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Interest rates

1. When interest rates declined, many individuals withdrew their deposits and invested in
stock mutual funds and bond mutual funds. Pg. 652 fmi7e

2. managing money market funds, if portfolio managers expect a stronger economy, they
may prefer an MMF that contains securities with some risk that offer higher returns that
t-bills. If they expect interest rates to increase, they could invest in MMFs with short
maturity.

3. as interest rates declined, most investors withdrew depostis from commercial banks,
they frequently investerd the proceeds in mutual funds sold by subsidiaries of the banks.

4. a mutual fund containing treasury securites is susceptible to interest rate risk, interest
rates rise, the market value of the t-bonds contained in the mutual funds will decline.

5. Risk of Mutual Funds. Is the value of a money market fund or a bond fund more
susceptible to increasing interest rates? Explain.
ANSWER: A bond fund is more susceptible to increasing interest rates because the
securities contained in a bond fund have longer maturities than securities contained in a
money market fund.

6. ANSWER: The performance of each type of mutual fund is influenced by a particular


economic factor. Thus, diversifying within one specific type of mutual fund creates
significant exposure to that factor. The stock market movements influence stock fund
performance, interest rate movements influence bond fund performance, and exchange
rates and foreign market movements influence international funds. Diversification across
stock funds, bond funds, and international funds limits the exposure to any single
economic factor.

7.

Managing in Financial Markets


As an individual investor, you are attempting to invest in a well-diversified portfolio
of mutual funds, so that you will be somewhat insulated from any type of economic
shock that may occur.
a. An investment adviser recommends that you buy four different U.S. growth stock
funds. Since these funds contain over 400 different U.S. stocks, the adviser says that
you will be well insulated from any economic shocks. Do you agree? Explain.
This entire portfolio is subject to adverse U.S. stock market effects, and therefore is
not a well diversified portfolio.
b. A second investment adviser recommends that you invest in four different mutual
funds that are focused on different countries in Europe. The adviser says that you
will be completely insulated from U.S. economic conditions, and that your portfolio
will therefore have low risk. Do you agree? Explain.
This portfolio may not be exposed to U.S. economic conditions, but it is highly
exposed to European economic conditions. Even though the portfolio contains stocks
of different European countries, all four mutual funds are subject to general
economic conditions throughout Europe.
c. A third investment adviser recommends that you avoid exposure to the stock
markets by investing your money in four different U.S. bond funds. The adviser
says that because bonds make fixed payments, these bond funds have very low risk.
Do you agree? Explain.
If U.S. interest rates increase, all of these bond funds will perform poorly. Even
though the bond payments are fixed, the values of the bonds (and therefore the
values of the bond mutual funds) will decline if U.S. interest rates rise. Therefore,
this portfolio of mutual funds has a high degree of risk.

Does a large fiscal budget deficit result in higher interest rates?

ANSWER: A large budget deficit does not automatically cause high interest rates.
However, it does result in a large demand for funds, which will place upward
pressure on interest rates unless there are offsetting forces.

Interest Elasticity. Explain what is meant by interest elasticity. Would you expect
federal government demand for loanable funds to be more or less interest-elastic
than household demand for loanable funds? Why?
ANSWER: Interest elasticity of supply represents a change in the quantity of
loanable funds supplied in response to a change in interest rates. Interest elasticity
of demand represents a change in the quantity of loanable funds demanded in
response to a change in interest rates.
The federal government demand for loanable funds should be less interest elastic
than the consumer demand for loanable funds, because the government's planned
borrowings will likely occur regardless of the interest rate. Conversely, the quantity
of loanable funds by consumers is more responsive to the interest rate level.

Impact of Government Spending. If the federal government planned to expand the


space program, how might this affect interest rates?
ANSWER: An expanded space program would (a) force the federal government to
increase its budget deficit, (b) possibly force any firms involved in facilitating the
program to borrow more funds. Consequently, there is a greater demand for
loanable funds. The additional spending could cause higher income and additional
saving. Yet, this impact is not likely to be as great. The likely overall impact would
therefore be upward pressure on interest rates.

Impact of a Recession. Explain why interest rates tend to decrease during


recessionary periods. Review historical interest rates to determine how they react to
recessionary periods. Explain this reaction.
ANSWER: During a recession, firms and consumers reduce their amount of
borrowing. The demand for loanable funds decreases and interest rates decrease as
a result.
Impact of the Money Supply. Should increasing money supply growth place upward
or downward pressure on interest rates?
ANSWER: If one believes that higher money supply growth will not cause
inflationary expectations, the additional supply of funds places downward pressure
on interest rates. However, if one believes that inflation expectations do erupt as a
result, demand for loanable funds will also increase, and interest rates could
increase (if the increase in demand more than offsets the increase in supply).

Impact of Exchange Rates on Interest Rates. Assume that if the U.S. dollar
strengthens, it can place downward pressure on U.S. inflation. Based on this
information, how might expectations of a strong dollar affect the demand for
loanable funds in the United States and U.S. interest rates? Is there any reason to
think that expectations of a strong dollar could also affect the supply of loanable
funds? Explain.
ANSWER: As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand
for loanable funds, and therefore reduce interest rates. The expectations of a strong
dollar could also increase the supply of funds because it may encourage saving
(there is less concern to purchase goods before prices rise when inflationary
expectations are reduced). In addition, foreign investors may invest more funds in
the United States if they expect the dollar to strengthen, because that could increase
their return on investment.

Nominal versus Real Interest Rate. What is the difference between the nominal
interest rate and real interest rate? What is the logic behind the Fisher effect's
implied positive relationship between expected inflation and nominal interest rates?
ANSWER: The nominal interest rate is the quoted interest rate, while the real
interest rate is defined as the nominal interest rate minus the expected rate of
inflation. The real interest rate represents the recent nominal interest rate minus the
recent inflation rate.
Investors require a positive real return, which suggests that they will only invest
funds if the nominal interest rate is expected to exceed inflation. In this way, the
purchasing power of invested funds increases over time. As inflation rises, nominal
interest rates should rise as well since investors would require a nominal return that
exceeds the inflation rate.

