Financial Institutions

Week III Textbook Problems

Week III Textbook Problems

Chapter 6

1. Primary Market Explain how the Treasury uses the primary market to obtain adequate funding.

Treasury issues T-Bills through a weekly auction; auctions off money bills to make money. Investors submit a competitive bid Treasury accepts the highest; noncompetitive bids are automatically accepted. The price to be paid by noncompetitive will be the weighted average price of accepted bids.

4. Commercial Paper Who issues commercial paper? What types of financial institutions issue commercial paper? Why do some firms create a department that can directly place commercial paper? What criteria affect the decision to create such a department?

Finance and Bank holding companies issue commercial paper. As a way to avoid transaction costs, firms who continuously issue Commercial Paper create departments that can directly place the paper.

Repurchase Agreements Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Why?

Since they are backed by treasury securities; they would have a slightly lower yield.

8. Banker's Acceptances Explain how each of the following would use banker's acceptances: (a) exporting firms, (b) importing firms, (c) commercial banks, and (d) investors.

Exporting firms protect from the risk of nonpayment by the importer. Importing firms protect from the risk of paying goods without ever receiving them. Commercial Banks offers exporters/importers a service in which they charge a fee. Investors theses BAs are traded on an active secondary market.

Chapter 7

9. Global Interaction of Bond Yields If bond yields in Japan rise, how might U.S. bond yields be affected? Why?

If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before.

10. Impact of Credit Crisis on Junk Bonds Explain how the credit crisis affected the default rates of junk bonds and the risk premiums offered on newly issued junk bonds.

Many junk bonds defaulted during the credit crisis, as economic conditions weakened and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time.

Chapter 8

1. Bond Valuation Assume the following information for an existing bond that provides annual coupon payments:

   Par value = $1,000

   Coupon rate = 11%

   Maturity = 4 years

   Required rate of return by investors = 11%

· a. What is the present value of the bond?

· b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond?

· c. If the required rate of return by investors were 9 percent, what would be the present value of the bond?

4. Bond Value Sensitivity to Exchange Rates and Interest Rates Cardinal Company, a U.S.-based insurance company, considers purchasing bonds denominated in Canadian dollars, with a maturity of six years, a par value of C$50 million, and a coupon rate of 12 percent. Cardinal can purchase the bonds at par. The current exchange rate of the Canadian dollar is $0.80. Cardinal expects that the required return by Canadian investors on these bonds four years from now will be 9 percent. If Cardinal purchases the bonds, it will sell them in the Canadian secondary market four years from now. It forecasts the exchange rates as follows:

a. a. Refer to earlier examples in this chapter to determine the expected U.S. dollar cash flows to Cardinal over the next four years. Determine the present value of a bond.

b. b. Does Cardinal expect to be favorably or adversely affected by the interest rate risk? Explain.

c. c. Does Cardinal expect to be favorably or adversely affected by exchange rate risk? Explain.

Chapter 9

1. Mortgage Rates and Risk What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements.

There is a high positive correlation between mortgage rates and long-term government security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change.

4. Mortgage Maturities Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year or a 30- year mortgage? Why?

The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-year mortgage exists for only half the period.

References

Madura, J. (2015). Financial Markets and Institutions. (11 ed.). Cengage

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Ch. 6

#1. The T-bill Yield

#4. Repurchase agreement

#8. Effective Yield

% change in S = 1.52 – 1.50/1.50 = 0.0133 = 1.33%

Ye = (1 + Yf) (1 + % change in S) – 1

Ye = (1.25) (1.0133) – 1 = 0.2666 = 26.66%

#14. T-bill Yield

a. Determine how the annualized yield of a T-bill would be affected if the purchase price were lower. Explain the logic of this relationship.

The annualized T-bill yield is more if the purchase prices is lower because the investor gets a large gain to a small investment.

b. Determine how the annualized yield of a T-bill would be affected if the selling price were lower. Explain the logic of this relationship.

The annualized T-bill yield is lower if the price is reduced because the investor will get a smaller gain to its investment.

c. Determine how the annualized yield of a T-bill would be affected if the number of days were reduced, holding the purchase price and selling price constant. Explain the logic of this relationship.

The annualized T-bill yield is more if the number of days of the investment is shorter because the investment is returned over a shorter period of time.

Ch. 7

#10. Global Interaction of Bond Yields

If bonds yields rise in Japan it can increase the flow of funds to purchase bonds, which can reduce the amount of funds available to purchase bonds in the U.S. If this happens the U.S. will sell its bonds at lower prices, which will make higher yields than before.

#11. Impact of Credit Crisis on Junk bonds

A lot of junk bonds defaulted during the credit crisis when economic conditions weakened and issuers of bonds failed. The risk premium offered on newly issued junk bonds when up during the credit crisis when investors would only consider purchasing junk bonds if the premium was worth the risk.

Ch. 8

#. Bond Valuation

a. What is the present value of the bond?

PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFA i = 11%, n = 4) + $1,000 (PVIF i=11%,n= 4)

= $110(3.1024) + $1,000(.6587)

= $341 + $659

= $1,000

b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond?

PV of Bond = PV of Coupon Payments + PV of Principle

= $110(PIVA i = 14%, n = 4) + $1,000(PVIF i = 14%,n = 4)

= $110(2.9137 + $1,000(.5921)

= $321 + $592

= $913

c. If the required rate of return by investors were 9 percent, what would be the present value of the bond?

PV of Bond = PV of Coupon Payments + PV of Principle

= $110(PFIVA i = 9%, n = 4) + $1,000(PVIF i =9%,n = 4)

= $110(3.2397) + $1,000(.7084)

= $356 + $708

= $1,064

#4. Bond Value Sensitivity to Exchange Rates and Interest Rates

a. Refer to earlier examples in this chapter to determine the expected U.S. dollar cash flows to Cardinal over the next four years. Determine the present value of a bond.

PV of C$ C$6,000,000 C$56,000,000

Cash Flows = (1+.09)^1 + (1+.09)^2

In 4 years

= C$5,504,587 + C$47,134,080

= $52,638,667

Year 1 2 3 4________

C$ cash flows C$6,000,000 C$6,000,000 C$6,000,000 C$6,000,000

Anticipated +C$52,638,667

Forecasted

exchange rate

of C$ $0.80 $0.77 $0.74 $0.72

U.S. $ each flows

anticipated $4,800,000 $4,620,000 $4,440,000 $42,219,840

b. Does Cardinal expect to be favorably or adversely affected by the interest rate risk? Explain.

Cardinal Co. will be affected if Canadian interest rates go down because the bonds will sell for a higher price at the end of the fourth year.

c. Does Cardinal expect to be favorably or adversely affected by exchange rate risk? Explain.

Cardinal Co. is affected by the exchange rate movements because the Canadian dollar over time has less U.S. dollar cash flows to be received if the Canadian dollar is weaker.

Ch.9

#2 Mortgage Rate and Risk

There is a lot of similarity between mortgage rates and long-term government security rates.

Lenders that have fixed rate mortgages could be affected by rising interest rates because the cost of financing the mortgages will increase and the interest received on mortgages does not change, The lender can reduce the exposure to interest rate risk by giving adjustable rate mortgages, so that the money received from mortgages could change in the same direction as the cost of financing as interest rates change.

#4. Mortgage Maturities

The 15-year mortgage is popular because there can be a reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is for a 30-year mortgage than for a 15-year mortgage because the 15-year mortgage exists for only half the period.

References

Madura, J. (2015). Financial Markets and Institutions. (11 ed.). Cengage

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