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Financial Markets and Institutions, 7th Edition Solution Manual

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    Part I Introduction

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    Chapter 1 Why Study Financial Markets and Institutions? Why Study Financial Markets? Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions? Structure of the Financial Sy stem Financial Crises Central Banks and the Conduct of Monetary Policy The International Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks ◼ Overview and Teaching Tips Before embarking on a study of financial markets and institutions, the student must be convinced t hat this subject is worth studying. Chapter 1 pursues this goal by showing the student that financial markets and institutions is an exciting field because it focuses on phenomena that affect everyday life. An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides the students with a guide as to how they will be studying financial markets and institutions with a unifying, analytic framework and an applied managerial perspective. In teaching this chapter, the most important goal should be to get the student excited about the material. I have found that talking about the data presented in the figures helps achieve this goal by showing the students that the subject matter of financial markets and institutions has real - world implications that they should care about. In addition, it is important to emphasize to the students that the course will have an applied managerial perspective, which they will find useful latter in their careers. Going through the web exercise is also a way of encouraging the students to use the web to further their understanding of financial markets and institutions.

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    Chapter 1 Why Study Financial Markets and Institutions? 3 ◼ Answers to End - of - Chapter Questions 1. Because they channel fu nds from those who do not have a productive use for them to those who do, thereby resulting in higher economic efficiency. 2. Businesses would cut investment spending because the cost of financing this spending is now higher, and consumers would be less likely to purchase a house or a car because the cost of financing their purchase is higher. 3. A change in interest rates affects the cost of acquiring funds for financial institution as well as changes the income on assets such as loans, both of which affect profits. In addition, changes in interest rates affect the price of assets such as stock and bonds that the financial institution owns which can lead to profits or losses. 4. No. People who borrow to purchase a house or a car are worse off because it costs them more to finance their purchase; however, savers benefit because they can earn higher interest rates on their savings. 5. The lower price for a firm’s shares means that it can raise a smaller amount of funds, and so investment in plant and equipment will fall. 6. Higher stock prices mean that consumers’ wealth is higher and so they will be more likely to increase their spending. 7. It makes foreign goods more expensive and so British consumers will buy less foreign goods and more domestic goods. 8. It makes British goods more expensive relative to American goods. American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise. 9. Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets. Also changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions. 10. In the mid to late 1970s and the late 1980s and early 1990s, the value of the dollar was low, making travel abroad relatively more expensive; that would have been a good time to vacation in the United States and see the Grand Canyon. As the dollar’s value rose in the early 1980s, travel abroad became relatively cheaper, making it a good time to visit the Tower of London. 11. Banks accept deposits and then use the resulting funds to make loans. 12. Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies. 13. Answers will vary. 14. The profitability of financial institutions is affected by changes in interest rates, stock prices, and foreign exchange rates; fluctuations in these variables expose t hese institutions to risk. 15. Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which have an important impact on the profitability of financial institutions.

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    4 Mishkin/Eakins • Financial Markets and Institutions, Seventh Edition ◼ Quantitative Problems 1. The following table lists foreign exchange rates between U.S. dollars and British pounds during April: Date U.S. Dollars per GBP Date U.S. Dollars per GBP 4/1 1.9564 4/18 1.7504 4/4 1.9293 4/19 1.7255 4/5 1.914 4/20 1.6914 4/6 1.9374 4/21 1.672 4/7 1.961 4/22 1.6684 4/8 1.8925 4/25 1.6674 4/11 1.8822 4/26 1.6857 4/12 1.8558 4/27 1.6925 4/13 1.796 4/28 1.7201 4/14 1.7902 4/29 1.7512 4/15 1.7785 Which day would have been the best day to convert $200 into British pounds? Which day would have been the worst day? What wou ld be the difference in pounds? Solution: The best day is 4/25. At a rate of $1.6674/pound, you would have £119.95. The worst day is 4/7. At $1.961/pound, you would have £101.99, or a difference of £17.96.

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    Chapter 2 Overview of the Financial System Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over - the - Counter Markets Money and Capital Markets I nternationalization of F inancial Markets International Bond Market, Eurobonds, and Eurocurrencies Global Box: Are U.S. Capital Markets Losing Their Edge? World Stock Markets Function of Financial Intermediaries: Indirect Finance Transaction Costs Following the Financial Ne ws : Foreign Stock Market Indexes Global Box: The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Types of Financial Intermediari es Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroa d ◼ Overview and Teaching Tips Chapter 2 is an introductory chapter that contains the background information on the structure and operation of financial markets that is needed in later chapters of the book. This chapter allows the instructor to branch out to various choices of later chapters, thus allowing different degrees of coverage of financial markets and institutions.