Impact of Stock Market Crises. During periods in which 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 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.
ANSWER: When investors shift funds out of stocks, they move it into money
market securities, causing an increase in the supply of loanable funds, and lower
interest rates.
Impact of Expected Inflation. How might expectations of higher global oil prices
affect the demand for loanable funds, the supply of loanable funds, and interest
rates in the United States? Will this affect the interest rates of other countries in the
same way? Explain.
ANSWER: The expectations of higher oil prices will cause concern about the
possible increase in inflation. Since higher inflation can increase interest rates, it will
cause an expectation of higher interest rates in the U.S. Firms and government
agencies may borrow more funds now before prices increase and before interest
rates increase. Consumers may use their savings now to buy products before the
prices increase. Therefore, the demand for loanable funds should increase, the
supply of loanable funds should decrease, and interest rates should increase in the
U.S.
The impact of higher global oil prices in other countries is not necessarily the same.
If the country produces its own oil, it can set the oil prices in its country. If it can
prevent high oil prices in its country, then the prices of products (gasoline) and
services (transportation) may not be affected. Therefore, interest rates may not be
affected.

Global Interaction of Interest Rates. Why might you expect interest rate movements
of various industrialized countries to be more highly correlated in recent years than
in earlier years?
ANSWER: Interest rates among countries are expected to be more highly correlated
in recent years because financial markets are more geographically integrated. More
international financial flows will occur to capitalize on higher interest rates in
foreign countries, which affects the supply and demand conditions in each market.
As funds leave a country with low interest rates, this places upward pressure on that
country's interest rates. The international flow of funds caused this type of reaction.

Impact of War. A war tends to cause significant reactions in financial markets. Why
would a war in Iraq place upward pressure on U.S. interest rates? Why might some
investors expect a war like this to place downward pressure on U.S. interest rates?
ANSWER: The Persian Gulf crisis placed upward pressure on U.S. interest rates
because it (1) increased inflationary expectations in the United States as oil prices
increased abruptly, and (2) increased the expected U.S. budget deficit as
government expenditures were necessary to boost military support. However, the
crisis also caused some analysts to revise their forecasts of economic growth
downward. In fact, some analysts predicted that a U.S. recession would occur. The
slower economy reflects a reduced corporate demand for funds, which by itself
places downward pressure on interest rates. If inflation was not a concern, the Fed
may attempt to increase money supply growth to stimulate the economy. However,
the inflationary pressure restricted the Fed from stimulating the economy (since any
stimulative policy could cause higher inflation).

Impact of September 11. Offer an argument for why the terrorist attack on the
United States on September 11, 2001 could have placed downward pressure on U.S.
interest rates. Offer an argument for why the terrorist attack could have placed
upward pressure on U.S. interest rates.
ANSWER: The terrorist attack could cause a reduction in spending related to travel
(airlines, hotels), and would also reduce the expansion by those types of firms. This
reflects a decline in the demand for loanable funds, and places downward pressure
on interest rates. Conversely, the attack increases the amount of government
borrowing needed to support a war, and therefore places upward pressure on
interest rates.

Impact of Government Spending. Jayhawk Forecasting Services analyzed several


factors that could affect interest rates in the future. Most factors were expected to
place downward pressure on interest rates. Jayhawk also felt that although the
annual budget deficit was to be cut by 40 percent from the previous year, it would
still be very large. Thus, Jayhawk believed that the deficit's impact would more than
offset the other effects and therefore forecast interest rates to increase by 2 percent.
Comment on Jayhawk's logic.
ANSWER: A reduction in the deficit should free up some funds that had been used
to support the government borrowings. Thus, there should be additional funds
available to satisfy other borrowing needs. Given this situation plus the other
information, Jayhawk should have forecasted lower interest rates.

a. “The flight of funds from bank deposits to U.S. stocks will pressure interest
rates.”
As the supply ofloanable funds declines (due to bank deposit withdrawals), there
will be upward pressure on interest rates.
b. “Since Japanese interest rates have recently declined to very low levels, expect a
reduction in U.S. interest rates.”
As Japanese interest rates decline, Japanese savers invest more loanable funds in
the United States, which places downwardpressure on U.S. interest rates.
c. “The cost of borrowing by U.S. firms is dictated by the degree to which the
federal government spends more than it taxes.”
As the federal government spends more than it taxes, it borrows the difference; the
greater the amount borrowed, the higher the pressure on U.S. interest rates.

Forward Rate. What is the meaning of the forward rate in the context of the term
structure of interest rates? Why might forward rates consistently overestimate future
interest rates? How could such a bias be avoided?
ANSWER: The forward rate is the expected interest rate at a future point in time.
If forward rates are estimated without considering the liquidity premium, it may
overestimate the future interest rates. If a liquidity premium is accounted for when
estimating the forward rate, the bias can be eliminated.
a. "An upward-sloping yield curve persists because many investors stand ready to jump
into the stock market."
Investors are holding short-term treasury securities, and are unwilling to hold long-term
Treasury securities, because they may liquidate these securities soon, andprefer liquid
securities that are less susceptible to interest rate risk.
b. "Low-rated bond yields rose as recession fears caused a flight to quality."
As investors selected safer bonds, they sold low-rated bonds, which placed
downwardpressure on prices oflow-rated bonds and upwardpressure on yields oflow-
rated bonds. Thus, the risk premium oflow-rated bonds increased.
c. "The shift from an upward-sloping yield curve to a downward-sloping yield curve is
sending a warning about a possible recession."
Ifthe shift is due to changes in interest rate expectations, it suggests that interest rates may
now be expected to decline. Such expectations can occur when the market expects that
economic growth is slowing or is negative.

The declining U.S. dollar and speculation that the U.S. Federal Reserve will again cut
interest rates also boosted prices. Some investors put their money into oil contracts,
betting that gains in their price will offset dollar weakness.

Oil prices also got support after the Fed said it thinks U.S. economic growth will slow
next year to between 1.8 percent and 2.5 percent, less than the Fed's previous projections.
It also projected that U.S. inflation should fall next year to between a 1.8 percent and 2.1
percent increase.

