Solution Manual For Money Banking And Financial Markets 4Th Edition By Stephen G. Cecchetti

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Solution Manual For Money Banking And Financial Markets 4Th Edition By Stephen G. Cecchetti

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COMPLETE TEXT B00K SOLUTION WITH ANSWERS

 

 

 

 

SAMPLE QUESTIONS

 

 

 

 

Money, Banking, and Financial Markets

Fourth Edition

Stephen G. Cecchetti

chapter 1 An Introduction to Money and the Financial System

 

Chapter Lessons

  1. A healthy and constantly evolving fi nancial system is the foundation for economic

effi ciency and economic growth. It has six parts:

  1. Money is used to pay for purchases and to store wealth.
  2. Financial instruments are used to transfer resources and risk.
  3. Financial markets allow people to buy and sell fi nancial instruments.
  4. Financial institutions provide access to the fi nancial markets, collect information,

and provide a variety of other services.

  1. Government regulatory agencies aim to make the fi nancial system operate safely

and reliably.

  1. Central banks stabilize the economy.
  2. The core principles of money and banking are useful in understanding all six parts

of the fi nancial system.

  1. Core Principle 1: Time has value.
  2. Core Principle 2: Risk requires compensation.
  3. Core Principle 3: Information is the basis for decisions.
  4. Core Principle 4: Markets determine prices and allocate resources.
  5. Core Principle 5: Stability improves welfare.

* Indicates more diffi cult problems

Conceptual and Analytical Problems

  1. List the fi nancial transactions you have engaged in over the past week. How

might each one have been carried out 50 years ago? (LO1)

  1. How were you, or your family or friends, affected by the failure of the fi nancial

system to function normally during the fi nancial crisis of 20072009? (LO1)

  1. List three items you formerly bought with cash but now purchase with a debit

card. (LO1)

  1. Various fi nancial instruments usually serve one of two distinct purposes: to store

value or to transfer risk. Name a fi nancial instrument used for each purpose.

(LO1)

  1. Financial innovation has reduced individuals need to carry cash. Explain how.

(LO1)

6.* Many people believe that, despite ongoing fi nancial innovations, cash will always

be with us to some degree as a form of money. What Core Principle could

justify this view? (LO2)

  1. When you apply for a loan, you are required to answer lots of questions. Why?

Why is the set of questions you must answer standardized? (LO2)

  1. Name two distinct fi nancial markets and describe the kind of asset traded in each.

(LO1)

9.* Why do you think the global fi nancial system has become more globally integrated

over time? Can you think of any downside to this increased integration? (LO1)

  1. The government is heavily involved in the fi nancial system. Explain why. (LO1)
  2. If offered the choice of receiving $1,000 today or $1,000 in one years time,

which option would you choose, and why? (LO2)

  1. If time has value, why are fi nancial institutions often willing to extend you a

30-year mortgage at a lower annual interest rate than they would charge for a

one-year loan? (LO2)

  1. Using Core Principle 2, under what circumstances would you expect a job applicant

to accept an offer of a low base salary and an opportunity to earn commission

over one with a higher base salary and no commission potential? (LO2)

  1. Suppose medical research confi rms earlier speculation that red wine is good for

you. Why would banks be willing to lend to vineyards that produce red wine at a

lower interest rate than before? (LO2)

15.* If the U.S. Securities and Exchange Commission eliminated its requirement for

public companies to disclose information about their fi nances, what would you

expect to happen to the stock prices for these companies? (LO2)

  1. If 2 percent growth is your break-even point for an investment project, under

which outlook for the economy would you be more inclined to go ahead with the

investment: (1) A forecast for economic growth that ranges from 0 to 4 percent,

or (2) a forecast of 2 percent growth for sure, assuming the forecasts are equally

reliable? What Core Principle does this illustrate? (LO2)

17.* Why are large, publicly listed companies much more likely than small businesses

to sell fi nancial instruments such as bonds directly to the market, while small

businesses get their fi nancing from fi nancial institutions such as banks? (LO2)

18.* During the fi nancial crisis of 20072009, some fi nancial instruments that received

high ratings in terms of their safety turned out to be much riskier than

those ratings indicated. Explain why markets for other fi nancial instruments

might have been adversely affected by that development. (LO2)

  1. Suppose fi nancial institutions didnt exist but you urgently needed a loan. Where

would you most likely get this loan? Using Core Principles, identify an advantage

and a disadvantage this arrangement might have over borrowing from a fi nancial

institution. (LO2)

Data Exploration

For detailed instructions on using Federal Reserve Economic Data (FRED) online to

answer each of the following problems, visit www.mhhe.com/moneyandbanking4e and

click on Student Edition, then Data Exploration Hints.

  1. Go to the FRED website (http://research.stlouisfed.org/fred2). Register to set up

your own account. Doing so will allow you to save and update graphs, alter them for

submitting assignments and making presentations, and receive a notice whenever

the data is updated.

  1. To begin using FRED, plot the consumer price index (FRED code: CPIAUCSL)

and fi nd the date and level of the latest observation. Then, plot the infl ation rate

measured as the percent change from a year ago of this index.

  1. Plot the level of real GDP (FRED code: GDPC1). Then, plot the rate of economic

growth as the percent change from a year ago of this index. Describe how real GDP

behaves in recessions, which are denoted in th e FRED graph by vertical shaded

bars. If you registered on FRED (as in Data Exploration problem 1 on the previous

page), save the graph so that you can recall and update it easily when new observations

become available.

  1. Examine nominal GDP (FRED code: GDP) by repeating the steps in Data Exploration

Problem 3. Based on the fi gure showing percent change from a year ago,

what was special about the behavior of nominal GDP during the fi nancial crisis of

20072009 compared to previous decades?

  1. Plot on one fi gure the percent change from a year ago of both the GDP defl ator

(FRED code: GDPDEF) and real GDP (FRED code: GDPC1). How does the GDP

defl ator link nominal and real GDP? Since the mid-1980s, does it fl uctuate more or

less than real GDP?