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    6 Mishkin/Eakins • Financial Markets and Institutions, Seventh Edition The most important point to transmit to the student is that financial markets and financial intermediaries are crucial to a well - functioning economy because they channel funds from those who do not have a productive use for them to those who do. Some instructors will want to teach this chapter in detail, and those who focus on international issues will want to spend some time on the section “Internationalization of Financial Markets.” However, those who slant their course to public policy issues may want to give this chapter a more cursory treatment. No matter how much class time is devoted to this chapter, I have found that it is a good reference chapter for students. You might want to tell them that if in later chapters they do not recall what particular financial intermediaries do and who regulates them, they can refer back to this chapter, especially to tables, such as Tables 1 and 3. ◼ Answers to End - of - Chapter Questions 1. The share of Microsoft stock is an asset for its owner because it entitles the owner to a share of the earnings and assets of Microsoft. The share is a liability for Microsoft because it is a claim on its earnings and assets by the owner of the share. 2. Y es, I should take out the loan, because I will be better off as a result of doing so. My interest payme nt will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $5,500. Since Larry’s loan - sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.) 3. Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly. 4. The principal debt instruments used were foreign bonds which were sold in Britain and denominated in pounds. The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads. 5. This statement is false. Prices in secondary markets determine the prices that firms issuing securities receive in primary markets. In addition, secondary markets make securities more liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if anything, more important than primary markets. 6. You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants. 7. Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member. 9. Loan sharks can threaten their borrowers with bodily harm if borrowers take actions that might jeopardize paying off the loan. Hence borrowers from a loan shark are less likely to engage in moral hazard. 10. They might not work hard enough while you are not looking or may steal or commit fraud.

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    Chapter 2 Overview of the Financial System 7 11. Yes, because even if you know that a borrower is taking actions that might jeopardize paying off the loan, you must still stop the borrower from doing so. Because that may be costly, you may not spend the time and effort to reduce moral hazard, and so moral hazard remains a problem. 12. True. If there are no information or transaction costs, people could make loans to each other at no cost and would thus have no need for financial intermediaries. 13. Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able to earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor. 14. Increased discussion of foreign financial markets in the U.S. press and the growth in markets for international financial instruments such as Eurodollars and Eurobonds.

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    Part II Fundamentals of Financial Markets

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    Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? Measuring Interest Rates Present Value Four Types of Credit Market Instruments Yield to Maturity Global Box: Negative T - Bill R ates? It Can Happen The Distinction Between Real and Nominal Interest Rates The Distinction Between Interest Rates and Returns Mini - Case Box: With TIPS, Real Interest Rates Have Become Observable in the United States Maturity and the Volatility of Bond Returns: Interest - Rate Risk Reinvestment Risk Mini - Case Box: Helping Investors to Select Desired Interest - Rate Risk Summary Calculating Duration Duration and Interest - Rate Risk ◼ Overview and Teaching Tips In my years of teaching financial mar kets and institutions, I have found that students have trouble with what I consider to be easy material because they do not understand what an interest rate is — that it is negatively associated with the price of a bond, that it differs from the return on a bond, and that there is an important distinction between real and nominal interest rates. This chapter spends more time on these issues than does any other competing textbook. My experience has been that giving this material so much attention is well rewarded. After putting more emphasis on this material in my financial markets and institutions course, I witnessed a dramatic improvement in students’ understanding of portfolio choice and asset and liability management in financial institutions. An innovative feature of the textbook is the set of over twenty special applications called, “The Practicing Manager.” These applications introduce students to real - world problems that managers of financial institutions have to solve and make the course both more relevant and exciting to students. They are not meant to fully prepare students for jobs in financial institutions — it is up to more specialized courses such as bank or financial institutions management to do this — but these applications teach them some of the special analytical tools that they will need when they enter the business world.

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    Chapter 3 What Do Interest Rates Mean and What is Their Role in Valuation? 11 This chapter contains the Practicing Manager application on “Calculating Duration to Measure Interest - Rate Risk.” The application shows how to quantify interest - rate risk using the duration concept and is a basic tool for managers of financial institutions. For those instructors who do not want a managerial emphasis in their financial markets and institutions course, this and other Practicing Manager applications can be skipped without loss of continuity. ◼ Answers to End - of - Chapter Questions 1. $2000 = $100/(1 + i ) + $100/(1 + i ) 2 +    + $100/(1 + i ) 20 + $1000/(1 + i ) 20 . 2. You would rather be holding long - term bonds because their price would increase more than the price of the short - term bonds, giving t hem a higher return. 3. No. If interest rates rise sharply in the future, long - term bonds may suffer such a sharp fall in price that their return might be quite low, possibly even negative. 4. People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent ( = 5 percent – 2 percent) to 1 percent ( = 10 percent − 9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that p eople will buy houses.) ◼ Quantitative Problems 1. Calculate the present value of a $1,000 zero - coupon bond with 5 years to maturity if the required annual interest rate is 6%. Solution: PV = FV /(1 + i ) n where FV = 1000, i = 0.06, n = 5 PV = 747.25 2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000 per year. If the first payment is made immediately, what is this grand prize really worth? Use a discount rate of 6%. Solution: This is a simple present value problem. Using a financial calculator, N = 20; PMT = 500,000; FV = 0; I = 6%; Pmts in BEGIN mode. Compute PV : PV = $6,079,058.25 3. Consider a bond with a 7% annual coupon and a face value of $1,000. Complete the following table: Years to Maturity Discount Rate Current Price 3 5 3 7 6 7 9 7 9 9

