4. Why is it essential that potential investors thoroughly read the prospectus for any mutual fund they are
considering as an investment?
Answer: The prospectus will detail all the fees that a fund may charge and illustrate the impact the fees
are likely to have on the fund’s net returns. In addition, the prospectus will define the securities in
which the fund is permitted to invest and will explain the risks associated with investments in the fund.
The prospectus may also give recent information on the actual securities held by the fund, and the
fund’s returns.
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1. Why would an investor want to invest in a hedge fund?
Answer: Hedge funds give investors the opportunity to add securities with higher potential returns to
their portfolios. They also allow investors to diversify their portfolios. It is especially true if hedge fund
portfolios are not highly positively correlated with the overall market.
2. How are hedge funds different from closed-end funds and mutual funds?
Answer: Hedge funds pool investments to provide consistent above-market returns while reducing the
risk of a loss. Hedge funds use a combination of market philosophies and analytical techniques to
develop financial models that identify, evaluate, and execute trading decisions.
Hedge funds are different from closed-end funds and mutual funds in that they
Are private, unregistered investment pools open only to a limited number of accredited investors;
Have great latitude in setting and shifting investment strategies;
Hedge funds can use short selling and high leverage and have investments concentrated in only a
few securities;
Hedge funds managers usually have performance-based incentives.
3. Why do hedge fund managers follow such specialized strategies?
Answer: Identifying profitable investment opportunities is difficult. Hedge fund managers must
specialize in particular investment strategies in order to develop the expertise required to be successful.
1. Explain the economic and regulatory climate that gave rise to MMMFs.
Answer: In the inflationary 1970's commercial banks faced interest rate ceilings on many types of
deposits under the Fed’s Regulation Q. This meant that small deposit bank customers could not earn
market rates of return on their deposits. As a consequence, many depositors turned to MMMF's which
had small minimum investments and offered limited check writing, relative safety, and higher market
rates of return compared to bank deposits.
2. What are the competitive advantages and disadvantages that money market mutual funds have relative to
depository institutions?
Answer: Money market mutual funds have low administrative costs and have never been constrained
by rate ceilings so they can pay rates nearly equal to the rates they earn on their money market
investments. Also, they can be part of fund management companies and brokerage firms where they
can automatically sweep funds in and out and use the funds to pay for stock purchases or debit card
usage. Furthermore, they are not required to maintain a certain level of reserves with the Fed in nonearning accounts. However, MMMF balances are not insured by the government, while small bank
deposits are.
3. In general, why do people often invest in specialized funds like REITs? Why have REITs become
more popular during the 1990s, and why do you think they operate like closed-end funds? What
problem were FREITs invented to solve?
Answer: In general, people buy specialized funds because they want to own assets similar to the
assets in which the fund invests. Investors in REITs want to own real estate-related assets and earn
returns from their real estate ownership. In the 1990’s, REITs have appealed to people because they
17
have generated relatively high yields and have not had high failure rates. Furthermore, they provide
passive real estate-related income that may be advantageous to some people depending upon their tax
situation. REITs operate like closed-end funds because they cannot quickly liquidate their assets at fair
market prices in order to generate cash. FREITs are REITs with a fixed life; they were established
because, like closed-end funds, REITs often sold for less than their net asset value. This would no
longer be possible when the FREITs assets are liquidated and distributed as cash to the fund’s
shareholders.
4. How have money market funds tried to cope with the fact that they do not have federal deposit
insurance?
Answer: Money market mutual funds (MMMFs) have variously restricted their asset holdings to riskfree government securities, tried to obtain private deposit insurance (which was too expensive), and, in
the past, were established by financial institutions that acquired non-bank banks so they could offer
deposit insurance on their deposits. In addition, fund management companies have typically made up
any losses incurred by the funds so they would not “break the buck” and therefore could retain
investors’ confidence that they would not lose money if they invested in the fund.
In general, MMMFs reduce risk by investing in securities of high credit quality issuers, diversifying
their portfolios across numerous issues, and maintaining a short average maturity of their investments.
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