 

 

chapter 2 Money and the Payments System

 

Chapter Lessons

  1. Money is an asset that is generally accepted in payment for goods and services or

repayment of debts.

  1. Money has three basic uses:
  2. Means of payment
  3. Unit of account

iii. Store of value

  1. Money is liquid. Liquidity is the ease with which an asset can be turned into a

means of payment.

  1. For fi nancial institutions, market liquidity is the ease with which they can sell

a security or loan for money. Funding liquidity is the ease with which they can

borrow to acquire a security or loan.

  1. Money makes the payments system work. The payments system is the web of

arrangements that allows people to exchange goods and services. There are three

broad categories of payments, all of which use money at some stage.

  1. Cash
  2. Checks
  3. Electronic payments
  4. In the future, money will be used less and less as a means of payment.
  5. To understand the links between money and infl ation, we need to measure the quantity

of money in the economy. There are two basic measures of money: M1 and M2.

M1, the narrowest measure, includes only the most liquid assets. M2, a broader

measure, includes assets not usable as a means of payment.

  1. Countries with high money growth have high infl ation.
  2. In countries with low infl ation, money growth is a poor forecaster of infl ation.

Conceptual and Analytical Problems

  1. Describe at least three ways you could pay for your morning cup of coffee. What

are the advantages and disadvantages of each? (LO2)

  1. You are the owner of a small sandwich shop. A buyer may offer one of several payment

methods: cash, a check drawn on a bank, a credit card, or a debit card. Which of

these is the least costly for you? Explain why the others are more expensive. (LO2)

  1. Explain how money encourages specialization, and how specialization improves

everyones standard of living. (LO3)

4.* Could the dollar still function as the unit of account in a totally cashless society? (LO2)

  1. Give four examples of ACH transactions you might make. (LO2)
  2. As of July 2013, 17 of the 28 countries of the European Union have adopted the

euro. The remaining 11 countries, including Great Britain, Denmark, and Sweden,

have retained their own currencies. What are the advantages of a common

currency for someone who is traveling through Europe? (LO1)

  1. Why might each of the following commodities not serve well as money? (LO2)
  2. Tomatoes
  3. Bricks
  4. Cattle
  5. Despite the efforts of the U.S. Treasury and the Secret Service, someone discovers

a cheap way to counterfeit $100 bills. What will be the impact of this discovery

on the economy? (LO3)

  1. You receive a check drawn on another bank and deposit it into your checking

account. Even though this is a demand deposit, the funds are not immediately

available for your use. Why? Would your answer change if the check is drawn on

the account of another customer of your own bank? (LO2)

  1. Over a nine-year period in the 16th century, King Henry VIII reduced the silver

content of the British pound to one-sixth its initial value. Why do you think he did

so? What do you think happened to the use of pounds as a means of payment? If you

held both the old and new pounds, which would you use fi rst, and why? (LO1)

  1. Under what circumstances might you expect barter to reemerge in an economy

that has fi at money as a means of payment? Can you think of an example of a

country where this has happened recently? (LO3)

  1. You visit a tropical island that has only four goods in its economyoranges,

pineapples, coconuts, and bananas. There is no money in this economy. (LO1)

  1. Draw a grid showing all the prices for this economy. (You should check your

answer using the n ( n 2 1)/2 formula where n is the number of goods.)

  1. An islander suggests designating oranges as the means of payment and unit of

account for the economy. How many prices would there be if her suggestion

was followed?

  1. Do you think the change suggested in part b is worth implementing? Why or

why not?

  1. Consider again the tropical island described in Problem 12. Under what circumstances

would you recommend the issue of a paper currency by the government

of the island? What advantages might this strategy have over the use of oranges

as money? (LO1)

*Indicates more diffi cult problems

  1. What factors should you take into account when considering using the following

assets as stores of value? (LO1)

  1. Gold
  2. Real estate
  3. Stocks
  4. Government bonds

15.* Under what circumstances might money in the form of currency be the best

option as a store of value? (LO3)

  1. Suppose a signifi cant fall in the price of certain stocks caused the market makers

in those stocks to experience diffi culties with their funding liquidity. Under what

circumstances might that development lead to liquidity problems in markets for

other assets? (LO1)

17.* Consider an economy that only produces and consumes two goodsfood and

apparel. Suppose the infl ation rate based on the consumer price index is higher

during the year than that based on the GDP defl ator. Assuming underlying tastes

and preferences in the economy stay the same, what can you say about food and

apparel price movements during the year? (LO3)

  1. Assuming no interest is paid on checking accounts, what would you expect to

see happen to the relative growth rates of M1 and M2 if interest rates rose signifi

cantly? (LO3)

  1. If money growth is related to infl ation, what would you expect to happen to the

infl ation rates of countries that join a monetary union and adopt a common currency

such as the euro? (LO3)

Scan here for quick

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Data Exploration

For detailed instructions on using Federal Reserve Economic Data (FRED) online to

answer each of the following problems, visit www.mhhe.com/moneyandbanking4e and

click on Student Edition, then Data Exploration Hints.

  1. Find the most recent level of M2 (FRED code: M2SL) and of the U.S. population

(FRED code: POP). Compute the quantity of money divided by the population. Do

you think your answer is large? Why? (LO1)

  1. Reproduce Figure 2.3 from 1960 to the present, showing the percent change from

a year ago of M1 (FRED code: M1SL) and M2 (FRED code: M2SL). Comment

on the pattern over the last fi ve years. Would it matter which of the two monetary

aggregates you looked at? (LO3)

  1. Which usually grows faster: M1 or M2? Produce a graph showing M2 divided by

M1. When this ratio rises, M2 outpaces M1 and vice versa. What is the long-run

pattern? Is the pattern stable? (LO3)

  1. Travelers checks are a component of M1 and M2. Produce a graph of this component of

the monetary aggregates (FRED code: TVCKSSL). Explain the pattern you see. (LO1)

  1. Plot the annual infl ation rate based on the percent change from a year ago of the

consumer price index (FRED code: CPIAUCSL). Comment on the average and

variability of infl ation in the 1960s, the 1970s, and the most recent decade. (LO3)

 

 

chapter 3 Financial Instruments, Financial Markets, and Financial Institutions

Chapter Lessons

  1. Financial instruments are crucial to the operation of the economy.
  2. Financial arrangements can be either formal or informal. Industrial economies

are dominated by formal arrangements.