That could mean the Fed will cut interest rates further, and that could weigh on the dollar.
On Tuesday, the euro hit an all-time high against the dollar, breaking through the $1.48
mark.

"When the U.S. dollar hit a record low, oil also surged ahead. It's been an inverse
relationship," Shum said. "Also, the Fed indicating worries about the U.S. economy has
caused worry that the Fed will cut interest rates."

Open Market Operations. Explain how the Fed increases the money supply through open
market operations.
ANSWER: The Fed can increase money supply by purchasing securities in the secondary
market.
Policy Directive. What is the policy directive, and who carries it out?
ANSWER: A policy directive is established by the Fed and submitted to the Trading
Desk. The manager of the Trading Desk must ensure that the directive is achieved.

Reserve Requirements. How is money supply growth affected by an increase in the


reserve requirement ratio?
ANSWER: An increase in the reserve requirement ratio reduces the proportion of
deposited funds that a financial institution can lend out. Consequently, it reduces the rate
by which money can multiply.

Control of Money Supply. Describe the characteristics that would be desirable for a
measure of money to be manipulated by the Fed. Explain why it is difficult to
simultaneously control the money supply and the federal funds rate.
ANSWER: A desirable measure of money is one that can be precisely controlled by the
Fed and has a predictable impact on economic variables.
It may be impossible to maintain money supply and the federal funds rate within specific
boundaries simultaneously. In order to maintain the federal funds rate within boundaries,
the Fed may need to manipulate the money supply, which could force it outside of its
boundaries.

8. Monetary Control Act. What are the two key objectives of the Monetary Control Act?
How does the Monetary Control Act help the Fed avoid improper adjustments in the
money supply?
ANSWER: The Monetary Control Act was intended to (1) deregulate the depository
institutions industry, and (2) enhance the Fed’s ability to control the money supply.
The Monetary Control Act requires the depository institutions report their deposit levels
promptly to the Fed, which may help the Fed avoid improper adjustments in the money
supply.
9. Impact of Monetary Control Act. Have the reserve requirement provisions of the
Monetary Control Act improved the Fed’s ability to manipulate the money supply?
Explain.
ANSWER: The Monetary Control Act has allowed two monetary policy tools (the
discount rate and reserve requirement ratio) to be applicable to all depository institutions
rather than just to the member banks of the Federal Reserve System. However, since the
Fed rarely uses these tools to control money supply growth, it is questionable whether
monetary control was enhanced.
Another provision of the Act is that all depository institutions report their deposit levels
promptly to the Fed, which may increase the Fed’s knowledge about existing deposit
levels in the banking system. This may help the Fed make appropriate decisions about
future monetary growth targets.
10. Tools Used by the Fed. Which tool used by the Fed is the most important on a weekly
basis from the perspective of financial market participants?
ANSWER: The open market operations are the most important, because it represents the
tool that is normally used by the Fed.
a. “The Fed’s future monetary policy will be dependent on the economic indicators to be
reported this week.”
The Fed makes policy decisions based on expectations about economic conditions, and
its expectations are influenced by the economic indicators.
b. “The Fed’s role is to take the punch bowl away just as the party is coming alive.”
The Fed attempts to prevent the economy from becoming too strong by slowing the
economy down during periods ofexcessive growth; in this way, it reduces the
upwardpressure on prices (inflation).
c. “Inflation will likely increase because real short-term interest rates currently are
negative.”
Negative real short-term interest rates imply that the inflation rate exceeds the existing
nominal interest rate. Under these conditions, savers may notperceive saving to be
worthwhile because interest rates are too low, and borrowers may borrow even more
because ofrelatively low interest rates. Therefore, inflation could increase in response to
the high degree ofspending.

As a manager of a large U.S. firm, one of your assignments is to monitor U.S. economic
conditions so that you can forecast the demand for products sold by your firm. You
recognize that the Federal Reserve attempts to implement monetary policy to affect
economic growth and inflation. In addition, you recognize that the administration of the
federal government implements spending and tax policies (fiscal policy) to affect
economic growth and inflation. Yet, it is difficult to achieve high economic growth
without igniting inflation. It is often said that the Federal Reserve is independent of the
administration in Washington, D.C. yet, there is much interaction between monetary and
fiscal policies.

Assume that the economy is currently stagnant, and some economists are concerned
about the possibility of a recession. Some industries, however, are experiencing high
growth, and inflation is higher this year than in the previous five years. Assume that the
Federal Reserve chairman’s term will expire in four months and that the president of the
United States will have to appoint a new chairman (or reappoint the existing chairman). It
is widely known that the existing chairman would like to be reappointed. Also assume
that next year is an election year for the administration.

a. Given the circumstances, do you expect that the administration will be more concerned
about increasing economic growth or reducing inflation?
While answers may vary among students, the administration is normally most concerned
with resolving the unemploymentproblem by increasing economic growth. This would be
especially true just before an election year.

b. Given the circumstances, do you expect that the Fed will be more concerned about
increasing economic growth or reducing inflation?
The Fed tends to focus on maintaining a low level ofinflation, because ofthe possibility
that sustained high inflation can cause high interest rates, which may result in a sluggish
economy in the long run. It is not unusualfor the Fed to focus on fighting inflation while
the administration is more concerned about economic growth. However, given that the
chairman ofthe Fed wants to be reappointed, he may be more willing to endorse a
monetary policy that is desired by the administration (assuming that he is politically
motivated).
c. Your firm is relying on you for some insight on how the government will influence
economic conditions and therefore the demand for your firm’s products. Given the
circumstances, what is your forecast of how the government will affect economic
conditions?
There is no definite answer, but some possible expectations are as follows. First, both
policies mayfocus on economic growth forpolitical or other reasons. In this case, there is
a high probability that the policies will be somewhat successful. Alternatively, the Fed
may focus more on solving inflation while the administration focuses on economic
growth. In this case, it is difficult to know whether either policy will be successful. Thus,
there may not be much ofan effect on the economic conditions. The key to this question
is to create class discussion, and make sure students realize how difficult it is to forecast
the impact ofthe government. Students should also recognize how politics can play a role
in the effect on the economy.

