Chapter 12 Part 9

Question 1

Commercial paper is

Answer 1

short-term unsecured corporate debt that typically matures in 270 days or less. Therefore, commercial paper would be exempt from the prospectus requirements of the 1933 Act. Commercial paper is usually issued at a discount as with Treasury bills, although some issues are interest bearing

Question 2

Commercial paper is usually issued by corporations with

Answer 2

high credit ratings and is consequently considered very safe.

Question 3

Moody’s and Standard & Poor’s issue credit ratings for commercial paper

Answer 3

P-1 (also called Prime 1) is the highest rating that Moody’s will assign to commercial paper. Intermediate ratings are P-2 and P-3. Speculative commercial paper would receive a rating of NP (not prime). S&P will assign ratings from A1 (highest) to A3, and Fitch assigns ratings from F1+ (highest) to F3

Question 4

Some large issuers of commercial paper sell their issues

Answer 4

directly to the public using their own sales force. This is known as directly placed commercial paper. Most other issuers sell to large commercial paper dealers who then resell the issue to the public. This is known as dealer-placed commercial paper. The minimum denomination is typically $100,000.

Question 5

Bankers’ acceptances are used to

Answer 5

“facilitate foreign trade. For example, suppose that an American food company is importing French snails. The American company wishes to pay for the snails after delivery and issues a time draft (a check that is good at a future date) secured by a letter of credit from a U.S. bank as payment. The French snail manufacturer can hold the draft until its due date and receive the full amount, or cash it immediately at a bank at a discount. The bank then has the draft guaranteed by the issuing bank and it is now called a banker’s acceptance. The bank can hold
the BA until the instruments due date or sell it in the market”

Question 6

BAs are actively

Answer 6

traded and are considered quite safe since they are secured both by the issuing bank and by the goods originally purchased by the importer

Question 7

In a repurchase agreement, a dealer

Answer 7

“sells securities (usually T-bills) lo another dealer and agrees to repurchase them at a specific time, at a specified price. In effect, the first dealer is borrowing money from the second dealer and securing the loan with securities (a collateralized loan). The second dealer (the lender) receives the difference between the purchase price and the resale price of the
securities in return for making the loan.”

Question 8

reverse repo or matched sale

Answer 8

If a dealer purchases securities and agrees to sell them back to the other dealer at a specific date and price, this is known as a reverse repo or matched sale. In that situation, the first dealer would lend money (with securities as collateral) to the second dealer and earn the difference in sales prices. Many corporations and financial institutions, as well as dealers, engage in repos and reverse repos. Repos and reverse repos are typically short-term, with most being overnight transactions

Question 9

Banks and savings and loans issue certificates of deposit. They are

Answer 9

time deposits carrying fixed rates of interest that mature after a specified period. While most CDs mature in a year or less, the minimum maturity is seven days and there is no maximum. CDs of up to $250,000 are currently insured by the Federal Deposit Insurance Corporation (FDIC), although the maximum FDIC coverage is scheduled to be reduced to $100,000 in January of 2014. Holders of CDs are penalized if they redeem them prior to their stated maturity

Question 10

Also known as jumbo CDs

Answer 10

negotiable CDs have a minimum denomination of$100,000 but typically trade in denominations of one million dollars or more. There is an active secondmy market in these securities. A negotiable CD is normally not covered by FDIC insurance since it exceeds $250,000, which is the current maximum amount the FDIC will insure

Question 11

Long-term or brokered CDs generally have maturities from

Answer 11

2 to 20 years and are, therefore, not considered money-market securities. They also may carry additional risks not associated with traditional bank-issued CDs

Question 12

Long-Term CDs

Answer 12

There may be limited liquidity, or potentially no liquidity; Investors may experience a loss of principal if CDs are sold prior to maturity; Brokered CDs may have call features that limit capital appreciation and subject the investor to reinvestment risk; FDIC insurance may not apply; Unique features, such as variable rates, step-ups and step-downs, may affect future interest payments