  1. A fi nancial instrument is the written legal obligation of one party to transfer

something of value, usually money, to another party at some future date, under

certain conditions.

  1. Financial instruments are used primarily as stores of value and means of trading risk.

They are less likely to be used as means of payment, although many of them can be.

  1. Financial instruments are most useful when they are simple and standardized.
  2. There are two basic classes of fi nancial instruments: underlying and derivative.
  3. Underlying instruments are used to transfer resources directly from one party

to another.

  1. Derivative instruments derive their value from the behavior of an underlying

instrument.

  1. The payments promised by a fi nancial instrument are more valuable
  2. The larger they are.
  3. The sooner they are made.

iii. The more likely they are to be made.

  1. If they are made when they are needed most.
  2. Common examples of fi nancial instruments include
  3. Those that serve primarily as stores of value, including bank loans, bonds,

mortgages, stocks, and asset-backed securities.

  1. Those that are used primarily to transfer risk, including futures and options.
  2. Financial markets are essential to the operation of our economic system.
  3. Financial markets
  4. Offer savers and borrowers liquidity so that they can buy and sell fi nancial

instruments easily.

  1. Pool and communicate information through prices.

iii. Allow for the sharing of risk.

  1. There are several ways to categorize fi nancial markets.
  2. Primary markets that issue new securities versus secondary markets, where

existing securities are bought and sold.

  1. Physically centralized exchanges, dealer-based electronic systems (over-thecounter

markets), or electronic networks.

iii. Debt and equity markets (where instruments that are used primarily for

fi nancing are traded) versus derivative markets (where instruments that are

used to transfer risk are traded).

  1. A well-functioning fi nancial market is characterized by
  2. Low transactions costs and suffi cient liquidity.
  3. Accurate and widely available information.

iii. Legal protection of investors against the arbitrary seizure of their property.

  1. Ability to enforce contracts quickly at low cost.
  2. Financial institutions perform brokerage and asset transformation functions.
  3. In their role as brokers or dealers, they provide access to fi nancial markets.
  4. In transforming assets, they provide loans and other forms of indirect fi nance.
  5. Intermediation reduces transaction and information costs.
  6. Financial institutions, also known as fi nancial intermediaries, help individuals

and fi rms to transfer and reduce risk.

Conceptual and Analytical Problems

  1. As the end of the month approaches, you realize that you probably will not be

able to pay the next months rent. Describe both an informal and a formal fi nancial

instrument that you might use to solve your dilemma. (LO1)

2.* While we often associate informal fi nancial arrangements with poorer countries

where fi nancial systems are less developed, informal arrangements often coexist

with even the most developed fi nancial systems. What advantages might there be

to engaging in informal arrangements rather than utilizing the formal fi nancial

sector? (LO1)

  1. If higher leverage is associated with greater risk, explain why the process of deleveraging

(reducing leverage) can be destabilizing. (LO2)

  1. The Chicago Mercantile Exchange has announced the introduction of a fi nancial

instrument that is based on rainfall in the state of Illinois. The standard agreement

states that for each inch of rain over and above the average rainfall for a

particular month, the seller will pay the buyer $1,000. Who could benefi t from

buying such a contract? Who could benefi t from selling it? (LO1)

  1. If you wish to buy an annuity that makes monthly payments for as long as you

live, describe what happens to the purchase price of the annuity if (1) your age

at the time of purchase goes up, (2) the size of the monthly payment rises, and

(3) your health improves. (LO1)

  1. Which of the following would be more valuable to you: a portfolio of stocks that

rises in value when your income rises or a portfolio of stocks that rises in value

when your income falls? Why? (LO1)

  1. The Wall Street Journal has a daily listing of what are called Money Rates or

interest rates on short-term securities. Locate it either in a recent issue of the

newspaper by looking at the index on page 1 of the Money and Investing section,

or in the Market Data Center of www.wsj.com . The most important money rates

are the prime rate, the federal funds rate, and the Treasury bill rate. Describe each

of these and report the current rate quoted in the paper. (LO1)

  1. Designated market makers, who historically have provided liquidity (i.e., have

stood by ready to buy and sell) in markets for specifi c stocks, have declined in

importance. Explain this decline in terms of technology and global economic

integration. (LO2)

  1. The design and function of fi nancial instruments, markets, and institutions are

tied to the importance of information. Describe the role played by information in

each of these three pieces of the fi nancial system. (LO2)

  1. Suppose you need to take out a personal loan with a bank. Explain how you

could be affected by problems in the interbank lending market such as those seen

during the 20072009 fi nancial crisis. (LO2)

11.* Advances in technology have facilitated the widespread use of credit scoring by

fi nancial institutions in making their lending decisions. Credit scoring can be

defi ned broadly as the use of historical data and statistical techniques to rank the

attractiveness of potential borrowers and guide lending decisions. In what ways

might this practice enhance the effi ciency of the fi nancial system? (LO3)

  1. Commercial banks, insurance companies, investment banks, and pension funds

are all examples of fi nancial intermediaries. For each, give an example of a

source of their funds and an example of their use of funds. (LO3)

  1. Life insurance companies tend to invest in long-term assets such as loans to manufacturing

fi rms to build factories or to real estate developers to build shopping

malls and skyscrapers. Automobile insurers tend to invest in short-term assets

such as Treasury bills. What accounts for these differences? (LO3)

  1. For each pair of instruments below, use the criteria for valuing a fi nancial instrument

to choose the one with the highest value. (LO1)

  1. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that

pays $1,000 in three months.