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    12 Mishkin/Eakins • Financial Markets and Institutions, Seventh E dition What relationship do you observe between yield to maturity and the current market value? Solution: Years to Maturity Yield to Maturity Current Price 3 5 $1,054.46 3 7 $1,000.00 6 7 $1,000.00 9 5 $1,142.16 9 9 $ 880.10 When yield to maturity is above the coupon rate, the band’s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate. For a given maturity, the bond’s current price falls as yield to maturity rises. For a given yield to maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond’s current price equals its face value regardless of years to maturity. 4. Consider a coupon bond that has a $1,000 par value and a coupon rate of 10%. The bond is currently selling for $1,150 and has 8 years to maturity. What is the bond’s yield to maturity? Solution: To calculate the bond’s yield to maturity using a financial calculator, N = 8; PMT = 1000  0.10 = 100; FV = 1000; PV = 1150 Compute I : I = 7.44 5. You are willing to pay $15,625 now to purchase a perpetuity which will pay you and your heirs $1,250 each year, forever, starting at the end of this year. If your required rate of return does not change, how much would you be willing to pay if this were a 20 - year, annual payment, ordinary annuity instead of a perpetuity? Solution: To find your yield to maturity, Perpetuity value = PMT / I . So, 15,625 = 1,250/ I ; I = 0.08 The answer to the final part using a financial calculator: N = 20; I = 8; PMT = 1,250; FV = 0 Compute PV : PV = 12,272.69 6. The price would be $50/.025 = $2000. If the yield to maturity doubles to 5%, the price would fall to half its previous value, to $1000 = $50/.05. 7. Property taxes in DeKalb County are roughly 2.66% of the purchase price every year. If you just bought a $100,000 home, what is the PV of all the future property tax payments? Assume that the house remains worth $100,000 forever, property tax rates never change, and that a 9% discount rate is used for discounting. Solution: The taxes on a $100,000 home are roughly 100,000  0.0266 = 2,660. The PV of all future payments = 2,660/0.09 = $29,555.55 (a perpetuity). 8. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2% and inflation is expected to be 6% over the next year. What nominal interest rate would you require from the bank over the next year? How much money will you have at the end of one year? If you are saving to buy a stereo that currently sells for $1,050, will you have enough to buy it?

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    Chapter 3 What Do Interest Rates Mean and What is Their Role in Valuation? 13 Solution: The required nominal rate would be: e 2% 6% 8%. r i i  = + = + = At this rate, you would expect to have $1,000  1.08, or $1,080 at the end of the year. Can you afford the stereo? In theory, the price of the stereo will increase with the rate of inflation. So, one year later, the stereo will cost $1,050  1.06, or $1,113. You will be short by $33. 9. A 10 - year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Compute your rate of return if you sell the bond next year for $880.10. Solution: 1 70 880.10 871.65 0.09, or 9%. 871.65 t t t C P P R P + + − + − = = = 10. You have paid $980.30 for an 8% coupon bond with a face value of $1,000 that mature in five years. You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, what price must you sell the bond for? Is this realistic? Solution: To find the price, solve: 1 1 1 80 980.30 0.09 for . 988.53. 980.30 t t t P P P + + + + − = = Although this appears possible, the yield to maturity when you purchased the bond was 8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the yield would have to drop to 8.35% for the price to be $988.53. 11. Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%. Solution: Year 1 2 3 Sum Payments 60.00 60.00 1060.00 PV of Payments 56.07 52.41 865.28 973.76 Time Weighted PV of Payments 56.07 104.81 2595.83 Time Weighted PV of Payments Divided by Price 0.06 0.11 2.67 2.83 This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76, which is the sum of the individual “ PV of payments.” 12. Consider the bond in the previous question. Calculate the expected price change if interest rates drop to 6.75% using the duration approximation. Calculate the actual price change using discounted cash flow. Solution: Using the duration approximation, the price change would be:

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    14 Mishkin/Eakins • Financial Markets and Institutions, Seventh E dition 0.0025 DUR 2.83 973.76 6.44. 1 1.07 i P P i  −  = −   = −   = + The new price would be $980.20. Using a discounted cash flow approach, the price is 980.23 — only $.03 different. Year 1 2 3 Sum Payments 60.00 60.00 1060.00 PV of payments 56.21 52.65 871.3 980.23 13. The duration of a $100 million portfolio is 10 years. $40 million dollars in new securities are added to the portfolio, increasing the duration of the portfolio to 12.5 years. What is the duration of the $40 million in new securities? Solution: First, note that the portfolio now has $140 million in it. The duration of a portfolio is the weighted average duration of its individual securities. Let D equal the duration of the $40 million in new securities. Then, this implies: 12.5 (100/140 10) (40/140 D) 12.5 7.1425 + 0.2857 18.75 D D =  +  = = The new securities have a duration of 18.75 years. 14. A bank has two, 3 - year commercial loans with a present value of $70 million. The first is a $30 million loan that requires a single payment of $37.8 million in 3 years, with no other payments until then. The second is for $40 million. It requires an annual interest payment of $3.6 million. The principal of $40 million is due in 3 years. a. What is the duration of the bank’s commercial loan portfolio? b. What will happen to the value of its portfolio if the general level of interest rates increased from 8% to 8.5%? Solution: The duration of the first loan is 3 years since it is a zero - coupon loan. The duration of the second loan is as follows: Year 1 2 3 Sum Payment 3.60 3.60 43.60 PV of Payments 3.33 3.09 34.61 41.03 Time Weighted PV of Payments 3.33 6.18 103.83 Time Weighted PV of Payments Divided by Price 0.08 0.15 2.53 2.76 The duration of a portfolio is the weighted average duration of its individual securities. So, the portfolio’s duration = 3/7  (3) + 4/7  (2.76) = 2.86 If rates increased, 0.005 DUR 2.86 70,000,000 926,852. 1 1.08 i P P i   = −   = −   = − +

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    Chapter 3 What Do Interest Rates Mean and What is Their Role in Valuation? 15 15. Conside r a bond that promises the following cash flows. The required discount rate is 12%. Year 0 1 2 3 4 Promised Payments 160 170 180 230 You plan to buy this bond, hold it for 2½ years, and then sell the bond. a. What total cash will you receive from the bond after the 2½ years? Assume that periodic cash flows are reinvested at 12%. b. If immediately after buying this bond, all market interest rates drop to 11% (including your reinvestment rate), what will be the impact on your total cash flow after 2½ years? How does this compare to part (a)? c. Assuming all market interest rates are 12%, what is the duration of this bond? Solution: a. You will receive 160 reinvested for 1.5 years, and 170 reinvested for 0.5 years. Then you will sell the remaining cash flows, discounted at 12%. This gives you: 1.5 0.5 0.5 1.5 180 230 160 (1.12) 170 (1.12) $733.69. 1.12 1.12  +  + + = b. This is the same as part (a), but the rate is now 11%. 1.5 0.5 0.5 1.5 180 230 160 (1.11) 170 (1.11) $733.74. 1.11 1.11  +  + + = Notice that this is only $0.05 different from part (a). c. The duration is calculated as follows: Yea r 1 2 3 4 Sum Payments 160.00 170.00 180.00 230.00 PV of Payments 142.86 135.52 128.12 146.17 552.67 Time Weighted PV of Payments 142.86 271.05 384.36 584.68 Time Weighted PV of Payments Divided by Price 0.26 0.49 0.70 1.06 2.50 Since the duration and the holding period are the same, you are insulated from immediate changes in interest rates! It doesn’t always work out this perfectly, but the idea is important.

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    Chapter 4 Why Do Interest Rates Change? Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Summary Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply - and - Demand Analysis Changes in Eq uilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds Case : Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect Case : Changes in the Interest Rate Due to a Business Cycle Expansion Case : Explaining Low Japanese Interest Rates Case : Reading the Wall Street Journal “Credit Markets” Column Following the Financial News : The “Credit Markets” Column The Practicing Manager: Profiting from Interest - Rate Forecasts Following the Financi al News : Forecasting Interest Rates Appendix 1: Models of Asset Pricing Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Appendix 3: Loanable Funds Framework Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework ◼ Overview and Teaching Tips As is clear in the Preface to the textbook, I believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then applying them over and over again to the subject matter of thi s exciting field. Chapter 4 introduces one of these basic principles: the determinants of asset demand. It indicates that there are four primary factors that influence people’s decisions to hold assets: wealth, expected returns, risk, and liquidity. The simple idea that these four factors explain the demand for assets is, in fact, an extremely powerful one. It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined, how

