HW Assignments will be uploaded to Kean Blackboard and must be accessed from there. You must work in groups where assigned (or independently if not assigned to groups) on homework assignments. Points are noted against each question. You are required to submit Home Work assignments electronically on Kean Blackboard using MS-Office or other text editor. You are required to complete your assignments as per the due date indicated by the Professor.
Total Points in Assignment: 100
(Points scored will be scaled down to a maximum of 10 towards the final grade)
1. Utilizing Financial Markets (5 points)
As a financial manager of a large firm, you plan to borrow $70 million over the next year.
c. What are the more likely alternatives for you to borrow $70 million?
b. Assuming that you decide to issue debt securities, describe the types of financial institutions that may purchase these securities.
c. How do individuals indirectly provide the financing for your firm when they maintain deposits at depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?
2. Flow of Funds (5 points)
Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and ten other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.
Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.
a. In what way is Carson a surplus unit?
b. In what way is Carson a deficit unit?
c. How might Carson use the primary market to facilitate its expansion?
d. How might it use the secondary market?
3. Regulation of Financial Institutions (5 points)
Financial institutions are subject to regulations to ensure that they do not take excessive risk and they can safely facilitate the flow of funds through financial markets. Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to facilitate their financial transactions. Why do you think the existing regulations were ineffective at ensuring a safe financial system?
4. Federal Budget Deficit and Interest Rates (5 points)
a. How does a large federal deficit impact demand for loanable funds?
b. What has been the recent trend in the US federal budget deficit during the period 2007-2011? (Feel free to research data from available public sources including the internet; a good source of historical budget data is available from the White House web site – www.whitehouse.gov)
c. Given the trend in the budget deficit, would you have expected interest rates to go up, down or stay the same in the period 2007-2011?
d. What actually happened to interest rates during the period 2007-2011? If applicable, explain why actual level of interest rates differed from your expectation.
5. Impact of Stock Market Crises (5 points).
During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.
6. Managing in Financial Markets (5 points).
As the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. You plan to borrow funds and may use the forecast of interest rates to determine whether you should obtain a loan with a fixed interest rate or a floating interest rate. The following information can be considered when assessing the future direction of interest rates:
• Economic growth has been high over the last two years, but you expect that it will be stagnant over the next year.
• Inflation has been 3 percent over each of the last few years, and you expect that it will be about the same over the next year.
• The federal government has announced major cuts in its spending, which should have a major impact on the budget deficit.
• The Federal Reserve is not expected to affect the existing supply of loanable funds over the next year.
• The overall level of savings by households is not expected to change.
a. Given the preceding information, assess how the demand for and the supply of loanable funds would be affected (if at all), and predict the future direction of interest rates.
b. You can obtain a one-year loan at a fixed-rate of 8 percent or a floating-rate loan that is currently at 8 percent but would be revised every month in accordance with general interest rate movements. Which type of loan is more appropriate based on the information provided?
c. Suppose that Treasury bills are currently paying 6 percent and the expected inflation is 2.5 percent. What is the real interest rate?
7. Yield Curve (3 points)
If liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market’s perception of future interest rates?
8. Managing in Financial Markets (5 points)
As an analyst at a bond rating agency, you have been asked to interpret the implications of the recent shift in the yield curve. Six months ago, the yield curve exhibited a slight downward slope. Over the last six months, the long-term yields declined, while short-term yields remained the same. Analysts stated that the shift was due to revised expectations of interest rates.
a. Given the shift in the yield curve, does it appear that firms increased or decreased their demand for long-term funds over the last six months?
b. Interpret what the shift in the yield curve suggests about the market’s changing expectations of future interest rates.
c. Recently, an analyst argued that the underlying reason for the yield curve shift was that many of the large U.S. firms anticipate a recession. Explain why an anticipated recession could force the yield curve to shift as it has.
d. What could the specific shift in the yield curve signal about the ratings of existing corporate bonds? What types of corporations would be most likely to experience a change in their bond ratings as a result of the specific shift in the yield curve?