  1. A U.S. Treasury bill that pays $1,000 in three months or commercial paper

issued by a private corporation that pays $1,000 in three months.

  1. An insurance policy that pays out in the event of serious illness or one that pays

out when you are healthy, assuming you are equally likely to be ill or healthy.

Explain each of your choices briefl y.

  1. Joe and Mike purchase identical houses for $200,000. Joe makes a down payment

of $40,000, while Mike only puts down $10,000; for each individual, the

down payment is the total of his net worth. Assuming everything else is equal,

who is more highly leveraged? If house prices in the neighborhood immediately

fall by 10 percent (before any mortgage payments are made), what would happen

to Joes and Mikes net worth? (LO2)

16.* Everything else being equal, which would be more valuable to youa derivative

instrument whose value is derived from an underlying instrument with a very

volatile price history or one derived from an underlying instrument with a very

stable price history? Explain your choice. (LO2)

  1. You decide to start a business selling covers for smartphones in a mall kiosk. To

buy inventory, you need to borrow some funds. Why are you more likely to take

out a bank loan than to issue bonds? (LO3)

  1. Splitland is a developing economy with two distinct regions. The northern region

has great investment opportunities, but the people who live there need to

consume all of their income to survive. Those living in the south are better off

than their northern counterparts and save a signifi cant portion of their income.

The southern region, however, has few profi table investment opportunities and

so most of the savings remain in shoeboxes and under mattresses. Explain how

the development of the fi nancial sector could benefi t both regions and promote

economic growth in Splitland. (LO2)

  1. What would you expect to happen to investment and growth in the economy if

the U.S. government decided to abolish the Securities and Exchange Commission?

(LO2)

  1. Use Core Principle 3 from Chapter 1 to suggest some ways in which the problems

associated with the shadow banking sector during the 20072009 fi nancial

crisis could be mitigated in the future. (LO3)

  1. What risks might fi nancial institutions face by funding long-run loans such as

mortgages to borrowers (often at fi xed interest rates) with short-term deposits

from savers? (LO3)

22.* As the manager of a fi nancial institution, what steps could you take to reduce the

risks referred to in Problem 21? (LO3)

Data Exploration

For detailed instructions on using Federal Reserve Economic Data (FRED) online to

answer each of the following problems, visit www.mhhe.com/moneyandbanking4e and

click on Student Edition, then Data Exploration Hints.

  1. Probably the most famous stock index is the Dow Jones Industrial Average. Plot this

index (FRED code: DJIA) over the period from 1960 to the present. (LO2)

  1. Plot the percent change from a year ago of the Dow Jones Industrial Average

(FRED code: DJIA). Discuss the behavior of changes in the index before, during,

and after recession periods, which are indicated by the vertical, shaded bars in the

graph. (LO2)

  1. Do changes in stock values affect the wealth of households? Beginning in 1960, plot

on a quarterly basis the percent change from a year ago of the Dow Jones Industrial

Average (FRED code: DJIA) and the percent change from a year ago of household

net worth (FRED code: TNWBSHNO). Compare the two lines. (LO2)

  1. The Dow Jones Industrial Average is an index of the prices of only 30 stocks. Consider

a much broader measure of the stock marketthe market value of equities

(FRED code: MVEONWMVBSNNCB)which sums the price of each stock times

the number of outstanding shares. After plotting it, comment on its pattern since the

mid-1990s. (LO2)

  1. In Data Exploration Problem 3, you looked at changes in household net worth. In

Data Exploration Problem 4 you examined stock market wealth. Aside from stock

market wealth, what other assets contribute to household net worth? (LO1)

 

chapter 4 Future Value, Present Value, and Interest Rates

 

Chapter Lessons

  1. The value of a payment depends on when it is made.
  2. Future value is the present value of an initial investment times one plus the interest

rate for each year you hold it. The higher the interest rate, the higher the

future value.

  1. Present value is equal to the value today of a payment made on a future date.
  2. The higher the payment, the higher the present value at a given interest rate.
  3. The higher the interest rate, the lower the present value of a given payment.

iii. The longer the time until the payment is made, the lower the present value of

a given payment at a given interest rate.

  1. For a given increase in the interest rate, the present value of a promised payment

falls more the farther into the future the payment is to be made.

  1. When computing present value, the interest rate and the time until the payment

is to be made must be measured in the same time units.

  1. Present value can be used to value any stream of future payments.
  2. The internal rate of return is the interest rate that equates the present value of the

future payments or profi ts from an investment with its current cost.

  1. A coupon bond is a promise to make periodic interest payments and a fi nal principal

payment on specifi c future dates.

  1. The present value of a bond depends on its coupon rate, date of maturity, and

the current interest rate.

  1. The higher the coupon rate, given the maturity and the interest rate, the higher

the present value of the bond.

iii. The price of a bond is inversely related to the interest rate. The higher the

price, the lower the interest rate that equates the price with the present value

of the promised payments.

  1. The real interest rate is the nominal interest rate minus expected infl ation. It

expresses the interest rate in terms of purchasing power rather than current dollars.

