Finance 4

Question 1

What is commerical paper?

Answer 1

Commercial paper is a short term unsecured promissory note that is fewer than 270 days to maturity and is issued as a zero-coupon security. Companies continue to roll over or pay off the holders by issuing new commercial paper in the market. The risk to investors is that the issuing company will not be able to place the new commercial paper to pay off their older debt.

Question 2

What are the two ways commercial paper is issued?

Answer 2

Directly Placed (The issuing company sells the paper directly to the investing public without the help of an agent or intermediary. An example would include GE Capital.) 2.Dealer-Placed
(The issuing company uses an agent to help sell its paper in the marketplace)

Question 3

What’s a CD?

Answer 3

A certificate of deposit is a promissory note issued by a bank. It is a time deposit that restricts holders from withdrawing funds on demand. Although it is still possible to withdraw the money, this action will often incur a penalty.

Question 4

negotiable CDs

Answer 4

A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the Federal Deposit Insurance Corporation (FDIC). The term of a CD generally ranges from one month to five years.

Question 5

asset-backed securities

Answer 5

An asset-backed security is a security that is backed by a pool of loans or receivables. These include: auto loans, consumer loans, commercial assets (planes, receivables), credit cards, home equity loans, and manufactured housing loans.

Question 6

special purpose vehicles

Answer 6

SPVs are also referred to as a bankruptcy-remote entity whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.

Question 7

Why issue asset-backed securities?

Answer 7

The primary motive for issuing asset-backed securities is to take an asset, such as a receivable, a loan or some other form of illiquid asset, and move it off the balance sheet. This helps the parent to clean up its balance sheet and monetize those receivables rather than waiting for the payments to come in. It can also help protect those assets in case the parent defaults. This is possible because the SPV that was created is a separate entity.

Question 8

Collateralized Debt Obligations

Answer 8

An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds.

Question 9

pure expectation theory

Answer 9

Pure expectation is the simplest and most direct of the three theories. The theory explains the yield curve in terms of expected short-term rates. It is based on the idea that the two-year yield is equal to a one-year bond today plus the expected return on a one-year bond purchased one year from today. The one weakness of this theory is that it assumes that investors have no preference when it comes to different maturities and the risks associated with them.

Question 10

liquidity preference theory

Answer 10

This theory states that investors want to be compensated for interest rate risk that is associated with long-term issues. Because of the longer maturity, there is a greater price volatility associated with these securities. The structure is determined by the future expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk increases with maturity, the yield premium will also increase with maturity. Also know as the Biased Expectations Theory.

Question 11

market segmentation theory

Answer 11

This theory deals with the supply and demand in a certain maturity sector, which determines the interest rates for that sector. It can be used to explain just about every type of yield curve an investor can came across in the market. An offshoot to this theory is that if an investor wants to go out of his sector, he’ll want to be compensated for taking on that additional risk. This is known as the Preferred Habitat Theory.

Question 12

Real Risk-Free Rate

Answer 12

This assumes no risk or uncertainty, simply reflecting differences in timing: the preference to spend now/pay back later versus lend now/collect later.

Question 13

Expected Inflation

Answer 13

The market expects aggregate prices to rise, and the currency’s purchasing power is reduced by a rate known as the inflation rate. Inflation makes real dollars less valuable in the future and is factored into determining the nominal interest rate (from the economics material: nominal rate = real rate + inflation rate).

Question 14

Default-Risk Premium

Answer 14

What is the chance that the borrower won’t make payments on time, or will be unable to pay what is owed? This component will be high or low depending on the creditworthiness of the person or entity involved.

Question 15

Liquidity Premium

Answer 15

Some investments are highly liquid, meaning they are easily exchanged for cash (U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss expected if it’s an issue that trades infrequently. Holding other factors equal, a less liquid security must compensate the holder by offering a higher interest rate.

Question 16

Maturity Premium

Answer 16

All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to maturity it is.

Question 17

stated annual rate (quoted rate

Answer 17

The interest rate on an investment if an institution were to pay interest only once a year. In practice, institutions compound interest more frequently, either quarterly, monthly, daily and even continuously. However, stating a rate for those small periods would involve quoting in small fractions and wouldn’t be meaningful or allow easy comparisons to other investment vehicles; as a result, there is a need for a standard convention for quoting rates on an annual basis.

Question 18

effective annual yield

Answer 18

The effective annual yield represents the actual rate of return, reflecting all of the compounding periods during the year. The effective annual yield (or EAR) can be computed given the stated rate and the frequency of compounding. We’ll discuss how to make this computation next.