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    Chapter 4 Why Do Interest Rates Change? 17 financial institutions manage their assets and liabilities, why financial innovation takes place, how prices are determined in the stock market and the foreign exchange market. One teaching device that I have found helps students develop their intuition is the use of summary tables, such as Table 1, in class. I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. I use this device continually throughout my course and in this book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly. The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond market. An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets, not in terms of flows. Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset - market approach: that is, stocks of assets are emphasized rather than flows. The reason for this is that keeping track of stocks of assets is easier than dealing with flows. Correctly conducting analysis in terms of flows is very tricky, for example, when we encounter inflation. Thus there are two reasons for using a stock approach rather than a flow approach: (1) it is easier, and (2) it is more consistent with modern treatment of asset markets by financial economists. Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principles of economics textbooks. The ceteris paribus derivations of supply and demand curves with numerical examples are presented, the concept of equilibrium is carefully developed, the factors that shift the supply and demand curves are outlined, and the distinction between movements along a demand or supply curve and shifts in the curve is clearly drawn. My feeling is that the step - by - step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of financial markets and institutions. I have found that even those students who have had excellent training in earlier courses find that this chapter provides a valuable review of supply and demand analysis. An additional innovative feature of the book that first appears in this chapter are the special applications, “Case: the Wall Street Journal. ” These cases show students how the analytical framework in the book can be used directly to understand the daily columns in the United States’ leading financial newspaper. The students particularly like the case on reading the credit markets column because it shows them that the concepts developed in the chapter are actually used in the real world. In teaching my class, I bring the previous day’s Wall Street Journal columns into class and then use them to conduct a case discussion along the lines of the “ Case: the Wall Street Journal “ in the text. My students very much like the resulting case discussions and have told me that they are better than case discussions in other classes because the material is so current. The Practicing Manager application at the end of the chapter shows how interest rate forecasts can be used by managers of financial institutions to increase profits. This application shows students how the analysis they have learned is useful in the real world. This chapter has an extensive set of appendices on the web to enhance its material. Appendix 1 provides models of asset pricing in case an instructor wants to make use of the capital asset pricing model or the arbitrage pricing model in this course. Appendix 2 shows how the analysis developed in the chapter can be applied to understanding how any asset’s price is determined. Students particularly like the application to the gold market because this commodity piques almost everybody’s interest. Appendix 3 provides an another interpretation of the supply and demand analysis for bonds using a different terminology involving the supply and demand for loanable funds. Appendix 4 provides an alternative approach to interest rate determination developed by John Maynard Keynes, known as the liquidity preference framework.

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    18 Mishkin/Eakins • Financial Markets and Institut ions, Seventh Edition ◼ Answers to End - of - Chapter Questions 1. a. Less, because your wealth has declined b. More, because its relative expected return has risen c. Less, because it has become less liquid relative to bonds d. Less, because its expected return has fallen relative to gold e. More, because it has become less risky relative to bonds 2. a. More, because your wealth has increased b. More, because it has become more liquid c. Less, because its expected return has fallen relative to Polaroid stock d. More, because it has become less risky relative to stocks e. Less, because its expected return has fallen 3. True, because the benefits to diversification are greater for a person who cares more about reducing risk. 4. Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both. 5. True, because for a risk averse person, more risk, a lower expected return, and less liquidity make a security less desirable. 6. When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve B s to the right. The result is that the intersection of the supply and demand curves B s and B d occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises. 7. When the economy booms, the demand for bonds increases: The public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves ( B d and B s ) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions, that is, interest rates are procyclical. 8. Interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase. The demand curve, B d , shifts to the right and the equilibrium bond price rises and the interest rate falls. 9. Interest rates would rise. A sudden increase in people’s expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve B d shifts to the left, and the equilibrium bond price falls, so the interest rate rises.

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    Chapter 4 Why Do Interest Rates Change? 19 10. Interest rates might rise. The large federal deficits require the Treasury to issue more bonds; thus the supply of bonds increases. The supply curve, B s , shifts to the right and the equilibrium bond price falls and the interest rate rises. Some economists believe that when the Treasury issues more bonds, the demand for bonds increases because the issue of bonds increases the public’s wealth. In this case, the demand curve, B d , also shifts to the right, and it is no longer clear that the equilibrium bond price or interest rate will rise. Thus there is some ambiguity in the answer to this question. 11. The increased riskiness of bonds lowers the demand for bonds. The demand curve shifts to the left and the equilibrium bond price falls and the interest rate rises. 12. The increased riskiness of bonds lowers the demand for bonds. The demand curve B d shifts to the left, the equilibrium bond price falls and the interest rate rises. 13. Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds, and the demand for bonds will fall. The demand curve B d will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise. 14 If the public believes the president’s program will be successful, interest rates will fall. The president’s announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases and the demand curve, B d , shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, B s , and the rightward shift of the demand curve, B d , causes the equilibrium bond price to rise and the interest rate to fall. 15. The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, the expected return on long - term bonds such as the 1 8 8 s of 2022 will fall, and the demand for these bonds will decline. The demand curve B d will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise. 16. Interest rates will rise. The expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds falls. The demand curve, B d , shift to the left and the equilibrium bond price falls and the interest rate rises. 17. Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall. The demand curve B d will shift to the left, and the equilibrium bond price falls and the interest rate will rise. ◼ Quantitative Problems 1. You own a $1,000 - par zero - coupon bond that has 5 years of remaining maturity. You plan on selling the bond in one year and believe that the required yield next year will have the following probability distribution: Probability Req uired Yield 0.1 6.60% 0.2 6.75% 0.4 7.00% 0.2 7.20% 0.1 7.45%