Conceptual and Analytical Problems

  1. Compute the future value of $100 at an 8 percent interest rate 5, 10, and 15 years

into the future. What would the future value be over these time horizons if the

interest rate were 5 percent? (LO2)

  1. Compute the present value of a $100 investment made 6 months, 5 years, and

10 years from now at 4 percent interest. (LO2)

  1. Assuming that the current interest rate is 3 percent, compute the present value

of a fi ve-year, 5 percent coupon bond with a face value of $1,000. What happens

when the interest rate goes to 4 percent? What happens when the interest rate

goes to 2 percent? (LO2)

  1. * Given a choice of two investments, would you choose one that pays a total return

of 30 percent over fi ve years or one that pays 0.5 percent per month for fi ve

years? (LO1)

  1. A fi nancial institution offers you a one-year certifi cate of deposit with an interest

rate of 5 percent. You expect the infl ation rate to be 3 percent. What is the real

return on your deposit? (LO3)

  1. Consider two scenarios. In the fi rst, the nominal interest rate is 6 percent, and the

expected rate of infl ation is 4 percent. In the second, the nominal interest rate is

5 percent, and the expected rate of infl ation is 2 percent. In which scenario would

you rather be a lender? In which would you rather be a borrower? (LO3)

  1. You decide you would like to retire at age 65, and expect to live until you are 85

(assume there is no chance you will die younger or live longer). You fi gure that

you can live nicely on $50,000 per year. (LO3)

  1. Describe the calculation you need to make to determine how much you must

save to purchase an annuity paying $50,000 per year for the rest of your life.

Assume the interest rate is 7 percent.

  1. If you wish to keep your purchasing power constant, how would your calculation

change if you expected infl ation to average 2 percent for the rest of your life?

  1. Most businesses replace their computers every two to three years. Assume that

a computer costs $2,000 and that it fully depreciates in 3 years, at which point it

has no resale value whatsoever and is thrown away. (LO1)

  1. If the interest rate for fi nancing the equipment is equal to i, show how to compute

the minimum annual cash fl ow that a computer must generate to be worth

the purchase. Your answer will depend on i .

  1. Suppose the computer did not fully depreciate, but still had a $250 value at the

time it was replaced. Show how you would adjust the calculation given in your

answer to part a.

  1. What if fi nancing can only be had at a 10 percent interest rate? Calculate the

minimum cash fl ow the computer must generate to be worth the purchase

using your answer to part a.

  1. Some friends of yours have just had a child. Thinking ahead, and realizing

the power of compound interest, they are considering investing for their

childs college education, which will begin in 18 years. Assume that the

cost of a college education today is $125,000. Also assume that there is no

infl ation and there are no taxes on interest income that is used to pay college

tuition and expenses. (LO2)

  1. If the interest rate is 5 percent, how much money will your friends need to put

into their savings account today to have $125,000 in 18 years?

  1. What if the interest rate were 10 percent?
  2. The chance that the price of a college education will be the same 18 years

from now as it is today seems remote. Assuming that the price will rise 3 percent

per year, and that todays interest rate is 8 percent, what will your friends

investment need to be?

  1. Return to part a, the case with a 5 percent interest rate and no infl ation.

Assume that your friends dont have enough fi nancial resources to make the

entire investment at the beginning. Instead, they think they will be able to

split their investment into two equal parts, one invested immediately and the

second invested in fi ve years. Describe how you would compute the required

size of the two equal investments, made fi ve years apart.

  1. You are considering buying a new house, and have found that a $100,000,

30-year fi xed-rate mortgage is available with an interest rate of 7 percent. This

mortgage requires 360 monthly payments of approximately $651 each. If the

interest rate rises to 8 percent, what will happen to your monthly payment? Compare

the percentage change in the monthly payment with the percentage change

in the interest rate. (LO1)

  1. * Use the Fisher equation to explain in detail what a borrower is compensating a

lender for when he pays her a nominal rate of interest. (LO3)

  1. If the current interest rate increases, what would you expect to happen to bond

prices? Explain. (LO2)

  1. Which would be most affected in the event of an interest rate increasethe price

of a fi ve-year coupon bond that paid coupons only in years 3, 4, and 5 or the price

of a fi ve-year coupon bond that paid coupons only in years 1, 2, and 3, everything

else being equal? Explain. (LO2)

  1. Under what circumstances might you be willing to pay more than $1,000 for a

coupon bond that matures in three years, has a coupon rate of 10 percent and a

face value of $1,000? (LO2)

  1. * Approximately how long would it take for an investment of $100 to reach $800 if

you earned 5 percent? What if the interest rate were 10 percent? How long would

it take an investment of $200 to reach $800 at an interest rate of 5 percent? Why

is there a difference between doubling the interest rate and doubling the initial

investment? (LO1)

  1. Rather than spending $100 on paint today, you decide to save the money

until next year, at which point you will use it to paint your room. If a can of

paint costs $10 today, how many cans will you be able to buy next year if the

nominal interest rate is 21 percent and the expected infl ation rate is 10 percent?

(LO3)

  1. The real interest rate is the nominal interest rate minus expected infl ation. It

expresses the interest rate in terms of purchasing power rather than current dollars.

Conceptual and Analytical Problems

  1. Compute the future value of $100 at an 8 percent interest rate 5, 10, and 15 years

into the future. What would the future value be over these time horizons if the

interest rate were 5 percent? (LO2)

  1. Compute the present value of a $100 investment made 6 months, 5 years, and

10 years from now at 4 percent interest. (LO2)

  1. Assuming that the current interest rate is 3 percent, compute the present value

of a fi ve-year, 5 percent coupon bond with a face value of $1,000. What happens

when the interest rate goes to 4 percent? What happens when the interest rate

goes to 2 percent? (LO2)

  1. * Given a choice of two investments, would you choose one that pays a total return

of 30 percent over fi ve years or one that pays 0.5 percent per month for fi ve

years? (LO1)

  1. A fi nancial institution offers you a one-year certifi cate of deposit with an interest

rate of 5 percent. You expect the infl ation rate to be 3 percent. What is the real

return on your deposit? (LO3)

  1. Consider two scenarios. In the fi rst, the nominal interest rate is 6 percent, and the

expected rate of infl ation is 4 percent. In the second, the nominal interest rate is

5 percent, and the expected rate of infl ation is 2 percent. In which scenario would

you rather be a lender? In which would you rather be a borrower? (LO3)

  1. You decide you would like to retire at age 65, and expect to live until you are 85

(assume there is no chance you will die younger or live longer). You fi gure that

you can live nicely on $50,000 per year. (LO3)

  1. Describe the calculation you need to make to determine how much you must

save to purchase an annuity paying $50,000 per year for the rest of your life.

