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Financial Markets > Topic 2 - Flow of Funds & Determination of Interest Rates > Flashcards

Topic 2 - Flow of Funds & Determination of Interest Rates Flashcards

1
Q

2.01 - In examining the flow of funds what are the two aspects that are of interest to financial market observers?

A
  • Sectoral balances

* Institutional features

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2
Q

2.02 - What is ‘institutional features’ referring to, as an aspect of interest in examining the flow of funds?

A

The role played by different types of financial institutions by means of direct or indirect finance.

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3
Q

2.03 - The domestic economy comprises what five aggregate sectors?

A 
Households
Corporations
Government
The rest of the world
Financial corporations
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4
Q

2.04 - Describe which of the five sectors of the domestic economy are currently net lenders of funds and how do they lend?

A
  • Households - raised by loans from banks and other ADIs
  • Non financial corporations - approx 60% raised by equity and 40% debt
  • Rest of the world
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5
Q

2.05 - Which of the sectors of the economy are currently net borrowers of funds and how do they borrow?

A
  • Government - sale of long term debt securities (govt bonds) and short term debt securities (treasury notes/bills)
  • Financial corporations - Borrows from households and rest of world to lend to the non-financial coprs and govt sector.
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6
Q

2.06 - Which are the sectors of an economy that are more prevalent to change their status as borrower or lender?

A
  • Households can change depending on the level borrowed compared to saved
  • Governments - based on whether a surplus or deficit is being run.
  • Rest of the world - depending on the country - some are borrowers and some are lenders.
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7
Q

2.07 - What are the different perspectives that can be used to view interest rates?

A
  • the cost of borrowing funds
  • the rate of return from lending funds
  • the opportunity cost of holding money
  • the time value of money
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8
Q

2.08 - What does the time value of money recognise?

A

That there is a difference between money’s present value (PV) and its future value (FV). This difference is represented by the amount of interest paid (I).

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9
Q

2.09 - What is the calculation to determine future value?

A

FV = PV+I

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10
Q

2.10 - What is simple interest and what is the formula associated with it?

A

Simple interest is termed flat interest and is calculated on the principal sum. It is calculated as I = PV x i x t where:
i is the annual interest rate; and
t is the term of the investment in years

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11
Q

2.11 - What is the formula to determine future value based on simple interest?

A

FV = PV + (PV x i x t)

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12
Q

2.12 - What assets normally use the simple interest formula to determine interest?

A

Money Market securities as these financial assets have a maturity of less than 12 months.

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13
Q

2.13 - What is compound interest ?

A

Interest is calculated on the accumulated principal amount; interest is added to the principal

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14
Q

2.14 - What is the formula for compound interest to determine the future value?

A

FV = PV (1+r)ⁿ

where r is the interest rate per compound period and n is the number of compounding periods

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15
Q

2.15 - To convert a nominal interest rate into an effective interest rate, what is the formula?

A

ie = (1 + i/m) to the power of m - 1

where m is the number of compounding periods in a year.

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16
Q

2.16 - What is yield?

A

It is the total return on an investment, comprising interest received and any capital gain (or loss)

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17
Q

2.17 - How would the price (PV) of a discount security be calculated?

A

PV = FV/(1+ yt)

where y is the yield or discount rate.

18
Q

2.18 - How would the price (PV) of a security with cash flows which occur more than one year in the future calculated?

A

PV = FV/(1+r)ⁿ

where r is the interest rate per compound period and n is the number of compounding periods

19
Q

2.19 - What is the ‘level of interest rates’ term used to describe?

A

The overall position of interest rates as a whole within the aggregate economy or financial system.

20
Q

2.20 - What is the preferred approach by financial market analysts in explaining the determinants of the level of interest rates?

A

The Loanable Funds approach.

21
Q

2.21 - What does loanable funds theory of the determination of interest rates explain?

A

It explains the aggregate level of interest rates in the economic and financial system as being determined by the interaction between the demand for and supply of, loanable funds.

22
Q

2.22 - What is the supply of loanable funds determined by and how are they viewed?

A

The savings, and lending, decision of surplus economic units and the lending policy of financial intermediaries. The supply of loanable funds is viewed as being directly or positively related to the level of interest rates.

23
Q

2.23 - Describe how the supply of loanable funds is impacted by high interest rates?

A
  • reflect greater returns from lending - therefore incentive to save and lend
  • encourage financial intermediaries to reduce holdings of cash and increase lending as the opp cost of holding money is high.
24
Q

2.24 - What is the demand for loanable funds determined by and how are they viewed?