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    20 Mishkin/Eakins • Financial Markets and Institut ions, Seventh Edition a. What is your expected price when you sell the bond? b. What is the standard deviation? Solution: Probability Required Yield Price Prob  Price Prob  (Price − Exp. Price) 2 0.1 6.60% $774.41 $ 77.44 12.84776241 0.2 6.75% $770.07 $154.01 9.775668131 0.4 7.00% $762.90 $305.16 0.013017512 0.2 7.20% $757.22 $151.44 6.862609541 0.1 7.45% $750.02 $ 75.02 16.5903224 $763.07 46.08937999 The expected price is $763.07. The variance is $46.09, or a standard deviation of $6.79. 2. Consider a $1,000 - par junk bond paying a 12% annual coupon. The issuing company has 20% chance of defaulting this year; in which case, the bond would not pay anything. If the company survives the first year, paying the annual coupon payment, it then has a 25% chance of defaulting in the second year. If the company defaults in the second year, neither the final coupon payment nor par value of the bond will be paid. What price must investors pay for this bond to expect a 10% yield to maturity? At that price, what is the expected holding period return? Standard deviation of returns? Assume that periodic cash flows are reinvested at 10%. Solution: The expected cash flow at t 1 = 0.20 (0) + 0.80 (120) = 96 The expected cash flow at t 2 = 0.25 (0) + 0.75 (1,120) = 840 The price today should be: 0 2 96 840 781.49 1.10 1.10 P = + = At the end of two years, the following cash flows and probabilities exist: Probability Final Cash Flow Holding Period Return Prob  HPR Prob  (HPR − Exp. HPR) 2 0.2 $ 0.00 − 100.00% − 20.00% 19.80% 0.2 $ 132.00 − 83.11% − 16.62% 13.65% 0.6 $1,252.00 60.21% 36.12% 22.11% − 0.50% 55.56% The expected holding period return is almost zero ( − 0.5%). The standard deviation is roughly 74.5% (the sq uare root of 55.56%). 3. Last month, corporations supplied $250 billion in bonds to investors at an average market rate of 11.8%. This month, an additional $25 billion in bonds became available, and market rates increased to 12.2%. Assuming a Loanable Funds Framework for interest rates, and that the demand curve remained constant, derive a linear equation for the demand for bonds, using prices instead of interest rates.

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    Chapter 4 Why Do Interest Rates Change? 21 Solution: First, translate the interest rates into prices. 1000 11.8% , or 894.454 P i P P − = = = 1000 12.2% , or 891.266 P i P P − = = = We know two points on the demand curve: 891.266, 275 894.454, 250 P Q P Q = = = = So, the slope = 891.266 894.454 0.12755 275 250 P Q  − = =  − Using the point - slope form of the line, Price = 0.12755  Quantity + Constant . We can substitute in either point t o determine the constant. Let’s use the first point: 891.266 0.12755 275 + Constant, or Constant 856.189 =  = Finally, we have: : Price 0.12755 Quantity 856.189 d B =  + 4. An economist has estimated that, near the point of equilibrium, the demand curve and supply curve for bonds can be estimated using the following equations: 2 : Price Quantity 940 5 : Price Quantity 500 d s B B − = + = + a. What is the expected equilibrium price and quantity of bonds in this market? b. Given your answer to part (a), which is the expected interest rate in this market? Solution: a. Solve the equations simultaneously: 2 940 5 [ 500] 7 0 440, or 314.2857 5 P Q P Q Q Q − = + − = + − = + = This implies that P = 814.2857. b. 1000 814.2857 22.8% 814.2857 i − = = 5. As in Question 6, the demand curve and supply curve for bonds are estimated using the following equations:

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    22 Mishkin/Eakins • Financial Markets and Institut ions, Seventh Edition 2 : Price Quantity 940 5 : Price Quantity + 500 d s B B − = + =