Assume the interest rate is 7 percent.

  1. If you wish to keep your purchasing power constant, how would your calculation

change if you expected infl ation to average 2 percent for the rest of your life?

  1. Most businesses replace their computers every two to three years. Assume that

a computer costs $2,000 and that it fully depreciates in 3 years, at which point it

has no resale value whatsoever and is thrown away. (LO1)

  1. If the interest rate for fi nancing the equipment is equal to i, show how to compute

the minimum annual cash fl ow that a computer must generate to be worth

the purchase. Your answer will depend on i .

  1. Suppose the computer did not fully depreciate, but still had a $250 value at the

time it was replaced. Show how you would adjust the calculation given in your

answer to part a.

  1. What if fi nancing can only be had at a 10 percent interest rate? Calculate the

minimum cash fl ow the computer must generate to be worth the purchase

using your answer to part a.

  1. Some friends of yours have just had a child. Thinking ahead, and realizing

the power of compound interest, they are considering investing for their

childs college education, which will begin in 18 years. Assume that the

cost of a college education today is $125,000. Also assume that there is no

infl ation and there are no taxes on interest income that is used to pay college

tuition and expenses. (LO2)

  1. If the interest rate is 5 percent, how much money will your friends need to put

into their savings account today to have $125,000 in 18 years?

  1. What if the interest rate were 10 percent?
  2. The chance that the price of a college education will be the same 18 years

from now as it is today seems remote. Assuming that the price will rise 3 percent

per year, and that todays interest rate is 8 percent, what will your friends

investment need to be?

  1. Return to part a, the case with a 5 percent interest rate and no infl ation.

Assume that your friends dont have enough fi nancial resources to make the

entire investment at the beginning. Instead, they think they will be able to

split their investment into two equal parts, one invested immediately and the

second invested in fi ve years. Describe how you would compute the required

size of the two equal investments, made fi ve years apart.

  1. You are considering buying a new house, and have found that a $100,000,

30-year fi xed-rate mortgage is available with an interest rate of 7 percent. This

mortgage requires 360 monthly payments of approximately $651 each. If the

interest rate rises to 8 percent, what will happen to your monthly payment? Compare

the percentage change in the monthly payment with the percentage change

in the interest rate. (LO1)

  1. * Use the Fisher equation to explain in detail what a borrower is compensating a

lender for when he pays her a nominal rate of interest. (LO3)

  1. If the current interest rate increases, what would you expect to happen to bond

prices? Explain. (LO2)

  1. Which would be most affected in the event of an interest rate increasethe price

of a fi ve-year coupon bond that paid coupons only in years 3, 4, and 5 or the price

of a fi ve-year coupon bond that paid coupons only in years 1, 2, and 3, everything

else being equal? Explain. (LO2)

  1. Under what circumstances might you be willing to pay more than $1,000 for a

coupon bond that matures in three years, has a coupon rate of 10 percent and a

face value of $1,000? (LO2)

  1. * Approximately how long would it take for an investment of $100 to reach $800 if

you earned 5 percent? What if the interest rate were 10 percent? How long would

it take an investment of $200 to reach $800 at an interest rate of 5 percent? Why

is there a difference between doubling the interest rate and doubling the initial

investment? (LO1)

  1. Rather than spending $100 on paint today, you decide to save the money

until next year, at which point you will use it to paint your room. If a can of

paint costs $10 today, how many cans will you be able to buy next year if the

nominal interest rate is 21 percent and the expected infl ation rate is 10 percent?

(LO3)

  1. Recently, some lucky person won the lottery. The lottery winnings were reported

to be $85.5 million. In reality, the winner got a choice of $2.85 million per year

for 30 years or $46 million today. (LO2)

  1. Explain briefl y why winning $2.85 million per year for 30 years is not equivalent

to winning $85.5 million.

  1. The evening news interviewed a group of people the day after the winner was

announced. When asked, most of them responded that, if they were the lucky

winner, they would take the $46 million up-front payment. Suppose (just for

a moment) that you were that lucky winner. How would you decide between

the annual installments or the up-front payment?

  1. You are considering going to graduate school for a one-year masters program.

You have done some research and believe that the masters degree will add $5,000

per year to your salary for the next 10 years of your working life, starting at the

end of this year. From then on, after the next 10 years, it makes no difference.

Completing the masters program will cost you $35,000, which you would have

to borrow at an interest rate of 6 percent. How would you decide if this investment

in your education were profi table? (LO2)

  1. Assuming the chances of being paid back are the same, would a nominal interest

rate of 10 percent always be more attractive to a lender than a nominal rate of

5 percent? Explain. (LO3)

20.* Your fi rm has the opportunity to buy a perpetual motion machine to use in your

business. The machine costs $1,000,000 and will increase your profi ts by $75,000

per year. What is the internal rate of return? (LO2)

  1. * Suppose two parties agree that the expected infl ation rate for the next year is 3

percent. Based on this, they enter into a loan agreement where the nominal interest

rate to be charged is 7 percent. If the infl ation rate for the year turns out to be

2 percent, who gains and who loses? (LO3)

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Data Exploration

For detailed instructions on using Federal Reserve Economic Data (FRED) online to

answer each of the following problems, visit www.mhhe.com/moneyandbanking4e and

click on Student Edition, then Data Exploration Hints.

  1. How does infl ation affect nominal interest rates? (LO3)
  2. Plot the three-month U.S. Treasury bill rate (FRED code: TB3MS) from 1960 to

the present. What long-run pattern do you observe? What may have caused this

pattern?

