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1. Suppose the default risk of corporate bonds decreases.

a, What would be the major effect?

- Increase in demand for loanable funds (increase in supply of bonds)

- Decrease in demand for loanable funds (decrease in supply of bonds)

- Increase in supply of loanable funds (increase in demand for bonds)

- Decrease in supply of loanable funds (decrease in demand for bonds)

b, Why is so?

2. Suppose the default risk of corporate bonds decreases

a, What would be the major effect?

- Increase in demand for loanable funds (increase in supply of bonds)

- Decrease in demand for loanable funds (decrease in supply of bonds)

- Increase in supply of loanable funds (increase in demand for bonds)

- Decrease in supply of loanable funds (decrease in demand for bonds)

b, Why is so

3. Suppose the Federal Reserve makes a discount loan to a bank

a, What would be the major effect in the market for federal funds?

- Increase in demand for federal funds

- Decrease in demand for federal funds

- Increase in supply of federal funds

- Decrease in supply of federal funds

b, Why is so?

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Irving Heathcote
Irving HeathcoteLv2
28 Sep 2019
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Contemplating an Initial Public Offering

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year.

a. If Carson issued stock now, it would have the flexibility to obtain more debt and would also be able to reduce its cost of financing with debt. Why?

b. Why would an IPO result in heightened concerns in financial markets about Carson Company’s potential agency problems?

c. Explain why institutional investors, such as mutual funds and pension funds, that invest in stock for longterm periods (at least a year or two) might prefer to invest in IPOs rather than to purchase other stocks that have been publicly traded for several years.

d. Given that institutional investors such as insurance companies, pension funds, and mutual funds are the major investors in IPOs, explain the flow of funds that results from an IPO. That is, what is the original source of the money that is channeled through the institutional investors and provided to the firm going public?

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

a. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase production by 10 percent with its existing facilities by obtaining short-term financing to cover the extra production expense and then using a portion of the revenue received to finance this level of production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity. Which alternative should Carson select?

b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the same in both markets?

c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds?

d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? What type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain.

e. Financial institutions such as insurance companies and pension funds commonly purchase bonds. Explain the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company.

PROBLEMS, GRAPGHING

1. Suppose a candidate who runs on a platform of “soak the rich” wins the 2016 presidential election. After being elected, he or she persuades Congress to raise the top marginal tax rate on the federal personal income tax to 65%.

a. Use one graph to show the effect of this change in tax rates on the market for municipal bonds and another graph to show the effect on the market for U.S. Treasury bonds.

b. What happened to the interest rate spread between municipal bonds and U.S. Treasury bonds and why?

Suppose that, holding yield constant, investors are indifferent as to whether they hold bonds issued by the federal government or bonds issued by state or local governments (they consider the bonds the same with respect to default risk and liquidity). Suppose that state government issued console with $60 annual payments and that the federal government has also issued console with $60 annual payments.

a. If the federal and state consoles have both the same after-tax yields of 6%, what are their pretax yields? (Assume that the federal income tax rate is 36%)

2. Suppose it is 2020 and 1-year interest rate is 5 percent. You observe that the interest rate on 2-year bond is 4.5%. Assume there is no liquidity premium and the interest rates are determined according to expectation hypothesis of the yield curve

a. Based on the interest rates above, what is the expected 1-year interest rate, starting one year from today?

b. If the interest rate on 3-year bond is 4%., what is the expected 1-year interest rate starting 2 years from today?

c. If the interest rate on 4-year bond is 4%., what is the expected 1-year interest rate starting 3 years from today?

d. Draw the yield curve for the next four years.

e. Is the yield curve for the next four years upward sloping or downward sloping? Explain why

f. What might the yield curve today indicate about future interest rates?

g What might the yield curve today indicate about future economic activity? Explain why?

h. What might the yield curve indicate about the markets’ prediction for inflation rate in the next four years?

i. What might the yield curve indicate about monetary policy today?

j. What might the yield curve indicate about a long-term bonds price? Expected return on long-term bonds? Explain

k. Given the slope of the yield curve today, would you rather be lender or borrower in the next five years? Why?

3. The following is from an article in the Wall Street Journal, describing events in the market for Treasury securities on the given day: “Treasury prices were mixed, with the shorter end of the yield curve falling and the longer- dated Treasury rising in prices”.

a. Draw Treasury yield curve, showing the situation on that day as described in the sentence above.

Explain why prices of Treasury were mixed with the shorter end of the yield curve rising in prices and the longer- dated Treasury falling in prices.

Given the latest data on the state of the U.S. economy, assume that the Fed signals the next increase in the target for the federal funds. The increase won’t happen until the Fed’s meeting in summer of 2016.

Will the Treasury yield curve become more or less steep today?

Which of the following would you expect in the market for Treasury? Explain your choice

- There will be an increase in demand for bond today?

There will be a decrease in supply of bonds today?

There will be a decrease in demand for bonds today?

There will be an increase in supply of bonds today?