Impact of Monetary Policy. How does the Fed’s monetary policy affect economic
conditions?
ANSWER: The Fed’s monetary policy can affect the supply of loanable funds available
in financial markets and therefore may affect interest rates. It may also affect inflation
(with a lag) and therefore affect the demand for loanable funds by influencing
inflationary expectations.

Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in
achieving its economic goals.
ANSWER: In general, a stimulative monetary policy can increase economic growth and
reduce unemployment, but may increase inflation. A restrictive monetary policy can keep
inflationary pressure low but may cause low economic growth and higher unemployment.

Choice of Monetary Policy. 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?

ANSWER: A loose monetary policy may be used to stimulate the economy, especially if
inflation is not a concern. A tight monetary policy may be used to slow economic growth
in order to reduce inflationary fears.
A loose-money policy may result in higher inflation.
The risk of a tight-money policy is a potential slowdown in the economy. A tight
monetary policy may result in higher interest rates, reduced borrowing, and reduced
spending to an excessive degree.
Keynesian Approach. Briefly summarize the pure Keynesian philosophy and identify the
key variable considered.
ANSWER: The pure Keynesian approach suggests that the money supply should be
adjusted by the Fed to influence interest rates and aggregate spending for goods and
services. A loose-money policy can lower interest rates and increase aggregate spending,
while a tight-money policy can increase interest rates and reduce aggregate spending.

Monetarist Approach. Briefly summarize the Monetarist approach.


ANSWER: The Monetarist philosophy advocates a stable, low growth in the money
supply. Monetarists may contend that sporadic changes in money supply growth are
likely to result in volatile business cycles.

Fed Control. Why may the Fed have difficulty in controlling the economy in the manner
desired? Be specific.
ANSWER: The Fed has difficulty in controlling the economy because it cannot always
maintain money growth within its target boundaries. In addition, the impact of monetary
growth on the economy may be different than what was anticipated.

Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation
lag.
ANSWER: The recognition lag represents the time from when a problem exists until it is
recognized by the Fed. It occurs because the economic statistics that are monitored to
detect problems are only reported periodically.
The implementation lag occurs when the Fed recognizes a problem but does not
implement a policy to solve the problem until later.

Fed’s Control of Inflation. Assume that the Fed’s primary goal is to cure inflation. How
can it use open market operations to achieve its goal? What is a possible adverse effect of
this action by the Fed (even if it achieves its goal)?
ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will
reduce economic growth and inflationary pressure. A possible adverse effect is an
increase in the unemployment rate.

Monitoring Money Supply. Why do financial market participants closely monitor money
supply movements? Why do financial market participants who monitor monetary policy
have only limited success in forecasting economic variables?

ANSWER: Money supply movements can affect interest rates and other economic
variables that influence security prices. Therefore, financial market participants can
monitor money policy to develop forecasts of future security prices.
Financial market participants may incorrectly forecast money supply movements, causing
them to incorrectly forecast economic variables. Yet, even if they forecast money supply
movements correctly, they may incorrectly anticipate the impact of money supply
movements on economic variables.
Fed’s Monetary Policy. Why would the Fed try to avoid frequent changes in the money
supply?
ANSWER: Frequent changes in the money supply may suggest that the Fed is unsure as
to what the appropriate monetary policy should be. This could reduce the market’s
confidence in the Fed.

Impact of Money Supply Growth. Explain why an increase in the money supply can affect
interest rates in different ways. Include the potential impact of the money supply on the
supply of and the demand for loanable funds when answering this question.
ANSWER: An increase in money supply increases the supply for loanable funds and
therefore can place downward pressure on interest rates. Yet, it can also cause
inflationary expectations, resulting in an increased demand for loanable funds and
upward pressure on interest rates.

Confounding Effects. What other factors might be considered by financial market


participants who are assessing whether an increase in money supply growth will affect
inflation?
ANSWER: Any factors that could offset or magnify the impact should be considered,
such as expected oil prices, the strength or weakness of the dollar, and the strength of the
economy.

Impact of Foreign Policies. Why might a foreign government’s policies be closely


monitored by investors in other countries, even if the investors plan no investments in
that country? Explain how monetary policy in one country can affect interest rates in
other countries.
ANSWER: Country economies have become highly integrated over time, so that one
country’s economy can affect others. Thus, a foreign country’s government policies may
affect its own economy, which in turn affects other economies and therefore security
prices.
If the monetary policy in one country (such as the U.S.) places upward pressure on the
country’s interest rates, investors from other countries may shift their funds there to
capitalize on the high interest rates. This results in a reduced supply of funds in the
foreign countries. Given the degree of integration between countries, the higher interest
rates in one country can place upward pressure on interest rates of other countries as well.

Monetary Policy During the War in Iraq. Consider the likely discussion that was
occurring in the FOMC meetings during the war in Iraq in 2003. The U.S. economy was
weak at that time. Do you think the FOMC should have proposed a loose-money policy
or a tight-money policy once the war began? This war could have resulted in major
damage to oil wells. Explain why this possible
effect would receive much attention at the FOMC meetings. If this situation was
perceived to be highly likely at the time of the meetings, explain how it may have
complicated the decision about monetary policy at that time. Given the conditions stated
in this question, would you have suggested that the Fed use a tight money policy, a loose
money policy, or a stable money policy? Support your decision with logic, and
acknowledge any adverse effects of your decision.
ANSWER: Normally a weak economy will cause FOMC members to push for a loose
money policy that is intended to reduce interest rates, encourage more borrowing (and
spending), and stimulate the U.S. economy. However, if oil wells were damaged, there
could be an oil shortage. Under these conditions, oil prices would rise and inflation would
likely rise as well. The Fed usually does not want to use a loose money policy in a period
when there is high inflation. Thus, it has a dilemma of either adding fuel to the higher
inflation with a loose monetary policy or leaving the money supply as is, which offers no
cure for the slow economy.
The student's decisions will likely be: (1) leave the monetary policy as is, which offers no
cure for the economy, or (2) use a loose money policy that could stimulate the economy
but cause more inflation. The key is that they recognize the tradeoff.

a. “Lately, the Fed’s policies are driven by gold prices and other indicators of the future
rather than by recent economic data.”
The Fed would like to focus on expectations ofthe future rather than on historical data.
Gold prices are perceived to reflect expectations offuture inflation. Conversely, recent
historical data may not necessarily represent economic conditions in the future.
b. “The Fed cannot boost money growth at this time because of the weak dollar.”
The weak dollarplaces upwardpressure on U.S. inflation. The Fed may be concerned that
high money growth will add to this pressure.
c. “The Fed’s fine-tuning may distort the economic picture.”
Monetarists believe that the Fed should not attempt to control economic conditions by
adjusting the money supply, because it may make conditions worse.