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    Chapter 4 Why Do Interest Rates Change? 23 Following a dramatic increase in the value of the stock market, many retirees started moving money out of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, such that the price of bonds at all quantities increased $50. Assuming no change in the supply equation for bonds, what is the new equilibrium price and quantity? What is the new market interest rate? Solution: The new demand equation is as follows: 2 : Price Quantity 990 5 d B − = + Now, solve the equations simultaneously: 2 990 5 [ 500] 7 0 490, or 350.00 5 P Q P Q Q Q − = + − = + − = + = This implies that P = 850.00. 1000 850.00 17.65% 850.00 i − = = 6. Following Question 5, the demand curve and supply curve for bonds are estimated using the following equations: B d : Price = 2 Quantity 990 5 − + B s : Price = Quantity + 500 As the stock market continued to rise, the Federal Reserve felt the need to increase the interest rates. As a result, the new market interest rate increased to 19.65%, but the equilibrium quantity remained unchanged. What are the new demand and supply equations? Assume parallel shifts in the equations. Solution: Prior to the change in inflation, the equilibrium was Q = 350.00 and P = 850.00. The new equilibrium price can be found as follows: 1000 19.65% , or 835.771 P i P P − = = = This point (350, 835.771) will be common to both equations. Further since the shift was a parallel shift, the slope of the equations remains unchanged. So, we use the equilibrium point and the slope to solve for the constant in each equation: B d : 835.771 = 2 350 constant, or constant 975.771 5 − + = B d : Price = 2 Quantity 975.771 5 − + and B s : 835.771 = 350 + constant, or constant = 485.771

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    24 Mishkin/Eakins • Financial Markets and Institut ions, Seventh Edition B s : Price = Quantity + 485.771

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    Chapter 5 How Do Risk and Term Structure Affect Interest Rates? Risk Structure of Interest Rates Default Risk Case : The Subprime Collapse and the Baa - Treasury Spread Liquidity Income Tax Considerations Summary Case : Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest Rates Term Structure of Interest Rates Following the Financial News : Yield Curves Expectations Theory Market Segmentation Theory Liquidity Premium Theory Evidence on the Term Structure Summary Mini - Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Case : Interpreting Yield Curves, 1980 – 2010 The Practicing Manager: Using the Term Structure to Forecast Interest Rates ◼ Overview and Teaching Tips Chapter 5 appl ies the tools the student learned in Chapter 4 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on public policy issues might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the student’s understanding of later chapters. A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the case on interpreting yield curves in the 1980 – 2010 period demonstrates. This chapter also has two cases that will pique students’ interest because they are so current. First is the effect of the Bush tax and its possible repeal on bond interest rates. Since the topic of repeal of the Bush tax cuts is such a hot political issue, evaluating what impact the repeal might have on interest rates is sure to be of interest to students. Also students are particularly interested right now in how the recent financial crisis has affected the economy, and this chapter has the first case that looks at this topic. The case on the

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    24 Mishkin/Eakins • Financial Markets and Institutions, Seventh E dition subprime collapse applies the analysis in the chapter to show how the recent financial crisis led to a dramatic increase in the spread between interest rates on Baa securities with credit risk relative to U.S. Treasury securities that do not. The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from the term structure using the theories outlined here can be used by financial institutions managers to set interest rates on their financial instruments. ◼ Answers to End - of - Chapter Questions 1. The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that of the Baa bond. 2. U.S. Treasury bills have l ower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate. 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. 4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line. 5. If yield curves on average were flat, this would suggest that the risk premium on long - term relative to short - term bonds would equal zero and we would be more willing to accept the pure expectations theory. 6. The flat yield curve at shorter maturities suggests that short - term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on. 7. The steep upward - sloping yield curve at shorter maturities suggests that short - term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short - term interest rates in the near future is above the current short - term interest rate. The downward slope for longer maturities indicates that short - term interest rates are eventually expected to fall sharply. With a positive risk premium on long - term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short - term interest rates is declining, which occurs only if short - term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on. 8. The reduction in income tax rates would make the tax - exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

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    Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 25 9. The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds. 10. Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium. 11 . Abolishing the tax - exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall. ◼ Quantitative Problems 1. a. The yield to maturity would be 5% for a one - year bond, 6% for a two - year bond, 6.33% for a three - year bond, 6.5% for a four - year bond, and 6.6% for a five - year bond. b. The yield to maturity would be 5% for a one - year bond, 4.5% for a two - year bond, 4.33% for a three - year bond, 4.25% for a four - year bond, and 4.2% for a five - year bond. The upward - sloping yield curve in (a) would be even steeper if people preferred short - term bonds over long - term bonds because long - term bonds would then have a positive risk premium. The downward - sloping yield curve in (b) would be less steep and might even have a slight positive upward slope if the long - term bonds have a positive risk premium. 2. Government economists have forecasted one - year T - bill rates for the following five years as follows: Year 1 - year rate 1 4.25% 2 5.15% 3 5.50% 4 6.25% 5 7.10% You have liquidity premium 0.25% for the next two years and 0.50% thereafter. Would you be willing to purchase a 4 - year T - bond at a 5.75% interest rate? Solution: Your required interest rate on a 4 - year bond = Average interest on four 1 - year bonds + Liquidity Premium = (4.25% + 5.15% + 5.50% + 6.25%)/4 + 0.5% = 5.29% + 0.50% = 5.79% At a rate of 5.75%, the T - bond is just below your required rate. 3. What is the yield on a $1,000,000 municipal bond with a coupon rate of 8%, paying interest annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume that you are in the 25% tax bracket.