What will happen to the yields on Treasury? Explain

4. The table below shows current and expected future one-year interest rates, as well as current interest rates on n-year bonds

Year One-year Bond Rate N-Year Bond Rate Liquidity premium

1 2% 2% _______

2 3% 3% _______

3 4% 5% _______

4 6% 6% _______

5 7% 8% _______

Assume the expectation theory of the term structure and calculate interest rates in the term structure for maturities of one to five years.

Draw the yield curve for the next four years.

Is the yield curve for the next four years upward sloping or downward sloping? Explain why

What might the yield curve today indicate about future interest rates?

What might the yield curve today indicate about future economic activity? Explain why?

What might the yield curve indicate about the markets’ prediction for inflation rate in the next four years?

Calculate the liquidity premium for each n-year bond

What does the liquidity premium stay for?

Compare the liquidity premium in 2-year bond and 5-year bond. Why is the liquidity premium on 2-year bond lower than the liquidity premium on 5-year bond?

5. A Suppose that you are the manager of the Bank One. Assume required reserve ratio 10 percent. The bank has the following balance sheet:

Assets Liabilities

Reserves $ 65 million Deposits $ 400 million

Loans $ 425 million Bank capital $ 90 million

Is Bank One meeting the reserve requirement?

By how much can Bank One increase its loans?

Suppose Bank One suffers a deposit outflow of $40 million .Illustrate numerically the effect of the deposit outflow of $40 million on the bank’s deposits and reserves

Does the bank now hold excess reserves?

Is the bank meeting a required reserve ratio of 10 percent?

What action must you take to meet the reserve requirement? List three or more actions. work

If a borrower defaults on a loan of $10 million, will be the bank able to sustain the loss?

Why no, why yes?

If Bank One ROA is 7%, what is the bank profit? What is the bank ROE?

How can you increase the bank’s ROE, what trade –off do you face?

6. Suppose that you are the manager of the Bank One that has $30 million of fixed assets, $20 million of variable interest rate assets, $15 million of fixed liabilities and $25 million of variable interest rate liabilities.

a. Is the rate sensitivity gap positive or negative? Explain

b. Explain verbally and show numerically what will happen to the bank profits if interest rates rise by 4 percent.

c. What action would you take to reduce the bank’s interest-rate risk? Explain

d. Explain and show numerically what happens to the bank profit if interest rates fall by 4 percent

e. What action would you take to reduce the bank’s interest-rate risk? Explain

f. Given the bank assets and liabilities explain how you can use the interest rate swaps to reduce the bank interest rate risk. Would you trade variable- rate payments for fixed- rate payment? Why yes, why not?

7. Assume the following information about the banking system

Quantities in billions of dollars

Currency (C) = $762

Excess Reserves ( R ) = $66

Required reserves (RR) = $0

Checking deposits (D ) = $604

Give the numerical answer to the following questions:

a. What is the size of the monetary base?

b. What is the money supply in the economy?

c. What is the size of the money multiplier?

Assume that the currency to deposit ratio rises to 1.5

a. Compute the effect of the change in currency ratio on the money multiplier, m

b. What will be the money supply now given the monetary base?

If the Fed wants to keep the money supply at the initial level in part b, how must the Fed respond? Explain

Would the Fed adjust the money multiplier, the monetary base or both to keep the money supply at the initial level?

How much would the Fed buy or sell in the government bonds to keep the money supply at the initial level?

8. Assume that the MB = $828, Money supply = $1366, Currency in the circulation = $ $762, Deposit = $$604, the currency to deposits ratio c is 1.262, the excess reserve ratio is 0.109, the required reserve ratio is 0, and the money multiplier m= 1.650. The non-bank public shifts $40B from currency to deposits, and the Fed wishes to keep the money supply at the level of $1366 B. Explain verbally and show numerically the effect of the currency shift on the following

a. The level of reserves in the banking system

b. The monetary base

c. The size of the money multiplier

d. How should the Fed respond given his goal of keeping the money supply at the level of $1366? Explain

e. How much in the government bonds should the Fed buy or sell to keep the money supply at the level of $1366?

9. Use the graph of the market for reserves to analyze each of the following situations. Be sure that your graph clearly shows changes in the equilibrium federal funds rate, changes in the equilibrium level of reserves, any shifts in the demand and supply curves, and any change in equilibrium federal funds rate

Suppose that the Fed decides to increase the federal funds rate from 2%to 2.25%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that the Fed decides to decrease the federal funds rate from 2.25%to 2.%. Show graphically and explain verbally what policy tools the Fed can use to bring the change in the federal funds rate.

Suppose that banks increase their demand for reserve. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose there is a switch from currency into deposits, everything else held constant. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged

Suppose that the Fed decides to decrease the required reserve ratio. Show graphically and explain verbally how the Fed can offset this change in order to keep the equilibrium federal funds rate unchanged.

f. Suppose that banks decrease their demand for reserves. Show graphically and explain

verbally how the Fed can offset this change in order to keep the equilibrium federal funds

rate unchanged.

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