The conference said that with a prudent fiscal policy and a tight monetary policy, China
will be able to achieve "the Two Prevents" in the coming year: to prevent economic
growth developing from rapid to overheating, and to prevent price rises evolving from
structural to evident inflation.

"A tight monetary policy can develop a progressive effect, which will help curb the
overheating in markets of assets, including equities and real estate, and then cap price
rises," Cao Honghui, an economic researcher with the Chinese Academy of Social
Sciences (CASS), said to Xinhua.

China has been implementing a prudent monetary policy since 1997. From 1998 to 2002,
the country increased money supply to counter deflationary pressure.

From 2003 to 2007, the monetary policy began to tighten in order to help address changes
in economic development, including rapid growth in credit extension, investment and
foreign exchange reserves.
Currency movement

"A stronger peso helps dampen inflationary pressures," the BSP reported, pointing out
that a one-peso gain against the US dollar translates to a 0.043-percentage point reduction
in average inflation

But the BSP also admitted that a strengthening peso is hurting exporters, the tourism
sector and households being supported by overseas remittances.

"Mindful of the potential impact of a strong peso on the export sector, the BSP has
undertaken measures to temper the appreciation pressure and maintain overall stability in
the foreign exchange market," the report said.

Performance of international mutual funds: As foreign currencies depreciate (appreciate)


against the dollar, the prices of foreign stocks as measured in dollars decline (rise). Thus,
depreciation (appreciation) of foreign currencies tends to decrease (increase) the net asset
value of international mutual funds that are held by U.S. investors.

Do financial institutions need to consider foreign exchange market conditions when


making domestic security market decisions?
POINT: No. If there is no exchange of currencies, there is no need to monitor the foreign
exchange market.
COUNTER-POINT: Yes. Foreign exchange market conditions can affect an economy or
an industry and therefore affect the valuation of securities. In addition, the valuation of a
firm can be affected by currency movements because of its international business.

WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more
about this issue. Offer your own opinion on this issue.
ANSWER: The counter-point is correct. Students should not view the foreign exchange
market as an isolated market.

Impact of Quotas. Assume that European countries impose a quota on goods imported
from the United States, and the United States does not plan to retaliate. How could this
affect the value of the euro? Explain.
ANSWER: A quota on goods imported from the United States by Europe will reduce the
supply of euros for sale (to be exchanged for dollars) and places upward pressure on the
euro.

Impact of Capital Flows. Assume that stocks in Great Britain become very attractive to
U.S. investors. How could this affect the value of the British pound? Explain.
ANSWER: U.S. investors would convert dollars to pounds to purchase British stocks.
Thus, the value of the pound may appreciate against the dollar in response to the
increased U.S. demand for pounds.

Impact of Inflation. Assume that Mexico suddenly experiences high and unexpected
inflation. How could this affect the value of the Mexican peso according to purchasing
power parity (PPP) theory?
ANSWER: High Mexican inflation would cause an increased Mexican demand for U.S.
goods (increased supply of pesos for sale) and a reduced U.S. demand for Mexican goods
(and therefore a reduced demand for Mexican pesos). Both forces place downward
pressure on the value of the peso.

Impact of Economic Conditions. Assume that Switzerland has a very strong economy,
placing upward pressure on both inflation and interest rates. Explain how these
conditions could place pressure on the value of the Swiss franc, and determine whether
the franc’s value will rise or fall.
ANSWER: A stronger economy will cause an increased Swiss demand for U.S. goods,
which places downward pressure on the value of the franc. A higher Swiss inflation rate
will also increase the Swiss demand for U.S. goods, which places downward pressure on
the franc's value.
Higher Swiss interest rates may attract U.S. funds and place upward pressure on the
franc's value. The first two factors relate to international trade while the third factor
relates to capital flows. If trade flows are larger, the franc’s value is expected to
depreciate.

Central Bank Intervention. The Bank of Japan desires to decrease the value of the
Japanese yen against the dollar. How could it use direct intervention to do this?
ANSWER: The Bank of Japan could flood the foreign exchange market with yen by
selling yen in exchange for U.S. dollars, causing downward pressure on the yen’s value.

Bank Speculation. When would a commercial bank take a short position in a foreign
currency? A long position?
ANSWER: A commercial bank tends to take a short position in a foreign currency if it
expects the currency to depreciate. It may take a long position in a currency if it expects
the currency to appreciate.

Risk From Speculating. Seattle Bank was long in Australian dollars and short in
Canadian dollars. Explain a possible future scenario that could adversely affect the
bank’s performance.
ANSWER: If the Canadian dollar appreciates against the U.S. dollar, while the
Australian dollar depreciates against the U.S. dollar, this implies that the Canadian dollar
is appreciating against the Australian dollar. Seattle Bank would be adversely affected by
this scenario. If the Australian dollar inflows from closing out the long position are used
to cover the short position in Canadian dollars, they will be worth fewer Canadian dollars
(because of the Australian dollar’s assumed depreciation).
Impact of a Weak Dollar. How does a weak dollar affect U.S. inflation? Explain.
ANSWER: A weak dollar tends to cause higher prices paid by U.S. firms for foreign
supplies and materials. It also reduces foreign competition and allows U.S. producers to
raise prices more easily without concern about losing business. Both forces reflect
upward pressure on U.S. inflation.

