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Series 52 > Unit 8-Economic Activity, Gvt Policy, and Interest Rates > Flashcards

Unit 8-Economic Activity, Gvt Policy, and Interest Rates Flashcards

1
Q

Business Cycle

A

-Expansion
-Peak
-Contraction
-Trough
-Short term contraction are recessions, longer are depressions
NOTE: Always start with expansion if asked

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2
Q

Definition of Recession

A

Decline in GDP for 6+ months

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3
Q

Definition of Depression

A

Decline in GDP for 6 quarters (18 months) with an unemployment rate of 15%+

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4
Q

Signs of Business Downturns

A
  • Rising bankruptcies and defaults
  • Rising inventories
  • Falling stock prices
  • Rising consumer debt
  • Falling GDP
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5
Q

Countercyclical Investments

A

Those that rise during a recession (gold)

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6
Q

GDP (may show as Gross National Product-GNP)

A

The sum of all annual goods and services produced within a year within a country. Includes:
-Govt spending
-Personal consumption
-Gross private investment
-Foreign investment
-Total value of exports
NOTE: To compare a current period with a previous one, GDP is set to constant dollars

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7
Q

Consumer Price Index (CPI)

A

Measures overall rate of increase/decrease of a basket of goods:

  • Transportation
  • Food
  • Housing
  • Clothing
  • Electricity
  • Medical Care
  • General Entertainment
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8
Q

Inflation

A

Increase in prices overall

  • Good if mild, as it stimulates growth
  • Bad if inflation is high, weakens buying power
  • Drives up interest rates and drives down bond prices
  • Low inflation leads to stable prices, low rates
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9
Q

Deflation

A

Period of falling prices

  • Rare
  • Usually only occurs when there is a severe depression and high unemployment
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10
Q

Leading Indicators

A

Up is good (expansion), down is bad (contraction):

  • Money Supply (M2)
  • Building permits and housing starts
  • New weekly unemployment claims
  • Average work week in manufacturing
  • New orders of consumer goods
  • Machine tool orders
  • Changes in inventories of durable goods
  • Changes in sensitive material prices
  • Stock prices
  • Changes in business and consumer borrowing
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11
Q

Coincident Indicators

A

Used to confirm where economy is:

  • Hours worked (proxy for personal income)
  • Employment levels
  • Nonagricultural employment
  • Personal income
  • Industrial Production
  • Manufacturing and Trade Sales
  • GDP
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12
Q

Lagging Indicators

A

Serve to confirm new trend in business cycle:

  • Corporate profits
  • Average duration of unemployment
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13
Q

Keynesian Theory

A
  • Govt involvement is key to economic stability
  • Demand for goods ultimately determines employment and prices
  • Govt should control demand by altering spending levels and taxation
  • Fiscal Policy
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14
Q

Monetarist Theory

A
  • Milton Friedman
  • Prices are determined by quantity of money in the economy
  • Business owners are better at stimulating economy that the government
  • FED should control money supply with reserve requirements, discount rate, and open market operations
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15
Q

Supply Side Economics

A

A subset of monetarist theory:

  • Government should reduce spending and taxes
  • Sellers can then price goods to meet demand and still make a profit
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16
Q

Laffer Curve

A

Shows relationship between tax rates and tax revenue collected by govt.

  • Higher tax rates lead to more govt revenue, but only to a point.
  • When taxes are too high, people are disinclined to work, which will lead to falling income and lower taxes
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17
Q

Primary Difference Keynes and Monetarists

A

Mainly, what should the role of govt be?

  • Keynes believes govt should be primary force in economy via fiscal policy
  • Monetarists believe business know what’s best, and that the govt should only intervene to stabilize economy
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18
Q

M1

A

Hard cash and demand deposits (checking account) that can be converted to cash immediately
-M1 is by far the largest and most liquid form of money

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19
Q

M2

A
  • All of M1 and:
  • Time deposits (less than 100K)
  • Savings accounts, money markets, CDs, overnight repurchase agreements, and any other instruments that can be converted to cash relatively quickly
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20
Q

M3

A
  • All of M1 and M2
  • Time deposits exceeding 100K
  • Repurchase agreements of longer than 1 day
21
Q

FED Composition

A
  • 12 regional banks

- Hundreds of national and state banks

22
Q

FED Roles

A
  • Acts as an agent of US Treasury
  • Regulating money supply
  • Setting Reserve Requirement
  • Auditing member banks
  • Supervising printing of money
  • Clearing fund transfers (e.g., wires)
23
Q

Open Market Activities (FOMC)

A

When the FED manipulates money supply by buying or selling U.S. Govt securities in the open market
-Sales to banks tighten money on reserve, reduces number of loans that can be made, rising interest rates