Question 19

EAR formula

Answer 19

Effective annual rate (EAR) = (1 + Periodic interest rate)^m - 1

Where: m = number of compounding periods in one year, and
periodic interest rate = (stated interest rate) / m

Question 20

Voluntary Export Restraints (VERs)

Answer 20

These restraints limit the quantity of goods that can be exported from the country to one or more of its trading partners. They are usually voluntarily negotiated so that quotas or tariffs are not imposed. (Ex. U.S. to Japan?)

Question 21

Exchange rate controls

Answer 21

Exchange rate controls set the exchange rate of a nation’s currency above the market rate. This makes the nation’s exports artificially expensive, which reduces the quantities of the nation’s goods that foreigners are willing to buy. This means that the country’s citizens have little foreign currency available to buy imported goods. With exchange rate controls, black markets usually exist where currency exchange occurs at a market rate. Exchange rate controls are declining in popularity, although some developing nations still use them.

Question 22

hidden methods for trade restriction

Answer 22

Hidden methods of limiting imports include special regulations and licensing requirements that restrict imports. For instance, the Japanese government imposes special quality requirements on food to restrict food imports and protect Japanese farmers.

Question 23

What are three rationales for trade restriction?

Answer 23

National defense, infant industries, anti-dumping

Question 24

What factors affect the Quantity of Demand and Supply for Currency?

Answer 24

Relative interest rates, Expectations concerning future exchange rates

Question 25

Say interest rates in the United States are higher than those of other countries. What will foreigners want to do, and what effect will it have on the U.S. currency?

Answer 25

Foreigners will want to convert their currencies to dollars in order to earn a higher rate of return. Their actions will cause a reduction in the supply of dollars, and thus an appreciation.

Question 26

Suppose the current exchange rate for euros and dollars is $1.20 per euro and an importer of European goods expects the euro to depreciate next month to $1.1 per euro. What will the importer do, and what effect will it have on the supply and demand for $ and euros?

Answer 26

The importer will hold off on converting dollars to euros thereby decreasing the current quantity demanded for euros and the quantity supplied for dollars.

Question 27

Purchasing power parity

Answer 27

Purchasing power parity expresses the idea that a bundle of goods in one country should cost the same in another country after exchange rates are taken into account.

Question 28

Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars in Canada than in the United States. How is purchasing power parity achieved?

Answer 28

We would then expect U.S. consumers to buy those goods in Canada. Thus U.S. dollars would be sold in exchange for Canadian dollars. As a result, the U.S. dollar would depreciate in relation to the Canadian dollar. We would expect the currency depreciation to continue until the bundle of goods costs the same in both countries.

Question 29

Interest Rate Parity

Answer 29

Interest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return.

Question 30

Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks. Why might this not happen?

Answer 30

Exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be indifferent to either investment choice, as both are expected to earn 6%.

Question 31

How could the Fed depreciate the dollar?

Answer 31

If the Fed buys euros with dollars, it will increase the supply of dollars and decrease the supply of euros. This action tends to cause the U.S. dollar to depreciate in relation to the euro.

Question 32

Direct method of foreign exchange quotations

Answer 32

the exchange rate is expressed as the number of units of the domestic currency needed to acquire one (1.0) unit of the pertinent foreign currency. Within the U.S., this method is also referred to as quoting exchange rates in American (U.S.) terms.

Question 33

Indirect method of foreign exchange quotations

Answer 33

The inverse of the direct method.

Question 34

Say you are given the direct quote, in U.S. terms, of 1.00 euro = $1.2830. What would be the indirect quote?

Answer 34

Take the reciprocal. $0.7794 = 1.00

Question 35

Calculating Spread on a Foreign Currency Quote

Answer 35

Profits for currency market dealers are derived from the difference between the bid, which is the exchange rate at which a dealer is willing to purchase a particular currency, and the ask, which is the exchange rate for which a dealer is willing to sell a particular currency. The average of the bid and ask (ask plus bid divided by two) is referred to as the midpoint price.

Question 36

Bid on a foreign currency quote

Answer 36

the exchange rate at which a dealer is willing to purchase a particular currency

Question 37

Ask on a foreign currency quote

Answer 37

the exchange rate for which a dealer is willing to sell a particular currency

Question 38

Name three factors that affect the bid-ask spread on foreign currency quotes.

Answer 38

Trading volume, currency rate volatility, perceived political/economic risks

Question 39

What effect will high political risk have on bid-ask spreads on a foreign currency?

Answer 39

It will widen the spread. (Currency dealers are exposed to higher risk.)

Question 40

What effect will low currency rate volatility have on bid-ask spreads on a foreign currency?

Answer 40

It will narrow the spread. (Currency dealers are exposed to less risk.)

Question 41

What effect will high trading volume have on bid-ask spreads on a foreign currency?

Answer 41

It will narrow the spread.