Speculating With Foreign Exchange Derivatives. Explain how foreign exchange


derivatives could be used by U.S. speculators to speculate on the expected appreciation of
the Japanese yen.
ANSWER: U.S. speculators could attempt to lock in an exchange rate at which they
could exchange dollars for yen at a future point in time. This could be accomplished by
purchasing forward contracts or futures contracts on Japanese yen, negotiating a swap for
yen, or purchasing yen call options. They could also sell yen put options to capitalize on
their expectations.

Interaction of Capital Flows and Yield Curve. Assume a horizontal yield curve exists.
How do you think the yield curve would be affected if foreign investors in short-term
securities and long-term securities suddenly anticipate that the value of the dollar will
strengthen? (You may find it helpful to refer back to the discussion of the yield curve in
Chapter 3).
ANSWER: Open-ended. Foreign investors may purchase more U.S. securities than
before to benefit from their expectations. A stronger dollar tends to place downward
pressure on inflation and therefore on future interest rates. Therefore, foreign investors
could benefit more from purchase long-term bonds than from purchasing short-term
securities. While there could be an increased demand for short-term and long-term U.S.
securities, the demand for long-term securities should be greater. Thus, while both short-
term and long-term rates should decline, long-term rates will decline by a greater degree.
The result is a new yield curve that is lower than the previous yield curve and is sloped
downward.

Interest Rate Parity. Determine how the forward rate premium would be affected if the
foreign interest rate is higher, holding the U.S. interest rate constant, under conditions of
interest rate parity.
ANSWER: The forward premium on a foreign currency would be lower if the foreign
interest rate is higher, because there would be more of an incentive for U.S. investors to
invest in the foreign interest rate and sell that currency forward at the end of the
investment period.

"The Effects of Currency Devaluation"


The clip begins with the panic selling that took place in the Brazilian stock market after
the Brazilian government had finally devalued the Brazilian real. The clip discusses both
the positive and negative implications of currency devaluation. On the negative side,
consumers face a drop in the purchasing power of the currency, and there is the potential
for runaway inflation to take place. At the time this devaluation occurred, most U.S.
businesses were rooting for a Brazilian recovery because Brazil is a large purchaser of
U.S. goods; devaluation made it less likely that Brazilian companies would be in a
position to purchase these goods from U.S. companies.
1. What is “financial contagion,” and what are its implications for the U.S. financial
environment?
Financial contagion is a cross-country transmission ofa financial shock. This situation
most recently occurred in 1998–99, certainly on a regional basis, in the Pacific Basin and
in South American and Asian countries. Two ways that contagion occurs are through
financial and real links. Financial links exist when two countries are tied together in the
internationalfinancial system. The implications for the U.S. economy and its financial
markets depends on the extent of the financialproblems in other countries and the degree
to which the U.S. economy is connected to those countries. For example, financial shocks
or crises in South America would have some spillover effect on the United States since a
fair amount oftrade takes place between the two.

Explain the advantage and disadvantage to Carson of using currency options instead of
currency futures.
Currency put options do not obligate Carson to sell euros in the future. Therefore,
ifCarson does not receive the order, and the euro ’s value declines over time, it can let the
option contract expire. Ifit receives the order and the euro ’s value is higher at the time it
receives payment than the rate specified in the option contract, it can let the option expire
and sell the euros in the spot market. The futures contract does not allow such flexibility,
as it would obligate to sell euros on a specified settlement date at the rate specified in the
futures contract. However, Carson has to pay a premium for put options, so the cost ofthe
hedge is more expensive than sellingfutures contracts.

Stock valuation and risk


Impact of Exchange Rates. Explain how the value of the dollar affects stock valuations.
ANSWER: The value of the dollar can affect U.S. stock prices for a variety of reasons.
First, foreign investors tend to purchase U.S. stocks when the dollar is weak and sell them
when it is near its peak. Thus, the foreign demand for any given U.S. stock may be higher
when the dollar is expected to strengthen, other things being equal. Also, stock prices are
affected by the impact of the dollar’s changing value on cash flows. Stock prices of U.S.
firms primarily involved in exporting could be favorably affected by a weak dollar and
adversely affected by a strong dollar. U.S. importing firms could be affected in the
opposite manner. Stock prices of U.S. companies may also be affected by exchange rates
if stock market participants measure performance by reported earnings. A multinational
corporation’s consolidated reported earnings will be affected by exchange rate
fluctuations even if the company’s cash flows are not affected. A weaker dollar tends to
inflate the reported earnings of a U.S.-based company’s foreign subsidiaries. Some
analysts argue that any effect of exchange rate movements on financial statements is
irrelevant unless cash flows are also affected.
The changing value of the dollar can also affect stock prices by affecting expectations of
economic factors that influence the firm’s performance. For example, if a weak dollar
stimulates the U.S. economy, it may enhance the value of a U.S. firm whose sales are
dependent on the U.S. economy. A strong dollar could adversely affect such a firm if it
dampens U.S. economic growth. Because inflation affects some firms, a weak dollar
value could indirectly affect a firm’s stock by putting upward pressure on inflation. A
strong dollar would have the opposite indirect impact.

Import and export

Stock market

Chinese stocks continued the downward trend on Thursday, tumbling more than four
percent to close below 5,000 points, amid a global sell-off.

The fall came amidst a meltdown in the global market on the previous day. In the United
States, the Standard & Poor's 500 index and the Dow Jones industrial average each fell
by more than 1.5 percent. Japan's Nikkei stock average closed down 2.46 percent, while
Hong Kong's Hang Seng index fell 4.15 percent.

Worries over further monetary tightening weighed on the market. Premier Wen Jiabao
vowed on Tuesday to prevent the economy from overheating and keep inflation in check.

The Consumer Price Index rose 6.5 percent in October from a year earlier, the highest
level in more than a decade. In the first three quarters, the world’s fourth largest economy
grew 11.5 percent year-on-year on rapid expansion in credit and investment.

