Financial Markets and Institutions

Q.(a) How does a money market mutual fund differ from a stock or bond market mutual fund?

Money Market Funds 

The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won’t get great returns, but you won’t have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD).

Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms “fixed-income,” “bond,” and “income” are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees.

Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren’t without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down.

Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below.

The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.

For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth).

1. 1. (b)

Explain why the existence of imperfect markets creates a need for financial institutions.
Current theories of the economic role of financial intermediaries build on the economics of imperfect information that began to emerge during the 1970s with the seminal contributions of Akerlof (1970), Spence (1973) and Rothschild and Stiglitz (1976). Financial intermediaries exist because they can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders. Financial intermediaries thus assist the efficient functioning of markets, and any factors that affect the amount of credit channeled through financial intermediaries can have significant macroeconomic effects.

There are two strands in the literature that formally explain the existence of financial intermediaries. The first strand emphasizes financial intermediaries’ provision of liquidity. The second strand focuses on financial intermediaries’ ability to transform the risk characteristics of assets. In both cases, financial intermediation can reduce the cost of channeling funds between borrowers and lenders, leading to a more efficient allocation of resources.

Diamond and Dybvig (1983) analyses the provision of liquidity (the transformation of illiquid assets into liquid liabilities) by banks. In Diamond and Dybvig’s model, ex ante identical investors (depositors) are risk averse and uncertain about the timing of their future consumption needs. Without an intermediary, all investors are locked into illiquid long-term investments that yield high payoffs only to those who consume late. Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments. Banks can improve on a competitive market by providing better risk sharing among agents who need to consume at different (random) times. An intermediary promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case enhances risk sharing and welfare.

Q.2.(a)

Explain what is meant by interest elasticity. What is the difference between the nominal interest rate and the real interest rate?

Interest elasticity: Characterizing a financial product, investment, or portfolio as being sensitive to changes in interest rates.

Nominal Interest Rate 
The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. The nominal interest rate is in essence the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.

Real Interest Rate
The real interest rate is slightly more complex than the nominal rate but still fairly simple. The nominal interest rate doesn’t tell the whole story, because inflation reduces the lender’s or investor’s purchasing power so that they cannot buy the same amount of goods or services at payoff or maturity with a given amount of money as they can now. The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%. The real rate of interest could be said to be the actual mathematical rate at which investors and lenders are increasing their purchasing power with their bonds and loans. It is actually possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be summed up in this equation:

Nominal interest rate – Inflation = Real interest rate

Q.2.(b). 

What is the logic behind the Fisher effects implied positive relationship between expected inflation and nominal interest rates?

An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.

Q.3.(a).

Suppose that Treasury bills are currently paying 9% and the expected inflation is 3%. What is the real interest rate?

Solution:

We know,

Real interest rate         = Nominal interest rate – Inflation 

=  9% – 3%

= 6%

Q.3.(b).

Assume, you paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield? What is the T-bill discount?

Solution:

T-bill discount = (Par – PP / PP) (360 / n)

T-bill discount = (100,000 – 98,000 / 100,000) (360 / 120)

T-bill discount = 0.06 = 6.00%

Formula 2.10
R_BD = D/F * 360/t

Where: D = dollar discount from face value, F = face value,
T = days until maturity, 360 = days in a year

 

 

Q.4.(a)

Why do rating agencies assign ratings to commercial paper?
Credit ratings are opinions about credit risk published by a rating agency. They express opinions about the ability and willingness of an issuer, such as a corporation, state or city government, to meet its financial obligations in accordance with the terms of those obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it may default. Ratings should not be viewed as assurances of credit quality or exact measures of the likelihood of default. Rather, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue.

Q.4.(b).

What types of financial institutions issue commercial paper?

Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by finance companies, banks, and corporations with excellent credit.

Welcome

Our Goal to achieve 

Universal access to education is the ability of all people to have equal opportunity in education, regardless of their social class, gender, ethnicity background or physical and mental disabilities. The term is used both in college admission for the middle and lower classes, and in assistive technology for the disabled. Some critics find this idea an example of “political correctness“. In order to facilitate the access of education to all, certain countries have right to education.

Universal access to education encourages a variety of pedagogical approaches to accomplish the dissemination of knowledge across the diversity of social, political, cultural, economic, national and biological backgrounds. Initially developed with the theme of equal opportunity access and inclusion of students with learning or physical and mental disabilities, the themes governing universal access to education have now expanded across all forms of ability and diversity. However, as the definition of diversity is within itself is a broad amalgamation, teachers exercising universal access will continually face challenges and incorporate adjustments in their lesson plan to foster themes of equal opportunity of education.

As universal access continues to be incorporated into the U.S. education system, professors and instructors at the college level are required (in some instances by law) to rethink methods of facilitating universal access in their classrooms. Universal access to college education may involve the provision of a variety of different assessment methods of learning and retention. For example, in order to determine how much of the material was learned, a professor may enlist multiple methods of assessment. Methods of assessment may include a comprehensive exam, unit exams, portfolios, research papers, literature reviews, an oral exam or homework assignments. Providing a variety of ways to assess the extent of learning and retention will not only identify the gaps in universal access but may also elucidate the ways to improve universal access.