  1. Plot the infl ation rate based on the percent change from a year ago of the U.S.

consumer price index (FRED code: CPIAUCSL) from 1960 to the present. How

does U.S. infl ation history refl ect your explanation in part (a)?

  1. In Data Exploration Problem 1, you saw the impact of U.S. infl ation on short-term

U.S. Treasury bill rates. Now examine similar data for Brazil. (LO3)

  1. Plot the Brazilian Treasury bill rate (FRED code: INTGSTBRM193N). Notice

the range of values and compare them with the range in the U.S. Treasury bill

plot from Data Exploration Problem 1.

  1. Plot the infl ation rate based on the percent change from a year ago of the Brazilian

consumer price index (FRED code: BRACPIALLMINMEI). Comment on the

infl ation rate in Brazil. Download the data to a spreadsheet. (You may need to

widen the spreadsheet column to see the data.) What happens to the index in the

19901994 period?

  1. The expected real interest rate is the rate that people use in making decisions about

the future. It is the difference between the nominal interest rate and the expected

infl ation rate, not the actual infl ation rate. How does expected infl ation over the

coming year compare with actual infl ation over the past year? Plot the infl ation rate

since 1978 based on the percent change from a year ago of the U.S. consumer price

index (FRED code: CPIAUCSL). Add to this fi gure as a second line the expected

infl ation rate from the University of Michigan survey (FRED code: MICH). Is expected

infl ation always in line with actual infl ation? Which is more stable? (LO3)

  1. Plot the ex ante or expected real interest rate since 1978 by subtracting the Michigan

survey infl ation measure (FRED code: MICH) from the three-month Treasury bill

rate (FRED code: TB3MS). Plot as a second line the ex post or realized real interest

rate by subtracting from the three-month Treasury bill rate (FRED code: TB3MS)

the actual infl ation rate based on the percent change from a year ago of the consumer

price index (FRED code: CPIAUCSL). What does it mean when these two

measures are different? (LO3)

 

 

chapter 5 Understanding Risk

 

Chapter Lessons

  1. Risk is a measure of uncertainty about the possible future payoffs of an investment.

It is measured over some time horizon, relative to a benchmark.

  1. Measuring risk is crucial to understanding the fi nancial system.
  2. To study random future events, start by listing all the possibilities and assign a

probability to each. Be sure the probabilities add to one.

  1. The expected value is the probability-weighted sum of all possible future

outcomes.

  1. A risk-free asset is an investment whose future value, or payoff, is known with

certainty.

  1. Risk increases when the spread (or range) of possible outcomes widens but the

expected value stays the same.

  1. One measure of risk is the standard deviation of the possible payoffs.
  2. A second measure of risk is value at risk, the worst possible loss over a specifi c

time horizon, at a given probability.

  1. A risk-averse investor
  2. Always prefers a certain return to an uncertain one with the same expected

return.

  1. Requires compensation in the form of a risk premium in order to take risk.
  2. Trades off between risk and expected return: the higher the risk, the higher

the expected return risk-averse investors will require for holding an investment.

  1. Risk can be divided into idiosyncratic risk, which is specifi c to a particular business

or circumstance, and systematic risk, which is common to everyone.

  1. There are two types of diversifi cation:
  2. Hedging, in which investors reduce idiosyncratic risk by making investments

with offsetting payoff patterns.

  1. Spreading, in which investors reduce idiosyncratic risk by making investments

with payoff patterns that are not perfectly correlated.

and Analytical Problems

  1. Consider a game in which a coin will be fl ipped three times. For each heads you

will be paid $100. Assume that the coin comes up heads with probability 2/3. (LO1)

  1. Construct a table of the possibilities and probabilities in this game.
  2. Compute the expected value of the game.
  3. How much would you be willing to pay to play this game?
  4. Consider the effect of a change in the game so that if tails comes up two times

in a row, you get nothing. How would your answers to parts ac change?

  1. * Why is it important to be able to quantify risk? (LO2)
  2. You are the founder of IGRO, an Internet fi rm that delivers groceries. (LO4)
  3. Give an example of an idiosyncratic risk and a systematic risk your company

faces.

  1. As founder of the company, you own a signifi cant portion of the fi rm, and

your personal wealth is highly concentrated in IGRO shares. What are the

risks that you face, and how should you try to reduce them?

  1. Assume that the economy can experience high growth, normal growth, or recession.

Under these conditions you expect the following stock market returns for

the coming year: (LO1)

  1. Compute the expected value of a $1,000 investment over the coming year. If

you invest $1,000 today, how much money do you expect to have next year?

What is the percentage expected rate of return?

  1. Compute the standard deviation of the percentage return over the coming year.
  2. If the risk-free return is 7 percent, what is the risk premium for a stock market

investment?

  1. Using the information from the table in Problem 4, calculate in dollar terms the

value at risk associated with the $1,000 investment. (LO2)

  1. Car insurance companies sell a large number of policies. Explain how this practice

minimizes their risk. (LO4)

  1. Mortgages increase the risk faced by homeowners. (LO2)
  2. Explain how.
  3. What happens to the homeowners risk as the down payment on the house

rises from 10 percent to 50 percent?

  1. Banks pay substantial amounts to monitor the risks that they take. One of the primary

concerns of a banks risk managers is to compute the value at risk. Why

is value at risk so important for a bank (or any fi nancial institution)? (LO2)

  1. Explain how liquidity problems can be an important source of systemic risk in

the fi nancial system. (LO3)

  1. * Give an example of systematic risk for the U.S. economy and how you might

reduce your exposure to such a risk. (LO3)

  1. For each of the following events, explain whether it represents systematic risk or

idiosyncratic risk and why. (LO3)

  1. Your favorite restaurant is closed by the county health department.
  2. The government of Spain defaults on its bonds, causing the breakup of the

euro area.