Stock Repurchases. Explain why the stock price of a firm may rise when the firm
announces that it is repurchasing its shares.
ANSWER: A stock repurchase signals to other investors that the firm’s managers believe
the stock is undervalued. Therefore, they purchase the stock, which places upward
pressure on the stock’s price.

Explain how ADRs enable U.S. investors to become part owners of foreign companies.
ANSWER: American depository receipts (ADRs) are certificates that represent
ownership of a foreign stock. They are traded in the United States. U.S. investors can
purchase ADRs as a method of investing in foreign securities.
Spinning and Laddering. Describe spinning and laddering in the IPO market. How do you
think these actions influence the price of a newly issued stock? Who is adversely affected
as a result of these actions?
ANSWER: Spinning is the process in which an investment bank allocates shares from an
IPO to corporate executives who may be considering an IPO or other business that would
require the help of an investment bank. Laddering involves investors placing bids for IPO
shares on the first day that are above the offer price.
Laddering ultimately results in upward price momentum, which may or may not
accurately reflect the fair value of the underlying stock. If spinning occurs at favorable
stock prices, this may keep the stock price from achieving its fair value.

The initial owners of the firm may be adversely affected because the firm may not
receive as much proceeds from the IPO due to spinning and laddering. Spinning may
result in shares sold at a lower than market price. Laddering might only occur if there is
an unusually strong demand for the shares. If there is such a strong demand, the IPO price
must be too low.

“The recent wave of IPOs is an attempt by many small firms to capitalize on the recent
run-up in stock prices.”
Firms prefer to go public when stock market conditions are favorable so that they can
benefit from high valuations in the market. Their stock will sellfor a higher price ifthe
prices ofother similarpublicly tradedfirms are high.

b. “IPOs transfer wealth from unsophisticated investors to large institutional investors


who get in at the offer price and get out quickly.”
Some institutional investors invest in IPOs at the offerprice, and then quickly sell (flip)
their shares to individual investors who were not able to buy shares at the offer price. The
individual investors pay a much higher price and the long-term performance ofIPOs is
poor, especiallyfor individual investors who pay the price that exists a day oftwo after the
IPO. Thus, the institutional investors gain while the individual investors lose.
c. “Firms must be more accountable to the market when making decisions because they
are subject to indirect control by institutional investors.”
Ifa firm performs poorly, the institutional investors with a large stake in thatfirm may
engage in shareholder activism to improve the firm ’s performance.

Why is venture capital financing a major source of financing for many biotechnology
firms?
Venture capital is basically private equityfinancing provided by an individual or a
company. In exchange forfinancing, the investor receives an ownership position in a
company and typically a voice in the direction ofthe company. Venture capitalists tend to
be risk takers and are willing to provide financingfor operations when the public markets
are unwilling. The cost ofventure capital financing is greater than the cost ofpublic equity
financing and certainly ofdebtfinancing.

c. Explain why institutional investors such as mutual funds and pension funds that invest
in stock for long-term periods (at least a year or two) may more be interested in investing
in some IPOs than they are in purchasing other stocks that have been publicly traded for
several years?

Institutional investors may believe that the market does notproperly price newly issued
stock, and they can capitalize on this discrepancy by investing in IPOs.

Given that institutional investors such as insurance companies, pension funds, and mutual
funds are the major investors in IPOs, explain the flow of funds that results from an IPO.
That is, what is the original source of the money that is channeled through the
institutional investors and provided to the firm going public?

The money invested by insurance companies comes from insurance premiums paid by
policyholders. The money invested by pension funds comes from retirement accounts of
employees and their respective employers. The money invested by mutual funds comes
from shareholders who want the mutual fund to invest their money.

Impact of Economic Growth. Explain how economic growth affects the valuation of a
stock.
ANSWER: The firm’s value should reflect the present value of its future cash flows.
Because earnings are a primary component of corporate cash flows, many investors use
forecasted earnings to determine whether a firm’s stock is over- or undervalued.

Impact of Interest Rates. How are the interest rate, the required rate of return on a stock,
and the valuation of a stock related?
ANSWER: Given a choice of risk-free Treasury securities or stocks, stocks should be
purchased only if they are appropriately priced to reflect a sufficiently high expected
return above the risk-free rate.
The relation between interest rates and stock prices is not constant over time. However,
most of the largest stock market declines have occurred in periods when interest rates
increased substantially. Furthermore, the stock market’s rise in the late 1990s is partially
attributed to the low interest rates during that period, which encouraged investors to shift
from debt securities (with low rates) to equity securities.

Impact of Inflation. Assume that the expected inflation rate has just been revised upward
by the market. Would the required return by investors who invest in the stocks be
affected? Explain.

ANSWER: An increase in expected inflation can increase the risk-free interest rate,
which is a key component of the required rate of return on stocks. Therefore, it should
cause an increase in the required rate of return on stocks.

Earnings Surprises. How do earnings surprises affect valuations of stocks?


ANSWER: Favorable earnings surprises increase the values of stocks. Negative earnings
surprises decrease the values of stocks.
Wall Street. In the movie Wall Street, Bud Fox is a broker who conducts trades for
Gordon Gekko’s firm. Gekko purchases shares of firms he believes are undervalued.
Various scenes in the movie offer excellent examples of concepts discussed in this
chapter.
a. Bud Fox makes the comment to Gordon Gekko that a firm’s breakup value is twice its
market price. What is Bud suggesting in this statement? How would employees of the
firm respond to Bud’s statement?
ANSWER: Bud is suggesting that the firm could be acquired and separated into divisions
and sold to various firms. The combined value of the individual divisions (when sold)
would be worth more than the firm’s prevailing market value.
b. Once Bud informs Gekko that another investor, Mr. Wildman, is secretly planning to
acquire a target firm in Pennsylvania, Gekko tells Bud to buy a large amount of this
stock. Why?
ANSWER: Gekko wants to accumulate much of the stock before Mr. Wildman attempts
to acquire the target. In this way, Wildman will need to purchase stock from Gekko at a
premium to obtain those shares held by Gekko. This strategy is known as greenmail.
c. Gekko states “Wonder why fund managers can’t beat the S&P 500? Because they are
sheep.” What is Gekko’s point? How does it relate to market efficiency?
ANSWER: Gekko is implying that all fund managers use the same type of information,
which is already known by the market. The market prices should already reflect that
information. Gekko focuses on obtaining information that is not known by the market to
outperform other investors in the market.