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    26 Mishkin/Eakins • Financial Markets and Institutions, Seventh E dition Solution: Municipal bond coupon payments equal $80,000 per year. No taxes are deducted; therefore, the yield would equal 8%. The coupon payments on a corporate bond equal $100,000 per year. But you only keep $75,000 because you are in the 25% tax bracket. Therefore your after - tax yield is only 7.5% 4. Consider the decision to purchase either a 5 - year corporate bond or a 5 - year municipal bond. The corporate bond is a 12% annual coupon bond with a par value of $1,000. It is currently yielding 11.5%. The municipal bond has an 8.5% annual coupon and a par value of $1,000. It is currently yielding 7%. Which of the two bonds would be more beneficial to you? Assume that your marginal tax rate is 35%. Solution: Municipal Bond Purchase Price = $1,061.50 After - tax Coupon Payment = $85 Par Value = $1,000 Calculated YTM = 7% Corporate Bond Purchase Price = $1,018.25 After - tax Coupon Payment = $78 Par Value = $1,000 Calculated YTM = 7.35% The corporate bond offers a higher yield and is th e better buy. 5. Debt issued by Southeastern Corporation currently yields 12%. A municipal bond of equal risk currently yields 8%. At what marginal tax rate would an investor be indifferent between these two bonds? Soluti o n: Corporate Bonds (1 − Tax Rate) = Municipal Bonds 12%  (1 − Tax Rate) = 8% 1 − Tax Rate = 0.67 or Tax Rate = 0.33 6. 1 - year T - bill rates are expected to steadily increase by 150 basis points per year over the next 6 years. Determine the required interest rate on a 3 - year T - bond and a 6 - year T - bond if the current 1 - year interest rate is 7.5%. Assume that the Pure Expectations Hypothesis for interest rates holds. Solution: 3 year bond: year 1 interest rate = 7.5% year 2 interest rate = 9.0% year 3 interest rate = 10.5% number of years = 3 (7.5% + 9.0% + 10.5%)/3 = 9.0% 6 year bond: year 1 interest rate = 7.5% year 2 interest rate = 9.0% year 3 interest rate = 10.5% year 4 interest rate = 12% year 5 interest rate = 13.5% year 6 interest rate = 15%

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    Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 27 (7.5% + 9.0% + 10.5% + 12% + 13.5% + 15%)/6 = 11.25% 7. The one - year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16%, 17.5%. Using the pure expectations theory, what will be the interest rates on a 3 - year bond, 6 - year bond, and 9 - yea r bond? Solution: 3 - year bond = [(3 + 4.5 + 6)]/(3) = 4.5% 6 - year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 6.75% 9 - year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 9.333% 8. Using the information from the previous question, now ass ume that the investor prefers holding short - term bonds. A liquidity premium of 10 basis points is required for each year of a bond’s maturity. What will be the interest rates on a 3 - year bond, 6 - year bond, and 9 - year bond? Solution: To solve this problem, you will need to use the following equation: 1 2 1 e e e t t t t n nt nt i i i i i l n + + + − + + +    + = + 3 - year bond = (0.30) + [(3 + 4.5 + 6)]/(3) = 4.8% 6 - year bond = (0.60) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 7.35% 9 - year bond = (0.90) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 10.233% 9. Which bond would produce a greater return if the pure expec tations theory was to hold true, a 2 - year bond with an interest rate of 15% or two 1 - year bonds with sequential interest payment of 13% and 17%? Solution: Both of the bonds would produce the same return. Two 2 - year bonds: = (13% + 17%)/2 = 15% 10. Li ttle Monsters Inc. borrowed $1,000,000 for two years from NorthernBank Inc. at an 11.5% interest rate. The current risk - free rate is 2% and Little Monsters’s financial condition warrants a default risk premium of 3% and a liquidity risk premium of 2%. The maturity risk premium for a two - year loan is 1%, and inflation is expected to be 3% next year. What does this information imply about the rate of inflation in the second year? Solution: If inflation were expected to remain constant at 3% over the life of t he loan, the interest rate on the two - year loan would be 11%. Since the actual two - year interest rate is 11.5%, the one - year interest rate in year 2 must be 12%, since 11.5 = (11 + 12)/2. The required rate of 12% = R f + DRP + LP + MRP + Inflation Premium = 2% + 3% + 2% + 1% + Inflation Premium So, the Inflation Premium in year 2 is 4%. But this is an average premium over two years. Inflation Premium 4% = (Year 1 Inflation + Year 2 Inflation)/2 = (3% + x )/2 or x = 5% 11. One - year T - bill rates are 2% cu rrently. If interest rates are expected to go up after 3 years by 2% every year, what should be the required interest rate on a 10 - year bond issued today?

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