A

Determined by the expenditure plans of deficit economic units and the requirement of financing this expenditure using borrowed funds. It is viewed inversely related to the level of interest rates.

25
Q

2.25 - Describe how the demand for loanable funds is impacted by high interest rates?

A
  • business demand for finance will decrease as the rate of return on real investment will not exceed the cost of finance
  • Household demand for finance will be lower.
26
Q

2.26 - How is the level of interest rates determined?

A

By consideration of the demand for loanable funds and the supply of loanable funds and where the equilibrium point is.

27
Q

2.27 - Changes in the level of interest rates will result from any factors which bring about changes in the demand for and / or the supply of loanable funds, what are the two main factors?

A
  • Inflationary expectations

* Central bank action

28
Q

2.28 - What is the impact of inflationary expectations on interest rates?

A

Suppliers demand higher rates of interest to cover the opp. cost so supply curve moves to left and demanders will then increase their demand for funds to maintain pre-inflation investment plans, so demand curve moves to right. As both have moved the quantity of loanable funds doesn’t change.

29
Q

2.29 - What is the impact of central bank action on interest rates?

A

If the Central bank embarks on open market bond sales, this will reduce the supply of loanable fund shifting supply leftwards. This is a movement along the demand curve. Interest rates therefore will rise and quantity of funds is decreased.

30
Q

2.30 - What does the ‘structure of interest rate’ refer to? and what does the explanation of such attempt to explain?

A

The relationship between the different interest rates that are present in a financial system and why different interest rates are present

31
Q

2.31 - What are the two main types of interest rate structure?

A
  • Risk structure of interest rates

* Term structure of interest rates

32
Q

2.32 - What are the two main financial risks that will influence the rate return expected by investors?

A
  • Liquidity risk

* Credit / default risk - risk that borrowers will not repay commitments when due

33
Q

2.33 - What does the ‘term structure of interest rates’ examine?

A

The yield curve - which is a graph illustrating the relationship between interest rates for securities with identical default risk but different terms to maturity at a particular point in time.

34
Q

2.34 - What are four shapes of a yield curve?

A
  • Normal yield curve
  • Inverse yield curve
  • Flat yield curve
  • Humped yield curve.
35
Q

2.35 - What are the three major explanations as to what determines the shape of the yield curve?

A
  • market (pure) expectations theory
  • expectations plus liquidity premium
  • market segmentation approach
36
Q

2.36 - What does the market (pure) expectations theory argue as the determination of the term structure of interest rates? and explain how this works.

A
  • Current short-term rates
  • Expected future short term rates
    For example, if current bond rate was 4% for 1 year, and expected bond rate for next year was 6%, then the 2 year current bond rate would be 5% (average of the two)
37
Q

2.37 - For the market (pure) expectations theory to hold true, what two requirements must be met?

A
  • The goal of investors is to maximise their returns - as such all bonds are perfect substitutes of each other regardless of term
  • Financial markets operate efficiently and yields will move to their equilibrium rates.
38
Q

2.38 - Under pure expectations theory, what does a normal yield curve imply?

A

That the future short-term interest rates are expected to be higher than current short-term interest rates.

39
Q

2.39 - What is the expectations plus liquidity premium approach to determining the yield curve / term structure of interest rates?

A

It accounts for the greater risk for investors in purchasing long term bonds and modifies the pure expectations approach to include a liquidity premium (see diagram in book)

40
Q

2.40 - What is the segmented market approach to determining the yield curve / term structure of interest rates?

A

Under the segmented market approach, the assets with different maturity terms are seen as imperfect substitutes.

41
Q

2.41 - What are the two key views related to the segmented market approach?

A
  • Markets for assets with different maturity terms are separate markets with different supply & demand conditions
  • The different markets have different participants who are more concerned with minimising risk than maximising profit (hedge) (see diagram in book)
42
Q

2.42 - If the term structure of interest rates within the market are correct and in equilibrium then what important indicators do the shape and slope of the yield curve provide to market participants?

A
  • Borrowers - informed decisions of future direction of borrowing costs
  • Investors - forecast futre rates which will influence their investment acquisition and disposal strategies
  • Govt and Reserve bank - analyse structure with regard to its economic, social and political objectives
  • Financial institutions - set prices of borrowing and lending products based on their interpretation of the future movement in interest rates.

Financial Markets (3 decks)

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