  1. Freezing weather in Florida destroys the orange crop.
  2. Solar fl ares destroy earth-orbiting communications satellites, knocking out

cell phone service worldwide.

  1. You are planning for retirement and must decide whether to purchase only your

employers stock for your 401(k) or, instead, to buy a mutual fund that holds shares

in the 500 largest companies in the world. From the perspective of both idiosyncratic

and systematic risk, explain how you would make your decision. (LO3)

  1. For each of the following actions, identify whether the method of risk assessment

motivating your action is due to the value at risk or the standard deviation

of an underlying probability distribution. (LO2)

  1. You buy life insurance.
  2. You hire an investment advisor who specializes in international diversifi cation

in stock portfolios.

  1. In your role as a central banker, you provide emergency loans to illiquid

intermediaries.

  1. You open a kiosk at the mall selling ice cream and hot chocolate.
  2. Which of the investments in the following table would be most attractive to a

risk-averse investor? How would your answer differ if the investor was described

as risk-neutral? (LO1)

  1. Consider an investment that pays off $800 or $1,400 per $1,000 invested with

equal probability. Suppose you have $1,000 but are willing to borrow to increase

your expected return. What would happen to the expected value and standard

deviation of the investment if you borrowed an additional $1,000 and invested a

total of $2,000? What if you borrowed $2,000 to invest a total of $3,000? (LO1)

  1. Looking again at the investment described in Problem 15, what is the maximum

leverage ratio you could have and still have enough to repay the loan in the event

the bad outcome occurred? (LO1)

  1. Consider two possible investments whose payoffs are completely independent

of one another. Both investments have the same expected value and standard

deviation. If you have $1,000 to invest, could you benefi t from dividing your

funds between these investments? Explain your answer. (LO4)

  1. * For the situation in Problem 17, suppose that there were 10 independent investments

available rather than just two. Would it matter if you spread your $1,000

across these 10 investments rather than two? (LO4)

  1. You are considering three investments, each with the same expected value and

each with two possible payoffs. The investments are sold only in increments of

$500. You have $1,000 to invest so you have the option of either splitting your

money equally between two of the investments or placing all $1,000 in one of

the investments. If the payoffs from investment A are independent of the payoffs

from investments B and C and the payoffs from B and C are perfectly negatively

correlated with each other (meaning when B pays off, C doesnt and vice versa),

which investment strategy will minimize your risk? (LO4)

  1. In which of the following cases would you be more likely to decide whether to

take on the risk involved by looking at a measure of the value at risk? (LO2)

  1. You are unemployed and are considering investing your life savings of $10,000

to start up a new business.

  1. You have a full-time job paying $100,000 a year and are considering making

a $1,000 investment in the stock of a well-established, stable company.

Explain your reasoning.

  1. You have the option to invest in either Country A or Country B but not both. You

carry out some research and conclude that the two countries are similar in every

way except that the returns on assets of different classes tend to move together

much more in Country Athat is, they are more highly correlated in Country A

than in Country B. Which country would you choose to invest in and why? (LO4)

Data Exploration

For detailed instructions on using Federal Reserve Economic Data (FRED) online to

answer each of the following problems, visit www.mhhe.com/moneyandbanking4e and

click on Student Edition, then Data Exploration Hints.

  1. Plot the percent change from a year ago of the S&P 500 stock index (FRED code:

SP500). Visually, has the risk of the S&P 500 index changed over time? (LO2)

  1. Another way to understand stock market risk is to examine how investors expect

risk to evolve in the near future. The DJIA volatility index (FRED code: VXDCLS)

is one such measure. Plot the level of this volatility index since October 1997 and,

as a second line, the percent change from a year ago of the S&P 500 index (FRED

code: SP500). Compare their patterns. (LO2)

  1. For the period since 1986, plot on one graph the 30-year conventional mortgage rate

(FRED code: MORTG) and the one-year adjustable mortgage rate (FRED code:

MORTGAGE1US). Explain their systematic relationship using Core Principle 2.

(LO2)

  1. Plot the difference since 1979 between the Moodys Baa bond index (FRED code:

BAA) and the U.S. Treasury 10-year bond yield (FRED code: GS10). Comment on

the trend and variability of this credit risk premium (see Chapter 7) before and

after the 20072009 fi nancial crisis. (LO1)

 

chapter 6 Bonds, Bond Prices, and the Determination of Interest Rates

 

Chapter Lessons

  1. Valuing bonds is an application of present value.
  2. Pure discount or zero-coupon bonds promise to make a single payment on

a predetermined future date.

  1. Fixed-payment loans promise to make a fi xed number of equal payments at

regular intervals.

  1. Coupon bonds promise to make periodic interest payments and repay the

principal at maturity.

  1. Consols (perpetuities) promise to make periodic coupon payments forever.
  2. Yields are measures of the return on holding a bond.
  3. The yield to maturity is a measure of the interest rate on a bond. To compute it,

set the price of the bond equal to the present value of the payments.

  1. The current yield on a bond is equal to the coupon rate divided by the price.
  2. When the price of a bond is above its face value, the coupon rate is greater than

the current yield, which is higher than the yield to maturity.

  1. One-year holding period returns are equal to the sum of the current yield and any

capital gain or loss arising from a change in a bonds price.

  1. Bond prices (and bond yields) are determined by supply and demand in the bond market.
  2. The higher the price, the larger the quantity of bonds supplied.
  3. The higher the price, the smaller the quantity of bonds demanded.
  4. The supply of bonds rises when
  5. Governments need to borrow more.
  6. General business conditions improve.

iii. Expected infl ation rises.

  1. The demand for bonds rises when
  2. Wealth increases.
  3. Expected infl ation falls.

iii. The expected return, relative to other investments, rises.

  1. The expected future interest rate falls.
  2. Bonds become less risky relative to other investments.
  3. Bonds become more liquid relative to other investments.
  4. Bonds are risky because of
  5. Default risk: the risk that the issuer m

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