9. Forward Rate (5 points)
Using the most recent issue of the Wall Street Journal (or accessing wsj.com website), review the yield curve to determine the approximate yields for the following maturities:
TERM TO MATURITY ANNUALIZED YIELD
Assuming that the above yields are due solely to interest rate expectations, determine the one year forward rate as of one year from now and the one year forward rate as of 2 years from now.
10. After-tax Yield (5points)
You need to choose between investing in a one-year municipal bond with a 8 percent yield and a one-year corporate bond with an 11 percent yield. If your marginal federal income tax rate is 30 percent and no other differences exist between these two securities, which one would you invest in?
11. Deriving Current Interest Rates. (5 points)
Assume that interest rates for one-year securities are expected to be 2 percent today, 4 percent one year from now and 6 percent two years from now. Using only the pure expectations theory, what are the current interest rates on two-year and three-year securities?
12. Commercial Paper Yield (5 points)
a. A corporation is planning to sell its 90-day commercial paper to investors offering an 8.4 percent yield. If the three-month T-bill’s annualized rate is 7 percent, the default risk premium is estimated to be 0.6 percent and there is a 0.4 percent tax adjustment, what is the appropriate liquidity premium?
b. If due to unexpected changes in the economy the default risk premium increases to 0.8 percent, what is the appropriate yield to be offered on the commercial paper (assuming no other changes occur)?
13. Reserve Requirements (3 points)
How is money supply growth affected by an increase in the reserve requirement ratio?
14. Monitoring the Fed (5 points)
Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Expecting a strong U.S. economy, Carson plans to grow by expanding its business and by making acquisitions. The company expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The Carson Company is also considering the issuance of stock to raise funds in the next year.
Given its large exposure to interest rates charged on its debt, Carson closely monitors Fed actions. It subscribes to a special service that attempts to monitor the Fed’s actions in the Treasury security markets. It recently received an alert from the service that suggested the Fed has been selling large holdings of its Treasury securities in the secondary Treasury securities market.
a. How should Carson interpret the actions by the Fed? That is, will these actions place upward or downward pressure on the price of Treasury securities? Explain.
b. Will these actions place upward or downward pressure on Treasury yields? Explain.
c. Will these actions place upward or downward pressure on interest rates? Explain.
15. The Fed’s Impact on Home Purchases (3 points).
Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for home by consumers?
16. Eurozone Monetary Policy (4 points).
Explain why participating in the euro causes a country to give up its independent monetary policy and control over its domestic interest rates.
17. Choice of Monetary Policy (5 points).
When does the Fed use a loose-money policy and when does it use a tight-money policy? What is a criticism of a loose-money policy? What is the risk of using a monetary policy that is too tight?
18. Interpreting the Fed’s Monetary Policy (5 points).
When the Fed increases money supply to lower the federal funds rate, do you think this will the cost of capital of U.S. companies be reduced? Explain how the segmented markets theory regarding the term structure of interest rates could influence the degree to which the Fed’s monetary policy affects long-term interest rates.
19. Anticipating Fed Actions (5 points)
Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The company also considers issuing stock to raise funds in the next year.
An economic report recently highlighted the strong growth in the economy, which has led to nearly full employment. In addition, the report estimated that the annualized inflation rate increased to 5 percent, up from 2 percent last month. The factors that caused the higher inflation (shortages of products and shortages of labor) are expected to continue.
a. How will the Fed’s monetary policy change based on the report?
b. How will the likely change in the Fed’s monetary policy affect Carson’s future performance? Could it affect Carson’s plans for future expansion?
c. Explain how a tight monetary policy could affect the amount of funds borrowed at financial institutions by deficit units such as Carson Company. How might it affect the credit risk of these deficit units? How might it affect the performance of financial institutions that provide credit to such deficit units as Carson Company?
20. FOMC meeting (10 points)
Review the latest FOMC meeting minutes released from the latest FOMC meeting held in from the Federal Reserve website: http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
What was the main outcome of the FOMC meeting with respect to:
(a) Fed’s view of the economy and its outlook going forward – relate this to the economic growth indicators and inflation indicators that you studied in class
(b) Recommended policy actions, if any; and
(c) Its rationale for the policy actions.
Feel free to research available public information and news sources and provide citations in supporting your conclusion.