24
Q

Discount Rate

A

The rate the FED charges member banks for short term loans

25
Q

Fed Funds Rate

A

The rate banks charge each other for loans (overnight)
-The most volatile interest rate
-Lowering the rate reduces the cost of borrowing money which increases demand for loans
NOTE: The FED does not set Fed Funds Rate

26
Q

Reserve Requirement and Federal Funds

A

Commercial banks are required to deposit a certain amount of customer funds with the FED

  • All deposits (including excess) is known as Federal Funds
  • When the FED raises the reserve requirements, banks must deposit more cash, and thus have less to loan out
27
Q

Fiscal Policy

A

-Govt Spending
-Taxes
-Federal budget surplus/deficits
Based on the Keynes idea that the govt can control unemployment and inflation by manipulating overall demand for goods and services

28
Q

Disintermediation

A

Often occurs when FED is tightening money supply
-Is when money is moved from low yielding instruments to higher yielding instruments without the bank acting as an intermediary
EX. Pulling money from a savings account to buy a mutual fund direct

29
Q

Balance of Payments

A

Measures of net surplus/deficit of money between nations

-A deficit may occur when another country is offering higher interest rates

30
Q

Balance of Trade

A

Largest component of Balance of Payments

31
Q

Value of Dollar Consideration

A
  • When dollar is weak, foreign currency buys more goods and exports increase
  • When dollar is strong, foreign currency buys less US goods. The dollar buys more foreign goods, so imports increase
32
Q

What determines a bond’s yield?

A

-The market
-Issuer’s Credit Rating
-Current interest rates
-Time to maturity
-call/put features
NOTE: Bonds may be quoted /traded in terms of yield or dollar per par

33
Q

Nominal Yield

A

The stated yield per par

-Fixed Rate

34
Q

Current Yield

A

Annual coupon/Current bond price

-When bonds trade at discount, current yield rises and vice versa

35
Q

Yield to Maturity (also called basis)

A
  • Annualized return of bond if held to maturity
  • Factors in price paid for bond and par value
  • If bought at discount, increase is total return and vice versa
36
Q

Yield to Call

A

Calculates early redemption and accelerated discount gain or premium loss from purchase price

  • YTC for a premium bond called at par is always lower than nominal yield, current yield, and YTM
  • Higher than all if bought at discount
37
Q

Yield Curve

A
  • Bond prices and yields are inversely related
  • Typically, the longer a bonds maturity, the higher its yield. This can lead to credit and inflation risks over time
  • In a normal (positive yield curve) the difference between short maturities and longer maturities can be about 3% (300 basis points)
38
Q

Inverted Yield Curve

A
  • Occurs during high inflation. Longer term bonds decline in price. Shorter term bonds have a higher yield than longer
  • FED tightening
  • Anticipated lower rates in the future
39
Q

Positive Yield Curve

A
  • Economic Expansion

- Anticipated higher rates in the future

40
Q

Flat Yield Curve

A

-Indicative of an economy that has peaked

41
Q

Selling Bonds in the Secondary (during rising rates)

A

EX. You have a 10 year bond with a 5% nominal yield. Suddenly, interest rates on similar 10 year bonds rise to 6%. In order to entice a buyer to buy your bond, you need to discount the price so the manipulated yield will be equal to, or exceed 6%

42
Q

Potential Test Scenarios

A

1) If given 2 bonds at discounts, and asked to choose which one will appreciate most if rates fall, choose the bond with the deeper discount (lower coupon)
2) If given 2 callable bonds and asked which will appreciate most if rates fall, choose the one with the farther out call date

43
Q

Calculating Current Yield

A

Ex. What is the current yield of a 6% (1000 par) bond trading at $800?

$60/800=7.5% Bond is trading at discount

EX. What is the current yield of a 6% (1000 par) bond trading at $1200?

$60/1200=5%

EX. A bond with a stated rate of 6% has a current yield of 7.5%. The bond must be trading at [discount]

44
Q

Average Bond Price

A

(price paid for bond) + (par received at maturity)/2

It is a simple average

45
Q

Calculating YTM

A

[Annual interest (in dollars)-(premium or discount/years to maturity)]/Average Bond Price

46
Q

YTM Calculation Example

A

An investor buys a $1000 par bond at 105 ($1050). The bond pays 10% What is YTM?

1) Find Average Price of bond (1050+1000)/2=1025
2) Annual interest is $100 (10% of $1000)
3) Premium is $50

4) Plug & Chug:
$100-($50/10)/1025

$100-$5=95

95/1025=9.3%

47
Q

Important note of rate and price volatility

A

Short term interest rates are more volatile than long term

Long term bond prices are more volatile than short

48
Q

Important Note on Supply and Demand of Interest Rates

A

In an inverted yield curve situation, people expect interest rates to fall. As such, they scramble to lock in the current long-term rates. This increase demand causes bond prices to rise–BUT, a rise in price will cause yields to fall. Hence the inversion.

Series 52 (10 decks)

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