Question 13

Long-Term CDs These instruments are issued by

Answer 13

banks and, although sold by broker-dealers, they are insured up to certain limits by the FDIC if the issuing bank declares bankruptcy. The amount of FDIC insurance and tax considerations are different depending on whether the CD is purchased in a retirement account. If the broker-dealer that sold the brokered CD to the client declared bankruptcy, SIPC coverage would apply since these products are defined as securities

Question 14

Broker-dealers or deposit brokers that offer long-term CDs must insure that

Answer 14

“potential customers understand the difference between these products and traditional bank-issued CDs, and disclose any potential risks. These disclosures would be based on the potential risk and investment considerations relevant to the client. The features that establish the interest rate of the security, such as an index of fixed-income or equity securities, is relevant to the client. For example, a step-down, long-term certificate of deposit will offer an investor an interest rate that is initially higher than current market rates will pay for that maturity period. Subsequent interest rates paid to investors would be lower and may be adjusted more than once. An RR should disclose to the client that he will not receive the higher interest rate for the life of the CD. In addition, a broker-dealer is not required to maintain a secondary market or act as a market maker in a CD that was sold to the client. this will
limit the liquidity of the security if the client needs the funds prior to maturity”

Question 15

If a brokered CD is callable, the following disclosures should be made

Answer 15

The issuer at its sole discretion may decide to call in the CD prior to maturity; therefore, the client does not have the right to redeem the CD prior to maturity. If the CD is called prior to maturity, the client may be unable to reinvest the funds and receive a comparable rate of interest (if rates have declined). A CD that is called prior to maturity may offer a client a return that is less than the yield to maturity. The CD may not be called by the issuer, requiring the client to hold the security until maturity

Question 16

Federal Funds (Fed Funds)

Answer 16

Money borrowed overnight on a bank-to-bank basis is known as fed funds. Borrowing is usually done to allow a bank to meet its rese1ve requirement with the Federal Reserve. A bank with excess reserves can lend to a bank in need of reserves. This allows the bank with excess reserves to earn interest on these otherwise dormant funds

Question 17

fed funds rate.

Answer 17

The rate charged on these overnight loans is known as the fed funds rate. It fluctuates on a daily basis and is a leading indicator of interest- rate trends. This is due to the fact that it reflects the availability of funds in the system. Although the Federal Reserve does not set the fed funds rate, it will attempt to influence the rate through purchases and sales of government securities in the secondaty market

Question 18

prime rate

Answer 18

A corporation pays the prime rate when borrowing from a bank if it is among the bank’s best credit rated customers. Other corporations would pay a higher rate, but it would be based on the prime rate

Question 19

LIBOR

Answer 19

is the London Interbank Offered Rate. It is the average rate that banks charge each other on loans for London deposits of Eurodollars

Question 20

From the perspective of the American investor, international bonds can be divided into two categories

Answer 20

(1) bonds that pay interest and principal in U.S. dollars (U.S. pay bonds) and (2) those that pay interest and principal in foreign currencies (foreign pay bonds)

Question 21

Eurodollar bonds are

Answer 21

one type of U.S. pay bonds. These securities are denominated in U.S. dollars but issued and traded outside the countty. Their issuers include corporations, foreign governments, and international agencies such as the World Bank. These bonds are not registered with the U.S. Securities and Exchange Commission and, consequently, may not be sold in the United States until 40 or 90 days after they are issued. For this reason, Eurodollar securities are bought primarily by foreign investors. As with domestic U.S. bonds, movements in U.S. interest rates can greatly affect the prices of Eurodollar bonds

Question 22

Yankee bond

Answer 22

Another common type of U.S. pay bond is a Yankee bond. Yankee bonds allow foreign entities to borrow money in the U.S. marketplace. They are registered with the SEC and sold primarily in the United States

Question 23

Many foreign bonds are sold primarily in one countty and denominated in

Answer 23

that country’s currency by an issuer that is domiciled in a different country