a. “The stock market’s recent climb has been driven by falling interest rates.”
The value ofa stock may be measured as the present value offuture cash flows provided
to investors. The present value is increased when using a lower discount rate. Ifinterest
rates decline, the required rate ofreturn by investors declines, and so does the discount
rate used to value stocks.
b. “Future stock prices are dependent on the Fed’s policy meeting next week.”
The Fed’s monetary policy affects the values ofstocks in various ways. First, it can affect
economic conditions, which affect the cash flow generated by a firm. Second, the Fed’s
monetary policy can affect the interest rates, which affect the discount rate used as the
required rate of return when valuing stocks.
c. “Given a recent climb in stocks that cannot be explained by fundamentals, a correction
is inevitable.”
The recent climb in stocks occurred without anyfundamental change in the performance
offirms. Stockprices will revert because there is no reason for their climb, and once
investors recognize this, they will sell stocks (which causes the reversal).

You have noticed that investors tend to invest more heavily in stocks after interest rates
have declined. You are considering this strategy as well. Is it rational to invest more
heavily in stocks once interest rates have declined?
One argument is that investors are unwilling to accept a very low interest rate on debt
securities, and are more willing to invest in stocks simply because their opportunity cost
(what theyforgo) on debt securities is low. The value ofstocks may rise in response to
lower interest rates, simply because the present value ofdividends should rise with a
lower interest used as the discount rate. However, it is riskyfor investors to heavily invest
in the stock market simply because they have no other type ofinvestment that is
acceptable. This type ofbehavior can force stockprices to exceed theirfundamental values,
and create a speculative bubble that will break in the future.

Assume that you are about to select a specific stock that will perform well in response to
an expected runup in the stock market. You are very confident that the stock market will
perform well in the near future. Recently, a friend recommended that you consider
purchasing stock of a specific firm because it had decent earnings over the last few years,
it has a low beta (reflecting a low degree of systematic risk), and its beta is expected to
remain low. You normally rely on betas a measurement of a firm’s systematic risk.
Should you seriously consider buying that stock? Explain.
No. Given that you expect the stock market to perform well, you would not be so
interested in a low-beta stock. You would consider stocks that would be more sensitive to
market conditions so that you can benefitfrom the expected market run-up.

c. You are considering an investment in an initial public offering (IPO) by Marx Co.,
which has performed very well recently, according to its financial statements. The firm
will use some of the proceeds from selling stock to pay off some of its bank loans. How
can you apply stock valuation models to estimate this firm’s value, when its stock was
not publicly traded? Once you estimate the value of the firm, how can you use this
information to determine whether to invest in it? What are some limitations involved in
estimating the value of this firm?
There are numerous possible solutions, but most solutions would involve the estimation
ofthe firm ’s future cash flows, and deriving a present value ofthose cash flows. You can
apply the dividend discount model by assessing past earnings to generate forecasts
offuture earnings. Then, the amount ofearnings to be retained can be estimated so
dividends can be estimated. Next, the dividend discount model can be used to estimate
the present value ofallfuture dividends that are to be paid. Once you estimate the value
ofthe firm, estimate the value ofstock by dividing the firm value by the number ofshares
outstanding. This provides an estimated value per share. Compare this value to the
prevailing price per share ofstock in the IPO. There are limitations in using past earnings
as a forecast offuture earnings, and in selecting the proper required rate ofreturn to
discountfuture cash flows. Consequently, the estimate ofthe firm ’s value is subject to
error.
d. In the past, your boss assessed your performance based on the actual return on the
portfolio of U.S. stocks that you manage. For each quarter in which your portfolio
generated an annualized return of at least 20 percent, you received a bonus. Now your
boss wants you to develop a method for measuring your performance from managing the
portfolio. Offer a method that accurately measures your performance.
There are many possible solutions. The method should include some controlfor the stock
market movements over the period ofconcern. For example, yourperformance may be
measured as an excess return beyond the return ofsome stock index representing U.S.
stocks. Ifyourportfolio is supposed to be focused on one particular industry, your
performance should be measured relative to that industry norm (perhaps compared to the
return on an industry index). You may also wish to accountfor risk by measuring a risk-
adjusted return ofyourportfolio and the comparable index.
e. Assume that you were also asked to manage a portfolio of European stocks. How
would your method for measuring your performance in managing this portfolio differ
from the U.S. stock portfolio in the previous question?
The European portfolio return should be compared to a European stock index. The reason
is that you have no control over the general stock market conditions in Europe. You only
have control over the European stocks to include in yourportfolio. Yourperformance
should be measured relative to the group ofstocks that were available. You may also wish
to accountfor risk by deriving a risk-adjusted return ofyour portfolio and comparing that
to a risk-adjusted return of the index. A Sharpe index might be applied to derive risk-
adjusted returns.

a. “Individual investors who purchase stock on margin might as well go to Vegas.”


Purchasing stock on margin is risky as it magnifies the returns, whether positive or
negative.
b. “Exchange traded funds allow you to bet on a market without supporting portfolio
managers.”
Exchange tradedfunds are designed to mirror stock indexes, and therefore do not require
you to incur high managementfees forfund management.
c. “The trading floor may become extinct due to ECNs.”
ECNs can serve a floor broker role and therefore may allow trades to be conducted
without the use ofa tradingfloor.

Negotiation

In general, the best preparation for any negotiation covers six things: the stylistic
differences between the people negotiating, the goals of each side, the standards
and norms that will govern what a “fair” price is, the prospects for a future
relationship, the underlying interests that are bringing the parties together, and the
issue of who needs the deal more (in other words, the leverage differences). If you
have covered these six topics, you will be well-prepared for most negotiations.